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Capacity Taxation:The Pakistan Experiment

SIJBREN CNOSSEN*

IN DEVELOPING COUNTRIES, an excess of industrial capacity is a dis-turbing phenomenon. Whereas at one time capital formation was

believed to be the basis for economic development, recent attention hasfocused on the underutilization of existing capital stock.1 Thus, in Pakis-tan, where it is assumed that capital is critically scarce, the use ofindustrial capacity is reported to be much less than it is in the capital-rich United States—a paradox of no small significance.2 This findinghas initiated a review of the accepted beliefs concerning economicdevelopment policies.3 Higher capacity utilization rates should berecognized explicitly as an alternative to saving, it is argued, and poli-cies should be designed specifically to increase these rates as this". . . holds great promise for increasing the level and rate of growthof income in underdeveloped countries." 4

* Mr. Cnossen, a Senior Economist in the Fiscal Affairs Department, is agraduate of the Netherlands Academy of Taxation and Erasmus University, bothin Rotterdam. He was formerly an income tax inspector with the NetherlandsMinistry of Finance and is author of The Indonesian Sales Tax. In addition tothanking staff colleagues for their assistance, the author wishes to express hisappreciation to Gordon C. Winston, Williams College, for his comments on anearlier draft of this article.

1 Gordon C. Winston, "Capital Utilisation in Economic Development," Eco-nomic Journal, Vol. 81 (March 1971), pp. 36-60.

2 Gordon C. Winston, "Overinvoicing, Underutilization, and Distorted Indus-trial Growth," Pakistan Development Review (Winter 1970), p. 416.

3 For a review of the literature, see Derek T. Healey, "Development Policy :New Thinking About an Interpretation," Journal of Economic Literature, Vol. 10(September 1972), pp. 757-97, with a summary of capacity utilization data for13 developing countries (p. 785).

4 Winston, "Capital Utilisation in Economic Development" (cited in footnote 1),p. 58.

127

©International Monetary Fund. Not for Redistribution

128 INTERNATIONAL MONETARY FUND STAFF PAPERS

When capital formation was still the dominant theme in developmenteconomics, tax incentives such as accelerated depreciation, investmentallowances, rate reductions, and exemptions of income and producttaxes played a prominent role in furthering a government's indus-trialization objectives. While the literature on these investment incen-tives is impressive,5 little attention has been given to the possibility ofusing taxation to promote a fuller utilization of existing capital stock.

In the past, production incentives have been largely associated withagricultural taxes. For example, the incentive aspects of presumptiveagricultural income taxes based on standard land yields or on standardrates of return from the capital value of land have often beenstressed.0 A similar effect is ascribed to land taxes based on potentialoutput or on the value of land determined as a function of potentialoutput.7 However, as a rule the incentive effect is only an incidental(though welcome) by-product of presumptive assessment methods,which are probably introduced in most cases because it is difficult totax the agricultural sector on the basis of actual yields and values.

Early incentive schemes relating to industrial production weredesigned to correct market imperfections such as those caused by themonopolists who, being in a position to set the price of their prod-ucts, could earn excess profits by keeping their output below the sociallyoptimum level. The most notable is the tax-and-bounty scheme of

5 For a summary and discussion of tax incentive studies relating to developingcountries, see Jack Heller and Kenneth M. Kauffman, Tax Incentives for Industryin Less Developed Countries, Harvard Law School, International Program inTaxation (Cambridge, Massachusetts, 1963), and George E. Lent "Tax Incentivesfor Investment in Developing Countries," Staff Papers, Vol. 14 (July 1967),pp. 249-323. Depreciation allowances can also be employed to increase capacityutilization by permitting higher write-offs for multiple shifts. For references tothis practice, see Richard M. Bird, Taxation and Development: Lessons fromColombian Experience (Harvard University Press, 1970), p. 86; Richard Slitpr,"Reform of the Business Tax Structure: Analysis of Problems and AlternativeRemedial Proposals," in Fiscal Reform for Colombia, ed. by Richard A. Musgraveand Malcolm Gillis, Harvard Law School, International Tax Program (Cam-bridge, Massachusetts, 1971), pp. 484-85; and Lauchlin Currie, AcceleratingDevelopment: The Necessity and the Means (New York, 1965), p. 111.

6 For a useful description of these agricultural income taxes, see George E.Lent, "Taxation of Agricultural Income in Developing Countries," Bulletin forInternational Fiscal Documentation, Vol. 27 (August 1973), pp. 324-42. In thespecific case of Colombia, an interesting and carefully argued study concludes:"Overall, it seems probable that a presumptive income tax on land is a relatively'safe bet' policy in terms of the output and distribution goals and in terms ofthe low probability of its having negative results. . . ." (See R. Albert Berry,"Presumptive Income Tax on Agricultural Land: The Case of Colombia,"National Tax Journal, Vol. 25 (June 1972), p. 180).

7 Resolution of the Third Inter-American Conference on Taxation, Mexico City,September 3-8, 1972.


CAPACITY TAXATION: PAKISTAN 129

Joan Robinson, who suggests that monopolies should be induced toproduce a purely competitive output by granting them a subsidy equalto the marginal cost minus the marginal revenue corresponding to thatoutput. The excess profit (inclusive of the subsidy) would then befully recouped through a lump-sum tax that would leave the post-bountyequilibrium undisturbed. However, she notes that the proposal wouldbe impractical because of the indefiniteness and instability of demandcurves.8

A more detailed incentive tax for production has been worked outby Knorr and Baumöl.9 They suggest that the rate of economic growthshould be accelerated through a tax-and-rebate scheme involving theimposition of a flat rate penalty tax on each firm's value added, inconjunction with the allowance of a tax rebate (or subsidy) dependenton the rate of growth of the value added to goods that the firm actuallysells. A similar tax was experimented with in Canada in the early1960s, when an offset against taxable income was made available inthe form of a tax credit on the taxable income from the sale of goodsmarketed in excess of the "sales base" (defined as average net salesin the three preceding years).10 Recently, the use of tax incentives forproduction has been recommended for developing countries by VitoTanzi, who proposed a levy on potential value added, measured bydeducting actual inputs from the full capacity output (determinedthrough annual surveys) of manufacturing enterprises.11

s Joan Robinson, The Economics of Imperfect Competition (London, 1950),p. 163. See also A. C. Pigou, A Study in Public Finance (London, 1949), Chapter 8;Alfred Marshall, Principles of Economics (London, 1961), Book 5, Chapter 14;Hugh Dalton, Principles of Public Finance (London, 1954), p. 42; and NedShilling, Excise Taxation of Monopoly (Colombia University Press, 1969), pp. 44and 99-101. In an analysis of Mrs. Robinson's scheme, Higgins proposed as analternative "a tax on profits in excess of a fair return on utilized capacity,"which in his view would approximately attain the same objective and be easier toadminister than the tax-and-bounty scheme. As long as the rate of net (aftertax) profits rises with output, it would be advantageous "not only to utilize exist-ing plant and equipment more fully but to operate the part that is utilized asefficiently as possible." See Benjamin Higgins, "Fiscal Control of Monopoly," inReadings in the Economics of Taxation, Vol. 9, ed. by Richard A. Musgrave andCarl S. Shoup (Homewood, Illinois, 1959), pp. 312-21.

9 Klaus Knorr and William J. Baumol, eds., What Price Economic Growth?(Englewood Cliffs, New Jersey, 1961).

10 See Richard Bird, "A Tax Incentive for Sales: The Canadian Experience,"National Tax Journal, Vol. 18 (September 1965), pp. 277-85.

11 Vito Tanzi, "Theory of Tax Structure Development and the Design of TaxStructure Policy for Industrialization," paper presented at the Conference onFiscal Policy for Industrialization in Latin America, February 17-20, 1971, heldat the Center for Latin American Studies, University of Florida (unpublished),pp. 16-17.



With the exception of the brief Canadian experiment, these incen-tive taxes for production never left the drawing board—perhaps largelybecause of their administrative complexity and the uncertainty of theireffect. Another possible reason is that there is little need in developedcountries to induce the business community to do what is usually in itsown interest and within its reach. On the other hand, various constraintsmay inhibit the growth of industrial output in developing countries,even though the necessary capital stock is already in place. Faced withthis situation, the Government of Pakistan designed a tax to increasethe level of industrial production through better utilization of existingcapacity. It believed that firms taxed on the basis of their full capacityoutput instead of their actual production could be induced to use theirplant and equipment more fully. In view of what appears to be atstake, Pakistan's experience with "capacity taxation" deserves closerscrutiny.

This paper first outlines the conceptual characteristics of the capacitytax, its setting, and its historical development. It then describes andcomments on the technical features of the scheme. Next it analyzes thelikely economic effects of capacity taxation and offers some evidenceon the development of capacity utilization rates after the impositionof the tax. This is followed by reflections on the revenue implicationsof the tax. Finally, the paper summarizes the major findings and con-clusions to be drawn from Pakistan's experience.

I. Concept of the Capacity Tax

The capacity tax was first imposed by the Government of Pakistanin 1966 in lieu of the excise duties previously charged on certainproducts under a system of production controls requiring the presenceof tax personnel on factory premises. By taxing capacity output insteadof actual production, the Government believed that the decline in aver-age tax rates as production expanded would stimulate output. In addi-tion, administrative procedures would be simplified to benefit bothtaxpayers and collectors, because the capacity tax obviated the needfor production controls and excise personnel could be withdrawn fromfactories. At the same time a potential source of collusion and taxevasion would be eliminated, because continuous contact between taxofficials and taxpayers would be unnecessary.

Initially the capacity tax in Pakistan was applied to three industries—cement, soda ash, and sugar—which were chosen because each pro-



duced a commodity that was homogeneous, uniformly priced, andmanufactured from indigenous raw materials.12 It was believed thatthese criteria would facilitate the imposition of capacity tax. Moreimportantly, these industries were not subject to the vagaries of importconstraints and restrictions; hence, in principle, each firm would befree to plan its own volume of production. In 1968 two industries—vegetable products (ghee and oil) and cotton textiles—were added,although they did not satisfy all of) thesel requirements. Vegetableproduct manufacturers depend partly on soybean oil imports for theirproduction (the other raw material being cottonseed oil, produceddomestically), and the products of the textile industry may differ widelyin price and quality because of the wide range of fabric fineness oryarn counts. Since most of the problems experienced with the introduc-tion and implementation; of the capacity tax are attributed to thetextile industry, more attention is given in this paper to it than to therelatively simpler systems applicable to the other products.

Production capacities were computed by the Central Board of Rev-enue, mainly from past and comparative physical production data aswell as machine ratings, and these were published in The Gazette ofPakistan. Local tax officials ascertained the tax liability by applyingthe tax rate, expressed as a specific amount per unit of production, tocapacity outputs. The annual capacity tax assessment was payable in12 monthly installments upon presentation of a demand notice;13

default carried a penalty of 1 per cent a month. The annual produc-tion capacity, and hence the tax liability, could be reduced by regionalallowances and adjusted with the installation of additional machineryor removal of old equipment. Abatements were granted if productionhad to be halted for reasons beyond a manufacturer's control or if wide-spread industrial setbacks occurred, and a refund scheme was in effectfor exports. A Review Board was set up to examine taxpayers' griev-ances about notified capacities.14

The basic workings of the capacity tax are illustrated in Table 1 fora Karachi-based cotton fabric mill assumed to be operating with 1,330looms for 897 shifts (each of 8 hours duration) annually.

12 Ministry of Finance, The Budget Speech for 1966/67, pp. 16-17. (Hereinafterreferred to as Budget Speech.)

13 Because of the seasonal pattern of production, sugar manufacturers weregiven the option of paying the total annual amount in eight equal installmentsbeginning in November of each year.

