PolicyReport.pdf

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SIMPLIFICATION AND PROMOTION OF LAWS AND PROCEDURES

FOR CORPORATIZATION OF SMALL AND MEDIUM ENTERPRISES

(SMEs)

A Study Conducted for the Ministry of Industries and Production, Government of Pakistan

and Securities and Exchange Commission (SEC) of Pakistan

Fiscal and Non-Fiscal Barriers to SME Growth, CRO and SECP Services and the Relevant

Policy Framework

Faisal Bari

Osama Siddique


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Acknowledgements:

We would like to thank all 80 plus entrepreneurs who gave us some of their very valuable time,and shared some great stories with us. We would also like to thank the CRO officers whom weinterviewed, and Mr. Shahim Shahid ofThe Nation in Peshawar, and Mr. Shahzada Zulfiqar ofThe

Nation in Quetta, for help with the interview process. We would like to thank Ali Rahim forassistance with interviews. We would also like to thank Ms. Jaweria Ather, Director, Ms. SarahParvez, Assistant Director, and Ms. Khalida Habib, of the SECP, for very helpful comments ontwo earlier drafts. A special thanks to Adeel Faheem who helped with the interview process,managed the data set, and helped with data compilation and analysis. The usual disclaimers aboutthe responsibility of authors apply.


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SIMPLIFICATION AND PROMOTION OF LAWS AND PROCEDURES FORCORPORATIZATION OF SMALL & MEDIUM ENTERPRISES

A Study conducted for the Ministry of Industries and Production, Government of Pakistan andSecurities & Exchange Commission of Pakistan

Review of the Fiscal and Non-Fiscal Barriers, and Regulatory Framework for Corporatization ofSMEs.

Table of Contents

CHAPTER I: Executive Summary

CHAPTER II: Fiscal and Non-Fiscal Barriers and Regulatory Framework for SMEs

CHAPTER III: SECP and CROs Functioning and Services

CHAPTER IV: Policy Framework and Recommendations for SMEs

CHAPTER V: Action Items

ANNEXURE A: List of People visited at CROs of Lahore and Islamabad

REFERENCES


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Chapter I. Executive Summary

The current government has, a number of times, expressed that the growth and promotion of SMEsis an important policy objective of the government. The government rightly holds that SMEsgrowth can lead to substantial increases in output and income of the country and can generate

significant employment creation, given their higher labour-intensity. SMEs can also allow Pakistanto diversify its export base and help introduce new technology in some areas. SME clusters caneven lead to significant gains in exports. Given these objectives, removal of impediments togrowth should be an important policy objective for the government. The SECP objective, to inducefirms to enter the formal sector and to become incorporated, gels nicely with the larger governmentobjective.

The constraints mentioned in the study below stultify the growth of large-scale firms too, and thedistortions introduced by them also lead to non-optimal decisions by large firms, but the impact ofthese constraints is more binding for the SMEs. SMEs have smaller capital bases, lower capitalintensity, fewer market or political connections, and more dependence on state or market provided

infrastructure and other services. To take one example, gas or electricity disruptions and load-sheddings hurt SMEs more as whereas the large firms can buy generators and cylinders from themarket, SMEs might not have the resources to be able to do so. Even if resources are there, SMEsmight not have the size to justify back-up power capacity. To take another example, rent-seekinghas a fixed element to it in the sense that side-payments to officials do not go up with sales at afixed percentage, and there seems to be a lower limit on the size of payments as well. Any givenlower limit would obviously be more onerous for the smaller firms than for the larger firms. Thesame is true of other impediments too.

This makes a case for SME-specific regulations, or at least for ensuring that rules and regulationsdo not discriminate against the SMEs. Couple the above with the government objective ofencouraging SMEs, for employment and income generation reasons, and the case for a coherentpolicy framework for SMEs -- one that allows SMEs to grow at a rapid pace -- becomes very clear.

This part of the study has looked at two issues in detail. In chapter two we study the major fiscaland non-fiscal barriers to growth and incorporation faced by SMEs. In the next chapter, we take adetailed look at the functioning of the CROs and the SECP, with reference to the services providedfor facilitating the incorporation process, and suggest some ways in which the functioning can bestreamlined even further.

SMEs face significant barriers to their growth, and a significant number of these barriers have todo with the way the tax and regulatory authorities of the government, as well as the utilityproviders function. To be specific, probably the single most important irritant identified bybusinesses is the CBR. Businesses mention that tax rates are too high, especially for income andsales tax; they complain of harassment; of the need to make side-payments, and of the significantburden that the paperwork requirements of the CBR impose on them. The federal government hasmore than a few reports on these issues, most notably the Shahid Hussain report on tax reform, andCBR reform has been on the government agenda for a long time, but our surveys reveal that notmuch has been accomplished on that count as yet.


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There are some complaints against provincial and local taxes as well, but these pale in comparisonto the complaints against the CBR.

Utility providers, especially WAPDA, cause major headaches as well. Electricity rates in Pakistan,for commercial and industrial use, are more than those in the region, and the quality of service is

also low. For industries where electricity forms a significant input, this acts as the major constraint.Gas and telephone provision is a problem too, in some areas, but again, the complaints are mostlyagainst WAPDA.

Infrastructure provision is another major constraint. The quality of roads, the cost of transport, theefficiency of ports and airports all impose significant costs on Pakistani businesses. For the smallerprovinces these problems are much more severe (Peshawar and Quetta).

With almost all government departments there is a side-payment burden involved as well. Sincethere are clear threshold effects present as well, some of the burden is more for the smaller firmsthan the larger ones. Most of these expenses are, of course, non-productive, and negotiating them

takes up significant management time as well.

Where there are significant externalities too, like in R&D and technical training, lack ofgovernment-business partnerships are leading to non-optimal investments in these areas.Businesses do not find trained employees, and there are few incentives to get trained, as the marketdoes not pay enough for training.

Though interest rate reductions and macro stability has made macro uncertainty less and hasimproved SMEs access of finance, there are still significant institutional issues there that need tobe addressed on a permanent basis.

As a generalization, it seems that a lot of SME problems stem from lack of access to a judicialsystem that is reasonably priced, fair and quick to respond. The lack of entrenchment of propertyrights makes it difficult to both go in for long term contracting under market structures and take ongovernment departments under bureaucratic ones.

From the discussion of constraints, we cull a list of actions that SECP can focus on immediatelyand refer them to the relevant departments for their consideration. These steps, if initiated, can go along way in addressing some of the constraints mentioned above.

