Published in The Express Tribune, May 8^th, 2020.

Co-authored with Dr. Adeel Malik.

While an inquiry on the sugar sector has been made public for the first time, the crisis that necessitated this inquiry is a recurring feature of Pakistan’s sugar industry. Rattled by a controversy every 18 months, why is the sugar industry so prone to crises?

To answer this, we must use a basic principle of political economy: rent-seeking. Imagine this: you want to open a restaurant, but there is a lot of competition. You want to make more money but other restaurants, serving better food at cheaper prices, keep opening up. Along with other restaurants, you lobby the government to require all new restaurants to have a new licence to operate. The government sets up a special committee to issue these licences. You convince them to put you or your friends on this committee and ask them not to issue new restaurant licences. The supply of new restaurants goes down, allowing you and other existing restaurant owners to capture the market. The money you make now isn’t profit, they are rents.

Rents are fundamentally exploitative: it implies that the business is making more money than it would otherwise in a competitive, fair market. They are rigging the game in their favour. This is how our sugar industry works: through administrative actions rather than the standard rules that govern a functioning market. Let’s consider three questions to illustrate this point.

First, who can open a sugar mill? You can’t unless you are politically connected and able to obtain a licence from the government, granted under the provincial Sugar Factories Control and Sugar Licensing Controlling Orders. Punjab has an outright ban on new sugar mills, in effect since 2003. Existing owners have used their political connections to path a way around it: rather than establishing new mills, many existing sugar mills have successfully sought permission to set up their “branches” in other regions.

The result of this has been a high degree of concentration of the industry in the hands of a few — nine families own more than half of the country’s sugar mills. And, six industrial groups control half of the total national production. Three of these six are owned fully or partially by a current (or a former) member of parliament, who sit on all sides of the political divide. One is a member of the current federal cabinet, the second is a member of the cabinet in all but paper.

Second, how are sugar prices determined? Normally, the price would be determined by the interaction of supply and demand i.e. how many people want to buy sugar and how much sugar can be produced in a country. Since the demand for essential food items, such as sugar, is relatively inelastic (large price increases have little effect on demand) and predictable (for example, demand increases during Ramazan), what happens on the supply-side is more important for sugar prices.

One key determining factor in sugar price is the minimum support price that is guaranteed by the government to sugar growers every year to shield them from income and price fluctuations. These support prices have increased by three times during the past decade and are typically negotiated between millers and sugarcane commissioners who are provincial civil servants. The second is the recovery rate or the amount of output that can be recovered from a typical length of sugarcane. These are declared by sugar mills. As indicated by the sugar inquiry report, the recovery rates are typically unverified. Even mills in the same region and using the same variety of sugarcane document different recovery rates.

Another factor that impinges on the supply of sugar is when support prices are announced and when mills start the crushing period. The former determines the incentives of the farmers to grow sugarcane and the latter influences the available sugar stock in the market. Both decisions are routinely delayed in ways that benefit sugar mills. Given greater bargaining power and control over the state’s administrative machinery, the millers exert a disproportionate influence on how sugar prices are determined.

The industry also benefits from a formal lobbying group, the Pakistan Sugar Mills Association (PSMA). When, in 2010, the Competition Commission of Pakistan launched an inquiry into the sugar industry, the PSMA earnestly went to the court and got a stay order, derailing the inquiry. Cleary, the fuel which runs our sugar mills is not competition. It is extraction.

Third, are there any special privileges provided to this sector? There are more than we can count, including high import barriers through tariffs and regulatory duties which restrict competition from foreign producers. But, the clearest privilege is export subsidies: when global sugar prices are surging or there is an excess stock for sugar available, sugar producers not only get permission to export but also get subsidies to do so. This export of sugar is typically followed by a drawing down of the national sugar stock, creating the perfect conditions for a price rise in the domestic market in the following season.

Unproductive rents harm all of us but benefit a few well-placed people who use political connections to restrict competition and extract benefits from the government. How much does it cost all of us? Between 2006 and 2010, calculations done by one of us estimate that Rs585 billion was transferred from the pockets of ordinary people to the sugar industry. This is likely to be much higher when we consider the costs of broader misallocation this creates in our economy. Another implication is that Pakistani farmers are moving away from cotton to growing water-intensive sugarcane. In 2010, this resulted in $1.4 billion in terms of lost exports of cotton.

Over time, this rent-seeking has been institutionalised — whichever party may be in power, the underlying vested interests remain the same. In an efficient economy, firms compete with each other fairly, lowering prices, innovating, and upping quality. Firms which can’t, fail; people who work in them move to other, better-performing firms. Ask yourself this: when did the last sugar mill collapse in Pakistan? Take the protection and subsidies away and see what happens.

Published: International Growth Centre, 12^th Aug 2020.

Virtually every country in the world taxes their populations. But, some do so more successfully than others. Most developing countries raise tax revenue equivalent to between 10% to 20% of their GDPs, some even less. Rich countries raise much more, on average 34%. If Pakistan distributed all its annual tax revenue equally among its 200 million citizens each would get less than 1% of the country’s legal minimum wage. The result of this is considerable differences between the abilities of governments to fund public services, explaining why India spends $62 per citizen on healthcare, while Germany spends over $4,000.^[1]

Why do developing countries find it so hard to tax? There is no one answer. For starters, developing countries are information-scarce environments – governments typically do not know who owes how much. This is why when developing countries do tax, they focus on taxing consumption and trade instead of labour, as the former are easier to target.^[1]

In most developed countries, this information is largely created by third-party reporting of income. Firms report how much they pay their employees, making it harder for people to cheat. In most developing countries, large informal sectors make this nearly impossible to achieve. Even in China, where formal employment is more widespread, only 28 million people pay direct income taxes, as of 2015. In Pakistan, it is about one million people.

Increasing income taxation is hard without widespread formal employment. In a 2019 working paper, Anders Jensen, of Harvard University, uses data from the United States to show that as people moved away from self-employment to wage labour, this was associated with increased income taxation usage. In a similar vein, research from Denmark shows that tax evasion is significantly higher among people who self-report their income than those whose income is reported by employers.

