This Selected Issues paper reviews Pakistan's tax regime, evaluates the level and composition of tax revenues, and estimates tax buoyancy and efficiency. Despite recent progress under the program, Pakistan's tax revenue remains very low relative to comparator developing countries and the tax effort expected for the country's level of development. This reflects narrow tax bases, overgenerous tax concessions and exemptions, weak and fragmented revenue administrations, and structural features of the economy. The findings suggest that unlocking tax revenue potential requires broadening tax bases, strengthening revenue administration and taxpayer compliance, eliminating distortionary tax expenditures, and rationalizing tax policy for greater efficiency and equity through a comprehensive and front-loaded reform agenda.

Abstract

This Selected Issues paper reviews Pakistan's tax regime, evaluates the level and composition of tax revenues, and estimates tax buoyancy and efficiency. Despite recent progress under the program, Pakistan's tax revenue remains very low relative to comparator developing countries and the tax effort expected for the country's level of development. This reflects narrow tax bases, overgenerous tax concessions and exemptions, weak and fragmented revenue administrations, and structural features of the economy. The findings suggest that unlocking tax revenue potential requires broadening tax bases, strengthening revenue administration and taxpayer compliance, eliminating distortionary tax expenditures, and rationalizing tax policy for greater efficiency and equity through a comprehensive and front-loaded reform agenda.

Unlocking Pakistan’s Revenue Potential1

Despite recent progress under the program, Pakistan’s tax revenue remains very low relative to comparator developing countries and the tax effort expected for the country’s level of development. This reflects narrow tax bases, overgenerous tax concessions and exemptions, weak and fragmented revenue administrations, and structural features of the economy. This paper reviews Pakistan’s tax regime, evaluates the level and composition of tax revenues, and estimates tax buoyancy and efficiency. The findings suggest that unlocking tax revenue potential requires broadening tax bases, strengthening revenue administration and taxpayer compliance, eliminating distortionary tax expenditures, and rationalizing tax policy for greater efficiency and equity through a comprehensive and front-loaded reform agenda.

A. Introduction

1. Pakistan’s revenue mobilization remains low compared to other developing countries and the tax effort expected for the country’s level of development. Pakistan faces significant challenges in realizing its tax revenue potential and thereby providing the much-desired fiscal space for growth-enhancing priority spending on infrastructure, education, healthcare, and targeted social assistance. While the tax revenue-to-GDP ratio has increased by 1.5 percent over the past three years to 11 percent in 2015, it remains significantly below comparator emerging market economies and the tax effort expected for the country’s level of development (Figure 1). The historical development of tax ratios confirms underperformance in revenue mobilization, with the tax-to-GDP ratio currently 1.4 percentage points below its peak of 12.4 percent of GDP in 1996. Pakistan has the potential to mobilize additional tax revenues by an amount as much as, if not more than, it currently collects: its tax capacity is estimated to be 22.3 percent of GDP, which implies a tax revenue gap of more than 11 percent of GDP.2 Although its estimated tax effort—the ratio between actual revenue and tax capacity—improved from 0.43 in 2011 to 0.49 in 2015, Pakistan is still significantly below the average of comparator developing countries (0.64) and high-income countries (0.76).

Figure 1.
Figure 1.

Tax Revenues in International Perspective

Citation: IMF Staff Country Reports 2016, 002; 10.5089/9781513582412.002.A001

Sources: IMF WEO Database; and IMF staff calculations.

2. The lackluster performance in mobilizing tax revenue is a result of a labyrinth of interconnected factors. Narrow tax bases, the extensive use of tax concessions and exemptions, weaknesses in revenue administration, and low taxpayer compliance through informal economic activity and underreporting of formal income result in substantial loss of revenue relative to potential. While many developing countries struggle with similar challenges, the situation is Pakistan is further complicated by intergovernmental fragmentation in revenue administration. According to the constitution, provincial governments are responsible for taxation of agriculture, services and immovable property, which represent a significant share of economic activity and thereby a substantial pool of potential tax revenues. However, provincial governments appear to have inadequate administrative capacity and limited incentive for local revenue mobilization, as they rely on the transfer of shared revenues from the federal government.

