Structural issues in tax system persist | Political Economy

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Pakistan’s tax system has long been subject to criticism. It is riddled with inefficiencies and irregularities that hinder economic growth and equitable distribution of resources. When compared to countries with high tax-to-GDP ratios globally and within Asia, the difference in Pakistan’s fiscal policies is clearly evident. These disorders affect businesses and individuals.

Pakistan’s current tax-to-GDP ratio of 9.2 percent is significantly lower than the global average. [how much?] and 34 percent of the Organization for Economic Cooperation and Development. Among Asian economies, it is weaker than regional leaders such as Japan (34.1 percent), Korea (32.0 percent) and Mongolia (24.6 percent). This disparity highlights Pakistan’s structural deficiencies and lack of comprehensive tax reforms. The Federal Board of Revenue has often failed to meet its collection targets, widening fiscal deficits and requiring frequent adjustments in tax policies.

In FY 2023-24, the FBR collected Rs 9,306 billion, marginally ahead of the revised target but short of the original target by Rs 109 billion. Despite a 30 percent increase over the previous year, the ambitious target of Rs 12,970 billion for FY 2024-25 appears elusive. A revenue shortfall of Rs 344 billion in the first five months of FY 2024-25 illustrates the challenges in meeting these targets. Repeatedly small budgets to address income gaps undermine economic stability and public confidence in government fiscal policies. finish

The regressive nature of Pakistan’s tax system places a disproportionate burden on the salaried class and small businesses. Recent reforms, such as the removal of tax incentives for export sectors and the increase in taxes on salaried individuals, have put a strain on disposable income and hampered business growth. These measures, aimed at broadening the tax base, fail to address the underlying problem of tax evasion and the informal economy, which constitutes a significant portion of Pakistan’s GDP.

Countries with high tax-to-GDP ratios have progressive tax systems that ensure a fair distribution of resources. For example, Denmark and Sweden, with tax-to-GDP ratios above 40 percent, benefit from strong social security contributions and efficient tax collection mechanisms to fund comprehensive welfare programs.

Asian economies such as Japan and Korea prioritize corporate taxes and social contributions, accounting for 21.3 percent and 32 percent of their tax revenues, respectively. These countries have successfully combined tax policies with economic development strategies, promoting a business-friendly environment while ensuring social equity.

Frequent changes in tax policies create an unpredictable business environment, deterring investment. For example, the Tax Laws (Amendment) Act, 2024, which was tabled in the National Assembly on December 18, 2024, proposes restrictive measures such as barring non-compliant persons from operating bank accounts. While intended to prevent tax evasion, such measures place an undue compliance burden on businesses, particularly small and medium-sized enterprises (SMEs).

This reactive approach provides a stark contrast to proactive reforms in countries like Singapore that have streamlined tax administration and encouraged compliance through digital platforms and transparent processes. In Pakistan, some people appointed to head tax agencies do not have advanced technical knowledge.

On the human development front, Pakistan’s tax system fails to convert revenues into tangible benefits for citizens. Lack of investment in health, education and infrastructure exacerbates socio-economic disparities. In contrast, countries with high tax-to-GDP ratios use tax revenues effectively to expand public services and improve living standards. For example, Norway and Finland put a substantial share of their tax revenue into education and health care, achieving high human development indices.

The agricultural sector in Pakistan, which contributes 24 percent to GDP, remains largely untaxed, maintaining fiscal imbalances. Recent initiatives by some provincial governments to impose an income tax on agricultural income, such as the amendments to the Punjab Agricultural Income Tax Act, 1997, are steps in the right direction. However, they still lack an agreement with the International Monetary Fund.

Sindh, Khyber Pakhtunkhwa and Balochistan are yet to amend their agricultural income tax laws to bring them into line with the federal personal and corporate income tax laws as per the IMF’s conditionality signed National Fiscal Agreement.

Comprehensive laws, effective enforcement and fair enforcement are essential in this regard. Countries such as New Zealand have successfully integrated agricultural income into the tax net, ensuring a fair contribution from all sectors of the economy. Other sectors that need immediate reform from a tax perspective are retail and real estate.

Incompetence, incompetence and corruption of FBR is a hindrance to effective tax collection. Absence of a comprehensive tax database and reliance on manual processes increase revenue leakage. Advanced economies use technology-based solutions, such as electronic invoicing and data analytics, to increase compliance and minimize theft. For example, Estonia’s e-tax system has revolutionized tax administration, achieving near compliance rates.

The share of social security, a significant share of tax revenue in developed countries, is only 7.6 percent of Pakistan’s tax revenue, compared to 23.7 percent in OECD countries. This highlights the need to reform Pakistan’s social security framework to increase coverage and ensure sustainable funding for welfare programs. Lessons can be drawn from Germany and Japan, where mandatory cooperation by employers and employees underpins strong social security systems.

Pakistan’s reliance on indirect taxes (even under the guise of direct taxation through multiple withholding provisions), which accounts for more than 60 percent of total tax revenue, disproportionately affects low-income groups. Direct taxes form a large share of revenue in developed economies, promoting equity. For example, personal income tax represents 23.7 percent of total tax revenue in OECD countries, compared to 15.9 percent in Asia Pacific and even less in Pakistan. A shift in focus from indirect to direct taxes is necessary to achieve equity.

Fluctuations in commodity prices and economic shocks, such as the Covid-19 pandemic, have further strained Pakistan’s tax system. While countries such as Fiji and the Maldives have taken advantage of improved tourism and commodity prices to raise their tax-to-GDP ratios, Pakistan’s reliance on external debt to cover fiscal deficits underscores the need for structural reforms. does Recent declines in tax-to-GDP ratios in Sri Lanka and Bhutan, due to policy mistakes and economic crises, serve as a cautionary tale.

To address these challenges, Pakistan should adopt a multi-pronged approach to reforming its tax system. First, broadening the tax base and eliminating/reducing exemptions by integrating the informal economy is imperative. Second, investment in technology and capacity building within the FBR can enhance efficiency and transparency. Third, revenue collection can be improved by promoting a culture of voluntary compliance through incentives and public awareness campaigns. Fourth, aligning tax policies with economic objectives, such as promoting exports and attracting investment, promotes sustainable development. can increase

The focus on achieving ambitious revenue targets should be complemented by fair tax policies and efficient use of resources. Introduction of digital tax platforms and simplification of procedures can reduce compliance burden and attract more investment. By learning from regional peers such as Vietnam and Indonesia, which have implemented tax reforms to boost revenues and economic growth, Pakistan can forge a path towards fiscal stability.

Pakistan’s tax system needs urgent and comprehensive reforms to remove its anomalies and align it with global best practices. By adopting a proactive and inclusive approach, the government can increase revenue collection, promote equity and achieve economic stability. Lessons from countries with high tax-to-GDP ratios and efficient tax systems provide valuable insights for building a strong and equitable fiscal framework for Pakistan. All this is well documented in the book, Broad, Flat, Low Rate and Predictable Taxes (Prime Minister, 2024) and the book, Tax Reforms in Pakistan: Historical and Critical Review (PIDE, 2020).

Dr. Ikram-ul-Haq, author and Supreme Court advocate, is an adjunct professor at Lahore University of Management Sciences.

Abdul Rauf Shakuri is a US-based corporate lawyer.