November 22, 2024

Overcrowded and Underprepared: Pakistan’s Crisis

By Shahid Sattar and Fatima Aamir

Population growth can be a double-edged sword: it can either provide a growing labor force that drives economic growth or become a ticking bomb waiting to implode. As the population rises, so does the demand for goods and services—especially for necessities like food, water, energy, and public services such as health and education, creating a need for increased business activity to meet increasing demand. Business activities, in turn, generate labor demand, which is fulfilled by an expanding workforce from within the same population that initiated the cycle. This creates a mutually beneficial cycle that circulates wealth in the economy: money flows from population to industry when goods are consumed and returns to population in the form of wages for the labor supplied.

As the economy grows, the role of government regulation and public policy becomes increasingly crucial for this process to work smoothly. Population growth must remain within levels sustainable by economic development. In the absence of comprehensive long-term planning, as is the case in Pakistan, population growth creates a strain on resources that a low-performing economy cannot support, ultimately leading to socio-economic deterioration. If Pakistan continues to grow at its current rate, its ability to sustain its people will diminish, plunging the nation further into poverty, inequality, and social chaos (Figure 1).

Figure 1. Pakistan’s population is projected to double by 2050 if the current growth trend prevails.

The latest population census of Pakistan reports an average annual growth rate of 2.55% from 2017 to 2023, three times the global rate of 0.88%. In contrast, other South Asian countries have reduced their growth rates to align with the middle-income average of 0.8%. Pakistan nearly achieved this milestone as well, lowering its growth rate from 3.1% in 2000 to 1.2% in 2016. However, since then, the trend has reversed, moving closer to the average of low-income countries (Figure 2). The population growth rate has consistently climbed in the years following 2016, raising the question: What happened post-2016 that unraveled decades of progress?

Figure 2. From 3.1% in 2000, Pakistan’s population growth was reigned in to 1.2% in 2016 but has been on the rise ever since.

Frequent political, economic, and social turmoil has shifted national focus away from human development to survival. In the hallways of policymaking, population is then a forgotten agenda. To date, there has been no national population policy that streamlines and guides efforts towards realization of Pakistan’s international commitments, including universal access to family planning services, addressing information needs, ensuring contraceptive commodity security, and mobilizing funds for family planning and reproductive health activities. Statements expressing concern are made every now and then by government officials, but these remain futile without policy prioritization of population planning.

To put the gross neglect in perspective, the government spent $38.6 million on contraceptive procurement[1] from 2014 to 2019 – an average of $7.72 million per year. In comparison, USAID invested about $18 million annually from 2010 to 2016 in contraceptive provision under the USAID | DELIVER Project. After the USAID project ended, subsequent governments failed to maintain stock availability uniformly, diverting two-thirds of the funds planned for contraceptive procurement elsewhere (Figure 3). This highlights the underlying problem in population planning: most progress made is contingent upon donor efforts, as the government appears to waive the cause in favor of other purposes. Funds in this country tend to flow towards projects with the highest political returns, and population planning simply does not make the cut.

The provinces of KPK and Balochistan that exhibit higher population growth[2] rates than the rest of the country spent the least in this regard, despite having greater reliance[3] on public sector provision of reproductive health services. Both supply and demand side problems are at play here: low prioritization of family planning by the government leaves the provinces with higher unmet need for contraceptives (21% in KPK and 22% in Balochistan, compared to 16% in Punjab and 18% in Sinch as of 2018), while cultural norms and remoteness of areas limit access to facilities. Desired fertility (the number of children an individual or couple wants) remains high; UNFPA[4] finds that most couples initiate family planning after the third or fourth child. Demand creation for reproductive health services remains a significant challenge as social norms and geographical isolation create hurdles for service delivery teams, particularly those engaged in door-to-door outreach. This calls for robust public awareness and accessibility programs that encourage and facilitate the use of family planning services.

Figure 3. Funds spent on contraceptive procurement are significantly lower than the allocated budget, especially in Balochistan and KPK.

Low prioritization of population planning is one issue, but another significant challenge is the inefficiency stemming from its poor integration into the broader economic development strategy. Population growth is tied to human development, particularly to gender equity and rights. Women who are educated, independent, and have the freedom to make decisions regarding reproduction have lower fertility rates and improved health. Investment in empowerment and autonomy of women through creation of education, employment, and participation opportunities is imperative for the success of population programs[5].

Public investment in human development avenues remains dismal in Pakistan, and socio-economic factors further limit women’s ability to benefit[6] from even these limited opportunities. Education and health expenditure are significantly below regional averages[7]. Female literacy stands at 49%, only 27% of women aged 15-49 years are using any family planning method, and only 25% of women participate in the labor force. Due to lack of employment opportunities, mobility restrictions, workplace insecurity, and a conventional view of gender roles, educated women display lower economic participation – only 25% of women with degrees are working[8].  

The impact of low public spending is exacerbated by the glaring gender disparity among beneficiaries, resulting in subpar performance on development fronts. A quick look at human development indicators shows that Pakistan is lagging in education, gender rights, and family planning compared to its regional neighbors. Countries like India and Bangladesh have much higher use of modern contraceptive methods, greater autonomy for women to exercise their reproductive and health rights, and better enrollment rates at all educational levels (Figure 4). It is no surprise, then, that Pakistan’s fertility rate is significantly higher than both India’s and Bangladesh’s (Figure 5).

Figure 4. Pakistan consistently lags India and Bangladesh in key drivers of population growth.

Figure 5. Despite an overall decline, Pakistan’s fertility rate remains ~1.5 times that of comparator countries.

Bangladesh is hailed as an exemplary model of population control, owing to its gender and social transformation. It augmented its family planning program with gender-focused initiatives[9] that improved literacy among girls, enhanced access to contraceptives, and dispelled traditionally held reservations regarding family planning. India, too, brought its fertility rate below the middle-income average through a framework focused on healthcare services and meeting needs, such as the unmet need for contraceptives.

It is important to note that Bangladesh and India did not achieve these results solely on the back of higher spending. In fact, their expenditure proportions are quite similar to Pakistan’s[10]. The key difference lies in the integration of human development efforts—particularly gender equity—with population planning, coupled with a visible commitment to both causes. These two are not the only lesson in successful population planning despite having limited resources; Thailand, Rwanda, and Costa Rica also share tales of success[11] with three things in common: investment in education and health, increased access to contraceptives, and women’s empowerment.

The question remains: What triggered the change post-2016, and why have policymakers and subject experts not addressed this alarming trend in Pakistan’s population growth trajectory? If a shift of this proportion is overlooked, all plans of economic development today will become unviable within a few years.

[1] Landscape Analysis Of Contraceptive Commodity Security In Pakistan, UNFPA (2020)

[2]  Population Census 2023, Pakistan Bureau of Statistics

[3] Pakistan Population Situation Analysis 2020 (UNFPA)

[4] Pakistan Population Situation Analysis 2020 (UNFPA)

[5] Issue 7: Women Empowerment (UNFPA)

[6] National Report On The Status Of Women In Pakistan, 2023 (NCSW & UN Women)

[7] Economic Survey of Pakistan 2023-24

[8] Policy Brief on Female Labor Force Participation in Pakistan (Asian Development Bank, 2016)

[9] Gender and Social Transformation in Bangladesh, World Bank (2008)

[10] Social spending in South Asia—an overview of government expenditure on health, education and social assistance (UNICEF, 2020)

[11] Population policies that work (Population Matters, 2023)



November 7, 2024

November 4, 2024

By Kamran Arshad

Industrialization is the backbone of economic growth, fueling GDP, enhancing export growth, and creating employment opportunities. Energy lies at the heart of this process. In many ways, energy is the economy, as it underpins productivity and innovation, fueling economic growth and prosperity. History bears witness to this, with the coal-powered Industrial Revolution and the oil-driven expansion of the 20th century both demonstrating the transformative impact of affordable and abundant energy on the economy, productivity, and industrial output.

