One of the more short-sighted fiscal measures recently introduced is the higher tax on banking income from government securities. This tax is directly linked to the advance-to-deposit ratio (ADR), imposing a 10-15% additional tax on banks with ADRs below 50% as of the banking year’s end.
Although intended to encourage private-sector lending, the primary aim appears to be squeezing more tax revenue from the profit-laden banks.
However, this policy is not prompting banks to boost private credit; instead, it’s creating distortions across the monetary system.
An obvious distortion is the widening gap between private credit risk pricing and government securities’ risk-free rates. Major banks now lend government-backed entities such as PASCO, TCP, and Punjab Food at a substantial discount, 6-12% below the KIBOR benchmark. Ironically, government borrowing rates on T-bills are now often higher than these concessional rates given to public sector entities. This pricing paradox is distorting capital allocation across the board.
The usual corporate giants remain the primary beneficiaries of private-sector lending, with banks competing fiercely to attract one another’s clients. In this scramble to meet the ADR threshold and avoid additional taxes, banks are prioritizing existing large borrowers over broadening access to credit.
With ADRs for most banks hovering below 50% - some even in the 20s- the quest of meeting the threshold has become a numbers game.
To fill the Rs3.4 trillion gap, banks would need to achieve an improbable 30% growth in lending. The only alternative is to shed deposits, which counteracts financial deepening, a key priority in Pakistan’s banking sector. Instead of expanding financial inclusion, this policy forces banks to pull back.
It’s like driving with one foot on the accelerator and the other on the brake. Meanwhile, banks are taking creative, albeit questionable, steps to avoid the tax. High-net-worth clients are being nudged to replace deposits with investments in bank mutual funds or to directly invest in T-bills, then using these to secure low-interest loans. This arbitrage for the wealthy adds a new layer of inefficiency and inequality.
The policy also shows little promise for small and medium-sized enterprises (SMEs), a crucial but underserved segment of the economy. Most banks are disinterested in finding new borrowers due to high non-performing loans (NPLs), which currently hover around Rs1 trillion. Court decisions favoring borrowers make loan recovery challenging, leading banks to prioritize large corporations over SMEs, who are essential to broadening economic participation and growth.
With the ADR tax inadvertently stimulating imports through cheap credit to big business, it directly conflicts with Pakistan’s monetary policy goals of curbing import-driven demand. Here, incentivizing private-sector lending falls squarely within the central bank’s remit, which has far more effective tools at its disposal.
For instance, the State Bank of Pakistan (SBP) could impose a capital charge on excessive government investments or adjust the Statutory Liquidity Requirement (SLR) to nudge banks towards private-sector lending.
The reality is that the government’s mounting borrowing needs are largely responsible for banks’ low ADRs. Domestic liquidity is stretched, and SBP has to inject funds through open-market operations (OMOs) to keep the lending wheel turning. Yet, a few large banks have exploited this, with some extending government loans exceeding their deposit bases.
A more targeted policy could link capital charges to deposit bases rather than blanket tax increases, which only dampen banking activities without achieving fiscal goals.
As the tax year-end approaches, banks are under pressure to artificially manipulate their balance sheets to meet ADR targets. Expect deposit-shedding, short-term loans, and even temporary maneuvers like issuing pay orders to adjust figures by December 30. To close these loopholes, the FBR plans to introduce a tax on average ADRs for the next fiscal year, effectively embedding the existing disto rtio ns into a year-roun d chal lenge.
As A rthur Laffer, the economist behind the eponymous “Laffer Curve,” aptly noted, “The ultimate effect of taxation on the economy is best observed when the taxes themselves do not distort incentives but rather allow for the market to allocate resources most efficiently.” The government’s intent here seems solely to raise tax revenue. If that’s the goal, it’s simpler—and far more effective—to raise the corporate tax rate on banks directly.
Why complicate a system already brimming with inefficiencies? Simplifying the tax approach and leaving credit allocation to the SBP would let Pakistan’s financial system function as intended—efficiently, with real growth in sight.
Copyright Business Recorder, 2024