A Critical Analysis of Income Tax Ordinance 2001

A CRITICAL ANALYSIS OF INCOME TAX ORDINANCE, 2001 A CRITICAL ANALYSIS OF INCOME TAX ORDINANCE, 2001 By M. Anum Saleem1 and Ussama Ahmad Khan2 INTRODUCTION Tax legislation is of concern to governments across the globe because of its effects on economic activity in addition to its fiscal importance. This paper seeks to highlight how the tax rates contained in _________________________ 1 M. A. ECONOMICS (PUNJAB), LLM (TORONTO), ADVOCATE HIGH COURT, ADJUNCT FACULTY, LUMS, PARTNER, SALEEM AND SHIRAZ, ADVOCATES AND LEGAL COUNSELS 2 BSC Final year student at LUMS the Income Tax Ordinance, 2001 cause injustice to tax payers, are fiscally inappropriate and affect economic activity negatively. In the course of the paper, comparisons to various countries, their tax policies and tax rates are made. CURRENT STATE OF THE ECONOMY Pakistan, through 65 years of its existence has suffered on the economic front due to several reasons. Among the most important are the political situation, massive corruption and inappropriate economic policies. Governments throughout these years have failed on most accounts to achieve a budget surplus. This is despite of the fact that Pakistan has been endowed with numerous natural resources and is strategically located. Yet the inclination of the government to exploit the resources for the country's benefit has been primarily missing. Corruption at all levels of hierarchy in government departments across the. country has been a major player in sinking the ship that could have been a world leader. Undue emphasis on politics has caused the economy to suffer further Pakistan currently faces a budget deficit of Rs. 1.4 trillion for the fiscal year 2011-2012. Nine months through the fiscal year the government has already spent 91 % of the total annual budget as reported by The Express Tribune. The deficit is a huge 6.6% of the total economy and is all set to increase further. "The development comes on the heels of the government's decision to revise downwards the target of tax collection by Rs.23 billion after the authorities missed the monthly targets for two consecutive months. The trend indicates that the federal government is set to miss all its budgetary targets." Such is the fledgling state of Revenue collection that FBR had to revise its revenue collection objectives on several occasions before settling on a way off the mark figure. Initially the aim was to collect a total of Rupees 1667 billion, a target which was later cut down to Rupees 1604 billion and then further dragged down to Rupees 1588 billion. Despite the continuous decreases, FBR managed to collect only Rupees 1558 Billion, well off the initial 1667 billion mark. Out of the figure collected, only 602 billion was from direct tax and the rest indirect. It is suspected that even the 602 billion is an inflated figure, reflecting a meager figure of 400 billion only. Experts say that the FBR can squeeze out as much as Rs. 6-8 trillion in tax from the economy but chooses not to, so that the poor are not further burdened by an influx of indirect taxes. ____________________________ 3 The figures above have been obtained from Shabaz Rana's article "Spendthrift ways: Govt. consumes 91% of the budget in nine months" published in The Express Tribune on 4 May 2012. According to various studies (see the latest report of World Bank), an estimated 42 per cent of our total national income belongs to only top 20% of the population-36 million persons have a combined income of $75.6 billion or a per capita income of $2,100 i.e., twice the national average. Nearly 27% of the national income goes to just 18 million people-whose per capita income is $2,700. Since the poorest 10 per cent of the population receives only 4 percent of the total income, their income per head is only $400 per annum. Population (%) Income (%) Per capita Income top 20% 42% $2,100_ top 10% 27% $2,700 poorest 10% 4% $400 As bad as it gets, the inefficiency of FBR in collecting taxes can be judged from the appalling fact that out of the 584 billion Rupees tax collected only 18 billion (3%) was collected through demand, and the rest 97% was collected through Advanced Tax and With Holding Tax. Even in the domain of Indirect Taxes, FBR does not fare too well. It collected Rs.684.2 billion from sales tax (Rs.308.7 billion on imports and Rs. 375.5 on domestic supplies), out of which share of petroleum products was about 39%. The contribution of petroleum and telecom sectors in domestic sales tax collection is 60%. This exposes the effectiveness of FBR in implementing sales tax across the board. Resultantly, the gap in collection is nearly 200% and there is also illegal