Dr. Sher Afghan Asad
Tax policy plays a vital role in the economic development of any country. All countries support economic activity through the use of tax policies. Through the judicious use of taxes, governments can promote specific sectors of the economy, limit others, and redistribute wealth. Tax policy includes how taxes are imposed, in what amounts, and on whom. Typically, a tax policy specifies a tax code that applies to all economic activities along with deviations from the standard code. These deviations are called “tax expenditures” and include provisions for preferential tax rates, exemptions, deductions, allowances, rebates, deferrals, and credits. Tax expenditures are used to grant differential tax treatment to various economic activities.
By their very nature, tax expenditures introduce distortions in the tax system. Preferential tax treatment for one sector encourages investors to invest in that sector when they may not have done so without the tax incentive. For example, the real estate sector in Pakistan has attracted massive capital due to low statutory taxes (and high evasion opportunities).
Tax expenditures are of importance not only for their effect on economic activity but also for their revenue implications. For Pakistan, in a recent tax expenditure report, the FBR has estimated federal tax expenditures to amount to PKR 1,482.3 billion, or 31.2 percent of the federal tax revenues in the fiscal year 2020-21, which are distributed among sales taxes (49.9 percent), income taxes (27.0 percent), and customs duties (23.1 percent). It is important to note that these estimates capture only the mechanical effect of the tax changes, i.e., they assume the economic activity or the reporting behavior of taxpayers does not change in response to the tax policy. Accounting for the behavioral effects, such as changes in economic activity or differential reporting by taxpayers, may substantially change the magnitude of the estimates. Additionally, these estimates do not consider the above-mentioned preferential treatment of capital gain taxes from real estate as expenditures. Nevertheless, these estimates highlight the importance of tax expenditures and their role in determining overall tax revenues in Pakistan.
The significant revenue impact of tax expenditures requires that they be carefully evaluated and rationalized. Pakistan’s government has historically lived beyond its means, leading to ballooning debts and hefty interest payments. Every year, the government spends more than one-third of the budget on interest payments (in addition to another third on defense). The total debt is close to 90 percent of GDP. The only sustainable way for the government to reduce its obligations is to reduce the size of the fiscal deficit, i.e., bridge the gap between spending and revenues. Pakistan’s tax-to-GDP ratio compares dismally to other countries at a similar level of development. Figure 1 shows Pakistan consistently lies near the bottom in terms of tax-to-GDP ratio compared to Asian and Pacific countries. Since tax expenditures are responsible for the loss of almost one-third of federal revenues, it warrants that they be rationalized for maximum economic impact with minimal revenue loss.
Figure 1: Tax to GDP ratios: Pakistan versus Asia-Pacific average
Source: OECD (2022), Revenue Statistics in Asia and the Pacific 2022
Countries generally incur tax expenditures for a variety of reasons as shown in Figure 2. These can be categorized into three broad objectives, including 1) supporting economic activity, 2) providing tax protection to specific groups, and 3) encouraging public goods provisions. The argument behind tax expenditures is that it is an alternative means to achieve particular fiscal and social objectives by governments instead of through direct government spending, i.e., many of these same objectives could instead be achieved through government expenditure programs (and hence the name tax expenditures).
Figure 2: Stated Policy Objectives of Tax Expenditures in the World
Source: Author’s Calculations from Global Tax Expenditure Database
Pakistan lacks a well-defined and transparent policy and regulatory framework to guide tax expenditures. The lack of transparency in reporting and accounting for tax expenditure programs invites fiscal opportunism through exemptions for special interest groups. This is facilitated by ad hoc law-making through Statutory Regulatory Orders (SROs). SROs have been used with impunity to dole favors and preferences to special interest groups. While the power to grant concessionary SROs has been withdrawn from FBR’s domain and granted to the elected parliament instead, their frequency has not declined during the last two decades (as shown in Figure 3 for sales tax concessions).
Figure 3: Use of Concessionary SROs by FBR for Sales Tax
Source: Author’s calculations using data from FBR’s Sales Tax SROs
The discretionary award of tax concessions creates an uneven playing field. However, the overall impact on the competitive environment, specific industries, exports, tax revenues, and national output has not been studied systematically. The author of this blog (with his colleagues) is already undertaking such analysis due to the support of the International Growth Center.
Examination of Pakistan’s reported tax expenditure reveals that around 1500 provisions in the law enabled various concessions amounting to PKR 1.27 trillion (one-third of federal tax revenues) in the fiscal year 2020-21. Almost half of these concessions were targeted toward sales taxes (Figure 4), and the primary beneficiaries of these exemptions were businesses, followed by households (Figure 5). There is no systematic data on the policy objectives of the concessions. Although the publicly available data is limited, it appears that, other than the non-profit sector, the primary beneficiaries of tax expenditures in Pakistan include the automotive, retail, agriculture, telecom, and textile sectors.
Figure 4: Distribution of Tax Expenditures by Taxes
Source: Author’s calculations using data from Global Tax Expenditure Database
Figure 5: Distribution of Tax Expenditures by Beneficiaries
Source: Author’s calculations using data from Global Tax Expenditure Database
In Pakistan, as in most other low-income countries, many tax expenditures are targeted toward attracting investments. However, it is not clear whether these exemptions are necessary or effective, i.e., whether the investment wouldn’t happen in the absence of exemption or that it would have happened anyway and the expenditures are just contributing to the fiscal costs. A study by IMF shows that good governance is probably more important than the size of incentives in attracting investments.
To summarize, this piece has highlighted that tax expenditures are common across the world but there is little evidence of their effectiveness. On the one hand, tax expenditures can help achieve some efficiency or distributional goals. On the other, they may introduce significant distortions in the tax system that may increase the deadweight loss on the economy. In addition to understanding the impact of tax expenditures, it is important to understand how these expenditures arise in the political economy context of Pakistan. Pakistan has long suffered because of the lack of reporting on tax expenditures, which finally led to the promulgation of the Public Finance Management Act 2019, which required the federal government to present estimated tax expenditures to the National Assembly on an annual basis along with the budget. Detailed and accurate reporting of tax expenditures will go a long way towards ecouraging debate and improving the efficacy of these expenditures.
Dr. Sher Afghan Asad is an Assistant Professor of Economics at the Lahore University of Management Sciences (LUMS).