Fix the EFS

Export-led growth is the mantra these days, but government seems uninterested in actually facilitating it.

The Export Facilitation Scheme (EFS) was a well-designed initiative that allowed exporters’ access to zero-rated inputs—i.e., duty-free and sales tax-free—be it imported or local, as well as zero-rated transfers of materials between EFS bond holders.

However, in the FY25 budget, the government inexplicably withdrew the sales tax exemption on local supplies for export manufacturing while imports of the same remain duty-free and sales tax-free.

As a result, exporters procuring domestically manufactured inputs must now pay 18% sales tax. Although refundable in principle, only around 60-70% of the refund is issued after delays of over 6 months, as the FASTER system that promised automated refunds within 72 hours has been made dysfunctional.

The remaining amounts are indefinitely deferred for manual processing with no progress on these refunds over the last 4 to 5 years.

This further adds an additional administrative and time cost of 6-10 months from the purchase of inputs to the export of manufactured goods when sales tax refunds can be claimed—a burden that imports do not face.

All else equal, this policy effectively provides foreign industry and agriculture an 18-30% advantage over local industry and farmers.

The Federal Board of Revenue (FBRs) offers three main justifications for withdrawing the sales tax exemption on local supplies: that the sales tax is refundable in any case, that exemptions break the “value chain” in the value added tax regime and limits the tax authorities’ visibility over it, and that there were significant pilferage and leakages in the system.

The first argument—that sales tax is refundable—would have merit if the refund system actually worked. Rule 39F of the Sales Tax Rules 2006 mandates that refunds be processed within 72 hours, yet the system is fundamentally broken, and the FBR has shown no intention of fixing it.

As of FY24, over Rs. 180 billion of the textile sector’s liquidity was stuck in sales tax refunds alone. Beyond this, the government also owes the textile sector Rs. 25 billion in unpaid duty drawbacks, Rs. 100 billion in pending income tax refunds, Rs. 35.5 billion in outstanding DLTL/DDT dues, Rs. 4.5 billion in pending TUF payments, Rs. 3.5 billion in unpaid markup subsidies, and Rs. 1 billion in outstanding RCET differential payments. This reflects a broader pattern of the government bring addicted to private sector liquidity to manage its own distraught cash flows.

If the intention is to refund the sales tax, then why charge it in the first place?

The second argument—that zero-rating local supplies disrupts the VAT chain — is, at best, a procedural data issue that the FBR should be able to manage given its grand digitalization ambitions.

Under a VAT system, each stage of the supply chain pays tax on its value addition while claiming refunds on previously paid tax, ensuring that only the final consumer bears the cost.

The FBR contends that exempting local supplies under EFS removes a stage of taxation, disrupting revenue tracking and enforcement. However, this issue is entirely solvable through proper documentation, as suppliers would still report transactions under EFS without charging sales tax, allowing the FBR to maintain oversight. If the system can handle tax-free imports under EFS, it can certainly apply the same controls to local supplies.

In fact, many countries operating under a VAT regime have successfully implemented zero-rated regimes for export-oriented industries:

The third argument – pilferage — is the weakest of all, as the bulk of leakages in EFS occurred on the import side, yet imports remain duty-free and sales tax-free. In fact, the tax disparity between local and imported inputs has worsened the issue.

The primary avenue for abuse is when exporters import zero-rated inputs but use them for merchandise sold in the domestic market while exporting goods made from locally procured inputs instead.

However, proposed amendments to the EFS framework — such as reducing the reconciliation period from five years to nine months and strengthening audits — are sufficient to curb such practices.

When all other justifications fall apart, the bureaucracy falls back to its favourite recourse: blame the IMF. But let’s be clear: the IMF does not dictate specific policy measures to governments. It negotiates policy conditions with governments seeking financial assistance, with Finance Minister and Governor State Bank proposing policy changes through the Memorandum of Economic and Financial Policies.

While the IMF pushes for broader objectives like higher revenue collection, specific measures to achieve these objectives are determined by the government. In this case as well, the government itself chose to impose sales tax on local inputs while maintaining duty-free and tax-free imports, expecting to generate Rs. 7-8 billion in revenue from what is essentially a revenue-neutral policy. It is the government’s responsibility to support local industry and protect livelihoods—something the IMF, a lender at the end of the day, has no stake in.

