Economic self-sabotage

During the past few weeks, there have been many acknowledgements of the difficult conditions faced by businesses and industries across Pakistan. But while various Ministers and even the SIFC (special investment facilitation council) were acknowledging, for example, the prohibitive tax rates and regimes restricting growth and targeting the same few compliant businesses, the FBR (federal board of revenue) is simultaneously on record in the Senate of Pakistan, expressing their preference for installing cameras in production facilities over tax collection (https://www.brecorder.com/news/40393343). This jarring contrast between the state’s rhetoric and its enforcement strategy is, perhaps, the single best characterization of the current, abysmal state of affairs.

Before analysing the failures of Pakistan’s tax system, it’s essential to understand the basic function of taxes. Fundamentally, taxes exist because public goods like national defence, infrastructure, and the rule of law benefit everyone, and no single individual can be excluded from using them.

This reality leads to a classic problem: why pay if you can enjoy the benefit for free? To overcome this “free-rider” challenge, taxes are instituted as the state’s mandatory, coercive instrument. They compel all citizens to contribute the price society must collectively pay to maintain the bedrock of national life. This non-negotiable nature of taxation gives rise to two fundamentally opposed philosophies on the matter.

On one end lies the idealistic view, rooted in political philosophy, that taxation is a voluntary contribution and a patriotic act. Drawing on concepts like the Social Contract, this perspective holds that citizens willingly cede certain freedoms and contribute to the general welfare in exchange for the benefits of an ordered society.

Since patriotism is defined as commitment to one’s country and its future, participating in its core financial structure is a tangible, measurable expression of that love. Taxes are an investment in future generations, prioritising the collective health of the nation, funding schools, bridges, etc., over purely private gain. From this standpoint, paying taxes is a noble fulfillment of civic duty.

On the other end is the libertarian and neoliberal critique, which argues that the most patriotic act is contributing to wealth creation, and that excessive or inefficient taxes actively hinder this process. For this school of thought, true patriotism means a strong, dynamic economy fuelled by private sector ingenuity.

If tax rates are prohibitively high, the system itself is an enemy of national prosperity. A person who creates jobs, generates legitimate profits, and drives exports is seen as contributing infinitely more to the nation than someone who simply pays an inefficient tax which is then squandered by a corrupt government. In this view, taxation is simply a coercive extraction—a necessary evil at best, and an act of state economic sabotage at worst.

The philosophical rift between these two views—civic duty versus wealth creation—is instantly resolved when the system fails. The moment a state is perceived as extractive, inefficient, and corrupt, the social contract is irreversibly broken.

If the taxes that could have otherwise been used for job creation and investment are perpetually used instead to fund wasteful public sector entities, provide political perks, or are simply withheld from compliant taxpayers (the refund issue), the patriotic justification for payment immediately collapses. Taxes cease being a collective contribution and become a mechanism of fiscal overreach by the state.

When the revenue collection is actively damaging the productive and compliant sectors, the very engine of national prosperity, overhauling the distorting tax regime is a necessary defence of the national economic interest against bureaucratic abuse.

In Pakistan, the erosion of institutional trust and therefore the social contract is a documented fact. Take for example the IMF’s Governance and Corruption Diagnostic, a damning document against the FBR and broader bureaucratic apparatus. While it may be news for the IMF, its findings are the lived experience of every citizen and business in the country.

The report bluntly highlights the FBR as a major governance failure, citing an over-complex tax policy, ad hoc changes driven by cash-flow pressures (not economic logic), weak internal controls, unmonitored field autonomy, and an incentive structure built on collecting revenues at any cost, most often from the already compliant. Importantly, it also highlights the chronic lack of disclosure regarding sales tax and income tax refunds that are pending and deferred.

The clearest example of this cash-flow driven policy sabotage is the double advance tax imposed on exporters. Despite being in place for eighteen months, and despite the Finance Minister himself acknowledging it is distortionary and harmful, the government continues with this regime only to plug immediate revenue gaps, knowingly damaging the country’s already small export sector.

But why would the Ministry of Finance continue this economic self-harm? Because, it is by design. The move followed pressure from the IMF to remove all preferential treatment for exporters, which included the fixed tax regime (FTR)—a full and final income tax liability of 1 percent of export proceeds. The IMF program required exporters to be moved to the Normal Tax Regime (NTR), putting them at par with all other businesses.

However, the Finance Ministry and FBR saw this not as a reform opportunity, but as a cash-flow opportunity. They fulfilled the letter of the IMF’s requirement by moving exporters to the NTR but kept them under the FTR in line with the Government of Pakistan’s long-standing implicit policy of utilizing advance and withholding taxes as a form of long-term, interest-free financing from the public.

Resultantly, exporters today face a punishing double levy. They pay 1 percent on export proceeds under the fixed tax regime, plus an additional 1.25 percent minimum turnover tax under the normal tax regime (for a total advance tax burden of 2.25 percent), both adjustable against a final 29 percent income tax and up to 10 percent super tax. By comparison, someone selling only in the domestic market faces only the 1.25 percent minimum turnover tax, creating a considerable disincentive to export.

