The Federal Budget 2009-10 is round the corner. Two of the major signals emanating from the Fiscal Policy makers camp ahead of the budget announcement are as amusing as they are amazing. While capital gains from stock market might be considered for taxation from 2010-11, the new budget will include measures to improve tax collection from the under taxed services sector.
But amazingly, despite current year's bumper crops, once again income from agriculture will continue to remain untaxed even after 62 years and may now be imposed later subject to an assessment of the "profitability" of the sector. And amusingly, an already heavily taxed real estate sector will "also be brought into the tax net".
Let us examine the tax and economic aspects of the agriculture sector vis-a-vis the real estate sector as the driver of the construction industry wherein a substantial demand for raw materials and inputs supplied by the industrial sector originates.
The economic managers of the country are well aware that the share of agriculture in the national income of the country constitutes more than 20 percent of the total. The GDP of Pakistan currently stands at more than $170 billion. About $40 billion of this income is generated in the agricultural sector which translates into over Rs 3000 billion.
Applying a current poor tax to GDP ratio of 9%, the agriculture sector should pay at least Rs 270 billion in income tax whereas it is not paying more than a few billions. The advocates of sparing agriculture from income tax continue to give the age-old argument that the sector needs stabilisation and the people belonging to the sector are poor.
Nevertheless, the fact is that only the labour force working for the agriculture sector is poor whereas the landowners, growers and middlemen are pocketing enormous profits without paying any income tax. The prices of agricultural products have also more than doubled in the last two years and if there is a problem in a crop or two in some areas, it is one of low production due to lack of proper supply of inputs rather than of profitability.
Besides, it is not unusual for various sectors of the economy of a country to come under pressure from time to time due to internal or external factors. But that hardly justifies across the board perpetual tax holidays for six decades enjoyed by the agriculture sector in Pakistan. How long will we continue to give excuses for exempting agriculture from imposition of income tax?
In fact, if there is a case for re-imposing wealth tax at all, cash and land assets that have been accumulating in the agricultural sector over the last six decades, and now generating over Rs 3 trillion in income per annum, could be the prime subject of such a proposal. But to begin with, the sector must be required to pay at least its due share of income tax in proportion to the income generated by it.
On the contrary, the performance of a good part of the industrial sector, just like the textiles, has come under severe strain due to domestic and global slowdown, high cost of capital, drastic fall in the rupee value, incessant energy crisis and steep tax structure.
Any tax relief to be provided, therefore, should be to the industrial sector with suitable monetary and fiscal policy incentives in order to rationalise its cost structure in tandem with a full capacity utilisation triggered by a robust growth in the demand for a major portion of its output as raw materials originating in the construction sector.
However, the effectiveness of any strategy based on fiscal/monetary policy stimuli to boost the industrial output will be minimised if the corresponding investment demand for the old and newly built up real estate assets itself is scuttled with the imposition of additional taxes like the capital gains tax on the sector.
Now let us examine the current position of the real estate sector first from the taxation point of view. The statements from the policymakers on the eve of the new budget sound as though the sector is presently not in the tax net at all or does not contribute duly to the national exchequer and hence the need to do so.
This stance is far from valid and needs shedding some light on it. Firstly, barring some proportion, most of the registered real estate assets are purchased either with funds saved from after-tax income, remittances from abroad or have been regularised after payment of due income tax under amnesty schemes from time to time.
Secondly, unlike any other class of assets, all commercial and residential real estate assets in Pakistan have been historically paying property taxes (in addition to water and conservancy charges) since the date of completion depending upon the size and location of the property with the exception of the exemptions allowed.
Thirdly, rental income from all real estate assets is liable also to income tax and is added to the income of the property owner from other sources to arrive at his final tax liability. Fourthly, registered property transfers in most developed areas of the country, are subject also to taxes of ten percent of their official value consisting of stamp duty (4%), registrar's fee (2%), capital value tax (2%) and mutation fee (2%) depending upon their size and location.
Fifthly, the commission income accruing to the brokers of the buyer and seller of a real estate transaction is also liable to income tax. Finally, open plots in the prime localities of the country are subjects also to heavy non-utilisation fee, transfer charges and CVT depending upon their size and location. More recently both the CDGK and the DHA, Karachi have imposed new taxes on properties for the maintenance and refurbishment of areas under their respective control. The real estate sector in Pakistan is thus already heavily taxed.
