Pakistan is burdened with a tax system that is unfair and corrupt as well as ineffective. This is a major factor in accentuating the economic crisis the country faces. Currently, Pakistan collects about 11 percent of GDP in taxes, whereas the actual potential is much higher. Between 2008 and 2021, Pakistan’s federal government collected between 36% and 39% of its tax revenue from direct taxes, while the rest came from indirect taxes

The taxation system suffers from a host of ills, including leaky tax administrations, weak enforcement, low compliance, numerous exemptions and concessions and a narrow base. Despite continued donor support, Pakistan has been unable to reform its taxation system. Due to low tax collection, the government cannot expand welfare services for the people. According to an estimate, 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.

The tax system is tilted towards import and consumption, leading to serious structural economic imbalances. These imbalances are worsened by the under-taxation of agricultural income. While agriculture contributes nearly one-fifth of the GDP, it accounts for less than 1% of national tax revenue.

The tax system is deeply fragmented. Value-added tax is split between federal and provincial governments, opening up avenues for fraudulent refund claims. Numerous exemptions through SROs cost the country over Rs1.7 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. 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.

Needless to say, improving the tax system is essential to generate funds for better service delivery and social protection. Pakistan inherited the tax structure of pre-partition India. After independence, Pakistan adopted the Income Tax Act 1922 as its official income tax law, which was extended to the whole country except some special areas. Later numerous amendments to the Act of 1922 were passed which made the law cumbersome.

It is important to note that income tax is almost one third of the tax revenue generated in Pakistan, constituting about 32.1 percent of Pakistan’s total tax revenue and 3.7 percent of its GDP in the financial year 2020. In recent years, successive governments have put in place various measures to increase income tax revenues; whether it is by increasing the documentation of the informal economy or bringing improvements in the tax system.

Only 2.74 million people file personal income tax in Pakistan, which is just 4.1 percent of the labor force and 1.3 percent of the population in Pakistan. It may be noted here that 35 percent of the individual filers pay zero income tax i.e. they fall below the taxable income and did not pay taxes during the year. In addition to this, 64 percent of all filed income tax is from corporate income tax.

Pakistan’s current income tax regime is fragmented. While non-agriculture income tax is collected by the federal government through the Federal Board of Revenue (FBR), Agriculture Income Tax (AIT) is collected by provinces at a lower rate. This fragmentation in the tax base results in significant loss of revenue, as citizens evade taxes by declaring their non-agriculture income as agriculture income.

Tax compliance is a delicate task and has to be handled with care. While the number of tax filers has doubled from 1 million, due to new prohibitions, tax filers are discouraged to continue filing because of needless questioning of their previous records. Moreover, the audit and verification of industry’s compliance or tax returns is also a cumbersome process. The self-assessment system has yielded good results, but extensive questioning of every single item in the tax returns as well as the companies’ profit and loss statements runs against the spirit and purpose of self-assessment.

Over-reliance on withholding tax is another weakness of the system. Almost 70% of all income tax is collected as withholding tax. Experience from other countries shows that overreliance on withholding taxes can become counterproductive as instead of bringing more people in the tax net, it may actually reduce their number.

An urgent need is to club agriculture and non-agriculture income which should be taxed at the same rate, preferably by FBR and all collections by FBR should be sent as straight transfers to provinces to reduce administrative costs. It is equally important to continually revise agri tax rates to capture value addition over time. To encourage compliance, tax rates should remain stable and not change with every finance bill. According to some experts, fixing flat rates may bring in more revenue than multiple tax rates which create confusion and result in evasion.