How to design a taxation system

No matter how low the tax rates, every citizen of a democracy will express outrage when asked to pay more.


Farooq Tirmizi November 22, 2010

No matter how low the tax rates, every citizen of a democracy feels that they are overtaxed and will express outrage when asked to pay more – no matter how justified the increase may be. This makes life difficult for our government, which has one of the lowest tax collection rates in the world and needs to increase them across the board.

If the country is to close the massive fiscal deficit and even think about beginning to pay down the national debt, conversation about reforming the taxation system must be a serious one. Nothing will be more damaging to the country than populism ruining the best chance we have to build national consensus on the taxation system.

When designing such a system there are several considerations that need to be taken into account, two of which hold primary importance in a developing country like Pakistan. The first is that it must be progressive, meaning that a higher rate of taxation is placed on the richest segment of the population and lower rates on poorer segments. Second, the burden of taxation must be spread throughout the economy, with as few exemptions as possible.

The devil, of course, lies in the details. While most commentators would agree with the two stated goals, putting them into practice is where the contradictory nature of both objectives comes to the fore.

The purpose of a progressive taxation system is to protect the poor from an excessive burden. But having a wider tax net also means taxing segments of the economy that also cater to the poor, thus increasing the odds that they will feel the pinch.

Taxes and inflation

One of the most talked about ways by which the poor can feel the pinch of taxation is through inflation. There is absolutely no such thing as a tax that does not have at least minor inflationary effects and for a very simple reason: a tax is an added cost to the producers of goods and services, which they will quite reasonably seek to compensate through higher prices.

Nowhere is this discussion more relevant than in the debate over the agriculture tax. According to the Household Integrated Economic Survey (HIES), conducted by the Federal Bureau of Statistics, the bottom 80 per cent of Pakistani households spend well over 50 per cent of their income on food. Food price inflation matters a lot to the overwhelming majority of the population.

Placing an income tax on agriculture will, by definition, cause an increase in food price inflation at a time when agricultural commodity prices are already rising fast. Admittedly, the increase is likely to be a one-time spike which stabilises over time.

So should the government tax agriculture or not? Would the cost of offsetting higher food prices for the poor through subsidies be lower than the revenue gained through agricultural income taxes? It seems unlikely.

Consumption vs income taxes

Another area where the contradiction between the desire for a wider tax net and a progressive tax system comes into play is in the debate between consumption and income taxes. Consumption taxes are generally considered regressive, since they tax all consumption at the same rate. As the rich tend to consume a smaller portion of their incomes, they pay a lower effective tax rate. On the other hand, consumption taxation is one of the surest ways of casting a wide tax net.

This debate has become particularly relevant during the ongoing deliberations in parliament about the value added tax (VAT), officially referred to as the reformed general sales tax (RGST). Yet it must be remembered that not all consumption taxes need to be regressive. For instance, by exempting certain basic items such as food and housing from the tax, a consumption tax can effectively be made to bear the characteristics of a progressive tax.

Consider the following example, where food is the only category of items exempt from the VAT. According to the HIES, a person in the lowest 20 per cent of income groups spends an average of 55 per cent of their income on food. If the person pays a 15 per cent VAT on everything else they buy, then the effective tax rate of this person comes to 6.75 per cent, assuming no savings.

Now take a person from the middle 20 per cent. They spend an average of 50 per cent of their income on food, bringing their effective tax rate to 7.5 per cent.

In essence, even a consumption tax like the VAT is behaving like a progressive tax by virtue of its design which exempts basic items. Hence, it is possible to avail the benefit of a wide tax net cast by a consumption tax, while still designing that tax in a way that it mimics a progressive tax.

Income taxes, of course, are progressive by their nature since they tax income as a whole and place higher rates on higher incomes. However, given the undocumented nature of much of the Pakistani economy, it is somewhat difficult for the government to make income taxes the sole vehicle through which they generate revenues.

Income taxes rely on a higher level of documentation than consumption taxes. Indeed, levying consumption taxes can aid the documentation of the economy which will ultimately allow the government to increase its reliance on income taxes.  However, even advanced economies like France rely on consumption taxes for as much as half of all government revenue.

Enforcement: the ultimate devil

None of the above discussion matters, however, if enforcement is not made into a transparent mechanism. Here, however, one would like to advise caution: do not make the perfect the enemy of the good.

It is no use asking for corruption to be completely eliminated before the government can start raising taxes. Corruption will always exist in all governments: the best that any government can do is to minimise it.

In fairness to the Federal Board of Revenue (FBR), it has increased the number of prosecutions against tax evaders, going after as much as Rs100 billion in tax theft. There is, however, still a long way to go.

The writer is a financial and management consultant based in Karachi.

Published in The Express Tribune, November 22nd, 2010.

COMMENTS (8)

Ammar | 13 years ago | Reply I must say, there is a lot room for generating revenue. There are so many flaws in the taxation system. - As author depicted that our economy is undocumented. Govt. needs to documnetize the economy, so it can levy tax. - Agricultural income should be taxed with the exemption of small farmers. Landlords having inocme more than Rs. 300,000 should taxed, it will not sour inflation as it has nothing to do with inflation rather it takes the income of an individual into account. - Shop owners do not pay any tax, however, they earn more than Rs. 500,000 a month. They should be taxed. - Salaried persons already pay a lot tax, levying more tax on them will be mistake. - Moreover, businesses don't display their board before their companies (smaall and medium enterprises in countryside areas), so they can skip from tax. In gist, GoP needs to reinvent its taxarion system. Cheers!
Asrar Ahmed | 13 years ago | Reply do we know what is broken before we try to fix it.?? the real problem is competency in FBR. they have no idea of what they are taxing,what is the potential,where is the potential. their officers are only interested in "lucrative" postings.The Chairman knows in fact he makes the calls in some cases to transfer.why does he do it?should not the officers using influence for transfers to "right" positions be blacklisted? Let FBR publish list of all members of MNAs and MPAs who pay tax and how much?. what right do people who do not pay tax have to subject others to tax? the rich agriculturist and fruit farm owners pay tax
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