Nepal’s tax system widens rich-poor gap

It is that time of the year again. The last-minute construction spree is underway to make up for chronic underspending of capital expenditure, right ahead of the new budget to be presented in Parliament on 29 May.

The paradox is that while the government faces a severe cash crunch due to falling revenue, it spent only one-third of the development budget in the last 10 months of the fiscal year. 

The new parties in Parliament like the RSP have been trying to shake things up and urge multi-partisan consultations before the budget, but given the obsolete structure and leadership of the parties, not much is expected to change.

But there is a strong argument for tax reform since the government faces a major challenge in balancing revenue with expenditure. The previous government’s ban on luxury items to augment depleting foreign reserves post-pandemic and increased bank interest led to the decline of real estate transactions resulting directly in a drop in revenue.

But what makes matters worse is that the government has been profligate in spending beyond its means. Salaries, allowances, administrative expenses, grants and loans have all gone up. The government collected Rs756 billion in revenue in the last 10 months against the target of Rs1.4 trillion whereas its expenditure has exceeded Rs1.04 trillion. 

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Taxation is the primary source of income for any government. Contrary to what the wealthiest Nepalis think, the government is not run with their tax money but by what ordinary citizens pay in taxes.  While tax evasion concentrates the wealth within the already privileged, the tax the poor pay is not proportional to their earnings.  

Nepal’s liberal economic policy since 1990 was expected to alleviate the income gap with trickle down effect, but the economic disparity in society is more stark than ever. A 2020 report Equality for Prosperity showed that while the wealthiest 20% of Nepalis own 56.2% of wealth, the poor 20% have only 4.1%. This economic gap is likely to have widened with the current crisis. 

This income gap is not just in Nepal. Worldwide, a skewed tax system is blamed for rising inequality. A new Oxfam report points out that two-thirds of the wealth that has increased globally after the Covid-19 pandemic is in the hands of the richest 1%. It recommends tax reforms based on wealth accumulation.

“Because the tax system is not progressive in Nepal, wealth is piling up in the hands of the rich, while the income of the poor is not increasing,” explains economist Dilliraj Khanal. “We don't have a system of taxing the rich because of policy weakness and dominance of middlemen.” 

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Who pays taxes?

Two-thirds of the government's annual revenue is collected not from corporations and industry, but from various taxes and revenue paid by the general public. The share of tax on corporate profit is in fact very small. 

In fiscal year 2021/22, the government collected a total of Rs989.62 billion in revenue. Of this, the income tax paid by businesses from the profits earned through private companies is only 5%. So while income tax did bring in Rs229 billion which is 24% of total revenue collected, this amount is largely from the income tax paid by ordinary citizens on their personal income.

The tax paid from the profits of private companies is only Rs47.5 billion. When adding public limited companies (issued shares to the general public) and other types of companies, corporate income tax comes to only about Rs114 billion,which is just 11% of the government’s annual revenue. 

The government collected Rs314 billion from VAT last year, and this made up about one-third of total government revenue. Similarly, Rs241 billion was collected as customs duty and Rs155 billion as excise.

“Society with unequal income and wealth, but equal taxes, burdens the poor and favours the rich, it is a regressive tax system that makes it difficult for the poor to survive,” says Khanal. For example, VAT is the same 13% for all Nepalis – rich and poor.  

“In essence, five-star hotels in Kathmandu and the poor are both taxed equally for LPG fuel,” he adds. “From a social justice standpoint, taxes must be based on income.”

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Taxation expert Roop Khadka disagrees, saying it is impractical to have a different VAT rate for rich and poor, and even if it was introduced it would be impossible to enforce.

Instead, Khadka favours revoking VAT exemption on goods and services consumed by the upper classes, which are worth nearly Rs100 billion per year. Tax evasion by the rich is another problem that needs to be tightened, and collusion between business and politicians means that the government itself abets tax evasion.

Real estate speculation has helped select groups in Nepal to become immensely rich immediately, but the government collects a bare minimum in tax from profits made in land transactions.  

A real estate sale within five years is required to pay 7% of its profit. If the transition happens within 10 years, only 5% of the profit is taxed. This means most of the astronomical profits made in real estate sales in the past years have gone into the pockets of brokers and large landowners.

On the other hand, the 60th report of the Auditor General's Office says many evade tax by showing less than the actual value of the property. The VAT bill scandal 10 years ago also revealed the widespread tax evasion by the commercial sector.

The politics of patronage means that businesses are now colluding with politicians and bureaucrats to loot the treasury. The Tax Settlement Commission decided to collect Rs9.54 billion from businesses that have not paid tax for a long time, but the Auditor General's Office later revealed that the decision was made in cahoots with the businesses themselves who actually needed to pay Rs30.52 billion.

The most egregious and blatant wrongdoing was by former Finance Minister Janardhan Sharma who was making backroom deals with select business groups importing steel rods and electric vehicles so their products got customised tax breaks in the budget last year. The deal cost Sharma his ministership but the unholy nexus between politicians and business continues with impunity. 

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Alternative to the wealth tax

In this state, the only sector keeping Nepal’s economy afloat is the estimated $9 billion Nepalis abroad send home every year. Still, Nepal’s debt has reached 43% of GDP, a sharp rise from 28% a decade ago. This will have a direct impact on the tax system. Sooner or later, the government will raise taxes. But for whom? 

If the status quo continues, and the poor are subjected to more taxes the income gap will widen further, inviting social unrest. Taxation relative to the size of the economy is about 22% in Nepal, one of the highest in South Asia. But for every Rs100 the government receives as revenue, only Rs23 is collected through income tax. The rest is made up of common citizens paying for the consumption of goods and services. 

All over the world, different levels of income are distinguished and income tax exemption is given to the lowest which is known as a basic exemption. Welfare states also have a weighted system of taxes of the richest that ensures socio-economic equality.

But even though there is a flat tax on salary and allowances, windfall profits including from real estate transactions are not taxed properly, leading to a consolidation of wealth among certain groups.

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Experts have proposed wealth-based taxation to reduce the disparity between rich and poor. Economist Keshab Acharya says that the government should levy an inheritance tax on ancestral property to children as is done in the US, Japan and Europe. This encourages entrepreneurship and inspires the new generation to find creative ways to earn money.

But the historical distribution of land in Nepal was largely unfair where families close to the ruling class were granted ownership exempt from tax. These assets have been handed down through generations and ownership of a large part of it is still limited to certain families. 

Historian Mahesh Chandra Regmi in his book Land Ownership in Nepal states that before 1951, more than one-third of the total arable land had been handed down intergenerationally in that manner. An inheritance tax will also reduce corruption because the mentality that wealth should be passed on to children will be weakened if such a tax is implemented.

Meanwhile, land prices in Kathmandu skyrocketed thanks to the government. Since the state has spent on infrastructure that led to the rise in value of property, it should get a share of the profits

“The government should get the benefit of increased property valuation in the form of taxes which will increase the spending purse for the welfare of the poor,” explains Khanal.

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