A case for restoration of zero rating

Exports remained largely stagnant from 2012 to 2018, while regional competitors witnessed commendable export growth rates that strengthened their economies considerably. Our inward-oriented trade policies served as a substantial roadblock to the economy’s ability to keep pace in global trade despite the great potential of our business sector.

Then in 2019, as a result of regionally competitive energy tariffs and TERF, considerable progress was made: a 60 perent increase in exports over the following 3 years. However, this progress led to a situation where exporters’ working capital and ease of doing business needs became more acute.

With the withdrawal of Zero-Rating (SRO 1125) and the implementation of a 17 percent General Sales Tax (GST) on export-oriented sectors, the cost of doing business has increased to unsustainable levels, as a consequence of the liquidity crunch from the non-payment and delay in refund of GST collected.

Sales tax is consumption based, which inflates inventory and capital costs, serving as an impediment to new projects as capital cost increases by 20 percent and refund can only happen after commercial operations.

According to a report by the IMF, the cascading effect of GST has harmed Pakistani exporters’ competitiveness as there is currently no systemic method to ensure that all tax paid on inputs may be charged against a final sale is fully refunded. In this huge cycle of sales tax collection, exporters suffer in the form of delayed pending and deferred refunds.

The cost of collecting and refunding sales tax outweighs the revenue collected by a significant margin. The administrative cost of collecting and refunding sales tax is estimated at Rs 10 billion. The imposition of sales tax has resulted in billions of rupees (over 250bn) in liquidity transfer from the industry to the FBR despite latter’s commitment to pay refunds within 72 hours under the FASTER system.

Rather than encouraging import substitution, these regressive policies are doing the exact opposite by dis-incentivizing local production and promoting cheap imports. For instance, when a company holding a DTRE, Bond or EOU licence needs to buy raw materials like cotton, yarn or greige fabric, if it imports them through these schemes, it does not have to pay sales tax or duties, whereas, if they buy the same material from domestic industry, it is required to pay 17% GST and wait for its ultimate refund after exports which entails a minimum wait of nine months.

The counterproductive GST system has distorted the level playing field for local manufacturers and now heavily favours sales tax-free imports. It appears that the government policies do not take into account the need to develop and support domestic industry and are actively substituting local production with imports. Consequently, the economy has been undergoing premature de-industrialization and capital is rapidly draining from the country.

Requiring businesses to first pay taxes and then later struggle to obtain refunds is an irrational policy measure for several reasons. Firstly, the government already owes refunds worth over Rs 250 billion to exporters and has no fiscal space for making that payment.

Secondly, there is no reason for exporters to believe that they will get their sales tax refunded in due time while their prior refunds still remain unpaid, thereby depriving them of liquidity and of their own resources which could very well have gone towards modernization and expansion. Eliminating the sales tax waiver for a fragmented industry with a long and complex value chain has increased the production cost for exporters.

In a rational policy environment, to keep businesses liquid this sales tax should have been imposed in a step-wise progressive manner. It is still in vital interests of exports and economy that the government should consult stakeholders for initially imposing a rational percentage of sales tax to ensure adequate cash flow and hence timely fulfillment of export commitments.

In all countries, Value Added Tax (VAT) begins at extremely low rates and gradually rises. When it is performing well, the tax would be gradually increased.

On one hand, the government advocates promotion of exports and ease of doing business, but on the other hand problems have been created for industries. The government should commit to the oft-quoted economic direction of export-led growth so that the country may move forward on the path of economic development by promotion of business and industrial activities.

The zero-rated regime for the whole textile supply chain was first introduced by the Finance Act 2005 to stimulate export-oriented sectors in Pakistan and minimize flying invoices, which was resulting in more refunds than tax collection.

Zero rating was then withdrawn in 2013 without providing the expeditious refund system that was committed, thereby creating liquidity a crunch for exporters. Then zero rating was restored in 2016 but subsequently rescinded for the export-based industry in the June 2019 budget announcement.

This decision was based on a misrepresentation of facts and pretext by Federal Board of Revenue (FBR). FBR claimed that the domestic sales constitute more than 50 percent of all sales from the textile sector and somehow the industry was evading approximately $12 billion worth sales tax on domestic sales.

