Pakistan Tax Policy Report Nov 08

8/8/2019 Pakistan Tax Policy Report Nov 08

1/158

1

Report No. XX-PK

PAKISTAN

Tax Policy Report

Tapping Tax Bases for Development

December 2008


2/158

2

TABLE OF CONTENT

Chapter I Tapping Tax Bases for Development ............................................................................................ 5Introduction................................................................................................................................................ 5Spending for Results.................................................................................................................................. 6Funding a Full Pipeline.............................................................................................................................. 7

Twin Deficits ............................................................................................................................................. 8Macroeconomic Unraveling ...................................................................................................................... 9Unreliable Non-Revenue Sources............................................................................................................ 10The Challenge of Tapping Tax Bases...................................................................................................... 11Scope........................................................................................................................................................ 13Process ..................................................................................................................................................... 14

Chapter II Structural Properties................................................................................................................... 15Introduction.............................................................................................................................................. 15Adequacy................................................................................................................................................. 17Efficiency................................................................................................................................................. 24Equity....................................................................................................................................................... 27Compliance.............................................................................................................................................. 32Policy Reform.......................................................................................................................................... 35

Chapter III Individual Income Tax.............................................................................................................. 36Introduction.............................................................................................................................................. 36Towards a Global Income Tax ................................................................................................................ 39Capital Gains ........................................................................................................................................... 40Schedules................................................................................................................................................. 43Tax Credits............................................................................................................................................... 44Equity....................................................................................................................................................... 45Compliance.............................................................................................................................................. 46Policy Options ......................................................................................................................................... 48

Chapter IV Corporate Income Tax .............................................................................................................. 49Introduction.............................................................................................................................................. 49Tax Design and Revenue Trends............................................................................................................. 51Tax Incentives.......................................................................................................................................... 54Withholding Taxes................................................................................................................................... 57Small Companies ..................................................................................................................................... 60International Tax Provisions.................................................................................................................... 61Equity....................................................................................................................................................... 63Compliance.............................................................................................................................................. 64Policy Options ......................................................................................................................................... 67

Chapter V General Sales Tax ...................................................................................................................... 69Introduction.............................................................................................................................................. 69Non-Neutrality......................................................................................................................................... 71Weak Legal Vessel .................................................................................................................................. 77Equity....................................................................................................................................................... 78Compliance.............................................................................................................................................. 79Policy Options ......................................................................................................................................... 83

Chapter VI Federal Excise Duties ............................................................................................................... 84Introduction.............................................................................................................................................. 84Legal Framework..................................................................................................................................... 86Equity and Compliance............................................................................................................................ 89Policy Options ......................................................................................................................................... 90


3/158

3

Chapter VII Custom Duties ......................................................................................................................... 91Introduction.............................................................................................................................................. 91Equity and Compliance............................................................................................................................ 93Policy Options ......................................................................................................................................... 94

Chapter VIII Provincial Taxes..................................................................................................................... 95Introduction.............................................................................................................................................. 95Tapping Provincial Tax Bases................................................................................................................. 97

Sales Tax on Services ............................................................................................................................ 101Motor Vehicle Taxes ............................................................................................................................. 106Urban Immovable Property Tax ............................................................................................................ 111Land and Property Transfer Taxes ........................................................................................................ 119Agricultural Income Tax........................................................................................................................ 124Professional Tax .................................................................................................................................... 129Other Taxes............................................................................................................................................ 131Vertical Equity....................................................................................................................................... 132Policy Reform........................................................................................................................................ 133

Chapter IX National Tax Policy Reform................................................................................................... 140Introduction............................................................................................................................................ 140

Individual Income Tax........................................................................................................................... 142Corporate Income Tax ........................................................................................................................... 145General Sales Tax.................................................................................................................................. 147Federal Excise Duties ............................................................................................................................ 148Customs Duties...................................................................................................................................... 149Provincial Taxation................................................................................................................................ 150Way Forward ......................................................................................................................................... 151What Next? ............................................................................................................................................ 158


4/158


5/158

5

Chapter I Tapping Tax Bases for Development

Introduction

Pakistan is once again at a cross-road where macroeconomic imbalances threaten to derail economic

development. Broadly speaking, high growth in the 1960s was followed by low growth in the 1970s, and highgrowth in the 1980s by low growth in the 1990s, as macroeconomic vulnerabilities derailed development.Supported by a favorable global environment, Pakistans development record was impressive once again for muchof this decade. Growth accelerated and fiscal and social indicators improved (Figure I.1). But as in the past, thegains proved unsustainable, as economic policies adjusted too little and too late to a deterioration in the externalenvironment. The looming crisis is threatening to undo much of the recent development progress.

The chapter makes the case that bolstering tax collection is a central part of the necessary policy adjustment

to overcome Pakistans macroeconomic weaknesses and to safeguard sustained development. The problemsof high fiscal deficit, high current account deficit, and high inflation are linked, in one way or another, to Pakistansfeeble tax revenue effort. Pakistans social and infrastructure gaps suggest that public spending outside of debtservicing, defense and economic subsidies will have to increase by around 6.5 percent of GDP over the next fiveyears (World Bank 2008). Funding such public spending through higher fiscal deficits or larger non-tax revenuesruns the risk of repeating the experience of the last five decades. Efficiency gains in the way in which the resourcesare spent can generate some of the fiscal space. But the bulk of the financing of development has to come frommobilizing revenues through tapping tax bases in a sustainable way (Figure I.2).

Figure I.1: Economic and Fiscal IndicatorsPublic Debt, Fiscal Deficit and GDP Growth

Public Debt

(% of GDP)

Budget Deficit

(% of GDP)

Growth (%)

0

10

20

30

40

50

60

70

80

90

1999/2000 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08

0

1

2

3

4

5

6

7

8

9

10Consolidated Public Spending (% of GDP)

Public Spending other

than Interest & Defense

& Federal Subsidies

Public Spending other

than Interest & Defense

3

4

5

6

7

8

9

10

11

12

13

14

15

1999/2000 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08

3

4

5

6

7

8

9

10

11

12

13

14

15

Figure I.2: Covering the Notional Financing Gap2007/08 Public Spending without Interest, Defense, and Economic

Subsidies (10.4% of GDP)

Notional Financing Gap for Additional Public Spending on

Infrastructure and Human Development (6.5% of GDP)


6/158

6

Spending for Results

Economic development depends, among other factors, on how key sectors are funded with public resources.Pakistan, with an unevenly developed private sector, is especially dependent on public investment (Box I.1). Publicexpenditures increased to unprecedented levels in recent years and are now far in excess of the levels during the1990s. The left panel of Figure I.3 shows the real per capita development expenditures of the consolidatedgovernment, including federal, provincial and district expenditures, from 1987/88 to 2007/08. Governmentspending tapered off from over Rs 1,000 per capita in todays prices in the early 1990s to just over Rs. 500 percapita in the late 1990s. Pakistans per capita development expenditures then peaked at Rs. 2,900 per capita in2006/07, before it declined somewhat to reach Rs. 2,600 in 2007/08. This still represents a 400 percent increase inseven years. The expansion of the overall budget envelope translated into higher allocations at the sectoral level.For example, Pakistans poverty reduction strategy prioritizes spending on 17 pro-poor programs. Spending onthese sectors grew from around Rs. 1,300 per capita in 2000/01, just prior to the launch of the poverty reductionstrategy, to Rs. 3,600 per capita in 2007/08, not counting any subsidies on fuel and electricity or expenses fromunanticipated wheat imports. As a percentage of GDP, PRSP expenditures increased from 2.9 percent to 5.5 percent of this period. And the broad spending patterns become more more-poor, as the share of the PRSPprograms in overall spending rose from 16 percent to 25 percent.

Has higher spending translated into better outcomes on the ground? After all, the experience of the SocialAction Program of the 1990s suggests that more resources might simply lead to more wastage rather than morepublic services. Low allocative efficiency (such as an imbalance between capital and recurrent expenditures, orspending resources benefiting the non-poor), low operational efficiency (such as weak expenditure managementfrom planning, procurement, execution, to audit); and weak accountability (such as lack of incentives for effectiveservice delivery of the providers) can all imply that services are failing poor people. In spite of such concerns,Pakistan has witnessed noticeable progress in the last years (Figure I.3, right panel). Some of the gains may havebeen favored through temporary factorsfor example, the reduction in poverty is in part related to the shift from adrought to a bumper crop); and other gains reflect to some extent the increasing role of the private sector in servicedeliveryfor example, the rise of primary enrolment rate in urban areas of Punjab. Nevertheless, the rise in coreindicators of livings standards across the board coincides with increases in public spending on pro-poor sectors.This is in sharp contrast to trends of the previous decade and suggestive of the important role that well-designedand well-executed government programs can play in furthering development.

