Notable name in tax policy, Vito Tanzi, has drawn attention to the connection between tax levels and macroeconomic policies such as exchange rate, import substitution, trade liberalisation, inflation, public debt, and financial policies. He believes that changes in tax levels cannot be attributed to traditional determinants alone, and greater attention should be devoted to the relationship between these macroeconomic variables and tax levels.
Factors influencing the tax-to-GDP ratio are many, and a variety of permutations and combinations can be used in empirical analysis. The choice of factors and their application is, however, constrained by the availability of data in a country.
Limitations of Inter-Country Tax Comparisons. Are inter-country comparisons of taxation levels meaningful? Some fiscal experts have sharply criticised these attempts. According to critics, the economic, political, and institutional characteristics of individual countries are so different that neither theoretical nor empirical studies provide useful information of policy relevance.
Tax-to-GDP ratios do not consider the fact that some countries are more favourably placed to levy and collect taxes than others. For example, Joergen R. Lotz and Elliott R. Morss analysed a sample of 72 developed and developing countries to examine the relationship between tax ratio variations and differences in per capita income and degree of openness. The sample included a wide spectrum of dissimilar economies ranging from Nepal to Singapore. It is prima facie erroneous to compare Nepal’s highly rural and agricultural economy with the highly commercial and industrial city-state of Singapore.
The higher ratio for industrialised countries is primarily due to the higher level of revenue from social security, payroll taxes, corporate taxes, and taxes on domestic consumption, while taxes from international trade and non-tax revenue are lower. In contrast, in developing countries like Pakistan, the major portion of revenue comes from indirect taxes, particularly taxes on international trade and domestic consumption, while direct taxes have a lower share.
It is difficult to establish a direct and precise statistical correlation between tax rates and private capital formation due to such factors as time lags, changes in the tax base, and other externalities determining investment
Pakistan’s tax-to-GDP ratio (11.1 per cent) in fiscal year (FY) 2024–25 was even lower than Sri Lanka (14 per cent) and Thailand (17 per cent), which proves beyond any doubt the failure of fiscal managers and tax collectors. The taxes collected by the Federal Board of Revenue (FBR) in FY 2025 at Rs 11,744.3 billion, i.e. 10.2 per cent of GDP, were overstated by at least Rs one trillion, if not more, by holding bona fide refunds of over Rs 800 billion (exact figure is not made public in violation of Article 19A of the Constitution) and taking advances of Rs 200 billion (not yet due).
Tax rates, savings, and capital formation
It is difficult to establish a direct and precise statistical correlation between tax rates and private capital formation due to such factors as time lags, changes in the tax base, and other externalities determining investment.
Nevertheless, historical and statistical trends tend to suggest that savings and private capital formation have been sensitive to effective tax incidence. It has increased during periods when taxation, particularly direct tax incidence, is low.
Therefore, it seems logical to conclude that, to promote savings and capital formation, the reduction in income taxation has to be considered a necessary, though not by itself a sufficient, condition. Unfortunately, Pakistan has done just the opposite and, due to excessively high corporate and personal taxation, pushed the country towards a crisis of industrial stagnation and youth unemployment.
Tax elasticity and buoyancy in development
A principal fiscal aim in any development strategy is to increase the elasticity and buoyancy of the revenue system. Elasticity reflects the built-in responsiveness of tax revenue to movements in national income or GDP. Buoyancy reflects the total response of tax revenue to changes in national income or GDP, including the effects of discretionary changes in tax policies over time.
An elastic system will automatically raise revenue at the same or at a faster rate than the growth of national income (or GDP) and facilitate a sustained increase in necessary government outlays. It would also reduce the economic uncertainties associated with frequent discretionary changes in taxes. Frequent ad hoc changes in tax policies, as is the case in Pakistan, create uncertainties among taxpayers and adversely affect investment and production. In Pakistan, it has been estimated that both the elasticity and buoyancy coefficients are below unity; hence, the tax system is inelastic to reflect changes in GDP or national income.
Taxation and demand management
Taxation has often been used in many countries as a tool for countering inflationary and deflationary pressures on the economy. Such pressures affect development through a lack of external balances and/or through a spiral of changing prices and employment.
In mitigating the effects of cyclical pressures, monetary policy, though traditionally more effective, is often limited by the structural nature of an economy, and therefore, tax policy assumes major importance.
In Pakistan, inflationary and deflationary pressures take three major forms: (a) price inflation due to rises in import prices; (b) inflationary financing by the government during boom periods and consequent pressure on the balance of payments; and (c) deficit financing during periods of deflation, resulting in balance of payments pressures.
Tax incentives (sic) continue to be a major instrument of rent-seeking in Pakistan, not for development strategy but to appease the powerful
Tax policy also aims at reducing or checking undue private consumption expenditure by the taxation of excess incomes. Income tax, being a progressive tax, has been well-suited to this purpose. However, our tax policy designers (sic), mainly the International Monetary Fund (IMF), for the last many decades, through presumptive and minimum regimes within the Income Tax Ordinance, 2001, have converted it into a Withholding Income Tax Law, facilitating the powerful manufacturers owned by two trusts having tax-free status and the trading class to pass on the burden to consumers.
Of the indirect taxes, import duties are not as flexible, as these may have the effect of transferring inflationary pressure to domestic prices. Export duties, however, have been far more effective in siphoning off excess income before it gets into the hands of producers during inflation or acting vice versa in times of deflation. In Pakistan, due to the perpetual crisis of the balance of payments, heavy taxes on exports imposed at the dictates of the IMF in 2024 are showing negative results.
Tax incentives in the development strategy
Tax and investment incentives have, in recent times, become a favourite tool in development strategy, both for domestic investors and for attracting foreign direct investment (FDI). The rationale for their use is that they constitute an important, if not major, element in determining investment behaviour.
Incentives increase the net-of-tax rate of return and thereby reduce the need for large initial capital investment and reduce risk. The availability of incentives tends to make otherwise unpromising and risky ventures more profitable. They are also valuable as an indirect stimulus to investment because they publicise and enhance the country’s investment climate. Our economic managers, and even experiments like the Special Investment Facilitation Council (SIFC), have miserably failed to attract FDI.
The role of tax incentives in determining investment behaviour has, however, been controversial. According to many studies, incentives by themselves do not play a major role in determining investment vis-à-vis other factors such as infrastructure facilities, cheap and easy credit, access to markets, reliable and skilled labour force, and political and economic stability. They have also been increasingly called into question on several grounds.
One is that they distort investors’ decisions and thus produce a less-than-optimum allocation of resources. They erode the tax base, affect tax revenues, and provide fertile ground for tax avoidance through “tax shelters”. The cost of incentives (sometimes called “tax expenditure”), it is therefore felt, outweighs their benefits.
Nevertheless, tax incentives are in place in a large number of developing countries, reduced in Pakistan gradually due to IMF policy design and form a significant part of the development strategy being adopted. Even Indonesia, which carried out major tax reform from 1983 onwards and did away with all tax incentives in favour of a broad-based, low-tax-rate regime, has abandoned this policy stance and reintroduced a range of tax incentives recently.
In Pakistan, tax incentives from 1959 onwards, and especially after 1991, became a major instrument of development policy. However, since 2013, attempts have been made to reduce their scope and coverage under pressure from the IMF, though without much success. Tax incentives (sic) continue to be a major instrument of rent-seeking in Pakistan, not for development strategy but to appease the powerful, e.g. income tax exemption to Fauji Foundation and Army Welfare Trust, and many other trusts that run businesses on a purely commercial basis.