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Economic notes

April 3, 2018

Economic reforms: part - XVI


April 3, 2018

Returning to our series on economic reforms, we turn to the subject of taxation that lies at the core of our economic malaise. As in previous articles in the same series, this one also focuses on major policy initiatives adopted in the last three decades to develop and evolve a tax system capable of generating the amount of resources consistent with our governance, security and development needs.

Tax revenues are the basic source of income to meet government expenses, both for running the government and undertaking its economic development. A tax system that does not generate enough resources, poses danger to the sovereignty and integrity of the country. In its absence, two things happen: first, the country uses its special privilege of borrowing from residents and thus begins the process of debt accumulation. This process has serious distributional consequences as only the wealthy lend to the government – often those who may have succeeded in not paying any taxes. Second, and because there is often the shortage of external resources, the country borrows from foreign countries – bilaterally, multilaterally and from capital markets and commercial banks.

All governments borrow and nearly all developing countries borrow from external sources in the initial phase of their development. It is the dependence on borrowed resources, both local and foreign, that is dangerous. A reasonable constraint of the borrowing policy is that it should only be as much as is needed to meet development needs, which means that borrowing should not be for paying salaries to government servants. Therefore, a fundamental question we ask is whether our tax system is sufficiently responsive to at least meet our current expenditures.

Other than the above basic question, there are several aspects of the tax system that should be of interest to readers. Tax policy, tax administration, distributional impact and fiscal federalism (revenue sharing between federal and provincial governments) are the four aspects we will discuss separately.

Let’s start with tax policy. Until the 1980s – the point of departure in the country’s history of economic management – we had a system of taxation that was primarily based on three taxes: customs, excise and income tax with a dormant wealth tax. The first two taxes are not only indirect but also supply-side taxes. It is important to understand that taxing production and imports essentially means taxing supplies. The demand side or consumption was nearly absent with the exception of a negligible sales tax which was collected essentially in conjunction with excise and customs. In some ways it is understandable, since taxing goods at the supplying points is easier than taxing at consumption points. But taxing supplies creates a distortion as it affects the capacity to supply. There is also a lack of uniformity, as supply taxes are not imposed across the board. Imports are taxed while domestic production would be exempt, except when there is an excisable commodity. Excises were selectively imposed because, as the name suggests, they are meant to discourage the use of certain items such as cigarettes.

There was another reason why the supply-side taxes had limited potential to meet the rising demand for revenues. Both tax bases were narrow and more revenues would be possible only by raising the rates of duty. Furthermore, the direction of world trade negotiations was rapidly moving in the direction of free-trade and bringing down the high walls of tariff protecting domestic industries. The trade taxes were falling out of favour and uniform taxation of domestic production and imports was gaining traction with advancing negotiations at General Agreement on Tariffs and Trade (GATT) and its successor WTO.

The income tax was also a moribund tax levied on a small number of corporations, association of persons (AOP) and salaried classes. All self-employed small businesses and trading establishments (wholesale and retail) were out of bound. Besides, from the day the country was born, it had inherited two major flaws in its tax structures. First, income from agriculture was declared a provincial subject under the constitution and excluded from federal income tax. In a remarkable move, just before announcing national elections in January 1977, it was none other than the most distinguished member of the landed aristocracy, prime minister Z A Bhutto, who took advantage of emergency provisions and had the temerity to announce the removal of this distortion, bringing agriculture income within the ambit of the federal income tax. However, this was undone by the military government that removed him from office within about six months of this announcement.

Second, the system of determining the value of immovable properties is woefully out of line with the actual market values. The rates fixed by the local administration are consistently different from the prevailing market rates by a vast margin. For the purpose of tax assessment there is hardly any meaningful revenue that flows from either capital gains or rental values of such properties.

‘No taxation without representation’ is a phrase that emerged during the American’s resistance to British parliament’s imposition of a tax on the colony from where no representative was elected to represent them. The two sources of tax avoidance we have mentioned (particularly, agriculture income) are reflective of how powerful interest groups have succeeded in extricating themselves from paying taxes, and yet a significant number of them have a representation in parliament.

Around the mid-1980s, the tax system had started failing to generate sufficient resources, even to meet the current expenditures. Prior to this, a small surplus (in revenue account) was generated to meet a part of the development expenditure. Therefore, repairing the tax system became the leading agenda of this era’s reforms. In 1985 the Tax Reforms Commission was established, headed by Qamar-ul-Islam, former deputy chairman of the planning commission. The commission gave a comprehensive report on measures needed to reform the sector.

Afterwards, when the first IMF programme was negotiated in 1988, tax reforms became the leading agenda. We will describe in detail the successes and failures, since then, in the evolution of a tax policy as it exists today.

To be continued

The writer is a former finance secretary. Email: [email protected]

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