Karachi, October 17, 2024 – The State Bank of Pakistan (SBP) on Thursday proposed a series of tax reforms aimed at significantly increasing the country’s tax-to-GDP ratio, which has stagnated at approximately 10% for the last two and a half decades.
This figure is notably below Pakistan’s estimated tax potential, which is believed to be 22.3% of GDP. In comparison to other emerging and developing economies, as well as regional peers, Pakistan’s tax-to-GDP ratio is one of the lowest, underscoring the need for urgent reforms.
Given that federal tax collections make up around 90% of the total tax revenue, the SBP emphasized the importance of overhauling federal tax structures. Drawing on international best practices, the central bank outlined several key recommendations aimed at raising Pakistan’s tax-to-GDP ratio and improving overall tax efficiency.
1. Proper Implementation of Value Added Tax (VAT)
VAT is one of the most commonly used consumption-based taxes worldwide, yet it remains underutilized in Pakistan’s tax system. A lack of trust between taxpayers and tax authorities hampers the effectiveness of the VAT refund and input tax credit process, which is crucial for VAT’s success. The tax base for VAT in Pakistan is narrow, often leading to rate increases and delays in refunds, which creates additional pressure to meet revenue targets.
To optimize VAT, the SBP recommends streamlining the refund process through digital solutions to reduce human intervention. The introduction of a broad-based, low, and uniform VAT on goods and services across all regions is also suggested. This approach would strengthen VAT’s role as a vital indirect tax and reduce the administrative burden on businesses.
2. Rationalization of Corporate Income Tax (CIT)
At 29%, Pakistan’s corporate income tax (CIT) is among the highest in the world, with certain sectors such as banking subject to even higher rates. The inclusion of additional taxes, like the super tax, further raises the effective CIT rate, which distorts economic incentives and encourages tax evasion.
High CIT rates have a detrimental effect on corporate investment, foreign direct investment, innovation, and overall economic growth. The SBP proposes lowering the CIT rate to encourage business investment and innovation. Rationalizing the corporate tax structure could also curb tax evasion and fraudulent practices, ultimately increasing revenue collection.
3. Rationalizing Tax Expenditure
Tax expenditures, including exemptions, concessional rates, and tax holidays, account for 4.6% of Pakistan’s GDP—substantially higher than the 3.2% average in low-middle income countries. The SBP recommends rationalizing or eliminating these expenditures, except for those benefiting exporters, after conducting cost-benefit analyses.
Exemptions granted through statutory regulatory orders (SROs) have introduced ad-hocism into the tax system, which undermines predictability and fairness. This system often favors powerful business lobbies, leaving small and medium enterprises (SMEs) and other taxpayers at a disadvantage.
4. Simplification of the Tax System
Pakistan’s tax system is complex and fragmented, resulting in higher compliance and administrative costs. Disparate tax bases, such as VAT on goods versus services and taxes on agricultural versus non-agricultural incomes, create unnecessary complications. The SBP suggests harmonizing tax rates and simplifying tax laws to reduce inter-jurisdictional frictions and compliance costs.
One positive step towards simplification is the Federal Board of Revenue’s (FBR) implementation of a Single Sales Tax Portal/Return system for the telecommunications sector, which has reduced the number of returns filed by the sector. However, sales tax rates still vary across jurisdictions, and broader reforms are needed to simplify the system across all sectors.
5. Efficient Use of Federal Excise Duty (FED)
Federal excise duty (FED) can serve as a complementary tool for revenue mobilization, especially as long-term reforms take effect. However, FED collection in Pakistan is low and declining. The SBP suggests removing distortions caused by varied tax rates and improving the implementation of FED to enhance its effectiveness as a revenue-generating tool.
6. Improving Tax Administration
Enhancing tax administration through the use of information and communications technology (ICT) is critical for improving enforcement and compliance. Currently, the FBR’s spending on ICT as a percentage of total operational expenditure is low. Digital solutions like the Track and Trace System and FASTER Plus, though in place, face operational challenges and lack proper integration.
To maximize the benefits of these technologies, the SBP suggests applying solutions like the Single Sales Tax Portal and Track and Trace System comprehensively across all sectors. Additionally, the cost of adopting digital tools, such as point of sale (POS) machines, should be reduced to encourage widespread use, helping to formalize the economy and expand the tax base.
The introduction of risk-based audits in 2019 was a step in the right direction, but these audits are yet to be fully applied across all levels of the tax apparatus. Manual interventions still dominate regional tax offices, which undermines the effectiveness of audits. The SBP recommends phasing out these manual processes and strengthening enforcement strategies to improve recovery rates.
7. Broad-based Ownership of Reforms
Finally, the SBP emphasizes the need for broad-based ownership of all these reforms. Successful implementation requires the cooperation of federal and provincial governments, tax authorities, and businesses. A unified commitment to these reforms will be key to transforming Pakistan’s tax system, increasing the tax-to-GDP ratio, and fostering sustainable economic growth.
In conclusion, the SBP’s recommendations provide a comprehensive roadmap for raising Pakistan’s tax-to-GDP ratio. By implementing these reforms, Pakistan can strengthen its revenue base, reduce fiscal deficits, and promote long-term economic growth. However, success will depend on the political will and the commitment of all stakeholders to drive these changes forward.