In Pakistan’s textile industry, affordability and reliability of power supply are not merely growth factors but necessities for survival. The sector now faces a scenario that threatens to erode its competitiveness and lead to widespread deindustrialization. The economic consequences of disconnecting gas and RLNG supplies to industrial in-house power generation facilities would be devastating, as misguided energy policies and resource misallocation ultimately translate into substantial losses in industrial competitiveness, exports, and employment.

Since the emergence of the 1994 Power Policy, industries have been incentivized to invest in their own energy solutions, enabling them to meet production energy demands essential for growth. This shift has allowed businesses to tackle persistent issues of power outages, reliability, and quality while providing affordable on-site energy with zero line losses. No subsequent policy has discouraged or banned in-house power generation, underscoring its role in industrial growth. Export-Oriented Units (EOUs) increasingly rely on these facilities to ensure an uninterrupted energy supply and consistent production.

However, as Pakistan plans to phase out gas-fired captive power plants (CPPs) from the gas sector to meet structural benchmarks of the 25th IMF Program, it risks stifling an essential lifeline: exports. This decision will further destabilize Pakistan’s economic foundation rather than strengthen it, as the country faces foreign exchange shortfalls of up to $25 billion annually for the next five years. With soaring grid electricity costs, increasing outages, and declining reliability, industries are grappling with significant financial burdens and operational disruptions. This policy will not only hinder industrial output but also directly impact exports and employment levels, raising concerns about potential inflation as power prices are expected to rise further.

According to data from the Ministry of Commerce, 34 leading exporters, consuming 65.65 MMCFD of gas at nearly double the prescribed rates, generated $7.51 billion in exports. Additionally, 137 firms used 98.63 MMCFD to contribute $5.33 billion. Together, these companies produced exports worth $13.31 billion in FY 2022, highlighting their substantial contribution to the national economy and underscoring the critical role reliable energy plays in sustaining export growth.

Table 1. Export Proceeds of Industries with Gas-Fired Onsite Generation.

Export Range No. of Companies No. of Connections Average Consumption (MMCFD) Exports (US$ in billions)
US$ > 100 million 34 108 65.65 7.51
US$ > 10 million 137 208 98.63 5.34
US$ > 1 million 97 120 27.14 0.43
US$ ≤ 1 million 81 87 12.34 0.02
Grand Total 349 523 203.77 13.31

Source: Ministry of Commerce

Industrialization as an engine to Economic Growth:

Export-led economies like China and Vietnam prioritized industrialization to drive economic growth, increase employment, and expand their global market share. In contrast, Pakistan’s industrial sector’s contribution to GDP is on a declining trend, slipping from 19.1% in FY2022 to 18.4% in FY2023 and further to 18.2% in FY2024, indicating weakening industrial momentum and competitiveness. Instead of creating an export-friendly environment, the policies and economic landscape in Pakistan have pushed industries to the verge of collapse.

The policy to shut down gas supply to industrial in-house power generation facilities will exacerbate the situation, as the financially unviable and unreliable grid supply cannot support this transition. This move will immediately impact Pakistan’s largest export sector, risking damage to $3 billion worth of exports.

Pakistan’s textile industry is already confronting a myriad of challenges that jeopardize its competitiveness and sustainability. An overall unfavorable business environment and tax policy distortions accompanied by soaring energy prices has significantly damaged the industry’s export potential.

These challenges are exacerbated by soaring energy costs and the lack of a reliable, uninterrupted power supply essential for textile manufacturing. From FY 2019 to FY 2024, electricity tariffs for B2 and B3 categories have risen by over 100%. Cutting off the gas supply to self-generation facilities forces industries to transition to a financially unviable grid or face complete shutdown. Ultimately, the former will push industries toward the latter.

Energy Dynamics in the Textile Industry: The Importance of Gas/RLNG

Gas and RLNG are essential energy sources for the textile sector, serving as the primary fuel for many industries. Since the Power Policy of 1994, in-house power generation facilities have been critical in providing the affordable and reliable energy needed for high-quality textile and apparel production. These facilities ensure smooth operations by preventing outages, interruptions, and voltage fluctuations that could disrupt manufacturing processes and damage expensive machinery, while also stabilizing production costs and ensuring export-quality products – essential for meeting international market demands. Transitioning entirely to grid power and shutting down in-house facilities would increase downtime, maintenance costs, and risk international export orders.

A 2022 study estimated that a one-hour power outage results in a revenue loss of approximately 24% for the textile industry (Yasmeen et al., 2022). Between 2014 and 2018, high energy costs and frequent power outages led to the closure of around 100 textile manufacturing units (PIDE, 2021), causing exports to stagnate during that period. As of 2024, over 40% of spinning mills have announced operational shutdowns due to escalating energy costs. With an unreliable grid and limited access to gas, industries are compelled to rely on alternative fuels such as coal, diesel, or furnace oil, further undermining their competitiveness. Additionally, since power sector merit orders prioritize imported coal power plants over RLNG plants, shifting demand from gas-fired self-generation to the grid will increase the dispatch of these coal plants, leading to higher carbon emissions, inefficient gas usage, and a setback to climate goals and distributed generation.

A study by Socioeconomic Insights and Analytics finds that in the immediate aftermath of cutting off gas supply to industrial self-generation facilities, over 1,400 large units and countless smaller ones are likely to shut down, leading to approximately 3 million job losses and $3 billion export losses per annum. These figures could rise even further when including smaller units. This drastic measure will lead to widespread deindustrialization and socioeconomic instability.

The benefits of in-house power generation for industries, lifeline consumers and the national exchequer

Approximately 50% of industrial gas is utilized for electricity generation in in-house facilities, while the remainder supports various other manufacturing industries, including fertilizers, cosmetics, plastics, pharmaceuticals, and synthetic materials. About 20% to 22% of the gas consumed in the industrial sector is specifically used for electricity generation in facilities not connected to the national grid.

The exit of high-paying bulk consumers of RLNG, such as CPPs, is projected to create a significant revenue shortfall of PKR 390.8 billion for Sui companies, threatening the financial sustainability of gas utilities. This shortfall jeopardizes the cross-subsidy mechanism that currently allocates over PKR 140 billion to subsidize residential consumers. Furthermore, shifting bulk gas consumers to retail could significantly raise Unaccounted-for Gas (UFG) due to the negative impact on the bulk-to-retail ratio, affecting both the profitability and sustainability of Sui companies.

This situation could lead to ‘Take or Pay’ penalties on LNG cargoes because of the absence of a gas diversion plan, which is likely to cause demand destruction as these penalties are passed through to RLNG consumers per the Petroleum Division guidelines. The lack of strategic planning in the gas sector and sudden policy shifts could seriously compromise the stability of the entire energy sector. This further risks a cascading collapse of state-owned entities in the Petroleum Division, emphasizing the necessity for an integrated energy plan and strategic direction.

There are a total of 1,386 CPPs, of which 1,265 are connected to the grid. It is essential to note that not all CPPs are dual-fuel engines for electricity generation; therefore, distinguishing between the gas used in industrial processes and the gas used for electricity generation can be challenging. Consequently, in most cases, the non-availability of gas implies a complete shutdown of industrial operations.

 

The power generated by CPPs has been essential not only for the industry but also for lifeline consumers. As of February 1, 2024, the current notified consumer gas sale prices, revised in August for CPPs, indicate that industries served by SNGPL and SSGCL will pay approximately 39% above the average sale price, while CPPs will face costs around 193% of the average prescribed price. In addition, CPPs are receiving RLNG at a distribution tariff that includes costs from illegal fertilizer diversions and inaccurately calculated UFG in the ring-fenced RLNG price. This disparity in tariff highlights a cross-subsidy that primarily benefits the lower six slabs in the domestic sector, potentially leading to social and political repercussions. Consequently, eliminating gas supplies to CPPs will have ripple effects on lifeline consumers, resulting in increased gas prices that will ultimately translate into higher headline inflation.

