The Federal Board of Revenue (FBR) has estimated that approximately 25 percent of the companies in Pakistan are zombie firms involved in tax evasion due to persistently declaring losses.

An FBR report on “Zombie Firms in Pakistan and Tax Revenue Drag” explains the phenomenon of these firms.

In its report, the FBR has highlighted that a zombie firm is characterized as a loss-making firm that has lost the ability to generate enough profits to cover its interest payments. It survives only by repeatedly refinancing its loans. In the competitive market, zombies have to either exit or restructure. The rise of zombie congestion potentially crowds out growth opportunities for more productive firms, because banks have to keep financing them to keep them as active on their loan portfolios.

The report explains that this also has huge implications for the lost tax potential as well from two channels. The first one is direct, where the firms are not earning or doing business at their potential level hence, there is a direct tax loss. The second channel is the tax lost in terms of the opportunity cost, where the more productive firm is denied the right for financing because of financing compulsion towards these zombie firms. Hence, when these companies are unable to produce what they could have based on the availability of adequate financing, it will also create a potential loss of tax resources.

The FBR disclosed, “Rarely discussed, but the concentration of zombies is the real challenge for industrial growth in Pakistan as well. The misallocation of capital to these unprofitable firms indicates that credit reallocation is not always to the healthier, innovative, and more productive firms. Using balance sheets of the listed firms, we estimate the share of these unproductive firms in the marketplace. Our estimates suggest that approximately 25 percent of firms show up as the zombie firms in Pakistan. Furthermore, roughly 47 percent of these nonviable firms exist in textile, 19 percent in chemical, and 10 percent in the cement sector. The concentration of these firms is not limited to any particular sector. They exist both in the private and public sectors. Our estimates suggest, roughly US$3 billion short-term bank credit flows to these firms annually. In a resource scarce country such as Pakistan, it is reasonable to assume that the efficient allocation of this credit could improve performance of the industrial sector.”

The FBR has explained that the public sector enterprises appear as zombie firms as well, which again is a big challenge to banks because the public sector enterprises have faced high levels of debt or overcapacity on the back of government guarantees. These firms, reveals the report, have created a debt cycle, as they are often forced to borrow from banks to repay interest payments. The banks lend to them because they come with a government guarantee, and even keep lending with non-performing loans.

It has further been explained that the support to zombie firms to stay alive impairs market competition. In this situation, banks let these otherwise unprofitable firms distort competition in the economy. They depress market prices and increase congestion of less productive firms in the market. The zombie’s distortion also impacts the overall productivity of industry and job creation that more productive firms could generate. The survival of unproductive firms for an extended period may crowd out investment opportunities, employment generation, and overall productivity of the industry that more productive firms could generate.

The FBR said that the identification of the prevalence and role of zombie firms in the Pakistani economy is essential for a variety of reasons, including enhancing productivity, effective utilization of financial resources, and establishing a fair and competitive market environment. Similarly, this identification is also important from a number of angles carrying significant revenue implications. There is a direct loss of potential tax from the zombie firms as these firms prefer to be on the lifeline credit supply and hence, do not actively progress up to their potentials and hence, incur a loss of potential revenues.

Misuse of tax exemptions and tax holidays has remained a festering sore for the Pakistani economy. These exemptions and holidays are directed to achieving certain economic objectives like bringing more investment in particular sectors of the economy, providing relief to a segment of the economy hit by adverse circumstances, providing a fillip to economic activities in less developed areas, etc. Zombie firms eat up these incentives and prevent the intended benefit to reach the targeted segments of the economy.

Effective and meticulous revenue forecasting is essential, both for goal-oriented development planning and robust fiscal policy. Zombie firms, by distorting economic statistics, compromise efforts for accurate revenue forecasting

The loss of industrial productivity and overall job losses induce an indirect loss of potential taxes. It needs to be determined whether businesses use loss declaration as tax evasion stratagem, or they actually earn negative profits.

If the firms earn negative profits for a longer time but are continued to be financed by the banks, the risk barometer for FBR should start ringing alarm bells to investigate the possibility of the firm’s Ponzi relation with banks for tax evasion. However, this should not distract from the contribution of banks in hard times to support firms.

The role of regulators, therefore, is key to breaking this ongoing debt cycle (Ponzi game by firms facilitated by Banks). Devising effective regulatory measures to capture the non-viable firms in the marketplace, regulators can generate larger space for the more productive and small-medium enterprises (SMEs) to access credit. Priority in credit access to productive firms, as well as small-medium and innovative enterprises, would improve 41 the health of financial markets and may reap higher investment, employment, and revenue generation in the country.

The regulators may also include a crucial parameter for determining creditworthiness in the shape of a firm’s tax contribution, say, in the last five years. Firms with dismal revenue records may be kept on the low priority of credit extension. There is also a need for greater information integration between FBR and financial institutions for sharing credit financing details. This will help in sifting out zombie firms and encourage more productive firms to enhance economic activity, FBR’s report concludes.

Source: Pro Pakistani – November 9, 2021