Taxing the formal, rewarding the informal

Historically, Pakistan has heavily relied on indirect taxes, which not only have inflationary consequences but also disproportionately increase the burden on middle- and low-income households. The lower the income, the higher the incidence. The GST was 15 percent in the early 2000s, and despite stated commitments to reduce it, the toll has increased to 18 percent in a staged manner. During this time, to document value chains, GST is applied in the value-added form. Plus, other kinds of taxes have been introduced on unregistered and non-filers. The objective was to enhance the formal footprint and broaden the tax base. Apparently, the efforts are not yielding results, as instead of the tax net expanding, the undocumented economy is on the rise. Currency in circulation (CIC) to monetary aggregate (M2) ratio increased from 22 percent in FY15 to 30 percent in FY23 before slightly coming down. The formal corporate sector, which fully complies with tax laws, is at a disadvantage. These firms must compete with the informal sector, which evades taxes and grabs market share. Naturally, the tax net did not expand and the tax-to-GDP ratio did not move up. To counter that, the government introduced super tax on businesses beyond certain sizes and increased penal tax on unregistered retailers and traders. The tax-to-GDP ratio slightly increased by overburdening the thin base, but documentation is not growing, and retailers are not registering. There are inflationary consequences. Moreover, the margins of formal firms decline, resulting in these firms losing market share. Today, a further sales tax of 4 percent is added on unregistered retailers. Apart from that, additional direct taxes in indirect form are also applied. All that the government gets is some additional revenue, which is either paid by the formal sector through absorbing costs or by consumers, as higher taxes are passed on to prices. The government needs to rethink its tax policy, as without improving the tax governance structure and bridging the trust gap between the tax authority and taxpayers, increasing rates mainly fuels the undocumented economy, while the higher burden is assumed by the masses. The overall tax structure becomes complicated, as the responsibility of collection within the value chain falls primarily on formal players. That increases the cost of doing business and unnecessary resources are deployed in dealing with taxation matters. No wonder investment is on the decline and multinational firms are exiting Pakistan. Thinking is required to be changed. Policy should focus on making the tax structure simpler. The problem is higher in goods which fall in the standard system of sales tax, as sales tax is collected at multiple stages of the value chain, which adds complexity, especially when informal players shy away from documentation. The process is better in the case of the third schedule, where the entire sales tax is paid upfront by manufacturers. Retail prices are printed and GST is paid by the manufacturer on behalf of the value chain. In the standard tax system, every part of the chain provides, and here, the distributor or manufacturer, at times, pays 6. 5 percent extra, 4 percent further tax and 2. 5 percent income tax, on behalf of unregistered retailers. The majority of products are already in the third schedule, while milk and dairy products, infant formulas, and a few other products are required to move to the third schedule to ease the taxation system and lower the burden on manufacturers and consumers. Pakistan might have a competitive advantage in dairy and other areas but these are eluded by high tax rates and complications. That is also hurting export potential and localization in certain categories, especially in the case of infant formula. Correcting these can create new markets. For example, last year coffee was shifted to the third schedule, and not only were higher revenues collected, but firms are also localizing part of the coffee value chain. The debate on tax policy for the next fiscal year has started. The government should start correcting anomalies and focus on expanding the base using simpler rules and regulations. In this regard, transitioning to the third schedule provides an opportunity to end distortions in certain segments. Copyright Business Recorder, 2026

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