Capital gains tax, high interest rates and uncertainty

Published: April 22, 2012
In developing countries where equity markets are by and large underdeveloped, businesses rely on loans to expand and run themselves. PHOTO: FILE

In developing countries where equity markets are by and large underdeveloped, businesses rely on loans to expand and run themselves. PHOTO: FILE

BRISTOL: This is how the story goes! With capital gains tax in place, profitability will decrease and therefore much needed investment from both within and abroad will not flow into the capital market. Instead it may even force existing investors to withdraw their investments from the country’s stock exchange.

With capital outflow, growth will decrease and much needed jobs will not be created leaving the country worse-off as a whole. As such restrictions on capital flows will affect investors’ confidence in the national economy; chances of future investment will decrease hence putting country’s future growth at stake as well.

With capital flows taking such an important role, one may ask what else can be done to increase such inflows? Ask any IMF official and the answer will be to increase interest rates. It serves two purposes. Firstly, an increase in interest rates decreases domestic demand and therefore inflation by making it more attractive for people to save more. Secondly, it increases the rate of return for foreign investors who are now more likely to take the required risk and bring their money into the domestic economy which also helps in stabilising the exchange rate. Makes sense, right?

Such free inflow of capital (money) is as good for short term stability as it is for instability, with close to no benefit for long term growth of country’s GDP. Capital flows are pro-cyclical. Investors enter the market during the high growth periods to make quick money and leave when the situation deteriorates. To be more precise, ‘hot money’ enters the economy when it is least needed therefore exacerbating the inflationary pressure and leaves when it is most needed hence pushing the economy further into recession.

When the East Asia crisis hit Thailand – which had liberalised its capital market as per IMF’s advice, a complete reversal of investors’ sentiment resulted in huge outflows which amounted to 7.9% of GDP in 1997, 12.3% in 1998 and 7% in the first half of 1999. The only country to stand up to the dictates of the IMF during the East Asia crisis was Malaysia. Their policies of putting breaks to the free flow of capital (or speculative capital which is a consequence of such a policy) and not increasing the interest rates paid off as Malaysia experienced the shorter and shallower downturn relative to other countries.

Interest rates are a useful tool to control inflation, given that the reason for inflation is excess demand. However, inflation in Pakistan has been largely due to global commodity prices and supply side constraints in both agriculture (floods) and manufacturing (energy shortages). With growth rates for last couple of years already at low levels, it is unlikely that excess demand is the cause for double digit inflation.

In developing countries where equity markets are by and large underdeveloped, businesses rely on loans to expand and run themselves. In Pakistan not even a fraction of businesses are listed on the stock exchange. Under an environment with high interest rates, likelihood of default increases for businesses as they are now required to pay huge amounts to their creditors (banks).

Apart from low growth rate, uncertainty at both political and security front makes it even more difficult to attract both local and international investors to Pakistan. In the case of East Asia, high interest rates, free capital flows and everything which the IMF says did not succeed in achieving the desired results.

Two main things which come out of this discussion are imposition of capital gains tax and lowering of interest rates. In addition corporate tax should also be lowered to compensate domestic businesses for the uncertainty. While capital gains tax will bring much needed stability to the capital markets, low interest rates and decrease in corporate tax will provide much needed breathing space to businesses so they can increase their production and expand further thereby overcoming the supply side constraints to some extent. The magnitude of the change is an empirical question and should better be left to those who have access to the data.

The writer is currently an MSc (Economics and Econometrics) student at the University of Bristol and has previously worked at the Planning Commission (Pakistan)

Published in The Express Tribune, April 23rd, 2012.

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Reader Comments (12)

  • Saba
    Apr 22, 2012 - 8:09PM

    Good argument!


  • Meekal Ahmed
    Apr 23, 2012 - 12:23AM

    I am an old PC man and since so are you, I will try and go easy on you.

    How can you talk about tax cuts and more concessions for the crooks and high-rollers on our casino who pay no tan anyway? Are you one of those dreadful supply-siders? I bet you are rooting for Romney who wants to cut taxes for America’s top 1% and would certiainly extend the Bush tax cuts that have cost the budget trillions if calculated over the next decade?

    If you are all of those things, please stay in Bristol.


  • Ahmed Jamal Pirzada
    Apr 23, 2012 - 7:51AM

    @Meekal Ahmed:

    Thanks for your frank comment.

