Wednesday June 19, 2024

Inflation and taxes

By Ammar Habib Khan
May 26, 2024
People buy pulses and grains at a wholesale market in Karachi. — AFP/File
People buy pulses and grains at a wholesale market in Karachi. — AFP/File

Indirect taxes make up roughly 60 per cent of total revenue collected by the government, while sales tax makes up 65 per cent of total indirect taxes.

Even direct taxes are largely extracted through withholding taxes, which is a form of an indirect tax, as many households that pay such taxes are often not able to claim such taxes due to complexity of the process. This is an easier way to extract taxes, without calling them indirect in the process. For example, it is estimated that more than Rs70 billion were recovered through usage of telephone from consumers across the country, while more than Rs86 billion were recovered through electricity bills from consumers across the country, mostly residential consumers, who are not able to claim this back.

Digging deeper, indirect taxes on food, beverages, tea, juices, etc. and other consumables, make up more than 12 per cent of sales taxes that are collected by the government. Indirect taxes whether in the form of sales tax, duties, or any other nomenclature increase prices across the board for all economic segments, and are distortionary. A high indirect tax on food and other consumables creates a lopsided environment where more vulnerable households, and income groups pay a higher quantum of taxes relative to their income, compared to richer households.

Such excessively layered taxation creates an environment that leads to an incentive to evade taxes through smuggling of consumables that are not manufactured in the country. Grocery shelves across the country are loaded with smuggled products at various price points. This effectively makes locally produced goods uncompetitive, as the same are loaded with various layers of taxation. Similarly, the consumer continues to burden the weight of indirect taxes.

A higher incidence of indirect taxes is effectively inflationary. Prices are downward sticky, which simply means that once prices increase, they are slow to come down, or rather remain flat. Once taxes are imposed, the price inadvertently increases, the burden of which is paid by the consumer’s wallet. Even when such taxes are reduced, or removed, the prices don’t really come down fast enough, as the available room is covered through an increase in price by the seller to ensure price stability.

Indirect taxes are the easiest way to generate revenue. A simple order that imposes or increases taxes on consumables, which can be something as basic as juices, which are largely manufactured locally, or something that is predominantly imported such as tea, or even electricity can lead to sizable collection in taxes without much effort of the tax authorities. However, this leads to unintended consequences, such as product demand reducing due to higher prices, eventually resulting in a disincentive for the producer to expand production, or scale.

Another unintended consequence is an increase in smuggled goods, which further disincentivizes producers, while also negatively hampering any formal industrial growth. Finally, the consumer continues to pay a heavy price in the form of inflation. Moreover, an increase in indirect taxes effectively fuels inflation, because such taxes are imposed to address budget deficits, which are covered through borrowing. The average consumer unfortunately carries the burden of inflation due to reckless spending at a macro level.

Although it has been mentioned infinite times to no avail, expanding the tax net to bring in more sectors in the economy is a more optimal decision than simply increasing indirect taxes. Such taxes have increased to a point where any more increase will only lead to lower formal consumption, and increasing reliance on smuggled goods, and a grey economy.

Indirect taxes need to be rationalized in a manner such that the overall tax net can be expanded, rather than further deepened. The limit to which existing taxpayers can be taxed has been effectively reached. By imposing or increasing taxes on essential consumables, or even key inputs, another inflationary spiral would be just around the corner.

There is no denying that ambitious tax targets need to be met to reduce deficits, but this needs to be done by expanding the tax net, bringing into the net those households and businesses that do not pay their fair share of taxes, and by rationalizing expenditures. Any more increase in indirect taxes will only result in contraction in local output, an increasing share of the grey economy, and inflation for the more vulnerable households.

Industrial growth has been flat-lining, and electricity consumption by industrial users has been declining. A tax policy that effectively discourages consumption of goods, to be substituted by the grey economy has resulted in a gradual drop in consumption of locally produced (and taxed) goods leading to a slow, and painful deindustrialization process.

If the country needs to reverse the course of deindustrialization, and make the taxation policy more equitable, it is essential that the tax net is expanded, and rates are rationalized across the board. These may be tough political decisions, but we aren’t the first country to do this. We can either take tough decisions, or slowly watch deindustrialization take place, and the purchasing power of households erode right in front of us.

The writer is an assistant professor of practice at the School of Business Studies, IBA, Karachi.