Research topic

“Reformed General Sales Tax (RGST) and its impacts on Inflation”

written By
Imranullah Khan

Table of Contents

S.NO. Contents Page No.

1 Abstract 03
2 Introduction 03
3 Objectives 06
4 Significance 06
5 Literature on RGST and inflation 07
6 Hypothesis 10
7 Operationalization of the Concepts 10
8 Data and Methodology 10
9 Results and Discussion 11
10 Concluding Remarks and Recommendations 12
11 References 14

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“Reformed General Sales Tax (RGST) and its impacts on Inflation”

Abstract:

Pakistan tax to GDP ratio is one of the lowest in Asian countries, which currently
stands at 9.2%. This low tax to GDP ratio has created a plethora of problems
which are necessary and urgent to be resolved. The situation demands that such
initiatives be taken to broaden the tax base and documentation of economy. The
bill has been floated in the parliament, proposing reforms in old General Sales
Tax system. The bill recommends a uniform tax on nearly 600 items, excluding
about all food items. In the old General Sales Tax system, the tax rate ranged
from arbitrarily 16-26%.The RGST is a taxation system that operates by 15 per
cent tax on each and every value addition on taxable products. According to the
government of Pakistan, RGST will lead to the documentation of economy and
most importantly, the increase net base which will increase our revenue base.
This tax is inherently regressive (meaning poor will have to give more of his
income in taxes as compared to rich one), thus rich will not be much affected and
will continue spending although at less rate than before. But the increased price
level will override this effect, hence resulting in inflation.

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Key Words: RGST, VAT, GST, Inflation, CPI, Taxation, government expenditure and
government revenue.

Introduction:
Aim of taxation is to increase the revenue of the government so that the government can provide
social goods and merit goods and subsidized the poor without causing inflation or balance to
payment difficulties. And of course taxation must not be set so high as to reduce private activity to
such an extent that unemployment results. Government don’t normally tax the rich to make them
poorer , what the authorities in effect do is to subsidize the poor and then look round for the most
efficient way of dealing with the inflationary pressure the subsidy implies.1
Taxation is basically levied to balance the government intended expenditures. Classical budget
required government revenue (Rg) equal to government expenditure (Eg), i.e. Rg=Eg2

According to most political philosophies, taxes are justified as they fund activities that are
necessary and beneficial to society. Additionally, progressive taxation can be used to reduce
economic inequality in a society. According to this view, taxation in modern nation-states benefits
the majority of the population and social development.3

Pakistan has made several reforms to its taxation system since its inception till today so that to
achieve equality in government revenue and expenditures (Rg=Eg). The most recent version of the
taxation system is the Reformed General Sales Tax (RGST), which is under consideration. It is a
new name of the old Value Added Tax (VAT).

The enactment of the Sales Tax Act, 1990 introduced its value added version renamed as General
Sales Tax (GST). This was levied on goods only (with many exemptions) and that too at the
manufacturing and import stages. A major leap forward was taken in 1995-96 when GST was
converted into a full-fledged VAT mode tax with all its basic features; self-assessment, functional
distribution, input tax credit facility and audit based procedures. To further increase its base, its
coverage was extended to importers in 1997 and to wholesalers and retailers in 1998. By 2004
VAT was administrated at five different rates i.e., 2%, 15%, 18%, 20% and 23%. 4

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Area of greater concern to the VAT administration was tax compliance. Tax compliance is fairly
low in Pakistan. Only 50 % of the registered persons and businesses file monthly tax returns.
Realizing that adversarial relationship between taxpayer and tax administration is the major cause
of this low compliance, a new taxpayer education and facilitation strategy has been designed.