 

In conclusion, cutting gas supplies to industrial self-generation facilities poses a grave threat to the textile sector, gas sector sustainability, and the broader economy. The discontinuation of gas to these facilities could lead to significant job losses, a decline in export revenues, and the bankruptcy of gas utilities. As industries grapple with soaring electricity prices, high taxes, and unreliable power sources, their competitiveness hangs in the balance. It is crucial for government authorities to reevaluate this policy and formulate long-term, sustainable strategies that protect Pakistan’s industrial and export sectors.



September 3, 2024

Have We Ditched Manufacturing?
By Shahid Sattar

Amidst a deepening economic crisis, the government seems intent on pushing the economy’s most vital sector—the textile industry—off a cliff.

Instead of confronting real issues, officials are choosing policies that strangle an industry capable of driving economic growth and stability and supporting millions of livelihoods through productive jobs. The slow asphyxiation of textile manufacturing, however, isn’t just a policy failure; it is more and more a deliberate dismantling of the very engine that could power Pakistan’s economic revival. If there is a strategy behind this, it is one that sacrifices long-term growth for short-term survival, with devastating consequences unfolding in real time.

Energy costs, whether for electricity or gas, remain prohibitively high. While the government has removed a substantial portion of the Rs. 240 billion cross-subsidy from industrial power tariffs, Rs. 75-100 billion remain. The economic downturn and escalating grid tariffs have also supressed power demand so much so that around 30% of the power tariff is now comprised of stranded costs, which represent capacity payments for unutilized capacity, as only around half the generation capacity is ever used.

Moreover, the power sector is rife with inefficiencies—high line losses, under collection of billing, outdated and inadequate infrastructure—that further inflate power costs, making industrial grid tariffs around twice the regional average and rendering manufacturing sectors internationally uncompetitive. We estimate that the stranded cost and other inefficiencies account for around 50% of the final consumer tariff and should these be managed correctly power tariffs can be easily brought within the regionally competitive range.  

When government officials are confronted with this issue, however, their scripted response highlights the recent reduction in the cross-subsidy, without ever discussing the inefficiencies nor their economic consequences. This completely misses the point. The question is simply whether Pakistani manufacturers face energy costs at par with their regional competitors—they do not. Until the spectrum of power sector inefficiencies is wholly addressed, industrial growth in Pakistan, particularly in the textile sector, remains a distant reality.

The situation with gas is equally dire. With an unreliable and unaffordable power grid, around 80% the industry that has survived has done so only through gas-fired captive generation. Captive power plants are an integral part of the industrial process as most are high efficiency combined heat and power plants that, in addition to power, provide hot water and steam for use in various applications across manufacturing value chains. Manufacturing export-quality products requires a stable and reliable supply of electricity which the grid, in its present form, cannot provide.

Over the past year, gas/RLNG prices for captive consumers have surged to well over $13/MMBtu. RLNG is being sold at significantly above cost, with explicit overcharging to offset revenue shortfalls from supplying highly subsidized RLNG to the fertilizer sector. Additionally, despite clear ECC directives specifying that RLNG volumes and prices should be ring-fenced for UFG benchmarking, with transmission losses capped at 0.5% and distribution losses based on actual figures, OGRA has failed to establish a UFG benchmark for RLNG. Instead, the excessive UFG standards for natural gas are being applied to RLNG consumers, imposing undue financial burdens.

Adding fuel to the fire, the government has also committed to the IMF that it will cut off captive gas supply by January 2025, without any consideration of the catastrophic economic consequences this will have. Pakistan is already locked into long-term LNG contracts, with the power sector and captive consumers being main off-takers. However, because of various factors including mismanagement and outdated planning methods, the system regularly faces surplus RLNG, which must then be diverted to highly subsidized domestic consumers at a significant cost to the exchequer.

If captive consumers are cut off from the network, this will severely exacerbate the surplus RLNG issue, forcing the surplus to be diverted to domestic consumers, adding to the circular debt which is already at ~Rs. 3 trillion, or to the power sector, forcing deviations from the economic merit order with additional costs passed on to consumers through higher fuel prices. A price-reopener for these contracts is scheduled for next year and this opportunity should be used to significantly reduce the price and volumes of contracted LNG, thereby creating space for a market driven gas system.

Moreover, as acknowledged by power sector officials, there is simply not enough power available in the South to meet the energy demand currently being fulfilled through captive generation. Similar issues plague the North, where several industrial applications for load enhancement have been pending for over three years. And finally, with gas/RLNG priced at over $13/MMBtu for captive consumers, they are the highest-paying customers of SSGC and SNGPL, effectively cross-subsidizing all other consumers. Cutting off gas to captive consumers will financially cripple both Sui companies, with high risk of cascading default across several state-owned entities, which will eventually reach the Government of Pakistan.

In the taxation domain, the Finance Act 2024 has shifted from a 1% fixed tax on export proceeds plus 0.25% export development surcharge to a 1% tax on export proceeds, 0.25% export development surcharge and 1.25% minimum turnover tax, adjustable against a 29% normal income tax and up to 10% super tax. Combined with various other taxes and surcharges, such as the Worker’s Welfare Fund and Worker’s Participation Fund, this results in effective tax rates of up to 135% depending on the original margin for the product.

The textile sector operates on low margins and high volumes. This inexplicable tax burden erodes all profitability, leaving businesses with insufficient capital for operations and investment. This financial strain cannot be passed on to international customers, who are already wary due to high operational costs. Low regional tax rates for competitor firms further disadvantage Pakistan’s exporters, inevitably leading to a loss of both business and FDI to more favourable economies.

Similarly, the withdrawal of zero-rating on local supplies for export manufacturing under the EFS has further harmed domestic manufacturers. Exporters are finding it increasingly cost-effective to import duty-free and sales tax-free raw materials and inputs instead of sourcing domestically. This has had a devastating impact on local producers of upstream products, with imports of cotton yarn, for instance, rising from ~2 million KG in July 2023 to over 15 million KG in July 2024. Procuring the same domestically, already uncompetitive due to high energy and operational costs, now entails paying 18% sales tax and waiting months for a refund—when and if it is processed—incurring an opportunity cost of at least 20% per annum. Over 40% of domestic yarn production has shut down as a result, with similar trends across other sub-sectors of the textile industry. This has severe implications for employment, government revenue, and external sector stability.

Simultaneously, the incomprehensible SRO 350 remains in force, despite explicit instructions from the Prime Minister to suspend it until it is made workable for all stakeholders involved. The new requirement of linking the entire supply chain to file sales tax returns has created chaos, where firms across the country are unable to file their returns within the deadline. Input tax claims of the buyer are restricted based on the seller’s timely filing of their returns, even when the buyer has paid the full amount, including sales tax, to the seller. Buyers are being penalized for circumstances beyond their control, and are forced to pay additional taxes and penalties, which are otherwise not their liability. The rule has a cascading effect: when a buyer is unable to file their return due to the above situation, their customers are also unable to claim input sales tax, leading to a widespread inability to file returns.

The list of issues is endless—one could write many books on it, and many have been written. But the critical question remains: why is nothing being done despite mountains of research, countless committees, and numerous reports? No one in the government or bureaucracy is willing to take responsibility. If every issue is to be blamed on the IMF, why not simply hand them formal control?

For the sake of increasingly expensive foreign loans and rollovers, the government is decimating a sector capable of generating $25 billion annually at current installed capacity, with the potential to expand to $50 billion per year within five years—if only it were supported by a conducive policy environment. Given the multitude of issues decimating Pakistani products’ international competitiveness, if the unintended consequences of an economic shutdown are not understood, then perhaps a swift and decisive end would be less cruel than the slow poison being administered to the industry.

Dragging this process out only prolongs the suffering of millions whose livelihoods depend on a once-thriving sector. The path we’re on leads only to economic collapse, and it’s time for those in power to choose: either commit to genuine reform that allows industry to thrive, or be honest about the fatal trajectory that has been set in motion. Yet, even now, there is hope. With the recent turmoil in Bangladesh, Western decoupling from China, and growing calls for sourcing diversification amidst heightened GVC risks, Pakistan is well-placed to capitalize on these opportunities if market distortions are addressed and manufacturing is made financially viable again; but the window of opportunity is already closing fast.


