Pakistan’s tax-to-GDP ratio lags due to narrow tax net, informal economy: ADB

ISLAMABAD: Despite numerous reforms, Pakistan’s tax-to-GDP ratio remains below regional averages, hindered by the limited reach of its tax system and the widespread prevalence of informal economic activity, says the Asian Development Bank (ADB).

The bank in its latest report, “Taxing informal and hard-to-tax sectors a policy guide”, stated that Pakistan’s experience shows that focusing solely on expanding the tax base without ensuring meaningful compliance among existing taxpayers yields minimal revenue gains and increases administrative costs. Nominal income tax revenue is increasing but there is no growth in real terms.

The bank recommended that policymakers should consider that simply increasing the number of registered taxpayers does not equate to a more robust tax system.

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Instead, they may need to focus on targeted approaches that enhance compliance among existing taxpayers while simplifying the tax process to encourage genuine participation. Revenue authorities operate with limited enforcement resources, necessitating strategic decisions about where to allocate these efforts for the greatest impact.

The increase in registered filers has not translated into meaningful revenue gains and no substantial evidence of non-revenue benefits, such as improved economic formalisation or enhanced financial transparency, these policies appear suboptimal from a policy perspective. These measures impose compliance costs on taxpayers, administrative costs on the government, and hurt economic activity.

The absence of measurable benefits against the backdrop of these significant costs suggests that the current approach may need re-evaluation to better align with sustainable fiscal objectives.

Aggressive measures to increase tax filings do not necessarily lead to higher revenue collections or broader economic benefits. To this extent, Pakistan’s experience is consistent with that of Rwanda, South Africa, Uganda, and other economies, where an expanded tax base did not result in higher revenue. In Pakistan’s case, these policies expanded the tax base nominally but failed to generate significant revenue gains, as many new filers either reported minimal income or remained noncompliant in their actual tax contributions.

A steady increase in nominal income tax revenue, rising from under Rs500 billion in 2007 to nearly Rs1,500 billion in 2021. This upward trend may convince policymakers and the public that reforms aimed at expanding the tax base and improving compliance are working.

However, in real terms, tax revenue as a share of GDP has remained stagnant, fluctuating 3-4 percent for most of the period. This discrepancy suggests that while more revenue is being collected, little progress has been made in enhancing compliance or effectively capturing income from informal and hard-to-tax (HTT) sectors. This lack of growth in real revenue indicates that new tax filers are contributing little to overall tax collections, raising questions about the effectiveness of these costly compliance measures.

The report noted that while the total number of tax filers has generally increased over the period, a substantial portion of the tax filers each year consists of individuals reporting zero tax payment. This highlights a key challenge in expanding the tax base.

When revenue authorities focus too much attention on individuals and businesses that fail to file tax returns, a common response is for these taxpayers to register as filers but declare no or minimal taxable income. Non-compliance within the registered sector is a central theme of this report, underscoring that simply increasing the number of filers is unlikely to expand the fiscal capacity of the state.

Existing evidence shows that the tax benefit of formalising a firm is often insignificant. Between 2014 and 2021, Pakistan tripled the size of its formal sector. The expansion of the tax base, however, did not translate into a corresponding increase in revenue: by 2021, the country was collecting nearly the same amount of tax revenue as it had in 2007.

Pakistan has one of the lowest shares of the labour force in the PIT register at 7.6 percent, while Viet Nam has more registered taxpayers than individuals in the labour force. In Pakistan, the income tax gap for 2022 was estimated to be about 30 percent of total tax collected while the sales tax gap was estimated to be about 24 percent of tax collected.

In recent years, Pakistan has implemented a range of intrusive, costly measures to broaden its tax base. These measures are aimed at increasing the costs of operating outside the registered tax regime by penalising non-filing. These measures include: Higher withholding tax rates on non-filers.

A distinction between tax filers and non-filers, leading to differential withholding tax rates, was introduced through the Finance Act of 2014. This legislation marked the first instance where non-filers were subjected to higher withholding tax rates compared to filers. The primary objective of this policy was to incentivise tax compliance by imposing higher tax rates on individuals and entities that did not file their income tax returns.

Over the years, the government has continued to adjust these rates and has introduced new categories for additional withholding.

The Bank further stated that in general, the withholding tax rate applicable to non-filers is twice that of filers. In some cases, however, this rate is substantially higher (e.g., 20 times for sales to distributors and wholesalers).

Restrictions on engaging in high-value transactions: To further discourage non-compliance, the government has imposed outright restrictions on non-filers to buy property and engage in other transactions. Since 2018, non-filers have been prohibited from purchasing properties valued above Rs5 million.

Additionally, these restrictions apply to the transfer of property ownership, requiring both buyers and sellers to be registered taxpayers for transactions above the specified threshold. In addition to property restrictions, Pakistan has implemented bans on vehicle purchases and registration for non-filers.

Mandatory proof of tax filing for professional licenses and contracts: To enforce compliance within the professional sector, the government has mandated that individuals provide proof of tax filing when applying for certain professional licences and government contracts.

Consultants, contractors, and suppliers who wish to work with government entities must be registered tax filers, a requirement intended to formalise freelance and contractual work, which is often part of the informal economy. Additionally, certain professional bodies, such as bar councils, now require their members to be registered taxpayers.

Measures against non-filing are becoming increasingly stringent over time. New proposals currently being contemplated include: Non-filers will be prohibited from undertaking international travel. Exceptions will include travel for religious or educational purposes. A proposed annual cash withdrawal limit of Rs30 million will be imposed on non-filers. Non-filers will be barred from purchasing immovable properties and vehicles.

Copyright Business Recorder, 2025