IMF, World Bank and other international institutions has also been highly instrumental in the
progress that Pakistan has made in adopting VAT so far and in undertaking its further reformation
and as a result the same VAT is introduced recently with a new name, Reformed General Sales
Tax(RGST).5

Pakistan is a country where the tax to GDP ratio is one of the lowest in Asian countries as well in
the world, which currently stands at 9.2%. In order to increase this ratio upto 11% by 2012/2013,
Pakistan needs to introduce Reformed General Sales Tax. This low tax to GDP ratio has created a
plethora of problems which are necessary and urgent to be resolved. It is necessary to broaden the
tax net and document the economy, so that the problem has to be solved. The bill has been floated
in the parliament, proposing reforms in old General Sales Tax system. The bill recommends a
uniform tax on nearly 600 items, excluding about all food items. In the old General Sales Tax
system, the tax rate ranged from arbitrarily 16-26%.The RGST is a taxation system that operates
by 15 per cent tax on each and every value addition on taxable products.

International organizations have pressed hard Pakistan for bringing reforms in taxation system to
increase the tax net/base. They linked further payments of installments of loan to Pakistan with the
implementation of RGST. The Reformed GST regime will change the mindset of the public at
large as well as of the tax machinery and will strengthen government’s efforts to formally depart
from excise-style of sales taxation on goods and services. The government is trying its best to
impose the RGST mostly because there seems to be no way out of it this time.6

The imposition of more taxes is a condition to which the IMF had agreed to give a monetary
injection to the failing economy of the country. Add flood related damage to the economy and
conditions of the donor countries, and the imposition of the new tax has become a must.7

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According to the federal RGST law introduced in the national assembly, the Federal Board of
Revenue would collect GST on services that have inter-provincial application or where input
adjustments are required. The tax recovered on such services would be transferred to the provinces
under a sharing mechanism agreed under the 7th National Finance Commission award.

The provincial RGST law to be introduced in the four provincial legislatures in the days ahead
would make it clear which services the provinces would hand over to the FBR for collection
purposes. The legislative process at the federal and provincial levels has to be completed and
collection mechanism put in place before December 31. As such, the revenue measures would
effectively come into force on January 1, 2011. But due to political crisis it is being delayed.8

Most of the economic experts say that Pakistan is in dire need of it. The new system of taxes will
not only raise our revenue but also help in documenting the economic growth.

Taxation and Inflation are related with each other here in this paper it is tried to be proved that the
implementation of RGST would give rise to inflation as the country is already facing high
inflation.

Inflation is basically a rise in the general level of prices of goods and services in an economy over
a period of time. When the general price level rises, each unit of currency buys fewer goods and
services. Consequently, inflation also reflects an erosion in the purchasing power of money – a
loss of real value in the internal medium of exchange and unit of account in the economy. A chief
measure of price inflation is the inflation rate, the annualized percentage change in a general price
index (normally the Consumer Price Index) over time.9

Objectives:
The objectives of the study are as follows;
1) To study the impacts of RGST on inflation
2) To suggest measure to cope with situation

Significance:

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Currently there is the debate that how the RGST will impact or influence the inflation in Pakistan.
Major political parties are of the view that RGST will bring the storm of inflation and that is the
reason that major political parties like PML-N, PML-Q, MQM and JUI-F furiously opposing this
kind of taxation. At the other hand, the government is of the view that this taxation will have little
impact on inflation. According to the estimates of Finance ministry, with the implementation of
RGST, 0.63% inflation is expected with extreme estimations of 2% inflation. Due to this debate
the study has theoretical as well as practical significance. The paper attempts to formulate
relationship between taxation system and inflation. Practically as the issue is contemporary one,
the study will explore more practical aspects of the story in order to put an efficient and productive
taxation system.

Literature on RGST and Inflation

RGST is a very recent regime which is under process and so for not implemented. The literature
on the phenomenon is not quite enough. But here, related to the nature of RGST and the
unfavorable situation for the implementation of RGST in Pakistan which will directly give rise to
inflation, some literature is reviewed which will guide us in our research.

