Special Tax Treatment of Agricultural Incomes

The federal government has taken the easy route of levying higher taxes on those who are already in the tax net without targeting those high-income earners who under-report their incomes or manage to remain outside the income tax net. This policy of squeezing taxpayers who are already heavily taxed is unimaginative and unfair. In this case, the federal government is at fault but we should not ignore the role of provincial governments in perpetuating an inequitable system of taxing equal incomes unequally. In Punjab, which accounts for over 65% of agricultural value-added, tax rates on agricultural incomes have been frozen at the 2003 level.

The 1973 Constitution gives provincial assemblies exclusive power to levy taxes on agricultural incomes. After a few abortive attempts, the tax was introduced in all four provinces in 1996/97. The tax was initially a per-acre tax; later, a provision for income tax was also introduced through an amendment, but the tax is effectively collected as a land tax rather than an income tax.

Even during the British period, farmers and landowners were exempt from income taxation but were taxed at the provincial level on their rental income or return to land. This practice was inherited by Pakistan in 1947. However, rental income is one component of a farmer’s total income. The income from crop farming includes not just the return to land but also the returns to the farmer’s labour, capital and entrepreneurship. The 1973 constitution allowed provincial governments to tax all components of a farmer’s income, not just the rental income. When Punjab introduced the Agricultural Income Tax (AIT) Act 1997, it also abolished the land revenue tax.

Till the 1980s, agricultural incomes were also subject to very high implicit taxation, which took the form of tax on agricultural exports, the compulsory procurement of agricultural goods and an overvalued exchange rate, forcing down agricultural prices to below their free market level. Thus, instead of taxing farmers directly through income tax, successive governments taxed farmers implicitly through pricing and exchange rate policies.

Starting in the 1980s, the implicit taxation of agricultural incomes has been largely phased out, and although AIT was introduced in all four provinces in 1996/97, provincial agricultural taxes bear little resemblance to income tax levied at the federal level. For instance, in Punjab, agricultural incomes below Rs. 100,000 are exempt from taxation and the highest tax rate is 15% for incomes that exceed Rs. 300,000. In contrast, for a comparable group at the federal level, incomes below Rs. 400,000 are exempt from taxation but the highest tax rate is 35% for incomes exceeding Rs. 6 million.

The prevalent mode of agricultural taxation in the provinces is not, however, income tax but land tax. In Punjab, the highest tax rate is Rs. 300 per acre, which is levied on irrigated orchards, and Rs. 250 per acre on irrigated land exceeding 25 acres. This means that a farmer with 50 acres of irrigated land pays Rs. 12,500 as AIT. Since land rental in Punjab’s agricultural heartland exceeds Rs. 30,000–50,000 per acre, the net income of a landowner with 50 acres of land is at least Rs. 1,500,000. Thus, a farmer with 50 acres of fertile irrigated land and an annual income well in excess of Rs. 1,500,000 pays a tax of Rs. 12,500. His counterpart who earns the same net income from a small business would be expected to pay a tax of Rs. 147,500.

This glaring contrast in the tax treatment of agricultural and non-agricultural incomes takes on added significance when the federal government raises tax rates on non-agricultural incomes as it has done this year. There has been no tax rate increase on agricultural land or incomes in the last 10 years in Punjab even though nominal incomes have increased several-fold over this period. The 7th National Finance Commission (NFC) award also required the provincial governments to initiate steps to effectively tax agriculture, but for the last three years the provinces have ignored this part of the compact. In fact, the tax revenue from AIT has been on the decline. In 2009/10, Punjab collected Rs. 1 billion from AIT; in 2012/13 it collected Rs. 0.86 billion.

This year, the Punjab government has budgeted tax revenues from AIT to increase to Rs. 2.09 billion. The increase of Rs. 1.16 billion is likely to come about by invoking a clause of the AIT Act 1997 that makes it compulsory for landowners who own more than 50 acres to file income tax returns. Applying income tax to these farmers instead of levying a land tax is expected to raise the additional revenue.

The potential increase in tax revenue is still miniscule compared with the full potential tax revenue, were the same tax rates applied to agricultural incomes as to businesses under the federal income tax. We estimate that the potential tax revenue from Punjab, if agricultural incomes were taxed at par with incomes earned in other sectors of the economy, would have been about Rs. 30 billion in 2012/13 compared with the actual AIT collection of less than Rs. 1 billion.

The exclusive constitutional power of provinces to set AIT rates has allowed the taxation of agricultural incomes and business incomes to diverge dramatically. The 18th Amendment failed to address the issue and the matter has languished in the Council of Common Interests for some time as well. The next NFC award could be an opportunity to address this issue more concretely. Having conceded a very large share of the divisible pool of tax revenues to the provinces in the 7th NFC award, the federal government may, however, have very little leverage with the provinces. Without strong leadership on this issue from within the provinces, this unfair system of taxation could continue for a very long time.

Disclaimer: The views expressed here are those of the authors and do not necessarily represent the views of the Institute of Development and Economic Alternatives