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August 13, 2024

Bring Back Zero-Rating

By Shahid Sattar and Absar Ali

Should the government ensure implementation of sales tax at the point-of-sale, ~Rs. 293 billion in tax revenue could be collected from ~Rs. 1,620 trillion domestically retailed apparel in 2024.

Yet, it insists on maintaining a dysfunctional sales tax regime that creates supply-side distortions, erects barriers to competitiveness and causes the exchequer to lose out on a significant chunk of tax revenue.

Pakistan operates under a value-added General Sales Tax (GST) regime, where at each stage of production manufacturers pay 18% sales tax on the difference between the value of inputs and output, with refunds allowed for exported goods. This system entails a high cost of compliance, around 10%, for businesses in addition to the opportunity cost of tying up funds that could earn a return of ~20% if simply parked in the bank. The costs are even higher for SMEs which often lack the financial resources and technical expertise to manage these complex requirements.

It also imposes a high administrative burden on the FBR. Even if the cost of administration is roughly 10% of the collected amount, the fact that over 70% of sales tax collected from the textile and apparel sector has been refunded in recent years (Table 1) means that the net collection is minimal. This raises a critical question: why subject businesses to these prohibitive costs and excessive red tape and the FBR to such administrative expenses when the bulk of the amount collected is simply returned?

Table 1. Textile and Apparel Sector Sales Tax Collection (million PKR)

The point is further underscored by the fact that while the Sales Tax Rules 2006 mandate all FASTER refunds to be processed within 72 hours, the FBR only processes partial refunds once a month with a significant portion of claims being deferred for manual processing that can take several months and even years. And even then, according to a report by the World Bank, sales tax refunds are never made in full causing industry liquidity to become perpetually stuck with the government.

This creates a severe liquidity crunch in a sector already struggling with prohibitive borrowing costs and an overall shortage of financing, shifting billions of rupees from the industry to the FBR every month. At present, approximately Rs. 250 billion of the textile and apparel sector’s liquidity is stuck in deferred sales tax refunds and Rs. 35 billion in provincial tax refunds. Another Rs. 200 billion is stuck in FASTER refunds at any given time, taking the textile and apparel sector’s total liquidity stuck in the refund regime to around half a trillion Rupees. This trapped capital could meet working capital and reinvestment needs that would ultimately result in higher exports. Instead, firms have been forced to scale back operations, delay expansion, and pause research initiatives, resulting in sizable unrealized export earnings—a lifeline for an economy struggling with unsustainable foreign debt and debt servicing.

The sales tax regime also has a detrimental impact on the medium- to long-term growth and development of the industry. SMEs, prevalent across the textile and apparel value chain, are faced with an inherent disadvantage compared to their foreign counterparts as well as larger and vertically integrated domestic firms.

When sourcing domestically produced raw material and intermediate inputs, for instance, exporters must first pay sales tax and then wait several months for it to be refunded, if at all. Conversely, the same exporters can import duty-free and sales tax-free inputs under the Export Facilitation Scheme, making domestic procurement of the same much more expensive due to the costs associated with payment and (delayed) refunds of sales tax, as well as higher energy and other operational costs.

Effectively, the GST regime provides protection to foreign producers of raw material and intermediate inputs over domestic ones. The result is that domestic inputs in export manufacturing are substituted with imported ones, as evidenced by the dramatic surge in yarn imports from 2 million KG in July 2023 to 14 million KG in May 2024. Consequently, there is a significant reduction in the domestic value addition in exports and deterioration of the trade and current account balances.

Another significant issue is the disparity between a large number of unintegrated SMEs and a small number of large, vertically integrated firms. Pakistan holds a ~2% share in global textile and apparel trade, with exports totalling around $16.7 billion in FY24—nearly two-thirds of which come from only the top 100 firms. Facilitating the entry of new players and the growth of existing SMEs is crucial for expanding Pakistan’s market share, but the sales tax regime is a major hinderance to this.

A T-shirt manufactured by a large, vertically integrated unit, for instance, is much more cost-competitive because all stages of production—spinning, weaving, dyeing and processing, and garmenting—occur within the same facility, avoiding the payment of sales tax at each stage. Conversely, if the same T-shirt were to be manufactured by four SMEs performing the same tasks, they would have to pay sales tax at each stage, making the final product more expensive than that of the vertically integrated firm. This results in SMEs being outpriced in the market, creating barriers to market entry and firm growth, and giving larger existing players an inherent advantage over newer and smaller ones.

The excessive rate of the sales tax at 18% also incentives unscrupulous elements to engage in smuggling and double bookkeeping. While this is not prevalent in the export sector due to strict compliance and reporting requirements, the same is not true for domestically oriented sectors. In the domestic arena, unscrupulous elements might resort to under-invoicing, misdeclaration of goods, and other fraudulent activities to avoid the hefty tax. This not only undermines the tax revenue collection but also puts compliant businesses at a competitive disadvantage.

The significant tax differential creates an unlevel playing field, encouraging illicit trade and making it difficult for legitimate businesses to compete. Additionally, the administrative burden and costs associated with ensuring compliance can be prohibitive for smaller enterprises, further driving them towards such practices. The overall effect is a distortion of market dynamics, where unethical practices become more profitable than legal operations, ultimately leading to a loss of government revenue, market inefficiencies and reduced economic growth.

The cotton sector is a prime example of this. Ginners, responsible for separating cotton fibers from seeds (banola), are required to pay sales tax on sales of banola to farmers. This additional tax burden creates a financial disincentive for accurately reporting cotton production volumes. As a result, many ginners resort to underreporting their output to minimize tax liabilities (gol maal). This underreporting not only skews official production statistics but also reduces the overall tax revenue. Moreover, the distortion in data hampers effective policymaking and planning for the cotton industry. The informal market thrives as ginners and other stakeholders in the cotton value chain seek to avoid the sales tax, leading to decreased transparency and increased illicit trade.

The broader economic consequences of the current sales tax regime are far-reaching and severe. Compliant small and medium-sized enterprises (SMEs), which are the backbone of the textile industry, are being driven out of business, resulting in millions of job losses. This decline reduces government revenue and diminishes value addition in exports, exacerbating Pakistan’s external sector vulnerabilities. The reduced domestic production also increases reliance on imports, further straining foreign exchange reserves and worsening debt sustainability issues. Consequently, overall economic stability and growth prospects of the country are severely jeopardized.

To mitigate the detrimental effects of the current GST regime and support industrial sectors, especially SMEs, it is imperative to restore zero-rating on sales tax and reinstate SRO 1125. This will alleviate the liquidity crunch by eliminating the need for cumbersome and delayed refund processes, allowing businesses to maintain healthy cash flow and meet their financial obligations. Restoring zero-rating will also level the playing field for domestic manufacturers vis-à-vis their foreign counterparts, encouraging local production and reducing the incentive for smuggling and tax evasion.

Additionally, shifting to a sales tax on final goods at the point of sale will significantly reduce the FBR’s administrative costs. By moving to a simpler POS-based sales tax, the FBR can streamline its workforce, reduce redundancies and operational costs, and improve efficiency. This transition would not only ease the compliance burden on businesses but also enhance government revenue collection through a more straightforward and effective system. In 2023, for example, domestic apparel retail was valued at $6 billion or Rs. 1,668 trillion, according to STATISTA, while net sales tax revenue from the textile and apparel sector was only around Rs. 71 billion (Table 1, above). Had a final sales tax been collected at the point of sale rather than the current value added tax at each stage of production, it would have yielded Rs. 300 billion in tax revenues.