This issue has been repeatedly highlighted before the government for two years by almost all businesspeople and business groups; the official response has cycled from ignoring and deflecting to a tepid acknowledgement, and now, to a promise of “reviewing it for the next budget.” The fact is, a conscious decision was taken to scapegoat the exporters to finance the government’s distraught finances. If this were a genuine oversight, it would have been fixed in the immediate subsequent budget cycle. Instead, the policy was continued for another year, confirming the government’s dependence on this and many other avenues of self-defeating taxation.

With a reported tax shortfall reaching Rs. 428 billion in July to November 2025, the necessary fiscal space to fix these policies will not just appear. All reforms remain narrowly focused on squeezing the most out of the already compliant, with little progress on expanding the revenue base or reducing government expenditures.

The main issue is that the government and FBR’s entire approach is fundamentally lopsided. They view advance and withholding taxes purely as an instrument of compulsory, front-loaded revenue collection, completely ignoring the established principle that tax payments and subsequent refunds—high emphasis on refunds—are a key tool for encouraging broad-based compliance and formalization.

Advance and withholding taxes (WHT) are designed to ensure the government receives its money reliably throughout the year, but their crucial secondary function is rooted in behavioural economics, specifically Prospect Theory. By withholding an amount slightly greater than the likely final liability, the system engineers a small, positive “gain”—the tax refund—when the taxpayer files their annual return. This expected “return” acts as a strong incentive for citizens and businesses to formally engage with the tax authority, submit their complete income statement, and, most critically, expand the tax base for the government.

The timely refund transforms a mandatory, coercive payment into an anticipated payoff, incentivizing large-scale compliance. In the United States, for instance, the annual exercise is colloquially called “filing your refund”, and the spring months are known as “tax refund season.” For millions, this season culminates not in a bill, but in the arrival of a cheque in the mail.

The FBR, however, subverts this entire process. By indefinitely deferring or withholding refunds (both income tax and sales tax), it converts the expected “gain” into an actual loss. Complying taxpayers are penalized with locked-up capital, facing a liquidity crisis while the state enjoys the float.

By decoupling the payment obligation (advance/WHT) from the subsequent refund mechanism, the FBR transforms an otherwise cooperative model into an adversarial, zero-sum game. For the compliant taxpayer, especially exporters and manufacturers, who face massive sales tax and income tax refunds, delayed refunds severely erode working capital and increase the cost of doing business. It forces them to secure expensive commercial loans just to fund their operations, negating the entire purpose of the compliance incentive that refunds create, and exporting the government’s cash-flow problem directly onto the business sector.

For the non-compliant, this practice sends the message that the state will punish you for not paying, but it will also penalize you for over-paying. No wonder social media is rife with people pondering if they should become filers or not. This destroys the fundamental trust required for voluntary tax compliance. Why go through the onerous process of filing a detailed return if the expected financial benefit (the refund) is indefinitely held hostage by an opaque bureaucracy?

The result is a self-defeating cycle: the state, desperate for cash, starves the compliant sector of liquidity by withholding refunds, which in turn destroys the incentive for others to join the formal system. The FBR’s focus remains purely on enforcement against the few, ensuring a higher tax rate on a shrinking compliant base, rather than using the refunds as an economic lubricant required to broaden the base and secure long-term, sustainable revenue.

The only path to creating trust is for the government to take the first step: aggressively cut down wasteful expenditures and curb bureaucratic excesses, thereby creating the essential fiscal space.

Instead of genuine action, the government continues to rely on influencing the narrative. Take the recent, Rs. 975 billion tax relief package it has proposed. Anyone even vaguely familiar with the fiscal and IMF dynamics knows that is it impossible. They will send the package to the IMF for review, and the IMF’s response will be: “Do it, but make it revenue neutral,” meaning the government must cut expenditure by the exact same amount. But that is literally not going to happen, as expenditure reduction requires political will that the entire system has repeatedly failed to demonstrate.

Meanwhile, on the ground, the FBR’s enforcement-first mentality rages on. In a dying spinning industry, they are sending bills of Rs. 5 million to install costly, FBR-approved cameras to monitor cotton consumption. The hardware they are charging that money for—a GPU, CPU, UPS, and a few cameras—are available in the open market for less than half that cost. This is the reality of the FBR.

The system is not broken; it is operating precisely as designed. In the face of this systemic collapse, the path forward appears almost impossibly narrow. True economic transformation cannot occur through incremental reforms or theatrical tax packages when the government’s institutional footprint is itself the primary economic distortion.

The only viable path, however politically difficult, is a radical reduction in the sheer size of the government and the bureaucracy. Without a firm commitment to dramatically shrink the government’s role, reducing its massive institutional appetite to perhaps one-quarter of its current scale, there is no hope for fiscal space or national progress.

The cost of maintaining the status quo is simply too high, especially considering this devastating, almost unbelievable statistic from the IMF report that the state employs a staggering 72 percent of all formal jobs in the economy. Unless this self-consuming system is fundamentally checked and corrected, Pakistan’s future remains bleak.

Copyright Business Recorder, 2025