enrichment as sales tax collected on local supplies from the consumers never reaches the government treasury due to unholy alliance between the unscrupulous businessmen and corrupt officials. The recent study of World Bank suggests that revenue losses under the head of customs were not less than US$ 30 billion.' THE INCOME TAX ORDINANCE, 2001 The Income Tax Ordinance, 2001 was made operative on 1st July, 2002 and has since been a source of criticism by tax payers, financial managers and tax lawyers. "After 10 years, there is a consensus in all circles - officials and professions - that the new law, aimed at simplifying income tax enactment, has been a total failure to achieve the much desired goal of inducing foreign direct investment and rapid industrial growth." 5 In order to analyze the tax rates and the associated policies we divide the Income Tax Ordinance into two broad categories: (i) the normal tax regime, (ii) the presumptive tax regime. The normal tax regime entails to five different sources of income: Salary, Business Income, Capital Gain Property and Other sources. It is interesting to note that the Income Tax Ordinance envisages numerous different tax rates for the above mentioned categories. The rates specifically are contained in the First Schedule to the Income Tax Ordinance. NORMAL TAX REGIME The Income Tax Ordinance divides the income of all persons into different heads. Section 11 of the Income Tax Ordinance ,states, "For the purpose of the imposition of tax and the computation of total income, all income shall be classified under the following heads, namely:- (a) Salary; (b) Income from Property (c) Income from Business (d) Capital Gains; and (e) Income from other sources." SEPARATE BLOCS OF INCOME The first schedule to the Income Tax Ordinance is divided into 4 parts and 30 divisions each of which is used to determine the rate of tax applied to different heads of income for different persons. The first thing ____________________________ 4 The figures in the above section have been obtained from Huzaima Bukhari and Dr. Ikramul Hag's article "Devising an equitable tax structure" published in the Huzaima and Ikram Tax Journal (February 5, 2012). 5 Huzaima Bukhari and Dr. Ikramul Haq..Tax Reforms" The Business Recorder.30 March 2012 to note in the normal tax regime of the Income Tax Ordinance is that it taxes income from property among others as separate sources of income for all persons. Tax rates in the different schedules are not harmonized and result in different tax liability for the same amount of income. In doing so it essentially reduces the amount of tax charged to a person earning a major part of his income in the form of rent compared to a person earning a major part of his income from business although the total income under all heads may essentially be the same. This happens primarily because of taxing property income as a separate bloc. However if that is to remain the case, the different tax rates and tax brackets contained in the first schedule should be harmonized. A numerical example of the injustice caused by these tax rates is contained in the following table: Person A Person B Income from Business 600000 1000000 Income From Rent 1000000 600000 Total Income 1600000 1600000 Tax rate applicable on Business Income 10% 15% Tax rate applicable on Rent Income Rs.12,500+ 7.5% of income over and above 400000 Rs.57,500+ 10% of income over and above 1000000 Tax on Business Income 60000 150000 Tax on Rental Income 57500 27500 Total Tax liability 117500 177500 We can see from the table that although the total income of both person A and person B are same. Person B pays a higher amount of tax. The effective rate of tax of person B is almost 4% higher than the effective rate of tax for person A. SALARIED CLASS AND NON-SALARIED CLASS INDIVIDUALS Division 1 of Part I of the first schedule establishes the rates of tax for individuals. Clause 1 sets out a table for the tax rates to be "imposed on the taxable income of every individual except a salaried taxpayer". Clause lA establishes the tax rates for individuals "where the income of an individual chargeable under the head "salary" exceeds fifty percent of his taxable income". Although for both types of individuals the minimum level of income for being taxed remains the same i.e. Rs.350,000 the lowest rate applicable on a salaried person is 1.5% while it is 7.5% for an individual who falls under Clause 1. Such a difference in tax rate means that for the same level of taxable income the tax paid by a salaried person would be 5 times less than the income tax paid by an individual whose main source of income is not salary. The case is similar for higher levels of income, where the highest rate of tax on an individual is 25% and for a salaried person it is 20%. Person X Person Y Income from Business 270000 500000 Income From Salary 500000 270000 Total Income 770000 770000 Tax rate applicable on Income 7.50% 15% Tax If No marginal Relief Given 57,750 115,500 Tax rate after marginal relief 6% of income up to Rs.750,000. 