impact of inflation on taxes in pakistan: an empirical...

ABSTRACT

Journal of Management and Social SciencesVol. 8, No. 2, (Fall 2012) 31-41

The material presented by the author does not necessarily portray the viewpoint of the editorsand the management of the Institute of Business & Technology (IBT) or Sindh University LAAR CampusBadin, Newports Institute of Communication and Economics and FAST School of Management, NationalUniversity, Karachi Campus

JMSS is published by the Institute of Business and Technology (IBT).Main Ibrahim Hydri Road, Korangi Creek, Karachi-75190, Pakistan.

*

C

Impact of Inflation on Taxes in Pakistan: An empiricalstudy of 2000-2010 period

Purpose- Aim of this study is to examine the relationship between tax revenueand inflation in Pakistan. It is further measuring the rate of change in a stochasticvariable of the taxes, i.e. direct, indirect, and total taxes, with a unit change ininflation in Pakistan with an assumption of other factors remaining constant.Methodology/sample- For this research secondary data for the period of 2000- 2010 was used. The relationship among the variables is examined at annualeffect of same period. The analysis is followed by some statistical tools likecorrelation, regression and significance test for error factor to test the hypothesisand infer some conclusion.Findings- Findings of the study suggest that inflation and taxes are positivelycorrelated and any change in inflation cause taxes to increase in Pakistan. Theinflation in the country explains the behavior of taxes positively, but less than1.Practical implications-This study can guide the fiscal policy planners to lookat this critical position of taxes which are inflation-oriented, rather productionor investment oriented. This study also proposes the further study of therelationships of taxes with change in investments and production within thecountry and also for all fiscal variables in compliance to the change in inflation.Research limitations-The results are based on secondary data, so the reliabilityis subject to the accuracy of the source. It also encounters the impact of inflationon taxes, which is not only the factor, so the results are based on assumptionthat other factors are held constant.

Abdul QadirPatoli *Sindh University LAAR Campus Badin.

Tayyaba Zarif *Newports Institute of Communication and Economics.

Nadeem A. Syed *FAST School of Management, National University, Karachi Campus.

Keywords : Inflation, Direct taxes, Indirect taxes, Total taxes

* Abdul QadirPatoli : [email protected]* Tayyaba Zarif : [email protected]* Nadeem A. Syed : [email protected]

Jel classification : E310

32 Journal of Management and Social Sciences

Abdul QadirPatoli, Tayyaba Zarif, Nadeem A. Syed

1. INTRODUCTION & AIM OF STUDY

This study examines the stochastic behavior of taxes towards rate of change in the inflation.The inflation-struck economy of Pakistan has remained the chronic problem over thedecades causing the increase in fiscal gap of revenue & expenditure. In such an economicenvironment the value of factor costs and the commodities, which are necessary to thesurvival of life and maintaining the living standards of society, are increasing in exchangeto the prevailing currency of the country. Such a change in the pricing may ultimately havesome influence on the tax value arising out of production, sale of good & services and theincome earned by the entities (Bilquees, 2004).

Nonetheless, this country is figured as a developing country in the economic raceof the entire world, but the economy of the state is highly influenced with consistent trendof inflation that has abrupt impact on the GDP growth as well as the tax structure andcollection methods. "One percent (1%) of exogenous change in tax to GDP causes declinein real GDP to 2 - 3 percent" (National Bureau of Economic Research). Such a phenomenonhas deteriorated the earning and paying capacity of the public by an inappropriate incomedistribution and extended burden of increasing prices.

As per Bilquees (2004) taxes are the financial blood supplly in the economy,being a major source of financing contributing towards country's public expenditures(Social, political and economic costs) for improving the living conditions and social welfare.The behavior of taxes is volatile with certain factors influencing on it and an increase inthe tax revenue causes decline in budget deficit and a decrease in tax revenue widen thegap between revenue and expenditures of the fiscal period.

