Pakistan’s FY26 fiscal improvement may not be sustainable without stronger tax reforms

Pakistan’s FY27 budget reflects the government’s commitment to fiscal discipline, but questions remain over the quality and sustainability of the country’s fiscal consolidation because several factors that supported a stronger-than-expected performance in FY26 are unlikely to be repeated, Fitch Ratings said.

The ratings agency said Pakistan’s public finances improved markedly over the past two years, with the government estimating the overall general government deficit at 3.0% of GDP in FY26, which ended June 30, 2026. The deficit was 0.9 percentage points below the official target and lower than Fitch’s expectations, while the country posted a record primary surplus of 2.5% of GDP.

However, Fitch cautioned that much of the fiscal improvement resulted from temporary factors rather than lasting structural reforms.

Lower interest costs, SBP profits boosted FY26

According to Fitch, lower interest costs played a key role in improving the fiscal balance as policy rate cuts reduced the government's domestic borrowing costs through lower debt repricing.

The agency also said unusually high profit transfers from the State Bank of Pakistan boosted non-tax revenue, while lower-than-budgeted capital spending helped offset a tax revenue shortfall equivalent to 0.7% of GDP.

Fitch expects Pakistan’s fiscal performance to remain stronger than historical averages in FY27 but forecasts a weaker outcome than the government’s budget targets.

The agency projects an overall fiscal deficit of 4.0% of GDP and a primary surplus of 1.9% of GDP in FY27, compared with the government’s targets of a 3.6% overall deficit and a 2.0% primary surplus.

Weak tax base remains key challenge

Fitch identified Pakistan’s narrow tax base as one of the biggest obstacles to sustaining fiscal consolidation.

The agency noted that tax revenue in FY26 was officially estimated at just 10.2% of GDP, among the lowest levels for Fitch-rated sovereigns.

It said Pakistan’s federal tax collection has consistently fallen short of official targets, with authorities focusing on improving tax administration, strengthening compliance and broadening the tax base.

While those reforms are moving in the right direction, Fitch said meaningful revenue gains are likely to materialize only gradually.

The agency forecasts tax revenue will edge up to 10.3% of GDP in FY27, while total government revenue will decline to 13.5% of GDP as elevated SBP dividend income normalizes in a lower interest-rate environment.

Limited room for spending cuts

Fitch said the government’s ability to offset weaker revenues through spending cuts has become increasingly limited.

The FY27 budget raises development spending to 0.9% of GDP, which the agency described as a practical minimum following the under-execution of capital expenditure in FY26.

It added that social spending remains low and is protected under Pakistan’s International Monetary Fund program, leaving little room for further expenditure cuts.

Debt affordability remains a major weakness

Despite recent improvements, Fitch said Pakistan’s debt affordability remains one of the country’s biggest credit weaknesses.

The agency projects the general government interest-to-revenue ratio at 40.4% in FY27, down from a peak of 61.5% in FY24, reflecting lower borrowing costs.

Nevertheless, the ratio remains the second highest among sovereigns rated in the "B" category and is well above the 12.7% median for similarly rated countries, underscoring the burden created by Pakistan’s weak revenue base, shallow domestic capital markets and historically high financing costs.

Provinces pose implementation risks

Fitch also highlighted risks to budget implementation at the provincial level.

The agency expects provincial fiscal surpluses to fall short of budget assumptions because of coordination and implementation challenges between the federal and provincial governments.

It said the risk is particularly significant for measures such as the agricultural income tax, whose success depends on provincial authorities effectively enforcing the reforms.

Fitch concluded that while Pakistan’s fiscal position has improved significantly, sustaining those gains will require lasting increases in tax revenue and effective implementation of structural reforms rather than continued reliance on temporary revenue windfalls and spending restraint.