March 18, 2005

Taxing Exercise

Singh Durbar : Challenges galore

Events that have unfolded in recent weeks suggest that Nepal might have to depend more on its internal resources in the days ahead. With various donor countries indicating they could cut down aid, the country would soon need to grope for alternate resources. However, for a country that has so heavily depended on foreign aid for so long, it would be highly difficult, if not impossible, to suddenly switch to internal resources that are largely inadequate. Tax collection has never been so robust in the country as to provide a viable alternative overnight. With tax/GDP ratio the lowest among the South Asian nations and narrow tax net, the effective mobilization of internal resources is easier said than done. As it has become clear that there will be more strain on the collection of tax and other internal resources in the days to come, it remains to be seen how the economy would fare in these taxing times

By SANJAYA DHAKAL

At a time when the country’s economy has been performing poorly, there has come new shock with some donors threatening to suspend their aid due to political change in the country.

Given the weak economy, the country will surely be hard-pressed if, indeed, the foreign countries suspend their assistance. This will also mean that the country will have to dig deeper into its own pocket. The internal sources of revenue will come under strain as the government would be compelled to take measures to collect more revenue even as the stagnant economic activities would mean lesser possibilities of doing so.

Due to the economic slowdown, recent adjustments have forecast that the economy would grow by just around 4 percent this year. The incessant obstructions and blockades have disrupted the market chain and thrown the regular business activities into disarray. In such a situation, expecting to increase internal revenue is going to be a tough ask by any measure.

Revenue Projections

The government had projected to raise around Rs 74 billion from revenue in the current fiscal year 2004/05. It also has projected internal loan to stand around Rs 9 billion. Together these amounts would total to Rs 83 billion and the rest of the remaining nearly Rs 33 billion (out of the total budget amount of Rs 116 billion) has to be raised through foreign grants and loans – and this amount has come under cloud now.

“Almost Rs 80 billion of the budget will be spent on regular expenditures like salaries, debt-servicing and so on. Only around Rs 3 billion from among the internally generated revenue will then be available for development purposes. In this situation if we do not receive foreign assistance and the promised budgetary support, then it will be hard to conduct development programs, especially when the recent mid-term review of the budget has pointed to the 52 percent increase in development expenditure in the first six months of the current fiscal year,” said Professor Dr. Bishwambher Pyakuryal, president of Nepal Economic Association (NEA).

Retail shop : Decrease in economic activities

“The mid-term review of the budget has shown that in the first six months, the import has decreased by 6 percent. This is going to further affect the revenue collection,” said Dr. Pyakuryal.

Recently, the government has reviewed the volume of foreign assistance for the current fiscal year. It was estimated that Rs 17.95 billion foreign loan would be received this fiscal year - now this figure has been brought down to Rs 9.09 billion.

In the first six months of the year, the development expenditure increased by 52 percent compared to the same period previous year to reach Rs 11.49 billion. Out of this total, Rs 6 billion was spent on education and Rs 2 billion on middle-Marsyangdi project. The regular expenditure, however, remained comparable with the same period last year at Rs 25.51 billion.

Likewise, the total expenditure in the period increased by 12 percent to reach Rs 36.99 billion and the revenue collection increased by 12.2 percent to reach Rs 29.83 billion. The government has also adjusted the projected revenue collection at Rs 72.7 billion for this year.

The revenue growth of over 12 percent is a far cry from the government expectations of increasing it by 18 percent. “I don’t see any possibility of revenue growth notching above 13 percent in this scenario,” added Dr. Pyakuryal. These facts reflect the tight situation the country is in.

History of Foreign Aid

In the history of modern Nepal, foreign aid has played a crucial role in economic sustenance and development.

After the first ever foreign assistance to Nepal in 1950 when American government gave 2000 dollar aid to then Rana regime, which incidentally collapsed a month later, a band of foreign countries joined in the bilateral assistance programs.

A hydropower project : Result of foreign aid

From the period of 1950 to late 1960s, countries like India, China, USA and even then USSR gave aid to Nepal for different development projects like building roads, health and educational services and human resource development. But most of their aid was, rightly or wrongly, seen in the light of then international political and geo-strategic considerations. Many say Nepal was cuddled by various countries for its unique geo-strategic locations.

“Since 1951 aid grew by leaps and bounds. During 1950s and 60s in the form of grants, but the proportion of loans increased subsequently. For instance country’s first foreign loans in 1964 comprised just 10 percent of the total foreign aid, a proportion that began to rise steeply in 1970s and by mid-80s had began to exceed the grant component (in 1984, loan constituted 35 percent of the total foreign aid, in 1990, 75 percent and almost 80 percent in 1994). From mid-1990s due to greater involvement of INGOs, the proportion of loan is decreasing but still in 2000 it constituted 67 percent of the total foreign aid. In the early years, US and India were major donors. The UK, Switzerland, China, UN joined in 60s. Then Soviet Union, West Germany and Japan came in 1970s later Nordic, Scandinavia, also came,” writes Sudhindra Sharma, scholar, in his introductory chapter of Eugene Bramer Mihaly’s Foreign Aid and Politics in Nepal (second edition). According to the book, Nepal received the total foreign aid of Rs 202588.3 million (or US D 5215.68 million), from 1950/51 till 2000/01.

“Foreign aid as an instrument of financing socio-economic development dates back to mid-fifties when Nepal embarked on the process of planned development with the launching of the First Five Year Development Plan (1956-61),” states the Foreign Aid Policy 2002. “Since then a substantial portion of development expenditure averaging about 55 percent per annum has been financed through foreign aid. Currently, foreign assistance remains around 5-6 percent of Gross Domestic Product (GDP) annually, and finances about 25-30 percent of total government expenditure. In terms of sectoral distribution of foreign aid, agriculture, forestry and fisheries have received the largest share followed by energy, transport, health social development and human resource development.”