In the second chapter we look at CRO functioning as well. We find that recent changes in both lawas well as administrative practice has made CRO functioning quite improved. The major problemsfor SMEs are the ones given in the first chapter and CROs are not acting as a major barrier toincorporation. Though we do suggest some changes, like a marketing strategy, introduction offacilitation officers, and longer hours, but these are only to make a fairly good system even better.

To concretize the matter even further, we even did a case study in which we followed a clientthrough the incorporation process. We identify all the problems that they faced, and suggestchanges that SECP can institute in the CROs to address some of these concerns. But the mainconclusion, that these are irritants and not major barriers to incorporation, remain.


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We do find that despite the introduction of Single Member Companies (SMCs) there are someissues that still need to be addressed. These have to do with allowing for more flexible partnershiparrangements, and for recognizing the reluctance of businesses, working in the environment givenin chapter 1, from ceding control, revealing information and introducing more transparency and

tractability.

In many ways the two chapters make it clear that the SECPs objective of increasing incorporationrate, with the aim of documenting various sectors, bringing enterprises in to the formal frameworkand net, and introducing them to some documentation discipline - a worthy aim - is fundamentallytied with firm growth. Of course, this in no way suggests that CRO functioning and gains inefficiency therein are not important or that marketing strategies should not be made orimplemented. But it does imply that even with efficient CRO functioning and SECP rules andregulations for incorporation, businesses might not incorporate if other factors, identified anddiscussed above, make incorporation too expensive or undesirable in any way.

A significant number of these other factors and constraints have nothing to do with the SECP.But they are constraints to firm growth and in many cases are binding constraints. So, they doaffect the SECP aim for increasing the incorporation rate. SECP then can play a leading role inidentifying these constraints, on behalf of the various businesses, for the various ministries anddepartments to address. It can also, through its research wing in Islamabad, suggest viable policyoptions and changes and can also monitor the progress on addressing the impediments. To anextent, unless SECP gets involved in this sort of leadership role, onetime studies that identifyconstraints will not be enough to bring out the changes that SECP hopes to make.


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Chapter II. Fiscal and Non-Fiscal Barriers and Regulatory Framework For SMEs

1. IntroductionIn this study we will identify the fiscal and non-fiscal constraints that small and mediumenterprises (SMEs) face in conducting their business and, especially, in expanding their business.The basic premise of the study is that by holding back firm growth these constraints slow down thegrowth rate of the economy, the rate at which new jobs are created, the opportunities that growingbusinesses can provide for people to enhance their incomes, and also slow down the rate at whichfirms enter the formal sector, corporatize, and the rate at which the economy can becomedocumented. The importance of higher growth, job formation, and creation of income-generatingopportunities is obvious, but the importance of the second set of objectives is also well established.If the first set of objectives is to be achieved on a sustainable basis, the second set of objectives, ofthe firms entering the formal sector, has to be taken as important as well. But it should be borne inmind that the second set of objectives is important because it facilitates the achievement of the first

set. In other words, formalization and documentation are important objectives as they facilitategrowth and development.

Once the constraints have been identified, we will not only discuss them in detail to understandhow they actually get operationalized and entrenched in the system, and how they discourageincorporation, we will also discuss linkages between the various sets of constraints. Finally, fromthe discussion, we will derive a set of recommendations to address these constraints. Given thenature of the study, these recommendations will point out the important areas for policy reform butwill not provide sector-specific measures.

In section 2 we describe some of the constraints identified by other researchers, while in section 3we describe the data sets we will be using for our work, and the methodology that was used incollecting the data sets. Section 4 will give details on these constrains. In section 5 we will discussthese constraints, including their connections with each other. Recommendations, culled from thisand later discussions, will be detailed in chapter 4.

2. Literature Review1The Pakistani literature2 identifies the state-led models of industrialization followed during thesixties, seventies, and the eighties as a major factor constraining the growth of SMEs. It is arguedthat industrialization was promoted in ways that discriminated against SMEs.

First, trade was regulated in a way that discriminated against small-firms. Large firms were betterable to obtain import licenses, official exchange rates for imports, and were also better able toobtain tariff rebates intended to alleviate some of the harmful affects of protection. Furthermore,the anti-export bias induced by import substitution strategies discriminated against the labourintensive SMEs. According to the literature, there was also discrimination against SMEs through

1 See Bari, Cheema and Haque (2002) for more details.2 Majid et al. (2000), SMEDA (2001), Roomi and Hussain (1998), and Kemal (1993).


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investment incentives, which SMEs were unable to access because of high rent-seeking costs.SMEs, having a smaller capital base, fewer contacts, lower capital intensity, and with higherdependence on more customized production, specialized production, niche markets or smallermarkets, are not able to compete with larger firms in areas where incentives depend on thedifferentiating factors mentioned above.

If an import license requires upfront payment or requires significant side-payments SMEs cannotcompete; if export licenses have the same character, SMEs are again marginalized. If access tofinancing requires collateral or access to subsidized loans is based on capital intensity, SMEswould again be left out. All of these policies were pursued in Pakistan over the last five decades.

Second, it is argued that financial sector interventions also discriminated against SMEs3. Selectivecredit controls in conjunction with controlled interest rates prevented banks from compensating forthe higher cost of small loans by charging more. As a result limited credit was allocated to thesmaller clients, which allowed large firms to grow at the expense of small firms. If cost of lendingto SMEs is higher than that of lending to larger firms, based on higher search and monitoring costs

(initial scrutiny and subsequent monitoring and evaluation) and if credit is in limited supply, as itwas for most of Pakistans history4, SMEs would get more severely rationed than larger firms, andthey did. The same result comes through if there are sectoral credit controls or interest rate controlsas well.

Third, a bias is also argued to arise because the problems of dealing with government regulationsand tax authorities weigh more heavily on small rather than large firms. This is because SMEs facehigher compliance costs and because of the fixed-cost entailed in complying with governmentregulations. Import/export regulations, tax regulations, labour-market regulations, licensing, andprice controls are argued to be the main areas of constraints hampering SME growth5.

Fourth, underdevelopment of the physical and social infrastructure is argued to create a bindingconstraint for SME growth. In the case of physical infrastructure this is because SMEs rely moreheavily on inefficiently provided state infrastructure as alternatives entail too high a fixed-cost forthem to develop. Similarly, the paucity of investment in human capital is deemed to constrain SMEgrowth because of the lack of availability of skilled workers, managers and entrepreneurs6.

Last, the market failure inherent in adopting technology in developing countries is argued toconstrain SMEs from adopting a path of dynamic growth7.

