Tax evasion, smuggling, and distorted scope of development in Pakistan

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A commonly asked question in economic development literature is why poor countries are poor. Interestingly, the answer is often found in the sphere that is not perceived as “typically economic” in nature: politics, society, and resulting institutions. The current perils of massive tax evasion and shadow economy in Pakistan also derive their genesis from its social and political inertia.

A basic course in macroeconomics tells that the circular flow of income with the government as a stakeholder needs tax money to make transfer payments and subsidies to households and firms, respectively. Augmenting it to reality, the government in this model is also responsible for ensuring smooth circular flow. The tax accruing to the government enables it to provide social and physical infrastructure, employment, and enforcement of law and order. However, when this (more than) perfect model is placed in the setup with a government with low political will and high levels of inertia, the model breaks down, leakages peak up, and market distortions and inefficiencies disrupt the flow. Putting it into context, this is the current situation in Pakistan, which is marked by distortionary practices.

Smuggling and tax evasion are ubiquitous across industries in Pakistan, whether it is consumer goods, real estate, or the pharmaceutical sector. Illegal trade activities have adversely affected the revenue generation from the nation’s tea imports and smuggling of counterfeit medicines. The real estate sector is besmirched with issues of under-invoicing and evading taxes on the market-determined worth of properties. Pakistan’s real estate sector is a safe haven for money laundering practices due to poor documentation and heavily cash-based transactions . Market distortions are very much in place, as the actual unreported transactions are often much larger than the property valuation rates set by the Federal Board of Revenue , creating a humongous space for black money.

As per the Federal Bureau of Revenue, despite various innovations in tracking software, the sugar sector successfully avoids paying 20 to 25 percent of taxes. As per one estimate, nearly 800,000 tons of sugar had been smuggled across the western border of Pakistan. In the tyre industry, as per an estimate, illegal or smuggled tyres comprise 65 percent of the market, while only 15 percent are imported through legal channels. In the tobacco sector, tax evasion due to the illegal trade of cigarettes costs Pakistan Rs. 240 billion annually, comprising 48 percent of the market share, out of which 38 percent are locally manufactured tax-evading cigarette brands, and 10 percent are smuggled brands that do not follow any licensing requirements. The majority of the market is flooded with cigarettes sold below the government’s minimum legal price, and thus evade taxes successfully . In the fiscal year 2023-24, the government lost tax revenue lost more than Rs.250 billion of tax revenue due to illicit trade in the tobacco sector.

The situation is alarming. Given the recent foreign exchange crisis in Pakistan, experts claim that if tax leakages were controlled through the enforcement of laws, the economy would not have required foreign funding, as the economy is currently losing Rs. 1 trillion through tax evasion annually.

The situation is dismal in the fuel and precious metals sector as well. Despite the official ban on importing Iranian fuel products, the smuggled Iranian oil comprises over 30 percent of Pakistan's diesel market. As per a report, around 10 million liters of diesel and two million liters of petrol are smuggled every day into Pakistan, costing the government over USD 1 billion annually . Similarly, smuggling like gold is burdening the economy. It has been estimated that only USD 94.5 million of gold is officially declared to tax authorities, which stands at only 1.32 percent of the market value. Around fifty percent of the nation’s gold consumption (by volume) is met through smuggling annually.

Another report reveals that smuggling and the black market are costing the Pakistani economy a loss of USD 23 billion per year . The increasing reliance on smuggled foreign goods is crippling the large-scale manufacturing sector and employment situation in the country.
It can be conclusively said that the macroeconomic problems that Pakistan currently faces, including fiscal deficits, high inflationary pressure, and heavy currency devaluations, are the offspring of tax-evasive economic practices.

Essentially, the current crisis arises due to weak enforcement and monitoring, as well as weak political will of the government. Pakistan’s border, shared with Iran and Afghanistan, is rather porous and not well monitored, leading to undocumented exports. Experts suggest advanced surveillance techniques need to be put in place to secure Pakistan's physical borders and crossing points.

However, the problem comes not only from international borders but also within the borders due to poor law enforcement and surveillance. Economic policies are not reaping the expected results. Import ban on certain commodities is neither able to effectively ban imports nor boost domestic manufacturing, but rather create more avenues for inefficiencies. Economic policies do not work in isolation. They are, after all, executed by institutions that are heavily influenced by socio-political ethos. Structural issues, as simple as under-invoicing and insufficient documentation, that could be easily dealt with are becoming a major bottleneck for the economy due to a lack of legislative reforms, substandard valuation methods, and low levels of transparency. Sufficient documentation and monitoring practices, like in the case of sugar production or real estate transactions, are missing. Enforcement mechanisms and regulations are weak, as discussed in the case of the tyre and tobacco industry.

One major reason for poor enforcement and regulation is that many of the stakeholders involved are the political elites of the country, who are involved in clientelism and corruption. For the political elite, the cost of stricter enforcement and regulation might be losing their share of votes and illicit earnings. Hence, they have not much of an incentive to ensue government intervention through monitoring, legislative reforms and enforcement.

The revenue lost due to leakages like tax evasion diverts the resources away from the federal budget toward private spending. These private spending is not able to create as much multiplier effect as the government spending on agriculture, education, or health infrastructure could, further distorting development . The problem is more political and social in nature, with unnerving economic outcomes; thus, it needs a political economy lens to understand and frame effective policy responses. As per experts, if the governance improves, the financial and economic environment of the country will improve, bringing financial stability . Stronger institutions, along with political will to curb the market distortions, are a pre-requisite. It is important to note that if the government is unpopular, the incentive to evade tax is even higher, as the taxpayers do not see the government as representative of their needs.

Tax evasion has decelerated the goals of human development in Pakistan, berefting the exchequer of the financial resources that could be used to provision public goods. Declining large-scale domestic manufacturing sector, employment, and exports are the outcomes of the current situation. Given the mammoth size of the shadow economy, estimated to be 40 percent of the nation’s GDP, unless the new government streamlines resources to curb tax evasion, black market activities like commodity smuggling, and money laundering, sustainable development goals will remain a distant dream.

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