Research Methods in Economics

Impact of Taxation on the economy of Pakistan

Ahmed Qadir Lakhani, Daniyal Majeed Shaikh, Syed Hammad Haider and Mehreen Irfan Ali.
IBA

Dr. Asma Hyder

Impact of Taxation of the economy of Pakistan

Table of Contents
List of tables and figures ........................................................................................................................... 3
List of Abbreviations ................................................................................................................................ 4
Acknowledgements ................................................................................................................................... 5
Abstract ..................................................................................................................................................... 6
CHAPTER 1 Introduction ............................................................................................................................ 7
1.1 Research Question .................................................................................................................... 8
1.2 Hypothesis................................................................................................................................. 9
1.3 Objective ................................................................................................................................... 9
1.4 Organization of the Study ......................................................................................................... 9
1.5 Timeline Gantt Chart ............................................................................................................ 10
CHAPTER 2 Literature Review .................................................................................................................. 11
CHAPTER 3 Data ....................................................................................................................................... 20
3.1 Description .............................................................................................................................. 20
3.2 Data Collection ........................................................................................................................ 23
CHAPTER 4 Methodology ......................................................................................................................... 25
4.1 Ordinary Least square ............................................................................................................. 25
4.2 Empirical Model ...................................................................................................................... 25
CHAPTER 5 Results and Discussion .......................................................................................................... 27
CHAPTER 6 Conclusion ............................................................................................................................. 30
References ............................................................................................................................................... 31

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Impact of Taxation of the economy of Pakistan

List of tables and figures

Figure 1 FDI inflow compared to tax revenue 20

Figure 2 Household expenditure vs. disposable income 21

Figure 3 Freedom of corruption 22

Figure 4 Control of corruption 23

Table 1 Model Summary [FDI] 25

Table 2 Model summary [Corruption] 26

Table 3 Regression for FDI 27

Table 4a. Regression for Household consumption expenditure (CPI) 28

Table 4b. Regression for Household consumption expenditure 28

Table 5 Regression for Control of Corruption 29

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Impact of Taxation of the economy of Pakistan

List of Abbreviations

FDI Foreign Direct Investment

GDP Gross Domestic Product
YD Disposable income
CPI Consumer Price Index
ST Sales Tax
HCE Household Consumption Expenditure
ECM Error Correction Model
IMF International Monetary Fund
WDI World Development Indicators
FBR Federal Board of Revenue
OECD The Organization for Economic Co-operation and Development
VAT Value added tax
EU European Union
GST General sales tax

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Impact of Taxation of the economy of Pakistan

Acknowledgements

We would like to start by thanking our mentor, Dr. Asma Hyder, for teaching us all that was necessary to
get this paper through. Building our interest towards research and helping us find excitement in our work,
giving us productive feedback and helping us improve our work at every step of the way. Then there is
Mr. Asadullah Qureshi, he too has been a major support, helping us resolve last minute issues and giving
helpful criticism.
Next we would like to thank our families, specially our parents, for taking care of us before during and
after all the sleepless nights that have gone into this project along with providing us with all the resources
we could possibly need to accomplish this task.
Lastly I would like to thank our friends, who have been by our sides, offering help, advisory and a
dumping ground for all our frustrations during this time of tireless work.

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Impact of Taxation of the economy of Pakistan

Abstract

This paper focuses on three factors that are vital to the development of an economy, foreign direct
investment, injects funds and boosts economic activity. Changes in household consumption is a
direct measure of economic activity, making it a factor of great importance and then lastly there is
corruption, a factor that brings down the country despite any amount of effort, if not controlled.
The focus of this study is on the impact that taxation will have on each of these factors. We perform
a regression analysis to draw conclusions regarding this impact. We build the models using basic
indicators, in either a linear or non-linear regression analysis. The models used in this paper
indicates no relationship between the FDI and taxation while consumption to have a positive
relationship and control of corruption to have a negative relationship with taxation. So when
talking about the overall impact on an economy no conclusions can be drawn.

Keywords: Direct Taxes, Indirect tax, FDI, Tax Corruption, Tax Simplification, Value-added
taxation, Consumption taxation, Investment, Household consumption

JEL Classification: H20, H25, H2, D73,

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Impact of Taxation of the economy of Pakistan

CHAPTER 1 Introduction

This study will aim to analyze the impact taxes have on the overall economy of Pakistan. Based
on our research driven perspective, taxes impact any countries household consumption, foreign
direct investment (FDI) and corruption, and hence impact the economy. Taxes are imposed on
individuals, firms and communities by the government so they can fund the development of the
economy. For those having to pay the taxes, it impacts their decision making with respect to
savings, consumption and investment. Taxes also impact job creation and investment in human
capital. Taxes are of many types, and each distorts decisions differently, income tax impacts
ones disposable income, while import and export duties or other indirect taxes effect purchasing
power. Corporate taxes have a highly negative impact for they lead to how simple or complex it
is for entrepreneurs to enter the market and/or expand businesses. Paying taxes always has a
negative impact to the GDP but the negative will be countered by the positive impact an increase
in government expenditure will have.
People are never in favor of paying taxes and burdening their incomes, but the funds collected
are vital for economic development, for the government will spend it by building infrastructure,
better transport and communication, building a healthy environment for trade, providing
subsidies, and protecting industries.
Foreign direct investment is the ownership of a business establishment in a foreign country,
while portfolio investment is the buying of stocks or other securities, governments reduce taxes
to attract more FDI, they do this through tax holidays, low corporate tax, infrastructure subsidies
etc. the lower the levels of tax the higher will be the level of FDI.
Household consumption is affected by consumption taxes that are usually indirect, such as sales
tax or value added tax, an increase in these will reduce the purchasing power of the consumer.
Consumption is also effected by the change in disposable income of a person that changes with
the level of direct income tax.
When tax levels are high in any economy, or the process of paying tax too complex or costly
people will avoid paying taxes, i.e. an increase in tax evasion. People will go on to
misrepresentation of income levels individually and of their businesses.