The area which really needs reforms in the real estate sector is the rationalisation of the difference between the market values compared with the official property values and the rates of taxes currently applicable on them. This will reduce the cost of real estate transactions thereby increasing activity in the sector and thus tax generation automatically without increasing the net current incidence of taxation on the sector.
Furthermore, there is need to impose as well as implement proper procedures, like with most classes of income, for checking tax evasion of already generating rental and commission income of property owners and brokers, respectively. As for the black money circulating in the economy, the real estate sector is no exception; the phenomenon is prevalent across the board in terms of asset holdings in bank deposits, NSS deposits, foreign currency deposits, gold, silver, commodities, price bonds and stocks.
Of these, foreign currency accounts and gold have registered tremendous capital gains of the order of 30% and 100% respectively during the last two years without any contributions to the national exchequer, followed by gains from stock market during 2002-2008.Thus a tax on foreign currency account gains or on declared gold assets which are currently out of the tax net sounds more in order than a new tax on the real estate sector which is already paying a variety of taxes and where values have been falling both in rupee and dollar terms over the last four years.
Let us now take a look at the economic aspect of the real estate sector which is an equally important investment avenue, just like stocks, bonds, currencies, commodities, metals and oil futures. People around the world invest in real estate for the purpose of residence, or financial return on it in the form of rental income and capital gains just like stocks provide dividends and capital gains; Pakistan thus ought not to be an exception.
Unfortunately, however, investment in the real estate assets by the domestic investors in Pakistan is looked at mainly as a speculative activity while its strong linkage with the construction activity and potential for economic growth has remained understated thus depriving it of the due recognition of its role in the economic policy of the country.
The growth in the demand for built-up real estate plays a significant role in the rate of economic development of any country. Growth in real estate activities drives the construction industry which constitutes a major chunk of the real sectors of the economy and is considered the engine of growth as it pulls along at least forty other allied industries catering to it.
The net impact is thus on growth in national income, employment and tax generation. Some of the roots of the current full-blown recession in the US may be found in the slump in its housing market. The new US administration is, therefore, making herculean efforts to accelerate construction activity in order to jumpstart the stagnating US economy by undertaking public spending programs of highways and railroads as well as boosting investment in the housing industry by providing incentives through the banking system.
Let us now look at the current situation prevailing in the real estate market in Pakistan. While the real estate market bubble in Dubai has burst just in recent moths with the global slowdown of the World economy, the real estate sector in Pakistan has been depressed for now over four years since the last boom subsided way back in the first quarter of 2005.
The real estate prices in prime areas like Defence Karachi have continued to be depressed since, slipping gradually by more than 30% in rupee terms and 45% in dollar terms over a four year period initially with the imposition of capital value tax on the sector followed by an unfavourable investment climate obtaining in the country owing to judicial crisis, political upheavals, internal and external insecurity, flight of capital and global recession; all leading to a prolonged economic crisis of a severe order which the country has not been able to fully recover from yet.
With the bubble burst in Dubai real estate market and investment capital looking for ways to flow to new destinations, a golden window of opportunity has thus opened up for Pakistan to attract foreign investment inflows into the housing and construction industry with an attractive investment policy that could accelerate the rate of investment in order to boost the much needed income and employment in the country.
Unfortunately, however, the due recognition on the part of the policymakers as to the significance of the role of construction industry, as an engine of economic growth, seems less than visible even in the wake of an inevitable drastic cut down in the current and next years PSDP due to budgetary constraints. In fact, the evidence so far points toward a sharp dichotomy.
Instead of formulating an attractive private investment policy for foreign inflows into construction and housing industry to cash in on the window of opportunity being presented, the policymakers seem to have embarked upon targeting the real estate sector to milk additional revenue by imposing the Capital Gains Tax.
Thus, contrary to the expectations, this opportunity is being squandered away by the policymakers with a myopic view of tax collection rather than tax generation which will not only impede the foreign inflow of investment into the real estate sector but also dampen the rate of growth of the economy amidst a global recession.
