- PSD Occasional Paper No. 21 December 1995 Governance and Fiscal Reform A Study of Pakistan Hafiz Pasha H The World Bank Private Sector Development Department PRIVATE SECTOR DEVELOPMENT DEPARTMENT OCCASIONAL PAPERS No. I Rhee, Katterbach, Belot, Bowring, Jun and Lee, Inducing Foreign Industrial Catalysts into Sub-Saharan Africa No. 2 Mody and Wang, Explaining Industrial Growth in Coastal China: Economic Reform...and What Else? 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Labor Policies and Regulatory Regimes No. 12 Kessides and Willig, Competition and Regulation in the Railroad Industry No. 13 Nagaoka, Antidumping Policy and Competition No. 14 Atiyas, Bankruptcy Policies No. I5 Brandio and Feder, The Case of Land Markets No. 16 Jebuni, Governance and Structural Adjustment in Ghana No. 17 Atiyas, Uneven Governance and Fiscal Failure: The Adjustment Experience in Turkey No. 18 Van Arkadie, Economic Strategy and Structural Adjustment in Tanzania No. 19 Tan and Batra, Technical Efficiency of SMEs: Comparative Evidence from Developing Economies No. 20 Oi, Cadre Networks, Information Diffusion, and Market Production in Coastal China Private Sector Development Department Occasional Paper No. 21 Governance and Fiscal Reform: A Study of Pakistan Hafiz Pasha December 1995 This paper has been cleared for inclusion in the occasional paper series by R. Shyam Khemani, Manager, Competition & Strategy. The views expressed are those of the author(s) and should not be attributed to the World Bank. This paper forms part of a forthcoming volume, Leila Frischtak and Izak Atiyas, eds.. "Governance, Leadership, and Communication: Building Constituencies for Economic Reform." The World Bank Private Sector Development Department ii Contents 1 Introduction...................................................................................................................1 2. Initial Conditions of Fiscal Reform ..............................................................................3 Political Process and the Changing Vision..........................................................................3 Process of Econom ic Reform ..............................................................................................5 State of Public Finances.......................................................................................................6 Revenues ..............................................................................................................................9 Expenditures......................................................................................................................11 Institutional Setting for Budget-M aking............................................................................ 6 Intergovernm ental Fiscal Relations ................................................................................... 18 Tax Adm inistration............................................................................................................19 Transparency, Accountability, and Controls......................................................................20 M ain Beneficiaries of Fiscal Arrangem ents ......................................................................21 3. Im peratives for Tax Reform ........................................................................................23 Fiscal Imbalance 3 Low Level of Resource M obilization................................................................................24 Econom ic D istortions ........................................................................................................24 Lack of Elasticity of the Tax System .................................................................................25 Regressivity of Tax Burden 5 Evasion and Corruption 6 Strategy of Fiscal Reform ..................................................................................................26 4. Introduction of Withholding, Presumptive, and Fixed Taxes..................................27 Degree of Success in Im plem entation................................................................................27 Political Econom y of the Reform ......................................................................................29 Determ inants of Success....................................................................................................32 Role of Gainers.............................................................................................................32 Role ofAgents of the State............................................................................................33 Role of Losers...............................................................................................................34 Lessons Learned.................................................................................................................34 5. Base-Broadening and Rate Reductions in Direct Taxes..........................................37 Degree of Success in Im plem entation................................................................................37 Political Econom y of the Reform ......................................................................................39 Determ inants of Success....................................................................................................41 Role of Gainers.............................................................................................................41 Role of Agents of the State............................................................................................41 Role ofLosers...............................................................................................................42 Lessons Learned.................................................................................................................45 ii i 6. Ongoing Reform ........................................................................................................ 47 Broad-Basing of the General Sales Tax.............................................................................47 Progress in Implementation..........................................................................................47 Gainers and Losers.......................................................................................................48 Determinants of Success ...............................................................................................49 Tariff Reform s ...................................................................................................................50 Progress in Implementation..........................................................................................50 Potential Gainers and Losers.......................................................................................52 Determinants of Success...............................................................................................53 7. Conclusions ................................................................................................................ 57 References.............................................................................................................................. 59 iv 1 Introduction 1.1 The objective of this paper is to examine the relationship between governance capacity and the success or failure of the fiscal reform pursued in Pakistan in recent years. Some measures of governance capacity are the ability of the state to design and enforce a common set of rules for the orderly and efficient conduct of economic activities and to autonomously develop policies that are not subservient to the interests of particular economic and social groups. 1.2 The paper focuses on the area of fiscal reform for a number of reasons. First, there is a general recognition of the magnitude of the fiscal imbalance, and that reduction in the budget deficit constitutes the core of the structural adjustment process. Second, the existing taxation system and the pattern of expenditure clearly highlight the quality of governance in the universality of the application of the tax code; "state capture," either in tax breaks or subsidies to special interest groups; and the general level of inefficiency and corruption. Third, fiscal reform has well-defined, sizable, and more or less immediate distributional consequences, and a study of this process clearly demonstrates how the government must be politically articulate and sell its vision of change to justify the reform, how coalitions are built to either force through or block the reform, and how the process of bargaining takes place whereby compensation mechanisms are found to minimize resistance by potential losers. 1.3 The paper demonstrates that the relationship between governance capacity and the process of economic reform is complex. It shows that the same government can meet with exceptional success in one area of reform, while it is confronted with ignominious failure in another. It appears that success or failure depends upon the combination of factors of governance capacity that come together in a particular situation. The paper also discusses major ongoing fiscal reform episodes, part of the agreement with the International Monetary Fund (IMF) on the Extended Structural Adjustment Facility (ESAF) and Extended Fund Facility (EFF), and concludes that the present government will have to adopt ingenious approaches and demonstrate a high level of governance capacity to successfully orchestrate these reforms. 1.4 The paper has both a macroeconomic and a microeconomic focus to facilitate an in-depth study of the process of fiscal reform. It is organized as follows. The second section outlines the initial conditions of fiscal reform in the country toward the end of the 1980s. The third section sets out the imperatives for tax reform and derives the implications for the reform strategy. We then analyze the degree of success and its determinants in two major areas of reform: the introduction of presumptive and withholding taxes (in the fourth section) and the broadening of the tax base with rate reductions (in the fifth section). The sixth section discusses 2 Governance and Fiscal Reform: A Study of Pakistan ongoing reforms of the general sales tax and import tariffs. Finally, in the seventh section we present the major conclusions of the paper regarding the relationship between governance capacity and economic reform. 2 Initial Conditions of Fiscal Reform 2.1 The objective of this section is to describe the initial conditions of fiscal reform as they prevailed in the year 1990-91, when the newly elected government of Nawaz Sharif came to power. This will indicate the structural problems that had emerged over time, and thus identify the broad contours of reform. Political Process and the Changing Vision 2.2 The Islamic Jamboori Ittehad (IJI) government that emerged as a coalition of political forces in August 1990 (see political chronology in Figure 1) was dominated by the Muslim League, the political party that had played a critical role in the creation of Pakistan under the leadership of Mohammed Ali Jinnah (father of the nation). The IJI consisted of the Muslim League, an essentially secular party, aligned with an assortment of religious parties such as the Jamaat-i-Islami. The major unifying factors were the common opposition to the Pakistan Peoples Party (PPP) led by Benazir Bhutto, and that most of the components of the IJI had been sympathetic to, and nurtured by, the previous martial law regime of General Ziaul Haq. The PPP was in power between 1988 and 1990, but it was removed by dissolution of the Parliament under the powers vested with the president (in the Eighth Amendment to the Constitution made by the military government) on the grounds of ineptitude and corruption. 2.3 The change of government in 1990 represented a major realignment of political forces in the country. During the decade of the 1970s. Pakistan had adopted the path of socialism through large-scale nationalization of industry and banking and a major expansion of the public sector role in the first PPP government of Zulfiqar Ali Bhutto (father of Benazir Bhutto). This was primarily a response to worsening regional and personal income disparities associated with the capitalist development of the 1960s that led to the breakup of the country. 2.4 The military coup of 1977 did arrest some of these developments, but there continued to be a commitment to a highly regulated economy and dominance of the public sector. The shock of nationalization led to a major retreat of the private sector, and private investment remained heavily depressed for many years. By the mid-1980s there was growing disillusionment with the inherent problems of inefficiency and corruption in the public sector. Industrial growth stagnated, affecting the overall dynamism of the economy. The Junejo government (from 1985 to 1988) and the Bhutto government (from 1988 to 1990) took some tentative steps toward liberalization and deregulation of the economy. 3 4 Governance and Fiscal Reform: A Study of Pakistan 2.5 The emergence of Nawaz Sharif as the prime minister in 1990 signaled the reemergence (after the Ayub Khan era in the 1960s) of capitalist forces in the country. Himself a leading businessman, Mr. Sharif was able to portray the image of an agent of change involved in dismantling the overgrown public sector through privatization and deregulation and restoration of the role of the private sector as the "engine of growth." Mr. Sharif moved with great vigor and dynamism. A number of industrial enterprises and financial institutions were sold back to private entrepreneurs. There was extensive deregulation, including that of the trade and foreign exchange regime. The financial sector was liberalized, and numerous fiscal incentives were offered to private investment, along with simplification of procedures. Figure 1: Political Chronology of Pakistan 1971 Breakaway of the east wing of Pakistan Induction of the Pakistan Peoples Party (PPP) government of Zulfiqar Ali Bhutto 1977 Coup d'tat by the military Installation of martial law government under General Ziaul Haql 1985 Partial transition to civilian government following constitutional amendments Formation of a nonparty government with Mohammad Ali Khan Junejo as prime minister 1988 Sacking of the Junejo government by the president (General Ziaul Haq), Assassination of General Ziaul Haq General elections, followed by formation of PPP government with Benazir Bhutto as prime minister 1990 Sacking of the PPP government by the president (Ghulam Ishaque) General election, with IJI emerging as winner Government formed with Nawaz Sharif as prime minister 1993 Dissolution of the Nawaz Sharif government Reinstatement of Nawaz Sharif government following Supreme Court judgment Dissolution of Nawaz Sharif government' General elections leading to formation of government with Benazir Bhutto as prime minister. 2.6 The overall vision was a rapid transformation from a highly regulated to a market economy to fully unleash the creative energies of the private sector. In the initial period, Mr. Sharif was successful in projecting this vision of change. The stock market soared, and there was a quantum jump in private investment; the economy once again showed some dynamism. Economic reforms during the period in general, and fiscal reforms in particular, are to be viewed in the context of this vision, which involved a shift toward the market economy, minimization of the role of the public sector, and the creation of an environment conducive to the growth of the private sector. 2.7 The Nawaz Sharif government saw fiscal reforms not only as a means of correcting macroeconomic imbalances (especially the large budget deficit), but also as a way to Caretaker governments were established on a temporary basis. Initial Conditions of Fiscal Reform 5 facilitate growth through large-scale investments in physical infrastructure (especially transport and communications and energy) to support higher private sector investments in industry. There was a widespread perception of defects in the tax system and a failure of tax administration, which had acted as a barrier to the conduct of private economic activities through the presence of complex and opaque tax laws, harassment by tax officials, and large-scale corruption and evasion. 2.8 As part of his economic reform program, within three months of the formation of his government, Mr. Sharif announced the appointment of a high-powered Tax Reforms Committee (TRC). It was headed by a senator and included businessmen, professionals (accountants, tax practitioners, lawyers, and the like), senior tax officials, and academics, who were asked to suggest ways to revamp the tax system and make it more transparent, simpler to administer, and more protective of the interests of taxpayers, while simultaneously expanding the revenue base. The Resource Mobilization and Tax Reforms Commission (RMTRC) was subsequently put in place to implement the recommendations of the TRC and to participate in the budget-making process. 2.9 Before we analyze the resulting process of reform, we first characterize the conditions that prevailed when the Nawaz Sharif government came into power. Process of Economic Reform 2.10 The impetus for economic reform in Pakistan has come either from installation of a political government with a new vision or ideology about the role of government and the strategy of economic growth, usually in response to some major underlying structural problem, or following an agreement with international agencies such as the IMF on a plan for structural adjustment, along with an increased inflow of funds. We have discussed the former in the previous section, and focus on the latter here. 2. 