Taxcon-2003: Issues in tax policy
By Dr. Ikramul Haq
Z. H. Jafri, a prominent tax expert and ex-President Pakistan Tax Bar Association pointed out a crucial impact of reckless tax policies pursued by different governments in Pakistan since 1990 on the dictates of the IMF and other donors that have pushed millions of Pakistanis below the poverty line. In the frenzy of collecting more and more taxes, the fiscal mangers and tax bureaucrats of Central Board of Revenue (CBR) completely ignored the social cost of it. Jafri very rightly pointed out that 'around 40 to 50 per cent of the population is living below poverty level and this means that there is some serious fault in the taxation system, which is making rich people more richer and poor segment of the society poorer.'

It is a matter of great tragedy that our economic managers never thought of using tax policy as a tool of economic development, and their sole stress on revenue targets has resulted into economic chaos. The persistent failure of our financial managers and tax collectors to overcome fiscal deficit and remove fiscal imbalances has created a situation of an economic disaster. The economic survival now lies in collecting taxes wherever due by abandoning the policy of appeasement towards the powerful and the rich. An unshakeable determination, consistency and political will is required to curb the 55-year-old habit of defying tax laws along with complete purge in tax machinery. The primary function of a tax system is to raise revenue for the government for its public expenditure as well as for local authorities and similar public bodies. Therefore, the first goal in development strategy as regards taxation policy is to ensure that this function is discharged effectively. The performance of the Pakistani tax managers is highly disappointing as fiscal deficit remained high during the last decade and the revenue targets fixed annually were revised downwards many a times.

There is a national consensus that existing tax policy needs to be reformulated to provide an equitable, pragmatic, investment-oriented and business-friendly tax system, integrating good tax administration with simplified tax laws that are easily to be understood and hassle-free from implementation perspectives.

There is a dire need to discuss the philosophical framework and principles that should be the main concern of our tax policy. The existing tax policies have failed to reduce the fiscal deficit (which has in fact increased many times over the last ten years), and on the contrary are destroying our industry and business

Equity principle

If a given amount of revenue is needed to finance public services, then each taxpayer should contribute in line with his ability-to-pay taxes. Those who possess more economic power (income and wealth) should contribute more to public exchequer and vice versa. The duty to pay taxes is seen as a collective responsibility rather than a personal one. The ability-to-pay principle views tax policy issues in isolation to incidence of public expenditure. This principle is regarded by many as the most equitable and just method of taxation. It is emphasised primarily for its redistributive role. We in Pakistan have completely deviated from this principle, which is constitutional obligation of the government.

The taxpayers with equal incomes should pay the same amount of tax. This is called horizontal equity; i.e. taxpayers in similar economic circumstances should bear the same tax burden, economic circumstances being defined in terms of level of income. The second aspect of ability-to-pay rule is vertical equity; i.e. taxpayers in dissimilar economic circumstances should bear dissimilar tax burdens. Thus, persons earning more should pay more tax than those, earning less.

The equal sacrifice rule, associated with such distinguished economists as J.S. Mill and A.C. Pigou, is based on the following assumptions:

(i) It is possible to relate units of income with units of utility.

(ii) The utility curve for income has a downward slope; i.e. marginal utility of income varies inversely with income.

(iii) The marginal utility of income curve is the same for all individuals.

Under these assumptions, the equal sacrifice rule is clear for taxpayers with equal incomes. They should surrender equal amounts as tax, which in turn means sacrificing equal units of utility (horizontal equity). However, difficulties arise in interpreting equal sacrifice rule for people with different incomes. How is the term 'equal' to be understood? In the tax literature the following interpretations of the equal sacrifice rule are found.

(a) Equal absolute sacrifice. It means the number of units of utility taken away from each taxpayer should be exactly the same.

(b) Equal marginal sacrifice. The marginal sacrifice is the same, i.e. utility left with, rather than taken from, every taxpayer after tax should be the same. This will ensure minimum total sacrifice for society, and hence it is also called 'least aggregate sacrifice principle'.

In short, determination of a tax base capable of measuring an individual's ability-to-pay is a major problem of our tax system. This rule is incorporated in the form of progressive rate schedule for personal income tax, estate duty, and property tax world-wide.

Benefit principle

According to this principle, an equitable tax system is one under which tax payments are based on the amount of benefits received from government services. In other words, the cost of government services should be apportioned among individuals according to the relative benefits they enjoy. Clearly, implementation of the benefit principle presupposes determination of the incidence of public expenditure before deciding distribution of tax burden. Thus it encompasses issues of both tax and expenditure policies.

Tax policy should be used as a tool of distributive justice. The government should launch programmes, financed mainly through taxes, to solve the twin problems of unemployment and poverty. These welfare-oriented schemes may also include subsidised/free medical and educational facilities, low-cost housing, and drinking water facilities in rural areas, land improvement schemes, and employment guarantee programmes. Once people see the tangible benefits of the taxes paid, there will be better response to tax compliance.

