Tax expenditure as subsidy to elites: myth or reality?

In the last ten or so years, economic issues and tax collection by FBR has been brought increasingly under focus. Matters that were previously discussed in economic and policy circles have been gradually brought in public domain due to the efforts of some brilliant and hardworking journalists working mainly in the English-language newspapers.

This is definitely a positive development having the potential of leading to a fiscally responsible government and enabling the electorate to make informed choices regarding who should be representing them in the parliament and executive.

However, the debates in the mainstream and social media carry a risk of ending up presenting a distorted picture to the public at large. At times it is due to the failure of FBR, the government of the time and the economists who do not provide the necessary perspective and interpretation to the statistics being hurled at the reader.

Indicting the government for granting astronomical benefits to the elite as per the report of Tax Expenditure published by FBR prior to the Budget for the current year is a case in point. Tax expenditure can be defined as the revenue forgone due to various exemptions and concessions in tax laws. Previously, the gross figures of tax expenditure were given in the Economic Survey for the relevant fiscal years.

However, in the interest of transparency, FBR since 2019 started reporting detailed breakup of the gross figures and these reports were made available online on the websites of FBR and the Ministry of Finance and Revenue.

For the current year Tax Expenditure report was made available online on 8th June, 2023, and immediately the government started receiving criticism for granting huge tax exemptions worth Rs. 2.24 trillion to the elites, a figure that was much higher than for the previous financial year.

Interestingly, the government of the day was castigated for giving in one year almost fifty percent of the total exemptions given by the previous government during its less than four-year tenure, completely ignoring the fact that the tax expenditure report clearly mentioned that the data related to Financial Year 2021-22, during which the government was in place for only the last three months.

Moreover, no one tried to quote the statement in the report that Pakistan’s current tax expenditure estimate at 3.36% for FY2021-22 is below the global average around 4.4% of GDP, with the Russian Federation providing a huge size of tax exemptions at 14.8% of their GDP. In U.S. income tax expenditure constitutes 6.6% of GDP.

Similarly, the government tax revenue gets reduced by around 8% of GDP in Australia. Canada, Japan, and the UK also allow tax expenditure up to 6.6%, 7.5% and 8.1%, respectively, of their GDP. The tax expenditure in Pakistan was quoted as a manifestation of the newly coined term ‘elite capture’.

The social media subscribers also joined the foray and the Twitterati having interest in economy or opposed to the government also started blaming the government for being a handmaiden of the influential and the affluent classes as evidenced by the colossal benefits granted to them in the shape of tax expenditure.

Leaving aside political considerations, this article attempts to delve deeper into the concept and rationale of Pakistan’s tax expenditure, as to whether it is justified and whom does it actually benefit. First of all, it has to be realized that any tax machinery does not like tax exemptions or concessions as these erode its capability to collect taxes and duties. This probably is truer in the case of Pakistan.

FBR, year after year, has to face the daunting challenge of achieving stiff revenue targets and would be loath to give tax exemptions or concessions.

The tax expenditure that the government makes can be justified on the grounds that it is meant to attain some broader economic objectives going beyond the aim of revenue maximization or to further social objectives such as providing relief to the poorer segments of society. If Pakistan’s tax expenditure largely meets these criteria, any criticism would be groundless.

The tax expenditure report needs to be appraised on the basis of the touchstone of whether the exemptions and concessions advance socio-economic objectives or benefit the select few.

The report under review gives the breakup of tax expenditure for the FY 2021-22 in Table 1.

==========================================================================
Tax Type            FY 2020-       FY 2021-         Increase       %age of
                      2201          22012              %               GDP
                    (Rs. In        (Rs In
                    Billions)      Billions)
==========================================================================
Income Tax           416.51         423.89            1.77            0.64
Sales Tax            739.77        1,294.04          74.92            1.94
Customs Duty         342.89         521.70           52.15            0.78
==========================================================================
Total               1,499.173      2,239.63          49.39            3.36
==========================================================================

The above figures certainly reveal a substantial increase in FY 2021-22 as compared to the corresponding statistics for FY 2020-21. But as pointed out earlier, the absolute or comparative figures do not tell the actual story. Let us start by analyzing the tax-wise expenditure in an attempt to settle the controversy surrounding tax exemptions and concessions.

