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February 13, 2014
News Analysis: Should Donor Countries Push Tax Reform?
by Stephanie Soong Johnston

Full Text Published by Tax Analysts®

The highest echelons of Pakistan's government were rattled as 2013 came to a close, and for good reason. A December 23 report from the Centre for Investigative Reporting in Pakistan (CIRP), an independent nonprofit organization, showed that nearly half of all lawmakers who won in Pakistan's May 2013 general elections paid no income taxes, and that more than 10 percent didn't even have national tax numbers, which are required in order to file tax returns. The report also noted discrepancies between what taxpaying lawmakers said they had paid and what was recorded with the Federal Board of Revenue (FBR), Pakistan's tax authority.

The international media quickly took notice, and word of the report spread rapidly. It soon became clear that Pakistan's tax evasion problem could have a dire effect on international aid and tax reform, which has long kept the country afloat. A December 23, 2013, Reuters article said the CIRP report's findings "may endanger the billions of dollars in IMF and other loans and aid shoring up a faltering economy."

It's no secret that Pakistan's tax-to-GDP ratio is one of the worst in the world. According to the FBR's most recent report on its performance in 2012-2013, the tax-to-GDP ratio dropped to a dismal 8.5 percent, down from 9.1 percent in 2011-2012, yet the country continues to receive financial assistance from the international community.

However, there have been signs that donor countries, specifically the U.K., are displeased with Pakistan and its inaction on tax evasion.

An April 4, 2013, report from the U.K. House of Commons International Development Committee (IDC) examined the rationale for the Department for International Development's (DFID's) decision to increase aid to Pakistan from £267 million in 2012-2013 to £446 million in 2014-2015, which would make the country the top recipient of U.K. aid.

While the IDC acknowledged that development aid is needed to support the poor who benefit from DFID-funded programs, it also proposed that any future planned increases in U.K. development assistance be conditional on the Pakistani government's efforts to collect more tax from the wealthy.

"If the Pakistan government is unwilling to take action to increase its revenues and improve services for its people, it cannot expect the British people to do so in the long run," the IDC said in the report. "We cannot expect the citizens of the U.K. to pay taxes to improve education and health in Pakistan if the Pakistan elite is not paying income tax."

The question remains: Should donor countries use their clout to push for tax reform in the countries that receive their financial support, and if so, can that work in Pakistan?

'Misrepresentation by Taxation'

The CIRP report, "Misrepresentation by Taxation," analyzed the income and tax records of candidates who won seats in the National Assembly, the lower house of the Pakistani parliament, as well as in the four provincial assemblies of Balochistan, Khyber Pakhtunkhwa, Punjab, and Sindh, during the country's landmark general elections on May 11, 2013. The elections were historic for Pakistan, as they marked the first civilian transfer of power after the end of a democratically elected government's five-year term.

However, the elections also presented a prime opportunity for CIRP to examine the tax compliance of elected officials. According to rules laid out by the Election Commission of Pakistan (ECP), all electoral candidates must file nomination papers comprising income statements and tax records for the past three years; the FBR was also required to provide the candidates' income and tax details. All the information, from both candidates and the FBR, was posted on the ECP's website.

CIRP took the publicly available data on the ECP website and measured them using five variables:
How many candidates had national tax numbers?
Did the candidates pay any income tax?
Were there any differences between the tax declarations made in candidates' nomination papers and the tax returns?
Did the candidates declare their annual incomes?
Were there any differences between the income declarations in candidates' nomination papers and the income data in their tax returns?

The report noted that of the 1,070 lawmakers elected to the national and provincial assemblies, information was available for 1,016. Of those 1,016 lawmakers, 461 did not pay tax (45 percent) and 550 (54 percent) claimed they paid taxes. The report also said that 123 lawmakers did not have national tax numbers.

Of the 550 lawmakers who said they paid tax, the tax claims of 171 (31 percent) contradicted the FBR data. The report noted that in general, lawmakers with discrepancies in their records fell into two camps: those who claimed they made tax payments but didn't, according to FBR data, and those who reported their tax payments as higher than what the FBR had on record.

The report also found several discrepancies in the politicians' income declarations. Of the 680 lawmakers who declared their income, the data of 169 (25 percent) conflicted with what was reported in tax returns on file with the FBR.

The report's findings resonated with the public, who realized that politicians were not paying their fair share of taxes, according to Umar Cheema, the report's author and co-founder of CIRP. Cheema, an award-winning investigative journalist for the Pakistani newspaper The News, said the paper was a follow-up to a similar report on Pakistani politicians' tax compliance that was published in 2012.

