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ISLAMABAD: Pakistan exporters competitiveness is impacted because of the cascading effect of General Sales Tax (GST), says the International Monetary Fund (IMF).

The IMF in its latest report on Pakistan noted that at the final stage, the factory produces a dress for export, and even though export is zero-rated, the exporter will have to charge a higher price compared to the fully harmonized system.

Not all taxation is removed from exports and additional costs are incurred in each segment of the production value chain, which disadvantages them in the international market.

The current GST system, with its cascading effect, undermines competitiveness and ease of doing business, biases production toward simple manufacturing activity, and discriminates against exporters and import-competing industries.

The IMF quoted an example that the cotton ginning company buys Rs 1,000 value of raw materials for production of cotton fibre, and with GST rate of 10 percent, pays total sales tax on goods of Rs 100. In addition to purchased raw material, it also uses certain services for Rs 500, like transportation, consulting, marketing.

Assuming the same tax rate of 10 percent on services, it pays additional Rs 50 in taxes. Input tax paid is therefore: Rs 100 (to the federal government) + Rs 50 (to a province) = Rs 150. Total input costs are (1000+500+100+50) = 1650.

The company then adds the value of Rs 100 and sells the cotton fibre to a textile manufacturer.

Given the fragmented tax base, it will be very difficult for the cotton company to claim and collect tax credits on input tax on services (Rs 50) initially paid, and the sale price will carry over that segment of the tax.

‘Textiles exports can cross $20bn this year’

The sale price will therefore be: total input costs (1650) +value added (100)-input tax that will be credited after the sale, in this case on goods (100) = Rs 1650, instead of Rs 1600 in a fully harmonized GST system.

At the sale stage, the company will collect output tax of Rs 165 and remit it to the Federal Board of Revenue (FBR) but will only be refunded for the portion of the input tax.

The net tax paid by the cotton ginning company will be 165–100=65, instead of 160–100–50=10 in a system of fully harmonized GST.

In other words, the effective tax rate will be 65 percent (tax paid/value-added), significantly diverging from the nominal tax rate of 10 percent.

In the next stage, the textile manufacturer, in addition to purchasing cotton fibre for Rs 1650 (on which sales tax Rs 165), uses certain input services of Rs 800 and produces finished fabrics.

Similar to the previous stage, the textile manufacturer pays input taxes of Rs 245 = Rs 165 (on goods) + Rs 80 (on services), adds value of Rs 200, and sells the fabrics to a garment factory for R 2,730 = 2308+10 percent GST (230.8).

If only input tax on goods will be recovered, the net tax paid by the textile manufacturer will be Rs 108, while in the case of fully harmonized GST the producer will pay only Rs 20.

The production costs for the textile manufacturer are therefore Rs 40 higher compared to a fully harmonized tax base regime.

The use of multi-jurisdictional inputs along the value chain means that the federal and provincial revenue authorities are interacting repeatedly in each transaction.

For example, a good being sold (sales tax paid federally) can have services input taxes from multiple provinces that need to be credited, as well as sales tax paid on the purchase of any goods inputs.

The current system makes this crediting incomplete.

It has also led to disputes over base definition and coverage, causing problems of double taxation for businesses, as certain activities are jointly claimed by both the federal authority and provinces.

The fragmented GST system as it stands now has a cascading effect since there is no systemic mechanism to ensure that all tax paid on input can be credited against a final sale (the output tax).

This results in the cumulative taxation of intermediate inputs of production and distorts the prices that producers face in buying and selling from one another.

It, therefore, causes a significant divergence of nominal and effective tax rates in the price of final goods.

Under the current system, it is harder to generate full information on all aspects of the value chain, which is critical to eventually remove all taxation from exports.

As a result, Pakistani exports carry unrecovered tax on their input, and exporters’ prices are systemically higher than those of exporters in countries without the cascading effect of the GST system.

This also contributes to a heavy reliance of the tax revenues on manufacturing, which is the main exporting sector of the economy.

The manufacturing sector, which accounts for only 14 percent of GDP, represents 58 percent of total tax revenue.

The cascading GST system hampers the development of sophisticated manufacturing and accentuates incentives for low value-add manufacturing partly as a result of low competitiveness and to limit tax burden.

As it gets unclear what the effective rates on inputs and outputs will be, relative prices across the value chain get distorted, which encourages inefficient production choices (e.g., switching from superior to inferior quality inputs).

The higher cost of intermediate goods or services due to GST makes it more costly to incorporate advanced technology into production and thus affecting productivity and competitiveness, discouraging integration into the global value chains (GVC).

The end result of this is that import-competing sectors face a disadvantage with imported final goods.

Export-oriented industries are also heavily skewed to low value-added products, requiring few manufacturing stages.

For example, textile exports (60 percent of total exports) are mainly comprised of simple knitwear, bed wear, cotton cloth, and readymade garments, while food exports (20 percent of total exports) are mostly made up of rice and fish.

These low value-added and non-branded goods mean that Pakistani exporters operate in the most competitive segments in the international markets and with limited profitability, the IMF added.

Copyright Business Recorder, 2022

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