11 The first major structural adjustment program in Pakistan covered the period from 1980 to 1985. Policy areas in this program included agriculture, with emphasis on removal of the fertilizer subsidy, a proper relationship between world and domestic prices, and an increase in irrigation water charges. Changes in industrial and trade policy involved price adjustments and management reforms of public industrial enterprises to convert losses into profits, relaxation of controls and streamlining of procedures for investment, and removal of quantitative restrictions on imports along with tariff reductions. In the area of development planning, rationalization of public investments was emphasized. The program was largely a failure, with either no progress or only limited achievement on the various fronts. 6 Governance and Fiscal Reform: A Study of Pakistan Table 1. Major Macroeconomic Indicators for Pakistan (percent) GDP growth Investment/ Savings! Inflation Budget deficit/ Current account Year rate GDP GDP rate GDP deficit/ GDP 1980-81 6.4 17.4 14.0 13.9 5.3 3.4 1981-82 7.6 17.9 13.2 11.1 5.3 4.6 1982-83 6.8 17.0 15.3 4.7 7.0 1.6 1983-84 4.0 16.7 13.8 7.3 6.0 2.9 1984-85 8.7 17.0 12.0 5.7 7.8 5.0 1985-86 6.4 17.4 13.8 4.4 8.1 3.6 1986-87 5.8 18.0 16.0 3.6 8.2 2.0 1987-88 6.4 17.3 13.1 6.3 8.5 4.2 1988-89 4.8 18.3 13.6 10.4 7.4 4.7 1989-90 4.6 18.2 13.6 6.0 6.5 4.5 1990-91 5.6 18.5 13.9 12.7 8.7 4.6 1991-92 7.7 19.9 16.8 9.6 7.5 2.7 1992-93 2.2 20.85 13.4 10.6 7.9 7.1 Source: Pakistan Economic Survey. 2.12 The next structural adjustment program, part of the agreement with IMF, was undertaken during the period 1988-93. It included explicit targets, such as reduction of the budget deficit to 5 percent of GDP, with a specific target for containment of federal and provincial government expenditure to between 25 percent and 26 percent of GDP. The current account deficit was to be reduced to 2.6 percent of GDP, and foreign exchange reserves raised to at least six weeks of imports. The target for the rate of inflation was 6 percent. Specific policy initiatives included tariff reforms, financial sector liberalization, and auction of public debt. In the achievement of the major targets, this program was not a success. The budget deficit exceeded 6.5 percent every year, the current account deficit averaged 4.7 percent of GDP, and the inflation rate remained at about 10 percent a year during the period (see Table 1). Policy changes were implemented. The maximum tariff was reduced from 225 percent to 95 percent, the process of the auction of treasury bills was started, interest rates on concessionary credit schemes were raised somewhat, two nationalized banks were privatized, and ten new private commercial banks were established. 2.13 Altogether, Pakistan does not appear to have an enviable record in implementing structural adjustment programs. State of Public Finances 2.14 The problem of major structural imbalances in the public finances of the country had been visible since the mid- 1970s. Over the fourteen-year period from 1977-78 to 1990-91, Initial Conditions of Fiscal Reform 7 the consolidated budget deficit of the federal and provincial governments combined2 had been in excess of 6 percent of GDP in twelve years (see Table 2). During the mid-1980s, the major source of financing of the budget deficit was domestic nonbank borrowing (see Table 3), which consisted primarily of the inflow of funds into voluntary savings schemes with relatively attractive real rates of return. This had depressed the development of the capital market and financial intermediation in the economy. Next in importance were external borrowings, largely on a concessional basis from bilateral and multilateral donors. The monetized component of the budget deficit, consisting of bank borrowing, was relatively small. This implied that large budget deficits were not accompanied by inflation, which generally remained at a single-digit rate. In the event that there was a large, unanticipated increase in the budget deficit, however, as happened in 1990-91 because of the Gulf War, bank borrowing represented the residual source of financing. 2.15 The record budget deficit in 1990-91 (primarily the result of the rise in oil prices, which reduced revenues from the petroleum development surcharge and import duties, while at the same time necessitating a larger subsidy to oil refineries), on the eve of a change in government, and the resulting rise in the rate of inflation to the two-digit level (12 percent) for the first time in twelve years greatly increased perceptions of a budgetary problem. Years of a sustained high level of borrowing had led to a very rapid growth in the cost of debt service. Historically, development and defense expenditures were the largest claimants to public resources. But by 1990-91, debt service had reached the same order of magnitude. The Nawaz Sharif government (and governments thereafter) attributed the budgetary problem primarily to financial profligacy on the part of previous governments, which had led to rapid accumulation of public debt and a concomitant increase in servicing costs; an inefficient and overgrown public sector that had displaced the private sector, even in directly productive activities; and an inadequate level of resource mobilization, primarily the result of rampant evasion and corruption. It is surprising that in the Pakistani setting there is very little recognition of the burden imposed by high defense expenditures (over 6 percent of GDP). Popular perceptions of the budgetary problem generally coincide with the government view. There are, however, stronger expressions of discontent with extravagance in government spending and losses to the public exchequer from tax concessions offered to favored social groups such as landlords (in the absence of a tax on agricultural incomes). 2 Excluding local governments. which account for a minor portion, less than 5 percent, of total public expenditure in Pakistan Because of a lack of support from higher levels of government and legislative constraints to borrowing. these governments generally have to balance their budgets from own revenues. 8 Governance and Fiscal Reform: A Study of Pakistan Table 2. National Budget Deficit of Pakistan, 1977-78 to 1992-93 (percentage of GDP) Tax revenue' Total without Nontax Total Current Development Budget Year revenue surcharges Surchargesh revenue' expenditure expenditure expenditure deficit 1977-78 15.0 11.9 0.3 3.1 23.2 14.5 8.7 7.9 1978-79 15.7 12.6 0.3 3.3 25.1 15.6 9.5 8.9 1979-80 16.4 13.7 0.3 3.1 23.3 14.0 9.3 6.3 1980-81 16.9 13.5 0.5 3.6 22.9 13.6 9.3 5.3 1981-82 16.0 12.9 0.5 3.3 21.9 13.7 8.2 5.3 1982-83 16.2 13.5 0.6 2.7 23.9 15.8 8.1 7.1 1983-84 17.2 13.0 0.9 3.9 23.8 17.1 6.7 6.0 1984-85 16.4 12.2 0.8 4.0 24.7 17.7 7.0 7.8 1985-86 17.5 12.4 1.7 4.0 26.1 18.4 7.7 8.1 1986-87 18.1 12.2 2.3 3.9 26.6 20.3 6.3 8.2 1987-88 17.3 11.9 1.9 4.4 26.7 19.8 6.9 8.5 1988-89 18.0 12.4 1.9 4.4 26.1 19.9 6.3 7.4 1989-90 18.4 12.8 1.1 5.3 25.9 19.3 6.5 6.5 1990-91 16.0 11.5 1.2 4.1 25.6 19.2 6.4 8.7 1991-92 18.0 112.5 1.2 5.3 26.7 19.1 7.6 7.5 1992-93 17.8 12.2 1.0 4.7 25.9 19.5 6.4 7.9 a. Taxes collected by the Central Board of Revenue. b. On petroleum and gas. c. Including self-financing by autonomous corporations. Source: Economic Survey, 1986-87, 1989-90, 1992-93. Table 3. Financing the Budget Deficit in Pakistan, 1985-86 to 1992-93 Percentage of budget deficit financed Budget deficit External borrowing Internal nonbank Internal bank Year (% of GDP) and grants (net) borrowing borrowing Total 1985-86 8.1 21 65 14 100 1986-87 8.2 18 59 23 100 1987-88 8.5 22 54 24 100 1988-89 7.4 32 67 1 100 1989-90 6.5 41 53 6 100 1990-91 8.7 25 27 48 100 1991-92 7.5 20 27 48 100 1992-93 7.9 23 19 58 100 Source: Pakistan Economic Survey. Initial Conditions of Fiscal Reform 9 Revenues 2.16 The predominant share (almost 90 percent) of revenues is collected by the federal government in Pakistan. This is primarily a reflection of the skewed distribution of the constitutional allocation of fiscal powers in the country, whereby most of the taxes with large and buoyant tax bases-such as income tax, customs duties, excise duties, sales taxes, and the like- lie in the federal domain. Within nontax revenues, the share of provincial governments is somewhat higher, because they are primarily responsible for delivery of economic and social services such as irrigation, education, and health, which are partly financed by user charges. Altogether, tax revenues are the principal source of revenue, with a share approaching 80 percent. The importance of nontax revenues has declined in recent years for three reasons. First, the ongoing process of privatization has reduced the flow of profits and dividend income from state enterprises. Second, profitable entities such as the Telephones and Telegraphs Department have been converted into autonomous corporations outside the budget. Third, there has been a sizable decline in state trading profits from exports. 2.17 Within federal tax revenues, there is heavy dependence on indirect taxes. In 1990-91, the share of direct taxes (income tax, wealth tax, and capital value tax) was very low, less than 14 percent. This highlights the imbalance in the tax system of Pakistan. The average share of direct taxes in countries at a comparable level of development was 35 percent in 1989- 90 (see Table 4). Reasons for the low collections from direct taxes (less than 2 percent of GDP) are to be found in a narrow tax base (created by widespread exemptions and concessions), poor quality of tax administration, and rampant tax evasion. Within direct taxes, the corporate component accounts for over 86 percent. As a whole, income taxes in Pakistan have been largely restricted to corporate profits and salary income (through deduction at source by employers), large publicly quoted companies and multinationals, and taxpayers living in the metropolitan areas. 2. 18 The primary contribution to indirect taxes is by taxes on international trade, which include a number of levies such as the import duty, export duty, surcharges, and sales taxes. It is estimated that in 1990-91 almost 50 percent of tax revenues originated from taxes levied at the point of entry to, or exit from, the country. This reliance can be attributed first to the ease and convenience of collection at the import stage, and second to an import substitution strategy of industrialization that relies on high levels of protection. Sales tax is levied at a uniform rate (12.5 percent in 1990-91) at the import and manufacturing stages, and it includes tax-invoicing features of VAT to avoid cascading of the tax burden. Excise duties are used in a selective manner to discourage consumption of goods such as cigarettes, beverages, petroleum products, and the like. 10 Governance and Fiscal Reform: A Study of Pakistan Table 1. Level and Composition of Tax Revenues in Developing Counties and in Pakistan (percentage of GDP) Developing countries, 1989 Pakistan" Per capita income of Per capita income of All Tax less than $360 $360 to $750 countries 1989-90 1992-93 Direct taxes 3.91 6.84 7.26 1.83 2.70 Income tax 3.27 5.53 5.11 1.75 2.58 Wealth and property tax 0.24 0.31 0.45 0.08 0.09 Social Security taxes 0.21 0.79 1.30 - - Other 0.19 0.21 0.40 - - Indirect taxes 4.55 4.74 5.21 5.37 4.84 (domestic) Sales, turnover, VAT 2.44 2.30 2.46 2.17 1.74 Excise 1.55 1.95 2.07 2.64 2.54 Other 0.46 0.49 0.68 0.56 0.57 Indirect taxes 5.30 7.58 5.13 6.24 5.21 (foreign) Import duties 4.05 6.70 4.32 5.11 4.45 Export duties 1.09 0.64 0.62 0.57 0.06 Other 0.16 0.22 0.20 0.56 0.70 Other 0.26 0.41 0.45 0.51 2.24 Total taxes 14.02 19.66 18.05 13.94 14.99 a. Inclusive of surcharges. Source: Burgess and Stern 1993; Pakistan Economic Survey. 1992-93. 2.19 As highlighted earlier, the salient feature of Pakistan's taxation system in the late 1980s was relatively high tax rates with narrow tax bases. The latter is the result of wide- ranging exemptions, concessions, rebates, tax credits, and so forth, which have mitigated against neutrality of the system and have tended to create major distortions in the allocation of resources in the economy. The exemption limit of personal income from tax in 1990-91 was Rs 40,000, equivalent to about four times the per capita income. Agricultural income enjoys a special exemption. In addition, various kinds of capital income are outside the tax net, including profits of companies established in backward areas and in designated industries, capital gains on financial assets, interest income from government savings schemes, and special accounts with commercial banks (for example, nonresident rupee accounts). In addition, there is provision for accelerated depreciation allowances for new investment, and tax credits for balancing and modernization. A special rebate has been granted on export income. On top of all this, there is a plethora of targeted exemptions embodied in the Second Schedule of the Income Tax Ordinance related to allowances as part of the remuneration package, pensions, charitable contributions, income of trusts and foundations, income of designated companies, and the like. Some of the largest public sector corporations, including the Water and Power Development Authority (WAPDA), the Karachi Electricity Supply Corporation (KESC), and the State Life Insurance Corporation (SLIC), have statutory exemptions of net income. 2.20 The tax base of the wealth tax has also been severely eroded by exemptions. These include a general exemption on assets worth up to Rs I million; effective exemption of Initial Conditions of Fiscal Reform 11 agricultural lands and owner-occupied property, irrespective of value; and exclusion of financial assets on which the Islamic tax, the Zakat, has already been collected. 2.21 Exemptions and concessions are also pervasive in import duties. An effort has been made to ameliorate high tariffs through selective exemptions. A large number of Statutory Rules and Orders (SROs) have been promulgated prescribing special tax treatment by category of commodity and importer. Industrial importers enjoy concessionary rates in comparison with commercial importers. Large public sector importers are given favored treatment over the private sector. Imports of machinery for backward areas have been granted exemption from customs duty. In addition, imports for essential consumption (such as foodstuffs and drugs), agricultural production (fertilizer, pesticides), defense needs, and the social sectors (such as hospital equipment) are exempt. With the increase in SROs over time, the import duty regime has ceased to be transparent and has become very complex to administer, with ample scope for misdeclaration and corruption. 2.22 All items are exempted from excise duties unless specifically declared as excisable. Consequently, only thirty-four industries pay excise duties, but this list includes some of the major industries, such as cement, sugar, tobacco, cotton yam, beverages, and so forth. The most important exclusion from sales tax is the wholesale and retail trade sector. In addition, basic food items and other essential goods and services do not carry a sales tax. 2.23 Given the dependence on indirect taxes and the wide variation of tax incidence on different kinds of income and sectors of the economy, there is a widespread perception of inequity in the distribution of the tax burden between rural and urban areas, between labor income and capital income, between the corporate sector and the informal sector, among households at different income levels, and among different parts of the country. This perception has created problems in the voluntary compliance of taxpayers. Expenditures 2.24 The distribution of public expenditures to different levels of government is more balanced than revenues. This balance has been made possible by an elaborate scheme of revenue-sharing between federal and the provincial governments (discussed in a subsequent section). In 1990-91, 68 percent and 70 percent of current and development expenditure, respectively, were incurred by the federal government, 29 percent and 22 percent, respectively, by the four provincial governments combined; and the remainder by local governments. Within public expenditure, the share of current expenditure has been increasing, while that of development expenditure has fallen. 2.25 Major categories of public expenditure are given in Table 5. In 1990-91, the largest single claimant of public resources was defense expenditure, with a share approaching 25 percent. Next in importance are interest payments on domestic and foreign debt (17 percent). This is the fastest growing item in expenditures, and it reflects the persistently high budget deficits. Other major categories of expenditure are economic services (22 percent), with large 12 Governance and Fiscal Reform: A Study of Pakistan development outlays in sectors such as fuel and power (9 percent), transport and communications 94 percent), and irrigation (4 percent). The overall share of the social sectors is low, at 14 percent, with 9 percent for education and 3 percent for health. This partly explains Pakistan's extremely poor performance in social indicators such as literacy, life expectancy, and infant mortality. The share of public administration is 9 percent, and it has shown a tendency to increase over time. 2.26 According to estimates made by the World Bank for 1989-90, current expenditure is about three times the level of development expenditure (see Table 6). The share of development expenditure is relatively high in economic services and community services. Current expenditure dominates allocations to social services, defense, public administration, and the like. The Constitution prescribes the allocation of functions between the federal and provincial government whereby the former plays a dominant role in defense, interest payments, subsidies, and economic services. The share of expenditure on public administration by the two levels of government is roughly equal (see Table 7), although provincial governments have a more important role in the provision of social and community services. Altogether, the federal government provides national public goods such as defense and performs more of a redistribution function through transfer payments and subsidies while discharging debt obligations. Provincial governments have traditionally supported agricultural operations and rural development, and in more recent years they have engaged in subsidized provision of social services such as primary education and curative health, especially in the rural areas. Provision of such services has increasingly become the responsibility of local governments and the private sector in larger cities. 