3. The government plans to increase the tax-to-GDP ratio to 14.5 percent by 2020 to reduce fiscal vulnerabilities and finance priority spending. Public debt is almost 600 percent of tax revenues and development spending is significantly less than interest payments. The government plans to increase the tax revenue-to-GDP ratio to 14.5 percent by 2020 to strengthen debt sustainability and resilience to fiscal shocks, and finance the country’s development needs. To this end, the Ministry of Finance established a high-level tax reform commission, and the Federal Board of Revenue (FBR) has implemented a series of reforms aimed at broadening the tax base and improving taxpayer compliance. These include the elimination of tax concessions and exemptions granted through the Statutory Regulatory Orders (SROs), introducing self-assessment for filing personal income tax (PIT) and the concept of differential taxation to reward compliance and penalize noncompliance, issuing more than 225,000 notices to potential taxpayers, rationalizing customs tariffs, integrating the National Tax Number (NTN) system with the Computerized National Identity Card (CNIC) database,3 and issuing a policy directive requiring all government suppliers to be on the current list of active taxpayers to conduct business with government departments.

4. Pakistan is heavily reliant on indirect taxes collected from very narrow tax bases and vulnerable to fluctuations in import prices. The number of people employed and commercial/industrial electricity users provides an illustrative benchmark for potential PIT and CIT users, even though not every employed person or commercial/industrial electricity user is liable to file for PIT and CIT. The number of people registered for PIT increased from 752,695 in 2000 to over 3.6 million in 2014, but it is still very small compared to 56.5 million people employed in Pakistan (Figure 2). Furthermore, the number of active PIT filers is 982,525, significantly below the number of 5.7 million people reportedly earning above the income tax threshold.4 Similarly, the number of corporate income tax (CIT) filers is 25,551 out of more than 60,000 companies registered for the CIT. Furthermore, the number of active CIT filers is a mere 0.8 percent of the number of commercial and industrial electricity users, which represent an illustrative pool of potential entities liable for taxation. Likewise, the number of entities registered for the General Sales Tax (GST) is 178,190 out of about 1.4 million retailers (and 3.4 million commercial and industrial electricity users). These underlying features of the tax landscape leave Pakistan with an unusually heavy reliance on indirect taxes collected from very narrow tax bases and vulnerable to fluctuations in import prices.

Figure 2.
Figure 2.

Number of Taxpayers

Citation: IMF Staff Country Reports 2016, 002; 10.5089/9781513582412.002.A001

Sources: Federal Board of Revenue; State Bank of Pakistan; NEPRA; IMF staff calculations.

5. Tax reforms aimed at improving tax morale and increasing efficiency can have a significant positive impact. Unlocking Pakistan’s tax revenue potential through reforms at federal and provincial levels can help achieve stable public finances, boost economic growth, employment and competitiveness, and contribute to a fair distribution of income.5 The government’s objective to raise the share of tax revenue in GDP to 14.5 percent by 2020 is consistent with various estimates of the country’s tax revenue potential. Simply aiming to increase revenue by further taxing already compliant taxpayers would worsen inequalities, undermine tax morale and cause distortions in economic activity. Sustainable domestic revenue mobilization therefore requires a concerted agenda of well-defined reform efforts aimed at broadening tax bases, strengthening revenue administration and taxpayer compliance, eliminating distortionary and overgenerous tax concessions and exemptions, and rationalizing tax policy in an efficient and equitable manner. In this context, improving the perceived fairness of the tax system is a cornerstone of revenue mobilization efforts, as Pakistan ranks low on measures of corruption and has weak auditing procedures.

