Understanding the Impact of
Income Tax Expenditures on
The estimated loss of revenue due to income tax, sales tax and customs duty expenditures was Rs.448 billion, Rs.578 billion and Rs.288 billion, respectively, in 2020-21. Thus, total revenue sacrificed due to tax expenditures in 2020-21 was Rs.1314 billion. Sectors that were the principal beneficiaries of this expenditure included general industry, poultry, textiles, pharmaceuticals, edible oils, dairy, fertilizer, petroleum, independent power producers, agriculture and the auto industry. Such businesses are largely owned and run by political families.
So whopping exemptions give rise to the question: what are the effects of the exemptions on the national economy. To answer this question, we enumerate some important reasons in the following paragraphs:
1. Tax Revenue
By international standards, Pakistan’s tax-to-GDP ratio is much low. The low and declining tax-to-GDP ratio has emerged as a matter of serious concern during the recent times, particularly when the fiscal deficits have recorded whopping increase. More importantly, the income tax (individual and corporate) as a share of GDP is also low by international standards. One important reason of low and declining share of income tax revenue is too many exemptions and concessions in the income tax code. The income tax base in Pakistan is alarmingly low due to large income tax exemptions and concessions.
2. Tax Avoidance and Tax Evasion
The extensiveness of exemptions and special treatments provided for the income tax may create opportunities for tax avoidance and evasion. For instance, a taxpayer who is deriving income from agriculture as well as from business may inflate agricultural income and reduce income from business at the time of filing tax return, in particular when economy is largely undocumented. Zaidi (2010) concluded that Pakistan’s tax evasion problem is caused by three things: poor legal frameworks and bureaucratic capabilities with regard to revenue extraction; corruption in the form of a predatory class that privileges certain sectors and vested interests with unjustified tax “exemptions”; and elites who cut deals with the state to avoid taxation, made possible by an anaemic agriculture income tax.
3. Horizontal Inequalities
In case, the income of a certain taxpayer is fully exempt from tax or is subject to concessional tax rates, horizontal inequalities (taxpayers with the same income or tax base should pay equal taxes) are bound to increase. According to Matinez-Vazquez (2006), there are two most important sources of horizontal inequalities: unequal treatment of taxpayers with same level of income through exemptions and the like, and different opportunities of tax evasion. Unequal treatment of individuals with the same income arises because of the exemptions of some form of income, such as is the case of agricultural income and the case of capital gains from the sale of securities.
There is general consensus amongst economists that tax exemptions and concessions make the income tax system unfair and non-neutral, and, thus, lead to economic distortions and inefficiencies. This appears to be particularly true in the case of Pakistan because the country’s income tax system does not provide level playing field for all economic agents and sectors of economy. Some economic agents or sectors are exempt from tax while others tend to be heavily taxed, and, consequently, the allocation of resources gets distorted. A neutral tax system does not interfere with the allocation of resources and, thus, does not disrupt the functioning of the market mechanism. Matinez-Vazquez (2006) concluded that the tax system of Pakistan features different marginal rates of effective taxation which lead to significant distortions in investment decisions and a lower level of efficiency of the economy, as well as slower rates of economic growth.
Since Pakistan has a considerable budget deficit and the lowest tax-to-GDP ratio amongst many developing countries, the country urgently needs to improve its financing situation. Since income tax expenditures erode the tax base and, hence, reduce overall tax revenues, eliminating income tax expenditures would increase tax-to-GDP ratio. Rationalizing tax expenditures will help to achieve the revenue target for tax year 2022 targeted at Rs.5.829 trillion, which is Rs.1.138 million higher compared to Rs4.691 trillion of previous tax year.
Elimination of the income tax exemptions that are exclusively to the benefit of inefficient producers and politically powerful lobbies would help make the income tax system fairer and more equitable and more competitive for all sectors of the economy, and it would have a positive effect on tax revenues.
In this context, it should be noted that, in many developing countries, tax expenditures are commonly- used instruments for promoting economic growth, developing infrastructure, education and health care, and reducing poverty, etc (Suleiman, 2008). Therefore, only those tax expenditures which are relevant for the actual needs of the country or its population, and those which should be effective and efficient in achieving the objectives of promoting economic growth and, as a result, raising tax revenues, are to be retained.
In order to rationalize tax expenditures and to make them more productive for the society and economy, it is imperative to conduct an independent cost-benefit evaluation of tax giveaways. In the evaluation exercise, it is essential to estimate whether the tax expenditures in the past yielded the desired objectives.
The author is serving as Additional Commissioner Inland Revenue at Federal Board of Revenue, Pakistan. He can be contacted at firstname.lastname@example.org