ISLAMABAD:
Pakistan set a highly ambitious tax revenue target of Rs13 trillion in 2024-25, which was declared unrealistic by most analysts. Set under the watch of the International Monetary Fund (IMF), this revenue target is now about to be revised downward significantly, almost offsetting the current shortfall of Rs600 billion.
Economic growth continues to be low, while the headline inflation rate has fallen sharper and deeper than anyone’s imagination. Are we witnessing the Laffer effect?
Pakistan’s tax rates are already among the highest in South Asia and relatively high globally, with GST rates on goods at 18% and the highest personal and corporate income tax rates at 35% and 29%, respectively. This does not account for the super tax.
Several studies, such as Waseem (2018), Latif et al (2019), and Mehmood et al (2022), have found empirical evidence indicating the presence of Laffer curve effects for both direct and indirect taxes.
More specifically, these studies have found that tax rates are so high that further increases trend to yield less revenue due to reduced economic activity, decreased compliance, and movement into informality. The World Bank (2024) also conducted a similar study based on data from 2006-2022, the results of which endorse the earlier studies cited.
No economic outcome can be attributed to a single factor, and thus, while the tax revenue shortfall may also be attributed to poor enforcement, low growth, or lower-than-anticipated inflation, it will be instructive to explore the Laffer curve at the micro level.
Take the case of markets where illicitly traded or manufactured goods thrive. We recently saw an advertisement from the association of leading tea packaging companies on the predicament they are facing due to the increasing share of smuggled tea. It was reported that the government lost Rs14 billion in tax revenue because goods were diverted to the illicit market.
Some days ago, similar ads were published in newspapers announcing that the government is losing Rs300 billion in tax revenue in the tobacco market to counterfeit and illicit tobacco traders. It has been reported that the illicit market share in tobacco (both locally manufactured and smuggled cigarettes) has continued to increase despite the increase in the FED by 153% in the last year.
The illicit market share has risen from 37% in 2022 to 54% as of April 2024, and now it is even higher. While the government has collected more revenue from the excise tax, its base has been narrowing sharply. With a narrow base, the collection will decline rapidly. This is consistent with the Laffer curve phenomenon.
Another example will be particularly interesting. Before 2024-25, Re1 per kg was imposed as FED on the import of acetate tow (filter), used in the production of cigarettes. This was increased to Rs44,000 – yes, Rs44,000 per kg – as an adjustable FED on import. It was estimated that Rs125 billion could be collected at the import stage from this tax. This move was welcomed by the industry as well. However, in November 2024, it was reported that only Rs240 million could be collected against this.
According to industry and government sources, it is most likely that acetate tow imports are now happening through illicit channels. Even the FBR chairman had to admit that higher tax rates have resulted in lower collections – or in this case, even evasion.
It is commonly believed that we are not paying enough taxes, which is then linked to our underperforming governance. However, another explanation is that we are not reducing our spending to any significant level. Thus, any nominal increase in tax revenue is swallowed by a greater increase in the size of the government, which then sets a continuous fiscal deficit.
In fact, over the last 15 years, our tax-to-GDP ratio has remained flat at around 10%, while the spending-to-GDP ratio has sharply increased to almost 20% (Pasha, A, 2024).
If the Laffer curve holds, as the above evidence suggests it does, lowering tax rates while simultaneously broadening the tax base by reducing exemptions should lead to increased revenue collections while decreasing economic distortions. Using this approach, the PIDE-PRIME Report (2024) estimated net gains of Rs1,194 billion in tax revenue.
Prime Minister Shehbaz Sharif knows this by heart. He recently stated that if he could, he would reduce tax rates to 15%, thus slashing them by 50%. I strongly wish he had all the power he needs to do it. This would unleash locked and dead capital, rejuvenate industry and exports, and send a very strong message to the professional working class of the country to work more and stay here.
THE WRITER IS THE FOUNDER AND EXECUTIVE DIRECTOR OF PRIME, AN INDEPENDENT ECONOMIC POLICY THINK TANK BASED IN ISLAMABAD
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