SMEs Still in the Lurch

It is an established fact that the small and medium-sized enterprise (SME) sector contributes significantly to the national GDP, employment creation, import substitution and export earnings. 

When we look at the phenomenal economic growth of countries like Germany and Japan post-World War II, the catalyst to their success was their SME sector and the enabling environment created by these countries to help them flourish and expand. In Germany, these export-oriented firms are characterised by elevated levels of productivity and quality standards and have been the backbone of Germany’s economic success for decades. Similarly, the Japanese Economic Miracle refers to Japan’s rapid economic growth from 1945 to 1991. This period saw Japan emerge as the third-largest global economy, driven by factors such as technological change, the accumulation of capital, increased quantity, quality of labour and expansion in international trade. 

Yet, in Pakistan, we do not even have a single definition for SMEs and various government agencies use their own definitions. Regardless, there is, however, a consensus that SMEs are businesses that employ a small workforce and dispose of lower fixed assets, which is reflected in the capital they deploy. It is noteworthy that most of these firms transact their business in cash, so that, on the one hand, the avoidance of banking channels and digital payments restrict governments’ initiatives towards digital inclusion, while on the other hand, they present a challenge for the tax authorities to assess their sales volumes and profitability.

Looking at the SME space in Pakistan, the current environment does not appear to be adequately enabling their growth and competitiveness. Key issues faced by SMEs include high input costs, power shortages, a lack of skilled labour, limited access to finance, and poor government policies. The current sticky inflation situation does not seem to offer any respite for these entities to sustain, let alone thrive.

More importantly, there is no motivation or encouragement from the government or the market. The trickle-down effect of the rent-seeking mentality flowing from both government and large business groups is evident amongst potential SME promoters. Potential sponsors prefer to invest in real estate or commodities for short-term gains rather than in any productive business activity, including manufacturing, assembling or services. Speculation (and trading) is the name of the game as opposed to the hassles of setting up a business.

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The narratives propagated by the government on behalf of SMEs, such as “creating an enabling environment” and the “ease of doing business,” appear to be worthless when compared to the ground realities of setting up and running a business in Pakistan.

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Now to the recently approved annual budget for FY 2024-25. It seems as if the budget-making process in Pakistan is more of an accounting exercise than a forward-looking, relief-providing one, and although the same approach has been happening historically, this time the disconnect between the government’s refusal to exercise austerity while further taxing the already-taxed has taken this to a higher level. 

There is a consensus among Pakistan’s intelligentsia that the country needs immediate economic reforms and consistent monitoring to get out of its debt trap. Yet, while there is no concrete reform agenda present in this budget, the oldest trick in the book – increasing the tax rate rather than the tax base – has again been exercised with impunity. This audacity is reflected in the fact that the government has increased its own expenditures rather than reducing them at the cost of record-high taxes for the public.

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Here are a few key aspects of the budget that could adversely impact SMEs:

The budget proposes raising GST on retailers of textile and leather products. These higher indirect taxes will increase the costs for SMEs operating in these sectors, making them less competitive.

The Finance Act has revised tax rates for Association of Persons (AOPs) and individuals (other than salaried individuals). Individuals (most SMEs fall into this category) will be subject to income taxes of 40% or more.

Section 236G provides for the collection of advance tax on sales to distributors, dealers and wholesalers by the manufacturer and commercial importer of 21 specified sectors. 

Section 236H provides for the collection of advance tax on sales to retailers by manufacturers, distributors, dealers, wholesalers or commercial importers.

– The Finance Act has increased the rate of withholding tax on payments on account of toll manufacturing.
– Mobile phones subject to sales tax of 18% and 25%
– Sales tax of 10% on LPG cylinders and 15% on the sales of shops with an attached stamp on the FBR.

– 100% increase on cement from two to four rupees per kilo and an increase in the FED rate on international travel tickets.
– Imposition of a five percent FED on lubricant oils.

– Proposes stamp duty worth Rs 1,000 on any application related to future remittance transactions for money collected by banks or financial institutions, be it in foreign or local currency.
– Approved increase in the Petroleum Development Levy (PDL) to Rs 70 per litre on high-speed diesel, high-octane blends and petrol, which is 10 rupees more per litre than current rates but 10 rupees less than what was proposed in the budget.
– Approved an 18% sales tax on vegetables and fruits from Afghanistan, pencils, paintings, research equipment and tractors.
– Imposed 18% GST on milk sold by dairy companies. It has also brought back the sale of scrap by producers who export recycled copper to GST.
– Lack of Targeted SME support: Although the budget does propose increasing credit facilities for SMEs, this may not be sufficient to address the broader challenges faced by SMEs, such as access to finance, infrastructure and skilled labour.

The budget highlights critical risks such as lower economic growth, currency depreciation and climate change impacts, which could create an unstable business environment and disrupt SME operations.

The proposed measures to eliminate tax exemptions and concessions and facilitate compliance through IT systems may create additional administrative and compliance burdens for SMEs, especially smaller ones.

To summarise, the budget’s focus on fiscal consolidation through higher taxes and the withdrawal of exemptions, coupled with macroeconomic instability and a lack of targeted SME support, will adversely impact the competitiveness of SMEs in Pakistan. A balanced approach and policy measures addressing SME-specific challenges are needed to create an enabling environment for this critical sector.

S.H. Irtiza Kazmi has three decades of experience in corporate and investment banking and financial advisory services.irtiza.kazmi@gmail.com