However, Kemal (1993) points out that the presence of technological indivisibilities andeconomies of scale cannot explain the low growth of SMEs in the Pakistani context. His estimatessuggest that most Pakistani industries in which SMEs have a significant presence face constant

3 Ali and Sipra (1998), Kemal (1993), Kemal (2000), Khan (1997), Nishat (2000), Roomi and Hussain (1998), SMEDA (2001), andWorld Bank (2001).4 The high interest rates almost throughout Pakistans history and till very recent times, where interest rates can be taken as the priceof credit, shows the supply constraint amply.5 Roomi and Hussain (1998) and World Bank (2001). For evidence on this issue from other developing countries see Snodgrass andBiggs (1996).6 Op. cit. note 39 and 40.7 See Hassan et. al. (1997).


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returns to scale; which implies that in the existing structure SME growth and expansion is notinhibited by technological barriers to entry.

These arguments are summarized by Roomi and Hussains (1998) survey on constraints to SMEgrowth in Pakistan, which lists the following as major problems faced by SMEs8:

1) Inadequate infrastructure2) Financing barriers and disincentives3) Adverse government policies4) Shortage of skilled personnel5) Technological constraints and lack of innovation6) Entrepreneurial handicap9

The review of the existing Pakistani literature10 provides illuminating insights for policy-makers inPakistan. The literature suggests that given Pakistans level of development, there is significantpotential to enhance growth and learning gains through the promotion of SMEs. Therefore, there is

clearly a strong case for removing the existing constraints on the growth of SMEs in Pakistan. Inthe remaining part of this study, we not only establish a ranking of the constraints to SME growthin Pakistans current economic environment on the basis of information culled from detailedqualitative surveys and a large quantitative survey, we also analyze the factors causing theseconstraints to emerge. This analysis forms the basis of our recommendations that are discussed inthe last section.

3. Methodology and Data SetsWe use three data sets to identify the fiscal and non-fiscal constraints to growth that SMEs face inPakistan:

a) A sample of 80 firms, interviewed for the specific purpose of identifying legal,fiscal and non-fiscal barriers to growth and incorporation. A detailed qualitativesurvey was conducted specifically for this study.

b) A sample of 60 firms interviewed, for an Asian Development Bank study,specifically to study the fiscal, non-fiscal and market based constraints to growth.The authors were involved in those interviews directly.

c) A sample of 650 firms, surveyed and interviewed, under the auspices of the Smalland Medium Enterprise Center (SMEC) at LUMS. Again, the authors wereinvolved in the design and implementation of this survey as well.

8 This list is not a ranking of constraints in order of severity.9 For other examples of such lists see Kemal (1993), Majid et al (2000), and World Bank (2001).10 For a review of the relevant international literature see Bari, Cheema and Haque (2002).


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a) For the current study we interviewed 80 firms from Lahore, Faisalabad, Gujranwala, Peshawar,and Quetta11, over the last two months. These in-depth interviews, conducted with a senior personin the management, and usually the proprietor or a partner, were each more than an hour long. Thepurpose of these interviews was to get more detailed, though qualitative, information on thevarious constraints faced by these firms, in doing business, in expanding, and in entering the

formal net. Since we were conscious of the fact that certain constraints may be area specific, wemade an effort to have geographical diversity. Table 1 shows the number of manufacturing andservice sector firms from each city in our sample.

Table 1: Geographical Break up of the Sample

Sectors Lahore Faisalabad Gujranwala Peshawar Quetta

Manufacturing 14 7 8 13 1

Services 20 3 3 3 8

Total 34 10 11 16 9

Table 2 shows the sectoral and legal breakup of the sample. 63 out of 80 firms are soleproprietorships or partnerships. This allows us to focus more on firms that are on the brink offormalization and are likely to face the constraints to growth mentioned above. The sectoraldistribution shows most major industries and service sectors represented in our sample12.

11 We did not interview firms from Karachi in this survey. Karachi-based firms are very well represented in the other two surveys,and in fact our second data set, with 60 firms, had 15 firms from Karachi. We felt that we could add more value by going to Quettaand Peshawar. The data from the two cities justified that. Transport and infrastructure problems, market-size problems, andsmuggling-related issues are clearly more of an issue in these smaller, border area cities.12 These include the sectors that SECP had identified.


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Trade (Wholesale) 5 2 1 8

Watches,FruitComputers,FMCGs, GasCylinder

Retail 5 6 11

Shoes, cloth,

bakers,HardwareWater filters,FMCGs

Miscellaneous 2 2 1 5

Sanitaryfittings,RenderingPlant (formeal),Hotels &Restaurants,shares/bonds

,Transportation

Total 23 11 1 2 37

Grand Total 39 24 1 13 3 80

Tables 3 a and b confirm that even by number of employees 73 firms in our sample fall in the SMErange, while 64 of the firms, with up to 99 employees, are in the range that should have substantialroom for growth. The constraints identified by these firms should give us a good idea of theproblems that SMEs face in general.


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Table 3a: Size of the SMEs

Size Of SMEs (No. of Employees)Sector

150

Textiles 1 2 3 2 5

Light Engineering 1 2 3 Leather 2 Metal Works 3 Marbles 2 1

Furniture 1 2 1 1 1

Miscellaneous 7 1 1 1Manufacturing

Total 5 19 5 7 7

Textile(Trading/wholesale)

3 1 . .

Stainless Steel (trade) 2

Printing Press 1 6

Trade (wholesale) 3 4 1 Retail 5 5 1 Miscellaneous 2 3

Services

Total 16 19 2

Grand Total 21 38 5 9 7

Table 3b: Size & Legal Structure of the SMEs

Number of EmployeesLegal Structure150

Sole Proprietorship 4 8 2 1 1Partnership 1 9 3 Single Member Company Private LimitedCompany

2 4 5

Unlisted Public company 2 1

Manufacturing

Total 5 19 5 7 7

Sole Proprietorship 13 10 Partnership 3 6 2

Single Member Company 1 Private LimitedCompany

2

Unlisted Public company

Services

Total 16 19 2

Grand Total 21 38 5 9 7


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dealing with these various departments. The higher this time commitment is, the more binding arethe constraints.

Table 4: No. of hours per month spent in dealing with Govt. Departments

Hours No of responses

1-10 17711-20 7421-30 6931-40 5741-50 1651-60 1961-70 571-80 30Above 80 25

Total 472

Statistics Time spent greater >=1 and


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the value of management time it imposes a high cost on the businesses in question as well on thesociety in general.

