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A Computational General Equilibrium Approach to Sectoral Analysis for Tax Potential: An Application to Pakistan

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Abstract

This study develops a dynamic general equilibrium model, applied to Pakistani data, in which optimizing agents evade taxes by operating in the underground economy. The cost to firms of evading taxes is that they find themselves subject to credit rationing from banks. Our model simulations show that in the absence of budgetary flexibility to adjust expenditures, raising tax rates too high drives firms into the underground economy, thereby reducing the tax base. Aggregate investment in the economy is lowered because of credit rationing. Taxes that are too low eliminate the underground economy, but result in unsustainable budget and trade deficits. Thus, the optimal rate of taxation, from a macroeconomic point of view, may lead to some underground activity. We note, in particular, that incorporating a VAT without any other tax reductions greatly reduces the tax compliance of the service sector. We have applied our model to Pakistan, and have calibrated our model to an 8 year period from 2004-2011. We note that it gives a reasonable approximation of Pakistani macro data. We then use a sectoral breakdown of tax data generated by the model to estimate tax gaps on a sector by sector basis. We note that certain sectors are currently paying taxes below their potential, while others may be above their tax potential. These sectoral gap estimates may be used as indicators of where greater tax enforcement efforts should be directed.

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  • Andrew Feltenstein & Musharraf Cyan, 2012. "A Computational General Equilibrium Approach to Sectoral Analysis for Tax Potential: An Application to Pakistan," International Center for Public Policy Working Paper Series, at AYSPS, GSU paper1226, International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University.
  • Handle: RePEc:ays:ispwps:paper1226
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    File URL: http://icepp.gsu.edu/files/2015/03/ispwp1226.pdf
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    1. John McMillan & Christopher Woodruff, 1999. "Interfirm Relationships and Informal Credit in Vietnam," The Quarterly Journal of Economics, Oxford University Press, vol. 114(4), pages 1285-1320.
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    3. Ball, Sheryl & Feltenstein, Andrew, 2001. "Bank failures and fiscal austerity: policy prescriptions for a developing country," Journal of Public Economics, Elsevier, vol. 82(2), pages 247-270, November.
    4. Kiyotaki, Nobuhiro & Moore, John, 1997. "Credit Cycles," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 211-248, April.
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    6. Abdul Qayyum, 2005. "Modelling the Demand for Money in Pakistan," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 44(3), pages 233-252.
    7. Blejer, Mario I. & Feldman, Ernesto V. & Feltenstein, Andrew, 2002. "Exogenous shocks, contagion, and bank soundness: a macroeconomic framework," Journal of International Money and Finance, Elsevier, vol. 21(1), pages 33-52, February.
    8. Jorge Martinez-Vazquez & Kaspar Richter, 2009. "Pakistan Tax Policy Report: Tapping Tax Bases for Development," International Center for Public Policy Working Paper Series, at AYSPS, GSU paper0908, International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University.
    9. Robina Ather Ahmed & Mark Rider, 2008. "Pakistan’s Tax Gap: Estimates By Tax Calculation and Methodology," International Center for Public Policy Working Paper Series, at AYSPS, GSU paper0811, International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University.
    10. Era Dabla-Norris & Andrew Feltenstein, 2005. "The underground economy and its macroeconomic consequences," Journal of Economic Policy Reform, Taylor & Francis Journals, vol. 8(2), pages 153-174.
    11. Friedman, Eric & Johnson, Simon & Kaufmann, Daniel & Zoido-Lobaton, Pablo, 2000. "Dodging the grabbing hand: the determinants of unofficial activity in 69 countries," Journal of Public Economics, Elsevier, vol. 76(3), pages 459-493, June.
    12. Feltenstein, Andrew & Shah, Anwar, 1993. "General Equilibrium Effects of Taxation on Investment in a Developing Country: The Case of Pakistan," Public Finance = Finances publiques, , vol. 48(3), pages 366-386.
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    Cited by:

    1. Ángeles Castro Gerardo & Ramírez Camarillo Diana Berenice, 2014. "Determinants of tax revenue in OECD countries over the period 2001-2011," Contaduría y Administración, Accounting and Management, vol. 59(3), pages 35-60, julio-sep.
    2. Andrew Feltenstein & Luciana Lopes & Janet Porras Mendoza & Sally Wallace, 2013. "“The Impact of Micro-simulation and CGE modeling on Tax Reform and Tax Advice in Developing Countries”: A Survey of Alternative Approaches and an Application to Pakistan," International Center for Public Policy Working Paper Series, at AYSPS, GSU paper1309, International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University.
    3. Andrew Feltenstein & Carolina Mejia, 2015. "The Poverty Implications of Alternative Tax Reforms: Some Countries Intuitive Results In an Application to Pakistan," International Center for Public Policy Working Paper Series, at AYSPS, GSU paper1506, International Center for Public Policy, Andrew Young School of Policy Studies, Georgia State University.
    4. Andrew Feltenstein & Luciana Lopes & Janet Porras-Mendoza & Sally Wallace, 2014. "Modeling tax reform in developing countries," Chapters,in: Taxation and Development: The Weakest Link?, chapter 3, pages 69-102 Edward Elgar Publishing.

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