Stop penalising productivity

The catastrophic floods that devastated lives, livelihoods, and infrastructure, exacerbated the external vulnerability challenge Pakistan faces. This challenge captures the attention from civil society and media, and the time of policymakers. Underlying this recurrent, short-term issue is a deeper, long-term one: a way of growing, based on consumption rather than on productivity growth, that is not sustainable, and that becomes so painfully apparent when global conditions get tough, and credit dries up.

At the beginning of this decade, the average Pakistani worker added 40% more value than his fellow thirty years prior. During the same period, the value added by the average Vietnamese worker increased by 330%. Put differently, her productivity grew 8 times faster than that of the average Pakistani. And this matters because productivity-based growth is the sustainable way to more and better paying jobs.

In a new report, ‘From Swimming in Sand to High and Sustainable Growth’, we argue that Pakistan’s low productivity growth is related to the inability to allocate its talent and resources to the most productive uses. Behind that, lie distortions, introduced or unaddressed by policies: distortive tax policies, subsidies, size dependent industrial policies, trade restrictions or gender norms, to name a few. These act as powerful incentives for firms and households to allocate resources in a way that is not socially optimal and that discourages productivity growth.

The thing is: distortions act as penalties on productivity growth.

Take one distortion: sectoral differences in income tax. As income from investment in real estate in Pakistan has historically faced lower tax rates, more capital was allocated into that sector, and less in manufacturing or in efficiency-enhancing services sectors. This reduced the size of the tradable sector, which is associated with productivity growth. It is time to increase property taxation instead.

Take another: differences in indirect taxes depending on from where a product comes from (‘import duties’). Within the tradable sector, high levels of protection to domestic industries, in the form of high import duties, introduce another distortion. High protection makes it more profitable for firms to sell domestically rather than to export. Evidence shows that a 10% import duty on a given product, increases profits of selling domestically relative to exporting by 40% on average in Pakistan. And because firms learn by exporting, this anti-export bias of policy penalises productivity.

Firms that, despite these distortions, choose to export nonetheless, face yet another distortion: export subsidies that are different across products.

If exporters want to innovate, they will miss out on export subsidies. It is 80% more likely for a potential exporter to be eligible for an export subsidy in Pakistan if she goes into traditional products like towels or bed sheets, than if she innovates, and diversifies into something new. Export subsidies in Pakistan prize traditional sectors big time. They boost profits by 30 to 35%. (A similar distortion is faced by farmers trying to diversify into high value crops. If they do, they miss out on support prices and subsidies offered to traditional crops). Because innovation is key to productivity, this anti-innovation bias of export subsidies acts as (yet another) penalty on productivity upgrading. It is time to make export incentives work for diversification and innovation.

Differences in regulations and their enforcement, depending on how big a company is, frequent in Pakistan, also act as a distortion. They reward staying small (de jure or de facto), and explain why firms struggle to grow large as they grow old: a young firm in Pakistan, in operation for 10 years is about the same size as one that has been in operation for more than 40 years. They also explain why the average Pakistani exporter ships annually less than half the value that the average Bangladeshi exporter does. The ‘up or out’ dynamic (either you grow, or you exit) found in well-functioning markets is missing. And because productivity grows with size, incentives for firms to stay small penalise productivity. It is time to stop regulations that discourage firms’ growth.

Distortions also affect how talent is allocated. Females in Pakistan have made strides in educational attainment, but their human capital is underused because they choose not to participate in the labour market. And those that would like to participate, face a coordination problem. Take manufacturing, where the share of female employment is at a low 4%. It may not pay off for firms to invest in dedicated spaces, restrooms, or transport, unless female employment reaches a certain level. But females might not be willing to work factories without dedicated spaces, creating a vicious circle, and talent waste. A further penalty on productivity.

The way forward

A complex insider-outsider dynamic makes reforms difficult in Pakistan. Distortions benefit insiders, a few, powerful and entrenched interests, at the expense of outsiders, innovation, small firms, new entrepreneurs. They all work against sustained, productivity-based growth. Eliminating these distortions requires a sequenced approach with strong political and civil society support. This is what this report is about.

First, remove distortions to stop penalising productivity. Widen the tax net to level the playing field, reduce the anti-export and anti-innovation biases of trade and subsidy policies (for exporters and farmers) and introduce innovative ways of promoting female employment.

Second, reducing distortions will be most impactful when accompanied by policies that enable new activities to emerge. For example, advance fiscal reforms so that private investment is crowded in as fiscal deficits are reduced. This requires efficient spending, reallocation of credit subsidies to boost investment and innovation, instead of public consumption. It also requires harmonising investment laws to tap into Pakistan’s FDI potential, and re-orienting expenditures that provide unconditional export subsidies into smart interventions to help firms gain efficiency.

Third, subject all publicly funded interventions to impact evaluations, creating a virtuous loop from evidence to policy. Cost expenditures, strengthen feasibility analyses in the PSDP process, and mandate impact evaluations of large public-funded projects. And all along, maintain strong links between public sector, academia, and the civil society.

The time to act is now.

Published in The Express Tribune, February 10^th, 2023.

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