Table 5 gives the overall constraints that exporters, manufacturers and retailers stated as bindingfor them. We explore these in detail in the following sections:


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Table 5: Binding Constraints18

in the Pooled Sample

Financial

Constraints

Infrastruct

ure

Constraint

s

Regulatory

Constraints

Human

Resource

Constraints

Market

Constraints

Macro

Constraints

Credit-

Related

Lack of accessto creditCollateralrequirementsof FIsDelays ingetting creditLack of

connectionswith FIsCorruption inobtainingfinanceHigh interestratesAccess toexport finance(exportersonly)

LeasingHigh costLarge Downpayments

PowerTransportCorruptioninobtainingutilities

Taxation

High ratesCumbersome procedureSpeed andcost of taxadjudicationCorruption

Corruptionrelated to

taxCorruptionby othergovernmentagenciesTrade

Policy and

Procedure

Dutydrawback/sales tax

refundprocedure(exportersonly)High tariffson importsofintermediategoods/rawmaterialMisc.

Law andOrder

Lack oftrainedmiddlemanagementLow skillsofworkforceInsufficientvocationaltraining

Lack ofadequatelyqualifiedtechnicians(exportersonly)

Contract-

Enforcemen

t

InefficientcontractenforcementSpeed andcost ofresolution ofcommercial

disputesCompetitionCompetitionfromsmuggledgoodsCompetitionfromunregisteredcompaniesMarket

TransactionCosts

Availabilityof qualityrawmaterialsAvailabilityof qualityintermediategoods andcomponents

Availabilityof qualitysuppliers(exportersonly)

High cost offoreignexchange (notfor exporters)High interestratesInflation/priceuncertaintyExchange ratevolatility

(exporters only)

18 A binding constraint is one that receives an average score of 3.5 and above out of 5, and is ranked as an above average constraintby at least 30% of the respondents.


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Source: Bari, Cheema and Haque (2003)

Table 5 shows that a combination of factors is constraining firm-level growth. These factorsinclude: resource availability, (in the form of financial constraints, cost and quality of rawmaterials, human resources and access to quality infrastructure); regulation; governance; macro-

instability; contract enforcement; and distorted competition. However, further analysis is requiredto detail specific mechanisms through which these constraints are emerging as well as tocorroborate how severe these constraints are. This exercise is conducted in the next sub-sections.

4.1 Manufacturers and Exporters19

4.1.1Financial Constraints:

Most SMEs work through retained earnings, personal and family sources (self-finance). Interviewssuggested that savings finance initial investments, while operations and expansion are financed

through retained earnings. Large firms rely heavily on both project and working-capital finance.Contrary to popular impression, none of the databases pointed out a significant role for informalcredit market.

Table 6 shows that even for the latest set of interviews, 52 out of 80 firms said that they only usedown savings, retained earnings, and family savings for their businesses, and only 20 used ownsavings and bank borrowing. The percentage of firms borrowing money from banks is higher inmanufacturing than in trade. But this is to be expected. Banks have stringent collateralrequirements, usually immovable property, that manufacturing firms find easier to satisfy. Of the37 firms in the trade sector that we interviewed only 7 had used bank financing, while 13 out of 43manufacturing firms had used bank financing.

19 If the constraint is general and applies to manufacturing as well as trade, we mention it here and do not repeat it in the retailsection.


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Table 8a: Name of the First Govt. Department and Time Spent in dealing with Issues

(Response 1)

Name of the Govt.

Departments

No of Responses

(Nos.)

Time Spend in

dealing with

issues with Govt.(hours)

Average hours

WAPDA (3) 203 0-120 15.04Tax Income / Tax (1) 90 0-80 11.61Bank (7) 51 0-64 6.44Sales Tax (12) 34 1-56 12.94Social Security (5) 27 0-32 7.18Labor Department (11) 16 0-24 11Sui Gas (8) 9 2-32 10Telephone (6) 8 1-40 12.63Miscellaneous 35

None 178 Note:Total Responses473

Table 8b: Name of the Second Govt. Department and Time Spent in dealing with Issues

(Response 2)

Name of the Govt.

Departments

No of

Responses

(Nos.)

Time Spent in

dealing with

issues with Govt.

(hours)

Average hours

Tax Income / Tax (1) 81 1-40 10.66WAPDA (3) 79 0-80 9.61Social Security (5) 28 1-40 6.54Sales Tax (12) 26 1-32 9.69Telephone (6) 22 1-40 11.77Bank (7) 20 1-48 8.3Sui Gas (8) 16 1-64 12.44Labor Department (11) 16 1-56 17.31WASA / Water Board / WaterTanker (9)

13 1-7214.38

Old Age Employers (10) 12 1-80 15.25

Miscellaneous 29 None 309 Note:Total Responses 342


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Table 8c: Name of the Third Govt. Department and time Spent in dealing with Issues

(Response 3)

Name of the Govt.

Departments

No of Responses

(Nos.)

Time Spent in

dealing with

issues withGovt. (hours)

Average hours

Tax Income / Tax (1) 42 1-112 13.09Labor Department (11) 23 1-30 5.95WAPDA (3) 21 1-64 12.05Social Security (5) 20 1-40 12.05Telephone (6) 17 1-64 13.29Sales Tax (12) 12 1-80 14.91Sui Gas (8) 10 1-24 7.22Bank (7) 10 1-40 14.30Old Age Employer (10) 9 1-40 15.55

WASA / Water board / WaterTanker (9)

7 0-25 8.14

Miscellaneous 37 None 443Note:Total Responses 208

Non-reliability of electricity leads manufacturers to set up back-up power supply units, which isexpensive and is hard to do for SMEs anyway.

WAPDA Blues

A textile manufacturer wanted to have his industrial electricity connection terminated as he wantedto install a gas generator, which would give him hot water and steam (co-generation). WAPDAtold him that they could only consider his termination request 3 years down the road. He is stuckwith using WAPDA electricity or not using it but still paying the fixed line rent for three years.This makes installation of generator non-viable.

There is a threshold-effect in moving from residential to industrial electricity connections. If youdo not take an industrial account when you are using it for manufacturing purposes, this is breachof law, but WAPDA imposes significant fixed and transaction cost related fees on people who do

want to move. Once you have a larger industrial connection but business downturn forces you touse less electricity for a month or two, WAPDA threatens or actually sends detection bills.

Telephone services have improved a lot in the last decade or so and few entrepreneurs identified itas a problem. Mobile phones have also reduced the pressure on PTCL and in places wherelandlines are still a problem, mobile phones give at least some connectivity. Falling rates on


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international dialing as well as the falling cost of computer telephony have further reducedproblems in the area.

Water is a major constraint in Karachi and Quetta. In Karachi manufacturers have to rely ontankers for provision of water. Tanker service is expensive as well as somewhat unpredictable.

While in Quetta the problem is that pumping ground water is quite expensive. The drought of thelast few years and excessive pumping has led to rapidly falling water tables and these have addedto the cost of pumping. In both places the net result is higher cost.

