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Taxation Issues and Challenges in Pakistan

Why does Pakistan tax so little?
Pakistan’s tax system is ineffective, unfair, fragmented, and leaves out entire sectors of the economy,
worsening structural economic imbalances.

Pakistan has been unable to expand taxation. Despite several donor-supported reform attempts, the
tax-to-GDP ratio continues to hover around 8.5% of the GDP. The inability to expand tax revenue
contributes to significant public service delivery gaps: over 20 million people live without clean water,
almost one in every three people do not have a decent toilet, and about 40% children under the age of
five have stunted growth.

Those who can afford to rely on private providers to access education, healthcare, and water, do so. In
Karachi, residents have to use a mix of private vendors, water mafia, and the government to get access
to water. The reason for this failure of sufficient public service delivery is partly Pakistan’s ineffective tax
system, which has struggled to expand beyond taxing imports and consumption. Between 2008 and
2021, Pakistan’s federal government collected between 36% to 39% of its tax revenue from direct taxes,
while the rest came from indirect taxes.

Figure 1: Tax collection versus government spending as a percentage of GDP

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A skewed tax system affects Pakistan's economic structures

By skewing the tax system towards import and consumption taxes, Pakistan worsens its structural
economic imbalances. For example, by levying extensive taxes on imports, Pakistani firms are more
incentivised to sell domestically to a protected market than to compete globally. Research by the World
Bank shows that a 10% import duty in Pakistan increases profits from selling domestically relative to
exporting by 40% on average. This feeds into Pakistan’s structural challenge of low exports which are the
core of its recurring balance of payment crises.

These imbalances are worsened by the undertaxation of agricultural income, urban properties, and
retailers. By undertaxing properties, Pakistan’s tax system incentivises firms and households to invest in
urban property as opposed to sectors that may generate exportable goods or services. As
IGC research has shown, with a population of over 100 million, all of the state of Punjab in Pakistan
collects less urban property tax than the city of Chennai in India, which is home to about 10 million
people. The agriculture sector is also undertaxed: while agriculture contributes to nearly one-fifth of the
GDP, it counts for less than 1% of national tax revenue.

Fragmentation and exemptions in the tax system reduce government

revenue
 The tax system is also deeply fragmented. Value-added tax is split between federal and
provincial governments, opening up avenues for fraudulent refund claims.
 Research by Mazhar Waseem shows that between 31% to 46% of the value-added tax base is
likely evaded. A large chunk of this is through overclaim of refunds based on spurious invoices.
 For firms that are to comply with this fragmented tax structure, it adds an enormous
administrative burden: a firm that operates nationwide is exposed to five tax jurisdictions and
has to submit a total of 62 tax returns.
 Pakistan’s tax code is also plugged with a range of exemptions that cost the country over PKR
1.7 trillion in forgone tax revenue in the past year alone. Most of these exemptions are applied
on the discretion of the federal government to provide preferential treatment to certain sectors.
 They also risk creating distortions to the tax system by undermining the information trail that is
instrumental to expanding the tax system. In some cases, these exemptions are simply odd: until
recently, Pakistan’s tax code exempted red chillies from sales tax, but not green chillies.

Even where tax policy is broadly effective the lack of information on tax obligation and weak
enforcement undermines revenue collection. Much of Pakistan’s economic activity is cash-based with a
limited information trail that the government can use to levy taxation, making evasion easy. Due to
limited information, proxies like electricity consumption have been helpful in estimating tax obligations.
However, powerful constituencies have often been able to push back attempts to expand taxes. Over
time, an ineffective tax system has bred an expectations problem: why should people pay taxes when
the government fails to deliver basic public services? But how can the government expand public
services when it has little money to do so because of low taxes?
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Taxation Issues and Challenges

Pakistan is a developing country that faces numerous challenges in its tax system. The taxation system in
Pakistan is complex and often problematic. In this article, we will discuss the common taxation issues
and challenges faced by Pakistan.

1. Low Tax-to-GDP Ratio:

 Pakistan has historically struggled with a low tax-to-GDP ratio, which indicates that the
country collects a relatively small share of its economic output as tax revenue.

Pakistan's tax-to-GDP ratio is approximately 8.5%, well below the desired level. For
comparison, the global average tax-to-GDP ratio was around 15-16%.

 Low revenue collection hampers Pakistan's ability to invest in infrastructure, education,

healthcare, and other essential services.

