The Export Facilitation Scheme (EFS) allows duty-free and tax-free import of inputs for export manufacturing. However, since the enactment of the Finance Act 2024, domestically sourced inputs for export manufacturing are subject to an 18 percent sales tax, which exporters can claim via the refunds scheme. Unfortunately, as refunds are often delayed by up to 12 months, EFS has led to a preference for duty-free imported inputs among exporters, which do not lock in working capital in the same way as local suppliers.
There is little point in arguing that the EFS scheme does not create distortion. However, the unintended consequence of this tax distortion has resulted in a net positive for Pakistan’s textile exports. Some context might help.
The most important element of the EFS scheme is that it has freed up liquidity for the export-centric industry. Firms that derive their revenue predominantly from export receipts no longer have to wait months (sometimes up to 18 months) for the settlement of GST and duty rebates with the Federal Board of Revenue (FBR). This freed-up liquidity proved invaluable over the last year when the domestic credit market froze due to severe monetary tightening and high markup on working capital financing.
As a result, EFS disproportionately favors direct export firms within the textile industry, particularly the high-value-added export segments, where export volumes have been witnessing double-digit growth for at least the past 12 months. But why only the value-added export firms?
That’s because the inherent benefits of the EFS distortions are not just limited to liquidity for working capital financing. The scheme has enabled value-adding exporters to access a broader variety of customers, orders, and export markets. How?
Access to duty-free imported inputs—whether in the shape of raw cotton, yarn, or greige fabric—means exporters now have access to a broader variety of inputs, often of higher quality, at a cheaper price. This allows direct exporting firms to service a broader variety of customer preferences and requirements.
On the other hand, there is overwhelming evidence that the distortion places local producers (otherwise known as indirect exporters)—particularly the cotton-based yarn and greige fabric-producing spinning industry—at a significant disadvantage, as their products no longer enjoy buyer preference.
So, should the distortion go?
Definitely. But it is important to remember that even if there were no distortions—and local industry’s sales to direct exporters were also GST-free and not dependent on refunds—local production was already losing competitiveness due to higher energy tariffs. All things held equal, imported inputs would normally cost less than locally produced inputs, as running yarn-only manufacturing has become an uncompetitive affair in Pakistan due to higher and unreliable energy tariffs. All things held equal (excluding freight costs and shipment time), value-adding buyers—i.e., direct exporters—may prefer foreign inputs over local, even if there were a level playing field.
The unacknowledged truth is that the low-end yarn and greige cloth manufacturing in Pakistan is not only uncompetitive due to higher energy tariffs but also because it has a very limited product portfolio. Yarn manufacturing in Pakistan predominantly consists of cotton-based fibers. Locally produced raw material—cotton—has (possibly irreversibly) become an unviable choice, not only because it offers lower profitability to farmers but also due to many other factors.
Cotton farming—especially picking—continues to be the most labor-intensive cash crop, yields poor quality crops that fetch low prices, has a high level of contaminants and adulterants, is the most chemical-intensive among major crops, and suffers from the highest degree of vulnerability to extreme weather events. Meanwhile, its byproducts, khal binola and cottonseeds, have also lost marketability for use in cattle feed and as a source of edible oil due to the availability of more nutritious and affordable alternatives.
Moreover, the collapse of local cotton production from 15 million bales ten years ago to an average of six million bales in recent years has also turned spinning into a highly import-dominant business. Up to 50 percent of raw cotton requirements are now met via imports. In addition, spinning is a highly energy-intensive industry, which in turn adds to the energy import bill, especially for processed gas, which cannot be substituted through locally produced renewable energy sources. Other inputs for local cotton production—such as pesticides—are also mostly imported.
Although importing raw cotton too allows access to higher quality ginned cotton, which can then be converted into locally produced yarn, why import cotton when you can import the intermediate input—i.e., yarn—at a similarly lower price?
The uncomfortable truth is that Pakistan’s spinning industry’s reckoning has been long in the making. Raw cotton and energy account for more than 90 percent of the cost of production in an average spinning business. Pakistan’s textile industry no longer has a comparative advantage to sustain as a sector dominated by spinning firms. Spinning is also a volume-driven business, which can no longer survive on a standalone basis in an energy-deficit economy chronically facing foreign exchange crises.
Enabling the textile industry to reduce its dependence on a cotton-dominant spinning supply chain has also led to greater use of synthetic fibers, which are cheaper, more sustainable, and allow more varied uses in manufacturing textiles and garments beyond traditional cotton-based products. It may be high time to let the weakest link die out.
For more than half a century, Pakistan’s spinning industry has enjoyed unfettered supremacy within Pakistan’s industrial policymaking. In fact, for much of its history, the regulatory structure was reversed—with all sales exempt from GST—whether used in manufacturing textiles consumed locally or for exports. Spinning enjoyed a captive market and became a stepping stone for every local business group that made it big in this rentier economy. Exporting remained a secondary consideration—in fact, a by-product, with exports restricted to the extent mandated for exploitation of other incentives, such as to avail concessional finance schemes.
In recent years, demands by the IMF have chipped away at its coveted status—first through the loss of GST-exempt status, then through the withdrawal of access to concessional finance, followed by the loss of concessional energy tariff schemes, and soon, the loss of access to captive energy supply.
Finally, after shaping industrial policymaking in its favor for much of history, spinning must face the same harsh macro-realities as faced by all other industrial sectors of the country.
But not like this. And not because of a fiscal distortion that paints it as a victim.
The tax distortion hurting the local spinning industry is an outcome of fiscal imperative—the government’s insatiable demand for revenue to finance its expenditure—not because of a considered tax policy that seeks to favor one industry over the other. Reinstate a level playing field. Let the weakest link die on its own.
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