Pakistan’s taxation system is unfair. Whenever it imposes higher taxes on a certain segment, the formal sector shrinks while the informal sector mushrooms. Tax collection falls short of its potential and, if the objective is to discourage consumption, that too often remains elusive.
A similar story is unfolding in the aerated beverages sector, where the imposition of a higher Federal Excise Duty (FED) has resulted in lower revenue collection. Some may argue that the objective is being achieved because consumption was meant to decline. Without debating whether that is the right way to think about it, consumption has simply shifted to newer local players who evade taxes, while there is little to no oversight of whether their products meet the country’s health and safety standards.
The outcome is straightforward: the government is losing revenue, formal tax-paying companies, including multinational corporations, are losing market share, and consumers are increasingly relying on products that may be substandard. The only beneficiaries are informal, tax-evading businesses.
The government must understand that in a country where tax enforcement is weak and incomes are low, striking the right balance is imperative. In this case, that balance can be achieved by reducing the FED rate.
The numbers tell the story. The sector grew at a volume CAGR of 14 percent, while tax collection increased by 23 percent during FY21-23 when the FED stood at 13 percent. The documented sector accounted for 90 percent of the market and contributed 95 percent of FED revenues.
Then the FED was increased to 20 percent, and the dynamics changed. In a highly inflationary environment, the higher tax rate became a catalyst for informal players to gain market share. Industry estimates suggest that the formal sector’s share declined to 80 percent, while the informal segment doubled its share within just three years (FY24-26), without making any meaningful contribution to FED revenues.
The story is simple. Prices of formal sector products rose by around 5 percent due to the additional taxation, and that was enough in a highly price-sensitive market, particularly at a time when the country was experiencing the highest inflation in its seven-decade history, to push consumers towards cheaper alternatives. These products were not only less expensive but may also contain higher levels of sugar and other undesirable ingredients.
In plain words, it is a policy failure.
It is now time for the government to rectify its mistake. One proposal is to reduce the FED rate to 15 percent. This could gradually allow the formal sector to regain market share while reducing the footprint of the tax-evading segment.
According to industry simulations, over the next three years (FY27-29), industry volumes could grow at a CAGR of 13 percent, the formal sector’s market share could recover to 90 percent, and tax collection could increase by 13 percent. One may debate the precise numbers, but the underlying logic is sound. The government should do what is right.
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