Review Of Federal And Provincial Taxation Structure

Published Date: 02 Nov 2017

Since the last two decades, Pakistan has undergone various economics difficulties. Recurrent political adjustments caused by lack of consistent policies and their implementation, poor governance, externally caused disasters like floods, terrorism activities etc has struck the country’s economy adversely. In order to finance and construct such policies, foreign financial assistance has always been in need. This is because the amount of tax revenue collected annually has never been adequate for such development as well as recurrent expenditures.

A Historical overview of the Taxation Structure, the tax network and tax compliance in Pakistan

The taxation structure and its compliance by the people vary from country to country. It is the responsibility of the Government to tax the public in the manner they see fit, in order to run the country.

For Pakistan, the 1973 Constitution lays down all the rules and regulations needed for all the tiers of the Government to function systematically. Therefore, the reviewing constitution is the first step to take in order to explain the functioning of the country, whether from a social aspect or from a financial one.

Under the finance chapter, Article 160 of National Finance Commission, the Constitution of Pakistan clearly defines the rules required for the distribution of the revenues between the federal Government and the Provincial Government. It defines the taxation system and structure that should be implemented in the country. According to the 1973 Constitution, taxes are imposed by the authority of the Parliament of Pakistan and it is the responsibility of the Federal Board of Revenue to enforce and collect these taxes. This tax is defined there as:

"taxes on income, including corporation tax but not including taxes on income consisting of remuneration paid out of the federal Consolidated Fund." (Constitution of Pakistan, 1973)

These taxes also include taxes on sales and purchases of goods which are domestically produced and consumed, export duties on raw materials, excise duties on imports and other taxes specified by the President.

Structure of Taxation through the Ages

The taxation structure of Pakistan has undergone changes throughout the years but to no avail. There has been slight improvement in the collection of tax revenue through the years but the ratio of tax to GDP has been not been improving as much. In order to better understand the mechanism and the structure of Pakistan’s taxation system it is important to review the responsibilities which comes under the different tiers of the Government.

Review of Federal and Provincial Taxation Structure

The structure of the Government of Pakistan is important to consider in explaining the structure of the taxation department. The government is divided into three tiers and its responsibilities and functions are outlined clearly in the 1973 constitution. These are the Executive, the Legislative and the Judiciary. Under the Legislative powers, the federal government carries its functions under the federal legislative list. According to Akbar Zaidi (2005):

"The federal legislative list includes functions of a regulatory and service nature. Service functions include defence, external affairs, currency, stock exchanges, national highways and strategic roads, railways, etc."(Zaidi, 2005)

After this there is a Concurrent Legislative List. This list of functions are performed by either federal or/and provincial governments. These functions include population planning, electricity (except KESC), tourism, vocational/technical training etc. Lastly, the residual functions are the responsibility of the provincial government including law and order, justice, public transport etc. Despite its acknowledgment in the Legal Framework Ordinance 2002, the existence of the local government as well as the District Government is not officially recognized in the 1973 Constitution. Due to this non recognition of the local government, many of the functions which should be performed by, or not are the responsibilities of the provincial government, are delegated to the local government most of the time. However, the role of the local government was recognized in the 1979 when the Local Government Ordinance was passed. Unfortunately it was implemented only in Punjab, Sindh and the then NWFP. In 1980, the same ordinance was extended to Balochistan till 2001 ordinance, which replaced them all.

After reviewing the structure of the Governmental hierarchy of Pakistan, it will help to systematically define the structure of the taxation system of the country itself.

Tax structure is the most integral part of the whole taxation system of the country. The Federal Tax Structure is made up of a large share of Income tax, General Sales tax, which was introduced in 1996 in Pakistan taxation structure, and the Custom duties. All these three taxes are collected by the Central or now the Federal Board of Revenue. The provincial tax structure is divided into three major categories; the Excise and taxation, land revenue and the funds provided to and collected by the local government. The Excise and taxation department is responsible for collecting the property tax, motor vehicle, the professional tax as well as the provincial excise. The land revenue includes the land related levies other than property.

Theoretically the sales tax on services should be a part of the Excise and Taxation, but unfortunately in Pakistan, the imposition and the calculation of such a tax has not been deciphered yet.

Elasticity of Indirect and Direct Taxation System

It is not as much as the tax rates itself which impacts the economy, but the elasticity and buoyancy of these taxes which helps determine the impact on the revenue. The elasticity of tax determines the responsiveness in tax revenue which is caused by a percentage change income or GDP. On the other hand, buoyancy measures the total response of revenue from changes in income or GDP. As tax rates increase over time therefore the buoyancy of tax rates, whether as a whole or individual tax, is greater than elasticity.

The extend of elasticity depends on the nature of the tax; whether it is a direct tax or an indirect tax, whether it is specific or ad valorem in character, its tax to base ratio etc. In the case of federally administered taxes, the direct taxes include income tax, corporation tax, wealth tax and property tax where as the indirect taxes include the sales tax, excise duty, exports duty, foreign travel tax etc.

Pakistan has never been able to raise its ratio of tax revenue to GDP more than 13 percent. According to Faiz Bilquees (2004), there are three major weaknesses in the tax system of the country which has caused such a failure, "narrow and distorted tax base, over-reliance on indirect taxes, and weak tax administration."

By observing the figures of direct and indirect taxes over the FY of 1974 to 2003 in the table below, it depicts the inadequacy of generating revenue and that ratio of tax to GDP has been not more than 13%. According to Faiz Bilquees (2004) the reason of very low share of direct tax to GDP was the high tax holidays and tax exemptions in the 1960s, but it raised in early 1990s. whereas the share of direct tax to GDP remained around 11 to 12% from 1970s to mid 1990s. "However, over time, the shift in the shares of direct and indirect taxes as a percent of total taxes has been quite significant" from 1974-75 to 2001-02.

Source: Pakistan Economic Survey (various issues)

According to the recent data of 2010 to 2011 from the Economic Survey of Pakistan, the federal indirect tax to GDP was around 5.3 percent while indirect tax to GDP was around 3.3 percent.

