In 2008 the Government of Pakistan agreed with the IMF to increase the tax/GDP ratio
by 3.5 percentage points over the medium term. This commitment has rekindled the
debate regarding the agricultural income tax. Advocates of an agricultural income tax
argue that the sector remains protected by political interests, while opponents to such a
tax maintain that agriculture is already subject to significant indirect taxation, mainly
because of prevailing price distortions in agricultural product markets.
One way to assess agriculture’s performance in relation to other sectors of the economy is
to calculate the returns to the sector, relative to the payouts made by the sector. This
requires the construction of inter-sectoral terms of trade indices which allow comparison
of the value of “exports” from the agricultural sector to other sectors (mainly industry)
with “imports” from other sectors into agriculture.

This paper reviews the literature on domestic terms of trade analysis in Pakistan and
calculates an updated set of terms of trade indices for agriculture relative to industry. The
paper also discusses key issues with regard to the imposition of agricultural income tax in
Pakistan, and uses simulation results from a Computable General Equilibrium (CGE)
model for the Pakistan economy to analyze the potential effects of the imposition of an
agricultural income tax on poverty and fiscal revenues.
The results suggest that the domestic terms of trade have remained unfavorable for
Pakistan’s agriculture during almost the entire 2000-2009 period. Agriculture’s terms of
trade declined from 2001-02 to 2003-04 before improving only slightly during the period
from 2004-05 to 2006-07. As of 2007 however, prices of agricultural commodities
started rising resulting in significant increases in agriculture’s terms of trade. But in spite
of the substantial increases in agricultural prices, the terms of trade for agriculture,
though on a rising trend, remained marginally unfavorable to the sector.
A CGE model for Pakistan was used to simulate the poverty impacts of the declining
terms of trade for agriculture. During the period when agriculture’s terms of trade were
declining (1999-2000 to 2005-06), the volume of production in agriculture declined by
1.4 percent, while the volume of production in industry improved by 2.5 percent. Output
of the service sector declined by 0.8 percent. During the period when agriculture terms
of trade were improving (2005-06 to 2007-08), the output effects were largely the
reverse.
The same CGE model was also used to assess the poverty impacts of a hypothetical
agricultural income tax. Levying an income tax on large farmers (> 50 acres) was found
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to be pro-poor. A 6 percent income tax on this group would reduce the poverty incidence
only marginally (i.e. by -0.02 percent). However, a 30 percent income tax rate on large
farmers would reduce poverty by nearly 0.5 percent. Keeping total government
expenditure fixed in the model in order to assure model closure implies that higher
government revenues from increased direct tax revenue result in higher total savings in
the economy, which in turn leads to higher investment in especially the construction
sector. The latter increases its use of urban skilled and (especially) unskilled labor. Even
though agricultural output declines which has an adverse effect on rural poverty, the
decrease in urban poverty more than offsets the increase in rural poverty.
On the other hand, an agricultural tax imposed on medium farmers (12.5-50 acres) is not
generally pro-poor and may even increase poverty. This is because medium farmers
greatly outnumber large farmers and the initial poverty incidence among medium farmers
is much higher than among large farmers. On the other hand, while taxing both large and
medium farmers is not pro-poor, most simulations suggest that it does increase the tax
base relative to a tax on large farmers only. To the extent that the increased fiscal
revenues would be used to mitigate the poverty increase and the remainder for public
investments, taxing medium farmers could lead to certain social welfare gains. However,
to find out the exact effects would require more research and in the short-run taxation of
large farmers only seems to be the preferred option.