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Economic reforms: Part – XVII

At the outset, let’s consider some basic facts about the state of public finances in the 1980s and the challenges that the country faced during this period.

The average expenditure was nearly 25 percent of the GDP while revenues stood at 18 percent and the fiscal deficit had averaged around seven percent. This period saw an average tax effort (tax-to-GDP ratio) of 14 percent. These facts point towards a grim state of public finances, with high expenditures (mostly inflexible) and low revenues that resulted in large deficits. Fixing fiscal finances was, therefore, the top priority of economic management. Tax revenues had to play the leading role in this regard.

Of the total taxes collected, 45 percent came from customs (including export duties); 26 percent from excise duties; 18 percent from income tax (including wealth tax); and 11 percent from sales tax. Evidently, 82 percent of tax collections were from indirect taxes and, given that 80 percent of the sales tax was collected at the import stage, more than half (53 percent) of the tax revenues were from foreign trade.

Domestic production as well as the income of residents contributed to only 47 percent of revenues. As we noted in the previous article in this series, this was a hugely distortionary regime as it overlooked the impact of taxes on the local availability of supplies; promoted industries that were incapable of competing on the basis of comparative advantage (thus imposing a huge burden on consumers and their consumption choices); created an import bias as against exports; and discouraged investment by imposing high import duties on the import of plant, machinery as well as on raw materials.

With such a major dependence on customs revenues, the tariff policy was least concerned with its underlying impact on industrialisation and its quality than with the ease of collecting desired revenues. A meagre contribution from income tax also reflected a poor base, low compliance and major exemptions.

This was the state of affairs as the country entered a new phase where survival would depend on domestic resource mobilisation; the ability to compete in the international market and attract foreign investment (as opposed to aid) for technology transfer; enhanced domestic absorption; and accelerated growth.

The reforms agenda was straightforward: (i) significantly reduce dependence on customs (or trade taxes); (ii) eliminate differences in taxes at the import and domestic production levels; (iii) reinvigorate the sales tax as a broad-based consumption tax in the value-added mode; (iv) confine excise duties to only those items that need discouragement; and (v) restructure the income tax and its collection procedures to realise its true potential.

Another affliction that affected the tax structure was its inelastic character – both generally as well as individually. As a result, it did not move in line with the growth in the respective bases (an elasticity of 1 makes growth in tax revenues and the tax base proportional). Customs – the mainstay of revenues – had an elasticity of 0.85 while the elasticity of income tax stood at 0.7. The elasticities of sales taxes, both with respect to imports and domestic production, were dismal, ranging from 0.33 to 0.68.

Excise duties, on an overall basis, were also inelastic. The elasticity of the overall tax structure was 0.8. This meant that as GDP would grow, the tax effort would continue to decline – unless, of course, additional discretionary tax measures were adopted at the time of the budget. Such a state gives rise to the uncertainty that new taxes would be imposed each year and agents would not know how their economics would be affected by these measures.

The sales tax was effectively an adjunct to customs and excise duties. Its independent character was missing. The provisions of the Sales Tax Act, 1951 were often disregarded as it was collected by the excise department as part of excise duty assessments and by customs officials in a similar fashion. On the domestic production, its coverage was extremely low, comprising mostly excisable and some non-excisable products. Since much of the tax was at the import stage, its input adjustment was problematic.

Even though it has some adjustment features at different stages, it was not meant to be a value-added tax as that would require extensive documentation as well as efficient administration. For the most part, a single rate of 12.5 percent was applicable – though in some years, the rate of sales taxes had ranged between 10 percent and 20 percent. Even when it was taking the sales tax to the wholesale and retail levels was considered, it was done by adding margins for those stages on the import or manufacturing points, which once again created disincentives for avoiding the tax through vertical integration.

The sales tax did not have an independent administration and it moved between the income tax and the customs and excise departments. Despite having provisions of input adjustments, the Sales Tax Act, 1951 did not impose a true value-added tax on consumption. In sum, the most desirable indirect tax (as it taxes value-added accruing to labour, profits, wages and rents) was dormant and needed an overhaul.

The state of customs, despite its status as the largest revenue spinner, was also quite precarious. Nearly half the imports were exempted. A plethora of rates for duties characterised the customs regime. There were 17 rates for duties that varied from 10 percent to 350 percent. Dutiable imports required higher duties to generate the required revenues. The reforms would require moving away from customs. But making up for the lost revenue would be a great challenge that would often come in the way of reforms.

Besides the sales tax, there were a large number of surcharges known as para-tariffs – education cess, flood surcharges and the import permit fee – that were added to the duties. The high effective tariffs were an incentive for smuggling as well as the misdeclaration of import values. The high walls of tariffs also promoted import substitution industries whose economics was suspect and were vulnerable to changes in customs tariffs. Capital goods were also subjected to high tariffs that implied a high rate of tax on investment. Exports were adversely affected as raw materials attracted higher rates of duties and the process of refunds (duty drawback) was cumbersome and inefficient.

As far as the income tax is concerned, we have already noted the shortcomings emanating from a large number of exemptions that not only eroded the base but created distortions as agents moved their assets into income-exempting activities. The wealth tax did not yield much but had an annoying presence in the tax code.

To be continued

The writer is a former finance secretary.

Email: waqarmkn@gmail.com

Waqar Masood Khan, "Economic reforms: Part – XVII," The News. 2018-04-10.
Keywords: Economics , Economical issues , Economic management , Income Tax , Economic growth , Exports , Trade , Revenues , Imports , GDP