2.27 Subsidies have largely been targeted at agricultural inputs (such as fertilizer) and urban consumption of such basic commodities as wheat, sugar, kerosene oil, and edible oil (see Table 8). With the expansion of public sector operations, however, the government has had to pick up losses of large industrial enterprises (such as The Steel Mill) and those incurred in state trading (export of cotton, for example). Initial Conditions of Fiscal Reform 13 Table 5. Composition of Public Expenditure in Pakistan, 1985-86 to 1990-91 1990-91 Category 1985-86 1986-87 1987-88 1988-89 1989-90 (R.E.)" ACGRb Public administration 8.0 9.8 8.6 9.4 8.4 8.2 7.7 General administration 4.7 6.3 5.1 6.1 5.0 5.4 8.1 Law and order 3.3 3.4 3.5 3.3 3.4 3.8 7.1 Defense 24.7 24.4 24.6 23.5 25.0 24.9 6.8 Social services 12.4 13.9 14.6 13.5 13.3 14.0 8.4 Education 7.6 8.5 8.9 8.1 8.3 8.5 8.6 Health 2.9 3.2 3.4 3.0 2.9 3.0 6.6 Other 1.9 2.2 2.3 2.4 2.1 2.5 9.0 Economic services 25.5 24.08 22.3 19.9 21.3 22.0 1.8 Agriculture 2.5 2.4 2.4 2.3 2.0 2.0 0.8 Irrigation 5.3 4.5 4.0 3.1 3.8 3.8 -1.9 Industries and minerals 1.0 1.4 0.7 0.6 0.4 0.4 -16.0 Works 1.0 1.1 0.9 0.9 1.2 1.3 10.6 Transport and communications 5.6 5.1 4.3 4.3 4.5 3.8 1.2 Fuel and power 9.0 8.0 8.1 7.6 8.0 8.5 3.4 Other 1.1 2.3 1.9 1.1 1.4 2.2 8.0 Community servicesc 3.2 3.5 4.0 2.6 2.6 2.3 1.0 Other 25.9 23.4 25.3 29.7 27.9 25.6 8.4 Interest payments 16.7 15.4 17.3 20.2 19.7 17.2 10.9 Subsidies 6.1 4.2 5.3 6.8 4.4 4.3 -2.0 Other 3.1 3.8 2.7 2.7 3.8 4.1 11.2 Special Development Program 0.3 0.2 0.7 1.4 1.5 2.0 62.2 Total expenditure 100.0 100.0 100.0 100.0 100.0 100.0 100.0 a. Revised estimate. b. Annual compound growth rate at constant prices of 1980-81. c. Mostly physical planning, housing, and public health. Source: World Bank 1993. 14 Governance and Fiscal Reform: A Study of Pakistan Table 6. Share of Current and Development Expenditure in Total Public Expenditure in Pakistan, 1989-90 Total expenditure Percentage share Category (Rs million , 1980-81 prices) Current Development Total Public administration 10,952 100 0 100 General administration 6,556 100 0 100 Law and order 4,396 100 0 100 Defense 32,540 100 0 100 Social services 17.372 74 26 100 Education 10,762 76 24 100 Health 3,839 61 39 100 Other 2,771 80 20 100 Economic services 27,708 26 74 100 Agriculture 2,606 63 37 100 Irrigation 4,987 38 62 100 Industries and minerals 485 72 28 100 Works 1,566 22 78 100 Transport and communications 5,918 24 76 100 Fuel and power 10,418 1 99 100 Other 1.728 64 36 100 Community services 3,366 37 63 100 Other 36,362 94 6 100 Interest payments 25,688 100 0 100 Subsidies 5,716 100 0 100 Other 4.957 54 46 100 Special Development Program 1.955 0 100 100 Total expenditure 130.256 76 24 100 Source: World Bank 1993. Initial Conditions of Fiscal Reform 15 Table 7. Share of Federal and Provincial Governments in Total Pubic Expenditure in Pakistan, 1989-90 Percentage share Category Federal Provincial Total Public administration 54 46 100 General administration 61 39 100 Law and order 42 58 100 Defense 100 0 100 Social services 31 69 100 Education 21 79 100 Health 19 81 100 Other 80 20 100 Economic services 59 41 100 Agriculture 20 80 100 Irrigation 22 78 100 Industries and minerals 48 52 100 Works 6 84 100 Transport and communications 42 58 100 Fuel and power 99 1 100 Other 63 37 100 Community services 47 53 100 Other 77 23 100 Interest payments 72 28 100 Subsidies 81 19 100 Other 94 6 100 Total expenditure 70 30 100 Source: World Bank 1993. 16 Governance and Fiscal Reform: A Study of Pakistan Table 8. Federal and Provincial Government Subsidies in Pakistan, 1985-86 to 1992-93 1985-86 1986-87 1987-88 1988-89 1989-90 1990-91 1991-92 1992-93 Total (Rs billion) 8.1 6.9 10.1 15.7 10.2 11.5 10.7 8.2 Percentage Wheat and sugar 47 40 39 46 44 38 45 57 Edible oil - - - 18 - 19 2 - Losses, Cotton Export Corporation - 22 19 - 25 1 - 6 Pakistan Steel Mill 1 20 12 15 - 11 18 15 KESC - - 1 3 - 13 7 2 Fertilizer 30 16 21 15 11 12 11 10 Other 22 2 8 3 20 6 17 10 Total 100 100 100 100 100 100 100 100 Source: Pakistan Economic Survey. 2.28 Following the process of Islamization in Pakistan in the late 1970s, state involvement in social welfare activities increased. Revenues from the Islamic tax on assets, Zakat, have poured into a dedicated fund (managed by a board headed by an administrator) outside the budget and used largely for income supplements to the mustaqeen (the poor). The fund is sizable, over Rs 3 billion, and it has grown over time, although there are increasing perceptions of misuse and leakage in the targeting and distribution of funds. The rural equivalent of Zakat is the Ushr, which is collected on agricultural production. Revenues from this tax are earmarked for distribution at the local level. Collections are very small. More recently a Bait-ul- Maal (a special Islamic social welfare fund) was established to fund the dowries of brides, support orphans, and so forth. 2.29 Along with the fiscal subventions, there are significant government interventions with credit through the financial system. Concessionary credit (share of over 30 percent in total credit) has been provided to promote exports and locally fabricated machinery, while mandatory targets have been established for loans to socially preferred sectors such as agriculture, small- scale business, and housing, either through the commercial banks or specialized public sector financial institutions such as the Agricultural Development Bank of Pakistan (ADBP), the Industrial Development Bank of Pakistan (IDBP), and the House Building Finance Corporation (HBFC). Significant rent-seeking activity has developed around access to subsidized credit, and there are general complaints of siphoning off of funds, mistargeting, and corruption. Institutional Setting for Budget-Making 2.30 The conventional practice in Pakistan in the formulation of expenditure budgets is based on the "bottom-up" demands of government ministries, departments, and agencies. A ceiling is imposed on these demands by the Ministry of Finance at the federal level, based on projected revenues and the acceptable level of budget deficit. Public expenditures in the current Initial Conditions of Fiscal Reform 17 expenditure and development expenditure areas involve different procedures and are subject to a variety of criteria. 2.31 The fiscal year in Pakistan is from July 1 to June 30. Estimates of current expenditures are prepared by the ministries in two parts. The first part relates to ordinary expenditures, which include standing charges such as establishment, travel allowance, and contingent expenditure. These expenditures do not vary much from year to year, and they are expected to be provided on a regular basis. The second part contains expenditure areas that are discretionary in character, and can show sizable fluctuation depending upon availability of funds. Demands for expenditures of this kind are generally subject to greater scrutiny than ordinary expenditures. 2.32 The Budget Wing of the Ministry of Finance plays the leading role in the formulation of budget estimates. Preparation of the revised estimates each year precedes the preparation of budget estimates. If revised estimates exceed the sanctioned budget, there is a need to indicate the source of extra funding from among reappropriation, savings, or a supplemental grant. Budget estimates for the next year are generally based on an incremental approach. 2.33 The budgetary process in Pakistan has been gradually decentralized through the appointment of financial advisers in each ministry. These officials are competent to approve budget estimates on behalf of the Ministry of Finance. Incremental budgeting has, however, created a tendency to inflate the initial requests and the base level of expenditure. 2.34 With regard to development expenditure, each year sponsoring agencies present a list of approved projects, some ongoing and others new. The larger the project, the more stages will be involved in the approval process. The divergence between demands and development resources is resolved by the Inter-Ministerial Priorities Committee, chaired by a senior official of the Ministry of Finance, on the basis of a given set of priorities. 2.35 There has been a long-standing tendency to exceed budgeted levels of current expenditure and to underspend on the development account. In general, there has been an erosion in budgetary discipline in Pakistan. The budget monitoring and control functions of the Ministry of Finance have been rendered largely ineffective. Public funds have frequently been used for patronage by elected representatives. Pet projects have received priority in funding, without obtaining proper prior approval. The development program is too thinly spread among a large number of ongoing schemes, leading to long delays in implementation and sizable cost overruns. 2.36 Defense expenditure has generally been accorded the highest priority in budget allocations. The defense budget is approved by Parliament without access to any breakdowns of expenditure or any evaluation of cost effectiveness. The overall salary and allowance component is also protected, and redundancies in the public sector are very uncommon. In the presence of a budget constraint, allocations for the social sectors and nonsalary areas are generally the first to be scaled down. 18 Governance and Fiscal Reform: A Study of Pakistan 2.37 Budgets have generally to be passed by Parliament prior to the beginning of the fiscal year. Elected representatives seldom focus on the broader macroeconomic issues or intersectoral priorities, and they tend to promote only their own favorite schemes or the development of their individual constituencies. Given the poor quality of debate and the low level of accountability, the executive has gotten their programs passed largely by default. Major ad hoc enhancements or reallocations in expenditure are made without recourse to supplementary budgets, and SROs granting tax concessions are promulgated without seeking legislative approval. 2.38 Accounting systems are primitive, and there have been no major innovations in financial management since the British Raj. There are long lags in reporting of expenditures, which precludes timely intervention. No mechanism has been developed to monitor the execution of projects on a regular basis. Auditing procedures are slow and cumbersome, and they have proved to be unsuccessful in combating inefficiency and corruption. 2.39 In addition, the Central Bank has tended to become subservient to the dictates of the Ministry of Finance. The consequence is that monetary policy has largely adopted an accommodative stance to the growing borrowing needs of government. Levels of deficit financing have been high, especially in recent years, and have fueled inflation. Altogether, the decline in the quality of governance is vividly manifested in the failure to effectively discharge the financial function. Intergovernmental Fiscal Relations 2.40 Fiscal federalism in Pakistan has been characterized by the extreme dependence of provincial governments on the federal government (see Table 9). The imbalance between allocation of fiscal powers and functions created a need for elaborate revenue-sharing arrangements. Decisions regarding which taxes should form part of the divisible pool and the formula for the distribution of revenues between the federation and each province are made by the National Finance Commission (NFC) under the instructions of the president. The NFC is expected to make a new revenue-sharing award every five years, but the last award remained valid for seventeen years (up to 1991) because of a deadlock among provinces on the revenue- sharing formula. According to this award, major taxes in the divisible pool were the income tax and the sales tax, with 80 percent of revenues (net of costs of collection) going to the provinces, to be shared on the basis of population. This award had proved to be inadequate to finance the growing expenditure needs of the provincial governments, and ad hoc arrangements were needed that required the federal government to take on additional functions (universities, flood control, waterlogging and salinity projects, highways, and the like) and to make special grants to pick up any residual deficits. This promoted profligacy in expenditure and slackening of fiscal effort on the part of provincial governments. The NFC Award of 1991 substantially expanded the divisible pool, linked revenue-sharing more closely to collection (see Table 10), and eliminated deficit grants. Fixed special grants, however, have been instituted for a limited period. Initial Conditions of Fiscal Reform 19 Table 9. Extent of Dependence of Provincial Governments on the Federal Government in Pakistan, 1990-91 Provincial government Item Punjab Sindh NWFP Baluchistan Federal revenue transfers, percentage of total provincial revenue receipts 73 74 84 93 Total federal revenue + capital transfers, percentage of total provincial expenditure 76 66 85 86 Source: Ghaus and Pasha 1992. Table 10. Revenue-Sharing Arrangements of Federal Divisible Pool Taxes in Pakistan Combined provincial share (percent)' Source Pre-1991 NFC' Award Post-1991 NFC Award Revenues shared on the basis of population Income tax 80 80 Sales tax 80 80 Export duty on cotton 80 80 Manufactures and sugar 0 80 Revenues shared on the basis of collection Excise duty and royalty on gas 100 100 Development surcharge on gas 0 100 Royalty on crude oil 0 100 Profits on hydroelectricity 0 100 a. National Finance Commission. b. Net of costs of collection. Source: Explanatory Memorandum on Budget, Ministry of Finance, GOP. 2.41 Contrary to the practice elsewhere, fiscal transfers (revenue-sharing or grants) from provincial governments or the federal government to the local governments are very limited. Provincial governments generally prefer to engage in direct provision of municipal services, such as water supply and sanitation, primary education, health, and the like, rather than hand over resources to local governments. This is motivated by considerations of political patronage and the limited institutional capability of most local governments to deliver services. This has tended to break the link between taxation and benefits, and has reduced accountability in service provision, while stunting the growth of representative local institutions in the country. Tax Administration 2.42 At the federal level, tax collection responsibility rests primarily with the Central Board of Revenue (CBR). This is a department of the Ministry of Finance (now upgraded to the Revenue Division), and it has separate cadres of tax officials for income and wealth taxes, customs, sales taxes, and excise taxes. The collection of income tax is administered through 20 Governance and Fiscal Reform: A Study of Pakistan zones and circles, while there are collectorates in the case of indirect taxes. A pivotal position in income tax administration is occupied by the Income Tax Office (ITO); it is, however, a relatively junior office in the hierarchy. The ITO is responsible for assessing returns and raising demands, and it has considerable discretionary power. Even large, publicly quoted companies and multinationals are initially assessed by these junior functionaries, who hold no specialized expertise. The excise system operates on the basis of supervised clearance, and individual factories have resident excise inspectors. Customs staff are available at all points of entry of goods into Pakistan, and they generally perform on-site inspection of consignments. The sales tax system, however, operates differently, based largely on self-assessment by the taxpayer with random checks by the department. 2.43 Costs of collection are low: 3 percent in the case of direct taxes, and less than 1 percent for indirect taxes. This is, however, not a reflection of high levels of efficiency, but of the low priority traditionally attached to tax administration. There is chronic understaffing, support facilities are absent, and no major investment had been made in improvements such as computerization up to 1990-91. 