Elasticity and Buoyancy of theTax System in Pakistan

By Afsar Nafees

Key Terms

Tax: To tax is to impose a financial charge on a taxpayer (an individual or legal entity) by a state. Direct Tax: paid directly to the government by the persons on whom it is imposed. For the purpose of the charge of tax , all income is classified under the following heads:1)Salaries, 2) Interest on securities 3) Income from property;4) Income from business or professions 5) Capital gains; and6) Income from other sources.

Indirect tax

• Indirect tax: collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the customer). The intermediary later files a tax return and forwards the tax proceeds to government with the return

1. Customs 2. Sales tax3. Central excise duty

Importance of tax• Growing expenditure in a country is considered a prerequisite for

economic growth, due to which in most of the developing countries expenditure growth rate commonly exceeds the rate of national income growth. On the other hand, economic growth increases the taxable capacity and enables , to obtain a larger share of national income in the form of tax revenues. Therefore, developing countries usually depend on their tax system to generate adequate revenues in order to finance their ever-expanding expenditures

• fiscal problems occurs, when the tax responsiveness remains below than that of expenditures than efforts are needed in this area to analyse the sources of revenues and their responsiveness in order to maximize the revenues

Tax Elasticity and Buoyancy

• The response of tax revenues to changes in the GDP is measured by tax elasticity and tax buoyancy.

These concepts,

a) help to explain the overall structure of a tax system.

b) serve as valuable analytical tools for designing tax policy.

Tax buoyancy

• Tax buoyancy measures the total response of tax revenues to changes in national income. Takes into account both the effect of increases in income and discretionary changes (i.e., tax rates and bases) on the revenues from a tax.

• Tax buoyancy is a measure of both the soundness of the tax bases and the effectiveness of past tax changes in terms of revenue collection.

Tax elasticity

• measures the pure response of tax revenues to changes in the national income.

• reflects only the built-in responsiveness of tax revenue to changes in national income.

• The tax elasticity calculation excludes the impact of changes in tax rates and tax bases. It considers only the effects due to changes in income levels, whether or not changes were made in the tax structure during that time period.

importance

• An elastic tax system is a highly desirable system, as it provides the government with a sustained fiscal resource base for financing its outlays.

• Inelastic tax system forces governments to continuously make discretionary changes, either in the tax bases or in the tax rates or both.

Importance

• A tax system that is subject to constant adjustments by policy-makers generates greater uncertainties and has adverse effects on long-term investments, due to uncertainties in the tax system.

• A comparison of buoyancy and elasticity coefficients gives the analyst a useful insight into the tax system.

REVIEW OF TRENDS IN DIRECT AND INDIRECT TAXES

• Pakistan has not been able to generate more than 14 % of tax revenues in relation to GDP.

• 3 Weaknesses of Pakistan’s tax system include– Narrow tax base,– over-reliance on indirect taxes– weak tax administration

• Example:– personal income tax had employee fringe benefit exempted .– Taxation of Gross income exemption amounted to Rs100,000 in

2003-04.– Agricultural tax was not fully implemented due to loopholes– Industrial sector had enjoyed tax holidays in 1960s’-70.

SHARE OF DIRECT AND INDIRECT TAXES AS A PERCENTAGE OF GDP

• Till late 1980s the Direct taxes were average 2% of GDP. Reason was tax holidays from 1960s-70s & exemptions.

• In the 1990s it rose above 3% of GDP. It is important to note that the increase in the share of direct taxes in the 1990s has come from the massive increase in the withholding taxes.

• In the late 1960s,withholding taxes were levied only on three sources of income: salaries, interest on securities, and payments to non-residents.

• Until 1979, six kinds of payments were subject to withholding tax, which increased to 19 in 1994-95 and to 25 in 1999-00

shares of direct and indirect taxes as apercent of total taxes

• indirect taxes declined from 86.8 percent to 68 percent reason Customs duties which formed the major chunk of tax revenues until early 1980s,have been rationalised from a maximum rate of around 125 percent in 1987-88 to 25 percent in 2002-03

Trends in the indirect taxes

• the share of customs duties in total indirect taxes also declined from 54 percent in 1990-91 to 19 percent in 2002-03

• In 1989-90 generalized sales tax was introduced comprehensively to increase tax compliance.

• In 2003-04 the sales tax has been fixed at 12.5% for all entities.

Empirical result

• The high elasticity of sales tax is attributed to the extension of sales tax to electricity, gas, and petroleum products.– They are inputs to all the production and

distribution networks in the economy– The demand for inputs is inelastic which means the

revenues from sales tax is more elastic.

Elasticity Estimates with respect to relevant basesUsing only Relevant Bases

• The income tax is only 35 percent of the total

tax revenue, and its elasticity is 1.15 despite the inclusion of Withholding tax which accounts for 70% of net income tax.

• Sales tax accounts for 64 percent of the revenues from indirect taxes

• sales tax on domestic output with respect to non-agricultural GDP base is the highest—1.81• Reason- petroleum gas & electricity are included in sales tax since 1999.

– The report of SBP revised end of year targets for inflation upward due to the rapid increases in petroleum prices resulted in decline in sales tax revenues from kerosene oil because the poor switched to cutting trees for fuel.

• elasticity of sales tax for imports is 1.23• elasticity of customs duties on imports is exceptionally

low at –1.25– The reduction in in tariffs of custom duty is picked up by sales

tax

Decomposition of Tax Elasticities• The process of decomposing of tax elasticities is

helpful in – identifying the dynamic and the lagging areas of the

tax system.– the governments can influence the tax to base

component to improve the elasticity of a particular tax

DIRECT TAX• the base-to-GDP elasticity is low,– occurance of tax exemptions and evasion both in the formal

and the informal sectors – unchecked growth of the informal sector

• The higher tax-to-base elasticity for income tax reflects the inclusion of the withholding taxes in income tax

CUSTOM DUTY• the base-to-GDP elasticity is low– the exemption from wide range of raw materials and

machinery

SALES TAX• high tax-to-base elasticity

that the tax net has been widened with the inclusion of electricity, gas, and petroleum product

EXCISE DUTY• Elasticities of the three components for excise

duties are less than unity– Low tax collection relative to the base is

attributable mainly to replacement of excise duty by the sales tax.

Overall reasons for low elasticities are cheaper smuggled as well as imported goods present in the domestic market has resulted in loss of revenues in sales and excise tax.

CONCLUSIONS AND POLICY RECOMMENDATIONS

• The low elasticites of the tax system confirm the existence of continued exemptions, allowances, and loopholes for evasion.

• The reforms in the tax structure since late 1990s—in terms of a relatively cleaner administration facilitating the tax-payers—and the broadening of the sales tax base are visible

• Efforts to increase the share of direct taxes are extremely limited.– There is an artificial increase in the share of income tax, which has

adverse implications for a genuine increase in income tax revenues

• Broadening of the sales tax base is a positive development• The decline in the customs duty coefficients is picked up by the

sales tax revenue from imports.• The capital gains on equity remain exempted from tax while

sales tax on petroleum products and utility prices has directly affected the common man with limited resources.

• Easy way to realize revenue is through imposing sales tax on petroleum products & a higher sales tax rate on luxury items which would prevent the taxation on essential items such as basic inputs to the production & distribution processes

• This would help increase production and hence employment• High cost of production is factor inhibiting investment which

calls for coordination between the revenue department, investment ministry.

THANK YOU!