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Entrepreneur activity and statuary tax requirement an empirical analysis for Pakistan.

ABSTRACT:

Pakistan has 36.5% corporate tax rate which is remarkably higher than other developing countries. The high corporate tax rate would drive capital away from the corporate sector and goes into housing and for other uses slowly but surely the negative impact is resulting in flight of capital from the country. These neither enhance productivity nor generate real economic activity in the economy. One way to encourage the investment and entrepreneurship would be to reduce the statutory corporate tax rate. Government choice of corporate tax would impact badly on both domestic and foreign investment. This paper focuses on the relationship between investment and corporate tax rate (CAT). Linear dependency has been checked for the period of 1991--2011; to verify the above simulations. Indicating the significant impact on private investment due to corporate asset tax while public investment is not much influenced by statuary requirement and this evidences; the impact it generates on over all investment environment and aggregate economic activity.

Key words:

Corporate asset tax (CAT), entrepreneur activity, economic growth

JEL--H2S, 04

1. INTRODUCTION:

A strong and vibrant corporate sector is a key to economic prosperity in the country in order to achieve this affectively government adopt various strategies to attract local as well as foreign investors thus this corporate sector not only generate economic activities but also provide a source of income to the government. Over the last 20 years, the need for tax slab has increasingly being felt to attract investment from footloose multinationals. Global rates have come down from high in early 1990's to a very low scale now. Existing corporate tax rate in Pakistan is 35% of the net taxable income of the companies. For non resident 15% is levied on the gross amount of royalties and other technical services fee and 30% on other payments. It could well be a major revenue source in budget and increase in corporate tax generates huge revenues albeit increased tax burden on corporate sector. This would increase the share of tax to gdp ratio but would have negative impact on growth in corporate sector.

One way to spur private investment in the economy and get it into the hands of the entrepreneurs would be to reduce the statutory corporate income tax rate. Reducing the corporate tax rate would make investment by domestic and international firms more attractive. The lower rate provides an incentive and would likely to result in more entrepreneurial activity with investment in new value creating ventures. Additionally, lowering corporate tax rates helps in minimizing distortions in financial markets and brings about more efficient mix of debt and equity.

Empirical findings suggest that user cost of capital has significant impact on capital formation i.e. supply of capital stock to entrepreneurs, hence enhancing entrepreneurial activity and economic growth. Although it can be seen that statutory tax requirements impact private and foreign sector investment more than public sector but Investment on whole is affected.

2. LITERATURE REVIEW:

Past theoretical studies suggest that higher corporate tax rate would reduce economic growth rates. The studies have used investment as an indicator to represent economic growth. Djankov, Granser, Mcliesh and Ramalho in (2009) present new data coming from a survey on effective corporate income tax rates. This study shows that the estimates of the effective corporate tax rate have a large adverse impact on aggregate investment, FDI and entrepreneurial activity. Lee and Gorden in (2004) explore how tax policies in fact affect a country's growth rate, using cross country data during 1970-1997. Finding that statutory corporate tax rates are significantly negatively correlated with cross sectional differences in average economic growth rates as studied by Cullun And Gorden in (2000) explore the potential effects of tax system on entrepreneurial activity. Most of the work done in Pakistan regarding investment evolves around the determinant of business fixed investment like Nishat and Aqeel, Padda and Akram so on so forth. Mostly the work relating to tax and investment comprises of cross sectional analysis highlighting certain issues either highlighting fiscal issues or financial variables like debt and equity etc. Padda and Akram empirically analyze that the increased tax rates may have permanent effects on output but will have only temporary effects on its growth rate. Nishat and aqeel in (2005) also empirically identify tax rate as a major determinant of growth in foreign direct investment in Pakistan during 1961-2003.

3. Pakistan Tax Structure

Tax system in Pakistan is extremely uneven, sector wise distribution are highly uneven, manufacturing sector have a 20% share in gdp producing 60% revenue, meanwhile agriculture sector have more than five percent 25% share to manufacturing producing minor amount 1% producing in country.

After 1990 the tax collection of Pakistan continuously worsened due to administrative weakness, system of tax evasion, narrow tax evasion, and loose structural problems resulting tax to gdp ratio decline from 10.6% to 10% in the years of 1999-2000 to 2007-08. Government perception about public funding and some stabilization policy in macroeconomic with support of IMF commitment, would increase tax collection from 10 to 13.2% in years 2012-13. Tax to GDP ratio of other developing countries like India, Bangladesh, Srilanka, Nepal have same administrative and tax policies but have higher tax to gdp ratio.

