Income, not consumption, taxes: Applying a ‘national income tax’ for a welfare state

‘The fundamental injustice of consumption taxes, relative to income taxes, is that the well-off can postpone them by saving, while the poor pay cash on the nail. “Justice too long delayed is justice denied”: this is true also when it comes to taxation.’ – An excerpt from a noted 2019 published book ‘The triumph of injustice: how the rich dodge taxes and how to make them pay’ by renowned economists Emmanuel Saez, and Gabriel Zucman.

Pakistan has not only a chronic problem of low tax collection as a percentage of gross domestic product (GDP, or simply national income), but also the nature of taxation is such that middle- and lower income groups bear most burden of taxes. While it has to do both due to low tax base, that is a large undocumented or informal economy goes beyond the tax radar, and certain sectors like agriculture, property, retail, and finance, for instance, are very lightly taxed in terms of income, there is a strong emphasis on consumption taxes like general sales tax (GST), excise tax, among others, on the overall economy.

The main problem with consumption tax, which is mostly an indirect tax, is that it is regressive in nature, putting most burden on least incomes. Although value-added tax (VAT) –not applied in Pakistan – has the advantage that it allows for documentation of the economy, and has a larger tax base therefore, since it taxes throughout the supply chain, nonetheless it is not a tax on income or, in other words, is not a direct tax.

In their same book ‘The triumph of injustice: how the rich dodge taxes and how to make them pay’, Saez, and Zucman, pointed out that while ‘VAT has clear advantage over the consumption taxes it replaced… taxes services as well as goods. …does not create cascading taxes over the chain of production – as turnover taxes do… is harder to evade than sales tax because the tax is collected at each stage of production, not only at the time of the final sale… VAT has two big flaws: it’s regressive and its tax base, although larger than that of payroll taxes [that is income tax on labour income or salaried class], is too small. VAT is regressive because it taxes consumption, not income.’

Moreover, a big drawback in terms of applying the VAT is that it lets the finance sector virtually off the radar, because it is difficult to see the supply chain of financial services in a disaggregated way. It is, therefore, important to tax income in the financial sector, including income on the interest earned. The same book pointed out in this regard: ‘VAT excludes finance because there’s no easy way to compute “value-added” in the financial industry.

For regular businesses, value-added is equal to sales to customers minus cost of intermediate inputs. The financial sector manages your funds (bank accounts, mutual and pension funds) by taking a cut on the returns and it lends you money (credit cards, student loans, mortgages) at a high rate.

But it does not explicitly and separately charge for its services.’ It is therefore, important to have income tax on financial sector. Hence, instead of moving towards a VAT regime, it is important to move towards a broad-based income tax, but more on it later in the article.

In the post-World War II era of greater financialization of global economy, including in Pakistan, and under the practice of over-board monetary austerity policies in the wake of neoliberal or Washington consensus-styled policies (wrongly) seeing inflation as mainly an aggregate demand-squeeze problem, financial sector – which in any case has an income growth rate greater than national income, while labour income grows at a far less pace, whereby lack of capital or financial sector taxation has immensely contributed to accentuating income inequality over this time – income needs to be taxed.

As an important corollary, lack of taxation in the financial sector, and a potent growth rate there, has resulted in increasing level of liquidity available with people with high level of profits and/or savings, particularly in the financial sector, for funding political parties, especially in terms of election campaign funding, creating in turn a collusion with policymakers, who when in power, in reciprocation to this financial assistance from this moneyed interest, have made policies that played an important part in keeping the financial incomes away from income taxation; especially when as indicated earlier, the financial sector provided little scope for taxing financial services through indirect taxation, in particular at the intermediate stages of supply.

Moreover, lack of public investments, mainly due to lack of fiscal space, which could have been considerably enhanced both through meaningfully taxing the financial sector, and through adopting non-austerity, and neoliberal policies overall squeezing the extent of role of public sector, and regulation have further depleted the political voice of the middle- and lower income groups, and with it the weight of their political voice to push for greater shift from indirect or consumption taxes, to income or direct taxes.

Here, it is important to highlight the ever-increasing role of market of tax dodging, with much more sophisticated and creative ways provided by the suppliers of tax dodging advice, exploiting the expanding space in tax law legislated in a sub-optimal way by compromised policymakers, leaving loopholes intentionally in the wake of perpetuating collusion of moneyed interests in the financial sector, and their financial contributions to political parties.