The central problems with the tax systems of developing countries is tax evasion. The questions of
efficient implementation of taxes, how an efficient information system can be set up in tax
administrations or how tax withholding can be expanded or presumptive taxation made more
palatable are part therefore, of the strategy to improve compliance. The questions of retaining tax
preferences or to do away with the selective measures and generalise the incentives by lowering
the tax rates and taxation of capital are also on the tax policy agenda. Discussion of tax reforms
within the framework of the integration of revenues and expenditure, administration, the role of
presumptive taxation, the funding of social security, environmental taxes, and the dynamic aspects
of taxation is also considered imperative.10

The mounting budgetary deficits and other macro-economic instabilities, governments need to
either to reduce their expenditures, particularly on public investments and social spending, or in
the alternative, restructure their tax systems to seek higher revenues and/or to improve the revenue

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elasticity and buoyancy of the tax structure. Having cut their expenditures as far as prudently
possible, several countries have in the recent years embarked upon tax reforms to raise additional
revenues.11

Tax Reform is a sensitive and difficult process. The pay-off tends to be of a long-term nature and,
therefore, it is difficult for political governments to commit to a comprehensive reform. The
pragmatic course is, therefore, to strive for incremental reforms in a consistent manner over time.12

To reduce the disincentive effects of taxation, reduction of average and marginal tax rates by
eliminating ineffective tax preferences and thereby broadening the bases is being explored.13

Tax reform issues expected to dominate during the 1990s include: design and administration of
taxes, the taxation of foreign investment, financial and resource taxation, the incidence of taxes,
tax policy and economic growth and the quantitative tools for tax policy analysis.14

The relationship between tax policy reform and tax administration, and its relationship with fiscal
policy and stabilization programmes is important and needs to be carefully looked into. Along
with the conceptual framework and design of the tax instruments, administrative efficiency is also
one of the vital components of the reform process.15

"The key to successful tax reform is a tax structure that can be administered adequately with the
available resources while at the same time making the best possible use of those resources from a
long-term perspective".16

Value added tax (VAT) is likely to be more efficient in raising revenue than both the ordinary
Sales Tax and Trade Taxes that it has replaced , the same cannot be said as far as the fairness issue
is concerned. This in no way implies that the trade taxes replaced by VAT were fairer. The
discussion argues that although RGST in general can broden the reneue base but on the other
hand, it is suspected that it can seriously hit the equity and fairness principles advocated by Adam
Smith in his Magnun Opus “Cannon of Taxation”17&18

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Another study shows that there is a significant impact of VAT on inflation but also had a positive
impact on redistribution policies.19

“Pakistan’s fiscal crisis is deep… taxes are insufficient for debt service and defence. If the tax to
GDP ratio does not increase significantly Pakistan cannot be governed effectively, essential public
services cannot be delivered and high inflation is inevitable. Reform of the tax administration is
the single most important economic task for the government.”20

Government borrowing from the central bank to finance the domestic and external deficits is now
at a record high – Rs3 billion a day in recent weeks and averaging 1.7 billion daily since July. This
injects a powerful inflationary impulse into the economy and imposes the most pernicious tax on
the poor: high prices.21

The highest share of the poorest households expenditure is going to food items where they are
spending 58 percent compared to 39 percent being spent by the richest ten percent. If we look at
the overall food expenditure category we can see that it follows Engle's Law i.e. the expenditure
on food declines as household becomes more affluent. If we disaggregate food into two categories
i.e. basic food (milk, vegetables, fruits, spices, lentils, oils and sugar etc.) and other food items
(biscuits, tea, eating out etc.) we find that in the case of basic food items expenditure, poorest ten
percent are spending 55 percent on basic food items compared to 37 percent being spent by the
richest ten percent households.22

Like all indirect taxes, RGST is also inequitable and regressive in nature. Inequitable tax means
that poor will be hit most with this tax, and regressive means that poor will have to pay more of
their income in the form of taxes.23

Taxes are a means to reduce inflation. This is certainly true if taxes are direct i.e. imposed on their
incomes directly. But I am afraid, this is not the case with RGST. This is because this tax is
imposed on goods and services and not on income. Since this tax is inherently regressive (meaning
poor will have to give more of his income in taxes as compared to rich one), thus rich will not be
much affected and will continue spending although at less rate than before. But the increased price
level will override this effect, hence resulting in inflation.24

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If there is direct tax, then it would have reduced the income level of rich while not affecting prices
of goods and prices and thus will reduce the overall consumption by rich and may not have
affected poor. Result will be reduction in inflation. This is because most of the spending comes
from rich and decrease in their incomes may have reduced the price level.25

Hypothesis:
”RGST will contribute to/cause inflation”
Dependent Variable: Inflation
Independent variable: RGST

Operationalization of concepts:
The independent variable is RGST and the dependent variable is inflation. The hypothesis says
that if RGST is implemented then there will be increase in inflation because there is a probability
that since this form of taxation is regressive so the burden may be faced by the poor due to the
taxes on new items. In our research the proxy for inflation will be the price index of consumer
price index which is the collection of food and no-food items of daily use include 374 items in
total.