The urgency for reforming the sales tax regime cannot be overstated. Restoring zero-rating and implementing a point-of-sale sales tax system will not only alleviate the liquidity crisis strangling the textile industry, but is essential to boost domestic production, enhance export competitiveness and push the economy towards resilience and sustainability. The choice is clear: embrace reform and pave the way for growth or persist with a flawed system that stifles industrial sectors and undermines the country’s economic future.  


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July 30, 2024

Beyond the Billionaires Bash: Pakistan’s Real Crisis
By Asif Inam

In a recent op-ed published in Dawn, Mr. Khurram Hussain has made several claims to misrepresent fundamental issues at the heart of Pakistan’s energy sector and overall economic crisis.

 
   

One of these is that “the core problem here is not capacity charges. The core problem is devaluation, because the dollar value of your electricity bills has not risen by much more than 30 percent in the past decade. Check and find out.” Well, we checked:

Notes: Effective power tariffs including base variable and fixed charges, financing cost surcharge, fuel price adjustment, quarterly tariff adjustment, and electricity duty, excluding additional taxes billed; Source: NEPRA

Over just the last five years, never mind the entire decade, power tariffs for B-3 industrial consumers—in dollar terms—have increased by 60-70%, and this is the non-RCET power tariff. For other consumers they have similarly increased by much more than 30%, in dollar terms:

Select Consumer Power Tariffs, cents/kWh
  Jul-19 Jul-24 Change
Residential (Unprotected) 0-100 Units 4.85 8.89 83%
Residential (Unprotected) 201-300 Units 7.63 15.27 100%
Residential ToU 11.25 18.49 64%
Commercial ToU 11.98 17.77 48%
Notes: Effective power tariffs including base variable and fixed charges, financing cost surcharge, fuel price adjustment, quarterly tariff adjustment, and electricity duty, excluding additional taxes billed; Source: NEPRA

These very high power tariffs are a direct result of increasing capacity charges and unutilized capacity, and a shrinking pool of consumption over which these are spread. However, it’s not even the absolute number or the increase that is plaguing the industry. It is that Pakistan’s industrial power tariff is over twice that of competing economies like Bangladesh, India, and Vietnam, and this disparity in energy costs is a critical factor undermining the economy’s industrial competitiveness.

It is widely understood that Pakistan’s most fundamental economic problem is a shortage of productive capacity, that is neither sufficient to meet domestic demand nor to generate exportable surpluses to meet import requirements. This shortfall creates a chronic shortage of foreign exchange and repeatedly lands the economy into balance of payments crises. The only sustainable solution is rapid industrialization, and a most basic input that any industrial setup requires is energy. But when that energy is twice as expensive as what competitors in other countries are getting, its cost—comprising 10-35% of input costs across the textile and apparel value chain—gets passed into the product and makes its significantly more expensive than those of your competitors, rendering it uncompetitive in the international market.

Expensive energy is one of the main reasons Pakistan’s industry struggles on the international stage and a major factor deterring efficiency-seeking foreign direct investment into the country. Imagine an investor looking to establish a garment factory in South Asia. A comparison of the business environment in India, Bangladesh, and Pakistan would reveal that while labour costs may be comparable, everything else, including energy, taxes, and borrowing costs, is two to three times as much in Pakistan. Naturally, Pakistan would be the first to be dropped from consideration.

The economy faces an annual foreign exchange shortfall of over $25 billion for the next five years. Without further debt—an entirely untenable option—the only way to bridge this gap is through a drastic increase in the industrial base and exports. However, this increase is impossible if something as basic as energy costs over twice as much in Pakistan as in the rest of the world.

Pakistan’s textile sector is a crucial component of the country’s economic fabric, contributing 8-9% of GDP, employing 40% of the industrial labour force, and bringing in over half of the country’s export earnings. In fact, the textile sector is one of the very few industries in Pakistan that does not receive protection, and that is why it has innovated and increased the share of value-added goods in textile exports from around 50% in 2013 to 80% in 2023. It has produced companies like Interloop, one of the largest of its kind in the world, and Gul Ahmed, IKEA’s single largest supplier, that is now also venturing into foreign markets with its branded goods. But the problem is that we have not been able to build enough companies like these because of the continuously prohibitive business environment faced by the private sector.

Where removing the cross-subsidy was sufficient to achieve a competitive energy tariff a year ago, failure to do so exacerbated the predicament. Inflated power tariffs, including the cross-subsidy, drove manufacturers out of business, causing a sizable reduction in demand for grid electricity and increasing the burden of growing capacity costs on the remaining consumers, further reinforcing the cycle. Today, despite a reduction in the cross-subsidy, power tariffs remain over twice the regional levels due to unutilized capacity costs, driving more firms out of business and affecting the livelihood of countless workers and their families.

The capacity payments issue is not about reverting to a subsidized energy regime. It is about addressing the fundamental imbalance in the power sector’s cost structure. In Pakistan, capacity constitutes around 70% of the total cost, with fuel making up the remaining 30%. Globally, this ratio is reversed, with 30% capacity cost and 70% fuel cost. This structural anomaly means that a significant portion of the power sector’s revenue goes to fixed payments to power producers, regardless of the actual electricity produced or consumed. This results in exorbitant costs for all consumers, including industrial, commercial and residential.

The campaign for fair energy tariffs is about the entire country, not just the textile sector. Both Fitch and Moody’s have predicted dangerous levels of sociopolitical instability due to rising inflation, taxes, and most importantly the unbearable cost of energy.

The textile industry is not merely seeking relief for itself but advocating for a restructuring of the power regime to benefit the entire nation, including the common man so he no longer must pay 22 cents for a kWh whose cost should be in single digits. We are calling for IPP contracts to be renegotiated in the same line as those calling for the country’s domestic and foreign debt to be restructured. Not out of self-interest, but to ensure that the power sector and the economy can be made sustainable. The opacity and inefficiency currently plaguing the power sector are detrimental to all Pakistanis, not just the textile sector.

There is a consistent theme across all such baseless criticism. And that is there’s always a lot of “billionaire bashing”, but never any realistic solutions to the problems faced by this country. It’s easy to sit back and criticize without understanding the complexities of the issues or offering viable solutions. Constructive dialogue requires an acknowledgment of the facts and a willingness to engage with the realities of the situation.

A comprehensive review and restructuring of capacity payments and the broader energy tariff regime is not just necessary but existential. The goal should be to align our energy costs with those of economies at a similar stage of development. This is critical to attracting investment, boosting industrial output, and increasing exports to address this dangerously unsustainable economic situation. Sustainable growth requires a stable, predictable, and competitive energy supply. This, in turn, fosters an environment conducive to investment, innovation, and growth.

Our stance is grounded in a vision for a prosperous, competitive, and economically stable Pakistan. We call for an open, fact-based dialogue involving all stakeholders to address these critical issues. The textile industry stands ready to work collaboratively towards a more efficient and equitable energy sector that serves the best interests of the entire nation.


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July 23, 2024

Export Ambitions vs Economic Realities

By Shahid Sattar and Absar Ali

While the Government is seeking a 100% increase in exports over the next three years, maintaining even the current level would be miraculous given current economic policies that fail to promote industrialization or exports.

Last week a high-level committee began consultations on rationalizing import tariffs with a view to increase exports to $60bn. Simultaneously, the FBR undermined industrial competitiveness and exports by withdrawing the sales tax exemption on locally manufactured inputs for export manufacturing, disproportionately impacting SMEs, especially in upstream segments.

This sales tax does not impact a small number of large vertically integrated firms, providing them with an edge over many unintegrated firms staggered across the value chain. It also makes duty-free and sales tax-free imports of the same inputs through the Export Facilitation Scheme more attractive than local procurement as unintegrated firms in downstream segments must now pay sales tax on the latter and wait several months for it to be refunded, if at all. That the EFS does not extend across multiple stages of the value chain, combined with existing and fresh import duties including 2% additional customs duty on all 0% base tariff goods, reinforces this as enterprises in upstream segments, like yarn and cloth manufacturers, cannot import duty-free inputs since their products go through multiple stages of production before reaching the final exporter.