B. Tax Regime and Revenue Performance

6. Pakistan’s tax system does not promote efficiency and fairness and is complex and fragmented. Under a federal system of governance, Pakistan’s constitution divides the responsibility of income and property taxes and GST in goods and services between federal and provincial governments. While fiscal decentralization can be designed to improve the delivery of public services, it could hinder revenue mobilization by complicating tax administration and reducing the efficiency of the tax system. In Pakistan, revenue collection remains highly centralized with the federal government collecting over 93 percent of total tax revenues, while provincial governments’ own revenues contribute the remaining 6.8 percent (or 0.8 percent of GDP). High levels of informality in the economy further constrains tax compliance and enforcement, especially given significant gaps in information gathering and sharing across all layers of government. In addition, institutional weaknesses in revenue administration, such as bureaucratic red tape and corruption, undermine tax morale and compliance. According to the World Bank’s Doing Business survey, time spent preparing and paying taxes for a typical firm in Pakistan is more than 594 hours, compared to an average of 325 hours in South Asia and 175 hours in OECD countries.

7. The composition of tax revenues is highly skewed towards indirect taxes, which account for about two-thirds of total tax revenue. The main sources of tax revenue are income taxes (CIT and PIT) and indirect taxes (GST, customs duties and excises), contributing over 92 percent of total tax revenues (Table 1). Although trade liberalization and tariff rationalization have lowered revenues related to foreign trade, indirect tax collections continue to account for about 63 percent of total tax revenue at the federal level. The share of direct taxes, on the other hand, has increased from an average of 18.5 percent in the first half of the 1990s to 29 percent in 2000 and about 37 percent in recent years.

Table 1.

Composition of Tax Revenues

(In percent of GDP)

article image
Sources: Ministry of Finance; and IMF staff calculations.

Other provincial tax revenue includes excise and stamp duties, motor vehicle tax and GST on services.

The overall level of income taxes in Pakistan (3.8 percent of GDP), however, is still unfavorable compared to other developing countries, where direct taxes amount to about 5.5 percent of GDP and 55 percent of total tax revenue. Although the statutory CIT and PIT rates declined from 45 percent in 1990 to 35 percent and 20 percent, respectively, by 2007, Pakistan’s low collection of direct taxes is mostly a result of weak compliance and enforcement and abundant concessions and exemptions. As a result, the greater reliance on indirect taxes relative to income taxes makes Pakistan’s tax revenue performance highly vulnerable to fluctuations in import prices.

8. Provincial tax revenues remain miniscule, mainly because agriculture, services and real estate remain largely untaxed. The latest National Finance Commission (NFC) award, signed in 2010, advanced fiscal decentralization and increased the provincial share in federal tax revenues from 45 percent to 57.5 percent, even though provinces already have exclusive power to tax agricultural income, property and services and account for only about 35 percent of total general government expenditures. Consequently, provincial governments have little incentive to boost own source revenues and instead rely on transfers from the federal government. The agriculture sector, for example, generates less than 0.1 percent of total tax revenues under the purview of provincial governments, although it accounts for about 25 percent of GDP and employs 45 percent of the workforce (Figure 3). Furthermore, agricultural tax revenue registered a significant decline over time as a share of total tax revenues at provincial and federal levels.

Figure 3.
Figure 3.

Agricultural Sector and Tax Revenues

Citation: IMF Staff Country Reports 2016, 002; 10.5089/9781513582412.002.A001

Sources: WDI; Ministry of Finance; and IMF staff calculations.

9. Agricultural taxation is based on the size of land holdings according to a fixed schedule of per acre rates, with no regard to actual earnings. Farmers with land of less than 12½ acres are exempted from taxation, while those owning up to 25 acres of land pay PRs 100 per acre and the per acre rate increases to PRs 250 for land holdings between 26 and 50 acres and to PRs 300 for over 50 acres of land. Farmers with over 50 acres of irrigated land are also required to file for income tax. Since over 90 percent of farmers appear to have land holdings less than 12½ acres, agricultural income remains largely untaxed. Similarly, taxes on property and services under the purview of provincial governments generate a mere 0.04 percent and 0.6 percent of GDP, respectively. With changes in consumption patterns and sectoral composition of economic activity over time, taxation of services has become far more important for revenue mobilization in Pakistan.1