DATA and Methodology

It is quite difficult to collect data on the contemporary issues like RGST so most of our research
relied on secondary sources. I used research journals articles, newspaper articles, books and
documents of FBR, SBP and Federal Bureau of Statistics. One another important problem during
research was RGST has not been implemented and it is believed that due to one or another reason,
it has been postponed for at least six months. Inflation is already high i.e. 15.8. This tax has a
broaden tax base. It will cover round about 600 items which is greater than the coverage of GST
i.e.160 items. Round about 440 new items if taxed, it means that it will be directly resulted in a
raise of 15% in the prices of the taxed commodities. It will then directly affect the overall inflation

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rate. As it is a value added tax, will be charge at every value added stage uniformly with the rate of
15%,which will directly result in high prices.

FBR,SBP and Fedral Bureau of Statistics data regarding the prices of commodities and inflation
have been studied. But as far as RGST 600 Items are concerned they are still ambiguous. But as in
this regime 440 new items will be taxed which will definitely result in raise in prices. But the
exact impact will be measure than when the exact list of items is known. In the next heading I
quote an example that how this value added tax will be resulted in raise in the prices.

Results and discussion

The RGST is a consumption-based tax which means that the more we consume, the more tax we
pay. It is levied on any value that is added to a product. It will levy upon round abound 600 items
while the existing taxation system covers round about 160 items. The 600 items are not clear, but
then there is a quite big difference between 160 and 600. Though the tax rate is uniform 15%, but
then the basket of the item it surrounds is greater. And now if those goods and services which
were previously exempted are to be taxed in RGST regime, will definitely affect the prices of
other goods and services. It will give a positive push to the current inflation rate i.e. round about
16%. Even if, the effect of RGST on inflation is 2% as the ministry of finance stated, it will be
quite dangerous developing country like Pakistan.

It is a value added tax. It will be uniformly levied upon all the goods and services, falling in its
sphere. It will be charged on each value addition to the goods and services. Its combined effect on
the products where many inputs are involved be greater than existing arbitrary GST effect. Let us
take an example of production of garment through the following RGST chain. To understand it
easily, I have taken an example26, which is simple and straight and has avoided complication:

• A spinner purchases raw cotton from the ginner for Rs 100 and pays Rs 15 being 15%
RGST to the ginner. who deposits Rs 15 received RGST to the government.

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 • The weaver purchases yarn from the spinner for Rs 140 and pays Rs 21 being 15% RGST
to the spinner. who deposits Rs 6 to the government (Rs 21 received RGST from weaver
and deduct Rs 15 paid to ginner).
• The garment industry purchases fabrics from weaver for Rs 200 and pays Rs 30 being 15%
RGST to the weaver, who deposits Rs 9 to the government (Rs 30 received RGST from the
garment industry and deduct Rs 21 paid to the spinner).
• Wholesaler/distributor/dealer purchases garment from garment industry for Rs 300 and
pays Rs 45 being 15% RGST to the garment industry. The garment industry deposits Rs 15
to the government (Rs 45 received RGST from wholesaler/distributor/dealer and deducts
Rs 30 paid to the weaver).
• Retailer purchases garment from wholesaler/distributor/dealer for Rs 360 and pays Rs 54
being 15% RGST to the wholesaler/distributor/dealer. Wholesaler/distributor/dealer
deposits Rs 9 to the government (Rs 54 received RGST from retailer and deducts Rs 45
paid to the garment industry).
• End-consumer purchases garment from retailer for Rs 400 and pays Rs 60 being 15%
RGST to the retailer, who deposits Rs 6 to the government (Rs 60 received RGST from
end-consumer and deducts Rs 54 paid to the wholesaler/distributor/dealer).
• End-consumer absorbed cost burden of Rs 460 being price of the garment of Rs 400 and
RGST expenses of Rs 60 as the end-consumer cannot take adjustment/refund of RGST
from the government.