All income tax in Pakistan is not hundred percent direct taxes. The reason behind this is the withholding tax. Withholding tax is technically taxation at source. This means that when a tax payer’s salary is paid, his withholding tax is cut when the tax payer is paid his salary. On the other hand, withholding tax is cut on wholesale or bulk supply by the purchaser before paying the due amount and this withholding tax should be filed to the income tax department by him. Same is the case of tax on services, custom duties etc.

Effectiveness of the Taxation Structure on Tax Compliance in Pakistan

The success of a taxation system of a country depends on the extent of compliance to the tax rates by the tax payers of Pakistan. It was recorded that in 2011-12 about 1.4 million filed their income tax returns, out of the 17 million people in the country. In addition to this, about 40,000 business units filed sales tax returns. Even these figures are a popular misconception among the country especially the statement that one percent Pakistanis pay taxes. The reason behind this is that millions of consumers pay indirect taxes in the form of sales tax, federal excise duties etc. These are counted as the income tax paid by the taxpayers.

There are few ways in collecting income tax in advance. Before the 30th June of every year, the tax payer has to show evidence to the income tax department that he has settled his taxes for the respective year; this is called filing a return of that fiscal year. For other cases, income taxes are cut in advance in the form of withholding tax. This causes income tax to be regressive because withholding tax has to be paid by everyone regardless their income. But for the taxpayers who earn salaries, it is not regressive because they pay according to the normal tax rate. For the salaries, this tax is considered as the final tax liability. This is proved to be injurious to the tax payers because the tax is cut on the principle payment and not on the profit after deducting the expenses. This shows that those who earn more, pays more tax but it is on the contrary. A lot of taxes go in the collection of withholding tax. Thus a large amount of income tax is collected under the withholding tax. Thus the income tax structure is not entirely progressive. Furthermore, a subset of withholding tax is the presumptive tax which assumes that the tax deducted is considered to be the final tax liability and it is applicable on salaries, payments, supplies and imports. Following is the table showing the collection of withholding taxes and its growth in fiscal year 2004-05.

Withholding taxes

Collection in 2004-05

Collection in 2005-06

Growth (%)

Share in Sub-total

Share in gross total

Subtotal

111,498

139,257

24.9

100

57.1

Gross Collection

202,801

243,736

20.2

-

100

Source: CBR Yearbook, 2005-06

The increasing reliance on withholding tax in clearly shown in the table as it has contributed about 57.5% in FY 2005-06. The gross collection was increases to 76.9% and there was a major growth of 25.2% in the tax revenue.

Inefficiency/Efficiency of Tax Network and the Macro economy

The tax network of Pakistan is different for every federal tax. For the income tax, the tax payers are required to file their tax return at the end of every fiscal year which is June 30th (trend over years). Furthermore, those who file their tax returns to the income tax department, FBR give a number to the filer called the NTN. This stands for the National Tax Number. In recent years there is a decreasing trend of NTN holders who file their tax returns annually. This is because people want to avoid tax deduction from their income or do not want to declare the amount of income they receive.

In order to detect income tax, tax authorities review properties and assets of an NTN holder and calculate his income. If the declared assets value is less than the actual value then there are charges on the unexplained or undeclared income of the individual. According to Amnesties, tax authorities can charge an individual for the undeclared income for not more than previous five years. If the individual pays the charges then he is not prosecuted at all. Unfortunately in Pakistan, there has never been any prosecution by the income tax department against individuals with undeclared income and assets, only penalties. Thus due to amnesty schemes, the tax network should increase as well as the tax revenue of the country. But unfortunately, neither did the tax network nor the tax revenue increased as much due to these schemes.

Another part of the tax network of Pakistan is the "money whiteners." In 1990, when Nawaz Shareef became Prime Minister, he introduced a law under the name of Economic Reform Order. This declared that if an individual opens a foreign currency account in Pakistan then the Tax authorities or the national accountability bureau cannot question its source. Along with this, they introduced a concept of foreign exchange Bearer certificates against dollars and no one can question its source as well. The purpose of these measures was that those who had undeclared income, and did not give the income tax, could convert that income into FEBCs or put them in foreign currency accounts thereafter making the money "white" or legal. A lot of these "money whiteners" were abolished at the time of Musharaf’s regime except for the remittances. The sources of these remittances were not questioned in his regime. This was also a way of money whitening in a way that individuals used to transfer money abroad from outside the banking channel and then that money was transferred back through the banking channel recognized as remittances.

Tax Reforms affecting Tax Collection and Compliance

According to the Economic Survey of Pakistan 2011-12, the government has placed the reform of tax administration the first agenda in order to improve the declining tax to GDP ratio along with the issues of debt servicing and defense needs. This reform strategy had three main categories; policy reforms, administration reforms and organizational reforms.

In order for these reforms to take action, according to the same survey, FBR has prepared a new recruitment policy which emphasizes on skills of the employees. This will improve the efficiency of the institution and may help increase tax effort. The main units of the Federal Bureau of Revenue namely Large taxpayers units (LTUs) and Regional Tax Offices (RTOs) will be responsible to reorganize the structure of income tax and sales tax as well as test it in order to avoid discrepancies.

Furthermore, in order to encourage individual taxpayers to comply to the income tax procedures, taxpayers’ education and facilitation centers has become the utmost priority of the government in order to improve voluntary compliance.

Moreover, Customs Administration reforms (CARE) were introduced in order to reduce the time of clearance of goods and reduce cost of doing business.

In addition to this, according to the Economic Survey of Pakistan 2011-12, the government has mentioned the purpose of introducing the following reforms by stating, "Reforms were made by the Government in the form of presidential ordinance and withdrawal of SRO based exemptions; amendments were made in the Sales Tax Act, 1990, Income Tax Ordinance, 2001 and Federal Excise Act, 2005."

Analysis of Determinants of Tax Policy and Administration in Pakistan

The tax administration is known for its ill organization, inefficient functioning, out dated procedures, lack of skills and over reliance on manual work rather than computerized records and procedures. There is also a common perception of corruption and arbitrariness in the tax system.

There are several determinants of tax administration of Pakistan. According to a former member of CBR, Ahmed Khan, in a macroeconomic setting, resource mobilization of the country improved till 1991-92 but after that it declined. And total revenue to GDP ratio went down from 19.1 to 16.1 percent in 1997-98 and was expected to decline further after that. Furthermore, the gap between federal and provincial fiscal effort kept increasing. This was due to litmited fiscal space and narrow tax base. In order to amend this gap it is suggested that radical structural adjustment in the federal and provincial taxation system is required.

