Direct taxation is considered an important fiscal instrument for spurring economic growth and redistribution of resources across different strata of society. However, it is abundantly clear that direct taxation has failed to achieve this goal so far.
There are several reasons for the failure of direct taxation in effective redistribution of resources, despite a significant rise in direct tax revenues.
Income tax is the only major direct tax levy and the share of income tax (corporate and individual) in total tax revenues has increased from about 20 per cent in 1991-92 to about 38 per cent in 2011-12. The average growth of income tax revenue was nearly 20 per cent over that period.
Looking at the three modes of income tax collection, more than 55 per cent of income tax is collected through a withholding mechanism. Of the total withholding tax collection, about 97 per cent comes from contracts, imports, salaries, telephone, exports, securities, electricity bills, dividends, cash withdrawal, surcharge, commission, transport etc.
Withholding tax collection is also an important source of direct tax revenues in advanced economies. For instance, about 27 per cent of the income tax was collected through this mode in Japan during 2012-13.
However, there is a big difference in the operational methodology of withholding tax in Pakistan and advanced economies. Withholding taxes in advanced economies are largely allowed to be adjusted against the gross tax liability at the time of filing tax returns, or taxpayers have the option to treat withheld taxes as final or adjustable for their convenience.
In sharp contrast, a majority of withholding tax cases here, final discharge of tax liability and taxpayers are not allowed to adjust against their gross tax liability. Non-adjustability of withholding taxes gives the spirit of indirect taxation, weakening the redistributive power of direct taxation.
There is huge tax evasion as measured by the tax gap, which also reduces the redistribution power of direct taxation. For instance, the direct tax gap was estimated to be around 143 per cent of actual direct tax revenues of Rs183.1 billion in 2004-05. In another study, the tax gap was estimated to be 97 per cent of actual receipts of salaried taxpayers, and 15 per cent of actual receipts of non-salaried taxpayers. This amounts to a tax gap of 27 per cent of individual tax revenues and three per cent of federal tax revenues in 2007-08. Likewise, the corporate tax gap was estimated to be about 218 per cent of the actual corporate income tax payments for 2007-08.
The informal economy is another factor that is weakening the redistribution power of direct taxation. The size of this economy was estimated to be 30 per cent of the total size of the economy in 2009-10. As long as the money continues changing hands in the informal economy, fiscal policy would largely remain ineffective in redistribution of income.
A long list of exemptions in the income tax law also favours wealthy people. Taxation of agricultural income is virtually exempted. About Rs70 billion in income tax revenue was lost due to various exemptions on account of income tax during 2011-12. The government provided subsidy to the tune of about four per cent of GDP during 2007-08, largely to the power sector, but the country is unable to cope with the electricity shortage.
Last but not the least, there is no levy on inheritance, wealth or gifts in the country. The absence of such a levy has certainly aggravated the problem of income inequality. As long as there is no inheritance tax, a few big landlords and wealthy people would continue to see their wealth blooming.
In advanced economies, inherence tax collection is sizeable. For instance, in Japan, inheritance tax revenue was 3.5 per cent to total tax collection during 2012-13.