Doing Tax Reform Right: Think Big, Think Bold

Posted on October 16, 2010
Filed Under >Salahuddin Khan, Disasters, Economy & Development
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Salahuddin Khan

On Pakistan’s already beleaguered economy, the added pressures of the recent floods are estimated to have created $10 billion of additional damage-related burden. It will likely cost double that amount if we’re to see more than simple replacement of the old buildings, farmlands and infrastructure and use the opportunity to rebuild the country leveraging all that we can in modern, cost effective technology. The disaster could thus be seen at least with some silver lining.

To be sure the international community has promised much, though much of what’s been promised has also to be delivered. Nonetheless that figure, if collected, would be barely 5% of what’s needed, given the truly vast scale of the devastation.

For these and other reasons, Pakistan has proceeded cap-in-hand to the IMF for additional assistance and as usual, IMF money comes with harsh strings including the abolition of energy subsidies and reform of the General Sales Tax.

But with barely three percent of its population paying taxes and its most wealthy escaping taxes more than in most countries around the world, Pakistan has to be close to the head of the pack in needing significant revenue reform. The recent floods simply serve to highlight the unacceptability of this situation and glowing with empty pride about being the “Land of the Pure” while over half the population is doing everything in its power to ignore or pay off the taxman with bribes, is hardly the way forward. We have no basis for national pride in the face of such behavior.

So what can be done to advance the state of affairs, and more particularly, how can we leverage the new momentum of national unity to repair our ravaged country?

Here’s a potential thought, with apologies for not recognizing anyone else who may have offered the same opinion either here or in other public media. What if we were to abolish all income tax and in its place introduce a gradually increasing property tax on real estate owned?

Here’s how it might be put into effect.

We would start phasing out personal income tax (“personal” here would include partnerships and sole proprietorships) over say, three or five years. All those people in the black economy, hiding their cash or income (which isn’t too hard to do), often with the collusion of corrupt tax inspectors and collectors, would be incentivized to bring it out of hiding. Much of it might have been hoarded in the past, where hoarding is to be distinguished from “savings” in its unavailability to the economy in a hoarded state. If this were to happen then we might get a useful bump in circulation before this new supply is soaked up in inflation.

Second, we would re-survey the land for all real-property (which is extraordinarily difficult to hide) and systematically establish ratable values based entirely on acreage and type of land, such as agricultural, residential, industrial or commercial. Rated to that value would be a progressively increasing tax rate (updated annually during the transition) whose level would be pegged to managing a smooth transition from income-tax based revenues to property tax based revenue. We could probably go the same three to five years to phase in the property tax before it stabilizes to its long term level.

Third, we would begin phasing out sales taxes on low level products and services and focus them on larger, hard to hide luxury goods. Consider just some of the interesting consequences of such a change.

As noted already, land and buildings are difficult to hide. I couldn’t stash my (hypothetical!) Pakistani farm in a Swiss bank. Sure, some of the wealthy might prefer to shift their assets into say, gold or diamonds but the land remains the land. Someone’s got to own it and it can’t be exported. If we design the land/property tax in a graduated fashion, then we can also make it disproportionately expensive to own above certain thresholds of land. For example, something below one acre might attract zero tax. (Even large homes in Pakistan don’t generally sit on a whole acre of land). One to five acres might attract 1% for land and 1% for dwellings. Above five and below twenty five might be 2%. Above twenty five but below a hundred might be 4% etc. The concept here is more important than the actual numbers which would clearly require some research to fine tune them to the country’s socio-economic circumstances.

A natural incentive would spring from such a provision. People would subdivide and sell parcels of land into separate ownership. Sure, at some level, merely handing out parcels to one’s own family members will be effective but this will soon dissipate and spread into the general population. Others will bear the cost and prefer to hold on to their land and dwellings, but the property tax could at least be a highly auditable and natural check-and-balance on extravagance.