Figure I.3: Public Spending and Development OutcomesPer Capita Expenditures of the Consolidated Government, (Rupees, 2007/08 Constant Prices)

Development PRSP

0

400

800

1,200

1,600

2,000

2,400

2,800

3,200

3,600

4,000

87/8888/8989/9090/9191/9292/9393/9494/9595/9696/9797/9898/9999/0000/0101/0202/0303/0404/0505/0606/0707/08

0

400

800

1,200

1,600

2,000

2,400

2,800

3,200

3,600

4,000 Selected Indicators of Livling Standards

Net Primary Enrolment

Rate (% Children Aged 5to 9)

Poverty Headcount( %)

Full Immunization Rate(% Infants 12 to 23

Months)

Piped Water(% of Households)

0

10

20

30

40

50

60

70

80

1998/99 2001/02 2004/05 2005/06 2006/07

0

10

20

30

40

50

60

70

80

Box I.1: Basic Services a Public Responsibility

Governments around the world contribute to decent living standards by financing, providing, or regulating basic services.Why? First, these services are replete with market failureswith monopoly power, as when students in remote villages haveonly one nearby school to go to; with externalities, as when an infected child spreads a disease to playmates; and withinformation problems, as when patients know little about the treatment prescribed by their doctor. Second, stark deprivation ofbasic needs violates often the basic values of fairness and equity in a society. So the private sector, left to its devices, will notachieve the level of, say, health and education that society desires. The challenge is to see how the government can mobilizeadequate resources to meet this fundamental responsibility together with the private sector, communities and other partners.


7/158

7

Funding a Full Pipeline

Whatever the recent achievements, much remains to be done in the near future. The numbers speak for thescale of the challenge:over 35 million people did not make ends meet in 2004/05; about 10 million children aged 5to 9 failed to attend primary school in 2006/07; about 2 million infants of 12 to 13 months of age were not fullyimmunized in 2006/07; and some 100 million people had no access to piped water as source for drinking water in2006/07. In addition, the sharp increases in food inflation are likely to have increased poverty, as the averagehousehold in Pakistan spends about half of total household expenditure on food. The rise in food prices by 28percent between May 2007 and May 2008 may have increased the number of poor by more than 10 million.

To address these and other needs, the government is planning to ratchet-up spending on human development

and infrastructure over the next five years. Due to historical underinvestment and rapid economic growth inrecent years, Pakistans infrastructure network is highly stretched and is need of massive investment. Similarly,there is growing demand for a skilled and healthy workforce that cannot be achieved without quality education andhealth services. In the newly drafted Poverty Reduction Strategy Paper II, the Medium-Term DevelopmentFramework and Vision 2030, the Government of Pakistan has announced a number of mega infrastructure projectsand programs such as the National Trade Corridor, large-scale dams, upgrading of transmission and distributionnetwork in the energy sector, and rural electrification. In addition, the Fiscal Responsibility and Debt LimitationAct stipulates doubling spending on education and health as percentage of GDP from 2.2 percent of GDP in2003/04 until 20012/13.

Ensuring adequate funding for essential social and infrastructure projects is crucial for economic growth. Incase the macroeconomic situation requires a fiscal contraction, the bulk of the adjustment tends to fall on publicexpenditures for development. Other expenditures, such as interest payments, defense, and wages are eitherpredetermined or difficult to cut for political reasons, and identifying revenue yielding measures in the short term proves often difficult. A popular phrase during the era of macroeconomic stabilization of the 1990s wasadjustment with growth. Yet, some types of fiscal austerity not only fail to bring growth, but they may not evenbring adjustment in the long run (WBRO 2008). Declining investment is a cause for concern when it results indecreased accumulation of productive public capital, and it is not compensated by increases in private investment.When such growth-promoting spending is cut so much that the presentvalue of future government revenues falls bymore than the immediate improvement in the cash deficit, then fiscal adjustment ultimately harms sustainablegrowth. Pakistans own experience is a case in point. As development spending dropped from 7 percent of GDP in

the early 1980s to only 2 percent by the end of the 1990s in response to fiscal problems, trend growth declined fromover 6 percent to no more than 3 percent over the same period. Furthermore, provisions for repair and maintenanceexpenditures were slashed along the way as they remained at around 1 percent of development spending, resultingin an erosion of the existing stock of capital at a fast rate.

Clearly, not all public programs are equally productive. Some projects are poorly selected and procured, or avehicle of dispensing political favors rather than acquiring productive assets. This is why in case of a fiscal cruncha careful prioritization for cuts rather than an across-the-board reduction is essential to protect growth-promoting programs. However, such prioritizations are difficult to do, as they typically rely on the same institutional processes that led to the adoption of unproductive projects in the first place. Furthermore, in time of liquidity pressures, there are calls for sharing the burden equally, and more often than not, the adjustments impinge onproductive and non-productive programs alike.

Even allowing for internal savings, overall public spending would have to increase by no less than 5 percent

of GDP within the next five years to fund essential development programs. According to estimates presentedin World Bank (2008), public spending would have to rise by 6.5 percent of GDP over the next five years to fundimportant growth-promoting programs. These resources could come in part from savings on the expenditure side ofthe budget. First, public-private partnerships can bring private and non-government sectors on board to finance and build economic infrastructure and provide social services. Second, improvements in allocative and operationalefficiency can reduce costs through better prioritization and better execution of government programs and projects.But the bulk would have to be funded from three sources: higher fiscal deficit; higher non-tax revenues; or highertax revenues. The remainder of this chapter will argue that the first two sources will not ensure a sustainedincrease. The rest of the report discusses how tax bases, the third source, can be tapped for Pakistans development.


8/158

8

Twin Deficits

Pakistans recent economic history provides the latest example of how fiscal and monetary imbalances can

undermine macroeconomic stability. At the beginning of the decade, Pakistans macroeconomic policies werecentered on reducing the countrys debt. Key steps included the renegotiation of external debt with Paris Clubcreditors, pre-payment of extensive debt, greater reliance on concessional borrowing for new loans, and a reductionin domestic interest rates through the liberalization of the financial sector. They, together with a strong expansionin the economy, led to a decline in public debt and debt servicing. At the same time, the consolidated fiscal deficitincreased from 2.3 percent in 2003/04 to 4.3 percent of GDP in 2006/07. When the government runs a deficit, itmeets some of its expenses by issuing bonds. In doing so, it competes with private borrowers for money lent bysavers, raising interest rates. This leads to crowding out of private investment. The reduction in domesticinvestment lowers the capital stock and productivity growth and reduces future national income, as the country willinvest less in new plant and equipment. This effect is muted when a country has access to foreign capital, becausethe budget deficit can be financed from abroad (Figure I.4, left panel), as the rise in interest rates due to government borrowing attracts foreign capital. Indeed, Pakistan experienced a surge of capital inflows from abroad, whichallowed the investment rate to increase in spite of the decline in national saving.

While foreign inflows may sustain investment and upgrade technology, they also carry costs. Foreign directinvestment has played a vital role in modernizing successful emerging economies through the transfer oftechnology and skills and by augmenting the recipients domestic capital stock. Nevertheless, other foreign inflowsare less likely to produce such benefits, and higher indebtedness to foreigners mean that a higher fraction of acountrys output will have to be sent abroad in future rather than being consumed at home. Net income of profitsand dividends to foreigners increased from $450 million in 2003/04 to over $800 million in 2006/07. Hence, in thelong run, if Pakistan wants to increase its investment and not pay increasing shares of income in interest ordividends, it has to finance this investment by raising its own national savings. In addition, as foreigners bid up theprice of the Rupee in order to get more of them to invest in high-yielding paper, the exchange rate appreciates. Thismakes imported goods cheaper in Pakistan and exports more expensive abroad, leading to a decline of the tradebalance. This effect underlines the twin deficits of budget and trade.