If today the government finds itself in a weak negotiating position with the IMF, it is entirely due to the shenanigans of the bureaucracy that has been handling these negotiations across 24 separate programs since 1959.

And despite all the experience they have gained, they continue to miss key quantitative targets like revenue collection, while failing to meet structural benchmarks such as the privatization of a national airline that drains over Rs. 100 billion annually.

Why should the private sector and the people of Pakistan bear the cost of their repeated failures? Will anyone ever be held accountable for the billions of dollars lost and the millions of livelihoods damaged by these policy decisions?

There is now broad consensus that the withdrawal of sales tax exemptions on local inputs was a blunder, especially for upstream segments of the textile sector, and that a level playing field must be restored.

There are two ways to achieve this: one option is to impose the same 18% sales tax on EFS imports, but this would only level the playing field by subjecting imports to the same refund delays and liquidity issues plaguing local suppliers and ultimately increase costs for exporters.

A far better alternative, preferred by all stakeholders, is to restore the Export Facilitation Scheme to its pre-FY25 form, reinstating the zero-rating and sales tax exemption for local supplies. This is the only viable path if the government is truly committed to export-led growth. In fact, the scheme should be expanded beyond a single stage to include multiple stages of the value chain, maximizing the benefits of zero-rating.

Pakistan is one of the few countries with a fully developed textile value chain, yet the government’s missteps have broken it. A surge in yarn imports has displaced the local spinning sector. Ironically, it includes from Uzbekistan—a country that modelled its own textile value chain reforms on Pakistan’s example and even extended zero-rating to cotton sales for yarn manufacturing, strengthening its domestic industry while Pakistan’s spinning sector collapses.

Sustained economic growth requires not just higher exports but greater value addition in those exports. A country can either import $3 worth of inputs and add $2 of value or capture the full $5 within its own supply chain.

The latter approach keeps capital circulating within the domestic economy, creating multiplier effects in income generation and tax collection. While shifting to a final consumer goods export model may yield higher absolute value, it results in lower domestic value addition and foregoes these economic benefits. More critically, Pakistan lacks the productive capacity and investment climate needed to sustain such a shift.

The sales tax disparity also discourages the long-term development of export-oriented sectors through backward and forward linkages. Given that Pakistan’s business environment is already burdened by high costs—whether in electricity, gas, taxation, or the overall cost of doing business—it is unrealistic to expect local suppliers to compete on an unequal footing with duty-free and tax-free imports.

Pakistan urgently needs a strong, labour-intensive manufacturing base to capitalize on its large and growing workforce.

The idea that a country of 250 million people will escape economic stagnation through $10 billion in IT exports is wishful thinking.

If the government is serious about economic revival and export growth, it must fix the Export Facilitation Scheme and ensure a fair, competitive landscape for local industry.

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Country                    Year                                                    Overview
===========================================================================================
Bangladesh                 1991                     The VAT Act, 1991 allows zero-rating on
                                                           local inputs for export-oriented
                                                     industries, mainly in textiles and RMG
                                                                         Domestic suppliers
                                                            to exporters do not charge VAT.
India                      2017                 Under GST Law (2017), exporters can procure
                                        local inputs tax-free using a Letter of Undertaking
                                                        (LUT), reducing reliance on imports
European Union             2006                          The EU VAT Directive (2006/112/EC)
                                                 provides zero-rating on goods supplied for
                                            export, with strict documentation requirements.
Turkey                     1985           VAT Law No. 3065 exempts local sales to exporters
                                                    from VAT, strengthening domestic cotton
                                                                   & textile supply chains.
Uzbekistan                 2020              Reforms in Tax Code allow zero-rating on local
                                        cotton sales to textile mills, shifting the country
                                           from raw cotton exports to value-added textiles.
Egypt                      2016          Under VAT Law 67 (2016), cotton and textile inputs
                                          for exporters are zero-rated, improving cash flow
                                                      and local demand for Egyptian cotton.
Brazil                     2004       The Special Regime for Textile Industry enables local
                                        cotton sales to be VAT-exempt for textile mills and
                                            exporters, reducing reliance on imported fiber.
Malaysia                   2018            The Sales & Service Tax (SST) system allows zero
                                     VAT on domestic raw material sales for export-oriented
                                                                  manufacturing industries.
South Africa               1991      The VAT Act (1991) exempts domestic supplies linked to
                                             exports, particularly in mining, agriculture, 
                                                                              and textiles,
                                                      provided documentation is maintained.
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