LUMS

Applied Taxation
Final Report
12020094 Hunain Mandvia 12020096 Jalal Hamid 12020131 Salik Gilani 12020178 Ali Saqib 5/21/2011

Q. The only purpose of taxation is to collect revenue. Discuss According to economic and fiscal theory, taxes are the price citizens of a country pay for the goods and services they collectively provide for themselves and for each other. According to Masood and Masood corporate and legal consultants, To tax is to impose a financial or other levy upon a taxpayer (an individual or legal entity) by a state or a functional equivalent of a state such that failure to pay is punishable by law. On a lighter note, they remark that you either have to pay taxes or plan to avoid them; there is no other way out. It is widely understood that the primary purpose of taxation is to accumulate funds for the appropriate functioning of government machineries. No government in the world can run its administrative machinery without the collection of taxes through an efficient and transparent tax system since the government has no system incorporated in itself to generate profit from its functioning and its existence. The government, as the primary caretaker and supervisory body of the public at large has a huge responsibility to raise money to spend on defense, public welfare, merit goods like education and health, public goods, and on more indirect government functions like market regulation or legal systems. The aim of this paper is twofold. Firstly, it aims to establish that collection of revenue is a fundamental goal of levying taxes without which the effective functioning of government machinery and public welfare will be a distant dream. It does so by exploring the various services that the government provides to the public by collecting revenue from taxation. Secondly, it then aims to establish that collection of revenue is by no means the sole purpose of collecting taxes. It does so by exploring the various other reasons for the imposition of taxes such as redistribution of wealth, re-pricing and representation to name a few. Each of these objectives of tax collection has sub-components that will be discussed in detail. The methodology of establishing a certain objective as that of taxation is to discuss empirical evidence of the achievement of a certain social and economic objectives with regards to sets of countries with high and low tax-bases. Then we shall be able to conclude, with a fair amount of certainty that countries with wider tax bases are more likely to achieve these social and economic objectives and hence collection of revenue for the government is, by far, not the only purpose of taxation. Taxation and Revenue Generation Aggregate Expenditure in an economy is a direct function of Consumption, Investment, Government Expenditure and Net exports. As mentioned earlier, a fundamental goal of levying taxes is collecting 1|P ag e

revenue to finance government expenditure. Thus an important consequence of levying taxes is that aggregate expenditure in an economy goes up due to an increase in government expenditure. Government expenditure comprises of expenditures on defense, law and order, protection of property, economic infrastructure, public works which includes construction or engineering projects carried out by the state on behalf of the community, social engineering which includes efforts to influence popular attitudes and social behaviors on a large scale, and the operation of government itself. Furthermore, government expenditure also includes funding for welfare and public services. These services include spending on ensuring an efficient education system, health care systems, unemployment benefits and pensions for the elderly. Spending on public utilities such as energy, water and waste management are also important avenues for government expenditure. Since we have established that access to essential services is directly related to the collection of taxes for the purposes of generating revenue for government expenditure, it may also help to compare important social indicators for health and education for sample high-tax Nordic countries (Sweden, Norway, Denmark, and Finland) with low-tax Anglo-American countries (UK, USA, Canada, Ireland, Australia and New Zealand). Taxes as a percentage of GDP classify countries as either high-tax or lowtax. Taxes and access to Health Services

From the table above, we can see that high-tax Nordic countries are slightly better in almost all measures of health outcomes than low-tax Anglo American countries. A wider tax base in Nordic countries helps the governments there ensure access to better health services for the public as opposed to governments in Nordic countries. In Pakistan taxation as a percentage of GDP is a lot lower than the
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Life Expectancy is measured in years (Table 7)

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Anglo-American country with the lowest percentage of GDP as Tax and therefore, indicators for health are even poorer. However, in Pakistan, a huge portion of the economy is undocumented and tax evasion and avoidance is a major problem which is why such an analysis may lead to misleading results. Therefore, taxes are important for financing government health projects Taxes and access to Education

Another important avenue for the allocation of government expenditure is expenditure on education and as shown above, the indicators for high-tax Nordic countries is better for Completed secondary school and Completed University that low-tax Anglo-American countries. However, the difference in PISA scores is not statistically significant. The Nordic countries spend a greater percentage of their GDP on education than Anglo-American countries (6.4% vs. 82%) and a much larger share of their expenditures for education is financed with taxes (97% vs. 82%). Therefore, taxes are important for financing government education projects. Taxes and Research and Development

The fields in the first three rows are in percentages (Table 8)