Taxes are levied on income of individuals and corporations with direct effect andsupply-chain and value-chain basis with indirect effect. These taxes are measured inmonetary units prevailing in the country. The value of the monetary units is fluctuatingon the basis of demand and supply of such currency, or value of exchange reduces asdemand of goods and services increases (Bird, R.M. 1976). This highlights the relationshipbetween inflation and taxes collected in due period of time.

Economists of the eighties had suggested a two-way relationship between moneyand price. Like Sargent and Wallace (1973), Frenkel (1977), and Jacobs (1977). Thoughit was a pioneer study of Olivera (1967), who conceptualized the two-way casualty betweenfiscal deficit and inflation, and later Dutton (1971) applied it for a self-generating modelof inflation for Argentina. Aghevli and Khan (1978) borrowed the idea and developed theirself-perpetuating model of inflation for developing countries. They argue that one of thedynamic forces sustaining inflation in developing countries is the presence of inflation-induced fiscal deficit, which arise because government expenditures adjust themselves toinflation more rapidly than government revenue. Several institutional and structural factorsare believed to cause the expenditure-adjustment coefficient to exceed the revenue-adjustment coefficient. Such a scenario has also been reported by Sundrum (1973) andSundrum et al. (1985) for Indonesia.

Bilquees (2004) stated in her study that in Pakistan, substantially a huge amountof taxes are persistently collected through indirect methods which are assumed to beaffected to a greater extent by the inflation, whereas the direct method of taxation is subjectto an increase in the income and profitability resulting from such inflationary trend. Sothis study is aimed at observing the relationships of inflation and taxes in Pakistan andeffect of a change in inflation causing the behavior of taxes to change at direct, indirectand total taxes and also to see the economic impact on fiscal policy. The objectives of thestudy are wrapped three fold i.e. identification of relationship and significance, the behavioralaspect of taxes and the conclusion & recommendations, so a set of following testablehypotheses are drawn

H1: There is significant relationship between inflation and direct taxes in PakistanH2: There is a significant relationship between inflation and indirect taxes in PakistanH3: There exists a significant relationship between inflation and total taxes in Pakistan

2. LITERATURE REVIEW

Immervoll, H. (2000), Samimi, A.J. and Jamshidbaygi, S. (2011), Samimi, et al. (2012),Tafti, F.C. (2012) had used CPI values as a measure of inflation. There are certainly someindices used to measure inflation in Pakistan are CPI, WPI, SPI, and the GDP deflator.The more commonly adopted measure is Consumer Price Index (CPI) which covers majorportion of the items (375 items) with their retail prices while estimating the cost of livingin the urban areas. The researcher here preferred to use CPI as an inflation measure toanalyze a relative change in taxes.

Victor, T. (1996) and Gerald, A. & Carroll, R.(1999) state three effects thatinflation may have on real tax liability and requires understandings for an adjustment are(1) erosion of amounts expressed in national currency, (2) erosion of the value of taxobligations, and (3) other effects on the measurement of the tax base. The techniques forcompensating for each of these effects are different. All, some, or none of these may applyto a particular tax. An ad valorem excise tax is said to be an example which implies noconsideration for or not affected from above three affects because of immediate collection.Therefore it requires no adjustment for inflation. On contrary, income tax is noticeablycomplicated for the effects of inflation in terms of all three effects are present.