Lose monetary policy compounded the effect of expansionary fiscal policy. Monetary growth exceeded GDPgrowth in five years between 2001/02 and 2006/07, and inflation rose from 3.5 percent to 7.8 percent over thisperiod. In spite of some increase over time, Pakistans savers received low returns, still remaining below inflation.

Average deposit rates on outstanding deposits increased from just 3 percent in 2002/03 to less than 5 percent in2006/07, staying far below inflation rates. Low returns on bank deposits discourage private savings and fuel asset-price bubbles as households seek higher returns by buying shares and property.

Government dis-saving and weak incentives for private savings combine to a low national savings rate. Pakistans national saving rate of 18 percent of GDP in 2006/07 compares unfavorably with the rapidly-growingeconomies in Asia. For example, China and Malaysias national savings rates are around 45 percent of GDP, andIndias national savings rates around 35 percent of GDP.

Figure I.4: Savings, Investment and Capital Flows

National Saving and Investment (% of GDP)

PublicSaving

PrivateSaving

National Saving National Investment

-4

-2

0

2

4

6

8

10

12

14

16

18

20

22

24

2001/02 2002/03 2003/04 2004/05 2005/06 2006/07

-4

-2

0

2

4

6

8

10

12

14

16

18

20

22

24

2000/011999/2000 2007/08

Capital Inflows to Pakistan ($ Million)

Foreign DirectInvestment

Net PortfolioInvestment

-2,000

-1,000

0

1,000

2,000

3,000

4,000

5,000

6,000

1999/2000 2000/01 2001/02 2003/04 2004/05 2005/06 2006/07

-2,000

-1,000

0

1,000

2,000

3,000

4,000

5,000

6,000

2002/03 2007/08


9/158

9

Macroeconomic Unraveling

Pakistans macroeconomic imbalances widened sharply in 2007/08, as two external shocks hit the economy. From July 2007 to June 2008, the international prices of crude oil and wheat increased by over 100 percent and 40percent, respectively, leading to a sharp deterioration in Pakistans terms of trade. In addition, Pakistans access tocapital and goods markets became more difficult with the turmoil in international financial markets and theslowdown in the global economy. Faced with the political uncertainty of an election year, the government passedon the increases in commodity prices only with delays and in parts, and resorted to financing the difference betweenimport and domestic prices through expensive budgetary subsidies. The budget deficit shot up from 4.2 percent ofGDP in 2006/07 to 7.4 percent of GDP in 2007/08, substantially over and above the sustainable level. The negativeconsequences of prolonged budget deficits of this order are likely to be more severe than just the crowing out ofprivate investment and decline in national saving. The inability of the government to restore fiscal balance maydirectly reduce business and consumer confidence, as the view of the ongoing deficits as a symbol of the nationsinability to address its economic problems permeates society, and the reduction in confidence can discourageinvestment and real economic activity. They can cause a fundamental shift in market expectations and a relatedloss of confidence both at home and abroad, which in turn can generate a self-reinforcing negative cycle among theunderlying fiscal deficit, financial markets, and the real economy (Rubin, Orszag and Sinai 2004).

First, the business community may become increasingly concerned that the government would resort to high

inflation to reduce the real value of government debt. The government financed the rising fiscal deficit to alarge extent through direct borrowing from the State Bank of Pakistan. While the SBP aimed for a reduction of thestock of government borrowing by Rs. 62 billion for 2007/08, the government increased its SBP borrowing byaround Rs. 630 billion over the course of the year. This translated into higher money supply and higher inflation.In June 2008, inflation 11.5 percent, compared to an annual target of 6.5 percent. One of the undesirableconsequences of the acceleration of the inflation rate is that it imposes an arbitrary (inflation) tax with highlydiscriminatory and regressive effects on income earners and savers.

Second, foreign investors may lose confidence, as they are concerned by ongoing budget deficits and large

current account deficits. High international high oil prices add to the budget deficit through fiscal subsidies tokeep domestic fuel prices low; as well as to the current account deficit through the burdening import bill, especiallywhen domestic demand stays high in view of subsidized prices. Pakistans current account deficit reached 8.4percent of GDP in 2007/08, compared to only 4.9 percent last year. Net capital inflows slowed from US$ 10.6

billion to US$8.2 billion, as portfolio investment dropping from over US$ 3.2 billion to zero. By end June 2008,foreign exchange reserves of the State Bank of Pakistan stood at US$ 8.1 billion, a fall of more than US$ 6 billionsince October 2007. With Dollar demand strong in view of the high oil price, and Rupee demand weak in view ofthe deterioration in the capital account, the Rupee-Dollar nominal exchange rate depreciated by 15 percent in2007/08.

Third, the decline in confidence can reduce stock prices and household wealth, raise the costs of financing to

business, and reduce private-sector domestic spending. These various effects can feed on each other to create amutually reinforcing cycle. For example, as investors and creditors reallocate funds away from Rupee-basedinvestments, the exchange rate depreciates further, requiring sharply higher interest rates on Rupee governmentdebt. Increased interest rates and diminished economic activity may further worsen the fiscal imbalance, which canthen cause a further loss of confidence and potentially spark another round of negative feedback effects. Although

it is impossible to know at what point market expectations about the nations projected fiscal imbalance couldtrigger these types of dynamics, the harmful impacts on the economy, once these effects were in motion, wouldsubstantially magnify the costs associated with tackling the macroeconomic imbalances. Indeed, the potential costsand fallout from such fiscal disarray provide perhaps the strongest motivation for avoiding substantial, ongoingbudget deficits. Budget projections are inherently uncertain, but such uncertainty does not provide a rationale forfiscal profligacy. It is much harder for the political system to reduce deficits than to expand them. As a result ofthis asymmetry, enacting a spending increase or tax cut today is costly because they constrain policy-makersflexibility to respond to unforeseen events in the future.


10/158

10

Unreliable Non-Revenue Sources

While running high fiscal deficits gets in the way of economic growth, perhaps the first place to look for

additional resources is non-tax revenues. After all, taxing citizens can be a quick way for governments tobecome unpopular. Indeed, Pakistans non-tax revenues have grown faster (15 percent annually in nominal terms)than tax revenues (14 percent) since 1999/2000, and made up in 2007/08 about 30 percent of total revenues offederal and provincial governments (Figure I.5, left panel) (Box I.2). In 2007/08, the government received someRs. 449 billion or 4.3 percent of GDP in non-tax revenues, which is more than the collection from direct or sales

taxes.

Non-tax revenues are likely to become less important in financing public expenditures in future: Receipts from public property and enterprises traditionally the most important non-tax revenue source - have

declined in nominal terms since 2003/04 due to privatization (Figure I.5, right panel). This trend is set tocontinue in the future as the selling of public assets to private owners is likely to proceed.

Civil administration revenues grew more than six fold since 2001/02, primarily due to rising defense receiptsfrom logistical support to US operation in the war on terror. Defense receipts are subject to politicaluncertainty, which led to delays in payments during 2007/08.

The rise in civil administration revenues also reflects higher profits of the State Bank of Pakistan, in part fromthe privatization of public stakes in banks in the context of the governments privatization agenda. Currentplans include the sale of Global Depository Receipts for leading banks, such as Habib Bank and National Bank,

so this is likely to remain an important revenue source in the next few years. However, the challengingenvironment in global credit markets might make an ambitious placement program difficult to implement. TheWorld Bank estimates that gross capital flows to developing countries will decline from US$683 billion in2007 to US$103 billion in 2008. Furthermore, this source of funding will deplete in the medium run once suchbank holdings have been transferred from public to private ownership.

The performance of provincial non-tax receipts has been disappointing in the past, and there is little to suggestthis would change in the near future within the current inter-governmental fiscal framework.

