SALES TAX: Sales tax is levied at two stages in Pakistan- at the stage of import and domestic production respectively. During the decade of the 90s, it acquired the characteristics of a value added tax. Therefore, the tax base for the tax is the value of dutiable imports plus revenue from import duty plus value added in large-scale manufacturing.
In recent years, there has been a major broad basing of the tax, which has increasingly substituted for customs duty, excise duty and the petroleum development surcharge. The size of the tax base has, therefore, been accordingly extended.
The sharp rise in the tax base is captured by the rapidly increasing tax base-to-GDP ratio (See Table 3.6). Magnitude of the tax base-to--GDP ratio shows a sharp increase, of roughly ten percentage points during 2000-07, primarily due to rapid growth in taxable imports and expansion of the tax base. Effective tax rates, on the other hand, exhibit a somewhat declining trend in the last few years. Reasons for this need to be explored.
====================================================
TABLE 3.6
====================================================
BOUYANCY OF SALES TAX TAX-TO-GDP, TAX-TO-TAX BASE
AND TAX BASE-TO-GDP RATIOS 1999-2000 TO 2006-07
====================================================
Years (%)
Tax-to-GDP Tax Base-to-GDP Effective
Ratio Ratio Tax Rate
====================================================
1999-00 3.1 26.3 11.6
2000-01 3.6 27.8 13.1
2001-02 3.7 26.5 14.1
2002-03 4.0 27.0 14.8
2003-04 3.9 30.6 12.7
2004-05 3.7 36.7 10.0
2005-06 3.9 37.8 10.3
2006-07B 3.6 36.0 9.9
====================================================
SOURCE: Estimates Based on Taxes Data from SBP website and GDP data from Economic Survey 2006-07.
In conclusion, the overall constancy or minimal increase in the tax to GDP ratio during the current decade is essentially because the gains due to the expanding tax bases were almost neutralised by the decline in effective tax rates (see Table 3.7).
The relative expansion has raised the tax-base-to-GDP ratio by 2.8 percent, but the decline in effective rates implied a fall in the tax-to-base ratio of 2.2 percent. This analysis has clear implications for the resource mobilisation strategy for the forthcoming budget.
====================================================
TABLE 3.7
====================================================
DECOMPOSITION OF THE CHANGES IN TAX-TO-GDP RATIO
====================================================
Tax Change in (% of GDP)
Tax-to- Base Rate
GDP Ratio Effec Effect
====================================================
Direct Taxes 0.9 0.3 0.6
Excise Duty -0.6 0.3 -0.9
Customs Duty -0.1 0.9 -1.0
Sales Tax 0.5 1.3 -0.8
Total Taxes 0.7 2.8 -2.2
====================================================
SOURCE: Estimates Based on Taxes Data from SBP website and GDP data from Economic Survey 2006-07.
Essentially, the losses in effective tax rates have to be regained through more effective exploitation of the tax bases. This takes us to another key area requiring reform in tax policy in Pakistan, exemptions and concessions allowed under existing tax laws, which erode the tax base.
TAX EXPENDITURES
Tax expenditures quantify the revenues foregone due to exemptions and concessions allowed under tax laws. Tax expenditures are usually justified on the grounds that they promote certain social or economic goals.
They include special tax relief (through deductions, credits, exemptions, etc) to encourage certain types of behaviour by taxpayers or support taxpayers in certain circumstances. Of course, some such concessions find their basis not only in economic rationale but are allowed under pressure from strong local lobbies and vested interest groups.
The most dramatic example of this is the continued exemption of capital gains from income taxation especially at a time when massive unearned incomes were accruing in the economy to the relatively well-off, due to the exceptional buoyancy of the stock market and property values. The Pakistan Economic Survey [2006-07] has admitted that the exemption alone of capital gains on stocks from income taxation cost the economy annually about Rs 112 billion, almost 11/2 percent of the GDP.
Other tax expenditures aggregate to Rs 186 billion as shown in table 3.8. These include import duty exemptions on import of sugar, machinery and other items, income tax holiday to independent power producers and sales tax exemption on items like pharmaceuticals and tractors etc. Notice the sharp increase in the cost of these exemptions to the economy.
TABLE 3.8
==========================================================================================
COST OF EXEMPTIONS
==========================================================================================
(Rs in Billion)
==========================================================================================
Type of Tax 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07
==========================================================================================
Income Tax 11.20 10.20 6.80 6.15 4.60 4.65 123.07
Sales Tax 13.20 8.60 10.39 9.25 7.85 8.65 12.00
Customs Duties 6.20 5.42 4.71 4.40 12.38 8.21 50.52
Central Excise 0.50 0.50 0.01 0.00 0.02 0.40 0.50
TOTAL 31.10 24.72 21.91 19.80 24.85 21.91 186.09
==========================================================================================
SOURCE: Pakistan Economic Survey
The list of exemptions can be extended to include accelerated depreciation allowances, lack of coverage of sales tax on wholesale and retail trade, effective exemption of a large number of services from GST, effective zero-rating of domestic sales of export-oriented sectors, etc.
