The budget's real test

BUDGET season in Pakistan follows a reliable script that portrays the IMF as the bogeyman, pretends the fiscal deficit is too wide and puts everyone under pressure to close the gap.

The instinct is always the same: to find more revenue, raise more tax rates and deepen into an already narrow tax base. One hopes that such an instinct can be resisted this year because the budget’s real mandate is not to maximise tax collection, but to engineer a step-change in investment.

Pakistan’s investment-to-GDP ratio sits at 14%; that number is the structural reason we grow at 3-4% in good years and contract in bad ones. Every serious middle-income transition in living memory, South Korea, Vietnam, China, Malaysia and Indonesia, was built on investment rates of 30% or above, sustained for decades. Pakistan cannot grow its way to upper-middle income at 14% investment.

The arithmetic simply does not allow it. No exchange rate adjustment, no circular debt resolution, no export incentive scheme closes that gap. The question the budget must answer is therefore not about how we collect more revenue from the existing base, but what tax policy unlocks private investment at scale.

Pakistan has approximately 2.5 million active tax filers in an economy of 240 million people, with a workforce estimated at over 85 million. The informal economy accounts for between 35% and 40% of GDP, according to most credible estimates, and may even be higher. The response of policymakers to this structural failure has been consistent and consistently wrong -- to: raise rates on those already in the system, create new levies on documented transactions, and hope that compliance improves through pressure alone. Hope is an emotion, and not a plan or a strategy.

What actually happens instead is more damaging, as every additional tax burden on the formal sector makes informality relatively more attractive. A manufacturer who is already paying 29% corporate tax, as well as a 10% super tax, on top of a cost of capital of 18%, electricity at twice the regional average and a logistics penalty that adds 10-15% to delivered cost, is not choosing between complying and not complying. They are choosing between investing and not investing. When the post-tax return on a greenfield manufacturing facility cannot clear the hurdle rate -- and, at current costs, most cannot -- capital sits idle, is redirected to real estate, various commodities (fueling speculation), or leaves the country.

The corporate tax rate at 29%, and a 10% super tax, is not a marginal irritant. It is a structural drag on capital formation. India, after years of losing manufacturing investment to Vietnam and other regional competitors, cut its corporate rate from 30% to 22% in 2019 and introduced a 15% rate for new greenfield manufacturers, the lowest effective rate in South Asia. Manufacturing investment applications under the Production Linked Incentive scheme exceeded targets within twelve months. The mechanism was not complicated, as a viable post-tax return made investment decisions legible.

Bangladesh, at a corporate rate of 27.5% with substantial carve-outs for export-oriented manufacturing, has mobilised investment-to-GDP ratios exceeding 30%. Vietnam’s rate of 20% is part of the architecture that drove investment from 28% to 33% of GDP during its manufacturing boom. Pakistan, at 29% and a shrinking formal base, is moving in the completely opposite direction, with no plan for any course correction. It is simply impossible to increase exports without incentivising investment in productive capacity. What can one really export when one cannot even produce?

The path to a wider tax base runs through a lower rate, not a higher one. This is not a Laffer curve abstraction. It is effectively a cost-benefit calculation that every informal operator makes every year. Registration exposes you to corporate tax, GST, withholding levies and FBR audit risk. The only rational counterweight to those costs is access to bank credit, to formal procurement channels, to export certification, to government contracts.

When the costs exceed the benefits, operators prefer to stay informal. Such a calculus shifts only when the tax rate falls and productive capacity is actively encouraged rather than looked down upon relative to real estate and other non-productive ventures.

This budget should do four things specifically. First, cut the corporate tax rate to 22% or even below, while either eliminating super tax, or converting that into an accelerated depreciation scheme. Second, introduce a 15% rate for new greenfield export-oriented manufacturing for the first seven years. The country needs anchor industrial investments, and anchors require economics that work. Third, allow full three-year accelerated depreciation on new plant and machinery, a fiscal cost that is a direct subsidy to capital formation, not consumption.

None of these measures are fiscally irresponsible. Pakistan’s primary fiscal deficit is approximately zero, the entire 7.9% fiscal gap is interest on legacy debt; which was acquired to fund expenditures which only encouraged consumption. The fiscal consolidation story is about reducing that interest burden over time, not squeezing more revenue from a base that is already over-taxed relative to what it can bear. Rate cuts that trigger investment growth and formalisation will, within three to five years, expand the taxable base more than rate increases on the current filers ever could.

The budget is not a revenue statement, it is more of an investment signal. Every rate increase suggests that deploying capital in Pakistan costs more than it should, while every levy on a documented transaction says that compliance is a penalty. Pakistan cannot tax its way to a 30% investment-to-GDP ratio.

It must make investment rational through energy reform, fiscal consolidation, and a tax structure that rewards the risk of building something formal. There is no other mechanism.

The writer is a macroeconomist and an assistant professor of practice at the School of Business Studies, IBA, Karachi.

Disclaimer: The viewpoints expressed in this piece are the writer's own and don't necessarily reflect Geo.tv's editorial policy.

Originally published in The News