Figure I.5: Pakistans Non-Tax Revenues

Consolidated Fiscal Revenues (Rs Billion, Current Prices)

0

200

400

600

800

1,000

1,200

1,400

1,600

1999/2000 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08

Tax Revenue

Non-Tax Revenue

Composition of Consolidated Non-Tax Revenue (% of Overall Non-Tax Revenue)

54

68

5658 50

28 26 25

2721

26

29

10

16 1616

2416

11

21 19

35

30

11

14

1011

8

1511

17

1315

10 12 14 14

27

12

52

25

28

30

9

28

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1999/2000 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08

Property &Enterprises

Surchargesand Levy

CivilAdministration

Provincial

Miscellaneous

Box I.2: Gas and Petroleum Surcharges and Petroleum Development Levy

From 1999/2000 to 2004/05, fiscal accounts subsumed gas and petroleum surcharges and petroleum development levy as taxrevenues. This report uses a consistent definition over the entire period and classifies these receipts as non-tax revenues.Petroleum and gas surcharges are an unstable source of budgetary revenue because retail prices, as well as margins for thedistributors, transporters, and dealers are regulated. In principle, petroleum and gas retail prices are adjusted regularly based onthe sum of lagged landed costs of fuel, fixed margins, surcharges fixed in Rupees per liter, and all other taxes, including the 16percent GST. However, due to political pressures to cushion domestic consumers, the surcharges were compressed as landedcosts of fuel and gas increased since 2002. While the surcharges yielded as much as 1.4 percent of GDP in 2002/03, theydeclined to naught in 2006/07.


11/158

11

The Challenge of Tapping Tax Bases

As the projections for non-tax revenues are at best uncertain, a sustainable increase in the governments

resource envelop requires higher tax revenue mobilization. Yet, Pakistans tax collection has failed to improvesince the late 1990s. Structural problems, such as a narrow tax base, tax evasion, distrust of the taxpayer vis--vis public institutions, and administrative weaknesses, have taken a toll on tax collection. The tax-to-GDP ratiodeclined from 10.6 percent in 1999/2000 to 10.0 percent in 2007/08 (Figure I.6). As discussed previously, in orderto ensure adequate public funding for development priorities, Pakistan will have to increase tax collection by 4.0percent over a five year horizon, or from 10 percent of GDP in 2007/08 to 14 percent of GDP by 2012/13.

Figure I.6: Turning Around the Tax-to-GDP Ratio

Pakistan's Tax Revenues - Actual and Projection (% of GDP)

10.6

11.4

12.3

13.2

14.0

10.09.9

10.0

10.5

9.79.8

10.6

10.2

9.0

9.5

10.0

10.5

11.0

11.5

12.0

12.5

13.0

13.5

14.0

1999/2000 200 0/0 1 200 1/0 2 2 002/03 20 03/04 2004 /05 20 05 /06 2006/07 2007 /0 8 200 8/09 2009 /10 20 10/11 20 11/1 2 2 012/13

PROJECTIONACTUAL

10.7

International experience shows that tax reform can delivery such ambitious targets. While there are otherdeveloping countries at Pakistans income level with similarly low tax-to-GDP ratios, a look across the bordersuggests that this does not have to be that way (Figure I.7). The simple average of the tax-to-GDP ratio in

Bangladesh, India, Nepal and Sri Lanka countries with similar tax policies and administration is systematicallyhigher than in Pakistan, and the gap increased during this decade. Furthermore, countries like Egypt, India,Thailand, Turkey, and South Africa experienced rapid growth and rising tax ratios, while Pakistan saw taxcollection rising just in line with economic growth. And while central government tax collection increased from13.8 percent in 2000 to 16.5 percent in 2004 in Asian and Pacific countries overall, it declined slightly as percent ofGDP in Pakistan since 2000. There is no immediate improvement in sight. Whereas the tax-to-GDP ratioincreased by 0.2 to 0.3 percent in 2005/06 and 2006/07, it declined by 0.2 percent in 2007/08 (Box I.3).

The weakness of Pakistans tax system goes beyond the issue of revenue adequacy. There are worries that therevenue is raised in an inefficient way by favoring certain sectors and economic activities over others. Such excess burden of taxation can deter people from investing in the most productive sectors and earning more form theresources available, and ultimately get in the way of economic growth. Some sectors are much more heavily taxed

compared to their contribution in terms of GDP than other sectors. Agriculture contributes about one fifth of GDP,yet no more than 1 percent in FBR tax revenue. Services make up almost half of economic value added, but onlyone quarter of central taxes due to the low tax receipts from wholesale, retail, and transport. Given the shortfall inagriculture and services, industry carries the brunt of the tax burden - its tax share is three-times as high as its GDPshare. In addition, there are question marks to what extent the tax system, through the way it treats differentincome classes of people differently, is sufficiently equitable. While some progress has been made, Pakistans taxcode remains complicated and most taxpayers have little knowledge on their obligations. Finally, provincial taxesyield no more than 0.4 percent of GDP, so that district and province governments depend on large fiscal transfersfrom higher levels to meet their expenditure responsibilities.


12/158

12

Figure I.7: Tax Collection in Pakistan and other Developing Countries

Tax Revenue in South Asian Countries (% of GDP), 20 00/01 to 2006/07

9.8

11.5

9.8

12.0

10.2

13.1

9.5

10.0

10.5

11.0

11.5

12.0

12.5

13.0

13.5

Paki st an Simpl e Ave ra ge of Ba ngla desh, In dia, Nepa l andSri Lanka

2000/01 2003/04

2006/07

General Government Tax Revenues and Per Capita Income

Pakistan and Other Emerging Economies (2003 or 2004)

Tax Revenue(% of GDP)

PPP GNI Per Capita

0

5

10

15

20

25

30

35

40

Banglad.

Nepal

Pakistan

Indones.

Egypt

SriLanka

Philipp.

Thailand

Vietnam

India

China

Mexico

Colomb.

S.

Africa

Brazil

Turkey

Ukraine

Russia

0

2,000

4,000

6,000

8,000

10,000

12,000

Growth (%) and Tax Revenue (% of GDP) in Emerging Market Economies, 2002/03 to 2006/07

10.0

13.414.0

14.5

22.422.9

10.2

15.816.3

17.7

23.9

26.3GDP Growth

(02/03 to 06/07)

0

2

4

6

8

10

12

14

16

18

20

22

24

26

28

Pakistan Egypt Thailand India Turkey South Africa

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Tax to GDP (%)

2002/03 2006/07

Box I.3: Why Did FBR Missed the 2007/08 Collection Target?After meeting revenue targets continuously for the last five years, FBR tax collection fell short of the target in 2007/08. FBRrevenue collection was 19 percent higher than in the same period last year. This compares to a target growth of 22 percent.What accounts for the disappointing performance? First, the original 2007/08 FBR revenue target was ambitious. Based onthe government projected GDP, it implied an increase in the tax-to-GDP ratio from 9.7 percent in 2006/07 to 10.4 percent in2007/08. The required increment of 0.7 percent of GDP compares to actual increases of 0.3 percent of GDP over the twoprevious years.

Second, the economy has slowed down in the current fiscal year. Most importantly, growth in the manufacturing sector, whichcontributes around three-fifths of FBR revenues, is declining due to domestic energy woes, increases in the price of importedinputs, and dampened international demand, especially for textile exports. Large-scale manufacturing expanded by only 4.8percent compared to an annual target of 10.5 percent.

Third, direct tax collection has been below target due to various idiosyncratic factors. The extended closure of business due toEid holidays and national mourning after the assassination of the former prime minister in December; frequent changes in the

dates of filing of income tax in response to political uncertainty, holidays and administrative reasons; and the profit reductionin the banking sector as a result of higher cash provisioning requirements by the State Bank of Pakistan all contributed to theweak performance of direct taxes. The poor collection of direct taxes is also linked to recent changes in income tax procedures,which implied that some companies paid no taxes with the December tax returns as because of advance payments in theprevious fiscal year.


13/158

13

Scope

In view of these concerns, it is important to take a thorough look at Pakistans tax policy reform options.

The main message of this report is that Pakistan can take tax policy measures to increase the tax to GDP ratio by4.0 percentage points over the next five years. In order to ensure a healthy long-run economic development,Pakistan needs to embrace substantial changes in tax policy aimed at increasing the buoyancy of the tax system,broadening the tax bases, reducing distortions and phasing out exemptions. Such tax reforms are also required todeal with the risks stemming from sustained large budget deficits. Failing to act sooner rather than later, onlymakes the problem more difficult to address without considerable instability, raises the probability of fiscal andfinancial disarray at some point in the future, and runs the risks of further constraining policy flexibility in future.

This report provides a comprehensive assessment of Pakistans tax policies and lays out options its reform. It is based on work commissioned for this report and on contributions of other researchers in Pakistan andelsewhere.1 The report has four parts (Figure I.8). The first part, this chapter, argues from a macroeconomicperspective that there are no viable alternatives to mobilizing tax revenues for financing government expenditures.The second part, Chapter II, subjects Pakistans tax system to a basic health check and assesses the tax system withregard to the four properties of adequacy, efficiency, equity and compliance. The third part, covered in Chapter IIIto Chapter VIII and the core of this report, takes each major tax and discusses how it squares up with regard to theproperties spelled out in Chapter II. The final part, Chapter IX pulls together the findings to lay out a roadmap forreform. It presents a comprehensive medium-term reform agenda of tapping tax bases for Pakistans development.

