IMF knocking our doors at a wrong time!

As reported in various newspapers during the last couple of days, IMF and World Bank have been consistently demanding that Reformed GST, as promised by the Minister for Finance, must be introduced by 1st of October 2010; otherwise the next tranche of loan will not be released. The donor agencies are reportedly in constant touch with the Government of Pakistan to ensure that the promise made by the minister is fulfilled. Even Mr. Halbrooke, during his recent visit to Pakistan, has insisted that Pakistan must broaden its tax base and increase revenue collection from domestic taxes. Pleas of the GOP officials that Pakistan is passing through a very critical juncture due to devastating floods have not been able to convince the donors to relent. Government of Pakistan and its officials negotiating with the IMF appear to be stricken by IMF terror. They don’t have the capacity to say upfront that it is not possible to introduce Reformed GST by the said date due to very valid reasons which include devastating floods, political uncertainty, inefficient tax administration and insufficient preparations. Some of the factors are self-inflicted but others are God gifted!

The net result is that Reformed GST cannot be introduced by 1st October whatever the IMF says. The Government knows that if it was not drowned by the floods, it will surely be drowned by the tsunami of public reaction against a so-called Reformed GST. It will therefore be suicidal on the part of the Government to introduce a Reformed GST through ordinance as being urged by the donors with democratic credentials. Even that is out of question because provinces apparently are still not willing to impose GST on services which fall in their domain.

I have consistently been saying that if Reformed GST is at all to be introduced, it may be planned for the next financial year but preparations must be started forthwith in right earnest and zeal. A strategy should be devised, planned and executed and monitored by a team of experts dedicated for the purpose.

Apparently neither the Government of Pakistan nor FBR is up to the task. FBR is at present heading an extremely inefficient, unorganized, untrained, unskilled, inept, indolent and leviathan tax administration. This tax administration needs surgical reforms, only then a genuinely self assessed Reformed GST can be introduced. As is true of all developing countries, tax administration is the tax policy. A reform project of tax administration is going on for the last more than nine years. This project has miserably failed to deliver, even under the watchful eyes of the IMF, World Bank and Foreign advisors and consultants appointed at fat salaries. The tax administration is as corrupt, inefficient and untrained as it was nine years ago. In all probability all these attributes have increased substantially if not multiplied.

FBR has to put its house in order before it embarks upon the project of Reformed GST. That is however, not in sight. The Government also needs to have political commitment which is badly lacking. A Government at war for its survival is not expected to have political commitment required for tax administration. The IMF and the World Bank are knocking at the wrong door and at a wrong time. The IMF also surely knows this!

Short Term and Long Term Implications of VAT/ GST/Sales Tax in Pakistan

The government under pressure from IMF and other donor agencies has been insisting that VAT will be introduced w.e.f. 1st July, 2010.  Statements to this effect were frequently made by all government functionaries/high ups including the then Finance Minister, Secretary Finance and Chairman FBR. In fact the statements by the then Finance Minister reflected his arrogant, hauteur and hawkish attitude, unsuited for the present day financial realities of the country. The saner elements, aware of limitations of tax policy, had consistently held that VAT could not be introduced by the said date for the simple reason that the government itself was not ready for the job, what to talk about the other stake holders i.e taxpayers who were not even consulted. Introduction of a true VAT on goods and services requires certain gestation period during which full-fledged preparations and efforts are to be mounted. All those countries which have been able to introduce a successful VAT have normally taken a period of 2-3 years for preparations and for allied purposes. We intended to do it in a period of less than one year and that too without any preparatory ground work. The effort could only boomerang. It was written on the wall; only the inchoate GOP and IMF could not read it.

I myself have been consistently writing that the time period is not sufficient for the purpose. If GOP was serious and sincere in introduction of VAT, it must have sought a period of 2-3 years from donor agencies. By not doing so, GOP had shown its intention loud and clear. Now the job at hand is first to convince the IMF to give us a further period of few months and then to make preparations for introduction of a tax resembling a VAT or Goods and Services Tax, being referred as ‘Reformed GST’. The new Finance Minister in his budget speech has now indicated the target date as 1st October, 2010.

However, the shift in emphasis and policy was crystal clear. The FM did not use the word VAT even a single time in his speech. He used the word GST only. The change was obvious and perceptible. The hawkish and arrogant attitude of the previous FM was gone. The new FM appears to be more humane, firm and understanding. He appears to be sensitized to the ground realities. Considering his budget speech and his no non-sense attitude, it appears that the new date might be possible for a reformed GST. However, there is lot to be done during this short period of three months. First of all the present Sales Tax Act needs almost a complete overhaul. Same will be the fate of present Rules and Notifications. A complete revamp of computer system alongwith highly efficient and trained work force will be required. A seamless refund system is to be put in place. All this might not be possible during this short period. However, something resembling this can be put in place. Therefore, a haphazard and disjointed, so called reformed GST, could be put together by 1st October 2010. This is a dangerous proposition which might even result in complete failure of the system. All these factors should be kept in view whatever decisions are made during this interim period.

Now the most important issue. How to convince the provinces to adopt sales tax on services by the said date so that the whole system consists of an integrated general sales tax on goods and services with cross adjustment / input tax credit. Apparently, no effort appears to be directed towards this goal. One reason might be that the new FM has lost hope of bringing the provinces on board and is preparing for reformed sales tax on goods only. Obviously, a long term strategy is required to introduce a general consumption tax covering both goods and services. This requires realization of magnitude of the issue and long term political commitment on the part of powers that be. It requires vision, strategy, planning, preparation and commitment; virtues very difficult to find in our political and ruling class.

