Zafar Iqbal
Pakistan’s tax problem is not what most people think it is. The standard narrative blames low collection, administrative weakness and a culture of evasion. All of that is true to some extent. But the more precise diagnosis is this: Pakistan has built a tax system that punishes the people who follow the rules and rewards the people who do not. Until that fundamental perversity is corrected, no revenue target will be met and no reform campaign will produce lasting results.
The latest episode making this contradiction visible is the renewed debate around the Third Schedule under the Sales Tax Act. The proposal involves collecting GST earlier in the supply chain, at the manufacturing or import stage, based on printed retail prices rather than through downstream invoice-based compliance. This has reignited a long-running argument about how Pakistan collects its taxes, from whom, and whether the mechanism itself is part of the problem.
The answer, unfortunately, is yes.
Consider what the current system actually looks like in practice. A registered manufacturer produces goods, maintains records, files returns, absorbs withholding tax obligations, faces audits and pays advance taxes. The retailer who sells those goods to the final consumer may be entirely undocumented: no registration, no invoice trail, no meaningful tax liability. The state has tried, repeatedly, to pull that retailer into the system. It has launched enforcement campaigns, imposed surcharges on non-filers, made it harder to open bank accounts and purchase property without filing records, and threatened increasingly severe penalties. None of it has worked at scale. The informal retail economy has adapted every time, and the compliant manufacturer has been left absorbing the consequences of leakage and non-payment elsewhere in the chain.
This is not a minor distortion. It is the central structural failure of Pakistan’s fiscal architecture. The formal sector effectively subsidises the informal economy. Businesses that document their transactions face higher effective costs, more intrusive regulatory oversight and greater administrative burdens than those operating in the shadow economy. The incentive this creates is entirely backwards. Transparency becomes commercially punitive. Informality becomes commercially rational.
The Third Schedule proposal responds to this reality, even if imperfectly. By collecting tax at the production or import stage based on printed retail prices, the government attempts to bypass the weakest link in the compliance chain: the undocumented retailer. If tax cannot be collected reliably at the point of sale, collect it before the goods ever reach that point. There is practical logic here. Pakistan’s retail sector is fragmented, cash-based and weakly documented outside the largest urban centres. Expecting full invoice-based compliance across millions of small traders has repeatedly produced administrative complexity without commensurate documentation gains. Collecting earlier, at a fewer number of identifiable and already-registered manufacturers and importers, is administratively cleaner.
There is also a consumer dimension that deserves acknowledgment. Printed retail prices reduce the space for arbitrary mark-ups in markets where enforcement is thin and price visibility is poor. For households buying packaged essentials like cooking oil, flour and dairy products under serious inflationary pressure, a cleaner pricing mechanism offers some protection, however modest. The benefit is real even if it is limited.
But the Third Schedule should not be mistaken for a solution. It is a workaround. It addresses a symptom without treating the underlying disease. Pakistan’s tax system remains structurally dependent on indirect taxation, which is inherently regressive, placing heavier proportional burdens on lower-income households than on wealthier ones. The tax net remains narrow not because collection mechanisms are technically inadequate but because the incentive architecture is fundamentally broken. Widening the Third Schedule without simultaneously addressing that architecture is simply applying another layer of correction to a framework already distorted by decades of patchwork fixes.
The deeper question is why the tax net stays narrow despite years of reform rhetoric. The answer is not mysterious. Expanding genuine documentation requires political resolve, institutional investment and long-term consistency. It means confronting powerful interests that profit from informality. It means reforming property taxation, agricultural income taxation and the treatment of wealthy non-filers across commercial sectors. Governments have found it far easier to raise rates on existing taxpayers, impose new surcharges and intensify audits of already-visible businesses. This produces short-term revenue without requiring structural courage. It also deepens the very distortions that make the system unsustainable in the first place.
The macroeconomic consequences of this approach are severe. A narrow and distorted tax base forces the state to borrow more, rely more heavily on petroleum levies and other indirect instruments, and remain perpetually dependent on external financing arrangements. Each of these pressures feeds back into inflation, which hits salaried workers and lower-income households hardest. The people who bear the formal tax burden and the people who suffer the inflationary consequences of fiscal failure are, very often, the same people. The informal economy escapes both obligations.
This creates a social and political problem as much as a fiscal one. When compliant citizens and businesses observe that operating within the documented economy costs more and invites more scrutiny than operating outside it, confidence in the system erodes. The argument for formality weakens. The incentive to remain documented diminishes. The tax base contracts further. The cycle deepens.
Pakistan cannot continue this way indefinitely. The Third Schedule expansion may be justified in specific sectors where retail informality is particularly entrenched and where upstream collection offers a genuinely cleaner alternative. That case can be made and accepted without pretending it represents comprehensive reform. It does not.
What genuine reform requires is a deliberate decision to stop treating tax policy as an exercise in extracting more from the documented minority. It requires restructuring the system so that formality becomes commercially advantageous rather than commercially punitive. It requires broadening participation through better incentives, simpler compliance mechanisms and consistent enforcement applied uniformly rather than selectively against the most visible and easiest targets.
Until policymakers make that choice, revenue targets will keep being missed. The informal economy will keep thriving. And the formal sector, already carrying a disproportionate and unsustainable burden, will keep paying the price for a system designed, in effect, to punish exactly the behaviour the state claims to want to encourage.
