Public Policy and Management

Topic: Direct taxation as a tool for Economic Development

Submitted to: Dr Sajid Nair

Submitted by: Hina Mushtaq MPA-R-012

Qurat-ul-ain MPA-R-06

Date: 24-07-2022
 Direct taxation as a tool for Economic Development

Introduction

Imposing essential levies on public by the government entities are known as taxes.

Taxes are imposed in every country; it is basically government’s earnings that are later spent

on the public welfare, defence and other economic activities. In modern economies taxes are

the most important part of the government revenue collection. Tax collection differs from the

type of revenue generation; there are compulsory taxes that are imposed not for providing any

specific service, like sale of property or paying public debt. Taxes are collected for the

general welfare of the taxpayers in general and that is independent of any specific benefits to

the taxpayers. Somehow there are some specific taxes that are imposed on the payroll to give

some specific benefits like social security, retirement benefits or medical provision. That

directly benefits the tax payers, because that are directly linked between tax payer and

benefits they get.

The purpose of taxation was mainly to get finances to run the government. An

American economist Richard A. Musgrave pointed that the purpose of tax collection by

government is resource allocation, income redistribution and economic stability, also

economic growth, development and competitiveness internationally. The purpose of tax

collection is that it does not interfere with the market, secondly redistribution of income and

reduce the gap between income inequalities between classes. Objective is the stabilization of

the economy and government through different policies like monetary policy, debt

management and government expenditure policy.

In the literature of public finance taxes has been classified as who pays them and

where they are being spent. There are mainly two types of taxes: Direct taxes and Indirect

taxes. Direct taxes are usually imposed on the individuals according to their capability,
income and consumption of net wealth. That is levied on the total net income of a person or a

family or a business. Some other direct taxes are like estate tax and inheritance tax. Indirect

tax is levied on the consumption and production of goods and services. Like value added

taxes sales tax, taxes on the production and manufacturing of the goods and also on the

import duties. There is same tax rate applied on all the items or tax can vary according to

products like sanitary, clothing or toys. Some taxes can be taken at the time of sale that is

called multi stage tax. They are applied to a range of items used on daily basis, sometimes

some products are exempt some necessities to reduce the tax burden on lower class.

All countries have different tax structures according to which they collect taxes from

public and generate their revenue. Some countries impose more indirect taxes while some

impose more direct taxes. These differ in policies which vary from developed and under

developed countries. Whereas some under developed countries like Pakistan impose taxes

like excise and import duties on every possible things from basic necessities such as Flour,

sugar, and cooking oil, to luxuries such as cigarettes, coffee, and tea, jewels and silk, taxes on

a limited group of products.

These taxes are not fulfil public’s need, they also contributes in economic growth of

any country. Both direct and indirect taxes may negatively or positively affect economic

growth. These taxes for revenue collection directly related to GPA which sows the economic

growth of any country. In this study, we are going to find out the relationship of direct taxes

as a tool for economic growth in the perspective of Pakistan. This study will be a systematic

literature review (SLR) based on previous conducted studies and grey literature of Pakistan. It

will also include the data about economic and taxation systems of other countries to compare

it with the economic growth of Pakistan. The result of the study will be drawn on these data

and studies mentioned in the literature review.

Direct and indirect taxes and economic growth:

In the last century the taxes rate has been increased from 5 to 10%, and is mainly

imposed due to the threat of war and security needs of recent times. It is said that the inflation

is inevitable in its nature as it affects the taxpayers and income receivers with same level.

There are same basic differences in the tax system in the developed and under developed

countries, backward economies need urgent taxes that is why the rely on the indirect taxes

more due to weak industrial structure and less revenue generated by the direct sources. As

well as the underdeveloped countries have pressure to develop the fiscal policy because

countries have ineffective and unstable economy, there is inflationary pressure where the

economy size is small as compared to the revenue generated.

Both direct and indirect taxes have a significant impact on economic growth of any

country. Different studies show different results of the impact of Direct and indirect taxes on

the growth of economy. According to Lee and Gordon(2005) argued that Direct taxes

particularly corporate taxes has negative relationship with economic growth as it effects

productivity negatively of firms whereas, Direct taxes are efficient in terms of revenue

collection. In contrast to this study both direct and indirect taxes have positive effect on

economic growth of a country while there is stronger and long term impact of direct taxes.

Hakim (2020), investigate economic growth of 51 countries including developing and

developed ones and concluding that direct taxes are harmful for the economy and its growth.

The studies mentioned in literature shows different results regarding direct taxes as a

tool for economic growth. These studies were based on the data about taxes and economic

growth of the countries other than Pakistan. We will further see the data of Pakistan about

taxes and how direct taxation is contributing in economic growth and what direct taxes can

do more to increase economic growth of Pakistan. Further data will be from different journal
articles, grey material which will include current and pasts facts and figures about taxes and

revenues.

Examples of other countries tax systems:

India

According to international standards Pakistan has performed better than India in tax to

GDP ratio since 2016 but India has managed fiscal deficit better. Both countries have similar

problems in term of taxes. These weaknesses show large informal economy and weak tax

compliance enforcement that give a way to large amount of tax evasion. Economic

projections of Pakistan do not indicate well because of its medium term budget strategy

paper. Pakistan can reduce its tax gap and become able to better project GDP by documenting

its economy better and will meet subsequent budget requirement.