The earlier report focused on 446 federal lawmakers in the Senate, or upper house of parliament, and the National Assembly and relied mostly on tax returns that incumbent members of parliament filed in September 2011. Cheema painstakingly collected details about MPs through informal and formal sources, such as letters requesting data directly from MPs, nomination papers obtained from the ECP, and data collected from sources within the FBR. According to the information available at the time, Cheema found that 67 percent of lawmakers filed no tax returns, and that about 20 percent did not have a national tax number.

Cheema told Tax Analysts that after his first report was published, the ECP contacted the FBR to verify the tax claims of the MPs when they were running for office, but it made no effort to further scrutinize any discrepancies between what MPs had reported in their nomination papers and the FBR data. Also, no politicians were disqualified for furnishing false information in their nomination papers.

The Pakistan Muslim League (NAWAZ), which now has a majority in the government after the 2013 elections, ordered its election candidates to file tax returns. However, according to Cheema, "the order turned out to be a media statement, as many lawmakers of the party have been found without [national tax numbers], are non-taxpayers, and have discrepancies in [their] income and tax details."

Shoaib Suddle, Pakistan's federal tax ombudsman, also took notice of the first report and ordered the FBR to release an annual tax directory for all public officeholders, as is required under the country's income tax laws, but there was no immediate movement on the issue. Suddle has since retired.

At the international level, CIRP's initial report on lawmaker tax compliance was used as testimony in January 2013 while the IDC evaluated the U.K.'s development aid to Pakistan. "The committee asked the DFID minister to confront Pakistani authorities on noncompliance of lawmakers [with] tax laws," Cheema said. "They may have done it, but no visible improvement on the lawmakers has been noted, as our latest report suggests."

However, it could be only a matter of time before the U.K.'s efforts to push the Pakistan government to deliver on tax reform are successful.

"That reform must start from the top down, with elected politicians and the wealthiest in Pakistan showing a commitment to reform by submitting tax returns and paying tax due," a DFID spokeswoman told Tax Analysts. "The U.K. government is clear that U.K. development assistance in Pakistan is predicated on a commitment to economic and tax reform and to helping lift the poorest out of poverty."

The spokeswoman said the U.K. has offered the new Pakistani government practical assistance to facilitate tax reforms, but she emphasized the importance of Pakistan's willingness to implement tax and economic reforms on its own.

"We have made it clear to government and opposition politicians in Pakistan that it is not sustainable for British taxpayers to fund development spending if Pakistan is not building up its own stable tax take," she said.

Trickling Down

Much is to be gained from tracking and publicizing the tax details of Pakistan's elected officials as a way to pressure the government into tax reform.

"A persistent spotlight on the taxes of lawmakers will improve the culture of complying with tax laws," Cheema said. "Lawmakers are the only authority to impose tax; no other institution can. Once they set a good example, others will follow."

Encouraged by the international attention his second report has received since it was published in late December, Cheema vowed to continue collecting data and publishing follow-up reports until it becomes commonplace for politicians to publish their annual tax declarations. "Once it happens, they will be concerned about complying with tax laws, knowing that failing in this will bring them huge embarrassment," he said.

John Christensen, director of the Tax Justice Network, agreed that a top-down approach to tackling tax evasion is ideal, since individuals in the lower social classes are likely to have little incentive to pay their taxes if wealthier people can easily avoid theirs.

"A fish rots from its head," he said. "Any attempt to tackle corrupt tax practices should start at the top, preferably with complete abolition of all tax exemptions given to politicians and a massive rolling back of exemptions to rentier and business elites. Leading by example is the best way forward."

While Christensen opposes conditional aid in general, he sees a strong case for donor countries to make aid conditional on the creation of a progressive, fair, and transparent Pakistani tax system. External aid inflows may have had the unintended effect of alleviating pressure for reformation of Pakistan's regressive, exemption-ridden tax system, which is undermined by tax evasion among the country's rich and powerful. However, if aid were conditional on tax reform, Pakistani politicians, which have become reliant on that aid, would be made more accountable to external donors than to their electorates.

"The goal must be to reduce dependence by substituting tax revenues for aid flows," Christensen said.

Aziz Nishtar of Nishtar & Zafar Advocates noted that developed countries are obligated to contribute to development initiatives in recipient nations under the Monterrey Consensus, a document signed in 2002 by heads of state and world governments and adopted as a reference for cooperation in international development. However, Nishtar said that donor countries are able to impose "reasonable conditions" on countries that receive aid.

