Laffer postulates: a way out of economic conundrum

Ali Salman

Economist suggests low tax rates, spending curbs, free trade, selling bleeding SOEs

ISLAMABAD: Arthur Laffer’s name is no stranger to economics. Known as creator of the “Laffer Curve” and the “Father of Supply-Side Economics”, the maestro was in Islamabad recently.

During his keynote address at the Pakistan Prosperity Forum, Laffer outlined six pillars of prosperity: low rate and broad-based flat taxes, spending restraints, sound money, reduce excessive regulations, promote free trade, and privatise the bleeding state-owned enterprises (SOEs).

An additional postulate in this presentation was redefining building codes, which impede economic activities in urban centres. In this article, we present his main postulates and briefly relate them with Pakistan’s situation.

Taxes used as a tool for expanding government services create hurdles in the way of businesses and put extra burden on the people. The purpv ose of tax is to discourage bad behaviour like curbing smoking by imposing taxes.

He said, “When we tax income, then earning more becomes less attractive, and economic activity declines.”

Higher number and rates of taxes have contributed to lower compliance and surging evasion in the country. Currently, 7.1 million people are registered with the Federal Board of Revenue (FBR) and only 3.1 million are filing annual tax returns while 4 million are evading taxes and the FBR is lacking capacity to bring those to the tax net. This manifests flaws in our contemporary taxation system.

Although there has been some improvement in tax collection, yet it has not contributed to significant changes in the underlying tax structure.

Laffer believes “the size of governments is increasing in the world and taxes are imposed to finance those expenses. Pakistan with low per capita income should not be spending more as government expenditures by generating revenues through taxes”.

The sugar industry of the country manifests inefficiencies emanating from excessive state regulations. From the crop sowing area to wholesale and retail prices, everything is determined by the government through administrative bodies at federal and provincial levels.

Yet, the price of the commodity increased sharply by 127% in the last three years from Rs55 per kg in December 2018 to Rs125 per kg in October 2021. This calls for the reduction in regulations and moving towards free market.

The total debt accumulated by SOEs amounts to Rs1.97 trillion. When annual losses of SOEs and tax exemptions are included, we will see a significant amount.

In addition, despite the closure of Pakistan Steel Mills in 2015, Pakistani taxpayers spent Rs55 billion over the last five and a half years on salaries of 9,350 workers, many of whom reportedly secured other employment during the period.

The government needs to move away from businesses and proceed with privatisation to make resources available for development. Private sector is better equipped to bring necessary capital to make these enterprises operational and promote their efficiency.

The domestic currency has seen significant devaluation in recent years on the back of unsatisfactory economic performance. Pakistan has not sound money, which creates uncertainty in the business environment.

Laffer said, “There is nothing that can bring your economy to its knees quicker than unsound paper money.”

It is pertinent for growth and prosperity to have a stable currency, which will only happen when businesses prosper and economy activity reaches its potential.

The country is suffering from low productivity and lack of innovation as a result of high trade barriers.

Laffer said, “There are some things we make better than foreigners and there are some things foreigners make better than we do. We and they would be foolish if we don’t sell them those products we make more efficiently than they do and they sell us those products they make more efficiently than we do. It’s a win win. Trade is critical not only to the economy but to prosperity, and it’s also critical to peace on earth.”

It is imperative to review our policies for the promotion of trade, which will only happen when we reduce tariffs and minimise regulatory barriers.

The economic policies of Pakistan should focus on promotion of these pillars to reach our potential. While many economists are saying these Lafferian ideas do not apply anymore, we see their understanding is needed more given where Pakistan’s economy is.

There is no harm in paying heed to one of the most influential economists of the 20th century for a country where economists are mostly busy telling a 19th century state tools for revenue extraction. Let markets work and let fountain heads of prosperity explode. Finally, while people may support free markets in general, when it comes to implementation, they usually try to procrastinate. In Laffer’s view, “Free markets are most needed when you’re in trouble because they are the way out of trouble.”

The writers are affiliated with PRIME, an independent think tank based in Islamabad

Published in The Express Tribune, November 22^nd, 2021.

Tariffs reforms: one step forward, two steps back?

Ali Salman | Tuaha Adil

Country has failed to diversify its produce as tariff structure restricts innovation, efficiency

ISLAMABAD:

Three years have passed since the Pakistan Tehreek-e-Insaf (PTI) government came to power with the agenda of reforms to remove structural inefficiencies in the economy and put the country on a growth trajectory.