I am pinning my hopes on the new FM. He perhaps realizes that the nomenclature VAT is not sacrosanct. He deliberately used the word GST in his budget speech and avoided any mention of VAT. He in all probability realizes the importance of this gesture. It is not the word VAT which is important. It is spirit of the system which needs to be protected and promoted. The present sales tax of Pakistan is already in the VAT mode. All it needs is purging of certain provisions of the Act and introduction of few newer ones to bring it at par with standard VAT practices. In fact more needs to be done in the realm of administration and the IT whose reform is more tedious, frustrating and time consuming. No seamless refund system is in place nor is one in sight. No state of the art information technology system is in place nor can be bought off the shelf, in view of our peculiar problems. No well-oiled, slim, hungry looking, well-fed tax bureaucracy has been established during all the reform years spread over almost a decade. There is no comprehensive audit strategy and no mechanism for affectively controlling fake / flying invoices. The dispute resolution mechanism is extremely poor and scaled heavily in favour of the government and therefore, not credible. Since VAT / Sales Tax refund fraud is a real possibility, it requires a proactive and effective machinery to deal with the same. Unfortunately, all these requisites of a better VAT/GST/Sales Tax model are missing. This requires time, planning, strategy and all that is required for such an exercise. No credible VAT / GST can be expected without these prerequisite. I hope that the new FM is aware of all this and is taking reasonable steps in the right direction. Apparently, there are no indications to suggest that.

Pakistan’s tax administration is typically in a reactive mode. We as a nation believe in doing things first and plan later on. That is true of tax administration as well. My fear is that this problem of poor planning will continue haunting us. GST to be introduced by 1st October, 2010 is likely to be in the same mode. Then there is the problem of taxing services, which being intangibles are always difficult to tax. Provinces are apparently neither serious not keen about it. Perhaps, no consensus will be achieved on taxing services by the said date and the Federal Government might have to do it alone and on goods only.

This article intends to examine short term and long term implications of VAT /GST. It is based on the premise that something resembling VAT / GST will be introduced in near future (say, July 2011, if not 1st October, 2010), sans sales tax on services.

In the short term no significant gain in revenue is expected from reformed GST because tax rate is likely to be reduced to 15% i.e. a reduction of 2%. There is also a possibility that highly anomalous 1% special excise duty will also be removed. Higher tax rates of 19.5% and 21% are also likely to be abolished. Obviously, many of the existing exemptions will be withdrawn but their revenue gain will be more than offset by reduction in rate. VAT has been used by many countries as a tool for documentation of economy. Hopefully, with most of the exemptions gone, documentation will likely improve which in turn might result in marginal increase in revenue over medium term.

Strangely, our experience has shown pitfalls of documentation. VAT tax chain had resulted in the phenomenon of fake and flying invoices during late 90s and in early part of the present decade. Resultantly, textile and other export oriented sectors were zero rated for local supplies as well. That phenomenon is likely to recur with the same ferocity. A well thought out strategy is required to counter the menace. At present the tax administration is as clueless as it was in 2005 when textile and other export sectors were zero rated. This is therefore going to be a major headache for tax administration.

Hopefully, domestic zero rating of textile and other export oriented sectors will be withdrawn. It will multiply the refundable amounts. If past is any indication, there will be delays in sanctioning of refunds. Upfront financial cost of exporters will increase significantly, rendering them more uncompetitive in the world market. Exports will suffer as also the country. Corruption will creep in due to refunds. It is obviously, not a happy sight. Three months is too short a time period to develop a strategy and an infrastructure to deal with the issue. It will be a test of Government’s resolve and commitment to effectively address the issue. I personally feel that it is not doable for the present tax administration. Unfortunately, it is expected that malpractices prevalent before the year 2005 will come back with full force and rage. This is for the policy planners to think and decide.

VAT has its advantages which will be apparent in the long run. If malpractices pointed out above are addressed, revenues are likely to increase significantly. An efficient VAT will likely improve collection of income tax as well. If Government is somehow able to extend VAT to retail sector (a very difficult proposition), it will be an extra icing on the cake. However, for this to happen, structural issues of VAT will be required to be adequately addressed. This is again a very difficult proposition. I doubt if the present tax administration is geared for the job at hand.

One thing is very obvious. We will try to emulate and imitate the best VAT practices so long as IMF is here. Once they are gone, we will revert to the old, tried and tested methods again. Special schemes for various categories of taxpayers will be back with a vengeance. For the present we are likely to do away with these schemes under pressure from IMF. In this go, we will discontinue even those schemes which are otherwise required for small traders / retailers. After IMF is gone, we will first bring back special scheme for small traders / retailers. Then will justify similar schemes for mild steel producers, CNG stations etc. and for host of other sectors. The list is un-ending. Since rule of law, tax policy, best practices are not our national norm, we will waver from best VAT model. This has already happened frequently. A case in point is the sales tax reform effort of 1996. After having adopted the then prevalent best VAT practices, we immediately started dithering.

In the end, it can be argued that there are no likely short term gains from introduction of reformed GST. However, if we continue on the right track and address design and implementation issues, long term implications are likely to be positive. All the advantages of VAT can be reaped with a well thought out strategy. Documentation can improve as can the tax recoveries. Once services are also brought in the net, tax to GDP ratio can be significantly increased. Buoyancy of VAT can improve the overall administration and collection of tax. Disputes with the taxpayers can be minimized once fully automated IT based system backed by highly efficient tax administration is put in place. In this exercise, another two very important and related issues will also be required to be addressed. These are (i) under invoicing;   and  (ii) smuggling. These two issues have a great bearing on successful implementation of VAT. This is however, a different subject and will be discussed separately. Suffice to say that these two issues also need to be addressed for a successful VAT/GST, although these two issues are generally not adequately discussed by VAT experts.