If all these concessions and erosions of the tax base are accounted for then the aggregate tax expenditure in the federal tax system could reach a whopping Rs 300 billion or so. This is equivalent to almost 31/2 percent of the economy and about one thirds of revenues actually collected.
The Federal Board of Revenue has made some moves for improving the quality of tax administration like facilitating the process of self-assessment, simplification of processes, establishment of large tax payer units, computerisation, etc. But, perhaps due to lack of political will, there has been limited effort to extend the tax net to hard--to-tax sectors like domestic trade, small-scale manufacturing and services, especially those provided in the informal sector, private companies and incomes of the self-employed. The share of withholding/presumptive taxes has remained high at almost 57 percent of direct tax revenue. The share of voluntary payments is still low at 39 percent.
Overall, a lax tax policy coupled with a reluctance to make tax administration more effective has implied that the tax-to-GDP ratio has remained stagnant or improved only marginally in the economy during a period of rapid economic growth. Given the emerging resource constraints it is important now to remove the slack in the tax system especially by taxing the incomes or consumption of sectors and households with greater ability-to-pay. This takes us to the subject of potential proposals for resource mobilisation which budget makers in Islamabad must be actively evaluating at this point of time.
TAXATION PROPOSALS Tax proposals for the federal budget 2008-09, will have to be designed not only to mobilise more revenues for the public exchequer, but also to generate them in a way that the burden of taxes is not on the lower income groups. We present below some such progressive tax proposals.
In income taxation, given the high level of inflation during the fiscal year 2007-08, a strong case exists for lowering the tax burden on lower income groups. It is suggested that that tax exemption limit should be enhanced from Rs 150,000 to Rs 200,000 for salaried and from Rs 100,000 to Rs 150,000 for non-salaried tax payers. Simultaneously, incidence of the tax has to be enhanced to make the structure more progressive for high incomes above Rs 100,000 per month.
Currently, more than half of income tax revenues are collected under the withholding/presumptive tax regime, which strictly speaking, acquires an indirect tax character.
We suggest that effort needs to be made to gradually withdraw the presumptive taxes and replace them by income tax collection based on self-assessment and tax audit. We suggest taxation of real estate which has historically been a "tax haven" for speculators who have diverted capital from productive activities. There is a strong case for the introduction of capital gains tax on real estate by the provincial governments, which could yield Rs 10 billion.
One other progressive proposal which can have favourable impact on the twin deficit is imposition of regulatory duty on non essential imports. We suggest imposition of a regulatory duty, say 10 percent, on luxury good imports. This proposal will not only mobilise extra revenues of upto Rs 30 billion, to partially finance the relief package for the poor, discussed in the subsequent section, it will also bring down the growing level of luxury imports in the country.
OTHER TAX PROPOSALS WHICH ALSO FOCUS ON 'TAXING THE UNDER-TAXED' ARE SUMMARIZED BELOW:
(i) A BROAD-BASED SALES TAX ON SERVICES: Many services cater primarily to the demand of upper income groups and to corporate entities. Their revenue contribution is very limited. Introduction of a broad-based sales tax could follow the lines of development of the service tax in India. The number of taxed services is 80 and the number of tax assesses has approached one million in India. The yield has crossed one percent of the GDP, with a tax rate of 12 percent. It is estimated that introduction of such taxes in Pakistan would lead to additional revenue of Rs 25 billion initially.
(ii) HIGHER TAX ON PRIVATE COMPANIES: Rate of corporate tax on private companies may be enhanced which could result in additional revenue of Rs 10 billion.
(iii) HIGHER PROPERTY TAX: The property tax is levied by provincial governments. Currently the assessed-to-market rental values are very low and could be enhanced significantly.
Altogether, the above menu of proposals could yield additional revenues of between Rs 70 to 85 billion. They have been identified from the viewpoint of balancing the sectoral incidence of taxes and collecting more from those with the greater ability-to--pay. They will help in reducing perceptions of inequality among the people.
SECTION IV
OIL PRICING POLICIES One of the most difficult policy choices in the Budget of 2008-09 is determination of the appropriate level of prices of petroleum products in response to the sharp jump in international oil prices, which have virtually doubled over the last one year.