"In Pakistan's case, pressuring the government to impose equitable tax on the rich and powerful would not be an unreasonable condition by the donor countries," Nishtar said. "In my opinion, pro-people conditions would be welcomed not only by the general populace but also would not be taken as interference in the internal matters of the recipient states."

However, it's up to the recipient state to pull itself up on its own through equitable taxation, with donor countries as secondary contributors to development financing, he said. After all, the sustainability and success of the development process depends initially on domestic public revenue, according to Nishtar.

Because Pakistan's dismal tax collection levels may be attributed to a lack of political will and poor tax administration, it's crucial for the country to implement appropriate legislative changes and improve tax administration. Nishtar estimates that if those changes were made, PKR 3 trillion to PKR 4 trillion could be collected under current economic conditions without overburdening businesses and individuals.

"That would need both political will and visionary leadership to lead the tax administration," he said.

Paul Davies, head of the revenue reform team at Adam Smith International, agreed that in developing countries, the government is typically controlled by a "narrow elite" that looks after its own interests instead of the public's.

"Solving it requires application of fundamental governance reform, and sometimes a long period of cultural adjustment," Davies said. "Political will and leadership within developing countries is absolutely essential, but strong support from donors has been shown to be vital as well."

He noted that it's uncommon for tax reform to be a strict precondition for aid but that typical key elements of advice from bilateral donors, the World Bank, and the IMF include introducing VAT, broadening the tax base, and setting up large-taxpayer offices in developing nations. The IMF is known to use these tax reforms as benchmarks to measure the success of its programs, which many developing countries, including Pakistan, rely on.

"The implication is therefore that without such reforms, developing countries risk losing support from the international community and" international financial institutions, Davies said.

Kieran Holmes, commissioner general of the Burundi Revenue Authority, said that donor countries must at least have a moral responsibility to insist that recipient countries make tax reforms, since development assistance comes from donor countries' own taxpayers.

Holmes has long advocated that international development aid be linked to a recipient country trying to make responsible fiscal reforms and that assistance provide the recipient countries with the expertise needed to implement those changes.

Holmes said that although he knows of no country that has formally made tax reform a precondition for development aid, the terms "precondition" and "conditionality" may be too strong for use in the donor-recipient relationship.

"Rather, donors should try to incentivize tax reform while bearing in mind that incentives can be both positive and negative," he said. "After all, aid is meant to be a partnership, with donors providing the assistance that the country is not able to provide for itself."

Other Tactics

Donor countries should also consider the diaspora in post-colonial or post-conflict recipient nations. "Donors should work with the diaspora when designing aid programs, particularly where tax reform is involved," Holmes said.

Also, donors should help improve tax compliance by offering technical assistance to a recipient country's tax administration to promote and support a range of reforms, according to Davies.

"Combating tax evasion at all levels is a core aspect of this. The other core aspect is to reduce compliance costs for both taxpayers and tax administrators," he said, adding that tax administration reforms can be complicated and take years in underresourced countries. "The reforms should be comprehensive and developed evenly to avoid the impression that motives are political or temporary."

Such reforms include making tax administration based on self-assessment, with an emphasis on streamlined and non-intrusive, risk-based approaches to compliance; getting intensive support to develop efficient information technology systems, implement proper infrastructure and equipment, and promote taxpayer communication and education; and focusing on improving areas of tax administration that collect the most revenue, such as establishing and developing an office dedicated to large taxpayers, as well as targeting reforms in geographic areas with the most revenue potential, Davies said.

Donor countries must also make a strong effort to eliminate exemptions awarded to special interests, including politicians and their benefactors, according to Christensen. Costs should be worked out for exemptions each year and itemized separately in annual financial statements, and governments should hold public debates about exemptions and conduct cost benefit analyses to justify each one.

"Priority should be given to tackling tax evasion and avoidance," Christensen said. "In most cases, this will require building the capacity of the tax authorities, especially in the area of taxing corporate profits."

However, promoting corporate tax reform in developing countries is easier said than done. Holmes, who has worked to improve the tax systems in several developing countries besides Burundi, including Kiribati, Rwanda, Yemen, Lesotho, and Swaziland, has encountered resistance from donor countries when it comes to taxing corporations.

"Tax reform in developing countries usually needs external factors to provide its impetus," Holmes said. "In the six or so countries where I have spent some years, I have found myself being that impetus, often in the teeth of opposition from donors who were in cozy relationships with international companies that benefited from domestic tax exemptions."

