How Pakistan's cities can become financially independent and focus on service delivery

What gaps stand in the way of more robust revenue generation in Pakistan, and how can these be bridged?
Published September 22, 2022

Pakistan has narrowly escaped an economic catastrophe: while funding flows have breathed some life into a faltering economy, the exchange rate is plummeting and net international reserves have nosedived, amounting to only $8.62 billion as of September 9. Food inflation has skyrocketed and Pakistan’s fiscal deficit has surged. The central questions to emerge from this economic fallout are: what gaps stand in the way of more robust revenue generation in Pakistan, and how can these be bridged?

In the past decade, Pakistan has been undergoing an unprecedented rate of urbanisation. In 2017, around 36.4 per cent of the population was living in urban areas. By 2030, it is expected that more than half of the country’s population will be city dwellers. As a result, urban service delivery is increasingly proving to be inadequate to meet the needs of Pakistan’s ever-increasing urban populations.

The most obvious recent example of this is the torrential rains that wreaked havoc in Karachi, claiming lives and damaging property. Stronger municipal-level governance could have managed drainage and responded to the disaster adequately and in time. The crisis of weak urban service delivery goes beyond this; only 15pc of urban households in Pakistan have access to drinking water adequately treated in a filtration plant, while only 61.8pc of urban households have access to toilet facilities connected to a piped sewer system, as per the Pakistan Demographic and Health Survey 2017-18.

To add to this, the fiscal crisis has already resulted in cuts in the development budgets of several ministries, which is likely to have downstream impacts on municipal-level development. While cities’ expenditure needs have rapidly increased, the resources required to fund development are entirely dependent on provincial transfers, which in turn depend on the federal government’s measly revenue streams.

Do city governments enjoy fiscal space?

The foremost reason for service delivery deficits is a lack of fiscal space at the municipal level, which harks back to the history of local government reforms in Pakistan.

Research shows local governments have historically been employed as a tool by non-representative military governments to weaken political parties by forming localised patronage structures that rival parties’ support. When in power, democratically elected governments have viewed local councils as a competing tier of ‘patronage’, and have thus been hesitant to devolve power to the local level in the fear that it would undermine their power. As a result, local governments have remained weak and unstable.

To quote some manifestations of this weakness in recent years: in Balochistan, local governments completed their tenures in January 2020 but elections for new councils were held in May 2022. Similarly, in Sindh, elected local governments were dissolved in 2020, but the second phase of elections is yet to be held. In Punjab too, local governments remained suspended for a long time.

Financial autonomy is also limited. Despite a series of reforms, local governments continue to struggle to gain financial autonomy. Provinces are tasked with creating their own system of local governance, so the shape and form of local governments vary between provinces. Likewise, the ability to raise local revenue also varies. Fiscally, local governments remain dependent on transfers from the provincial government, and generate very little revenue of their own.

Read: Strengthening local governments

While local governments can use a broad array of tools for financing urban service delivery independent of provincial transfers, such as user charges and cost-sharing mechanisms like public-private partnerships and municipal bonds, discussed below are the most significant yet underutilised source of municipal revenue: property taxes.

Underperformance of property tax

Local governments should aim to capture a portion of a city’s economic growth in order to finance rising expenditure needs, and to structure and administer cities in such a way that the urban economy operates effectively and sustainably. Property tax can help realise this goal.

Globally, property taxes have been used to finance urban service delivery: across the Organisation of Economic Cooperation and Development (OECD) countries, a group of largely high-income economies, property taxes are equivalent to about 2pc of GDP. In emerging markets, property taxes are typically 0.6pc of GDP, while in low-income countries they form 0.3pc of GDP.

In Pakistan, however, the Urban Immovable Property Tax remains a significantly under-utilised tax, accounting for only 3.83pc of the total tax revenue from all provinces in FY21, and about 0.1pc of GDP. Punjab collects a small fraction (6pc in FY18) of the total provincial tax from this source. All of Punjab, with a population of over 100 million, collects less urban property tax than the city of Chennai in India, home to about 10m people.

Similarly, Khyber Pakhtunkhwa currently collects $0.1 per capita in property taxes, eight times less than the tax collected in Punjab and 129 times less than the tax collected in Indian cities that have introduced property tax systems based on property value. Sindh collects the lowest property taxes out of all provinces, at 0.97pc of total provincial taxes.

