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September 21, 2018

The roots of our budget crises


September 21, 2018

The root cause of the perennial crisis of public finance in Pakistan is as easy to understand as it is difficult to correct. The crisis does not arise, as many would have us believe, because some this-to-that ratio is much less than in another country. This is just arithmetic.

Apart from effectively unrestrained excessive spending, the crisis is largely due to three intractable facts. First, tax collectors routinely extort bribes, and are so well-connected politically that they can’t be restrained. Second, the rich lend to the government, but won’t pay taxes (nor return loans). Consequently, the government spends more on interest payments to rich citizens (in 2017-18, Rs1,320 billion, or 30 of every Rs100 collected in taxes) than it does on defence (Rs1,030 billion) or development (Rs790 billion).

Third, the many exemptions (especially of landlords from federal income tax) and the non-coverage of newer sources of income (like capital gains from real-estate transactions), reduce tax yields and open the floodgates to tax avoidance and evasion.

First, unless extortive corruption in taxation is controlled, only the helpless taxpayer will comply. Corruption has been addressed at length in reports of the 2001 (Shahid Husain) Task Force on Reform of Tax Administration and the earlier 1984 National Taxation Reform (Qamar ul Islam) Commission. While neither was fully implemented and subsequent developments are also relevant, the bottom-line recommendation of the Islam Commission remains valid: “Inquiries, suspensions and periodic wholesale removals have been tried but the basic weapon against corruption is the confiscation of the ill-gotten gains. This has not been practiced so far”. This is still true in 2018.

Second, there is a need to rewrite and simplify tax laws, which have become an incomprehensible jumble of ad hoc appendages to a now-incomprehensible original text. As a result, tax authorities are both unable and unwilling to assist taxpayers. Instead, they direct them to a booming industry of accountants, lawyers and tax advisers who settle tax matters through negotiation rather than law and precedent, thus institutionalising corruption.

There is a need to rationalise tax structure; reduce the discretionary powers of officials, strengthen monitoring and supervision, increase accountability and transparency in tax administration, and reduce — if not end — interference from the political leadership. Without credible, comprehensive, effective action to address these problems, there is no sustainable solution to the fiscal crisis.

Finally, as for bringing rich – rather than the lower- and middle-income –taxpayers into the tax net, the government must strengthen personal income tax by eliminating most exemptions and taxing newer sources of income (like capital gains on the sale of immovable property). Although they don’t cover real estate, the Husain and Islam commissions’ recommendations are a good starting point for many of the other actions required.

Of these, the rest of this article examines the exemption of “agricultural income” from federal (but not provincial) “taxes on income” (under Article 142(a) of the constitution, read with the Fourth Schedule, 47), and suggests ways to eliminate this distortion.

For centuries, Mughal kings appropriated a share of the produce of land, which was more than sufficient to finance their armies, clerks and courtiers. When the British took over progressively from the Mughals, they sought to continue this (“land revenue”) system. But Cornwallis (in Bengal, 1973) and Wellesley (in Madras, 1805) upturned the Mughal system of administration and ceded the state’s right to the peasants’ surplus, by transferring land ownership to a newly-created landlord class, with a fixed (hence inelastic) revenue obligation. This had far-reaching consequences, with which we are still struggling.

Initially, the British met the resulting deficit from their opium monopoly. But when expenditure on suppressing the 1857 revolution created a revenue deficit, they introduced an income tax in India in 1860 (revised in 1869-73), without any exemptions.

The Income Tax Act of 1886, however, exempted landed proprietors from income tax. Numerous efforts since then have foundered on the politics of self-interest. Ultimately, the Government of India Act, 1935 – the template for all constitutions of Pakistan (1956, 1962, 1973) – included the taxation of agricultural incomes in the provincial list.

After Independence – really, a graduation from a colony to a dominion – efforts, including by land reforms, to get landlords to share the burden of financing government didn’t get anywhere. In 1977, however, Bhutto succeeded in promulgating the Finance (Supplementary) Ordinance which, after it was passed by the National Assembly, became an act, under which the exemption given in the Income Tax Act, 1922 was withdrawn. However, before it could be implemented, martial law was declared and the Income Tax Ordinance, 1979 restored the old exemption.

Early in 1989, Benazir Bhutto formed the (Feroze Qaiser) Committee of Experts on Taxation of Agricultural Incomes, which came to a unanimous conclusion on removing the exemption. But the news leaked and a bipartisan delegation of landlords prevailed on Benazir to withdraw this proposal. Consequently, the published report of the committee makes alternative recommendations; the previously agreed draft appears in substance as a note of dissent to the report.

But where there’s a will, there’s a way. We have cited only two prominent proposals; numerous others lie buried in past reports and the scope for innovation remains unexploited. In particular, the Constitution (Eighteenth Amendment) Act, 2010, which further destabilises federal finances, creates new possibilities.

Although provinces have levied agricultural ‘income’ tax, the tax is based mainly on land-holding and not on agricultural income, and the collection is negligible. The federal government, for example, can negotiate a revised low-rate provincial income tax (with full offset of federal income tax, land revenue, and ‘ushr’ paid) with the award of the next National Finance Commission. This could be implemented in Khyber Pakhtunkhwa and Punjab, while deducting imputed revenues from non-compliant provinces.

In terms of the politics of the day, it may be fruitful to remind the PML-N and the PPP that both Quaid-e-Azam (in 1918) and Quaid-e-Awam were against this exemption.

On January 5, 1977, Zulfikar Ali Bhutto said it best:“My fellow citizens, the second decision I am communicating to you tonight relates to the abolition of a centuries old social division which has been perpetuated by imperialism. This was the division between the urban and the rural, the agriculturist and the non-agriculturist which has become entrenched through the land revenue system and through the exemption from income tax of earnings derived from agriculture.

“I am happy to tell you that from today we are doing away with this relic of our colonial past. From today we are abolishing land revenue and making agricultural income liable basically to the same taxation to which non-agricultural income is subject.”

The times demand a new system of taxation, built on the advice of French finance minister Jean-Baptiste Colbert (1665-1683): “The art of taxation consists in so plucking the goose as to procure the largest quantity of feathers with the least possible amount of hissing”.

Our present system exempts the golden geese and (with its corruption, unclear laws, and inadequate coverage, exemptions, and a plague of withholding taxes) plucks the least feathers with the most hissing. In a nutshell, if we can’t get the rich to pay for the government, then we are doomed to borrow the nation into slavery.

The writer is a retired economist.

Email: [email protected]

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