The Macroeconomic Scenario For 2008-09: The previous section has highlighted that the current fiscal year is likely to close with burgeoning deficits in the budget and in the current account of the balance of payments along with galloping inflation.
The real economy is also witnessing a slowdown in the rate of growth, especially in the agricultural and manufacturing sectors, and poverty is on the rise again in face of high and rapidly increasing food prices. Sustainability of the growth process requires, no doubt, the attachment of high priority to containment of the 'twin' deficits and to achievement of moderation in the rate of inflation. This has to be accomplished at the minimum cost in the short run to the rate of economic growth.
The objective of this chapter is to project magnitudes of macroeconomic indicators like growth, inflation, public finances and balance of payments which we consider achievable in 2008-09 on the basis of implementation of a relatively strong package of policies. An attempt must be made to ensure that the measures proposed have a minimal impact on the living conditions of the poor. Demonstration of a strong commitment on the part of the government to stabilising the economy will calm markets and help in restoring confidence.
GROWTH PROJECTIONS FOR 2008-09 Table 2.1 below gives the government projections of growth in 2008-09 as presented for approval initially to the Annual Plan Coordination Committee (APCC) and subsequently by the National Economic Council (NEC). SPDC projections are also given in the table. These are based on the economic performance in 2007-08 and the challenges being faced by the economy.
==================================================
TABLE 2.1
==================================================
GROWTH PROJECTIONS FOR 2008-09
==================================================
(%)
Government* SPDC Variation
==================================================
GDP 6.5 5 - -5.5 -1.0 - -1.5
Agriculture 4.0 4.0 0.0
Manufacturing 8.5 5.0 - 6.0 -2.0 - -3.0
Services 6.7 5.5 - 6.0 -0.7 - -1.2
==================================================
-- yet to be approved by NEC
The government projections are very optimistic and essentially ignore the difficulties being experienced by the economy. In the present context of trends both in the global and in the domestic economy it is difficult to visualize in the short run a recovery in the growth rate of the economy from 5.8 percent in 2007-08 to 6.5 percent in 2008-09.
In fact, given the need to stabilise the economy, emphasis will have to be placed on management of aggregate demand through contractionary fiscal and monetary policies. As such, subject to skillful management of the economy with the appropriate mix of policy instruments, an outcome in terms of the growth rate of 5 to 5 1/2 percent may be considered as a good performance of the economy in 2008-09.
Factors which will influence the level of aggregate demand in the economy are the level of interest rates and tax rates, the size of the public sector development program and so on. Ideally, the containment in aggregate demand will be reflected more in consumption than on investment, especially by the private sector.
Turning to sectoral growth rates, there was a sharp decline in the performance of the agricultural sector in 2007-08, with a growth rate of less than 2 percent. This was probably due to a fall in the production of wheat and cotton. During 2008-09 agricultural prices are likely to remain high because of high international commodity prices. A supply response could be forthcoming, especially if government intervenes in terms of easier and cheaper availability of inputs. Therefore, we concur with the government's projection of a 4 percent growth in the agricultural sector in 2008-09. This is based on growth rates of 4.5 percent in major crops, 4 percent in livestock and 2.5 percent in minor crops.
The manufacturing sector has shown a considerable loss of dynamism in 2007-08. The growth rate has plummeted from 8.4 percent in 2006-07 to 5 percent in 2007-08. Factors responsible for this are, first, the limits to capacity being approached in a number of industries, second, the stagnation in exports of textiles and clothing and, third, the high incidence of power outages which has adversely affected production. The anticipated near-doubling of the growth rate of the manufacturing sector during 2008-09 is optimistic.
High energy prices and rising interest rates will raise costs of production. Also, industries producing luxury consumer durables, like automobiles, face the prospects of higher taxes. As opposed to this, the depreciating rupee could provide a fillip to export-oriented industries although the introduction of margin requirements on raw material imports could stretch the liquidity of industrial enterprises.
The services sector has the largest share in GDP and has been the main contributor to growth in recent years, including 2007-08. The initial government projection is that this sector will grow by 6.7 percent in 2008-09. Relatively high growth rates are anticipated in sectors like banking and insurance at 12 percent, 8 percent in social, community and personal services and 6.5 percent in wholesale and retail trade.
