Pakistan’s tax-amnesty scheme would relieve fiscal and external pressures: Moody’s

Last Thursday, Pakistan’s (B3 stable) Prime Minister Shahid Khaqan Abbasi announced a new one-off tax amnesty scheme to incentivize the declaration of previously undeclared local and foreign assets and the repatriation of assets held offshore. The credit-positive scheme is part of the government’s broader tax reform package, also announced last Thursday.

Pakistan’s tax-amnesty scheme, if successful, would increase the government’s revenue base and alleviate fiscal pressure from its low revenue generation capacity and increasing capital expenditures for the China Pakistan Economic Corridor (CPEC). Capital inflows resulting from the repatriation of liquid foreign assets also would ease balance-of-payment pressure in the past few months of the current fiscal year, which ends in June 2018.

This is Pakistan’s first tax-amnesty scheme to target foreign assets, which the accounting firm AF Ferguson estimates at $150 billion (45% of our 2018 forecast GDP). Through June 2018, residents can repatriate undeclared local liquid assets with a 5% penalty, undeclared foreign liquid assets with a 2% penalty (if repatriated, or a 5% penalty if remaining abroad or in foreign currencies), and undeclared fixed assets – whether held locally or abroad – with a 3% penalty. The low penalty rates, particularly for repatriated assets, increase the likelihood of the scheme’s success. (Pakistan has previously launched tax-amnesty schemes for businesses and the real estate sector).

Broadening the tax base by including previously undeclared assets would alleviate Pakistan’s ongoing fiscal pressures. In a country of more than 20 million people, only 1.2 million file income tax returns, of which only 700,000 paid taxes, according to the government’s latest estimate. Pakistan’s revenue-generation capacity, as measured by the ratio of tax revenue to GDP, is among the lowest across the Asia-Pacific (see Exhibit 1) region and among our rated sovereigns. Pakistan’s credit profile is consistently constrained by its weak tax revenue generation: the government has not recorded a fiscal surplus in the past 25 years.

A successful tax-amnesty scheme would provide a one-off benefit to government revenue, and the low penalty rate for repatriated assets increases the scheme’s chance of success. Penalty rates on foreign liquid assets are similar to those in Indonesia’s (Baa3 positive) 2016-17 tax-amnesty scheme: it offered a 4% penalty on the declaration of foreign assets and a 2% penalty if those assets were repatriated. Based on Indonesia’s and others’ tax-amnesty schemes in recent years, we expect a one-off increase in government revenue of 0.3%-1.0% of GDP (see Exhibit 2). The success of this scheme also depends on whether residents expect future tax amnesty schemes with similar incentives, which could lower the uptake of the current scheme.

The repatriation of foreign liquid assets would reduce Pakistan’s external vulnerability risk, although the positive effect would only last through the end of June 2018, when the amnesty expires. Pakistan is facing external pressures, with higher imports largely from CPEC weighing on the current account and foreign reserves. The central bank has allowed the currency to depreciate twice (by about 9% in total) since early December 2017 and has raised policy rates 25 basis points to cool domestic demand. However, foreign reserves continue to decline and reached a 34-month low in March 2018.