Adapting existing social contracts for business transactions hold the answer towards documentation; not levy of more taxes.

By Ali Salman

One of the key policy objectives associated with the levy of RGST is to expand the tax net or in other words to reduce the undocumented economy. Economists identify low tax to GDP ratio in the times of high economic growth as main indicator of an increasing black, or extralegal, economy. I argue that a high tax rate of 15% is a sure barrier for small businesses to disclose themselves. Therefore an imposition of RGST is unlikely to bring new businesses on the register and is in fact more likely to reduce the overall collections.

Writing in Hindustan Times, Pramit Pal Chaudhuri has recently argued that Pakistani firms are shrinking, avoiding raising capital, moving out of the formal and into the informal sector, and otherwise declining to do what you would expect a private sector to do.

A bulk of Pakistan’s economy is underground, or ‘extralegal’. Out of 3.2 million non-agricultural enterprises in Pakistan, 99% are SMEs. 97% among these are small enterprises with less than 10 full time employees. It is here the bulk of the extralegal sector resides. They are mostly vendors, suppliers, retailers, wholesalers and manufacturers. The accounts are multiple, but most would identify the size of the extralegal economy within 30% to 50% of Pakistan’s economy or about at least 51 billion dollars. In addition, according to government’s own estimates the black economy has continued to grow at 9% per annum since 1977 to 2003, wherein the national GDP growth during the same period was less than 5%.

People do not opt to live in extralegal sphere out of a fear to pay taxes; they may end up paying far more than the legal taxes, as extralegal framework is not free. Therefore, according to Hernando De Soto, what determines whether “you remain outside is the relative cost of being legal.” However to understand these relative costs, and to convince those who abide by extralegal framework to abandon it takes very minute level decoding of the extralegal social contract.

Adapting existing social contracts for business transactions hold the answer towards documentation; not levy of more taxes. The instances of legal failure-not in the sense of implementation failure-but in the sense of failure in evolving laws according to social contracts are many.

The case of remittance transfer presents an interesting example of how the written law is abandoned by the people in favour of a social contract. The hawala or hundi system represents the social contract while the telegraphic transfer method represents the written law. Some where in between, the market has embraced the Western Union and many other agencies like it, which are as efficient as hawala, certainly expensive than hawala though less ‘official’ than the bank transfer. According to an estimate, USD 5 billion is transferred through this network each year, which is 130% age of the official remittances.

Given the administrative loopholes in tax collection system, the impact of a reformed sales tax on reducing the extra-legal economy will be open to debate. This argument applies to all kinds of tax evading businesses: those who are registered and pay less than their share and those who remain out of the tax net and continue to thrive in their businesses. According to another study done by LUMS, out of every Rs. 100, 62 rupees are pocketed back by the tax payer, tax collector and tax practitioner.

Federal Board of Revenue faces the herculean task of expanding the tax base. For this, they must start with trust on the millions of small enterprises which are ready to pay taxes to get other benefits from documentation such as access to formal credit. A sales tax of even 15% after reform is simply too high to induce these millions of businesses to disclose them. An ideal tax rate will be much lower but its exact calculation should be best left to detailed economic research. A tax structure must reward businesses for disclosure, not punish them.