Trends of Tax to GDP ratio of Pakistan in recent years

The historic trend of the ratio of tax to GDP of Pakistan has been more or less stagnant and has not shown much improvement through the years. It has been less than 13 percent to date as compared to the ratio of other developing countries in the world, which averages around 18.5 percent.

According to the former member of CBR, Ahmed Khan, when talking about the trends of taxes in the 1990s, historically the ratio of direct taxes to GDP has "remained between 2.68 per cent to 3.8 per cent of GDP as against an average of 7.2 per cent for other developing countries." Whereas, the share of indirect taxes was "around 9 per cent in Pakistan as against 5.2 per cent in other developing countries."

While highlighting the recent trends of Pakistan’s tax to GDP ratio, it can be observed that it is expected to increase from about 8 percent in 2010-11 to about 9.5 percent of GDP in 2011-12. This trend can be seen in the graph below.

The indirect tax to GDP ratio was recorded to be around 5.3percent while direct tax to GDP ratio to remain around 3.3 percent in 2010-11, while it was recorded to expect to decrease to 4.3 percent and direct tax to GDP ratio to 2.6 percent. The ratio can only increase if the untaxed sectors and contributors of the economy are included in the tax base.

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Source: Fiscal development. Economic Survey of Pakistan. 2011-12

Relationship between Tax Evasion and Tax effort.

Tax evasion is defined as the deliberate avoidance of an individual in paying taxes or filing tax returns to the Tax authorities. While tax effort is a conglomerate of tax administration, tax policies and laws, tax compliance and the tax base which enables an institution to have the capacity to collect tax revenue as a percentage of the income generated from that country. Therefore, the relationship between the tax evasion and the tax effort would be of negative in nature. This is because due to the increase in the trend of tax evasion by the potential taxpayers, the amount of tax collected will reduce, resulting a decrease in the tax to GDP ratio. The following graph represents data of tax evasion to GDP of Pakistan as against the ratio of Tax revenue to GDP of Pakistan from the years 1990 to 2010. The graph clearly shows the decreasing trend thus a negative relationship between tax evasion and tax revenue as a percentage of GDP.

Source: Self made. It shows the Relationship of Tax evasion as a percentage of GDP with Tax revenue as a percentage of GDP during the years 1990-2010. Data of Tax to GDP from WDI and data of Tax evasion to GDP from Kemal (2007).

Reforms and Policies in order to boost Tax Effort

There are various reforms and policies introduced by the Pakistan Government in order to increase tax collection and tax effort. Some were successful; others did not show much impact on tax revenue or the tax to GDP ratio of the country. Following are few of the major reforms are laws introduced by the Government of Pakistan and were implemented since the country’s inception.

Income Tax Ordinances

There has been three major income tax ordinances passed by the government of Pakistan. Nowadays the income tax ordinance which is being observed is the 2001 income tax ordinance.

The first income tax law adopted by the Government of Pakistan was the Income tax Act in 1922. This was replaced by the income tax ordinance in 1979 and finally in 2001 a refined income tax ordinance was introduced which is applicable to date.

National Finance Commission Award

National Finance Commission Award is a way of domestic resource distribution in Pakistan and to improve domestic resource mobilization. The revenue collected by the central government is redistributed to the provincial government which further distributes funds to the local government.

There has been several NFC Awards throughout the history of Pakistan. The years in which they were made were 1974, 1979, 1985, 1990,1996, 2000, 2006 and the latest in 2009. Officially these awards should be made after every four years but there has always been a huge gap of years between them. The criterion for the distribution of funds of all the National Finance Commission Award, from the divisible pool, has been population of the provinces. But this notion has always been of debate especially from the provinces with relatively less population. They insist on inclusion of other criterions of funds distribution. On the other hand, absence of adequate technical skills and permanency of the award causes friction among the provinces.

The effect of Tax noncompliance on tax effort of Pakistan

There are economic, political as well as social issues pertaining to non compliance to tax payment which effects tax effort.

There is a very low trend of saving in Pakistan. This causes individuals to avoid paying income taxes which would reduce their income. Resultantly, they do not tend to declare their assets and income in order to avoid tax cut from the authorities.

In this country, people have a deep unpopular notion against the Government and its associated authorities. They do not trust governmental departments and their functions. Therefore, there is a high tax non compliance because they know that the tax proceeds will go in the hands of the corrupt politicians and their officials. They will not be put in a productive use for the betterment of the country’s population.

The extent of dependency of Pakistan on Foreign Aid

Foreign Aid has been the major source of finance, may it be for development or non development purposes, for Pakistan since the beginning. Since then Pakistan has majorly been dependent on such foreign Aid due to various domestic and foreign issues which has kept its domestic funds and reserves to a minimum as compares to the country’s expenditures.

Determinants that effect Foreign Aid inflows in Pakistan

The list of reasons for Pakistan to ask for and receive foreign aid has been innumerable. The most important determinant of Pakistan for being a foreign aid receipt is its geostrategic location. This can be observed during 1979 to 1988 when the Soviet Union invaded Afghanistan, the United States being a major player in this war, wanted the Soviet Union to be defeated thus it increased its aid to Pakistan. This was so that Pakistan could not make alliance with the Soviet Union and help Afghanistan to win the war. Furthermore, after the 9/11, Pakistan again was a given Aid from the US for the purpose to "battle terrorism from the region" especially from Iraq.

One of the various reasons is the corrupt government of Pakistan. It has been observed that for government officials tend to use funds from the national treasury for their own personal purposes. This causes the treasury to have fewer funds for the execution of national projects and other federal expenditures. Therefore in order to fill the gap of savings and expenditure, there is high need for foreign assistance.

The effect of Major Donors on Pakistan Economy

There are various donors of Aid to Pakistan from all around the world including various developed countries from Europe, Australia, few from Far East Asia like Japan etc. The major donor of aid to Pakistan throughout has been the United States of America, followed by the United Kingdom. Other than countries, there are various foreign agencies, nongovernmental and governmental alike which actively contribute to the economy of Pakistan.

