How Not Taxing the Rich Got Pakistan Into Another Fiscal Crisis

A balance of payments crisis has been silently brewing in Pakistan for the past year. With dwindling foreign exchange reserves and growing imports, the country has been struggling to meet its external financing needs.

The country is in the grip of twin deficits, making it difficult to balance both its fiscal and external accounts. This is hardly a new challenge for Pakistan, since its macroeconomic vulnerabilities resurface every few years, forcing it to seek an external bailout. In 2008, Pakistan had to seek emergency assistance from the International Monetary Fund (IMF) soon after a political transition took effect from Pervez Musharraf’s military rule to a civilian government.

Six years later, in the midst of declining global oil prices, the next elected government under Nawaz Sharif also signed up to an IMF programme. And once again, three months after assuming power, Pakistan’s newly elected government is desperately trying to shore up its foreign reserves and stave off a potential economic collapse.

While Pakistan’s recurring economic crisis has multiple origins, including an undiversified export structure and the near stagnation of its large-scale manufacturing, the country’s economic dilemma is best illustrated by its fiscal disorder.

The fiscal deficit ballooned to 6.2 percent of gross domestic product (GDP) this year. This fiscal crisis emanates from limited constraints on spending, fuelled by politically motivated development spending and subsidies for loss-making public enterprises, and a failure to institute genuine tax reform.

Successive governments have tried to balance their books by resorting to domestic and international borrowing rather than directly taxing the rich. The country’s elites have effectively been running a fiscal Ponzi scheme that exudes an illusion of sustainability but is predicated on borrowed existence and remains perpetually vulnerable to a sudden collapse.
The elites don’t want to tax themselves

The costs of sustaining this fiscal arrangement are passed on to the poor, the future generations and productive sectors of the economy. While less than one percent of people in a country of 220 million pay direct income taxes, the burden of taxation is imposed on the poor through a raft of indirect taxes.

Financing the deficit through unrestrained borrowing means that the economic burden is also being shifted to future generations. And the prevailing arrangement systematically disincentivises productive activity in the real economy.

Continued recourse to domestic borrowing means that private banks are content with lending money to the government rather than providing much-needed credit for the private sector. The imperative of revenue generation also distorts the tariff policy and undermines private sector competitiveness.

This fiscal arrangement is sustainable only to the extent that the country is able to access concessionary international finance. Foreign assistance tends to alleviate the resource constraint in the short-run but distorts political incentives for reform.

In this context, the recent announcement of a $6bn aid package from Saudi Arabia poses a moral hazard. Once again, it will insure the ruling elite against any genuine economic reform that could potentially redistribute economic power away from them.

If past experience is any guide, an IMF programme will also adversely affect any incentives for the elite to implement reform. Pakistan’s strategic decision-makers recognise that an IMF package is readily available as long as they have negotiated a geopolitical concession with the United States behind the scenes.

The IMF team can then step in and do all the necessary accounting exercises. And, as on previous occasions, when crunch time arrives, the IMF will stand ready to provide waivers and exemptions on the politically sensitive elements of reform. In this context, both the Saudi support and a potential IMF engagement will serve to bail out the elites.

Pakistan has a persistently low tax-to-GDP ratio (currently at 10 percent of GDP) – lower than its neighbours, India and Bangladesh, and countries with comparable income levels. The taxation structure is complex, inefficient, regressive, overly reliant on indirect taxes and defined by multiple exemptions.

Pakistan’s Federal Board of Revenue (FBR), for example, regularly issues exemptions on duties and tariffs. By one estimate, in 2011 more than half of the total number of tariff lines were subjected to such tax exemptions.

Agricultural incomes have also practically evaded direct taxation even though the agricultural sector still contributes more than 20 percent of national GDP and remains an important employer. The principal beneficiaries of such exemptions are the politically influential landed classes.

Over the past two decades, the booming urban real estate sector has emerged as another untouchable for tax collectors. Although real estate is associated with capital flight from Pakistan (their profits are often invested properties in Dubai, London and Toronto), urban property is only lightly taxed and the capital gains made through real estate transactions remain hugely undertaxed.

Similarly, an expansion of the services sector has been accompanied by growing incomes for professionals, such as doctors and lawyers, but has generated fewer dividends for tax authorities. And the country’s retail traders have long resisted the introduction of value-added tax (VAT), deemed as a more efficient form of indirect tax and an important step towards documenting the economy.