Tax revenue of a developing country is highly elastic, low elastic and no elasticto inflationary trend at different segments of tax collections when they are observed forthe tax liability and the period of collection. The fiscal response to inflation also causesthe revenue and expenditure gap. Aghevli, B. and Khan, M. (1978) advance hypothesisthat public expenditure adjusts more rapidly than revenue (taxes) in response to inflation,as a result of that budgeted deficit is enlarged. If such deficit is financed by more moneysupply will further the inflation and perpetuate the process. Fiscal response to inflationvaries country to country due to their inflationary trends. Later Heller, (1980) tested Aghevliand Khan (1978) hypothesis for a sample of 24 countries and concluded that the net impactof inflation on the budget deficit is not generally predictable as higher the inflation rate,higher is the response of expenditure, and lagged the tax revenue which can widen the gapbetween revenue and expenditure of the fiscal period. Hossain, (1987) extended the abovestudy to measure the impact of inflation on fiscal deficit in Bangladesh economy thatempirically supported the similar fact which results in increasing size of fiscal deficitduring the period of inflation. He also suggested that fiscal deficit-oriented developmentpolicy cannot generate a sustainable economic growth in the long-run, as it can perpetuateinflation which hampers long-term investment, and reduce long-term economic growth.

In 2000, Samimia, A.J. so focused on two-way relationship of inflation and fiscaldeficit in Iran and concluded that the country which is financing its fiscal deficit withmoney creation causes increase in inflation. However, Dornbusch, R. et al (1990) hadargued the same phenomenon for developing countries that the budget deficit becomes aprincipal determinant of money growth & inflation, if only way to finance budget deficitis money creation. Tanzi, V. (1977) has noted, in terms of revenue adjustment, two criticalparameters that influence the rapidity of adjustment of tax revenue to inflation are; theresponsiveness of tax and the collection period & the time when tax liability accrues.Personal income tax is said as highly elastic, subject to its progressiveness. The corporationtax response is based on the growth of corporate sector in relation to other sectors of theeconomy for which collection lag extending to 18 months in many developing countries.The rapidity of indirect tax adjustment to inflation will be influenced significantly by thenature of taxes (ad valorem or specific) and the accounting system in manufacturing andwholesale developments.

33Vol. 8, No. 2, (Fall 2012)

Impact of Inflation on Taxes in Pakistan: An empirical study of 2000-2010 period

Inflation can alter the characteristics of tax and contribution systems in numerousways; Immervoll, H. in 2000, showed in his research that if the tax values are computedin a nominal fractional change, inflation will lead to increasing effective tax rates. Capitalgains tax is an important example of this. A tax base is not affected by inflation if the taxis a fraction of a transaction's value at the time of the transaction (ad valorem taxes, vat).For changing general price levels, the tax changes in line with the nominal value of theunderlying transaction. Thus, the real value of the tax liability remains unchanged. However,Robert, C. et al (2006) and Feldstein M. S. (2008) concluded that the effect of taxes oneconomic behavior is based on behavioral response of tax payers, economic efficiency andshort-run macroeconomic consequences of tax changes on aggregate demand andemployment. Furthermore, Rasheed, F. (2006) while analyzing the tax buoyancy rate inPakistan in his study concluded that growth in investment, credit, the rate of inflation andpublic debt are not the functions of tax revenue. It is also observed in Musgrave R.A.(1969) and Tanzi, V. (1977) studies that economic development is expected to bring aboutboth an increased demand for public expenditure and a larger capacity to meet thesedemands. In 2012, Tafti, F.C. however, concluded that liquidity, import price index andreal GDP are determinants of inflation in Iran.

A comparative study conducted by Amir, M.Q. et al. (2011) for measuring thedeterminants of taxes in Pakistan & India concluded that Indirect taxes levied areproportionately higher in Pakistan as compared to India. Indirect taxes widen the gapbetween rich and poor which exploit labor class that are needed to lower down to boostthe economy which is due to the fact that rich landlords and larger parts of the country'seconomy are not being taken into tax circle, constituting 60% of the economy. Whereasemployment of direct taxes can relocate the harmful effect on the economy to the least therich and poor gap and can generate more revenue for the country. Robert, C. et al (2006)and Chaudhry, I.S. & Munir, F. (2010) also focused on identifying the determinants of lowtax share and revenue performance in Pakistan for 37 years.

