The trust deficit

The fundamental basis for government and law is the concept of the social contract, according to which human beings begin as individuals in a state of nature, and create a society by establishing a contract whereby they agree to live together in harmony for their mutual benefit, after which they are said to live in a state of society. This contract involves the retaining of certain natural rights, an acceptance of restrictions of certain liberties, the assumption of certain duties, and the pooling of certain powers to be exercised collectively.” – Constitution Society

By the quoted definition, trust is an important factor for the social contract to work. We trust that as individuals and institutions, we will do our best to follow the social contract that we collectively create for the mutual benefit of all. Through trust, society determines whether or not the social contract between people and the government is working.

As mentioned in the conclusion of last year’s article on the impact of the 2015-16 Budget, while budgets and policies are important, the main obstacle to Pakistan’s growth is the trust deficit. It perpetuates a sense of scepticism, justifies the violation of the social contract, and fuels sentiments such as, “why pay taxes when the government does not fulfil its obligation of ensuring law and order or providing water and electricity?” This sceptical attitude or indifference towards society continues to stunt the growth of the tax base despite incentives and penalties.

In last year’s budget, a penalty was introduced for non-filers with the expectation that it would encourage people to comply and increase the tax base. While the policy seems to have increased tax receipts, it was ineffective in significantly increasing the number of taxpayers in the country. This policy is being continued in 2016-17.

The Pakistan Business Council (PBC) in its letter to the Finance Minister, Ishaq Dar, on June 9, 2016, commented that: “the budget proposals to subject non-filers to further or higher rates of withholding taxes (WHT) may meet short-term cash flow objectives... Withholding taxes are eventually passed on by non-filers to consumers and the formal sector, thus raising the cost of living and doing business... Until the Federal Bureau of Revenue’s powers to inflict arbitrary audits and other measures bordering on the harassment of existing taxpayers are curbed, avoidance of withholding taxes alone will not provide incentive to non-filers to join the tax base until it is added.”

In essence, the current taxpayers continue to pay more taxes to make up for the non-compliance of a large segment of society. So what would make the non-filers want to pay tax?

Sweden is a country where the income tax is high, but contrary to what one would expect, polls show that the Swedish Tax Authority is popular. One of the reasons attributed to the positive perception is that Swedes seem willing to pay higher taxes for “a largely fair and well-functioning society, with decent public services and a universal safety net.” Additionally, the Tax Authority’s accessibility and customer friendliness is attributed as a reason for its popularity.

Evidently, in a society where people see benefit, they are willing to pay taxes. In Pakistan, most people perceive that paying taxes to the government does not lead to any benefits. Over time those who could afford it have taken it into their own hands to support their needs whether it’s energy through generators, tankers for water, or security guards for personal safety.

In the case of energy alone, if 0.5% of Pakistani households have invested in a generator with an average cost of Rs 500,000 per generator, the collective capital outlay would be over Rs 75 billion. Annual operations cost (fuel/gas, etc.) of the generator would be an incremental nine billion rupees per year. The investment by industry in generating its own energy to sustain its operations will substantially increase the total amount privately spent to bridge the gap in public services.

Spending such as this, coupled with the notion that Pakistan is a giving nation in terms of charity, indicates that people have the capacity and inclination to pay, yet when it comes to taxes only about 0.3% of the population complies! If the trust deficit in Pakistani society did not exist and people had the confidence that taxes are an investment in their quality of life, the same investment could have been paid in taxes for the collective good of the society.

There needs to be a concerted effort to close the trust gap through more simple, efficient and friendly tax policies to increase the tax base. Instead, there seems to be a continued reliance on generating more revenue through indirect taxes and increasing the burden on those who are already paying. The latter, in particular, continue to plague the media and advertising industry and hamper growth and entry of SMEs.

1 The proposed increase in withholding tax (WHT) on print and TV media from one to 1.5% will impact the cash flow of media entities and potentially create a downstream impact on the timing of payments to their suppliers. Smaller independent producers will probably be most impacted by the potential disruption in cash flows.

2 The burden of non-filers continues to fall on those who file. Non-filer service providers, particularly individuals, expect to top-up their demand by the incremental WHT. The increase in cost is passed on to the customer adding to their cost instead of affecting the non-filer. Hence, there is no incentive for non-filers to comply.

3 The complication of complying with Federal and Provincial taxes for WHT and sales tax is increasing the cost of doing business. This is likely to encourage people to remain non-filers, particularly young entrepreneurs who may not have the tax expertise for proper compliance.

4 The eight percent WHT on advertising agency services and 10% WHT on media commission to advertising agents continue to unfairly penalise the industry. Since WHT is deducted at source on revenue and effectively ‘prepaid’, for an agency with a healthy profit margin of 20%, it would mean that the company has already paid 40 to 50% of its profit in advance tax. So a reduction in corporate tax to 32% as proposed in the 2016-17 budget is of very little or no benefit because a complying agency pays more tax in advance than what would be due at the end of the year. Refunds take time and the amount is usually not fully paid. This makes the industry unattractive for new investments or further growth. The WHT rate for agency services and media commission should be five percent, which would be closer to the corporate tax due at the end of the fiscal year. It would minimise the administrative cost of refunds on both sides and increase the agency’s cash flow which could be deployed for further growth.

5 Pakistan will continue to face pressure to generate additional revenue to support government spending and loan repayments. The Federal and Provincial Tax Authorities are expanding the tax apparatus to enforce compliance with incentives for tax officers to meet their targets. While enforcing compliance is necessary, the increasing number of notices to companies which are already complying is unfair. This may be a result of inducting new tax officers who may not have the proper understanding about the economics of the particular industry. Regular interaction between representatives from the industry and the relevant tax authorities can improve the understanding. However, the selected industry representatives need to be filers themselves, with a track record of proper compliance.

Overall, Pakistan’s economic performance continues to improve, but its potential still remains constrained. While the economy grew by 4.71% during FY 2015-16 (higher than the previous year), it was below the budgeted rate of 5.5%, despite favourable trends in Pakistan, such as historically low cost of borrowing, contained inflation and relative improvement in law and order. Pakistan can achieve its rightful potential as a South Asian tiger if it works as a nation that has confidence in itself. Trust between the people and the public institutions serving for the common good is critical.

Amin Rammal is Director, APR, The Brand Crew and Firebolt63. amin.rammal@thebrandcrew.com