The tax-to-GDP ratio combined of taxes collected by the Federal Board of Revenue (FBR) has gone up appreciably over the last four years. It was 8.4% of the GDP in 2012-13. By 2016-17, it had increased by over two percentage points to reach 10.5% of the GDP. In other words, while the GDP increased during this period by 39%, FBR revenues showed cumulatively an increase of 74%.
The basic question is what explains the higher growth in tax revenues? Is it due to the relative buoyancy of the different tax bases on which the four FBR taxes are levied? Alternatively, is it the consequence more of escalation in statutory and/or effective tax rates in the four budgets or mini-budgets announced during these years? Answers in the case of income tax, sales tax, customs duty and excise duty are given below.
The change in the tax-to-GDP ratio can be decomposed into two parts. The first is the 'base' effect which reflects the impact of a divergence between the growth in the tax base of a tax and in the GDP. The second is the 'rate' effect which captures the impact of a change in the overall incidence of revenues from the tax on its tax base.
The tax base for income tax can broadly be defined as the non-agricultural GDP. Agricultural incomes are outside the purview of FBR and within the taxation powers of the provincial governments. Non-agricultural incomes grew by 39% between 2012-13 and 2016-17, almost exactly the same as the rise in the overall GDP. Income tax revenues grew substantially faster by 83%. This can be effectively attributed to an enhancement in the statutory and/or effective rates of taxation. The latter captures the effect of reduction in tax expenditures or some success in reducing tax evasion.
The income tax-to-GDP ratio has increased by one percentage point in the four years. Virtually all the rise is attributable to the 'tax rate' effect. What has been the change in statutory tax rates? There have, in fact, been some reductions. The corporate income tax rate was reduced from 35% to 31% and the highest personal income tax rate brought down to 30%.
As opposed to this, the presumptive and withholding tax rates have generally been enhanced in the case of imports, services, contracts and telecom services, capital gains from shares, etc. On top of this, substantially higher rates have been introduced in the case of non-filers. Further, the minimum tax on turnover was enhanced to 1%. More recently, a super tax has been introduced. Tax evasion has been reduced by expansion in the number of withholding levies, as for example, in the case of banking transactions in cash above a minimum level.
Sales tax is the second largest source of FBR revenues, after the income tax. It is essentially in the nature of a value added tax and collected at the stage of imports and manufacturing of goods from units above a certain minimum size. As such, the relevant tax base for the sales tax is the duty-paid value of imports plus the value added by the large-scale manufacturing sector.
The sales tax base has grown cumulatively by only 27% between 2012-13 and 2016-17. This is attributed to the modest growth in the manufacturing sector and lack of buoyancy in the rupee value of imports, due to a, more or less, nominally fixed exchange rate and a big drop especially in the prices of oil imports. Consequently, in the absence of rate escalations, there was the likelihood that the sales tax-to-GDP ratio would have fallen.
However, sales tax revenues have demonstrated some buoyancy and risen cumulatively by 57%. Consequently, the tax-to-GDP ratio has gone up from 3.7% to 4.2%. The 'base' effect as highlighted above is negative at 0.4% of the GDP and the 'rate' effect is a positive 0.9% of the GDP.
Initially, the standard sales tax rate was raised from 16% to 17%. The major escalation in sales tax rates since has been in the case of POL products. It was possible to raise these rates in the face of sharply falling import prices. For example, at its peak, the tax rate on HSD oil was as high as 51%, three times the standard rate. Similarly, the rate on motor spirit reached 25% in mid-2015. There has also been a 'cascading effect' on sales tax revenues. As import duties went up, the effective sales tax rates have gone up correspondingly. Another step taken by FBR was the levy of the sales tax on the retail price on a number of consumer goods. This amounted to a higher effective rate on the ex-factory price. It is worth noting that if these steps had not been taken the revenues from the sales tax would have been lower by Rs 287 billion, equivalent to 21% of the revenues actually collected in 2016-17.
Import duties have traditionally been a declining source of revenue. Up to the mid-90s they were the largest source of revenue but they now occupy the third place in FBR sources of revenue. However, during the last four years the tax-to-GDP ratio of this tax has actually gone up by 0.5 percentage points. While the tax base consisting of the total value of imports went by 28%, revenue from import duties increased by an impressive 107%. Consequently, while the 'base effect' was a negative 0.1% of the GDP, the 'rate' effect was a positive 0.6% of the GDP.
What explains the relatively large 'rate effect' in the case of a relatively small tax like import duties? This question needs to be answered especially in light of import tariff reforms, whereby the maximum rate was reduced to 20% from 30% along with corresponding reductions in the lower slabs.
The answer is to be found in three steps taken by FBR. First, a large number of items with zero duty were subjected to a minimum duty of 3%. Second, the rates of import duties on POL products were also enhanced. For example, in 2012-13 the tariff on furnace oil was zero percent which was raised to 11%. Third, more recently, regulatory duties have been introduced on over seven hundred items. In the absence of these changes, the revenue from import duties in 2016-17 would have been lower by Rs 191 billion, equivalent to almost 39% of the revenues actually collected.
Excise duty is the smallest tax of FBR and levied on a few select industries. Its tax-to-GDP ratio has gone up marginally by 0.1 percentage points, due primarily to a change in the tax structure on cigarettes.
Overall, for FBR revenues as a whole, the base effect has been negative at 0.6 percent of the GDP and the rate effect is positive and large at 2.7 percent of the GDP. This has yielded an overall increase in the FBR tax-to-GDP ratio of 2.1 percentage points.
This important finding highlights, first, that in the absence of tax rate escalations and improved tax administration the tax-to-GDP ratio would have actually fallen. In 2016-17, total revenues would have been almost Rs 870 billion less, equivalent to 26% of the revenues actually collected.
However, the strategy of raising tax rates to initially protect and then raise the tax-to-GDP ratio has had some important implications. First, it has limited the growth of the various tax bases, especially the large-scale manufacturing sector.
Second, many of the tax moves have been regressive in nature. These include enhancement in withholding tax rates on non-filers. Some of them may be tax evaders but the majority is persons with low incomes who are genuinely exempt from payment of the income tax. This has led to a perverse outcome whereby smaller taxpayers face higher tax rates.
Regressive moves in indirect taxes include, first, the levy of a 3% duty on historically exempt imports, including many food items. Second, the heavy taxation of HSD oil has implied higher transport costs while the enhanced import duty and sales tax on furnace oil have raised the price of electricity. Third, enhancement in withholding/tax rates on imports, contracts, telecom, etc., have had widespread impacts.
Looking ahead, FBR will have to find ways of raising the tax-to-GDP ratio by tapping relatively fast growing income in sectors like services demanded by the upper income groups, more comprehensive coverage of companies and increase in the number of filers. A conscious effort must be made to avoid tax measures which enhance the regressivity of the tax system and over burden the poor.
(The writer is Professor Emeritus at BNU and former Federal Minister)
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