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Impact of Taxation of the economy of Pakistan

1.1 Research Question

What is the impact of taxation on the Foreign direct investment, household consumption and
corruption in Pakistan.
The three factors selected here are very different from one another with little connection between
them, but according to many writers there is definitely is a connection between these factors and
taxation individually.
A wide range of literature on the topic of FDI and Taxes but internationally there seems to be a
gap as most of the studies are conducted on OECD countries, even the working papers of IMF
and other supra national organizations are mostly based on OECD countries. GROPP and
KOSTIAL (2000), Beck and Chaves (2012) are two of the many such articles. Articles for
OECD have a lot of variety from empirical to analytical, tax rate to tax revenue and industry to
country level. However, for Pakistan the literature doesnt have much variety and is generally of
low quality.
Corruption is one of the important factors for the downfall of any economy. If there is corruption
in the economy government officials, then the growth of the country is difficult. Tax regime is a
sector from where Pakistan government officials are earning a lot of money, whether it is from
direct taxes or indirect taxes. Indirect taxes are the ones, that not only upper and middle class of
people are made to pay but low income earners also forced to pay them. There is also corruption
in the form of evasion, according to Awasthi and Bayraktar (2014) the simpler the tax procedures
and lower the tax rates the higher tax revenue percentage collected is in developing countries.
Pashev (2006) presented similar arguments.
When talking about consumption, there are different views that exist, Alm and El-Ganainy,
(2012), talk about the consumption tax, the value-added tax (VAT), on the aggregate
consumption of fifteen European Union (EU) countries over the period 1961-2005. This papers
looks at impact of VAT on consumption and saving. The theory says that for taxing consumption
rather than income is that it is believed that consumption taxes discourage consumption,
encourage savings, and thus generate higher economic growth. On the other hand, there is Saqib,
Ali, Riaz, Anwar and Aslam (2014) claim that direct and indirect taxes lead to a fall in
consumption and investment that negatively impact the economy.

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 Impact of Taxation of the economy of Pakistan

Based on these theories we wish to test these factors based on data collected in Pakistan,
considering the lack of research done here. It would be interesting to see how far Pakistan
follows patterns similar to those of other developing countries and discuss the efficiency of the
fiscal policy implemented here.

1.2 Hypothesis

- 0 :Changes in taxation has a significant change on the level of FDI ;

1 :Changes in taxation doesn' t have a significant change on the level of FDI
- 0 :Correlation exist between the changes in the level of tax revenue and the level of household. ;
1 : Correlation doesn't exist between the changes in the level of tax revenue and the level of household.
- 0 :Tax rate have a impact on corruption in a economy ;
1 :Tax rate doesn' t have an impact on corruption in an economy

1.3 Objective

The main objective of this study is to analyze the impact taxation has on the economy of
Pakistan, in terms of the impact it has on the countrys FDI, consumption expenditure and
corruption. Despite there being many other factors that are impacted, we limit our study to these
three factors alone, for these seem to be impacted directly and also have a direct relationship
with the GDP and overall wellbeing in the economy.

1.4 Organization of the Study

The paper starts by explaining the researchers perspective, the variables under consideration and
the bigger picture being studied here, next we explain the outline we will follow the specific
research question and hypotheses being tested, along with the main objective and timeline along
which we are working. We then present the similar works that have been done in the field, their
inputs and outputs to further explain the perspective under which this study will be followed we
then explain and describe the data that will be used along with the reasoning and its sources. then

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 Impact of Taxation of the economy of Pakistan

there will be an explanation of the methodology being used, the results achieved, a detailed
analysis of these and then finally the final conclusion we draw.

1.5 Timeline Gantt Chart

Dates 8/30 9/8 9/10 9/11 10/2 10/6 10/20 10/28 10/29 11/6 11/17 11/24 12/5 12/12
Tasks
research
decide a topic
prepare a proposal
further indepth research
filtering and selecting research
compiling the three different
themes (Consumption, FDI,
corruption) in a literature review
deciphering which data is
collecting and compiling the data
defining and anlysing the data
re-edit the proposal
re-edit the literature review
review the data
run the methodology
prepare a description of the
prepare a discussion and
compile the research paper
work on formatting
do a final review
prepare a presentation

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Impact of Taxation of the economy of Pakistan

