The Prime Minister has ordered a review of the corporate tax rate and income tax rate after the Federal Board of Revenue missed the tax collection target by Rs 276 billion.
Sometimes raising taxes beyond a certain level ends up reducing tax collection. This happens both at the direct tax as well as the indirect tax levels. A very high income tax rate can be a disincentive to work for many people, especially if a higher income bracket leads to reduced disposable income, because of the higher tax slab.
An unreasonably high corporate tax rate can cause companies to fold and close, which in turn can lead to significant job losses. Unemployed people no longer earn, and the total level of income in the economy falls. This reduces consumption and aggregate demand for goods and services in the economy. Consumption is one of the components of a country’s Gross Domestic Product, which means GDP can fall when taxes are raised.
This can also lead to a recession, especially in cases where the economy is already contracting or not growing fast enough for real incomes to rise; the higher tax rates will reinforce the contraction.
Furthermore, when companies fold because of excessively high tax rates or when foreign-owned companies leave for the same reason, this reduces economic activity and output, and average incomes fall. That also means that the tax collected on those incomes, be they at the individual level or for corporations, will fall.
This is what has happened in Pakistan.
And it's kind of shocking that the country's economic policymakers didn't foresee this – maybe they didn't have a proper education in economics, and in particular macroeconomics, where such concepts are taught at the very basic level.
Raising taxes beyond a certain point would actually cause a reduction in GDP
Anyone who has studied economics would remember that a rise in the tax rate usually ends up lowering incomes, and that in turn lowers overall national income, or GDP. This is kind of common sense: if an individual’s taxes rise, the income at his or her disposal for spending on goods and services will fall, and if that happens all across the economy, then total income or GDP will fall. Furthermore, if disposable income falls, the individual will spend less, and if that happens at the economy-wide level, then total or aggregate demand for goods and services will fall; in other words, GDP will fall.
A good economic policymaker will, or should, know where to draw the line. And that’s not the case with Pakistan's finance ministry, which is run by a banker in any case and not an economist. What’s also somewhat surprising is that the IMF, with its plethora of trained economists, did not foresee this happening.
For this purpose, students of economics are taught something called the 'tax multiplier', and it's very simple. It gives a measure of how much a country's GDP changes when there is a change in its tax rate, and almost always the effects are in opposing directions; that is, a reduction in taxes will increase GDP, and a rise in taxes will reduce a country's GDP.
This is probably why the Prime Minister has now ordered a proposal which sees a cut in the corporate tax rate from 29% to 25% and the income tax rate, with the highest slab tax of 45% being slashed to 25%.
So, despite imposing very high corporate and income tax rates, the government was unable to meet its tax collection target, and by a substantial amount of Rs 276 billion. One could argue that this goes to show that the Government of Pakistan does not have proper economists in the Ministry of Finance.
Had that been the case, the economists would have been able to tell the government that raising taxes beyond a certain point would actually cause a reduction in GDP.
The logic is simple and would be known to anyone who has studied even basic macroeconomics. Consumer spending is a part of GDP. When taxes rise, consumers spend less because their disposable income falls; consequently , GDP falls. Similarly, when taxes are cut, consumers will spend more since they have more disposable income to spend; consequently, GDP rises.
How a country’s GDP responds to changes in taxation is measured by something called the tax multiplier – again, something that would be known to anyone who’s studied economics.
So the question arises: how did the government’s own economists fail to advise it of this possibility – that if it persisted in raising taxes beyond a certain point, GDP would be adversely impacted?