Budget FY25 through the Laffer Curve

The Laffer Curve, a concept named after American economist Arthur Laffer, expresses the relationship between tax rates and government revenue. This theory becomes particularly relevant in light of Pakistan's recently announced federal budget for FY25, which sets ambitious tax collection targets.

The Laffer Curve suggests that there exists an optimal tax rate that maximizes government revenue, beyond which further increases in rates can actually lead to decreased revenue due to reduced economic activity and increased tax avoidance. Pakistan's new budget aims to collect Rs12.97 trillion in taxes, a substantial 30 per cent increase from the previous fiscal year, with direct taxes projected to be 30 per cent higher and indirect taxes 45 per cent higher than in FY24.

However, this strategy raises concerns about its potential effectiveness and economic impact. The multiplier effect of tax imposition can be fatal for sustainability, equitability and inclusivity, for instance, the levy on LPG has been increased in this budget, which will create bottlenecks in attaining SDG-7 progress of Pakistan and overall inflation targeting in Pakistan.

The budget appears to rely heavily on increasing tax rates for existing taxpayers rather than focusing on broadening the tax base, which could lead to several issues. Increased burden on existing taxpayers may result in decreased compliance and increased attempts to evade taxes. This can potentially lead to more brain drain, business shutdowns, and income inequalities. Moreover, excessive taxation can discourage investment, entrepreneurship, and productivity, potentially slowing economic growth.

By neglecting to broaden the tax net, the government misses an opportunity to create a more equitable and sustainable tax system. There's also a risk that Pakistan could find itself on the wrong side of the Laffer Curve, where further tax rate increases actually lead to decreased revenue. Finding the optimal point on Pakistan's Laffer Curve is crucial, requiring a delicate balance between the need for increased revenue and the potential negative effects of high tax rates.

To achieve its revenue targets more sustainably, Pakistan could consider alternative approaches such as broadening the tax base, improving tax administration through better use of technology and data analytics, simplifying the tax code to improve compliance and reduce administrative costs, implementing gradual rate adjustments instead of sharp increases, and introducing measures that incentivize honest taxpayers and encourage voluntary compliance.

As Pakistan aims to significantly increase its tax revenue, it must steer carefully to avoid the falls of the Laffer Curve. While ambitious targets can drive progress, they must be balanced with economic realities and the potential for unintended consequences. By focusing on broadening the tax base, improving administration, and finding an optimal tax rate, Pakistan can work towards a more robust and sustainable fiscal future.

As Pakistan will be pitching for the IMF’s Extended Fund Facility (EFF), the coming fiscal year will be crucial in determining whether Pakistan's tax strategy aligns with the principles of the Laffer Curve or risks pushing the economy towards decreased productivity and revenue. Policymakers should closely monitor the effects of these tax changes and be prepared to adjust course if needed to ensure long-term fiscal health and economic growth.

Ultimately, the success of Pakistan's tax policy will depend on its ability to strike the right balance between revenue generation and economic stimulation, a challenge that requires careful consideration of the insights provided by the Laffer Curve.

The government's efforts to reform and modernize its tax system, particularly the allocation of Rs7 billion for reforms and digitalization of the Federal Board of Revenue (FBR), are commendable steps towards improving tax administration and collection. This investment in technology and infrastructure can potentially enhance efficiency, reduce corruption, and improve taxpayer services. However, to truly broaden the tax base and create a more equitable and effective taxation system, additional policy measures are necessary.

To broaden the tax base, the government could implement a comprehensive national tax registration drive, coupled with a simplified registration process. This could involve leveraging existing databases such as utility bills, property records, and vehicle registrations to identify potential taxpayers. Simultaneously, a nationwide awareness campaign could educate citizens about their tax obligations and the benefits of participating in the formal economy.

The expenditure profile of collected taxes is equally important to build the trust of citizens in the taxation system, if the taxpayers’ money is being utilized for unproductive expenditures and it is not stimulating any growth nor fostering a conducive investment climate or providing basic social services to the citizen will generate a trust deficit in the system.

Taxing agricultural income, which has long been a contentious issue in Pakistan, requires a delicate approach. The government could consider introducing a gradual and progressive taxation system for agricultural income, starting with larger landholders and commercial farming operations. This could be accompanied by incentives for farmers to maintain proper financial records and investments in rural financial literacy programmes. Moreover, the agriculture sector in Pakistan is largely informal particularly in terms of disguised unemployment, therefore, transforming the agriculture sector as an industry will be vital in multiple regards.

The retail sector, a significant part of Pakistan's economy, often operates informally. To bring this sector into the tax net, the government could introduce a simplified tax regime for small retailers, possibly based on turnover rather than profit. This could be coupled with incentives for digital payments and record-keeping, such as tax credits for businesses that adopt point-of-sale (PoS) systems integrated with the FBR.

To formalize the informal economy, a multi-pronged approach is needed. This could include offering amnesty schemes with reasonable conditions, providing access to credit and social security benefits for businesses that formalize, and gradually increasing the costs of remaining informal through stricter enforcement and penalties. Additionally, simplifying business registration processes and reducing regulatory burdens could make formalization more attractive.

Other measures to consider include introducing a comprehensive property tax system based on current market values, implementing a more robust capital gains tax on real estate and stock market transactions, and improving the taxation of the digital economy and e-commerce sectors.

To make taxation easier and develop trust in the FBR, a comprehensive policy framework could be implemented. This comprehensive framework should prioritize transparency, simplicity, and taxpayer rights, encompassing several key elements. First, it should focus on simplifying the tax code and reducing the number of different taxes and exemptions. Second, implementing a taxpayer charter that clearly outlines rights and obligations is crucial.

Thirdly, establishing an independent tax ombudsman to address grievances and disputes would enhance fairness. Fourth, enhancing digital services for tax filing, payments, and refunds would improve efficiency. Fifth, introducing a fair and efficient audit system based on risk assessment rather than arbitrary selection would boost confidence. Sixth, providing regular public reporting on tax collection, usage of funds, and efforts to combat corruption would increase transparency.

Seventh, investing in taxpayer education and support services, including helplines and walk-in centres, would improve understanding and compliance. Eighth, implementing a reward system for honest taxpayers, such as priority processing of refunds or access to certain government services, would incentivize good practices. Ninth, enhancing data sharing and coordination between various government departments would improve compliance and reduce opportunities for evasion, creating a more robust and trustworthy taxation system overall.

Lastly, the government must refrain from using utility bills as a source of revenue collection, in this regard, the rationalization of energy tariff is a must, particularly for electricity consumers, so that the power consumption profile of Pakistan can be transformed in such a way that there is more productive consumption rather than the unproductive electricity consumption.

Pakistan can work towards creating a more inclusive, efficient, and trusted tax system. This would not only help in achieving the ambitious revenue targets set in the federal budget but also contribute to long-term economic stability and growth. The key lies in balancing the need for increased revenue with measures that encourage compliance, support economic activity, and distribute the tax burden more equitably across society.

Twitter/X: @Khalidwaleed_

Email: khalidwaleed@sdpi.org

The writer has a doctorate in energy economics and serves as a research fellow in  the Sustainable Development Policy Institute (SDPI).