Pakistan is stuck in a cycle of repeated external crises owing to distortions such as under-taxed real estate, import duties at every stage, and support prices for crops.
The World Bank (WB) in its report “Pakistan’s Country Economic Memorandum” explains that the country’s growth challenge is linked to how resources and talent are allocated, and distortions through the misallocation of resources are significantly stalling growth.
The report is a four-part representation of how trade bottlenecks, tax policies, and gender norms impact growth.
Real Estate and Taxes
Firstly, the real estate sector is heavily under-taxed, which leads to productive resources being diverted toward a non-tradable sector. Distortions in the form of differences in direct tax rates tend to make it more profitable to invest in real estate relative to manufacturing or tradable services. This results in productive resources stuck in the land, under-taxed gains, and a rise in imports, and as a result of these factors, the productive capacity of the economy declines.
And because the size of the tradable sector tends to be associated with growth, this reduces growth potential. Within tradables, high import duties make it more profitable for firms to sell domestically rather than export.
Imports
Secondly, within the tradable sector, cascading import duties are also crucial distortions affecting resource allocation. For example, a bicycle manufacturer in Pakistan can import pedals, wheels, saddles, brakes, or frames paying a 26 percent import duty, while at the same time it is protected by a 51 percent import duty that applies on completely built imported bicycles.
While cascading tariffs—a distinctive feature of Pakistan’s tariff policy —intend to help industrialize and substitute imports, they end up substituting exports instead. This generates yet another distortion, with consequences on the external vulnerability (imports of parts and components but no exports, exacerbating the trade deficit) and the productivity (less exposure to competitive export markets) fronts. The result is fewer and relatively smaller, less productive, and domestic-oriented firms, instead of more, larger, dynamic, and outward-oriented ones.
Gender
Thirdly, gender norms can also act as distortions, with important consequences on the allocation of talent. For example, if gender norms limit the ability of females to actively participate in the labor market, then the pool from which firms can recruit for productive undertakings is restricted. When the restriction applies to half of the population with growing levels of formal education, then these norms have important consequences for allocative efficiency.
The fourth and final roadblock highlights how distortions affect the way land and capital are allocated. In agriculture, for example, subsidies and support prices for specific crops coupled with additional subsidies on key inputs (e.g., water) induce farmers to allocate land to sugarcane rather than diversifying into other crops that would fetch better prices internationally, or that embed less water.
Limited Diversification in Agriculture
Over time, regressive input subsidies and support price regimes have incentivized the use of underpriced water, affecting future generations, prevented diversification toward higher-value crops, distorted public resources away from investments in support of technological change (R&D, extension), and benefited the land-owning elite. The report says these elites have resisted the implementation of reforms to liberalize agricultural markets, reform water pricing, and increase the agricultural taxations that they benefit disproportionately from in the status quo.
Remove Distortions by Focusing on Key Determinants
The report recommends the removal of the above-mentioned distortions by focusing on:
- Tax policy: Widen the tax net, harmonizing tax rates across sectors, to ensure a level-playing field and facilitate the reallocation of resources from non-productive non-tradable (e.g. real estate) and into more productive sectors (tradable or efficiency-enhancing nontradable).
- Trade policy: Gradually reduce the anti-export bias of trade policy by reducing import duties, to facilitate the reallocation of resources, from domestic to outward-oriented activities.
- Export schemes: Expand eligibility of export subsidies to favor export growth and diversification.
- Size-dependent policies: Re-consider size-dependent industrial policies, to reduce incentives for firms to stay small de jure or de facto.
- Agriculture subsidies: Gradually phase out subsidies and price support in the agriculture sector, to facilitate a market-based allocation of land, labor, and equipment based on comparative advantage, and re-allocate the created fiscal space toward investment in climate-smart technologies and infrastructure for crops and livestock, and agriculture extension services and research.
- Working conditions for women: Enact gender-unbiased hiring policies, enforce existing legislation on workplace harassment, and consider wage subsidies to boost female employment at intermediate skills levels, to improve the allocation of talent in Pakistan.
- Female Transport: Invest in safe, dedicated transport and improved soft connectivity to facilitate remote work, to boost female labor force participation and productivity more generally.
Way Forward
To ensure the maximum positive impact of the alleviation of distortions, consider enhancing fiscal space, reallocating subsidized financing to innovation-focused financing, reducing regulatory complexity, harmonizing investment laws, and upgrading insolvency laws, amongst other things.
Moreover, subject all interventions that require public funds to rigorous evaluations by determining the cost of expenditures, the feasibility analysis of the PSDP process, impact evaluations in large PSDP projects, and involving academia to invest in such evaluation studies.