Some developing countries have made some progress on this front by targeting the small number of people who work in formal firms. This is largely done using withholding taxes, in which businesses deduct the tax before giving paychecks to their employees. But doing so risks pushing the administrative burden on formal private firms — a bad precedent to set, especially when so few exist.

The expansion of value-added taxation (VAT), under which the government levy tax on each firm across a supply chain, is also in part motivated by the desire to create more information. To calculate the value, each firm needs to subtract the difference between its output and its input. By doing so, they create an information trail that can verify the tax liabilities of other firms in that chain. 8 out of 10 countries in sub-Saharan Africa levy the VAT today.

It is ingenious, on paper. In practice, it has led to mixed results. In Chile, third-party reporting due to the VAT has strongly disincentivised tax evasion. While researchers in Uganda have found widespread discrepancies in amounts reported by sellers and buyers, despite the paper trail created by the VAT.

The secret might be how much enforcement capacity a given state has. Firms may eventually realise that the state does not do anything if they do not accurately report their profits. After all, information is worth only if someone acts upon it. But, capacity is a whole other beast: you need the capacity to raise revenue, and revenue to raise capacity.

One way to address this problem is to motivate tax bureaucrats to perform better. When researchers in Pakistan provided property tax collectors with performance pay schemes, revenue jumped by as much as 46%. But, incentives can be tricky to tweak. Some of them can also be costly: in Ghana, one out of five revenue collectors earn a monthly salary that is greater than the revenues they collect, giving them bonuses might not help nor be feasible for the government coffers.

Given all these limitations, developing countries may need to think about a different set of tax policies, such as those we find unwise for developed countries. Economists Adnan Khan and Henrik Kleven term such policies as ‘third-best’.

One policy they consider is taxing full firm revenue instead of profit. Doing so is inefficient because it does not allow firms to deduct the costs of input and may distort a firm’s production decisions. But some inefficiency maybe tolerable if it raises enough revenue. Researchers estimate that in Pakistan’s case this could raise as much as 74% more tax revenue.

There are other factors: less technocrat, more political. An important one is the prevalence of double tax treaties between countries. Signed to prevent taxing the same income twice, they have undermined the tax capacity of several developing countries. Firms can base their operations in one country, usually that has a treaty with another country and very low taxes, evading taxes in the latter because they pay in the former.

In a 2018 paper, IMF Economists Sebastian Beer and Jan Loeprick have used the fact 11 African countries have such treaties with Mauritius, where firms are effectively taxed at a rate of just 3%. They find that these treaties have not only not led to increased foreign investment in countries that sign these treaties with Mauritius but also lead to significant revenue losses. Zambia has just torn up its tax treaty with Mauritius.

The cross broader implications do not end here. The elite in many developing countries evade taxes by moving their wealth abroad, supported by a network of financial and legal firms. African governments collectively lose about $15 billion a year because of offshore wealth, calculations by economist Gabriel Zucman show. It is hard to tax when much of the tax base is signed away, or hidden in Swiss bank accounts.

Published under the title “What is stopping developing countries from taxing more?” on theigc.org as part of IGC’s Ideas Matter campaign to celebrate the launch of the Little Book of Growth.

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^[1] This moves the tax burden to lower-income groups. However, in new research, Bachas et al. (2020) argue that consumption taxes might be more progressive in countries with large informal sectors, because people in the bottom decile tend to rely more on informal transactions which are not taxed.

^[1] Data by World Bank’s WDI database. PPP dollars.

Published in Dawn, November 23rd, 2019

VIRTUALLY every country which has economically advanced in modern history has done so while becoming urbanised. Pakistan’s path can be no different; to prosper, we need well-connected, vibrant, and liveable cities that bring people and firms together in dense environments.

But such cities don’t emerge naturally; they are the result of policy actions. New York City functions effectively because of its expansive infrastructure, including an over 10,000 kilometres-long elaborate water supply system.

Building and maintaining such infrastructure isn’t possible without effective governance

structures. Take New York mayor Fiorello La Guardia’s example. In the 1930s, he created a cross-partisan coalition to replace a corrupt network which had controlled the city for nearly eight decades. Over his three terms, he expanded the use of competitive exams to recruit public officials, adopted new administrative practices such as centralised purchasing to reduce corruption, and help set up a public agency to provide urban housing.

If La Guardia and others like him hadn’t taken measures to modernise city governance, New York would look very different today. Such investments have paid off, as demonstrated by the fact that the city has a per capita income that is 172 per cent higher than the national figure.

Pakistani policymakers have failed to understand this importance of cities. Small wonder the people who move to cities in search of prosperity face poor living conditions.

If Pakistan reverses this and manages its urban transition effectively, it can unlock significant economic gains. By bringing people and firms closer, cities provide a dense market for products and workers, where both can focus on interdependent activities. Because of this inter-dependence, cities allow people and firms to learn from each other, fostering creativity.

Think about it this way: if you’re in a city big enough, you can specialise in a narrow but effective set of skills and find a firm interested in hiring those skills. After work, social interaction at cafes or restaurants allows you to learn from others. If you change your job (which is easier in a big city), you take your skills to your new employer, enabling firms to learn from each other.

On a national scale, Pakistan can transform its economic structure by moving people from agriculture, which is generally less productive as it requires more people to produce relatively little output, to manufacturing and services, which are primarily undertaken in cities. But simply moving people to cities is not a condition that unlocks prosperity; people could still move to cities and find themselves in unstable, informal jobs, unable to benefit from density. Some katchi abadis in Karachi have housed people for generations, but they remain poor. Nationally, one in eight urban residents lives in poverty.

This is where effective public policy comes in. To benefit from urbanisation, policy needs to expand the good things about urbanisation such as density and connectivity; and reduce the downsides of urbanisation: crime, pollution, and congestion. New York’s Mayor La Guardia understood this. Backed by federal assistance, his administration oversaw the rapid construction of bridges, highways, parks, and houses, transforming the city’s physical infrastructure.