The lack of adjustment of domestic POL prices last year to this development led to a large increase in the oil subsidy which is reflected in the budget as deferred claims of OMCs. According to the Finance Minister's statement of the of April, this liability has increased to Rs 153.6 billion in 2007-08 as compared to the original provision of only Rs 15 billion.
Therefore, in the absence of a clear policy on linking domestic POL prices to international prices, the implied oil subsidy has emerged as one of the principal reasons why the fiscal deficit in 2007-08 has risen so sharply in relation to the original target set at the beginning of the financial year.
The issue of domestic POL prices not only has significant fiscal policy implications but could also impact on the overall price level in the economy, on the level of competitiveness of Pakistani industry and on the level of energy demand in the economy which would determine the size of the oil import bill that has made a major contribution to the deterioration in the balance of payments position of the country. Therefore, the setting of domestic POL prices is confronted with serious policy tradeoffs which have to be carefully considered by the government.
The objective of this section is to identify first the extent of price adjustment that has been made since March 1 2008, after a period, since January 2007, when prices remained unchanged despite underlying increase in international prices. The apparent explanation for this is the reluctance to raise prices prior to general elections. We derive on an annualised basis the extent to which the oil subsidy has been reduced effectively in 2008-09 due to the recent price increases.
The next part of the analysis relates to the estimation of the present level of subsidy (as of 31st May 2008) on individual POL products and the extent of taxation, principally the general sales tax. This enables derivation of the projected net subsidy bill in 2008-09 on the basis of currently prevailing prices.
The Prime Minister has apparently indicated in his meeting with the Vice President of the World Bank on May 27, 2008 that the government has decided to eliminate the subsidy on POL products in a phased manner in 2008-09, in order especially to relieve the pressure on the budget.
This is a major policy decision. We derive the extent to which prices will have to be raised in order to achieve this goal of subsidy elimination. Finally, some of the broader implications of the POL price enhancements are indicated.
RECENT INCREASES IN POL PRICES: The Oil and Gas Regulatory Authority (OGRA) makes recommendations to the government on the level of POL prices (except high speed diesel oil) on a fortnightly basis. After a gap of over one year the first price increase was announced on the 1st of March 2008 at the fag end of the tenure of the caretaker government, followed by another increase on the 16th of March.
Thereafter, following the induction of the new government, two more price increases have been announced on the 18th of April and 1st of May respectively. Table 4.1 gives the resulting cumulative price increase since 1st of March. It is Rs 15.11 per litre in the case of motor spirit/petrol, Rs 12.40 in high speed diesel oil (HSD), Rs 12.02 in light diesel oil (LDO) and Rs 6.21 in kerosene oil. These are fairly substantial increases, over 30 percent on average. Therefore, a significant effort has been made recently to respond to the rising international prices, although the process is incomplete.
======================================================================
TABLE 4.1
======================================================================
CHANGE IN RETAIL PRICES OF POL PRODUCTS
======================================================================
(Rs per litre)
HOBC Petrol Kerosene Oil HSD LDO
======================================================================
17th February 2008 64.88 53.70 35.23 37.73 32.57
1st March 2008 69.88 58.70 38.73 41.23 36.07
16th March 2008 74.77 62.81 41.44 44.13 38.59
18th April 2008 77.77 65.81 41.44 47.13 41.59
1st May 2008 80.77 68.81 41.44 50.13 44.59
Cumulative % 24.5 28.1 17.6 32.9 36.9
Increase
======================================================================
SOURCE: OGRAThe reduction in subsidy on an annualised basis in 2008-09 is quite sizeable at over Rs 151 billion. The biggest saving is in the case of high speed diesel oil of almost Rs 118 billion, due largely to the much greater volume of consumption of this product.
The next big reduction in subsidy is in the case of motor spirit of Rs 29 billion. Credit must be given to both the caretaker and the newly elected governments for having announced the relatively large price increases which imply significant savings for the forthcoming budget. During the last quarter of fiscal year 2007-08 these increases should reduce the claims of OMCs by Rs 38 billion.
However, there has been a visible jump in the monthly rate of inflation during the months of March and April 2008. The Consumer Price Index has risen by over 3 percent each month as compared to the average monthly rate of inflation of 1.1 percent in the previous six months. Part of this jump in the rate of inflation is due to the direct and indirect effects of higher POL prices.
OIL SUBSIDY IN 2008-09: The present pricing structure of POL products is highlighted in Table 4.2. The international fob price is based on prices prevailing internationally between May 14 and May 31, 2008, while the import parity price has been worked out at the exchange rate of Rs 66.36 per dollar. Given the outlook of rising oil prices and the depreciation beyond the assumed value already of the rupee, it is likely that the import parity prices for 2008-09 are somewhat understated.
