Federalised tax reform strategy

Business Recorder

5 days ago

The Constitution (Eighteenth Amend-ment) Act, 2010, [18th Amendment], became effective on April 19, 2010, brought a major shift in Pakistan's fiscal and administrative architecture. With principal objective of granting greater autonomy to provinces by devolving critical functions, the 18thAmendment transformed federal-provincial relationship, with re-sharing of taxation powers conforming to fiscal federalism and decentralized governance model.
The Federal Board of Revenue (FBR) retained power to collect major taxes, e.g., income tax, sales tax on goods, customs duty and federal excise duty. Provinces were empowered to collect capital gains tax, estate duty, capital value tax and wealth tax on immoveable property, as well as retaining income tax on agricultural income and self-collection of sales tax on services—an indirect tax that has since emerged as a vital source of provincial revenue.
The devolution embedded in the 18th Amendment held immense potential to redefine the country's financial model envisioning a federation where provinces would act as self-sufficient units, driving competition, enabling business-friendly policies, and harmonizing fiscal discipline with regional development goals. If implemented with prudence and vision, the model could have stimulated inter-provincial competition in ease of doing business, infrastructure development, and investment attraction.
Reality, however, has unfolded far differently. Having gained greater fiscal access through federal transfers under the National Finance Commission (NFC) Award, the provinces have largely failed to generate proportional revenues of their own—collectively itremains 0.7-0.8% of the GDP. The result is a pronounced fiscal disparity where spending powers have grown while revenue capacities have stagnated, increasing provinces' dependency on federal transfers.
Lack of coordination between federal and provincial tax authorities has created a fragmented tax environment that burdens businesses and deters investment. Businesses operating across multiple provinces now encounter varying tax rates, legal definitions, compliance portals, audit procedures, and dispute mechanisms.
The duplication and contradiction in tax regimes have raised the cost of doing business and spawned a growing number of tax disputes. In several instances, both federal and provincial authorities claim jurisdiction over the same transaction, leading to double taxation. The resulting uncertainty not only affects businesses' financial planning but also shakes investor confidence in Pakistan's regulatory environment.
The most recent provincial budgets for Punjab, Sindh, and Khyber Pakhtunkhwa for fiscal year 2025-26 [FY 2026] have further complicated the already convoluted tax framework. Introduction of a negative-list regime signifies a massive shift, wherein all services are considered taxable by default unless explicitly exempted or assigned a different rate.
The Punjab Sales Tax Act, 2012is amended to tax commercial property rentals at 16%, exempting only residential rentals, under Entry 19 of the First Schedule. Similarly, the Sindh Finance Act 2025 adopted a comparable structure under which commercial property rentals are taxed at 3% pursuant to Entry 17 of Part II of the Second Schedule of the Sindh Sales Tax on Services Act, 2011.
The new legislation in Sindh marks a key moment in the province's efforts to expand its tax base, though it also raises critical constitutional and legal questions. The previous legal position, enunciated by the Sindh High Court in Constitutional Petition No. D-2421 of 2016 (Young's Private Limited v. Province of Sindh), explicitly ruled that renting of immoveable property does not constitute service. The Court clarified that leasing property does not involve active provision or rendering of a service by the landlord and is merely the transfer of a right to use premises. Therefore, rental income, which lacks the characteristics of economic activity or facilitation by the owner, cannot be brought within the purview of sales tax on services.
The Sindh Finance Act 2025 attempts to circumvent this legal clarity by amending the definition of 'service' in the Sindh Sales Tax on Services Act to include 'the granting, assignment, cession or surrender of any right,' thereby legally justifying taxation of property rentals. The law has further codified this change through amended Section 2(79) and provided statutory backing to tax transactions, notwithstanding past judicial interpretations. Punjab has mirrored this approach with its new legal provision taxing commercial rentals, effectively creating a multi-jurisdictional expansion of sales tax regimes into domains previously exempt or deemed untaxable.
Imposition of sales tax on property rentals, which are already subject to income tax under the federal Income Tax Ordinance, 2001, represents a severe escalation in the cost of doing business. Rental income is taxed federally at rates reaching up to 25% for individuals and associations of persons and as high as 39% for corporate entities.