The aid inflow in Pakistan comes mostly in the form of loans and grants. The following chart shows the average annual record of grant and loan assistance to Pakistan from various countries and foreign aid agencies from the years 2004 till 2009. It can be observed the major share is taken by the assistance given by United States among the countries and the Asian Development Bank followed by the World Bank among the agencies.

D:\BSc IV\Re Meth\data\loans_and_grants_pie-600.jpg

Source: State Bank of Pakistan Annual Report

Foreign Aid Inflow, Political Dimensions of Taxation and the Tax Effort

Foreign Aid: A Curse for Pakistan?

The previous literature has always highlighted the positive aspect of foreign aid to a country for economic development. It has been recorded that Pakistan has received US$73.14 billion amount of foreign aid from 1960 to 2002 [Anwar and Michaelowa (2006)]. Despite the huge amount it has not caused a substantial change in the country’s economy and the society as a whole. It has always been utilized for the benefit of the influential elite of the country and has hardly been used for the development purposes. Various studies have shown that aid does not have any relationship with different aspects of the economy like savings, investment and others. Boone (1996), Easterly (2001), [Levy (1984)]. Therefore, it was concluded that "Inelastic revenue structure, large size of non-development expenditures, reduction in public investment, infrastructure deficiencies, and lack of social services are the main gifts of aid." (Khan, M.A., Ahmed, A, 2007)

Foreign Aid, Aid Conditionalities and the Tax Effort

The foreign Aid to Pakistan has more or less always been subject to conditionalites by the donors. Historically when the country had its first nuclear test in 1998, U.S put sanctions on the country and stopped the aid inflow in Pakistan. Since 1988 to 2002, Pakistan’s aid was stopped by the U.S due to the Nuclear Programme started by the country. There several other incidences when the donors have stopped to started the inflow of aid to Pakistan where their vested interests were fulfilled.

These conditionalties are in the form of more interest payment, low inflation, or that the funds should be used for military purposes etc. Nevertheless, whenever conditions are imposed by the donor countries it affects the Pakistan’s economy adversely. It has been known that the country increases the rates of indirect and direct taxes and puts the economic burden on the working population. This does not affect significantly because of the poor system of tax collection, tax evasion and corruption. Resultantly, the government has to borrow in order to pay back the debt and fulfill conditionalities. This causes the economy to enter into a debt spiral making the situation worse.

Aid Effectiveness on Tax Effort in Pakistan

There have been conflicting theories about the effectiveness of aid on tax revenue and tax collection. (Khilji and Zampelli,1991, Khan and Hoshino,1992). According to Salman Ahmed, foreign aid does effect taxation of Pakistan butgrants and loans both have different on taxation. In his studies he incorporated government expenditure and investment to measure this relationship. He concluded that foreign aid is regarded as an increase in income by the government and it is used for public investments. He also said that loans are used to generate investment in the country while grants usually decrease the tax burden due to its non repayment characteristic. In the case of loans it is vice versa.

Managerial concerns pertaining to research

As Pakistan is a major recipient of foreign aid around the world, especially of the United States of America, this thesis may help facilitate the policy makers in analyzing the high dependency of foreign aid and how to tackle this situation. Furthermore, it can allow review the structure of the tax system of the economy and to formulate steps and make reforms so that the taxation system and tax collection becomes more effective and efficient in generating more revenue. In addition to this, policies can be made to enhance the tax collection procedures by the provincial and local government and further decentralize powers for affective results.

Keywords and definition

Tax Effort, Tax Revenue, Gross Domestic Product, Official Development Assistance, Grants and Loans

Tax effort: "Tax effort is defined as an index of the ratio between the share of the actual tax collection in gross domestic product and the predicted taxable capacity. Actual tax revenue as a share of GDP is one of the most commonly used measure of tax effort." (Minh Le,T., Moreno-Dodson, B., Bayraktar, N. 2012)

Tax revenue: "Tax revenue refers to compulsory transfers to the central government for public purposes. Certain compulsory transfers such as fines, penalties, and most social security contributions are excluded. Refunds and corrections of erroneously collected tax revenue are treated as negative revenue." (World Bank, WDI)

Gross Domestic Product: "GDP at purchaser's prices is the sum of gross value added by all resident producers in the economy plus any product taxes and minus any subsidies not included in the value of the products. It is calculated without making deductions for depreciation of fabricated assets or for depletion and degradation of natural resources." (World Bank, WDI)

Official Development Assistance: "Net official development assistance (ODA) consists of disbursements of loans made on concessional terms (net of repayments of principal) and grants by official agencies of the members of the Development Assistance Committee (DAC), by multilateral institutions, and by non-DAC countries to promote economic development and welfare in countries and territories in the DAC list of ODA recipients. It includes loans with a grant element of at least 25 percent (calculated at a rate of discount of 10 percent). Net official aid refers to aid flows (net of repayments) from official donors to countries and territories in part II of the DAC list of recipients: more advanced countries of Central and Eastern Europe, the countries of the former Soviet Union, and certain advanced developing countries and territories. Official aid is provided under terms and conditions similar to those for ODA. Part II of the DAC List was abolished in 2005. The collection of data on official aid and other resource flows to Part II countries ended with 2004 data." (World Bank, WDI)

Study objectives

The aim of the thesis is to gauge whether foreign aid inflows affects the fiscal behavior in terms of the tax structure, tax collection, tax compliance and tax effort in Pakistan , or not for the time period 1990 to 2010 in Pakistan’s history.

To test the proposition whether the incidence of corruption impacts the tax collection and revenue generated in Pakistan, or not, in a time series setting from 1990 to 2010. Here, a proxy variable to represent corruption has been taken as ‘Tax evasion to GDP ratio’. The foreign Aid components focused in this thesis are grants, loans and the net aid indicated as the Net Official Development Assistance. In order to measure tax effort, few proxies are used including Tax to GDP effort, growth in tax revenue, difference in potential tax to GDP and actual tax to GDP and the ratio of predicted Tax to GDP and actual tax to GDP. Other variables incorporated in this thesis, in order to test this hypothesis are taken from various databases, mostly World Development indicator, Political Risk Services and International Country Risk Guide and various publications listed.