================================================================================================================
PRICES TRUCTURE OF POL PRODUCTS
(at present retail price)
================================================================================================================
International Import Inland Freight Price
FOB price* Parity Price + OMC Margin Tax (with no Current Subsidy
($ per barrel) (Rs/Litre) + Dealers Margin GST + PDS subsidy) Price
Rs per litre
================================================================================================================
HSD 144.35 68.81 5.01 6.54 80.36 60.13 30.23
Motor Spirit/Petrol 118.40 51.63 7.40 9.78 68.81 68.81 0.00
Kerosene Oil 144.67 62.63 5.54 5.41 73.58 41.44 32.14
Light Diesel Oil 135.37 58.17 4.46 5.82 68.45 44.59 23.86
HOBC 121.10 52.76 12.78 15.23 80.77 80.77 0.00
================================================================================================================
-- OGRA calculations for May 15 - May 31 2008 and exchange rate of Rs 66.3646 per $.
According to Table 4.2, government collects GST at 15 percent on all petroleum products. In addition, there is a small petroleum development levy on motor spirit and HOBC. Given the price build-up it appears that high speed diesel oil, light diesel oil and kerosene oil continue to receive large subsidies of Rs 30.23, Rs 23.86 and Rs 32.14 per litre respectively. Motor spirit and HOBC receive no subsidy.
The estimated subsidy bill for 2008-09 in gross terms (after covering taxes) is derived in Table 4.3. It adds up to the massive amount of Rs 300 billion, just under 3 percent of the GDP. The bulk is on high speed diesel oil of over Rs 287 billion. Therefore, any policy of elimination of subsidy in 2008-09 will essentially involve raising the-price of HSD. It is likely that government will continue the policy of subsidisation of kerosene oil, consumed primarily by the lower income groups, and light diesel oil, which is largely used in running tubewells for agricultural purposes.
===================================================================================
TABLE 4.3
===================================================================================
ESTIMATED SUBSIDY BILL AND TAX REVENUE IN 2008-09
(with retail prices at current level)
===================================================================================
Subsidy Annual Consumption Subsidy Bill Tax Revenue
(per litre) (million litres) (million Rs) (million Rs)
===================================================================================
HSD 30.23 9502.9 287272 62148
Motor Spirit 0 1952.3 19093
Kerosene Oil 32.14 286.7 9214 1551
Light Diesel Oil 23.86 156.0 3722 907
HOBC 0 17.4 265
TOTAL 300208 83964
-----------------------------------------------------------------------------------
Net Subsidy = 216244
===================================================================================
The projected revenue generation (at current prices), primarily from the general sales tax, is about Rs 84 billion in 2008-09. Therefore, the estimated subsidy bill in net terms on petroleum products in 2008-09 is approximately Rs 216 billion, almost 2 percent of the GDP. However, as indicated above, if oil prices continue rising (already approaching $130 per barrel of crude oil) and if the rupee continues to depreciate then the net subsidy bill could be even higher.
SUBSIDY ELIMINATION
We now work out the implications of subsidy elimination (at current prices). Prior to doing this exercise, we discuss the issue of elimination of taxes on POL products, specifically the GST. It has been suggested that in the presence of subsidies there is no logic in the retention of taxes. This is apparently a rational argument.
But there are two problems. First, there is no subsidy on motor spirit (and HOBC), an item largely consumed by upper income groups, and removal of GST on these products would represent an unnecessary loss of revenue of over Rs 19 billion and reduce the element of progressivity in the tax system. Second, the GST forms an important part of the federal divisible pool of revenues which is shared with the provinces.
Withdrawal of GST from petroleum products would lead to a loss of transfers of as much as Rs 35 billion to the provinces. This is unlikely to be acceptable to the provincial governments, especially at a time when efforts are being made to strengthen the federation. On top of this, the elimination of GST on petroleum products can reduce the already low tax-to-GDP ratio by 0.8 percent of the GDP. Based on the assumption that GST will continue to be levied, we derive below the required price increase to eliminate the subsidy.
=================================================================================
PRICE INCREASE FOR ELIMINATION OF SUBSIDY
=================================================================================
(Rs / iitre)
=================================================================================
Current Price Price with Absolute. % increase
no subsid increase
=================================================================================
HSD 50.13 84.88 34.75 69.3
Kerosene Oil 41.44 78.38 36.94 89.1
Light Diesel Oil 44.59 72.01 27.42 61.5
=================================================================================
The results are striking. In the case of HSD, the product which accounts for bulk of the subsidy bill, the price would have to be increased by about Rs 34.75 per litre, equivalent to a 69 percent increase on the present price.