This reports deals only with some of the many aspects of Pakistans tax system. This coverage reflects theemphasis recommended by the Federal Board of Revenue and peer reviewers at the concept stage of this report, thedesire to avoid duplication with existing literature, data constraints, and, last but not least, the need to keep the taskmanageable. Three limitations are worth highlighting explicitly. First, the reports principal focus is on tax policyissues. Yet, tax policy is intimately related to tax administration, as any implemented tax policy has to pass the testof administrative feasibility. Tax policies should not just generate resources efficiently and equitably, but alsoensure broad compliance. While a detailed discussion of the capacity of Pakistans tax administration is beyond thescope of the report, it provides estimates of tax revenues lost due to tax evasion, and highlights priority areas foradministrative reforms of the Federal Board of Revenue. Second, the report presents a fairly aggregate view.Particular sectors, like oil and gas or banking, face special tax regimes that are not discussed in detail. Beingmindful of such sectoral dimensions will be important when translating the reform into tax policy changes. Third,

provincial tax polices are discussed for Punjab and NWFP only. As each province faces unique challenges whileSindh has a large tax base through the commercial hub of Karachi, Balochistan is much devoid of any sizable taxbase , a similar analysis for Sindh and Balochistan would be important, especially in the context of a discussion onthe intergovernmental architecture.

Figure I.8: Navigational Aid for the Report

Adequacy Efficiency Efficiency Compliance

CHAPTER III CHAPTER IV CHAPTER V CH APTER VI CHAPTER VII CHAPTER VIII

National Tax Policy Reform

CHAPTER IX

CHAPTER I

CHAPTER II

Tapping Tax Bases for Development

Individual

Income Tax

Corporate

Income Tax

General Sales

Tax

Custom

Duties

Provincial

Taxes

Federal

Excise Duties

OBJECTIVE

PROPERTIES

TAXES

STRATEGY

1 Pakistan has a long tradition of tax policy analysis. In their seminal contribution, Ehtisham Ahmad and Nicolas Stern (1991)show how design principles of tax policy can help to assess the impact of tax reform for households, producers andgovernment, and apply the framework to Pakistan. Other contributions include Pasha and Iqbal (1994), Pasha (1995) andvarious reports of the International Monetary Fund.


14/158

14

Process

This report is the outcome of a partnership among three parties : the Federal Board of Revenue; the AndrewYoung School of Policy Studies (AYSPS) at Georgia State University, and the World Bank. The Government ofPakistan attaches high priority to broadening the tax base in an efficient and equitable manner, and is aware of theneed for further improvements in the tax system. After launching a project of the FBR and the World Bank on taxadministration reform in 2005, the government sought to complement this work with a parallel initiative on taxpolicy. In response to the government request, a partnership among the three parties was formed in January 2007.Additional government counterparts include the Ministry of Finance and finance departments in Punjab andBalochistan. The services of AYSPS were generously supported through the UK Department for InternationalDevelopment.

This collaboration extended beyond the delivery of a report, as process was viewed as a key input for impact.Pakistans capacity to undertake fiscal policy analysis is limited, despite selective strong points at FBR andelsewhere. Long-term remedies to this situation require initiatives such as training at the Masters level in fiscal policy of FBR and Ministry of Finance personnel, expanding the number of positions dedicated to tax policyanalysis in those institutions, and offering more attractive salary and working conditions to attract and retain theright people. Such measures were beyond the scope of this project. Nevertheless, other forms of capacity buildingtook place by the joint work of the AYSPS experts and government tax policy analysis experts, ensuring that theprocess of preparing the report served as a teaching tool for capacity building and a collaborative tool to buildownership. Many of these mechanisms also served as dissemination tools to stimulate dialogue. The reports primary audience is the federal and provincial governments. The report is also written for policymakers anddevelopment practitioners in Pakistan, as well as for governments and international donors that support tax policyreform in other South Asian countries. The report is expected to generate debate and discussions among the civilsociety and research communities.

Timely delivery of analytical work and regular dissemination of intermediary outputs is crucial for

stimulating on-going dialogue with counterparts and the broader set of actors. For this reason, the backgroundstudies for this report were structured as a series of seven tax policy papers. The AYSPS teams visited Pakistantwo times in the course of the preparation of each policy papers. The first mission gathered the basic information,held detailed discussions with government staff and other stakeholders, and came to an agreement with the Pakistanauthorities on the coverage of each tax policy study. The second mission presented the draft policy paper and

collected comments and feedback for the finalization of the study. The final report will be disseminated through atax policy workshop.

The collaboration involved three modes of capacity building. First, three FBR officials spent each three monthsas visiting scholar at AYSPS to collaborate with the report team on tax policy papers. Second, the AYSPS teamdelivered in-country training program for civil servant on the methodologies and findings of the tax policy papers.Third, government staff engaged in learning by doing on the policy papers through regular discussions with thereport team. In addition, the report team went with a FBR delegation on a study tour to Turkey to learn about itssuccesses and failures in the reforms of their tax systems.


15/158

15

Chapter II Structural PropertiesIntroduction

Tax systems are not just about raising revenues. This primary objective offinancing government expendituresis sometimes termed adequacy. Corresponding, dynamic concepts relate to the ability to generate adequate(buoyancy and elasticity) and predictable (stability) resources over time in line with growing expenditurerequirements. But while raising revenue is important, taxes should in general not influence the behavior of thosewho pay them unduly; in choosing taxes, a common goal is to minimize the interference of taxes in the economicdecisions of individuals and firms (efficiency). Another objective is to distribute the burden of taxation in a waythat meets with a societys notions of fairness; such equity is typically defined in terms of ability to pay, suchthat those with greater ability should pay greater taxes (vertical equity), and those with equal ability should payequal taxes (horizontal equity). Finally, taxpayers should adhere with the tax system (compliance). Thismeans the tax system should make it easy to comply with tax laws and be simple to administer.

This chapter subjects Pakistans tax system to a basic health check and assesses the tax system with regard

to the four dimensions of adequacy, efficiency, equity and compliance. While many features of Pakistans taxsystem are in line with international practice (

Table II.1), the examination also reveals important structural problems. For starters, the tax system has failed todeliver sustained increases in the tax-to-GDP ratio over the last few decades. While the revenue performanceimproved over the last few years, the pace of progress is slow and indeed halted altogether in 2007/08. Todaystax-to-GDP ratio remains inadequate to meet Pakistans development agenda. These shortcomings are, in part, thedirect result of exemptions and special regimes, which, in combination with administrative problems, also weakenefficiency, equity and compliance and undermine the overall coherence of the tax system.

Box II.1: Brief Overview of Pakistans Tax System

In 2007/08, Pakistan collected approximately Rs. 1,050 bn in tax receipts, of which the provinces collected some Rs. 40 bn (4percent of national tax revenues). Not unlike other developing countries, about two-fifth (Rs. 389 bn or 39 percent) of thefederal taxes come from direct taxes, and three-fifth (Rs. 617 bn) from indirect taxes. A direct tax is one paid directly to thegovernment by the persons (juristic or natural) on whom it is imposed. An indirect tax is one which is collected byintermediaries who turn over the proceeds to the government.

Federal direct taxes consist of an income tax, payroll taxes, a capital value tax, and a wealth tax. About 95 percent of the directtax revenues come from the income tax. Taxable income under the individual Income tax consists of income derived from

wages and salaries, rental income, business income, capital gains, except for stock market capital gains, and other sources ofincome. There is a progressive tax rate schedule that increases gradually from zero to 20 percent. There is a long list ofdeductions, exemptions, credits, and preferential tax rates. The base of the corporate income tax is conventionally defined asincome earned from the sales of goods and services, and any income received in the form of rents, interest, management fees orroyalties. A fairly usual list of business expenses is deductible from chargeable income. Pakistan, with the exception of smallcompanies, applies a uniform corporate tax rate of 35 percent. In addition, there is an extensive network of withholdingmeasures that include many forms of presumptive taxation. To a large extent, Pakistans withholding tax regime consists offamiliar withholding taxes on income at source which has proven to be an effective means of increasing tax compliance inmany countries. But in addition to these familiar source based withholding taxes, there is an important, in revenue terms,regime of what are essentially excise and transactions-type taxes, which are characterized in the reports and financialstatements of the FBR as withholding taxes. This part of the withholding regime may be unique to Pakistan. Some of thesewithholding taxes are considered to be final, and others are considered to be advanced or adjustable taxes.