These statements make it amply clear how important the foreign aid is for Nepal. But, unfortunately, due to various reasons, Nepal never really has been able to come out of this aid-dependent syndrome. In fact, the proportion of foreign aid has gradually increased over the years.

Weak Tax Administration

One reason why the volume of foreign aid continued to increase is the lack of expansion of tax revenue. The figures of taxation in Nepal speak volume about the country’s weakness in raising internal resources. Tax revenue constitutes about 80 percent of the total government revenue.

Financial resources : In short supply

Tax revenue including both direct (like income tax, property tax etc) and indirect tax (VAT, customs, excise) have not yet been able to grow in a manner as to sustain/finance the country’s regular as well as development expenditure.

Besides the fact that tax contributes to merely 12 percent of the country’s GDP reflects how low in the development ladder Nepal is at (lowest in the SAARC region). Tenth Plan does aim to increase this contribution to 20 percent. Developed countries boast of 40 to 50 percent of tax contribution to their GDP.

Likewise, in Nepal, indirect tax contribute 75 percent of total tax revenue while direct tax comprises merely 25 percent. “This shows the weak tax administration,” said Dr. Pyakuryal. In strong economies, direct taxes contribute to over 80 percent of total revenue.

Even among the indirect taxes, customs continue to contribute over 35 percent while VAT contributes 35 percent and excise the rest. High custom revenue is not going to be sustainable at a time when Nepal has already joined free trade regimes like World Trade Organization (WTO), South Asian Free Trade Area (SAFTA) and BIMSTEC.

In getting WTO membership, Nepal has made a number of commitments. It has vowed to allow Joint Venture equity partnerships permitting 51 to 80 percent of foreign equity investment. It has opened 70 service sectors for foreign investment.

“As per our commitment, the domestic taxation system including excise and others are our rights but they have to be made non-discriminatory. But this does not mean that we cannot give any subsidy to our industries. We have not bound our tariff on arms/ammunition, cement and petroleum products. In agriculture we have bound for 42% percent tariff on average compared to the existing 14%. Likewise, in non-agriculture products we have bound for 24% tariff on average compared to the existing 11%. On 148 IT products, we have committed to bring down tariff rate to 0 within five years. We bound the tariff rate of 480 products on existing applied rate; for 58 products, we bound their rate lower than the existing one. So, there will be revenue implications for us on these 58 products plus 148 IT products. According to one study, the loss due to these revenue implication will be to the tune of Rs 192 million,” said Prachanda Man Shrestha, joint secretary at the Ministry of Industry, Commerce and Supplies, highlighting the revenue implications of WTO membership at a program organized by Nepal Law Society (NLS) recently on Tax Laws.

Likewise, Nepal will also need to do away with Other Duties and Charges at the Custom point. “At present we are imposing special Tax, Local Development Tax and Agriculture Improvement Tax at the custom point, which we will have to get rid of within 2 to 10 years. Ridding ODCs will result in losses worth Rs 430 million,” added Shrestha.

Presently, the government earns 30 percent of total revenue from customs, which means our revenue is custom-based.

Areas for Improvement

One area that has certain potential of increasing revenue is the non-tax revenue like registration fee, royalty etc that government offices charge for delivering different sorts of services. “At present, non-tax revenue contribute to 20 percent of total revenue. And they have the potential to increase substantially,” said Dr. Pyakuryal, who believes that there are possibilities to increase fees under certain headings by several fold.

It is not that the government has not taken any step to modernize its tax administration. The new Income Tax policy and laws point towards the gradual improvement in tax administration. “The Income Tax policy embraces the principles of equality/equal treatment; equity; fair play; proportionality and ability to pay; non-retro-activity; and the source versus residence principle. The IT Act adopts a full-fledged self-assessment system and the presumptive taxation and current year taxation system. Taxpayers are required to maintain their accounts themselves. The key issues and challenges before the tax policy is tax incentives; shifting of income and profits (offshore); international tax; and voluntary compliance and self-assessment,” said Avanindra Kumar Shrestha, Director General of Inland Revenue Department, presenting a paper on “Income Tax Policy & Statute” at a program organized by the NLS recently.

The NLS along with RAS project of DANIDA has been involved in studies and exercises towards tax reforms. “We have already prepared a number of reports and conducted a number of workshop and training on Income Tax, VAT and Revenue Tribunal with the help of Tax Department and RAS Project. These efforts are aimed at strengthening the capacity of the government to raise internal resources, “ said Krishna Man Pradhan, executive director of NLS.

Major Implications

If the government is unable to make available adequate resources, many programs mentioned in the budget could suffer. The budget had made sectoral allocations to the four main pillar objectives of the Tenth Plan. Rs 17.81 billion had been allocated for achieving the strategic target of broad based economic growth.

Likewise, Rs 21.2 billion was to be utilized to achieve the target of social sector and rural infrastructure development; Rs 2.75 billion for the social inclusion and participation; and Rs 5.41 billion for good governance programs. The regular administration and debt servicing were to use up Rs 64.48 billion.

However, in changed circumstances, it would be difficult to assume that these projects and programs would remain unaffected. Even the programs like Education For All, rural infrastructure development, health projects and drinking water schemes could get derailed.

As such, the country appears set for a long and hard days ahead. Amid the continuing instability, economy stands little chance of expanding and it offers minimum areas for increasing the internal resources that would become vital in case the foreign assistance dry up.