Taxation structure and trends

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October 17, 2007
Wednesday

By Sami Saeed

Macroeconomic stability depends to a large extent upon fiscal consolidation, particularly in the context of emerging economies. Generating sufficient government revenues for provision of public goods and designing progressive tax structures which address both efficiency and equity considerations are indeed challenging tasks.Another important dimension is the emergence of the private sector as the main source of economic activity. Providing a hassle-free environment for businesses on the one hand and catering to social imperatives of income redistribution are, therefore, equally important. These objectives require a well designed fiscal policy and an efficient, equitable and business-friendly taxation system.Despite substantial pick up in tax revenues over the last few years, fuelled by high economic growth, tax to GDP ratio remains low and stagnant. This calls for a critical analysis of the taxation structure, trends and reforms.Our analysis should start with a brief description of how the tax structure has evolved since the early years. The country, without an industrial base at the time of partition, started with a tax to GDP ratio of four per cent, with customs duties on imports and exports of cotton and jute as the principal source of revenue.By the end of the 1960s, with rapid industrialisation, tax to GDP ratio rose to 6.4 per cent, with excise duties as the major revenue source. Income tax, due to tax holidays to promote investment, as well as sales tax taken over from the provincial governments since 1951, did not show buoyancy.There was a quantum jump in tax to GDP ratio during the 1970s (14 per cent by 1979-80) mainly due to an increase of four percentage points of GDP in customs duties as well as phasing out of tax holidays. Since the early 1990s, tax to GDP ratio has remained stagnant, with decline in the share of customs duties being offset by improved performance of income and sales tax.In broad terms, 1960s was the decade of excise duties, 1970s and 1980s of customs duties, and 1990s of income and sale taxes (Hafiz A. Pasha and Mahnaz Fatima, Fifty Years of Public Finance in Pakistan: A Trend Analysis, in Shahrukh (ed.), 50 Years of Pakistan’s Economy, Oxford University Press, 1999).As Table 1 shows, tax to GDP ratio averaged at 13.2 per cent during the 1990s and at 10.6 per cent during the period 2000–07. Adjusting for the effect of re-basing of GDP in 2000-01 after a long interval of 20 years, it is evident that tax to GDP ratio has remained broadly unchanged. A comparison with tax revenue levels in developing countries reveals a relatively low level of fiscal effort Countries in a similar income bracket as Pakistan have an average tax to GDP ratio of 20 per cent.Table 2 gives a disaggregated analysis of how major taxes have fared in relation to economic growth. It shows that direct tax to GDP ratio has improved from 1.85 in 1989–90 to 3.8 per cent in 2006-07. However, it is still much lower than the developing countries standard of around seven per cent. As a percentage of GDP, indirect taxes as a whole have declined from 12.4 of GDP in 1989-90 to 5.9 in 2006-07, and within indirect taxes, customs duties came down from 5.7 to 1.5 per cent, sales tax moved up from 2.2 to 3.6 per cent, and excise duties declined from 2.2 to 0.8 per cent.Changes in the relative shares of major taxes are reflected in Table 3. The share of direct taxes in total taxes has increased from 18 to 39.4 per cent in 2006-07, while the share of indirect taxes declined from 82 to 60.6 per cent during the same period. Even within indirect taxes, the structure has changed profoundly, with the share of customs duties declining from 45 of total tax collection and 55 per cent of indirect taxes in 1990-91 to 15.6 and 25.8 per cent respectively.The share of sales tax increased sharply from 14.4 to 36.5 per cent of total taxes and from 17.6 to 60.3 per cent of indirect taxes during the same period. Central excise as a tax is being phased out; its share in total taxes and indirect taxes has gone down from 22.5 and 27.5 per cent in 1990-91 to 8.4 and 13.9 per cent respectively during the same period.This represents a structural shift in the composition of taxes on account of reforms, which were initiated since the early 1990s and vigorously pursued from 2000 onwards. The base of taxation is rightly moving from trade and investment to income and consumption. However, though the share of income and sales tax has increased, yet the quantum of increase is not so strong as to offset the reduction in customs and excise duties. The incremental tax effort should, therefore, focus on income and sales tax, which would not only enhance the revenue yield but also contribute to a more balanced, equitable and buoyant tax system.The taxation system suffered from a number of structural weaknesses. These included narrow and punctured tax bases; vicious circle of high tax rate and tax base erosion; over-reliance on trade-related taxes; multiple taxation hampering investment; complex and opaque procedures encouraging rent-seeking behaviour; and organisational efficiency and mindset. A lot of progress has been made to address these issues, but a lot more needs to be done to deepen the reform process.