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Political economy of new taxes

December 14, 2015

THE imposition of Rs40bn worth of additional duties by the federal government has two aspects: legal-cum-constitutional and socioeconomic. Regarding the legal-cum-constitutional side, the foremost question is whether the executive can levy duties or taxes on its own without the approval of the legislature.

Article 77 of the constitution provides that no tax can be imposed by the federal government ‘except by or under the authority of’ an act of parliament.

Take a look: New taxes to limit use of luxury items: Dar

This means that to levy new taxes, the government should either get a law enacted by parliament or use a law already in force to provide a legal cover to such measures. The situation would have been different if the constitution had provided that new taxes can be imposed only ‘by an act of parliament’. In that event, fresh legislation would have to be introduced each time the government wanted to impose new taxes.

Before the start of each financial year, the government introduces the finance bill in parliament, which contains the annual budget statement, including the proposed expenditure and revenue measures. This is done under Article 80 of the constitution.

Meanwhile, Article 84 provides that in case the government wants to spend on a service in excess of the sum authorised by the finance bill, the new measures taking the form of a supplementary or excess budget statement also require the parliament’s approval.

The list of items on which the regulatory duty has been imposed or raised includes food items, garments and home textiles. It is difficult to categorise all these as ‘luxury’ goods

The constitution, however, is silent on whether additional taxation measures also need a nod from the legislature before they come into effect. Be that as it may, constitutional conventions require that all such measures are also laid before the parliament.

The next aspect is the socioeconomic side of the new revenue measures. The government has imposed a regulatory import duty (RID) of 5-10pc on 61 hitherto exempted items; enhanced the RID from 10 to 15pc on another 289 items; raised the customs duty by 1pc on each of the five import tariff slabs; increased the customs duty on imported, used vehicles by 10pc; and pushed the federal excise duty up by 7.5pc on cigarettes.

The additional duties will yield Rs40bn in revenue and thus help the government overcome the shortfall in revenue collection for the first quarter of this financial year. The new measures also enjoy the blessings of the International Monetary Fund (IMF) and will ensure that the country continues to receive capital inflows from the lender under the $6.6bn Extended Fund Facility.

Two questions arise. One, what would be the impact of the new taxes? And two, was it not possible for the government to resort to alternative means to bridge the gap between the targeted and actual revenue collection?

All the new taxes are indirect in nature. As such, they are inflationary, as the price increases are conveniently shifted to the consumers in the form of higher retail prices. Indirect taxes are also regressive, as consumers pay the same amount irrespective of their income. This is the reason why indirect taxes hit the low-income groups the hardest.

Finance Minister Ishaq Dar’s argument that the new duties have been imposed on the import of luxury items — and therefore would not adversely affect the low-end consumers — is not sound for multiple reasons. The list of items on which the RID has been imposed or raised includes food items, garments and home textiles. It is difficult to categorise all these items as ‘luxury’ unless one assumes that virtually every imported item is a luxury good.

An increase in import tariffs causes domestic prices to go up, benefiting domestic producers at the expense of consumers. Therefore, whether the items concerned are luxurious or essential, the price increases caused by the additional duties will push up the demand for their locally produced substitutes. Thus, the price level will rise in the wake of the new taxes.

In addition to generating revenue, import duties protect the domestic industry and, by extension, reward powerful lobbies. But in the world of dynamic equilibrium, rewarding one segment of the economy or society always comes at the expense of another. If there is a winner, there is invariably a loser. In this way, additional duties are also likely to cause distortions in the market.

Now we take the second question. What other means were available to the authorities to fill the revenue gap? Any increase in revenue comes from either direct or indirect taxes. Given the nature of the country’s political economy, a significant increase in direct taxes is always a difficult proposition.

Therefore, additional revenues must come from indirect taxes. Other than customs duty, the other major indirect tax is the general sales tax (GST), which is also both inflationary and regressive. Increasing the GST further would have evoked strong opposition from businesses, in particular, which are the PML-N government’s major constituency. This made increasing import duties the most convenient choice for the decision-makers.

Published in Dawn, Business & Finance weekly, December 14th, 2015