This follows SRO 350(I)/2024 that requires linking up the entire supply chain to file sales tax returns, conditioning them on compliance by upstream suppliers. Firms are blocked from filing their returns on time due to upstream suppliers’ non-compliance, resulting in sales tax already paid by them to be disregarded and incurring substantial penalties. Government-owned entities in the energy sector top this list, frequently delaying filing and preventing their consumers from doing the same. The rule has cascading effects; when a buyer cannot file their return, their customers also cannot claim input sales tax, leading to further delays. Despite persistent requests and the Prime Minister’s assurances, the FBR is yet to address these issues.

Then comes the energy sector; one of the most significant factors contributing to the low competitiveness of Pakistan’s textile industry, and overall manufacturing, is the prohibitive cost of energy. While the government took an appreciable step to reduce cross subsidies embedded in industrial power tariffs by around Rs. 150bn, they have not been eliminated entirely. Simultaneously, unutilized capacity costs in the power tariff have ballooned so much that for the upcoming year industrial power tariffs will range between 15-17 cents/kWh compared to 6-9 cents/kWh in competing economies.

The same disparity exists in gas/RLNG prices, with gas supplied to industry in Bangladesh, for example, costing as low as $7.4/MMBtu, while rates for Pakistani industry are as much as $14/MMBtu. While on one hand the government is reducing cross subsidies in power tariffs, on the other, RLNG consumers are being subject to a Rs. 50bn cross subsidy to the fertilizer sector, increasing the cost of gas supplied to industries. There are also ill-advised and impractical plans to cut off gas supply to captive power plants by January 2025, despite the fact that the grid is in no position to supply the quantity or quality of power required by manufacturing units. This move will force them onto a financially unviable grid, leading to more closures and severe negative impacts on employment and the economy.

The textile sector—responsible for over half of the economy’s exports and employing up to 40% of the industrial workforce—has been struggling to compete internationally for the past two years as the sector’s exports have declined from $19.3bn in FY22 to $16.7bn in FY24. The government should be actively cutting down red tape and slashing expenditures to reduce the fiscal burden on the private sector and bringing manufacturing costs at par with international levels. Instead, it is continuously ignoring on-the-ground realities and going against economic fundamentals.

Comparisons with major competitors such as India, Bangladesh, and Vietnam highlight significant disparities in key input costs like energy and an overall high cost of doing business that erode Pakistan’s competitiveness in the international market. The minimum wage—an indicator of labour costs—is around $0.64/hour in Pakistan compared to $0.55 in Bangladesh, $0.68 in India, and $1.59 in Vietnam. While Pakistan enjoys relatively competitive labour costs, this does not offset the high energy costs and other inefficiencies. Moreover, the lack of investment in skill development and technological advancements means that Pakistani labour is less productive compared to its counterparts in these countries.

Similarly, while Pakistan has an advantage with domestic cotton production over countries like Bangladesh, its yield and productivity are low and there are serious quality issues that make it unfit for export without mixing with higher quality imported cotton. These productivity and quality gaps further exacerbate the uncompetitiveness of Pakistan’s textile industry.

To add to these challenges, the budget has increased the tax on export proceeds from a 1% fixed tax regime to 2% advance tax on export proceeds, adjustable against a 29% tax on profits plus a 10% super tax. Not only is this significantly higher than regional benchmarks, the advance tax increases cost of compliance and dries up liquidity in low-margin high-volume businesses like textiles, leaving no space for working capital or reinvestment.

                               

In contrast, regional economies offer a highly favourable environment for exporters. In Bangladesh, export-oriented industries are eligible for exemptions from income tax for up to 50% of their earnings and preferential income tax rates of 10-12%. India provides substantial incentives as well, including rebates of state and central taxes and levies for exporters, rebate of up to 3% of the turnover of new export-oriented units and R&D finance for up to 80% of project costs. Vietnam’s policy environment is similarly favourable, with lower corporate tax rates and extensive support for export enterprises.

The financial support available to exporters in Pakistan is inadequate and prohibitively expensive compared to its competitors as caps on financing schemes like EFS and LTFF have not been increased despite repeated demands from the industry. Bangladesh offers 15% cash credit for pre-shipment expenses and post-shipment finance at 50-80% of the Letter of Credit (L/C) value. India provides pre- and post-shipment working capital financing through foreign exchange accounts and term loans for capital expenditures.

Vietnam and India also facilitate long-term financing for the acquisition of plant machinery and ancillary equipment. In contrast, Pakistani manufacturers face high benchmark interest rates at 20.5%, significantly higher than the 8.5% in Bangladesh, 6.8% in India, and 5.3% in Vietnam. While TERF was successful in supporting the upgradation and expansion of production capacity across the industry, much of this investment was never operationalized due to unviable energy and other operational costs.

India and Bangladesh also have more favourable policies regarding the import of raw material and intermediate inputs, offering lower import duties and other support to their textile and apparel sectors. Vietnam has signed multiple free trade agreements (FTAs) that allow for duty-free import of raw materials, significantly reducing production costs. In contrast, Pakistan imposes a 5% and 7% import duty in addition to up to 12% anti-dumping duty on imports of purified terephthalic acid and polyester staple fibre, basic raw material for man-made fibre-based products, to protect select inefficient manufacturing facilities that keep domestic PSF prices around 20% above the international market.

The result of these disparities is that Pakistan has seen its exports, as well as the domestic value addition in exports, plummet. According to the PBS, yarn production is down by ~30% compared to FY22 and cloth production by ~20%. Importing intermediate goods has become cheaper than procuring the same domestically due to increasing costs and tax and compliance burden, as evidenced by a dramatic surge in imports of cotton yarn, up seven times from 2 million KG in July 2023 to 14 million KG in May 2024, because the basic textile industry cannot compete—even in the local market—and is thus being wiped out.

These trends have serious economic implications. The economy has an annual foreign exchange shortfall of over $25bn. Any reduction in exports or domestic value addition in exports exacerbates this shortfall. The country desperately needs higher exports with significant domestic value addition to meet its foreign exchange requirements. Furthermore, Pakistan has a large, young, and unskilled population that needs employment opportunities to escape poverty. Manufacturing export-led growth represents the only viable solution for addressing these issues and avoiding a major social and political catastrophe.

Yet, the FY25 budget fails to prioritize the growth of this important sector and has significantly increased the challenges facing it, further diminishing its ability to compete internationally. To expect the manufacturing base and exports to increase and the economy to grow under these circumstances is purely unrealistic; even maintaining the current level of exports would be miraculous.

To turn the tide around, a major reorientation in policies, reduction in energy costs, and a holistic export-focused strategy are essential.


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July 10, 2024

By Shahid Sattar and Absar Ali

Ten days into the new fiscal year, the FY25 budget is already in disarray.

Amid calls for a nationwide strike, the turnover tax on petroleum dealers was reversed. This was followed by a strike from the All Pakistan Flour Mills Association against newly imposed taxes, while the newly formed Salaried Class Alliance is on the streets Monday through Friday.

After two years of severe economic hardship, the public expected relief and a fairer redistribution of the tax burden. What it received is the exact opposite.

The “tax to GDP ratio” has become a strange obsession, demonstrating a lack of direction, and the government’s unwillingness to reduce its own wasteful expenditures and address structural flaws that have plagued the economy for decades. This is reinforced by the fact that while the tax to GDP ratio is frequently referred to, we never hear about the government expenditure to GDP ratio.

It needs reminding that the tax to GDP ratio is little more than a symptom, not a cause, of deep underlying problems that remain unaddressed to safeguard the ruling elite’s interests. In the same breath where a crushing burden of taxes was announced for the public, and private sector enterprises, there was no reduction in government expenses. Instead, only an increase in allowances and exemptions for the state’s own employees.

Perhaps the state of the country is best explained by the fact that a 30-year-old Assistant Commissioner must use a Rs. 20 million vehicle, accompanied by three guards and two clerks—one to carry his water bottle, another to hold an umbrella over his head—to investigate whether vegetable vendors on the poverty line are overcharging Rs. 20 on a kilo of tomatoes.

