SMEs Need a Foundation, Not Just Tax Concession

Pakistan’s economic conversation keeps circling to two sectors Small and Medium Enterprises (SMEs) and Agriculture. The State Bank of Pakistan (SBP) captures both the promise and the limits of the current approach. The State Bank of Pakistan has suggested a 20 percent income tax rate, lower than the standard corporate rate on the incremental profits that banks earn from SME and Agri financing between the tax years 2027 and 2030. That idea is sensible and narrowly targeted. When I look at the deeper structural picture of Pakistan’s SME sector it shows how much heavier lifting remains undone and how to fix it.

SME finance has grown to Rs. 1.15 trillion, serving than 324,000 borrowers. Agricultural finance has reached Rs. 1.2 trillion, covering three million borrowers. The government has set a target of Rs. 2 trillion in financing for each sector within two years. To reach that target the SBP wants to make the deal more attractive for banks by taxing the profits on lending to SME and agricultural sectors at a lower rate than for the rest of their business as was tried for tax years 2020 to 2023 and is now proposed for this tax year.

I think this is a lever to pull. Banks in Pakistan have long preferred the safety of government paper and large corporate clients over the work of underwriting small borrowers. A lower effective tax rate on lending directly improves the business case, for expanding into SME and agricultural credit. If this measure works more capital flows to sectors that account for 40 percent of GDP and nearly 80 percent of non‑agricultural employment. However, financing supply is one half of the equation—and perhaps not the half where Pakistan’s SME problem truly lies.

Closer examination of the sector structure reveals a sobering truth. SMEs are mainly found in low‑productivity retail trade rather than in manufacturing or export‑oriented activity in Pakistan. Even though SMEs dominate employment SMEs share of GDP and exports has not grown in line, with SMEs numbers. In contrast China, Japan or South Korea have SMEs that drive economic activity; SME businesses are more productive are part of global value chains and are supported by well‑designed institutions. In words Pakistan’s problem is not the size of its SME sector. It is the SME sectors efficiency, formalization and productivity.

This is where financing conversation hits a wall. Giving credit to a sector that stays largely informal, undocumented and stuck in low‑value work may simply give more money to the same old pattern, instead of change. Pakistan already offers a generous set of tax rules for SME. Section 28 of the Income Tax Ordinance backs SME Bank lending arrangements; the Seventh Schedule allows banks deductible provisioning for SME advances; and the Fourteenth Schedule sets up a truly simplified regime, with rates as low as 0.25 percent of turnover for the smallest firms. On paper this appears as a many‑angled incentive plan.

In reality these rules have had effect because enforcement is weak incentives for proper documentation are lacking and audit pressure is low which sometimes lets firms hide more income. But the deeper issue is structural: Pakistan still has no unified definition of what a SME is, with the State Bank, SMEDA and the Punjab Small Industries Corporation each using different thresholds. This split is not a bureaucratic note. It erodes data trust makes targeting policy and truly keeps us from knowing if any specific help is working.

But there is a regional dimension that can’t be solved with a financing-only solution. The SME activity is strongly skewed towards Punjab and Sindh with the provinces of Khyber Pakhtunkhwa and Balochistan remaining far behind in terms of SME development, reflecting and reinforcing overall infrastructure and market access differences across the country. An incentive to banks that would increase the attractiveness of SME lending won’t necessarily address imbalance if the business environment where banks wish to provide loans is as challenging as that in less-developed areas.

Policymakers should be honest about what a measure like this can and can’t achieve. It can have a slight push on the supply of credit. Neither government nor the private sector can alleviate the demand-side and structural constraints that have kept Pakistan’s SMEs small, informal and low value: inconsistent definitions, inadequate coordination between SMEDA and PSIC and between the government and the FBR; and a business environment still burdened by cumbersome taxation, slow contract enforcement, and archaic land registration processes.

If Rs. 2 trillion in financing per sector is a target, but it must be accompanied by an on-going effort towards formalization: One window system for registering, filing tax and accessing credit facilities; a definition of SME that is uniform across all government departments; and a deliberate drive to push companies away from low-margin retail and wholesale trading and into manufacturing and export-driven business, such as through SEZs and CPEC-facilitated industrial opportunities.

A tax break on profits of banks is a useful tool. It cannot be considered as SME policy in itself. Incentive-only policies were previously attempted in Pakistan under the Fourteenth Schedule and elsewhere but again the results were less than expected because there was no institutionalization of the policy (documentation, coordination, enforcement), which is essential to ensure that access to capital translates into actual productivity. So, unless there is a change in this, we may see a repeat of the following progress report, with more borrowers and larger sized loan books, but a similar frustrating outcome an SME sector that continues to grow in numbers but not in economic impact upon the economy.

“I am from Loralai, Balochistan, and have completed an MPhil in Economics from PIDE. I am working at the Tax Policy Office, Ministry of Finance. The views expressed are solely my own and do not necessarily represent the views of my office.”