Taxation versus Borrowing

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Taxation

A nation-state is entrusted with managing administrative as well as financial governance aspects of a country. It pre-dominantly uses two methods to finance its national operations. Taxation and borrowing are usually the main sources of raising revenues for a government. Taxes can be direct taxes as well as indirect taxes. Similarly borrowings can be both domestic as well as external. Most governments currently follow a mix of taxation and borrowing as states have devised a relevant balance between them.

Sources for raising public debt within the country can be from State Bank, commercial banks, other institutions of banking sector and from non banking sector thereby implying general public. External borrowings can be from a specific country, from a consortium of several countries and from lending institutions such as the World Bank and IMF. In case of Pakistan, foreign remittances by overseas Pakistanis is a valued system of raising finances though the monies so obtained remain under financial ownership of the remitters.

As with most governance matters there exists a continuous debate on the merits and demerits of taxation as against borrowing to finance the operations of a government. In Pakistan governance experience has proved that both forms of raising finances have conveyed impression of financial inefficiency. Despite the fact that both methods of governmental finance are part of a legitimate process but successive governments in Pakistan have failed to convince the people of Pakistan about their efficacy and final outcomes. The debate has become acute as the tax base of the country has not been raised to the level that it could provide adequate finances to the government to manage its affairs.

Balance of payments

Before embarking on the detailed analysis of the issue it must be borne in mind that the primary difference between borrowing and taxation is that the former allows a government greater freedom in choice of time for downward adjust­ment of private sector consumption. With taxation a government is compelled to make the adjustment immediately. Taxation is considered a national burden as it directly affects the ability-to-pay of the citizenry. The phased process of handling borrowing is less painless than imposition of taxation although both methods involve raising a financial liability on regular individuals. The only difference is that borrowing saves an incumbent government the resentment of the populace.

The argument entails that with borrowing, a government is given the space to utilise the monies for investment into productive sectors aimed at ultimately offsetting liability for public debt. It also allows the space to a government to defer reduction in spending to a future date, when its taxes are higher because of repayment of principal along with interest. Borrowing is a tried-and-tested technique that provides the advantage of postponement. From the government’s point of view the borrowing method is advocated on the ground that the government can borrow more cheaply than individuals because of lesser risk.

It is argued that the government should not borrow, except in those specific circumstances, in which its use is warranted, in preference to other means of raising revenues. The first and most obvious disadvantage is the interest cost that is created which tax payers of the future periods will have to repay along with the principal amount. But the advantage is hidden in the prospective profitability of the investment undertaken through borrowed money.

Borrowing

On the other hand, the taxes imposed to meet the interest costs are almost certain to have adverse effects on the economy and will retard economic development. The bond holders receive interest income but it does not offset the adverse allocation effects of taxes. The tax and interest payments programme may produce undesirable redistribution effects. This is so because bond holders are usually rich people and their total income is increased by the additional interest income which they receive. In this way, higher taxes will be needed to payoff interest to these people, thereby rich people becoming richer.

Another argument is that during the periods of inflation, imposition of taxes is likely to have anti-inflationary effects but the dilemma is that borrowing is also much inflationary. Thus large scale borrowings in the periods of full employment are likely to permit inflationary pressures to continue. In this connection, people regard bonds or government securities as their personal wealth and ignore the tax liability which these bonds give rise to and whose burden they ultimately have to bear and their decisions on allocation of income between consumption and savings get distorted.

Resultantly, they may spend relatively more on consumption as they ignore the future reduction in their personal wealth from higher taxes which they and their heirs might have to pay in future. It is very obvious that taxation forces many people to reduce their consumption but borrowing does not, and their consumption remains the same. This relatively increased consumption is likely to lower the rate of savings and Income/Savings ratio. Greater reduction in savings, in turn, lowers the full employment rate of private sector, capital formation rate and potential rate of economic growth.

Public interest

It must, however, be taken into account that if the government borrows freely without regard to the future consequences, large obligations will be built up for future taxpayers who are not likely to be benefited by such borrowings. Another aspect is that if the politicians are corrupt they may raise large funds through internal and external borrowings simply for non-development expenditure. In case of Pakistan a large amount of the borrowed external debt in Pakistan was mostly squandered on meaningless projects. The result is that about half of the government budget is spent in meeting debt retirement liabilities.

To make it effective and productive, borrowing demands judicious use of the borrowed sums, because it is to be repaid back along with interest in future years. It should be in fitness of things if borrowings are approved only for such government projects which after maturity become profitable enough to pay back the principal amount along with interest and at the same time help in the economic development and growth.

In comparison raising funds through taxation is not considered good by the general public as they feel its pinch directly either by rise in the prices or by reduction in their hard earned money. Therefore it is likely to create resentment against the government. People are generally unaware of the ultimate perils of borrowing and keep on resisting paying taxes. The general impression is that taxation is likely to damage productive efficiency of the people. It may discourage people to save and the investors to invest hampering economic growth in the country.

Direct impact

It should also be taken into consideration that taxation reduces the consumption and distorts the consumption-saving ratio. Lack of consumption reduces the level of effective demand and particularly in periods of depression, taxation can do great damage to the economy. In developing countries like Pakistan huge financial outlays are required to undertake large infrastructure projects that are possible through borrowing because such amounts could not be raised through taxation.

While debating the issue it is also pointed out that borrowing introduces a much greater degree of uncertainty about each person’s ultimate tax liability. If the current tax approach is used uncertainty is lessened but not entirely removed. The significance for any decision about the matter will depend upon estimates of future tax liabilities. If a taxpayer believes that he is likely to pay less in the future than he would pay now, he will have greater preference for borrowing. On the other hand, if a person expects his tax liability to rise, as would younger persons expecting increases in their incomes, he will be less sympathetic towards borrowing. TW

Asrar Raouf is a former civil servant

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