CHAPTER 2 Literature Review

This paper follows a thematic organization for the literatures reviewed starting with the impact of
taxes on FDI in Pakistan, followed by the impact taxes have on household consumption and then
lastly there is, impact of taxation on corruption.
Azam and Khattak (2009), in their paper evaluate empirically the effect of different demand side
determinants on the inflow of FDI into Pakistan during the period from 1971-2005. Though there
are various qualitative and quantitative factors determining the inflow of FDI but this study
considers only economic factors such as market size of the host country, domestic investment,
openness, inflation rate, return on investment, government consumption, taxes and external debt.
It is important to note that the authors are taking into account indirect taxes in this study. The
Ordinary Least Square (OLS) method was used as an analytical technique for empirical
estimation. In addition, Augmented Dickey Fuller (ADF) test and Error Correction Model
(ECM) have been used. Due to non-linearity of the data log linear regression model was used.
This study found the effect of market size, domestic investment, trade openness, infrastructure
and return on investment on FDI inflow positively statistically significant. Also found the effect
of external debt, and indirect tax on FDI inflow negatively statistically significant. While,
inflation rate has found insignificant and government consumption has been found insignificant,
with expected negative sign. But it does not mean that these variables have no effect on FDI but
they are equally important in the determination of FDI inflow.
Shahzad and Zahid (2012) conducted this study to investigate the various economic factors
which effect Foreign Direct Investment (FDI) inflow into Pakistan. The data which is utilized in
this study is time series data based on the period as of 1991 to 2010. Gross domestic Product
(GDP), Interest Rate, Inflation Rate, Domestic Investment and Taxation Rate are taken as
independent variables and the only dependent variable is Foreign Direct Investment. At first the
combined effect of all the Independent variables was observed as a whole on Foreign Direct
Investment and then individual effects of every mentioned independent variable were observed
individually on foreign Direct Investment.
Jointly the variables are found to have a positive, strong and significant impact on Foreign Direct
Investment. The value of R Square (0.557) indicates that 55 percent of the variance in Foreign

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Impact of Taxation of the economy of Pakistan

Direct Investment can be accounted for by Gross Domestic Product, Interest Rate, Domestic
Investment, Inflation Rate and Tax Rate.
As for individual impacts, gross domestic product produces positive impact with unit value of
7.610 on foreign direct investment almost significant t-test. The interest rate produces negative
impact on foreign direct investment with unit value of 1.234 with insignificant t-test. Domestic
investment produces positive impact of 4.104 on foreign direct investment with significant t-test.
The fifth independent variable is inflation Rate that is showing its impact value on foreign direct
investment is positive 6.339 with significant t-test. The last independent variable impact value
for foreign direct investment is found negative 1.283 with insignificant t-test.
Gropp and Kostial (2000) in this paper they analyze the link between Foreign Direct Investment
(FDI), corporate taxation, and corporate tax revenues. There are indications that the tax
competition in many OECD has led to an unhealthy decline in corporate tax revenues. These
authors point out that past articles have focused on the relationship between FDI and Corporate
Income Tax rates but none has analyzed the relation between FDI and Corporate Income Tax
revenue therefore this is the first paper to do both. Also these authors point out that most such
studies before 1990 showed that FDI was not impacted by the host countrys tax rate however
recent studies show that FDI is sensitive to host countrys tax rate. These authors have tried to
isolate the impact of taxes as much as they could for example countries with low tax rate might
generally be more business friendly hence the entire effect of FDI couldnt be attributed to lower
taxes. While analyzing FDI and tax rates the authors divide the OECD countries into low and
high tax rates countries. The low tax rate group includes Switzerland, USA and UK etc and high
tax rate group includes Australia, Germany etc. according to the results the low tax group
experienced much less net FDI outflows relative to the high tax group; on a net basis, outflows in
the low tax group were about half of those in the high tax group. When analyzing FDI and
Corporate Income Tax revenue, for example in Japan and Germany, both have high Corporate
Income Tax rates, low FDI inflows and high FDI outflows there seems to be some persistence in
the decline of Corporate Income Tax revenues. In contrast, USA which has been a low Corporate
Income Tax rates, has experienced substantial FDI inflows, appears to have steady increase in
Corporate Income Tax revenue.
Previous work on the effect of taxes on foreign direct investment (FDI) focused primarily on
capital income taxes. Beck and Chaves (2012) investigate the proposition that other forms of

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Impact of Taxation of the economy of Pakistan

taxation may also affect FDI. The authors use tax ratios, i.e., average effective tax rates, on
consumption, labor and capital income for a panel of 25 OECD countries from 1975-2006, most
previous studies of tax impact on FDI are concerned with taxes levied on corporations or on
capital income. Little attention has been paid to other types of taxes, such as those exacted on
workers or consumers. However, it is possible that other taxes have an influence on FDI as well.
Taxes on labor income and consumption impact the return on work effort. While labor supply
may be inelastic in the short run, so that tax incidence falls on workers, in the longer run labor
supply elasticity is higher. This study finds that higher capital income taxes encourage
international investment outflow from high-tax countries to low-tax countries. The estimate of
the impact of capital income tax changes is higher than previous studies when changes in labor
income taxes and consumption taxes are controlled for. Results state that higher labor income
taxes reduce international investment outflow from high-tax countries. The authors conjecture
that this is because the incentive to replace labor with capital causes firms to redirect investment
toward domestic operations, at least in the near term.
Aqeel and Nishat (2004) in this paper empirically identify the determinants of growth in foreign
direct investment (FDI) in Pakistan over the period 1961-2003. Their aim is to study how
different variables or indicators reflecting the trade, fiscal, and financial sector liberalization
attract FDI in Pakistan. The study uses the cointegration and error-correction techniques to
identify the variables in explaining the FDI in Pakistan. The study considers the tariff rate,
exchange rate, tax rate, credit to private sector, index of general share price variables and average
wage to see if they may explain the inflow of foreign direct investment. The results are
consistent with theory as the signs of all variables are what were expected by theory. All
variables except average wage and general share prices are statistically significant. The study
concludes with the remarks that these policy variables have significant effect on FDI therefore
governments must focus on policies which promote FDI such as low tax rate on FDI.
There is a wide range of literature review on the topic of FDI and Taxes but internationally there
seems to be a gap in literature as most of the studies are conducted on OECD countries, even the
working papers of IMF and other supra national organizations are mostly based on OECD
countries. GROPP and KOSTIAL (2000) is one of the many such articles. Articles for OECD
have a lot of variety from empirical to analytical, tax rate to tax revenue and industry to country
level. However, for Pakistan the literature doesnt have much variety and is generally of low

