The Great Divide

Written by Chris Cork • June 2008

The federal budget currently under construction is going to be a difficult balancing act; how to increase tax revenues without alienating vested interests or producing the tensions that lead to civil strife, inquires Chris Cork

Political orthodoxy dictates that the annual budget process in Pakistan is geared to the needs of ‘the common man’, a fiction maintained by every government since partition. The ‘common man’ as understood by most – including those who see themselves as ‘common men’ - will typically be married and with a multitude of children, have a poor diet and may be malnourished but not yet starving, and is likely to be either illiterate or have a very low level of functional literacy. What will identify the ‘common man’ most easily in the mind of himself and the rest of the world is the fact that he is poor – poor in every respect; poor of education, assets, opportunity, influence, food, money – the poverty of everything that cripples both an individual and a nation.

Poverty is the defining feature of life for the common man in Pakistan, and the definition of poverty is endlessly redefined and haggled over, usually to ensure that it can be shown that political action has reduced poverty in some way. Poverty reduction programmes have been a part of every budget for decades and political claims to have subsequently reduced poverty have mostly been proved wrong – poverty in Pakistan is increasing inexorably and no single budget is going to fix the problem.

Understanding the relationship between the budget and poverty necessitates an understanding that poverty is not a ‘steady state’ and has gradations and variations. A recent study by the Centre for Research on Poverty and Income Distribution (CRPID) indicates that 63% of those defined as poor – using a mean over a basket of definitions to iron out the differences – are now in the category of ‘transitory poor’, or below the poverty line for the majority of the time but not always in any defined period. Of the rest of the poor population 32% are chronically poor and 5% are extremely poor. The chronic and extremely poor groups are always below the poverty line for all of the time in any defined period. Of those who live above the poverty line 13% and 21% of the total non-poor were classified as ‘transitory vulnerable’ and ‘transitory non-poor’ respectively. We are thus able to see that the words ‘poverty’ and ‘poor’ are far from definitive, and families and individuals can move in and out of poverty and once in poverty may experience it at a range of levels.

Increasing numbers are moving from ‘transitory poor’ to ‘chronic poverty’ principally as a result of the endemic inequitable distribution of income and wealth, a monopoly of assets by a wealthy minority and a tax regime that always favours the rich over the poor. The tax burden for the poor and almost-poor has increased by about 35% in the last decade (taxes from all sources, direct and indirect) whilst there has been little or no increase in taxes due or collected from the richest 2% of the population. What can the upcoming budget do, if anything, to narrow the inequality gap and produce a taxation system that spreads the burden a little more equitably?

Having a large and poor population limits the opportunities for direct taxation, and in that sense successive governments are tied to indirect taxation as a means of collecting tax revenue. Indirect taxation is of necessity biased against the poor and places a greater burden on lower income households. It is the only reliable tax-income stream in a country where the poor predominate, are not part of a deducted-at-source tax regime – and would avoid compliance even if they were.

However, being poor does not exempt an individual from taxation, but being rich does give the individual the opportunity of tax avoidance which is an opportunity availed by a significant proportion of those in the higher deciles. Even where the are ‘pro – poor’ tax exemptions that might be seen to favour the common man the tax man still gets his cut. Rice and wheat are zero-rated of GST – which takes no account of the fact that the commodities that go into the production of these staples are not zero-rated. Thus, though there is a nominal zero rating for rice and wheat the effective tax rate on these essential foodstuffs is 7%.

A report by the Social Policy and Development Centre in May 2005 says that the poorest 10% of households contribute 16% of their income to the three indirect taxes – General Sales Tax (GST), Central Excise Duty (CED) and Customs Duty. However the burden of tax progressively declines as income rises and the report concludes that the richest 10% of households contribute only about 10% of their income to indirect taxation; whilst GST alone takes 9.3% of the income of the poorest 10% of households, but only 5.9% of the income of the richest 10%. Thus the burden of GST on the lowest deciles is 58% higher than that paid by the higher deciles. The inequity carries across the tax systems, with CED affecting the poorest most severely – being 100% higher on the lowest deciles as compared to the higher. Shifting the balance is a complex – and potentially destabilising – process.

The government has to find a way to reduce the burgeoning fiscal deficit, which is easier said than done. In theory you reduce expenditure and increase income, but there are obligations to be met which come before all other considerations, obligations that have little of interest to the common man. Broadly, expenditure is of two types, current and development. In the 2007 FY total expenditure was Rps 1,675bn, of which current expenditure was Rs. 1,375.5bn or 82% of the total while development expenditure was Rps 300.2bn or 18%. The principal components of current expenditure were debt servicing and defence spending, at 27% and 18% respectively. Debt servicing is an inescapable obligation and Pakistani governments tinker with the defence budget at risk of finding themselves decapitated. It is easy enough when in opposition to criticise defence expenditure or any other expenditure against the current account but the realities of governance quickly dispel any notion of cuts in military budgets. The new government will only have discretionary spending (which might be translated into easing the tax burden on the poor) after meeting expenditure on these two budget heads.

In order to increase tax revenue there will have to be an increase in both direct and indirect taxation. Any increase in indirect taxes shifts the burden to the consumer or end-user of a good or service, resulting in a price increase. The increase in the price of fuel over the last two months has fully to work through but is bound to impact on every sector – and the pocket of the common man. Further, increases in indirect taxation are essentially regressive as the burden is shifted equally to all consumers regardless of their income – thus widening the gap between those who have and those who do not, and leaving those who do not even poorer.

Yet more complications emerge when we consider what is known as ‘elasticity of demand’. Demand for essential goods – food, fuel, power, etc. – is inelastic and that for luxury goods – elastic. Any increase on taxation for luxury goods may actually reduce the tax revenue they generate as fewer people choose to buy them, whilst that on essential goods will produce an automatic increase in revenue. It therefore makes better – if somewhat cold-blooded – economic sense to increase taxes on essentials, but given the fragile nature of both civil cohesion and political structures such a move is fraught with danger. It would further reduce the disposable incomes of the poorest in society who already spend most of their income on essentials and have nothing to spare for luxuries.

Civil unrest lies just around the corner from such a move. Increasing direct taxation would therefore seem to be the road to go down, but the big problem with direct taxation in Pakistan (see above) is that it is easier to avoid and requires an efficient system of tax collection plus a willingness to comply; both of which are clearly absent. Add to that the fact that imposing anything other than a moderate increase in direct taxation will inhibit business activity - thus reducing rather than increasing, tax revenues – and we begin to glimpse the problems faced by those who make the budget.

There is no such thing as a popular tax, yet taxes are the only way governments can fund core services and development. The new budget-maskers will face exactly the same problems as their predecessors, and their chances of pleasing any but a minority are as remote as they ever were. And the common man? The common man will get poorer, of that we can be sure; what we cannot be sure of is how long he is prepared to endure his poverty before he boils over into destructive rage.