WE PROJECT A SOMEWHAT SLOWER GROWTH RATE FOR THE FOLLOWING REASONS:
(i) The interim monetary policy measures announced recently by SBP, especially the introduction of a minimum return of 5 percent on savings deposits, could adversely affect profitability of commercial banks and reduce the growth in value added.
(ii) Measures like the introduction of margin requirements and depreciation of the rupee are likely to reduce the volume of imports and the level of wholesale and retail trade in imported goods.
(iii) A possible extension of the sales tax/excise duty net to services in the federal budget of 2008-09 could restrict growth in value added from social, community and personal services.
(iv) In an effort to contain the size of the fiscal deficit the government is likely to limit the growth in current expenditure, both civilian and military. This will dampen the growth of value added in public administration and defence.
INFLATION IN 2008-09
The official projection of the rate of inflation (in the consumer price index) for 200809 is 8 percent, while this year's outcome according to SBP is close to 11 percent.
THIS PROJECTION ALSO APPEARS TO BE OPTIMISTIC IN LIGHT OF THE FOLLOWING FACTORS:
(i) Inflation has acquired a galloping character and during the last two months of March and April 2008 the monthly rate of inflation has crossed 3 percent. Inflationary expectations have become embedded in the behaviour of economic agents and imparted a strong dynamic to inflation in the country.
(ii) There is a strong monetary 'overhang', due especially to the high rate of government borrowing from the Central Bank, which has substantially added to the stock of reserve money.
(iii) There has been incomplete adjustment yet to the rising oil prices internationally and if the government opts to raise domestic POL prices accordingly in 2008-09, to reduce the large oil subsidy bill (see Section IV), then this could impact significantly on the overall price level.
(iv) The rupee has depreciated rapidly in recent months by over 10 percent and, as highlighted by the Governor of SBP, this will imply more imported inflation in coming months.
Altogether, arresting inflation is going to be a huge challenge in 2008-09. Somehow, the tendency for inflation to acquire a runaway character has to be controlled. This will depend clearly on the strength and nature of the adjustment process. In our view, real success will have been achieved if inflation can be contained to 10 percent in 2008-09. Targeting for a single-digit rate of inflation may become possible only after 2008-09. If, however, the government proceeds to adopt almost draconian measures to being down the inflation rate to, say, 8 percent then this could seriously impair the process of growth and employment in the economy.
FISCAL ADJUSTMENT The announcement by the Finance Minister on 9th April 2008 that the fiscal deficit could reach a high of 91/2 percent of the GDP in 2007-08 exceeded all expectations. It is due apparently to underreporting of some expenditures, like interest payments, by the previous government and unanticipated higher expenditures, like the deferred claims of oil marketing companies due to higher oil prices and inadequate policy response to these shocks.
A break-up of the expenditure overrun (if no actions are taken before the end of the fiscal year) of Rs 522 billion (over 5 percent of the GDP) and revenue shortfall is given in Table 2.2. About 54 percent is due to factors of domestic origin like higher interest payments on domestic debt, cost of military operations in Swat, R & D allowance for textiles, etc. The remainder of 46 percent is the consequence of external shocks leading to higher subsidies on oil, power and wheat import. Therefore, contrary to perceptions, the substantial deviation from budgetary targets is due more to domestic than to international factors.
===================================================================================
TABLE 2.2
===================================================================================
FACTORS LEADING TO RISE IN FISCAL DEFICIT, 2007-08
===================================================================================
(Billion Rs)
Provision Actual Projection Variation from
in Budget July-February Budget Provision
===================================================================================
DOMESTIC 303.5 54.4%
Domestic Interest Payments 318.2 265.3 443.0 124.8
Military operations in Swat - 38.5 75.0 75.0
Export Subsidy - 19.4 43.0 43.0
Supplementary Grants - 12.0 25.0 25.0
Revenue Shortfall (Net) 902.2 535.9 890.0 -12.2
Provincial Surplus 51.7 10.9 28.2 -23.5
INTERNATIONAL 254.1 45.5%
Oil Differential Claims 15.0 15.0 153.6 138.5
WAPDA Subsidy 52.8 34.5 123.5 70.7
Wheat Import Subsidy - - 44.9 44.9
557.6 100.0%
===================================================================================
There are a number of consequences of the explosion in the size of the fiscal deficit. First, as highlighted earlier, the incremental deficit has been largely financed by borrowings from the Central Bank which have approached Rs 550 billion (51/2 percent of the GDP). This high rate of magnetisation of the deficit implies continuation of strong inflationary pressures, as highlighted earlier. Second, the large public sector deficit is spilling over into a higher current account deficit.
