The IMF program and Reformed GST; a positive step forward

There have been a lot of talks over the Reformed GST (RGST) since the cabinet has approved the RGST to be imposed effective from January 2011. There has been a hue and cry all day yesterday with majority (barring a few) well known media, social and political personalities appeared on various TV programs and criticized Government and IMF on this matter.

To me, it’s an extremely important and a good decision on behalf of the Government. RGST or VAT should have been implemented long time ago and those who have a little bit of basic understanding of what the nature of this tax is will appreciate it.

I am writing this blog just to give a basic understanding of the IMF program and what RGST is all about and what are its mechanics, costs and benefits.
First of all to those who are IMF bashers, please accept the fact that we are under IMF's program since the day we decided to procure USD from them to meet our expenses and run the country. (You can bash Government for going up to IMF, but NOT IMF itself). IMF is just like another Multilateral and it makes money by lending to countries in need of money. Like any other lenders, they impose certain covenants in order to make sure they get their money back with due interest, and this is how they do their business. (It is pertinent to mention here that I am in no way related to IMF or any of its associates, I am just a banker, an Investment Banker, and therefore I understand the mechanics of lending).

Before moving on to RGST lets first understand the IMF program.
Pakistan entered into IMF program in November 2008. A 25 months Stand-By Arrangement (SBA) of US$11.3billion was sanctioned for the country. In addition to that the IMF Board also approved US$451 million disbursement under the Emergency Natural Disaster Assistance framework to help Pakistan manage the immediate effects of the massive and devastating floods.
The SBA program aims to:
1) restore financial stability through a tightening of fiscal and monetary policies to bring down inflation and strengthen foreign currency reserves;
2) protect the poor by strengthening the social safety net—this is a key element of the government’s policy strategy; and
3) raise budgetary revenues through comprehensive tax reforms to enable significant increases in public investment and social spending required for achieving sustainable growth (Source: www.imf.org).

To achieve the above mentioned objectives, one of the key covenants is that the budget deficit should NOT surpass 5.1% of the GDP for the current financial year and 4.9% for the next financial year.
RGST buds from the above mentioned covenant, to enable the Government to generate more revenue and lower the budget deficit.

Here I would like to mention that all the criticism on government to plug the leakages in the system, curtail corruption, taxing the agriculture and real estate sector is truly justified and should be taken care immediately, without any further delays, full stop., and there is no disagreement in this regard whatsoever. BUT, saying that all these actions should be a conditions precedent to the implementation of RGST in highly unjustified. Let’s take whatever “good” coming in our way!!

Now, let’s try to understand what RGST or VAT theoretically is and what will be its mode of implementation.
A value added tax (VAT) or RGST is a form of consumption tax. It is a tax on the estimated market value added to a product or material at each stage of its manufacture or distribution, ultimately passed on to the consumer. It differs from a sales tax, which is levied only at the point of purchase.
Maurice Lauré, Joint Director of the French Tax Authority, the Direction générale des impôts, was first to introduce VAT on April 10, 1954. Personal end-consumers of products and services cannot recover VAT on purchases, but businesses are able to recover VAT (input tax) on the products and services that they buy in order to produce further goods or services that will be sold to yet another business in the supply chain or directly to a final consumer. (Source: Wikipedia)

15% RGST or VAT and 15% Sales Tax should result in the same end price to the consumer, meaning that RGST is NON inflationary; let me demonstrate how:
Assume that currently there are no taxes (Sales tax or RGST) and a Farmer (A) grows potatoes and sells it to a Chips Manufacturer (B) at a price of PKR 100. B now sells it to the Distributor (C) at a price of PKR 150. C sells it to the Retailer (D) at PKR 175 who further sells it to the consumer (E) at PKR 200.
Let’s now look at and compare two tax scenarios: 1) Sales Tax is 17% (like it is currently in Pakistan); and 2) RGST of 17% is implemented instead of Sales Tax.
In Scenario 1, the end consumer (E) will be paying PKR 200 plus 17% i.e. PKR 34, total of PKR 234 for a packet of chips.
In case of scenario 2, where RGST is implemented, the farmer (A) will receive a sum of PKR 117 from (B). The breakup will be PKR 100 for potatoes and PKR 17 in lieu of RGST. Farmer (A) then deposits the PKR 17 with the FBR as RGST. Chips manufacturer (B) receives a total of PKR 175.5 from the Distributor (C); PKR 150 for the manufactured chips and PKR 25.5 as RGST. The Chips manufacturer (B) has actually paid PKR 17 to the farmer (A) in lieu of RGST while it has received PKR 25.5 from the Distributor (C). Therefore, the Chips manufacturer (B) will pay the incremental amount i.e. PKR 8.5 (PKR 25.5 minus PKR 17) to the FBR. Similarly Distributor (C) will charge a total of PKR 204.75 from Retailer (D) (i.e. PKR 175 for the chips and PKR 29.5 in lieu of RGST). The Distributor (C) shall pay PKR 4 as tax to FBR (PKR 29.5 received from D minus PKR 25.5 already paid to B). The Retailer (D) shall similarly charge PKR 234 from the Consumer (E) i.e. PKR 200 plus PKR 34 as RGST. The Retailer (D) shall pay PKR 4.5 as tax to the FBR.

It is important to note that the end consumer ends up paying the same amount PKR 234 for the packet of chips regardless of Sales tax (Scenario 1) or RGST (Scenario 2).
The question is then … what is the advantage of RGST?
The answer is simple and straightforward and can be derived from the example above. In case of RGST, every party in the supply chain (A, B, C and D above) are accountable and pay tax to the government directly, and thus to avail the tax credit they have to be registered (i.e. have an NTN number) and maintain appropriate documentation. So, the bottom-line is that all those traders, distributors, and retailers who currently evade taxes, will come into the tax net since they will have to maintain all the documentation to avail the tax credit. (Tax credit in our example for B is PKR 17 already paid to A)

It is estimated that GoP will raise 0.8% of GDP additionally in next financial year upon implementation of RGST provided the rate is similar to the current sales tax rate of 17%. Theoretically, the impact will be non – inflationary if the goods already exempted under current sales tax policy remain exempted for RGST as well. I can only hope that RGST is implemented in its true spirit (corruption free) to attain the desired results as discussed above.