This Policy Brief addresses four issues: enhancing fiscal equity, enhancing horizontal equity, federal fiscal constraint concerns, and dangers of any attempt to dilute or roll back the 2010 devolution.
The National Finance Commission (NFC) is a constitutional body that has to be constituted every 5 years and which is tasked to determine the respective shares of the federation and provinces of specified federal tax revenues, referred to as the Federal Divisible Pool. The 7th NFC Award, concluded in 2009-10, was historic on three counts.
One, it changed the long-standing single criterion - population - formula for fiscal (horizontal) distribution between the provinces to a multiple criteria - population, revenue, backwardness and population density - formula.
Two, it devolved GST Services to the provinces, as stipulated in the Constitution.
And three, the change was brought about by consensus, without any province feeling it had been shortchanged.
The primary credit for the success of the 7th NFC belongs to the then Federal Government, as it committed itself to cover any loss, via increase in the provincial share in the vertical distribution, that any province would incur as a result of the change from single to multiple criteria. In the event, the provincial share was increased from 47.5% to 57.5% - and Punjab, which was the sole loser on account of the change of the inter-provincial (horizontal) distribution formula, received 113 rupees for every 100 rupees it gave up.
There are expectations with regard to the next NFC on all sides. Provinces expect the federal share to be reduced further and cases for meeting rising provincial expenditures are being built up. To an extent, the federal government is itself responsible for raising provincial expectations by commissioning them to draw up estimates of their future fiscal requirements. Some provinces are also gearing up for a demand to raise the weight of one or the other of the four criteria. Even the federal government has thrown in their claim for more resources, asking for 7% of the gross Divisible Pool for security expenditures and financing federal expenditures in FATA, Gilgit-Baltistan and Azad Jammu & Kashmir.
The 7th NFC Award is of great significance as it broke the stalemate in the inter-provincial distribution formula and strengthened provincial fiscal autonomy. However, the Award is static and the tax revenue debate is restricted to 'who can get how much'. It may now be necessary to take the debate forward towards making the NFC distribution formula advance equity goals.
2. Composition and distribution of Divisible Pool:
The basis for resource distribution between the federation and provinces and between provinces is the Federal Divisible Pool. Over the years since NFC was constituted in 1974, the composition of the Divisible Pool has changed, as shown in Table 1. The process began with the 1st NFC in 1974 with a 20:80 distribution between the federation and the provinces, with the Divisible Pool including three taxes - Income & Corporate Tax, Sales Tax, and Export duties. The 4th NFC in 1991 enlarged the Divisible Pool by adding Central Excise Duties, but retained the federal-provincial distribution ratios at 20:80. The 6th NFC in 1997 further enlarged the Divisible Pool by adding Import Duties, but drastically reversed the federal-provincial distribution share to 63:37.
In other words, the 6th NFC raised the federal share from 20 percent to 63 percent and the provincial share was reduced from 80 percent to 37 percent. The rationale for this shift was explained by the following: Import Duties constituted the major revenue source for the federal government - single largest tax revenue source, accounting of one-quarter of tax revenues - and its inclusion raised the size of the Divisible Pool significantly. Resultantly, provincial revenues increased in absolute terms despite the reduction in its share. The composition of the Divisible Pool has since remained the same; however, the federal-provincial distribution was changed to 52.5:47.5 in 2006 and to 42.5:57.5 in 2010.
3. Imperative of equity:
Taxes impose a burden on those taxed and the burden can be proportionate or proportionately higher or lower relative to income. The burden is termed as incidence and is designated as progressive if the burden of the tax is higher on the rich and regressive if it is higher on the poor. Generally, direct taxes, i.e. taxes on income, wealth, property, etc., are said to be progressive and indirect taxes, i.e. sales taxes, customs duties, excise duties, etc., are said to be regressive. A tax regime that is progressive is said to be equitable and fair relative to one that is regressive.
In Pakistan's case, about 40 percent of federal tax revenue is accrued from direct taxes and 60 percent from indirect taxes. However, over two-thirds of income tax is collected in advance as withholding tax is, in effect, indirect in nature. Thus, if the withholding tax component is excluded, the effective share of direct taxes falls to a mere 12 percent, with the effective share of indirect taxes rising to 88 percent (see Table 2).
In this respect, attention to the incidence of taxes, particularly indirect taxes, is rendered pertinent and there have been a number of studies in this respect.
- Kazi (1984) concluded that rich farmers in agriculture sector are under-taxed.
- Malik and Saqib (1989) reported the entire tax system to be regressive, i.e. a greater proportion of the burden falling on the poor.
- SPDC (2004) has estimated that the richest 10 percent of the population pays 10 percent of their income in taxes, the same is 16 percent for the poorest 10 percent of the population. GST, in particular, is shown to claim 9 percent of the income of the poorest 10 percent of households, but less than 6 percent of the income of the richest 10 percent.
- Refaqat's (2008) results are mixed ranging from progressive to proportional, with the incidence of GST on food and clothing shown as regressive.
4. Options for greater equity:
Collection of indirect taxes is relatively administratively easy and politically low cost. Resultantly, the federal government has tended to rely rather heavily on indirect taxes for its revenue needs. It even went to the extent of abolishing Wealth Tax on spurious grounds.
Herewith, the objective of rendering the tax regime equitable - inter-personally and inter-sectorally - can be achieved by correcting the currently skewed balance between direct and indirect taxes and between agricultural and non-agricultural income. This objective requires that the federal-provincial tax sharing mode provides the federal government with the incentive to prioritize direct tax collection over indirect taxes and can be realized in the context of the NFC tax distribution formulation.