Economic growth and public trust are crucial for improving the tax to GDP ratio, and the FY25 Budget misses the mark on both. The World Bank estimates that around 40% of Pakistan’s population lives below the poverty line, with 96% at subsistence level. This indicates a limited capacity for the majority to contribute to the government’s wasteful expenditures and need for boosting incomes to increase revenue collection.

Around 20% of Pakistan’s GDP comes from agriculture, 20% from industry, and 60% from services, of which 20% is wholesale and retail trade. Yet, agricultural income and retailers remain excused from contributing their fair share. This means the government wants to extract taxes worth 15% of GDP from only 60% of GDP, effectively subjecting 40% of GDP to no taxes while the remaining 60% are subject to 25%. While reality is more complex, this simple illustration demonstrates the incentives created for capital and human resources to exit more productive tax-ridden sectors for less productive under-taxed sectors. The result is that the share of GDP that is relatively tax-free will increase, while that being taxed will decrease, leading to an overall reduction in the tax to GDP ratio.

Effective tax policy must be guided by long-term development priorities and a vision for growth. It has been repeatedly emphasized that the lack of productive capacity is the country’s most pressing issue. Because domestic production is neither sufficient to meet domestic demand nor enough to generate exportable surpluses to meet import requirements, there is a persistent shortage of foreign exchange and surplus demand that leads to repeated episodes of devaluation and inflation.

     

Of the $30.65 billion exported in FY24, about one-third is by only 100 top firms, most of which are in the textile and apparel sector. Moreover, the 10.5% increase in exports compared to the abysmal performance last year is largely due to an increase in exports of unprocessed foods driven by external circumstances. Compared with FY22 exports declined by 6%, with textile exports down 15% from $19.3 billion in FY22 to $16.7 billion in FY24. There is also a reduction in the share of domestic value added as basic industry producing yarn, cloth and other inputs has been wiped out due to prohibitive energy, borrowing and other operational costs, with yarn imports having surged seven times from 2 million KG in July 2023 to 14 million KG in May 2024.

             

Given these realities and that the country’s gross external financing requirements stand at over $25 billion annually for the next five years, the ratio we should worry about is the export to GDP ratio.

At around 10%, Pakistan has the lowest exports-to-GDP in the region, with Bangladesh at 13%, Sri Lanka at 20%, India at 22%, and Viet Nam at a whopping 94%. In view of these horrid numbers, the government should have prioritized and incentivized productive export-oriented activities with a focus on increasing domestic value addition in exports. Instead, the 1% fixed tax on export proceeds has been changed to a 2% advance tax on turnover adjustable against a 29% tax on profits, not only raising the rate but also adding to the cost of compliance.

To make matters worse, the sales tax exemption on local supplies for export manufacturing has been withdrawn because—according to the Chairman FBR—audits revealed that five companies, out of around 1800 beneficiaries, had misused it. Because the FBR’s incompetence does not permit increased checks and balances, it decided to resort to collective punishment and do away with the entire program instead.

The sales tax exemption on local supplies for export manufacturing was valuable trade facilitation that ensured a level playing field for domestic manufacturers of raw material and intermediate inputs, primarily benefiting SMEs. Its withdrawal removes all incentives for exporters to use domestically manufactured inputs and will cause a further reduction in domestic value addition in exports. These policies are akin to providing protection to imported inputs by making domestically manufactured inputs significantly more expensive.

And it doesn’t stop there; 0% base tariff goods, including critical inputs for textile and apparel manufacturing that are either not produced domestically or in insufficient quantities to meet industry demand, have been slapped with an additional customs duty of 2%. Like the withdrawal of the sales tax exemption, this too will have a disproportionate impact on basic industries, especially SMEs.

Very few firms possess full vertical integration, and the benefits of duty-free import for export EFS do not extend across the entire value chain. For instance, a spinner cannot import under EFS because the yarn they manufacture goes through several stages of value addition—such as weaving, processing, and dyeing—before reaching the final exporter. Despite persistent efforts for a multi-stage EFS with a robust traceability system, it has been actively sabotaged by the FBR.

One of the textile and apparel sector’s main challenges is that around two-thirds of its exports are cotton-based compared to only one-third of international textile and apparel trade. Diversification of exports towards man-made fibre-based products is essential for the industry’s growth and the imposition of the ACD on synthetic/artificial fibres not produced domestically, and the failure to rationalize duties on purified terephthalic acid and polyester staple fibre will prove severely detrimental towards this goal.

When, consequently, investment is diverted from productive export-oriented activities towards less productive and less taxed agriculture and real estate, the same voices will complain that savings aren’t being utilized towards productive activities and that tax collection is not increasing, while conveniently ignoring the fact that it is their tax policies that incentivized such behaviour in the first place.

There is an endless list of regressive measures that the Finance Act 2024 has imposed in hopes of increasing the tax to GDP ratio. However, the two most essential ingredients for this recipe are fostering economic growth and building public trust; the budget fails to achieve either. Instead, it only perpetuates a cycle of fiscal mismanagement and public disillusionment.

Without addressing the underlying structural issues, incentivizing productive activities, and ensuring equitable tax policies, the government is merely setting the stage for further economic decline. The current budget is not a roadmap to recovery but a prescription for continued doom and gloom.

 

 


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June 7, 2024

By Shahid Sattar | Absar Ali

The turnover tax regime in Pakistan poses significant challenges for small and medium enterprises (SMEs), placing them at a disadvantage compared to vertically integrated firms.

Despite contributing around 40% of GDP, 25% of export earnings, and employing 78% of the non-agriculture labour force, according to the SBP, small and medium enterprises (SMEs) face numerous challenges that hinder their growth and development.

These include limited access to finance, as SMEs often struggle to secure financing due to stringent collateral requirements and high interest rates which limit their ability to invest in growth and innovation. Poor infrastructure, such as unreliable electricity supply and poor transportation networks, increase operational costs and reduce efficiency, especially in rural areas.

Many SMEs also suffer from inadequate management skills, leading to poor decision-making and inefficient operations. Complex and cumbersome regulatory requirements, often difficult to navigate for SMEs, further inhibit their growth. (Khan, Hussain & Afraz, 2013; Khan, 2022; Zeshan, 2023)

SMEs being large firms of the future, this is also one of the reasons Pakistan has very few large firms, and even these are relatively small by global standards. For instance, according to the Pakistan Export Directory, the largest exporter in 2021 exported goods worth Rs. 52 billion, the 10th largest Rs. 29 billion, and the 100th largest only Rs. 5 billion.

“Among these barriers, the turnover tax stands out as a significant impediment that disadvantages SMEs as compared to vertically integrated firms. The turnover tax in Pakistan mandates that all businesses, regardless of profitability, pay a minimum tax of 1.25% on their turnover.”

While this policy aims to create a uniform tax environment, it inadvertently imposes a heavier burden on SMEs due to the cumulative nature of the tax across multiple production stages.

When a single, vertically integrated firm manages the entire production process, the turnover tax is applied once on the final product. However, SMEs, which typically rely on multiple independent businesses for various production stages, face a different reality.

Each stage—from raw material processing to manufacturing, distribution, and retail—involves separate entities, each subject to the turnover tax on its revenue. This results in the tax being applied multiple times across the production chain, significantly increasing the overall tax burden on SMEs.

For example, in the textile industry, an SME might source yarn from one company, fabric from another, and finally sell the finished product. Each transaction between these businesses incurs the turnover tax, creating a compounding effect that does not affect a vertically integrated firm in the same way. This cumulative tax burden increases costs for SMEs, making their products more expensive and less competitive compared to those produced by integrated firms.

This compounded tax significantly hampers the competitiveness of SMEs. Vertically integrated firms, by consolidating all production stages, incur the turnover tax only once, resulting in a lower overall tax liability. SMEs, unable to vertically integrate due to financial and operational constraints, end up paying much higher cumulative taxes. This creates a market environment where SMEs struggle to compete on price and profitability, stifling their growth and innovation.