Removal of the imbalance in the external balance of payments, therefore, depends also on the containment of the fiscal deficit. Third, the large deficit implies that there will be a big revenue deficit and the public debt-to-GDP ratio will start rising once again, leading to a violation of the provisions in the Fiscal Responsibility and Debt Limitation Act.
THE FINANCIAL SCENARIO FOR 2008-09 IS DEVELOPED BY US IS BASED ON THE FOLLOWING CONSIDERATIONS:
(a) Getting back to the path of debt sustainability by limiting the size of the fiscal deficit and preventing the debt-to-GDP ratio from rising in 2008-09.
(b) Exploring limits to non-bank borrowing and external assistance and keeping borrowing from the SBP within 'safe' limits of deficit financing from the inflation point of view.
(c) Avoiding too drastic a reduction in expenditure, especially on development, and too big a hike in tax rates which could fundamentally impair the process of growth.
Recent statements made by government indicate that strong efforts are underway to limit the fiscal deficit in 2007-08, although not much time is available for making adjustments. There are some indications that the budget deficit will be brought down to 61/2 percent of the GDP by the end of the fiscal year, representing a sizeable reduction of almost 3 percent of the GDP from the level projected in early April.
We believe that this is perhaps too optimistic and instead base our projections for 200809 on a fiscal deficit outcome of 71/2 percent of the GDP in 2007-08 as indicated in the previous section. There is the danger that in an effort to bring down the deficit to 61/2 percent of the GDP some expenditure liabilities may be transferred to 2008-09.
Given the three above-mentioned considerations, our calculations reveal that the budget deficit in 2008-09 can be up to 51/2 percent of the GDP, representing a downward adjustment of 2 percent of the GDP from the likely level this year. This size of deficit keeps the public debt-to-GDP ratio, more or less, constant in 2008-09. Also, it is small enough to obviate the need for large-scale borrowing from the Central Bank. Further, it provides enough space for keeping the PSDP at a reasonably high level and is based on a feasible level of resource mobilisation without fundamentally affecting the growth process.
Table 2.3 gives SPDC projections of the key public finance magnitudes for 2007-08 and 2008-09. Total current expenditure is essentially derived as a residual in order to ensure attainment of the fiscal deficit target. The assumptions underlying the fiscal projections for 2008-09 are as follows:
================================================================
TABLE 2.3
================================================================
PROJECTION OF KEY PUBLIC FINANCE MAGNITUDES
================================================================
(Rs in Billion)
2007-08 2008-09 Growth Rate
(%)
================================================================
Total Federal Revenue (Net) 890.0 1080.0 21.3
Tax Revenue 995.5 1250.0 25.6
Non-Tax Revenue 346.9 400.0 15.3
Less Provincial Share -452.4 -570.0 26.0
Total Federal Expenditure 1684.9 1800.0 6.8
Current Expenditure 1415.6 1500.0 6.0
Development Expenditure 269.3 300.0 11.1
Federal Fiscal Deficit 794.9 720.0 -9.4
Provincial Surplus 28.2 50.0 77.3
Overall Fiscal Deficit 766.7 670.0 -12.6
As % of GDP 7.5 5.5
================================================================
TAX REVENUES: the tax-to-GDP ratio is projected to increase by 0.7 percent of GDP to 10.4 percent of the GDP in 2008-09. This will require a relatively high level of fiscal effort in the form of taxation proposals aggregating to Rs 80 billion. Specific proposals for mobilising additional revenues of this magnitude are highlighted in Section III. Non-tax revenues: assumed to remain unchanged as a percentage of the GDP.