301 of income above Rs.750,000 No Marginal Relief Given Total after Marginal relief 51,000 115,500 Also important in the analysis of the injustice done by the Income, Tax Ordinance are the tax brackets drawn up in the two tables. There are a total of six tax brackets in the table in clause 1 and a whopping 17 tax brackets in clause 1A allowing tax rates to increase much more slowly than in the first table. For example for an individual who is not a salaried person an increase in income from 750000 to 1000000 would mean an increase of tax rate by 5%. If the same individual was a salaried person the tax rate would rise by a mere 1.5%. It is important to also note that the salaried person is granted marginal relief under Clause 1A, allowing him to apply a lower tax bracket if his income falls into a higher tax bracket by a small amount. No such provision is made for the non-salaried taxpayer who already bears the burden in the form of fewer tax brackets and comparatively higher tax rates. Tax Brackets Tax rate Inter bracket Marginal Tax burden 0 < x < 350000 0.00% 350000 < x < 500000 7.50% 26250 500000 < x < 750000 10.00% 12500 750000 < x < 1000000 15.00% 37500 1000000 < x < . 1500000 20.00% 50000 1500000 < x 25.00% 75000 Interestingly such an individual is subjected to Rs.12,500. in additional tax for approximately the same level of income if it falls into the third bracket by a single rupee. The injustice goes even further as depicted in the table above. The methodology applied to business income and salary however does not apply to Income from property. Division VI of Part I of the First Schedule establishes the tax rates for income from property. Interestingly the tax rates apply to discrete slabs of income rather than income as a whole. On a global front the tax policy regarding taxing salaried and non-salaried taxpayers separately is unique. Countries like Singapore, UK, Malaysia or India do not employ such a system. The policy however has severe repercussions in terms of restricting and discouraging small scale startups and sole proprietorships. A comparison across countries reveals the following policies6:-- (1) In Singapore personal tax is levied in a system which is not only progressive but also is marginal at all levels. Singapore's tax brackets are shown in the table below. Tax is charged at a higher rate on only the additional income earned, the entire income is not charged to a single tax rate. This, however, also means that the effective tax rate is actually quite lower than the highest tax rate applicable on the person's income. , _________________________________________ 6 Tax rates and policies have been obtained from "Worldwide tax guide 2011" published by PKF International Tax rate on` first 20,000 0% Tax rate on next 10,000 2% Tax rate on next 10,000 4% Tax rate on next 40,000 7% Tax rate on next 40,000 12% Tax rate on next 40,000 15% Tax rate on next 40,000 17% Tax rate on next 120,000 18% Tax rate above 320,000 20% (2) India's personal tax rate is progressive and is also very simple. The tax rates are divided into four brackets of 0%, 10%, 20% and 30%. There is no difference in rates for a salaried and non-salaried individual. (3) UK's personal tax rate is also divided into four brackets but the system is not as simple as the Indian tax rates. UK's personal tax policy' is progressive but it does not give marginal relief at all levels of income. All incomes above 2560 are applicable to a rate of 10%. If the income exceeds 35000 all the income is applicable to a rate of 40% tax. However if the income also exceeds 150000 the additional income above 150000 is charged to tax at 50%. In a country with the minimum wage at merely Rs.8000 a month there is a need for small startups to help eradicate poverty. However, when a major chunk of the profits are taken away in taxes efforts to increase living standards through entrepreneurship seem futile in nature. Also interesting is the fact that by taxing the salaried class on considerably lower rates the government loses out on a major chunk of revenue because of the lack of harmonization in the tax rates. INCOME FROM BUSINESS: THE CASE FOR ASSOCIATION OF PERSONS' Division IB of the First Schedule specifies the rate of Tax for the Association .of Persons. At first there was no tax for income of an AOP for incomes less than Rs.100,000. However, now there