The financial strain imposed by the turnover tax also limits the ability of SMEs to reinvest in their businesses. With higher taxes eating into their margins, SMEs find it challenging to fund expansions, adopt new technologies, or enhance their workforce, further hindering their competitive edge.

To support the growth of SMEs and create a more equitable tax environment, several policy reforms can be considered. Implementing lower turnover tax rates specifically for SMEs can alleviate the compounded tax burden they face, helping them to price their products more competitively. Providing tax rebates or credits for SMEs that engage in multiple stages of production could further offset the cumulative effect of the turnover tax and encourage SMEs to expand their operations without facing prohibitive tax penalties.

Facilitating access to finance and resources for SMEs to achieve greater vertical integration can reduce the number of taxable events in the production process, while also fostering firm growth. Government programmes that support mergers and collaborations among SMEs are essential to achieve this goal. Introducing a graduated tax structure that imposes lower rates on the initial stages of production or for lower turnovers can also help reduce the overall tax burden on SMEs, making the tax system more progressive and fairer.

In conclusion, reforming the turnover tax policy is crucial to ensure that SMEs have a fair chance to compete with vertically integrated firms. Addressing the inherent disadvantages posed by the current tax system will not only support the growth of SMEs but also drive economic diversification, innovation, and employment. By creating a more equitable tax environment, Pakistan can unlock the full potential of its SME sector, fostering a more dynamic and robust economy.


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June 6, 2024

By Kamran Arshad

As Pakistan prepares for a significant increase in electricity prices next year, driven by further rupee devaluation and capacity payments of over Rs 2.1 trillion, addressing these issues that have bogged down the entire economy has become a question of survival. One of the biggest contributors to prohibitive power tariffs is the heavy burden of capacity payments of over Rs 2.1 trillion per annum, which necessitates an urgent action.

Pakistan’s energy sector has long been entangled in flawed contractual arrangements with Independent Power Producers (IPPs). These contracts, dating back to the Power Policy of 1994, were intended to resolve the energy crisis by attracting private investment. However, the terms of these agreements have led to a spiralling circular debt, reaching Rs2.64 trillion as of February 2024.

The incentive structures offered to IPPs, including guarantees indexed to the US dollar, mean any depreciation of the Pakistani rupee increases returns for IPPs and places a heavier financial burden on the government. Initially, the return on equity for IPPs was set at 18%, later reduced to 12% in the Power Policy of 2002, but it remains high compared to global norms.

Additionally, cost comparisons with similar projects in other countries suggest that many IPPs were funded through over-invoicing on capital goods, resulting in no “real” underlying equity. Consequently, Pakistan is burdened with perpetual returns on ghost equity. An analysis of various published accounts and balance sheets further reveals that actual dollar-based returns to many IPPs exceed 70%.

Additionally, the government’s decision to incorporate residual fuel oil (RFO) plants, known as Peaker plants, to boost base capacity has proven problematic. These plants are inefficient, costly to operate, and environmentally unfriendly.

While the inclusion of Peaker plants is not inherently problematic, their disproportionate share in Pakistan’s energy mix, currently at 14%, is concerning. Globally, these plants typically operate during peak demand periods and constitute a maximum of 4-6% of total consumer bills.

Pakistan has an installed capacity of approximately 44,943 MW, with a huge disparity between a base-load of around 12,500 MW and summer peak load of around 30,000 MW due to shifting of winter heating loads to gas.

However, due to contractual obligations, the government must pay for the entire installed capacity year-round, regardless of utilization. In contrast, global grid planners operate some plants solely during peak demand periods, paying only when the capacity is actively utilized, while Pakistan’s generation mix is heavily skewed towards take-or-pay base-load plants.

There are two main types of energy contracts: take-or-pay and take-and-pay. Pakistan operates under a take-or-pay contract system with IPPs, where a fixed percentage of their capacity must be purchased regardless of actual demand.

This setup can be unfavorable for buyers, as they must pay for electricity up to the contracted capacity, leading to increased unit costs. In contrast, take-and-pay contracts involve buyers paying solely for their electricity consumption, though this can lead to higher prices due to negotiation or competitive buying.

The tariff structure in IPP contracts also raises issues. Consumer tariffs include various components like Energy Purchase Price (EPP), Capacity Purchase Price (CPP), T&D losses, Distribution and Supplier Margin, and prior year adjustments.

Besides IPP charges, consumer tariffs also include add-ons from Distribution Companies (Discos), such as technical losses (typically 5-10%) and factors like theft and uncollected receivables, which inflate these add-ons to over 20%.

In FY 2022, EPP comprised roughly 60% of the tariff, with CPP at 40%. By FY23, both EPP and CPP were around 50%, marking a shift from historical trends. Projections for FY24 suggest a further deviation, with CPP expected to rise to 67% and EPP decreasing to 33%. This increasing emphasis on fixed charges significantly inflates tariffs, posing challenges for consumers.

Moreover, there is significant alleged misreporting and overbilling done by IPPs as the tariffs enshrined under the take-or-pay contracts are guaranteed under international law. For instance, the actual oil consumption of several oil-based plants is allegedly less than what is billed by the IPPs; there have been alleged attempts to audit these occurrences, but any such efforts are thwarted by IPPs through, among other means, stay orders, etc.

Similarly, the O&M margins are also overstated, where the expense is Rs 500 million it is being billed at Rs 1.5 billion per annum. All other heads are similarly overstated but because the sanctity of these contracts is protected under international law and the government of Pakistan has surrendered its sovereign rights there is little that can be done to reevaluate these contracts.

Currently, electricity tariffs in Pakistan are prohibitively high. Over the past 24 years, tariffs have surged from Rs 1.37/unit in 1990 to Rs 34.31/unit in 2024, a 25-fold increase. This rise is not solely due to variables like PKR-USD parity but also due to factors like the introduction of private generation and the government’s tendency to pass on its own socio-economic obligations to certain power consumers like industrial and high-end domestic through cross-subsidies.

This scenario has contributed to premature deindustrialization, causing a decline in electricity consumption and elevated electricity costs. Immediate action is required to lower power tariffs for industries to 9 cents/kWh, stimulating demand for electricity and effectively utilizing idle capacity. Furthermore, the addition of new capacity to the system should be halted for the next 3-4 years.

Removing cross-subsidies, which act as indirect taxation on exports, is essential. Increasing tax collection to directly subsidize energy for economically disadvantaged segments and transitioning to other direct support mechanisms like unconditional cash transfers, as advised by IMF and World Bank consultants, is more economically efficient compared to cross subsidies in power tariffs.

Moreover, to reduce the undue burden of capacity payments within current contractual agreements across all consumers, there must be a significant increase in power consumption. Typically, industries drive electricity demand globally.

However, in Pakistan, inefficient allocation leads to unproductive sectors consuming a significant portion of electricity (around 47%) while industries consume only 28%. This results in industries bearing the burden of inefficiencies through cross-subsidies and additional transaction costs.

Competition plays a pivotal role in the effectiveness of take-or-pay contracts. Competitive bidding often results in favourable arrangements, especially in cases involving multiple investors and suppliers in large countries. However, problems may arise in government-to-government contracts without competitive bids, highlighting the importance of clear contract pricing through market mechanisms.

“In advanced countries with competitive electricity markets, take-or-pay contracts are prevalent. Here, electricity prices are influenced by supply and demand in spot markets, offering a mix of options for both buyers and sellers to mitigate risks effectively. Even in Pakistan, the ADB-funded Jamshoro coal power plant has demonstrated cost-effectiveness through competitive bidding.”

 

 

However, while these points must be kept in mind while negotiating future contracts, ultimately, the resolution to Pakistan’s existing capacity payment woes lies in stimulating industrial growth, which will significantly increase power consumption and reduce the per-unit burden across consumers.


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