Cost of Taxing National Savings
Withdrawal of rebates provided through sections 62 and 63 of the Income Tax Ordinance proposed by the Finance Bill that will be voted on by the National Assembly in the next few days will be counterproductive for the capital market, insurance, and mutual fund sectors of the economy.
Budget 2022-23 continues a trend of increasing tax rates and withdrawing exemptions, raising the tax burden on existing taxpayers. Like all previous budgets, the current one aims to reduce the fiscal deficit, which has remained between 7 and 8% of GDP for two decades, by increasing revenue. In the past, such an approach rarely worked, as neither real revenue nor the deficit decreased.
This budget eliminates rebates and allowances for retail investors in insurance, pensions, and mutual funds. Withdrawal of rebates provided through sections 62 and 63 of the Income Tax Ordinance proposed by the Finance Bill that will be voted on by the National Assembly in the next few days will be counterproductive for the capital market, insurance, and mutual fund sectors of the economy.
Pakistan's economic issues
These proposals will exacerbate our economy's deep-rooted problems.
Pakistan's savings rate is below 15% of GDP, compared to 28-30% in Bangladesh and India. Due to low savings rates, investment rates have remained below 15%, as any additional investment must come from borrowings or foreign direct investment, both of which have dried up due to continuing fiscal and current account deficits and low investor confidence.
The total market cap of all listed companies on PSX has fallen to Rs. 7.1 trillion or $ 34.6 billion, less than 10% of the GDP. Absolute and relative to GDP, it's at its lowest level in the last 20 years.
Under sections 62 and 63 of the Income Tax Ordinance, 2001, individuals are entitled to tax credits for investing in mutual funds, life & health insurance, and approved pension schemes, which reduces their tax liabilities within a specified threshold. The Finance Bill, 2022 proposes to eliminate rebates and tax credits. Withdrawing these small incentives / tax rebates to retail investors will be counterproductive for these formal sectors - life & health insurance, voluntary pension schemes, mutual fund industry, and capital market as a whole - and will undermine savings & investment levels, which are already the lowest in the world. In addition, the proposed changes will increase the salary group's tax liabilities even more than the increase in tax rates for individuals would do on their own.
Life insurance and Mutual Funds are instruments through which savings are mobilized from retail investors for investment in productive sectors, especially the capital market. It may be noted that we hardly have less than 300,000 investors in the capital market compared to nearly 50 million in India- just 0.6% of the number of investors in India, which shows that our ecosystem for raising capital has significant holes.
Considering Pakistan’s paltry rate of savings (one of the lowest in the world) and lowest penetration of life & health insurance – less than 0.6% compared to 3% in India and global average of 3.7%- & market cap of Mutual Fund industry of barely 1.3% compared to 15% in India & over 50% in the world, this is a highly negative development for the institutionalized parts of the economy.
Impact on FBR Revenue
The government estimated a tax savings of Rs. 3.9 billion as a result of withdrawing these tax savings, but ignored the negative impact of these withdrawals due to reduced tax liability due to reduced profitability of insurance companies and mutual funds and consequent reduction in dividend distributions by these entities, which are also taxable in the hands of recipients. Insurance firms and mutual fund dividends are taxed at higher rates.
Retail investor base in mutual funds is over Rs. Over Rs. 340 billion in open-end schemes and a total of over Rs. 39 billion in pension schemes. Most of these investments are made by salaried individuals seeking tax benefits. Individuals pay a lot for health and life insurance, which qualify for tax rebates. In light of the current interest rate environment and the expanding insurance market base brought on by increased consumer knowledge of personal finance, it is expected that these industries will expand by at least 20% over the next few years. Failure to implement these reforms will have a direct impact on corporate profits and the amount of tax collected from businesses. However, in case the proposed withdrawals are enforced, it will significantly influence the business of these firms degrading their profitability, and subsequently their tax liabilities. In fact, there is a concern that even the existing consumers who no longer enjoy the advantage from these tax refunds may withdraw their money Or cancel their insurance contracts. Losses in corporate tax revenue will outweigh tax savings.
Insurance businesses and mutual funds participate heavily in the capital and money markets. Insurance Association of Pakistan estimates insurance sector investment at Rs. 2 trillion. As a large chunk comes from Life & health insurance, 60% or Rs. 1.2 trillion is from Life & health insurance. 200 billion rupees of mutual fund industry's 1.2 trillion rupees are invested in equity market. Reduced retail investments in insurance and mutual funds will reduce their growth or stagnancy, reducing capital and money flow. The capital market, which is already at its lowest level, may further shrink, increasing capital losses and eroding capital gains, which will hurt FBR capital gains tax revenue. Considering all of these factors, it is more likely that these proposals will have a negative impact on FBR revenue, as potential tax revenue from natural increases in company Gains in profit, dividends, and capital appreciation will outweigh the rise in tax revenue attributable to the elimination of tax breaks.