The goal of an ideal tax regime is not to create an extractive system but to increase the yield from economic activities while running the state efficiently
Nepal celebrated the eighth National Tax Day on Mangshir 1 (November 17). Every year on this day, a routine program is usually organized by the Internal Revenue Department (IRD) with insipid speeches from important government officials. Important tax payers from different categories are also recognized. Industrialists attend the program and grudgingly praise the government, while making private remarks about how oppressive the tax regime has progressively become. This year was no different. In fact, the tax day came on the heels of the Doing Business report for 2020 which ranked Nepal 175th out of 190 economies it studied in Paying Taxes subcategory. Nepal was ranked 157th last year in this subcategory. This drop was ironic as Nepal’s aggregate ranking had jumped from 110th position last year to 94th this year and was enthusiastically celebrated by the Ministry of Finance.
A pattern which goes back to 1951, when Nepal first started publishing annual budget of the government, is that at the beginning of the fiscal year the government announces ambitious revenue target, accompanied by high foreign aid expectation and capital expenditure target. At the end of the year, revenue target is often met, foreign aid target is not met and sometimes covered by the foreign loan, and capital expenditure falls shy of expectation despite last minute flurry of project execution, budgetary transfer from one item to another item (more than likely to the projects located at the constituencies of influential leaders), and other similarly dodgy end-of-the-year practices. In this whole charade, those who contribute to the revenue suffer. They neither get the infrastructures the capital expenditure was supposed to provide nor become certain about the business environment for the future. Almost all parties resort to shrill, anti-business speeches and practices, and seek vote by portraying themselves as pro-poor.
This year was no different. With abysmal capital expenditure and high revenue target, the big squeeze on the industrialists is already here. The industrialists lament the inability of the government to timely provide the promised road and electricity infrastructure as well as VAT rebates. Similarly, extremely inconsiderate high-handedness of the government officials is also at odd with the otherwise liberal political and social environment in the country. The arrest of Roop Jyoti, former state minister of finance with strong industrial and academic background, has spooked many. While Jyoti was in police custody, his other family members were also at a serious risk of being sent to the custody because of some impractical legal provision. If anything, Jyoti’s arrest made many industrialists aware of how inadequate legal protection they have and how precarious an environment they are working in.
Many industrialists also hope that there will be an integrated tax code and tax payment process is simplified to the extent that all the taxes are unequivocally defined and can be paid at one place. Such a single window system may be far-fetched right now. The average number of payments a Nepali firm has to make in a year is 46, according to the DB report. This contrasts unfavorably with the 26.7 for South Asia and 12 for Mumbai. In a program organized by Confederation of National Industries (CNI), the secretary of finance for revenue asserted that many initiatives are afoot to simplify this rigmarole. The industrialists hope it certainly would be so in the near future. The DB report also pointed that the total time it takes to prepare, file and pay the corporate income tax, value added sales tax, labor tax etc in Nepal is also the highest in Nepal compared to other South Asian countries.
If one looks at Nepal’s recent history, these numbers should not shock us. At the turn of the last century, when the government mulled replacing the existing customs inspection system with Asycuda, the officials there were not very happy. Being able to check every bag that passes through the customs, rather than modeling risk and automatically letting many of the baggages pass through the customs, gave many officials an additional satisfaction of being in power. This was almost like an additional perk for many of them. They argued that since the ministry of finance gives them a certain revenue target, they would not be able to meet the target if they were restricted in any way. The mindset is likely very similar in the Internal Revenue Department.
This excessive checking situation is prevalent also in auditing, with DB report indicating VAT auditing rate in Nepal is almost 75-100 percent. Incidentally, the chairman of the CNI has noted that this rate is one hundred percent for his firms. Such excessive checking shows the inefficiency of taxation regime which also increases the cost of doing business.
The DB report also pointed out that Nepali businesses pay more in terms of total taxes and other contributions than firms in any other countries in South Asia. It should not surprise us. Our revenue to GDP ratio is already almost 30 percent and ranks the highest in South Asia. The government officials often disingenuously claim that such a high ratio is due to the large size of informal sector in Nepal and that the ratio is low if informal sector is properly accounted for in the GDP. That can only partially be true as every country in the world, and more so in the South Asia, has a significant presence of informal sector.
Relying on excise tax
An important trend in Nepal’s tax regime is the increasingly excessive reliance on excise tax. In the last two decades, the contribution of excise tax on total revenue increased from about 10 to 15 percent. The high revenue target each year and international trade treaties and obligations therein has forced the government to seek the avenue of income elsewhere. They have been using excise tax to impose additional tax on many goods. Unfortunately, the revenue coming from excise tax is not ring-fenced, and not used to address the negative externality the goods supposedly impose on the society. Hence revenue raised from increased excise tax on cement industries, for example, is also being used to pay the government’s recurrent expenditure.
The goal of an ideal tax regime is not to create an extractive system but to increase the yield from economic activities while running the state efficiently. In Mahabharat, Bhishma recommended a limit of one sixth taxation on agriculture. This was an accepted rate for a long time in many countries in the Indian subcontinent. Evidence from Licchavi era (about two thousand years ago) in Kathmandu indicates that prevalent tax at the time was about 12 percent, consistent with what Bhishma prescribed. However, with the advent of Shah dynasty and the martial era that saw the formation of modern day Nepal, our tax system became oppressive mainly to finance the increasing size of salaried armed force. This precluded the process of capital accumulation among entrepreneurs. In fact, with the fragmented domestic market, entrepreneurs rarely emerged and grew. This situation prevailed until the end of feudal era (which started to fade beginning with the eradication of birta in 1960 and the subsequent land reform throughout the 60s).
Feudal land tenure structure, fragmented market, and an absence of good transportation system all has jointly made firm size small in Nepal. These firm owners are severely limited in how much they could invest in modern technologies. The copper and iron mines of Midwestern Nepal, for example, remained at the hands of small ore extractors, and never really modernized. Agriculture, mostly at the hands of small farmers except during the Rana regime when they allotted a lot of birta lands to their family members, also remained fragmented, small, and lacked investment for technological upgrade.
Lack of reinvestment
In fact, almost all sectors in Nepal suffer from lack of reinvestment. Firm owners normally buy land or park their money elsewhere after they make good profit. Most of it is also due to the uncertain political environment of the last few decades. Reinvestment in Nepal is so low that a firm making hefty profit in dairy industry was at the forefront of opposing Amul’s entry in Nepal’s dairy market lest Amul disrupts its profit. The firm, rather than reinvesting in new equipments and introducing new products to strengthen its grip in Nepal’s market, chose to oppose a promising FDI in Nepal. Important industry leaders in many other sectors have the same tendency. Rather than reinvesting their profit and increasing their capacity while anticipating their challenges, they take the profit and often buy land and other unproductive but relatively well protected assets. To ensure the regular stream of income, they then form cartels to restrict the entry of efficient firms in their market. In a survey of trucks involved in syndicates, we found that the more intensely cartelized a route is, the older the trucks plying there are.
This all has resulted in the inability of Nepali firms to increase in size and be a regional (or hopefully, a global) player. Low and simple tax is good but tax system can be smartly designed to facilitate capital accumulation process that increases reinvestment, creates more jobs, and does not let inequality rise arbitrarily. It won’t be easy to design such a system but that should be our goal.