4.1.3Human Resource Constraints:

For small manufacturing firms lack of trained middle management and low skills, education, andvocational training of workers are the main problems. The same is true for exporters as well. Forlarge manufacturers lack of trained higher management and availability of qualified techniciansemerge as constraints. For exporters, lack of trained workers becomes very binding, as their market

is more quality conscious.

4.1.4Macro and Monetary Constraints:

Inflation, the inability to predict inflation, and the volatility of exchange rate were the mainconstraints for manufacturers. Interestingly, even though inflation has been low for a number ofyears now in Pakistan, it still continues to be a concern. It seems that a lot of people doubt thegovernment claims and figures about inflation. Both exporters as well as importers mentionedexchange rate volatility as a problem in the earlier data sets, but this has not been a major concernfor the last couple of years.

4.1.5Regulatory and Fiscal Constraints:

Three areas of regulation impose constraints for firm-level growth: taxation, trade policy andprocedure, and law and order.

High income tax and sales tax rates are an issue. Export refund is the main constraint for exporters(discussed below). Manufacturers also find it a hassle to deal with a mixed lot of firms, some are inthe sales tax net and others are out of it. Competition from smuggled goods and unregistered firmsalso acts as a constraint and distorts incentives.

All data sets identify the Central Board of Revenue (CBR) as the source of most of the problems ofthe businessmen. Tables 8a, b, and c have already identified income tax and sales tax as importantproblems. Table 9 below shows that in our recent interviews when we asked SMEs to identify thethree main irritants to their growth and working, most of them identified tax- related issues to bethe main source.


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Table 9: Main Issues impeding the growth & working of SMEs

Issues Irritant 1 Irritant 2Irritant

3

No

Problems

Tax Issues 27 11 2

Over regulation 3 2 6Corruption of Govt.agencies / depts..

12 8 8

Utilities 8 8 9Labor 7 13 10Lack of Education& Information

4 4

Others (BlackMarket, CustomclearanceInfrastructure,

Processing,Transport, Fuel cost,EPB, Creditrecovery, Banks)

17 18 16

6

Total 74 64 55 6

Tax Hurdles (Reported by Entrepreneurs)

For the slightest delay in submission of tax related documentation, the fines are very heavy andexcessive.

An entrepreneur, from the light engineering sector, has five or six tax-related cases pending incourts. He has won some cases after 6-7 years of battle with the department, taking them up to theSupreme Court of Pakistan. The time and money cost for getting decisions has been very large.Even in cases where viciousness on the part of the tax department was obvious, and theentrepreneur got relief from the courts, there was no punitive or compensatory action taken againstthe department or the concerned officials.

One entrepreneur has some 15 tax-related cases pending in the judicial system right now. Some asold as 8 years.

Almost every sales tax refund case requires speed money.

For one sales tax collectorate, since there is a limit on the amount of refunds that the departmentgives from that collectorate every time period, businesses have to pay for just getting their filemoved so that their case is processed within the limit.

A textile exporter had six people in his business just handling the sales tax refund issue. Sales tax,income tax and other taxes were handled by other people.


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An importer complained that introduction of computers in Customs in Karachi has slowed thingsdown even further. Officers with limited computer knowledge have to now follow an electronictrail. The paper trail was easier to manage for some importers.

Import duty assessments, and more importantly value assessment for sales tax purposes, forimports of consumer items, are still fraught with rent-seeking activities.

In fact, many of the businesses under sole proprietorship and partnerships mentioned that one ofthe reasons for their choice of legal structure was the tax advantages that they enjoyed. The mainadvantage with these legal forms was that the entrepreneurs could avoid being in the tax net, atleast for some taxes, and could avoid some others.

Table: 10 Tax Advantages and Legal Structure

Legal Structure Tax advantageTax

disadvantage

Neither

Advantage

nor

disadvantage

/ No idea

SoleProprietorship

28 11

Partnership 15 7 2

Single Membercompany

1

Private LtdCompany

4 5 4

Unlisted PublicLtd Company

3

Total 47 15 18

The bureaucratic burden associated with managing government is quite high. Above we have also

discussed the time it takes to deal with government. Apart from this, uncertainty related to taxpolicies adds to the burden and increases the space for negotiation (corruption). This again ties inwith why entrepreneurs choose the legal forms they do, and why they think there are taxadvantages associated with these legal forms, even though there might not be any differences inthe tax rates at the formal level. The chapter dedicated to tax issues in our previous report isrelevant in this regard.


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Bureaucratic Burden

A non-payment of a Rs. 100 fine, due to unavoidable delays on the part of one entrepreneur,resulted in his arrest warrants being issued by a magistrate. He had to then spend the next threedays arranging for bail, paying the fine, and getting things settled.

Delay on payment of Rs. 1000 fee led to a fine of Rs. 20,000 from the Monopoly ControlAuthority (MCA).

An entrepreneur wanted to wind up one of his private limited companies as the business had to beterminated for some reason. It has been three years since he got clearance from all the banks.SECP is still not allowing him to let the company die. He still has to pay fees on that companysname.

Another entrepreneur has about 20 cases pending, against various departments, in courts.

A lot of businesses mentioned that they pay regularly to a number of departments. Even CivilDefence department people get some rent.

An automotive parts manufacturer had to give up an export order to sell parts to Japan because hecould not guarantee delivery time in Japan. He could tell when his goods will reach the Pakistaniports and be submitted for Customs inspections but he could not predict how much time theclearance process and shipping would take. The buyer sourced his parts from an East Asiancountry.

An edible goods exporter (sausage coverings) complained that for the reason mentioned above alot of his items were returned as they go bad if clearance takes too long. This cost him quite a few

customers in the past.

A partnership does not want to form a limited company as the costs of registration and maintainingproper records are high. But, more important, according to him was the ease with which he coulddissolve or start the new business structured as a partnership. And finally, one additional reasonquoted was the fact that limited companies became visible to government departments.

The threshold burden associated with tax administration is limited for micro and small enterprises,is highest for medium enterprises, and again falls for large firms. Small firms are exempt from anumber of regulations and can evade some others more easily than larger firms. Larger firmsspread fixed costs of compliance21 on higher turnover. So the burden is bigger for middle firms.

Labor laws, social security, and EOBI are no longer mentioned as major problems but only assmaller irritants, with some cost (in terms of monthly payoffs to officials). See Tables 8 a, b, c, andTable 9.

21 Even corruption has a fixed cost element, and payoffs do not rise proportionately with turnover.


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Although tariffs have come down significantly over the years, importers still find tariffs on rawmaterials and intermediate goods to be a constraint. Tariff rationalization, rather than across-the-board reduction, is likely to have significant stimulatory effect for industry. Competition fromChina, and possibly India, specially with WTO in perspective, highlight the need for rationalizingthe tariff structure even more.

