Bring back zero-rating

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?

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Table 1  Textile and Apparel Sector Sales Tax Collection (million PKR)
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FY          Gross Collection      Amount Refunded     Percent Refunded
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2017-18        29,656                36,612                        123
2018-19        31,568                15,120                         48
2019-20       140,281                75,893                         54
2020-21       200,691               171,864                         86
2021-22       293,923               229,225                         78
2022-23       291,527               219,837                         75
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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 un-integrated 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 hindrance 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 out-priced 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 incentivizes 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.

Copyright Business Recorder, 2024