The indirect tax system consists of a sales tax, a federal excise tax, and import duties. Sales tax, in the form of a invoice-creditvalue-added tax, is imposed on all traders, other than those involved in providing services, with a turnover above theregistration threshold of Rs. 5 mn ($62,500). A zero rate regime applies to exports and a number of other sectors, and somesectors are exempt. The sales tax rate was increased from 15 percent to 16 percent in 2008/09. The federal excise tax baseconsists of 48 excisable goods. These can be grouped into six categories, vegetable oils, carbonated beverages, tobaccoproducts, cement, and 17 different types of oils and fuels, and certain luxury items. Finally, customs duties are applied toimports. The tariff schedule generally provides for duty rates, ranging from 0 to 25 percent in 5 percentage point increments,i.e., 0 percent, 5 percent, 10 percent, and so on, with tariff peaking beyond these rates for imports of automobiles, automobileparts, aerated beverages, and tobacco products.

While the constitution assigns the federal government the more buoyant and easy-to-reach taxes, provincial taxes include theproperty and property transfer taxes, motor vehicle taxes, the agriculture income tax, and the sales tax on services.
http://en.wikipedia.org/wiki/Juristic_personhttp://en.wikipedia.org/wiki/Natural_personhttp://en.wikipedia.org/wiki/Indirect_taxhttp://en.wikipedia.org/wiki/Indirect_taxhttp://en.wikipedia.org/wiki/Natural_personhttp://en.wikipedia.org/wiki/Juristic_person


16/158

16

Table II.1: Main Findings of Chapter II

Topic FindingsTax-to-GDP Ratio Pakistans development needs require that the tax-to-GDP ratio should increase by at least

4.0 percent of GDP over the next five years. This would raise Pakistans tax effort close to14 percent of GDP, roughly equal with the simple average of the tax collection inBangladesh, India, Nepal and Sri Lanka, as well as the figure for Indonesia.

Narrow Tax Base In 2006/07, relative to its share in GDP, industry paid 60 times more taxes than agriculture,

and 5 times more taxes than services. Among the 24 subsectors, there are 10 subsectorswhose tax contribution is below its GDP contribution: textile, ownership of dwellings,agriculture, construction, transport and communication, wholesale and retail trade, food andbeverages, public administration, other services and telecom. All four major federal taxesrely heavily on the performance of a few sectors.

Long-Term Buoyancy The overall buoyancy of the FBR taxes declined from above unity in the 1960s and 1970s to below unity in the 1980s and 1990s, and increased above unity in the 2000s, although itremains below the levels of the 1960s and 1970s. At 1.05, it is rather low: a one percentincrease in GDP implies an increase in the tax-to-GDP ratio of only 0.05 percent (that is 5percent of 1 percent).

Short-Term Buoyancy At 9.6 percent of GDP, federal tax collection is about the same in 2007/08 as in 2002/03,and only some 0.5 percentage points of GDP higher than in 1999/2000.

Federal Tax

Expenditures

According to government estimates, tax expenditures of the federal government, calculated

as the estimated revenue loss in percent of GDP, declined from around 0.8 percent in2000/01 to 0.33 percent in 2005/06, and then increased to 2.1 percent in 2006/07 and 0.9percent in 2007/08.

Federal RevenueTargets

Since 1999/2000, fiscal year outcomes for FBR collection fell short of what should havebeen expected under the realized growth factors and budgeted revenue measures in four outof the last eight years.

Provincial Tax Effort The share of provincial taxes in provincial revenues is very low. In 2006/07, it was no morethan 2 percent in Balochistan, 4 percent for NWFP, 9 percent for Sindh, and 8 percent forPunjab. Sindh collected no more than Rs. 390 in own-source tax revenues from each of itscitizens, Punjab Rs. 230, NWFP Rs. 110 and Balochistan Rs. 100.

Excess Burden Pakistans tax system provides economic agents with an uneven playing field. The specialtreatment of particular sectors and sources of incomes through differences in tax bases andtax rates is widespread. This distorts the allocation of resources as too many resources are

allocated in the lightly taxed sectors and too few in the more heavily taxed sectors.Investment Climate In the area of paying taxes, the 2008 Doing Business survey ranks Pakistan only 146th out of

178 countries. Out of the ten areas covered, the area of paying taxes is Pakistans 2ndworst ranking.

Vertical Equity Pakistans overall tax burden is somewhat progressive. The lowest decile of households pays 2 percent of all taxes, while the highest decile pays 41 percent of all taxes. Thiscompares to a share in total income of less than 3 percent for the lowest deciles, and morethan 32 percent for the highest decile.

Horizontal Equity Pakistans tax system has a large degree of horizontal inequity. For example, amonghouseholds in the same income group, some households consume a larger share of low-taxgoods and services than others, and some households earn a larger share of low-tax incomesources, such as income derived from capital, than others.

Tax Gap Pakistans federal tax gap in 2007/08 is estimated to be 76 percent of actual tax receipts.

This sum amounts to Rs. 4,600 worth of cheating by every man, woman and child inPakistan.

Tax Compliance Since taxpayers become more compliant when they are more likely to be caught, the largesize of the tax gap suggests that Pakistans enforcement measures are vastly inadequate.Taxpayers are also likely to be more compliance when they perceive that the money is put togood use in the delivery of public services.


17/158

17

Adequacy

Tax-to-GDP Ratio

The government intends to increase Pakistans tax-to-GDP ratio by at least 4.0 percent of GDP over the next

five years. Chapter I argued that Pakistans development needs require an additional tax effort of this magnitude.This would raise Pakistans tax effort to 14 percent of GDP, roughly equal with tax collection in Sri Lanka. This

target is clearly ambitious. Only few countries managed to make such large and rapid progress. India and SouthAfrica did increase tax collection by about 4 percentage points of GDP between 2002 and 2007, but they are rareexceptions. Even then, they were helped by rapidly growing tax bases of sales, incomes and profits on the back ofa strong economic expansion.

Figure II.1: Inadequate Revenue - Factors behind the Low Tax-to-GDP Ratio

Large T ax Exemptions Low Tax Compliance

Narrow Tax Base

Low Buoyancy

Tax Policy Tax Administration

The reasons for the low tax effort in Pakistan relate to large tax exemptions and low tax compliance . AsPakistans tax rates are not unusual by international standards, the low tax-to-GDP ratio is linked to the narroweffective tax base. The effective tax base is narrow as many economic activities are lightly taxed or fully exemptby law (large tax exemptions); in addition, many economic activities contribute only a part or even nothing of theirlegal tax obligation (low tax compliance reduces the effective tax base relative to the statutory tax base). Large taxexemptions and low tax compliance often imply that the growing activities in Pakistans economy contribute toolittle to the overall tax effort. For example, the recent reduction of tax rates, such as the introduction of the 15percent single rate for GST and the move to a uniform 35 percent tax rate on companies and individuals, was notcompensated through a corresponding enlargement of tax bases. Similarly, the reduction in duty rates on importsand excisable goods did not go hand in hand with an expansion in tax collection from other domestic goods andservices. The narrowness of the tax bases adds to the low buoyancy of the tax system.

Tax exemptions are the result of large federal tax expenditures and the poor mobilization of the provincial

tax base. There are various ways to categorize the overlapping and mutually reinforcing factors behind large taxexemptions, but it might be useful to highlight two. First, tax policy itself has contributed to lackluster collections by defining very narrow tax bases for the major federal taxes. This is reflected in a large number of for taxexpenditure, as well as, in many years, fairly low tax policy measures introduced at the time of the budget. Second,provincial own-source revenue mobilization is weak, as discussed in detail in Chapter VII. According to the 1973Constitution, agricultural income, capital gains on physical assets, the consumption of services, motor vehicles, andurban property are exclusively provincial tax bases. Yet, almost no tax is imposed on the first two bases, little ismobilized from wholesale, retail, and transport, and Pakistans housing market boom over the last few yearsappears to have bypassed completely the subnational exchequers. The poor provincial performance is linked toweaknesses in the overall intergovernmental fiscal architecture.