2.44 Symbols of corruption in the popular culture are the ITO, the customs preventive officer, and the excise inspector. Despite being junior positions, they carry considerable patronage, and individuals are frequently recommended for appointment by senior and powerful politicians. Tax evasion--either with the connivance of these officials or otherwise-has become a way of life. Application of the tax code is largely restricted to corporate and salaried taxpayers. Self-assessment schemes, with relatively low probability of audit, have been put in place by the income tax department to assist taxpayers with relatively small incomes (up to Rs 200,000 annually) who are essentially self-employed and do not maintain detailed accounts. Similarly, the excise and sales tax acts are not very strictly enforced in the case of small-scale industrial units, which frequently either enjoy exemption or pay fixed taxes (no link with production) only. Transparency, Accountability, and Controls 2.45 The general characterization of the pattern of governance at all levels of government and within most departments is one of a general lack of transparency in rules and regulations and a virtual absence of accountability. Most agencies are supply-driven. The lack of transparency reinforces bureaucratic power, increases discretion, and allows the intrusion of increased bribery and corruption. In the context of tax administration, we have examples of large import duty savings that can be realized through changes in commodity classification or the use of some obscure SRO for granting exemptions. Similarly, the absence of proper yardsticks and procedures for assessment enables ITOs to behave arbitrarily and to extract a price for a favorable assessment. Given the day-to-day contact of excise inspectors with factory owners or management, it is not surprising that side deals are struck for releasing consignments from the premises without payment of tax. Initial Conditions of Fiscal Reform 21 Main Beneficiaries of Fiscal Arrangements 2.46 The main beneficiaries of fiscal arrangements are groups that can either reduce their tax payments-by obtaining exemptions/concessions and favored treatment in the assessment process from the tax department-or get higher transfer payments or subsidies. The mostly commonly quoted examples of privileged treatment are owners of agricultural land and personnel of the armed forces. The former do not pay income tax, receive concessional credit, have access to subsidized inputs such as fertilizer and irrigation water, and benefit directly from development allocations, especially from the provincial governments. The defense budget is sacred, and it receives top priority, even in times of financial stringency. Consequently, salary and fringe benefits of defense personnel are higher and more secure than those of others. The economic power of these groups is a reflection of their privileged political status. The military has had a major role in governance in Pakistan, either directly or indirectly. The traditional feudal elite has regularly captured a very large share of the seats in the Parliament because of their control over rural votes. 2.47 Other beneficiaries are those self-employed in the informal sector, engaged in activities such as trading, transport, and miscellaneous services. The income tax code is not so strictly enforced here, and the possibilities of successful underdeclaration are great. Small-scale industrial establishments also enjoy special exemptions or favored treatment in the collection of indirect taxes, although they are at a disadvantage in access to imported raw materials, credit, and infrastructure (for example, power). Recipients of capital income also face a lower tax burden because of exemptions, less likelihood of detection, and benefit from the general view of government that such income should be encouraged to promote the process of capital formation in the country. 22 Governance and Fiscal Reform: A Study of Pakistan 3 Imperatives for Tax Reform 3.1 We now turn to a discussion of the imperatives for tax reform when the newly elected government of Nawaz Sharif came to power in 1990-91. Fiscal Imbalance 3.2 Large budget deficits had become a chronic problem in Pakistan. This had led to very rapid growth in the debt-servicing burden; along with defense expenditure, it had become the largest claimant on public resources. The first year of the IJI government was an exceptionally bad one, largely because of the adverse effects of the Gulf War, and the budget deficit (in 1990-91) reached a peak of almost 9 percent of GDP. The government, which was strongly committed to the vision of a process of investment and growth led by the private sector, was concerned that large budget deficits would not only crowd out the private sector, but would also make it impossible to embark on the major public investments in physical infrastructure- such as motorways, ports, power plants, and the like-needed to remove constraints to growth. 3.3 During the 1980s, much of adjustment had been through decline in development expenditures, which fell from about 9.5 percent of GDP in 1978-79 to about 6.5 percent by 1990-91. This had led to postponement of maintenance expenditures on public assets such as the vast irrigation system, the network of roads, and the electricity transmission and distribution system. Simultaneously, expenditures on social sectors had to be restricted, which implied slow progress in Pakistan's already poor human development indicators. Clearly, it was nol possible to achieve further cutbacks in public development expenditures. 3.4 The strategy of budget deficit reduction required action in both the current expenditure and resource mobilization. Scope for reduction in the former was limited by downward rigidities in debt-servicing and defense expenditure. Debt-servicing had grown very rapidly (doubling every four years) in the face of large and persistent budget deficits and the rising marginal costs of public sector borrowing following financial sector liberalization. The only prospect for significant cost saving was debt retirement with the proceeds of privatization. It was necessary to limit real growth in defense spending by improving cost effectiveness. Simultaneously, the Nawaz Sharif government assembled the Economy Commission to identify scope for expenditure cuts in wages and salaries of the ministries, departments, and semiautonomous organizations. The commission's proposals have proved difficult to implement. however, because of the political difficulty of achieving large-scale retrenchments of 23 24 Governance and Fiscal Reform: A Study of Pakistan employment in the public sector. It was clear that the major element in correcting the budget deficit would have to be resource mobilization, particularly development of the tax system. Low Level of Resource Mobilization 3.5 Government revenues have tended to stagnate as a percentage of GDP. Tax revenues have generally ranged from 13 to 14 percent of GDP, which is low compared with tax revenues of other countries at a comparable stage of development, which average about 19 percent (see Table 4). This low level was maintained despite a period of rapid economic growth (approaching 6 percent annually) in the 1980s, and rapid expansion in such tax bases as industrial production and imports. Pakistan had an unrepresentative military government for most of the period that was actively engaged in supporting the freedom struggle in neighboring Afghanistan. During this period concessional foreign aid flowed in freely, and there was exponential growth in home remittances by Pakistanis working abroad (primarily in the Middle East). The military government chose to give tax breaks to promote a veritable consumption boom in the country, and thus keep the populace content. Given the ready availability of foreign and domestic savings to finance budget deficits, there was little realization of the underlying structural problem of public finances. Consequently, the tax-to-GDP ratio stagnated, and there was little fiscal effort, even in the presence of large budget deficits. This strategy became unsustainable as the foreign aid environment changed and the load of debt-servicing became increasingly heavy. The LII government felt that there was considerable scope for incremental resource mobilization to solve the budgetary problem, given the low tax-to-GDP ratio. Economic Distortions 3.6 A series of major economic distortions resulting from the policy of high tax rates on narrow tax bases had become visible. The nonneutrality of the tax system mitigated against an efficient allocation of resources in the economy. High rates of corporate taxation compared with personal income tax rates discouraged incorporation of businesses and created a strong preference for debt financing (interest payments are tax deductible) over equity financing. Wide- ranging exemptions of capital income encouraged speculative investments in real estate and short-term participation in the stock market. Tax rate differentials by firm size promoted fragmentation of units and loss of potential economies of scale. Fiscal incentives for investment in backward areas led to suboptimal choices of locations from the viewpoint of minimization of economic costs. Consumption choices were manipulated, especially by the favored treatment of perquisites in kind such as housing, transport, and the like. 3.7 The presence of high tariff walls gave excessive protection to domestic industry and permitted survival of many inefficient activities (with negative value added at world prices), created an anti-export bias, and induced large-scale smuggling into the country (almost 5 percent of GDP, according to some estimates). Altogether, there was a growing realization that the tax system was not conducive to the conduct of efficient economic activities by the private sector, Imperatives for Tax Reform 25 and that if deadweight losses were minimized, there could be significant gains in national income. Lack of Elasticity of the Tax System 3.8 One of the reasons for the lack of increase in the tax revenue/ GDP ratio was the low elasticity of the tax system. For federal taxes as a whole, this has been estimated at about 0.8. This implies that in the absence of any tax rate changes or improved tax administration, a 1 percent increase in GDP is accompanied by a 0.8 percent increase in tax revenues. Elasticity of income tax and excise duty is estimated at below unity, while it is close to unity for customs duty and significantly above 1 for sales tax. 3.9 The low elasticity of excise duties is attributable to the specific (and not ad volorem) character of the tax rates and that the tax is levied on industries that are basic in nature and have low income elasticities of demand. It is surprising, however, that income tax also has low elasticity. In most countries income tax revenues are relatively buoyant. The inherent reason for this buoyancy is that because the tax structure is progressive, with rising marginal tax rates, revenues from the tax rise disproportionately with the increase in income. This, however, has not happened in Pakistan. The explanation for this is either that the quality of income tax administration is declining over time, or that the tax base is increasingly oriented toward sectors with relatively high levels of tax evasion. 3.10 One of the policy goals of tax reform must be to raise the elasticity of the tax system so that revenues increase automatically with growth in the economy. This will obviate the need for frequent enhancements in tax rates, which are not only politically costly for elected governments, but also increase the deadweight losses associated with taxation disproportionately. Regressivity of Tax Burden 3.11 Research on the tax system of Pakistan has demonstrated the regressivity of the tax burden with respect to the income levels of households. The major reason for this, of course, is the low share of direct taxes in revenues. In addition, the burden of excise duties and import duties is markedly regressive in character, while the incidence of the sales taxes is generally neutral. Therefore, the imperatives of tax reform are to increase the contribution of direct taxes and to move from selective taxation of imported and domestic consumer goods toward broad- based taxation of consumption expenditure through the uniform rate GST. Evasion and Corruption 3.12 There is a common perception that the size of the black economy in Pakistan is very large, and growing. One of the main objectives of tax reform thus must be to bring incomes that have remained outside taxation into the tax net. Research commissioned by the 26 Governance and Fiscal Reform: A Study of Pakistan RMTRC reveals that in 1989-90 the assessed income for income tax purposes was only 15 percent of GDP. Fifty-two percent of assessed income was from the corporate sector, followed by 43 percent from individuals, and 5 percent from registered firms. The high tax evasion sectors of the economy are small-scale manufacturing, construction, wholesale and retail trade, transport and communications, ownership of dwellings, and services. The combined share of these sectors increased during the 1980s. A recent application by Ahmed (1994) of the monetary approach (adopted by Vito Tanzi 1983) to quantification of the size of the black economy reveals that it was almost 40 percent of GDP in the late 1980s. 3.13 A fiscal approach that relies on estimation of potentially assessable income comes to a similar conclusion, with an estimate of the black economy at about 26 percent of GDP. The ratio of assessable to assessed profits was 1.6:1, while the ratio of assessable to assessed wages was 2.4:1, with the overall ratio close to 2:1 in 1989-90. For the large-scale manufacturing sector, the extent of base erosion was 35 percent-20 percent as a result of tax holidays or government ownership, 3 percent from depreciation, and 12 percent because of wages below the income tax limit. The research also reveals considerable underreporting of unearned income such as dividends, rent, interest, and the like in relation to earned income. 3.14 The implications for tax reform strategy are that significant revenue gains could be realized if inroads can be made into the black economy through broad-basing of the income tax system, largely through presumptive and withholding taxes. Strategy of Fiscal Reform 3.15 Given the structure of the public finances of Pakistan, it is clear that action to remove the fiscal imbalance will have to focus on revenue and curtailment of unproductive expenditures. Within revenues, taxes in particular need to be developed, because nontax revenues will continue to decline with the process of privatization and a shift toward a market economy. 3.16 Pakistan's fiscal effort is revealed to be low when it is placed in the international context. This is especially true of direct taxes, where there is considerable slack. The strategy of fiscal reform will thus need to focus on the development of the income and wealth taxes. This will require development of mechanisms to combat the rampant evasion and corruption in the system, including presumptive and withholding taxes and removal of the large number of tax expenditures. This will not only raise additional revenues, but will also enable a transition to a more neutral, buoyant, and efficient tax system. In the following two sections we analyze the relationship between governance capacity and the degree of success in implementation of these reforms. 4 Introduction of Withholding, Presumptive, and Fixed Taxes 4.1 As mentioned in the previous section, the focus of tax reforms in Pakistan has been on the broad-basing of direct taxes through extension of withholding taxes (deductions at source, with adjustment following the filing of the return) and presumptive taxes (representing the fixed and final settlement of tax liabilities on the basis of standard tax rates on presumed tax bases), with the objective of reducing tax evasion, especially in the declaration of capital income, and generating revenues from sectors that have been difficult to tax. Degree of Success in Implementation 4.2 Withholding taxes have traditionally represented ad hoc deductions at source at the point of accrual of income, with subsequent adjustment following assessment by the tax department of the statement filed of income from all sources. In this sense they have the obvious merit of preventing leakage of income from the tax net. The responsibility to collect withholding taxes is essentially decentralized, however, and there is a possibility of collusion between the withholding tax authority and the taxpayer. There is thus a tendency to restrict the role of the tax collector to government agencies, public corporations, and large companies. Another problem is that if withholding tax rates are set too high, they can create the problem of refunds by the tax department. These refunds are prone to misuse and corruption. Initially there was a tendency to convert withholding taxes into presumptive taxes, representing fixed and final settlement of tax liabilities. The primary objectives were increased simplicity and a reduction in the compliance cost to taxpayers. 4.3 Withholding and fixed taxes have primarily been used to extend the coverage of the income tax to various forms of capital and unearned income. Traditionally, Section 50 of the Income Tax Ordinance (ITO), which covers such taxes, was generally restricted to salary income, with deduction at source on a monthly basis by employers. In the initial stage this was extended to cover other forms of income, such as interest income of financial institutions from government securities; income of nonresidents; and income of contractors, suppliers, and importers. From 1991 onward there were significant developments in the withholding/fixed tax regime. In the Finance Act of 1991, a fixed tax at the flat rate of 10 percent was levied on interest income from financial institutions and on dividends, and at 5 percent on property rental income above Rs 100,000. This was followed, in the Finance Act of 1992, with the extension of 27 28 Governance and Fiscal Reform: A Study of Pakistan a fixed tax (at 0.5 percent to 1 percent of value) on exporters, to be collected by the State Bank of Pakistan at the time of realization of foreign exchange proceeds. 4.4 Use of withholding/fixed taxes has not remained restricted to deductions at source in Pakistan. These taxes have increasingly been levied at points where it is possible to get a proxy of the income of a taxpayer. This innovation in the tax system is largely attributed to the desire to detect tax evasion. For the first time a withholding tax was levied on commercial and industrial consumers of electricity in the Finance Bill of 1992. The objective was to bring a large number of small to medium-size taxpayers into the income tax net, on the assumption that there is a relationship between electricity consumption and income. The magnitude of the withholding tax was linked progressively to the value of the electricity bill, with collection responsibility resting with the power utilities. A similar concept was applied in 1992 to justify the imposition of a withholding tax at the time of granting and updating the registrations of private motor vehicles, and in 1993, a 5 percent tax at the time of issuance of foreign exchange for travel abroad (withdrawn in 1994), and at the rate of 2 percent of estimated cost at the stages of approval of building plans and issuance of completion certificates to developers. 