Dr. Ikramul Haq
The Laffer Curve indicates the effect of tax rates on government tax revenue. Briefly, the proposition of the Laffer Curve takes as its starting point the simple notion that tax revenue is zero if the tax rate is either zero or 100%, with a smooth relationship between tax rates and tax revenues connecting these two polar points.
The existence of such a relationship suggests that if tax rates are sufficiently high, “the prohibitive range”, then a reduction in tax rates could lead to an increase in tax revenues. This is the case now in Pakistan.
The Laffer Curve analysis leads to the following conclusions:
- high rates of taxation act as disincentive to work and thus reduce output and employment;
- an increase in tax rates does not always necessarily lead to increased revenue. There is a crucial point beyond which an increase in tax rates leads to decreasing revenues and national income;
- there are always two tax rates available (A and B) which can produce the same total tax revenue, one a higher rate and another a lower rate. Governments therefore need not necessarily choose a higher rate to achieve the required quantum of revenue.
Studies of selected countries also seemed to indicate that those that imposed a lower effective average tax burden achieved substantially higher rates of growth in real gross domestic product than did their moiré highly taxed counterparts.
The Laffer Curve, however, has had its critics like Paul W. McCraken, Paula Krugman, Robert Lekachman and John Kenneth Galbraith. They have questioned the assumptions and theory behind the Laffer Curve and proved that it is not as scientific as it appears. The supply side cuts of the early 1980s do not appear to have raised work effort or saving and they unquestionably increased the deficit. Empirical studies carried out in two countries (Jamaica and India) where tax changes relevant to the Laffer Curve had been implemented have also concluded that the assertion and tax reductions would lead to revenue increases should at best to be treated with caution. (Ebrill, 1987).
While there is no doubt that excessive rate of taxation act as a disincentive to savings and capital formation and retard investment and growth, there is no real evidence that mere reduction in tax rates by themselves would increase investment and growth. The level of taxation is only one factor in the complex process of development which is influenced by many variables both endogenous and exogenous. Hence it is doubtful that tax cuts could ever serve as a “quick fix” for a sick economy.
Further, this approach to development has its social ill effects. The “trickle down” theory of development on which it is based has in practice been found to be not as effective as anticipated. The benefits have not trickled down to the lower segments of society and the supply side vision, as David Stockman said, was simply a cover for the reduction of taxes of the upper income tax brackets.
The Reagan and Thatcher experiments in supply side economics with the resultant tax cuts and reduction of government expenditure led to mismanagement and has become discredited. An analysis of the patterns of income distribution in countries like Pakistan has shown that the upper deciles have benefited more and the lower deciles have reduced their incomes through these policies. This has also been confirmed by the Gini ratio that measures the degree of income concentration.
Role of tax administration in development
Finally, development policy requires the existence and functioning of a sound and effective tax administrative machinery. No amount of development planning would have the intended effect if the required stability and level of administrative resources were not invested in their implementation.
The purpose of tax administration is to fully implement the government’s tax programmes and proposals effectively and efficiently. In the short run, this means optimizing the revenue collectible with the resources, which the government makes available to the administration. In the long run, it means collecting all the legislated tax with the minimum of cost. All this requires an efficient and sound administrative machinery and effective coordination between the fiscal policy making body and the administrative mechanism.
The above sections dealt with some of the main components in the relationship between taxation and development. While there is often no direct perceptible correlation between tax policy and actual development performance due to the prevalence of a variety of variables, the links between fiscal policy and economic growth are there. Often this is indirectly operating through the capital, labour and product markets.
Taxation affects the amount of capital available by encouraging or discouraging savings and foreign investment. It may also divert investment and labour from one sector to another. It affects the level and productivity of employment by influencing individual choices between work and leisure, the intensity of effort on the job and employers’ decisions on technology. Taxes affect a firm’s ability to diversify and expand through their import or input costs and managerial behaviour.
They may also have a bearing on less tangible factors such as entrepreneurship and technical progress. Some empirical evidence also suggests causal relationships between the level and types of taxes and key growth determinants in the areas of investments, export, employment, productivity and innovation (Marsden, 1986).
Finally, another important reason why taxation is essential in getting macroeconomic policies right is that alternative ways of financing government expenditure – money creation, mandating larger required reserves, domestic borrowing and foreign loans can have very harmful effects on the economy. It is painful to note that the successive governments in Pakistan have resorted to presumptive taxation that has complicated the poverty problem of Pakistan.
According to a study of Asian Development Bank, the tax system of Pakistan, which was progressive till 1990, was converted into regressive regime in 1991 with the introduction of provisions like section 80B, 80C, 80CC and 80D in the Income Tax Ordinance, 1979—these were retained as such in existing Income Tax Ordinance, 2001 and since 2019 made minimum tax further adding insult to injury.
The result is that during the period (1991-2025), the tax burden on the poorest households is estimated to have increased by 35 percent, while it declined by 55 percent for the richest households. The studies of ADB, PIDE, SPDI, PRIME are eye-openers for the target-oriented policymakers who in the frenzy of showing higher figures to lenders/donors have put intolerable extra burden of taxes on the poor of Pakistan.
Like civilizations, tax systems evolve over centuries. Harley Hinrichs in his book General Theory of Tax Structure Change During Economic Development has mentioned five stages through which tax structure has changed historically as economies have developed. These are:
First Stage. A traditional society relies primarily on traditional direct taxes like taxes on land, livestock, water rights etc.
Second Stage. Society breaks away from old ways and indirect taxes become more important, especially external indirect taxes (i.e. taxes on foreign trade).
Third Stage. Traditional direct taxes decline relative to national income and governmental revenues.
Fourth Stage, Domestic commodity production increases and internal indirect taxes (excise duties and sales taxes) grow rapidly to replace customs duties.
Fifth Stage. Economy gains maturity and modern direct taxes like personal income and corporate profit taxes become dominant
Pakistan is still far behind from Fourth Stage, what to talk of coming closer to the last stage. It is high time that our economic managers revaluate the entire tax system and policy and take immediate steps to use tax measures as a tool for economic development rather than fixing of irrational targets and creating problems for the local industrialists and businessmen.
The economy will never stabilize on long term basis through harsh and illogical tax measures. We need to develop a national consensus on tax policy. The potential of Pakistan is much higher than presently fixed by fiscal managers. We can easily generate tax revenue between Rs. 30-34 trillion provided taxation is made through representation, by a democratic process and after soliciting national consensus. (concluded)
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Dr. Ikramul Haq, Advocate Supreme Court, Adjunct Faculty at Lahore University of Management Sciences (LUMS), member Advisory Board and Visiting Senior Fellow of Pakistan Institute of Development Economics (PIDE), holds LLD in tax laws. He was full-time journalist from 1979 to 1984 with Viewpoint and Dawn. He also served Civil Services of Pakistan from 1984 to 1996.