Medium-sized exporters remain prone to many adverse export regulations. The customs dutydrawback and the sales tax refund procedures appear to impose severe financial costs on medium-sized exporters. The duty drawback system is currently being modernized in line with ADBs TEPIproject in order to reduce the costs for SMEs. However, the sales tax refund system remainsdysfunctional and its compliance costs appear to entail a step function, with the costs ofcompliance increasing for medium-sized exporters and then falling for large exporters. This,perhaps, reflects the high fixed costs of creating a managerial pool that ensures compliance withrefunds at a low cost. In large firms dealing with the sales tax refund procedure has become aspecialized managerial function and in some firms one even comes across the category GM (salestax).

Law and order problems are a binding constraint as they weaken property rights and reduceincentives to invest. These are clearly linked to law enforcement and how the criminal justicesystem functions. Significant research and work is needed in this area to understand the nexusbetween political conflict, law and order deterioration, and investment incentives. The problemseemed to be particularly acute for Karachi businesses22. A number of businesses there mentionedthat they had to pay protection fee to various groups, a number had faced armed robberies at theirplaces of work or residences, some had even been abducted or had suffered losses in terms of livesof loved ones. None of the entrepreneurs from other cities mentioned problems of the same natureand extent, but the difference is one of degree and not of kind as the following example illustrates.

Law And Order

One of the interviewees was abducted two weeks ago for ransom (interviewed end of March 2004in Peshawar). He shared his views about entering into the formal sector by saying that as thegovernment does not even provide security of life, how can it secure our businesses?

4.2Retail and Trade

4.2.1Financial Constraints:

For retailers most financing comes from retained earnings and self-financing as well (See Table 6above). Medium and large retailers have better access to financial institutions than small retailers.

22 Based on interviews conducted by the author, for the ADB study already mentioned, in 2002.


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Small retailers, who are trying to go from one small shop to more, or increase the size of the shop,are the most credit constrained.

The problems with credit market, for small retailers are the same as for manufacturers andexporters: access, collateral requirements of banks/FIs, personal guarantee requirements (which

dilute limited liability), lack of connections with banks, delays in the loan process, and corruptionin obtaining finance. High cost of finance was also identified as a constraint.

4.2.2Infrastructure Constraints:

Infrastructure constraints for retailers are similar to those of manufacturers. Small and mediumretailers are the worst hit as cost of back-up power is too high for them to invest in. Commercialelectricity rates are even higher than industrial tariffs. Thus cost of power is the main constraint forretailers.

In Quetta, the poor quality of roads was identified as a major constraint. Trucks to Karachi taketwo days and two nights, making the transport of perishable goods too difficult. Trucks cost up toRs. 30,000 for a trip to Islamabad, and it takes 24 hours to come to Lahore from Quetta by train.The net result is that traders said transport costs could add up to 25 percent or more to their costswhen moving goods to and from Quetta to other large city centers in the country.

4.2.3Human Resource Constraints:

Micro retailers have no problems in the area. Lack of trained middle management is a constraintfor small, medium, and large retailers. With expansion the need to manage supply chain,inventories and so on increases, and this is when the management constraint hits.

4.2.4Macro and Monetary Constraints:

Inflation, and inability to predict inflation, was the main constraint mentioned here by retailers.

4.2.5Regulatory and Fiscal Constraints:

Three areas of regulation impose constraints for firm-level growth: taxation, trade policy andprocedure, and law and order.

High income tax and sales tax rates are an issue. Paperwork requirements for sales tax areconsidered to be excessive. Small retailers find building/property tax rates and regulations to bebinding as well. High property tax rates, high rates on transfers, building taxes, and bureaucraticburden associated with official visits were identified as key constraints. Competition fromsmuggled goods and unregistered firms also acts as a constraint and distorts incentives.


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Tax Issues for Service Providers

Wholesalers from a large market in Lahore said that they dealt with the tax department only

through their association and this way they were able to reduce transaction cost. They had anunderstanding regarding the sum that needs to be deposited as tax by them every year.

Retailers from one Lahore market said that they were only safe from raids from the taxdepartments as they had a strong association and anytime there was a raid in the past, theassociation had made a very public and street display of their power. Only this street powerdeterred the tax department from harassing them.

Traders from Quetta mentioned that they had to pay heavy amounts of speed money whenmoving goods to and from Quetta. This involved all of the security forces stationed on variouscheck posts, whether international borders or provincial ones.

The threshold burden is low for micro retailers, rises for small and medium firms, and then falls forlarge firms. Small retailers are exempt from a number of regulations and can evade some othersmore easily than larger retailers. Larger retailers spread the fixed costs of compliance on higherturnover. So the burden is larger for middle retailers.

LDA Regulation

Lahore Development Authority (LDA), till some months ago, had a rule that only allowed buildingto go up to 130 feet in the city of Lahore. Recently they raised it to 200 feet first and then to 300

feet. Why should there be a height restriction at all, even in commercial centers of the city is agood question, but one that LDA does not choose to answer.

All major constraints are mentioned in the table below:


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Binding

constraints

identified by

respondents

Exporte

rs

Sma

ll

medium larg

e

mic

ro

Small Large Factors causing

constraints

V. Market

ConstraintsMarket

Transaction Costsa. Lack of qualitysuppliers

9 9 9 9 Low trustenvironment

b. Lack of qualityraw materials

9 9 9 9 Inefficient contractrepudiation

c. Lack of qualityintermediate goods

9 9 9

d. High cost ofspare parts

9 9 9 9

Repudiation ofContracts

a. Speed and costof commercialdispute resolution

9 9 9 9 Time delays andinefficiency ofcommercial courts

b. Inefficient legalrecourse tocontract violation

9 9 9 9

Distorted

Competition

a. Competitionfrom smuggledgoods

9 9 High tariffs leadingto smuggling

b. Competitionfrom unregisteredgoods

9 9 9 Undocumentedeconomy

c. Competitionfrom counterfeitgoods

9 9 Weak intellectualproperty rights

Source: Bari, Cheema and Haque (2002), with updates from other data sources.

5. General DiscussionIn the write-up above we have documented the constraints that have been identified in the threesurveys we have been involved in. The findings of two surveys, one done to study constraintsspecifically, and the other to study SME behaviour specifically, were supplemented by evidencefrom recent SMEs interviews conducted specifically for this report. In this write-up we identify


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some of the harder-to-quantify but more fundamental constraints to growth. The basis for thefindings reported here are also interviews with entrepreneurs.