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Impact of Taxation of the economy of Pakistan

quality. Most articles on Pakistan do not give any background as to why the authors have chosen
the variables and whether there is any theory supporting that. Azam and Naeem (2009) stood out
in this case as the authors did not mention any theory and instead just ran regressions and
produced the output. Aqeel and Nishat (2004) provided a good review of why they were
choosing the variables and gave references to previous pioneering papers which they were
following in their study. Another important issue missing from literature on the impact of taxes
on FDI in Pakistan is that there are few, if not none, studies done on an industry level.
Telecommunication industry in Pakistan has seen a lot of growth in the recent past but no study
considered tax as a variable to be studied.

To consider the relationship between household consumption and taxation we start by reviewing
Steindel (2001), who has shed light on the debate of how past tax changes affected consumer
spending. This study looks at major federal income tax changes in 1968, 1975, and 1982 and
how these changes have affected consumers to react. In order to test the impact of tax change on
spending, the authors claim to look at the behavior of the personal saving rate around the time a
tax change becomes effective. At any point in time, the level of the personal saving rate may
give a very distorted picture of household saving out of permanent income (Peach and Steindel
2000).
The author now takes into account all three Years major tax changes and check differing
consumer responses. The results indicate that households do indeed distinguish permanent
changes in taxes from temporary ones. Therefore, households are forward looking. However, the
apparent failure of spending to change in anticipation of the 1968 and 1982 effective dates, the
failure of consumers to distinguish between the 1982 change in liabilities and withholding, and
the failure of spending to react to preannounced changes in Social Security benefits and taxes all
suggest that there are limits to forward-looking behavior. All these connect to Liquidity
constraint (Wilcox 1989). Many consumers are limited to their cash on hand. Liquidity
constraints helps to explain all the irregularities from the major tax changes.
In conclusion, consumer spending will not change until a tax change affects take-home pay.
Consumers measure the size of a tax change by its immediate effect on tax payments, not its
effect on tax liabilities. Consumer spending will react more strongly to a permanent than to a
temporary tax change.

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Impact of Taxation of the economy of Pakistan

In my opinion, this paper could not relate scheduled changes in taxes with consumer spending. It
didnt talk about upper-income households which shows that we have much more to learn about
consumer responses to policy changes. It didnt talk about other form of taxes which can also
affect household expenditure. This paper relies on assumption that are unconvincing and not
reliable. We will try to resolve the issues.
Alm and El-Ganainy, (2012), talks about the consumption tax, the value-added tax (VAT), on the
aggregate consumption of fifteen European Union (EU) countries over the period 1961-2005.
Before this paper, Steindel, (2001), talked about Effect of tax changes on Consumer spending.
This paper focuses more on the specific tax which is VAT on the consumption. This papers looks
at impact of VAT on consumption and saving. The theory says that for taxing consumption
rather than income is that it is believed that consumption taxes discourage consumption,
encourage savings, and thus generate higher economic growth.
Alm and El-Ganainy use the recently developed dynamic panel GMM-system estimator and
sample of fifteen EU-countries, which states that effective VAT tax rate is negatively correlated
with the level of aggregate consumption. This shows that policy makers should consider the
impact of VAT on consumers when deciding a VAT. This paper states that there is significant
relation between the exogenous component of the effective VAT and the level of private
aggregate consumption.
This papers needs further research in order to determine the impact of Sales tax on consumption.
It needs to add additional explanatory variables. It only estimates the effect of the VAT on
consumption behavior. It emphasizes that policymakers should consider the potential impact of
the VAT on household consumption but it should include other considerations that influence any
decision to tax consumption versus income.
Saqib, Ali, Riaz, Anwar and Aslam (2014) talks about effects of taxes on Pakistan Economy. My
concern in this Paper is by looking at Sales tax for consumption model and how it effects
Pakistan Economy. Time series data is used from 1973 to 2010. In the case of consumption taxes
have adverse effects on house hold consumption as well as aggregate consumption. An increase
in taxes on consumption through increase in VAT rates reduces the consumption in short-run and
a larger reduction in the long-run (Alm and El-Ganainy,2012). In the conclusion, both
consumption and investment, that are major economic variables have shown negative responses

