ANALYSIS: A reality check on fiscal reform —Shaheen Rafi Khan - Friday, April 15, 2011

Direct taxes on agriculture, corporate incomes and residential and commercial property are beginning to look like an increasingly attractive source on tap. Their combined revenue potential is huge 

The IMF is sharpening its knives to inflict yet another dose of fiscal pain. The warning, orchestrated through the country’s top bankers and economists, is to shrink the deficit or face economic meltdown. The government will unload a salvo of new taxes, job cuts and subsidy rollbacks. However, things are changing. The distaste for IMF nostrums, formerly the remit of a few left-leaning liberals, is taking a more tangible shape. Politics and poverty have come together in a coalition unwilling to dance to the IMF tune. Across Greece, Ireland and Pakistan, people have taken to the streets to protest government-imposed austerity. Clearly, in future, such changes will need to be negotiated rather than enforced.
No one disputes the need to balance the budget. Economists have presented the spectre of deficit financing crossing one trillion rupees, and repeatedly invoke the low (10 percent) tax-to-GDP ratio. However, having set the bar high, the fiscal remedies fall considerably short. They look fine on an economic barometer but produce temperature spikes when seen through the prism of politics, governance and equity. Such considerations impose a reality check on fiscal reform. For each of the proposed measures, one can attempt what is referred to in the jargon as a multi-criteria assessment.
Let us start with the Reformed General Sales Tax (RGST), the value-added version of the sales tax on goods and services. The official version is that the tax rate will be brought down to 15 percent and applied across the board, rationalising rather than incrementing taxes. But no one is buying this legerdemain. It is nothing short of a tax increase, which, inevitably, will be passed on to the public, fuelling inflation already at intolerably high levels.
Second, the government intends to replace zero-rated exemptions for critical export items with tax rebates. This too does not wash with businessmen because the government’s credibility is at a low ebb and they see the rebates trickling in slowly at best. For them it is bad economics to have funds locked up when they could be invested.
Third, Pakistan’s tax system has been traditionally regressive. This means it hurts the poor more than it does the rich. If a WTO-inspired initiative can succeed in reducing tariffs — another form of indirect taxation — why hike up its local version and condemn the system to stasis? Clearly, on all three counts, the RGST does not measure up: politically, it is a non-starter; it is likely to hike up prices; and the manner of its implementation is opaque. More critically, it does not address the generic imbalance in the tax structure.
Policy makers are less circumspect about the inflationary consequences of fuel and utility price hikes. However, in the same breath, they distinguish between core and transient inflation. What they mean is that they can jack up these prices at will because real or ‘core’ inflation is only fueled by monetary expansion. However, the jury is out that tight money policies have done little to offset the ‘transient’ effects of fuel and utility price rises. Try as it might, the government cannot wish away street protests. It may resort to subterfuge, as evident in the recent two-step on fuel prices — incidentally a favourite IMF ploy, but its wriggle room for such maneouvres is shrinking.
Direct taxes on agriculture, corporate incomes and residential and commercial property are beginning to look like an increasingly attractive source on tap. Their combined revenue potential is huge: they are a sustainable source of revenue, unlike the one-off flood tax; their inflationary impact is minimal; and, their inclusion makes the tax structure look respectable. Similarly, steeply graduated taxes on utilities and imports of luxury vehicles can yield rich dividends.
But then comes the rub. Our current crop of politicians cower before the clergy but will fight like Spartans to protect their economic turf. Instead, the focus has shifted to tax governance, the current rubric for eliminating evasion, avoidance and exemption. Is this not tantamount to placing the cart before the horse? In other words, if the rich pay their taxes would governance not improve by default? Dr Mahbub-ul-Haq devised an ingenious solution, factoring agricultural income in the calculation of taxable income but not actually taxing it. So while one moved into a higher tax bracket, the tax rate was applied on non-agricultural income only. It would take a brave heart to go beyond this point. In a similar vein, a progressive tax on vehicles and utilities will raise the ire of the moneyed lot accustomed to using electricity, gas, water and gas-guzzlers like a free good.
Expenditure adjustments, the other side of the fiscal coin, falter on the multi criteria test as well. Two components of expenditure, namely, defence and debt servicing are non-negotiable and rising. The apparent give is in subsidies, administration and state-run enterprises. In compliance with the IMF dictates, the process of phasing out food, fuel and energy subsidies has begun. Concurrently, the federal and provincial governments have launched the Benazir Income Support Programme and sasti roti (cheap bread) scheme. But are income and price supports interchangeable? If historical precedent is anything to go by, targeted subsidies are prone to leakages and misuse and impose a heavy financial burden on the state. The new schemes are already being criticised on various counts of insufficiency, misidentification and leakages.
Few would deny that the government and quasi-government organisations are over-manned. Responding to the need to downsize or rightsize — depending on how diplomatic one wants to be — large-scale retrenchments were attempted and just as quickly reversed. The KESC, PIA and department employees were reinstated, even by presidential decree. Similarly, privatising state enterprises and utilities, traditionally likened to selling the family silver, now runs the additional gauntlet of a public fired up about job losses and price hikes.
Whether the IMF is right or wrong is no longer an issue. It holds the purse strings and will continue to demand its pound of flesh in the manner it deems appropriate. The onus is on the government to tailor an appropriate response. It is no longer a question of whether to; it is rather how to comply. Will the volatile combination of street riots, corruption and economic mismanagement produce sustainable fiscal outcomes, namely taxes on the rich? Probably not, but here is to hoping.

The writer is a development researcher. He can be reached at

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