Pakistan’s taxation trap: overburdening formal economy feeds the informal

Tax compliance in Pakistan has been dismal for decades, and every increase in tax rates or the imposition of new levies - whether GST, income tax, or withholding tax (WHT) on non-filers - only pushes more economic activity into the shadows. Instead of increasing revenues, these measures have largely expanded the informal sector.

The grey economy has flourished, particularly since 2015, when discriminatory taxes on non-filers - including levies on cash withdrawals - drove a sharp rise in currency circulation. The ratio of currency in circulation to broad money surged from an average of 22% (FY06-15) to 28% (FY16-24), despite improvements in payment infrastructure and digitization incentives.

Over the past few years, exorbitant tax rates on formal businesses and salaried (and non-salaried) individuals have only intensified the incentive to evade taxes. Informality has exploded across multiple sectors, flooding markets with substandard, tax-evading products. A dysfunctional system is taking root—one that punishes compliant individuals and businesses while rewarding those who operate in the shadows.

Nowhere is this more evident than in the food industry. The government has repeatedly increased GST and Federal Excise Duty (FED) on dairy and juice products, forcing price hikes at a time of soaring inflation. Instead of boosting revenues, this policy has shrunk the formal dairy market, driving consumers toward untaxed, unregulated open milk. Just a few years ago, under Shehbaz Sharif as Punjab’s Chief Minister, there were plans to introduce pasteurization laws in urban centers. Today, under his premiership, the pasteurized and UHT milk sector is being taxed into decline.

Overall, sales of juices and dairy products have plummeted by 20% to 40%, yet the Federal Board of Revenue (FBR) has failed to generate the expected revenue growth. Instead, a vacuum has emerged - filled by informal players selling cheaper, untaxed, and often substandard products. The ripple-effect extends across the value chain, hurting packaging companies that rely on formal-sector sales, while informal players sidestep taxes by smuggling packaging materials from China.

A similar story unfolds in the tobacco industry. As the FED on cigarettes has nearly doubled, a wave of tax-evading local brands has flooded the market, rapidly overtaking formal players. The government is losing approximately Rs300 billion in revenue annually, while the only real winner is the grey market.

With an ever-growing informal economy, the tax burden on the formal sector has become unbearable. The government’s revenue targets for this fiscal year are unrealistically high, and the formal sector - already taxed to its limits finding new ways to dodge the system.

Salaried individuals are structuring their income to minimize taxes, with executives dividing salaries among family members. Firms with international operations are classifying employees as freelancers to escape taxation. Some textile and export firms are registering as IT companies to benefit from lower tax rates. Even genuine IT firms are exploiting loopholes by paying local employees through offshore entities, evading local salary taxes while still enjoying tax incentives meant for export earnings.

At the same time, high GST rates and import duties are throttling exports and obstructing import substitution. Smaller exporters, particularly in non-traditional sectors, cannot compete globally because they lack the lobbying power to secure tax refunds.

Meanwhile, multinational corporations (MNCs) struggle to compete with smuggled goods, as tax-evading imports undercut their locally manufactured products. The result? A market where innovation stalls, competition is distorted, and economic growth is stifled.

The formal sector has no more capacity to bear the tax load.

The government’s only viable path forward is to broaden the tax base. Even the IMF, in its ongoing review, has made tax broadening a key demand. The logical place to start is customs reform, cracking down on under-invoicing and over-invoicing. The clock is ticking, and fiscal space is running out. If the government doesn’t act now, the only thing left to tax will be a collapsing economy.

Copyright Business Recorder, 2025