When Pakistan’s government imposed restrictions on imports to reduce the country’s trade deficit in 2022, it did not deter the inflow of goods – it encouraged substitutes and possibly smuggling, which is growing at 18% annually.

In particular, the large-scale manufacturing firms and multinational companies were negatively impacted, whereas small-scale firms and commercial importers managed to find alternative routes, often without the knowledge of the government, and at times in connivance with some elements within the state.

Taking account of the impact, Prime Minister Shehbaz Sharif had to recently declare that “illegal trade and smuggling have caused huge losses to the country”.

I present an informed guess to quantify this loss here. First, I qualify that for this article, illicit trade comprises legitimate goods, being produced, sold, and consumed through illegal means including non-documentation and tax evasion.

The illicit trade can be classified into: counterfeit, tax evasion, smuggling, and under-invoicing/misdeclaration.

According to some sources, smuggling through the Afghan Transit Trade (ATT) alone may be responsible for causing at least Rs1,000 billion loss to the national exchequer in terms of foregone import-related tax revenue.

Looking at another dimension of the illegal trade, the government is losing approximately Rs300 billion every year in tobacco taxes, which is rising. If we add another Rs270 billion estimated to be lost due to Iranian oil smuggling into Pakistan, the overall loss is at least Rs1.5 trillion.

These are only estimated numbers and as the nature of illegal trade would dictate, it is impossible to find a reliable number.

Using another source, the Pakistan Business Council estimates the size of grey and shadow economy to the tune of $68 billion. If the tax is assumed to be 10%, this would translate into tax losses of almost Rs1.9 trillion.

Therefore, it is safe to assume that the overall loss to the national exchequer caused by illegal trade, smuggling and tax evasion can be between Rs1.5 trillion and Rs2 trillion, which would be 21% of the current tax target.

This is more than 100% of the total targeted collection of federal excise duty and customs duty, as announced in the budget for 2023-24. This is coincidentally almost equal to the new loan being negotiated with the IMF.

These estimates do not include under-invoicing or misdeclaration as well as losses due to counterfeit products. These also do not include implications for business environment, and in particular, incentives for international investors, who look for a level playing field when it comes to tax policy and its practice.

Clearly, in a country where the government is seemingly focused on extracting taxes only from large-scale and corporate businesses, it provides wrong signals to existing investors, who essentially sends similar messages to future investors.

One should not be surprised that foreign direct investment (FDI) rates in Pakistan have remained abysmally low over the last few years.

According to the Transnational Alliance on Combating Illicit Trade (TRACIT), Pakistan is ranked 72nd out of 84 countries on the “Global Illicit Trade Environment Index”, which is published by the Economist Intelligence Unit. Its parameters are government policy, supply and demand, transparency and trade, and customs environment.

Illegal trade may provide short-term benefits to the economy in terms of cheaper alternatives, but in the long run, it deprives the country of productive investment, innovation, and competitiveness. In some cases, such as spurious medicines or pesticides, this also implies direct threats to public health.

Prime Minister Shehbaz Sharif’s government is rightly concerned about damages being caused by illegal trade activities and tax evasion. The strategy is multi-dimensional: tax compliance, improving enforcement, evaluation of track and trace mechanism and digitalisation of FBR.

It is not the first time that the government has launched such drives. A tax compliance initiative, known as “Tajir Dost Scheme” launched without due homework, is already failing.

It was able to bring only around 200 enterprises on the tax register, out of, well over, three million enterprises. The prime minister has already expressed his dismay over the track and trace system, which was implemented in four sectors in 2020.

Industry sources claim that counterfeit stamps are being produced in tobacco and sugar sectors. This system has met with similar failures in many other countries.

We have borrowed hundreds of millions of dollars for digitalisation of FBR in the last few years, and have found, to the national embarrassment, that FBR was using fake software!

While I hope that recent measures will bear fruit, one should remain wary of over-reliance on technology where policy design is faulty.

As Pakistan remains one of the most protected economies of the world, unless we minimise barriers (as demonstrated in taxes, tariffs, and regulations) to legal trade, the government has no chance of generating enough growth to raise required tax revenues and is set on a clear path towards bankruptcy.

