Estimating behavioural responses and improving efficiency of income tax in Pakistan

Weak fiscal capacity is one of the major impediments to sustainable growth in Pakistan. At 9.2%, Pakistan’s tax to GDP ratio is among the lowest in the world. This not only severely constrains government’s ability to invest in human development and infrastructure but also makes the country vulnerable to destabilizing fiscal shocks. Pakistan’s policymakers are aware of the importance of the issue and domestic resource mobilisation remains one of the more hotly pursued – and unfortunately also one of the more elusive – of the medium-term policy goals.

Of all the taxes, personal income tax is more important for two reasons. The tax is very efficient and along with the VAT raises most of the revenues in the developed world. A progressive income tax structure can also reduce the inequality gap in the society through redistribution of wealth. Unfortunately Pakistan’s tax yield from the tax is extremely low and gross revenues from the source declined from 1.5 % of GDP in 2000/01 to 1.1 % in 2007/08. A significant effort to study and reform the tax is hence needed if the country has to realize its medium-term target of increasing tax revenues to 15% of the GDP (Country Partnership Strategy 2010-13, World Bank). The research conducted under this project aims to uncover the reasons underlying poor efficiency of the tax in the country. More specifically, it will use the administrative tax records of the country for the period 2006-09 to estimate the elasticity of taxable income for various groups of taxpayers. Recent literature in public finance suggests that, under some conditions, such elasticities can be used as the sufficient statistic for efficiency and optimal tax analysis of such a tax system. Results of the estimation will help us come up with the policy interventions needed to enhance efficiency of the tax in Pakistan.