Give SMEs a chance

The turnover tax regime in Pakistan poses significant challenges for small and medium enterprises (SMEs), placing them at a disadvantage compared to vertically integrated firms.

Despite contributing around 40% of GDP, 25% of export earnings, and employing 78% of the non-agriculture labour force, according to the SBP, small and medium enterprises (SMEs) face numerous challenges that hinder their growth and development.

These include limited access to finance, as SMEs often struggle to secure financing due to stringent collateral requirements and high interest rates which limit their ability to invest in growth and innovation. Poor infrastructure, such as unreliable electricity supply and poor transportation networks, increase operational costs and reduce efficiency, especially in rural areas.

Many SMEs also suffer from inadequate management skills, leading to poor decision-making and inefficient operations. Complex and cumbersome regulatory requirements, often difficult to navigate for SMEs, further inhibit their growth. (Khan, Hussain & Afraz, 2013; Khan, 2022; Zeshan, 2023)

SMEs being large firms of the future, this is also one of the reasons Pakistan has very few large firms, and even these are relatively small by global standards. For instance, according to the Pakistan Export Directory, the largest exporter in 2021 exported goods worth Rs. 52 billion, the 10th largest Rs. 29 billion, and the 100th largest only Rs. 5 billion.

Among these barriers, the turnover tax stands out as a significant impediment that disadvantages SMEs as compared to vertically integrated firms. The turnover tax in Pakistan mandates that all businesses, regardless of profitability, pay a minimum tax of 1.25% on their turnover.

While this policy aims to create a uniform tax environment, it inadvertently imposes a heavier burden on SMEs due to the cumulative nature of the tax across multiple production stages.

When a single, vertically integrated firm manages the entire production process, the turnover tax is applied once on the final product. However, SMEs, which typically rely on multiple independent businesses for various production stages, face a different reality.

Each stage—from raw material processing to manufacturing, distribution, and retail—involves separate entities, each subject to the turnover tax on its revenue. This results in the tax being applied multiple times across the production chain, significantly increasing the overall tax burden on SMEs.

For example, in the textile industry, an SME might source yarn from one company, fabric from another, and finally sell the finished product. Each transaction between these businesses incurs the turnover tax, creating a compounding effect that does not affect a vertically integrated firm in the same way. This cumulative tax burden increases costs for SMEs, making their products more expensive and less competitive compared to those produced by integrated firms.

This compounded tax significantly hampers the competitiveness of SMEs. Vertically integrated firms, by consolidating all production stages, incur the turnover tax only once, resulting in a lower overall tax liability. SMEs, unable to vertically integrate due to financial and operational constraints, end up paying much higher cumulative taxes. This creates a market environment where SMEs struggle to compete on price and profitability, stifling their growth and innovation.

The financial strain imposed by the turnover tax also limits the ability of SMEs to reinvest in their businesses. With higher taxes eating into their margins, SMEs find it challenging to fund expansions, adopt new technologies, or enhance their workforce, further hindering their competitive edge.

To support the growth of SMEs and create a more equitable tax environment, several policy reforms can be considered. Implementing lower turnover tax rates specifically for SMEs can alleviate the compounded tax burden they face, helping them to price their products more competitively. Providing tax rebates or credits for SMEs that engage in multiple stages of production could further offset the cumulative effect of the turnover tax and encourage SMEs to expand their operations without facing prohibitive tax penalties.

Facilitating access to finance and resources for SMEs to achieve greater vertical integration can reduce the number of taxable events in the production process, while also fostering firm growth. Government programmes that support mergers and collaborations among SMEs are essential to achieve this goal. Introducing a graduated tax structure that imposes lower rates on the initial stages of production or for lower turnovers can also help reduce the overall tax burden on SMEs, making the tax system more progressive and fairer.

In conclusion, reforming the turnover tax policy is crucial to ensure that SMEs have a fair chance to compete with vertically integrated firms. Addressing the inherent disadvantages posed by the current tax system will not only support the growth of SMEs but also drive economic diversification, innovation, and employment. By creating a more equitable tax environment, Pakistan can unlock the full potential of its SME sector, fostering a more dynamic and robust economy.

Copyright Business Recorder, 2024