is an across ____________________________ 7The analysis was obtained from Huzaima Bukhari and Dr. Ikramul Haq's article "Why penalize association of persons" published in the Huzaima and Ikram Tax Journal (January 8, 2012) the board rate of 25%. There is also a long list of items that are not admissible for the AOP under section 21(j)_such as Salary for partner, commission and profit to partners. However, these or similar expenses are allowed for Companies. This discriminatory behavior is not fair for AOP coupled with the fact that a high rate of 25% means that an AOP is taxed as a small company without enjoying the benefits that are so graciously bestowed on companies. This is obviously done by the FBR in order to boost revenue collection, ignoring the bitter reality that the long term viable solution lies not in getting more from those that are already paying but by widening the tax base. INCOME FROM BUSINESS: CORPORATE TAXATION Corporate taxation is another area of the Income Tax Ordinance that deserves its fair share of criticism. Under Division II of Part I of the First Schedule the Income Tax Ordinance, 2001 imposes a flat 35% tax rate on the income of companies and 25% tax rate on the income of small companies. Evidence from countries across the globe however is significantly different. In India companies are subject to a tax rate of 33.22% while small companies are subject to 30.9%. In UK companies are subject to a tax rate of 27% while small companies are subject to 20%. Marginal relief is given to companies where they fall into the category of a large company by a small amount. Malaysia imposes a 26% tax rate on companies and a 20% tax rate on large companies. In a country that most often fails to meet its fiscal and economic targets, a high tax rate on companies is detrimental to growth. It limits the number of individuals wishing to set up companies. MINIMUM TAX ON CERTAIN PERSONS Section 113 of the Income Tax Ordinance imposes minimum tax on the income of certain persons. For companies a minimum tax of 1% of turnover is imposed. Although the minimum tax can be carried forward and set off for five subsequent years, it may well be possible that some companies may end up paying tax even if they are making losses. Since the minimum tax is a percentage of turnover it turns out to be a significant amount. Companies with low profits in consecutive years may end up paying an effective tax rate that is beyond the 35% imposed by the Income Tax Ordinance. Both the idea of minimum tax and its tax rates are problematic and are a burden on companies. The minimum tax also applies to companies operating in tax free zones or companies that have been granted tax holidays by the government. TAX ON DIVIDENDS It is important to discuss tax on dividends at this stage because of their association with corporate taxation. The income from dividends is taxed as a separate bloc of income at the rate specified in Division III of Part I of the First Schedule. Corporate dividends are therefore taxed at 10% under section 5. What is important to note here is that the dividends are essentially distributed from a company's profit which has already been subjected to taxation. Taxing it again at a high 10% essentially means that they are double taxed and that the effective tax rate on corporate profits in the hands of the shareholders is much higher than it seems. TAX ON CAPITAL GAINS Sections 37 and 37A of the Income Tax Ordinance pertain to tax on capital gains. Section 37A specifically applies to the tax on capital gains from the sale of securities. The Income Tax Ordinance taxes capital gains on securities at a lower rate than it taxes other capital gains. It is interesting to note that capital gains arising from securities held for more than one year are not chargeable to tax. Evidence from India indicates that both short term and long term gains are taxed. Short term capital gains on securities in Pakistan are taxed on rates specified under Division VII of Part I of the First Schedule. Also interesting is the fact that where India levies a generous 15% tax on short term capital gains, Pakistan fails to exploit this source of revenue by charging 10% and even lower in the case of securities held for more than six months but less than a year. Countries like New Zealand and Malta include capital gains as ordinary income and tax it accordingly. PRESUMPTIVE TAX REGIME Sections 149 to 158 are part of the presumptive tax regime. These sections primarily impose tax on presumed income. Analysis of the presumptive tax regime is complicated since it yields both positive and negative effects. It primarily seeks to bring tax evaders into the tax net, but in doing so it under