Illegal trade: short-term gains, long-term economic decline

Instead of asking IMF for $6b, govt must aim to plug tax loss hole of Rs1.5-2tr

ISLAMABAD:

When Pakistan’s government imposed restrictions on imports to reduce the country’s trade deficit in 2022, it did not deter the inflow of goods – it encouraged substitutes and possibly smuggling, which is growing at 18% annually.

In particular, the large-scale manufacturing firms and multinational companies were negatively impacted, whereas small-scale firms and commercial importers managed to find alternative routes, often without the knowledge of the government, and at times in connivance with some elements within the state.

Taking account of the impact, Prime Minister Shehbaz Sharif had to recently declare that “illegal trade and smuggling have caused huge losses to the country”.

I present an informed guess to quantify this loss here. First, I qualify that for this article, illicit trade comprises legitimate goods, being produced, sold, and consumed through illegal means including non-documentation and tax evasion.

The illicit trade can be classified into: counterfeit, tax evasion, smuggling, and under-invoicing/misdeclaration.

According to some sources, smuggling through the Afghan Transit Trade (ATT) alone may be responsible for causing at least Rs1,000 billion loss to the national exchequer in terms of foregone import-related tax revenue.

Looking at another dimension of the illegal trade, the government is losing approximately Rs300 billion every year in tobacco taxes, which is rising. If we add another Rs270 billion estimated to be lost due to Iranian oil smuggling into Pakistan, the overall loss is at least Rs1.5 trillion.

These are only estimated numbers and as the nature of illegal trade would dictate, it is impossible to find a reliable number.

Using another source, the Pakistan Business Council estimates the size of grey and shadow economy to the tune of $68 billion. If the tax is assumed to be 10%, this would translate into tax losses of almost Rs1.9 trillion.

Therefore, it is safe to assume that the overall loss to the national exchequer caused by illegal trade, smuggling and tax evasion can be between Rs1.5 trillion and Rs2 trillion, which would be 21% of the current tax target.

This is more than 100% of the total targeted collection of federal excise duty and customs duty, as announced in the budget for 2023-24. This is coincidentally almost equal to the new loan being negotiated with the IMF.

These estimates do not include under-invoicing or misdeclaration as well as losses due to counterfeit products. These also do not include implications for business environment, and in particular, incentives for international investors, who look for a level playing field when it comes to tax policy and its practice.

Clearly, in a country where the government is seemingly focused on extracting taxes only from large-scale and corporate businesses, it provides wrong signals to existing investors, who essentially sends similar messages to future investors.

One should not be surprised that foreign direct investment (FDI) rates in Pakistan have remained abysmally low over the last few years.

According to the Transnational Alliance on Combating Illicit Trade (TRACIT), Pakistan is ranked 72nd out of 84 countries on the “Global Illicit Trade Environment Index”, which is published by the Economist Intelligence Unit. Its parameters are government policy, supply and demand, transparency and trade, and customs environment.

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Illegal trade may provide short-term benefits to the economy in terms of cheaper alternatives, but in the long run, it deprives the country of productive investment, innovation, and competitiveness. In some cases, such as spurious medicines or pesticides, this also implies direct threats to public health.

Prime Minister Shehbaz Sharif’s government is rightly concerned about damages being caused by illegal trade activities and tax evasion. The strategy is multi-dimensional: tax compliance, improving enforcement, evaluation of track and trace mechanism and digitalisation of FBR.

It is not the first time that the government has launched such drives. A tax compliance initiative, known as “Tajir Dost Scheme” launched without due homework, is already failing.

It was able to bring only around 200 enterprises on the tax register, out of, well over, three million enterprises. The prime minister has already expressed his dismay over the track and trace system, which was implemented in four sectors in 2020.

Industry sources claim that counterfeit stamps are being produced in tobacco and sugar sectors. This system has met with similar failures in many other countries.

We have borrowed hundreds of millions of dollars for digitalisation of FBR in the last few years, and have found, to the national embarrassment, that FBR was using fake software!

While I hope that recent measures will bear fruit, one should remain wary of over-reliance on technology where policy design is faulty.

As Pakistan remains one of the most protected economies of the world, unless we minimise barriers (as demonstrated in taxes, tariffs, and regulations) to legal trade, the government has no chance of generating enough growth to raise required tax revenues and is set on a clear path towards bankruptcy.

The prime minister has a stark choice: instead of asking the IMF to provide another $6 billion (or Rs1,674 billion) to be disbursed over three years, he can take a different route and aim to plug the hole of tax losses estimated at Rs1.5-2 trillion over the same time period.

The writer is founder and executive director of the Policy Research Institute of Market Economy (PRIME), an independent economic policy think tank based in Islamabad

Published in The Express Tribune, May 13^th, 2024.

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