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Impact of Taxation of the economy of Pakistan

against taxation in Pakistan. This paper concludes that not only consumption has a negative
effect but also investment and GDP have a negative effect on economy.
This paper looks only at the economy and how the overall economy is affected. Well, when
looking at Tax impact on house-holds consumptions, we need specific details of which type of
households. This paper needs to identify the need to increase the number of tax payers, efficient
collection of tax amount and reducing distortions.
Abdullah and Kalim (2009) talks about the factors affecting food price inflation in Pakistan
during 1990-2013. The variables in the study is ssunsidy, indirect taxes and food export on Food
price inflation. This paper checks individual relationship between these variables. After applying
all the tests, the authors conclude that indirect taxes and food exports have positive and
significant impact on food price inflation while government subsidy and GDP are negatively
correlated with food price inflation in Pakistan.
Refaqat (2003) talks about the social incidence of the general tax (GST) in Pakistan. This paper
checks whether Sales Tax in Pakistan is regressive and if so, to what extent. This paper uses the
Household Integrated Economic Survey(HIES) section of the Pakistan Household survey 2001-
2002 for analysis. The sample from the HIES survey consists of 14,713 households. It talks
about types of Sales Tax effects on consumption. This paper analyzes the impact of GST taxation
on petroleum products, Electricity and all other taxable items from the HIES. The results show
that poorest 1,471 households in the sample consumed, on average, goods and services worth Rs
28,937 per annum. The richest 1471 households in the sample consumed goods and services
worth Rs. 248,675 per annum. This paper check whether these products are regressive or not
against GST taxation.
This papers looks at only products which are affected by the GST whereas it should look at the
overall impact on the economy. In expectation of a more explanatory result, one that accounts for
more factors, the inputs will include disposable income and then the impact of sales tax and CPI.

In this paper, Tariq, Ahmed, Sheraz, and Mehmood (2012), evaluated the most important reason
for the downfall of any economy or government to be corruption. Corruption is a curse which
exists throughout the world including developing and developed countries. But the difference
between both types of countries is the amount of corruption. U-Myint (2000); World Bank
(2011); Law Commission of Government of India (2001); Anupam Das et al (2011), all share the

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Impact of Taxation of the economy of Pakistan

same belief that corruption was established in the early world, but it has progressed as the world
progresses especially in unindustrialized countries. Corruption is defined as abuse use of public
position for personal gains or for the benefit and gains of an individual or group to whom one
owes faithfulness. U-Myint (2000) has described the word corruption in simple words, use of
official position, rank or status by an office bearer for his own personal benefit. In this paper,
Maqbool (2000), has talked about the history of corruption in Pakistan. He states that corruption
and biasness exist together. And after independence, the nationalization of banks and industries
in 1970s, the use of foreign aid, and infusion of drug money into the economy have been the
reason for more enhancement of corruption. Also, informal structure of Pakistan has created
many more opportunities for corruption for private sector, tax authorities and government
officials.
The reason for corruption in Pakistan which are stated in this paper. they are policies in Pakistan,
program and activities that are poorly considered and managed by the government officials,
failing of accountability, and public servants lacks the mentality of service. It has been seen as a
trend that corruption arises in countries where government institutions are fragile, government
policies and regulatory provide scope for other institutions as they are corrupt as well. There are
many types of corruption, in which one of them is tax regime. It broadly talks about the
consequence of corruption and how it has effected Pakistans economy as well. As the research
by IMF also indicates that countries with high corruption rate have lower growth rate, and low
literacy rate as well. From the facts and data, The National Corruption Perception Survey 2010
indicates that corruption in Pakistan has increased from Rs.195 billion in 2009 to Rs.223 billion
in 2010, and 70% of the Pakistani feels that current government is more corrupt then the
previous one, where they rated Punjab as the cleanest provincial government sector. On the other
hand, Khyber Pakhtunkhwa is rated as the most corrupt province of Pakistan. And according to
FBR, Taxations and Customs are the least corrupted sectors of Pakistan. Whereas, the most
corrupted sectors are Police and Power. As per U-Myint (2000), corruption is because of poor
governance, and all the efforts to remove corruption from the economy had been unsuccessful.
The state may need to establish credibility by punished corrupt high officials but in the past
parties have used this notation to attract public support, but not to solve the corruption in the
economy.

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Impact of Taxation of the economy of Pakistan

