Taxation, inflation and development

By Aftab Ahmad Khan

One of the most important objectives of economic development suggested by recent experience is the need of avoidance of inflation or control of the tendency to persistent climb in prices. A sharp price uptrend interferes seriously with the successful implementation of programmes of development. It directly inflates the money cost of development projects and programmes and results in escalation in financial terms of medium and long-term plans with self defeating consequences for their real targets, which get eroded in the process. It distorts besides the investment pattern as income and price relationships alter. It eats away exports and gives fillip to home consumption. In some ways, the most serious consequence of this phenomenon is the direct accentuation of economic inequality as rise in prices impairs the real value of wages, pensions and other fixed incomes.

Endemic rise in prices destroys the continuity of economic life and economic processes, the basis of contract, of foresight, of incentive to work and save and invest, for it threatens a flight from money, makes organised business like banking and insurance difficult, turns investment into a gamble, impoverishes persons who finance business and industry on terms of a fixed return and others who depend on relatively fixed incomes, renders cost and efficiency in business of little account, honesty of no meaning, thrift no longer a virtue but sheer folly and thus undermines the economic foundations of civil society and leads to ultimate collapse of the economy.

It is generally insufficiently appreciated that many of our social, political and administrative problems have their roots in the persistent rise in prices.

History tells us that countries in a state of inflationary ecstasy are generally prone to administrative breakdown, class conflict and disorder – the precursors of totalitarian government. It is with the background of this picture that the Government and the State Bank of Pakistan (SBP) are trying to fashion their policies with the primary objective of avoiding high inflation in the process of effecting the transference of financial resources of the people for the purpose of meeting public expenditure obligations in the fields of development, defence, administration, and economic and social services.

The seeds of inflation lie in what is called the inflationary gap or the gap between money incomes generated on the one hand and the value at existing prices of the goods and services available for purchase on the other. An important source of inflation in Pakistan for a number of years has been the part of the government expenditure, which has been met by the creation of new money or deficit financing. The safeguards against inflation lie in the deft and skilful adaptations of fiscal and monetary tools to prevent too excessive a pressure of demand supplemented by measures designed to ensure a steady boost to production and productive efficiency through fuller and more effective employment of resources.

Some what erroneously many leaders of business and industry as well as some economist have attributed the prevalence of inflationary pressures in the economy to the level and structure of taxation.

It may be said at once that over and above the savings placed at the disposal of the government through receipts of loans and small savings and the external resources mobilised by it, major reliance for financing expenditure on administration, economic and social services, defence and development has to be placed on taxation in an economy where the propensity to consume is abnormally high. The structure of taxation, which will be suitable and efficacious for the purpose of enhancing investment, is an adequately diversified scheme of taxation-direct and indirect-that seeks to secure the diversion of financial and physical resources from consumption to investment on a scale appropriate to the dimensions of the development programme. Taxation of a wide range luxury or semi-luxury products at fairly substantial rates as well as broad-based taxation of articles of mass consumption is therefore indicated. In the field of direct taxation the problem is one of extending the coverage especially to agricultural incomes as well as of repairing the net and improving its efficacy to collect the taxes that are levied.

Indirect taxation has to remain a more important means of adding to government resources for sometime. A major issue which the extension of the scope of indirect taxation throws up is whether such increase in taxation will not be inflationary, by adding to the costs of production and prices generally so that the very objective of taxation, namely to avoid inflationary consequences of expenditure might run the risk of being defeated. The possibly wide appeal of this argument lies in the fact that theoretically there is a point beyond which additional taxation itself becomes inflationary, when the only way to avoid inflation is to avoid incurring the expenditure that gives rise to it. The objective of such taxation being primarily to increase public resources by reducing private consumption, if the point is reached where increase in taxation does not reduce private consumption any further, but is met by transfer to the state of past savings through drafts on capital of proceeds of fresh indebtedness (say by liberal credit policy), then taxation ceases to be disinflationary but itself becomes inflationary. The fallacy of this argument consists is what undoubtedly is correct in a certain theoretical context to the existing context of the country. There is little doubt that selection and discriminating increase in prices resulting from specific indirect taxes should help in restraining consumption and in releasing resources for investment. Indirect taxes in any case are for superior to deficit financing as a means of raising resources. With indirect taxes, the price rise cannot be, by and large, of the order of general rise in prices under an equivalent system of deficit financing. To the extent taxes are levied on certain goods and services, the incomes of producers and consumers of those goods and services will be reduced and their demand for other goods and services will be curtailed, so that rises in some prices would tend to be compensated by falls in other prices. In practice, other prices may not fall as deficit financing and other sources of inflationary pressure may remain in simultaneous operation.

On the whole, however, transference from private incomes to public revenues can be carried out with a much smaller rise in the price level them would occur if deficit financing were used in lieu of indirect taxes.

Direct taxes, however, are definitely superior to indirect taxes as a means of resources mobilisation as also on grounds of equity. While taxes are never popular in any country, rich or poor, unfortunately there is no escape from then in view of public expenditure requirements.

Of course, no definite percentage of Gross Domestic Product (GDP) can be termed as the proper limit for the cost of the government, since such a limit must depend on the relative circumstances. The proper size of public expenditure depends on the desires and needs of the community, the stage of economic development and other variables.

In Pakistan, to a significant extent our dependence on external resources, excessive reliance of the budget on domestic borrowing, inflationary pressures and inadequate expenditure on infra structure and development of human resources can be attributed to our inability to tax ourselves adequately and equitably. Our tax-GDP ratio in 2006-07 was 10.2 per cent, white total public revenue as a percentage of domestic out put has 14.9 per cent.

In Pakistan, the establishment of an adequate and efficient tax system faces formidable challenges on account of the structure of the economy which is characterised by a large share of agriculture and services in our output and employment and large informal sector activities and occupations through many small establishments. The structure of the economy in association with low literacy has rendered the task of fashioning a good tax system quite difficult.

The ineffectiveness of our fiscal system in arresting the rapid advances of the parallel economy has resulted in the creation of a “glass curtain society”, wherein a very small minority has access to many of the goods and services which the people in high income countries enjoy, whereas the vast majority without adequate purchasing power watch the consumption being indulged in by the privileged people with no rights of entry to the luxury market. This is an important cause of social tensions, alienation and anomic trends in our national life. The inadequacies and inequities of the tax system, however, are not irremediable. Given political will, these certainly can be rectified.