Strengthening trade, revitalising industries and boosting exports are part of PTI manifesto.

Customs tariffs, if effectively employed (or perhaps not used at all), can help in import of innovation, leading to economic growth, whereas their regressive use could erode competitiveness, cause de-industrialisation and push down exports. Clearly, Pakistan’s is a case of latter.

“Make in Pakistan” has been used as a slogan both by businesses and government agencies to gain support and promulgate policies, but the country has failed to diversify its produce because the contemporary tariff structure restricts innovation and efficiency. There is correlation between imports and exports, as the former comprises necessary inputs that will be morphed into value-added commodities for domestic and foreign consumption. But the country is following an import substitution policy, which restricts productive activities, hinders adoption of modern technology, limits competitiveness of domestic industries and creates anti-export bias.

Import substitution is an idea from the 1960s playbook, which has long been shelved, especially in Asian economies, which were later called Asian tigers.

The heart of import substitution-based industrialisation lies in levying protectionist duties and other associated tariff and non-tariff measures. They exponentially increase the value of imports, translate into higher cost of production and deprive manufacturers of necessary capital.

They also diminish the competitiveness of commodities internationally and cause inflation domestically. As a result, Pakistan is in the list of countries having high tariff and non-tariff barriers to trade and its weighted average tariff stood at 12.1%. In contrast, the weighted average tariff of China, Indonesia, Malaysia and even Sri Lanka is 7.5%, 8.1%, 5.7% and 9.3% respectively. Imposition of additional customs duties and regulatory duties makes the gap even wider. In November 2019, a major policy change took place in the form of entrusting the Ministry of Commerce, instead of the Federal Board of Revenue (FBR), the task to determine tariffs. Therefore, a tariff policy board was constituted and the Tariff Policy Centre was established in the National Tariff Commission (NTC) for assistance.

Although NTC was assigned the task to carry out research and formulate proposals in consultation with stakeholders, the Ministry of Finance still played a leading role in the determination of regulatory and other duties imposed during the year.

The PTI government can be credited with the formulation of country’s first National Tariff Policy (NTP), yet implementation of the policy remains to be seen in true sense.

Customs duty on raw material was slashed but on intermediate and final goods it remained unchanged while additional customs duty and regulatory duties were increased, thus making the overall impact insignificant.

The reason behind the myriad duties is the protection of domestic industries from international competition and revenue generation to manage budgetary requirements.

In the framing of country’s trade policy, revenue generation has taken precedence over long-term sustainability and industrial competitiveness, which can be illustrated by the fact that revenue collection at the import stage has stood above 40% of the total FBR collection, ie Rs2,129 billion was collected at the import stage out of total FBR’s collection of Rs4,732 billion in FY21.

On the other hand, continuous provision of protection to industries without realisation of their potential to become internationally competitive has eliminated the incentive to innovate, thereby making them crippled and in need of government support. Subsequently, the transfer of knowledge and technology associated with trade did not happen in the case of Pakistan. NTP envisages reducing complexity in the entire tariff system, but items are frequently moved from one schedule to another through which application of duties remains consistent along with time to time promulgation of SROs, which negates the purpose of creating different tariff slabs, and the implementation has become more intricate.

Moreover, the government has promulgated 43 SROs in the last three years while the PML-N government had promulgated 53 SROs in five years, which created uncertainty and difficulty in the implementation of tariff policy along with making the system more complex.

The application of multiple duties and complexity of the system makes the implementation of policies difficult and leads to the emergence of distortions. It has been globally acknowledged that higher the number and amount of taxes, higher will be the tax avoidance. Similarly, high tariffs have contributed to under-invoicing, mis-declaration of quality and quantity of goods and more importantly smuggling, which is a signal that tariffs are priced too high for customers.

Pakistan’s complex and progressive tariff policy contributes to stagnant exports and requires revision. There are several recommendations:

First, the tariff structure needs simplification through reduction in the number and rates of tariffs. Second, the country needs a comprehensive long-term trade policy to create certainty and provide a road map to businesses, and move away from distortion-creating SROs.

Third, imports translate into exports, therefore, import substitution policy should be rescinded.

Four, tariffs should not be used as a revenue generation tool. Lastly, the protection provided to inefficient industries should be ended to incentivise innovation and adoption of modern technology for higher production and exports.

The writers are affiliated with PRIME, an independent economic policy think tank based in Islamabad

Published in The Express Tribune, October 25^th, 2021.