We’re several steps behind 1930s New York; instead, Pakistan needs to first focus on building three first-order conditions:

First, build local urban governments which are accountable downwards to the people, not upwards towards provincial or federal governments. Pakistan’s record on this is abysmal: when such governments have existed, their purpose has not been to decentralise control. Take Karachi where the reverse has happened; more power has been taken away from the local government and fragmented between various provincial agencies, making accountability impossible.

Punjab doesn’t do much better. In Lahore, provincial agencies provide vital services like water and sanitation. The 2019 local government law might change this but it’s anybody’s guess when elections will be held and how much the law will be implemented by the provincial government, which stands to lose power. There is the possibility of a repeat of what we’re seeing in Islamabad, where the elected Metropolitan Corporation has been in a tug of war with the unelected Capital Development Authority over the control of the city — a battle which now has now gone to the courts.

Ideally, urban areas need to have a single elected urban government with clear authority to provide services like housing, water and sanitation, and local transport.

Second, to pay for our urban transition, we need a robust urban finance base. This can be done by allowing local governments to raise taxes, mainly from land and property (as land cannot be moved between cities). Over time, if these taxes can be tied to visible service delivery, accountability will improve.

Currently, Pakistan is using this revenue source ineffectively. Provinces have their immovable property tax acts but their application is far from effective. For starters, they are often based on outdated valuation measures or proxies. Such is the case in Punjab, where a rigid annual rental value is used to levy this tax. Only now, with help from the World Bank, is the Sindh government planning to revaluate properties.

This leads to the third point, improving urban land rights. Land is a critical feature of urbanisation: people need land to build houses, firms need to locate themselves where they can get customers, and the government can use appreciation of its value to finance public investments.

Ideally, land rights need to be transparent and secure, so everyone knows who owns what. Unfortunately, land in urban Pakistan is regularly exposed to competing claims. Think how many times you have heard of people investing in real estate only to land into uncertainty. In Karachi, as Arif Hasan has argued, land is used as a political tool. This is not what efficient land markets look like.

These are some fundamental policy directions. Our urban transition is already well under way and will occur regardless of what the government does or doesn’t do; official statistics claim that 36pc of Pakistanis live in ‘urban’ areas, but the World Bank puts this at around 55pc. Whether it is 36pc or 55pc, we’re ignoring the proactive public policy needed to manage this transition properly, the consequence of which will be felt for generations to come.

Published by Dawn.com on 26th Sep, 2019

It has been a few weeks since we — the collective we, that is — and the International Monetary Fund (IMF) entered into a staff-level agreement, paving the way for a multi-billion dollar bailout, marking the 22nd such occasion.

As it should, the deal has been followed by a vibrant public debate. Primetime news anchors, op-ed columnists and the twitterati have pondered upon the impact of the devalued rupee, higher interest rate, more taxes and lower government spending.

All of these questions are warranted and they should demand our time and attention. However, there are two substantially more critical questions we need to ask ourselves.

First, why do we keep getting into a dire-enough condition that we need an IMF bailout? And second, what can we do so that we’re not in such a position again?

I have already given my thoughts on the first question, which I hold is fundamentally due to the extractive nature of our country’s political institutions that incentivise politicians to grant patronage to firms rather than establish fair competition in the economy and create short time-horizons for politicians because of instability in maintaining a democratic political system.

I continue to believe that we need to redistribute political power more fairly in order to unlock transformative economic change.

That aside, in this article, I make my contribution to the second question and outline a few policy directions and reforms to increase domestic productivity, so that we don’t end up with the IMF again.

Before going forward, I will add a caveat: there is unlikely to be any single answer to such large policy questions; at best we have a variety of answers which we can experiment with, and learn from. That is what good policy-making entails.

At a familiar place

Let’s recap. We were largely in this position not so long ago, and not long before that. So, what did we do to get back into the same position again? The answer lies in our idea of growth. To illustrate, I will rewind to 2013.

We got an IMF loan which did what it was meant to do — averted a balance of payments crisis, stabilised the economy and allowed us to leverage the stability for more borrowed capital. This allowed us to pay for our imports.

We combined it with other loans, particularly domestic ones, so the government could spend more without substantially raising more taxes.

We used the increase in foreign reserves to overvalue the rupee, which essentially meant that we subsidised imports by making them cheaper. It also made our exports more expensive.

This helped boost the consumption of mainly imported goods, which drives up economic growth, measured as increasing gross domestic product (GDP).

In essence, people bought more stuff and the government got capital to spend on some large-ticket infrastructure projects, some on hiring more people and some on subsidies.

Everything looks good on paper unless you read it closely — but who really does that?

This created a bad set of incentives for firms as they would have found more profit in acquiring import licences rather than investing in capacity to export, or simply moving their investment towards non-tradable sectors.

For example, think about the growth in real estate that lured many textile firms to move investment away from expanding their manufacturing capacity and towards the property market.

But the problem with real estate is that you can’t export it.

This is in no way exclusive to the past five years or so, but a wider reality of our growth story that continues to be dominated by the non-tradable sector — the part of the economy that can neither substitute imports nor produce goods or services that can be exported: real estate, retail and construction.

In 1995, for example, we exported about $11.6 billion of goods and services — that’s about $95 for each Pakistani. By 2017, our exports jumped to just over $21 billion, or $108 for each Pakistani.

In contrast, Bangladesh pushed its per-capita exports from about $20 to about $164 during the same period.

We have been left behind; it is time to change that.

What can we do about it?

If we need to export more, substantially more, then how do we do it?

The answer lies, in my view, on increasing domestic productivity — that is, how much output our economy can produce given a set of inputs.

In other words, how much resources do you need — people, money and materials — to produce a good or provide a service?

For example, if a factory in Faisalabad were to produce a t-shirt and a factory in Dhaka is producing the same type of t-shirt — how much time and resources will each need to produce that product?

So far, our growth model has mainly focused on the accumulation of physical assets, such as building roads and factories, but not the broader investments needed to increase productivity.

No wonder it is estimated that only 11 per cent of our GDP growth between 1998 and 2008 was due to an increase in productivity. It is not that physical assets aren’t important for us — they are — but growth is more than just roads.

