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FBR and the informal economy

At the peak of this year’s budget preparation, the Federal Board of Revenue has tried hard to mine the data available and go after the so-called informal segments of the economy also known as undocumented or cash-based activities.

Whatever definition of the informal economy we use, this will perhaps be an unusual year in that despite a decent identification of such sectors and activities, the FBR may not be able to go after them. The overarching concern is that the welfare impact of Covid-19 has been so harsh that choking the informal operators could result in a further loss of jobs and liquidity at the bottom of the pyramid.

Research at Sustainable Development Policy Institute argues that the answer may lie neither in letting the informal sector businesses go totally free nor in bringing them in the tax net through coercive means at a time when their break-even is at risk. A satisfactory answer may lie in correctly determining the level of informality and then perhaps go after an individual business outfit.

How does one unpack formalisation? The UK-based International Centre for Tax and Development says that there may be various degrees of formalisation in developing economies. There may be regions where a large number of firms are registered with some registry but not tax bodies while other firms may not be registered at all. Some firms may be tax filers but not paying their full liability. Some may not be filers at all but would be willing to face higher levels of indirect taxes or other levies usually imposed on non-filers.

The data available with tax bodies in Pakistan currently doesn’t show those evading or avoiding taxes by various degrees of above-mentioned formalisation.

Such information is vital as we often see that large-scale efforts to formalise businesses using ‘registration of new tax payers’ as a measure, doesn’t necessarily result in more revenue for the state. Studying various degrees of formalisation is also important from the viewpoint of understanding challenges to informal businesses while trying to formalise. For example, the government almost brought the entire wholesale and retail sector to a halt last year and locked horns with the traders’ associations whose members would have paid more in presumptive forms of taxes than they are now contributing after failed negotiations.

Research argues that the answer may neither lie in letting the informal sector businesses go totally free, nor bringing them into the tax net through coercive means at a time when their break-even is at risk. An answer may lie in determining the level of informality.

A more pragmatic approach is to use the substantial amounts of data available with the FBR to identify and go after large informal businesses with significant cash-based transactions. It is these entities that not only are evading taxes but will also bring significant revenue which, in turn, will cover the administrative cost of this exercise. Instead, the tax bodies spend their energies going after cottage, micro, and small business which: a) will bring very little revenue compared to the large administrative burden of administering their records, b) may come under the tax net once through coercive means but remain out of the tax net during the next year or close the business and rename the entity going forward.

Have efforts to achieve ‘formalisation’ delivered? If one asks the FBR, the answer would be affirmative. However, the truth is that most ambitions linked with increased tax payer registration result in an increase which falls short of FBR’s own targets.

Also, the assessment of why a large majority of recently formalised businesses fall out of the tax net during the next fiscal year is weak. Many micro and small firms we interview inform us that higher compliance costs deter them. This is primarily a result of proliferation of tax bodies across the country after the 18th Amendment.

Provinces today have various requirements of documentation, filing and tax rates. It has become near impossible for a small-scale enterprise to operate in more than one province during its first three years as provincial authorities demand separate registration. Such a tax regime is a clear barrier to entry and growth of private enterprise.

One would like to think that the federal and provincial governments are aware of the above-mentioned predicament for the businesses. However, lack of a structured public-private dialogue has resulted in tax payers not getting timely and adequate information regarding measures to mitigate the pain. For example, National Tax Council was approved by all federating units with the aim of harmonising taxes across the country.

Both small and large enterprises continue to wonder if there is a timeline to achieve such tax harmonisation. Most donor bodies in Islamabad have also tried to persuade the decision makers with evidence on this subject. Second, the government had also given mandate to Pakistan Regulatory Modernisation Initiative (PRMI) to look deeply into how federal, provincial, and local level taxes, fees, surcharges, permits, and other levies could be rationalised, automated, or completely eliminated if they don’t make economic sense. This again remains an agenda without a timeline. The business community is not certain of what relief will arrive before businesses die out.

Finally, there is a need to look deeply into the causes of economic informality. Our research indicates that while informal businesses do not pay formal taxes, they do contribute to informal taxes. This could include local user charges for utilities, transport and physical space; property taxes, market fees, business licence fees charged by formal or informal market associations, contribution to local development initiatives undertaken by communities; and informal payments to individuals from government or non-government institutions.

It is important to recognise that a key reason why informal businesses exist is that taxes may not be providing public goods necessary for the entrepreneurs. In essence, Pakistan’s informal economy ranges from a street vendor to large-scale traders — some even involved in cross-border trade. The leadership at the FBR now needs to decide if in Covid times it wishes to spend its scarce time and energy to chase small-scale vendors or to effectively target large non-compliant taxpayers.

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The opinions expressed in this article are the author's own and do not necessarily reflect the viewpoint or stance of SDPI.