As stated in this paper, corruption is one of the important factors for the downfall of any
economy. If there is corruption in the economys government officials, then the growth rate for
the country is difficult. The authors, in this paper have discussed slightly about the types of
corruption in the economy and rated tax regime as least sector which is corrupted for Pakistan.
Tax regime is a sector through which Pakistani government officials are earning a lot of money,
whether it is from direct taxes or indirect taxes. Indirect taxes are the one, where not only upper
class, and higher middle class of people need to pay but low income earners also end up paying
these. They havent discussed why institutions are not willing to invest in Pakistan even after
having relatively cheap labor force compared to other parts of the world.
In this paper of Awasthi and Bayraktar (2014) discusses about the importance of taxes in the
economy and the role tax corruption plays. This is talking from the perspective of general public
or citizens of the country. The taxes revenue helps the government to finance the public
expenditures of the country. The willingness of taxes depends upon the strong establishment of
the state or government. The moral of the citizen would be high when the government of the
state would be good. This paper focus more on observed studies on the relationship between tax
complexity and taxes corruption. It has use regression and econometrics model to study and
predict the impact of taxes if the economy is corrupted. And whether making tax simplification
have a significant impact on corruption or not? According to their result, more simple the tax
complexity, the higher the corruption will exist in the economy. This trend is mostly founded in
low income or developing countries. They used the data of 104 countries, and then ran the model
to check if it does have impact on tax corruption or not. The author uses the data from World
Bank database, and all of different type of income group countries. Use a regression model, they
founded out they are different method to reduce tax complexity and simplification of tax system
which are useful in the fighting against tax corruption. In this regression model, the authors have
use variables such as tax simplification, economic determinants, political determinants, judicial
determinants, and geographical determinants to calculate the tax corruption in the economy. And
in the other regression model, they have use tax simplification, bureaucracy quality, democratic
accountability, government effectiveness, burden of government, rule of law, country fixed
effects, and time fixed effects to calculate the country tax corruption.
This paper is specifically on numerical than theory to prove that tax corruption is effected from
tax complexity. This paper did talk about something important which is strong governance result

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Impact of Taxation of the economy of Pakistan

into more tax collection for the government. But they had lack of data to prove this a particular
country. And there is no guarantee of the data, as the survey were held, which could be biased
enough to make the result skewed. And lack of data resulted them to do cross country, which
ignore the fact all the countries are different. And they ignore the fact, in developing countries,
direct taxes are difficult to collect and trust of citizen in the country is the least. Developed states
are where they charge high direct taxes and people are willing to pay as well.
In this research paper by Konstantin Pashev (2006), he argues about the understanding tax
corruption in the transition economies. In this paper, the author discusses about the bribe as a
price paid by the taxpayer in exchange income maximizing services supplied by corrupt tax
officials. According to World Bank study on corruption in transition economies, tax corruption is
ranked second among other types of corruption in terms of number of companies involved. This
paper talks about types of corruption which occurs in business world and types of corruption
government officials make in this world. They have clearly explained the concept of indirect and
direct cost. It also clearly tells which side benefits from tax bribes. Usually the benefits are
received by the person who bribes the other person. This helps to compare tax corruption across
transition countries.
The critics for this paper are that it has specifically talk about business side of the taxation which
as a result, indicated about the bribes made by the seller with the government. They talked less
about the government revenue from taxes and how they misuse the revenue from direct taxes.
This paper was specifically for Bulgaria, which could be made from Pakistan as well. And these
types of problems are usually faced by developing countries. Developed countries have proper
taxation department, and their laws helps them to reduce the corruption in taxes.

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Impact of Taxation of the economy of Pakistan

CHAPTER 3 Data
3.1 Description
Governments impose taxes to earn tax revenue. Revenue that is supposed to be utilized in
development of the economy and increasing the general level of welfare of the people. But an
economys taxation policy can have negative or positive effects on the individuals and firms who
are required to pay this amount. For an individual, it impacts their disposable income, while
import and export duties or other indirect taxes effect purchasing power. Corporate taxes have a
highly negative impact for they lead to how simple or complex it is for entrepreneurs to enter the
market and/or expand businesses.

Foreign direct investment is the ownership of a business establishment in a foreign country,

while portfolio investment is the buying of stocks or other securities, governments reduce taxes
to attract more FDI, they do this through tax holidays, low corporate tax, infrastructure subsidies
etc. the lower the levels of tax the higher will be the level of FDI. To measure this relationship
exactly we consider the FDI inflow figures from the 1990 to 2015 and compare them to the level
of income tax and sales tax charged and the revenue collected.

Figure 1

FDI inflow compared to tax revenue

6E+09 45
40
5E+09
35
4E+09 30
25
3E+09
20
2E+09 15
10
1E+09
5
0 0
1994

2011
1990
1991
1992
1993

1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010

2012
2013

FDI inflow Income tax (% revenue) Sales Tax (%revenue)

source: The World Bank (govindicators.org)

20
Impact of Taxation of the economy of Pakistan

Between 2004 and 2001, FDI seems to have spiked upwards abnormally, but it also seems like it
has little to do with taxation.

Household consumption is affected by consumption taxes that are usually indirect, such as sales
tax or value added tax, an increase in these will reduce the purchasing power of the consumer.
Consumption is also effected by the change in disposable income of a person that changes with
the level of direct income tax.

Figure 2

Household expenditure vs Disposable income

300000000000.00

250000000000.00

200000000000.00

150000000000.00

100000000000.00

50000000000.00

0.00
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Household Consumption Expenditure(US $) Disposable Income( GDP-Direct taxes)

source: The World Bank (govindicators.org)

To understand the impact of taxation of household consumption we consider the levels of income
tax and sales tax along with the general level of household consumption and expenditure
separately and as a percentage of the GDP, inflation at the time and disposable income.
Disposable income has been calculated using the model followed by Saqib (2014). The reason
for selecting these variables is very logical as mentioned before, direct taxes affect disposable
income and hence purchasing power, while indirect taxes impact the cost of a good and service,
making it a little less affordable to the consumer, to consider how far it affects the price levels
we also take inflation rate of the year into consideration.