The basic proposal is as follows:
- The federation retain income tax - net of withholding tax - in full and share indirect taxes with the provinces.
- The federation collect and retain income tax on agricultural income in full.
Full retention of (net) income tax and income tax from agricultural income is likely to induce the federal government to expend greater effort in collecting tax from the rich, reducing the relative burden on the poor and, thereby, make the tax structure more progressive.
The proposed arithmetic of change, based on the fiscal year 2014-15 and depicted in Table 3, is as follows:
The current (2014-15) size of the Divisible Pool is Rs. 2,590 billion, with the federal and provincial shares being Rs. 1,100 billion and Rs. 1,490 billion, respectively. If (net) income tax of Rs. 316 billion is removed from the Divisible Pool, its size diminishes to Rs. 2,274 billion, with respective federal and provincial shares out of the (reduced) Divisible Pool declining to Rs. 966 billion and Rs. 1,308 billion. However, if the federal government retains all of (net) income tax, its share rises to Rs. 1,282 billion (Rs. 966 billion + Rs. 316 billion) - a gain of Rs. 181 billion. Correspondingly, the provinces stand to lose Rs. 181 billion. And resultantly, the effective vertical sharing ratio turns out to be 49.5:50.5.
The loss to the provinces can be compensated by raising their vertical share and correspondingly reducing the federal share. Table 4 provides the range of three different vertical sharing scenarios - 40.0:60.0, 37.5:62.5, and 35.0:65.0 - that can be adopted, depending on federal-provincial agreement on the latter's willingness to accept the extent of a cut in the provincial share.
Inter-sectoral equity:
The Constitution of Pakistan mandates the federation to collect "taxes on income other than agricultural income". Namely, "taxes on agricultural income" is the domain of provincial governments. The arrangement is problematic on two counts.
- One, it creates an inter-sectoral inequity in terms of how the income sources are treated
- Two, it has created a window for using the agricultural sector as a 'tax shelter'. Namely, profits from non-agricultural sources, which are subject to federal income tax, can be shown to accrue from agriculture and tax on which can be effectively evaded on account of weak provincial institutional procedures in respect of assessment and collection of income tax on agricultural incomes.
- And three, provinces have failed to collect tax on agricultural incomes to its full potential partly on account of the close proximity of the tax collector and tax payer and room for collusion between them.
This above stated situation can be remedied if collection of income tax from agricultural income is shifted from the provincial to federal domain. The transfer is not likely to substantially raise the quantum of revenues; however, it is likely to realize inter-sectoral equity and shut off the tax shelter avenue. Given that the revenue from provincial income tax on agriculture of all the provinces combined is just a little over Rs. 3 billion, the revenue loss to the provinces is likely to be small.
(To be continued)
Table 1: History of Composition of Federal Divisible Pool
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Award Federal-Provincial Share (%) Taxes (in Divisible Pool)
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1st 1974 20 : 80 Income & Corporate Tax
Sales Tax
Export duties
4th 1991 20 : 80 As above + CED
6th 1997 63 : 37 As above + Import Duties
Presidential
Order 2006 52.5 : 47.5 As above
7th 2010 42.5 : 57.5 As above
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Table 2: Composition of Federal Divisible Pool (Rs. Bill.)
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Tax Head Current Share in Proposed
(2014-15) all taxes
(%)
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Direct Taxes 1,034 39.9 718*
Income Tax (IT) 1,007 38.9 -
Withholding Tax (WHT) 691 26.7 691
IT net of WHT 316 12.2 -
Other Direct Taxes 27 1.0 27
Indirect Taxes 1,556 60.1 1,556
Customs Duty (CD) 306 11.8 306
General Sales Tax (GST) 1,088 42.0 1,088
Federal Excise Duty (FED) 162 6.3 162
FEDERAL DIVISIBLE POOL 2,590 100.0 2,274
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* net of Withholding Tax component of Income Tax
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Table 3: Arithmetic of reconfiguring federal-provincial
sharing of tax bases (base year 2014-15)
(values in billion Rs.)
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Unit FDP Current Revised Revised Gain Revised
shares FDP FDP size 1 FDP size 2 /(Loss) FDP
(%) size (less 316) (add 316 to shares
federal share) (%)
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Federal 42.5 1,100 966 1,282 + 181 49.5
Provincial 57.5 1,490 1,308 1,308 -181 50.5
Total 100 2,590 2,274 2,590 100
Provincial shares:
Punjab 51.74 771 677 677 -94 51.74
Sindh 24.55 366 321 321 -45 24.55
KP 14.62 218 191 191 -27 14.62
Balochistan 09.09 135 119 119 -15 09.09
Total 100.00 1,490 1,308 1,308 -181 100.00
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Table 4: Arithmetic of compensating provinces for reconfiguration
of federal-provincial sharing of tax bases (base year 2014-15)
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(values in billion Rs.)
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Unit Current Revised Revised Revised Revised
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FDP FDP FDP FDP FDP
distribution distribution 1 Distribution 2 Distribution 3 Distribution 4
Shares Shares Shares Shares Shares
42.5 : 57.5 49.5 : 50.5 40.0 : 60.0 37.5 : 62.5 35.0 : 65.0
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Federal 1,100 1,282 1,226 1,169 1,112
Provincial 1,490 1,308 1,365 1,421 1,478
Total 2,590 2,590 2,590 2,590 2,590
Provincial shares:
Punjab 771 677 706 735 765
Loss - 94 65 36 6
Sindh 366 321 335 349 363
Loss - 45 31 17 3
KP 218 191 199 208 216
Loss - 27 19 10 2
Balochistan 135 119 124 129 134
Loss - 15 11 6 1
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