Why we need greater revenue from property taxes

Property taxes can generate development growth for urban centres in Pakistan. They can actuate a virtuous cycle, where the rising value of urban land and property can finance public investments, which in turn can push up their prices. Since this process is continuous, such taxes can provide a long-term and significant source of revenue for municipal services. Moreover, research also suggests that taxes based on the value of land and/or property are more resilient to shocks and can be a great potential source for financing urban recovery.

However, the utility of property taxes goes beyond just their use for providing essential urban services. In the present context, where property investments are widely used to park untaxed wealth, taxing property is even more important. By not taxing properties adequately, Pakistan forgoes a major potential source of revenue and the government ends up actively encouraging investments in property, an unproductive sector of the economy, while disincentivising the more productive export-enhancing sectors.

Literature also illustrates a link between property taxation and greater local autonomy and government accountability. Unlike income tax, it is not deducted at the source, and taxpayers pay it directly on a recurrent basis, which makes it highly visible. As a result, taxpayers are more conscious of the property taxes they pay, which are likely to fund services that are highly visible, such as roads, garbage collection, and neighbourhood parks. Due to this visibility, taxpayers are more likely to feel ownership of government revenues and demand benefits in return.

Governments in need of revenue are more likely to deliver to those taxpayers in order to encourage tax compliance. This also makes the tax difficult to leverage politically and even more difficult to increase or reform relative to other taxes. Beyond this, property tax can be an important instrument of local autonomy, in that it allows local governments to self-finance the provision of basic services. For property taxes to actuate some semblance of local autonomy, tax rates must be set locally and not by a senior level of government.

It is also important to note that recurrent property taxes prove to be more efficient than other taxes on property, like the Capital Gains Tax, which is imposed at the federal level. Taxes on property transfer can effectively become consumption taxes because they can reduce or distort the market.

If individuals are forced to pay more for the purchase or transfer of properties, they will likely do it less (deadweight loss of taxes). This can reduce revenues from property and encourage the inefficient use of land. Land should ideally be easily transferable so it is allocated to its most efficient use. By taxing land on a recurrent basis through property taxes, governments can encourage landowners to use their land more efficiently.

There are several reasons for the underperformance of property tax in Pakistan. Some of these are highlighted below:

Currently, the liability for property taxes is assessed on the annual rental value, which greatly undervalues any property’s actual worth. It taxes properties on the current but not the most optimal use of land. Additionally, rental value is assessed every five years, which limits its responsiveness to market conditions that fluctuate property prices.

Moreover, the rental value is determined through presumptive surveys which greatly undervalues a property’s worth. Finally, the formula used for calculating the annual rental value is set in law, which limits its ability to improve without a long legislative process.

There is a vast difference in the tax rates for owner-occupied and rented properties, which discourages owners from declaring rental status; plus there is a high exemption floor — plots up to 151 square yards are exempt from taxes irrespective of their value

And not to mention, tax enforcement capacity is limited and in many cases, enforcement is selective and politically motivated. Evaders often pursue long-drawn legal processes, which impose high administrative costs on the Excise and Taxation Department.

How collection can be increased

Properties can be valued in a variety of ways. A capital-based valuation system prioritises taxing the value of land and improvements like construction, based on market rates. While such a system of valuation provides the closest approximation to the actual value of land, it requires a thriving real estate market, which can rapidly generate data on the value of properties, relating to their specific characteristics.

Another way of valuing properties is to consider only the property’s surface area or location, also referred to as an area-based valuation system. This is easy to implement but does not factor in the condition of the land or built structure and does not reflect a property’s true market value.

A third method of valuation called the rental value tax considers the revenue a property can generate in the rental market. It also typically reflects the present rather than the best use of property, which could induce inefficient market behavior.

A hybrid system assigns a standard number of points based on a property’s surface area. This is supplemented with points based on the property’s positive or negative characteristics — such as its location, the number of floors, and the neighbourhood.

While there are significant trade-offs between different valuation techniques, Punjab’s current property taxation system could greatly benefit from moving towards a capital value-based valuation system.

The greatest challenge for municipal revenue generation, however, is political; landed elites, who compose our legislative bodies, and those outside who wield enough power to influence policymakers will oppose the imposition of property taxes. However, the current economic crisis has put Pakistan in a tight spot.

If Pakistan is to break the cycle of external debt, it must start by making itself less dependent on external sources of revenue. The city, the basic unit of governance, is where it must start.

This article is based on a paper titled ‘Urban property taxes in Pakistan’s Punjab’ by the International Growth Center (IGC).

Header photo: A mini truck moves on a road with sewerage water on it after rain in Karachi. — Shutterstock