DEVELOPMENT EXPENDITURE: fixed at 21/2 percent of the GDP for the federal PSDP, at about the same level as in 2007-08.
CURRENT EXPENDITURE: given the above assumptions and the target level of fiscal deficit of 51/2 percent of the GDP, the implied level of current expenditure is Rs 1500 billion, representing an increase of 6 percent over the likely level in 2007-08.
The big question is whether the growth of current expenditure can be restricted to 6 percent in 2008-09.
A NUMBER OF FACTORS WILL PUT PRESSURE FOR HIGHER OUTLAYS AS FOLLOWS:
(i) Interest payments are likely to increase faster because of the debt build-up in 2007-08 due to the large deficit and short-term interest rates (on treasury bills) will be higher as monetary policy becomes tighter. Also, the depreciation of the rupee will add to external debt servicing.
(ii) The oil subsidy bill will be under pressure as international prices of oil continue to rise (in excess of $130 per barrel currently), as highlighted in Section. The magnitude of this bill will depend upon the extent to which domestic prices of POL products are raised in line with the international prices.
(iii) The power subsidy to Wapda could rise in lieu of higher fuel costs unless appropriate adjustments are made in tariffs.
(iv) Given a larger volume of imports of wheat (up to 2.5 million tons), the wheat subsidy could be larger than in 2007-08.
Therefore, success in attainment of the fiscal deficit target of 51/2 percent of the GDP will hinge crucially on containing the overall subsidy bill in 2008-09.
OUR SIMULATIONS REVEAL THAT THE GROWTH OF CURRENT EXPENDITURE CAN BE RESTRICTED TO 6 PERCENT IN 2008-09 WITH THE FOLLOWING ACTIONS:
(i) POL prices are adjusted upwards in 2008-09 to eliminate at least half the level of subsidy, as recommended in Section IV.
(ii) The defence budget is brought down by Rs 50 billion from the likely level of Rs 350 billion in 2007-08 following a peace settlement and cessation of military operations in Swat/FATA.
(iii) Power tariffs are raised by about 15 percent during 2008-09.
(iv) Non-salary expenditure of all government departments is kept constant in nominal terms at the 2007-08 level.
Of course, if the government is able to eliminate a larger component of the subsidies through enhancements in administered prices then more fiscal space will become available for higher PSDP and/or higher outlays on social safety nets.
The above analysis indicates that the process of fiscal adjustment involving deficit reduction to 51/2 percent of the GDP in 2008-09 is achievable. It will involve intensive, but feasible, efforts at mobilising resources and containing expenditure in ways that hurt growth the least and do not impact adversely on the poor.
How should the fiscal deficit be financed in 2008-09? The government will have to limit its recourse to Central Bank borrowing given the high build-up already. As such, this should be limited to a maximum of 1 percent of GDP.
Another 1 percent of the GDP could be mobilised, largely through sale of PIBs, from the commercial banking sector without leading to major 'crowding-out' of the private sector. As in the past, external resources of about 2 percent of the GDP could be mobilised. The remainder, up to 11/2 percent of the GDP, would need to be generated from the National Savings Schemes. This would require an enhancement of about 3 percentage points in the returns on the various certificates.
Overall, it appears that a pattern of financing of deficit (of up to 51/2 percent of the GDP) can be evolved which has minimal inflationary impact and does not lead to a major displacement of the private sector. As highlighted earlier, containment of the fiscal deficit could also help greatly in reducing the gap in the balance of payments, projections of which are given next.
BALANCE OF PAYMENTS ADJUSTMENT
Curtailment of the current account deficit in the balance of payments has assumed prime importance in view of the large decline in foreign exchange reserves of more than $5 billion in 2007-08 and the rapid depreciation in the value of the rupee during the last few months. In fact, at $11.5 billion the reserves already represent an import cover of goods and services of less than three months. A significant decline in coming months could usher in a full-blown financial crisis.