3. METHODOLOGY

This research is of descriptive and quantitative nature, for which data has been collectedthrough secondary data source, covering a period of eleven years (i.e. 2000 to 2010) in acontinuous annual trend, given in the Table 1 below. The information drawing source wasthe annual report of the State Bank of Pakistan (SBP official website).

Table 1Statistical Data CPI & Taxes 2000 - 2010

Source: State Bank of Pakistan: Annual Reports

CPI has been taken as the fixed variable which explains the dependent or explained variablei.e. stochastic or random variable of taxes.



Year20002001200220032004200520062007200820092010

CP Index3.604.403.503.104.60 9.307.907.80

12.0020.8011.70

Direct Taxes113.00124.60142.50151.30165.15183.40225.00333.70387.50496.00540.40

Indirect Taxes234.20267.70261.60308.90355.92407.00488.50513.50621.90755.50942.60

Total Taxes347.20392.30404.10460.20521.09590.40713.50847.20

1,009.401,251.501,483.00

Chart 1Inflation & Taxes trends during 2000 - 2010 period

The results are inferred from use of some statistical tools i.e. correlation among variablesof inflation, direct taxes, indirect taxes and total taxes and use ordinary least square method(OLX) is used to measure the empirical relationship. Significance of the parameters andthe fitness of the model are observed through t-test and F-test resp.

The statistical tests are run through SPSS 16. This period of research encompassesthe governance under military leadership (i.e. 2005-2008) and the democratic leadership(i.e. 2008-2010) which itself tries to eliminate the element of biasness of researcher towardsa particular regime and emphasize on measure of the relationship of inflation and taxesand any possible impact of inflation over tax behavior during the period.

Conceptual Model for the Study

This model suggests the elements of tax revenue and the effect of inflation on each partof the equation. If the change in inflation is equal to the change in taxes than the nominalvalue of taxes is not affected. If change in taxes is greater than 1, inflation is adjusted fortaxes, if less then nominal value of taxes reduces with an increase in inflation.

Figure: 1


35Vol. 8, No. 2, (Fall 2012)

4.RESULTS

The apparent position of the Chart 1 above describes that successive increase in inflationcauses an increase in the tax revenue. The responsiveness of direct taxes is quite loweras of indirect taxes and the total is averaged. The higher rate of inflation results in hoveringup the taxes in three brackets indicates the positive relationship of taxes with inflation andalso indicates acceptance of the hypothesis as well.

Table 2Descriptive Statistics

Descriptive statistics in Table 2 above produce an ample response of taxes toaverage inflation. As for average rate of inflation at 11.5833 at some scattered point of±4.8627, the average increase in total taxes is 19.0833 with deviation of ±3.5045, showingits spread i.e. of less volatility whereas the responsiveness of direct taxes is comparativelyhigher than that of indirect taxes.

Table 3Correlations

**. Correlation is significant at the 0.01 level (2-tailed).

Table 3 above depicts the results of correlation of inflation with direct taxes, indirect taxesand total taxes. The Pearson Correlation suggests that the inflation is directly correlatedwith direct taxes up to 85%, indirect taxes up to 81.3% and total taxes up to 83.2%,depicting any increase or decrease in inflation will cause simultaneous effect on direct,indirect & total taxes. The significance of the correlation of inflation with direct, indirectand total taxes also suggests that the results are true at 99% confidence interval or 1%error interval.

4.1 Regression Analysis for Direct Taxes & Inflation

The objective of regression is to predict the value of a variable based on the value ofanother variable. In this case, the variable that has been used to predict the other variablesvalue will be called the independent variable or sometimes the predictor variable while



NStatistic

1111111110

MinimumStatistic

3.10113.00234.201.00

MaximumStatistic20.80540.40942.601251.50

MeanStatistic8.0636

2.6023E24.6885E25.9435E2

Std. DeviationStatistic5.32321

154.16248226.50573345.80167

INFLATION (CPI)DIRECT TAXESINDIRECT TAXESTOTAL TAXESValid N (listwise)

