S. Masoud Ali Naqvi Senior Partner KPMG Taseer Hadi & Co. 17 March 2006 GLOBAL SERVICE/ INDUSTRY AUDIT / TAX / ADVISORY / LINE OF BUSINESS Asia Pacific Tax Conference – 2006 Tax Incidence - Equity & Distortion

2 Tax Incidence – Equity & Distortion Revenue sources for a Government TaxationBorrowing Money Creation

3 Tax Incidence – Equity & Distortion Basic Principles of Taxation FairnessEfficiency Effectiveness – sufficient Simple – Convenient

4 Tax Incidence – Equity & Distortion Standards for a good tax system Sufficient to raise necessary government revenues Convenient to administer and to pay Efficient in economic terms Fair to taxpayers

5 Tax Incidence Who actually bears the final burden of a particular tax or set of Taxes. The final burden is distinguished from the initial burden. The initial burden is borne by those who makes the payment to the tax authority The final burden is borne by those whose real income is reduced as a result of it

6 Tax Incidence Progressive Tax Incidence A tax is progressive if final tax burden is higher for high income households relative to low income households Regressive Tax Incidence A tax is regressive if its burden is higher for low income households relative to high income households

7 Tax Incidence Direct Tax The initial and final burden are the same Indirect Tax When the initial burden can be passed on as a final burden to others.

8 Incidence of Tax SPDC Study Conclusions: Indirect taxes are regressive and neutralizing their regressivity appears to be difficult Direct taxes are progressive although their progressivity has declined over time The regressivity of direct and indirect taxes combined is reduced relative to the regressivity of indirect taxes

9 Incidence of Tax …. (Contd.) Implication is that enhancing the weight of direct taxes by styling the primary ones of revenue generation from indirect to direct is likely to render the incidence of the tax regime proportional and progressive Expenditure regimes is also regressive resulting in overall regressive fiscal structure as the greater burden of taxation falls on poor and they do not appear to be primary beneficiary of public expenditure The above has resulted in transfer of resources from the relatively lower income group to relative higher income group which has compounded inequality and poverty

10 Tax Incidence – Equity & Distortion Concept of equity / fairness Reflects each taxpayers’ ability to pay and enhance horizontal and vertical equity Ability to pay is measured by : IncomeWealth Standard of living

11 Tax Incidence – Equity & Distortion Horizontal equity That persons with the same ability to pay the tax should owe the same amount of tax. Vertical equity That persons with greater ability to pay owe more than persons with a lesser ability to pay.

12 Tax Incidence – Equity & Distortion Equals Equals will be these having the same pre-tax income. Equal treatment is equal post tax living standards for pre-tax equals. Equal average tax rule and equal taxes among equals.

13 Tax Incidence – Equity & Distortion Tax Rate Structure Regressive Rate Structure Proportional Rate Structure (Flat Tax) Progressive Rate Structure

14 Tax Incidence – Equity & Distortion Tax Rate Structure Average Tax Rate The tax rate on income determined by dividing tax paid by an income measure. Income measures selected are usually gross income or taxable income Marginal Tax Rate The rate of tax applied to the next dollar of taxable income. In a progressive rate structure this rate increases as income levels increase. In a proportionate rate structure average and marginal rates are the same.

15 Taxation Policy - Factors Hampering the Economic Development The Growth Crisis The Resources Mobilization Crisis The Balance of Payment Crisis The External Debt Crisis The Distributional Crisis

16 Tax Incidence – Equity & Distortion Distortions Political disharmony between Centre and province Lack of equitable distribution of fiscal and powers amongst Federal, Provincial and local Governments Provincial Government generates only 5 percent of tax revenue as against 38 percent in India

17 Tax Incidence – Equity & Distortion Distortions (contd….) Exemptions/Exclusions from tax base Agriculture income Capital gains on real estate Exemptions, allowances, tax credits, tax reduces and tax defends resulting in tax expenditures

18 Tax Incidence – Equity & Distortion Tax Revenue Gap Tax actually payable and tax actually collected Shadow Economy Size Lack of tax ethics and social norms Inconsistency in growth sectors versus tax incidence in these sectors Network/Lobby culture

19 Potential tax revenue minus Actual budget collection Tax revenue gap Inadequate legal base Institutional inefficiency Legal tax avoidance Inadequate tax administration Tax avoidance Tax evasion Unreported economic activities Shadow economy Tax burden Limited budget resources ▪ Income ▪ Traditions ▪ Networks Tax Revenue Gap