    Im all for taxing the rich while at the same time encouraging businesses to expand. When it comes to taxing the rich there are other more important tax tools which are more useful such as income tax (disappointingly low in pak for those in top income bracket). Similarly lik i have already mentioned, capital gains tax must also be imposed. We have already seen how zero capital gains tax turned millionaires into billionaires over night while the small investor lost his investment to speculation.

    Tax problems in pakistan are more deeply rooted in the fact that not all sectors are properly taxed. Similarly poor tax collection, cumbersome procedures and moral corruption on part of those who scheme to avoid tax payments is also an issue.

    However, any decrease in the corporate tax will help those businesses (not rich people) who are already paying their taxes to the government. One must also keep in mind the poor business environment which is currently prevalent in Pakistan. Given high interest rates, energy shortages, uncertainty etc, any breathing space will definitely help compensate businesses for the additional risks they are forced to take in this country for their investment. Such incentive can also be specifically targeted at businesses earning less than a certain threshold as they are less likely to successfully lobby and get quotas allocated to themselves for scarce (even scarce sounds a lot here) energy resources.

    and im personally very averse to getting myself tagged to a certain ideology, but now that you have mentioned so i must clear out that im very much against what Romney proposes.



  • Meekal Ahmed
    Apr 23, 2012 - 2:01PM

    A further point. “High” interest rates? How high are interest rates when inflation is still in the 11-12% range and is likely to go UP and not down? If adjusted for inflation, real interest rates are probably ZERO or even negative!


  • Falcon
    Apr 23, 2012 - 5:58PM

    Good article. But I think as Meekal Ahmed said…lowering interest rates might not be beneficial since the real interest rates are already too low…furthermore, even if the real interest rates can be lowered further, the additional borrowing space that will be created will be usurped by Govt. crowding out the private sector anyways so the expected benefit will not materialize …essentially, what you are proposing is that shift taxes from corporate tax to capital gains tax, which brings in marginal benefit in my humble opinion…unless, a comprehensive tax reform is done, all cures will be temporary and worse than the fiscal malady itself…


  • Ahmed Jamal Pirzada
    Apr 23, 2012 - 8:40PM


    im speaking at both micro and macro level wen i say that corporate tax should be lowered. Micro: our businesses should be provided some breathing space for the additional risk (uncertainity plus energy shortages etc) they take wen making any investment in pakistan. Also any such breathing space will only benefit those who are already paying their taxes.
    Macro: lik you rightly mentioned, our poor tax to gdp ratio is due to poor tax enforcement, cumbersome procedures, disproportionate taxes across sectors, low income tax (especially for high income earners), no capital gains tax etc. Lowering corporate tax by few points (currently at 35% of taxable income) is very unlikely to have a great impact on our revenue collection. However, it will definitely mean a lot for individual businesses who struggle to get loans from banks even at high cost due to government crowding them out (as u pointed out).



  • Not me
    Apr 23, 2012 - 9:07PM

    @ Meekal: i fully agree with you.
    Someone has to really un-pack the cartel of big brokers in the stock market in Pakistan.The market is totally manupilated.And now the Stock Exchange is asking the government to provide amnesty from probe as to source of investment in stock market ( ala money laundering)


  • Meekal Ahmed
    Apr 23, 2012 - 10:56PM

    @Not me:

    and I agree with you, Sir.

    That is another thing I detest. Amnesty’s.


  • Ahmed Jamal Pirzada
    Apr 23, 2012 - 11:56PM

    @Meekal Ahmed:

    well we really have to look at what exactly is the cause of inflation? interest rates can only be used as an appropriate tool if the underlying cause is excess demand. In my limited understanding this is not the case.
    GDP per capita growth has been close to zero over the last few years. 1/3rd of the population is already living below subsistence levels and this goes up to 1/2 if we look at multidimensional poverty. Demand must be very inelastic at this end of the income group. Excess demand is therefore very unlikely.

    Also saying that drop in inflation over the last year was due to central bank’s policy of keeping the interest rates high is itself debatable. This is visible from the data compiled by the State Bank of Pakistan. Year on Year CPI Inflation has declined from 13.9 in January 2011 to 10.1 in January 2012. Much of this is attributed to the decrease in inflation for the food group (from 20.2 to 9.2 over the same period) due to better crop production and sufficient levels of buffer stock. Considerable decline is also due to fall in the global food prices which saw an year on year increase of 29.9% in January 2011 but declined by 10.7% in January 2012.

    Similarly, persistence in double digit inflation is largely due to rising energy costs (or exogenous cost shocks) rather than demand.