However, government projections for 2008-09 appear to be largely oblivious of the extremely fragile position of the balance of payments. The current account deficit next year is projected at $12.5 billion, only marginally lower than the estimated deficit of $13.5 billion this year. The latter was financed by a drawdown of reserves as mentioned above. If this process of depletion of reserves continues because of a lack of adjustment in the balance of payments then in the next few months reserves could fall below the psychological threshold level of $10 billion, leading to greater nervousness in the markets and putting further pressure on the rupee.
Therefore, if stabilisation is to be achieved then the target must be to keep foreign exchange reserves throughout 2008-09 at a relatively high level. If, as promised by the Finance Minister, aid inflows of $3 billion are expected during the month of June 2008 then these must all be used to build up the level of reserves.
As such, efforts must be made to keep reserves at the relatively safe level of $14 billion or more throughout 2008-09, thereby restoring confidence in markets and facilitating the inflow of FDI.
The crucial element in the process of adjustment is, therefore, the size of the current account deficit which can be financed without any reserve depletion. During 2007-08, we estimate that the inflow of FDI and external assistance were able to finance a deficit of up to $8.5 billion.
Allowing for some growth in the size of the economy, a deficit of up to $9.5 billion in 2008-09 can be financed without cutting into foreign exchange reserves. Therefore, the target for the current account deficit in 2008-09 has to be fixed at $9.5 billion or about 5 percent of the GDP, as compared to the target of 6.5 percent initially set by the government.
What are the implications of a process of balance of payments adjustment which targets for a reduction in the current account deficit from about 8 percent of the GDP in 2007-08 to 5 percent of the GDP in 2008-09?
Clearly, this a sharp adjustment and has to be achieved without disrupting the growth process in the economy. It hinges on success in raising exports, maintaining the growth momentum in home remittances and containing the increase in imports. We have derived the level of imports which is consistent with the attainment of a 5 percent current account deficit in 2008-09 in Table 2.4.
=====================================================================================
TABLE 2.4
=====================================================================================
BALANCE OF PAYMENTS PROJECTIONS Current Account
=====================================================================================
($ Billion)
July - April July - June July - June
-------------------------------------------------------------------------------------
2006-07 2007-08 2006-07 2007-08 (P) 2008-09 (P)
=====================================================================================
Current Account Balance -6.6 -11.6 -6.9 -13.5 -9.5
Trade Balance -8.3 -12.7 -9.7 -15.2 -10.5
Exports 14.0 16.2 17.3 19.7 22.7
Imports 22.3 28.9 27.0 34.9 34.2
Services (Net) -3.9 -5.6 -4.2 -6.7 -8.0
Income (Net -2.9 -3.1 -3.6 -3.8 -4.0
Current Transfers 8.4 9.8 10.6 12.0 14.0
=====================================================================================
The calculations reveal that imports will have to kept at, more or less, the same level as 2008-09. This is sharp contrast to government projections of an increase in imports of 12 percent next year. There are a number of factors which will operate on the level of import demand in the economy.
Factors which could exert an upward pressure are, first, continued rise in the oil import bill due to higher prices, especially if domestic prices are not adjusted fully to contain demand and, second, a higher level of food imports, especially of wheat. These factors could add up to $3 billion to the import bill.
As opposed to this, there are a number of factors which could restrict the growth in imports, including, first, the management of aggregate demand via contractionary fiscal and monetary policies which could depress import demand in the economy, second, depreciation in the value of the rupee of 14 percent already in 2008-09, third, the introduction of 35 percent margin requirements on imports (except oil and food), and, fourth, the prospect of introduction of regulatory duties on non-essential imports, especially luxury goods in the forthcoming Budget.
Overall, if oil and wheat imports are higher by $3 billion in 2008-09 then, if total imports are to remain constant, all other imports combined will have to fall by $3 billion. The implied extent of containment of such imports is about 13 percent.
Depreciation of the rupee, introduction of margin requirements and possible imposition of regulatory duties along with more aggressive overall demand management may prove to be adequate to bring about this containment otherwise additional measures may be necessary.
Efforts should be made to curtail more the import of consumer goods rather than raw materials and capital goods, if necessary, through variation in margin requirements and level of regulatory duties.