14 "Act No. XI of 1966," Gazette of Pakistan, June 30, 1966, pp. 545-46.



TABLE 1. PAKISTAN: SAMPLE COMPUTATION OF CAPACITY TAX LIABILITY, 1969/70

Annual ProductionCapacity

Kind of Fabric

CoarseMediumFineSuperfine

Total tax liability

Monthly installment

Tax payment per shift(abatement)

(square yards) 1

8,565,63515,228,7209,412,1428,699,745

(per loom)2

6,44011,4507,0776,541

CapacityTax Rate3

square yard)

10204070

CapacityTax

Liability4

(rupees)

770,9072,741,1693,388,3715,480,839

12,381,286

1,031,773

13,8021 S.R.O. No. 61(R)/68, Gazette of Pakistan, April 22, 1968, p. 198.2 Capacity adjustment if loom is installed or removed.3 S.R.O. 120(1) /69, Gazette of Pakistan, June 28, 1969, p. 526.4 After reduction of capacities with the regional allowance for West Pakistan of 10

per cent; see S.R.O. No. 61(R)/68, rule 3(5), op. cit.

The capacity tax forms an integral part of Pakistan's extended systemof excises that are levied under a tariff schedule consisting of 54 sepa-rately identifiable commodities and one service activity.15 The schedulecomprises sumptuary commodities, benefit-based levies, commoditiesprimarily justified to be taxed on revenue grounds, luxury items, and afairly wide range of raw materials and intermediate goods. Most rates,including those on commodities subject to capacity tax, are specific.Excise taxes are an important source of revenue in Pakistan, contrib-uting 40 per cent to total Central and Provincial Governments' taxreceipts, or 3.3 per cent of gross domestic product, in the fiscal year1970/71 (Table 2). The products subject to capacity tax form a sub-stantial part (9 per cent) of total tax receipts. Apart from the large taxbase (cotton textiles being by far Pakistan's most important industry),this high percentage can be explained by the high tax rates, as theopportunity was taken to merge existing duties into a single capacity

15 Pakistan has excellent budget documents with details of the tax system. TheMinistry of Finance issues the Budget Speech, The Budget in Brief, and TheExplanatory Memorandum on the Budget annually. For an analysis of indirecttaxes, including excises, for the period 1954/55-1962/63, see Stephen R. Lewis,Jr., and Sarfraz Khan Qureshi, "The Structure of Revenue from Indirect Taxesin Pakistan," Pakistan Development Review, Vol. 4 (Autumn 1964), pp. 491-526,and Ghulam Mohammed Radhu, "The Rate Structure of Indirect Taxes in Paki-stan," ibid., pp. 527-51.

(paisa per



TABLE 2. PAKISTAN: CENTRAL AND PROVINCIAL GOVERNMENTS' TAX RECEIPTS, 1970/711

(In millions of rupees)

Type of Tax

Income taxCorporation taxTaxes on property 2

Sales taxDomestic transactionsImports

Excise taxesCapacity tax

Cotton fabrics and yarnVegetable productsSugarCementSoda ash

Other 3

Stamp dutiesImport dutiesExport duties 4

Other taxes 5

Total tax receipts

Amount ofTax Receipts

794355191559189370

2,521579

(251)(123)(107)

(90)(8)

7,942165

1,243113373

6,314

Percentage ofTotal Receipts

12.65.63.08.93.05.9

39.99.2

(4.0)(2.0)(1 .7 )(1.4)(0.1)

30.72.6

19.71.85.9

100.0

Percentageof GDP

1.00.50.30.70.20.53.30.8

(0.3)(0.2)(0.2)(0.1)(— )2.50.21.60.10.58.2

Sources: Tax receipts: The Explanatory Memorandum on the Budget, 1972-73 andThe Budget in Brief, 1972-73. Gross domestic product: Central Statistical Office,Monthly Statistical Bulletin, Vol. 20 (January 1972).

1 The fiscal year is July I/June 30. The figures cover the whole of Pakistan, before theseparation of Bangladesh.

2 In decreasing order of revenue importance : land revenue, net wealth tax, estate duty,and gift tax.

3 Tobacco, benefit-based levies (gasoline, petroleum products, tires, tubes), revenuelevies (synthetic textiles, yarn, wool, kerosene, tea, salt, soap, matches), luxury goods(batteries, bulbs, tubes, electric and gas appliances, cosmetics, perfumery, shoe polish,creams, glass products, beverages, hotel and restaurant consumption), raw materials andintermediate products (natural gas, paints, varnishes, plastics, steel products, jutemanufactures, paper, tanned leather).

4 On cotton yarn.5 Motor vehicle taxes, entertainment duties, and other miscellaneous provincial levies.

tax rate when the new tax was introduced.16 The Government stressed,however, that additional taxation was not intended.17

16 Thus for four products—cement, sugar, vegetable products, and textiles—the capacity tax rate was made up of the old excise duty, the sales tax (a 20per cent levy at the manufacturing and importing stages), and two surchargeslevied for defense and the rehabilitation of refugees.

17 "Central Finance Minister Defends the Budget in the National Assembly" inBudgets of Pakistan, 1966-67 (prepared by the Economic Adviser, Ministry ofFinance), p. 71. It is worth mentioning that a reduction in revenue was alsonot envisaged. In this respect the capacity tax, like a presumptive income or landtax in the agricultural sector, differs from the usual tax incentive that sacrificesrevenue.



HISTORICAL DEVELOPMENT

The capacity tax was first mentioned in the Finance Minister's speechannouncing Pakistan's 1961/62 budget: ". . . to provide production in-centives to industry . . . power is also being taken for levying duty onthe basis of installed capacity. This alternative, which, wherever applied,will do away with the day-to-day excise control, will be adopted inrespect to such excisable commodities as are found suitable for thistreatment. We intend to adopt this system wherever possible and hopethat it will give a great fillip to production. As the amount of duty pay-able by a manufacturer will not be related to the actual production, themore he produces the lower would be the incidence of the duty." 1S

In the three years that followed, little attention was given to the tax,except as an administrative expedient for collecting excise duty fromsmall manufacturing units. Because the small industry exemption fortextiles had been used as a tax avoidance device by larger units thatsplit up operations, diverting their highly taxed production to smallerunits,19 the excise administration gradually withdrew the exemption andstarted taxing small units—not on the basis of their actual production(square yardage), which would be difficult to assess, but by referenceto the number of looms installed. Tax was levied in this manner onsmall cotton cloth manufacturing units with not more than 20 powerlooms.20 In 1963, the scheme was extended to small art-silk manufac-turers who would henceforth pay duty at a flat monthly rate on the basisof installed capacity. The Government stressed the measure's incentiveeffect on production, especially when there were three shifts.21

In 1964, the payment of excise duty per loom—considered to be asuccessful experiment because both revenue and production increased—was extended to art-silk units with up to 50 looms.22 More significantly,

18 Budget Speech for 1961-62, pp. 23-24.19 Reportedly, the incentive became so strong that in 1965 the exempt, small

industry sector comprised 13,000 looms as against 35,000 looms in the mill sector(Budget Speech, 1965-66, p. 26). For similar avoidance techniques in the sugarindustry, see Government of Pakistan, Taxation Enquiry Committee Report,Vol. 1 (1961), pp. 180-81.

20 Budget Speech for 1959-60, p. 19. However, units with not more than fourpower looms remained exempt from tax. A similar administrative expedient wasadopted in India in 1964 (Government of India, Budget Speech for 1964-65,part B, p. 4).

21 Budget Speech for 1963-64, p. 15.22 Budget Speech for 1964-65, p. 27. Another interesting production incentive,

similar to the Canadian experiment cited above, was proposed at budget time.It involved a rebate of the excise duty on tea for outputs above the highest levelof production attained during the preceding four years. For small tea gardenswith less than 500 acres under cultivation, the rebate would be 50 per cent andfor larger gardens, 25 per cent (ibid., p. 26).



it was proposed that for all cotton textiles standard rates combining theexcise duty and the sales tax should be worked out on a per-loom basisfor each factory in the light of past production records. Mills opting forthis alternative would pay the fixed rate throughout the year, irrespec-tive of changes in production. Similar arrangements would be made forthe vegetable ghee and cement industries, although these would pay thealternative rate per ton of productive capacity.23

The introduction of the capacity tax would be facilitated by the ex-perience gained with the self-clearance procedures, introduced in1962/63, that replaced the cumbersome production controls admin-istered by excise personnel stationed on factory premises. These pro-cedures permitted manufacturers at principal industrial centers to cleartheir own goods under the obligation to debit for the tax incurred an"account-current" that they maintained wih the excise administration.The credits to this account were advance payments determined by theadministration on the basis of such past production patterns as the out-put of various taxable categories of fabrics. Under the new procedures,excise staff was gradually withdrawn from factories, and the administra-tion relied on documentation such as accounts prescribed for rawmaterials and on surprise inspections to verify compliance with thelaw.24

However, the capacity tax proposal could not yet be implemented.The Government thought that a simple amendment of Section 3 of theCentral Excises and Salt Act of 1944 would be sufficient to impose thecapacity tax, but taxpayers argued successfully in court that the tax wasnot an excise duty but was levied in lieu thereof. Therefore, a constitu-tional amendment was required to levy the capacity tax, and it was notadopted until March 1966. The Government then made cement, sugar,and soda ash subject to capacity tax from the beginning of fiscal year1966/67. It described the tax as an ". . . incentive for increasing effi-ciency, maximising production, reducing tax evasion and lessening theburden of the tax collecting machinery both on the industry and Gov-ernment."25 Later it was also stated that the capacity tax would provideincentives for export, but arguments for this assertion were not given.26

23 Ibid., p. 27, and Budget Speech for 1965-66, pp. 27-28.24 Pakistan Ministry of Finance, Central Board of Revenue, Central Taxes in

Pakistan: A Decade of Development and Self Effort (Islamabad, 1968), p. 16.25 "A Talk by the Secretary, Ministry of Finance, Broadcast from Radio

Pakistan, Rawalpindi, on 12th June 1966," Pakistan Budgets 1966-67, p. 205.26 Ministry of Finance, The Budget, 1969-70, p. 33 (hereinafter referred to as

The Budget) and Ministry.of Finance, The Budget in Brief, 1972-73, p. 28(hereinafter referred to as The Budget in Brief).



Presumably it was thought that an exporting manufacturer selling partof his output domestically would be completely exempt from duty if hisexports equaled or exceeded his notified capacity. However, the tax dif-ferential vis-à-vis his competitor, with the same output and capacity butselling his whole production locally, would remain the same as underthe excise system.

Tax evasion was described in the budget speech as ". . . malpracticesand collusion between some of the manufacturers and the lower officialsof the Government departments."27 There is evidence, particularly inthe textile industry, that manufacturers sometimes used night shifts toproduce excisable commodities with high rates of taxation, but did notreport them because excise officers were not on the scene.28 The CentralBoard of Revenue is said to have estimated that revenue thus lost onsome products ranged from 10 to 25 per cent.29 Since capacity estimateswere in part determined by historical output data, it appears that theintroduction of the capacity tax would not necessarily prevent this typeof tax evasion; in fact, underreporting may thus have been institu-tionalized.

At the time of the 1966/67 budget, the Minister expressed the hopethat it would soon be possible to extend the capacity tax to cotton andart-silk fabrics. So far it had been impossible to devise a suitable for-mula, presumably because these products showed wide variations inform, price, and quality.30 A committee was appointed to examine thematter, but its recommendations could not be accepted in time for the1967/68 budget because of legal and technical difficulties. Instead, acentral committee under the Ministry of Industries was set up to for-mulate rules and to determine production capacities for the textile in-dustry. In this task it would be guided in the application to individualunits by certain broad principles that would take into account "the na-tional average annual production of each statutory category of fabricsor yarn on a per loom or per spindle basis, the average production ofthe unit itself, the production of a comparable unit, and . . . changes in

27 Budget Speech for 1966-67, p. 16. The collusion argument was also voicedby the Finance Secretary on June 13, 1964 (Pakistan Budgets, 1964-65, p. 211).See also A. Farouk, "Pakistan Budget for 1965-66," in Pakistan Budgets, 1965*66,p. 238.