Chapter 2: Literature Review

2.1 Taxation system, Fiscal governance and resource mobilization

2.1.1 Taxation structure: international historical overview

Historically, the structure of taxation has been seen and analyzed under the groups of direct and indirect taxation. Most developing countries have relied heavily on indirect taxation, mainly on consumption and other indirect taxes since it is easier to tax consumption than to tax income- a direct means of taxation (Ahmed et al, 2008). In lieu of this, numerous developing countries have opted for excise taxes and tariffs.

On the other hand, indirect taxation such as the Value Added Tax (VAT) has never been so easy to implement for the developing countries. Ehtesham Ahmed and Nicholas Stern of the London School of Economics and Political Science have done a great deal of research over tax issues pertaining to the VAT. Typically, VAT was implemented in the form of Gross Sales Tax in many countries since it was easier to supervise and monitor it within the given administrative expenses. Moreover, with VAT, the coverage of collection is more extensive as compared to income tax because VAT takes care of the shadow economy as well.

Burgess and Stern (1993) yielded a number of useful facts pertaining to taxation. According to them, developing countries, relative to advanced countries, generally tend to rely more on non-tax revenues and obtain a high share of their total tax revenue from indirect taxes (mainly international trade taxes and domestic taxes on goods and services) as compared to direct taxes such as social security contributions and taxes on income, capital gains, payroll, and property (Mahdavi, 2008).

The structure of taxation in a typical developing country such as Pakistan is, characterized by "direct taxes not being paid by those who should be paying them; indirect taxes being largely paid by those who are otherwise considered underprivileged to pay taxes and subsidies and exemptions being cornered by those who should not receive them." The drawbacks for such countries of taxing income include high administrative costs, tax evasion and disobedience to the regulatory law. Other than this, income tax collection has generally been lower in developing countries due to lower income levels where collection at higher marginal tax rate has been minuscule.

2.1.1.1 Effectiveness of taxation structure: a cross country analysis

Mahdavi (2008) studied the structure and composition of taxes over a panel data of countries. The composition of tax structure and its effect on the process of economic development is important for many reasons. First, a given level of taxation may be related with different tax revenue compositions across time and countries. So, even if the level of taxation is taken as "appropriate", its mix may not essentially be "desirable" to the extent that the ‘tax system "overuses" some tax types and "underuses" others’ (2008). Second, possible determinants of the level of taxation are expected to have "differential impacts on various components of total tax revenue." An understanding of the way a change in a specific determinant shifts the composition of tax revenue is vital in designing policies to improve the tax revenue mix. Third, various tax types may differ in relation to their effects on ‘labor–leisure and saving–consumption choices, administrative and compliance costs, the scope for evasion and avoidance, simplicity and transparency, stability, and elasticity with respect to economic growth’ (Mahdavi, 2008). Similarly, at any given level of taxation, a change in the composition of tax revenue may have unusual implications regarding output growth, efficiency, reliability as the basis of revenue stability, depending on the type of tax that caused the adjustment. Lastly, focusing on the behavior of tax level may cover the information regarding the feasibility of alternating revenues from one type of tax for revenue losses in another. Astoundingly, the empirical study of the mix of tax revenue in developing countries are generally limited and limited to description of the differences in the structure of tax revenues between developing countries and advanced industrialized countries.

2.1.2. Tax Administration impacting Tax Effort

A proxy indicator for tax administration is the number of tax payers in the country, which remains significantly low in developing countries, such as Pakistan. As a developing country, Pakistan is of striking importance for its slackening quality of tax administration. Low growth in the number of income tax payers, which remained at approximately two million in a nation of 180 million people, is another crucial reason why the country held a stagnant tax-to-GDP ratio for the last decade, or even more. Also, from about 17000 existing enterprises in Pakistan, only 4000 officially declare taxable income. Statistics reveal a astonishing fact that more than a 100 million cell phone users in Pakistan pay a 10 percent income tax as a rule, but a majority does not file tax returns. Owing to the fact that a lot of tax evasion happens as a result of the rich being outside the tax net or failing to pay income taxes, poverty deepens in society. The poor are overburdened with taxes- mainly including a 16 percent sales tax on the items of consumption as well as being subjected to withholding taxes at source below the income bracket of Rs, 350,000 (Ghaus Pasha, 2010).

2.1.2.1 Role of the Government to increase Tax Effort

There are several drawbacks of taxing income for developing nations, including elevated administrative costs, tax evasion and noncompliance with the regulatory law. Other than this, income tax collection has usually been on the lower end in developing countries due to low income levels where collection at higher marginal tax rate has been very small. Theoretically speaking, a more progressive tax system should lead to the lessening of the extent of tax evasion. Governments have been participating in efforts to increase tax effort. In a typical developing country, such as Pakistan, the government introduced a universal self-assessment scheme (USAS) in the 1990s which, unfortunately, was not accompanied by a fair audit process. This very scheme took tax collections on demand after the audit process, approximating over 20 percent of total tax revenues, which fell drastically to a 10 percent in 2004-05 (Ghaus-Pasha, 2010). Corruption is deepening in the Pakistani society day by day and is a major root cause of a low and almost non-existent tax effort. The People’s Party government under the leadership of Mr. Asif Zardari, has recently announced the cancellation of National Identity Cards (NICs) of those citizens who have not registered or declared their incomes officially to the Federal Bureau of Revenue (FBR) and do not currently hold a National Tax Number (NTN). Such efforts on the part of the government will produce results with a huge time lag and its efficiency might be put under question.

The way forward in order to improve tax revenue collection and management is the government’s implementation of a proper resource mobilization plan in any nation of the world, which should have various aspects to address such as the development of the existing General Sales Tax (GST) to cover the exempted sectors of the economy, typically in the developing world; improvement in the regional tax- to-GDP ratio by improved quality of tax administration and considerably less prospects of tax evasion; and an expansion of direct tax or the income tax administration. These changes will lay the path into bringing any country out of low tax revenue trap. However, the political will of the country’s leadership is a critical factor in order to bring further improvements in tax administration, adjustment and implementation of sound rational tax policies and the promotion of higher tax compliance by the citizens of countries.