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The revenue that is generated from Taxation is also important for funding research and development expenditure and from the table above, it is clear that high-tax Nordic countries are well placed to capitalize on future opportunities for growth and development because they can use their wide tax base to significantly outperform Anglo-American countries when it comes to spending on research and development. Not only does their wider tax base enable them to spend a significantly greater percentage of their GDP on Research and Development but the number of researchers per 10000 is higher for Nordic as opposed to Anglo-American countries. Therefore, Taxes are important in financing research and development for future growth and productivity prospects. Taxation and State Building On a more general level, taxation has always been the key to successful state building and existence and quality of state infrastructure has been directly related to the level of taxes. Both the form and level of taxation influences state building. For instance, in Latin America, the state heavily depends on taxing international trade rather that domestic production. Therefore, the fiscal infrastructure is not as well established since the collection of tariffs and duties does not require an elaborate fiscal infrastructure. Furthermore, if the level of taxes collected in a certain country is less than the average for countries with similar development and economic indicators, the state as well as the fiscal infrastructure is not going to be that well established. This, however, should not be taken to mean that state infrastructure is only dependent on taxation. Class structure, the relationship of classes to political elites, the level of economic development and concentration are also important. The fundamental point to take back is that contrary to popular belief that state infrastructure is solely dependent on economic and class based forces, the form and level of taxation has a phenomenal impact on state and fiscal infrastructure. Taxation and Law and Order

The revenue that is collected from taxation is also channeled towards providing a strong framework for law and order and thus ensuring physical security. An intuitive measure of physical security is the number of homicides per 100000 people and from the table above, we can see that homicides for hightax Nordic countries is lower than that for low-tax Anglo-American countries. In Pakistan, where the tax 4|P ag e

base is extremely narrow as opposed to the countries mentioned here, the homicide rate is phenomenally high. However, a narrow tax base is, by no means, the only reason for the high homicide rate because Pakistan is plagued with fundamentalism, Talibanization, Kalashnikov culture and ethnic rivalries. Therefore, Taxation is essential for creating and maintaining a stable and efficient law and order system. Taxation and Re-pricing to Discourage Certain Activities There are certain ills in every society that the state or any functional equivalent wishes to eliminate or keep in check. One example could be carbon emissions from cars which exacerbate the problem of global warming and generally bring harm to the environment. Furthermore, these pollution inducing agents also reduce the life expectancy and the general standard of living of the citizens of the state. In other words, these activities result in huge negative externalities3. More example of such activities include cigarette consumption which results in passive smoking, consumption of alcohol which makes people lose focus, is a major cause of injuries and car accidents and unnecessary harms the well being of the society in addition to the person involved in the activity. To reduce, or curtail the consumption of such activities, the government imposes taxes so that in addition to generating revenue, it helps to deter individuals from engaging heavily in such acts. Now the question that is automatically raised in relation to this argument is as follows: If the government wants to fully shutdown industries that promote such activities, why doesn t it impose ridiculously high taxes. The answer is that the government also needs to keep track of its objectives and strike a fine balance. For instance, a ridiculously high tax on cigarettes may lead to significantly decreased cigarette consumption, but it will firstly deprive the government of a major source of revenue and secondly, with the closure of a good proportion of these industries, there will be unemployment at a massive scale since a handsome number of people will lose their jobs. This extreme is also unacceptable to the state. A comparison of high-tax Nordic countries with low-tax Anglo-American countries shows that Nordic countries outperform Anglo-American countries in the field of environmental sustainability because a fair proportion of taxes in Nordic countries goes towards curtailing those industries that promote negative externalities. Therefore, a major reason for the imposition of taxes is to reduce the consumption of demerit goods by re-pricing them.

Costs to third parties who are not directly involved in the contentious activity in question

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Taxation and Redistribution of Wealth One of the most pressing issues of every democracy is the distribution of its limited economic resources and more often than not, these resources are distributed quite unevenly between the rich and the poor. This phenomenon is much more strongly felt in developing countries as opposed to developed countries. This is not to say that developed countries are immune to such inequality. In fact, in the United States, income is more unevenly distributed than in any other industrialized country where the richest 10 percent of the families receive almost 16 times as much of national income as the poorest 10%. Large economic inequalities hold adverse consequences for the personal well being of the citizens of the country; they lead to worse health and personal security outcomes. It leads to exclusivity and isolation of certain segments of society and reduction of general welfare. Therefore, the imposition of direct taxes where the rich are taxed the most and the poor are taxed the least can help to redistribute scarce economic resources from the richest sections of the society to the poorest.

The table above shows that the GINI coefficient5 for high-tax Nordic countries is significantly less than that for low-tax Anglo-American countries because the high taxation in Nordic countries helps to ensure that economic resources are distributed more evenly. Therefore, an important purpose of taxation is the redistribution of wealth.

