POPULAR discourse pertaining to Pakistan's economic problems usually takes place at a highly superficial level, looking merely at symptoms. It is essential to go beyond generalisations and diagnose the real sources of the malignancy affecting the economy.

Several disconnects and mismatches of various kinds are sapping the economy's energy and vitality. These need to be fixed as part of a medium-term consensus agenda. First, unlike the past where the rural population lived under miserable conditions, the increase in commodity prices has transferred additional purchasing power worth about Rs450-500bn from the urban economy to the rural. Rural incomes are exempt from direct taxation and therefore the government is unable to capture a share of this additional income. The rural aristocracy spends its newly earned incomes on luxuries such as cars and travelling abroad. Farmers and other members of agricultural labour spend on either tax-exempt goods or on goods and services provided by the unorganised sector.

Therefore, the incidence of indirect taxation is also quite low. Rural poverty may be declining and this is gratifying, but the state, which is in dire need of additional revenues, is losing out. On the other hand, urban consumers already facing high unemployment have been hit hard by a combination of food, imported goods and government borrowing-induced inflation.

While direct tax cannot be realised by the federal government, local governments — which can easily collect levies, taxes, user charges, etc. from the rural and semi-urban population — have become dysfunctional. All over the world, people are more inclined to pay taxes for activities closer to home and whose benefits they can directly see. In Pakistan, the tendency to centralise all authority by the federal government and now the provincial governments is inhibiting these tested methods of resource mobilisation at the local level.Related to the above development is the rising level of workers' remittances. In the last three years, at least an additional $4bn have poured into the country. An analysis of the geographical origin of these inflows shows a major structural shift. In 2005, about 45 per cent of the total remittances originated from the Middle East. By 2011, this ratio has risen to 58 per cent. The majority of the workers in the Middle East are unskilled and come from poor backgrounds and less developed areas; their families have received a large infusion of money. As these remittances are exempted from taxation, the state is unable to share this buoyancy.

Second, in urban areas skilled professional, self-employed entrepreneurs and businessmen are able to adjust their incomes in tandem with inflation. Fixed income groups — the poor, the daily-wage workers, the salaried class, unemployed pensioners and widows — are unable to do this. The inflation-adjusted incomes of the former class rise along with the national income. Tax evasion among this class is quite rampant as only a small fraction of registered firms file tax returns and even fewer show taxable incomes.

A large number of businesses, such as boutiques, beauty salons, tuition centres and clinics operate from residences and are not registered. Outsourcing and sub-contracting by established firms to small, unorganised outfits also results in a diminution of the tax base.

Consequently, the inflation-adjusted and tax-evaded incomes of well-to-do sections of the population are growing while those of fixed income groups and the salaried classes, who pay their taxes, are shrinking. This reduces the tax base. Organised firms in the formal sector are bearing a disproportionate burden of taxation, nullifying their incentives for expansion.

Third, assets and speculative gains have never been taxed in any meaningful manner. Rural land is exempt from any wealth, property or capital gains tax, other than some modest land revenue collection. Meanwhile, for the purposes of official registration, urban property transactions take place at a fraction of the actual market value. Eighty to 90 per cent of the proceeds are thus transformed into black money and the rise in currency in circulation attests to the veracity of this trend. Tax rates on urban immovable property in Karachi, Lahore and Islamabad are ridiculously low because ownership is concentrated among the elites.

Recent experience with the capital gains tax on equities aptly illustrates the difficulties of introducing an element of fairness into the tax system. Commodity trade in Pakistan is totally unregulated and should therefore in principle be highly competitive. But intervention by the state in the form of public procurement or through administered pricing has brought about distortions such as hoarding and speculation. The tax system, which ought to have penalised these gains, is incapable of doing so.

Fourth, Pakistan's external economy has done well during the first half of the current fiscal year. Exports and remittances have grown by 22 per cent while growth in imports of goods and services has been contained. The current account deficit is much lower than the previous year. Foreign exchange reserves are at a comfortable level and the exchange rate has maintained stability. But the link between the external and domestic economy, particularly public finances, has proved to be tenuous.

A higher level of exports does not translate into higher tax revenues since they are exempted from being taxed, except for a negligible withholding tax. Imports on which duties can be levied have not risen due to lower levels of economic activity, while an increase in non-dutiable food and other essential commodities does not yield any government revenues.

Fifth, the recent National Finance Commission award has rightly altered the nature of the inter-governmental fiscal relationship but has caused serious disequilibrium in the transition phase. The federal government is saddled with all the inflexible expenditures but has a reduced share in the divisible part of taxes. The provincial governments have a much larger share in revenues but have high discretionary expenditures.

It can thus be seen that the precarious fiscal position of the country arises due to disconnects and mismatches between the origins and destination of incremental incomes being generated. The rise in rural, export and informal sector incomes has had no beneficial effect on government revenues.

Meanwhile, gaps, corruption and inefficiency in tax administration, collection and compliance have allowed taxable private urban incomes to escape the tax net. At the same time, urban fixed income groups, the salaried class, the unemployed and the poor are bearing the brunt of the government borrowing from the central bank to finance the fiscal deficit. The high-powered money created by the bank is fuelling inflation and intensifying inflationary expectations.

These conditions create uncertainty for investors and the level of investment declines. If there is inadequate investment in the production of goods and services, the country will face a lower growth rate and high inflation. A vicious cycle will thus set in.

The writer is a former governor of the State Bank of Pakistan.