Small and Medium Enterprises - An Engine of Growth and Need for Policy Measures

Small and Medium Enterprises (SMEs) play a significant role in the economic growth of a country. They are considered the primary sources of employment creation, income generation and poverty alleviation. As per the World Bank, the sector accounts for about 90% of the businesses and more than 50% of the employment across the world. The contribution of SMEs in the growth of developing economies is of fundamental importance. In Pakistan, 80% of the non-agricultural labor is employed in the SME sector. Moreover, the sector represents 90% of all the private businesses, contributes to 40% of the country’s GDP and directly accounts for 25% of the manufacturing exports according to a report of the Small and Medium Enterprises Development Authority (SMEDA).

In the developing countries and, especially in Pakistan, the SME sector has long been grappling with composite problems and failed to harness its full potential. Resultantly, the contribution of SMEs to economic development of the country is suboptimal, which is a consequence of multiple factors: Financial constraints, high tax rates, labor laws, lack of skilled workforce, limited regulatory support and outdated technology.

Access to equity and debt financing has been recognized as a foremost impediment to SME growth and development. SME sector remains largely undocumented. Majority of the firms do not maintain financial record that can be used by the financial institutions to evaluate their credit worthiness. Lack of precise and reliable information by SMEs makes them unworthy of credit by financial institutions which are anyways risk averse and happy lending to state at risk free rates. Banks make the lending both process and paper heavy and build in higher risk premium which makes the financing expensive.

The government has adopted a proactive approach in facilitating sector wide reforms and alliances fortunately. In the National Financial Inclusion Strategy (NFIS) of 2015, the then government envisioned to increase the private sector SME credit from 7% to 17%. The current government had also included the NFIS in its 100 days agenda to expedite the delivery of set goals. Establishment of Pakistan Credit Guarantee Company and Secured Transaction Registry are steps that will encourage the private sector financial institutions to lend the SMEs. There is a long list of loss making or under-utilized development finance institutions (DFIs) or other state-owned financial entities such as SME Bank, Zarai Tarqiati Bank etc. which have failed to make any impact. Government needs to consider whether a financial institution under state control can ever deliver. The evidence to date doesn’t support this assumption. SECP regulations enable setup of venture capital and private equity funds but only a handful exist in Pakistan. Similarly, SECP has created a mechanism for SMEs to access the capital markets. The platform has yet to pilot and demonstrate some successful transactions.

Majority of the SMEs are not registered with the Federal Board of Revenue (FBR), and therefore, Pakistan’s SMEs share in total tax revenue is less than 10% of the total revenue. Pakistani SMEs experience complicated legal and tax environment. A study done by SMEDA tells us that 67% of enterprises term tax regulations as most problematic and Smaller firms found tax related issues more restrictive than larger firms. Sixty-nine (69%) of the firms, whose size of assets was less than Rs 1 million, faced the greatest of tax related problems. Small firms experience specific size related disadvantages compared to large firms. It is not feasible for small firms to hire a professional accountant to maintain the books as per law. High tax rates are another major reason for firms to remain elusive to formal economy.

The government needs to incentivize the SMEs to enter the formal economy. It should introduce a simplified tax regime for SMEs. The Tax Reforms Implementation Committee (TRIC) recommended that income tax rate should be lowered to 20% for encouraging the firms to register with FBR and pay their taxes. In reality, an even more generous and welcoming approach is needed, tax policy as of now incentivizes investment is real-estate, the proverbial plots, but not in SMEs which create jobs, generate income to pay taxes and spur growth. For instance, if as small investor, you buy a plot and hold it for four years, the capital gain on its sale is exempt from any tax whereas if you invest same amount in an SME, 75% of capital gain in case of sale of that investment would be taxed at highest rate appliable to you. One wonders about the signaling which FBR is doing to retail investors.

Labor Laws and regulations in Pakistan are complex for a business enterprise. An enterprise has to deal with fifty-six labor laws and inherent consistencies of these laws have made compliance impossible for the SMEs. The Labor market dynamics have changed considerably over the years and time calls for a higher degree of adaptability and flexibility. The government should take into account the changing realities of the labor market to create a favorable environment for facilitating industrial promotion and revival.

Firms must continue to recruit, develop and promote right people in order to survive and thrive in this age of competition. The high illiteracy and low level of skills of our workforce present a challenge to our competitiveness. Businesses in Pakistan, and especially SMEs, find it difficult to recruit and develop right human resource for right job. Our labor market lacks technical skills that leaves SMEs with no other choice but to recruit an un-skilled resource. As a result, our businesses become un-competitive in the longer run.

Though, we have number of institutions that impart training and skill development such as Technical Education and Vocational Training Authority (TEVTA), Provincial Vocational Training Council and various other support institutions. However, they have largely remained passive in responding to human resource requirements of SMEs. The Punjab Skills Development Fund (PSDF), an interesting experiment, is an exception in this regard. Since its inception, PSDF has been working on providing the grant-based financing to private sector to impart the effective and cost-efficient training to youth to create sustainable employment. The government should ensure that output of our human resource development institutions matches with the skills demanded by our SMEs. Employability of trainees should be key criterion for funding of skills training institutions.

Technology plays an important role in development and advancement of firms, moving them up the economic ladder in terms of effectiveness and efficiency. In Pakistan, the SME sector heavily depends on traditional and relatively low technology crafts. The processes are less cost and time efficient. Thereby, the quality of products is also uncompetitive in international markets. Weak system of technology transfer among SMEs with low research and development expenditures further make the matters worse. Organizations like Pakistan Council for Scientific Industrial Research (PCSIR), Pakistan Industrial Technical Assistance Centre (PITAC), Ministry of Science and Technology etc. need to adopt an active approach to provide their services to SMEs in an effective manner to bridge the major technological gaps.

The SME sector has the ability to grow beyond expectations and do wonders for Pakistan. We hear new SME Policy is about to be unveiled, it will be advisable that the policy attends to above mentioned areas and accompanies an action plan too.