10. The extensive use of tax concessions and exemptions results in a distortionary and unfair tax regime. The overall cost of tax expenditures increased from 0.2 percent of GDP (or about 2 percent of tax revenues) in 2000 to the peak of 1.9 percent of GDP (or almost 20 percent of tax revenues) in 2014. Moreover, most of these concessions and exemptions have been granted under a variety of schemes and modalities, such as the SROs, with limited transparency and parliamentary oversight. As part of the fiscal consolidation and tax reform plans, the government has eliminated tax concessions and exemptions amounting to about 0.9 percent of GDP since 2014. In addition, parliament passed legislation that now limits the authorization for concessional SROs on a temporary basis in a number of exceptional circumstances by the Economic Coordination Committee of the cabinet. There is, however, further need for rationalizing overgenerous tax expenditures, which pose a considerable threat to the integrity of the tax system as a whole as it creates loopholes in legislation and distortions in economic activity (IMF, 2011).

Table 2.

Cost of Tax Expenditures

(In billion rupees)

article image
Sources: Ministry of Finance; and IMF staff calculations.

C. Estimating Tax Buoyancy and Efficiency

11. The institutional structure and policy parameters of the tax system determine its responsiveness to macro-financial developments. One of the critical concepts is tax buoyancy, explaining how tax revenues vary with changes in the underlying tax base as measured by national income (Belinga, Benedek, de Mooji and Norregaard, 2014). Tax buoyancy is defined as the change in tax revenue in a given year, divided by the change in the tax base. A buoyancy of one would imply that an additional one percent of GDP would increase tax revenue also by one percent, which results in a neutral impact on the tax-to-GDP ratio. The objective of tax reforms is therefore to raise tax buoyancy above one in order to increase tax revenue collection by more than the extent of change in nominal GDP.

12. Pakistan’s tax buoyancy has exceeded unity in recent years, but it remains extremely volatile. Over the last two and half decades, Pakistan’s tax revenue-to-GDP ratio remained in a narrow range—oscillating between the low of 9 percent and the peak of 12.4 percent. Tax buoyancy, on the other hand, has exhibited a boom-bust pattern with high volatility that reflects not only tax policy changes, but also the impact of administrative challenges, political crises and economic difficulties on taxpayer behavior. In recent years, tax buoyancy has improved to well above unity from an average of less than one in the 1990s (Figure 4). The five-year moving average of aggregate tax buoyancy increased by 23.5 percent from 0.99 in 2013 to 1.22 in 2015. The analysis using disaggregated data at the federal level, however, indicates an underlying weakness in tax buoyancy. The GST buoyancy, for example, recovered in recent years with the elimination of exemptions, following a steep downward trend since 2000 when provinces agreed to the GST collection by the FBR. Similarly, the buoyancy of direct taxes shows no sustained improvement, except over the past few years with the elimination of concessions and exemptions. The buoyancy of customs duties and excises (which are generally structured as non-ad valorem) is another significant cause of limited progress and partly held back overall tax buoyancy because of loss of revenue caused by trade liberalization. This is consistent with cross-country experience. As shown by Baunsgaard and Keen (2010), developing countries tend to struggle in mobilizing domestic tax revenues to compensate for the loss of revenue caused by trade liberalization and tariff rationalization.

Figure 4.
Figure 4.

Tax Buoyancy

Citation: IMF Staff Country Reports 2016, 002; 10.5089/9781513582412.002.A001

Sources: Ministry of Finance; Federal Board of Revenue; and IMF staff calculations.

13. Indicators of tax efficiency confirm the weakness of Pakistan’s tax system, due to distortionary policies and weaknesses in administration. Tax buoyancy is a useful concept, but it does not help identify whether the tax system is efficiency and, more importantly, whether the degree of efficiency is improving over time. Accordingly, tax efficiency—measured as tax revenue as a percentage of GDP, divided by the standard tax rate—is an appropriate gauge of revenue mobilization efforts. The revenue efficiency of the GST showed an improvement from an average of 0.11 in the 1990s to the peak of 0.27 in 2003, but it declined to an average of 0.23 over the past three years (Figure 5). The rise in GST efficiency, however, was a result of the agreement between the provinces and the FBR to collect GST on their behalf. Furthermore, the GST efficiency in Pakistan is still significantly below the unweighted average of 0.28 in Africa and 0.44 in Asia Pacific.2 Pakistan’s relatively low GST efficiency partly reflects the recent increase in GST exemptions (from 0.1 percent of GDP in 2012 to 0.8 percent in 2015) and a limited progress in bringing retailers into the tax base. On the other hand, the productivity rates of the CIT and PIT regimes show a sustained improvement over the past decade with greater use of withholding taxes. Fundamentally, however, Pakistan’s performance in CIT and PIT remains below those of other developing countries, owing to overgenerous tax concessions and exemptions, weaknesses in tax administration, and low taxpayer compliance through informal economic activity and underreporting of formal income.