Deborah Brautigam (2009) consolidates the political economy theories of taxation, which stress on elite dominance and ethnic division and would very well be useful in explaining why growth in developing countries cannot be translated into development and higher tax revenues. Let’s take the case of Pakistan, again, for reference. The rural areas of Pakistan are notorious for being dominated by large ‘feudal’ landowners. Such landowners have been outstanding and influential in almost all Pakistani government coalitions is a rationale as to why fiscal efforts have been resisted, especially in agriculture. Their power and influence was so great that they were long able to obstruct direct taxation of agricultural income, depriving the nation of a major revenue source. These landowners had formed a coalition with the military leadership under the Musharraf regime (1999-2008), too, and have over time played an important role in Pakistani politics.

Moreover, the economists and academics within the governments may also resort to econometric modeling and other mathematical techniques over the national data to ensure tax compliance. Using a data mining technique over a panel of countries, Wu et all (2012) develop a "screening framework to filter possible non-compliant value-added tax reports that may be subject to further auditing. The results show that the proposed data mining technique truly enhances the uncovering of tax evasion, and can be employed to effectively reduce or minimize losses from VAT evasion."

A crucial effort on the part of the public sector, again, is required when it comes to bringing large underground economies to documentation within the developing world. With the expansion of informal sector in the developing economies and government's futile efforts to increase the revenue collection from this very sector, the importance of taxing informal sector has become even more crucial. Various advisory and regulatory organizations have stressed to focus on the tax payers in the formal sectors, with the expectation that VAT or other indirect taxes will eventually swallow up the informal sector (Tanzi and Zee, 2001). Nevertheless, the importance of taxing informal sector should remain the core of the tax system to avoid the formal sector bearing the brunt of tax regime individually and to increase the accountability in relationship with taxation for a sound, healthy economy.

The most apparent reason as to why it is difficult to tax informal sector is the nature of the sector itself. Informal sector has a multifaceted structure with large number of diverse operators involved in it. Most businesses are carried out at homes which remain undocumented and difficult for the authorities to keep an eye on. Moreover, lack of illiteracy means less trust in banks and more hard cash dealings. Amidst these grave issues, the government finds it cost-ineffective to allocate the essential resources for taxing informal sector. Not only this, some countries do not have the capacity or the resources to carry out thriving revenue collection in this sector (Joshi and Ayee, 2008). Furthermore, in places with feudalism, especially in South Asia, and parallel government structures, in African Countries for example, where many non-state actors exist, the incentive to tax informal sector is even lower. Tax officials find it unrewarding and sometimes life-threatening to carry out their activities in these circumstances. Hence, it is safe to say that taxation involving the underground economy is very challenging, and so is dismal on the part of many developing countries, such as Bangladesh, to lack a hike in annual tax revenues, which would otherwise have been possible.

2.1.3. International Tax Effort Models

Tax effort models have been viewed as providing a policy maker with a normative, somewhat monotonous, prescription concerning the appropriateness of a country’s tax rate. So to say, the tax effort model has been used to suggest whether a specific country has a low or a high tax capacity and tax effort, relative to other countries (Clyde Taylor, 1979). In a tax effort model, it is important to explain only those variations in the share of taxes which are due to taxable capacity factors in a multiple regression equation. The few main models include the Lorz and Morss Model, The UNCTAD model, the Bahl model and the Fiscal Decision Maker model of tax effort.

2.1.3.1 Lorz and Morss model

The Lorz and Morss tax effort model (1967) represent an addition of state and local tax effort models to cross-country comparisons. It attempts to explain those factors measuring a country’s taxable capacity in order to determine a country’s tax effort.

2.1.3.2 UNCTAD model

The United Nations Conference on Trade and Development (UNCTAD) model (1970) differed from the Lotz and Morss model in that it pooled cross-section and time series data. A crucial assumption made was that those factors which determine taxable capacity cross-sectionally also determine taxable capacity over time.

2.1.3.3 Bahl Model

The Bahl model (1971) summarized many of the previous tax effort models, examined their differences and came up with a tax effort model that dealt with some of the main methodological and theoretical problems related with the tax effort approach. Bahl noted that three main determinants of tax effort are the crucial ones: the relative productivity of public versus private investments; a desire of the government to intervene in the resource allocation procedure for distributional reasons; and historical institutional arrangements for particular activities between public and private sectors. The three variables measuring taxable capacity in his model are the stage of development, the size of the foreign trade sector, and a measure of the sectoral composition of value added.

2.1.3.4 Fiscal decision maker model

In the fiscal decision maker model, the concept of a country’s taxable capacity is the tax share generated by the general adaptation of fiscal decision makers to expected changes in the socioeconomic environment in which they act. Tax effort is envisaged as deriving from specific country differences in the socioeconomic environment to which the fiscal decision maker can adapt to some degree. Political survival as his primary goal, the fiscal decision maker chooses the taxes and social good expenditures that enhance the probability of his reelection or reappointment. In this new tax effort model, the level of development variable becomes a proxy for the network of changes in tax resistance while the openness variable becomes a proxy for the cost of tax administration. So, tax effort is determined by the willingness of the fiscal decision maker to utilize taxable capacity.

2.1.4 Indicators and instruments of assessing tax effort

‘Tax effort’ is the "index of the ratio between the share of the actual collection to GDP and the expected taxable capacity. A tax effort of above 1 - high tax effort- implies that the country utilizes its tax base well to increase revenues (Stotsky, et al. 1997). While on the other hand, a country with the tax effort below 1, implying low tax effort, is likely to have relatively considerable scope or potential to increase revenues. The concepts of taxable capacity and tax effort can be further extended to measure ‘fiscal revenue capacity’ and ‘fiscal revenue effort’. Total fiscal revenue consists of both tax and non-tax collection; it represents cash receipts from taxes, nontax sources such as fines, fees, rent, and income from property or sales and the size of the foreign trade sector. Selecting the methodology used to estimate and interpret the tax effort index is a point of caution. The computation of the index is sensitive to the expected results of a country’s taxable capacity (Minh Le et al, 2008).

Stotsky and WoldeMariam (1997) examined tax-to-GDP ratio as a proxy for tax effort, which is defined as total government tax collection divided by the country’s GDP. The actual tax to Gross Domestic Product ratio is usually interpreted as a measure of tax effort and used as the basis for cross country tax comparison. The use of such ratio seems reasonable if attempted to establish trends or to compare tax revenue performance across countries with comparable economic structure and at the same level of income. The advantage of using this approach is that it is simple and provides a quick overview of the trends of the international tax collections. However, when used to evaluate the effectiveness in revenue mobilization across countries in various income groups, the tax-GDP ratio could provide a ‘completely distorted’ picture because of the different economic structures, institutional arrangements, and demographic trends of the countries (Prest, 1979). In such circumstances, this ratio does not reflect the tax potential or capacity of a country, making it impossible to assess whether or not a country is out of line in assessment with its peers in its effort to increase domestic tax revenues.