Another consequence will be that people will prefer to focus on income generation instead of amassing land, which as a dynamic in the economy would drive the country to greater industrialization. The focus will shift to generating tax free income from the land if it is to be owned at all. This beats simple speculation in land value, while keeping the land in disuse. Satellite imagery would be fairly effective in detecting land use and support any ground-based monitoring for non-usage. Certain sophisticated software algorithms can even be imagined which would automate land use detection—see below.

An emerging middle class would be very income focused and that would be good for the economy, leaning it more in the direction of modern knowledge-based economic models. Gone would be the bribing of tax inspectors and collectors to fend them off from examining complicated income statements, along with the back-end infrastructure for tax collection that presently exists.

Home ownership patterns for the middle class might evolve more to resemble those of Japan than of the USA, with most property optimized as income properties using economies of housing scale, such as multiple floor-plate buildings, though we would need to be intelligent about codes and regulations to avoid the worst excesses of multi-family living.

For lower middle-class people, there would be little, if any tax burden. This would encourage them to step up to the next rung in the social ladder as relatively unfettered income would be available to meet both subsistence needs and savings (with appropriate incentives on savings) or investment in small/medium businesses. In such cases, there would be virtually no need to deal with tax inspectors and collectors. This might even attract foreign investment.

The poorest people might get the opportunity to earn out the land under their feet if they are agrarian, supported by the incentives for land owners to shed some land to escape graduated property taxes.

Of course, with modern satellite based surveying and computerization, it is quite easy to virtually automate tax assessment and with yet more incentives to pay by automatic withdrawal based on the assessment, it would eliminate much of the labor involved. This would free up resources primarily for property audits, which as mentioned previously, would be much easier than for income.

Pakistan probably doesn’t have many more years left to continue rolling from crisis to crisis with a polarization of have’s and have-not’s. If our claims to patriotism for the country are to have meaning, we must shoulder the burden of paying the price albeit with some assurance that we aren’t going to be consumed by corrupt and hungry officials.

The proposal above clearly doesn’t eliminate all corruption which can certainly continue on the other side of collections in the bureaucracy even if more taxes were to be collected. However, it would do much more to balance things out in society without stepping into socialism and it would leverage natural incentive structures to achieve land redistribution without impossible-to-pass land reform legislation. Alright, I guess it would quickly be recognized as indirect land reform but there’d be some carrots too—abolition of personal income tax?

One thing is certain. We can’t continue relying on the generosity of other nations, mirroring in ironically poetic parallel, the artful and sometimes prospering beggar we see in so many of our country’s streets.

Salahuddin Khan is an engineer, an entrepreneur and author of the recent novel Sikander.

38 responses to “Doing Tax Reform Right: Think Big, Think Bold”

  1. Salahuddin says:

    Mahmood,

    As a follow on from my last comment, the prices of homes have nothing to do with the tax rate. The concept of ratable value is different from valuing homes through conventional real-estate valuation principles.

    The only factors would be (a) land area, (b) land use permissions and (c) land placement (one can imagine high value districts and low value districts and can easily define categories of placement e.g. Ultra-high, high, average, low, ultra-low) for each class of permitted use. This would set the rate on a very algorithmic basis having nothing to do with the ebb and flow of house prices, since we’re not talking about transacting home title transfers.

  2. Salahuddin says:

    Mahmood,

    A more in-depth reading of my proposed reform would have revealed to you that I do not propose a tax on homes. The property tax is on land and only if it is larger than a certain size which depends on the zoning for that land. Thus for residential land, the threshold might be one acre (a more in-depth study would yield a better view of this number) and since this is larger than most single-family residences it is not likely to hit poor and middle-class families at all.

    The proposal’s entire purpose is to bring many wealthy tax-avoiding (or evading) members of Pakistani society into a tax-paying condition, while leaving unaffected the majority of poor people, most of whom don’t have any land to their name.

  3. Mahmood says:

    Interesting idea and discussion. The importance of tax reform is clear and we need to think about this more creatively. Any solution should be simple and must also be just so that it does not effect the poor classes. I think this idea of taxing homes is not the best because homes are often the only investment for middle and poor classes and also the home prices which will be taxed can be very erratic.

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