But there is no doubt that one of the biggest challenges in 2008-09 will be to contain the growth in imports in order to fundamentally enhance the sustainability of the balance of payments position of Pakistan. It needs to be emphasised, however, that over the medium run the emphasis will have to be at diversifying the export base and achieving a faster growth in exports, beyond the 15 percent targeted for 2008-09.
How will the projected current account deficit of $9.5 billion in 2008-09 be financed? As highlighted earlier, if any drawdown of reserves is to be avoided in order to improve market perceptions then it will have to be largely financed by foreign direct investment and aid inflows.
Net aid inflow of up to 2 percent of the GDP of just under $4 billion is feasible especially if the democratic process continues successfully and the government demonstrates a strong commitment to the process of adjustment through far-reaching reforms, especially in the area of fiscal policy.
The remaining needs of financing of about $5.5 billion could be mobilised through foreign direct investment (including privatisation proceeds), especially if a degree of market confidence is restored through maintaining foreign exchange reserves at about $14 billion, preventing volatility in the foreign exchange and stock markets and perhaps, most importantly, achieving stability in the functioning of the political process in the country.
SECTION III
TAXATION POLICIES
Among the many challenges coming to the forefront in the last few years is also the growing perception of increasing inequality among different segments of population. The general feeling is that growth in the earlier part of the decade has benefited few, and the masses have been silent spectators witnessing others prosper. Though hard core estimates on distribution of income are not available after 2004-05, perception of inequality is almost as harmful as actual inequality as it leads to a feeling of being disenfranchised and causes unrest in the people. Therefore, budget of 2008-09 has to address the sense of growing inequality in the country while focusing on the macroeconomic objectives. A concerted effort has to be made to remove both interpersonal and inter-regional inequalities. Though the latter can best be addressed by the National Finance Commission which decides on inter-governmental revenue sharing transfers between the federation and the federating units, the former is more directly under the fiscal policy ambit.
The key fiscal policy tool for redistribution is taxation. According to taxation theory, it has three goals: to transfer resources from the private to the public sector; to distribute the cost of government fairly by income classes (vertical equity) and among people in approximately the same economic circumstances (horizontal equity); and to promote economic growth, stability and efficiency. The uneven distribution of tax burden across sector has led to serious concerns regarding the equity of tax structure in Pakistan. Has taxation in Pakistan contributed to redistribution? Kemal [2006] quantifies the incidence of the overall tax system of Pakistan. He finds that from being progressive in 1987-88, the incidence had become regressive by 1999-2000. The decline in corporate income tax rates and tariff rationalisation have benefited the well off, while with the broadening of the sales tax base, the tax burden on the poor has increased.
Developments since 1999-2000 may have contributed to even greater regressivity of the tax system?
THESE INCLUDE THE FOLLOWING:
Abolition of the wealth tax in 2000 and continued reduction in personal and corporate income tax rates, as highlighted above, especially on private companies and on the banking sector, at a time of sharply rising corporate profitability.
Further reduction in import tariffs, especially on luxury consumer goods, like automobiles, and withdrawal of excise duties on domestically produced consumer durables.
Reduction of revenues from the petroleum development surcharge and its virtual elimination in 2007-08. The surcharge has historically taxed motor spirit at a differentially higher rate, with the burden falling more on the upper income groups.
The extension of GST to fertiliser which has impacted relatively more on small farmers.
A positive development, however, is the rise recently in the share of direct taxes in total tax revenues.
Another key concern related to taxation in Pakistan is the lack of buoyancy in federal and provincial tax revenues. In fact one of the disappointments in the four previous years when there was continuously high economic growth was that the tax-to-GDP ratio did not rise correspondingly.
It has remained stagnant at 10 to 11 percent of the GDP. Is this because the tax base of different taxes has somehow been concentrated in the slower growing parts of the economy, possibly because of conscious policy direction, or that the opening of fiscal space in the economy (especially due to the decline in the debt servicing burden) has led to a slackening of fiscal effort both in terms of tax policy (erosion in tax base due to increased exemptions and concessions) and tax administration (increased evasion)?
This section attempts to answer these questions and suggests a strategy to make the incidence of taxes progressive and tax revenues more buoyant.
