IMF policy, but not practice? Regressive tax in Pakistan

13 June 2011

Guest analysis by Azhar Lashari, ActionAid Pakistan, and Rachel Sharpe, ActionAid UK

Pakistan’s IMF programme is on hold, but the Fund’s demands fail to address the under-taxation of the wealthy elite. The IMF’s policy approach, articulated in a March board paper, is starting to consider the distributional effects of taxation, but this has not translated into practice.

Since 2008, Pakistan has received nearly $8 billion of its $11.2 billion Stand-by Arrangement from the IMF, but the remaining amount has been suspended since May 2010 due to the country’s failure to alter the general sales tax (GST) and increase overall tax revenue, among other measures. Pakistan collects less in taxes as a percentage of its overall economy than almost any other country its size. Tax revenue was less than 10 per cent of GDP in 2009 compared to Malaysia which raised 15.7 per cent. The IMF wanted Pakistan to improve its tax-to-GDP ratio to 14 per cent by 2013, and to reduce the budget deficit to 4.7 per cent of GDP from 6.3 per cent in 2009-10.

the poor and salaried class bear the major burden

While Pakistan failed to achieve several of the IMF’s conditions, one of the most important was the implementation of a value added tax (VAT). Pakistan’s constitution requires that each of the four provinces assent to any tax on services, but consensus on the VAT was never reached. In an attempt to keep the programme alive, the IMF agreed that Pakistan could instead transform the GST into a reformed general sales tax (RGST). While the passage of the RGST through parliament is struggling, the Federal Board of Revenue chairman Salman Siddique has said that the government plans to double the existing GST from its current 8 per cent to 16 per cent.

Sales taxes can be regressive, meaning they take a proportionally greater amount from those on lower incomes, since they are charged at a flat rate on all purchases, regardless of the income level of the purchaser. Pakistan has a very narrow tax base. Only 1 per cent of the population pays income tax and politically powerful rural landlords have kept their land-related incomes out of the tax net. It is the poor and salaried class who bear the major burden of the GST and income tax.

IMF programme documents highlight the importance of broadening the tax base by reducing the number of non-filing and under-reporting taxpayers, as well as emphasise the need to increase public investment and social spending in order to compensate for the distributional impacts of a higher GST. However, both the IMF and the government have failed to put adequate emphasis on these measures. The reforms do not appear to be bringing elites into the tax net and it is those who already pay the majority of taxes that are being taxed more heavily by the reforms.

Besides asking the government to expand its tax base, the IMF is pressing for withdrawal of subsidies for the energy sector, which will increase the cost of production both in the agricultural and industrial sectors. This will have serious implications for food inflation in the country. Following the 2010 flood, the food security situation is already alarming, particularly in Sindh and Balochistan provinces, where millions of people continue to face a high risk of malnutrition.

As a result of Pakistan not meeting its conditions, the IMF is now exercising its gatekeeper function, signalling to other donors – such as the World Bank, Asian Development Bank and the United States – to withhold new funds. In the absence of external funds, the budget deficit could go up to 8 per cent of GDP this financial year, according to finance ministry officials.

The pressure to meet the conditions on tax and release funding is causing the government to avoid parliament, leading to undemocratic fiscal policy. The finance minister has described the parliament as the biggest obstacle standing in the way of achieving the IMF reform targets. Instead, the government used a presidential order to bring in a 15 per cent income tax surcharge, a 2.5 per cent excise duty and removal of exemptions. This is depriving the country of the debate that would normally accompany decision making on how the state levies taxes.

Becoming more progressive?

This casts a shadow on some of the positive changes the IMF appears to be making in tax policy advice, as articulated in a recent policy paper (see Update 74). The IMF’s tax policy advice has emphasised raising revenue in developing countries from consumption taxes, such as VAT, which are often regarded as regressive.

The policy paper, Revenue Mobilization in Developing Countries, recognises the importance of the tax burden being fairly spread saying that “distributional effects are important in themselves (poverty relief is a major motivation for raising revenue in the first place) and for their impact on compliance” and that “political and social views on the proper degree of progressivity vary widely.” Real estate taxation is identified as having significant revenue potential for local taxation, building local accountability and boosting progressivity because of the “positive correlations between property ownership, income, and wealth.”

The paper qualifies and defends the IMF’s backing for VAT, and particularly its advice to raise VAT at a single rate without exemptions, saying that the poor can benefit from the elimination of exemptions when the additional tax revenue is used to finance targeted spending measures. They cite 2005 research from Ethiopia, which looked at the combination of VAT and related spending and found that health spending could have substantial impact. Importantly though, they concede that “precise measures to address any equity concerns from proposed tax reforms … are often left unspecified.”

In Pakistan, it is the poor who will feel the impact of a rise in energy tariffs, the introduction of the RGST and elimination of exemptions in the sales tax. In this case it seems that the IMF’s official recognition of the importance of fair tax systems has been subordinated to the more pressing need to increase revenues in the traditional way – through consumption taxes that hurt the poor.