Senator Gravel, FairTax, and taxation in Pakistan

Senator Gravel, one of the Democratic presidential candidates, has been making some noise online recently. It’s pretty funny — I watched Robin Williams’ Man of the Year two days ago, and then yesterday, the video below was featured on Reddit. As you can see, Gravel does the closest impersonation of Williams’ character possible without losing credibility.

One of the things Gravel’s proposing is to implement FairTax, a system that does away with traditional income tax and instead applies additional duties to goods and services. It’s not quite revolutionary in that other forms of tax, such as highway tolls and the congestion charge here in London, are already applied on a per-use basis, but it has some pretty cool effects.

The first thing to notice is that, under the scheme, the additional tax is collected from producers, not retailers or consumers. This means the tax base shrinks immediately, which is good because it makes tax evasion harder and the process more transparent. In addition, the cost of collecting revenues falls dramatically.

The second thing is that a flat tax applied to goods and services (assuming it’s flat — we’ll get to that in a minute) makes it almost impossible for special-interest groups and lobbyists to try to have the tax regime biased in favour of the rich or the organised. This isn’t a serious problem in Pakistan, but it’s nice to have.

Thirdly, the scheme ties revenue generation to consumer spending, rather than earnings, which probably has significant implications for inflation. At the very least, it encourages savings, which is a good thing, particularly in a credit-hungry country like the US.

It’s a little unclear to me whether a flat tax on all goods and services would be a good thing. The argument that it’s fairer doesn’t really hold water, since luxury goods that are consumed only by the rich would raise the tax rate for everyone. Consequently, a tiered tax rate might make more sense. The scheme includes the notion of pre-bates to relieve unfair burden from the ultra-poor, which sounds like a good idea.

I have read, though, that the ratio of spending between the rich and the poor is approximately the same as the ratio of earning between the rich and the poor, which would mean that the gulf between rich and poor wouldn’t be bridged in any way by this scheme. That actually sounds fair enough to me, since the point of taxation isn’t to artificially redistribute wealth (which would invariably lead to inflation).

My interest in this, of course, relates to taxation in Pakistan. The two big problems we face are ridiculously high levels of tax evasion and a culture of kickbacks and corruption.

The former, it is often said, is difficult to tackle simply because much of Pakistan’s economic activity is unrecorded. This doesn’t imply a lot of black market activity, but rather just that smaller retailers don’t maintain records that can be easily examined. The government has resorted to increasingly lax policies to fix the situation, including a recent one which promises that tax returns, no matter how absurd, will not be disputed by the government. There’s no guarantee this will work, of course: some people claim the reason economic activity isn’t recorded is illiteracy. It’s obvious how a system like FairTax would be useful here: the government would no longer have to worry about tracking down and auditing every small retailer (and all his employees), since it would only deal with the producers supplying the retailers with goods.

The problem of corruption would also be addressed, since the scheme is far more transparent and enforceable than filing returns. In effect, you pay tax every time you buy an item, whether it be a sandwich or a Mercedes. There is simply no reason left to slip envelopes to tax officials.

There are other benefits of FairTax that I have not discussed, for example that the overall tax burden over an average lifetime is much reduced under the scheme. Clearly, it is a promising idea and given the failure of our current tax regime, it might be one worth considering.

4 thoughts on “Senator Gravel, FairTax, and taxation in Pakistan

  1. Pingback: FairTax in Pakistan? at Syed Uzair Aqeel’s Weblog

  2. Uzair Post author

    What I said about the tax being collected from producers is slightly confusing. I meant that the government actually collects the tax from producers, who then directly pass on the additional cost to consumers. It’s probably more likely to be implemented as an indirect tax (in the spirit of sales tax, VAT, etc.), in which case retailers would levy the additional charge and be responsible for paying it to the government, but the idea of having producers levy it, if plausible, would probably be more useful in Pakistan.

    Also, there’s a great piece on consumption tax (which is what FairTax is) here: A Consumption Tax

    (Thanks for the link, SAA.)

    I found this particularly pertinent, given what I’ve said above:

    Q.6: Adopting a consumption tax would hit the underground economy.

    A: False. Drug dealers and others engaged in illegal economic activity currently evade income taxes but would have to pay taxes on their purchases under a consumption tax. The same is true for those engaged in legal economic activity who currently fail to report or pay taxes on their income. But the tax evaders also have customers, who currently pay income taxes before using their after-tax income to make purchases.
    Under a consumption tax, purchasers of illegal drugs would no longer have to pay income tax but would evade the consumption tax. The increased taxes on producers in the underground economy would be offset more or less by the reduced taxes on consumers in the underground economy.

  3. A.

    Interesting quote from the link. Takes a bit of slow reading to get his meaning, but interesting thought. However, one thinks of someone like Tony Soprano (yes, from the HBO drama!) who doesn’t pay consumption taxes, nor does he then pay an income tax. He simply steals from people and sells (potentially) stolen goods – so his consumption is not taxable at all. I find the idea that charging him 23% in taxes on a paint job is going to cover our bases a bit naiive.

    The tax scheme seems not to have been discarded out of hand, at least in the US – one would have to read academic papers on this a bit closely to figure out what assumptions are being made in calculating not just revenue replacement but even revenue boosts from an outright abolishment of all taxes and substitution of a hefty sales tax. My initial feeling is also that this might itself be an inflationary policy.

    As for Pakistan, my primary contention with whether a FairTax scheme would work there is that retail outlets of all sizes are largely paperless there rather than being underground. Individual rent-seeking (i.e. tax collectors seeking bribes when they come to the shops to make tax assessments based on observed traffic in the commercial enterprise) cannot be stopped in that case, because it is still up to the retailers to provide a truthful figure of how many units are sold in their shops, and hence how much of the extra 23% in prices they have collected should be passed on to the government.

  4. Uzair Post author

    You’re absolutely right — and that’s exactly why I think this scheme would be perfect for Pakistan, with the proviso that tax be collected from the producers.

    Producers of goods and providers of services number in the hundreds of thousands at most in Pakistan. Compare that to retailers and wage-earners, who number in the tens of thousands, and you can see why I keep repeating this. With the smaller tax base, the government could really chase down figure-fudgers. And of course, there’d be less incentive for people to fudge, since the more they do, the higher the consumption tax rate levied on them would have to be (since the government would be computing the tax rate based on the total revenues they want to generate).

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