Economic reforms: part - XVIII

During 1988 - 2000, a number of efforts were expended to reform the tax system in the country. In 1985, a tax reforms commission was established to recommend a complete reform of the tax system – both policy and administration.

Then in 1988, the first structural adjustment programme of the IMF was undertaken, followed by an extended programme in 1993, and two more such programmes in 1995 and 1996. The reforms agenda of all these programmes majorly focused on tax reforms. There were also some task forces established for the purpose of tax reforms in the interregnum.

The reforms menu had three main items: (i) customs or taxes on trade; (ii) general sales tax; and (iii) income tax. We give a brief account of what was accomplished during this period.

In the area of trade taxes, three reforms were inevitable: lowering the high walls of tariffs (breeding inefficient industries, discouraging investment and adversely affecting export competitiveness), removing taxes on exports and reducing the number of tariff rates to simplify the regime. Additionally, para-tariffs (education and flood surcharges) that added to effective rate were also to be removed.

In the first round, the maximum tariff of 350 percent was sharply reduced to less than 100 percent. By the close of the 1990s, the maximum rate was 65 percent. All para-tariffs were merged within the statutory tariff rates. The number of tariff rates was reduced from 17 to 12 and finally to 6. However, this was not a sacrosanct reform, as additional slabs were added when revenue requirements so dictated. More significantly, new taxes were invented to continue burdening tradeable goods. A withholding income tax was introduced in the early 1990s, which acted just like the para-tariffs and surcharges removed earlier. At a larger scale, use was made of Section-18(3) of the Customs Act, 1969, that allows federal government to impose regulatory duty on imports over and above the applicable customs duty. The effective duty rates, therefore, were not reduced as much as the steep reduction in customs duties. Though lessened, the problems associated with trade taxes continued to afflict the tax system.

The second major reform undertaken by the first Nawaz Sharif government was replacement of the Sales Tax Act, 1951, with a new law called the Sales Tax Act, 1990, which came into effect on July 1, 1990. This law was more in line with the consumption tax and provided for imposition of tax at different points in the supply chain, with appropriate input adjustments, as the goods moved to the final point of consumption. It was applicable on both imports and domestic products. The act was a major step towards putting together a framework capable of providing legislative basis for a value-added tax.

Initially, the coverage of the sales tax was significantly below its potential. There was considerable resistance from businesses and exporters were justifiably apprehensive despite zero-rating of exports. Successive governments, most notably the second Benazir Bhutto government, in June 1994, made major expansions in the coverage of the sales tax. However, the tax remained at the manufacturing and import stage, without any attempt to go down to the retail and wholesale stages.

Unlike the ideal recommendation of a single tax-rate regime, the act provided for multiple tax rates – zero-rated, 5, 10 and 15 percent. Subsequently, the 15 percent was frequently adjusted upward, while another slab of 23 percent was also added. The cascading effects (accumulating incidence of the tax rather than shifting to the next stage) were not prevented. As the tax was not extended at the wholesale and retail level, provision was made for a ‘further tax’ when sales were made to non-registered people. The prices at which the sales tax would be levied were also subject to the government’s discretion. This was frequently influenced by powerful lobbies.

Curiously, a separate sales tax department was still missing and sales tax collections kept shifting between income tax and excise (customs) departments. There was also an interesting arrangement whereby sales tax was collected in excise mode and such excise duties were admissible for input adjustment like sale tax. At the import stage, the sales tax was collected in customs mode and relevant provisions of the Customs Act were made applicable for such collections. Despite such shortcomings, the sales tax rose from less than one percent of the GDP in 1987 – 88 to about four percent of the GDP in 1999 - 2000. Experts say this was not even half the GST potential that the country should have been able to mobilise.

Income tax underwent significant improvements during this period, thanks mainly to the widespread liberal imposition of withholding, advance, presumptive and adjustable taxes to broaden the tax base. The revenues from income tax improved significantly from less than two percent of the GDP to nearly 3.7 percent, and its share rose from 18 to 28 percent in the total taxes. This meant that growth in income tax was significantly higher than the growth in the GDP.

At the end of the 1990s, income and sales taxes emerged as the leading sources of revenues. Customs tax lost its primacy as it was down from about 6 percent of the GDP to only about two percent, and excise duties stagnated at around the same number. This was a desirable transition and a major achievement. However, there was also an unhappy ending: the tax to the GDP ratio fell from about 14 to 12 percent, which was quite disappointing. The decade of the 1990s was often described as the ‘lost decade’. Pakistan saw frequent changes in the government that disrupted economic management. Economic reforms were either prematurely terminated or sporadically implemented.

A major point of the opposition to tax reforms was that shifting the tax regime from import-based to domestic production, consumption and income would entail significant revenue losses, as the tax machinery would not be able to cope with highly dispersed tax bases compared to a single point at the seaport. Such an argument dismisses the distortionary nature of trade taxes and loss of efficiencies. The direction of reforms was right and continued to progress in the later years.

To be continued

The writer is a former finance secretary.

Email: waqarmkn@gmail.com