2. Tax Evasion and Informal Economy:

 Widespread tax evasion and a significant informal economy limit the tax base and result
in lost revenue.

 According to estimates, the size of Pakistan's informal economy is substantial, making

up a significant portion of the country's economic activity.

 Many businesses and individuals engage in underreporting income, hiding assets, or

operating entirely off the books to avoid taxes.

3. Complex Tax Structure:

 Pakistan's tax system is complex, with multiple taxes and exemptions, making it
challenging for taxpayers to understand and comply.
 There are several layers of taxation in Pakistan, including federal and provincial taxes,
leading to administrative complexities.

 The General Sales Tax (GST) system in Pakistan has multiple rates and exemptions,
making it difficult to administer and prone to tax evasion.

4. Weak Tax Administration:

 Tax administration in Pakistan faces issues related to inefficiency, corruption, and
limited capacity.

 Tax collection agencies have struggled to effectively enforce tax laws and reduce tax
evasion.

 Instances of corruption within tax authorities can undermine revenue collection efforts
and erode public trust.
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5. High Tax Burden on Formal Sector:

 The formal sector bears a disproportionately high tax burden, while the informal sector
often escapes taxation.

 A significant portion of Pakistan's workforce operates in the informal sector, leading to

an imbalance in the distribution of the tax burden.

 Formal businesses and taxpayers are subject to various taxes and regulations, while
informal businesses often operate without taxation.

6. Tax Amnesties:

 Frequent tax amnesty schemes have been introduced as short-term measures to boost
revenue, but they do not address the root causes of tax evasion.

 Pakistan has introduced several tax amnesty schemes in the past to encourage the
declaration of hidden assets.

 While tax amnesties may temporarily increase revenue, they can also promote a culture
of non-compliance and undermine the integrity of the tax system.

7. Lack of Technology Integration:

 Outdated and manual tax administration processes hinder efficiency and increase the
potential for human error and corruption.

 Pakistan's tax authorities have been slow in adopting modern technology for tax
collection and data management.

 Manual processes for tax filing and assessment can lead to delays and inaccuracies in
revenue collection.

How Taxation System can be Improved in Pakistan?

Ergo, the country needs tailored, strategic solutions to our tax woes that address the underlying issues
and are supported by domestic efforts, strong political determination, and equitable taxation policies.
Coming to home-grown solutions, we need to deal with everything ranging from addressing policy-
related gaps to issues of implementation and interface with taxpayers. Here is a five-point agenda, that
confronts the realities of Pakistan’s underlying problems, as the foundation of various facets of reform.

1. Define and Clearly Communicate the Vision of Our Tax Policy

First, there is a need to define and clearly communicate the vision of our tax policy and exercise strict
adherence to it. The principle of equity — both horizontal and vertical — should supersede all other tax
objectives. Horizontal equity means that all equals should be taxed equally, and vertical equity means
that all unequals should be taxed unequally. In Pakistan, both these principles have been consistently
compromised. The rich pay the least, whereas the salaried class and a few industrial and business
sectors carry the entire tax burden.
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2. Weak Provincial tax collection

Second, weak provincial tax collection means that the centre remains under pressure to spend
on matters that lie under the provincial domain. In addition, weak provincial taxation
exacerbates the problem of equity. Although provinces enjoy the constitutional authority to levy
and collect agriculture income tax, sales tax on services, and provincial property tax, the
slackness in their efforts is evident from the fact that they collectively cannot mobilise taxes
even up to 1pc of GDP. Despite such performance, provincial tax authorities do not receive the
kind of flak the FBR gets for low resource mobilisation.
3. Adhocism has to be done away with
Third, adhocism has to be done away with. In their desperate attempts to meet revenue targets,
governments take stopgap measures to improve tax numbers. The use of tax/duty rate increases,
imposition of advance/withholding taxes, or withdrawal of exemptions are the easiest tools to raise
incremental tax revenues. The frequent recourse to these measures has made our tax system highly
inelastic and is often in conflict with long-term economic policy objectives and strategic goals. For
instance, the imposition of withholding taxes on cash withdrawals and non-cash banking transactions in
the not-too-distant past impaired financial inclusion and increased informality in the economy.

