Pakistan’s fiscal deficit is a structural problem driven by weak revenues and rigid expenditures. Federal revenues remain modest relative to the size of the economy, while spending on debt servicing, defence and pensions leaves little room for development.
After transfers to provinces under the 7th NFC Award, federal revenues are often insufficient even to cover annual debt-servicing costs. As a result, key expenditures such as defence, pensions, government operations and development projects are frequently financed through borrowing, worsening fiscal sustainability. This challenge is compounded by recurring revenue shortfalls of the Federal Board of Revenue.
To bridge gaps, governments increasingly rely on the Petroleum Development Levy (PDL), a fixed non-tax charge on petroleum products. While easy to impose and collect, the PDL carries high economic and social costs, both immediate and long-term.
The PDL, which is beyond the federal divisible pool, is entirely retained by the federal government to manage revenue shortfalls or undertake fiscal operations, with a view to stabilising the fuel prices or controlling circular debt. PDL-driven increases in fuel prices translate into hikes in freight, food, and agricultural input prices, school transport charges and supply chain disruptions for merchandise, along with costly mobility. With regard to its dynamic implications, it cripples industrial productivity, leaving dents in both the country’s export competitiveness and economic growth, limiting the economy’s taxable size. All these translate into further revenue shortfalls, which, in turn, create a vicious circle of fiscal deficit, borrowings and IMF bailouts, conditionalities-led constraints on the primary balance, the imposition of PDL, stagnating economic growth and further fiscal deficits.
Similarly, the repercussions of PDL extend to other sectors such as agriculture, construction and mining, and create uncertainty for investors in the country. In a nutshell, instead of redressing structural hurdles, Pakistan’s tax collection apparatus is being transformed into a device for direct extraction from end consumers, which does not fit into broader patterns of revenue sharing and contributes to the persistence of the fiscal deficit.
As far as the current figures are concerned, the expected revenue shortfall for the financial year 2025-26 is around Rs1 trillion, with a gap of Rs683 billion already evident as of the end of April 2026. At the same time, the government’s target for PDL for the current fiscal year is Rs1.47 trillion, with Rs1.234 trillion already extracted under the same head, as of the end of April, 2026. The remaining Rs236 billion is to be extracted in the last two months of the ongoing fiscal year. According to the latest staff-level report of the IMF, the PDL target for FY2026-27 is Rs1.727 trillion, an increase of Rs259 billion or 17.6 per cent over the target for the current fiscal year. In other words, it is a condition of the IMF that the PDL be increased by 17.6 per cent in the coming fiscal year. So, in the near future, there is no clue to ward off the vicious circle of PDL-financed revenue shortfalls.
Keeping the household-level adverse impacts aside, the PDL-crafted oil prices combined with spillovers from the war in the Middle East in the form of higher cost of energy imports or supply disruptions will cause economic growth to stagnate in the coming years. In the third IMF Staff Report, which is released recently, economic growth in Pakistan has been projected to be 3.6 per cent and 3.5 per cent in FY2025-26 and FY2026-27, respectively. However, the estimate for 2026-27 seems less likely, given the impact of fuel prices and likely shocks to remittances, as roughly 55 per cent of remittances are associated with GCC countries. So, the size of the taxable pie is expected to remain limited, at least in the near future.
Can we break this vicious circle of persistent fiscal deficits and short-term resort to PDL? I would like to posit that, yes, we can do it, but by pursuing structural reforms rather than relying on short-run cushions. First, we need to give deep attention to the structural causes of revenue shortfalls or low tax-to-GDP ratio in the country. The sheer size of the informal economy, systematic tax evasion through exemptions, especially by politically powerful sectors, economic stagnation due to frequent power disruptions and high fuel costs, heavy reliance on import taxes, etc, are the primary causes of revenue shortages.
The size of the informal economy ranges from 40 to 60 per cent, with estimates varying across studies, thereby limiting tax revenue in a static sense while overlooking its dynamic consequences. Likewise, highly profitable sectors of the economy, such as wholesale and retail trade, real estate, and large-scale agriculture, are undertaxed, thereby constraining the economy’s tax base. For instance, the wholesale and retail trade contributes less than 3.0 per cent to direct taxes, despite its sizeable contribution to GDP. So, in short, instead of increasing taxes on the existing taxpayers in the coming budget, we should focus on expanding the tax base with simplification of the tax structure, harmonisation of the agricultural income tax across the provinces, bringing the wholesale and retail sectors to the tax net, and documentation of the economy.
Second, we must rationalise public spending by removing inefficient subsidies and exemptions, overhauling the pension systems, managing the circular debt in the power sector, reforming state-owned enterprises and strictly prioritising high-yield development projects. For instance, tax expenditure, which includes exemptions, zero-rating and other concessions, is estimated at Rs3.8792 trillion for FY 2025-26, with sales tax at Rs2.8587 trillion, income tax at Rs477 billion, and customs duties at Rs543.5 billion. This aggregate accounts for around 30 per cent of the expected total tax revenue, which is huge. So, we would have to give up these exemptions for politically powerful elites and eliminate tax evasion.
With regard to the power sector circular debt, reducing generation costs and capacity charges, implementing cost-effective pricing, improving transmission and distribution mechanisms, introducing competitive practices in the energy market, ensuring energy efficiency and strengthening corporate governance would ameliorate the existing situation.
Likewise, reforms such as corporate governance, market-based CEO induction, joint-ownership structures and the privatisation of irremediable SOEs would eliminate leakage in SOEs. All these measures will mitigate our reliance on PDL on the one hand while ensuring long-term fiscal sustainability on the other.
The writer is a professor of economics at the Pakistan Institute of
Development Economics (PIDE).