28 Winston, "Capital Utilisation in Economic Development" (cited in foot-note 1), p. 60.

29 Gordon C. Winston, "Capacity Taxation," (unpublished, Pakistan Instituteof Development Economics, Karachi, November 1967), p. 2.

30 Budget Speech for 1966-67, p. 20.



production because of technological improvements, normal growth orother such factors." 31 After the committee reported its findings andrecommendations in early 1968,32 textile fabrics and yarn, as well asvegetable products, finally came under the capacity tax, bringing to fivethe number of industries to which this novel tax was being applied.

But the initial problems that had beset the capacity tax were not over.Almost all textile units filed with the Review Board applications fora review of notified capacities and subsequently went before the highcourts. In response, the Government appointed a review committee tostudy the effects of the tax on production, prices, exports, and revenue,with particular reference to the alleged inequitable and discriminatoryconsequences of the system.33 Following the committee's recommenda-tions, the Government provided taxpayers with more complete informa-tion on how capacity was determined, widened possibilities for appeal,and decided to review notified capacities at four-year or five-year inter-vals.34

However, objections and appellate procedures continued. Partly asa result of the stay orders granted by the courts, arrears of tax accumu-lated which would not have been possible under the traditional excisetax system because goods could only be cleared after payment of tax.The backlog in collections amounted to some 15 per cent of annualexcise tax collections at the end of 1970/71. These and other factorsled to a diminished role for the capacity tax in the following year. Bang-ladesh abolished the tax altogether. In West Pakistan, the cement unitsand one of the two soda ash units were transferred to the public sector,relegating to the background the role of the capacity tax in these indus-tries. The textile industry was given an opportunity to opt out of thecapacity tax if the plant had been installed prior to 1956, presumablyon the grounds that the obsolescence of machinery affected the feasibilityof operating at theoretical capacity. Twenty-nine units subsequentlyreverted to the traditional system of paying excise duty on actual pro-duction. Sugar mills were given a similar option, and 17 units outof a total of 19 in West Pakistan requested to be taxed on actual pro-duction. In the case of the vegetable product industry, involving 23units, capacity taxation was discontinued as of July 1, 1971.

31 Budget Speech for 1967-68, p. 15.32 Pakistan Ministry of Industries and Natural Resources, Report of the Textile

Industry Capacity Committee (unpublished, February 1968).33 Budget Speech for 1970-71, p. 16.34 Ibid., p. 17.



However, in 1972 interest in capacity taxation revived. In October ofthat year, with the simultaneous promulgation of new rules, the Govern-ment brought the whole sugar industry back under the capacity tax.35

Thus, the capacity tax became applied to four industries in West Paki-stan: cotton textiles (97 factories), sugar (19 mills), cement (9 fac-tories), and soda ash (2 factories).36

II. Technical Features of the Capacity Tax

Although it may be clear that "capacity" represents a rate of produc-tion that can be attained rationally (economically) in the short run,given a fixed plant and equipment, further specification is obviouslynecessary. Is capacity a maximum (physical) production concept, anoptimum (cost-related) frame of reference, or is it sufficient to usepreferred operating rates? 37 In practice, even more important than theconcept is the measurement of capacity. Generally, five differentapproaches have been adopted, separately or in combination: (1) aquestionnaire inquiry as to what firms themselves regard as capacityoutput, (2) peak forward extrapolations of historical output data, (3)peak capital-output ratios, (4) capital outlays themselves, or (5) engi-neering data,38 This section examines the way in which capacities are

35 Dawn, November 22, 1972 and Gazette of Pakistan, October 14, 1972.36 Central Statistical Office, Monthly Statistical Bulletin, Vol. 20 (July 1972).

(Hereinafter referred to as Monthly Statistical Bulletin)37 See Richard E. Gift, Estimating Economic Capacity: A Summary of Con-

ceptual Problems (University of Kentucky Press, 1968), pp. 30-31.38 Thus, in the United States, the McGraw-Hill Company, arguing that

". . . companies follow a commonsense definition of capacity, such as maximumoutput under normal work schedules," accepts the aggregated composite responseof what manufacturers themselves regard an appropriate level of output. TheWharton School Econometrics Unit, on the other hand, ascertains capacity fromthe peaks of seasonally adjusted, averaged quarterly production figures. Capacityfor any period is then the straight line from one peak to another. (For fore-casting purposes, the last straight line is extrapolated.) A third measure, usedby the Industrial Conference Board, involves the computation of constant dollarbook values of fixed capital which are in turn combined with deflated andinventory-adjusted output data into capital-output ratios. Peak ratios indicating"virtually full capacity" utilization are selected by inspection, and other outputrates are measured with reference to the peak capital-capacity output ratio.Fourth, it is sometimes assumed that capital outlays themselves reflect capacityutilization. Finally, engineering or historical data are used to establish productionfunctions—the relationship between the quantity of output and the quantitiesof various inputs, for example, machine ratings—that offer a basis for deter-mining physical production capacity. See Almarin Phillips, "An Appraisal ofMeasures of Capacity," American Economic Association, Papers and Proceedingsof the Seventy-fifth Annual Meeting, American Economic Review, Vol. 53(May 1963), pp. 275-92.



determined in Pakistan. In addition, the rules for duty abatements whenactual production falls short of target, the export rebate scheme, and afew other provisions are reviewed. Finally, the relative merits anddemerits of excise and capacity tax administration are compared.

MEASUREMENT OF CAPACITY

Basically, the Pakistan excise administration used three factors todetermine annual production capacities : ( 1 ) estimates made by manu-facturers themselves, (2) machine ratings, and (3) past productiondata. For sugar the recovery rate from cane formed an additionalcriterion, and for vegetable products output data of comparable factorieswere also used. More complicated rules were devised for cotton fabricsand yarn which, in addition, made reference to such factors as nationalaverage production, growth rates, and the hypothetical production ofa profit-maximizing firm. The criteria used for each industry aresummed up in Table 3.

Machine ratings—that is, engineering estimates readily available forthe standard type of plant and machinery employed in the sugar,cement, and vegetable product industries—appear to be the mostobjective criterion. A manufacturer's declaration about the productioncapacity of his factory refers to responses to industrial surveys or, moreoften, to requests for permission to import raw materials or capitalgoods. Since the import-licensing system was administered on a ratedcapacity basis, these requests probably overstated capacity. On theother hand, as noted earlier, there is some evidence that past outputdata collated by the Central Board of Revenue reflected underreportingto evade tax. By extension, this would also be the case with the maxi-mum output of factories of identical capacity. In some cases this mayhave introduced a downward bias in capacity estimates, particularlybecause great weight was attached to past production figures.

Considerable uncertainty is introduced when the capacity conceptrelies on such characteristics as the percentage yield of sugar fromcane. A not uncommon change in the recovery rate of, say, 2 per centfrom one year to the next may mean a swing in production of some25 per cent. A factory may then be crushing cane 24 hours a day, butit will be unable to increase its output beyond what inputs will yield.Disputes on this point led to a ruling by the Review Board that recoverypercentages should be made dependent on the recovery percentageachieved by the most efficient unit in a particular geographical zone,due allowance being made for variations in soil, climate, irrigation facili-


TABLE 3. PAKISTAN: SALIENT FEATURES OF CAPACITY TAX RULES

Date of TaxProduct Introduction

Sugar July 1, 1966

Cement July 1, 1966

Soda ash July 1, 1966

Vegetable February 1,products 1968

Number of Factors Used in DeterminingFactories Annual Production Capacity

6 Manufacturer's declaration toGovernment

Daily rated crushing capacityof factory

Percentage yield of sugar fromcane

Actual production in precedingyears


Declared or rated capacity ofeach kiln


Manufacturer's declaration toGovernment



Declared or rated capacity ofdeodorizing, hydrogenating,or other hardening machines


Maximum production of otherfactories of identical capacity

Total NotifiedCapacities (A)

and ActualProduction (B) »

A: ...B: 426,151 tons

A: 2, 385, 000 tons 3B: 2, 573, 000 tons

A: 42,000 tonsB: 31,517 tons

A: 143,350 tonsB: 102,513 tons

Rates of StandardTax on Number ofRated Export Working

Capacity Rebates Days

Rs 14/cwt At duty rate 160

White or At duty rate 300colored : deductibleRs 100/ton from monthlyOther : installmentRs 36/ton

Rs 150/ton Not provided 300

Rs 40/cwt Not provided 300

Abatementof Tax

Liabilityfor WorkStoppagesPer Day

or Shift 2

1/160

1/300

1/300

1/300

14

0 IN

TE

RN

AT

ION

AL

MO

NE

TA

RY

FU

ND

ST

AF

F P

AP

ER

S


Cotton May 1, 1968 90 4 National average production of Square yards Rs/sq. yd. At duty rates, West Pakistan : 1/897fabrics past three years per loom for (thousands) A B plus: 897 shifts

each of four statutory cate- 1. Coarse 676,415 241,741 0.10 0.55/lb. East Pakistan : 1/766gories 2. Medium 568,217 445,014 0.20 1.10/lb. 766 shifts

Category-wise production of 3. Fine 65,433 ) R4 ,42 0.40 1.75/lb.past three years 4. Superfine 39,524 f ' 0.70 2.80/lb.

Category-wise production ofcomparable units

Technically possible maximumproduction if profits are max-imized

Growth factor

Cotton May 1, 1968 1375 National average production of Pounds West Pakistan : 1/1,000yarn past three years per spindle (thousands) A B Rs/pound At duty rates 1 , 000 shifts

for each of four statutory 1. <21 410,306 . . . 0.55 East Pakistan : 1/921categories 2. _>21 <35 225,085 ... 1.10 921 shifts

Category-wise production of 3. >35 <48 74,776 . . . 1.75past three years 4. _>48 16,015 ... 2.80

Category-wise production ofcomparable units

Technically possible maximumproduction if profits are max-imized

Growth factor

Sources: In order of listing. Statutory Rules and Orders (S. R. O.) 87(R)/66, 86(R)/66, 85(R)/66, 18(R)/68, 61(R)/68, and 62(R)/68; and Central Statistical Office, MonthlyStatistical Bulletin, Vol. 20 (January 1972). Unless otherwise indicated, all data relate to the date on which the tax was introduced.

1 Actual production of the year in which capacity tax was introduced, unless otherwise indicated.2 This is the abatement rule for work stoppages beyond a manufacturer's control. For closures excluded from abatement and for the general disaster clause, see text,s As amended May 6, 1969 (S-R-O No. 73(R)/69).< 37,754 looms,s 2,783,384 spindles.




ties, and the manufacturing process.39 The Review Board also decidedthat the highest daily crushing capacity achieved in any year shouldbe regarded as the norm but that the degree of obsolescence of themachinery should be taken into account for the individual units. Somevariation may also be inherent in determining output capacities ofcement units if output is based on clinker-crushing capacity. The addi-tion of hardening agents may mean gains in output of from 4 to 6 percent. Clearly, tax liabilities that cannot take account of substantial dif-ferences in interunit outputs are inequitable.