4.5 Altogether, there has been considerable success in reducing evasion by extending the network of withholding and presumptive taxes. Total revenues under Section 50 of the ITO have grown very rapidly during the last two years, with a cumulative increase of almost 150 percent in 1991-92 and 1992-93 (see Table 11). This is the major factor responsible for the unprecedented growth in income tax revenue in recent years. The income tax/GDP ratio has improved by almost one percentage point, from less than 2 percent to almost 3 percent. This has led to a corresponding reduction in the budget deficit compared with 1990-91. 4.6 Simultaneously, the component of refunds has been largely eliminated from the tax system (see Table 12). These were equivalent to over 14 percent of revenues in 1990-91, but were down to about 4 percent by 1992-93. As a result, tax deductions at source currently account for over 70 percent of total income tax revenue. 4.7 The extension of presumptive/withholding taxes has not only contributed to a rapid growth in revenues, but has also probably implied greater equity in the tax system. The share of direct taxes has increased dramatically, and there has been more effective taxation of capital income such as interest, dividends, rent, and the like, which accrue largely to upper- income households. In addition, the change in tax regime has meant greater elasticity of income tax revenues, which are now linked to rapidly growing income streams such as interest income from bank deposits, interest on government securities (from rapid growth in government borrowing), income from the rendering of professional services, and so forth. Introduction of Withholding, Presumptive, and Fixed Taxes 29 Table 11. Trend in Revenues from Withholding and Presumptive Income Taxes in Pakistan, 1988-89 to 1992-93 (Rs million) Section of ITO Type of income 1988-89 1989-90 1990-91 1991-92 1992-93 ACGR(%) 50/1 Salary 705 930 1,395 1.732 2,431 36.3 50/2 Interest on securities 1,836 1.850 1,673 4,609 7,072 40.0 50/2A Interest - - - 1,020 1,963 - 50/3 Income of nonresidents 264 232 494 2,077 239 19.5 50/3A Technical fees - - - 3 42 - 50/4 Income from contracts 2,286 2,833 3,822 5,080 6,846 31.5 50/4A Brokerage fees - - 335 55 47 - 50/5 Importers 931 1,952 2,071 3.039 3,556 39.8 50/5A Exporters - - - - 1.190 - 50/6 Transporters 60 106 121 128 286 47.8 50/6A Dividends - - - 100 124 - 50/7A Auctions 90 84 139 138 157 14.9 50/7B Rental income - - - 12 39 - 50/7C Winnings from lotteries - - 21 47 110 - 50/7D Interest on bonds - - - 20 68 - 50/7E Electricity bills - - - - 334 - Total 6,172 7,987 10,071 18.060 24,804 41.6 Source: CBR Yearbook, 1991-92; Resource Mobilization and Tax Reforms Commission. Table 12. Trends in Income Tax Revenue in Pakistan, 1988-89 to 1992-93 Category 1988-89 1989-90 1990-91 1991-92 1992-93 Total income tax revenue (Rs million) 13,407 15,000 19,079 27,913 35,018 Income tax revenue (% GDP) 1.7 1.7 1.9 2.3 2.6 Share (percent) Collection of demand 26.0 22.8 25.3 12.1 9.5 Payment with returns 38.8 42.4 35.8 28.0 23.4 Deductions at source 46.0 53.4 53.3 65.1 71.0 Miscellaneous 0.2 0.2 0.1 2.0 0.3 Less Refunds -11.0 -18.8 -14.5 -7.2 -4.2 Total 100.0 100.0 100.0 100.0 100.0 Source: CBR Yearbook, 1991-92, Directorate of Research and Statistics. CBR. Political Economy of the Reform 4.8 Analysis of the political economy of reform requires determination of the gainers and losers of the reform. For this purpose, we set up the simple methodological framework below. 30 Governance and Fiscal Reform: A Study of Pakistan 4.9 For a particular taxpayer, we designate the following: y = income T, = true tax liability To = actual tax liability in old system T2 = actual tax liability following extension of the withholding/presumptive tax regime Bo = bribe to income tax officer (ITO) in old system Co = compliance cost to taxpayer in old system C2 = compliance cost to taxpayer in new regime Do = collection cost of department in old system D2 = collection cost of department in new system. 4.10 Based on the above, the outcomes (in net income) in the old system (based on filing of return of global income) were as follows: Taxpayer : y - (To + Bo + Co) Income tax officer Bo Government : To - Do (1) 4.11 The compliance cost, Co, includes the cost of maintaining accounts as required by the income tax law, filing the return (possibly with the help of an income tax practitioner/lawyer), making visits to the ITO, documentation to handle queries, filing of appeal (if dissatisfied with initial assessment), and the like. These costs could be substantial in financial terms or as opportunity costs of time. Similarly, Bo not only includes the value of monetary payment of bribes, but also the monetary equivalent of the psychic cost of engaging in an illegal transaction. Do is the cost of time devoted by the ITO and other departmental staff to assessing the return and handling the appeal (if filed). 4.12 From (1), it may be observed that there is stable equilibrium (the taxpayer is better-off) if: To + Bo < T, (2) and the bribe is less than the difference between the true and actual tax liabilities. Introduction of Withholding, Presumptive, and Fixed Taxes 31 4.13 Following introduction of the withholding/presumptive tax regime, we now have these outcomes: Taxpayer : y - (T + C) Income tax officer : 0 Government : T2 - D,. 4.14 We then have the following possibilities: Case 1: T2> TO* In this case, despite an increase in actual tax liability, the taxpayer could still be better-off if: To+ BO + Co > T, + C2. That is. B,, + (C,, - C,) > T, - ,3 bribe saving in additional compliance cost taN payment 4.15 Therefore, the taxpayer is better-off (and a gainer) if the increase in tax liability is less than the bribe in the old system plus the saving in compliance costs brought about by the introduction of the new system. Taxpayers who are more effectively taxed under the new system. however, are likely to be worse-off. 4. 16 The government is a gainer if T, - D, > To - Do. (4) This is likely to be the case if T, > T , because collection cost, D,, in the new system is lower than Do. 32 Governance and Fiscal Reform: A Study of Pakistan 4.17 Because no bribe is paid in the new system, the ITO is worse-off (and a loser). Therefore, in this case both the taxpayer and government are potential gainers, while the income tax officer is a loser. If, however, the taxpayer had succeeded in avoiding declaration of his income by not filing a return, he will be worse-off in the new system. This takes us to the next case. Case H: T2 < To. 4.18 In this case, condition (3) is always satisfied, and the taxpayer is unambiguously better-off. The government is a gainer or a loser depending on whether condition (4) is satisfied or not. The former outcome is the case if the savings in costs of collection exceed the loss of revenue. Therefore, in this case, while the taxpayer is clearly better-off (a gainer), and the ITO worse-off, the government can be either a gainer or a loser. 4.19 Combining the two cases, we have the conclusion that relatively honest taxpayers who declared a higher proportion of their income in the old system are likely to be gainers, while tax evaders lose. The government generally is also a gainer, unless the withholding/presumptive tax rate is pitched at very low levels. The clear loser from the reform is the income tax officer, who no longer has the power to extract bribes. It is interesting to note that agents of the state tax collection machinery have a strong vested interest in blocking this reform, and are therefore unlikely to adopt a neutral or promotional stance. Determinants of Success Role of Gainers 4.20 In its vision of change, the Nawaz Sharif government, which was sympathetic to business interests, forcefully articulated the view that the income tax system had failed. On the one hand, it did not generate enough revenue because of rampant evasion and corruption. On the other hand, it had become a hindrance to the smooth conduct of private sector economic activities because of the high taxpayer compliance costs, the frustration resulting from harassment by tax officials, and the arbitrary nature of assessments that led to lengthy and time- consuming appeals processes. In his public statements, the prime minister said that evaded income was as much as five times the declared income, and that while this was the result of fundamental problems of taxpayer compliance and morality, it was also the consequence of thoroughly inefficient and corrupt tax machinery. Newspapers frequently carried information about sackings and transfers in the income tax department. 4.21 The RMTRC was charged with the responsibility of proposing and implementing reforms in the tax system. In its initial meetings with Chambers of Commerce and Industry and various trade associations, there was unanimous affirmation of the need to simplify the income tax system by the introduction of presumptive/withholding taxes to reduce the discretion of tax Introduction of Withholding, Presumptive, and Fixed Taxes 33 officials and lessen harassment and compliance costs. It was also commonly asserted that simplification of the tax system could actually generate more tax revenues by curbing tax evasion. The common argument put forward by businessmen was that rather than pay bribes, which went into the pockets of corrupt tax officials, they would much prefer that these payments were converted into revenues for the government. 4.22 Lobbying activities to bring about the desired changes in the tax system were intense. The Nawaz Sharif government made a significant departure from past practice by substantially "opening up" the budget-making process to outside interests. Traditionally, this task had been performed by the bureaucracy in a climate of almost complete secrecy. A high- powered Budget Committee was convened (chaired by the prime minister), with representation of leaders of trade and industry. These representatives forcefully argued in favor of mechanisms for reducing tax evasion, because it compelled them to pay higher tax rates to achieve the targeted level of revenues. They also presented proposals for tax simplification through introduction of presumptive/withholding taxes on different streams of income and in different sectors of the economy. Role of Agents of the State 4.23 This area of reform is unique, because one component of the state, the tax collection machinery, actually had a vested interest in the nonimplementation of this reform. Presumptive/withholding taxes reduce the role of the income tax department and lead to a decentralization of tax collection. At the individual level, tax officials find their income levels drastically reduced because there are fewer bribes. 4.24 The CBR as a whole, however, and the income tax department in particular, had already been subjected to a great deal of criticism because of historically poor performance in tax collection, as reflected in the low and stagnant tax/GDP ratio. Therefore, revenue officials found themselves in a position where they could not forcefully argue against the violation of the traditional norms of income taxation based on filing returns of global income by taxpayers. The aggressive attitude of the prime minister and the danger of punitive action through large-scale removal and sacking of tax officials represented a credible threat to their position. The tax bureaucracy decided that the best policy was to go along with the reforms, at least temporarily, and see how presumptive/withholding taxes performed. Also, the tax department was effectively bypassed when responsibility for development and implementation (through provisions in the Finance Acts) of proposals was given to the RMTRC, and actual responsibility for collection shifted to large public sector and corporate entities. 4.25 Another factor contributing to success was that other organs of state, primarily senior officials of the ministries of finance, industry, and commerce, fully supported the move. Not only was there a desire to increase the flow of revenues into the exchequer by curbing evasion, but there was also general sympathy with the view that the existing tax system had failed because of the complexity of laws and the inefficiency and misconduct of tax officials. In more cynical terms, it seems that other elements of the bureaucracy felt that there was a 34 Governance and Fiscal Reform: A Study of Pakistan disproportionate allocation of lucrative positions to the tax department, and this imbalance required remedy. Role of Losers 4.26 Losers from the reform belong to two distinct groups, income tax officials and tax evaders (who either did not file any return or underdeclared a substantial proportion of their income, and subsequently escaped assessment). As indicated above, the former could not lobby aggressively against the reform because of the prevailing climate of hostility toward their role, and the prospect that if revenues did not improve quickly, there could be large-scale retrenchment of the income tax department. Within this group, the few honest officers were inclined to support this reform, because it considerably simplified their jobs and reduced their assessment load. 4.27 Chronic tax evaders did not fall into a homogenous category. By definition, it was difficult for them to reveal their identity lest they become targets for any future revenue drive. Also, there was a realization that the government meant business, and the alternative to the reform was potentially worse, because it meant stronger investigation and enforcement activity by the department. The pragmatic approach was to pay somewhat more in the form of presumptive or withholding taxes, while preserving anonymity and not coming into contact with tax officials. 4.28 Of course, not all opposition to the reform was muted. Income tax practitioners, lawyers, and accountants found that their practices would be severely eroded by the transition to a simpler tax system. There were also some tax purists who felt that the introduction of presumptive and withholding taxes represented a vulgarization of the system. A campaign was launched in the newspapers, and echoed occasionally in the higher echelons of government, that the shift from global to scheduler income taxation (for example, of interest income) would reduce the progressivity of the tax system; that levy of fixed taxes on crude proxies to income, such as turnover, would convert direct taxes to indirect taxes, leading to a shifting of the tax burden; and that the problem of inequity would be exacerbated because the presumptive/withholding tax regime would not be able to distinguish between persons with income below the exemption limit and those with taxable income. Consequently, the argument continued, the system would end up taxing poor households, widows, orphans, and the like. Nevertheless, all these arguments paled in the face of a government that appeared to be determined to simplify the tax system, reduce arbitrariness and harassment by tax officials, broaden the base of income tax by checking evasion, and generate more tax revenues. Lessons Learned 4.29 The extraordinary success achieved in implementation leads to the identification of the main elements of governance capacity that contribute to successful adjustment. In the context of the above case study, these include the following. Introduction of Withholding, Presumptive, and Fixed Taxes 35 * A government that was able to adequately articulate the need for the reforms as part of its overall vision of social and economic change, and successfully portray the losers in the reform (tax evaders and income tax officials) to the general public as the "devils" of the system, who had exploited the laws and led to a breakdown of the tax machinery, implying a slackening of the overall fiscal effort. * An approach to reform that was shown to be superior to other approaches in the costs imposed on society at large and the time frame for achieving gains. Mechanisms for tackling evasion were shown to be better than a policy of raising tax rates (to generate more resources from existing taxpayers) or stronger enforcement activity (leading to more harassment and corruption). * Ability to build a strong base of diversified support for the reform from business, employee, and other interest groups. * Strong leadership from the chief executive, the prime minister, who personally campaigned for the reform and presented proposals for its implementation. * Adoption of an approach that essentially bypassed one major loser, the income tax department, by decentralizing the process of tax collection. * Presence of credible threats to losers, that if the reform was not implemented, they would actually be even worse-off. For the income tax department, this meant large-scale retrenchment; for tax evaders, the prospect of stronger enforcement activity and detailed investigations. In a perverse way, therefore, potential losers stood to gain from the reform, which preempted even stronger action. * Opening of the budget-making process, leading to greater transparency and access to new, innovative approaches. * Lack of homogeneity and difficulty in -coordination within one major group of losers, the tax evaders. Transaction costs of building an organization and a common front were too high. Lobbying against reform had to be done by surrogates such as tax practitioners, lawyers, and accountants, whose level of commitment was not very great. * The reform package gained momentum over time, because it was able to demonstrate very quickly a considerable degree of success, as measured by the phenomenal growth in revenues. 