A lower rank indicates better Environmental performance A measure of income inequality; ranges from 0 to 1 with 0 being perfect equality and 1 being perfect inequality. In Table 5, a higher Gender gap index reflects a narrower gender gap. Gender empowerment ranges from 0 to 1 and a higher figure indicates more empowerment.

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Taxation and Gender Inequality Another important social goal that is facilitated through the imposition of taxes is reducing gender disparity. Gender inequality is a problem that plagues large sections of society in many countries whereby women are confined to their homes, are unable to participate in economic activities and are generally viewed as lesser than their male counterparts. It is empirically proven that countries with higher taxes have had much greater success in reducing gender disparity as compared to countries with lower taxes. One possible explanation for this is that a considerable amount of care giving work in lowtax Anglo-American countries that is borne by women is financed through taxes in high-tax Nordic countries which frees up women to take part in the economic, civil and political life. As shown in the table below, Nordic countries trump Anglo-American countries in every indicator of Gender Equality. For example, women in high-tax Nordic countries are more empowered than women in low-tax AngloAmerican countries (0.868 vs. 0.773). Similarly, the percentage of female labour force participation is higher for Nordic countries as compared to that in Anglo-American countries (75% vs. 68.6%). Thus, taxes are levied to address the problem of Gender Disparity.

Taxation and Price Stability In layman terms, inflation is defined as too much money chasing too few goods. The government, by imposing taxes, can take away the excess disposable income to reduce aggregate demand in the economy and bring down demand-pull inflation. However, dampening aggregate demand through reducing the consumption function is counteracted by the increased government expenditure so the net effect on aggregate demand depends on the relative impacts on government expenditure and consumption. Therefore, a more apt impact of taxation with regards to inflation will be that it ensures 7|P ag e

price stability and smoothes out fluctuations in aggregate demand. Furthermore, imposing direct taxes also helps to dampen fluctuations. For instance, if the distribution of personal income is more equitable, then consumption will fluctuate less over the business cycle because the consumption pattern of lower income families is fairly stable whereby they continue to spend on the essentials while the spending pattern of high income families is more haphazard and is juxtaposed between cautionary savings and bouts of credit-financed consumption sprees. The association between higher taxes and lower inflation rate is fairly strong and it is proven by inflation rates in high-tax Nordic countries as compared to low-tax Anglo-American countries. Therefore, Taxation, as an instrument of fiscal policy, is used to dampen fluctuations in aggregate demand and ensure price stability.

Incentives for local industries and Balance of Payments The government may also use taxation to promote/protect local industries. These local industries are the life and blood of the economy and future growth opportunities rely heavily on the continued existence and flourishing of these industries. Furthermore, taxes are also used as a means to protect local industries which are at their infancy stage and cannot compete with large foreign industries that enjoy huge economies of scale and brand loyalty even from foreign consumers. In order to protect these industries, the governments imposes heavy duties and tariffs on imports and provide tax concessions to local industries in order to bolster economic growth and fuel the resources of its own country. Imposing heavy tariffs on imports serves a dual purpose from the point of view of taxation. On the one hand, it bolsters local/infant industries and on the other hand, it improves the country s balance of payments position by not only helping to finance the deficit but also by discouraging imports and boosting exports, it improves the position of the current account. On Average, high-tax Nordic countries had a current account surplus of 7.4% of GDP in 2004 as compared to a deficit of 3.2% for AngloAmerican countries, the reason being that high levels of tax collection in Nordic countries are used to support local industries and thus exports; at the same time, imports are heavily taxed and therefore a current account surplus is not uncommon. The table below shows the current account position of various countries at the end of the fiscal year 2004. This presents a strong case for taxes being used as a means to improve the country s balance of payments position. 8|P ag e

Taxes and Representation Taxes have been historically known to increase representation and accountability in an economy. It helps to bring the hidden, unchecked black economy into documentation. In many underdeveloped countries, tax evasion and avoidance is turned a blind eye upon by the ruling elite in exchange for no interference in policy making. Not only does this go against all the agreed principles of democracy which advocate equal representation from all sections of the public, policy making without proper representation only helps to further the ruling elite s own selfish interests while they remain apathetic to the needs of the citizens. In fact, this phenomenon is commonplace in Pakistan where the ruling elite buy the silence of extremely influential quarters by providing huge tax concessions or turning a blind eye towards tax evasion or avoidance. It is no surprise therefore, that Pakistan s undocumented economy is in fact larger than its documented economy and is a major reason for why Pakistan has almost always been able to pull itself back up in times of economic crisis and recessions because it is always the undocumented economy that comes to the rescue. Therefore, the imposition of taxes can help to bring the economy into documentation. This will not only increase transparency in economic activities by generating tax revenue from sources which were previously undocumented, but also help to crack down uneconomic activities such as drug, weapons and organs trafficking to name a few. Finally, when rulers impose taxes on the citizens, the citizens will want to voice their opinions in policy making and hold the government accountable for its actions as the other end of the bargain; this is the essence of a true democracy. Poverty and Social Exclusion