Considerable effort was put into the proper calculation of the annualproduction capacities of cotton fabric and yarn units. The Textile Indus-try Capacity Committee, composed of a chairman and three othermembers, undertook an intensive four-month survey of weaving andspinning activities in Pakistan by sending working groups (consistingof a textile technician and a cost accountant) to each mill. The groupsworked under the supervision of committee members who determinedannual production capacities on the basis of the standard number ofshifts a year and the average output for each spindle shift (in pounds)or loom shift (in linear yards). To determine shift production, standardefficiencies and machine utilization rates per spindle and loom werecomputed, the latter being reduced by allowances for maintenance,repair, and technical depreciation. In the case of spindles, the standardnumber of shifts a year was set at 1,000 for West Pakistan and 921for East Pakistan, reflecting the extra time lost because of more fre-quent shift changes (every four hours in East Pakistan, instead ofevery eight hours in West Pakistan). The corresponding number ofloom shifts were 897 and 766, respectively. The production data thuscomputed were compared with the national average production for thepreceding three years. To permit the cotton fabric industry to catch upwith the new standards, a country-wide rebate of 20 per cent of capacitywas allowed for the first year after the tax came into operation and 10per cent for the second year.40

39 It will be noted that this closely parallels similar methods of determinationof standard yields under some agricultural taxes. Fluctuations are also inevitablein the crushing season, which may last from 120 days to 200 days, but this wastaken care of by an amendment of the sugar capacity rules to the effect that aday on which no crushing of sugar from cane took place in the factory wasdeemed to be a day of closure, making the factory eligible for abatement. SeeStatutory Rules and Orders (S.R.O.) 1984 (K)/68 and the section of this paperon Abatements, below.

40 United Nations Economic and Social Council, The Tax System in Pakistan:Studies in Tax Reform Planning (July 19, 1971), p. 40 (revision of a study



However, no rebate was granted to units that had already achieved theprescribed efficiency standard, as indicated by their average annualoutput for the preceding three years. Moreover, units whose productionexceeded the notified capacity were taxed on the basis of the threeyears' average annual output.

The Committee did not take into account any growth factor (definedin the capacity tax rules for the textile industry as "the past rate ofimprovement in production and likely increase in efficiency relating toimprovement in technical, managerial, labour and financial factors ofindividual mills"), because the recommended annual production capaci-ties were in excess of actual production figures. Similarly, "the tech-nically possible maximum production potential" of a unit aiming at"maximizing its profits before tax" was not considered. Clearly, theoutput at which profits are maximized can hardly, if ever, be ascertainedin the real world. At best, profit maximization is a process of trial anderror and not a goal which can be achieved by following a textbookprescription.

After the capacities for each of the four taxable categories of cottonfabrics has been determined, tax is assessed on the basis of squareyardage, the rate depending on the fineness of the fabric.41 The taxliability is adjusted if an additional loom is installed or if a redundantmachine is dismantled and removed from the factory. The adjustmenttakes effect immediately if capacity has expanded, but if a loom is takenout of production, tax payments are corrected from the first of themonth following the month in which the loom went into disuse. Taxablecapacity is then increased or reduced by the production capacity of theparticular loom, computed by dividing the annual production capacityof the factory for each of the four categories of cotton fabrics by thenumber of looms.42

originally prepared by Nurul Islam, Director, Pakistan Institute of DevelopmentEconomics, Karachi). For the rebates, see S.R.O. No. 61 (R)/68, rule 3, Gazetteof Pakistan, April 22, 1968, p. 198; the common denominator of the regionalreliefs is taken as the country-wide rebate. For cotton yarn a one-time 10 per centrebate was given for 1968/69.

41 For brevity, reference is mainly to cotton fabrics in the following paragraphs.The only difference between the capacity tax rules for cotton fabrics and yarnlies in the kind of machines (looms versus spindles) and the tax rate structure(fineness per square yard versus counts per pound).

42 S.R.O. No. 61 (R)768, rule 3(9)~(11) op. cit. Further implementing rulesprescribed that each manufacturer had to maintain a daily account of each work-ing shift, showing inter alia their time of commencement and termination, thenumber of looms worked, and the quantities of each category of cotton fabricsmanufactured during the shift.



In this connection, an important point to note is that downwardadjustments in the tax liability are made only if a loom is dismantledand removed but not when it is temporarily shut down. On the otherhand, the installation of new machinery results in an immediate increasein tax. The penalty for creating or operating with excess capacity isthus reinforced. Of course, once a firm is operating at full capacity, theprospect of upward tax revisions may act as a deterrent to new invest-ment. Administratively, the tax adjusment provisions are an effectiveantiavoidance device, because machinery would otherwise be shiftedaround. Finally, for cotton textiles, the Government decided that capaci-ties would be reviewed at four-year or five-year intervals. Notifiedcapacities of all other industries were changed several times by theCentral Board of Revenue and the Review Board before a final figurecould be agreed upon with the taxpayer.

ABATEMENTS

To alleviate hardship, the capacity tax rules provide for two kinds ofrelief.43 The first is based on production: if, for reasons beyond thecontrol of the factory's management (such as a cyclone or labor strike),actual production in a financial year falls short of notified capacity, theCentral Board of Revenue, with the prior approval of the Government,may grant abatement at the rate and to the extent that it considersproper. This form of abatement, which is similar to the "disaster relief"provisions common in agricultural tax schemes, applies to industry-wideproduction failures. It was reported to have been put into effect in 1967when a number of sugar mills were seriously affected by a drought thathad substantially reduced the sugar yield of cane. At that time reliefwas granted if actual production fell short of notified capacity by 10per cent or more.44

Under the second relief provision, applicable to individual cases,abatement is given for any day or shift for which the factory has to beclosed due to circumstances beyond the management's control at arate corresponding to the tax payable per day or shift (see Table 3).Normal cleaning or repair operations, as well as closures for a periodof less than six days at a time (and longer if the tax authorities havenot been properly notified), do not qualify for abatement, as they hadalready been taken into account in determining machine utilization

43 S.R.O. No. 61(R)/68, rules 4 and 5, op. cit.44 Winston, "Capacity Taxation" (cited in footnote 29), p. 6.



rates. To safeguard revenue and presumably to limit abuse of theserules, the Government prescribed that abatement would not be allowedif actual production exceeded capacity output; and, if a shortfall arosein production, the abatement would not exceed the difference betweenthe duty payable under the capacity tax and the tax that would havebeen due if the capacity tax had not been levied.

Although the abatement rules generally facilitate the administrationof the capacity tax, they do not lessen the extent to which actualproduction must still be ascertained nor do they remove the potentialconflict between normal cleaning and repair activities and closuresbeyond the management's control. It is tempting to evade the six-dayrule by resuming (but not reporting) production before the periodexpires. More seriously, there is a curious incentive to postpone opera-tions until the next six-day period, in order to qualify for abatement.Furthermore, factories may try to bunch production, particularly if theyforesee supply bottlenecks, and then halt operations (claiming circum-stances beyond their control). In practice, the abatement provisions mayfavor firms with fluctuating production patterns over similar firms withoutput spread more evenly throughout the year, as the former are in abetter position to evade the rules. Finally, a general economic effect,often noted in connection with presumptive agricultural taxes, is thatabatements reduce the incentive effect of the tax.

EXPORT REBATES

To achieve the Government's objective of freeing exports from tax,the administration allows exporters a rebate on the capacity tax rate.45

Although it sounds simple, this rule has led to some of the most cumber-some provisions of the capacity tax. Under the excise system a simplecheck at the time of export is usually sufficient to establish the claimand amount of the rebate, whereas under the capacity tax the rebatewould be too little if actual production (assuming it is all exported)falls short of notified capacity; similarly, without explicit provisions tothe contrary, too much would be rebated if exports exceed notifiedcapacity for a particular category of fabrics or yarn.

In Pakistan excessive rebates have been the main concern. Whengoods are exported, the rebate is credited against the notified capacity

45 In the case of cotton fabrics, an additional rebate is granted ranging fromRs 0.55 a pound to Rs 2.80 a pound, depending on the fineness of the fabricand reflecting the estimated incidence of the duty on yarn; see Table 3 and S.R.O.No. 61(R)/68, rule 8(3), op. cit.



of the exportable category of fabrics or yarn and deducted from themonthly installments due on the capacity tax. If exports exceed thatnotified capacity, the rebate is credited against the notified capacity ofthe next lower category (or if that credit is exhausted, against thecapacity of the next higher category, but at the rate corresponding tothe category exported). This procedure ensures that despite any increasein production beyond the notified capacity or any changes in the patternof production from the notified pattern, the rebate remains restrictedto the quantum per the notified capacity.

Obviously, the understandable desire to safeguard revenue resultsin substantial administrative ramifications,46 necessitating (1) a linkbetween the exportable product and the notified capacity under whichit has been produced—an administrative millstone as industry diversifiesand the number of middlemen increases—and (2) the keeping ofaccounts for each factory, showing its capacity tax status and the rebatesreceived. A solution would be to allow rebates on the basis of thecountry-wide average tax per pound of yarn or square yard of cloth,but this may unduly favor firms eligible for other rebates (for example,those granted on a regional basis). An obviously undesirable effect isthat if available credits have been exhausted, manufacturers may beinclined to hold up their exports until the following year's capacitiesare notified. Moreover, a shift in the composition of a firm's exportproduction may become more difficult because capacity estimates arebased on historical production patterns.

OTHER ASPECTS

Through rate differentiations and exemptions, the Government hassought to use the excise system to achieve a number of social andeconomic objectives—such as a fairer tax burden distribution, thedevelopment of small industries and particular regions, and the controlof prices.

46 The rebate problem is particularly difficult to solve in the case of fabricscontaining mixed counts or mixed fibers. Initially, when fabrics with mixed countswere exported, a rebate was allowed on the basis of average count, but withrevenue apparently suffering, the rules were revised and rebate is now granted onthe basis of the actual weight of each category of yarn. To qualify for the rebate,the exporter has to keep a record of the number of ends per inch and countsof warp yarn, as well as the number of picks per inch and counts of weft yarn,even though the administration continues to draw samples from export consign-ments. See S.R.O. No. 3(1)771, Gazette of Pakistan, January 4, 1972.



These features have also been carried over into the capacity tax.Thus, for cotton fabrics and yarn a bracketed specific rate structureis in effect; the duty rates increase with the fineness of the fabric or thenumber of counts of yarn, and by extension, with the price of the tax-able categories. Purportedly, the incidence of the duty would be pro-gressive as a result of this measure.47 Prima facie, however, it is difficultto see how the progressive rate structure's potential to improve theburden distribution can be retained once the capacity tax assessment isissued and any connection between tax payments and the nature of thetaxable commodity (for example, coarse, medium-fine, or superfinefabrics) is severed. If recent tax/price ratios in the Islamabad market arean indication, the progressive effect is negligible.48 In March 1972 thetax expressed as a percentage of the retail price was 8 per cent for finecotton fabrics but only 1 per cent lower, or 7 per cent, for coarsefabrics. Last, but certainly not least, the bracketed rate structure pro-vides an incentive for manufacturers of coarse fabrics and low-countyarn whose tax liability has been determined accordingly to switchto finer fabrics and higher-count yarn.49

The capacity tax appears to serve about as well as the excise sys-tem for the administration of small industry exemptions and incentivesto stimulate the industrialization of particular regions. At present,textile factories with not more than four power looms are exempt fromthe capacity tax. To allow for a lag in efficiency and a lower degreeof utilization, notified capacities of cotton fabric units in East Pakistanwere reduced by 20, 15, and 15 per cent successively for three years,commencing in 1968/69. In West Pakistan, the facility was limited totextile factories in Peshawar, Dera Ismail Khan, Quetta, and Kalat,

47 See Budget Speech for 1969-70, pp. 8-13. In the excise system a large num-ber of other bracketed specific and ad valorem rates employ quality, price, orother differential characteristics of the taxable commodities. Products that aretaxed in this way include tea, cigarettes, soap, cosmetics, knitting wool, electricbatteries, bulbs, tubes, and lubricating oil.