4.30 Altogether, this reform experience was unique in the Pakistan setting, because most of the positive aspects of governance capacity came together in ensuring its success. 36 Governance and Fiscal Reform: A Study of Pakistan 5 Base-Broadening and Rate Reductions in Direct Taxes 5. 1 One of the major elements of the strategy of tax reform is to broaden the base of taxes, especially direct taxes, and simultaneously bring down tax rates. This will not only protect (and perhaps even increase) revenues by reducing the incentive for evasion, but will also lead to a more neutral and efficient tax structure with less distortionary effects on the economy. In this section, the success Pakistan has had in achieving this component of tax reform will be considered. Broadening the base through withdrawal of major exemptions is an excellent case study, highlighting the political economy of the tax reform process. Degree of Success in Implementation 5.2 As we described earlier, the income tax system of Pakistan is characterized by a large number of exemptions, tax credits, rebates, concessions, and the like, which have led to substantial revenue losses. The estimated magnitude of tax expenditures (revenue cost of the differential tax treatment) is colossal, and in excess of revenues actually collected, as shown in Table 13. 5.3 Major tax expenditures include statutory exemption of major public corporations (such as WAPDA and T&T), interest income from government savings instruments, agricultural income and wealth, capital gains on financial assets, tax holidays, salary perquisites in cash and in kind, export income, accelerated depreciation allowances, owner-occupied properties, and so forth. The total revenues foregone because of these exemptions and concessions is over 2 percent of GDP. This is one major reason that the direct tax/GDP ratio was very low, less than 2 percent of GDP in 1990-91, as compared with over 7 percent for other developing countries at a comparable stage of development. 5.4 Given these large-scale concessions, the government needed to pitch tax rates at relatively high levels. During most of the 1980s, the maximum marginal tax rate for personal income tax was as high as 60 percent. The corporate tax rate was 55 percent. These high tax rates had placed a premium on tax evasion. 5.5 The tax reforms pursued in Pakistan appear to have been launched with an upfront announcement of tax rates, without any link to a simultaneous removal of exemptions. In this sense, the approach of bargaining with particular social groups was not adopted. This has made it politically more difficult to subsequently withdraw concessions. 37 38 Governance and Fiscal Reform: A Study of Pakistan Table 13. Estimates of Tax Expenditure in Direct Taxes in Pakistan, 1990-91 (Rs million) Type of exemption / concession Tax expenditure Tax holidays 350a Capital gains on financial assets 1,1 00a Bonus shares 170b Salary perquisites 2,800b Interest income from government savings instruments 3,100b Income of public corporations 5,600b Agricultural income 3.000a Agricultural wealth 3,300a Rebate on export income 1,800b Accelerated depreciation allowances 1,200b Exemption of owner-occupied properties from wealth tax 700b Total tax expenditure 23,120 Total direct tax collection 19,868 Tax expenditure as percentage of revenue 116 a. Economic approach. b. Accounting approach. Source: Ahmed and others 1993. 5.6 In the Finance Act of 1991, the government announced an immediate slashing of personal income tax rates, with the maximum marginal tax rate cut to 35 percent. For the corporate sector, it was proposed to bring down rates substantially over a five-year period starting in fiscal year 1992-93. The decline envisaged by 1997-98 is from 66 percent to 55 percent in the case of banking companies, from 44 percent to 30 percent for public companies (other than banking companies), and from 55 percent to 40 percent for other companies. In addition, the supertax, or surcharge, on companies was withdrawn. It is likely that this measure contributed greatly to reduction in uncertainty about future tax rates and facilitated better investment planning. 5.7 Up to the budget for fiscal 1994-95. however, no major success appears to have been achieved in the rationalization of the major exemptions and concessions in direct taxes mentioned above. The last caretaker government (from July to October 1993) made a bold attempt at introducing both income and wealth taxation in the agricultural sector through ordinances. These were proposed as schedular, presumptive (linked to produce index units of land) taxes to simplify the process of administration. Tax rates were deliberately kept low to ' Some minor exemptions embodied in the second schedule of the Income Tax Ordinance have. of course, been withdrawn. This includes the tax credit on balancing, modernization, and replacement of machinery; income of Chambers of Commerce and Industry and stock exchanges: moderabas (after the first three years): some welfare trusts: and financial institutions. Base-Broadening and Rate Reductions in Direct Taxes 39 minimize resistance. The present government, however, with strong support from the feudal lobby and a rural vote bank seen in the 1993 elections, has allowed the agricultural income tax ordinance to lapse (except for one province, the NWFP), while the wealth tax proposal was accepted and embodied into law. In the latest Finance Act the special exemption to wealth in the form of agricultural land has been increased tenfold, from Rs 100,000 to Rs 1,000,000. This implies that although agricultural land is part of the wealth tax net, very few landowners will actually end up paying this tax. Also, agriculturists have generally refused to file wealth tax returns. 5.8 This failure in withdrawal of the major exemptions and broad-basing of taxes clearly demonstrates the lack of political will in government to take on the powerful social groups that enjoy special privileges in Pakistan. The historic opportunity to strike a bargain with these groups at the time tax rates were brought down appears to have been lost. The failure of this reform implied that potential revenue gains of between I and 2 percent of GDP have not been realized. This could have made a major contribution to reducing the budget deficit. Political Economy of the Reform 5.9 Determination of gainers and losers in reform that involves broad-basing the income and wealth tax, coupled with a reduction of tax rates, requires development of a simple methodological framework. 5.10 We designated the following: y = global income of a taxpayer YT = taxable income (existing provisions) YN = exempt income (existing provisions) to = existing tax rate (assumed for simplification purposes to be proportional, as in the case of corporate income) tj = new tax rate. The existing tax liability, To, can be derived as To = tOYT. (1) 40 Governance and Fiscal Reform: A Study of Pakistan In the event that all exemptions are withdrawn, the new tax liability, T , is given by: T, = tly. (2) 5.11 Therefore, the taxpayer is a loser if: T, > To that is, toyT < ti y t, VT and > _> to y tI V.. or -> 1-- to Y which transforms to - > - (3) y to 5.12 This implies that for the taxpayer, if the percentage of his income that was originally exempt exceeds the percentage decrease in the tax rate, then he is worse-off. 5.13 Therefore, taxpayers can be separated into losers and gainers from a reform package involving broad-basing of direct taxes and reduction of tax rates. The status of taxpayers under the reform depends primarily on the extent to which their income is in exempt forms. A similar result can be obtained in the case of the wealth tax. 5.14 This, however, essentially assumes that there is simultaneously a reduction in tax rates and a withdrawal of exemptions. If a two-step procedure is followed, as happened in Pakistan, then the results could be very different. If, in the first step, only tax rates are lowered, then all taxpayers benefit and there is unambiguous support for this reform. If a subsequent attempt is made to withdraw exemptions, all taxpayers with exempt income potentially lose (in relation to their position after the first step), and there is every likelihood that this phase of the reform will be strongly resisted. Therefore, the optimal strategy, which maximizes chances of success, is a simultaneous movement on both broad-basing taxes and reducing tax rates. Base-Broadening and Rate Reductions in Direct Taxes 41 Determinants of Success Role of Gainers 5.15 The real gainers from reform are the general population of relatively poor households, who can expect that a rise in direct tax collections will lead to some alleviation of the burden of indirect taxes, which fall primarily on them, or that the overall increase in tax revenues will lead to some reduction in the budget deficit and less inflationary financing, which burdens them with a disguised tax. 5.16 Given the complexity of the income tax code and the generally low level of literacy in Pakistan, however, there are serious information problems with regard to gainers. Very few people have knowledge of the wide array of exemptions and concessions embodied in the direct tax system. It is only recently that research by independent institutions has demonstrated the sizable tax breaks that exist, especially for the rich, in Pakistan. But an awareness campaign remains to be launched. The government has been reluctant to disseminate this information, lest it sharpen the class struggle and lead to a further decline in voluntary taxpayer compliance. 5.17 Knowledge of the favored treatment granted to agricultural income, however, is widespread. This has been a flash point of debate over the last forty-seven years, since the creation of Pakistan. It has now become a symbol of the conflict between the new, emerging urban middle-class and the traditional, rural, feudal elite. By now, the degree of polarization on this issue is complete. 5.18 Other gainers are social groups who traditionally have received most of their income in taxable forms. This includes salaried taxpayers, who have benefited significantly from the large decline in personal income tax rates. Nevertheless, this group is apprehensive that any change in the tax treatment of salary perquisites in cash or in kind will once again raise tax liabilities. The corporate sector has also gained, although in the short run the tax savings are not so sizable. Resistance, however, is likely to efforts to broaden the tax base by withdrawal of tax holidays, accelerated depreciation allowances, exemption on bonus shares, and the like. Role of Agents of the State 5.19 The attitude of agents of the state toward the reforms has been ambivalent. On the one hand, there is a commitment to a more neutral, less distorting tax regime. On the other hand, there is concern that if specially targeted concessions are withdrawn, there could be adverse economic consequences, and the government could be accused of being anti-agriculture, anti- export, anti-savings, anti-investment, anti-backward-areas, and so on. Consequently. the same degree of commitment was not visible on the part of the Nawaz Sharif government to this part of the tax reforms as to extension of presumptive and withholding taxes. 5.20 For example, in the context of withdrawal of the exemption of agricultural income, the IJI government was particularly vulnerable to the criticism that it was anti- agriculture, because it had strong support from business and trade interests in the cities. The 42 Governance and Fiscal Reform: A Study of Pakistan government had to consider that the feudal class still had considerable political clout, and would play a vital role in future elections. It is ironic that although the Nawaz Sharif government did not promulgate the agricultural income tax, it still lost in the rural areas of Pakistan in the 1993 elections. 5.21 Tactically, it appears that the government played its cards badly in the reform process. The opportunity to engage in bargaining with different social groups for a tradeoff between withdrawal of exemptions and reduction in tax rates was not utilized. There was too much of a hurry to appease the vote bank of business interests by announcing a reduction in corporate and personal income tax rates. Also, the Nawaz Sharif government was convinced that purely from the viewpoint of increasing private investment in the economy, it was necessary to bring about a reduction in tax rates. This conviction was perhaps motivated by a more dynamic understanding of the relationship between the growth of tax bases and tax rates (or supply-side economics). Role of Losers 5.22 Behind each major tax exemption or concession in Pakistan, there is a strong, entrenched, vested interest group. Each group has organized itself as an effective lobbying entity, which has not only blatantly demonstrated its power in political terms, but also has, in a more subtle fashion, played the game of seeking patronage through party donations, buying off influential politicians, and so forth, and has developed credible arguments to explain why retention of these exemptions and fiscal incentives is actually in the greater national interest. 5.23 Perhaps the best example of this is the agricultural lobby. It is extremely well- organized and enjoys enormous political power. A large majority of the elected members of the Parliament either represent the feudal class or are sympathetic to the interests of this group. It is not surprising, therefore, that any legislation to change the status quo is effectively blocked. A number of arguments have been developed to justify the tax exemption of agricultural income (see Figure 2), including the contention that the sector is already overtaxed through the pricing mechanism (domestic prices below world prices), that food production is vital for national security, and that the high costs of collection of the tax on agricultural income will not be justified because of the low likely revenue yield. Base-Broadening and Rate Reductions in Direct Taxes 43 Figure 2. Arguments against Withdrawal of Major Exemptions and Concessions in Direct Taxes Type of exemption/concession Arguments given in favor of retention of tax benefit 1. Tax holidays * Adverse impact on the overall level of private investment in the economy. * Difficult to divert entrepreneurs to backward areas, and thereby reduce regional disparities, in the absence of the fiscal incentives. * Need for tax breaks to induce private investment in high- risk, high-tech industries. * Support to infant industries. * Necessary for attracting foreign private investment. * Higher investment (resulting in increased production) yields higher indirect tax revenues (excise duty and sales tax), which more than justify the tax expenditure. 2. Exemption of interest income on government * Raise the level of household savings in the economy. savings instruments * Divert funds to government and reduce need for resort to inflationary mechanisms to finance the budget deficit. * Improve income distribution, because investment mostly by lower- and middle-income households. * Withdrawal of exemption confers no benefits to the exchequer because increased revenues will be used largely to increase pretax rates of return to keep post-tax rates of return constant. * Need for favored tax treatment to induce investment in long-term assets. 3. Capital gains on financial assets * Promote development of the capital market for channeling savings, especially through stock exchange. * Tax deductibility of interest payments has created preference for debt financing. Therefore, exemption of capital gains on financial assets is necessary to preserve incentive for equity financing. * The share price index is a barometer of the economy. If tax benefit is withdrawn, share prices will plummet. * Necessary to attract foreign portfolio investment in the stock market, which helps improve the balance of payments position. * Taxation of capital gains is difficult because scope for evasion in reporting of such income is high. * Capital gains must enjoy different tax treatment in any case, because it may largely represent inflation-linked, and not real, increases in value. 44 Governance and Fiscal Reform: A Study of Pakistan Figure 2. Arguments against Withdrawal of Major Exemptions and Concessions in Direct Taxes Type of exemption/concession Arguments given in favor of retention of tax benefit 4. Salary perquisites in cash or in kind * Employee remuneration package is relatively low in Pakistan. and tax break on perquisites is necessary to preserve reasonable standard of living. * If multinationals are to be attracted into Pakistan with high-level technical and administrative manpower, such tax breaks are necessary. * Provision of salary perquisites in kind automatically indexes a part of the remuneration package to inflation. * If benefits in kind are monetized into a cash salary, tax burden will rise disproportionately, and reduce incentives for greater effort. 5. Income of public corporation * These corporations provide basic services such as power, telecommunications, and the like. Growth in demand implies rapid growth in financing requirements, part of which can be met at relatively low cost through savings in tax payments. * The tax benefit keeps down prices of utilities and encourages growth in the economy. * The tax benefit reduces borrowing requirements of large public corporations, which effectively means lower budget deficit and interest rates. 