However, domestic sales of the sector do not exceed 20% of industrial output, as later conceded by FBR. Back in 2019, the government assured industrialists that they will examine the issue in 6 to 8 months, but no such review has been taken even after the passing of 3 years.

In July 2019, FBR issued bonds in lieu of sales tax refunds pending, but these bonds were not of any value as no bank was willing to discount them. Following the failure of the bond system, the FBR implemented the FASTER system, which guaranteed reimbursements within 72 hours.

FBR claimed that they had implemented a robust and sustainable sales tax claim refund system to ensure that exporters do not face a liquidity crisis as a result of the withdrawal of sales tax exemption for them. Despite making a commitment to pay refunds within 72 hours, the FBR has not honoured this commitment. It must be noted that a significant amount has accrued as “Deferred Sales Tax.”

As a matter of routine, a portion of the claims through Sales Tax returns are routinely deferred or rejected by FBR. A large proportion of the amount vanishes into thin air being neither paid nor rejected or deferred.

The FASTER system usually raises typical objections and errors in the data, which can be resolved by refund processing officers. Yet the system is unresponsive and unable to cater for the complexity of the textile sector, and is therefore in need of serious review and modifications.

Because of the high rate of sales tax, trade volumes outside the Sales Tax System have expanded, resulting in smuggling, outright fraud, and the import of used clothing into the country. Pakistan is among the top importers of used clothing.

Meanwhile, India, which has a much larger population and higher poverty rates, has at least half the import value of Pakistan. This indicates that Pakistan is importing fresh textile and apparel under the guise of used clothing in order to avoid taxes and tariffs.

This happens to be rejected new apparel and clothing from all over the world that is dumped on our market at extremely low prices under the guise of worn clothing. This creates a cheap alternative that is impossible to compete with.

Pakistan imported used clothing in FY21 at a cost of about $1.4 per capita per year, while India usually imports at a cost of $0.8 per capita per year. Pakistan imports about 43 percent more used garments than India.

TABLE

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                 Pakistan Import of Used Clothing
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Year       Quantity      Value          Increase in      Increase
                                        Quantity         in Value
=================================================================
           000 KG        000 Dollars
FY17       386,247       144,881          153%               199%
FY22       978,699       433,430
=================================================================

In the last five years, Pakistan’s imports of worn clothing increased by 153 percent in quantitative terms and nearly 200 percent in value terms.

Since our import of used clothing is unsustainably high, we suggest that the government must;

• Incentivize local production and sales to prevent smuggled and imported apparel, which impact the balance of trade;

• Implement effective anti-dumping and under-invoicing laws;

• Impose 20% regulatory duty on used clothing imports in order to prevent the misuse of regulation. Duty-free imports should be available exclusively to registered charities importing used clothing; and

• At the point of entry, the Customs Enforcement Directorate shall conduct a routine check on all containers labelled as used clothing.

When collecting sales tax on domestic sales, it should be deducted at the Point of Sale. This will subject any product sold domestically from any source to a 17 percent sales tax, including smuggled goods. As a result, the domestic market will remain regulated and classified as “Made in Pakistan”.

Textile exports are expected to increase from $19.35 billion (FY 22) to $ 25 billion this fiscal year and $50 billion over the next four years. Considering that our currency has depreciated by 60-70% in the last year, exports have climbed to over Rs 3 trillion, but working capital has not increased.

To bridge the gap, industry requires double the amount of working capital that is currently available - and this is further exacerbated by the situation where in order to impose sales tax on domestic sales of textiles, the whole sector gets roped in.

Under these circumstances, the restoration of zero-rating is imperative to improve exporters’ liquidity position, improve competitiveness and act as a deterrent to cheating and smuggling, and as a result, the market will remain documented and largely ‘made in Pakistan’.

The pace of competitiveness and modernization in the global textile market is progressing exponentially. In order to effectively compete, we must lower our cost of doing business and make it comparable to our regional competitors such as India, Bangladesh, and Vietnam.

To achieve the targeted exports, business-friendly policies should be ensured for the industry to grow and further achieve increased targets on a yearly basis. There is immense potential in the textile industry to engineer an economic turnaround and achieve targets not only in exports but in economic growth, through consistent policy support.

Copyright Business Recorder, 2022