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Alleviating poverty in a nation is on the agenda of the government of every country. A social contract should be struck and mechanisms should be in place to ensure that as few people as possible are deprived of economic resources because poverty leads to exclusion, isolation, unrest and harms the general well being of the nation. The number of children living in poverty is of particular concern. The high-tax Nordic countries have lower rates of poverty across all social groups than low-tax AngloAmerican countries. As shown above, in all four indicators of poverty, the Nordic countries have performed better than Anglo-American countries. This is particularly because in Nordic countries, the high levels of taxation are used to divert resources to poverty alleviating schemes. Greater transparency in government machinery coupled with support from the public in the form of higher taxes as a percentage of GDP has phenomenally improved indicators of poverty and social exclusion. Taxation: A local Perspective In theory, the reasons discussed above for the imposition of taxes are valid for any state. However, their applicability and measuring their effectiveness can be a challenge especially in the context of a country like Pakistan which has a mind blogging taxation system that defies comprehension of the average citizens and experts alike. The various social and economic indicators that vary in tandem with the level of taxation in industrialized countries do not exactly follow the same trends in a country like Pakistan where scores of other socio-economic and geo-political factors are working simultaneously with the imposition of taxes. Therefore studying the taxation structure of Pakistan and trying to correlate the level and form of taxation with the various social and economic indicators would have led us to no man s land and we would have made no headway in establishing the various reasons for why Taxes are imposed. Therefore, in the above analysis, we compared the social and economic indicators of Nordic countries with those of Anglo-American countries because they have the most commonalities which give us a common ground to assess the impact of the level of taxation on these indicators. The evolution of Pakistan s tax system has four essential features Changes in taxation policies are frequent and ad hoc. Consequently, the tax payers have insufficient knowledge of their tax obligations and the tax collectors are able to exercise a fair degree of discretion. Tax policy changes are not followed by a change in the administrative framework to oversee the new policy. Therefore, an adequate surveillance and monitoring apparatus does not exist.

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The tax collector and the tax payer are generally on adversarial terms and one is always cautious of trusting the other. As in the rest of the government, the management of human resources is not up to par. Tax officials are paid such low salaries that honesty becomes a distant dream and corruption comes built into the system and in fact becomes even necessary for the mere functioning of the tax system; In other words, corruption has become a form of governance. According to the report on the task force on Reforms of Tax Administration by the federal board of revenue Pakistan s fiscal crisis is deep and not easily resolved. Tax receipts are insufficient to pay even for debt service and defence and there is hardly any net foreign assistance for development. Simultaneously, there is a crisis of confidence between the taxpayer and the government. If taxes relative to the GDP do not increase significantly, without new levies, Pakistan cannot be governed effectively, essential public services cannot be delivered, and high inflation cannot be avoided. The reform of tax administration is the single most important economic task for the government. Consequently, in June 2000, the Chief Executive appointed a task force to review tax administration and make recommendations to improve its effectiveness significantly

Concluding Remarks After exploring the various reasons for the imposition of taxes both from the global perspective as well as the Pakistani perspective, it can be reasonably concluded that collection of revenue for government expenditure, although one of the most important reasons for the imposition of taxes, is by no means the only reason. The government, as the primary representative of the state, has a duty to not only ensure 11 | P a g e

that state machinery is functioning effectively but also that public welfare is not discounted. Therefore, it needs to have an efficient and transparent tax structure so as to achieve the social and economic goals of collecting taxes as opposed to just raising revenue to finance government expenditure.

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13. "Purpose of Taxation." India Business Directory, Indian Business Information. Web. 20 May 2011. <http://business.mapsofindia.com/india-tax/concepts/purpose-taxation.html>. 14. "Report of Task Force on Reform of Tax Administration." Reforms Wing- FBR Pakistan. Web. 20 May 2011. <http://www.fbr.gov.pk/reforms/taxadmin/chap1.pdf>. 15. Siddiqui, Salma M. "Survival of the Richest: Taxation in Pakistan." ISN ETH Zurich. Web. 20 May 2011. <http://www.isn.ethz.ch/isn/Current-Affairs/ISNInsights/Detail?lng=en&id=122110&tabid=122109&contextid734=122110&contextid735=12210 9>. 16. "Taxation | Purpose of Taxation | Dineshbakshi.com." IGCSE, GCSE, A Level Business Studies, Economics, Accounting and ICT Revision | Dineshbakshi.com. Web. 21 May 2011. <http://www.dineshbakshi.com/Role-of-government-in-an-economy/Revision-notes/taxationpurpose-of-taxation.html>.

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