Even the agriculture sector has been unable to sustain an increase in productivity. Growth in the sector has been mainly driven by an increase in inputs rather than efficiency in using these inputs.

Domestic productivity is also intrinsically tied with trade. Economists have found evidence that increasing trade raises domestic productivity; when firms trade with foreign firms, the competition forces them to be more productive or die out. On the other hand, you need higher domestic productivity to make your products competitive globally.

So if we want to increase domestic productivity, how do we do it? Here are a few areas to think about.

First, we desperately need to invest in building the institutional structures conducive to an increase in domestic productivity.

Let’s start with the basics. The rule of law and secure property rights are essential to productive societies and are worthy of significant public investment.

It needs to be made certain that when you, or a firm, make an agreement, the law will make sure it is fulfilled. Or, when you buy a property, it is reasonably protected from theft and can be used by the owner effectively. For this, reforms are needed of our courts, laws and the police force.

Second, there needs to be significant public investment in human capital, an important element in increasing domestic productivity.

We currently fare poorly. The World Bank’s Human Capital Index, which tries to capture human capital a child born today is expected to gain by the time he or she turns 18, puts us below our regional and income-level average.

This means that, even compared to countries of similar income level, we are failing to invest in our people.

A large part of human capital is schooling, but much of it is beyond that and includes various other types of skills and attributes that allow people to achieve their potential.

This requires Pakistan to continue its investments in basic education while making sure that these years in school are translating into tangible learning outcomes for students.

This should be combined with an increase in the quality and quantity of post-secondary education through investing in both traditional undergraduate programmes and non-traditional programmes that allow people to gain skills faster.

Research and development spending adds on to this, making it an important part of the human capital stock of a country.

Greater human capital also allows people and firms to adapt to new technology, which in itself is an important part of boosting productivity.

Third, we need to re-evaluate the government’s protection of firms, and in some cases entire sectors.

Presently, we run the risk of creating a poor set of incentives for firms as they can rely on subsidies and other forms of state-granted protection to generate profits, rather than increase their productivity.

The sugar industry and automobile sector are the most clear examples of this ‘protection’, but it is not limited to them. Several other firms and sectors also receive special tax breaks (through statutory regulatory orders) or frequent ‘packages’ from the government.

These protections can lead to misallocation of labour and capital. In other words, we are keeping people (and money) in sectors that aren’t productive enough. This misallocation makes all of us worse off by reducing our combined productivity.

Ideally, these poor performing firms should either improve their performance, or die out and allow people and capital to move towards better performing firms.

If our goal with these subsidies is to help the poor, it is hardly the way to do it. Instead, this revenue could be redirected towards targeted social welfare programmes that don’t lead to misallocation in the market.

This is not to say that we shouldn’t have a policy to protect specific industries, but such policies need to be designed carefully and not allow patronage relationships to develop.

Fourth, we need to make an integrated and coherent move to invest in cities. By creating vibrant cities that bring people and firms together in dense environments, we can unlock significant productivity gains.

Some of these gains will be due to more people moving away from agriculture and into manufacturing and services, which are more productive activities and are primarily undertaken in cities.

The rest will be due to gains from density. This is done by bringing people and firms close to each other; cities allow for sharing of ideas and unlock the ability of people and firms to specialise. Both lead to higher productivity.

However, these gains are going to be untapped if we don’t actively invest in building the institutions and infrastructure cities need not only for the population already living there, but also the people who can move from rural areas.

This requires independent and empowered urban governments who can provide public services and undertake context-specific policy decisions, particularly those that can help build a stock of knowledge through schooling, research and attracting skilled people, and housing them in high-density settlements.

Even though we currently lack many elements of vibrant cities, they are still more productive than rural areas. One measure of this is that our cities, while home to 38pc of our population, count for about 55pc of our GDP.

An added advantage of vibrant and empowered cities is that they are best placed to enforce property taxes. These taxes can be used to discourage speculative investment in this non-tradable sector, which has accumulated significant capital over the past few years.

Looking forward

Should we ignore these underlying reforms, we are destined to continue to be stuck in this vicious cycle which is pushing us from one IMF loan to another.

For this, our policy needs to move away from merely fire fighting. At the risk of oversimplifying, think about this:

If our house bursts into flames every few years, we certainly need to put the fire out, but we also need to ask ourselves what keeps causing this fire and make the necessary changes to prevent it.

Illustration by Rajaa Moini

This was published under a different tittle by Dawn.com 21st Aug 2019 here.

There is no path to prosperity which does not pass through cities. Absolutely none. Every country which we today call an advanced economy — like Britain, the United States or Japan — has urbanised as part of their path towards economic prosperity.

This usually meant that these countries experienced rapid economic growth mainly driven by higher productivity unlocked by industrialisation, and during that, more and more of their citizens moved to cities. So for a long time, economists thought that urbanisation happened alongside rising per capita income.

And perhaps that trend made managing these cities more feasible, because growth meant governments had more ability to raise revenue and invest that revenue in infrastructure which cities desperately need to run effectively. London was able to invest in an underground rail system; New York built an elaborate system to deliver water to its residents “that goes as deep as the Chrysler Building is high”, as David Grann once put it.

But increasingly, urbanisation no longer guarantees prosperity in itself. This is due to the trend experienced by many postcolonial countries, where urban populations have grown — and continue to do so — without being accompanied by the rise in per capita income. Urbanisation without significant growth, you might say.

This means that more and more people are living in cities but, increasingly, cities don’t have the resources to build the institutions and infrastructure people need to benefit from urbanisation — turning urbanisation, a potential, into a challenge.

Pakistan is a case in point. Our cities are growing, but we have consistently failed to allow them to govern themselves properly. And here lies the tragedy. If we can govern our cities effectively, they can unlock the kind of prosperity we have never experienced.

The opposing forces in which cities exist

Cities are subject to two kinds of opposing forces. Understanding these can allow us to comprehend the challenge of governing cities better.

The first is a good force, which makes cities worth living in. They’re mainly driven by what economists call the benefits of agglomeration economies. The term makes it sound more complicated than it is: it merely refers to the benefits of people and firms being close to each other.

