VAT's hidden 'working capital' tax

State takes money from producer who, in turn, is forced to borrow to meet costs

LAHORE:

Sales tax is supposed to be borne by the final consumer. Pakistan makes importers, manufacturers, exporters and service providers finance it before consumption. A levy presented as value-added tax has become a hidden tax on working capital in Pakistan.

The distinction is fundamental. VAT is not tax on every receipt. A registered person charges output tax on sales, deducts tax paid on business inputs and deposits only the balance. The invoice-credit chain ensures that each participant accounts for tax attributable to its value addition. Break the credit, and the tax no longer follows value added. It enters cost.

Start with an importer. Sales tax is paid at the customs stage before imported inventory is sold. The amount remains tied up while goods are cleared, stored, transported and marketed. Credit becomes usable only when the importer generates output tax or qualifies for refund. During that interval, the importer finances the treasury, often through borrowing. The financing cost is not recoverable as input tax; it is added to the price.

A manufacturer faces the same burden repeatedly. Tax is paid on raw materials, packing, machinery, energy and services before finished goods produce revenue. Section 7 of the Sales Tax Act, 1990 recognises input deduction, but Sections 8 and 8B impose exclusions and limits. The law even restricts ordinary adjustment to 90% of output tax, subject to exceptions and later relief. What is carried forward on a return remains cash removed from the business.

For a zero-rated exporter, refund is not a reward. It completes the VAT mechanism. The exporter charges no output tax to the foreign buyer but has already paid tax on inputs. If that amount is not returned promptly, domestic tax is exported in the price and Pakistan's competitiveness is weakened by its own tax administration.

The federal statute understands this principle. Section 10 says excess input tax arising from exports or zero-rated supplies is to be refunded within 45 days. Section 67 provides compensation at Karachi Interbank Offered Rate (Kibor) where a due refund is delayed. These provisions acknowledge that money has a time value. Their very existence demolishes the official habit of treating refund as a favour to be released when revenue targets permit. A delayed refund is an interest-bearing liability in law and an involuntary loan in economics.

The state takes money from a producer, uses it to improve current collection and leaves the producer to borrow for wages, electricity and the next production cycle. Headline revenue may look stronger precisely because a private liability has not been discharged. Service providers suffer a less visible version of the same problem. Their outputs are generally taxed by provincial authorities, while computers, vehicles, office equipment and goods bear federal sales tax.

Manufacturers, conversely, incur provincial sales tax on transport, banking, insurance, advertising, information technology and services used to make federally taxable goods. A modern enterprise cannot divide its inputs along constitutional lines. The tax system does. The Sales tax Act, 1990 includes specified provincial sales tax within the definition of input tax, but allows exclusions, conditions, restrictions and limitations. Section 8 also denies federal credit where adjustment is barred under the relevant provincial law.

Provincial statutes and schedules have their own exclusions, reduced rates without credit and documentation requirements. Cross-credit is therefore conditional rather than seamless. A genuine business input can be recognised in one jurisdiction and stranded in another. The result is cascading. Suppose a provincial service provider buys equipment for Rs100 and pays Rs18 federal tax. If that Rs18 cannot be credited against provincial output tax, it becomes part of the service's cost. The provider adds a margin and charges provincial tax on a price already containing federal tax. The customer pays tax on tax. This is the evil VAT was designed to eliminate.

Withholding deepens the distortion. When a customer deducts sales tax from the gross invoice before the supplier's net output-input position is determined, cash leaves first and credit follows later, if allowed at all. The supplier's return becomes a claim for adjustment or refund rather than an account of tax on value addition. Collection by deduction replaces taxation by design.

The output-input adjustment is not an accounting concession. Our superior courts have described it as the essence of VAT. Administrative restrictions that routinely deny, defer or fragment credit do more than inconvenience taxpayers. They change the character of the levy.

The damage extends beyond balance sheets. Trapped tax favours cash-rich conglomerates over smaller formal businesses; raises inventory and financing costs; discourages documentation; penalises exporters; and feeds inflation through higher prices.

An undocumented competitor avoids the chain altogether. The compliant enterprise is punished for possessing invoices that should have protected it. Reform must begin with cashflow neutrality. Admissible credit should move across federal and provincial boundaries through a common clearing mechanism. Export refunds should be automated, time-bound and paid with statutory compensation, where delayed. No-credit and fixed-rate regimes should be exceptional and temporary.

Withholding should target demonstrated fraud risks, not every convenient payment channel. Authorities must publish the stock, age and sectoral composition of pending refunds and carried-forward credits. The governing test is simple: does a legitimate business input receive timely and complete credit? If the answer is no, the state is not merely collecting consumption tax. It is borrowing from production, taxing the borrowed amount again and calling the result VAT. The next reform debate must begin from this economic truth.

The writer is the Advocate Supreme Court, adjunct faculty at Lahore University of Management Sciences (LUMS), member advisory board and visiting senior fellow of PIDE