6. Agricultural income/wealth * Agricultural income is already subject to heavy disguised taxation in the form of procurement and support prices that are significantly below world prices. * Taxation of agricultural income will reduce food production, which is vital for national security. * Taxation of agricultural income will impose high costs of collection, which will not be justified by the low likely revenue yield. 7. Rebate on export income * Vital to boost exports to improve foreign exchange position. Fiscal incentive is necessary, especially to achieve diversification of export products and markets. * There is strong anti-export bias because of the overvalued exchange rate and high protection against imports. Need to remove this bias at least partially through rebate. * Exports are supply-elastic and will decline precipitously if the income tax rebate is withdrawn. 8. Accelerated depreciation allowance * Need to raise post-tax rates of return, especially in initial years, to promote private sector investment in industry. * Need to encourage provision for depreciation to finance subsequent replacement investment. Base-Broadening and Rate Reductions in Direct Taxes 45 Figure 2. Arguments against Withdrawal of Major Exemptions and Concessions in Direct Taxes Type of exemption/concession Arguments given in favor of retention of tax benefit 9. Owner-occupied properties (from wealth tax) 0 Need to encourage home ownership as a means of security and comfort. * Since there is no cash income from owner-occupied property, there will be serious liquidity problems in payment of taxes. * Owner-occupied property is already subject to the provincial property tax. Removal of exemption will lead to double-taxation. * Widows, orphans, and others without large incomes will be adversely affected. In this sense, it will represent an oppressive form of taxation. Source: Public statements as witnessed by author, newspapers. 5.24 Tax holidays have been aggressively supported by industrial interests, which have formed an alliance with the provincial governments of backward areas. They have been successful in playing up the sensitive issue of the large and widening regional disparities in the country. The Ministry of Finance (a key agent of the state itself) has justified the exemption of interest income on government savings instruments on the grounds that this actually improves the income distribution because the bulk of the participants in such savings schemes are from lower- and middle-income households, and that this incentive reduces the need to resort to inflationary mechanisms to finance the budget deficit. 5.25 The need for retention of the capital gains on financial assets has been successfully argued by representatives of the stock exchanges in the country. The various associations of members of the stock exchanges have portrayed the share market as a barometer of the performance of government and the economy. They have stressed the need for fiscal incentives to attract foreign private portfolio investment, and thereby improve the balance of payments position, and so on. 5.26 Altogether, tax reform involving broad-basing of direct taxes by removal of major exemptions and concessions has been effectively frustrated by entrenched, powerful, well- organized, and articulate interest groups. The government has had to retreat in the face of opposition from such groups. It has been left with the worst possible outcome. Tax rates have come down, while the plethora of tax expenditures continue. Lessons Learned 5.27 The virtual total failure of government to broaden the base of direct taxes by withdrawal of exemptions or concessions leads to the identification of a number of factors that mitigate against success of reform initiatives. These include the following. 46 Governance and Fiscal Reform: A Study of Pakistan * Ambivalence and a resulting lack of commitment to the reform by agents of the state, arising from a perception that the reform may damage vital national interests such as food production, savings, exports, and the like. * "State capture" by special interest groups such as the traditional feudal elite, bureaucracy, defense establishment, and the emerging corporate business interests, which extract substantial rent from the existing tax expenditure system, and are unwilling to give up their privileges. * Bad implementation of reforms. By first reducing tax rates, the opportunity for bargaining with (and compensating) losers was lost. * Strong coordination among potential losers. Each group of losers had established representative and articulate bodies that could present their case and lobby intensively in the inner-sanctums of government, in Parliament, and in the popular press. * Dispersed gainers, consisting largely of relatively poor households with no taxable income, or households with taxable forms of income. There were serious information problems because of a general lack of knowledge of tax expenditures, which largely remain hidden from the public eye. * Successful campaign launched by potential losers that the status quo (that is, retention of tax incentives and concessions) is better. Potential gainers were convinced through well-presented arguments that they might be even worse-off if reforms were implemented. 5.28 This case study thus demonstrates how in the presence of negative elements of governance capacity, objectively desirable reforms can be largely frustrated. 6 Ongoing Reforms 6.1 The present elected government of the PPP under Benazir Bhutto inherited an economy beset with the continuing problems of a large budget deficit, a decline in the growth rate of the economy (from 6 percent to about 4 percent), and a perilously low level of foreign exchange reserves. In late 1993, soon after its installation, the government signed an agreement with the International Monetary Fund for the Extended Structural Adjustment Facility (of SDR 606.6 million) and the Extended Fund Facility (of SDR 379 million). The agreement involves wide-ranging reforms, to be implemented between 1994-95 and 1996-97, in diverse areas that include taxes and public expenditure, administered prices, intergovernmental fiscal relations, trade, the financial sector, privatization, deregulation, and agricultural pricing. One of the major macroeconomic targets in the agreement is a reduction in the budget deficit to about 3 percent of GDP by 1996-97. The path of fiscal adjustment from 1994-95 onward is predicated on structural reforms in taxation and public sector pricing and sustained efforts to reduce unproductive expenditure. 6.2 Within the area of tax reforms, the agreement focuses on several areas: first, reduction of wide-ranging exemptions and concessions in direct taxes (of the kind discussed in the previous section); second, development of the general sales tax (GST) as a modern, broad- based VAT (along with adjustments in excise taxes), and its extension to trade and services; and third, rationalization of trade taxes, primarily through tariff reforms that involve merger of para- tariffs, scaling down of the maximum tariff rate, and withdrawal of exemptions. 6.3 We discuss below the issues related to the ongoing process of broad-basing the GST and tariff reforms. Broad-Basing of the General Sales Tax 6.4 The primary motivations for broad-basing the GST, following its conversion to a VAT-style tax with tax invoicing features in 1990-91, are: first, to compensate for revenue losses from the ongoing tariff reforms (discussed in the next section); second, to move the tax base toward consumption to encourage savings; third, to achieve a more neutral tax structure by taxation of a broad range of items (excluding food and other necessities); and fourth, to bring about the process of greater documentation of the economy as a result of the incentives created for invoicing to claim tax refunds. Progress in Implementation 47 48 Governance and Fiscal Reform: A Study of Pakistan 6.5 The GST was levied on 59 additional industries between 1991 and 1993. Many of these industries are small in value, however, and revenue gains have been marginal. In an attempt to cover small units, a noninvoicable GST at the rate of 5 percent has also been introduced. Simultaneously, in some industries a kind of forfeit (shoora-e-tashkees) system has been introduced, leading to the negotiated fixed tax liabilities of all units within an industry. Some tentative attempts have been made to extend the GST to the wholesale and retail trade sector, and thus give it more of the character of a consumption tax. The Nawaz Sharif government was reluctant to fundamentally extend the tax net to this sector because of a virtual absence of documentation of transactions, and because the urban trading community represented a major support base for the IJI government. In the budget of 1993-94, primarily out of considerations of revenue enhancement, the standard GST rate was raised from 12 /2 percent to 15 percent. 6.6 The Finance Act of 1994 represents a major effort to broad-base the GST. An additional 277 industries, excluding those producing food items, have been brought into the tax net. Simultaneously, the fixed sales tax system has been abandoned on the grounds of inelacticity of revenues and low effective rates. This reform, however, led to a nationwide strike by business and trading interests that compelled the government to temporarily suspend the withdrawal of the fixed tax system and evaluate industries proposed for inclusion in the GST regime. Gainers and Losers 6.7 The potential gainers from reforms of the sales tax are the recipients of benefits financed by the additional revenues, or from the decline in inflation resulting from less deficit financing. Of particular significance in this context is that 80 percent of the revenues from GST accrue to the provinces, and are likely to be used largely for enhanced provision of social and economic services such as education, health, roads, and water supply. Also, large-scale units that have been placed at a competitive disadvantage are likely to support the collection of the tax from smaller units. 6.8 Losers are essentially industries that are brought into the tax net as a result of the broad-basing measure. Depending on the relevant price elacticities, however, at least part of the burden of the tax is shifted forward to consumers, who in this sense are the real losers. Opponents of the reform have argued that this will put a regressive tax burden on households. Given that the burden of the tax can be shifted, it is perhaps surprising that there is so much resistance from industry to the imposition of this tax. The reasons for this resistance are: first, greater documentation of transactions increases the ability of the tax department to more efficiently ascertain income tax liabilities; second, even though the system is based on self- assessment rather than supervised clearance of consignments (as in the case of excise duties), there is the prospect of payment of bribes to tax officials at the time of registration and the annual audit, and third, the VAT nature of the tax imposes substantially higher compliance costs on tax- payers because of the need to maintain proper records and accounts. These factors are responsible for the strong preference of industry for the fixed sales tax system. Also, it appears Ongoing Reforms 49 that special factors have been operative in 1994. Given the conditions of an economic recession, the view of business is that enhancements in indirect taxes at this time can only add to the problem of stagnant or declining output levels. Furthermore, given the impending tariff reforms, industry believes that imposition of the GST will further impair competitiveness with respect to imported goods. Determinants of Success 6.9 The support for mobilizing revenues from the GST has been greatly diminished by the indirect nature of this tax and its tendency to raise prices. There is widespread opposition in Pakistan to further enhancements in indirect taxes, which already account for the dominant share of revenues. These taxes are generally considered as regressive, distortionary, and inflationary in character. It is unlikely, therefore, that there will be major spontaneous support for the broad- basing of the sales tax, even if it is shown that it can fetch substantial additional revenues. From the viewpoint of both equity and efficiency, the popular demand is for resource mobilization through reduction in evasion and elimination of concessions in the direct tax system. 6.10 There is apparently a degree of contradiction in tax policy that highlights problems of commitment on the part of the agents of state. In the context of direct tax reform, the philosophy has essentially been one of simplification, reduction in compliance costs, and less direct contact with tax officials. This explains the move toward presumptive and withholding taxes (discussed in the fourth section). In the area of indirect taxes, however, the emphasis now is on the introduction of a broad-based VAT, a sophisticated tax that has found its place internationally only in the last two decades. It will require high levels of documentation and force substantially higher compliance costs on taxpayers. This contradiction has sent confusing signals about the broad directions of tax reform in the country. Many of the senior tax officials are not entirely clear about the mechanisms of operation and economic benefits of a VAT. The lack of commitment to a pure form of VAT is evidenced by the eagerness with which improvisations in the form of presumptive, fixed, or noninvoicable GSTs have been adopted in special cases in the past. Perhaps in recognition of the perceived lack of commitment to reforms in the GST, the prime minister, in her speech on the eve of the presentation of the budget for 1994-95, extolled the virtues of a sales tax. 6.11 It also appears that the pace of implementation of the reform has been artificially increased by the presence of IMF conditionalities. Consequently, the broad-basing is taking place without adequate strengthening of the tax department, proper survey, registration and education of taxpayers, and printing and circulation of forms. This will jeopardize the successful implementation of the reform proposals. 6.12 The strong resistance to extension of the GST has motivated government to take some potentially significant actions. The most important tactical move is to bifurcate the present chambers into separate bodies for trade and industry, respectively, on the grounds that interests fundamentally differ. Traditionally, industry has had the necessary lobbying powers in the corridors of Islamabad (as demonstrated by the effectiveness of All Pakistan Textile Manufacturers Association, APTMA), while trade has provided the street muscle at times of 50 Governance and Fiscal Reform: A Study of Pakistan agitation. The break-up of this coalition could potentially weaken opposition to reforms such as a scaling down of tariffs or broad-basing of the GST. It is also possible that in subsequent attempts at reform, government may try to split existing taxpayers away from new entrants into the tax net by simultaneously announcing a reduction in tax rate (say, back to 12 '/2 percent) and a major broad-basing initiative, such as extension of the GST to the retail level. 6.13 The effectiveness of losers in organizing a coalition to resist the reform has already been demonstrated. The success achieved will strengthen the motivation to block future changes. A crucial time will arrive next year, when a fundamental step is proposed by government (as part of the agreement with IMF)-to extend the GST to the wholesale and retail trade. 6.14 The experience with reforms of the GST demonstrate how an effective coalition of potential losers can be organized in the presence of weak support for the reform from potential gainers that results from the dispersed, uncertain nature and uneven distribution of gains, and agents of state who have demonstrated some lack of consistency, commitment, and preparedness for the reform. Tariff Reforms 6.15 As highlighted earlier, Pakistan's taxation system is characterized by excessive dependence on taxes on international trade. Statutory tariffs are high, and while these were justified in the past on the basis of the "infant industry" argument, their continuation has perpetuated excessively high levels of protection to a large number of industries, including those that are inefficient (either with negative value added at world prices or high domestic resource costs). This has led to a large-scale diversion of resources toward import substitution and created a strong anti-export bias. High tariffs have also encouraged rampant smuggling (of over 5 percent of GDP according to PIDE 1993), which has not only eroded the tax base and adversely affected industrial production, but has also implied all the social evils associated with the generation and use of illicit incomes. 6.16 Technical flaws have also crept into the tariff structure. Ad hoc tinkering with rates, largely for revenue purposes, has created fiscal anomalies. There is no rational "cascading" of rates, and average rates do not vary significantly by stage of processing. High statutory tariffs have led in many cases to the promulgation of SROs to grant exemptions or concessions by region, type of end use, or nature of importer. This has greatly complicated customs administration and promoted corruption and rent-seeking activity. In 1992-93, almost half of dutiable imports paid concessionary duties under the provisions of some SRO. Therefore, tariff reforms are required, not only from the viewpoint of influencing the future process of industrialization of the country in the desired directions, but also for rationalizing the tax regime, making it simpler to administer and transparent, while using fiscal policy as the prime instrument for tackling the problem of smuggling. Progress in Implementation Ongoing Reforms 51 6.17 A gradual process of reforms in the trade regime has been ongoing in Pakistan for some time. In the first phase, quantitative restrictions on imports were largely removed, and the "negative" list now largely consists of items that are prohibited for religious or other reasons. During the last few years, the maximum tariff rate (except for automobiles) has been brought down from 225 percent to 80 percent. Efforts at reform have been piecemeal in character, however, and no attempt has been made to bring about comprehensive changes that eliminate fiscal anomalies and provide well-defined signals for allocation of domestic resources. 