Amplified policy distortions

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TWO inextricably linked policy distortions, and poor governance, have impacted the economy’s competitiveness. They have created and reinforced potentially grim challenges in the not-too-distant-future for the financing of our external bills.

These relate to:

a) An increasingly slanted tax structure conjoined with the unpredictable interpretation of the laws that incentivise the movement of investable funds to either unproductive sectors of the economy (eg real estate, speculative activities) or to sub-sectors of a ‘rentier’ nature that involve heavy protection against global competitors. This tax structure simultaneously raises, for all businesses, the cost of compliance with tax laws;

b) An exchange rate (and other supporting policies pertaining to taxation in general, and tax refunds, in particular, on exported products) that is overvalued, considering the downward adjustments in the exchange rates of our trading partners and competitors, as well as the higher rate of our domestic inflation compared to theirs; and

A deformed tax structure has spawned many beneficiaries who will resist any attempt to recalibrate it.

c) Governance issues. The obvious example of this is the energy sector where losses on account of theft (manifest in the steadily growing circular debt despite a substantial decline in international oil prices) are being addressed by increasing energy tariffs, inflating the cost of production, hence the competitiveness of our exports.

This article attempts to examine the first two policy warps by explaining the links between them. The rupee is overvalued (the State Bank suggests by as much as 27 per cent overall and 22pc since June 2013). Whereas the currencies of Malaysia, Indonesia, India and Korea have devalued by 47pc, 38pc, 30pc and 7pc respectively since 2013 the rupee has depreciated by only 3pc!

This has made imports of even daily consumables cheap, while remittances through official channels have been discouraged (the open market rate being Rs150 per dollar, higher than the inter-bank rate). Resultantly, the current account deficit has deteriorated alarmingly. Export receipts and remittances combined now fall short of our import bill by an unsustainable $1 billion a month. (The official argument that much of it is of a transitory nature owing to machinery imports under CPEC and higher private-sector investment suggests that officialdom is either too complacent or in a state of denial.)

Our response to these developments was to treat the symptoms. The patient needed surgery but we chose treatment for rising blood pressure. Instead of adjusting the exchange rate, the State Bank imposed 100pc cash margins to dampen imports while the government raised import duties and slapped regulatory duties on ‘non-essential imports’. (The latter is a bizarre category that can only be defined by the all-knowing mandarins living in Pakistan’s own version of Disneyland better known as Islamabad.) In the process, an already dense and inequitable tax structure was made more irrational and cumbersome.

This complex tax regime was further perverted by an Infrastructure Cess on goods traded externally and flawed non-adjustable GST on services levied by provincial governments (especially on the most productivity-enhancing sectors like telecom and IT), and by Sindh even on exports of services.

Policies, transactional processes and import tariff structures are critical in enabling firms to participate effectively in global value chains based on core competencies — manufacturing of different components and services like design, logistics, marketing and distribution. Our tariff levels are high, serving as a major impediment to integration in global supply chains, hampering the diversification of exports.

These high rates of duties have induced complicated regulations and procedures to manage trade, as demonstrated by the case of the Afghan transit trade. A convoluted administrative system involving high processing charges, costs and penalties and excessive documentation got erected to check the abuse of concessions and prevent goods with high import duties from flowing back into the country. Such a regulatory burden has raised the cost of steering trade, besides incentivising smuggling.

These aberrations, complemented by Islamabad’s refusal to refund taxes to exporters and the rising cost of energy for reasons mentioned here, resulted in literally all segments of the exporting industries experiencing sharp increases in the cost of doing business, continuously losing market share.

Some simple examples help reveal the extent of loss in competitiveness, largely owing to our tax structure. For similar type and quality of textile products, South Korea is 3pc cheaper. Cost of gas as industrial input is 37pc cheaper in Central Europe. Yet another example — a one-hour 55-minute international return flight from London to mainland Europe costs Rs23,600 whereas the domestic fare for a one-hour 30-minute return flight from Lahore to Karachi is more than Rs25,200.

Islamabad didn’t stop at this. It also raised protection levels further for powerful lobbies that were finding it more difficult to compete notwithstanding years of protection. The ‘infant’ protected from competition, in the hope that he would ‘grow up’, remained lazy, never putting in the effort to become strong enough to compete globally without these artificial props. And the growth of one domestic industry has created a market for another.

Resultantly, all kinds of industries, operating with varying degrees of inefficiencies have flourished, unable to compete internationally; a glaring example of a policy distortion.

A disturbing consequence is a polarised, dichotomous economic edifice. It is characterised by heavily protected sub-segments of industry, that essentially serve the domestic market enjoying relatively high profit levels while those operating in global markets find survival difficult. Because of this, the pattern of industrialisation is fast changing for the worst; it is one which is not viable without high walls sheltering it from competitors.

The upshot of the discussion is that a deformed tax structure has spawned many beneficiaries who will resist any attempt to reconstruct and recalibrate it. The necessary work to address these contortions and the costs of tax revenues likely to be lost during such a transition will now need three to four budget cycles to carry out.

And finally, by not gradually adjusting the value of the rupee there is enough cause to worry about the possibility of an abrupt and agonising disruptive trimming of its price not far down the road, rather like a sudden jump off the cliff.