Friday, February 11, 2011

Pakistan: A tax heaven for the rich

The coat of arms of Pakistan displays the nati...Image via WikipediaFrom Dawn.Com
Invert the pyramid By Sakib Sherani | From the Newspaper

TWO weeks ago, I had concluded my op-ed piece by asserting that, essentially, Pakistan faces a classic agency problem. This refers to how Pakistan has been governed by its ‘managers’ (political and economic) on behalf of its true ‘owners’ — the people, electorate, as well as future generations, usually under misaligned incentives.

Hence, policymakers have operated with a short-term horizon, have used public policy for private gain, or have completely disregarded the interests of the masses.

As the political parties sit together to evolve a roadmap out of the present ‘crisis’, it is imperative to recognise that Pakistan is afflicted with a far deeper malaise than the antidotes (band-aids) brought to the table are able to deal with. The biggest challenge for those discussing agendas to bring the economy back to health is how to incentivise their own political class to think beyond an election cycle. The manifestation of this malady — state capture by an elite with its attendant atrophy of institutions — and its pernicious effects are everywhere.

The most egregious example is found, of course, in our tax who’s who. With around 2.5 million income tax filers (not necessarily all payers), a large portion of who are salaried, it is hardly surprising that direct taxes on income constitute a meagre 3.6 per cent of GDP. Hence, of the abysmally low — and declining — tax-to-GDP ratio, 60 per cent comes from taxing the consumption of every Pakistani, irrespective of income.

For the people at the top of the pyramid, Pakistan is a tax haven — much of it officially. Less than 50 per cent of the economy is taxed — significantly less if the thriving informal economy is taken into account. So if the media reports that over 60 per cent of parliamentarians declared in their election filings to have paid zero income tax, it should not come as a surprise.

Still, the scale of tax evasion, much of it in collusion with tax authorities, is staggering. In Shaukat Tarin’s tenure as finance minister, a study was conducted on identifying large tax evaders using the country’s various databases. The result was mind-boggling. Our computerised search yielded 776,000 people with records of asset ownership, including multiple bank accounts and properties, but who were not even on the tax register. And these were the results for just the three largest cities.

On the expenditure side, the pattern of patronage is equally telling. An important manifestation of state capture can be found in the per-capita spending by the state on the upkeep of the ruling elite — president, prime minister, cabinet, parliamentarians, the armed forces and the civilian bureaucracy, all put together — versus the rest. While thousands of teachers, lady health workers, railway staff and pensioners are routinely denied salaries and pensions for months, it is inconceivable that any ‘freebie’ of the president, prime minister or a chief minister is delayed.

Two egregious examples from the recent past of public policy priorities skewed to the benefit of ‘small’ constituencies. First, the exemption from capital gains tax on equities under Musharraf-Shaukat Aziz is estimated to have cost the exchequer Rs120bn in foregone tax revenue in 2007 alone. The pool of beneficiaries: less than half a million estimated stock investors, with the biggest gains accruing to a handful of the largest stock brokers.

With such largesse (and misplaced priorities) little wonder that the same government borrowed nearly Rs700bn from the central bank between 2004 and 2007, laying the seeds for the inflation spiral that was to follow.

The second example: encouragement of private ownership of cars, which led to a pre-emption of resources towards a small car-owning elite. The continued obsession of the cabinet with lowering car prices, an issue affecting around 100,000 people a year, at a time of far larger economic issues to deal with, is reflective of a similar mindset. Focusing on delivering an efficient mass transit system for the larger urban centres should have concentrated the minds and consumed the energies of policymakers ostensibly from the people. No such luck. Two different governments, similar priorities.

In short, state capture by an entrenched ruling elite has subverted resources to the use of a relatively small minority, while the vulnerability of the rest has only increased. This ecosystem of pelf and patronage, and the rents that flow from it, can only thrive in the absence of strong institutions.

Hence, not only have institutions of the state been deliberately undermined, the beneficiaries have been the full spectrum of Pakistan’s elite — civilian and non-civilian, political as well as non-political — and the country’s external ‘patrons’. The last lot, the US and UK in particular, pressured an autocrat to construct the National Reconciliation Ordinance, which undermined Pakistan’s judicial and accountability processes rather than strengthening them.

The weak institutional framework has stultified the economy and is the leading cause by far of Pakistan’s economic stagnation over the past two decades. Because institutions provide a rules-based system of checks and balances, an economy with a weak institutional framework will inherently lack policy stability and be more volatile for businesses.

It is no surprise then that growth of businesses has been more constrained in Pakistan, or that the informal sector is growing faster at the expense of the formal sector. Such an environment has arguably shortened investment horizons and increased the required rate of return — hence constricting the universe of potential investments that businesses have been willing to undertake.

The elite should take heed. It is not just the hungry and dispossessed who are marching on the streets of Tunis or Cairo. Weak institutions, bad governance and corruption will widen the ambit of brewing discontent to a disaffected urban middle class. While the dismantling of their present brings out the poor onto the streets, the undermining of their economic future will bring out the rest.

The writer was until recently the principal economic adviser to the Ministry of Finance.
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