21
Impact of Taxation of the economy of Pakistan

When tax levels are high in any economy, or the process of paying tax too complex or costly
people will avoid paying taxes, i.e. an increase in tax evasion. People will go on to
misrepresentation of income levels individually and of their businesses. To measure the level of
corruption we use to variables one is the index for Control of Corruption which captures
perceptions of the extent to which public power is exercised for private gain, including both petty
and grand forms of corruption, as well as capture of the state by elites and private interests, and
the second is the score for the Freedom of corruption index that is derived primarily from
Transparency Internationals Corruption Perceptions Index. For countries that are not covered in
the CPI the freedom from corruption score is determined by using information from
internationally recognized and reliable sources. Higher index values denote lower level of
corruption.

Figure 3

source: Pakistan: freedom of corruption, The global economy.

22
Impact of Taxation of the economy of Pakistan

Figure 4

source: The World Bank (govindicators.org)

Control of corruption index is extremely low, while freedom from corruption gives
comparatively higher numbers indicating low levels of corruption, except a serious spike in
1998.

To measure tax evasion, we compare the expected tax revenue to the collected amount as part pf
our analysis for this part.

3.2 Data Collection

As required by the study we break down the analysis into three parts, starting with the impact of
direct and indirect taxes on inflow of FDI, then we go onto its impact of disposable incomes,
purchasing power, general price levels and hence household consumptions and lastly is tax
evasion and other forms of measurable corruption.

All data is of secondary nature and has been collected from reliable websites like the world bank
and IMF data banks. Due to constrictions, the data used for the three parts is not of identical time
periods, but we have considered the maximum time period possible for each, so that individually
the findings can be as accurate as possible.

The data for consumption and FDI are from world bank data set while corruption is from The
Heritage Foundation, which has also collected the data from other sources. The sources they

23
Impact of Taxation of the economy of Pakistan

have used include, Transparency International and World bank. The methodology by both of
them is to collect the data in 4 basic steps. (1) selection of source data, (2) rescaling source data,
(3) aggregating the rescaled data and then (4) reporting a measure for uncertainty.

We have attained parts of the data from FBRs online sources as well, while cross checking the
values received from other sources.

24
Impact of Taxation of the economy of Pakistan

CHAPTER 4 Methodology
4.1 Ordinary Least square
The methodology used is as suggested Hill, Griffiths and Lim (2008). The first step in all of the 3
models in this paper was to figure out the order of integration of the variables. As the book states
that if all variables in a model are I(1) then we need to check for cointegration. If cointegration
exists, then we can either use Error Correction Model (ECM) or simple regression. Regression
with cointegrated I(1) variables makes the least squares estimator super-consistent and,
moreover, is economically useful to establish relationships between the levels of economic
variables (Hill, Griffith & Lim, 2008, page 492). Since all variables used in the 3 models are
I(1) and the models for household consumption and corruption are also cointegrated, we have
used nonlinear regression in levels. However, the model of FDI was not cointegrated therefore
we have used nonlinear regression in first difference.

4.2 Empirical Model

FDI equation:
d(logfdi) = 0.0307465 + 0.0509542d(tax)
taking the first difference, this models uses log of FDI as the independent variable and tax
revenue as a percentage of the GDP as the independent variable.
Source SS df MS
Model 0.203790708 1 0.203790708
Residual 4.27216879 21 0.203436609
Total 4.47595949 22 0.203452704
Note: number of observations = 23, F (1,21) = 1.0, Prob >
F = 0.3283, R-squared = 0.0455, adjusted R-squared =
0.0001, Root MSE = 0.45104

Table 1 Model Summary [FDI]

Household consumption expenditure equation:

Lnhce = 20.9.4212+1.037424lncpi
Lnhce = -5.503243+0.976909lnyd+0.049242lnst

25
Impact of Taxation of the economy of Pakistan

The first is a linear model while the second is a non-linear model where the dependent variable is
the log of household consumption expenditure, while the independent variables considered are
CPI with base year 2010in the first model and in the second we take log of disposable income
and log of sales tax as a percentage of the GDP as the independent variables.

Control of corruption equation:

Controlofcorr = -0.8195984 0.0101916tax
This is a linear model with control of corruption as the dependent variable and tax revenue as a
percentage of GDP as the independent variable.

Source SS df MS
Model 0.00473368 1 0.004733682
Residual 0.28486 14 0.020347143
Total 0.28959369 15 0.019306246
Note: number of observations = 16, F (1,14) = 0.23, Prob >
F = 0.6370, R-squared = -0.0163, Adjusted R-squared = -
0.0539, Root MSE = 0.14264

Table 2 Model Summary [control of corruption]

26
Impact of Taxation of the economy of Pakistan

CHAPTER 5 Results and Discussion

The results are stated and analyzed individually for each model, along with its strengths and
weaknesses and related policy implication.
Theory and common sense states that the relation between FDI inflow and corporate tax rate
should be negative. However, results in this study show a positive relation between FDI inflow
and corporate tax as a percentage of total revenue since this is taken as a proxy of corporate tax
rate.
Coefficient of first Difference
Model Coefficient standard error t P>t
tax
D1. 0.0509542 0.0509099 1 0.328
_cons 0.0307465 0.1033369 0.3 0.769
Note: Dependent variable = D.logfdi

