Recently, there have been talks about a one-time ‘flood tax’ being considered by the Government of Pakistan. If approved, among other measures, it would entail increasing the income tax bill of individuals whose annual income exceeds Rs. 300,000 by 10 per cent. The tax is essential for providing the government with the required revenues to undertake reconstruction projects and to facilitate the desperately needed income redistribution, which is necessitated by the ever growing income divide between the rich and the poor. However, in face of a monumental crisis, does this measure in itself have the capacity to achieve these goals? More importantly, in the midst of the current crisis, is this a step in the right direction or is it just another short-term relief measure that would allow the government to evade the much needed tax reforms? To answer these questions one has to understand the economic implications of taxes.

For most of the post-World War-II era, taxes were believed to be the most widely prescribed measures to bolster public savings. These views were changed by the mid-80s when many economists started arguing that high tax rates did not necessarily help in generating optimal tax revenues. Such views were primarily propagated by supply-side economists and led to the famous Reagan tax cuts in the US, followed by tax cuts throughout most of the developed world. The logic that goes behind it can be derived from an informal concept known as the Laffer Curve. It states that under really low and really high tax rate regimes, the government generates insignificant tax revenues due to lower tax revenues per dollar/rupee of tax base and decreased economic activity, respectively. This concept hypothesizes that there must be a tax rate in between these two extremes that would generate the highest tax revenues. Hence, if a country is above that rate, taxes need to be reduced and if it is below that rate, taxes need to be increased. In the US’s case it was believed that the tax rates were above the optimal rate and hence, needed to be reduced. This idea is not a new one and traces its roots to the Muslim scholar Ibn Khaldun, who stated in his famous work, Muqaddimah, that “at the end of the dynasty, taxation yields a small revenue from large assessments.”

When we apply this concept to developing economies, there is another dynamic that gets accentuated: the element of risk. In order to mitigate some of the negative effects that risk adds to the expected payoffs of an investment, governments frequently reduce their tax rates. Such has been the case in many of the Latin American countries where income tax rates have been extremely low; however, most of these countries have well developed and organized financial systems which allow them to mobilize private savings. These savings in return contribute towards growth in areas that lack entrepreneurs and necessary technological advances.

In case of Pakistan, to counter the economic risks, the government needs to keep tax rates low; however, the poorly developed financial system does not favor the mobilisation of private savings that facilitate growth. In order to finance its budget, the government needs to have revenues and ideally these revenues should come from taxes. If the government is unable to meet its budgetary requirements through internal tax collection, it has to borrow. Needless to say, this can have serious repercussions for the economy since excessive debt after a certain point has a negative impact on growth. This belief was reinforced in a recent study conducted by the European Central Bank, which also concluded that “if policy makers let high debt ratios linger for fear that fiscal consolidation measures will be unpopular with voters, [they will] undermine growth prospects and thus will put an additional burden on fiscal sustainability.” Hence, to keep the debt burden from impairing growth, the government needs to be self-sufficient in revenue generation. This is even more relevant these days as the post-flood Pakistan would require billions of dollars for reconstruction and a continuation of heavy dependence on debt would seriously undermine Pakistan’s future growth prospects.

So does the solution for Pakistan lie in high tax rates? Some other studies have shown that there exists a ‘fiscal limit,' which is defined as the point where the government no longer has the ability to finance higher debt levels by increasing taxes. Moreover, income taxes imposed at higher marginal rates have also proven difficult to administer, even for developed countries, due to the increased chances of evasion and the risk of capital flight. So how does the government increase its tax revenues without increasing the tax rates?

The answer lies in expanding the tax base and improving the tax collection rate. Value-added Tax (VAT) is one way of expanding the base; however, a much bigger problem for Pakistan is tax evasion. Most forms of tax evasion are illegal but some of it has also been legalized in the form of certain tax shelters. By clamping down on tax evasion, the government can not only increase its revenues in the short-run, it can also increase the stream of tax revenues in the long-run. The revenues that the government would generate from clamping down on tax evasion would far exceed the revenues from the one-time flood tax. Reports revealing that only around 1.5% of Pakistanis pay their income tax are not hidden from anyone. In a country where authorities are not allowed to question money transfers from abroad, importers can easily evade custom payments, tax brackets unfairly punish the lower and middle-income population, and the black market makes up a major part of the economy, introducing another tax without at the same time reforming the tax system would only add to the undue burden of tax payments that a tiny proportion of our population is bearing.

As a nation we have shown incredible resilience in the face of crises; however, when someone on a motor bike sees himself paying the same amount of taxes as someone in a luxury car, then the feeling of injustice overpowers the feeling of nationhood. Our leaders need to benefit from the current situation by pushing through reforms in the economic system. This is a time when they can use the risk of an economic meltdown to bypass the political impediments in the path of tax reforms, but we do not see any progress in that direction. Without reforming the system, the flood tax in itself would only disgruntle investors and the small population that is responsibly paying its taxes.

There needs to be a reduction in special tax incentives and abolition of tax shelters. Such measures were undertaken by countries like Boliva, Indonesia, Jamaica and Sri Lanka, to successfully broaden the tax base and increase revenues, without increasing the tax rates. The 1974 tax reforms in Colombia completely revamped the dysfunctional tax system that they previously had. In just the first year of the implementation of these reforms, tax revenues grew by 45% and a staggering 1.5% of GDP shifted away from the top 20% of income earners. Although there were still a few people who were able to find loopholes in the system to evade taxes, nonetheless, the reforms were a step in the right direction.

Shaukat Tareen – our ex-finance minister who some claim resigned due to his disagreements with the government on tax reforms – in an interview with the Financial Times, also warned that imposing such a tax without reforming the tax system and restructuring the public sector companies that are incurring billions of rupees in losses would only discourage investors and frustrate the manufacturing sector, which pays 51% of the taxes.

The flood tax is a welcoming proposal to mitigate some of the costs of reconstruction and our debt burden; however, if the government does not stop hiding from its fears and take the bigger problem of tax evasion seriously, the flood tax could backfire by not generating sufficient revenues and estranging the small population that pays taxes. Moreover, the uneven income distribution could cause serious social consequences that would further weaken our nation. For once, our leaders need to put the national interests ahead of their political interests. In the words of Ibn Khaldun,

“the grand vezir, as the physician … must treat the society’s ills by restoring the balance between the constituent elements, since it is only their equilibrium which ensures the health of society.”

Shujaat Ali Khan is a research associate at the Fed. He is interested in the applications of deterministic chaos and complexity in the field of economics. He can be contacted at khan@alumni.middlebury.edu The views expressed herein are solely those of the author and do not necessarily reflect the views of the Federal Reserve System.

The views expressed by this blogger and in the following reader comments do not necessarily reflect the views and policies of the Dawn Media Group.

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