Untaxed incomes and budget deficit

January 29, 2007
By Yousuf Nazar
EFFECTIVE taxation of agriculture income and imposition of capital gains tax on short-term stock trading and real estate investments can raise at least an estimated Rs200 billion (equivalent to about 66 per cent of the budget deficit) in additional government revenues.Large areas of economy get away with paying no tax at all. The culprit is the lack of will of the successive rulers (past and present) who have never attempted to address the core issues and mobilise political support to undertake the tax reforms that are essential to reduce fiscal deficits.Pakistan must widen its tax net to raise sorely needed revenues for the development of a decrepit physical infrastructure and for educating and training one of the six largest and youngest (albeit relatively illiterate) working populations in the world. This will also reduce the dependence on foreign aid, especially at a time when the democrats-controlled US Congress is considering a ban on US assistance to Pakistan if Islamabad fails to halt the resurgence of Taliban inside its territory. During FY 2005-06, the government’s collections from direct taxes amounted to Rs224.6 billion or about $3.7 billion. The trading volume at the Karachi Stock Exchange averaged around $500 million a day during 2006 or about $120 billion (almost equal to Pakistan’s GDP) for the entire year. Stockbrokers do not pay taxes on capital gains and nor do those who make millions and billions on property and land deals. The income tax collection from agricultural estates is a paltry Rs1 billion or so per annum.It is not difficult to understand why the government is so poor and runs budget deficits that result in higher interest rates and inflation – a form of regressive tax on the middle and poor classes. Pakistan has one of the lowest tax to GDP (gross domestic product) ratios in the world and this ratio has declined in the recent decade despite growth in the absolute amount of taxes. As the size of the economy has grown, so has the volume of taxes but is the situation any better than it was ten years ago?According to the data released by the Ministry of Finance last week, the tax collections (direct and indirect) amounted to Rs383 billion during the first half of FY07 (July-December, 2006) as against Rs324 billion in the corresponding period last year as given below:Rs billions Per centincreaseover2005-06Direct taxes 151.6 45.4of whichwithholdingtaxes 73.0 21.7Indirect taxes 231.8 5.5Sales tax 143.5 8.1Custom duty 59.8 (2.8)Excise duty 28.5 12.5Total 383.4 18.4That the share of direct taxes (withholding taxes accounted for approximately fifty per cent of direct taxes) has gone up to 39.5 per cent is good news and it appears that the Central of Board of Revenue (CBR) is working hard. However, withholding taxes include tax deductions on bank withdrawals and stock trading (introduced in 2005-06 budget) – activities with hundreds of billions in turnover. Hence, it is not surprising that direct tax collections have gone up.However, the indirect taxes’ 5.5 per cent growth is negative in real terms given the inflation rate of nine per cent. Due to a liberal import policy and tariff reductions, custom duty collections are down 2.8 per cent despite a 9.1 per cent increase in the imports.Moreover, over 50 per cent of the increase in the indirect taxes is attributable to the (largely public sector) oil and gas industry that has been booming due to higher energy (petrol/gas) prices. Notwithstanding these issues and going beyond the six months data, the real picture of government’s domestic finances has not changed much during the past decade. In fact, it has gotten worse and is a major cause of growing income inequality and social tensions. Let’s see why?The most relevant indicator to determine if a tax regime has improved is the tax to GDP ratio. As GDP or country’s income grows, so does the volume of taxes. But if the growth in taxes lags behind that of the GDP, tax to GDP ratio declines. This is usually due to an increase in tax evasion and/or because major sectors are exempted from paying taxes.As shown in the graph, the tax to GDP ratio that stood at 12.64 per cent in 1996-97 has steadily declined to 9.97 per cent to in 2005-06 and even if this year’s target of Rs835 billion in tax collections is met, this ratio will not be significantly higher than 10 per cent.Failure to increase this ratio has caused the fiscal deficit (excluding the impact of earthquake and grants) to grow both in absolute and relative terms as shown below:Fiscal year Total deficit As per cent(Rs. billion) of GDP2003-04 129 2.32004-05 217 3.32005-06 259 3.42006-07budget 294 3.4An inequitable and unfair tax regime is the principal cause of not just low taxes to GDP ratio and persistent fiscal deficits but also for creating distortions in the economy that are harmful for investment in manufacturing in particular