Cascading effect of GST affects competitiveness of Pakistani exporters (IMF)
ISLAMABAD: The competitiveness of Pakistani exporters is affected due to the cascading effect of the General Sales Tax (GST), according to the International Monetary Fund (IMF).
The IMF, in its latest report on Pakistan, noted that in the final stage, the factory produces a dress for export, and even if the export is zero-rated, the exporter will have to charge a higher price compared to the fully harmonized system.
Not all taxes are removed from exports and additional costs are incurred in each segment of the production value chain, putting them at a disadvantage in the international market.
The current GST system, with its cascading effect, undermines competitiveness and the ease of doing business, steers production towards simple manufacturing, and discriminates against exporters and import-competing industries.
The IMF cited an example where the cotton ginning company purchases Rs 1,000 of raw materials for the production of cotton lint and with a GST rate of 10% pays full sales tax on the goods of 100 rupees. In addition to the raw material purchased, it uses certain services for Rs 500, such as transport, advice, marketing.
Assuming the same tax rate of 10% on services, he pays an additional 50 rupees in taxes. The input tax paid is therefore: Rs 100 (to the federal government) + Rs 50 (to a province) = Rs 150. The total input cost is (1000+500+100+50) = 1650.
The company then adds a value of Rs 100 and sells the cotton fiber 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 the input tax on services (Rs 50) originally paid, and the sale price will defer this segment of the tax.
“Textile exports may exceed $20 billion this year”
The sale price will therefore be: total cost of inputs (1650) + value added (100) – input tax which 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 business will collect an outbound tax of Rs 165 and remit it to the Federal Board of Revenue (FBR), but will only be refunded for the upstream portion of the tax.
The net tax paid by the cotton ginning company will be 165–100=65, instead of 160–100–50=10 in a fully harmonized GST system.
In other words, the effective tax rate will be 65% (tax paid/value added), which deviates considerably from the nominal tax rate of 10%.
In the next stage, the textile manufacturer, in addition to the cotton fiber purchased for Rs 1650 (on which the sales tax Rs 165), uses some input services of Rs 800 and produces finished fabrics.
Similar to the previous step, the textile manufacturer pays input taxes of Rs 245 = Rs 165 (on goods) + Rs 80 (on services), adds a value of Rs 200 and sells the fabrics to a factory clothing for Rs 2,730 = 2308 + 10% GST (230.8).
If only input tax on goods is reclaimed, the net tax paid by the textile manufacturer will be Rs 108, while under fully harmonized GST the producer will pay only Rs 20.
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 throughout the value chain means that federal and provincial tax authorities interact multiple times in every transaction.
For example, a good sold (sales tax paid federally) may have service input taxes from multiple provinces that must be credited, as well as sales tax paid on the purchase of any goods inputs.
The current system makes this accounting incomplete.
It has also led to conflicts over the definition of the tax base and coverage, causing problems of double taxation for businesses, with certain activities being claimed jointly by the federal authority and the provinces.
The fragmented GST system as it currently stands has a cascading effect since there is no systemic mechanism to ensure that all tax paid on inputs can be deducted from a final sale ( output tax).
This leads to a cumulative taxation of intermediate inputs of production and distorts the prices that producers face when buying from and selling to each other.
It therefore causes a significant divergence of nominal and effective tax rates in the price of final goods.
Under the current system, it is more difficult to generate comprehensive information on all aspects of the value chain, which is essential to eventually remove all taxes on exports.
As a result, Pakistani exports are subject to an unrecovered tax on their inputs and exporters’ prices are consistently higher than those of exporters in countries without the cascading effect of the GST system.
This also contributes to a heavy reliance of tax revenues on the manufacturing industry, which is the main export sector of the economy.
The manufacturing sector, which accounts for only 14% of GDP, accounts for 58% of total tax revenue.
The cascading GST system hampers the development of sophisticated manufacturing and accentuates incentives for low value-added manufacturing, partly due to low competitiveness and to limit the tax burden.
As it becomes difficult to know what the effective rates on inputs and outputs will be, relative prices along the value chain are skewed, encouraging inefficient production choices (e.g. switching from quality inputs superior to inferior inputs).
The higher cost of intermediate goods or services due to the GST makes it more expensive to incorporate advanced technologies into production and thus affects productivity and competitiveness, discouraging integration into global value chains (GVCs).
The end result is that import-competing sectors are disadvantaged by imported end products.
Export-oriented industries are also heavily focused on low value-added products, requiring few manufacturing steps.
For example, textile exports (60% of total exports) are mainly composed of simple knitwear, bedding, cotton fabrics and ready-made garments, while food exports (20% of total exports) are mainly consisting of rice and fish.
These low value-added and unbranded products mean that Pakistani exporters operate in the most competitive segments of international markets and with limited profitability, the IMF added.
Copyright Business Recorder, 2022