Pakistan’s tax system: an overtaxing Leviathan or a wake-up call for reform?

With the federal and provincial budgets due next month, public and business sentiment is once again shadowed by fiscal apprehension. Recently, media reports suggested that the IMF projects Pakistan’s revenue receipts to reach Rs 20 trillion in the next fiscal year.

To put this in perspective, the current year’s federal budget estimated total revenue at Rs 17.8 trillion, including FBR-related tax revenue of Rs 12.9 trillion, which has since been revised downward to Rs 12.3 trillion. As of April 30, the FBR had collected Rs 9.29 trillion, leaving nearly Rs 3 trillion to be recovered in May and June—a Herculean target in the current environment.

Assuming the IMF projection is reflected in the upcoming budget, the tax revenue target may hover around Rs 14.5 trillion—an 11 percent increase from the previous year. On the surface, this seems reasonable when compared against projected inflation of 7.7 percent and expected GDP growth of 3.6 percent.

But these numbers tell only part of the story. Mathematically, the forecast looks neat. Behaviourally and structurally, it raises serious questions.

A tax system of complexity and contradictions

Let me share two interactions that illustrate the inherent distortions in our tax system.

A friend recently asked whether capital gains on unlisted company shares would be taxed at 15 percent or zero-rated due to long-term holding. I had to clarify that the concept of a 0 percent tax on long-term holding of shares, as well as a standard rate of 15 percent, applies only to listed securities. For unlisted shares, there is no relief for holding period, and gains exceeding Rs 5.6 million face an effective tax of around 45 percent. If gains exceed Rs 10 million, a surcharge applies, bringing the rate to 49.5 percent. At Rs 150 million, the rate increases to 50.5 percent, and if they exceed Rs 500 million, the total tax rate hits a staggering 59.5 percent.

His response: “Why go through with the transaction if nearly 60 percent goes to the state, while I still rely on private services for health, education, water—even personal security?”

Another time, a foreign investor asked about the effective tax burden on a proposed business venture in Pakistan. My answer? “It depends.” Legal structure, business size, nature of business, treaty jurisdiction of the holding company, and the dividend distribution model—all influence the final burden.

Last but not least, every year the annual budget proposes such major amendments, which hamper an investor’s decision to invest in any long-term project, particularly of an industrial nature. Not only are rates fragmented, but compliance complexity is deterring investment, besides a lack of certainty on long-term tax policy measures.

Four pillars of equity—all under strain

Any fair tax system stands on four pillars: horizontal equity (equal treatment for equal income), vertical equity (those who earn more should pay more), exchange equity (reasonable public services in return for taxes paid), and process equity (fairness and transparency in the tax system’s administration, enforcement, and compliance procedures). In Pakistan, all four are weakening.

Horizontal equity

The tax regime varies drastically across sectors and income sources. For instance, a service provider dealing with withholding agents pays a minimum tax of 9 percent on gross receipts, while the same provider working with non-withholding clients is taxed on net income with a minimum tax rate of 1.25 percent on his annual turnover. Some service sectors enjoy a reduced 4 percent rate, and distinctions between active and inactive taxpayers add further layers of unfairness and confusion.

Every business segment is taxed on some different basis, whether it’s an industrial undertaking, commercial importer, exporter or distributor, to name a few. Those dealing in the documented sector are further burdened with withholding taxes on a transactional basis often treated as minimum tax, besides ensuring compliance with withholding tax provisions on their expense payments. It is customary that such withholding taxes are added to the transaction costs.

Vertical equity

While progressive taxation is vital, it turns punitive beyond a point. Companies with over Rs 500 million in income are taxed at 39 percent. Dividends distributed are taxed again at 15 percent–25 percent, depending on jurisdiction and monetary threshold of such dividends, pushing effective tax burdens beyond 55 percent —excluding levies like WWF and WPPF. Ironically, these are the most formal and audited entities, while the undocumented economy remains under-taxed and under-regulated.