Figure 5.
Figure 5.

Tax Efficiency

Citation: IMF Staff Country Reports 2016, 002; 10.5089/9781513582412.002.A001

Sources: Ministry of Finance; Federal Board of Revenue; and IMF staff calculations.

D. The Way Forward

14. Well-designed tax reforms at federal and provincial levels can unlock Pakistan’s tax revenue potential. Pakistan has the potential to double its tax revenue-to-GDP ratio, while improving the efficiency and equity of the tax system. To this end, revenue mobilization will require concerted and well-defined efforts aimed at broadening tax bases, strengthening tax compliance, eliminating distortionary tax expenditures, and rationalizing the tax system in an efficient and equitable manner.

15. Strengthening tax administrations across all layers of government is key to sustainable revenue mobilization. To improve taxpayer compliance and curb tax avoidance and evasion, reform efforts must aim to modernize and bolster the effectiveness of tax administrations at federal and provincial levels by reorganizing along functional lines, integrating databases and information technology, and requiring a tax identity number in all financial and immovable property transactions. This would also help deal with the potential problem of using remittance transfers as a mean of tax evasion. Cross-country figures indicate that there is also a strong relationship between the tax revenue-to-GDP ratio and business climate and corruption (Figure 6). Therefore, institutional reforms aiming to reduce the incidence of corruption and to improve the country’s business climate will help boost tax revenue collections across all layers of government. From an operational point of view, the FBR and provincial revenue administrations should adopt and implement a risk-based auditing system focusing on taxpayer noncompliance risks, defined as the likelihood of yielding large amounts of audit adjustments and penalties, and increase tax fraud penalties and make tax evasion a criminal offense. In this context, fighting tax evasion should initially focus on a comprehensive list of high-wealth individuals and corporate entities they control and prohibit “benami” transactions, which are commonly used for tax avoidance and evasion.3 At the same time, it is important for the Ministry of Finance to enhance analytical capacity by establishing a tax policy research and analysis unit—outside the FBR—to improve revenue forecasting and upgrade the quality of fiscal policymaking.

Figure 6.
Figure 6.

Corruption, Business Climate and Tax Revenues

Citation: IMF Staff Country Reports 2016, 002; 10.5089/9781513582412.002.A001

Sources: Transparency International; World Bank WDI Database; and IMF WEO Database.

16. Tax policy reforms must aim to increase revenue yield, while improving the fairness of the tax regime. Direct taxes can be designed better for enhancing efficiency and equity. In the case of PIT, the tax exempt income threshold is set at PRs 400,000 (or about US$3,800). Since this is almost four times per capita income, a significant share of employed people does not pay any income tax at all. Accordingly, reducing the tax exempt income threshold, widening tax brackets, adopting more progressive and lower tax rates, and rationalizing concessions and exemptions would not only reduce distortions and increase revenue yield, but also improve the fairness of the tax system. This sense of social justice is key to boosting tax morale and thereby tax buoyancy. In this context, there is also need to strengthen the capital gains tax regime by adopting a common rate schedule for all financial assets and eliminating exemptions for real estate transactions. In the case of CIT, simplifying the system and reducing concessions and exemptions are necessary to pave the way for lower rates while enhancing revenue yields, which would also help on improving the economy’s international competitiveness. With regards to agriculture—a difficult sector to effectively tax, a reasonable approach would be the introduction of presumptive taxes on turnover and land-based tax rates adjusted according to productivity characteristics of agricultural land on a progressive scale with an appropriate threshold to protect low-income farm households. Modernizing recurrent property taxes, on the other hand, can be achieved by establishing a central fiscal cadastre and a central valuation agency and adopting a market-based valuation methodology. For greater efficiency in indirect taxes, Pakistan should integrate the GST collection system (goods and services) with a single statutory rate under one collection agent, and eliminate GST exemptions, zero-ratings, and special schemes. Simultaneously, the implementation of federal and provincial excises should be based on ad valorem rates to maximize the revenue yield, while better addressing negative externalities associated with some products such as tobacco.

