Budget review: Taxing the taxed … again

At a time when real capital is stranded in unproductive segments like real estate, losing intellectual capital through excessive taxation measures is akin to killing the goose for the golden egg.
Published June 12, 2024

The taxed are being taxed again, just like they were taxed last year, and the year before that, and so on. The untaxed remain untaxed, but they get a slight pat on the wrist for being untaxed; the pat being a slight increase in withholding taxes — which effectively increases the cost of doing business.

With the expected real GDP growth rate at around 3.6 per cent, the budget is anything but aggressive and avoids bold initiatives — it can hence be deemed cautious in its approach. What it does is that it continues to deepen the existing taxpayer base while making little effort to expand the tax net to include entities and individuals currently outside it. Although Finance Minister Muhammad Aurangzeb’s speech clearly articulated the need to transition from a consumption-oriented economy to an investment-oriented one, it did little to explain how this transition will be achieved.

Lofty targets

The federal budget forecasts a 37.8pc rise in tax revenue, with a goal to increase the tax-to-GDP ratio to 10.4pc. This is a lofty target, as such a growth in tax revenue is extremely rare. One cannot recall when the tax revenue increased by more than 20pc in real terms, without expansion of the tax net, considering that inflation is expected to be in the range of 15pc. Achieving this significant real growth by deepening the current tax base will be challenging.

Meanwhile, income taxes are expected to rise by about 48pc — another ambitious target. Although the tax rate for the salaried class remains unchanged, changes in tax slabs have increased their burden. Over the past five years, real incomes of the salaried segment have dropped by more than 30pc. Higher taxes will further reduce post-tax income, increasing financial pressure on salaried individuals.

Furthermore, tax incidence has increased substantially for middle-income households, further squeezing real disposable income. This has a fairly negative effect on household sentiment, and accelerates an exodus of intellectual capital from the country. At a time when real capital is stranded in unproductive segments like real estate, losing intellectual capital through excessive taxation measures is akin to killing the goose for the golden egg.

To put it plainly, the budget continues to focus on existing taxpayers while largely ignoring the untaxed segment. One major change is the revised tax regime for export-oriented industries, which will raise corporate tax and reduce reinvestment incentives. Most of the increase in direct taxes comes from existing taxpayers, indicating further deepening rather than an expansion of the tax base.

Indirect taxes

A look at indirect taxes shows that sales tax is expected to increase by 36pc, and the Petroleum Development Levy by 33pc The latter already accounts for roughly 10pc of the total taxes collected. These taxes are inherently inflationary, raising overall costs.

On the other hand, the increase in withholding taxes from 1pc to 2.5pc on the manufacturer-distributor-retailer value chain may not effectively convert non-filers to filers, but will likely result in manufacturers passing the cost on to consumers, further contributing to inflation. This environment will encourage the informal cash market to thrive, as there will be more incentives to avoid the formal system.

It is unclear if any evaluations have ever been conducted to determine if increasing withholding taxes for non-filers has led to more individuals filing taxes. Furthermore, it is questionable if those who do file are doing so fairly. Withholding taxes have been around for a long time and have done little to improve the conversion of non-filers to filers. Draconian measures such as blocking mobile phone SIMs of individuals who fail to file taxes have further discouraged compliance.

Simply put, the tax policy design is flawed, as seen in the budget. Withholding taxes for non-filers increases the cost of doing business without significantly improving compliance or tax collections.

The majority of taxes continue to be paid by the usual contributors — corporations in the formal system, salaried individuals, and indirect taxes like the Petroleum Development Levy. An ever-increasing reliance on consumption-based indirect taxes disproportionately affects vulnerable households compared to affluent ones.

Is there an upside?

The budget offers some hope for macroeconomic stability, targeting a real growth rate of 3.6pc with minimal reliance on external funding to cover deficits. This suggests that growth will be largely domestic rather than import-driven. Another positive aspect is the plan to privatise loss-making state-owned entities, particularly power distribution companies and the national airline. Privatisation could reduce recurring losses and subsidies in the power sector. However, achieving this requires extensive structural reforms, which the government has shown some commitment to.

On the revenue side, the budget has yet again failed to broaden the tax base, further burdening salaried and formal segments of society. Higher withholding taxes will likely speed up the shift from the formal to the informal economy. An expansion in the cash economy is also probable, as little has been done to discourage it. The budget is cautiously optimistic but inherently inflationary. It continues to penalise existing taxpayers and does little to shrink the informal economy. While it aims to encourage investments, it does not implement any policies to achieve this. Capital outside the system may continue to circulate in cash, leaving the formal economy starved of resources. As a result, overtaxed segments will continue to bear the burden of a narrow tax base, struggling to stay within the system.

In conclusion, the federal budget, while optimistic in its projections, falls short of addressing critical issues such as broadening the tax base, and is instead instituting measures that are inflationary in nature.

By continuing to target existing taxpayers and failing to incentivise compliance among non-filers, it risks exacerbating the transition from the formal to the informal economy. The inflationary nature of indirect taxes further complicates the economic landscape, potentially undermining efforts to achieve sustainable growth.

Without significant reforms and a broader tax base, the burden on the formal economy will only increase, limiting the country’s ability to foster a truly investment-oriented environment, and a path for sustainable growth.

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