TREND IN REVENUES Important structural changes are visible in tax revenues during the last decade or so as shown in Table 3.1. The share of direct taxes has increased significantly from about 32 percent in 1999-2000 to 39 percent in 2006-07. In fact, the share jumped by almost 8 per cent in one-year in 2006- 07.
=================================================================================
TABLE 3.1
=================================================================================
TREND IN TAX REVENUES, 1999-00 TO 2006-07
=================================================================================
Year Tax Revenues Direct Taxes Excise Duties Imports Duties Sales Tax
Rs Rs Share Rs Share Rs Share Rs Share
Billion Billion (%) Million (%) Million (%) Million (%)
=================================================================================
1999-00 347 113 32.5 56 16.1 62 17.8 117 33.6
2000-01 392 125 31.8 49 12.5 65 16.6 154 39.1
2001-02 404 143 35.3 47 11.7 48 11.8 167 41.2
2002-03 461 152 33.0 45 9.7 69 14.9 195 42.4
2003-04 521 165 31.7 46 8.7 91 17.5 219 42.1
2004-05 590 183 31.1 53 9.0 115 19.5 239 40.4
2005-06 713 225 31.5 55 7.7 138 19.4 295 41.3
2006-07 847 334 39.4 72 8.5 132 15.6 309 36.5
=================================================================================
SOURCE: Estimates Based on Taxes Data from SBP website and GDP data from Economic Survey 2006-07.
The rise in the share of direct taxes can largely be attributed to the introduction of withholding/presumptive tax regime in the early 90s and in 2006-07 to improved voluntary compliance. More than half of the direct tax revenues are presently generated as withholding/presumptive taxes. Within indirect taxes, there have been significant changes in the importance of different taxes.
The contribution of excise duties has declined sharply while that of sales tax has risen, as the latter substitutes the former. Import duties have virtually stagnated due to the decline in tariff rates which were brought down from a maximum level of 35 percent to 25 percent in an effort to liberalise trade.
Table 3.2 gives the overall and individual tax-to-GDP ratios of federal taxes collected by Federal Board of Revenue (FBR), which constitute over 90 percent of the tax revenues in the country. The table clearly reveals the lack of elasticity of some FBR taxes. The tax-to-GDP ratio of income tax and sales tax has risen, that of customs duty has remained constant while that of excise duty has fallen. Clearly there is need to understand these changes, which we attempt in the next section by decomposing the tax-to-GDP ratio into its two key components- tax-to base and base-to GDP ratios.
DIRECT TAXES
=================================================================
TABLE 3.2
=================================================================
TAX-TO-GDP RATIO, 1999-00 TO 2006-07
=================================================================
Total
Direct Excise Customs Sales Indirect Total
Year Taxes Duties Duties Taxes Taxes Tax
=================================================================
1999-00 3.0 1.5 1.6 3.1 6.1 9.1
2000-01 3.0 1.2 1.5 3.6 6.4 9.3
2001-02 3.2 1.1 1.1 3.7 5.9 9.1
2002-03 3.1 0.9 1.4 4.0 6.3 9.4
2003-04 2.9 0.8 1.6 3.9 6.3 9.2
2004-05 2.8 0.8 1.8 3.7 6.3 9.1
2005-06 3.0 0.7 1.8 3.9 6.4 9.4
2006-07B 3.8 0.8 1.5 3.6 5.9 9.7
=================================================================
SOURCE: Estimates Based on Taxes Data from SBP website and GDP data from Economic Survey 2006-07.
Using non-agricultural GDP as the tax base, we have decomposed the buoyancy of direct taxes into its components, as shown in Table 3.3. The rise in the tax-to- GDP ratio is a combined consequence of both a rise in tax-to-tax base and base-to GDP ratios.
The former is also referred to as the effective tax rate. The tax base effect appears to be large, as indicated by the 7 percentage point increase in the tax base-to-GDP ratio. A high growth momentum was witnessed during the period, 1999-00 to 2005-06, when this ratio rose rapidly. Thereafter there was a clear slow down. In contrast, the effective tax rate showed a decline of 0.4 percent during 1999-2000 to 2005-06. Beyond this, the effective rate has shown a sharp increase of 1.1 percent.