E. Conclusion

17. The objective of tax reforms is not simply collect more from already compliant taxpayers, but to expand the tax base and improve tax morale. The tax revenue-to-GDP ratio has rebounded in recent years, mainly owing to the elimination of concessions and exemptions, and improved to 11 percent in 2015. It is, however, still significantly below comparator developing countries and Pakistan’s own tax potential. This reflects a plethora of factors including narrow tax bases, overgenerous tax concessions and exemptions, weak and fragmented revenue administrations, and structural features of the economy. Relative to comparator countries, Pakistan’s tax system does not promote efficiency and fairness and is complex and fragmented. Although Pakistan’s constitution assigns significant revenue responsibility the provinces, provincial governments’ own revenues contribute only 6.8 percent of total tax revenues. The composition of tax revenues is highly skewed towards indirect taxes, which account for about 63 percent of federal tax revenue, while the extensive use of tax concessions and exemptions results in a distortionary and unfair tax regime. Consequently, even though Pakistan’s estimated tax effort—the ratio between actual revenue and tax capacity—improved from 0.43 in 2011 to 0.49 in 2015, it is still significantly below the average of comparator developing countries (0.64) and high-income countries (0.76). The findings presented in this paper suggest that a concerted agenda of well-designed federal and provincial policy adjustments and institutional reforms—aimed at expanding tax bases, reducing tax concessions and exemptions, addressing structural weaknesses in fragmented tax administrations, and improving tax compliance across all sectors of the economy—will not only boost revenue mobilization, but also improve the perceived fairness of the tax system in Pakistan.

References

  • Baunsgaard, T., and M. Keen, 2010, “Tax Revenue and (or?) Trade Liberalization,” Journal of Public Economics, Vol. 94, pp. 56377.

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  • Belinga, V., D. Benedek, R. de Mooji, and J. Norregaard, 2014, “Tax Buoyancy in OECD Countries,” IMF Working Paper, No. 14/110 (Washington: International Monetary Fund).

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  • Fenochietto, R., and C. Pessino, 2013, “Understanding Countries’ Tax Effort,” IMF Working Paper, No. 13/244 (Washington: International Monetary Fund).

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  • International Monetary Fund, 2011, “Revenue Mobilization in Developing Countries,” IMF Policy Paper (Washington: International Monetary Fund).

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1

Prepared by Serhan Cevik (FAD).

2

Fenochietto and Pessino (2013), estimate tax capacity—the maximum level of tax revenue that a country can collect—and tax effort with a stochastic frontier function, based on a panel of 113 countries, using economic, demographic and institutional characteristics as explanatory variables.

3

The NTN system covers 3.6 million individuals (or less than 2 percent of population) compared to about 150 million people (or about 80 percent of population) covered in the CNIC database.

4

To put it in a broader context, there are 15.6 million broadband internet subscribers and over 40 million individual bank accounts in Pakistan. From a cross-country perspective, the share of population filing for income tax in Pakistan is a mere 0.5 percent, compared to over 5 percent in India and 90 percent in Canada.

5

Expenditure rationalization aiming to change the composition in favor of growth-enhancing social and infrastructure spending is also critical, but beyond the scope of this note.

1

Services make up over 52 percent of GDP, while industry and agriculture account for about 22 percent and 25 percent, respectively.

2

Alternative measures of tax efficiency, such as the ratio of the change in tax revenues to the change in tax rates, confirm these trends.

3

In “benami” transactions, assets are held by or transferred to a person, but have been provided for, or paid by, another person.

Pakistan: Selected Issues Paper
Author: International Monetary Fund. Middle East and Central Asia Dept.