Think about them in this way: when people are located close to each other, it allows the unlocking of two interconnected forces.

The first is the ability to specialise, allowing people to build their careers on a narrow set of skills thanks to the size of the city. You can be a lawyer focusing simply on mergers of firms and, because you live in a city large enough, you can work in a firm which demands that skill.

At mass, specialisation allows people to have better matching of skills with firms, with people able to invest in narrower — but more effective — skills which can reap considerable returns.

The second is knowledge spillovers, something which comes out of scale and specialisation. When people are close to each other, it allows them to share ideas and information. In cities, people move from one firm to another, taking their skills with them and sharing them with others. They meet at cafés and talk about new ideas and might even start new firms.

Silicon Valley is a good example of this. If there is one industry you would expect to work without clustering its employees in a single office, surely it is one which works on producing technology.

But technology firms still cluster a large number of their employees in Silicon Valley, and many people who want to work in the technology sector want to move there. This is because firms benefit from having a large workforce with specialised accumulated knowledge, and people benefit from being able to leverage their skills for jobs they want and learn new skills from other people.

Clearly, they benefit from being close to each other.

But there is also a bad force, which makes cities less than great. If people are close enough to give you a new idea, they are close enough to make you sick, stab you or just come in your way and make your life unbearable. (Edward Glaeser wrote something to this effect in the Triumph of the City).

This is mostly due to two reasons. First, congestion. When cities don’t have the infrastructure necessary to connect a large number of people, congestion occurs. Cars are stuck in traffic and people are unable to move smoothly due to lack of public transport. This disconnects people from each other and undermines those good forces.

Second, affordability. Cities are usually more expensive than the countryside everywhere. This is because, in the best of cities, people have higher incomes which drive up the cost of housing, food and other goods and services.

But in developing countries like Pakistan, the problem is made worse by lack of infrastructure which forces people to spend more on moving around, for traders to bring in food and for people to pay for housing, which there is often a deficit of.

Pakistan’s urban landscape

With this largely theoretical background, let’s come to Pakistan. Here, I want to make a few points which embody much of our urbanisation experience, although this is hardly exhaustive.

Let’s start by recognising that we’re an urban country. Let’s not kid ourselves anymore. Official statistics claim that about 36 per cent of Pakistanis live in urban areas, but the World Bank estimates that a majority — about 55pc — of the population lives in areas with urban characteristics.

This is in part because we need to understand that, when we say cities, we really mean metropolitan areas.

These metropolitan areas are part of the larger trend of our urbanisation which is incredibly low-density. Our cities don’t resemble the high-density ones in the advanced countries. Instead, people live in sprawling metropolitan areas which are costly for people to move around in.

This, as the World Bank rightly says, makes our urbanisation hidden: people are increasing living in peripheries of major cities. Some of these metropolitan areas are joining together, forming mega-metros. This is the case in Punjab, where there is a continuous belt of people living in a large swath of area connecting Lahore, Sahiwal, Faisalabad and Gujrat into a single mega-metro.

This also feeds into unequal delivery of services. People who live in the core of the city or wealthy suburbs might benefit from better provision of services like policing and transport networks — and those who live in peripheries don’t.

Despite this, our cities are already incredibly important to our economy. They generate about 78pc of the national GDP and 10 of our largest cities produce 95pc of federal government revenue (Karachi alone accounts for the majority of this). They’re already the engines of our economy.

The law and the Institutional architecture for effective cities

So, what do we do to unlock this urban potential? We need an overall institutional architecture which embodies three principles.

First, the institutional architecture needs to allow for the independence of urban governments. Cities are complex and higher complexity makes it harder to undertake policy decisions away from the context of the city. Because of this, we should benefit from an independent layer of government at the city-level.

While there will always be some coordination and interdependence required by each layer of government, by independence I mean where accountability runs downwards to the residents of the city, not upwards towards provincial or federal governments.

We have often done the opposite. Motivated by the desire to undermine the national political elite, Musharraf introduced this layer, but it was marred with various problems.

For one, it excluded political parties, which allow easier collective action and without which the costs of cooperation — theoretically — rise. As Jean-Paul Faguet and Mahvish Shami put it: “it is notable that local government died a quiet death in Pakistan, in full view, lamented by no one.”

Politicians who have followed Musharraf didn’t want to decentralise power, or if they did, they did an excellent job at hiding the fact.

But Punjab might have made a departure from this trend by adopting a Musharraf-like model in the Punjab Local Government Bill 2019, with some significant changes. Punjab has established nine metropolitan corporations in the province for almost all major cities. (I’m specifically restricting the analyses to metropolitan corporations here.)

The new law, if implemented, would pave the way for a directly-elected head of metropolitan corporations, supported by a cabinet and checked by a locally-elected council. The council members would be elected through proportional representation lists which, unlike the Musharraf system, empower political parties at an unprecedented scale.

But true independence of this layer is going to depend on various factors, including the degree of interventions made by the provincial government into the areas which have been decentralised to these corporations, especially as the law provides the provincial government enough wiggle room to interfere into local affairs.

For example, the provincial government can give policy directions and fix objectives for the areas decentralised to the local government. This could be used to undermine the urban government’s independence.

Another source which could possibly undermine this independence is the role of chief officer, a bureaucrat who will be appointed by the provincial government and has been assigned significant administrative powers in the local government under this law.

Second, we need an institutional architecture which empowers urban governments by providing sufficient control over key local policies and the ability to raise sufficient local revenue.

Generally, policies over local transport, waste management, land use and housing need to be decentralised to cities. Punjab’s new law does decentralise power over these areas to the metropolitan governments (with the exception of housing).

But how effective this empowerment is in practice will come down to the province’s willingness to radically restructure the bureaucratic apparatus it has built over the decades. This is correctly pointed out by Umair Javed as a litmus test for the success of this law.

Another dimension to this is money. Control means little if the urban government isn’t able to pay for it.