Assignment of tax

Assignment of a tax means transfer of taxation power from a higher level to a lower level government. Taxation power includes the following: (i) right to levy the tax, (ii) collect the tax, and (iii) appropriate the proceeds from the tax. Thus, there can be three interpretations of assignment of a tax. Firstly, higher-level government may levy and collect a tax but hand over the entire proceeds to lower level governments. Secondly, the higher-level government may levy a tax but allow the lower level governments to collect it and retain fully the proceeds therefrom. Finally, the higher-level government may transfer a tax to lower level governments, a situation, which defines assignment of a tax in its strictest sense.

Generally, the purpose of tax assignment is to augment the resources of lower level governments. The assignment of tax may be conditional. Thus, it may be obligatory on the part of a lower level government to levy the tax assigned to it. Not only this, the lower level government may not have powers to alter the basic structure of the assigned tax. It may enjoy flexibility in fixing the tax rates within a minimum and maximum range prescribed by the higher-level government.

Tax revenue may change through automatic response of the tax yield to changes in national income and/or through the imposition of new taxes, revision of the bases and/or the rates of the existing taxes, tax amnesties, stricter tax compliance and other administrative measures backed by legal action. Changes in the tax yield resulting from modifying tax parameters (bases, rates etc.) are called discretionary changes. Variations in the tax yield flowing from the combined effects of automatic responses as well as discretionary changes constitute the buoyancy of a tax. It is computed by dividing percentage change in tax yield by percentage change in national income.

Buoyancy estimates assess the overall success of government measures to increase tax revenues while elasticity coefficients indicate the inherent responsiveness of a tax system to changes in national income. In the absence or weakness of elasticity attribute of the tax system, a government will have to revise tax rates and tax bases every year to keep the share of tax revenue in national income undiminished. Taxation is a potent instrument to shape and influence the socio-economic polices of a country. It is, therefore, imperative for us to formulate a nationally acceptable tax policy keeping in view our own peculiar conditions. Our Tax policy must take into account:

* Present stage of our economic development.

* Objectives of economic policy.

* Priorities of economic policy continually change with the changing economic, social, and political milieu.

New tax policy should entail the following three functions:

(i) Resource Mobilisation: the first and foremost objective must be to raise resources for public authorities for administration and development. Taxes are the main instrument for transferring resources from private to public use. By designing an appropriate tax structure, resources can be raised from those who are holding them idly or squandering them on luxury consumption. According to Roy Gobin, 'the revenue criterion is usually the dominant consideration, since governments in LDCs have become increasingly aware of the active role which budgetary measures can play not only in initiating and promoting growth but also in maintaining political power. Not only are higher revenue levels needed, but also tax yields should be increased at a faster rate than income, if infrastructural investments and social welfare expenditures are to be financed without generating unacceptable inflationary pressures and/or increasing reliance on foreign assistance.'

The revenue performance is in fact the best and optimal use of resources. Since the composition of investment is an important determinant of growth rate of the economy, public policy must discourage the flow of resources to low priority areas so that they could be diverted to vital sectors of the economy. By imposing high tax rates on luxuries and other low priority items (such as motor cars, air conditioners, and jewelers), the government can discourage the consumption and production of such items, ensuring in the process release of resources for high priority sectors. Conversely, offering tax concessions or even subsidies can encourage production of necessities of life and employment-oriented industries.

(ii) Distributive Justice: distributive justice or economic justice is an important function of tax policy. Economic justice relates largely to distribution of tax burden and benefits of public expenditure. It is a component of the broader concept of social justice, which encompasses, besides distributive justice, such questions as treatment of women and children, and racial and religious tolerance in a society. Tax policy is a democratic method to influence the distribution of income and wealth on desired lines. The main ingredients of this policy can be: (a) progressive direct taxation of income, wealth, and property transactions, (b) taxation of commodities (customs duty, excise levy, and sales tax) purchased largely by high-income groups, and (c) subsidies (negative taxation) on goods purchased by low-income groups.

(iii) Stabilisation: initial developmental efforts are generally marked by inflationary tendencies in an economy. Inflation, if uncontrolled, may thwart all development plans and bring misery to the poor. A reasonable degree of price stability should be a primary concern of a government's economic policies. The overall level of economic activity in an economy depends upon aggregate demand, relative to capacity output. At times, the level of aggregate demand may be insufficient to secure full employment of labour and other factors of production. At other times, aggregate demand may exceed available output at full employment level. Government intervention in both the cases becomes essential to correct such dis-equilibria in the economy.

The evaluation of our existing tax system with reference to the foregoing objectives is a difficult task because various other policies (like public expenditure policy) may be geared to achieve the same objectives. The Task Force on tax reform, headed by Mr. Shahid Hussain, should concentrate on these questions. To what extent the redistributive objective has been served and what was the relative role of tax policy in it is a difficult question to answer. Moreover, the various objectives of tax policy may not always work harmoniously. Rather, they are often in conflict with each other if not mutually exclusive.

Since the tax system of a country grows out of the interaction between political judgement and economic rationale, political expediency and economic logic, the former, in most cases, having the upper hand, influence the process of compromises and trade offs. In fact, political requirements and economic thinking change with time, giving new directions to tax policy. As Richard Bird has observed, 'tax reform is, therefore, a never-ending process, not something that can be brought about once and for all and then forgotten.'

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