Making taxation system reform central focus of public policy development

Muhammad Mahmood | Published: October 20, 2018 20:57:45

The taxation system in Bangladesh has proved to be very resistant to any fundamental change despite many efforts to overhaul it. More remarkable is the very vigorous persistence of resistance to any broad tax reform. Bangladesh in its continuing drive to achieve and maintain its growth trajectory needs a taxation system which combines a mix of taxes that encourages entrepreneurial drive, investment, innovation and, above all, creation of employment opportunities. At the same time the system must not discourage people participating in the workforce. It will be, indeed, a very retrogressive act to shun broad taxation reform from the policy agenda on the plea that it is deemed politically or administratively difficult. However, the absence of a broad taxation reform agenda cannot be an excuse to delay any tax reform.

As the Bangladesh economy continues to grow, the tax base will also continue to expand. A growing economy requires extra revenue to meet the increased demand for expenditure. But the country appears to be facing budgetary constraints with raising extra revenue to meet the increased demand for expenditure on infrastructure, education and health care. This is because the taxation system now in place appears not to be coping well to meet increased demand for public resources. For example, government tax revenue in 2016-17 equalled 11.17 per cent of Gross Domestic Product (GDP), one of the lowest tax/GDP ratios in the world. This indicates the inability of the system to tap the full revenue potential.

The tax revenue collection in Bangladesh has been much well below the level of countries having the similar stage of economic development. The narrow tax base and widespread exemptions including discretionary exemptions, which foster corruption and administrative inefficiencies, are the key factors that contribute to the low tax/GDP ratio. Even the existing flawed taxation system is seriously compromised. The share of VAT revenue, since its introduction in 1991, has increased with the expansion of its base but over time numerous distortions have been introduced resulting in the VAT system failing to generate revenue in terms of its potential.

In essence, the tax system is characterised by a large range of exemptions, incentives and special regimes with discretionary power given to tax collectors to interpret them. All these open up opportunities for both tax payers and tax collectors to bargain over the distribution of economic rents resulting from the manipulation of the system. Creation of "economic rents'' under such circumstances is a synonym for corruption.  The bargain over the rent remains within the framework of social power structure. Thus it does not create any vibes which may lead to upsetting the power balance in society and that remains the key to maintaining the stability of the system.

The taxation system in Bangladesh is administered by the National Board of Revenue (NBR) and taxes are collected through Direct Tax (income and wealth taxes) and Indirect Tax (VAT and Customs duties). There is a very heavy reliance on indirect taxes for revenue collection. In 2016-17, indirect taxes accounted for 69.83 per cent of total revenue collection. The principal sources of revenue for the year were VAT (37.98 per cent), Customs and Supplementary Duty or SD (30.48 per cent) followed by Income tax (29.50 per cent). The existence of an informal economy, estimated at equal to one quarter of GDP, makes it more difficult to make full coverage of the economy for tax collection. The main reason for the existence of an informal economy in developing countries like Bangladesh is the result of higher fixed costs of entry into the formal economy for those who are involved in legitimate economic activities.

When the tax reform was introduced in 1991 which brought in Value Added Tax (VAT), there was an implicit understanding at that time that reductions in trade taxes (tariffs) would follow with an increase in VAT to raise revenue thus making it revenue neutral. This is indeed the general consensus when such a change-over is made anywhere in the world. But still a significant amount of tax revenue comes from border taxes i.e. customs and SD, close to one third of total tax revenue (30.48 per cent in 2016-17). Domestic taxes are primarily from two sources - VAT (37.98 per cent) and Income taxes (29.50 per cent in 2016-17. But most income taxes are on corporate profits rather than from individual income earners. Corporate tax accounts  for bulk of total income tax revenue and about 2.0 per cent of the population pay any income tax (estimated to be 3.3 million tax payers in a country of 167 million people).

Overall, there is a very high reliance on consumption-based taxes (e.g. VAT, SD & import duty) and VAT, in particular. Such a very high level of reliance on consumption-based taxes is symptomatic of a tax system incapable of designing and implementing a fair and equitable taxation system. The economic literature is quite unanimous on the regressive nature of any consumption-based taxes - and more so is in poorer countries like Bangladesh. It appears that the government is unable or unwilling to expand the scope of direct taxation based on income and wealth. Only an expansion of direct taxation base can ensure the application of the basic principles of taxation - fairness and equity. On the contrary, it appears that the government has been expanding the scope of indirect taxes based on consumption. Such a policy favours a number of industry groups as they not only pay a very small amount of direct tax but also benefits in many instances from tariff protection.

Why the Bangladesh taxation system is so resistant to change, let alone any fundamental change? Also, why whatever changes that have been designed or introduced (mostly at the behest of the International Monetary Fund or IMF and the World Bank) get compromised with the progression of time? It is well recognised that resistance to tax reform comes largely from two groups: firstly, from the corporate sector including small businesses and shop owners who are very well organised and who also have personal ties to the political establishment (in fact almost half of the current members of the Bangladesh Parliament are directly or indirectly connected to just one industry, RMG and  other members have significant connection to other industries including  the powerful financial sector); and secondly, the tax administration itself which has vested interest in defending the existing system because it enormously benefits tax officials at the expense of maximising tax revenue. Consumers, being a very disparate group, are not organised for their voice to be heard.

Despite repeated government attempts to bring in ambitious changes to tax laws, most of these reforms have been very convoluted, even suffered delays and reversals under intense pressure from various interest groups. The integrity of the tax system that exists now has been undermined by tax officials by using their discretion both in terms policy development and administration. The tax administration system remains very complicated so much so that it works against potential revenue collection even under the existing tax laws, and also equity and fairness. As a consequence the system fails to raise sufficient tax revenue for the government.

Fundamental changes to Bangladesh's taxation system should now be the central focus of public policy development to face the challenges of economic growth. The tax reform must focus on the existing taxation system with particular emphasis on reforming the direct taxation regime rather than tax design. Tax reforms rarely follow the text-book ideals as espoused in the theory of taxation - equity and efficiency. Yet, any tax reform in a country like Bangladesh, where the vast majority of the people are poor,  is to be made in a way which generates increased revenue while improving income distribution with incentives for efficiency.





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