Some of the revenue will come through the provincial or federal governments and these fiscal transfers need to be stable over time. The new law, for example, provides this stability by setting a floor of minimum transfers (about 26pc of the province’s general revenue receipts, to begin with) and mandates a formula to be set up by a finance commission to divide this pool for every four years.

However, a significant proportion of the revenue can be raised by the cities themselves. This is mainly through what urban economists call land-value capture.

As the work done by the International Growth Centre’s Cities that Work initiative shows, when cities grow, the value of land and properties often increases significantly. This provides an opportunity for urban governments to capture some of this value — for example, through taxes — and invest it in the infrastructure they need.

Punjab’s new law provides, in my view, ample mandate over raising revenue locally, including the tax on urban immovable property.

It goes further and stipulates that the province consider the financial capacity of the local government while making the transfer. It is unclear as to how this is will be translated into exact policy, which will depend on the specific formula adopted. But if the province is able to incentivise cities to invest in their independent financial capacity, it would go quite far to empower urban governments in Punjab.

Third, we need institutional architecture that makes cooperation between various urban governments conducive. This goes to my earlier point of urban populations expanding beyond jurisdictions of a single overreaching local government.

Decentralising power often requires cities to coordinate policies among various their neighbouring governments or with lower-tier bodies, such as neighbourhood councils — like joint provision of transport services for allowing people to move around the metropolitan area, but only the legal jurisdictions.

Punjab’s new law makes extraordinary provisions for this. An entire chapter is dedicated to cooperation between local governments (Chapter VII to be particular) which allows joint authorities to be set up for the provision of one or more of such public services.

Going forward

On all these three fronts, Punjab’s new law does a decent job in establishing an institutional framework for better cities.

But there are various factors which will determine if cities can leverage this framework, particularly whether there is enough political commitment to maintain this framework and power is distributed accordingly by the provincial political and bureaucratic apparatus.

We need to keep our eye on the ball. Cities which are operated by independent and empowered local governments, who can cooperate with each other, can provide context-specific, pragmatic policy solutions.

Going forward, the metropolitan corporations will need to build local capacity and institutions which make them genuinely responsive to the jurisdictions they govern.

The story is now as Pakistani as it gets. We go to the IMF, get a few billion dollars, we use it to finance an import-led growth bubble which increases domestic consumption. It’s all good so far.

We say goodbye to the IMF. Consumption allows us to proclaim that we’re growing. The GDP is growing, after all. We make some speeches. We also take loans from the Chinese. We don’t tell you on what terms, though, we promise they love us (sweeter than honey, we proclaim).

People buy more stuff, the government spends some on infrastructure, others to hire more people, some on subsidies for those good-old industrialists. Our currency is overvalued because we have made the value of rupee somehow part of our pride.

All is jolly good. Then we import more to consume, but something is going wrong. We aren’t exporting enough. Why? We wonder. But who really cares. Oh, we do now, because we need to pay some of the loans we took back.

We also need to pay for all this imported stuff to keep this consumption-driven bubble going. Oh God, we’re running out of dollars. Maybe, we borrow some more, but for how long? Turns out not long enough.

Let’s try to crowdsource it from the diaspora. Jeez, patriotism goes out of the window when we ask them for dollars. Let’s try to ask the Saudis, oh, that is not enough. The Malaysians, maybe? They aren’t rich enough.

The growth bubble has burst. What do we do now? Devalue the rupee. Screw pride. Oh, that isn’t working. Why aren’t other countries buying our goods? Foreign conspiracy, maybe.

Let’s just print money. Damn, why are things becoming so expensive? Oh, that is why countries don’t print money. Wait. Can’t we pay for our imports or loans with rupees? We forgot we need dollars.

Who has dollars? Let’s call the IMF; hey can you bail us out? We promise this time will be different.

(this is a simplified version of real events which took place between 2013 and 2019 in Pakistan; I tweeted is here)

Published by the International Growth Centre (IGC) on the 3rd Dec 2018.

Pakistan tax-to-GDP ratio is about 12% . In comparison, OECD countries raise taxes equivalent to about 34% of their GDP. This limits Pakistan’s capacity to fund public investment. Where it does collect taxes, it principally relies on indirect taxes on goods and services, which account for 6.3% of GDP. The other 4.2% of the GDP that make up direct taxes are collected mainly by businesses withholding a percentage of economic transactions for the government. Hence, they do not require voluntary tax compliance from individuals, which, as a result, remains extremely low.

Start with improving enforcement

There is a relatively strong consensus that effective enforcement can lead to more tax revenue. Weak enforcement ranges from a property tax collector taking a bribe to not enforcing the tax, or a just a simple lack of capacity of the tax authority.

Improving enforcement may also result in more productive firms in Pakistan. Ilzetzki and Lagakos (2017) created a model of Pakistan’s economy to understand the impact that increased enforcement could have. They find that increasing enforcement will not only allow Pakistan to raise more tax revenue from firms in the short-run, but it would also result in higher growth by bringing these firms into the formal sector. By formalising, they would be able to make productivity enhancing investments and as a result be able to grow.

Enhancing enforcement requires Pakistan to do two things. First, hire better trained staff who have access to the right technology and resources. Piracha and Moore (2015), using a case study of Punjab, Pakistan’s largest province, find that each property tax circle needs to collect on average about $350 a month themselves to cover operational costs of their offices.

Furthermore, Pakistan will also have to focus on aligning the incentives of the bureaucrats associated with tax collection, with the incentives of the government. This is the classic principal-agent problem: politicians delegate tax collection power to bureaucrats, but cannot monitor them perfectly. At the same time, the front-line bureaucrat will most likely have better information. Due to this information asymmetry, tax collectors need to be effectively incentivised to fully and fairly enforce taxes. To this end, Khan et al. (2016) collaborated with the Punjab government to run an experimental study by assigning different incentive

schemes to property tax collectors. They found that over two years of the study, performance incentives encouraged tax collectors to add new properties to the tax collection roster, significantly increasing revenue.