Inflation Pearson CorrelationSig. (2-tailed)N

Direct Taxes Pearson CorrelationSig. (2-tailed)N

Indirect Taxes Pearson CorrelationSig. (2-tailed)N

Total Taxes Pearson CorrelationSig. (2-tailed)N

Inflation1

11.850**

.00111

.813**.002

11.832**

.00111

Direct Taxes.850**

.001111

11.978**

.00011

.992**.000

11

Indirect Taxes.813**

.00211

.978**.000

111

11.996**

.00011

Total Taxes.832**

.00111

.992**.000

11.996**

.000111

11

the variable being predicted will be called the dependent variable or sometimes the outcomevariable.

Table 4Model Summary

a. Predictors: (Constant), INFLATION (CPI)

Table 6Coefficientsa

a. Dependent Variable: DIRECT TAXES

Table 5ANOVAb

a. Predictors: (Constant), INFLATION (CPI)b. Dependent Variable: DIRECT TAXES

The values of parameters B0 = 61.735 show the intercept constant with standard error of48.453 and B1 = 0.825 of explaining variable describing the slope of the equation withstandard error of 5.085. It can be said here that one unit change in inflation (CPI) wouldaffect the direct taxes by 85% with an assumption that the other factors remaining constantor unaffected. This trend shows the elastic nature of direct taxes toward inflation (CPI)which is not unitary. Sample test of parameter B1 showing significance at 99% confidenceinterval and verily dependent variable (i.e. direct tax) is well explained by the inflationas R2 suggest up to 72% as described in model summary (table-04). The goodness of fitof the model is quite fit due to the significance of F-test that is also observed at 99%confidence interval (table-05) suggesting the results are not due to chance factor. Hence,H1, hypothesis of significant relationship between inflation and direct taxes in Pakistanstands accepted.

4.2 Regression Analysis for Indirect Taxes and Inflation


a. Predictors: (Constant), Inflation

37Vol. 8, No. 2, (Fall 2012)


Model1

R.850a

R Square.722

Adjusted R Square.692

Std. Error of the Estimate85.60373

Model1 Regression

ResidualTotal

Sum of Squares171708.69765951.994237660.691

df1910

Mean Square171708.6977327.999

F23.432

Sig..001a

Model1 (Constant)

INFLATION (CPI)

B61.73524.616

Std. Error48.4535.085

StandardizedCoefficients

Beta

.850

t1.2744.841

Sig..235.001

UnstandardizedCoefficients

Model1

R.813a

R Square.661



Table 8ANOVAb

a. Predictors: (Constant), Inflationb. Dependent Variable: Indirect Taxes

Table 9CoefficientsA

a. Dependent Variable: Indirect Taxes

The values of parameters Bo = 189.977 show the coefficient constant with standard errorof 48.453 at 95% confidence interval. Whereas B1 = 0.825 of explained or dependentvariable describes the slope of the equation with standard error of 5.085. It can be saidhere that one unit percentage change in CPI would affect the direct taxes by 85% with anassuming other factors unaffected. R is highlighting the correlation of variables up to81.3% of which R2 (table-7) that suggests that inflation explains the indirect taxes up to66.1% which is showing strength of its impact. As far as fitness of the model (Table 8)i.e. F-test is concerned, it is also significant at 98% confidence interval and describes theequation as stated.

Following the above information through correlation & regression it is inferred that theH2, hypothesis of relating to significant relationship between inflation and indirect taxesin Pakistan also stands accepted.