Low compliance with tax laws reflects a weak tax administration and a large shadow economy . Sometaxpayers evade taxes simply because of greed. Others evade taxes because they see little point in funding agovernment that they view as poorly governed and at times corrupt. For both groups, FBRs limited capacity toaudit tax returns and enforce tax payments, including in the hard-to-tax sectors, further reduces the incentives tocomply. The weaknesses in tax administration are so damaging for tax collection because of the structure of theeconomy. There is a large underground economy and informal sector, including agriculture and retail, where thebulk of transactions is in-cash or in-kind leaving behind little paper trail. The issue of compliance is taken up againat the end of this chapter, but for now we are turning the focus on the narrow tax base.


18/158

18

Narrow Tax Base

Differences in compliance and exemption levels as well as tax rates imply that some economic activities are

taxed more heavily than others. In 2006/07, agriculture contributed about one fifth of GDP yet no more than onepercent in FBRs tax revenue (Figure II.2). Services made up almost three-fifth of economic value added but onlyone third of central taxes. Given the shortfall in agriculture and services, industry carries the brunt of the taxburden. Relative to its share in GDP, industry pays 60 times more taxes than agriculture, and 5 times more taxes

than services. Breaking down the sectors further shows even more accentuated differences (Figure II.3, left panel).Among the 24 subsectors, there are 10 subsectors whose tax contribution is below their GDP contribution: textile(whose tax contribution is negative), ownership of dwelling, agriculture, construction, transport andcommunication, wholesale and retail trade, food and beverages, public administration, other services and telecom.Clearly, this does not in itself demonstrate that these activities are under-taxed. After all, GDP is not synonymouswith tax base, and some activities, like petroleum, are heavily taxed for good reasons. Also, the calculationsconcern FBR taxes only (although accounting for provincial taxes would not make much of a difference as theymake up only 5 percent of overall taxes). Nevertheless, these differences in tax and GDP contributions areindicative of the potential for widening the tax base across activities and the direction of required tax reforms.

Figure II.2: Contributions of the Three Sectors to GDP and FBR Taxes in 2006/07GDP (%)

Agriculture (20%)

Industry (23%)

Services (58%)

FBR Taxes (%)

Agriculture (1%)

Industry (66%)

Services (33%)

The narrowness of the tax base is also apparent from the dependence on a few revenue spinners. All fourmajor federal taxes rely heavily on a few commodities (Figure II.3, right panel). For example, the top six

withholding taxes collected 43 percent of all direct taxes in 2007/08. Striking is also the growing concentration ofimport taxes on a small group of commodities. The top 10 commodities contributed 81 percent of import sales taxcollection in the first nine months of 2007/08, compared to only 50 percent in 2002/03; likewise, the share of thetop 5 commodities in customs duties increased from 40 percent to 57 percent over this period. Overall, taxcollection is heavily dependent on imports. The joint contribution from the sale tax on imports, custom duties, andwithholding taxes on imports is around 55 percent of overall taxes. Add to this, as we have seen above,manufacturing, and you get the two principal bases for federal taxes. This is why any reductions in growth ofmanufacturing or dutiable import can put FBRs annual collection targets at risk.

Figure II.3: Contributions of Subsectors, Commodities and Heads to FBR TaxesRatios of Tax Share to GDP Share of 24 Sectors in 2006/07 (%)

0

1

2

3

4

5

6

7

Textiles

OwnershipofDwelling

Agriculture

Construction

Transp.,

Stor.&Commun.

Wholesale&RetailTrade

Food&Beverages

PublicAdmin.

&Defense

OtherServices

Telecom

Electricity&GasDistrib.

Finance&Insurance

Chemicals

Mining&Quarrying

Fertilizer

Sugar

Machinery

Cement

Iron&Steel

OtherManufacturing

Cigarrettes

Automobiles

EdibleOils

PetroleumProducts

29.5

Tax Share Above GDP Share

Tax Share Below GDP Share

Contribution of Top Commodities and Heads to FBR Taxes (%)

Top 6 Withholding Headsin Direct Taxes

Top 10 Commodities in

Import Sales Tax

Top 10 Commodities inDomestic Sales Tax

Top 5 Commodities inCustoms Duties

30

40

50

60

70

80

90

2002/03 2003/04 2004/05 2005/06 2006/07 2007/08

30

40

50

60

70

80

90


19/158

19

Long-Term Buoyancy

Todays narrow tax base is the result of the low buoyancy of Pakistans tax system over the decades. As thedemand for public services tends to increase as per capita income rises, tax systems should be able to deliver overtime automatic growth in fiscal revenues relative to the size of the economy. If the proportional change in taxrevenues exceeds the proportional change in economic activity, then, everything else equal, the tax-to-GDP ratio

would rise with per capita income. Unfortunately, measuring such tax elasticity is far from straightforward, as theobserved changes in tax revenues are not just the result of changes in the tax base arising from changes in economicactivity. Instead, they could also reflect changes in the structure of taxes, such as tax rates or the definition of thetax base, as well as changes in the tax administration, such as a stricter enforcement of the tax laws. Since it isdifficult to disentangle these effects, analysts typically look at tax buoyancy, which measures the ratio of theproportional change in tax revenues to the proportional change in GDP. Figure II.4 (left panel) looks at the averagebuoyancy measures over the last five decades, using a World Bank GDP series that adjusts for the periodic rebasingin national value added. The buoyancy measures are derived by regressing the natural logarithm of the tax revenueseries on the natural logarithm of the GDP series. Buoyancy above unity indicates tax revenue growth in excess ofGDP growth. The overall buoyancy of the FBR taxes declined from above unity in the 1960s and 1970s to belowunity in the 1980s and 1990s, and increased above unity in the 2000s, although it remains below the levels of the1960s and 1970s, and at 1.05 it remains rather low: a one percent increase in GDP implies an increase in the tax-to-GDP ratio of only 0.05 percent (that is 5 percent of 1 percent). There are distinct differences in the buoyancy of thefour main taxes. Direct taxes outgrew GDP in the last two decades, and sales taxes in the last three decades, but notpreviously. Custom duties grew far slower than GDP during the trade liberalization of the 1990s, but not otherwise.Excises were by far the most buoyant revenue source in the 1960s, grew slower than GDP since the 1970s, andwere the least buoyant revenue source in the 2000s.

Low revenue stability compounds low buoyancy. Tax revenues display a high degree of volatility. Thecoefficient of variation measured as standard deviation divided by the mean equals to 0.33 in the 2000s, justsomewhat below the 0.39 in the 1960s (Figure II.4, right panel). The tax-to-GDP ratio changed on average by 0.4percentage points from one year to the next since 1959/60, and by 0.3 percentage points since 1999/2000. Suchvolatility makes it difficult to forecast tax revenue collection accurately and undermines budget planning. Recently,direct taxes, with their dependence on enterprise profitability, and custom duties, with their dependence on importvolumes, were the most volatile revenue sources.

Figure II.4: Long-Term Buoyancy and Stability of FBR TaxesBuoyancy of FBR Taxes (%)

1.34

0.89

1.05

0.96

FBR

Direct

Sales

Excise

Customs

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

59/60-68/69 69/70-78/79 79/80-88/89 89/90-98/99 99/00-07/08

1.09

Coefficient of Variation of FBR Taxes (%)

0.39

0.35

0.380.38

FBR

DirectSales

Excise Customs

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

59/60-68/69 69/70-78/79 79/80-88/89 89/90-98/99 99/00-07/08

0.56


20/158

20

Short-Term Buoyancy

In a growing economy, the tax collection machinery has to run fast just to stand still. From 1999/2000 to2002/03, nominal GDP increased by 8.4 percent annually. Hence, just in order to keep the tax-to-GDP ratioconstant, nominal tax collection had to increase by the same rate. In fact, federal tax collection grew by 10 percentannually, so that the tax-to-GDP ratio increased from 9.1 percent in 1999/2000 to 9.6 percent in 2002/03. From2002/03 to 2007/08, federal tax collection grew faster (17 percent annually), yet nominal GDP expanded also faster

(17 percent annually), so the tax-to-GDP ratio remained constant at 9.6 percent. This is surprising. After all,international experience suggests that tax collection is pro-cyclical in developing economies (Box II.2).

