Statement and History of The Problem

The U.S. wants Pakistan to do more on taxes. “Pakistan cannot have a tax rate of nine percent of GDP when landowners and all of the other elites do not pay anything or pay so little it’s laughable,” says U.S. Secretary of State Hillary Clinton. “And then when there’s a problem, everybody expects the United States and others to come in and help.”

The U.S. and others have come in and helped Pakistan cope with the social and economic fallout from the country’s worst ever floods. Officials in Islamabad estimate recovery and reconstruction will cost $43 billion. The U.N. made a record high appeal for emergency funds of $2 billion for Pakistan. But with this aid and foreign assistance come renewed calls for Pakistan to get tough on taxes so it can fund its own way in the long term.

The burden among taxpayers is unevenly spread. Stakeholders have resisted more rational taxation on agriculture, landholdings and real estate, and capital gains. The services sector, at 53 percent of GDP, contributed 26 percent of total taxes collected in the financial year which ended June 30, 2010, while agriculture, which accounted for 22 percent of GDP, contributed only one percent to total tax receipts. The manufacturing sector, at 25 percent of GDP, chipped in 63 percent of all taxes. More rational taxation could increase tax revenues, currently at some Rs. 910 billion, substantially.

Ongoing support from the International Monetary Fund is linked, among other things, to tax reforms, and the World Bank has been helping Pakistan achieve these since 2004. Finance minister, and later prime minister, Shaukat Aziz began reformation of the tax system in 2002. The set of reforms included several measures including amnesty schemes appealing to people’s desire to live respectably, and simply, by keeping a single set of books-reducing their administrative costs, and risks-simplification of the tax code, consolidation of departments to facilitate filing, and a “self assessment” program which nearly eliminated opportunities for corruption in the bureaucracy. Such measures encouraged people to pay taxes: between 2007 and 2009, for example, the number of companies registered to pay sales tax rose by 494 percent to 83,031.

But even with the reforms made so far, Pakistan is no closer to where it needs to be. At the close of the last financial year, Pakistan’s had some 2.75 million registered taxpayers-or less than 2 percent of the total population, and about 5.1 percent of the labor force comprising 53.78 million people. Pakistan ranks 143rd out of 183 countries in terms of ease of paying taxes according to a recent report by the World Bank and the International Finance Corporation. And corruption remains a problem: in 2010, a report from the Auditor General of Pakistan cited 153 cases of tax fraud totaling Rs. 21.7 billion.

The problem, therefore, lies in meeting a four-fold need. Firstly, there is a need to respond to a disaster of epic proportions that requires massive relief efforts over a sustained time period as detailed above.

Secondly, Pakistan must display credibility to the international community in terms of the effort put in by the Pakistani elite itself for meeting the needs of the people of Pakistan and avoiding what economists call “moral hazard”. Aid sets up perverse incentives in the recipient economy. Several studies have shown that it supplants rather than supplements domestic savings. If a recipient country knows that help is forthcoming, it will be inclined to defer taking tough, often unpopular measures to improve the economy; and to close the financing gaps between savings and investments, and exports and imports. In the same vein, the international community’s willingness to bail Pakistan out (repeatedly) poses a moral hazard. Knowing that rescue is assured before things go very wrong, Pakistan’s economic policy-makers are likely to be imprudent and take undue risks with the economy—as they have in the past. The New York Times quoted Pakistan as being the inventor of moral hazard.

Thirdly, accountability and transparency needs to be established in the relief efforts of the Government of Pakistan towards the flood-affected areas and people, which can only be achieved through the democratic pressures of monitoring Government data and activity along with pressurizing the judiciary and legal system of the nation to fulfill its watchdog obligations and reassure the international community of the fact that their contributions are well spent. Such collaboration between the judiciary, media and civil society will be invigorated with a greater monetary stake on the part of the people in the Government efforts.
Fourthly, Pakistan’s historical fiscal imprudence needs to be set right. The tax system must be reformed so that the incidence of the tax is evenly spread and unnecessary discretionary spending is minimized without harming mandatory spending on socio-economic development imperatives. Credibility as a borrower economy must be reestablished at this crucial juncture with the International Monetary Fund which has maintained the need for imposing the RGST and the onetime flood tax as a key condition for the delivery of the IMF’s sixth tranche of the currently frozen $11.3 billion aid package. Lack of coordination within the government policy already created a scare when a Minister made an official claim for debt-relief that was later taken back. The image of Pakistan – for which several debt-restructuring and postponements have already been made – is losing credibility and this needs to be reestablished by meeting the conditions of the IMF as part of the aid package while, at the same time, establish an egalitarian tax system in the long term benefit of the country as a whole.