Basically fiscal structure of Pakistan consists of federal and provincial governments. Collection of tax revenue comprises by indirect taxes as

1. Personal and corporate tax (excluding tax on agricultural income)

2. Capital taxes (excluding tax on immovable property)

3. State duty and gift tax

Through province wise direct taxes are

1. Tax on agriculture income

2. Urban immovable property tax

3. Capital gains tax on land and building

4. Taxes on professions, trades and callings.

5. Land Revenue tax

Corporate tax system is one of those levied on fixed assets on Business Corporation. Through Pakistan corporate sector with the SECP (security and exchange commission of Pakistan) 55,511 companies were registered. They are main contributor in national revenue and also producing remarkable employment generating sector. Although corporate sector is largly tax noncompliant in Pakistan; hardly 19,000 companies file their returns and few thousand companies actually pay tax. Thousands of corporate entities do not file their mandatory corporate tax returns and FBR has selected some 50,000 corporate taxes by May 15, 2011.

According to World Bank report (2010) showed the persistent 35% corporate rate existing still from 2003 to 2010.

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Planning Commission Pakistan task force for private sector recommended that reduction in corporate tax rate in 2011-12 budget will focus on documenting the formal sector, integration of domestic taxes, tax management improvement, administrative procedures and bring GST(general sale tax) into VAT(value added tax). Federal board of revenue announced that due inclusion of 15% flood surcharge the corporate sector will have to pay 36.5% corporate tax during the fiscal period of 2010-2011.

1. Theoretical discussion a) Why corporate tax matters:

Corporate asset tax matters for economic growth because all corporations' investment decisions are influenced by the tax rate effects on a projects rate of return. The after tax rate of return determines that whether the project in question should be considered or forgone. Additionally it influences as to where multinationals businesses decide to invest in new productive revenues. Investors are the sole supplier of capital stock to entrepreneurs the greater volume of investment will increase the overall capital stock and the level of technology available to businesses, increasing the overall productivity and real wages of the workers.

Reducing the corporate tax rates might help in minimizing distortions in financial sector and bring a more reflective mix in debt and equity. Corporate tax turns corporate financing choices toward debt financing. Allowing the split between debt and equity financing to be chosen according to the underlying economic fundamentals; sending clearer signals for investment returns which are so critical for all economic activities

Since economy is the complex system based on trade and specialization, those who incur a tax liability is not necessarily the ones who would bear its burden. Theories show that higher corporate income tax is particularly bad for economic growth, because the burden falls on all of the productive sources (workers, capital and entrepreneurs) of the economy. This is due to the fact that corporations do not pay taxes as the individuals do because they merely are an organizing mechanism for the resources. And last but not the least; high corporate asset tax may possess a motivation for small entrepreneurs to switch toward the informal economy hence evading legal tax requirement.

Rates of Income Tax on Companies (including Surcharge)

The rates of tax on companies have been reduced gradually from the assessment year commencing on July 01, 1993 as per the following chart:-
Assessment  Banking Co's %  Public Co's % other  Private & non-listed
                                   than banking                Co's %

1993-94                 64                   42                    52

1994-95                 62                   39                    49

1995-96                 60                   36                    46

1996-97                 58                   33                    43

1997-98                 55                   30                    40


Investment:

The investment here is used as a combination of public, private and business fixed investment Each investment sector has its own determinants but here we try to find out the impact of corporation statutory tax requirement on public, private and foreign investments in particular controlling the impact of other determinants of investments. This high corporate tax rate causes a misuse of our capital stock. More specifically it drives investment out of corporate sector into other less productive sectors that neither increases productivity nor real wages. Since interest payments by companies are deductible in calculating taxable profits, the higher tax rate induces firms to use too much debt to finance their operations, increasing risk for them in particular and the economy in general.

More over the difference between the domestic corporate tax and the lower rates abroad encourages domestic firms to locate production in foreign countries and discourages foreign firms for producing in domestic economy unless absolutely unnecessary, resulting in less capital at home; reduced productivity and therefore low economic activity. Higher corporate tax rate also makes the cost of capital higher for firms than their foreign competitors, forcing them to charge higher prices on domestic production. Corporate tax rate in Pakistan is the highest among regional countries, which is one of the disincentives for multinational groups to locate their manufacturing base in Pakistan.

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The relationship between corporate tax rate and investment on private companies shows upward trend that is as corporate asset tax rate on private entities decreases over the years the investment on private enterprises increases. Especially after 2002 there has a significant jump in investment behavior of entrepreneurs because the other determinants of investment that had become stable like interest rate, exchange rate, favorable economic condition and huge upsurge in FDI.