================================================
TABLE 3.3
================================================
BOUYANCY OF DIRECT TAXES
================================================
TAX-TO-GDP, TAX-TO-TAX BASE AND TAX BASE-TO-GDP
RATIOS 1999-2000 TO 2006-07
================================================
Years Tax-to- Tax Base-to- Tax-to-Tax
GDP Ratio GDP Ratio Base Ratio
================================================
1999-00 3.0 69.0 4.3
2000-01 3.0 70.7 4.2
2001-02 3.2 71.4 4.5
2002-03 3.1 71.3 4.4
2003-04 2.9 72.4 4.0
2004-05 2.8 74.0 3.8
2005-06 3.0 75.7 3.9
2006-07B 3.8 76.0 5.0
================================================
SOURCE: Estimates Based on Taxes Data from SBP website and GDP data from Economic Survey 2006-07.
What explains the decline in the effective rate of direct taxes in the first half of the decade? The answer can be found in the movement of statutory rates, which have tended to decline. The marginal rates of personal income tax and the corporate tax rates have generally been brought down over the period.
For instance, corporate tax rates on banking companies declined from over 50 percent to 35 percent. Similarly, corporate tax rates on private companies declined by 10 percentage points and personal income tax rate for highest slab declined from 35 percent to 20 percent. Clearly these modifications disproportionately benefited the upper income groups. Excise duty.
The tax base of excise duty consists primarily of value added in large scale manufacturing. Major revenue contributors include petroleum products, cigarettes, sugar, cement, etc.
During the early 90s, the tax net of excise duty was extended to cover services like banking, telephones, electricity and professional services. As such, the tax base for excise duty has been extended to include value added in finance and insurance, and transport and communications.
The tax base for excise duties is large and fast growing as indicated by almost an 8 percentage point improvement in the tax base-to-GDP ratio as shown in Table 3.4. The slow growth in revenues is largely explained by the declining effective tax rate. This is essentially a reflection of, first, incomplete adjustment of the tax rates to inflation, as the duty continues to be levied at specific rates on certain items and, second, the gradual replacement of excise duties by sales tax.
=================================================
TABLE 3.4
=================================================
BOUYANCY OF EXCISE DUTY
=================================================
TAX-TO-GDP, TAX-TO- TAX BASE AND TAX BASE-TO-
GDP RATIOS 1999-2000 TO 2006-07
=================================================
Years Tax-to- Tax Base-to- Effective
GDP Ratio GDP Ratio Tax Rate
=================================================
1999-00 1.5 22.8 6.4
2000-01 1.2 24.7 4.7
2001-02 1.1 24.9 4.3
2002-03 0.9 25.4 3.6
2003-04 0.8 25.9 3.1
2004-05 0.8 27.9 2.9
2005-06 0.7 30.3 2.4
2006-07B 0.8 30.7 2.7
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SOURCE: Estimates Based on Taxes Data from SBP website and GDP data from Economic Survey 2006-07.
CUSTOMS DUTY
The tax base for customs duty is the value of dutiable imports, that is, total value of imports minus the value of exempt items like food, fertiliser and pharmaceuticals. Table 3.5 shows that the tax base-to-GDP ratio varies year-to-year depending, in particular, on fluctuations in international prices. But 200405 onwards, the base-to-GDP ratio appears to be noticeably higher.
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TABLE 3.5
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BOUYANCY OF CUSTOMS DUTY TAX-TO-GDP, TAX-TO-
TAX BASE AND TAX BASE-TO-GDP RATIOS
1999-2000 TO 2006-07
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Years Tax-to- Tax Base-to- Effective
GDP Ratio GDP Ratio Tax Rate
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1999-00 1.6 8.4 19.1
2000-01 1.5 8.7 17.8
2001-02 1.1 9.0 12.0
2002-03 1.4 9.5 14.8
2003-04 1.6 11.3 14.3
2004-05 1.8 15.8 11.2
2005-06 1.8 15.1 12.1
2006-07B 1.5 14.5 10.5
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