Sales Tax

Since the tax expenditure relating to sales tax at Rs. 1,294, constitutes more than half of the total tax expenditure and the increase over the preceding year at 74.92% is also the highest in respect of this tax, any analysis has to start with this tax. Another reason for taking up this tax first is that this can readily expose the fallacy in the criticism mentioned above.

Sales Tax is an indirect tax on consumption; in other words, despite being admittedly collected from businesses, some of which may be owned by the elite, the actual payer of this tax is the consumer. The tax collected on value addition at each stage of the production and supply chain is recovered fully from the consumer who bears the entire burden of the tax.

The misconception that sales tax exemptions and concessions are a relief for the businesses is probably a result of the tendency of businesses to claim credit of sales tax paid by them in media and before policy-making circles.

In fact, they are not paying this tax but only collecting it from the public at large and depositing it in the national treasury. This tendency of crediting the businesses with the payment of sales tax that they are merely collecting creates other problems in reporting and understanding of data.

For example, the sales tax paid on agricultural inputs like fertilizers, pesticides, energy and fuel is allocated to the industrial sector, whereas the burden is borne by the farmers and this less than accurate reporting leads to outcries that the agricultural sector does not pay any federal taxes, despite having approximately 20% share in GDP.

However, payment or otherwise of taxes by the agricultural sector will be dealt with at some other time. For the purpose of our present discussion, after the conceptual clarity that it is not the businesses who are paying sales tax, but the consumers who are the real beneficiaries of the tax expenditure in the form of sales tax exemptions and concessions, we can proceed to examine the myth of sales tax expenditure being a gift to the so-called business elites.

It would be useful to present the breakup of the sales tax expenditure as provided in the report in Table 2.

==============================================================================
Exemption Heads                                                Tax Expenditure
                                                                 (Rs. Billion)
                                                                     FY2021-22
==============================================================================
Zero Rating under Fifth Schedule to Sales Tax Act 1990                 139.448
Exemptions given on POL Products Through Various SROs                  632.950
Exemption under Sixth Schedule on (Imports)                            257.537
Exemption under Sixth Schedule on Local supplies                       133.178
Reduced Rates Under Eighth Schedule                                    129.906
Sales Tax on cellular Mobile Phones under Ninth Schedule                 1.021
==============================================================================
Total Sales Tax Expenditure                                          1,294.041
==============================================================================

Now, we can examine each head of exemption, to test the hypothesis of the above tax expenditure being incurred to benefit the elite classes.

The first head is zero-rating under the Fifth Schedule to the Sales Tact, 1990. Zero-rating under sales tax law is distinct from exemption and the supplies are subjected to zero rate of sales tax, this entitles the person making the zero-rated supply to reclaim the sales tax paid upstream at various stages.

Out of the total tax expenditure of Rs. 139 billion on zero-rating, Rs. 118. 800 billion is given on local supplies and Rs. 20.647 at import of various goods. It is not possible to list and discuss each item which has been zero-rated at the stage of local supply and import, which is available in the report with the cost of exemption for each, but the major items are mentioned to bring clarity.

Among items zero-rated at domestic supply stage, the cost of zero-rating of medicines is Rs 63 billion, of milk products, including infant preparations, is over Rs 33 billion and for crude oil worth Rs 2.24 trillion Rs 16 billion.

These three items alone make over 95% of the tax expenditure through zero-rating on local supplies and the rest is made up of many items including supplies to diplomats, diplomatic missions, privileged organizations given on reciprocal arrangements under international obligations, stationery items, raw materials for export industries, bicycles, etc.

Out of the tax expenditure in the form of zero-rating at the import stage, the major expenditure is on zero-rating of imported medicines at close to Rs 9 billion and the rest include minor items such as milk products, stationery, etc. There is no item which appears to be directed towards elites except that they admittedly must also be using milk products and stationery items.

Next comes the big-ticket item of exemptions given on POL Products at Rs 633 billion, which was single-handedly responsible for the increase over the preceding year, as the tax expenditure on POL products in the preceding year was zero.

The exemption of sales tax on petroleum products was a consequence of the increased prices of oil in the global markets and deteriorating PKR- dollar parity, which forced the government to curtail the increase for domestic consumers by waiving off sales tax. It, however, did not mean that the government did not impose any charge on the petroleum products as these remained subject to Petroleum Development Levy (PDL) at increasing rates throughout the year and in the next year.