4.3 Regression Analysis for Total Taxes and Inflation


a. Predictors: (Constant), Inflation

Table 11ANOVAb

a. Predictors: (Constant), Inflationb. Dependent Variable: Total Taxes



Model1 Regression

ResidualTotal

Sum of Squares338915.140174133.310513048.450

df1910

Mean Square338915.14019348.146

F17.517

Sig..002a

Model1 (Constant)

INFLATION

B189.977345.84

Std. Error78.7318.263


Beta

.813

t2.4134.185

Sig..039.002


Model1

R.813a

R Square.693



Model1 Regression

ResidualTotal

Sum of Squares993087.093440658.8431433745.936

df1910

Mean Square993087.09348962.094

F20.283

Sig..001a

39Vol. 8, No. 2, (Fall 2012)


Table 12Coefficientsa

a. Dependent Variable: Total Taxes

The situation of such relationship is also similar to those of direct & indirect taxes. Therelationship of inflation & total taxes is direct & positive. Parameters Bo = 189.977 at 95%confidence interval for sample t-test & B1 = 0.825 of explained or dependent variable at99% confidence interval refers to significance of relationship between variables andestimating an expected regression line (Table 12). It means percentage change in CPI byone unit would affect the total taxes by 83% with assuming other factors unaffected. R ishighlighting the positive correlation of variables up to 83.2% of which R2 suggests (Table10) that inflation explains the indirect taxes up to 69.3%, showing strength of its impact.As far as goodness of the fit of the model is concerned, it also entails the significance ofthe model at 99% confidence interval. Hence, H3, hypothesis of significant relationshipbetween inflation and total taxes in Pakistan has also been accepted.

5. CONCLUSION

This study analysis suggests that the relationship between inflation and the taxes is positive,so any increase (decrease) will cause an increase (decrease), on average, in the taxes. Inother words, inflation and taxes move in the same direction but with different magnitude.Such a change in the taxes, on average, with respect to change in inflation is not a unitary,as one percent change in inflation does not equate the change in taxes. Rather the resultsare significantly explaining that the one percent increase in inflation will cause direct taxesto change by 85%, indirect taxes by 81.3% and total taxes by 83.2% on average. It isassumed that the other interacting factors on taxes are constant.

Increase in tax revenue are greatly responsive to change in inflation, whereasother factors like tax base or net, increase in production volume (agricultural, industrial& services), business growth (new organizational ventures branches, franchises, etc.),investment (shareholding, mergers, acquisitions, etc), and employment (Public & Private)might be having a meager or negligible impact. If this situation is true for tax revenue inPakistan then the expenditure side might have shown a greater significance towards inflationthat will result into fiscal deficit with negative response. And if the fiscal deficit is financedby internal bank borrowings or excessive money supply then the value of currency willdecline consequently. This scenario will itself perpetuate inflation. Though, inflation isone of the macroeconomic variables which may have some significance on factors costs,demand & supply of goods, supply of currency, etc. which are proposed to be analyzed& studied.

From the above results it becomes imperative to recommend that the fiscal policyplanners and the budget makers should emphasize on some preventive measures that cancontrol inflation which can serve as a key element in contracting the fiscal deficit. As theinflation increases it will result in contraction in the taxes, widening the fiscal balance gapin revenue and expenditure. Such a fiscal deficit can protract the inflationary trend if it isfinanced by money supply. This study will no doubt create a basic understanding for thosewho can elaborate the relationship at smaller periods of taxes under direct and indirectclasses and can enhance work on the tax rate and tax base relationship which may producean ultimate model for tax revenue and would be considered apposite to meet the futurerequirements.

Model1 (Constant)

INFLATION

B251.71559.200

Std. Error125.24413.145


Beta

.832

t2.0104.504

Sig..075.001




It is also proposed that the similar study to be conducted for expenditure sideand measure the impact of inflation over fiscal policy, so that it can further test the Aghevli-Khan hypothesis in case of Pakistan. In order to increase the tax revenue, tax base or taxnet should be enhanced, expenditure side should be reduced, new investment & businessopportunities should be given a favorable space so that tax revenue can exceed theexpenditure side and control the aspect of inflation in return. Such relationship of inflationwith other factors can also be studied in future esp. in perspective of Economy of Pakistan.

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