TINKERING WITH TAXATION

SHOAIB AHMED FARID 
June 8 - 14, 2009

Two of the major signals emanating from the fiscal policy makers camp are as amusing as they are amazing while the federal budget 2009-10 is around the corner. While capital gains from stock market might be considered for taxation from 2010-11, the new budget may include measures to improve tax collection from the under taxed services sector. But amazingly, despite current year's bumper crops, once again income from agriculture would continue to remain untaxed even after 62 years and may now be imposed later, subject to an assessment of the 'profitability' of the sector. And amusingly, an already heavily taxed real estate sector would be brought into the tax net.

Let's examine the tax and economic aspects of the agriculture sector vis--vis the real estate sector as the driver of the construction industry wherein a substantial demand for raw materials and inputs supplied by the industrial sector originates.

The economic managers of the country are well aware that the share of agriculture in the national income of the country constitutes over 20 percent. The GDP of Pakistan currently stands at more than $170 billion. About $40 billion of this income is generated in the agricultural sector, which translates into an over Rs.3000 billion as per current exchange rate. Even within poor tax to GDP ratio of 9%, the agriculture sector should pay at least Rs. 270 billion in income tax whereas in fact it is not paying more than a few billions. The advocates of sparing agriculture from income tax continue to give the age old argument that the sector needs stabilization and the people belonging to the sector are poor.

Nevertheless, the fact is that only the labor force working for the agriculture sector is poor whereas the landowners, growers and middlemen are pocketing enormous profits without paying any income tax. The prices of agricultural products have multiplied rapidly in the last two years and if there is a problem in a crop or two in some areas, it is due to lack of proper supply of inputs rather than of profitability.

Besides, it is not unusual for various sectors of the economy of a country to come under pressure from time to time due to internal or external factors. But that hardly justifies across the board perpetual tax holidays for six decades to agriculture sector. How long will we continue to give excuses for exempting agriculture from imposition of income tax?

In fact, if there is a case for re-imposing wealth tax at all, cash and land assets that have been accumulating in the agricultural sector over the last six decades, and now generating over Rs.3 trillion in income per annum, could be the prime subject of such a proposal. But to begin with, the sector must be required to pay at least its due share of income tax in proportion to the income it generates.

On the contrary, the performance of a good part of the industrial sector, just like the textiles, has come under severe strain due to domestic and global slowdown, high cost of capital, drastic fall in the rupee value, incessant energy crisis, and deformed tax structure. Any tax relief, therefore, should be provided to the industrial sector with suitable monetary and fiscal policy incentives in order to rationalize its cost structure.

However, the effectiveness of any strategy based on fiscal/monetary policy stimuli to boost the industrial output will be minimized if the corresponding investment demand for the old and newly built-up real estate assets itself is scuttled with the imposition of additional taxes like the capital gains tax on the sector.

REAL ESTATE SECTOR UNDER TAXATION

The statements from the policymakers on the eve of the new budget sound as though the sector is presently not in the tax net at all or does not contribute duly to the national exchequer and hence there is a need to do so. This stance is far from valid and needs to be put right. Firstly, barring some proportion, most of the registered real estate assets are purchased either with funds saved from after-tax income, remittances from abroad or have been regularized after payment of due income tax under amnesty schemes from time to time. Secondly, unlike any other class of assets, all commercial and residential real estate assets in Pakistan have been historically paying property taxes (in addition to water and conservancy charges) since the date of completion depending upon the size and location of the property with the exception of the exemptions allowed. Thirdly, rental income from all real estate assets is liable also to income tax and is added to the income of the property owner from other sources. Fourthly, registered property transfers in most developed areas of the country, are subject also to taxes of ten percent of their official value consisting of stamp duty (4%), registrar's fee (2%), capital value tax (2%) and mutation fee (2%) depending upon their size and location. Fifthly, the commission income accruing to the brokers of the buyer and seller of a real estate transaction is also liable to income tax. Finally, open plots in the prime localities of the country are subject also to heavy non-utilization fee, transfer charges and CVT depending upon their size and location. More recently both the CDGK and the DHA, Karachi have imposed new taxes on properties for the maintenance and refurbishment of areas under their respective control. The real estate sector in Pakistan is thus already heavily taxed.

