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Taxes and revenues

Last week I wrote about a proposal floated by some researchers connected with the World Bank and a few other donor agencies to begin relying more on turnover taxes instead of corporate income taxes because the latter has more room for evasion and the former can increase revenues. The authors had backed up their argument with empirical work which suggested that large-scale evasion was taking place in the corporate sector in reporting profits, most probably by inflating costs.

Some of the responses that came in the wake of that article deserve to be shared here. One industrialist wrote in suggesting that if the rate of corporate income taxes were to be reduced, it would incentivise compliance and reduce the need for evasion. Pakistan has the highest rates of corporate income taxes, according to this writer, and there is a need to rationalise these.

My response was that reducing rates to encourage compliance is a losing strategy and rates will naturally tend towards zero if it is adopted. Rationalising with neighbouring countries can only be a viable suggestion once all other costs and incentives enjoyed by local industry can also be taken into consideration. So if there is large-scale evasion under way in the corporate sector, as is widely supposed, tampering with rates is probably not going to be effective in changing this.

A sharp reaction came from Dr Ehtesham Ahmad, one of the leading authorities on fiscal matters in the community of Pakistani economists. Ahmad has long been a proponent of the VAT and argues that without a comprehensive overhaul of the tax system, Pakistani policymakers have only been tinkering on the margins over the years, with the result that the fiscal foundations of the state have been eroded and are groaning under the weight of the expenditures that they have to carry.

A number of Latin American countries have tried similar schemes, he says, and found they produce no real increase in revenue and cause distortions in the economy. “Nobody has been stupid enough to try turnover taxes as minimum tax, as that really begins to add to the cost of production,” he adds. The best reforms are those that enhance the ability of the state to target previously hidden revenue bases. The proposal turns the clock back to the 1980s, when the tax-to-GDP ratio was indeed higher than it is now. “Indeed, the tax system in Pakistan in the early 1980s generated around 15pc of GDP — but was characterised by ‘third-rate’ turnover taxes/production excises, high tariffs and quantitative restrictions on trade, and let’s not forget the infamous ‘octroi’ at the local level,” he has argued in response to this proposal.

“It would be a terrible mistake to go back to the old policy framework and antiquated colonial administrative techniques. The consequence would be to increase the cost of doing business in Pakistan. And now that China has fully integrated its VAT, Chinese goods would be even cheaper in Pakistan with CPEC. This would likely wipe out what remains of Pakistani industry and 70-year-old infants!”

Shaukat Tarin agrees with this. “Taxes should only be levied on incomes and consumption. All others are either unfair or create distortions. If there is widespread evasion, the answer is to tackle the evasion through strengthening tax administration” not through changing the nature of the tax.

I asked the authors of the article if they had anything to say in response to the conversation under way in Pakistan around their work. The article is titled Production versus Revenue Efficiency with Limited Tax Capacity: Theory and Evidence from Pakistan. The authors are Michael Carlos Best, Anne Brockmeyer, Henrik Jacobsen Kleven, Johannes Spinnewijn, and Mazhar Waseem.

In response to an email from me, Michael Best of Stanford University promised to gather responses from his co-authors and revert by close of business on Saturday last. There was no further contact.

Over the years, successive Pakistani governments have been resorting to more and more expedient taxes in order to raise revenues for a rapidly growing population, and multiplying expenditure heads, from security to development, provincial transfers, and climate emergencies. But they have fallen further and further behind due to the rigidity of our revenue system, which goes very far back in time.

The failure of fiscal reforms in line with the requirements of a changing and growing economy means the banking system has been changed into a surrogate revenue generation apparatus, and we are back to square one — where the fiscal system has become a drag on growth.

Reforms are clearly the way forward, and the best kind of reforms are those that enhance the ability of the state to target revenue bases previously hidden, and to make incomes and consumption the bedrock of the fiscal system. But for that to happen, the state needs to be able to see incomes and consumption in the first place, and taming the unruly space of the undocumented sector where the bulk of these activities are taking place is key. This is a function of state capacity as much as political will.

Clearly this is going to take time, so we are left with the question: what to do in the meantime? Expedient revenue lines will continue playing a role in budget-making for years to come. So the question will also naturally hang over us: are there good and bad expedient revenue lines? Is it better to tax turnovers or to tax fuel and electricity?

If there is room to squeeze more revenue out of the corporate sector, it might yet save us from other taxes on the poor, like hikes in the GST or petroleum levies. And if there is research establishing empirically that large-scale evasion is taking place in the corporate sector, a useful discussion around this could take place. But since the authors of the paper have themselves opted for silence, it seems there is nothing further to do but let the proposal die.

The writer is a member of staff. khurram.husain@gmail.com, Twitter: @khurramhusain

Khurram Husain, "Taxes and revenues," Dawn. 2016-05-19.
Keywords: Economics , Economic aspects , Economic issues , Income taxes , World Bank , Policy making , Economic reforms , Turnover tax , Economy-Pakistan , Petroleum , Dr. Ehtesham Ahmad , Pakistan , China , VAT , GST , CPEC