Manufacturing Sector

In more than 100 interviews with different manufacturers, there were just a handful ofmanufacturers who were happy with the prevailing regulatory environment, while the restcomplained of major problems. Many went to the extent of saying that if they could recoup theirsunk investment, or in other words what they had put in, and get a fair price for their plant andequipment, they would sell immediately, and would move to trading. Almost every manufacturerthought traders made more money, had fewer hassles, and faced fewer obstacles in conductingtheir business. We also did not find a trader who strongly refuted the impression.

Problems caused by the Central Bureau of Revenue (CBR) outnumber complaints against anyother department or regulation. Complaints against the CBR are for all taxes, but they are the mostfrequent against Sales Tax and Income Tax.

Sales Tax: Manufacturers pointed out that 15 percent tax was too high, and since it was notapplicable to all sectors and to all producers uniformly this not only set up incentives for hidinginformation it also distorted the market for inputs and output. Since taxes are lower for buyingfrom and selling to sales tax registered producers and traders, there is an active market for sales taxinvoices that exists and flourishes in most manufacturing sectors. In sectors where input-outputtables are not present (like in light engineering), value-added sales tax sets up incentives forcreating faking invoices to reduce the value addition. All of the above distort prices at the marginand set up inefficiencies in investment and trade. They also force manufacturers to maintain doubleand false accounts. This opens them up to rent-seeking and extortion from tax officials.

Exporters have major problems with the sales tax refund area. Refunds are delayed for months andsometimes years and heavy side-payments are involved in getting refunds processed -- andprocessed quicker. Where size limits are imposed on refunds per month and so on, the level of sidepayments to come within the limit, increase substantially.

Importers mentioned that they have to register for sales tax even when their imports (like incomputer equipment) are zero-rated. They are also required to submit quarterly accounts, likeanyone else, and they are occasionally even audited for sales tax purposes.

Sales tax department requires significant amount of paperwork. Registered manufacturers have tosubmit quarterly reports, they have to hire a number of people for this, and have to manage theiroverheads, and have to also deal with excessive red-tape. Sales tax official and manufacturerinteraction occurs regularly and far too often. These paperwork requirements and frequentinteractions impose a substantial transaction cost on manufacturers.

The high interaction interfaces between officials and taxpayers, the high paperwork requirements,ambiguity of rules and the issue of refunds and need for invoices all add to the uncertainty thatmanufacturers face in dealing with the tax officials. They also raise the transaction cost of dealingwith the CBR and increase the rent-seeking opportunities for tax officials.


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Income Tax: Manufacturers complain of high rates of income tax. They also point out that incometax rates are higher for limited companies than for sole proprietorships and partnerships. Soformalization of business imposes additional cost on businesses.

The issues related to ambiguity of rules (there is a new income tax ordinance that even thedepartment officials do not know quite well), interaction with officials, audits, and paperworkrequirements are the same as given for the sales tax. But the problems, for manufacturers, are lesssevere for income tax than for the sales tax. This is largely due to the fact that income tax needs tobe filed only once a year and audits are not supposed to happen every year.

Infrastructure: WAPDA is considered to be a significant constraint. Electricity rates are high. Butapart from the rates, WAPDAs quality of service, lack of customer orientation, poor infrastructure(leading to higher breakdown rate), and high cost of arranging for backup power are all constraints.The high rates also sets incentives for rent-seeking as well. Poor service means that quite oftenmanufacturers have to invest in expensive backup power arrangements, and small manufacturers

suffer, as they cannot afford to pay the fixed cost for this. Some manufacturers have even resortedto cost-inefficient bypasses of the main WAPDA system to ensure reliability of service. This isespecially true for processes that require continuous electricity supply. WAPDA regulations aboutconnection and disconnection costs, meter transfer fees, delays in getting these done, and thepropensity for sending detection bills, all raise the cost of interacting with WAPDA formanufacturers. Since electricity costs form a significant portion of input costs for mostmanufacturers in textile, light engineering, and other major industries, a non-competitive WAPDAimposes heavy costs on the manufacturers and contributes significantly towards making theminternationally non-competitive as well.

Manufacturers complain that their transportation costs, for airports and dry-ports, as well as timecosts involved in actual transportation are too high. Trucks take three days to deliver goods toKarachi from Lahore. And delivery times happen to be unpredictable. The quality of roads is alsopoor. All of these add to costs for manufacturers, making them less competitive internationally.Uncertainty in delivery times has the same effect.

Human Resource: Growing businesses find severe shortage of both skilled workers as well asmid-level managers. The standard of education and vocational training is considered to be more orless uniformly low by most manufacturers. This becomes a significant problem in industries with ahigher requirement for Research and Development (R&D) and marketing skills. Manufacturersfrom light engineering complain of worker shortage more than manufacturers in more traditionalproducts such as bed linen. Mid-level management shortage becomes an important issue forgrowing manufacturers, and is especially binding when family businesses run out of familymembers to manage a growing business.

Though most manufacturers complained of poor human resource quality, they did not seem tothink that they, as a group, in an industry or area, could change the situation. They put theresponsibility, for investments in the area, solely on the government. There is a broader issue oftrust involved here that merits some discussion.


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the more knowledgeable. Hence their distrust, their desire to stay out of the formal net, their desireto stay below the government radar, and their need for keeping business fairly non-documentedand opaque.

Further Generalization

In some ways each of the hassles mentioned above in the text and in the examples, as well as theconstraints mentioned in the previous section are important and need to be addressed. At this levelthey also seem to be department specific. So designing a particular intervention is not too difficult.But, at the risk of generalizing too much, at another level almost all of the issues mentioned abovehave to do with property rights and judicial issues. It is lack of access to an efficient, fair, quickand cost-effective remedy and relief-providing justice system that allows distortions to getentrenched.

If the courts disposed of tax cases swiftly and fairly, and imposed compensatory and punitivedamages on both the department and individual officers, the officers will think twice before

making a wrong case or asking for graft. If breach of a contract, whether between two privateparties or between a business and government, could be settled by the courts quickly, breach wouldno longer be a low-cost option and entrepreneurs would be able to go into long-term contracting.

But this level of judicial fairness and effectiveness is not easy to achieve. And there are significantparts of this that are not in the purview of a single department, but they do need to be addressed,and they should be addressed simultaneously with the addressing of more department specificissues.

From the identified constraints and the discussion given above, we generate a set ofrecommendations, for the SECP and various government departments to pursue, that cater to boththe specific and the general constraints discussed. We will discuss these, in the context of a policyframework, in chapter four of the study.

In the next chapter we scrutinize the functioning of the Company Registration Offices (CROs), andthe services provided by CROs and the SECP with regard to the company registration process.Company registration process itself can also act as a constraint against incorporation. By studyingthe process explicitly we ensure that if there are problems in that area we can identify them for theSECP and also recommend appropriate changes. This has already been done, from the legalperspective, by our previous report. In this report we attempt the same from an operationalperspective.


