Economic Growth or Corruption Control Conundrums

 

Spearhead Analysis – 13.02.2017

By Hira A. Shafi
Research Analyst, Spearhead Research

Around the world replicas of monuments depicting the wealth of the Ancient Egyptians adorn the entrances of buildings such as malls, casinos, hotels. Their symbolic presence synonymous with wealth and opulence.In Pakistan, such symbolic references can often be seen in the gardens and entrances of residential schemes and houses. Traditionally the real-estate sector has served as a profitable segment of the economy, generally, considered a ‘risk-free’ investment, and often promising high returns on mainly speculative investment.

While the sector remains lucrative, it has been cited as a factor in widening the wealth gap and perhaps, inadvertently promoting some form of underhand dealings, be it tax evasion, money laundering, or outright fraud. Reports suggest that in Pakistan around 16% of the population accounts for 55% of the wealth, whereas around 72% of the population accounts for 1% of the wealth. Tax evasion remains a significant obstacle, with one recent report claiming that a mere 1% of the Pakistan population are registered active taxpayers. As a result the government has in a way been forced to concentrate on increasing the burden of indirect taxes to increase the tax revenue.

The post 9-11 scenario, created a surge in investment in the Pakistan real-estate sector, and it appears that this upward trend has continued, and the real estate sector has over the years entered a period of becoming more organized as it has consolidated itself and gained the status of an important and autonomous segment of the economy.

The growth, has led to the government taking a serious notice of the sector with efforts to regulate it and bring it within the tax ambit. One of the main issues highlighted by the government in the last fiscal budget were the discrepancies between property rates set by the DC Rates (District Commissioners) vs. the actual market rates. The market rates were considerably higher than the archaic DC rates and as a result created an opportunity for understatement of taxes, excise and stamp duties. Thus depriving the government of considerable revenue, when the deals were conducted on market rates, but for official purposes were registered at the DC rates. This contributed to the creation of ‘undocumented’ wealth within the economy, which in turn led to tax evasion and money laundering.

The government initiated reforms to address these issues but something remains amiss. The amendments to property taxes were made as well to deal with two core issues of tax evasion in general and taming of the undocumented wealth generated due to differences in property values set by DC and market rates.

As per the amendments:

1. The Capital Gains Tax (tax on profits earned by the seller) increased to 10% if property is sold within a year, 7.5% (if sold within 2 years) and 5% (if soldwithin 3 years). Anything beyond this timeframe was at 0%.

2. The withholding tax (to be paid by the buyer) increased to 2% for tax filers and 4% for non filers.

Further, the FBR was to determine the property values and also probe into sources of income in order to counter various forms of corruption, including money laundering and terrorist financing (the latter condition has now been dropped).

These changes witnessed strong opposition from the real-estate developers, property dealers etc, supposedly leading to an 85% drop in property transactions in the major cities.

This ultimately, resulted in creating a new, somewhat agreed upon scenario: The property taxes have increased, source of income is not to be probed, and what appears to be somewhat of an NRO for the realty sector, is the tax amnesty scheme, which provides the people with a chance to pay 3% tax on difference between the DC and FBR set rates of property, and become tax filers. The Capital gains tax along with Withholding tax is to be paid to the FBR, while other fees and payments are made to the provincial sectors.

Certain risks could emanate from the current decisions – especially the tax amnesty scheme:

Pakistan has ratified the FATCA and CRS – which in its essence requires probing of the sources of income and violations could lead to sanctions.

It is expected that around ‘’7 trillion’’ rupees would be added to the economy – thanks to the tax amnesty scheme and the influx of money in the realty sector could further grow post Trump. The impact of such an increase would have to find a balance, and opportunities would need to be carved out in the best interest of the country, in order to prevent chances of hyper inflation, or future property bubbles.

A key component which appears to be preventing a colossal disaster so far-in terms of a property bubble – appears to be the banks’ stringent policies in offering loans to the real estate sector for speculative investments, with loans restricted to only house purchases primarily for the high income earners.

Therefore an overall decrease in home loan defaulters has been witnessed. Some suggest relaxed loan options, but, as “inhumane” as the bank’s policies may appear such policies insulate the sector against potential bubbles and situations such as the 2008 financial crises.

The question of ‘which type of unethical’ behaviour is being dealt with – also remains unanswered. The 2 per cent hike in taxes would not impact the major speculators, but, it could negatively impact decisions of ‘genuine’ buyers –including the non-residents, and the money could find its way to other countries.

Conclusion: So far out of the two problems of tax evasions in general and dealing with the burgeoning undocumented wealth generated due to prices disparities; the second one could – at least – temporarily witness a resolution. Resolving, grievances of the lower income home buyers should be worked out. More effective ways to counter corruption should be crafted – the recent Benami Bill appears promising, but issues of hard cash smuggling should be looked into. A careful balance would have to be carved out between international laws and local laws in regards to identification of source of incomes.

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