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Exorbitant tax on formal sector to make the nation poorer

The annual ritual of budget presentation was completed on June 29 with the passage of the Finance Act 2022 by the National Assembly without the usual debate and opposition. One hopes that the budget achieves its paramount objective of revival of International Monetary Fund (IMF) programme within a few weeks, paving the way for the government to mobilize necessary financing required to meet the current year’s forex requirements of over $ 30 billion to meet debt obligations and current account deficit. It is hoped that after the IMF programme is revived, some of the fatal flaws in the budget that will cause irreparable damage to the economy are reconsidered and rectified.

In an earlier article in this newspaper, I had discussed the budget proposals of withdrawal of tax rebates on investments in life and health insurance schemes, mutual funds and voluntary pension schemes (VPS), retained by all past governments to encourage and improve savings in these formal sectors of the economy. Unfortunately, except for the VPS, all other rebates stand withdrawn. In this article, I have discussed another drastic change a further increase in tax rates on persons with incomes higher than Rs 150 million and an exorbitant increase up to 10% on persons earning incomes higher than Rs 300 million. Done in the garb of taxing the rich, will mainly impact organized corporate sector (as in most cases, such level of income is earned and reported by companies) and cause this formal sector to shrink. All of this seems to have been done as it was the easiest way to increase tax collection by taxing high earning corporates who report what they earn.

Pakistan already has one of the highest income tax rates in the world as far as Corporates are concerned. Effective tax rates on shareholders of companies before the levy of supertax comes to 44% (considering 5% levy for workers profit participation fund (industrial establishments), 2% workers welfare fund, 29% normal tax rate, and 15% on dividends). Additional supertax on entities earning higher than Rs 300 million of 10% will increase the effective tax rate on shareholders to 52% for specified sectors (cover large part of the formal economy). In the case of banks, effective tax rate on shareholders (including tax on dividend) will increase from current effective tax rate of 49% to 52% in tax year 2022 and 60% in tax year 2023.

Why additional supertax of up to 10% on higher income is disastrous. Reasons:

Over 95% of this additional tax burden will be on large number shareholders of companies/banks, who are actually earning income much smaller than Rs 150 million. Thus, there is a clear discrimination with the individuals who invest in companies.

It goes without saying that people do business to earn profits, and if more than 50% of earnings is taken away by the government, who will be interested to do business in such jurisdiction. At such exorbitant rates, together with host of withholding taxes, it is simply unviable to operate in a corporate structure; the message to the business community is to operate as sole proprietors or small partnerships.

In most countries, corporate tax rates are significantly lower than individual rates as large scale business, big value creation, productivity and innovation happen in corporate sector. Under this structure, a large number of people can put together their capital, resources and skills to undertake large-scale competitive business. Unfortunately, our tax policy discourages this structure.

Contrary to the above policy, countries all over the world are competing to reduce corporate tax rates to attract foreign direct investment and multinationals to locate in their headquarters/operations. One case study in this regard is that of Ireland. George Bernard Shaw once joked that he would like to be in Ireland when the world ended, as Ireland was considered 50 years behind rest of the world. Irish economy was abysmal, with significantly lower per capita income in Europe; until 1986, its liabilities were 116% of its GDP, taxes were high and the economy was growing at 1.6%. During the 90s, Ireland began to liberalise its economy including cutting tax rates and around year 2000, the corporate tax rate was cut to 12.5%. In 13 years (by 2004/5) its GDP tripled, exports grew 4.5 times and unemployment reduced from 12.9% to 4.8%. Irish exceeded average the EU growth by 6%. While some believed that this may be a temporary phenomenon, Ireland has continued to amaze in recent years. In 2015, the Irish GDP grew by 26%. Thus, Ireland turned into a ‘Celtic tiger’ from a struggling European economy. Major contribution in this transformation was very low corporate tax rate of 12.5 which resulted in large increase in Foreign Direct Investment and relocation of large MNCs like Apple, Google, Microsoft, Facebook, Twitter, IBM, etc.

The trend of reduction in corporate tax rates has become a global phenomenon — described as race to the bottom- as a result, virtually all the developed countries have cut their tax rates to around 20%. As against this, tax rates on high income individuals are virtually double of the corporate tax rates. For instance, corporate income tax in the UK is 19%, while tax rates for high income individuals are 40% & 45%. A similar trend prevails in most economies, including the US.

Given the fact that a very large portion of our economy remains in informal sector, imposing excessive tax on few corporates that are in formal sector and transparently report higher profits tantamounts to punishing honesty and transparent reporting; it is clearly counterproductive and will promote tax evasion.

The biggest reason behind Pakistan’s ‘bankruptcy’ is huge cost and inefficiency of public sector — our government spending is 22% of GDP vs 15% in Bangladesh. Much of such spending is wasted — payments of salaries to much larger number of people than required and other costs against which service delivery remains poor. Even the so-called development expenditure (Total Rs 2.3 trillion for federal PSDP and provincial ADPs in current budget) is poorly spent on projects that do not generate adequate economic benefits. Most projects are initiated based on political considerations without adequate economic justification and are poorly executed, resulting in huge cost over-runs and inordinate delays. It would have been far better, if such development spending was cut by 50% for reducing fiscal deficit rather than imposing exorbitant taxes on private sector.

All over the world, it is through private sector that countries produce goods and services at lower cost for their citizens and become competitive to generate exports. The bulk of employment is created in private sector. All of this happens when you have small and smart governments that promote capital formation in private sector through appropriate economic policies and efficient and beneficial regulation aimed at developing a competitive private sector.

Unfortunately, in our country, we keep expanding the public sector through excessive taxation on a very small formal sector that is shrinking with time. I fervently hope that our fiscal policy of incentivising informal sector through excessive taxation on the corporate sector, and dis-incentivising savings is reconsidered after revival of the IMF programme.

Syed Asad Ali Shah, "Exorbitant tax on formal sector to make the nation poorer," Business recorder. 2022-07-05.
Keywords: Economics , Monetary fund , Tax rates , Income Tax , Economic policies , Public Sector , Formal sector , Higher profits , GDP , PSDP , IMF , VPS , US

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