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a) Foreign Direct investment

This is another kind of business fixed investment in Pakistan. For the host country the value of foreign direct investment is more than that of foreign investor due to the creation of capital, transfer of advanced technology, improvement in managerial expertise, labor force skill development and other areas relating to that development. Higher tax reduces the after tax return which is not only in conflict with the prudent tax policies but also influence the markets, the size of human capital and also the regulatory frame work in investment and well being of the people. It is also argued that international markets create influence on government to reduce corporate tax rate so as to make it attractive to foreign investors. The harmful effect of corporate tax rate could be reduced by bringing it into the line of other industrial countries as done by other developed countries like India, Bangladesh, Malaysia and Thailand who had reduced their C.A.T rate to 30 percent. It reduce rate would generates new tax revenue that might offset some of the direct revenue losses caused by a lower corporate tax rate. In past general Mushraff government missed no opportunity to explain the numerous measures government had taken to protect the interest of foreign investors in Pakistan.

b) Entrepreneur Activity:

An entrepreneur is defined as someone who starts and controls business. According to the economist John Stewart mill & Joseph Schumpeter risk bearing and innovation are the key characteristics that define entrepreneur. Entry of new firms introduces new product, new method and also try new locations and form new organizations. This will result in spillover of information leading to increase productivity and economic activity as suggested by "New growth" theory. Hence there is strong incentive to subsidize such activities through the tax system, considering the spillover effect generated by entrepreneur activity. Given the beneficial behavior of the entrepreneurship, government ought to have policies that will encourage their citizens or companies to become entrepreneurs. For many companies corporate tax rate will be lower than personal income tax rate of the owners and investors. Hence keeping low corporate tax rates for companies with modest earnings is an important way to encourage owners to reinvest their earnings rather than take it out of business.

c) Interest Rate;

This variable has multiple links that connects to cost of using capital to inflation to corporate tax rate and investment. The slight change in interest rate will affect the supply to capital stock that investors provide for the entrepreneur hence effecting employment and over all aggregate economic activity. It is crucial to understand the link that generates around due to the slight change in interest rate. On one hand it directly affects the saving behavior; investment decisions and entrepreneurship whereas on the other it directly targets corporate tax rate through inflation channel.
a) Tax Regulations

                                                   2005   2006    2007

% of firms identifying tax rates as major         40.00  23.50   34.44
constraint

% of firms identifying tax administration         23.04  17.91   23.17
as major constraint

% of firms expressing that a typical firm report   7.57  36.26   54.39
less than 100% of sales for tax purposes

ECONOMIC REVIEW February-March 2012


d) Informal Economy:

This is not used as a determinant or formal variable of investment but as a consequence that may arrive due to the high corporate asset tax rate in Pakistan. Firms and corporations do not want to play save all the time and would like the opportunity to increase their after tax income. The small firms and entrepreneurs in Pakistan would not hesitate to turn toward undocumented or informal sector of Pakistan in order to evade high corporate asset tax rates.

Pakistan (2007)

Region: South Asia

Income category: Lower middle income

Population: 173,383,000

GNI per capita (US$): 1,050

Number of firms surveyed: 935

1. Methodology and Data Description:

The theoretical findings have enabled us to suggesting and verifying an empirical relationship between corporate tax rate and investment. Here the dependent variable is investment; further classified as public, private and business fixed investment (FDI). The independent variables include corporate tax rate on public and private and foreign companies, interest rate and exchange rate controlling the impact of other determinants. Simple ordinary least square (OLS) method is used to empirically suggest the relationship between the corporate asset tax rate, investment and entrepreneurship. For analytical convenience all the variables are taken in log level. The model has the form:

PbInv = [^.a]o + [[^.a].sub.1]pbcat + [[^.a].sub.2]Ir + [[^.a].sub.3]exr + [[micro].sub.1]--1

PvtInv = [^.a]o + [[^.a].sub.1]pvcat + [[^.a].sub.2]ir + [[^.a].sub.3]exr + [[^.a].sub.4]pbInv + [[micro].sub.2]--2

FDI = [^.a]o + [[^.a].sub.1]nre + [[^.a].sub.2]ir + [[^.a].sub.3]exr + [[^.a].sub.4]pbInv + [[micro].sub.3]--3

The data has been collected annually during the period of 1991 till 2010, from the Pakistan economic survey (PES), Central board of revenue report (CBR), International financial statistic (IFS), Joint stock exchange companies listed, World Bank entrepreneur survey 2007 and price cooper survey jointly conducted by Hong Kong. References from different studies have been used for the years, for which data was not available.