While such a policy will not only rule out Pakistan as an attractive investment destination for foreign investment inflows into the real estate sector, the growth of construction and housing sector and the allied industries in terms of employment, income and revenue generation will also be hampered as a consequence of the CGT. For one, Capital gains taxes are barriers to the mobility of savings because the tax can be avoided by simply holding on to one's assets.
For example, the owner of an old house bought twenty years ago who wishes to buy a new one will most likely defer the idea or decide against it once he calculates the penalty he will have to pay in terms of CGT on the sale of his old house. Thus, the greater the tax barrier, the fewer will be the transactions involving capital gains.
Furthermore, while the CGT reduces the amount of savings available for investment on the one hand, it also misallocates resources on the other. It tends to raise the capital cost of new productive investment for both individuals and corporations thus dampening such investment by lowering return on them.
As a result, future growth in output and living standards is impaired. Thus CGT is economically inefficient because of its punitive effect on entrepreneurship, thrift, and investment. This is primarily because the tax hits saving more than once first when income is earned and again when capital gains from the investments are realised.
A good part of the capital gains is inflation generated and is illusionary. The CGT has been studied to impact the economy with a long lag of up to five years and has been estimated to have a weak negative correlation (-0.35) with the GDP growth rate besides retarding the growth of tax revenue and rate of capital formation.
The historical experience with the capital gains tax in the US as well as findings of more than 50 economic studies lead to the conclusion that in order to provide a true level playing field over time for individual and business decisions to save and invest, stimulate economic growth, and create new and better jobs, capital gains should not be taxed at all.
This view was held by top economists in the past and is held by many mainstream economists today. There is still time for the policymakers to seriously re-examine the cost benefit of their taxation strategy in terms of revenue collection versus growth-led revenue generation.
CONCLUSIONS The impending major taxation measures of the fiscal policy to be announced in the budget 2009-2010 seem to be based neither on an objective recognition of the sectors of the economy which are untaxed/under-taxed (or those that drive it), nor on a conscious assessment of their impact on the economy in terms of cost/benefit. The application of these measures must be based on a priority ranking while their degree must be within an acceptable limit and tuned to the genuine needs of the government to generate resources.
The thrust of the tax strategy should be on first thoroughly taxing the income from and consumption of the output and services being produced annually in the various sectors of the economy rather than on taxing capital gains on historical assets purchased from after-tax savings.
In the real sectors of the economy, the agricultural income that has remained untaxed for more than six decades must be the first avenue to be properly taxed beginning at the rate of at least the current tax to GDP ratio of 10%. Secondly, there is ample capacity in the under-taxed services sector to contribute revenue in proportion to the income generated by it and must be tapped.
Thirdly, while the stock market is a very important investment avenue in the financial sector, yet it really does not drive the economy; in fact it is driven by the economic performance of the real sectors and gains accrued there have been historically under-taxed.
It will continue to perform well, even after fiscal measures are taken to tax it properly, provided the real sectors continue to perform well and other sources of revenue have been optimally tapped. Finally, the revival of the industrial sector is pivotal for a robust economic growth and hinges on at least two crucial factors namely (a) cost reduction with appropriate fiscal and monetary incentives and (b) return to full capacity utilisation.
Since there is a close nexus and a positive correlation of the output of a number of allied industries in the manufacturing sector with the activities in the housing and construction sector, a CGT on latter will be a prescription for trouble for the former.
For, while incentives for the manufacturing sector are indispensable, imposition of CGT on real estate sector will dampen the investment demand for old and newly built up units thereby resulting in sluggish activity in the housing and construction industry with significant implications for a big proportion of the demand for the output of manufacturing sector and its capacity utilisation.
Thus the imposition of CGT on real estate assets will be unwise and prove counterproductive. It will tend to keep the bulk of the unrealised gains locked up with zero economic advantage in terms of lost reinvestment opportunity, generation of new income, employment and revenue in the economy.
Conversely, the capital gains from the real estate assets are likely to be used more efficiently by the private investors themselves in the absence of CGT with a positive impact on the economy. An ideal fiscal policy stance would, therefore, among other things, be one that is geared towards appropriately taxing these gains automatically at the consumption level on the one hand while encouraging their reinvestment back in the economy for a sustained growth on the other.