Elasticity and Buoyancy of the Tax System in Pakistan

By Afsar Nafees

Key Terms
Tax: To tax is to impose a financial charge on a taxpayer (an individual or legal entity) by a state. Direct Tax: paid directly to the government by the persons on whom it is imposed. For the purpose of the charge of tax , all income is classified under the following heads: 1)Salaries, 2) Interest on securities 3) Income from property; 4) Income from business or professions 5) Capital gains; and 6) Income from other sources.

Indirect tax ‡ Indirect tax: collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the customer). Customs 2. Sales tax 3. The intermediary later files a tax return and forwards the tax proceeds to government with the return 1. Central excise duty .

developing countries usually depend on their tax system to generate adequate revenues in order to finance their ever-expanding expenditures ‡ fiscal problems occurs. due to which in most of the developing countries expenditure growth rate commonly exceeds the rate of national income growth. On the other hand. when the tax responsiveness remains below than that of expenditures than efforts are needed in this area to analyse the sources of revenues and their responsiveness in order to maximize the revenues . economic growth increases the taxable capacity and enables .Importance of tax ‡ Growing expenditure in a country is considered a prerequisite for economic growth. to obtain a larger share of national income in the form of tax revenues. Therefore.

a) help to explain the overall structure of a tax system. b) serve as valuable analytical tools for designing tax policy.Tax Elasticity and Buoyancy The response of tax revenues to changes in the GDP is measured by tax elasticity and tax buoyancy. These concepts. .

tax rates and bases) on the revenues from a tax. . Takes into account both the effect of increases in income and discretionary changes (i.e.Tax buoyancy ‡ Tax buoyancy measures the total response of tax revenues to changes in national income. ‡ Tax buoyancy is a measure of both the soundness of the tax bases and the effectiveness of past tax changes in terms of revenue collection..

The tax elasticity calculation excludes the impact of changes in tax rates and tax bases. whether or not changes were made in the tax structure during that time period. ‡ . reflects only the built-in responsiveness of tax revenue to changes in national income. It considers only the effects due to changes in income levels.Tax elasticity ‡ ‡ measures the pure response of tax revenues to changes in the national income.

either in the tax bases or in the tax rates or both. ‡ Inelastic tax system forces governments to continuously make discretionary changes. . as it provides the government with a sustained fiscal resource base for financing its outlays.importance ‡ An elastic tax system is a highly desirable system.

Importance A tax system that is subject to constant adjustments by policy-makers generates greater uncertainties and has adverse effects on longterm investments. . due to uncertainties in the tax system. A comparison of buoyancy and elasticity coefficients gives the analyst a useful insight into the tax system.

000 in 2003-04. ± Taxation of Gross income exemption amounted to Rs100. ‡ 3 Weaknesses of Pakistan s tax system include ± Narrow tax base.REVIEW OF TRENDS IN DIRECT AND INDIRECT TAXES ‡ Pakistan has not been able to generate more than 14 % of tax revenues in relation to GDP. . ± over-reliance on indirect taxes ± weak tax administration ‡ Example: ± personal income tax had employee fringe benefit exempted . ± Agricultural tax was not fully implemented due to loopholes ± Industrial sector had enjoyed tax holidays in 1960s -70.

and payments to non-residents. ‡ Until 1979. ‡ In the late 1960s. six kinds of payments were subject to withholding tax. ‡ In the 1990s it rose above 3% of GDP. It is important to note that the increase in the share of direct taxes in the 1990s has come from the massive increase in the withholding taxes.withholding taxes were levied only on three sources of income: salaries. which increased to 19 in 1994-95 and to 25 in 1999-00 . interest on securities.SHARE OF DIRECT AND INDIRECT TAXES AS A PERCENTAGE OF GDP ‡ Till late 1980s the Direct taxes were average 2% of GDP. Reason was tax holidays from 1960s-70s & exemptions.

8 percent to 68 percent reason Customs duties which formed the major chunk of tax revenues until early 1980s.shares of direct and indirect taxes as a percent of total taxes ‡ indirect taxes declined from 86.have been rationalised from a maximum rate of around 125 percent in 1987-88 to 25 percent in 200203 .

Trends in the indirect taxes ‡ the share of customs duties in total indirect taxes also declined from 54 percent in 1990-91 to 19 percent in 200203 ‡ In 1989-90 generalized sales tax was introduced comprehensively to increase tax compliance.5% for all entities. ‡ In 2003-04 the sales tax has been fixed at 12. .

. and petroleum products. ± They are inputs to all the production and distribution networks in the economy ± The demand for inputs is inelastic which means the revenues from sales tax is more elastic.Empirical result ‡ The high elasticity of sales tax is attributed to the extension of sales tax to electricity. gas.

and its elasticity is 1.Elasticity Estimates with respect to relevant bases Using only Relevant Bases ‡ The income tax is only 35 percent of the total tax revenue.15 despite the inclusion of Withholding tax which accounts for 70% of net income tax. .

23 ‡ elasticity of customs duties on imports is exceptionally low at 1. ± The report of SBP revised end of year targets for inflation upward due to the rapid increases in petroleum prices resulted in decline in sales tax revenues from kerosene oil because the poor switched to cutting trees for fuel.‡ Sales tax accounts for 64 percent of the revenues from indirect taxes ‡ sales tax on domestic output with respect to nonagricultural GDP base is the highest 1.petroleum gas & electricity are included in sales tax since 1999.25 ± The reduction in in tariffs of custom duty is picked up by sales tax . ‡ elasticity of sales tax for imports is 1.81 ‡ Reason.

± the governments can influence the tax to base component to improve the elasticity of a particular tax .Decomposition of Tax Elasticities ‡ The process of decomposing of tax elasticities is helpful in ± identifying the dynamic and the lagging areas of the tax system.

gas.DIRECT TAX ‡ the base-to-GDP elasticity is low. and petroleum product . ± occurance of tax exemptions and evasion both in the formal and the informal sectors ± unchecked growth of the informal sector ‡ The higher tax-to-base elasticity for income tax reflects the inclusion of the withholding taxes in income tax CUSTOM DUTY ‡ the base-to-GDP elasticity is low ± the exemption from wide range of raw materials and machinery SALES TAX ‡ high tax-to-base elasticity that the tax net has been widened with the inclusion of electricity.

EXCISE DUTY ‡ Elasticities of the three components for excise duties are less than unity ± Low tax collection relative to the base is attributable mainly to replacement of excise duty by the sales tax. . Overall reasons for low elasticities are cheaper smuggled as well as imported goods present in the domestic market has resulted in loss of revenues in sales and excise tax.

and loopholes for evasion. ± There is an artificial increase in the share of income tax. ‡ The reforms in the tax structure since late 1990s in terms of a relatively cleaner administration facilitating the taxpayers and the broadening of the sales tax base are visible ‡ Efforts to increase the share of direct taxes are extremely limited. allowances. which has adverse implications for a genuine increase in income tax revenues .CONCLUSIONS AND POLICY RECOMMENDATIONS ‡ The low elasticites of the tax system confirm the existence of continued exemptions.

‡ The capital gains on equity remain exempted from tax while sales tax on petroleum products and utility prices has directly affected the common man with limited resources.‡ Broadening of the sales tax base is a positive development ‡ The decline in the customs duty coefficients is picked up by the sales tax revenue from imports. investment ministry. . ‡ Easy way to realize revenue is through imposing sales tax on petroleum products & a higher sales tax rate on luxury items which would prevent the taxation on essential items such as basic inputs to the production & distribution processes ‡ This would help increase production and hence employment ‡ High cost of production is factor inhibiting investment which calls for coordination between the revenue department.


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