Pair wise correlation between corporate asset tax rate on public, private and foreign investment:

Pair wise correlation shows the strength of relationship between corporate asset tax rate of public, private and foreign entities (C.A.T) on their respective investment. Here -0.9671 indicates that a strong inverse correlation exist between private investment and corporate tax rate.
              Public     Private  Foreign direct     Gross
          Investment  Investment      Investment  domestic
                                                   product

C.AIT        -0.7605           -               -   -0.7644
Public

C.A.T              -     -0.9671               -   -0.6741
Private

NR                 -           -          0.4106         -
Entities


Empirical results:
Results:

                                 PubInv        PvtInv            FDI

Corporate asset tax rate:

Public entities             (-0.454) ***  (-0.808) ***  (-0.718) ***

Private entities

Nonresident entities

Interest rate                 (-0.495) *   (-0.427) ***    (0.536) *

Exchange rate                  (-0.022)      (0.021) **  (0.331) ***

Public investment                            (0.337) **    (0.032)

The figures in bracket ( ) shows the coefficients of dependent variables
with different level of significance.

*** Shows at 1 % level of significance

** Shows at 5% level of significance

* Shows at 10 % level of significance


The above result verifies that all the explanatory variables has shown desired results as per suggested by theoretical discussion. Investment is negatively and significantly dependent on corporate asset tax rate (CAT) on public, private and foreign companies and interest rate. On the other hand private investment is significantly related to with exchange rate & public investment confronting crowd out hypothesis.FDI is negatively related to corporate asset tax rate (CAT) and positively related to exchange rate. FDI is not influenced by public investment therefore, showing insignificant relationship. Hence regressions findings verify that the investment in Pakistan is negatively related to corporate asset tax rate (CAT)

1. Conclusion:

The reduction in corporate tax rate will help develop corporate culture and promote establishment of more companies against the current trend of establishing family owned companies, the economic advisory council. There have been no headways to impose tax on farm incomes and attempts at broadening the sales tax as this has already face rejection not just in public forum but also in legislative levels. Quickening the pace of imposition of taxes on corporate sectors to increase tax to gdp ratio will have its adverse consequences in the form of reduced investment entrepreneurial activity and economic growth as suggested in the recent EAC meeting

The federal corporate tax rate matters for economic growth because all corporations' investment decisions are influenced by after tax rate of return on project. One way to spur investment and would be to reduce statutory corporate tax rate requirement. This will result in increased demand and supply of capital stock, hence maintaining equilibrium in the economy. Empirical findings suggest that the reduction in corporate asset tax rate by 10% will lead to 4.54% increase in Public sector, around 8% increase in private sector and more than 7% increase in foreign sector investment respectively. This statistics shows that the public private and foreign sector investment is been significantly and greatly affected by corporate tax rate in Pakistan.

2. Policy reforms:

The corporate tax in Pakistan is highest among the regional countries, which is a disincentive for domestic and foreign investment groups to locate their manufacturing in Pakistan. Among other reforms there should be a motivation for entrepreneurial activities there should be some sound government policies to improve the public investment that will itself encourage private investment that will increase capital stock, employment and further economic activity. Following are some of the suggestions that government should use in order to increase investment and encourage entrepreneur activity in the country.

* Pakistan should lower the statutory tax rate or corporate tax rate from 35 % to 25% and at the same time will have to expand tax base for the protection of revenue losses.

* Instead of taxing already high taxed sector, the government should bring untaxed sector into the tax net hence reduced motivation for tax evasion and informal activity. Establishment of the fiscal policy board will help improve the tax collection mechanism.

* The government should also provide tax incentive to listed companies over non listed ones. Incentives will bring more companies to the stock market that will have multiple benefits for the government.

* Corporation tax rates should be dipped below personal tax rates, so that individuals would have the incentives to create companies and increase entrepreneurial ship and declare profits rather bulging themselves with wages.

References

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A Global survey (2000): Asit Advisory service. Tax incentives and forien direct investment, un newyork.

Ben lockwood and Michela (2001):, Do countries compete over tax corporate tax, warwick economic research papers department of economics.

Chiristina and David (2007): The macroeconomic effects of tax changes, estimated base tax changes. university of California, berkely.

Ihtashamulhaq and Naeem(2007): The impact of tax policies and economic growth evidence from asian economies university of arts and technology Islamabad.

Joel slemrod (2001):, Are corporate tax rates, or countries, converging. University of Michigan

Michael p.and Grifth:, the impact of corporate taxation on the location of capiatal, Swedish economic policy review.

Mauro, paolo and fedrici (2008):, Fdi determination and corporate tax competition in a volatile world, department of economics, University of Torino.

Rozena shaheen(2008): Measuring the dynamic effects of fiscal policy shocks in Pakistan economics department loughborough uk.

State bank of Pakistan (2006) working paper series. no.13, Corporate tax model a review

Ilma Ghouse

M.Phil Student (AERC) University Of Karachi Pakistan

Humera Sultana

Research assistant, (AERC) Applied Economic Research Centre
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Comment:Entrepreneur activity and statuary tax requirement an empirical analysis for Pakistan.
Author:Ghouse, Ilma; Sultana, Humera
Publication:Economic Review
Geographic Code:9PAKI
Date:Feb 1, 2012
Words:3558
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