'Pakistan in worst than 2008 economic crisis; integrated VAT is essential': an interview with Dr Ehtisham Ahmad, Sr. Fellow at London School of Economics

As a new government takes shape in Islamabad in the thick of a serious economic crisis, talks of tax reforms have begun to make headlines once again. What could be the way forward; and what long and short run options lay before the incoming government? To answer these and other related questions BR Research turned to Dr Ehtisham Ahmad this weekend.
A seasoned economist with over two decades of IMF experience behind him, his research interests include taxation, federalism, intergovernmental fiscal relations and other ancillary affairs.
Currently, he is a Senior Fellow at the LSE, and Pao Yu-Kong Professor at Zhejiang University; he is also associated with the Chinese Academy of Fiscal Science and Ministry of Finance Research Institute. Dr Ehtisham Ahmad has advised Mexican and Chinese governments for their respective tax reforms and was asked to write research papers for the Indian Finance Commission.
He directed a research program on tax reform in Pakistan, India and Mexico with Lord Stern during 1980-90.In 2008, he was Pakistan's Senior Advisor to the IMF Executive Board and assisted with the 2008 programme that had tax reforms as a key performance criterion. He resigned at the end of 2009.Below is edited transcript of that conversation.
BR Research: What is the most important component of a modern tax system?
Ehtisham Ahmad: A simple tax policy design is needed to generate revenues, improve the business climate and stop cheating, and for ease of administration. The modern design of tax administration is based on management of information: the VAT yields information on the whole value chain because the information on wages and profits is generated at each stage of the value chain.
This together with information from assets is critical to make income taxes effective. A simple and integrated design of policy and administration are critical.
The tax administration should operate on an arm's length principle to improve the business climate and reduce opportunities for corruption. This also requires self-assessment together with an effective and strong audit. A modern tax administration does not have to be very large.
Unfortunately, things start getting complicated if tax policy and administration are not in sync. So even if there is an independent tax agency, often headed by a separate minister as is in China, there has to be close coordination to ensure that tax policy proposals from the Finance Ministry can be implemented. If tax policy and administration are not in sync, the reforms will generally not work.
BRR: Is VAT the only answer to collect that information?
EA: The collection of sales tax on goods and services in VAT mode provides the information needed to stop cheating of taxes, as it generates full information on wages and profits at each stage of the value chain. But this does not work if there are breaks in the value chain (e.g., SROs) or the base itself is split across provinces and separate administration.
These breaks not only make life harder for taxpayers and businesses, they make it very hard to issue prompt export refunds. The SROs also seldom achieve national distributional or investment objectives, although individual rents are collected.
I have worked on tax reforms in India and Pakistan since the early 1980s, and the major problem in both countries is the splitting of tax bases between levels of government that is a colonial legacy from the Government of India Act 1935-applying both to income taxation as well as sales taxes on goods and services.
BRR: How have other countries managed fixing VAT?
EA: The reforms in Mexico in 2013, that I had the opportunity to contribute to, and in China in 2015, focused on "fixing the VAT"-which had previously the same "holes" as in Pakistan. In Mexico, the tax/GDP ratio rose from less than 11% in 2012 to over 17% in 2017, largely due to the reduction of cheating in the income taxes.
China also integrated the VAT on services (the provincial business tax) with the national VAT to reduce the cost of doing business and consolidate the economic space helping to remove borders around SEZ, like Shenzhen, to better develop growth and employment linkages.
Recently, India has tried to integrate the GST base through a constitutional amendment, although separate administrations and additional state level rate setting powers greatly complicate the system that has not yet achieved the efficiency of the Chinese or Mexican solutions.
The attempt is to create a unified information management system, which is the crux of a modern tax administration design, and a uniform audit system, although separate administrations complicate matters for the taxpayers and businesses.
One of the main objectives of the Indian reforms are to ensure their competitive edge Vis a vis China, and countries like Viet Nam with a modern VAT system. Pakistan has gone in exactly the wrong direction by assigning GST on services to provinces in the 18th Amendment, along with a split in tax administrations.
BRR: But isn't it true that GST on services was already a provincial right as per the 1973 constitution.
EA: In 1973 Constitution, the taxation of services was primarily related to "final activities" such as haircuts. The VAT had only just been introduced in some European countries and had not been considered an option for developing countries.
However, a Tax Reform Commission set up in 1970 headed by State Bank Governor M. Raschid, and then reconstituted in 1972 after the separation of the Eastern Wing, considered that the VAT would be a possible instrument to stop "corruption" in addition to raising revenues, which at 13% of GDP were higher than they are today.
Their report in 1974 was marked "SECRET" and buried. Thus, there was no consideration of the VAT or how it might operate in the 1973 Constitution. As a matter of fact, the VAT is still not correctly understood in Pakistan, and operates much like a production excise-where businesses try to get exemptions and SROs. This actually destroys the logic of the VAT and actually adds to the cost of doing business, and it is consequently is one of the worst performing in the world in terms of revenue collections.
BRR: Are you not in favour of assigning provinces any major taxes?
EA: I am all for giving provinces a major tax handle to generate revenues. This is critical to ensure true accountability under a federal system. Unfortunately, the split VAT is a dreadful base to assign to the provinces, and results in a pathetic revenue performance. As Pakistan's moth-eaten and split GST actually adds to the cost of doing business, it makes it even more difficult for firms to compete with Chinese competitors.
This also succeeds in creating trade distortions and domestic barriers across provinces. A much better base for the provinces would be a surcharge or "piggy back" on a consolidated income tax, as in the US and many other countries.