Regarding tax dodging, which results in tax avoidance, and tax evasion, Saez and Zucman in their same book underscored the need for taxing all income, arguing: ’When companies book profits in tropical islands, when lawyers incorporate, when doctors invest in tax shelters – they are not driven by laws of nature.

Such actions arise when the tax code favors certain forms of income over others, and when governments let people exploit these differences. …The supply of tax dodges in circulation is too large. Before we can effectively tax the wealthy more, avoidance must be curtailed. We need to create the institutions that make a robust tax system sustainable in the long run…’ One important way to create such an institution in the fiscal sector is applying, as the two authors (rightly) recommend in their same book is a ‘national income tax’ that is applied on all incomes.

Hence, instead of consumption taxes, which are regressive in nature, there is a need for a quick shift towards taxing all income, and in an overall progressive way, whereby some direct taxes are placed in a proportional or flat way – for instance to cater to needed ease of administrations, and for fulfilling the objective of documenting the economy– and others in a progressive way, but both catering to exceptions, for instance, transfer payments to protect the vulnerable sections of the society.

The same book pointed out in this regard: ‘…value-added taxes can generate large flow of revenue that can help fund education, health care, and other public goods that raise standard of living. …Development is not primarily a matter of mechanically collecting taxes to fund spending, no matter how useful this spending may be. Development is about building trust in institutions, including, most importantly, governments. When governments take more from the poor than from the wealthy, sustained trust becomes impossible.’

Moreover, as earlier indicated, consumption taxes are very regressive, because it is mainly the lower income groups that spend most of their incomes, while the wealthy save, and the ultra-wealthy save most of their incomes. At the same time, tax on interest rate, which will target both lending institutions, and also savings, mainly of the wealthy.

More than providing tax, taxing interest rates will also push or incentivize people to shift their idle resources from the financial sector, to larger productive activities in the real sector. This would not only provide better resource sharing across income groups for providing public goods, otherwise used by all, but will also help reduce income- and wealth inequality created by sub-optimal taxation policies significantly influenced by moneyed interest, and provided cover by the collusion of such interest with political parties and, in turn, policymakers in political power.

Hence, there is a need to move towards a broad-based tax that targets all national incomes, and is needed for not only lowering income and wealth inequality, but also overcomes the issue of undocumented segment of the economy as it targets all incomes – except transfer incomes, for instance, to protect the vulnerable sections as earlier indicated – including lower income groups because the proposed ‘national income tax’ comes in replacement to consumption taxes like sales tax, and in conjunction with other direct taxes like wealth tax, income tax, and corporate tax.

Such a tax is important for funding the social welfare state that is in line with catering for the basic human rights of every citizen, like universal health care, child care, and free education, and also safeguards against regressive taxation, tax avoidance, and tax evasion. Such economic empowerment of demos will also help enhance political voice of the demos, with positive consequences for strengthening democracy, and diminishing the stranglehold of elite capture, or collusive politico-economic extractive institutional design.

This tax also allows going over the VAT regime, which is also regressive in nature, and can also capture the positive impacts of VAT at the same time like optimally shifting tax burden – over the entire supply chain, across income groups, and equally over labour and capital sectors – and reducing the size of informal economy to minimum possible. The authors highlight the contours of the proposed ‘national income tax’ as follows: ’[Like Pakistan] the United States can leapfrog the VAT.

It can pave the way for creation of the fiscal institutions of the twenty-first century… How? By creating a national income tax. …[which] is a tax on all income, whether it derives from labor or from capital, and whether it originates from the manufacturing sector, finance, nonprofits, or any other sector of the economy.

The tax does not exempt saving, which is highly concentrated among the well-off and is more effectively encouraged by government regulations (such as automatic enrollment in pension plans and financial regulation) than tax breaks.

To keep administration simple, the national income tax has a single rate and offers no deductions. …[it] is certainly not meant to replace the income tax, or any other progressive tax for that matter. It is meant to supplement progressive taxation and to replace regressive taxes… The national income tax is a true flat income tax.’

Copyright Business Recorder, 2024