Free electricity distribution by state

Ali Salman | Tuaha Adil

Subsidy policy revision, technological solutions can address inefficiencies in power sector

ISLAMABAD: According to a recent report released by PRIME, state-owned electricity distribution companies (DISCOs) have caused a cumulative loss of Rs1,355 billion over the last five years.

This includes the loss due to failure in bill recoveries (Rs495 billion), financial loss due to transmission and distribution loss (Rs195 billion), and tariff differential subsidy (Rs708 billion) over 2016-2020.

This should not be surprising given the inefficiencies with which the distribution component of the power sector is marred with.

It has a direct bearing on under-utilisation of the electricity surplus capacity, which in turn has led to the ever-increasing circular debt and rising electricity tariffs.

Failure on the part of successive governments to take tough decisions has landed the country into this quagmire.

As the report shows, the performance of state-owned DISCOs remains unsatisfactory as they have not met National Electric Power Regulatory Authority’s (Nepra) targets for transmission and distribution (T&D) losses, bill recovery, investment and public safety.

The ultimate burden of the inefficiencies is put on the consumers. The higher cost of electricity and power outages has disrupted economic activities in the country, increased the operational cost of businesses, contributed to sluggish growth in gross domestic product (GDP), and led to a decline in the competitiveness of local industries.

In terms of T&D performance, DISCOs are found to be slightly in breach of Nepra targets, therefore, their five-year accumulated losses reached Rs195 billion.

To keep DISCOs operational, governments are forced to regularly pour in money to bail out the defaulting distribution firms in the form of tariff differential subsidy.

Public safety is a cardinal component of power sector efficiency, but DISCOs’ performance is lacking with total fatal accidents mounting to 680 in five years.

FY21 saw an increase in cases of electrocutions where 185 people lost their lives. The incidence of fatal accidents is contingent upon a number of factors such as the condition of infrastructure, population density, encroachments and planning of cities.

Although there is surplus generation capacity in the country, there is still prevalence of power outages, which manifests inefficiency. DISCOs have shown improvement in curtailing T&D losses while the performance of some companies has deteriorated as per latest Nepra report released a few days ago.

Consumers face average daily load-shedding of more than two hours in jurisdictions of various DISCOs. The indiscriminate power outages in loss-making regions are compelling the compliant citizens to look for alternative sources of uninterruptable electricity, therefore, DISCOs are drawing less power from the allocated quota.

This is further exacerbating the problem of surplus generation capacity and subsequently, the burden will fall on the narrow consumer base in the “take or pay” regime.

There are over 1.2 million pending electricity connections, which suggests a significant level of unmet demand. Delays in the provision of electricity connection put the burden of capacity payments on the narrow consumer base and prompt the government to raise tariffs.

As K-Electric example suggests, once incentives are realigned, it can be hoped that the private sector will start investing in the T&D sector.

Total investment made by K-Electric after privatisation has been $3 billion, including Rs68 billion between 2016 and 2020. It has also received a subsidy of Rs143 billion in five years.

Its financial loss from unrecovered bills and T&D losses is calculated at Rs134 billion in five years.

To promote consumer compliance in the lower-tier income groups, the company started a programme in which people could pay bills in installments.

It removed 200,000 Kundas (illegal electricity connections) in 2020 alone to curb power theft. It indicates that despite all shortcomings, K-Electric privatisation has been an overall success story.

Reforms

The government needs to move away from the business-as-usual strategy and temporary fixes, as they threaten the sustainability of power sector. Therefore, a sustainable framework is needed for power sector reforms starting with restructuring and privatisation, either partial or segment-wise, and adoption of competitive tariffs.

The policy of subsidy allocation needs a revision to create incentives for DISCOs to innovate and improve. Besides the policy, technological solutions are also needed like GIS mapping, automated meter reading (AMR), energy audit and accounting, and prepaid metering system, which are the technical solutions to the power sector issues.

As recent news suggests, the distribution firms have admitted sending inflated bills to consumers. A private sector entity free from political power but under a watchful regulator cannot do it.

It is high time that T&D segments are freed from state clutches after strengthening energy regulators at all levels. An efficient and transparent market of electricity generation and distribution is what customers need.

This will also help the government to directly support lifeline consumers instead of distributing the cost of inefficiency across the board.

The writers are affiliated with PRIME, an independent think tank based in Islamabad

Published in The Express Tribune, October 4^th, 2021.