Last year’s tax measures resulted in a very high burden for the salaried class, causing a lot of uproar and disenchantment, which is often reflected in employees demanding net-of-tax salaries, thus increasing the tax burden for documented employers.

Exchange equity

This principle — that citizens should receive basic services in return for taxes—is nearly extinct. In Urban centres, healthcare & education are privatized, public transport dysfunctional or insufficient. And yet, the public watches VIPs cruise in luxury convoys under heavy security, often funded by taxpayers’ money, while minimum wageworkers earning Rs 37,000 per month struggle to survive without housing support, transport, or food & utilities’ subsidies. The message is clear: contribution is compulsory; return is optional.

Process equity

Whilst in theory, tax returns are covered by a universal self-assessment scheme, most of the documented taxpayers are subjected to yearly audit, amendment, and withholding tax monitoring, causing heavy costs they have to incur in defending their returned positions, followed by a lengthy and uncertain appellate process, with a risk of coercive recovery of disputed tax demands in certain scenarios.

A distorted system driving disengagement

The current tax design discourages productivity and formalization. High earners feel penalized. Small businesses shift to less regulated sectors. Even foreign investors hesitate to invest in long-term projects due to inconsistent regimes. The result? Behaviour changes not to create value, but to minimize exposure.

This is where the Laffer Curve becomes more than just theory. At some point, higher rates reduce—not increase—revenue, as people disengage from the formal economy. Pakistan may already be past that inflection point.

Can the state’s argument be empathized with?

Certainly. The government also feels constrained—unable to deliver services due to limited tax collection. But the over-reliance on short-term targets and repeated extraction from the same documented sectors has led to unsustainable outcomes.

Encouragingly, there are signs that a change in direction is being considered. It was recently reported that tax policy (in the form of Tax Policy Office) may be carved out from the FBR and placed in a separate unit, removing the inherent conflict between policymaking and collection goals. If implemented with sincerity, this could mark a paradigm shift in Pakistan’s tax governance.

It is expected that such a measure would result in the formulation of long-term tax policy measures based on economic principles and not merely driven by short term revenue collection targets, duly supported by academic studies identifying the behavioural impact of such measures, as well as identifying who will actually bear the economic burden of any particular tax measure. Technology and other documentation tools can really help in this regard.

Proposed reforms for a sustainable future

A long-term, inclusive tax strategy should be anchored in equity, simplicity, and growth. Some foundational steps include:

a) Adopt a uniform income tax regime having the economic character of a direct tax across all sectors, eliminating presumptive and minimum tax models which otherwise alter the character of income tax from direct to indirect in economic terms and hence result in regressive taxation. Taxes should apply to net income, not arbitrary proxies.

b) Apply progressive personal tax rates across all income sources with a reduction in top-line tax rates.

c) Long-term capital gains of all sorts should be taxed at a reduced rate, with a mechanism of indexation available for the cost of such long-term capital assets.

d) Lower corporate tax rates to regional averages to attract investment and encourage documentation.

e) Eliminate tax on intercorporate dividends by encouraging holding company structures for capital formation, and allow individual shareholders to receive proportional tax credits, avoiding economic double taxation.

f) Reduce the number of withholding taxes and exempt sales tax registered persons from the purview of withholding tax collection, who pay their due quarterly advance taxes.

g) Constitutionally clarify direct vs. indirect taxes, to protect the ‘ability to pay’ principle and promote true tax equity.

A budget beyond numbers

As the budget looms, we must ask: Are we building a sustainable tax system—or simply maintaining an extractive one? One that expands participation—or expands pressure?

Because whether it’s a wage earner struggling to survive, a local entrepreneur scaling back, or an international investor stepping away—the sentiment is growing clearer: the cost of compliance outweighs the benefit of contribution.

Unless the tax system reforms itself—with fairness, clarity, and purpose — it may continue to raise targets but lose taxpayers.

Copyright Business Recorder, 2025