TAX Evasion and Economic Growth

TAX Evasion and Economic Growth

Finding the correlation

Tax evasion is among the biggest problems Pakistan is faced with today. The fiscal deficit of the country has increased from 4.6 percent of GDP in 2015-16 to 6.8 percent in 2017-18. Increase in the fiscal deficit is due, mainly, to excessive expenditures and extremely low tax-to-GDP ratio, which remained within a narrow band of 9.8 percent in 2012-13 to 12.4 percent in 2016-17 (Table 1). Similarly, non-tax revenue-to-GDP ratio has also decreased from 3.5 percent in 2012-13 to 3.0 percent in 2016-17.

TAX Evasion and Economic GrowthIn view of extremely low and further dwindling non-tax revenue, tax revenue remains the leading source of income for the government to balance the budgets. However, tax-to-GDP ratio remains low despite increase in real GDP growth in the recent years mainly because of wide tax gap, which is as large as 9.8 percent of GDP – equivalent to nearly Rs 3,200 billion. In other words, potential tax revenue is much more than actual tax collection.

Given the same level of tax enforcement, the tax gap will further enlarge in the coming years due to substantial increase in the income tax exemption threshold for the individuals, including salaried persons from Rs 4,00,000 to Rs 12,00,000, effective from current tax year (Tax Year 2019). With this enhanced threshold, about 521,597 income tax return filers will be out of the tax net in the current tax year and it will cause reduction in tax revenue by around Rs 35.2 billion.

Furthermore, reduction in corporate income tax rates will result in a greater decline in tax collection as income tax rate for companies, excluding banking and small companies, for the tax year 2019 has been reduced to 29 percent from 30 percent, which will be further reduced by 1 percent for each of the following years until the tax year 2023 (Table 2).

In view of the increasing trend in fiscal deficits, it is indispensable to mobilize additional tax revenue and it is possible only by reducing the tax gap, which is the difference between anticipated tax revenue and actual tax revenue. For bridging the tax gap, strict enforcement through audits and penalties is recommended.

Read More: Causes for failure to achieve tax revenue target

TAX Evasion and Economic GrowthThere are different approaches towards tax evasion. An important perspective is to see whether tax evasion reduces economic growth. Higher economic growth is required for optimum welfare of the people. A benign attitude towards tax evasion may be warranted if evasion results in greater economic growth by leaving more resources in the private sector for investment that otherwise could go wasted due to corruption, ineptness or inefficiency in the public sector.

There are no two opinions that tax evasion increases disposable income, the use of which is important from growth perspectives. It is because savings increase due to increased disposable incomes and saved incomes increase the economy’s capital stock, and boost thereby economic growth. Alternatively, the evaded money invested abroad would reduce the capital stock of the economy. Moreover, higher tax evasion results in lower revenue for the government that places greater constraints on government spending on public goods and services that hurts economic growth as well.

To overcome the revenue shortfall due to greater evasion, the government may be forced to raise tax rates or devote more resources for enforcement to curtail tax evasion in a bid to increase revenue levels. Higher tax rates would create more distortions in the economy, resulting in lower economic growth. Higher resource allocation to enforcement reduces resources available for more productive purposes, thus, leaving the effect of stunting economic growth.

Tax evasion also has an associated excess burden in the form of anxiety costs of hiding income that reduces welfare. Additionally, tax evasion may result in allocation of resources toward non-productive purposes, as the illicit money may be shifted to the underground sector. Tax evasion also imposes an externality on honest taxpayers as they must compensate for the evaded revenue with their own income.

The large shortfall in revenues compels the government to seek loans. In the recent years, Pakistan has experienced significant increase in the public debt from 64 percent of GDP in 2012-13 to 70 percent of GDP in 2017-18 as shown in Table 3.

The growth of public debt beyond 60 percent of GDP is a violation of the Fiscal Responsibility and Debt Limitation Act (FRDLA), 2005, which has been amended to provide legislation for bringing down the federal fiscal deficit to 3.5 percent by 2017-18 and overall debt to 50 percent of GDP within the next ten-year period. But, oppositely, the debt-to-GDP ratio has reached 70 percent in 2017-18.

TAX Evasion and Economic GrowthIn view of the growth effects of tax evasion and its compliance factors, the economic growth maximizing government needs to make more informed decisions regarding compliance factors such as audit rates and any potential trade-offs with economic growth. For example, increasing audit rate may result in higher tax revenue and if higher tax rates result in lower economic growth, the government may revisit the enforcement policy and may forego the additional tax revenue that higher audits bring. Similarly, if the private sector is unable to use proceeds of evasion productively or those are shifted abroad, the government may resort to strict enforcement measures in a bid to use that revenue for more productive purposes to boost economic growth.

Leave a Reply

Your email address will not be published. Required fields are marked *