As mentioned earlier, prices of kerosene oil and light diesel oil are unlikely to be changed significantly, implying a continuing subsidy of about Rs 13 billion. The basic question is what are the implications of a big increase in the price of HSD?
In order to soften the adjustment we have done a simulation of price increases of an equal magnitude in HSD and motor spirit (and HOBC) such that the required price in the former is reduced by generation of more revenues (in the form of petroleum development levy) from the former.
Results of the simulation are that an increase of Rs 20 per litre is necessary in the price of HSD, motor spirit and HOBC for elimination of the overall net subsidy on petroleum products. The next section traces the likely broader implications on the economy of these price increases.
IMPACT OF PRICE INCREASES The enhancement especially in the price of high speed diesel oil has wide ranging impact on prices throughout the economy because of the associated increase in the costs of goods transportation or in production costs.
There is also a direct impact on households in the form of higher transport fares both for inter-city and intra-city passenger transportation by road or by rail. SPDC has undertaken earlier in 2000 a study on Economic Modeling of Inter-fuel pricing which estimates via an input-output matrix the impact of change in HSD price on prices in various sectors of the economy.
If the oil subsidy is to be eliminated then we have suggested that the price of HSD needs to be raised by 20 Rs per litre from the present level, implying a cumulative increase of 86 percent over the price prevailing prior to March 1 2008. We use the SPDC model to identify which sectors are likely to be impacted most by this price increase and by how much. Results are given below in Table 4.4.
=======================================================================================
EXTENT OF PRICE INCREASE IN SELECTED SECTORS DUE TO
86 PERCENT INCREASE IN HSD PRICE
=======================================================================================
% Price % Price
Sector Increase Increase
=======================================================================================
Road Transport 11 Fisheries 4
Rail Transport 11 Chemicals 2
Cement 8 Mining 3
Water works and supply; electricity 5 Construction and land improvement 3
Basic metal products 4 Cotton cloth 2
=======================================================================================
Therefore, the price impacts are sizeable, ranging from 11 percent in the case of rail and road transport to 2 percent in the case of industry producing cotton cloth. The overall impact on households, both direct and indirect, is derived below in Table 4.5.
=======================================
TABLE 4.5
=======================================
IMPACT ON HOUSEHOLDS BY INCOME LEVEL
DUE TO 86 PERCENT INCREASE IN HSD PRICE
=======================================
(%)
=======================================
Households Rural Urban
=======================================
1st Quartile* 2.4 2.4
2nd Quartile 2.1 2.3
3rd Quartile 1.9 2.1
4th Quartile 1.3 1.5
Total 1.6 1.9
=======================================
-- by level of income
Therefore, the effective loss in real income of households due to the rise in HSD price approaches 2 percent in urban areas and is somewhat less in rural areas, due primarily to less demand for transportation. More importantly, the impact is regressive, at almost 2.5 percent for the poorest households. In fact, the price increase could wipe out over one year's gain in real income for the poor due to GDP growth.
TURNING NOW TO THE DEMAND SIDE EFFECTS, THE SPDC STUDY HAS DERIVED THE PRICE ELASTICITIES OF DEMAND AS FOLLOWS:
====================================
High speed diesel oil: -0.121
Motor spirit: -0.223
====================================
This implies that a 86 percent increase in the HSD price could translate into a 10 percent reduction in demand. This could lead to a contraction in oil import by about $850 million. The simultaneous increase in price of motor spirit of 65 percent could yield further savings in the import bill of $200 million. Therefore, the combined reduction in the cost of oil imports is in excess of $1 billion.
POLICY RECOMMENDATIONS The above analysis has demonstrated that elimination of the oil subsidy in 2008-09 would involve primarily an increase in the price of HSD by almost 35 Rs per litre. This is not only a massive increase which would cause dislocation in the transport sector and jeopardise the process of growth but also the inflationary impact is sizeable, with a relatively higher burden falling on the poor.
THEREFORE, WE RECOMMEND THE FOLLOWING:
(i) The elimination of the oil subsidy should be phased over a period of two years and be implemented in small steps periodically.
(ii) Equal absolute increase in price per litre of Rs 10 be resorted to in 2008-09 of HSD, motor spirit and HOBC. A staggered process of adjustment will reduce the probability of severe protests from people at large.
Elimination of the subsidy by half in 2008-09 will mean that the net subsidy on petroleum products will remain at about Rs 108 billion. Efforts will have to be made in the forthcoming budget to cover this through expenditure-switching from other heads and overall higher resource mobilisation.
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