48 Of course, the crucial underlying assumption is that the tax is actuallypassed on to the consumer; presumably this is largely the case for the highlycompetitive cotton textile products. Another point is that bracketed rate structuresmay be deceiving because rates which are progressive in relation to quality mayonly be proportional or even regressive in relation to price.

49 Similarly, small changes at the margin (for example from 34 to 35 countsof yarn) involve an increase in the export rebate from Rs 1.10 to Rs 1.75 perpound. The share of fine and medium cloth in total production increased by7.5 per cent in West Pakistan over a four-year period ended 1971/72, whilecoarse cloth output declined correspondingly. Data computed from MonthlyStatistical Bulletin, Vol. 20 (July 1972.)



which were granted a uniform allowance of 5 per cent for the entireperiod.50

The capacity tax rates for cotton fabrics and vegetable products arereduced "if the retail price is legibly printed or woven on the selvedgeor border of every linear yard of all cotton fabrics," or "legibly, prom-inently and indelibly printed" on each container of vegetable product.This curious device, introduced in 1966 and also applicable to a num-ber of other excisable commodities, is meant to control retail prices.51

The measure has been less than successful, however, as goods areoften sold above stated prices.52 As regards its feasibility, there appearsto be little choice between the capacity tax and the excise duty system.

COMPARISON OF EXCISE AND CAPACITY TAX ADMINISTRATION

The technical analysis in the preceding paragraphs permits a com-parison between excise and capacity tax administration with respectto such basic processes as ascertaining the tax base, computing the.tax liability, collecting and recovering the tax due, settling disputes,and ensuring the compliance and cooperation of taxpayers.

To be sure, the capacity tax obviates the need for the cumbersomeproduction controls in effect under the traditional excise system. Thesecontrols, governed by complex provisions prescribing such things asthe design of buildings in which excisable commodities are producedor stored and the movement of goods and personnel on factory premises,necessitate the continuous presence of excise staff during working hours.They involve considerable interference in the day-to-day operations ofmost factories. On the other hand, the capacity tax still requires excisestaff to verify closures for abatement purposes, and, as an antiavoidancemeasure, to ascertain actual production in that connection. Moreover,prevailing arrangements require elaborate checks and balances to ensurethat export rebates do not exceed liabilities for the capacity tax.

Compared to the sure and straightforward controls on production,the determination of capacity remains an inherently arbitrary exercise,

50 The regional development incentives were in addition to the general reliefmentioned above. For yarn units, a 10 per cent rebate was granted to factoriesin East Pakistan in 1968/69 and 1969/70. During the same period, specifiedunits in West Pakistan received rebates of 5 and 10 per cent. Again, rated capaci-ties could not be reduced below average actual production in the three yearsprior to the imposition of capacity tax. See S.R.O. No. 61(R)/68, rule 3(3), (4),and (5), op. cit.

51 Budget Speech for 1966-67, p. 1.8, but in particular Budget Speech for1969-70, pp. 8-13. For textiles, see S.R.O. No. 120 (I)/69, Gazette of Pakistan,June 28, 1969.

52 Budget Speech for 1972-73, p. 46.



no matter how much expertise and ingenuity are applied. Disagreementsabout the volume of actual production are of a factual nature, but dis-putes regarding the capacity of a plant have conceptual overtones, mak-ing them much more difficult to resolve. A taxpayer's idea about thecapacity of his factory presumably changes as often as any of its deter-minants. The danger then becomes real, particularly if tax rates arehigh, that he will regard the assessment as inequitable and will sub-sequently request abatement, withhold his cooperation, or resort tolitigation. Whereas taxpayers hardly ever went to court in Pakistanto dispute their liability for the excise tax, many taxpayers filed peti-tions under the capacity tax. Obviously, the objections and appeals, aswell as the increased correspondence with taxpayers and field units,require considerable time of regional and headquarters tax officials thatcould otherwise be spent on supervision and control.

Under the excise system collections are safeguarded by the provisionthat goods cannot be cleared without payment of tax, whereas therules for the capacity tax permit the payment of the assessment inmonthly installments. This deprives the tax administration of an effec-tive enforcement tool, even though late payments carry a penalty of 1per cent a month. Default in payments and stay orders of the courtsresulted in a considerable backlog in tax collections in Pakistan,amounting to almost two thirds of capacity tax receipts in 1970/71(15 per cent of total excise collections, inclusive of the capacity tax, or6 per cent of total tax receipts). The considerable gains on the assess-ment side (particularly for the taxpayer) should therefore be weighedagainst the increase in appellate and tax collection work, even if theincreased workload is temporary.

Tax evasion in the form of collusion between taxpayers and minortax officials would probably not occur to the same extent under thecapacity tax as under the excise system. Although there would still bethe possibility of malpractices in the verification of abatements and theascertainment of, say, the fineness of cotton fabrics as the basis forthe export rebate, daily contact would be eliminated. Since actual pro-duction would not have to be reported to the excise administration,underreporting would similarly not affect the tax liability directly. How-ever, to the extent that past production figures are one of the deter-minants in ascertaining capacity—and the Pakistan experience showsthat they became increasingly the critical variable, perhaps because theywere less open to taxpayer objection—underreporting is reflected ina lower estimate of capacity. Moreover, if past production figures con-



tinue to play a crucial role in the determination of capacity, it is impor-tant that current production data should be as accurate as possible. Thisin turn means that regular audits by the excise administration wouldstill be indispensable under the capacity tax.

III. Economic Effects of the Capacity Tax

An intriguing aspect of the capacity tax concerns its usefulness asa production incentive. The originators of the tax believed that it wouldcreate a built-in reward for entrepreneurs who worked harder and moreefficiently, as they would not have to pay tax on any part of their pro-duction in excess of assessed output. Since the marginal tax rate wouldbe zero, the return on the incremental product would fully accrue to theentrepreneur himself. In their view, the penalty aspects of producingbelow capacity would act as a powerful disincentive, up to the pointwhere actual production equals notified capacity.

This section examines that claim and also considers the price, income,substitution, and other effects of the tax. First, the theoretical incidenceof a capacity tax is considered quite apart from the environment inwhich it is applied, although illustrations are drawn from the Pakistaneconomy. Second, a closer look is taken at capacity utilization rates ofthe Pakistan manufacturing sector and the attendant variables at thetime the capacity tax was introduced. Third, the development of utiliza-tion rates after the imposition of the tax is reviewed for specificindustries.

INCIDENCE THEORY

The change in the tax base may alter the nature of the tax for theindividual firm. The traditional liability for excise duty varies with afirm's production volume, whereas in principle liability for the capacitytax shows no such variations but is a fixed (lump-sum) levy. In otherwords, the excise duty is part of a firm's variable costs, but the capacitytax belongs to its overhead or fixed costs. Another point of view, prob-ably more realistic, is that the capacity tax is an excise duty on plantand equipment, or rather a property tax on business assets. The latterconcept appears to apply most aptly to the cotton textile and vegetableproduct industries, where changes in the tax liability are a function ofthe number of machines. For continuous integrated production proc-esses, such as cement, soda ash and perhaps sugar, the lump-sum taxidea has relevancy.



It appears that partial equilibrium analysis can be appropriatelyapplied to the incidence effects of a capacity tax levied in lieu of exciseduties. The Government of Pakistan did not intend to increase theamount of tax previously payable by the taxable industries; therefore,their supply and demand schedules or those of related industriesshould not have been appreciably affected. Moreover, factors of pro-duction would probably not change if incomes declined, in view of thehighly specialized nature of the taxed industries. Finally, the numberof untaxed substitutes to which demand could be diverted was small.53

The effect in theory, on output and price, of a capacity tax in lieuof a specific excise duty, may be identified as the combined effects of:(1) the abolition of an excise duty, and (2) the imposition of thecapacity tax.54 In a competitive world, the abolition of an excise dutyhas an expansionary effect on industry's output, while the price declinesto an extent depending upon the supply and demand schedules. Underincreasing cost conditions, the decrease in price will be less than thereduction in duty. Similarly, if demand is relatively elastic, price willdecline less than it would if consumers were strongly attached to theproduct. Mutatis mutandis, these results are similar for a monopolist,except that the adjustment is affected through a change in the individualfirm's marginal cost curve rather than in the industry's supply sched-ule,55

A capacity tax viewed as an addition to fixed costs does not haveany effect on output and price in the short run.56 If a firm is in equilib-rium before the tax is introduced, equating marginal cost and marginalrevenue, this point should still determine the most profitable output(or least loss) after the tax is imposed. However, there would be long-run effects. In a competitive industry, the imposition of such a tax causesthe average fixed and total cost curves to shift upward. Unable to covertotal cost, marginal firms will be taxed out of business and leave theindustry; subsequently, the average revenue schedule of the remainingfirms will shift upward. The size of the ultimate effect will depend on

53 Carl S. Shoup, Public Finance (Chicago, 1969), pp. 9-10. Sugar may be anexception to the condition that there should be no untaxed substitutes. Cane isoften diverted to the production of gur or khandsari, crude forms of sugar witha very low recovery rate.

54 In the following analysis, the effect of differences in assessment and collec-tion methods is ignored. (Excises are payable at the time of sale, but capacity taxis assessed annually and payable in monthly installments.)

55 The effects are opposite to the imposition of an excise duty, the case gen-erally examined in literature. See Richard A. Musgrave, The Theory of PublicFinance: A Study in Public Economy (New York, 1959), pp. 288-89.

^ I bid., p. 210.



long-run supply and demand elasticities, but under the assumptions theprice increases along with the scale of operation of the remaining firms(the number of firms in the industry is reduced), although this neednot affect their degree of capacity utilization. In the case of a mono-polist, price and output do not change in the first instance, but overtime, however, capital would be shifted out of the monopolist's sector,if his profits net of capacity tax are less than the return that he canearn elsewhere (although this is unlikely if the monopolist still earnsexcess profits after the imposition of capacity tax). As a lump-sum levy,the income effects of the capacity tax may possibly induce entrepreneursto' increase their efforts.57

A capacity tax that is a function of the number of machines in opera-tion, and is measured by their notional output, resembles a propertytax on business assets based on physical quantities. A firm's productwould then be taxed indirectly through a production tax on one of thefactors (machines) that produces it, and the incidence of such anequal yield levy on machinery would be in the nature of a specificexcise duty on the product itself. The output-inducing effects of thewithdrawal of the excise duty would be offset by a decline in productionafter the imposition of the capacity tax. Similarly, the initial decline inprice would be offset by the rise in price that can be expected after theexcise tax is replaced by a capacity tax. The exact extent of these effectsagain depends on supply and demand elasticities, and interfirm adjust-ments differ because of divergent machine-to-production volume ratios.58

A firm's demand for machines—a derived demand depending on thedemand for its products and the supply of substituting factors of pro-duction—will also be affected. Machinery already installed, being ahighly specialized factor of production, may have to absorb part of thenew tax, and its value would fall accordingly; to that extent the ownersof the machinery would have to carry the burden. They may try to shiftpart of the new tax backward but, because much of the machinery isimported, that would probably be difficult; forward shifting is morelikely. In any case, it is likely that the effective cost of the taxed factor(machinery) will increase. Assuming that the new levy fell entirely on

57 In "Capital Utilisation in Economic Development" (cited in footnote 1), p. 57,Winston says: "In making it more expensive to let plant sit idle, the tax mayincrease utilisation through an income effect on entrepreneurial utility maximisa-tion such that managerial input may increase as profits are reduced." For support-ing arguments he refers to Tibor Scitovsky, Welfare and Competition: The Eco-nomics of a Fully Employed Economy (Homewood, Illinois, 1951), pp. 142-47.