According to Holmes, Africa is the birthplace of transfer pricing and base erosion. Fifty or 60 years ago, multinational corporations wanting to invest in Africa included transfer pricing arrangements in their investment strategies and often negotiated low corporate tax rates to reduce the risk of doing business in politically unstable countries, ensuring they would get a minimum amount of profit with little trouble, he said.

"Transfer pricing was probably the only way that their investors and shareholders would invest in those countries at that time," Holmes said. "But I think that reason no longer applies. Africa has been going strong for many years now."

Developing countries therefore need the international community at large to crack down on transfer pricing abuse. According to Christensen, the existing rules for taxing multinational corporations leave the door open for shifting profits to tax havens, and international tax rules need a complete overhaul to tax multinational corporations based on where their economic activities take place.

"Developing countries must engage with the OECD [base erosion and profit-shifting] program to ensure this process doesn't result in a quick-fix bodge which serves the interests of OECD countries but not others," Christensen said, adding that it is also important for developing countries to combat tax haven secrecy by pressuring the G-20 to create an international framework for multilateral exchange of information and to clamp down on tax evasion.

A Ripple Effect

The CIRP report may have sparked a broad discussion about the role of donor countries in promoting tax reform in recipient nations, but at its core, it has a clear objective -- to help keep Pakistan's serious tax evasion problem in the public eye.

Cheema said that reports on politicians' tax compliance have led to greater public awareness and to real signs of change. He noticed that lawmakers who had previously paid very little tax in the past have made notable increases in tax payments to avoid bad publicity and that the Election Commission of Pakistan made a better effort to upload to its website data of the 23,900 candidates who initially registered to run in the 2013 election.

Also, the government's swift public response to CIRP's most recent report seemed to indicate that it had stirred up a hornet's nest. Within days of the report's publication, the FBR posted a news release on December 27, 2013, to distance itself from the CIRP report and assure taxpayers that there were no security leaks involving taxpayer information. The agency also clarified that the discrepancies in parliamentarians' tax declarations were independently verified by CIRP using publicly available records on the ECP website and that the FBR did not directly participate in the report.

"The tax authorities, instead of proceeding against the culprits identified in the report, have issued a clarification stating that the findings of the report were mine and not theirs," Cheema said.

On January 1 the FBR posted another news release announcing that the Public Accounts Committee, a body within the National Assembly that monitors public spending, had discussed the report in a meeting with Secretary of Finance Ishaq Dar and FBR Chair Tariq Bajwa. According to the release, members of the Public Accounts Committee "expressed annoyance" about media reports alleging that they do not pay income taxes, arguing that income tax is deducted from all parliamentarians' salaries and that they also pay agricultural tax to provincial governments.

The Public Accounts Committee asked the FBR to clarify the rules, and the FBR confirmed that income tax is deducted on parliamentarian salaries under section 149 of the Income Tax Ordinance, 2001. However, the tax authority clarified that parliamentarians' agricultural income is taxable at the provincial, not the federal, level.

The FBR then seemed to go on the defensive. In a January 3 news release, it said it had explained to the Public Accounts Committee that even though income taxes are deducted from the salaries of MPs, every taxpayer is required to file an income tax return. Those tax records remain confidential except in the case of public officials, whose tax details may be published by the federal government.

The FBR also said it took "strong exception to the negative profiling of its entire workforce" in the media, arguing that it has made "concerted efforts" to hire officers with integrity to important posts.

But perhaps the most telling sign that the CIRP report raised concerns was Dar's announcement on January 6 that he had directed the FBR to assign national tax numbers to all MPs by January 31. He also said that a directory of parliamentarians' tax details up until January 31, 2013, will be published by February 15, 2014, and that a directory of tax details for all taxpayers will be implemented by March 31, 2014. Both directories will contain names, national tax numbers, annual income, and tax paid.

Cheema said Dar had called him directly to inform him of the decision to make all taxpayer records public.

"I believe that the publication of a tax directory will improve the culture of tax compliance," Cheema said. "Our last report had also demanded the publication of a tax directory. By releasing this, Pakistan will be the fourth country in the world after Sweden, Norway, and Finland to publish an annual tax directory."

According to Cheema, Dar also said that during a recent meeting, officials from the U.K. and the U.S. had asked him why 12 percent of lawmakers did not have national tax numbers. Apparently, those officials had only become aware of that statistic through the CIRP report.

The report's findings underscore the need for international pressure on Pakistan to make substantial tax reforms. "Tax issues should be taken as seriously as terrorism," Cheema said.

Stephanie Soong Johnston is a reporter with Tax Notes International.
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