20 Tax Gap – Pakistan Scenario The tax to GDP ratio for a developing economy should be around 15 percent 5 percent additional tax revenue =300 m 1 percent additional tax revenue = 60 m ( on 2005 GDP ) ( on 2005 GDP ) With expected Growth Targets on an average 1 percent additional revenue to GDP should yield annually 75 m over next four years Tax expenditure for was estimated at Rs.25m

21 Summary of Tax Expenditures

22 Tax Incidence – Equity & Distortion Tax Reforms Model Optimal Tax Model Harberger Tax Model Supply side Tax Model

23 Tax Incidence – Equity & Distortion Optimal Tax model (OT) Design optimal tax system for tax efficiency Harberger Tax Model (HT) Design system that will minimize tax induced tax distortions which may be administratively feasible and politically acceptable (Uniform Tariff / Broad Base VAT)

24 Tax Incidence – Equity & Distortion Supply-side Tax Model (SST) Reduce role of state Reduce tax rates to minimize disincentive on work, saving and investment Minimize distortions in related prices

25 Tax Incidence – Equity & Distortion Recent Trends – Combination of all these models Enhance the revenue productivity of the tax system Minimize relative price distortions Tax system to be comprehensive, simple and transparent Broaden tax base Lower marginal rates

26 Reforms Initiative LTUMTU Customs Administration Reforms (CARE) project Installation of Scanners Liquidation of Refunds Sales Tax Project STARR / STREAMS Effective Dispute Resolution

27 Tax Incidence – Equity & Distortion Broaden Tax Base To ensure horizontal equity is desirable from the political economy point of view as it reduces influence of special interest group on tax policy and reduce administrative costs

28 Tax Structure Issues Narrow base Over dependence on import related taxes High tax rate Tax concessions and exemptions SRO culture

29 Income Tax NTN holders2.28 million2.11 million Tax return filers (20%)1.23 million1.0 million (growth over ) Sales Tax Registered persons115,702101,851 Growth percentage14%

30 Tax Incidence – Equity & Distortion Reforms imperative Institutional locks for credible commitment Transparency Allocation to political sequencing Incentive and compensation Public Education and communication Encouraging participation in Reforms

31 Tax Incidence – Equity & Distortion Customerised subsidies to invest Training expertise Pricing of land and utilities Large equity stake in some ventures

32 Taxation Policy - Underground Economy Large number of economic activities outside reporting system and tax net. Constituents of underground economy Illegal activities, smuggling, narcotics, corruption etc., Legitimate, but not reported to tax authorities. Causing Large fiscal losses Distorts incentives structure and growth path of economic system Loss of fiscal revenue and demand on public services a contributing factor for fiscal deficit. High and uncertain cost of doing business an important constraint for the private sector led development strategy.

33 Taxation Policy - Areas Requiring Policy changes to Counter Underground Economy Economic liberalization Fiscal discipline Enhanced space for private sector Tax reforms comprising of low rates and broad base Transparent decision making Severe punitive measures against the errant Equitable and expeditious justice

34 Taxation Policy - Major irritants in achieving Policy Objectives UNEMPLOYMENT / POVERTY LEVEL Social net Lack of basic amenities (Medical, clean water etc.) Taxes impact on savings National Saving Schemes TAXATION Multiplicity of taxes – Federal, Provincial, Local In-equity in allocation of taxes amongst provinces and local bodies Incentive for tax evasion Complexity of tax laws High incidences of taxes

35 Taxation Policy – Unemployment / Poverty Level Engendering growth Implementing broad based governance reforms Improving income generating opportunities Improving social sector outcomes Reducing vulnerabilities to shocks

36 Distributional Crisis Key to inequality Equity content sharply eroded Incidence of poverty is a function of economic growth and distribution Inequality in holding of assets

37 Distributional Crisis Inequality measured by Gini coefficient that: 1 percent reduction in equality is likely to reduce poverty by 8.5 percent 1 percent increase in per capita income is expected to reduce equality by only 3.6 percent

38 Alternate Estimates of Poverty Elasticity Table 3.6Alternate Estimates of Poverty Elasticity With reference to Inequality MeasuresGrowthInequality Gini coefficient Quintile dispertion ratio* Extreme inequality represented by square of Gini *share in national income of the highest 20 percent of population to the lowest 20 percent of population Source: SPDC estimates

39 Composition of Tax Revenue (%)

40 Burden of Indirect Taxes by Income Group (%)

41 Burden of GST Net of Tax on Key Agricultural Inputs (%)

42 Thank you

43 © (year) KPMG (member firm name if applicable), the (jurisdiction) member firm of KPMG International, a Swiss cooperative. All rights reserved. Printed in (country). (Insert document code) Presenter’s contact details Syed Masoud Ali Naqvi Senior Partner KPMG Taseer Hadi & Co.