The additional layer of provincial sales tax now results in tax stacking, further eroding business margins. The move reflects growing financial appetite of both federal and provincial governments, which have resorted to aggressive revenue extraction from compliant sectors instead of undertaking the difficult but necessary task of broadening the tax base.
The resulting tax framework is not only complex and burdensome but also fundamentally regressive. Small and medium enterprises (SMEs) that constitute the backbone of Pakistan's economy are most vulnerable to these cumulative tax measures. Fragmentation and overlapping of federal and provincial tax domains create an environment where formal businesses face constant regulatory uncertainty, financial unpredictability, and operational challenges. Instead of encouraging entrepreneurship and investment, the system punishes compliance and disincentivizes growth.
Taxation of rental income under both income tax and sales tax frameworks violates the principles of tax neutrality and legal certainty. The notion that mere possession of a commercial property constitutes a taxable (sic) service under provincial sales tax laws defies traditional legal definitions of the term 'service'. This overreach raises constitutional issues and is likely to be challenged again in courts. The issue becomes even more concerning when considered in the light of prior judicial pronouncements that protected rental transactions from such encroachments.
The fundamental role of taxation is to facilitate development, incentivize formalization, and ensure equity. However, Pakistan's tax system increasingly appears to be functioning in reverse, penalizing documented sectors whereas leaving the vast informal economy untouched. Absence of coordination between FBR and provincial revenue authorities further exacerbates the problem. Duplication of audit notices, contradictory assessments, and arbitrary application of tax laws are all symptoms of a governance system that is out of sync with the needs of a modern economy.
Focus on squeezing existing taxpayers, rather than creating an enabling environment for expanding the tax net, reflects a short-term, reactive approach to revenue generation. This mindset overlooks the larger structural issues, such as outdated tax administration systems, lack of data integration between authorities, and the political reluctance to bring influential untaxed segments into the tax fold. Consequently, the formal sector continues to shrink under the weight of growing tax demands, however, informal operators flourish without oversight.
Time has come to adopt a holistic and forward-looking tax reform strategy. The federal and provincial governments must first recognize the 18th Amendment's constitutional spirit, not just as a political realignment, but as a responsibility to harmonize policies for national progress. The need for an integrated tax policy framework, jointly developed by federal and provincial governments, is more pressing than ever.
The policy must provide clarity on jurisdictional boundaries, eliminate overlapping taxes, and ensure that the same transaction is not subjected to dual taxation under different laws.
Harmonization of definitions, rates, procedures, and audit mechanisms across federal and provincial jurisdictions would significantly reduce the cost of doing business and enhance voluntary compliance. The creation of a unified tax portal, shared audit protocols, and coordinated taxpayer databases would go a long way in restoring confidence in the tax system. The provinces must be encouraged and supported to generate their own revenues, but not through regressive and legally questionable means. Instead, focus should be on widening the tax base by formalizing real estate, retail, agriculture, and service sectors that currently escape the tax radar.
The rental taxation issue should be revisited through a constitutional and economic lens. If commercial rentals are to be taxed, then the mechanism must be clear, justified, and proportionate. The burden on taxpayers must be fair and rational, and any dual taxation must be eliminated through amendments or harmonization agreements between federal and provincial entities. Moreover, existing judgments of superior courts must be respected in both letter and spirit to maintain the sanctity of judicial oversight in fiscal policy.
The future of Pakistan's economy depends on its ability to move from fiscal coercion to fiscal cooperation. Governments at all levels must treat taxpayers as partners in national development rather than as easy targets for revenue collection. A simplified, harmonized, and fair tax system is not only a constitutional imperative under the 18th Amendment but a foundational requirement for economic stability, investment promotion, and social trust. Only through serious institutional reform, coordination, and legal clarity can Pakistan transform its tax regime from a deterrent into a driver of prosperity.
Copyright Business Recorder, 2025