The prime minister has a stark choice: instead of asking the IMF to provide another $6 billion (or Rs1,674 billion) to be disbursed over three years, he can take a different route and aim to plug the hole of tax losses estimated at Rs1.5-2 trillion over the same time period.

The writer is founder and executive director of the Policy Research Institute of Market Economy (PRIME), an independent economic policy think tank based in Islamabad

In his 2011 article, Dr Muhammad Yaqub, the former governor of the State Bank of Pakistan (SBP), emphasised the need for controlling money supply to maintain its soundness.

PRIME’s report on Sound Money, which evaluates Pakistan’s monetary stability and analyses macroeconomic policies that have shaped its current state, echoes the same.

Pakistan’s economy is struggling with low growth due to a lack of necessary prerequisites for economic prosperity. The path towards prosperity is determined by the functioning of markets, which requires economic freedom for its agents.

Economic freedom is defined as the degree to which individuals’ property rights are respected in society. Money is a property held by almost all individuals, as market transactions now take place in exchange for money.

To ensure property rights over money, macroeconomic policies must maintain its soundness. In the modern world, a country’s money is sound if its value remains stable against domestic and foreign goods, services, real and other financial assets.

The Fraser Institute of Canada uses the Economic Freedom Index to evaluate and rank countries based on their economic freedom. The index consists of five categories, including sound money.

According to the latest annual report, Pakistan ranks 123rd out of 165 countries with a score of 5.98/10. Unfortunately, Pakistan’s rank for sound money is even worse, standing at 150th out of 165 countries with a score of 6.37/10.

Pakistan has maintained an average score of 6.22 for sound money from 2001 to 2023, with the highest score of 6.83 observed in 2002 and the lowest score of 4.60 in 2023.

From 1974 to 2023, the purchasing power of money for the goods and services included in the Consumer Price Index (CPI) basket decreased by a factor of 68. Similarly, the value of one US dollar went up from less than Rs10 in 1974 to Rs248 in 2023, leading to a 25-fold loss in the rupee value.

This monetary fragility can be attributed to excessive monetary growth, where broad money (M2) has grown significantly faster than the real and nominal gross domestic product (GDP).

Over the past 50 years, the real GDP increased by 10 times and the nominal GDP increased by 644 times, while money supply expanded by over 1,000 times.

The report reveals that the government is mainly responsible for the unsoundness of money due to the inefficient mix of monetary, fiscal, and exchange rate policies. Specifically, the rate of monetary expansion has been out of sync with economic fundamentals.

Pakistani government has historically relied heavily on borrowing from the SBP to finance its budget, leading to an unsustainable monetary expansion. Although the amended SBP Act has limited the government’s ability to issue debt to the central bank, monetary expansion has continued.

The SBP has attempted to control inflation and currency depreciation through a reactionary approach, using interest rate as its policy instrument. However, this approach has been unsuccessful, as keeping market interest rates close to the SBP policy rate makes it difficult to control money supply.

If the government, the lead borrower in the market, does not reduce its demand for funds in response to interest rate hikes, achieving the interest rate target becomes challenging. The SBP has to provide necessary liquidity to the market to achieve short-term interest rate targets, making it impossible to control monetary expansion.

The government’s fiscal branch is often held responsible for monetary expansion, resulting from increased spending without the matching revenue. While this argument holds, the federal government is currently caught in a cycle of debt accumulation.

The seventh NFC Award increased the share of provinces compared to the federation, which may be desirable but has made the federal government vulnerable to shocks. The delay in implementing reforms to reduce the size of the federal government in accordance with the 18th Constitutional Amendment exacerbated the problem.

After paying the provinces their due share, the federal government is left with limited resources that are hardly sufficient to service its debt. Debt servicing being charged expenditure is paid first, leaving the government with no room to provide public goods.

Moreover, the government has to borrow more to service its debt when the SBP raises interest rates to control inflation. This borrowing strains the market for loanable funds, prompting the SBP to inject liquidity. Hence, the money supply expands despite the government being barred from directly borrowing from the SBP.