and productive activities in general. The uneven mismatch between sectoral contributions to growth and tax revenue lies at the heart of this regressive tax regime.The following table compares the per cent contribution or share of some key sectors in national income (or GDP) to their per cent share in national taxes in 2005-06.Share in GDP Share in TaxesAgriculture 22 1Manufacturing 18 62Wholesales &Retail Trade 19 3Agriculture with 22 per cent of national income contributes to just one per cent of the taxes while manufacturing sector shares bulk of the burden. Now why should the local capital go to manufacturing when it can find tax shelter in land, agriculture, stock investments or in just trading goods and services?The growing deficit can be reduced by extending the tax net to three major areas. First is obviously agriculture income, which was taxed - for the first and only time in history - in January 1977 by late Zulfiqar Ali Bhutto but General Zia never implemented the law. Even merely a 10 per cent tax on income from agriculture, which accounts for 22 per cent of national income, would yield Rs. 160-190 billion in income tax revenues. It is grossly unjust that while a salaried person pays not just income tax but more and more withholding taxes on utilities and bank transactions, large landlords’ incomes should go completely untaxed.Two other main areas are property and stocks. It seems that the government by levying very nominal capital value tax (CVT) on real estate and stocks (CVT has little economic justification and discourages active trading which is necessary for market efficiency and development) has tried to divert the public opinion from the more fundamental and much larger issue of the exemption of tax on capital gains from property and stocks.The most common international practice is to exempt capital gains tax on one property (usually the primary residence of a household) if it is held for a certain number of years or tax it at a lower rate by treating it as a long-term capital gain. Any other capital gains resulting from buying and selling of property are treated as usual income and taxed accordingly. Uniform indexed values and low standard rates are and can be used to value and tax properties to avoid the usual issues of understatement of values and corruption. Few years ago, India imposed capital gains tax on property at 20 per cent based on an indexation system. Property taxes account for about 10-11 per cent of total tax revenues in the United States, United Kingdom and Japan.Based on the assumption of even three per cent of the total tax revenues, there is a potential to raise Rs. 20-24 billion from property taxes in Pakistan. There is little justification to continue to exempt capital gains from property especially when it comes to gains on plots and houses whose aggregate values run into hundreds of millions of dollars.Last and not the least is the matter of capital gains tax on stocks. Apologists of this exemption argue that its imposition may deter foreign investors. This assertion is simply a distortion of facts. Foreign investors’ share of investment in average daily volume at the Karachi Stock Exchange is about 3.5 percent. Nearly 70 per cent of the trading activity is speculative and does not result in actual delivery of shares. The brokers themselves undertake almost all of this speculative trading and there is no reason why it should not be taxed like any other business income.True the foreign investors hold about 17 per cent of the float-adjusted market capitalisation but most foreign investors can use international tax laws and double-taxation treaties to avoid paying taxes on genuine long-term investments. Therefore, imposition of capital gains tax on the short-term trading profits of local investors (mostly brokers) would make little difference to foreign investors.India grants exemption from capital gains tax only if the stocks are held for a period of one year but taxes short-term capital gains at 30 per cent. Even if we assume that short-term capital gains account for just one per cent of the value traded on our stock exchanges, a 30 per cent tax would still yield Rs22 billion compared to about a billion rupees being collected from CVT on stock market trades.Given the vastly untapped tax revenue potential in the above three sectors, the least the government can do is to make a start by (a) bringing the ‘big fish’ under the tax net even at initially low tax rates, (b) lowering tax rates on manufacturing concerns and salaried persons to bring more equity and (c) reducing the number of small taxes to streamline the tax administration. This may lend some credibility to its claims of reforming the tax regime. Unless it is prepared to do so and bring some fairness to the tax regime, it should not complain about the tax evasion culture since unfair tax regimes do not generally command legitimacy and compliance from taxpayers.