It has long been recognised at the highest level of policymaking that the country needs to broaden its tax base. Last year, the army chief, considered the most powerful man in the country, alluded to the woefully inadequate tax effort. And, upon assuming elected office, Prime Minister Imran Khan promised wide-ranging tax reform in his maiden speech. Despite this, both khakis and civilians are poorly incentivised to institute genuine tax reform. The reason is simple: a widening of the tax base would essentially require the country’s elites to tax themselves and to tax politically sensitive constituencies.

For any political dispensation, including Imran Khan’s party, this is a dangerous prospect. Hanging on a thin electoral majority, the newly elected government will face immense resistance from treasury benches, many of whom belong to the same tax-exempt classes. Even the government’s core urban constituency, the newly empowered middle classes, are more enthused by an anti-corruption drive than a broad-based tax reform.

For this reason, the new government has resorted to the same policy tools as the last one: imposing regulatory duties, revising tariffs, jacking up energy prices and slashing development expenditures. Far-reaching tax reform still appears to be a distant prospect. But this policy dilemma is not unique to Imran Khan’s government. All political incumbents face the same commitment problem when it comes to instituting economic reform. While on the election trail it is politically optimal to promise economic reform, once in office, they are poorly incentivised to undertake these reforms. How can this adverse political equilibrium be broken?
The solution

In my opinion, the solution to this commitment problem lies in the hands of Pakistan’s powerful military establishment. If Imran Khan – or any other leader for that matter – is to take on tax dodgers, he needs a commitment from the military that it will lend its support.

While Pakistan suffers from weak bureaucratic capacity, the military is still the locus of whatever limited state capacity exists in the country. It is the most well-organised institution with a capacity for long-term strategic thinking.

When the military throws its weight behind any reform proposition, it is more likely to happen (the integration of Federally Administered Tribal Areas, known as FATA, in the national mainstream is one recent example). Importantly, among all the political and institutional actors, the military faces the strongest incentive to build a sound tax base. After all, it will be the direct beneficiary of a strong extractive capacity, since a lack of fiscal sustainability poses a long-term danger to its financing needs.

This is a central political economy dilemma – one that historically incentivised European states to develop fiscal capacity. External wars necessitated European states to develop tax structures that could finance standing armies. Why has then the Pakistani military not mainstreamed tax reform as an important pillar of national security even in years when it directly ruled the country?

Three historical and contemporary factors help to explain this. Firstly, from an early period, Pakistan’s military and political elites have relied on external assistance rather than domestic resource mobilisation. The country has received significantly more foreign aid during its military regimes than during its elected governments.

This aid was part of a geo-strategic bargain – a reward for Pakistan’s services in supporting anti-communist alliances in the 1950s and 1960s and supporting the Afghan war operations in the 1980s and 2000s. Even as aid flows dried up over time and the threat of a balance of payments crisis became a recurring feature, it never posed an existential threat to elites who knew well that when push came to shove, foreign support would be forthcoming if they are ready to grant a geo-political concession.

Secondly, since the late 1980s, the military’s top brass has been heavily invested in real estate development through the military-linked Defence Housing Authority (DHA). Residential and commercial properties developed under the auspices of DHA provide an important source of institutionalised rents for military officers and afford an important avenue for upward mobility for the service class. Bringing these capital gains into the tax net, however, could face stiff resistance from within the military.

Thirdly, genuine tax reform could hurt politically influential groups whose support the military routinely relies on for cobbling together loose political coalitions. Popularly described as “electables”, these are typically candidates who readily offer their political brokerage to the military and lend greater certainty to any electoral race. Undermining their economic interests can spoil the political game and impede the military’s capacity for electoral engineering.

Taken together, these are difficult trade-offs for the military’s top brass to navigate, especially when most military commanders have a short-time horizon where the individual incentive is to pass the buck rather than broach difficult reforms.

To break the stop-start cycle of growth and the recurring risk of default, the country’s strategic leadership needs some out-of-the-box thinking. It is time to recognise that Pakistan’s continuing status as a “semi-rentier state” poses a grave threat to national security. It is a security threat that is perhaps far more existential to Pakistan’s survival as an independent state than the one posed by India.

Sadly, with the Saudi support package in hand and an IMF programme on the horizon, it is more likely that the prospect for reform will be delayed by another five years until the country faces the same scenario again and readies itself to deliver another geo-political concession.

This game suits our elites and their foreign backers. Neither of them is interested in building genuine fiscal capacity. For the country’s ruling elites, foreign assistance provides another reason for delaying reform that could hurt their economic interests. For the US (and its rich clients like Saudi Arabia) it provides a valuable strategic lever that can be deployed every five years.

Source : Aljazeera