exploits the tax potential and causes undesired effects on the economy. TAX ON PROFIT ON DEBT The first in the category of the presumptive tax regime is the tax on profit from debt. Again it is important to note that it is -taxed as a separate bloc of income rather than being included in the calculation for taxable income and is taxed at 10% which is considerably lower than the tax rates applied to the non-salaried class in the first schedule of the Income Tax Ordinance. Another aspect of the presumptive tax on the profit on debt is that it charges tax to even those who fall below the taxable limit. A widow earning a nominal amount that falls below the taxable limit is forced to pay the tax on profit on debt which cannot be adjusted or more specifically refunded. Thus, there is an effective tax rate that the widow ends up paying even though she falls below the taxable limits. OTHER PRESUMPTIVE TAXES Various other provisions of the presumptive tax regime are to a great extent discriminatory and are under exploitative of the fiscal policy. The following are listed with reference to sections:-- The tax on importers is 5% of the value of goods. It is interesting to note that the tax is final and the importer is not required to pay further tax on the income generated from selling those goods. Much of this tax is passed onto consumers in the form of higher prices The tax on contractors is 6% of the gross amount payable. The tax is full and final and no further tax has to be paid by the contractors. Although these taxes are imposed on gross amounts and are substantially high, it is important to note that such taxes may be passed on to consumers by incorporating them in the price. Such incorporation leads to inflation. TAX CREDITS The Income Tax Ordinance, 2001 allows generous tax credits under sections 61, 62 and 63. It is important to note that the formula devised in each of the three sections essentially churns out the tax rate charged to the taxable income computed before allowing for tax credits. It here becomes imperative that the higher the tax bracket that a person lands into, the higher the tax credit that he receives. This essentially leads to a regressive effect based on provisions of section 61 to section 64. The problem lies here in the fact that the tax credit is determined by the tax rate. The higher the tax bracket the higher the tax credit is likely to be although the amount of donation may largely remain the same. RECOMMENDATIONS With reference to the Income Tax Ordinance there is a need for harmonization of tax rates across the different heads of income and different individuals. Although the tax systems should be progressive they should not cause injustice to any individual where the level of income remains the same. There is also a need to tap the untapped areas of income such as gain from sale of property and agricultural income. Following is a set of recommendations with comparison across countries and the benefits that may be yielded by taxing agriculture and property. TAXING GAINS ON SALE OF PROPERTY The Constitution excludes legislation on taxation of capital gains on immovable property from the purview of the federal government. The income tax law has also been aligned with these constitutional provisions by excluding the immovable property from the definition of a capital asset under section 37. Despite this exclusion, profits on some transactions concerning immovable property are taxable under the Income Tax Ordinance for example disposal of property acquired as a stock in trade or with commercial intent to make profit. However, gains realized on disposal of immovable property transferred as a consequence of family inheritance, gifts or without commercial motives, or the property held as a business capital asset are still exempt. CAPITAL GAINS TAX ON PROPERTY: EVIDENCE FROM OTHER COUNTRIES8 In India, when a property is sold, depending on the holding period, one will either earn a short term or a long term capitals gain. If the holding period is more than three years, the capital gains will be long-term; otherwise it will be a short-term capitals gain. In Philippines, An individual is subject to capital gains tax on the sale of real property at a rate of 6% of the gross sales price or current fair market value, whichever is higher. In Malaysia, capital Gains on the disposal of property are taxed at the rate of 5%. Hence as we can see, Pakistan is losing out on a big source of tax revenue that other developing countries are making the most use of. Property tax on capital gains is a valuable resource especially because it is a direct form of taxation and its imposition will not only allow the government to collect large amounts of revenue but this will also serve as a source of wealth redistribution and poverty alleviation in the country. AGRICULTURE TAX9 The tax on income from agriculture should be made a federal subject in order to improve both the effectiveness and efficiency of tax ______________________ 8 The analysis of tax in India was obtained from Sandeep Shanbag's article "Capital gains tax on property decoded" published in Daily News and Analysis on 15 September 2011. 