6.18 The last caretaker government formed a Tariff Reforms Committee to develop a new tariff structure to be implemented over a three-year period, keeping in view the impact of the proposed changes on levels of effective protection to industry, overall tax revenues, and the trade balance. The committee had interministerial representation, and also sought the view of leaders of major industries. 6.19 The committee made a large number of recommendations, including: first, the abolition of para-tariffs; second, scaling down of the effective (inclusive of surcharges and license fee) maximum tariff from 92 percent to 50 percent over the three-year period; third, cascading of tariffs, with lowest rates for noncompetitive, primary raw materials, and highest rates for finished goods; fourth, promotion of exports by duty-free imports of raw materials, intermediate goods, and machinery for export-oriented sectors, while simultaneously phasing out the cumbersome and difficult to administer export rebate scheme; fifth, protection to locally fabricated machinery; sixth, duty-free imports of food and other basic items; seventh, sizable tariff reductions on items prone to smuggling; eighth, large-scale withdrawal of SROs, including removal of differential treatment between industrial and commercial importers and concessions to public sector entities; and ninth, introduction of minimum tariffs to reduce rate dispersion. 6.20 The committee carried out case studies of effective protection, before and after reforms. Contrary to expectations perhaps, it was able to demonstrate that protection actually increased in over half of the industries studied following reform, despite lower levels of tariffs, primarily because of cascading. Also, preservation of revenue neutrality was proposed, with 50 percent of the revenue losses being recovered by phasing out SROs, 35 percent by broad-basing of the sales tax, and 15 percent by withdrawal of exemptions in the income tax regime. Impact on the level of imports was not considered to be sizable, because the stimulatory effect exercised by lower tariffs was likely to be counter-balanced by the withdrawal of concessions and the introduction of minimum tariffs. 6.21 The major tariff reform package accepted by the present government as part of the Structural Adjustment Program with the International Monetary Fund incorporates many of the principles of reform enunciated by the committee. It envisages a faster program of reduction of tariffs, however, with the maximum tariff brought down to 35 percent (rather than 50 percent, as recommended by the Tariff Reforms Committee) by the beginning of fiscal year 1996-97. The first phase of this reform package has already been implemented in the 1994 Finance Act, which merges para-tariffs into the basic tariff structure; reduces the maximum tariff to 70 percent: withdraws some SROs, including the distinction between commercial and industrial importers; and makes drastic reductions in rates on items prone to smuggling. Neutrality of tax 52 Governance and Fiscal Reform: A Study of Pakistan revenues has generally been preserved by the revenue gains from the merger of para-tariffs and the consequent favorable effects on sales tax collections. 6.22 The impact on levels of protection has not been very pronounced in the first year of reform because of the merger of para-tariffs. While industries with competitive imports at the maximum tariff rate have experienced some decline, most industries have yet to receive the shock of downward adjustment in tariffs on competitive imports. For the same reason, the impact on the level of imports is unlikely to be significant. Potential Gainers and Losers 6.23 Tariff reforms of the kind envisaged under the ESAF will represent one of the major events in the industrial history of Pakistan, with vital implications for income distribution, many of which have not yet been fully understood. In broad terms, protection levels for a large number of industries will be altered dramatically; some will gain and others will lose. Beneficiaries will include industries where the tariff rate on output will fall less than the tariff rate on intermediate inputs, while the opposite case will apply to losers. There is considerable uncertainty at this early stage of the reform process about to the industrywide distribution of gains and losses. This uncertainty is partly the consequence of the strategy pursued by the government in implementation of the reforms. The Tariff Reforms Committee had recommended that an open and transparent approach be adopted whereby industry was consulted at every stage, and at the micro level that views be incorporated subject to adherence to the broad principles of reform. It was proposed that model tariff schedules be prepared for each year of the three-year reform period, and circulated in advance to representatives of trade and industry to elicit their views. 6.24 This has not happened. Instead, the traditional approach of maintaining total secrecy until the announcement of the Finance Bill has continued. Consequently, there has been a spate of complaints from various industry groups about the emergence of new fiscal anomalies, and the government found it necessary to form a committee to address these problems. Perhaps in the view of the policymakers, the only viable approach is to create a de facto situation, and then handle the fallout. The alternative of an advance announcement of the details of the reform package could lead to the formation of strong coalitions to block the change. 6.25 While the strategy adopted may minimize the resistance of losers in the short run, it also carries a risk of failing to mobilize support from potential gainers. Given the complex nature of the tariff reform process and its wide-ranging ramifications, it is clear from a political economy perspective that the active resistance of potential losers has to be traded off against the aggressive and vociferous support of potential gainers. This can only happen, however, if the potential gainers clearly perceive the gains, and are then able to lobby in favor of the reforms. 6.26 Serious informational problems also exist with the broad mass of consumers who will benefit from the reduction in the landed costs of imported consumer goods and through a fall in profit margins on smuggled goods because of greater competition from official imports. The government must identify specific cases of price reductions in major consumer items (for Ongoing Reforms 53 example, bicycles and electronic goods) brought about by the tariff reforms and advertise them in the popular press and media to create broad-based support for the change. 6.27 One of the key target groups of gainers from the reforms is exporters, who not only benefit in a broad macroeconomic sense from the narrowing of the differential between the effective exchange rate on exports and imports, thus tilting relative profitability in favor of the latter, but also in a more direct and visible manner through the elimination of duties on imports of raw materials, intermediate goods, spare parts, and machinery for export purposes. This coincides with the phasing out of the export rebate regime, however, which had become a mechanism for making large but hidden transfer payments to many exporters. As such, support for tariff reforms from exporters is likely to remain muted. 6.28 Since the announcement of the tariff reforms package in the budget speech of 1994-95, there has been a growing recognition of the disequilibrium that this will create in the industrial sector, and a general apprehension that there will be serious dislocation, large-scale plant closure, and labor displacement. The downward adjustment in the maximum tariff rate from 92 percent to 35 percent within three years is being seen as too rapid in view of the rigidities in response mechanisms arising from the high costs of capital, union agreements, lack of technology transfer, and the like. In the minds of losers, this reform will contribute, at least in the short run, to a process of deindustrialization in the country, and there will be a flood of imported goods, which will not only lead to a major deterioration in the balance of trade, but will also price out domestic industry. Given that this set of reforms is part of the agreement with the IMF, there is also the perception that the initiative is not indigenous in origin. 6.29 Withdrawal of SROs is likely to pose the same problems confronted in the removal of major exemptions from the income tax (discussed earlier). The government will have to contend with the pressure and lobbying powers of powerful special interests. First, the multinationals, which have invested in import-substituting industries with high levels of profitability in a protected market, will be adversely affected by the scaling down of tariffs. This includes sectors such as chemicals, automobiles, and polyester fiber. Second, removal of the preferential treatment given to imports by major public sector importers such as WAPDA, PTC, and OGDC will be strongly resisted on the grounds that this will imply higher project costs and necessitate higher levels of borrowing, while leading to higher utility prices. Third, the case for retention of fiscal incentives such as exemption of import duties on machinery for rural industrialization will be strongly argued at the political level as a means of removing regional disparities. Of course, as tariff levels come down generally, the value of concessions should decrease substantially. The government has recently tended to move in the opposite direction of that required by the tariff reforms, by granting duty concessions for power generation and import tractors. Determinants of Success 6.30 The true test of implementation of the reforms will come next year, when by agreement the maximum tariff rate will have to be reduced from 70 percent to 45 percent, with a 54 Governance and Fiscal Reform: A Study of Pakistan consequent downward change throughout the tariff schedule, and it will no longer be possible to cushion the impact by merger of para-tariffs. 6.31 Success will hinge largely on the government's ability to orchestrate the process and mobilize support from potential gainers, including specific industries, commercial importers. consumers, and exporters, while introducing safety nets to minimize the social costs of adjustment, including provisions for Social Security, labor retraining, credit for modernization, and the like. It is also of significance to note that up to now resistance has come from owners of industrial capital, but as some industries run into structural problems and there are retrenchments, the trade unions could also launch a protest movement. This will create special problems for the present government, which has a strong vote bank in unions and is sympathetic to labor interests. There will be difficulties in selling the argument-because of the inevitable time lags-that employment will eventually be promoted by the increase in labor-intensive exports. 6.32 Implementation problems are also likely to be compounded by the degree of ambivalence and apparent lack of full commitment of agents of state to the tariff reform process. First, there are genuine concerns voiced by the tax administration and the Ministry of Finance about whether the transition can be achieved in a revenue-neutral manner, without exacerbating the already existing problem of the large budget deficit. Reductions in customs duty revenues (of about 3 percent of GDP) will require quantum jumps in revenues from domestic taxes such as the income, sales, and excise taxes. Growth in income tax revenues is limited by the presence of large tax expenditures, described earlier, and the state appears to be have been captured by special interest groups. Broad-basing of the sales tax will hinge on the level of taxpayer compliance and greater documentation of transactions. Existing excise duty rates are high, and further enhancements could be counter-productive. Also, the federal government could be a major loser, even if overall revenue-neutrality is somehow achieved, given the nature of revenue sharing arrangements whereby customs duties are outside the divisible pool, while income and sales taxes are shared with the provinces (as described earlier). 6.33 Second, there is a degree of pessimism with regard to the possibilities of export growth in the short-to-medium run, given the limited product diversification and low quality of Pakistani exports, the increasingly competitive international environment, and adverse supply- side factors. There is some apprehension that any deterioration in the trade balance will lead to destabilization brought about by cumulative exchange rate depreciation. In broad terms, a strong level of commitment of agents of state to the process of tariff reforms, as part of the overall vision of the government about industrial development, does not appear to exist. 6.34 The next two years will determine the success or failure of this package of reforms. The government will have to carefully orchestrate the reforms by playing off gainers against losers. The former will have to be identified through microeconomic research, and their support for reform mobilized. A vigorous public awareness campaign will have to be launched to acquaint the larger population with the immediate and long-term gains from the reforms, including consumer benefits, less corruption and smuggling, and the like. Losers may have to be compensated by establishment of safety nets, including unemployment benefits, credit facilities, and subsidized labor training programs. In the absence of these steps, there is a danger that the Ongoing Reforms 55 tariff reform process may be interrupted by resistance from a broad coalition of industrial and labor interests, as happened with the broad-basing of the GST this year. 56 Governance and Fiscal Reform: A Study of Pakistan 7 Conclusions 7.1 This paper has adopted both a macroeconomic and a microeconomic focus to analyze the relationship between governance capacity and successful adjustment. It examines the degree of success or failure in implementing two major elements of fiscal reform in the Pakistani setting, one relating to the introduction of presumptive/withholding taxes as a means of simplifying the tax system and combating evasion, and the other dealing with broad-basing of direct taxes by rationalizing tax expenditures. It also analyzes two ongoing reforms relating to broad-basing of the general sales tax and tariff reforms. 7.2 The paper demonstrates that while a government can meet with exceptional success in one area, it can be confronted with ignominious failure in another. The Nawaz Shariff government achieved notable success in extending the network of presumptive/withholding taxes because a number of favorable factors of governance came together, including the projection of the reform as an integral part of the vision of change, demonstration of superiority of the reform to other available actions, building a strong and diversified coalition of support, strong leadership from the top, by placing losers in a negative light, bypassing losers, presence of credible threats to losers, lack of homogeneity of losers, initial success of reforms, and an opening up of the budget-making process. 7.3 In contrast, elimination of tax concessions and exemptions to make the tax system more neutral and fair floundered because of ambivalence toward the reform on the part of agents of state; state capture by special interest groups; lost opportunities for bargaining with potential losers, strong organization and lobbying power of losers as opposed to the dispersed nature, uncertainty of benefits, and lack of information of the gainers; and launching of a successful campaign by losers that the status quo is actually in everybody's interest. 7.4 Similarly, the partial retreat by the Benezir Bhutto government from implementation of reforms in the general sales tax this year reveals how an effective coalition of potential losers can be organized (with street agitation) in the presence of weak support for the reforms from gainers because of the dispersed, uncertain nature, and uneven distribution of gains, and agents of the state with a lack of vision, commitment, and preparedness for the reforms. 7.5 The ongoing tariff reforms will require a high level of governance capacity for the careful orchestration of the reforms by skillfully playing off gainers against losers. The imperatives and need for reform have to be successfully demonstrated within the overall vision of industrial development. A vigorous public campaign will have to be launched to acquaint the larger population with the immediate and long-term gains. Support of specific groups of gainers, 57 58 Governance and Fiscal Reform: A Study of Pakistan such as commercial importers, exporters, and consumer groups may have to be mobilized. Compensatory mechanisms will need to be developed for losers, and a more transparent process of negotiations will need to be adopted to create a greater sense of ownership of the reforms. 7.6 The next two years will represent a major milestone in the path of fiscal reforms in Pakistan. As part of the ESAF, deep cuts will have to be made in tariffs, and the sales tax extended to one of the most difficult to tax sectors, wholesale and retail trade. 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