Super ‘Smart’ Tax

The Pakistan government faces yet another predicament as it continues to introduce measures that are intended to reduce the burgeoning deficits and stabilize the economy. Although, the goal is to secure the much-needed financing from the IMF, the route to the ‘golden treasure’ is laden with contentious unpopular decisions that can hurt the economy at a time when business confidence is particularly low. One such measure adopted by the government was to impose a super tax on several sectors, some that are crucial in generating much needed exports from Pakistan, while the other is to tax the rich by imposing a ‘poverty alleviation’ tax. The purpose of such tax is to meet financing needs by increasing the tax burden on those already in the tax net rather than seeking to expand the tax net by targeting the undocumented. Further, a super tax could deter larger firms from investing in productive activities if they believe that the government could impose super tax on the profits earned, particularly at times when the economic conditions are poor.

The super tax is imposed on 13 sectors, including sugar, banking, textile, cement, steel, automobiles, and LNG terminals, with the purpose to reduce the budget deficit. However, such policies can have implications on economic growth, particularly if large businesses curtail their activities due to increased uncertainty from government policies. The overall quantum index of large-scale manufacturing was reported at 197.95 on 31st March 2022, the highest level reported. It decreased to 152.85 on 30th April 2022. Although, the fluctuations in the index have a seasonal effect, the sharp increase in the index between July 2021 and March 2022 has been unprecedented. The subsequent collapse in April 2022 is also disconcerting, indicating the rising challenges faced by the industries. Specific industries such as the cement, automobile and fertilizer industries had performed relatively better as they recovered from the COVID-19 induced adverse shock. These industries were provided incentives to boost their production and had responded by increasing their production. According to the data from the Pakistan Economic Survey 2021- 2022, the large-scale manufacturing sector had grown at 10.4%, faster than the industrial sector that grew at 7.2%. The banking sector too had expanded considerably in FY22. It points to the vibrancy of the large-scale businesses, which will be adversely impacted with a poor set of policies.

According to the Pakistan Economic Survey 2020-2021, the government had provided several incentives to the business and industrial sectors to ensure their survival through the COVID-19 pandemic. The federal government provided refunds to exporters, cheaper electricity tariffs, removal of regulatory and additional custom duties on raw materials, reduction of federal excise duty on the cement sector as well as special package to the construction sector to revive growth in the allied industries. These measures did help to prop up the large-scale manufacturing industries in Pakistan, the desired effect in the short-term. The sharp decline in KSE-100 on the day the tax was announced is indicative of the fact that the investors did not receive the news of the super tax on large-scale industries well. This does suggest that future incentives offered to large-scale industry are likely to be less effective, particularly if they fear an increase in tax on their profits in subsequent years. Hence, it is imperative for the government to reduce unpredictability as business investment is likely to be crucial at a time when the government will face shortage of goods, inputs, fuel, and other commodities.

The tax to GDP ratio in Pakistan in FY22 was 10.8%. According to the World Bank’s data, the world average was 13.6% in 2020 and the average for lower middle-income countries was 12.2% in 2018. The low tax collection rate in Pakistan has often created significant challenges for the government as it widens the budget deficit. With an increasing budget deficit as well as the current account deficit, the government must rely on borrowing from domestic and external sources to finance its expenditures. Falling investor and business confidence, rising PKR depreciation and increasing inflation will all pose a challenge to the government as it struggles to generate revenue to meet its expenses.

Pakistan has one of the lowest rates of gross fixed capital formation (GFCF) as a percentage of GDP in the world, according to data extracted from the World Bank’s World Development Indicators. At 13%, it is much below the South Asian average of 27% and the average in lower middle-income countries of 26%. Even the sub-Saharan African countries average 23%. The percentage for Pakistan collapsed from 18% in 2008 to 13% in 2011 and since then has maintained the level. On the other hand, India and Bangladesh reported GFCF as a percentage of GDP at 28% and 31%, respectively. Further, the value added by the manufacturing sector contributes to 12% in Pakistan compared to 21% in Bangladesh in 2021.

It is imperative that the government focuses on ensuring improved competition and entry of more businesses into the manufacturing sector rather than tightening the noose around existing businesses through higher tax payments. Policies that increase the tax burden at the intensive margin are likely to encourage non-productive business practices that may not only hurt the development of the manufacturing sector but also eventually reduce tax collection. In essence, it is important to ensure that the government introduces policies that rather improve the business conditions, regain the confidence of investors as well as businesses and increase the level of investment in the country.