Tax base availability, which is an interpretation of tax capacity again, shows the predicted tax-to-GDP ratio estimated from a regression, while taking into account country’s specific characteristics. These have been indicators in literature for tax effort that the four models previously discussed above have been used for further analysis. Every model uses its own different definition of taxable capacity and the economic assumptions that come with it. Traditionally, indictors of development were used to measure tax effort. For example, in the later Fiscal Decision-Maker model, tax effort is determined by the willingness of the fiscal decision of the fiscal decision maker to maximize taxable capacity (Clyde Taylor, 1979). The different approaches chosen by Lotz and Morss, Bahl and the later tax effort models can be seen as deriving from their varying buoyancy showing that there exists a pattern of development in relation to tax structure for least developed countries.

Chelliah et al. (1975) emphasize the fact that tax effort indexes are not solely intended to be applied in a mechanistic manner ‘but rather to be considered useful additional information in judging the scope for more taxes’ (1975). Tax effort as a variable cannot be a replacement for a comprehensive study of taxation in relation with the need for and composition of public expenditures of any particular country.

2.2 Defining and Measuring Foreign Aid

Foreign aid and foreign private investment are two important sources of capital for developing countries. Foreign Aid can be categorized into grants and low interest rate loans. The last three decades have observed important changes in the trend of such foreign capital flows from the developed to developing countries. Foreign aid to developing countries increased from US$1.9 billion in 1970 to US$27.1 billion in 1998 (Ghaus Pasha, 2010).

Source: Hang Le, Ataullah, 2006

2.2.2 Evolution of Foreign Aid

Foreign aid has been an important source of foreign capital for many developing countries, especially during the 1960s, 1970s, and 1980s. Initially, being an important economic bloc, the USA strategically started its first foreign aid program in the early Cold War. It demonstrated the nation's assumption of their new economic and political role, as represented by the Truman Doctrine and its support to former British clients as Greece and Turkey. The United States also used foreign aid to give rise to free-market standards for development, the integration of West European economies and the limitation of economic protectionism, through instruments such as the Marshall Plan. It was thought that these programs would greatly benefit the U.S. economy by giving orders at home. Most importantly, such efforts were designed to thwart the spread of international communism, since in early 1946 the U.S. policymakers started becoming convinced that the Soviet Union was aiming towards word domination.

Foreign aid has always been an important source of capital for many African and Asian countries. Pakistan, especially during the 1960s and 1970s, was one of the largest aid recipients in Asia. In the 1980s, Pakistan received large foreign aid flows due to its front-line role in the American-Russian conflict over Afghanistan. These aid inflows, which reached US$2 billion annually by the mid-1980s, are claimed to have supplemented already inadequate domestic savings and foreign remittances, and increased the credit worthiness of Pakistan (Husain, 1999).

The end of the Cold War, which has lessened the strategic importance of foreign aid, has led to a decline in foreign aid during the 1990s. Although the amount of aid has declined, the number of aid agencies has increased from about 7 in 1960 to about 50 in the 1990s. The multilateral organizations, such as the World Bank (WB) or the International Monetary Fund (IMF) have taken a somewhat eminent authority over the economic policies of developing countries. These agencies impose strict conditions on the recipient countries and intimidate them to withdraw aid if the conditions are not met. Foreign aid, to some extent, has helped to promote growth and structural transformation in the recipient countries, especially at the time of post-war reconstruction and natural disasters. It is, however, widely argued that the impacts of foreign aid on development are limited because foreign aid is usually directed towards military and political fields instead of human development (Hang Le and Ataullah, 2007).

2.2.3 Types and nature of foreign aid

Foreign aid has an extremely diverse and heterogeneous nature. We cannot give a single figure to it and analyze the whole situation based on just one figure (Mavrotas, 2002).

2.2.3.1 Sources of foreign aid

At least four different categories of aid are presented in literature: "project aid with a rather lengthy gestation period, technical assistance, and food aid and other commodity aid which adds directly to consumption." To these four types of foreign aid, emergency or relief aid could be added as a distinct category, given its rising importance in recent years (Mavrotas, 2002).

2.2.4 Theories and models of foreign aid in literature

2.2.4.1. The dual gap model

A theoretical model of foreign aid in literature is the dual gap model. The Dual-gap theory emphasizes the role of imports and foreign exchange within the development process. The characteristic contribution of the dual-gap analysis is that though foreign exchange is the leading constraint, it points to the dual role of foreign borrowing in increasing not only scarce domestic saving but also foreign exchange. It is evident that domestic provision requires domestic saving; and that foreign provision of goods requires foreign exchange. There is always a need for a minimum amount of foreign exchange to sustain the growth process. The model takes both the traditional and modern view on foreign assistance- as a boost to domestic saving and, on the other hand, import of goods necessary for growth with the aid of foreign assistance. The dual-gap analysis also presents a more relevant theory of trade for developing countries which justifies protection and import substitution (Ahmed, 2001)

2.2.4.2 The foreign exchange gap

The foreign exchange gap is defined as the deficit on the country’s current account where the balance of payments exceeds the capital inflows. The foreign exchange gap is a concept very pertinent to developing countries. They are usually characterized as being short of capital, since their saving and investment rates differ from developed nations. With external aid and other forms of monetary assistance, developing and underdeveloped countries can get initial capital required to embark on the pathway to industrialization. Once industrialization is underway, the problem of domestic saving resolves gradually. The two gap model is based on the assumption that for developing countries to maintain high growth and industrialization, foreign currency is needed to import capital equipment, raw materials and intermediate goods. Thus foreign exchange gap can become a big development constraint.

Hence, recipient countries may require foreign aid in order to cater to their foreign exchange gap.