Table 3 Regression for FDI

Table 3 shows the result which can be interpreted as both the constant and the dependent variable
of tax being insignificant at 5% level of significance (p value of 0.328 and 0.769 are both greater
than 0.05). This can be well interpreted in case of Pakistan as it is evident that the major hurdles
in attracting FDI for Pakistan has been the law and order situation, load shedding and political
instability. These factors are much more significant as we can see the inflow of FDI in terms of
CPEC in just a short time after the security situation started to improve in Pakistan.
Many studies have been carried out which test the relationship between FDI inflow and corporate
taxes. This study falls among those which conclude that corporate tax rate is insignificant in
attracting FDI. This study can be further improved by taking either corporate tax rate or
corporate tax revenue rather than using a proxy.
As for consumption expenditure, we can see in the model, the relationship between household
consumption expenditure and CPI is positive. It shows that 1% increase in CPI there is 1.037%
increase in household consumption expenditure. This relationship has also been analyzed by

27
Impact of Taxation of the economy of Pakistan

Abdullah and Kalim (2009). This makes sense since more expenditure is required for high price
level.
Unstandardized Coefficients
Model
Coefficient Std. Error t-Statistic Prob.
LNCPI 1.037424 0.090577 11.45351 0
C 20.94212 0.331813 63.11413 0
Note: dependent variable = LNHCE, number of observations = 19,
R-squared = 0.885277, Adjusted R-squared = 0.878528, S.E. of
regression = 0.155474, Sum squared resid = 0.410926

Table 4a. Regression for Household consumption expenditure

Secondly, the relationship between household consumption expenditure and disposable income
is positive.

Model Unstandardized Coefficients t-Statistic Prob.

Coefficient Std. Error
LNST 0.049242 0.019107 2.577152 0.0203
LNYD 0.976909 0.04888 19.98603 0
-
C -5.503243 1.031674 0.0001
5.334285
Note: dependent variable = LNHCE, number of observations = 19,
R-squared = 0.994368, Adjusted R-squared = 0.993664, S.E. of
regression = 0.035508, Sum squared resid = 0.020174
Table 4b. Regression for Household consumption expenditure

It shows that 1% increase in Disposable income(Yd) causes 0.97% increase in household

consumption expenditure. The relationship between total sales tax and consumption is positive;
1% increase in collection of sales tax causes 0.0492% increase in household consumption
expenditures. This is also examined by Refaqat (2003), the type of sales tax on consumption.
This can be justified since increase in the collection of sales will only result when household
consumption expenditure is increased.

28
Impact of Taxation of the economy of Pakistan

Lastly, there is our model for control on corruption, this variable indicates how much control
have the country gotten from corruption in the economy. The higher the points a country
receives, the more control they have gotten from corruption in the country.
Unstandardised Coefficients
Model
Coefficient Standard Error t P>t
tax -0.0101916 0.0211298 -0.48 0.637
_cons -0.8195984 0.2406181 -3.41 0.004
Note: dependent variable = Control of corrucption

Table 5 Regression for control of corruption

According to the results, tax effects have an impact on corruption and leaves a negative impact
on the economy. If the tax rates and revenue changes, if will have an impact on corruption as it
will change corruption pattern as well. Corruption and tax rates are directly related to each other.
The equation for this model indicates that if the tax rates and control of corruption has a negative
relationship between them. Which means, as tax rates increases, control of corruption would
decrease which would mean that higher level of corruption in the economy exists. It shows that
1% increase in tax, there is -0.01% decrease in control of corruption. This relationship signifies
that, as tax rate increases by 1%, the worse will be the governments control of corruption in the
economy. And if tax rate is equal to zero, then control of corruption in Pakistan would be -0.82
which means that there are variables other than tax, that have an effect on corruption in Pakistan.

29
Impact of Taxation of the economy of Pakistan

CHAPTER 6 Conclusion

It can be concluded from the results stated above that taxation impacts an economy in different
ways. As for FDI we conclude that it has little relation to taxation for Pakistan has larger costs
that the investors face. As for household consumption expenditure, we first see how an increase
in price levels has a positive effect on consumption and hence when prices increase due to the
indirect sales tax, it too leads to an increase in consumption. And then for corruption again we
see a negative relationship between tax collection and control of corruption, control of corruption
reduces as tax collection increases.

Considering the bigger picture, the overall economy can be improved through higher taxation, as
it would lead to increased consumption expenditure, leading to an improved GDP, the larger tax
revenue could be utilized to develop infrastructure and improve the volatile security status of the
country and the administrative system present here. These factors should encourage FDI and lead
to a further growth in the economy. But the factor that will always pull any economy down is
corruption. Corruption affects the tax morality of taxpayers and distorts tax structure. The tax
revenue collection processes involve several major stakeholders in society, which makes the
opportunities for and motivations to engage in corruption both numerous and widespread. These
stakeholders include the tax officials, politicians, patrimonial networks and the taxpayers
themselves. In contrast to corruption, taxation is a legitimate method of extracting resources
from the economy. However, economists have argued that excessive taxation can lead to adverse
effects on economic activities. While increases in public resources through taxation can help
governments provide more public goods these benefits may be offset by negative effects on
growth due to higher taxes. A higher tax rate can potentially induce more corruption in an
economy by incentivizing tax evasion - individuals will have stronger incentives to accept and
pay more bribes so as to diminish the tax burden.

30
Impact of Taxation of the economy of Pakistan

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