Tackling Informal Economy, Addressing the root cause of all social ills


Taxation policy has been widely used as an instrument to enhance the size of formal economy, considered crucial to allow economy to operate at full employment level, fizzle out underemployment, wipe out poverty, ensure gender equality and stabilize economic growth. Empirical evidence shows that workers in the informal economy face higher risk of poverty than those in the formal economy. The working conditions in the informal economy are inadequate and unsafe and workers have high illiteracy levels, low skills levels and insufficient training opportunities. Therefore, informal economies have higher levels of unemployment and underemployment.

In view of multifaceted nature of informal economy, it is not an easy task to reduce its size rather it requires vertical integration and coherence across the range of policies to curb informality. Pakistan is a lower-middle-income country typically having a large informal sector, very high self-employment rates and low levels of tax collection. Informal economy in the country is estimated to be as large as the size of the formal economy.

The business concerns, especially small and medium ones, continued operating in informal economy largely to avoid taxes by keeping costs and revenues off the books. Such a trend restricted the growth of such firms and kept tax authorities away from enforcement measures. Hence, there is an urgency to enhance the size of formal economy to correct distortions induced by informality by facilitating the firms to get registered under the tax laws. This can be achieved by lowering the cost of registration and making it easier for the firms to pay taxes and file returns and declarations.  

Since many years, it is being considered that property sector in the country is a major destination of all types of black money. Under-declaring or mis-declaring the value of property in order to avoid taxes has become a norm in the country. In certain cases, the declared value of property transaction is as low as 20pc of fair market price. Such a practice has weakened the efforts of documenting the economy. The housing society developers have accumulated enormous wealth by employing these tactics and avoiding due payment of tax. The money in the property sector is considered idle and counterproductive for economic growth. It is being suggested that we should induce money out of property and channelize it toward productive economic sectors that would spur economic growth and result in reduction in unemployment and underemployment.

Accordingly, in the federal budget for FY2016-17, necessary changes have been made in Section 68 of the Income Tax Ordinance, 2001 (hereinafter ITO). The tax authorities would not use Collector/DC rate as a base to determine property value for assessment of tax rather fair market price of property would be determined by the professional evaluators approved by the State Bank of Pakistan to be used as tax base. Now, instead of the valuation of property by the approved panel of the State Bank of Pakistan, the valuation table has been released by the Federal Board of Revenue for assessment of property for the purpose of taxation. This initiative to document the fair market value of property transactions is a step in the right direction and requires true implementation to broaden the tax base. This would not only generate additional tax revenue for balancing the budget but would also document the economy by discouraging lending black money in the real estate.

Further, the government has empowered the commissioner to issue notices under Section 114 of the ITO to a taxpayer who has not filed tax return for the past ten years. Earlier, the time limitation for issuance of notice under the said section was five years. With extended tax period, there are ample opportunities for tax authorities to nab non-filers and to recover evaded amount of tax.

In the previous financial year, the government attempted to document the money by imposing withholding tax on bank transactions exceeding Rs. 50,000 a day to bring the non-taxpayers and non-filers into the tax net. It is because a considerable number of persons engaged in trading activity are out of tax system. By bringing these persons into the tax net, the number of tax returns filers can be increased significantly.

As another measure to enhance documentation of unregistered businesses, the government introduced tax amnesty scheme aimed at bringing business capital into the tax net. It was expected that the amnesty would net thousands of non-filers and would yield revenue to the tune of billions of rupees but the results fell far short of expectations.

The Federal Board of Revenue (FBR) also attempted to enhance the size of formal economy by taxing different transactions at different tax rates for filers and non-filers. This tax policy has yielded some positive results and non-filers are forced to file tax returns to get benefit of low tax rates.

Efforts are also being made to enhance the size of formal economy by denying the input tax benefits to unregistered persons under the sales tax regime.  Section 2 (25) of the Sales Tax Act, 1990 reads that “a registered person means a person who is registered or is liable to be registered under this Act provided that a person liable to be registered but not registered under this Act shall not be entitled to any benefit available to a registered person under any of the provisions of this Act or the rules made there under.” Thus not only the registered person but also one who is liable to be registered under the Act falls within the purview of ‘registered person’. The ‘proviso’ provided in the very definition of ‘registered person’ is an illustration of the intention of the legislature to enhance the size of formal economy as one of the means adopted by the legislature to achieve the aim of bringing as many persons as possible into the formal economy is to provide incentives to persons who are registered under the Act, while expressly disallowing the same to those who fail to do so.

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