4. There Needs to be a Strong and Effective Audit Mechanism

Fourth, there needs to be a strong and effective audit mechanism in place. Voluntary compliance is
important. However, results from over-reliance on half-hearted administrative measures to minimise
evasion have been elusive. Therefore, voluntary compliance must be backed by robust audits along with
stern enforcement against tax dodgers and delinquents. Heightened risk of being caught and associated
penalties can be a strong deterrent to concealment and under-reporting of income.

5. A Serious Institutional Reform of the FBR is Crucially Needed

Fifth, a serious institutional reform of the FBR is crucially needed. This institution needs to be
restructured into a professional, autonomous organisation with an independent board consisting of
eminent personalities qualified in the fields of economics, public policy, law, chartered accountancy,
finance, business administration, and IT. The board should drive the vision and strategic direction of tax
policy and exercise oversight over the management of tax administration. Its members, having no
conflict of interest, should be appointed for a fixed term with legal protection against undue pressure. A
change in the incentive structure in FBR will promote a culture of transparency and integrity. Such a
restructuring plan is also needed in provincial revenue authorities. Indeed, without first fixing the
institutions, all other types of reforms may be akin to throwing good money (often borrowed foreign
exchange) after bad!

Govt mulls ordinance to digitize economy

In a recent meeting, the Special Investment Facilitation Council (SIFC) under Caretaker Prime Minister
Anwaarul Haq Kakar discussed strategies to broaden the tax base in Pakistan. The Ministry of
Information Technology proposed playing a central role in data collection from the four provinces to
identify non-filers and register new taxpayers. This initiative aims to digitize the economy and tax
system, with a focus on increasing tax compliance. The Ministry of Information Technology, led by
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Minister Umar Saif, is tasked with these efforts and may receive legal backing through a presidential
ordinance. The SIFC also considered restructuring the Federal Board of Revenue (FBR) to improve tax
collection, addressing concerns about its performance, and exploring new approaches for tax reform.
Technology to play the role of a data-gathering agency to broaden a narrow tax base of 4.2 million
filers. During first two months of the current fiscal year, the FBR pooled Rs1.208 trillion in taxes,
roughly Rs25 billion more than the assigned target.

However, there was skepticism among some participants about the FBR's reported 30% increase in tax
collection, attributing it to high inflation. They expressed concerns about reaching the annual tax target
due to potential reductions in taxes at the import stage. The meeting also highlighted challenges in the
FBR's tax-to-GDP ratio and overreliance on withholding taxes, leading to discussions about potentially
involving a third ministry to address tax-related functions. Overall, the focus remains on enhancing tax
compliance, digitizing the economy, and improving the effectiveness of the FBR to meet revenue
collection goals.

Singapore's taxation system

Pakistan can learn several valuable lessons from Singapore's taxation system to improve its own tax
collection and administration. Here are six comprehensive points on how Pakistan can draw inspiration
from Singapore:

1. Simplify the Tax Structure:

 Pakistan can streamline its tax system by reducing the number of taxes, rates, and
exemptions. Singapore's simple tax structure makes it easier for taxpayers to
understand and comply with their obligations. Simplification can help reduce tax
evasion and administrative complexities.

2. Progressive Taxation:

 Pakistan can consider adopting a progressive taxation system similar to Singapore,

where higher-income individuals pay higher tax rates. This approach ensures a fair
distribution of the tax burden and can help address income inequality.

3. Efficient Tax Administration:

 Pakistan should invest in modern technology and digital platforms for tax filing,
payment, and administration, similar to Singapore. An efficient and transparent tax
administration system can reduce compliance costs, minimize errors, and enhance
taxpayer services.

4. No Capital Gains Tax:

 Pakistan can explore the idea of not imposing capital gains tax, as is the case in
Singapore. This can encourage investment in the country's capital markets and stimulate
economic growth.

5. Territorial Tax System:

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 Pakistan can consider adopting a territorial tax system like Singapore, where only
income earned within the country is subject to tax. This approach can attract foreign
investment and simplify tax compliance for multinational corporations.

6. Taxpayer Education and Outreach:

 Pakistan should launch taxpayer education and outreach programs modeled after
Singapore's initiatives. These programs can inform individuals and businesses about
their tax obligations, promote voluntary compliance, and foster a culture of tax
responsibility.

By incorporating these principles and best practices from Singapore's taxation system, Pakistan can work
toward simplifying its tax regime, enhancing revenue collection, and improving the overall tax
compliance environment. However, it's crucial to adapt these lessons to Pakistan's unique economic and
social context and consider the country's specific challenges and opportunities.