    @Falcon i think just because additional borrowing space created will be used by the government is not a gud enuf reason for not creating that extra borrowing space. Given that majority businesses in developing countries are highly leveraged, any decrease in nominal interest rates will be a blessing for them anyways.

    From what i can observe, there is enuf evidence available to at least question the high interest rate policy.

    Yes every policy has its benefits but to me the cost of keeping the interest rates high is a lot more.



  • Meekal Ahmed
    Apr 24, 2012 - 12:27AM

    @Ahmed Jamal Pirzada:

    You make some good points but leave me unconvinced.

    When we went to the IMF in 2008, the headline rate of inflation was 27% — largely because of food and oil but also because of the overly expansionary policies of the previous government.Their “cheap” money policy caused over-heating pressures (which they had been warned about four years earlier), a surge in imports and speculative bubbles in the stock market, real estate and commodities (mainly gold).

    With tight fiscal and monetary policies (we are always good at that when we just got the scare of our lives and were looking at a melt-down and staring at debt-default in the face) inflation dropped to 9%! Then came the floods and all bets were off. The policy-makers took their eye off the ball. Slippages, missed targets, multiple requests for waivers….and another failed IMF program.

    Please don’t look at the headline rate. A change in the headline rate may NOT call for a policy response if it is, for example food-price driven,. Then you need to address the supply side: imports, market imperfections, transportation bottlenecks, smuggling, hoarding and so on.

    Look at the core rate and the core trimmed mean.The core is still in double-digits. THAT calls for a policy response or at least vigilance.

    No excess demand? The government has already borrowed a trillion rupees and they are still going great guns! They have pre-empted 84% of domestic money and credit! The private sector has been shut out and the main engine of growth and jobs, the SME sector is suffering a credit crunch. No money for them.

    India got their inflation down after THIRTEEN rate adjustments. So did China. As well as a lot of other Asian countries which were clearly over-heating with large positive output gaps..

    of course we must analyse the sources of inflation carefully and make informed judgements. But to say that tight money does not supress inflation — working in tandem with a tight fiscal — flies in the face of emirical evidence around the world, as well as Pakistan’s own experience.

    But you will corrupt the correlation if tight money is combined with a loose fiscal stance. Is it small wonder then that we have had to suffer double-digit inflation for the past four years (something that Pakistan has never experienced before) and there is no end in sight? Monetary policy is powerless in a regime of “fiscal dominance”.

    So are you going to call for an easier monetary policy regime so that we can have more inflation down the road?And you are worried about poverty?

    You strike me as too intelligent to suggest such a course of action.

    I HOPE you are not a supporter of IK who, my moles tell me, is being advised that he can INFLATE HIS WAY OUT OF STAGFLATION. Just let it rip and watch the supply-side respond to demand and Pakistan will be soaring!

    Sorry for the long response.


  • Sheikh Ali Tariq
    Apr 24, 2012 - 1:18AM

    As a student of both free market economics and centralized systems I have come to a very general but important conclusion: a system is only as good as its inherent values and the implementation by all involved whether on the demand side, supply side or the government.

    In my opinion the real cause of inflation in Pakistan is lack of price regulatory frameworks and law enforcement.

    For example the recent rise in urea prices last year and early this year would not have happened if the “Sind High Court” had ruled in favor of Engro Fertilizer as the company had secured sovereign guarantees for gas supply from the government when it had decided to invest in its new plant.

    We have excess supply in terms of capacity. So all that is and was needed: rule of law to prevail. Even if people starve and die because of lack of gas Engro should be supplied with gas because that’s their right (lawful right); not to forget that we are enjoying precious gas to fill our car tanks; what a silly use of a precious resource.

    Secondly I think a crucial point that needs to be highlighted is that our economy comprises of a large underground segment. Similarly not a lot of people and companies use banking for their credit and deposit needs therefore interest rate can hardly help in controlling inflation.

    All we need is a few dozen strong headed guys at the top who strengthen supply side economics and make some tough decisions in courts, parliaments, police stations and barracks.

    The question is: how many of us are willing to accept and make those tough calls?


  • Ahmed Jamal Pirzada
    Apr 25, 2012 - 8:55PM

    @Meekal Ahmed:

    i have tried replying to your last comment several times but for some reason it has not been posted. Probably i’m violating some rule which i am not aware of !

    It was nice talking to you and very informative as well. It will be my pleasure if you could share your email id with me we can take our discussion further over the email if you may wish.

    Irrespective of our different views, lots of respect.


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