Comment: A brewing tax rebellion

FOR too long has the question of tax reform in Pakistan been treated by successive governments and international donors as a narrow technocratic issue. As witnessed in the budget passed last week, the default practice is to vary the tax rates on a narrow base and add a raft of indirect taxes on the hapless masses.

To make it a more serious endeavour, tax collection is reduced to a problem of legal enforcement to be solved by hounding tax evaders into submission, the latest example being the blocking of SIM cards.

But that is missing the point. Pakistan is in the throes of a major distributional struggle over how the state extracts resources from its citizens and how it spends them. Historically, the tax burden has been overwhelmingly borne by the captive salaried classes, productive sectors of the economy, and the poor who are more harshly subjected to indirect taxes.

By contrast, only a very small fraction of self-employed individuals and businesses pay direct taxes on their incomes, while politically influential constituencies benefit from a variety of tax exemptions that further narrow the tax base. Even as the poor have borne a growing tax burden, real estate, which is the least productive sector of the economy and where the bulk of wealth generation has taken place since the 2000s, is only taxed very lightly. As a result, Pakistan has a perverse taxation system under which the poor are effectively subsidizing the rich, and the most productive sectors of the economy are taxed more heavily. Unfortunately, this year’s budget has only reinforced this pattern.

Around the world, successful states strive to raise revenue in a manner that is perceived to be fair, does little collateral damage to the wider economy, and can be easily enforced. Pakistan struggles on all these counts. The consequences are visible in a low tax take, a large informal economy, dependence on foreign aid, and rising public debt. They are a major obstacle to creating a more productive and globally competitive economy. All of this is widely known, and much has been written in Pakistan about how to solve the issues from a technical standpoint. Why, then, has tax reform remained such an intractable issue?

The answer lies in political economy. A thousand years ago, the Arab philosopher Ibn Khaldun argued that to judge how just and well-governed society is, one should look at how it is taxed. A well-governed society will have a small tax rate applied to the widest possible base. The complete opposite is true for Pakistan. Khaldun warned that a taxation system like ours is unsustainable, typically resulting in conflict.

More fundamentally, for a state to be functional, it should be able to extract sufficient revenues from within its borders, while also being able to protect itself from threats outside its borders. Throughout world history, those who have held the state’s coercive power have helped build fiscal capacity, not least because war-making required resources.

Perhaps more importantly, this process of building fiscal capacity forged a new relationship between the state and society. More specifically, in the US and Europe, states gathered resources from merchants to finance their militaries. In return, merchants received concessions, notably rule of law and protection of property rights. This process of give and take around taxation and spending proved vital to building a culture of trust and reciprocity between the state and its citizens. Given this long-standing link between revenue raising and governance observed across American and European history, it is surprising that this critical state-building function is ignored when designing tax policy in poor countries, including by international donors.

Viewed in this light, Pakistan’s tax woes reflect our historic failure in state building. The only thing that will make Pakistan a fiscally viable state is the emergence of a new social contract. A contract under which the state extracts resources but provides genuine representation to the people and allows them to hold it accountable for its expenses.

This reciprocal relationship will require bargaining and compromise. For example, if retailers and traders are to be brought into the tax net, they need to buy into a new vision for the country where they feel protected and benefit from state spending. For this, they need to perceive the tax system as being fair, observe that other taxpayers are also complying, and have confidence that the government will use the money wisely.

We are far from such a social contract today. It is difficult when a regime is viewed as lacking political legitimacy. It is even more difficult when this year’s budget features a doubling down on indirect taxes and penal levies on the salaried class, egregious tax exemptions for the privileged, profligate increases in government spending, and continued under-investment in social services. Moreover, given anaemic growth and a historic cost of living crisis, it is no wonder that the public is up in arms. It would be shocking if international donors turned a blind eye to this brewing social tension and signed on to such a budget. The silver lining may be that moments of crisis can lead to bold reforms. Pakistan is facing such a moment. However, the window for genuine tax reform is closing. History is littered with cautionary tales of how perceived unfairness and illegitimacy of the state can lead to tax rebellions that reallocate power across societies, often violently.

When English barons forced King John to sign the Magna Carta in the 12th century, it heralded the rise of parliamentary democracy. When the Patriots of Liberty dumped British tea into the Boston Harbor under the banner of ‘no taxation without representation’ in the 18th century, it laid the foundation for the American War of Independence. And in Europe, at around the same time, popular dissatisfaction with the excessive and unfair taxation of the ancien regime played a key role in fomenting the French Revolution.

Such tax rebellions are seldom just about taxes. They are a tipping point, reflecting more fundamental disputes over how power is distributed across society. Pakistan must find a way to resolve its fiscal problems through an inclusive political discourse. This path would sustain the power of the state and rebuild its troubled relationship with society. As previewed in Kenya last week, the alternative involves violence that can easily spiral out of control. It is too bleak to contemplate.

Murtaza Syed is former acting governor of the State Bank of Pakistan.

Adeel Malik is an associate professor of development economics at the University of Oxford.

Disclaimer: The viewpoints expressed in this piece are the writers' own and don't necessarily reflect The News' editorial policy.