What is holding Pakistan back from growth? The Elite Capture.

The rich-poor divide has widened in Pakistan over the past few years. This document tries to examine the root cause of this divide and sheds some light on how the elite capture favors the rich in the country.

Today it is an admitted fact, that the richest 10% of Pakistanis have accumulated colossal assets in the last three decades without paying due income tax. In other words, those who control 90% of resources contribute less than 2% in total tax revenue. The result? These tax waivers, concessions and exemptions influenced by the elite are depriving the State of revenue worth billions of rupees while common citizens are overburdened with indirect taxes and have little to no breathing space.

The binding constraints to Pakistan’s growth are both structural and emerging. The structural constraints include low access to finance and market failures that lead to insufficient investment, entrepreneurial activity, and competitiveness, blocking the transition from low productivity to high productivity activities (productive diversification). The slow transition to productive diversification and low competitiveness of Pakistan businesses is largely due to dysfunctional tax system, ineffective civil service, large anti-export bias and other cumbersome business regulations. The contributing market failures include weak coordination (governance) and insufficient innovation and learning externalities.

Two government failures are binding constraints to productive diversification: a dysfunctional tax system, resulting in low tax revenues, and a strong anti-export bias in the trade regime.

Data shows that Pakistan’s taxation system is regressive and allows a great deal of space for tax evasion.  In the outgoing fiscal year 2018, Pakistan lost a record Rs972.4 billion in tax exemptions, which is higher by 80% or Rs431 billion than the previous year. Another important indicator of the elite bargain is the mismatch between contribution to GDP and contribution to revenue. For example, agriculture sector contributes 21 percent to GDP but just 1 percent to taxation. The services sector on the other hand contributes over 50 percent to GDP and 30 percent to taxation.

The result? While tax system is designed to favor the rich, 75% of tax difference is recovered through indirect taxes.  And who suffers? The common man. While citizens pay heavy tariff for electricity, officers of WAPDA and Pepco get free-of-cost electricity every month. Top judges and army personals are exempted from several taxes with free car, petrol and house allowance while poor pay tax even if they are earning below the threshold of Rs. 400,000 annually. The entire nation pays the price of cumbersome tax terms and over 65 withholding taxes without any compensation while 1600 tariff lines on raw materials and intermediate goods have been exempted from import duty. The list goes on. At industrial level IPPS are the super example of elite capture.

In perspective of growth, strategies often include a long list of constraints and reforms, but literature on growth acceleration suggests that smaller changes that relax just a few binding constraints on growth can trigger rapid growth (hausmann, Pritchett and Rodrik 2004).

Many structural reforms undertaken by Pakistan may have improved secondary aspects of growth dynamics without substantially easing binding constraints and sustaining high growth. The debate has followed the international literature, moving from exogenous to endogenous models. The real challenge is to identify which have the highest marginal return (are truly binding) so that policy changes can have the greatest beneficial effect on growth.

But Pakistan is far from achieving the benefits of an effective growth unless it has an efficient tax system that generates adequate revenue to fund public investments, services and keeps the tax burden low on important business activities, facilitating tax compliance. On the contrary, Pakistan has a narrow tax base with multiple exemptions and a high corporate income tax rate. Similarly, from 1996 to 2002, politically connected companies received 45 percent larger loans than other companies. These firms had a 50 percent higher default rate on loans as well. The defaulted loans were inefficiently invested, leading to a further loss of an estimated 1.6 percent of GDP per year which makes a total of Rs.67 billion. On the other side, lack of access to adequate financial services inhibits small and medium enterprises from playing their role as a vehicle for income generation and employment opportunities.

Former Finance Minister Hafiz e Pasha has publicly said thatthe Elite Capture costs Pakistan 2.5% of the national GDP. The fundamental question remains - whether the high burden of taxation will be borne  through collecting tax from the rich or will it again fall on the shoulders of the entire nation?

The budget documents do not show a good picture.  30% of revenue of the current fiscal year target is already planned to come from Income Tax while rest of the 70% from indirect taxes. Meanwhile, prices of several basic consumer goods  that have a higher share of expense for lower and middle-income groups has already started increasing due to regressive taxation. Inflationary impact of the regressive taxation has resulted in increasing prices of basic consumer goods e.g., sugar by 8%, clothing & footwear by 17%, CNG by 4%, LNG by 5% leading electricity & gas tariffs higher, consumer durables by 4%, aerated waters by 5%, vegetable ghee/ oil by 1%, small cars by 3%, lower quality cigarettes over 33% whereas inflation project will remain 11 to 13% overall which could even increase more by 2-3%.

Inefficient tax collection and poor culture of tax compliance is holding back Pakistan from paying its bills. The government needs dramatic improvement in its fiscal policies and free it from the clutches of the economic policy elites so that Pakistan can be on the path to sustainable growth. It is high time that the government introspects how and why the fight for money corrodes national cohesion and widens the already existing gap between the haves and have-nots in the country.

(Asim Jaffry, development professional in the area of finance for development)