58 For the treatment in this and the following paragraph, reference may bemade to Shoup, Public Finance (cited in footnote 53), pp. 273-79 and 394-99.



capital, Winston estimated the tax per rupee of installed capacity andfound that the effective cost increases in the cement and sugar industrieswere 12 and 24 per cent, respectively.™

Such an increase in factor cost may have a beneficial effect oncapacity utilization, if it is assumed that its optimal level in a two-factormodel depends, as postulated by Winston, on the relative prices ofcapital and labor.00 Tn this view, excess capacity may have been con-sciously built into capital stock as part of a perfectly rational profit-optimizing decision. As a result of the increase in the price of capital,firms will increase their desired utilization of capital stock rather thanexpand their existing stock; therefore, with a given investment budget,resources will be freed for capital investment elsewhere or, probablymore important, for increasing raw material supply. Another effect (inmost cases beneficial) will be that the increase in the cost of the taxedproduction factor (machines) will induce firms to substitute labor forcapital. However, if capacity utilization is adversely affected by capitalunderpricing, direct adjustments would appear more appropriate. Thiscould be achieved by a tax on capital equipment or, since capital isgenerally imported in developing countries, appropriate corrections inthe exchange rate and import duty tariff.

However, the simplified assumptions underlying the foregoing analysismay be unrealistic in view of prevailing market imperfections. Thus,the existence of excess profits and monopoly prices (inter alia resultingfrom a scarcity of imported inputs), in conjunction with licensing andother direct controls, would make the ultimate effect of a capacity taxindeterminate/'1 If entry into an industry is limited or blocked, because

59 Winston, "Capacity Taxation" (cited in footnote 29), p. 11. Since both sugarand cement operated at high levels of capacity when Winston made this calcula-tion, it was only necessary to express the tax as a percentage of sales, so thatthe product of this ratio and the inverse of the capital output ratio (computedin connection with another study) gave an estimate of the tax per rupee ofinstalled capacity. In this form, the tax is expressed as a yearly charge on installedcapacity—an addition to the effective interest rate.

60 Two other variables are the capital intensity of the production process andthe elasticity of substitution. See Gordon C. Winston, "The Four Reasons for IdleCapital" (unpublished, Williams College/Nuffield College, September 1971) andhis pioneering study "A Primer on Pure Flow Production Analysis" (unpublished,Williams College, January 1973).

61 For Pakistan, the prevalence of oligopolistic tendencies is argued persuasivelyby many authors. For example, see Mohammed Yaqub, "The Elasticity of Taxesin a Developing Country—A Case Study of Pakistan" (unpublished, PakistanInstitute of Development Economics, Karachi, 1966), as quoted in M. Z. Farrukh,"Tax Concessions to Industries—An Overview of Pakistan's Experience" (unpub-lished, Harvard University Law School, International Program in Taxation), p. 26;also Lewis and Qureshi, "The Structure of Revenue from Indirect Taxes inPakistan" (cited in footnote 15), p. 498.



costs are high and credit facilities are largely in the hands of estab-lished firms, a capacity tax viewed as a lump-sum levy may strengthenthe oligopoly, because the increase in fixed costs makes entry even moredifficult. On the other hand, it can also be argued that the capacity taxmakes production restrictions more costly and therefore forms an incen-tive for the individual firm to break the "agreement." 62 Imported rawmaterial inelasticities may mean that a firm's marginal cost curve iskinked and intersected by the marginal revenue curve within the unde-fined range.63 The abolition of the excise duty would then cause themarginal cost curve to shift downward, but the output associated withthe equilibrium level of production does not change; neither does price.Profits would increase and a capacity tax subsequently imposed wouldbe paid out of profits with no salutory effect either way.64 Such a situa-tion limits the effectiveness of a capacity tax, although it should benoted that the Pakistan Government excluded from the tax the indus-tries dependent on imports. This point is further developed below.

EXPLANATORY VARIABLES OF CAPACITY UTILIZATION

Although the production incentive was one of the main reasons forimposition of the capacity tax, the industries to which this novel taxwas applied were among those with the highest capacity utilization ratesof the entire manufacturing sector. Cotton textiles, sugar, cement, andvegetable products all fall within the top one third of the ranking com-puted by Winston (see Table 4, column A). Cotton textiles, Pakistan'slargest industry by number of units and total turnover (Table 4, columnsC and D), has the second highest utilization rate, operating at 70 percent of capacity (94 per cent if not adjusted for the number of shifts)in 1965/66.

From Winston's analysis, it is clear that the above-mentioned indus-tries and others with high utilization rates have important characteristicsin common that enable them to utilize their resources more fully evenin the absence of tax incentives. First, they are less dependent onimported raw materials than most other industries (column E) and aretherefore not subject to the perennial foreign exchange constraints or

62 Winston, "Capacity Taxation" (cited in footnote 29), p. 9.63 See Ghulam Mohammed Radhu, "The Relation of Indirect Tax Changes

to Price Changes in Pakistan," Pakistan Development Review, Vol. 5 (Spring1965), pp. 54-63.

64 Compare also Budget Speech for 1970-71, p. 13, in which the Governmentof Pakistan indicated that it expected that the duty on paper and paperboardwould be paid out of profits and would not be passed on to the consumer.



TABLE 4. WEST PAKISTAN: INDUSTRIAL CAPACITY UTILIZATION DATA, 1965/66

A B C D E F G

Utilization Rates

Industry

FertilizersCotton textilesLeatherMatchesSugarPetroleumNonmetallic minerals

(cement)Edible oils (vegetable

products)TeaSilk and art silkWood, cork, and

furnitureSoaps/perfumesMiscellaneous foodTransportPaperMiscellaneous

manufacturingPrinting/publishingTobaccoMetal productsRubberMiscellaneous

chemicalsBeveragesFootwearBasic metalsElectric machineryNonelectric machinery

Adjusted1

79.7769.7362.7556.9750.2845.41

42.52

38.1136.4428.93

24.0722.8522.3221.3520.87

20.8120.8019.8619.4818.97

18.6817.7617.7516.1616.1314.33

Unadjusted2

79.7794.3265.48

142 A494.3245.41

67.16

66.7391.0972.00

60.1943.5749.4353.3744.48

49.8252.0049.6648.7147.41

45.2644.4044.3640.4040.3335.82

ReportingUnits 3

3668

551

115

80

1315

201

468657

18311

19714945

29542

124245797

173252

AverageSize4

269.7224.08

6.26105.81299.90973.06

16.21

28.55308.57

7.62

4.3618.3716.438.492.90

3.604.97

77.553.728.60

26.9210.476.46

19.1512.353.32

ImportedRaw

Materials 5

7.5816.1022.0625.77

8.7149.12

25.79

—1.18

78.88

19.3251.1025.4678.1963.46

42.0741.10

9.7771.3463.41

29.8923.9655.5685.7474.4630.53

CompetingImports G

1959/60

58.102.701.10

—0.10

67.20

22.00

3.400.60

49.00

17.305.80

26.2065.5033.40

67.6011.100.40

56.0066.10

60.7037.800.20

56.0069.7087.30

Exports 7

1959/60

54.6621.7398.34

—2.36

14.96

0.59

—23.990.01

2.070.95

18.1410.04

1.16

68.541.700.104.661.44

10.280.01

1.220.091.57

Source: Gordon C. Winston, "Capital Utilisation in Economic Development," Economic Journal,Vol.81 (March 1971), p. 55.

1 These aggregated rates are a weighted (by capacity) average of industry utilization rates computed fromannual production (value) and annual production capacity (adjusted to a two and a half shift level if theindustry worked less than that) reported in Census of Manufacturing industries 1965/66 (unpublished, WestPakistan Provincial Ministry of Industries).

2 Computed as in column A, but without adjustment of annual production capacity to a two and a halfshift operation.

3 Summed for each sector.4 Annual production in millions of rupees per reporting unit.5 The proportion of the value of total raw material inputs purchased from abroad.6 Imports as a proportion of total supply.7 As a proportion of gross output at factor cost, f.o.b.

the vagaries of a raw materials licensing system that was administered on

a rated capacity basis, thereby inducing the creation of excess capacity.65

65 Winston, "Capital Utilisation in Economic Development" (cited in foot-note 1), p. 48. For an analysis of Pakistan's import substitution policies, see alsoStephen R. Lewis, Jr., Pakistan: Industrialization and Trade Policies (OxfordUniversity Press, 1970), in particular Chapter 5; also Lewis and Stephen E.Guisinger, "The Structure of Protection in Pakistan," in Bela Balassa and Associ-ates, The Structure of Protection in Developing Countries (The Johns HopkinsPress, 1971), Chapter 10.



Winston found that for every 1 per cent decrease in dependence onimported raw materials, capacity utilization rose by 0.267 per cent.66

A second characteristic of these industries is that they do not facedemand competition from imports to the same extent as industries withlower uitlization rates (Table 4, column F). But there may also bea negative relationship on the supply side; if import substitution policiesfavored the creation of industries with competing imports, it is likelythat at least some excess capacity was created.67

A number of other characteristics, such as exports (inducing demandexpansion—Table 4, column G), firm size (economies of scale),capital-income ratios (reflecting profit-maximizing adjustments to pre-vailing cost patterns) and rates of growth, are also positively relatedto capacity utilization. More interestingly, competitive firms appear tohave higher utilization rates than industries with only a few firms thatcan substitute either inventory accumulation or excess capacity forprice fluctuations when faced with changes in demand.68 The textileindustry is an interesting example: it is one of the most competitiveindustries in Pakistan and also has one of the highest utilization rates.Moreover, competition may have prevented manufacturers from install-ing excess capacity by importing (overinvoiced) capital goods in excessof requirements, which was considered an easy, although illegal, meansof transferring capital abroad.69

66 Winston notes that, since imported raw materials and competing imports arehighly correlated, the problem of multicollinearity arises. However, other studiessupport the hypothesis regarding the negative correlation between imported rawmaterials and capacity utilization. See, for instance, Pakistan Central StatisticalOffice, Economic Affairs Division, Report of Survey on Capacity Utilization byManufacturing Industries 1965, Annexure B, and Warren Hogan, "Capacity Crea-tion and Utilisation in Pakistan Manufacturing Industry," Australian EconomicPapers, Vol. 7 (June 1968), pp. 36-38, who also lists the inefficiencies in policiesand planning, both of government and private enterprise, as well as some formsof technological or demand determinism often associated with capacity under-utilization.

67 Winston, "Capital Utilisation in Economic Development," (cited in foot-note 1), p. 43.

68 Ibid., pp. 43-49.69 For an analysis of this phenomenon, see Winston, "Overinvoicing, Under-

utilization, and Distorted Industrial Growth" (cited in footnote 2). Earlier, thepractice was signaled in Budget Speech, 1965-66, p. 24. It was facilitated by anovervalued exchange rate that made imports artificially cheap, import duty exemp-tions, and a liberal system of depreciation allowances—up to 35 per cent onplant and machinery in the first year of installation, which further reduced thecost of capital goods. See Central Board of Revenue, Tax in Pakistan: A BriefOutline With Particular Reference to Tax Concessions to New Industries andIncentives to Foreign Investment (rev. ed., Karachi, December 1965).



Thus, by using independence from raw material imports as a cri-terion for choice, the Government in effect applied the capacity tax tothose industries that did not need an incentive to increase capacityutilization. On the other hand, firms with low utilization rates may notbe able to improve their performance, regardless of the incentive offered,because of constraints on input supply; however, since the tax was notlevied on these firms, its practical effectiveness cannot be ascertained.As a general point, it may be stressed that capacity production presup-poses that demand is strong enough to clear the market of the goodsproduced at capacity level operations and, more importantly in mostcases, that there will be an adequate flow of variable inputs—rawmaterials and intermediate goods—at current prices. The effectivenessof any device used as a production incentive will be limited by theextent to which these two conditions are satisfied.

