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Economic notes

May 8, 2018

Economic reforms: Part-XX


May 8, 2018

The failure of the wide-ranging tax reforms to raise the tax-to-GDP ratio during 2000-08 made the foundation of the economic achievements of the then military government fragile.

This was so proved when a series of crises in 2007-2008 erupted – removal of the chief justice, assassination of former prime minister Benazir Bhutto, global financial turmoil and Pakistan’s transition to democracy. The economy could not handle the disruption and the country was pushed towards a new IMF programme.

Tax reforms again featured prominently in the 23-month Stand-By Arrangement (SBA) signed in November 2008. Key lessons learned from the previous experience were kept in view. The programme targeted the following reforms in tax policy and administration: (a) an integrated tax administration organisation on a functional basis will be established at the Federal Board of Revenue (FBR) (integrating both income and sales taxes and excise administration); (b) audits will be introduced as part of a risk-based audit strategy; (c) income and sales taxes would be harmonised by amending the respective laws; (d) the draft law would be submitted for approval and would be effective on July 1, 2010.

The success of the entire programme hinged on this single reform. However, no sooner had this agenda become public and the implementation work started that the forces of resistance were activated. First, within the FBR, there was a major pushback on the idea of establishing the Internal Revenue Service, through integration of the income and sales taxes and excise departments. This has been a sensitive issue among the competing cadres of civil servants administered by the board. The income tax department had previously looked after the sales tax but then it was passed on to the customs and excise department in view of its applicability on imports and domestic production, with no interest in the income of those facing incidence of excise and sales taxes. With the need for harmonisation as the primary goal – and as recommended by the World Bank in the tax administration reforms project that started in 2004 – it was now the income tax department to host the programme so that officials of the two tax departments could interact with each other.

Several petitions were filed by customs officers in several high courts under their jurisdictions. Officers also moved a request for inspection with the World Bank, alleging that its programme was detrimental to the welfare of customs officers. A lot of time was taken before these petitions were decided in favour of the department and eventually the reform was implemented.

Second, businesses, especially of the export-oriented sector, such as the textiles industry, were deeply opposed to the value-added nature of the tax with no exemptions. They had successfully forestalled a similar effort a few years ago, on the plea that the refund system was deficient, flying invoices were causing revenue losses and piled up refunds blocked working capital. They carried their grievances to the legislators.

In the meanwhile, the revenue performance was quite poor. It was the imposition of the petroleum levy (initially called ‘carbon tax’) at a higher rate (subsequently rationalised after the Supreme Court’s remarks) that partly filled the gap. But the main focus of the programme was to see the passage of tax reforms and was, therefore, ready to ignore the shortcomings so long as the work on reforms was on track.

Yet another development that radically altered the country’s economic landscape was the announcement of a new NFC Award and passage of the 18th Constitutional Amendment Act, 2010. The former significantly changed the shares of the divisible poor in favour of the provinces (at least 13 percent more), while the latter changed the taxation powers between the federal and provincial governments. In particular, the sales tax on services, which was also previously with the provinces, but was essentially a dormant tax, and when imposed at the federal level, was included in the federal divisible pool, was now asserted as a full-fledged provincial tax.

The immediate effect of these changes was on the GST law planned under the IMF programme for enactment in June 2010. Under the law, the services sector was to be excluded. This meant that a true value-added system would be impracticable with changing jurisdictions during the course of the value-added chain. As a rearguard action, seven services were identified (mostly related to shipping and transport) where no single service would be in a position to truly claim exclusive jurisdiction, since services moved across provincial borders. It was argued that if the provinces continued administration of sales tax on these services, the value-added character of the GST could be saved. However, there has been no agreement on this subject to this day.

Another unforeseen development was the departure of the then finance minister, Shaukat Tareen, in February 2010. He had negotiated the programme and carried it until then. His replacement took a couple of months to take charge.

Finally, the budget session of 2010 arrived. A draft bill duly endorsed by the Fund was placed in the National Assembly. It envisaged a single GST rate at 15 percent and eliminated a large number of exemptions that had distorted the regime – except food items and medicine. The bill also withdrew the exemption powers from the FBR and vested them with parliament. The GST was applicable at the retail stage with a threshold of Rs7.5 million or more.

The opposition was naturally opposed to this amendment. But the biggest upset was the exit of the MQM from the coalition, leaving the PPP as a minority government. Since it did not have the necessary votes to pass the amendment bill, the government withdrew it. The IMF mission chief was most disturbed with this development as he had supported the programme by staking his personal reputation. Thus, another failed programme had cast the country in a poor light in the community of development partners. This programme was unusual for its generosity as it provided $8.5 billion (mostly upfront) in an SBA. Unfortunately, the tax–to-GDP ratio declined further.

To be continued

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

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