9 The analysis on agriculture tax was obtained from "Taxing the Agriculture Income in Pakistan", briefing paper by PILDAT. collection. Tax from agriculture has a huge potential for revenue generation, based on the following table:-- TABLE 4: Sources of Growth and Tax (for 2009-2010) Contribution to (in %) GDP Growth Taxes Agriculture 22 10 1 Industry 25 30 63 Services 53 60 26 Source: Federal Bureau of Statistics, Federal Board of Revenue However, the decision to increase tax rates and to make it a federal subject has both its pros and cons. Arguments for the tax are as follows:-- (1) The present fragile economic situation requires the government to raise more revenue in order to lift the low tax-to-GDP ratio and in order to meet revenue and fiscal targets, which it has missed for the past four (4) years. An oft-quoted estimate of the revenue potential of the agricultural sector is Rs.250-300 billion, which is calculated on the basis of the agriculture sector's contribution to the GDP and the income tax rates that are currently applied to non-agricultural sectors. (2) Agricultural income tax can be made progressive, i.e., those who earn more, pay more. This is tied to the fact that many rich and influential landlords do no significantly contribute to tax revenues, and so' their incomes may be targeted through a progressive tax rate that is comparable to income tax rates for financially similar individuals earning from non-agricultural sectors of the economy. (3) Discrimination against the agriculture sector through the imposition of low prices has diminished in the past decade due to the implementation of structural adjustment programme and the sector now has an untaxed potential because of the decline in implicit taxation. Looking at the success story of Uruguay as it moved through a land based to an output based tax: One relatively successful story is that of Uruguay, which adopted a gradual transition from land-based taxes to a form of agricultural (presumed) income tax. One lesson that is particularly applicable to Pakistan is that this transition began by targeting large/more commercial farmers and then moved to a wider presumptive income tax. The agricultural tax reforms in Pakistan must be paced appropriately so that the benefits of a more gradual process of reformation may be availed. Following are the recommendations for bringing the agriculture sector into the tax net:- (1) The tax rate per acre is very low (Rs.150-250 per acre). This amounts to only around 1 % of the estimated net income per irrigated acre of Rs.25,000-30,000. The BNU Institute of Public Policy. (IPP) recommends that these rates should be enhanced to Rs.750 per acre (for up to 25 acres) and Rs.1,250 per acre (beyond 25 acres) with a minimum exemption limit of 12.5 acres. (2) The penalties on non-compliance with taxation procedures are extremely low. For example, the penalty for failure to file a return is a maximum of Rs.1,000. The IPP recommends that this should be raised to Rs.10,000 in order to enforce compliance. It is expected that if a penalty is lower than the tax amount being evaded, this creates an incentive to pay the penalty instead of the tax. (3) 50% of the tax collected from any individual should go directly to the Zila Council of the individual's district. Such a policy may have the effect of improving tax payer compliance. (4) The IPP estimates that if changes A and C are incorporated into current legislation, and collection efficiency is improved, the taxation potential of the sector could rise to Rs.10-15 billion. CONCLUSION The dilemma of the Income Tax Ordinance is huge. Pakistan continues to suffer under the weight of corruption, tax evasion and inappropriate economic policies. The need for the moment is first to realize that each individual is responsible for the country and sabotaging the interests of the country and those of its citizens for personal gain will not bring any benefit. Although unjust and harsh it is still the responsibility of all individuals to pay the due to taxes to allow the country to operate without dependence on foreign aid. In doing so over the years we may be able to bring to governance, people who devise just and appropriate policies for the benefit of this country.