UTILIZATION RATES AFTER THE CAPACITY TAX

Nevertheless, it would still be of interest to see whether any changesoccurred in the capacity utilization rates of the industries to which thecapacity tax applied in Pakistan. Without taking into considerationtechnological improvements, obsolescence factors, and changes in effi-ciency, Table 5 shows capacity outputs computed on the basis of stand-ard machine ratings, number of shifts (days of production), and othertechnical data for the cotton textiles, sugar, and cement industries. Itshould be noted that the standards used are peculiar to each industryand do not conform to those employed by Winston, who in calculatingcapacity disregarded the firms' ideas of full utilization, arguing thatthese did not necessarily reflect the presumed capital scarcity; instead,he took two and a half shift operations, each of eight hours duration,as the norm.70 In Table 5, for cotton fabrics the number of shifts hasbeen set at the standard used by the Excise Department. Data formachine outputs conform to those used by provincial governments,although corresponding figures underlying the capacity estimates of theExcise Department for all of Pakistan are lower—being 190 poundsper spindle and 21.250 square yards per loom. For sugar and cement,the provincial governments' standards were adopted.

The development of utilization rates, that is, actual production as apercentage of capacity output, is illustrated in Chart 1. The cotton

70 If the industry reported higher operating rates, actual operations were takenas the standard. See Winston, "Capital Utilisation in Economic Development"(cited in footnote 1), pp. 41-42.


TABLE 5. WEST PAKISTAN: ACTUAL AND CAPACITY PRODUCTION, AND CAPACITY UTILIZATION RATES FOR SELECTED INDUSTRIES 1

Year

1964/651965/661966/671967/681968/691969/701970/711971/72

Year

1964/651965/661966/671967/681968/691969/701970/711971/72

Cotton

Number ofProduction installed(thousand spindlespounds) (thousands)

455,575427,681456,339495,111526,522602,383669,745712,082

Production(tons)

156,478371,432316,800247,876401,239599,946499,664358,376

19672056204320482175239726052752

24-Hourcrushingcapacity

(tons)

16,00021,00024,00025,50030,00031, 000 6

32, 000 6

Yarn Cotton Fabrics

Capacity Number of Capacityproduction2 Utilization Production installed production3

(thousand rate (thousand looms (thousandpounds) (per cent) square yards) (thousands) square yards)

472,493,490,491,522,575,625,660,

Sugar

080440320520000280200480

Capacityproduction

(tons)*

252,000330,750378,000401,625472,500488,250504,000

9686,93,

100,100,104,107,107.

.5 714

.7 651

.1 683

.7 714

.9 710

.7 725

.1 787,8 751

Utilizationrate

(per cent)

62. 1112.383.861.784.9

122.999.1

,755,358,617,825,250,421,313,059

3131303030313030

Production(thousand

tons)

16291607193421282510261426592666

834,210834,210807,300807,300807,300834,210807,300807,300

Cement

Annualcapacity(thousand

tons) 5

1642180622952310309030902918 6

Utilizationrate

(per cent)

85.778.184.788.588.087.097.593.0

Utilizationrate

(per cent)

99.289.084.392.181.284.691.1

Sources: Central Statistical Office, Monthly Statistical Bulletin, Vol. 16 (September 1968) and Vol. 20 (July 1972); and Govern-ment of the Punjab, Bureau of Statistics, Development Statistics of Punjab, Sind, N. W. F. P., and Baluchistan, October 1971.

1 Cotton yarn and fabrics became subject to the capacity tax on May 1, 1968; sugar and cement, on July 1, 1966.2 240 pounds per spindle working 1,000 shifts per annum.3 30,000 square yards per loom working 897 shifts per annum.4 Average seasonal run of 200 days, downtime during the season 10 per cent, and assuming a recovery rate of 8.75 per cent.5 Continuous operations of 330 days a year.6 Estimates.

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CHART 1. WEST PAKISTAN: CAPACITY UTILIZATION RATES, 1964/65-1971/72

Sources: Central Statistical Office, Monthly Statistical Bulletin, Vol. 16 (Sep-tember 1968) and Vol. 20 (July 1972); Government of the Punjab, Bureau ofStatistics, Development Statistics of Punjab, Sind, N. W. F. P., and Baluchistan,October 1971.



textile industry has slightly higher utilization rates under the capacitytax than before, although the upward trend is already discernible duringthe three years preceding the tax. The rates for the sugar and cementindustries show no noticeable long-term improvement. More impor-tantly, the trends and fluctuations in utilization rates can be largelyexplained by supply conditions and do not appear to be related to thecapacity tax. Cotton textile production in 1965/66 inevitably declinedbecause of crop diseases and the smaller area planted in the previousyear on account of adverse weather conditions; the decline was alsocompounded by industrial unrest and breakdowns in power supply.However, the upward trend in production and capacity utilizationresumed in 1966/67, when the supply of raw cotton increased becauseof improved imputs and the greater availability of irrigation facilities, aswell as rising demand in export markets. After 1967/68, acreage andproduction leveled off somewhat, but record production levels werereached in the early 1970s, reflecting the farmers' response to highercotton prices following the 10 per cent government bonus of 1970.71

In addition to supply problems, capacity utilization of many mills isadversely affected by a lack of knowledge about textile engineering,inefficient use of machinery, absence of proper maintenance and tem-perature controls, lack of standardization and specialization (by rangeof counts and variety of fabrics), and ineffective managerial supervision.More generally, this suggests that the improvement of industrial exten-sion services will enable firms to do what the capacity tax is supposedto force them to do. Again, the agricultural parallel is striking.

The utilization rates in the sugar industry follow sugarcane supplypatterns exactly. After bumper crops were harvested in 1965/66 and1969/70, production and utilization rates increased. On the other hand,in the first year that the capacity tax was imposed, lack of winter rainsand heavy frosts damaged the crop so severely that the normal recoveryrate dropped considerably. The effect was carried over into the 1967/68season, because the seeds were adversely affected. The sugar mills arealso subject to supply and demand restrictions. Besides facing trans-portation holdups that reduce the sugar content of cane, mills cannotprocure sugarcane from outside the zone alloted to them by the pro-vincial governments. On the demand side the Central Government oftenprohibits the sale of sugar on the open market in order to controlprices, causing stocks to accumulate at factories and causing farmers

71 For these and following developments, see Ministry of Finance, PakistanEconomic Survey (Islamabad), various issues.



to divert sugarcane to gur or khandsari (crude sugar made outside themills).

The utilization rates in the cement industry cannot be explained byconstraints on input supply. Production increased steadily in the periodunder review, concurrent with the rise in demand because of the large-scale building programs that were initiated. The supply of raw materialswas abundant, and capacity utilization rates were high.72

IV. Tax Revenue Implications

The response of the tax system to changes in income is an importantconcern in developing countries, since an income-elastic tax systemenables governments to finance their growing expenditures in a nonin-flationary way. In Pakistan, excise taxes have shown a remarkabledegree of income elasticity. Over a ten-year period ending 1970, revenuefrom this source increased 4.4 per cent for every 1 per cent growthof the economy, in contrast to the much lower income elasticity (1.2)of all other taxes and duties. The exceptional increase in excise dutycollections can be accounted for by the fast growth of the domesticmanufacturing sector and the frequent upward adjustments in tax rates.73

Prima facie, a capacity tax seems relatively less elastic than specificexcise duties. Both the tax rate and the tax base (quantum of produc-tion) remain the same as the economy expands, provided investmentin new machinery does not lead to an immediate revision of the taxliability. An attempt has been made to find some support for this prop-osition by computing quantitative production indices and comparingthese with the indices of tax receipts as adjusted for rate increasesthat took place at the time of and after the introduction of the capacitytax (Table 6).74 Over a five-year period prior to capacity tax, cement

72 The rate of 42.52 in Table 4, representing the whole nonmetallic mineralsindustry, understates the degree of capacity utilization in the cement sector itself;actually cement had the highest utilization rate of the industry. See Report ofSurvey on Capacity Utilization by Manufacturing Industries (cited in footnote 66 ) ,

73 See, on earlier years, A. H. M. Nuruddin Chowdhury, "The Predictabilityand the Flexibility of Tax Revenues in Pakistan," Pakistan Development Review,Vol. 2 (Summer 1962), pp. 189-214.

74 No changes in rates were made before the introduction of the capacity tax.The figures have some inevitable shortcomings. Thus, actual output data couldnot be corrected for changes in stocks of excisable commodities. Tax collectionsfor some years show lags or leads, if only on account of the litigation procedureswhich were initiated. In addition, the fact that many production figures are col-lated by the Central Board of Revenue may have some effect on their reliabilitybecause firms that evade tax would also be likely to suppress production figures.


TABLE 6. INDICES OF PRODUCTION AND TAX RECEIPTS OF ITEMS SUBJECT TO THE CAPACITY TAX

Cement

Year

1961/621962/631963/641964/651965/66

1966/671967/68

1968/691969/701970/71 2

Index ofproduction

100112112131128

156171

199203204

Adjustedindex of

taxreceipts1

Sugar

Index ofproduction

100 100111 145121 128132 123158 241

153 225197 200

197 246241 339186 254

Adjustedindex of

taxreceipts1

100178417222222

389361

383403297

Vegetable

Index ofproduction

100130163174194

166177

188237242

Products

Adjustedindex of

taxreceipts1

Cotton Fabrics

Index ofproduction

100 100125 103150 105187 108187 98

162 105190 109

f'imPÎtV tT5f

184 109212 111187 118

Adjustedindex of

taxreceipts1

100100849982

9253

133118103

Sources: Production figures: Central Statistical Office, Monthly Statistical Bulletin, various issues. Tax receipts: Ministry of Finance,Pakistan Budgets, 1969-70, p. 24, and The Explanatory Memorandum on the Budget, 1971-72 (pp. 4 and 5). Tax rates: Ministry ofFinance, The Budget in Brief, 1969-70, pp. 78-91; 1971-72, pp. 121-30; and 1972-73, pp. 61-69.

1 According to the formula: Adjusted index of tax receipts =2 Based on revised estimates ; not included in the flexibility ratio calculations.

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excise collections increased by 58 per cent. At the same time, the pro-duction index showed a gain of 28 per cent. Thus, the flexibility ratioof excise to index of manufacturing is 2.07.75 A similar computationfor a four-year period following the introduction of the capacity taxyields a ratio of 1.90. For sugar and vegetable products the ratios are0.87 and 0.68 for the excise tax periods and 0.07 and 0.58 for thecapacity tax periods (covering four and two years respectively). Forcotton fabrics, the ratio is negative (-5.32) under excise duties, butreceipts became even more inflexible ( — 6.28) after the capacity tax wasintroduced.

Thus, the capacity tax appears to have been a less flexible sourceof revenue than excise duties, although allowance has to be made forthe growing tax arrears that may not have reached a stable level.Whether this should be considered a drawback of the experimentdepends on what happens to other taxes. If the capacity tax reduces theoptimal capital stock-output ratio, allowing income to grow faster witha given investment budget, the base of other taxes would expand withyield effects that may offset the greater revenue inflexibility of thecapacity tax.

To increase tax collections, the Government of Pakistan could adjustthe tax base periodically or raise the tax rate. In practice, capacity esti-mates were revised rather frequently in Pakistan, reflecting decisions onappeals to the Review Board (particularly by the sugar and vegetableproduct industries; by the end of 1970/71 no decisions had yet beentaken on appeals by the cotton textile industry), as well as direct actionby the Central Board of Revenue, which undertook a full-scale revisionof capacities in the cement industry.76 Of course, frequent adjustmentsof capacities work against the zero marginal rate effect of the tax. Onthe other hand, changes in the tax rate would not have that effect. Toadjust rates automatically, they could be linked to price changes.77 Sucha system applies to land revenue collections in Sind Province, permittingadjustments of tax liabilities in step with changes in the average marketprice of the products over a defined period.78 As regards the capacity

75 It will be noted that this ratio differs from the elasticity concept used in thefirst paragraph of this section, as it relates to production volume rather than valueand eliminates the effect on collections of rate increases.