Information is the key

Most developing economies have large proportion of their economies based on informal, cash-driven transactions, which means they are not captured by the tax base. There are a few ways Pakistan can attempt to create better information. Evidence suggests that implementation of a value added tax (VAT) helps raise more revenue by generating a paper trail between firms through cross-reporting of liabilities. This is evident in the paper by Pomeranz (2015) in the case of Chile.

Building on this line of thought, Pakistan’s VAT structure has certain challenges. First, intuition suggests that VAT should be applied uniformly by a single agency. In Pakistan, it is however split between federal and provincial governments, creating administrative and coordination challenges.

Second, by providing extensive exemptions in the VAT, Pakistan distorts the information trail; VAT is levied at 17% on the majority of goods, however, several goods have a either a lower rate or are exempt. One example is the exemption of red chillies but not green chillies.

Empower cities to tax

Similar to other countries, Pakistan’s cities are its principal engines of growth. Due to rapid urbanisation about 38% of Pakistanis are estimated to live in cities, yet they contribute to about 55% of the GDP.

These cities both require extensive public investment, and are sources of revenue potential.

Presently, Pakistan does not have financially empowered local urban governments, instead, most urban taxes are implemented by one of Pakistan’s four provincial governments. These provincial governments have large jurisdictions, with populations ranging from 12 million to over 110 million. As managing cities is not the central function of these governments, most of them have not developed effective urban administration mechanisms.

As noted through the synthesis of research conducted by the IGC’s Cities that Work initiative, land and physical properties are a major source of untapped revenue for most developing country cities. Punjab, for example, despite being home to nine cities home to over a million people, collected only Rs. 10 billion, or about 6% of its total tax revenue, from property taxes. Other parts of Pakistan have not fared better. Sindh, which is home to Karachi, Pakistan’s largest city, has not had a revaluation of land and property since 2001.

Yet there is large potential to increase this. For example, an estimate from the IGC (2011) shows that Punjab could more than double revenue from property taxes if it undertook comprehensive administrative reforms.

There is some hope here. Reforms passed earlier this year granted government the power to forcibly acquire any property that a citizen holds by paying 100% over the price they have declared in their tax returns (hence creating incentive for them to declare the true value of property). However, it is unclear whether these reforms will be implemented in practise.

Increasing taxation is possibly the most fundamental challenge Pakistan faces today, not only to adequately finance public investment and services, but also to establish a fairer society. To do so, it is useful to bridge the gap between research and policymaking by integrating research findings into policy decisions. This article points towards three avenues which can act as a point of departure for such a discourse.

 Originally published in Dawn.com on October 16, 2018 here (where it was the third most read article of the day, to my surprise). It was subsequently cross-posted at Scroll.in here. Header image by Dawn.com.

Pakistan’s formula for economic growth is as flawed as it gets: borrow foreign currency-denominated loans, build some large-scale infrastructure, get a minor growth spurt in the process, and wait until this growth spurt fades so we can repeat the process again.

This is what the previous government did. And, the one before that. It could have worked if, while borrowing to build infrastructure, it did not ignore the underlying constraints to growth and productivity.

Because they did not do that, Pakistan has ended up with an increasing level of debt, a balance of payment crises, and a government struggling to keep the growth spurt going.

When these challenges become dire — Pakistan often ends up getting a loan by the International Monetary Fund (IMF).

This time, if we’re successful in persuading them which looks to be the case, will be the 22nd occasion we will be loaned capital by the fund since 1958.

And, if our public discourse and policies remain the same, we will without doubt keep knocking at IMF’s door every few years (or some other lender for that matter).

The logical argument made by analysts in Pakistan here is that the government needs to bring meaningful reforms to our economy.

So, in due course, we are in a fiscally sound enough condition that we not require bailouts like the ones we get from the IMF.

This is a perfectly accurate demand. But, it often masks the politicalcauses to our economic despair.

The problem with talking about the economy divorced from politics is that we end up with superficial reforms.

This is because any meaningful reforms are impossible if the political structure does not allow them.

For this to change, our public discourse needs to take a holistic overview of our institutions. This is a contribution to that end.

Digging deeper

Let me explain. Take the much talked about balance of payment crisis as an example.

The most direct culprits are lack of exports and the increasing cost of imports. Pakistan imports nearly twice as many products and services than it exports.

In turn, there are many causes for low exports, some are macroeconomic determinants. The unsound infatuation of the previous government with an appreciated rupee is an example of this.

Dig deeper, we are exposed to the fact that Pakistan has developed little comparative advantage over the years. Which means that we mostly export basic textiles, cotton and rice and other related products.

Most of them are low-value items in the global value chain, so we earn little revenue from exporting them, and are hence unable to cover our import bill.

Dig further, we find that even in products which we do export, we face structural problems  —  such as lack of capital, whether it is human or financial.

Hence, exporters struggle to grow, move up the value chain, compete with foreign firms, and boost productivity.

But, why is this? Why does Pakistan fail to provide an environment which is conducive to developing globally competitive enterprises?

There are many explanations here — but one persuasive thought is that our institutions do not create the set of incentives needed for the growth of a competitive market.

Instead, they encourage a reliance on state patronage even if it comes at the cost of the larger industrial growth.

Pakistan’s public discourse has been rather good at ignoring these underlying causes. The result of this has been that, whenever Pakistan has found itself in such crises, it has been able to get loans to sail, or crawl, through the crisis.

But, all those reasons why this crisis emerged in the first place will remain — waiting to fuel another crisis down the road.

It is like putting the fire out but not fixing the leaking gas socket in the basement.

What are institutions?

A good place to start is understanding what institutions are, and how they influence our collective behaviour.

Simply put, institutions are the ‘rules of the game’ as Douglas North popularly put it in his 1990 book.

Think about cricket — we have certain rules under which everyone plays the game. There has to be a fixed number of players, they have a number of balls to play with, and everyone has a consensus on how we determine which team wins.

Now, apply the intuition behind this analogy to the broader institutions which shape our daily life.

Like the rules which govern the game of cricket, we have humanly devised rules which govern our lives in a more consequential manner.

They can be formal which are written down, such as the laws of the land often codified in the constitution, or informal ones widely accepted by the population, such as kinship bonds.