2.3 A review of the demand and supply side factors of foreign aid

2.3.1. Demand side factors and the three gap model

As opposed to macroeconomic growth models of full employment, the three-gap model unambiguously considers the interplay between ‘capacity expansion and capacity utilization’. In addition, less data requirement of the model makes it well-suited to countries such as China and Pakistan, where the reporting, coverage and accessibility of time series data is very limited. Gap analysis assumes that the incremental capital-output ratio and other behavioral indicators are fixed in the medium-term and that there is restricted replacement and substitution between domestic and foreign resources.

According to the three-gap model, the expansion and utilization of current productive capacity is constrained by not only the domestic and foreign savings, but also by the impact of fiscal limitations on government spending and hence on its public investment choices (Zhang and Chen, 2006).

2.3.1.1 Motives of Recipient Countries of Foreign Aid

Many recipients receive aid from at least some OECD donors annually. Recent research suggests that corrupt recipient governments, especially of the developing world, have incentives to comply with donor objectives in the public health sectors but they will do so in aid sectors, in which compliance is less costly. This strategy allows corrupt recipients to achieve at least some developmental tasks successfully, hence justifying additional aid inflows (Dietrich, 2011).

2.3.1.2 Policies of recipient countries regarding foreign aid

Many developing nations experience a phenomenal debt burden in lieu of the increasing tendency towards providing loan-type aid instead of grant-type aid and also towards tying aid to the exports of donor countries. Given the ambiguous effects of foreign aid and limited control over the amount of aid received, policy makers in developing countries have started seeking substitute sources of foreign capital i.e. foreign private investment- foreign direct and portfolio investment.

Also, the conditions imposed by aid agencies such as IMF and World Bank, may lead to limitations on policy autonomy of the recipient country and become influential in dictating governments of recipient countries. Empirical evidence suggests that foreign aid has not contributed intensely to the economic growth and development of recipient countries and it has even amplified inequalities among different groups (Hang Le and Ataullah, 2011). Many studies even suggest that aid has the potential to delay the timing of important reforms by providing additional resources to vested interests that persuade authorities of the recipient country ‘to resist adjustments and delay the day of reckoning’ (Casella and Eichengreen, 1996).

2.3.2. Supply side factors

2.3.2.1 Determinants of donor’s aid allocation policies

The increasing tendency toward providing loan-type aid instead of grant-type aid and toward tying aid to the exports of donor countries is a way of the donor to increase the debt burden of the recipient country so that it becomes economically dependent on it for servicing its debt (Le and Ataullah, 2011). Aid agencies, such as IMF and WB, have become more influential in dictating the governments of recipient country in their own strategic interests.

Bermeo (2011) uses data from the AidData project to analyze the relationship between foreign aid and the possibility of democratization in aid recipients. According to him, the association between aid and democratization depends on characteristics of the aid donor. During the period 1992 to 2007, aid from democratic donors was found to be linked with an increase in the probability of a democratic transition. It suggested that democratic donors use scarce aid resources to encourage democracy. However, during the same period, aid from authoritarian donors shows a negative relationship with democratization. Authoritarian donors are doubtful to include democracy promotion in their objective function when determining aid policy. China also places low conditionality on its aid and does not prioritize democratization.

Examining the websites for the Abu Dhabi Fund for Development, the Kuwait Fund for Arab Economic Development and The Saudi Fund for Development confirms that problems of governance are not listed as big priorities for these donors. The Saudi Fund clearly states that loans are made without conditions and the Fund deals directly with governments of the developing countries in financing developments projects, providing direct evidence that it does not follow new ways of channeling of aid that many OECD donors use. It is possible that any differences observed between democratic aid and authoritarian aid in their association with regime change is driven by the choice of recipients to a great extent.

Balla and Reinhardt (2008) have another viewpoint. They find that donors have responded to balanced incentives to decrease recipient poverty and further donor political and economic goals. Every bilateral donor conditions aid on conflict. The U.S. allocates huge amounts of development aid to countries bordering a conflict, in both pre- and post-Cold War times. However, controlling for development levels and donor economic and political interest, ‘most donors reduce aid to a recipient with an in-house or nearby intense conflict’ (Balla and Reinhardt, 2008).

It is seen that most western donors give substantial amounts of foreign aid to corrupt countries. While this might suggest a policy failure to some, it may well be indicative of donor practice that is often overlooked in literature: recipient governments’ ‘good behavior’ in foreign aid sectors, irrespective of their poor national institutions, matters for allocation. ‘When evaluating the high fiduciary risks associated with spending money on the world’s poorest and often most corrupt countries, donors look for specific sector-related progress’ (Dietrich, 2011).

2.3.3 Politics and geopolitics of foreign aid

2.3.3.1 Geopolitics and foreign policy

Many democratic aid donors state democracy promotion as a foreign policy goal. The United States Agency for International Development (USAID) claims that "our work supports long-term and equitable economic growth and advances US foreign policy objectives by supporting: economic growth, agriculture and trade; global health; and, democracy, conflict prevention and humanitarian assistance." The United Kingdom’s Department for International Development (DFID) created the Governance and Transparency Fund to address issues such as "the ability of citizens to make their voices heard and hold their governments to account." Japan’s Official Development Assistance Charter states that "preventing conflicts and terrorism, and efforts to build peace, as well as efforts to foster democratization have become major issues inherent to the stability and development of the international community" (Bermeo, 2011).

2.3.3.2 Geopolitics and foreign aid

Tingley (2009) uses a time-series cross-sectional data set to examine the influence of changes in political and fiscal variables. According to him, as governments become more and more conservative, their aid effort starts to fall. Domestic political variables emerge to influence aid effort, however, only for aid to low income countries and multilaterals as compared to aid effort to middle income countries which remains unaffected. This emphasizes donor economic and international strategic interests as reasons of donor aid policy may be misjudged. His results also suggest foundations of aid volatility that might pressure recipient growth prospects (2009).

2.3.3.3 Governance and its relation to foreign aid

Burnside and Dollar’s (2000) study introduces governance into the effectiveness of aid debate. They analyze the fact that aid increases overall economic growth in the recipient country, provided it is used optimally with good governance practices and fiscal and monetary policies. They shift their focus from policies to institutions, finding empirical support and evidence for a multiplier effect of good governance.

The focus of research aid effectiveness is the conditioning effect of political institutions. Kosack (2003) also looks into the conditioning effect of democracy but adds the aspect of human