WANTED: TAX REFORM AND TAX PAYERS

UNCLAS SECTION 01 OF 02 ISLAMABAD 002554

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: EFIN ECON EINV ETRD EAID PREL PK
SUBJECT: WANTED: TAX REFORM AND TAX PAYERS

Summary
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1. (U) Non-payment of taxes by Pakistan's numerous small businesses,
large agricultural sector, and informal economy continue to
constrain GOP taxation efforts. The tax base has not been able to
keep pace with economic growth spurred on by the services and
industrial sectors, and GOP efforts at tariff rationalization and
broadening of the tax base have not resulted in significant
increases in collection. Most tax collection is done by the federal
government. Provincial tax collection efforts are weak, with low
compliance, numerous exemptions, and special treatment regimes,
creating a gap between potential and actual tax revenue. Despite
recommendations from multilateral institutions, the GOP has been
unable to tax agricultural and service income effectively due to
powerful lobbies, undocumented workers, and the fact that such
taxation falls under the purview of provincial governments.


2. (U) Summary Continued: The World Bank and the Andrew Young
School of Policy Studies at Georgia State University have assisted
the GOP Federal Board of Revenue in developing tax reform options
and building capacity, and the World Bank continues to assist
through a $100 million tax reform program that will conclude in

2009. Sustained increases in revenue will require a stronger effort
by both the federal government and provincial governments if the GOP
is to reach its goals of poverty reduction and devolution of
political power. Provincial spending must be matched by increases
in provincial revenue collection, which will require reform of both
tax policy and administration. End Summary.

Details of the Taxation Regime
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3. (U) Pakistan has a low tax-to-GDP ratio and narrow tax base that
has not kept pace with economic growth. An inadequate audit system,
misuse of self-assessment schemes, undocumented economic activity,
and refund claims contribute to the low tax-to-GDP ratio. The
income tax base is narrow, with only 2 percent of the population
paying income tax. Taxation is heavily skewed towards indirect
taxes, which include sales taxes, federal excise duties, and customs
duties. Sales tax is the leading source of federal tax receipts and
contributed some 38 percent to total revenue collection during the
first nine months of FY2007-08.

Lack of Diversification
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4. (U) Indirect taxes lack diversification. Customs duties make up
15 percent of total tax revenue, but 79 percent of customs duties
collected come from only 15 commodity groups. (These commodity
groups are: petroleum products, telecom equipment, automobiles,
edible oil, cigarettes, machinery, iron and steel, chemicals,
plastic and plastic products, paper and paper board, carbonated
beverages, coffee and tea, textiles and apparel, electrical goods,
and rubber products.) Another example of a lack of diversification
can be seen in the fact that these same 15 commodities plus
utilities, which represent a little less than 5 percent of the
revenue to GDP ratio, make up approximately three quarters of total
indirect tax revenue.

Increasing Tax Collection in Some Sectors
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5. (U) Sales tax collection from services saw healthy growth in
FY2007-08. This can be attributed to improved performance by
airlines, media, and courier services. Sale of petroleum products
and telecom services are also bright spots. Tax collection on
petroleum products has increased 47 percent and tax collection on
telecom services has grown some 25 percent over the previous fiscal
year. The greatest contributors to federal excise duty are
cigarettes, cement, carbonated beverages, natural gas, and petroleum
products and services. The FY2005-06 introduction of a federal
excise duty on services such as international air travel and
insurance has helped to enhance federal excise revenues
substantially. The corporate tax rate of 35 percent in the
FY2008-09 budget is unchanged from FY2007-08.

Weak Provincial Tax Collection
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6. (U) The federal government collects most taxes. While some
provinces have experienced a degree of success, overall, provincial

ISLAMABAD 00002554 002 OF 002


revenue collection remains weak due to inadequate tax policies and
lack of capacity. Agricultural income, capital gains on physical
assets, consumption of services, and taxation of urban property are
constitutionally mandated to be within the provincial purview, yet
regional governments have been unable to acquire significant revenue
from either transport services, or wholesale and retail sales.
While wholesale and retail trade constitute 16 percent of GDP,
taxation of wholesale and retail items represent only 2.4 percent of
national tax revenue.

Rampant Tax Evasion
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7. (U) Of the more than 39 million people who are a part of
Pakistan's official labor force, less than 4 percent (1.5 million)
pay income tax. Pakistan's tax base remains narrow and tax evasion
is rampant due to: 1) a large proportion of the labor force being
employed in small-scale agriculture and the informal economy; (2)
numerous exemptions; and, 3) the high frequency of undocumented cash
transactions. Furthermore, due to the lack of government efforts to
curb abuse of the self-assessment scheme and a lack of speedy and
transparent audits, many taxpayers, particularly Pakistan's rich,
continue to underpay.

World Bank Tax Reform Assistance
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8. (U) In January 2006, the GOP requested World Bank assistance on
comprehensive tax reform, and the Bank funded a review of Pakistan's
federal tax system that was done by the Andrew Young School of
Policy Studies at Georgia State University (which specializes in tax
policy in developing countries). This was completed in June 2006.
Pakistan began its 22-month Tax Policy Program (TAP) in March 2007.
The objectives of TAP are to provide a comprehensive assessment of
Pakistan's tax system, learn lessons from other countries'
experiences with tax reform, develop tax reform options for
Pakistan, and build the capacity of the Federal Board of Revenue.
The World Bank continues to assist Pakistan with tax administration
and policy reform by funding a USD 100 million program that will
conclude in 2009.

World Bank/Andrew Young School of Policy Studies Report Findings
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9. (U) The World Bank/Andrew Young School of Policy Studies report
offered some short-term options to expand the direct and indirect
tax bases. Regarding indirect taxation, the report recommended:
imposing excise tax fees and commissions on banks and companies
providing certain services (such as non-fund services, advisory
services, etc.); withdrawal of the sales tax exemption on some duty
free imports; and lowering of the sales tax threshold for retailers
(currently at 5 million rupees). The 2007-08 GOP budget imposed a 5
percent excise tax on banking sector non-fund services (such as bank
drafts and letters of credit) which increased to 10 percent in the
2008-09 budget. In regard to direct taxes, the report suggested
elimination of the exemption on short-term capital gains, taxation
of pension income, and taxation of employee benefits at market
value.

Comment
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10. (U) Provincial revenues have dropped steadily in recent years
and are currently only 0.5 percent of GDP. Sustained increases in
revenue will require a stronger effort, not only by the federal
government, but also by provincial governments. In order to reach
the GOP's goals of poverty reduction and devolution of political
power, provincial spending, particularly in education and health as
well as on infrastructure, must be matched by an increase in
provincial revenue collection. This will require reform of both tax
policy and capacity building for tax officials. Possible areas of
tax reform might be in the areas of capital gains and the sale of
real estate, as well as in the services and agricultural sectors.
The GOP must expand their tax base to generate much needed funding
for the plethora of policies which are publicly announced but rarely
funded and fail to make a difference for the average Pakistani
living on less than two dollars a day. End Comment.

PATTERSON