Pakistan Tax Reform

This year, 2019, is expected to be the year Pakistan takes significant steps towards improving its tax system.

The national economy inherited by Prime Minister Imran Khan and his new Tehreek-e-Insaf (PTI) government is a troubled one, with a growing fiscal deficit, rising intercorporate debt in the power sector, inflationary pressures, declining exports, and a widening current accounts gap. To stabilize the external sector in the short term, the government arranged much-needed loans from the Gulf states and China, and it is now pursuing policies that it believes will help realize the country’s industrial potential. Most importantly, the government has introduced a package of tax and administrative reforms for industry and agriculture. It is part of the of the government’s strategy to deploy supply-side, business-friendly, and pro-growth policies to improve market sentiment and get the economy back on track to recovery and sustainable growth.

[pullquoteleft]Pakistan’s economy is recuperating from a stifling investment climate and what can best be described as a “consumption-led” growth period financed by short-term debt[/pullquoteleft]. Consumption as a percentage of GDP rose to 94.5 percent in 2018. Total gross investment, which includes government investment, was reported at just 16.4 percent of GDP in FY18—compared to 30 percent in India and 31 percent in Bangladesh. Constrained by low revenues, the government’s expenditures on health are estimated at just 0.7 percent of GDP, while education comprises less than 2 percent; again, both lower than regional averages. It is not surprising, therefore, that Pakistan continues to struggle to meet its human development and poverty reduction goals.

Research indicates that, [pullquoteright]apart from restrictive economic policies that hinder savings and investment in Pakistan, there are two additional factors in the country’s economic malaise: insecurity and taxes[/pullquoteright]. While security has improved significantly over the last few years, little attention has been paid to Pakistan’s unfriendly tax policies. Pakistan ranks 136th worldwide in the World Bank’s Ease of Doing Business Index, and 172nd in ease of paying taxes. These rankings suggest that tax laws are currently the single largest hindrance to investment in the economy.

Pakistan’s narrow tax base, its limited capacity to collect taxes, and the low national rate of tax compliance point to the crying need for better tax administration. Further aggravating the problem is the large number of tax exemptions available to certain segments of society. Taxes on agriculture, capital gains, and real property, for example, are essentially negligible, shifting the taxpaying burden to low-income groups through withholding taxes and the sales tax, which consume large parts of their income.

Exemptions and preferential treatment, which are granted by the executive through Statutory Regulatory Orders without prior approval of the Parliament, and which are not reported, reduce tax collections by approximately 2 to 3 percent of GDP each year. A comparison of the agriculture, manufacturing, and service sectors can help illustrate the extent of these distortions. The agriculture sector, which accounts for 21 percent of GDP, pays less than 1 percent of all taxes. The manufacturing sector, on the other hand, contributes 13 percent of GDP but 52 percent of all taxes, while the service sector contributes 58 percent of GDP but just 37 percent of tax revenues.

Total tax revenues in Pakistan stand at just 13.7 percent of GDP according to the Pakistan Economic Survey 2017–18, among the lowest of all emerging economies. Compliance costs are the highest in South Asia, and the tax administration system itself is weak overall, because the Federal Board of Revenue has neglected its primary responsibility of establishing a functional organizational structure. Deductions at source—withholding—account for the majority of tax revenues, which means that wage earners carry a disproportionate burden under the current system.

At a roundtable on the future of tax reform convened by The Asia Foundation and the Sustainable Development Policy Institute, participating experts recommended that tax policy and tax administration be systematically reformed, based on principles of equity and fairness, with further deregulation of parts of the economy. Exemptions and tax credits should be reduced to remove distortions in the tax system, and tax-withholding regimes should be rationalized to lessen the burden on low-income citizens. Participants also identified a clear need for taxpayer education to improve compliance and increase tax revenues.[pullquoteleft]The government has recently proposed a business-friendly tax- and administrative-reform package[/pullquoteleft]. Reducing the corporate tax rate to less than 30 percent over the next two to three years would also promote economic growth. Since Imran Khan has taken the reins of the country, the government appears to have given high priority to tax reform and increasing the tax base.

Haris Qayyum is strategy and program development lead for The Asia Foundation in Pakistan. He can be reached at [email protected]. The views and opinions expressed here are those of the author, not those of The Asia Foundation.