One point of commonality in all twenty-three International Monetary Fund (IMF) programmes secured by Pakistan to date is an emphasis on raising tax revenue with more recent programmes seeking not only a higher tax-to-Gross Domestic Product (GDP) ratio, which is appallingly low at under 10 percent but also widening of the tax net through bringing in the elite currently outside the net - either through the grant of exemptions or opting to operate through proxies (benami accounts) or preferring to be non-filers even if that requires operating on cash.
The question is why is tax- to-GDP ratio, which measures a nation’s revenue relative to the size of its economy, so relevant? This ratio is used as a yardstick to assess how well any given administration is directing its economic resources through tax policies.
In 2021, OECD countries averaged 34.1 percent, New Zealand 33.8 percent, Japan 33.2 percent, South Korea 29.9 percent, Australia 28.5 percent and China 21 percent. Typically developed nations have a much higher tax-to-GDP ratio relative to poorer nations and the usual reason cited is that as incomes rise associated with development, people begin to demand more services from their government be it in education, healthcare or transport.
This logic is not applicable to the US with a tax-to-GDP ratio of 16.4 percent in December 2023, reaching an all-time high of 19.5 percent in 2000 and a record low of 13.7 percent in 2009.
The reason behind the US registering a significantly lower tax-to-GDP ratio relative to other developed economies may be explained by the backgrounder uploaded on the Council on Foreign Relations website titled The State of US Infrastructure by McBride and Siripurapu (updated September 2023): “US infrastructure is both dangerously outstretched and lagging behind that of its economic competitors, particularly China……in its 2021 report card the American Society of Civil Engineers, an industry group, gave the nation’s infrastructure a C-, up from D+ in 2017, the highest in twenty years.
Still the Group estimated that there is an infrastructure investment gap of nearly 2.6 trillion dollars that, if unaddressed, cost the US 10 trillion dollars in lost GDP by 2039…some analysis show the quality of US infrastructure compared to its peers steadily declining over the past two decades. US infrastructure spending also ranks towards the bottom amongst Group of 20 countries.”
Soon after being elected Jo Biden signed on a one trillion-dollar infrastructure investment bill with the objective of jumpstarting the recession ridden economy; and it took two years for the administration to launch 40,000 projects.
In Pakistan’s context, the infrastructure sector has never been a major budgeted expenditure recipient (physical and even less so social) with only 6.5 percent of the total budgeted outlay earmarked under federal public sector development programme (PSDP) in the current year (against 92 percent for current expenditure).
Last fiscal year 7.5 percent was budgeted under PSDP though actual disbursement has generally been lower especially when the country is on a rigidly monitored International Monetary Fund (IMF) programme, which stipulates a budget deficit target.
In the last two programmes (2019 and 2023 Strand By Arrangement) the Fund focused more on primary as opposed to budget deficit, which disturbingly accounted for a massive rise in domestic debt (resulting in negative growth of private sector credit) with an extremely adverse impact on raising the domestic mark-up from what was budgeted with repercussions on inflation.
The percentage allocated on the following major items of current expenditure as a percentage of total outlay (projected at 14460 billion rupees) for 2023-24 are as follows: (i) budgeted debt servicing payments on domestic and foreign debt at 50.4 percent, defence (12 percent), subsidies (7.4 percent), pensions (5.2), and civilian administration (4.9). In other words, if the objective is to immediately reduce inflation then reducing the budgeted expenditure may be a much more effective and appropriate approach especially as the recipients of expenditure are the relatively better off. Subsidies considered to be pro-poor are largely untargeted in this country and hence need to be more targeted.
So what constitutes a good tax-to-GDP ratio? World Bank suggests that tax revenues above 15 percent of GDP can be a key ingredient for growth and poverty reduction. Average tax-to-GDP ratio in emerging markets and developing countries increased from between 3.5 to 5 percentage points driven by taxes on consumption (general sales tax) and excise taxes as per an IMF blog dated September 2023 titled Countries Can Tap Tax Potential to Finance Development Goals.
The blog noted that Pakistan performed poorly on both counts: a tax-to-GDP of 10.3 percent in 2020 and 2021 and between 2011 and 2021 the tax-to-GDP ratio increased by 1.2 percentage points only – from 9.1 to 10.3 percent. But noted that 42 percent of tax revenue collected was from sales tax/value added tax on goods and services (which is contributing to a steady rise in collections either through each subsequent finance bill that brings more items under the net or increasing the standard rate).
Taxes on goods and services accounted for 64 percent of all collections with value-added tax/goods and services accounting for 41 percent of all collections, taxes on specific goods and services accounting for another 22 percent, customs and import duties 14.5 percent and excise 7 percent.
It is little wonder that an attempt to check imports to ease the balance of payment issues leads to lower collections raising the budget deficit, an inflationary measure in itself but its impact is exacerbated as the government borrows from the domestic market to meet its current expenditure.
Data compiled by the Consortium for Development Policy Research noted that in 2020 income tax as a percentage of total revenue was 69 percent in Malaysia, 51 percent in India, 40 percent in Thailand and 32 percent in Pakistan; and the proportion of active tax payers in 2020 was 88 percent in Australia, 44 percent in the US, 49 percent in Indonesia, 5 percent in India and barely 1 percent in Pakistan. The challenges were a fragmented tax base, generous income tax thresholds, weak enforcement and costly compliance, and overreliance on withholding tax but in the sales tax mode.
The disturbing conclusion given the failure of administration after administration to check the rise in current expenditure from one year to the next, reluctance to seek voluntary sacrifices from the largest recipients of current expenditure and deferring implementation of reforms in the tax and energy sectors, the pension system and not targeting subsidies to the poor and vulnerable is the root cause of the economic impasse today.
To conclude, the ideal tax to GDP ratio must take account of expenditure priorities, and with the devolved subjects together with the higher provincial share of the divisible pool taxes as per the National Finance Commission award, slashing expenditure must go hand in hand with implementing politically challenging tax, pension and energy reforms (which must look at long standing policies for example tariff equalization policy that would make privatization ineffective).
Copyright Business Recorder, 2024
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