United States

When we talk about US direct taxation, they use different strategies to collect taxes

from public. As US follow the free market economy whose notion is that by limiting the

market, economy cannot grow. According to the history of US economy, empirical evidence

is present which links to its economic growth. Empirical evidences illustrate that capital

taxation, broad taxation, individual income taxes is linked to the US economic growth. It is

seen that cutting capital taxes and corporate taxes result into less revenue but positive

economic growth as it increases the investments. These data show that these kinds of direct

tax cuts have positive relationship with economic growth of US economy.

China

One of the breath-taking positive economic growths of china is also a great example

which has positive relationship with taxation. Two decades ago, china collect its revenue by

collecting taxes from government owned large intensive firms and high tariffs. Tax evasion
was also high and state-owned bank also gave cheap and easy loans to the firms, and firms

are hesitant to make investments. This was the time when china was considered as one of the

poorest country and having lowest GDP. But now two decades later, they made substantial

changes in their tax structure. Taxes is now collected from all, small, large, private and state

owned firms as government’s control on banking system also has been diminished and local

governments are also given the powers of collecting and retaining taxes from firms under

fiscal decentralization. They lowered the income taxes and increases the taxes on goods and

services and also made the tax system accountable to end corruption. In this way of fiscal

innovation, china has made rapid economic growth rapidly in very short time.

Direct taxes in Pakistan

Pakistan being a developing country has many issues and challenges regarding tax

system as Pakistan has lowest tax-to GDP ratio in the world that is the main reason of large

budget deficit from many years. In terms of tax collection, Pakistan falls somewhere in

middle when compared to emerging economies. Most of the taxes in Pakistan are collected

through indirect taxation for the purpose of generating revenue. Direct taxes are a progressive

way to collect income and balancing its distribution and narrowing down the inequality gap.

In Pakistan, tax structure is under-utilized and tilted towards the regressive indirect tax

system. Income tax, corporate tax and capital value tax are considered major form of direct

taxes while general sales tax, custom duties and federal excise are the components of indirect

taxes in Pakistan. According to the official data, direct taxes are of total 39% in Pakistan.

Around 60-70% of taxes are collected in the form of indirect taxes. And the major source of

indirect tax is withholding tax which is collected through advance tax on imports and

contracts that add to the final prices of goods and services. Excluding withholding tax, the

share of direct taxes into total FBR taxes falls to 12.5% from 40%. The income tax

contributes to the 92% of direct taxes.

 However, there are lot of problems in tax system of Pakistan as none of the

government tried to improve tax administration or establish simple laws regarding taxation.

But in recent years during PTI government, FBR tried to raise revenue by collecting more

taxes and visible growth in tax collection is also seen in recent years. But also major tax

evasion is seen which increases the national expenditures like subsidies on petroleum. This

also causes the loosening ties and cooperation with other countries and IMF which are not

satisfied with subsidies on such products.

However, the income tax ordinance provides exemptions to the different segment of

society. These are called expenditures and loss of 1.6% has to bear the total 14 % of FBR

taxes. Also there are many illegal tax evaders which also increase the national expenditures

and government has failed to catch such financial criminals which are now living outside the

countries having offshore accounts. At the government’s end, it is reluctant to use technology

to increase tax collection which clearly shows the unwillingness of political actors and strong

resistance of major tax payers of the country due to their vested interests.

Conclusion:

In the light of above studies and national and international data, direct taxes can

contribute to the economic growth of Pakistan if standardized changes made in tax structures.

Pakistan has 39.1% direct tax chunk in the total tax collection according to the FBR’s report

of 2021-2022. Imran’s government was successfully improving the Tax collection rate by

encouraging people by giving them awareness, but none of the government till now has done

anything to simplify the tax laws and any improvement in tax administration which is the

mere need of time. Government of Pakistan can simply improve the direct tax collection by

upgrading the laws and make the easy, so the new or the already running businesses can

flourish easily and Tax to GDP will grow. There are a lot of tax evasions in Pakistan because
of political influences and corruption. A lot of indirect taxes are already being paid by the

public which is imposed on basic goods and services. Also our local firms and small business

are not being empowered rather Multi-national corporations are more empowered and pay

very low taxes of 1.25% and also wanted to reduce this tax to 0.25%. This make burden not

only on small and local businesses but also increase inequality ratio. If the powers of

collecting taxes from small and local firms are being given to local government, MNCs are

forced to given proper good amount of taxes, accountability mechanism being strengthen,

then direct taxes can contribute in Pakistan’s positive economic growth.

In recent years, government has taken many steps to meet the tax collection targets by

engaging Real-estate, retail and wholesale sectors by focusing on the documentation from

registration to evaluation. Many advanced steps has been added like ‘Trace and track’, Point

of Sale, integration of retailers with FBR system are the main steps towards the improvement

of direct tax ratio in Pakistan.

By doing tax reforms, FBR can minimize its dependence on the withholding tax,

removal of anomalies, preferential treatment and exemption and Tax Harmonization so that

the process of tax collection is accelerated. However tax collection got improved froms -0.4%

to 4.4% after Imran came into power and it increased by 18.4% in year 2021. It shows if

government shows serious interest in the improvement of tax system in country and tighten

its rules for the tax thieves so it can successfully make peoples accountable to institution and

can achieve its targets, which can ultimately improve the economy situation, it contribute to

the economic growth of Pakistan if standardized changes has made in tax system.

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