Since PDL does not form a part of the FBR taxes therefore, its impact was not included in working of the tax expenditure despite the fact that for the consumers the name under which the government is collecting additional amounts from them does not matter.

The reasons for the Federal Government preferring to collect its share on the POL products in the shape of PDL rather than sales tax need not be discussed here, but are well-known to those who understand the dynamics of fiscal federalism and distribution of federal taxes between the federation and the provinces. Coming back to our subject we need to understand that the exemption on POL products was again not directed to any special interest group but to alleviate the sufferings of already hard-pressed consumers at large.

It is also well-known as to how the increase of fuel prices enhances the transportation costs and acts as a boost for already spiraling costs of goods. It can, therefore be safely concluded that this tax expenditure was also not incurred by the government for benefitting the elites.

On the other hand, had the government not provided relief to the public by waiving off sales tax on POL products, the same people who criticized it for the huge increase in tax expenditure would have held it to account for not cushioning the masses against the excessive increase in fuel prices.

Coming to the third component of the sales tax expenditure, that is the cost of exemptions on local supplies, the report reveals that it is made up almost entirely of exemption on unprocessed food items (including pulses, meat, vegetables, flour, milk, bread and bakery products and cereals), oil cake, exemption to erstwhile tribal areas, pesticides, poultry feed, medicines and their active ingredients.

When we realize that the elites expend a much lower percentage of their incomes on food items and medicines we can conclude that exempting such items, rather than benefitting the elites as alleged are actually a disfavor to them and add an element of equity to sales tax which is otherwise accused of being a regressive tax.

The next component of sales tax expenditure, namely cost of exemption on imports tells a similar story. The major amount of revenue is forgone on import of pulses, rice, wheat, wheat and muslin flour, newsprint and books, raw materials for the manufacture of pharmaceutical active ingredients, imports of plant, machinery and equipment for installation in tribal areas, import of equipment and machinery for power projects, equipment for solar energy etc.

Coming to the last category which is that of revenue lost due to reduced rates of sales tax we find that the tax expenditure is overwhelmingly made up by reduced rates on import of agricultural tractors, natural gas and fertilizers (all types). Here again, one will have to really strain his imagination to allege that the concessions are benefitting the elites.

Income Tax

Total tax expenditure of Rs 423,894 on account of exemptions under income tax law, reflecting only a marginal increase of 1.77% over the preceding year, has been bifurcated into seven categories. For the sake of brevity, it would be better not to discuss these seven categories separately, as done in the report but collectively.

The report mentions a loss of Rs 26 billion on account of exemption to Federal Government, provincial and local governments. Another loss of around Rs 15 billion is recorded on account of allowances for contributions to Zakat, Workers’ Welfare Fund and Workers’ Participation Fund. These contributions are actually compulsory payments under the relevant laws and are meant for the benefit of the workers and downtrodden and in no way benefit the elites.

Next, we come to tax credits, which are primarily of two kinds, the first being tax credits for charitable donations, charitable non-profit organizations and Investment in Shares and Life Insurance Premium at around 35 billion and the second are meant to incentivize investments in new industrial undertakings and in plant and machinery for modernization and expansion of existing industrial units, at a cost of around Rs 40 billion. Both kinds of tax credits have been given to achieve governmental objectives.

The tax credits given for industry need a proper study beyond the scope of this article to ascertain whether the industrial entrepreneurs would have made the investment even in the absence of the incentive of tax credit or not. In the earlier case the tax credit can be termed an undue benefit for the industrialists, some of whom would definitely be members of the proverbial elite. In the absence of such a finding criticising this tax expenditure would be unjustified.

The biggest share of total income tax expenditure is in the form of exemptions in the second schedule to the Income Tax Ordinance, 2001.

