“Pakistan’s fiscal crisis is deep and cannot be easily resolved. Taxes are insufficient for debt service and defence. If the tax to GDP ratio does not increase significantly, Pakistan cannot be governed effectively, essential public services cannot be delivered and high inflation is inevitable. Reform of tax administration is the single most important economic task for the government.
[Quote from report of General Musharraf’s June 2000 Task Force on Reform of Tax Administration]
If the big business and landed aristocracy could be convinced that by eliminating the budget deficits, they stand a good chance of trebling the value of their property and stock holdings, they might start paying taxes. But what might persuade them to do that?
When President Bill Clinton took over in 1992, the US economy was in recession and government finances were in bad shape. The fiscal deficit had hit a record level of almost $300 billion (or 4.7 per cent of the GDP), that is, more than double its $145 billion-level in 1987.
He introduced his historic deficit-reduction budget in 1993, worked to reduce the deficit every year and within a matter of six years, was able to turn it into a surplus of nearly $40 billion. Under his leadership, the US economy grew at a rate of more than four per cent in the late nineties compared to 2.7 per cent average during 1987-1992 period.
Inflation dropped to an average of less than two per cent compared to over four per cent annual average period during 1987-1992, and the stock market skyrocketed and trebled in value by 1998 from its depressed levels in 1992.
There were a host of factors that helped the US at the time but one lesson is unmistakably clear: deficit reduction can translate into huge benefits for the entire economy; for consumers, businesses, and property owners. And this is why the businesses and agriculturists should pay serious attention to the deficit and demand that the government reduce it to less than two per cent of the GDP as soon as possible.
The number one reason of persistent budget deficits is the low tax-to-GDP ratio, which is around 10 per cent compared to average of 18 percent for the developing countries. It may sound like a paradox but if these businesses and agriculturists start paying taxes and help cut the deficit, they will be the greatest beneficiaries of not only lower inflation and interest rates, but more significantly of the rise in value of their assets that will follow. Historically, taxation has been treated as a political patronage tool or the public debate has focused on the administrative aspects.
But the current crisis demands that a political economy approach be adopted to expand the revenue base and cut budget deficits. The stakeholders need to appreciate that the current system is weakening the state, is regressive, inflationary, and unable to mobilise the resources needed to enable the state to perform its core functions of maintaining law and order and developing the infrastructure. In other words, it is in the interest of the large stakeholders that comprehensive tax reforms are introduced.
The history of tax reform around the world provides more than ample evidence that the single most important ingredient for effective tax administration is clear recognition at the highest levels of politics of the importance of the task and the willingness to support good administrative practices even if political friends are hurt in the short-term.
The institutionalisation of corruption, the extent of criminalisation of politics and standards of public morality are generally regarded as significant factors upon which the extent and nature of feasible tax administration reform depend.
Public acceptance is a necessary condition for a tax system to work successfully. If the taxpayers have doubts about either the fairness of the system or the legitimacy of government spending, they may not co-operate to make a reform programme work. Pakistan has generally treated tax reform as an administrative issue with the most commonly heard refrain being, ‘it is only a matter of implementation.’ Wrong!
Pakistan has not made any significant progress in reforming its tax administration during the past decade. Its ministers and bureaucrats have been misleading public opinion by just quoting numbers of absolute growth in tax revenues which is meaningless if not adjusted for inflation and size of the economy.
A recent study, “Paying Taxes 2008” published jointly by the World Bank and PricewaterhouseCoopers (one of the biggest accounting firms in the world), compares the ease of paying taxes in 178 countries around the world.
The study is subject to a system of ranking based on three indicators; namely, the number of tax payments, the number of hours to comply with the company’s tax obligations, and the Total Tax Rate (TTR). Pakistan’s rankings are as follows:
Ease of paying taxes (overall rank) 146
Number of tax payments 138
Time to comply 156
Total tax rate 80
These rankings point to not just an urgent need to introduce tax reforms but also to Pakistan’s failure to address what was described as the single most important economic task for the government in June 2000. But designing tax reforms can not be left to just bureaucrats and accountants. The political leadership must get the help of economists and public finance professionals. Turkey got help from external professionals of a World Bank study group and Egypt utilised the services of the experts from the Organisation Economic Cooperation and Development (OECD).
Pakistan’s current tax structure is anti-development, anti-growth and anti-poor. It discourages investment in the real sectors, particularly manufacturing. It passes on most of the ultimate burden of the taxes to middle and lower income classes and is one of the reasons for persistently higher inflation rate compared to other Asian countries.
While the salaried class pays more than Rs14 billion in taxes, textile barons and stock brokers combined pay less than that. The indirect taxes currently account for 62per cent of the total revenues. The largest among the indirect taxes is the general sales tax (GST) which accounts for 39 per cent of the total tax collections. Such indirect taxes are regressive, inflationary, and hurt consumer spending which is a key driver of economic growth.
Many countries have benefited from the experience of East Asian countries and followed their policies. In Bolivia, a highly complicated tax system existed until 1985 with around 400 taxes and it had one of the highest rates of tax evasion in the Western hemisphere.
The Tax Reform Law of 1985 repealed all the previous taxes and replaced them with seven new taxes. More recently, Turkey and Egypt have made notable progress in introducing and implementing tax reforms. Some key common features of successful reform programmes have been as follows:
* The overall numbers of taxes are reduced to a dozen or less.
* Maximum rates are slashed as high rates have historically encouraged tax evasion.
* Rebates, exemptions and special treatments are eliminated or reduced to a few.
* Tax administration is simplified using technology.
High tax rates can force companies into the informal sector. In the Democratic Republic of Congo, with taxes twice as high as the commercial profit for a company with a profit margin of 20 per cent, businesses have a strong incentive to evade taxes.
Indeed, half the country’s manufacturing activity is in the informal sector. Even countries with a smaller informal sector can gain from this strategy. Greece saw its corporate tax revenue grow from four per cent of GDP to five per cent after reducing the corporate tax rate in 2005. Egypt saw the number of complying taxpayers increase by 47 per cent to 2.5 million in just one year after reducing both corporate and personal income tax rates in 2005. Turkey reduced the top rate for corporate income tax from 30 per cent in 2005 to 20 per cent in 2006 and introduced a new corporate tax code. Turkey also reduced the tax on interest from 18-15 per cent in 2006 and simplified other taxes, such as the property tax and the tax on cheque transactions.
Pakistan’s tax regime resembles, in general, to more that of Latin America countries where indirect taxes, and in particular sales tax, occupies a relatively higher share within the overall tax. Pakistan indirect tax to GDP ratio is around six per cent, and its direct tax to GDP ratio is four per cent and less than two per cent if withholding taxes are excluded. The following data contains a comparison of the structure of direct and indirect taxes between East Asia and Latin America over selected periods during 1975-2002.
East Asia countries (even if exclude China and India) have enjoyed high growth rates for decades compared to Latin American countries. They grew at an annual average rate of 5.25 per cent during the last twenty years, which is almost double the average growth rate for Latin America. Pakistan’s political, agriculture, and industry leaders should ask themselves: which taxation and growth model they want to follow?