Value Added Tax Compliance in Cigarette Industry in Pakistan: An Empirical Analysis

Objective: Measuring tax compliance and evasion is particularly challenging because tax evaders have a strong incentive to conceal their actions. While assessing any crime presents similar difficulties, tax evasion is unique in that it lacks identifiable victims, meaning there are no victim reports or surveys to gather data from. However, unlike most crimes, changes in tax evasion can be observed through fluctuations in reported tax bases. The fear of punishment and potential social stigma makes many taxpayers reluctant to provide truthful responses, even in surveys conducted by organizations not affiliated with tax authorities. Consequently, almost all empirical studies on tax compliance and evasion, even the most reliable ones, lack an accurate measure of compliance and evasion. Voluntary tax compliance as a function of the tax rate is a critical determinant of tax revenue collection. As a result, a model and estimation methodology have been developed in this article to explore this relationship. Methods: This research offers a novel methodology for estimating tax compliance and the underground consumption by theoretically introducing and empirically estimating a tax compliance function for the cigarette industry in Pakistan. Results: In Pakistanʼs cigarette industry, the tax compliance rate is 11.53%, and 37.5% of cigarette consumption is underreported in surveys. Conclusion: Fractional compliance is inversely related to the tax rate. Tax revenue initially increases with higher tax rates, reaching a peak before declining as the tax rate rises. On the other hand, gross domestic product (GDP) behaves oppositely to the tax revenue. The highest GDP occurs at either a 0% or 100% tax rate, where tax revenue is zero. As the tax rate rises, GDP decreases initially until it reaches a minimum, after which it begins to increase again, eventually reaching its peak at a 100% tax rate at a specific point in time. This contrasts with the Laffer Curve, which suggests that a decrease in the supply of goods leads to lower tax revenue as the tax rate increases. (JEL A14, H19, H83)