Why is Bangladesh so bad at collecting taxes?

The year 1991 marks a watershed in the taxation system in Bangladesh. In that year, the indirect tax system got a shot in the arm and Value Added Tax (VAT) was introduced to replace the age-old cascading sales tax.

Before that came the Income Tax Ordinance in 1984. But it didn't bear much significance as it was virtually a newer and simpler version of the British-era Income Tax Act of 1922.

Significant and more substantive changes in the direct tax system started taking place from 1991 thanks to the waves of economic liberalisation throughout the world with the collapse of the Soviet Union.

All of these changes in the legal setup in the direct and the indirect taxation systems were made at the behest of the structural adjustment programme of the IMF and World Bank. Bangladesh now had a sustainable tax-revenue generation and management regime that would allow the country to break away from the foreign-aid-dependent economic development regime.

To complement the legal reforms, important managerial changes were also underway with the direct recruitment of personnel through Bangladesh Public Service Commission made fairly regular from the early eighties.

VAT is a tax on consumption at each stage of the value chain. As the good or service progresses through the value chain, VAT is collected based on the value created at each stage as opposed to sales tax which is collected only at the final consumption stage.

At each stage, a purchaser can claim credit for the tax paid at the immediately preceding stage in the value chain. This tax is collected and remitted to the tax authorities by a vast multitude of business establishments.

As such, the VAT system requires sufficient invoicing and record-keeping, and strict monitoring on the part of tax authorities to stop tax evasion by the collection agents.

On the other hand, a big portion of the annual collection of income tax is also collected in advance (AIT- advance income tax and TDS- tax deducted at source) by the business establishments and other collection agents whose number is growing each year with the expansion of the system.

Here also, adequate invoicing and record-keeping is a sine qua non for the system to be protected from misuse and tax evasion.

Improving the VAT system requires sufficient invoicing and record-keeping, strict monitoring, and sincere efforts by the VAT collecting agents. PHOTO: COLLECTED

The other (final) part of the income tax collection results from the year-end calculation of the taxpayer. From 2007, this has also been transferred to the taxpayer through the enactment of the universal self assessment system. However, this was done without any well-coordinated plan of action.

Regardless, all these developments in both the direct and the indirect tax systems have revolutionised the private sector's role in government tax collection and management.

Given that businesses and taxpayers now have the lead role in taxing exercise, the tax office must play their legally mandated role of overseeing the entire exercise to protect government revenue.

Since VAT increases the price of products or services, business establishments may opt not to collect VAT from customers or they may collect but not deposit the same to make the tax a source of income for themselves to remain competitive in business.

TDS, on the other hand, is the final tax and does not come in the usual year-end proforma total income and tax liability calculation.

So, tax collecting agents may, in connivance with the taxpayer, opt not to collect the tax or collect it at a lower rate or may collect but not deposit the same in the government accounts.

In a weak enforcement environment, malpractices by taxpayers and collecting agents proliferate and frustrate the revenue collection objectives of the government.

How to stop these malpractices

One way to stop such malpractices is to make the act of cheating costly for the taxpayer and collection agents by implementing deterrence. Given the deterrence measure (rate of penalty), the cost of cheating for a taxpayer/collecting agent is given by the following equation.

cost of cheating = rate of penalty * probability of detection

This implies that deterrence is not enough to discipline taxpayers unless the probability of detection is also high. However, in reality, only a small number of cases are audited and the probability of detection depends upon the probability of being selected for audit.

After a case is selected for audit, the probability of detection of cheating then depends upon the capability of the tax office to unearth adequate information against the accused on selected audit issues.

This detection capability depends upon certain things such as the quality of audit selection, the existence of a third-party reporting system, the quality of human resources engaged for the work and the technology used for the purpose.

Assuming that human resources with a certain level of training exist, the probability of detection of cheating then depends upon the other three criteria.

Ideally, audit selection needs to use stratified random sampling methods based on criteria like profession, income size, the volume of turnover, location of business of the taxpayer etc. The selection process should be automated and the selection criteria should be announced in advance before the beginning of the tax year.

In Bangladesh, however, audit selection is done manually by the people under whose jurisdiction the cases fall and there is no standard operating procedure for the purpose.

As a result, there is a very high probability of the selection being tainted by subjective bias and the revenue-risky cases may not be selected for audit. In such a situation audit selection criteria may get compromised.

The selection decision is often made much late in the year and the officials don't have sufficient time left to complete their scheduled tasks within the legally mandated time.

When these happen the entire policy tool of audit is rendered meaningless. And when audit-tool as a threat to evasion becomes ineffective, self assessing taxpayers hardly care for compliance.

The need for a third-party, automated reporting system

An integrated third-party reporting system does not exist in Bangladesh. For certain types of income like labour income, interest, dividend etc., it exists in law and tax authorities sometimes collect certain information from land registry offices, banks, city corporation offices (for real estate property), territorial survey and the like.

But in absence of any automated database, necessary information may be lost or be difficult to collect. More importantly, the available information can hardly be matched and processed with taxpayer records.

In absence of any database generated from third-party reporting networks, whatever audit is conducted has no verifiable hard data to rely on and, as a result, has become a mere repetition of the 'estimate-based' discretion tyranny of the tax officials.

Any watchful observer may even notice a rather lenient societal attitude towards income tax cheating in Bangladesh. Penalty for tax cheating, for instance, has been drastically brought down from the range of two-and-a-half times (in normal cases) or five times (in self assessed cases) of the evaded tax to only 10 per cent in 2008.

Given the profit margins in businesses and interest earnings on saving schemes, this change has made income tax cheating virtually costless.

Similarly, the provision of charging additional interest on late payments of arrear income tax has also been abolished in 1998.

While the collection of additional interest on arrear utility charges like electricity, gas and government land development tax is still mandatory and built into the system, the different treatment to arrear income tax payment may send the wrong message to the public.

Depending on the rate of inflation, this has also reduced the real value of arrear income tax collection (Tanzi-Olivera effect). In the case of VAT, in contrast, the penalty was 200% of the tax up to FY 2020-21 which has been reduced to 100% from FY 2021-22.

The late-payment interest, on the other hand, was 24% per annum up to FY 2020-21 which has been reduced to 12% from FY 2021-22.

One factor that has seriously entangled the tax auditing mechanism in particular and tax collection machinery in general into a serious conflict-of-interest zone is the insider tax practice phenomenon.

Many tax officials while holding positions in office also engage themselves as (hidden) consultants to taxpayers. While still holding official positions, they camouflage themselves as relatives and friends of taxpayers to extract the best deal for them from subordinate officials through influence-peddling.

After retirement, they just walk into an already established tax-practising business with an already secure clientele base. In such an office environment, wrong cases get selected leading to loss of potential revenue and non-complying taxpayers driving out still-complying taxpayers. This practice has become a major source of the lack of professionalism and tax evasion in Bangladesh.

All these factors have combined to exert a very strong pull-effect on due compliance by taxpayers and a very strong push-effect on tax evasion to keep the tax-GDP ratio stagnant while GDP continues to grow over the last two decades.

The author is a retired Commissioner of Taxes. He can be reached at [email protected].

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.