Why Do Taxes Matter?
A state must be able to collect resources in order to invest in future growth.
Last week’s newsletter highlighted issues with Pakistan’s tax system, which is essentially regressive in nature. In today’s post, I will talk about how an ineffective and regressive taxation system undermines economic and human development.
But first, take a look at long-term trends in tax revenue collection.
The chart above shows a 12-month moving average of total taxes collected by the Federal Bureau of Revenue (FBR). As you can see, tax revenues have shown robust growth all the way from 2004 to 2018.
In 2018, the 12-month moving average flattened, then declined by a bit, grew sharply for a little while, and then sharply declined as the economy went into a lockdown due to COVID-19. Revenues has recovered a bit in the last few months, but the moving average is still below its historical peak of over Rs. 350 billion a month.
Why does it all matter?
Countries need to collect and pool resources in the form of tax revenues to invest in economic and human development. Additionally, they need to fund necessary national security needs, and build public infrastructure to boost long-term growth prospects.
For many developing countries, these revenues are not enough, so they borrow additional sums of money from both domestic and foreign lenders to meet additional needs.
The fiscal deficit is viewed as one of the key indicators that is used to measure a country’s borrowing needs. Run too high a fiscal deficit and concerns about the state’s long-term fiscal stability grow, leading to a downgrade of a country’s credit rating. Additionally, too much borrowing can lead to inflation, forcing a central bank to raise interest rates, which increases borrowing costs tremendously.
A country like Pakistan, which has chronic issues when it comes to its fiscal deficits, needs to broaden its tax base in order to fund its development and national security needs. When tax revenues plateau and decline, as the chart above shows, Pakistan ends up borrowing increasing amounts of money to simply meet its necessary expenditures.
This means that there is a resource constraint for spending more money on education, healthcare, public infrastructure, and other categories that would boost long-term economic growth.
By not fully funding these key categories, long-term growth suffers. As that happens, the economic pie simply does not grow at a fast enough pace, which means that future tax revenues also remain constrained.
Which means that in the future, there is a further constraint on spending for education, healthcare, public infrastructure, etc.
And all throughout this period, the country continues to borrow more and more just to fund the most important spending categories, with national security and interest payments on debt taking a large chunk of fiscal resources.
This borrowing also crowds out private sector investment. Because of the fact that the state needs additional resources to fund its deficits, banks have a risk-free borrower they can lend their money to. This reduces the incentive to lend to riskier borrowers, such as businesses, particularly small- and medium-sized businesses that need capital to scale up and invest in their growth.
This stunts the growth of the private sector, which in turn means that tax revenue growth is also stunted, which means that resource constraints grow in the future.
In short, a self-reinforcing cycle of higher fiscal deficits, higher borrowing, and constrained tax revenues paralyzes Pakistan’s future economic growth prospects, leading the country to fall further and further behind peer economies.
An equitable taxation system is the only path forward.
Tax reforms is a necessary precondition to solving this problem.
Yes, other inefficiencies also need to be solved for, particularly issues related to circular debt and loss-making state-owned enterprises. These reforms will help alleviate some of the fiscal constraints faced by Pakistan. But even if these were to be solved, the country simply would not be raising enough taxes as a percentage of total economic output to invest in all the things that need investment.
If Pakistan is to become a modern, globally-competitive economy, it must overhaul is taxation system, making it more equitable and less regressive in nature. Without that, future growth prospects will remain dim and the country’s citizens will continue to be buried under mountains of debt.