The major exemptions and their costs are (i) exemption to IPPs Rs 56 billion, (ii) Non-collection of withholding tax on imports of POL Products, imports into manufacturing bonds, imports by Federal, Provincial and Local Governments, goods exported under export facilitation schemes with a cumulative cost of Rs 67 billion, (iii) exemption to income of philanthropic organizations at Rs 22 billion, (iv) exemption to income from profit on debt and capital gains derived by any agency of foreign government or any non-resident person approved by the Federal Government at Rs 30 billion, (v) exemption to income derived by a Collective Investment Scheme or a REIT Scheme at Rs 21 billion, (vi) reduced rate of deduction on sales made by distributors of specific goods with a cost of Rs 21 billion, (vii) exemption to subsidy granted by the Federal Government to public sector organizations like Utility Stores Corporation at Rs 18 billion, (viii) exemptions to pensions and retirement benefits with a cost of Rs 16 billion and (ix) exemptions in FATA/PATA costing Rs 10 billion.

Some of the above exemptions need no discussion as it is self-evident that these are for the benefit of the general public.

Out of the remaining, the exemption to the income of IPPs (independent power producers) was built in the power purchase agreements entered in by the government and Ministry of Finance or the FBR have no power to withdraw these exemptions. In the defense of those who agreed to these exemptions, it can be argued that had these exemptions not been granted, the government would have been forced to agree to a higher tariff thus burdening the consumers.

Exemption to income from profit on debt and capital gains derived by any agency of foreign Government or any non-resident person approved by the Federal Governmentis given for raising international loans by the government, here too in the absence of the exemption on the interest and capital gains income, the lenders would be charging higher mark-ups and prudent financial management demands this exemption.

This leaves us only with the exemption granted to incomes derived by Collective Investment Schemes or REIT Schemes which can be termed as being primarily for the elites in the guise of documentation and other such laudable objectives and can be considered for withdrawal of the same.

Customs Duty

Out of the total tax expenditure of Rs 521 billion, the major item is the exemptions under bilateral arrangements with different government including Pak-China FTA, Pak-Malaysia PTA, Pak- Indonesia PTA and Pak-Sri Lanka FTA, with a cumulative cost of Rs 102 billion.

These Free Trade Agreements and Preferential Trade Agreements can be criticised on may grounds and require a separate study to evaluate the benefits accruing to Pakistan, but being beneficial solely to the domestic elites would probably be not one of the grounds for criticism.

Exemptions to the vendors of automotive sector with a cost of Rs 66 billion and OEMs of automotive sector with a cost of Rs 113 billion should raise alarm bells in the Ministry of Industries & Production and Ministry of Commerce.

How long are we going to protect an inefficient industry that has failed to provide quality products to the consumers at regionally competitive prices? However, the blame for these undue benefits again does not lie with FBR. Exemptions on import of Plant, Machinery and equipment at a cost of Rs 38 billion and by Poultry and Textile sectors at Rs 65 billion have obvious justifications as do export related concessions of Rs 30 billion, a cost of Rs 42 billion on import of essential edible items and Rs 20 billion on import of active pharmaceutical Ingredients, drugs, packing material by pharma sector and diagnostic kits. Same is the case with exemptions for gifts and donations for charitable hospitals causing a loss of Rs. 9 billion, for relief goods at Rs 4 billion, for imports by diplomats, diplomatic missions and privileged organizations at Rs. 5 billion and exemption for Exploration and Production companies at Rs 7 billion.

The above discussion is expected to take care of the accusations regarding the tax expenditure of Rs 2.24 trillion being incurred to benefit the elites of the country.

On the contrary, it shows that to a very large extent the government is foregoing precious revenues to provide some sort of relief to the general public and for promoting exports and boosting economic development. One can argue with the design of some of the tax incentives, but attributing hidden motives to the government for giving these exemptions and concessions does not seem to be justified.

It is also worth mentioning that during the IMF (International Monetary Fund) Extended Fund Facility between 2013-2016, a comprehensive review of the available tax exemptions and concessions was undertaken and all distortionary and discriminatory exemptions were withdrawn with an impact of over 1% of GDP.

The tax experts may therefore reappraise their strategy of blaming the exemptions and concessions in tax codes for the low collection by FBR. However, it is not being suggested that elites do not get disproportionate benefits from the governmental policies, but there are other instruments to achieve and sustain this ‘elite capture’, identification of which would require greater insight into the working of the government and powerful lobbies, this can only be accomplished if the tendency of picking easy routes such as blaming the tax expenditure is discontinued in favor of more meaningful work.

Copyright Business Recorder, 2023