A comprehensive reform agenda is required to improve Pakistan’s money stability. This includes reducing the size of the government, coordinating fiscal and monetary policies more effectively, managing debt efficiently, and creating an environment that promotes sustained and inclusive economic growth.

Reviewing the current monetary-fiscal policy mix and determining an appropriate operating instrument for the State Bank to limit monetary expansion and maintain its autonomy is crucial.

The practice of expanding money supply in response to government borrowing from scheduled banks while setting the policy rate to contain inflation is not productive.

Pakistan held a general election on February 8th, 2024, and the Pakistan Muslim League-Nawaz (PML-N) formed its government on March 4th, 2024. Mian Shehbaz Sharif, who led the previous government under the Pakistan Democratic Movement (PDM) coalition, is the current prime minister.

However, according to major macroeconomic indicators like inflation, growth rate, and unemployment, the performance of the PDM government hasn’t been impressive.

When PDM assumed office in April 2022, the economy was not functioning well. Rather than pursuing structural reforms that could bring long-term gains, the government decided to maintain the status quo and stabilise the economy using conventional tools that have a long history of failure. As a result, almost two years have passed, and the economic situation remains dire.

The new government may repeat past mistakes, but good hope remains for economic reforms. In this article, I propose four major reforms that can benefit the economy in the long run.

Firstly, rationalising the current economic model is a complex but necessary task. The model has failed and will only produce the same results if it remains in its present form. It has weak institutions, relies on debts and remittances, has an uncompetitive industrial structure, declining exports, brain drain, a lower tax base, economic uncertainty, regulatory burden, and a large government size.

To survive, the government is raising taxes at the cost of savings, consumption, and citizens’ welfare.

It is necessary to audit the entire economic structure, analysing what works and what does not, and removing all inefficiencies.

Without it, no policy is effective since these inefficiencies are deeply embedded in the present model. This long, continuous process needs improvement at each stage but must be done as soon as possible.

Secondly, creating state institutions that ensure the rule of law and accountability.

It also requires a strong political commitment despite high political costs to the dominant state institutions that maintain the status quo. They may prefer to keep their present position. But if they are concerned about the country’s development, they must not create barriers to institutional reforms.

Thirdly, we require market-led reforms that facilitate the growth of the private sector in the market. The private sector is the main driving force behind economic development, job creation, tax revenue, lower inflation, and an improved standard of living for the citizens. A stronger market paves the way for a stronger economy.

Unfortunately, doing business in Pakistan is not easy due to various factors. Some are institutional, such as corruption and regulatory burdens, while others are structural, such as a lower comparative advantage in the competitive market. To address these issues, we need institutional reforms to tackle the former and industrial policy to address the latter.

My fourth suggestion is about industrial policy. It doesn’t involve creating a further government footprint in the market while eliminating some. Its economic justification is simple: internalising externalities to capture learning and innovation and offsetting those externalities that cause market failure. Its objective is to promote industrial development to improve productive capacity and diversification in the economy and to facilitate some industries to gain a comparative advantage in the local and international markets. It will ultimately increase the market size and boost the export sector.

Regarding industrial policy, the most influential economist, Dani Rodrik, warns, “The kind of discipline that’s required is the discipline of monitoring, figuring out whether what you’re doing is working, and being able to move away from mistakes when things aren’t working. Successful industrial policy is not about picking winners; it’s about letting the losers go. Some of the worst cases of industrial policy are when you keep putting good money after bad.”

Therefore, before starting the industrial policy, Pakistan must ensure its policymakers and political economy are efficient enough to maintain that discipline Rodrik advises. Otherwise, a new industrial policy will create new evils.

Almost all industrialised countries, including East Asian economies, have achieved economic success due to the abovementioned factors. These are not easy to implement and require strong political commitment, which is why not all countries are successful economically.

However, the evidence confirms that these policies work and have contributed to the economic success of many countries.

THE WRITER IS A RESEARCH SCHOLAR AT THE PRIME INSTITUTE, A DOCTORAL RESEARCHER AT BRUNEL UNIVERSITY AND A LECTURER OF ECONOMICS AT THE UNIVERSITY OF BEDFORDSHIRE