Cha-Ching!: How Pakistan can expand the tax net to include wholesale and retail traders

Wholesale and retail trade is one segment that barely pays any direct taxes and often creates the most noise whenever there is any effort to extract even a minimal amount of tax.
Published June 11, 2024 Updated June 11, 2024 11:00am

Wholesale and retail trade make up 18.1 per cent of Pakistan’s Gross Domestic Product while contributing only 2pc in direct taxes. On the other hand, the industrial sector makes up 18.4pc of the GDP and contributes 40pc to total taxes, with salaried individuals contributing 15pc of the total direct taxes while making up only 2pc of the total labour force.

A majority in the country pays taxes indirectly, primarily on consumption — which disproportionately affects the poor and vulnerable households more than the affluent. As the gap between the destitute and elite increases, there is a need to increase direct taxes, which would also help expand the tax net.

Presently, the corporate tax rate, dividend tax rate, and some form of super tax make tax incidence on corporate activity one of the highest in the world — acting as a deterrent to any form of formal investment activity.

This also creates distortion wherein informal businesses that do not pay their fair share of taxes have an unfair advantage, making tax-paying businesses uncompetitive. This is one of the reasons that has kept the investment-to-GDP ratio in Pakistan within the range of 12pc, compared to 30pc for the rest of South Asia and other emerging market economies.

In essence, Pakistan’s taxation structure actively discourages formal business activity and makes taxpayers uncompetitive in the market.

Electricity, SMEs and taxes

Wholesale and retail trade is one segment that barely pays any direct taxes and often creates the most noise whenever there is any effort to extract even a minimal amount of tax. Considering the largely informal nature of the sector, it is difficult to estimate its total size. However, there are ways to circle in on the same.

These are mostly small and medium enterprises (SMEs), utilising a commercial electricity connection to conduct economic activity. A major caveat here is that there would be many businesses that are either using a residential connection or sharing a single connection. Effectively, the number of commercial electricity connections would at least provide a floor to estimate the number of commercial business entities in the country.

As per the State of Industry Report 2023, published by the National Electricity & Power Regulatory Authority (Nepra), there were 4.1 million commercial electricity connections as of June 2023. On average, these connections consumed around 181 units of electricity monthly. There would certainly be wide distributions, where some high-end retailers would be consuming much more electricity, while some would be consuming less than 100 units.

Given that the commercial tariff per kilowatt-hour (kWh) is in the range of Rs55 — after incorporating all spurious charges and indirect taxes on consumption — it may be implied that a commercial enterprise would pay an average monthly or annual bill of around Rs10,000 or Rs120,000, respectively.

This suggests a total collection of Rs489 billion on an annual basis from commercial enterprises, which are primarily SMEs. Obviously, there would be a wide distribution of the various sizes of SMEs, but an average consumption of 181 units on a monthly basis makes it fair to say that such an entity would be a small business.

It is difficult to ascertain how much revenue is generated by various SMEs at an individual level, or in aggregate. But the same can be estimated through various means.

Estimating profit margins

CreditBook is a digital ledger or a khata, that is used by more than 1m micro and small enterprises across the country for over the last 30 months. Through such a ledger, in which entities keep a record of their transactions, it is possible to estimate their gross profit margins — even on a conservative basis, the same is estimated to be in the range of 7pc.

Electricity bills usually make up around 15pc of any small enterprise’s gross profit. Working back from the same, it can be estimated that on average, the gross profitability of entities having a commercial connection would be Rs100,000 per month on average, suggesting a monthly turnover of Rs1.2m per month. Anecdotally, this seems fairly conservative.

On an aggregate basis, it can be estimated that the turnover of entities having commercial electricity connections would be in the range of Rs61 trillion. A commercial entity on average, being able to generate gross profitability of Rs100,000 per month, ought to be able to pay a fixed tax of Rs3,000 per month, or lower, depending on the scale of operations.

A monthly fixed tax of Rs3,000 on such entities would be sufficient to generate additional tax revenue of Rs147bn annually. It is to be noted here that there may be some entities that operate at a much smaller scale, and tax for the same can be reduced. Likewise, entities operating on a much larger scale can pay a higher fixed tax rate. Even reducing the same fixed tax to just Rs1,000 per month can generate additional revenue of Rs50bn, providing a baseline to build on.

The assessment can be further improved by utilising GIS estimates to specifically identify the number of businesses and the potential size of the establishment, etc. This can then be cross-referenced with electricity consumption data, as well as sales and distribution data of major suppliers of different goods to get a fair idea of tax potential.

The economic pie

The proposed structure of a fixed tax rate is clunky at best, but it sets the groundwork for getting higher-quality data. The next step should be to transition away from cash and towards electronic payments over a certain threshold. Such a manoeuvre can capture the true value of commerce that takes place, and the same can be used for better tax assessment. The technology to capture the same already exists, and so does adoption.

There are more than 61m digital wallets, or bank accounts that are active and used for transactions. To avoid taxes and a formal trail of transactions, many businesses abstain from receiving payments through formal financial channels and strictly deal in cash only.

Such activity needs to be discouraged through better enforcement. If an establishment does not want to pay a fixed tax, it can voluntarily start accepting electronic payments.

Pakistan’s tax-to-GDP ratio has remained in the 9-10pc range for the past several years, and it can only be increased through better enforcement and widening of the tax net. Yesteryear’s excuses do not hold true with the prevalence of technology. Through the collation of various publicly available data sets and GIS mapping, it is possible to estimate the income and tax potential of different markets, clusters, etc.

The truth is out there, and so is the data. The political will to collect taxes fairly and the ability of tax authorities to actually utilise available data for tax estimation purposes are the two missing ingredients.

A fixed tax rate is a brute force solution, but it is the first step. The inability to take that first step for years has led to a situation where regressive and disproportionate taxation has stalled the formal economy.

The tax playbook is simple in numbers, but complex in terms of politics. Further exerting pressure on already stretched tax payers may lead to a breaking point where there is more exodus from the formal economy. Expanding the tax net, to bring more direct tax payers in the economy through a fair and equitable process, is literally the only way forward.

We can either grow the economy’s pie for everyone, or we can keep the pie small, and push people away from the table, till the pie rots, and no one benefits from the same.