These institutions are important because without them, society as we know it would collapse. But, these institutions differ from country to country, and a persuasive strand of economic literature argues that they are the key to understanding our development outcomes.

We can also split them between economic and political institutions. The former directly shape our economic incentives, such as ownership rights of property, and the latter determine the political structure, such as whether we’re a parliamentary democracy or not.

As a society, we decide which economic and political institutions to adopt, and these institutions shape much of our behaviour through shaping our incentives.

Incentives, any economist can tell you, are fundamental to understanding any society’s prosperity or lack thereof.

It’s not economics, stupid. It’s politics

The political institutions, I’d argue, are more important in determining our prosperity. As Acemoglu and Robinson argue, those who control the political power determine economic institutions.

So, if political power (which in turn determines the political institutions) is controlled by a small, extractive elite, they will set up economic institutions which benefit them, not the majority.

If the elite benefit from an economy underpinned by clientelism and patronage rather than a well-functioning competitive economy, they will choose the former.

It is important to remember that there is plenty of profit in poverty. It just happens to be controlled by few.

Now, look at Pakistan. Our political economy is defined by an embedded culture of rent-seeking and patronage.

This means we have a system which grants profits to certain players in our economy unfairly, hence undermining the central principle of efficient market allocation — fair competition — and creating a wrong set of incentives for businesses.

Our manufacturing sector is rife with examples of rent-seeking practices. For example, Pakistan’s automobile sector is dominated by a handful of Japanese manufacturers known for selling low-value cars while making a considerable profit.

Despite this, Pakistan provides them with extensive trade barriers to protect them from foreign competition. The recent finance bill (since amended) further shows the extent of their political patronage.

This is not by accident. Because Pakistan’s political power is controlled by an extractive elite, it has allowed for such political institutions to emerge which permit its government to provide these rents to certain car manufactures with immunity, even if this negatively impacts our shared prosperity.

Direct evidence of our political structure influencing economic outcomes comes from a paper by Asim Ijaz Khwaja and Atif Mian.

They show that politically connected firms in Pakistan receive loans from government banks in Pakistan at lower rates despite defaulting more than non-politically connected firms.

This is evidence of unaccountable political power translating into inefficient economic allocation.

Look at this from another angle. A large amount of economic history literature argues that one of the many reasons why some East Asian countries prospered in the second half of the 20th century was because of land reforms.

By undertaking substantial land reforms, these countries were not only to increase agricultural output but also raise living standards for their surplus labour, which, in the long run, subsidised their move towards industrialisation.

If land reforms are important for growth, would Pakistan ever adopt them in any meaningful way?

Despite attempts to do so, Pakistan has not gone through significant land reforms and over 10 million acres of land still remains under tenancy, while one estimate puts the average farm size in Pakistan at about six acres.

In South Korea, despite a significant increase in average farm size over the recent past, it still averages at about 3.5 acres (as of 2005).

Without making a deep dive into the history or merits of land reforms, if we agree for the sake of argument that more radical land reforms are needed in Pakistan — can we undertake such reforms when political power and institutions are so highly influenced by those who control large farm holdings?

In other words, if feudal lords control the political institutions, it shouldn’t be a surprise that economic outcomes will favour them.

To fix the economy, focus on the political discourse

What may seem to a passerby as a country which continues to choose poorly thought-out economic policies, sees rampant corruption and a failure to establish a productive industrial base, are in fact symptoms of the political institutional structure which benefits a narrow extractive governing elite at the cost of everyone else.

Our economic failure is a symptom of our collective political choices. Once we can allocate political power more fairly, we can make better economic outcomes.

Tweaking institutions at the margins does have some impact. Hence, the IMF’s stabilisation programme will provide some macroeconomic stability.

The stock market might recover, the fiscal deficit might get narrower. Taxes might increase a bit, so will inflation.

And, in due course, we will issue a statement saying goodbye to the IMF for few years. Before repeating the process again and again.

But, if the new government wants to break this cycle and make a sincere attempt at reforming Pakistan into some sort of an egalitarian, prosperous nation, it needs to start by looking at political power and the political institutions which rise from them, as they are the real constraints to our growth.

Even if it can make marginal changes on the economic front, they would not unlock the kind of transformative shift we need for widespread prosperity.

I just completed Joe Studwell’s new book “How Asia Works: Success and Failure in the World’s Most Dynamic Region.” Here are some thoughts I tweeted about after reading it.

1) Size of farms matters! Studwell argues that having a small (3ish acre) family-owned farms boosts agriculture productivity (read: land reforms!). There are various loopholes countries (like Philippines/Indonesia did) can fall in while doing this.

2) This will create a surplus which can be used to set up an export-oriented manufacturing base. (exporting makes companies productive). This is pretty much in line with broader evidence: the state protects certain industries, but also punishes losers if they are not productive.

3) Meanwhile, these countries set up a financial sector which promoted these export-oriented industries. But, here is the important part: these Asian countries made sure that the financial sector’s incentives were to assist long-term dev. goals, not speculative short-term ones.

4) Throughout this journey promoting exports is important. Because this is the best way to push your industries to become more productive. In other words: competition=developing comparative advantage. Let your industries fight with each other, and more productive ones globally.

5) Now think about Pakistan. We didn’t go through the kind of land reforms these countries did, so we don’t have the egalitarian, productive base. We protect inefficient manufactures despite them to not being globally competitive. We even had an over-valued exchange rate.

6) Having an equalitarian land ownership structure is good for development trajectory – I didn’t know that it is good for productivity too! Despite economic intuition arguing otherwise: small farms are good. So, it might be wise to talk more about agrarian reforms in Pakistan.

7) Another thing for us to think about is that the state vs market paradigm is flawed – there is no such binary relationship in the real world! Gov.’s need to work to promote market efficiency not protect patronage industries (I’m looking at you the Pakistan’s car industry)

8) Lastly, this is a great book and you should read it (no technical stuff) But, at the end of the day some of this stuff will work for Pakistan, others will not. Every country has its own path – but there is some stuff I’m willing to bet will work, agrarian reforms is one of them.