End consumer will be affected more because the whole burden will be multiplied towards him,
especially the poor because he consumes more of his income and will be left with very minimum
saving than the richer. Most of the population in Pakistan is poor and even the minimum increase
in prices will result in higher inflation.

Concluding Remarks and Recommendations

Pakistan is a developing country and is suffered from high inflation. In this situation, any
incompatible economic decision will result in serious outcomes. Especially in implementing a new

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taxation system. It should be a step by step implementation. The taxes should be direct and
progressive in nature.

The following measures should be taken for generating revenue;

Firstly, it must be progressive, meaning that a higher rate of taxation is placed on the richest
segment of the population and lower rates on poorer segments.

Secondly, the burden of taxation must be spread throughout the economy, with as few exemptions
as possible.

Thirdly, the government does stop Rs.500-600 billion of seepage in corruption. By stopping this
corruption government can generate revenue of 500-600 rupees while through implementing
RGST government can generate 60-160billion rupees.

Fourthly, while going for any tax reform the government should keep in mind the Adam smith
Cannon of Taxation i.e. Equity, Efficiency, Certainty, Convenience

Fifthly, Real Estate, Retailer and Agriculture (income) should be brought into the tax net.

Sixthly, Tax Administration should be improved.

Seventhly, harsh penalty should be given to the tax evaders.

Eighthly, Government should reduce its expanses, so, that to balance its revenue and eliminate
fiscal deficit.

Definitely, if Government of Pakistan has adopted the above mentioned measures, she will cover
her expenditures and will be able to generate revenue. And inflation in the country will be
controlled.

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Refrences:

1-(“The theory of taxation” by Charles M. Allan,p23)

2-(“The theory of taxation” by Charles M. Allan,p20)

3-Population and Social Integration Section (PSIS), United Nations Social and Economic

Commission for Asia and the Pacific

4- Redistributive impact of GST tax reform: Pakistan, 1990-2001. Saadia Refaqat , PhD candidate

at the Department of Economics and International Development, University of Bath, UK.

5- IMF seeks 100pc guarantee on RGST, By Khalid Mustafa,The News,Sunday, December 19,

2010

6- http://www.cssforum.com.pk “What you need to know about RGST”

7- http://www.marketwatch.pk/news/pakistan-business-news, Reformed General Sales Tax’s Deal

in hand, September 27, 2010

8- The DAWN December 23, 2010

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9- Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting,

New York: Harcourt Brace Javonovich, Inc. Page 429.

10-( Pakistan Development Review, Winter, 1993 by Ahmad Khan

11-[McLure and Zodarow (1991]

12-[Shalizi and Wayne (1991)].

13-[Musgrave (1991)].

14- summers’s (1991)

15- Eduardo Wiesner's

16- Richard Bird

17-( Nellor, D. (1987) The Effect of Value Added Tax on the Tax Ratio. International Monetary

Fund, Washington D. C. (IMF Working Paper 87/47.),

18-( Liam, Ebrill, M. K., Jean-Paul Bodin, and Victoria Summers (ed.) (2001). The Modern VAT.

Washington, D. C.: International Monetary Fund.)

19-. Besley, T., and Harvey Rosen Harvey Rosen is the current mayor of the city of Kingston,

Ontario, Canada.Rosen's main focus upon election was to make a concrete decision on the future

of the dilapidated Kingston Memorial Centre. (1998) Sales Tax and Prices: An Empirical

Analysis. National Bureau of Economic Research.

20-http://www.pkcolumnist.com

21- State bank of Pakistan

22-(Pakistan (2001-02)] Household Integrated Economic Survey(HIES)

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23- Express Tribune december23,2010

24-the DAWN December 27,2010

25- Express Tribune November17,2010

26- http://www.brecorder.com/news/articles-and-letters/articles/1142749

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