Famous scientist and philosopher Benjamin Franklin (1706-1790) once said that in this world, nothing can be said to be certain, except death and taxes. Death, of course, cannot be avoided; but what about taxes? Let us talk about the current level of tax coverage and compliance in Nepal.
Are people looking at taxes as being as absolute and certain as death, and complying fully with it? How many people and businesses are registered with tax authorities? Are all the income earning sectors/persons paying taxes? This article is a small effort to analyze the tax compliance level in Nepal and to initiate a discussion on tax reform.
The financial year 20011-12 has been a successful year in terms of tax collections in Nepal . The revenue growth was over 22 percent, which exceeded the target by over Rs 2 billion. Such success is rare for Nepal. However, there is no room for complacency. In Nepal, just over eight hundred thousand taxpayers are registered into the tax bracket from a population of over 28 million. The tax –GDP ratio is about 13 percent, even lower than the Low Income Countries (LIC) average, which stands at over 15 percent .
A tax compliance cost survey conducted by IFC has revealed compliance costs are unnaturally high in Nepal. In the Doing Business Report of the IFC , Nepal ranks 107th among 180 countries studied in the report. Studies from the Asian Development Bank (ADB) and the World Bank have suggested that about 38 percent of Nepal’s economy is being run through the informal sector. Moreover, due to the meager domestic revenue, the government’s dependence on foreign aid - which is not a sustainable or predictable source - is very high. Hence, initiating tax reforms is of utmost importance.
Though some reforms have been carried out in the past decade and a half –the implementation of Value Added Tax (VAT), restructuring of tax administration with the application of functional structure and writing a new Income Tax act– they remain insufficient. N. Gregory Mankiw, professor of economics at Harvard University, has summarized the principles of tax reform into four broad categories, which are concise and widely agreed upon. They include, broadening the base lowering the rate (BBLR), taxing consumption rather than income, taxing bads rather than goods, and KISS – Keep it Simple, Stupid.
The BBLR simply means widening the tax base to bring all potential payers within the tax net. Tax deductions and exemptions should be either zero or at a minimal level. Such a rule broadens the tax coverage and the tax incidence is distributed among a larger segment of the population. This yields a higher collection despite maintaining low tax rates.
When the base is narrow, the existing taxpayers will be charged higher rates to meet government targets and the growing expenditure needs. This will discourage tax compliance and may even force taxpayers to enter the informal sectors. Any tax reform should start from this point and aim at reversing this situation.
Likewise, the second category - taxing consumption rather than income - is based on a simple principle of ‘pay taxes as you spend money’. Higher the consumption, higher the tax. The popularity of Value Added Tax (VAT) worldwide can be linked to this principle. Even the USA, which earns a handsome revenue from income tax, is preparing for VAT. A consumption-based tax is popular because any tax on the income hurts not just the income earners but also economic growth because there will be no incentive for people to save and invest. An economy cannot thrive without a robust level of saving and investment.
The third principle, taxing bads rather than goods, is again a simple formula. Society would want less of ‘bad things’ but more of ‘good things.’ So tax the ‘bad things’ more, and ‘good things ‘ less or do not tax them at all. For example, levy heavy taxes on fuels, which are a source of pollution, or on alcohol. But levy less tax on education materials, medicines, etc. Professor Mankiw says that by taxing bad things more, we could tax good things less. This is what every government would want too.
It is due to meager domestic tax revenues that the government’s dependence on foreign aid is high. Hence the need for vital tax reforms now.
KISS, the fourth and the last principle, advocates for keeping tax laws, rules and processes simple as well as taxpayer and compliance friendly. This helps minimize compliance costs as well administrative costs. In such a situation, the cost of compliance will be less than the cost of non-compliance and hence, there would be an incentive to enter the tax net and pay taxes. Voluntary compliance will increase. Clarity in tax laws makes the system transparent, and the effortless process of filing returns, tax calculation and payment would also reduces chances of collusion between taxpayers and tax officials. An extensive application of IT in taxation would be one of the best instruments for keeping the system simple and taxpayer friendly.
These four principles provide a broad direction for tax reform. However, tax collection and compliance depend on several variables, including the structure and composition of the economy, apart from the efficacy of tax policies and administration. How far countries are able to apply these principles depends mostly on their commitment to reform.
For Nepal, given that a very small fraction of the population is registered in the tax bracket and the tax-GDP ratio still leaves a lot to be desired, there is sufficient ground and need for a broad-based reform, while keeping the policies, processes and administration simple. Moreover, the enormous resource gap for the economic development of the country has made the need to enhance tax revenues even more critical. Nepal must initiate tax reform, and as soon as it can.
The author is deputy director general, Inland Revenue Department. Views are strictly personal.