If Pakistan hopes to learn from China, its 1993/4 tax reform is a good place to start. At that time, the tax/GDP ratio was around 10% but is around 20% today, largely due to the VAT and a new tax administration at the center. The fiscal reform generated one of the fastest growth performances the world has seen, taking 750 million people out of poverty since then.
After the integration of the goods and services base in 2016, the VAT in China is one of the most efficient in the world, and all taxes on inputs are refunded on exports.
BRR: How does one restructure the tax regime?
EA: Given that the 18th Amendment is in place and cannot be changed easily, an intermediate solution could be to have a unified information management function and audit between the centre and the provinces. And I had worked on alternatives with representatives from Sindh in 2011, at the request of the then Finance Minister Hafeez Shaikh.
The objective was to develop a proposal that would protect the value chain keeping the legal constraints of the 18th Amendment in mind. The options were never seriously considered and the split in the tax base and administration has gelled over the past eight years.
In the long run, however, Pakistan really has to revisit the constitutional tax assignments, including the VAT and the incomes taxes. In order to get the tax/GDP ratio anyway near the 20% target, an integrated VAT will be essential. In return, the provinces should have the power to tax incomes on an integrated tax base managed by the federal government.
Also, the property tax system needs a major overhaul - and again simplification would help, perhaps adapting the simple UK-band system based on occupancy and local spending needs - creating a beneficial tax for local accountability and sustainable access to credit for city infrastructure.
In the United States, the federal IRS manages the income tax base and audit, but the provincial and city governments add their rates on top of the federal rates. The sub-national governments get the revenues automatically without going through the federal treasury system.
BRR: How robust are Pakistan's GST laws; can we tweak it into VAT mode without reassignment of taxes between centre and provinces?
EA: As part of the 2008 IMF programme, I coordinated redrafting the VAT laws with a team of Pakistani lawyers, for presentation to the parliament by end-2009. This was a structural benchmark. It kept the legal split of GST on goods and services between federal and provincial governments, but it also created an integrated administration.
The draft was later buried; in fact, it was never submitted to the parliament. I quit my position as Senior Advisor for Pakistan on the Board at the end of 2009, as a golden opportunity to "fix" Pakistan perennial domestic resource mobilization weaknesses was missed.
BRR: So in your opinion, some sort of national tax agency could be the solution. And whether FBR could be made into one or should Pakistan set up a new agency altogether ala Peru?
EA: In the short term a national tax agency is perhaps the best solution; an agency that collects on behalf of the centre and the provinces, manages information on behalf of both, and also conducts the audit function in an arm's length manner.
Coordination among several tax administrations is never easy and adds to the cost of doing business, as is also evident in India. In the long run, the revenue reassignments commensurate with the spending responsibilities will require a constitutional amendment; there is no question about that. But that's probably not on the cards at present.
BRR: Do you think Pakistan can avoid going to the IMF this time?
EA: Pakistanis in an economic crisis of unparallel proportions; and is in a position worse than in 2008, with a hostile United States and a much tougher IMF than in 2008 or 2012. Raising the tax-to-GDP ratio is critical.
Without an IMF program the cost of borrowing will be much higher, if the markets are willing to lend to Pakistan to roll over the large amounts that are coming due in 2019. Short cuts to raise the tax to GDP ratio by the imposition of inefficient presumptive taxes, and restrictive duties raises the cost of doing business, and makes it less likely that the Chinese or anyone else for that matter would be interested in investing in Pakistan. Tax amnesties create an incentive to wait for the next amnesty and punish the honest tax payers.
The IMF dropped the VAT condition in the 2013 programme, even though it had been a staple requirement since the early 1990s. But the 2013 program was defensive lending on the part of the IMF to recoup the amounts disbursed under the 2008 program. Unfortunately, successive governments have avoided structural reforms for domestic resource mobilization to ensure that the country can stand on its own feet and actually "break the begging bowl." The poor domestic resource mobilization may have serious security consequences.
BRR: Whole scale reforms or piecemeal. What should be the strategy?
EA: Mexican Finance ministers tried piecemeal reforms over two decades but failed. Things began to improve when they rolled out whole scale reforms off setting gainers and losers among states (provinces) and households. As a result, Mexico's tax-to-GDP ratio rose from less than 11% in 2012 to 17% percent in 2017.In geo-political terms, because of higher domestic resource mobilization, Mexico is now in a much stronger position to negotiate with the United States.
BRR: The incoming PM wants to learn from China. What key lessons are there to be learnt in so far as taxation is concerned?
EA: China addressed the political economy question very nicely. A package approach ensured that no province lost revenues, and that the overall revenues continued to grow strongly, ensuring a buy-in from the provinces, not an easy task even in China. The funds were not wasted on handouts, but went to education and infrastructure, with tightened budgetary procedures.
Also, better information was generated that greatly helped identify and tackle corruption. This is part of an integrated strategy of taxation and spending, linked to sustainable growth, effective management of risks, attention to poverty reduction and income distribution and concern for the environment.
BRR: Would you agree that taxation lies at the heart of current NFC deadlock in Pakistan?
EA: The 18th Amendment and the 7th NFC Award shifted wide ranging spending to the provinces, but these cannot be financed with 6% of GDP, which should be spent on education alone. With an 18-20 percent tax to GDP ratio, there would be fiscal space for debt servicing and defence at the central level, and basic services.
With 10 percent of GDP there is an impossible trade-off between social and development requirements and the need to spend on security and debt service. The idea behind having an NFC Award every five years is that you should periodically look at the system of sharing revenue and spending responsibilities. But unfortunately, this hasn't been the case in Pakistan.