76 S.R.O. No. 73(R)/69, Gazette of Pakistan, May 6, 1969.77 Islam, The Tax System in Pakistan (cited in footnote 40), p. 40.78 J. Russell Andrus and Azizali F. Mohammed, The Economy of Pakistan

(Stanford University Press, 1958), p. 342.



tax, over the period under review only the rate applicable to vegetableproducts was increased—from 40 to 45 rupees per hundredweight ofrated capacity in 1970/71.79

V. Summary and Conclusions

It is now possible to sum up some of the arguments and to evaluatethe capacity tax in the light of the objectives it was purported to serve :(1) administrative simplification and convenience, and (2) increasedcapacity utilization. These conclusions regarding Pakistan are augmentedby a few more general considerations.

INCENTIVE ASPECTS

Partial equilibrium analysis suggests that if the capacity tax worksas a lump-sum levy, there should be no short-run effects on output,except those induced by the income effect of the fixed levy. The long-run effects are largely indeterminate; although under competitive condi-tions the size of operations may increase, this need not involve a higherdegree of capacity utilization. If the capacity tax is a function of thenumber of machines in operation, resembling a property tax on busi-ness assets, cost and supply curves of the final product are likely tobe affected by its imposition; price will rise and output will decline.If it is assumed that the desired level of capacity utilization dependson the relative prices of capital and labor, by raising the price of capitala capacity tax will increase utilization of capital stock and induceentrepreneurs to substitute labor for capital. To make an overall judg-ment on incidence in Pakistan, the effects of the withdrawal of the exciseduty that was previously chargeable—leading to an increase in outputand a decline in price—should be taken into account as well.

These theoretical considerations presuppose that there are no con-straints on the supply of raw materials and intermediate goods. However,in developing countries, import-substituting industries may dependheavily on imports of raw materials. If these cannot be procured inadequate quantities at prevailing prices because of a limited foreignexchange budget, firms may not be able to utilize existing capital stockfully regardless of the incentive offered. For this reason, Pakistan'scapacity tax was applied to industries that used only indigenous raw

^S.R.O. No. 127(1)770, Gazette of Pakistan, June 29, 1970, p. 847.



materials. Since it appears that these industries were already operatingat the highest utilization rates in the entire manufacturing sector, theefficacy of the capacity tax as a production incentive cannot be readilyascertained. From the evidence it may be surmised, however, that theremoval of constraints on supply rather than the application of a pro-duction incentive would solve to a great extent the basic policy conun-drum.

Of course, neither production incentives nor adequate supplies canprovide a solution for excess capacity resulting from inefficiencies inpolicies and planning, although a capacity tax in the form of a propertytax on business assets could correct a relative underpricing of capitalgoods and thereby inhibit further unjustified expansion.80 Such a meas-ure is never as effective as direct recourse to the price of the scarcityfactor, the exchange rate itself, because it is not as comprehensive. InPakistan, the complex and overvalued exchange and trade system,involving multiple currency practices and widespread restrictions, wasoverhauled in May 1972—accompanied by a substantial devaluationof the rupee and some import liberalization.81 In the same year thetax holiday scheme was abolished, after having been suspended in theprevious year. Over time these measures should redress the imbalancescaused by the relative underpricing of capital and should give theeconomy a chance to grow up to capacity. Furthermore, liberalizedimports and commodity loans should have a favorable effect on capacityutilization by increasing the supply of raw materials.

ADMINISTRATIVE FEATURES

Clearly, by its nature, the proper measurement of capacity is a verycomplicated exercise requiring expert accounting and engineering skillsif it is not to become, like some methods of presumptive income taxa-

80 The phenomenon that capital goods may have a substantial cost advantagerelative to labor is not restricted to Pakistan. An overvalued exchange rate thatcheapens the cost of imported capital goods is cited as one of the main reasons,but other contributory factors are : ( 1 ) comparatively low interest rates for largeforeign producers or government-owned enterprises, (2) the transplanting ofcapital-intensive techniques from abroad, and (3) as regards labor, the prevalenceof artificially high wage levels on account of minimum wage laws, union demands,and the employment of well-paid foreign staff against which local wages aremeasured. See Bird, Taxation and Development (cited in footnote 5), pp. 124-25,and John F. Due, Indirect Taxation in Developing Economies (The Johns HopkinsPress, 1970), pp. 142-43.

81 For a review of these measures, see IMF Survey, November 6, 1972,pp. 103-104.



tion, "mainly a guessing game organized according to variable rules."82

Even if machine ratings or peak forward projections from past andcomparative production data provide useful approximations, someinherently arbitrary elements remain; this is a crucial flaw in the newscheme. Obviously, each manufacturer will have his own ideas aboutthe capacity output of his plant; moreover, these will probably changeas often as any of the other factors that determine capacity.

In Pakistan, virtually unavoidable ambiguities in capacity conceptsproved difficult to reconcile with the taxpayers' ideas of equity. Thisresulted in frequent recourse to courts, pressures to set up committeesto review capacities, increased correspondence and file work, anddelays in tax collections—thus nullifying most of the gains made at theassessment stage. This process may be repeated if capacities are reas-sessed. In this respect, the capacity tax resembles a real estate tax,under which a taxpayer's sense of equity is usually not satisfied untilhis assessment is reduced to that of his neighbor who occupies a similarabode, with the result that tax demands are often adjusted to thelevel of the lowest assessment. In addition, conceptual difficulties ledto increased reliance on past production data as the crucial variablein determining capacity output, thereby reintroducing the biases causedby underreporting in the excise system. Of course, if past productiondata are the primary determinant, the excise administration must verifytheir reliability, and that can only be done by thorough audit work.Under the capacity tax there really seem no shortcuts that enable thetax administration to avoid the problems, first of proper initial assess-ment, and second, of adequate updating and verification.

On the other hand, a capacity tax interferes less with the utilizationof capacity than a conventional excise tax. This is a considerableadvantage. Production controls are probably acceptable when excisetaxes are a relatively minor source of revenue levied mainly on a fewhomogeneous sumptuary commodities, but they become an archiac toolof tax enforcement, completely disregarding the taxpayer's convenience,when industry expands and diversifies. Of course, the thwarting restric-tions thus placed on manufacturers can be removed in other ways,such as changing and expanding the tax base to a general sales tax andshifting the verification process to account books, thereby modernizing

82 Amotz Morag, "Some Economic Aspects of Two Administrative Methodsof Estimating Taxable Income," National Tax Journal, Vol. 10 (June 1957),p. 180, quoted by Richard M. Bird in Taxing Agricultural Land in DevelopingCountries (Harvard University Press, forthcoming), Chapter 7.



a country's manner of conducting public business. For instance, tofacilitate the transition of an extended excise system with productioncontrols to a manufacturers' sales tax relying on documentary verifica-tion, a capacity tax might be employed as an interim device, pro-viding the tax department with a valuable interlude for training itspersonnel in audit and accounting techniques, for making the publicaware of oncoming changes, and for actively educating taxpayers inproper record keeping.

A second case in which a capacity tax can be usefully employed isthat of a country which has only recently turned toward industrialdevelopment. Typically, the first industrial ventures relate to productsthat were previously largely imported and that usually contributed heav-ily to customs revenue. The loss must be made up through the imposi-tion of domestic levies. Excises are generally considered the appropriateform of taxation, but a capacity tax is a viable alternative, particularlyas the country will initially be short of supervisory and audit staffrequired for administering the excises. Machine ratings can be estab-lished without much difficulty (and the tax liability computed accord-ingly), since the new industries generally engage in the manufactureof basic foodstuffs, such as sugar or margarine, beer, soft drinks, soap,tobacco products, cement, and similar products. But in the light ofPakistan's experience, rules would have to ensure a limited applicationof relief provisions, inter alia putting on the taxpayer the onus ofproving that actual production falls short of capacity output by aspecified margin.

Of course, the capacity tax would always be useful as an adminis-trative tool for ascertaining the excise or sales tax liability of manu-facturing units that are not willing to keep adequate accounts nor todisclose to the tax department their sales or any other informationrequired for tax purposes. However, to discourage such practices andto encourage the keeping of books of account, estimated assessmentswould have to be on the high side, and this practice would be resistedby the taxpayers. Finally, for taxpayers who cannot be expected to keepadequate records, such as small textile manufacturing units, the capacitytax could serve as a proxy for the excise or sales tax liability otherwisepayable.83

83 In this respect, the capacity tax can be compared with the forfait systemof assessment for the sales and business income taxes in French-speaking WestAfrica and other countries. See Due, Indirect Taxation in Developing Economies(cited in footnote 80), p. 169.



EVALUATION

Pakistan's case shows that tax reformers should consider the sub-stantial uncertainties affecting both taxpayers and the tax administrationwhenever new taxes are introduced or significant changes are madein old levies. Taxpayers cannot be expected to accept willingly measureswhich they regard as being confiscatory. New laws and proceduresare bound to lead to an increase in litigation, and legitimate pressureswill strongly increase if the determination of tax liabilities is at allarbitrary. If a number of firms are successful in getting their taxliabilities reduced or in delaying their payments, others will follow tokeep their competitive position. This concerns the certainty aspect oftaxation.84 The public's respect for the law is undermined by the arbi-trary nature of tax provisions, and, more generally, by continuouslychanging tax regulations, procedures, and practices. To be respected,tax provisions must be precise and must be changed as little as possible,so that a country's citizens may know their content and accept themeither out of fear or custom.85

This point can be usefully illustrated by the Canadian productionincentive tax, which had uncertain economic and operational effects,with subsequent undesirable repercussions on business decisions, depart-mental efficiency, and effectiveness. Cumbersome antiavoidance sectionshad to be devised to prevent noneligible integrated companies fromsplitting up. In addition, there was discrimination against unincorpo-rated businesses excluded from the benefits, while firms with sharplyfluctuating sales were unintentionally favored over firms whose salesincreased at the same rate each year. Moreover, price as well as volumeincreases were rewarded, although the former obviously did not con-tribute to higher output.86

To conclude, it should probably be emphasized that if a govern-ment's objective is to increase production, an essential requirement isthe provision of a suitable macroeconomic framework in which business

84 The classic reference is to Adam Smith, An Inquiry into the Nature andCauses of the Wealth of Nations, edited by EdwinCaiman (London, 1950), Vol. II,pp. 310-11. In a more recent study, Harley H. Hinrichs considers "certain"tax administration preferable to appealing tax inducements of doubtful merit. See"Certainty as Criterion: Taxation of Foreign Investment in Afghanistan," NationalTax Journal, Vol. 15 (June 1962), p. 153.

85 See G. Schmölders, Der verlorene Untertan (Düsseldorf: Econ. Verlag),pp. 181-82, quoted by J.C.L. Huiskamp, "Belastingontduiking" in EconomischStatistische Berichten, November 1, 1972, p. 1048.

86 See Bird, "A Tax Incentive for Sales: The Canadian Experience" (cited infootnote 10).



activities can be carried on. Disincentives and imperfections whichhinder an efficient functioning of the market mechanism should beremoved before incentives to increase production are added to thegovernment's tax policy arsenal; even then, the potentially beneficialeffects of the incentives should be carefully weighed against the costs ofthe uncertainties and administrative complications that are inevitable. Animportant, if unintended, effect of the capacity tax is that it mayincrease capacity utilization through an upward correction of the priceof capital. The tax also has some merits on administrative grounds,particularly as a transitional device. Pakistan's experience with thisnovel tax device may have useful lessons for other developing countries.


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