The area which really needs reforms in the real estate sector is the rationalization of the difference between the market values compared with the official property values and the rates of taxes currently applicable on them. This will reduce the cost of real estate transactions thereby increasing activity in the sector and thus tax generation automatically without increasing the net current incidence of taxation on the sector. Furthermore, there is a need to impose as well as implement proper procedures, like with most classes of income, for checking tax evasion of already generating rental and commission income of property owners and brokers, respectively.

The real estate sector is an equally important investment avenue like stocks, bonds, currencies, commodities, metals and oil futures. People around the world invest in real estate for the purpose of residence, or financial return on it in the form of rental income and capital gains just like stocks provide dividends and capital gains; Pakistan thus ought not to be an exception. Unfortunately, however, investment in the real estate assets by the domestic investors in Pakistan is looked at mainly as a speculative activity while its strong linkage with the construction activity and potential for economic growth has remained understated thus depriving it of the due recognition of its role in the economic policy of the country.

The real estate market bubble in Dubai has burst just in recent months with the global economic downturn. The real estate sector in Pakistan has been depressed for now over four years since the last boom subsided way back in the first quarter of 2005. The real estate prices in prime areas like Defence Karachi have continued to be depressed ever since, slipping gradually by more than 30% in rupee terms and 45% in dollar terms over a four year period initially with the imposition of capital value tax on the sector followed by an unfavorable investment climate obtaining in the country owing to judicial crisis, political upheavals, internal and external insecurity, flight of capital and global recession-all leading to a prolonged economic crisis of a severe order which the country has not been able to fully recover from yet.

With the bubble burst in Dubai real estate market and investment capital looking for ways to flow to new destinations, a golden window of opportunity has thus opened up for Pakistan to attract foreign investment inflows into the housing and construction industry with an attractive investment policy that could accelerate the rate of investment in order to boost the much needed income and employment in the country. Unfortunately, however, the due recognition on the part of the policymakers as to the significance of the role of construction industry, as an engine of economic growth, seems less than visible even in the wake of an inevitable drastic cut down in the current and next years PSDP due to budgetary constraints. In fact the evidence warns a sharp dichotomy.

Instead of formulating an attractive private investment policy for foreign inflows into construction and housing industry to cash in on the window of opportunity being presented, the policymakers seem to have embarked upon targeting the real estate sector to milk additional revenue by imposing the CGT. Thus, contrary to the expectations, this opportunity is being squandered away by the policymakers with a myopic view of tax collection rather than tax generation, which will not only impede the foreign inflow of investment into the real estate sector but also worsen contraction in economic growth amidst global recession.

While such a policy will not only rule out Pakistan as an attractive investment destination for foreign investment in the real estate, the growth of construction and housing sector and the allied industries in terms of employment, income and revenue generation will also be hampered as a consequence of the CGT. For one, capital gains taxes are barriers to the mobility of savings because the tax can be avoided by simply holding on to one's assets. For example, a person who wants to buy a new house by selling his old house bought twenty years would most likely defer the idea or decide against it once he calculates the penalty he would have to pay in terms of CGT on the sale of his old house.

Thus, the greater the tax barrier, the fewer will be the transactions. Furthermore, while the CGT reduces the amount of savings available for investment on the one hand, it also misallocates resources on the other. It tends to raise the capital cost of new productive investment for both individuals and corporations thus dampening such investment by lowering return on them. As a result, future growth in output and living standards is impaired.

CONCLUSION

The impending major taxation measures of the fiscal policy to be announced in the budget 2009-2010 seem to be based neither on an objective recognition of the sectors of the economy which are untaxed/under-taxed (or those that drive it), nor on a conscious assessment of their impact on the economy in terms of cost/benefit. The application of these measures must be based on a priority ranking while their degree must be within an acceptable limit and tuned to the genuine needs of the government to generate resources.

The thrust of the tax strategy should be on firstly thorough taxation of the income from and consumption of the output and services being produced annually in the various sectors of the economy rather than on taxing capital gains on historical assets purchased from after-tax savings. In the real sectors of the economy, the agricultural income that has remained untaxed for more than six decades must be the first avenue to be properly taxed. Secondly, there is an ample capacity in the under-taxed services sector to contribute revenue in proportion to the income generated by it and must be tapped. Thirdly, while the stock market is a very important investment avenue in the financial sector, yet it really does not drive the economy; in fact it is driven by the economic performance of the real sectors and gains accrued there have been historically under-taxed. It will continue to perform well even after fiscal measures are taken to tax it properly, provided the real sectors continue to perform well and other sources of revenue are optimally tapped.