Government Taxation Strategy: Impact on Banks and Private Sector Lending

Government Taxation Strategy-Banks find themselves in a new predicament as the federal government shifts its focus from combating inflation to imposing higher taxes on banks whose lending to the private sector falls below 50 percent of total deposits.

This move reflects the government’s desire for riskier investments and quicker returns, prompting concerns within the banking industry. A banker based in Islamabad cautioned that the government might resort to legal intervention to compel banks to comply with these targets.

The government’s initiative isn’t unfounded, given the rise in non-performing loans following the State Bank of Pakistan’s decision to raise its key interest rate to 22 percent last year. This resulted in a surge of defaults on loan repayments, amounting to Rs. 60 billion, which borrowers simply couldn’t afford.

There are warning signs regarding the effectiveness of this taxation strategy. Banks facing higher taxes for failing to meet lending targets may opt to return deposits rather than risk further tax liabilities.

The government’s rationale is to incentivize banks to extend credit to riskier clients rather than relying solely on low-risk government lending.

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However, this approach could have adverse effects, particularly on small and medium-sized enterprises (SMEs) struggling under high-interest rates in the current economic climate.

Economic analyst A H H Soomro expressed skepticism, stating, “While intended to spur lending, the impact of this measure remains uncertain. The risks associated with provisioning outweigh potential benefits from additional taxation. Instead, the government should focus on lowering interest rates, expanding the tax base, and promoting exports.”

The tax scheme, based on banks’ advance-to-deposit ratios (ADR), may yield unintended consequences. Banks with ADRs below 40 percent face a 16 percent tax on income from government debt securities, while those with ADRs between 40-50 percent will face a 10 percent tax. Banks exceeding a 50 percent ADR threshold will be exempt from this tax.

Reinstating this tax measure could prompt banks to limit high-value deposits to meet ADR requirements, thereby curbing private sector lending. Interestingly, a decrease in deposits in December 2023 led to higher private sector advances, ensuring compliance with ADR requirements and exempting banks from the tax for 2022.

Rather than targeting a sector already subjected to significant taxation, the government could explore alternatives such as reducing interest rates, expanding the tax base through agriculture and property sectors, boosting exports, and controlling inflation.