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Taxation & Entrepreneurship: Role of Government in Fostering Entrepreneurship.

This is the third and last article in the series on the Role of Government in Fostering Entrepreneurship in the country. The first article, which appeared in the April issue of this publication, laid out the case for fostering entrepreneurship and its vital role in the development of the country. The article identified two key components of an entrepreneurship friendly economic ecosystem. They are 1) a transparent and effective legal framework and 2) a diversified tax base. Last month's article laid out the case for over-hauling our antiquated legal framework to truly bring it in the 21st century and accelerate the economy's transition to a knowledge economy. The subject of this article is how to make our indirect tax heavy tax base more diversified and why a broad tax base is a critical element for accelerating the growth of entrepreneurship.

Saying that a diversified tax base is good for the economy is like saying exercise is good for your health, or do not drive over the speed limit. What I mean is that everyone knows that a diversified tax base is better than a concentrated tax base. But what do I mean by a diversified tax base. To me, diversification occurs at two levels. First, diversification between direct taxes (paid on income) and indirect (paid on consumption). Second, within each type, the sources of taxes are varied. It is also important to understand that desire to pay as little in tax as possible is universal. In my personal experience, mechanics, painters, landscapers, handymen, etc. quote one price if payment is made in cash and another if it is made using a credit card. The shining star on the hill known as Apple is in the press these days for allegedly avoiding U.S. taxes by concentrating profits in its Irish subsidiary (Ireland has a relative low corporate tax rate). The Bill mandating companies to collect sales tax on majority of Internet purchases in the U.S. is making its way through the Congress as I write. Right now, majority of sellers do not collect state sales tax on purchases if the buyer does not reside in the same state as the seller. The buyer, in such a case, is supposed to pay the sales tax when he files taxes each year. In reality, approximately 1% of taxpayers reported unpaid sales tax on their returns in 2012!!!

So, while tax avoidance is not limited to any one country, the situation is alarming in Pakistan. As per State Bank of Pakistan's 2011-2012 State of the Economy report, total tax receipts for the year totaled Rs. 2,052.9B. Of this, direct taxes represented Rs. 731.9B or approximately 36%. In contrast, direct taxes (personal and corporate) represented about 56% of U.S. tax revenues in 2012. According to published statistics, the tax authorities could identify only 768,000 individuals who paid taxes last year. Of these, approximately 270,000 paid taxes in the last three years. Our tax to GDP ratio of 9.1% places us between Ethiopia and Afghanistan. In contrast, Turkey's tax to GDP ratio is 32.5%. India, the country we are always comparing ourselves against, is at 17.7%--nearly twice that of ours. Sri Lanka is at 15.3%.

With only 36% of tax revenues coming in the form of direct taxes, the remaining (64%) is collected via indirect or consumption taxes e.g. property taxes, taxes on goods and services, tax on international trade, petroleum levy, etc. Don't get me wrong, I am not against indirect taxes. They have an important role within an effective tax base. My problem with over-reliance on indirect taxes (as is the case with us) is that it distorts consumer and capital behavior and increases cost of doing businesses as indirect taxes are regressive in nature and price inelastic i.e. after a certain level they stop increasing as people adjust behaviors. In short, a high level of indirect taxes does more harm than good and is a detriment to fostering entrepreneurship. So, what to do to grow the direct tax base? My proposed solution is twofold--plug the leaks and grow the pond.

There is no doubt that there is significant leakage in our tax collection process whether through connivance of the tax collectors, lack of documentation in the economy, or the prevalent culture of tax evasion. One of the most effective ways to reducing, if not stopping tax revenue leakage, is to eliminate the agency problem in the Federal Board if Revenue (FBR). An agency problem occurs when the agent (in this case the tax collectors) don't act in the best interest of the principal (in this case the government). My solution is to provide the tax collectors performance related cash incentives (similar to bonuses in the private sector) for meeting direct tax collection targets. Rightly or wrongly, monetary compensation (or the lack thereof) is the most effective way of influencing behavior in our societies. If implemented correctly, this solution has the potential to eliminate a significant portion of tax revenue leakage. The second leakage that needs to be staunched is the loss of tax revenue as a result of the undocumented economy. Estimates of the size of Pakistan's undocumented or informal economy range from a low of 20% of GDP ($46B) to a high of 90% of GDP ($207B). Even assuming the current measly 9% tax collection rate, we can be collecting $4.1B to $18.6B in additional taxes each year. The primary characteristic of the informal economy is transactions are conducted in cash (recall my example at the start of the article). Therefore, efforts should be used to encourage the use of checks and credit cards for transactions over a certain monetary value. Using either method creates a record of the transaction and can be used, in conjunction with other tools, to ensure taxes are being paid by both parties to the transaction.

As far as growing the pond is concerned, one of the most effective and immediate steps to do this is to eliminate the exemption on agricultural income. There is no justification why agricultural income needs to be treated any different than any other income. It is not like wheat, rice, sugar, etc. are available at a low price in the country as a result of this policy. On the contrary, there are chronic food commodity shortages due to hoarding and black-marketing by the very groups who are the beneficiaries of this exemption. In principle, income from all sources should be taxed. The tax rates between industries can vary depending upon economic imperatives, but there should be no blanket taxation exemptions.

A study conducted by The Journal of Public Economics titled "Taxes and entrepreneurial risk taking: Theory and evidence for the U.S." looked at how taxes can affect incentives due to differences in tax rates on business vs. wage income, due to differences in the marginal tax rates faced on losses vs. profits through a progressive rate structure and through the option to incorporate, and due to risk sharing with the government. Here is what the study concluded: Low personal tax rates on wages, as are the norm in many low income countries, are a detriment to entrepreneurship by taking away the incentive to take risk. According to the study, a uniform cut in personal tax rates by 5 percentage points leads to a 40% fall in entrepreneurial risk taking. The reason is simple, if personal taxes on wages are low, we give less of our incomes to the government and are, therefore, less likely to engage in risky entrepreneurial type of activity in order to grow our incomes in absolute terms.

All suggestions and studies on how to expand the tax base are going to be useless if the government fails to fulfill its end of the bargain i.e. providing concomitant benefits to the populace. Our politicians and bureaucracy are chiefly to blame for fostering a culture of tax evasion in the country. If there is no power, roads are broken, law and order exists only as a concept, public healthcare system is dysfunctional, can one truly blame the people for not paying taxes? Yes, it is a chicken vs. egg situation but the vicious circle of low revenues leading to poor provision of services leading to low revenues need to be broken. Pakistan will be inaugurating a new government in a few weeks. In my opinion, the most powerful benefit democracy offers is a fresh start every election cycle. While the country is facing enormous economic challenges at the moment, we have all the natural factors of production in abundance and a workable foundation to put them to use. We need our government to step up and start doing its job serving us. Time is ripe for Pakistan to finally live up to the promise of its founding fathers. My message to the incoming government is, carpe diem!!!

Abbas A. Mohib is a senior, New York based, corporate banker. He specializes in Liquidity Management, M, A&D, Client Relationship Management, Treasury, Credit, Strategy, and Business Management.

He has an MBA from New York University's Stern School of Business, an MBA and BBA (Hons.) from the Institute of Business Administration, Pakistan as well as Series 7 & 63 securities brokerage licenses.
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Comment:Taxation & Entrepreneurship: Role of Government in Fostering Entrepreneurship.(TAXATION / ENTREPRENEURSHIP / GOVERNMENT)
Author:Mohib, Abbas A.
Publication:Economic Review
Geographic Code:9PAKI
Date:Jun 1, 2013
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