The sales tax gap

April 15, 2019


In 2017-18, the combined collection of sales tax on the supply of goods and services was Rs1,715 billion. However, the sales tax gap, i.e. the difference between the sales tax revenue to be collected theoretically and the sales tax revenue actually collected, was considerable.

Sales tax is an indirect levy and is similar to value added tax (VAT) in all aspects. Domestic supplies and imports are taxable at a standard rate whereas exports are zero-rated.

Presently, sales tax is administered by five independent sales tax authorities — the Federal Board of Revenue (FBR) for sales tax collection on supply of goods and four provincial revenue authorities for sales tax collection on services. These are the Punjab Revenue Authority (PRA), the Sindh Revenue Board (SRB), the Khyber Pakhtunkhwa Revenue Authority (KPRA) and the Balochistan Revenue Authority (BRA).

Sales tax gap of Rs2,565 billion has been estimated using data of total consumption (household plus government) and total sales tax revenue (federal and provincial). Average standard rate calculated from provincial standard rates on services and federal standard rate on goods for the period 2010-11 to 2017-18 has been applied. GDP ratio of 4.7 and collection efficiency of 0.31 was taken.

The estimated sales tax gap was nearly 67pc of the total sales tax collection

The estimated sales tax gap is nearly 67 per cent of the total sales tax collection of Rs 1,715 billion. The estimated gap is close to FBR’s estimate of 65pc based on the analysis of different sectors, including sugar, cement and steel.

Informal economy or cash-based economy usually has a high rate of uncollected sales tax revenue. Legitimate businesses have difficulties purchasing inputs from registered suppliers because of the dominance of unregistered businesses in large informal sectors.

Purchases from legitimate suppliers include sales tax, but that can be deducted by the customer. This means that the sales tax is not an actual burden on the purchaser, unless the purchaser is not registered.

Considerable tax revenue losses occur due to sales tax frauds. All persons engaged in making taxable supplies are required to be registered. As a considerable part of the economy is informal, taxable supplies are being made by persons who are liable to be registered. Even the registered businesses do not always operate within the limits of the sales tax legislation, because they frequently acquire fake purchase invoices in order to boost deductible input tax.

Analysis of data of some registered businesses reveals that they have applied for input tax in relation to purchases that were not related to their business activity. Some registered businesses are dormant and file nil returns for many years. In reality, they issue fake invoices enabling other registered businesses to deduct large amounts of input tax.

As with many economies in the world, it is a daunting challenge to tackle the issue of fake and flying invoices in Pakistan. A number of people have been found in sales tax related identity frauds, which involve the use of identity of other persons.

More revenue losses are reported in jurisdictions where tax capacity is inadequate. Sales tax capacity may be influenced by many factors, including political institutions, level of development, trade openness, hard-to-tax supplies, etc.

Political institutional determinants such as government effectiveness, regulatory quality and rule of law are statistically significant determinants of C- efficiency. The C-efficiency ratio is a commonly used indicator for evaluating revenue performance and overall efficiency of the VAT system.

Other political institutional variables such as political stability, absence of violence (terrorism), control of corruption and perception regarding accountability are also correlated with C-efficiency.

Weak government writ, poor rule of law, fragile institutions, pervasive corruption and ineffective accountability processes in Pakistan could be important sources contributing to limited tax capacity and to significant sales tax gap.

Development is associated with higher level of education, literacy and technology. Such variables raise the capacity of the country to administer taxes. Pakistan is a developing country with human development index at 150 out of 189 countries in 2018, which was amongst the lowest in the region.

Pakistan falls in the bottom quartile of countries in terms of human capital index (HCI) launched by World Bank, which could be an important factor contributing to low per capita GDP ($1,541). Poor HCI also provides evidence regarding low level of investment in human resource development.

For example, education spending is less than 2.5pc of GDP. Consequently, Pakistan’s literacy rate (individuals of age 10 and above) stands at 58pc, which is also the lowest in the South Asian region, barring Afghanistan.

Low literacy rate associated with less development is an obstacle to provide sufficiently knowledgeable and technically sound workforce. Such a workforce is essential for effective implementation of sales tax policies and preventing of sales tax evasion and fraud.

The country’s economy is predominantly agro-based with 24.7pc contribution of agriculture to total GDP. However, exemptions, reduced rates and zero rates are applied to agriculture inputs and outputs. Thus agriculture sector continues to avoid full taxation under the sales tax regime due to limited tax capacity.

Published in Dawn, The Business and Finance Weekly, April 15th, 2019