Box II.2: Why is Fiscal Policy Procyclical in Developing Countries?

A standard normative prescription of fiscal policy is that it should be countercyclical. During bad times, the governmentshould increase spending (due to automatic stabilizers such as social safety net spending) and lower taxes (even with constanttax rates due to progressive taxation) to spur the economy out of the downturn; during good times, the government should reignin spending and increase taxes to smoothen economic activity and save for the rainy day. Empirical evidence for the lastdecades shows that OECD countries, but not developing countries, conform to this pattern, although recent global trends in tax policy, such as the move towards reductions in tax rates in view of a robust world economy and globalization may haveweakened fiscal stabilizers also for developed countries. The literature has proposed economic and political economy reasonsfor the puzzling behavior of fiscal policy in developing countries. First, as credit market restrictions prevent developingcountries from borrowing during bad times, they are required to cut back expenditures and raise taxes during a downturn.

Second, the fluctuations in the tax base are much larger in developing countries than in developed countries. During goodtimes, pressures for spending increases become hard to resist in view of plentiful tax revenues. Alternatively, voters may wantto avoid wasteful spending through lower tax rates, which again results in procyclical fiscal policy. How does this discussionon the benefits of counter-cyclical fiscal policy square with the discussion in Chapter I on the need for fiscal consolidation inPakistan? Chapter I focuses on the effects of ongoing, sustained budget deficits. Whatever decisions are made about short-runfiscal policy when the economy is weak, the objective should be budget balance over the business cycle. This requires taxcollections to grow faster than GDP when the economy is strong.

Based on Alesina, Campante and Tabellini (2007); Norregaard and Khan (2007), Perroti (2007), and Talvi and Vegh (2005).

Breaking down the federal taxes into the main components suggests little structural change since 1999/2000.The most important adjustment is the decline in excise duties due to a reduction in rates and the number ofexcisable goods (Figure II.5, left panel). With the steady switch from import substitution to trade integration,Pakistans simple average tariff rates fell from over 20 in 1999 to 15 percent in 2007. As a result, custom duties

remained roughly constant around 1.5 percent of GDP in spite of rising import volumes. At the same time, theperformance of the sales tax was disappointing. After increasing from 3.1 percent of GDP in 1999/2000 to 4.1percent of GDP in 2002/03, it declined subsequently to 3.6 percent of GDP in 2007/08. It took until 2006/07 beforethe good profitability of the corporate sector translated into higher income tax collection, and only some of thegains could be maintained in 2007/08. Overall, at 9.6 percent of GDP, federal tax collection is the same in 2007/08as it was in 2002/03, and only some 0.5 percentage points of GDP higher than in 1999/2000. Direct taxes and GSTare the most important revenue sources (Figure II.5, right panel), contributing close to two-fifths of federalcollection each. The balance is picked up by excise duties and custom duties.

Figure II.5: Composition of Federal Tax Collection since 1999/2000Composition of Federal Taxes (% of GDP)

Overall Federal

Direct

Sales

Excises

Customs

Non-FBR

0

1

2

3

4

5

6

7

8

9

10

1999/2000 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5 Composition of Federal Tax Revenue (% of Federal Tax Revenue)

3235

31 31 31 31

39 39

3439

41

42 4240

41

36 37

1612

1210

98

8 9

1215

19 1916 15

1 1

33

9

1718 17

000

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1999/2000 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08

Direct

Sales

Customs

Excise

Non-FBR


21/158

21

Federal Tax Expenditures

Tax exemptions are one of the principal reasons for a narrow tax base with low buoyancy . They come indifferent shapes and forms, including concessions, special regimes, and incentives, but they all amount to anexemption from certain taxes that the tax authorities would otherwise collect from an individual or an organization.While they are part of government fiscal activity, they may go unnoticed because the revenue foregone does not

explicitly show as spending. If used properly, tax expenditures can play an important role in helping implementpolicy priorities. However, the assessment of tax exemptions is often complicated since reporting and accountingpractices fall far short of what is used for government expenditures. This makes it difficult, if not impossible, toevaluate the cost, efficiency, and equity impact of tax exemptions. This lack of scrutiny may invite fiscalopportunism through exemptions for special interest groups. The political economy of granting tax exemption issimple but powerful. While the benefits of exemptions are highly concentrated among the members of the interestgroup, the costs are dispersed among all taxpayers.

Many countries report regularly on one type of tax exemptions: tax expenditures. They are exemptions orconcessions that fall outside a tax norm or benchmark. The tax norm includes the rate structure, accountingconventions, deductibility of compulsory payments, and provisions to facilitate tax administration. Identifyingcertain provisions in the tax law as tax expenditures is less straightforward as it may seem, since distinguishingintegral tax rules and deviations from such rules involves invariably many judgment calls. In addition, tax normsare defined differently across countries, making it difficult to make comparisons.

Official figures suggest that the reduction in Pakistans tax expenditures has recently been reversed.Pakistan reports regularly on tax expenditures in the annual Economic Surveys (Figure II.6). Tax expenditures,calculated as the estimated revenue loss in percent of GDP, declined from around 0.8 percent in 2000/01 to 0.33percent in 2005/06, and then increased to 2.1 percent in 2006/07 and 0.9 percent in 2007/08. The main reason forthe sharp variation in these estimates over the last three years is the change in the estimated revenue losses for theexemption on capital gains, although tax expenditure on custom duties have also increased. This underscores boththe conceptual difficulties in estimating tax expenditures consistently over time, as well as the need for a continuedreduction of tax expenditures.

Figure II.6: Pakistans Tax Expenditures

Government Estimates of Revenue Loss from Tax Expenditures (% of GDP)

Income Tax

Sales Tax

Customs Duties

0.0

0.5

1.0

1.5

2.0

2.5

2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/8


22/158

22

FederalRevenue Targets

Over-estimated revenue forecasts have contributed to reducing the pressure on eliminating tax exemptions.Unrealistic forecasts contribute to poor budget management, such as expenditure arrears and a stop-and-goexpenditure policy, and make meaningful medium-term budget planning difficult. Inaccurate budget plans alsoweaken transparency and diminish public accountability of fiscal operations. Yet, more often than not, developingcountries tend to overestimate their tax revenues. This might be because of political pressures to boost public

expenditures without adjusting the overall fiscal balance, ambitious revenue forecasting as incentive device for ahard-to-control tax administration, or unanticipated economic difficulties. Administrative shortcomings play also arole, such as weak planning and meager resources for the implementation of budget measures, or inadequateinformation analysis of the impact of measures. Indeed, Pakistans federal budget revenue estimates systematicallydeviated from actual revenue receipts during the 1990s. Then, from 2002/03 to 2006/07, FBR broke with the pastand outperformed its collection targets (Figure II.7, left panel). In 2007/08, tax collection fell short of the budgetedtarget once again, although by a small margin only. The over-projection of tax collection runs the risk thatinadequate tax policy measures are taken at the time of the budget. Pakistans federal tax policy measuresamounted to at most Rs. 11 billion between 1999/2000 to 2005/06, and were even negative in three years. The2007/08 and 2008/09 budgets, with the greater focus on raising the tax-to-GDP ratio, incorporated more substantivepolicy measures, amounting to Rs. 35 billion and Rs. 70 billion, respectively.

Tax performance should be seen in the light of evolving economic circumstances which sometimes deviatesubstantially from the initial estimates. A rough ex post examination of tax by tax outcomes since 1999/2000 isrevealing (Figure II.7, right panel).2 Actual FBR collection fell short of what could have been expected under therealized growth factors and budgeted revenue measures in five out of the last nine years. In particular, FBR met therevenue collection targets from 2003/04 to 2005/06, but the better-than-expected economic performance suggeststhat revenue collection might have been even larger. Likewise, higher-than-expected inflation implied higher-than-expected nominal growth factors in 2007/08, notwithstanding the otherwise difficult economic conditions.

Excise duties and sales taxes have underperformed in recent years. There are large differences in performanceacross taxes. Excise collections were consistently lower than what could have been expected, perhaps due tounderestimation of the impact of relief measures at the budget stage. Sales taxes have been underperforming since2003/04, which might point to creeping erosion of the tax base due to special regimes and zero-rating. Customduties have fallen

Pakistan Tax Policy Report Nov 08

Documents

Transcript of Pakistan Tax Policy Report Nov 08