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Chapter IV. Policy Framework and Recommendations

1. Introduction

The last two chapters have established that there are significant constraints that businesses ingeneral, and SMEs in particular, face to their growth, corporatization, and formalization. Theseconstraints are not, on the whole, related to how the CROs function and how SECP regulates thecorporatized sector. They have more to do with the rules and regulations of other departments --how they are implemented and how the various laws of the country shape the overall businessenvironment in which enterprises function. In this chapter we look at the case for creating a policyframework that clearly states and upholds the case for facilitating the growth and formalization ofthe SMEs, and looks at specific changes that can be made in the specific rules, structures andinstitutions as well as the general changes that need to be affected with the active cooperation of allgovernment departments.

The current government has, a number of times, expressed that the growth and promotion of SMEsis an important policy objective of the government. The government rightly holds that SMEsgrowth can lead to substantial increases in output and income of the country and can lead tosignificant employment creation, given their higher labour-intensity. SMEs can also allow Pakistanto diversify its export base and help introduce new technology in some areas. SME clusters caneven lead to significant gains in exports. Given these objectives, removal of impediments togrowth should be an important policy objective for the government.

The constraints mentioned in the last two chapters stultify the growth of large-scale firms too, andthe distortions introduced by them also lead to non-optimal decisions by large firms, but the impactof these constraints is more binding for the SMEs. SMEs have smaller capital bases, lower capitalintensity, fewer market or political connections, and more dependence on state or market providedinfrastructure and other services. To take one example, gas or electricity disruptions and load-sheddings hurt SMEs more as where the large firms can buy generators and cylinders from themarket, SMEs might not have the resources to be able to do so. Even if resources are there, SMEsmight not have to size to justify back-up power capacity. To take another example, rent-seekinghas a fixed element to it in the sense that side-payments to officials do not go up with sales at afixed percentage, and there seems to be a lower limit on the size of payments as well. Any givenlower limit would obviously be more onerous for the smaller firms than for the larger firms. Thesame is true of other impediments too.

This makes a case for SME-specific regulations, or at least for ensuring that rules and regulationsdo not discriminate against the SMEs. Couple the above with the government objective ofencouraging SMEs, for employment and income generation reasons, and the case for a coherentpolicy framework for SMEs -- one that allows SMEs to grow at a rapid pace -- becomes very clear.In the following sections we will identify the specific measures that could be implemented toaddress specific constraints, identify the government department or body that should take a lead inimplementing the reform, and also focus on the common strands of policy that need to go acrossdepartments to ensure the harmonization and consistency various initiatives.


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2. Policy InitiativesThere has been some progress in the last couple of years on issues pertaining to labour laws, EOBI,and other employee benefit labour-related areas, and entrepreneurs from Faisalabad, Peshawar and

Lahore pointed that out. Traders also pointed out that now they have better access to banks forworking capital finance as well, though they attributed this more to the fall in the interest rate andthe cash-heavy situation of the banks. But on the whole most entrepreneurs thought that thegovernment needed to do a lot more.

Table 12, given below, shows, that when entrepreneurs were asked what productive andconstructive steps had the government taken to address their problems, an overwhelming majority-- 584 out of 650 -- said none. A few mentioned the reduction in interest rates and the removal ofoctroi tax as good steps. This response, whether perception or reality, needs to be readdressed.

Table 12: Productive and Constructive Steps Taken by the Govt.

Productive and Constructive Steps No of Responses (Nos.)

None 584No knowledge 8Reduction in Rate of Mark up 6Reduction in District Tax 4Reduction inchungi Tax 3Better opportunities of Exports 3Construction of Roads 3Provision of Loans 3

Miscellaneous 37Note:Total Reponses 651

Department-specific recommendations, based on the constraints identified, are given below:

Financial Reforms

Interest rates have already come down. This has increased the access of firms to credit. But banksstill do not lend on cash-flow basis. Heavy collateralization and asking for personal guarantees actas constraints. Banking and legal sector reforms are needed to address this. State Bank of Pakistan,

with help from individual banks as well as SMEDA, has to take the lead here. The SME Bankcould also play a crucial role in helping SBP and others in drafting and implementing the requiredregulations.

Creditor rights have been strengthened by Ordinance No. XLVI of 2001. The issue is just speedyenforcement through courts and specialized courts. The judiciary has to take the lead here, amplysupported by the government.


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There is great need to establish a specialized credit-registry as well as to improve the existingcredit reporting system. With regard to improvements in the credit reporting system there is a needto enhance the current technical platform to provide a basis for on-line secure connectivity withusers that enhances the efficiency and effectiveness of the system. There is also a need to revisitSBP policy and to define a comprehensive framework to improve the role that should be played by

private sector credit information providers including the role of rating agencies. The lattercomponent is important as it will strengthen the credit reporting structure by creating competitionbetween rating agencies. Finally, there is a need to strengthen regulation that allows reportingcoverage of small and medium-sized borrowers. This could involve creation of rating agencies forSMEs and facilitating legal changes. Again, SBP has to take the lead here.

Judicial Reform

Our findings also suggest that inefficient contract repudiation is acting as a major constraint on thegrowth of small and medium manufacturers and small retailers. A major cause of inefficientcontract repudiation is the inefficiency associated with judicial enforcement of commercial

agreements. Commercial disputes in Pakistan are governed by an agreement under the ContractAct (1872) and can only be adjudicated by civil courts. Civil courts enjoy both a plenary and anunlimited pecuniary jurisdiction over such disputes. Major problems associated with this foruminclude time delays and judicial corruption. The two feed on each other resulting in very slowtime-disposal rates. This adds to the delay in dispute resolution, which often takes years. Theseinefficiencies set incentives for individuals to seek returns through extra-economic coercion, bythreatening property rights, and enables individuals to capture short-term payoffs by breakingagreements. Weakened property rights and contract enforcement adds to the atmosphere of lowtrust that prevails in Pakistans markets and increases their inefficiencies. Specificrecommendations are needed in this area, but these go beyond the scope of this report. This is alsocross-cutting area where the initiative has to come from a number of sources and numerousdepartments have to coordinate their activities to effect a change. SECP can take the lead here andsuggest changes for the ministry of law and others to consider. That said, any change, if it is to besuccessfully implemented will require the cooperation of the judiciary.

Tax related Reforms

Restructuring of CBR is a major requirement. Income tax, sales tax, sales tax refund, and exportrefund, all deal with the CBR. The Ministry of Finance (MoF) and the CBR need to take the leadhere, but the SECP should clearly convey the message to the MoF and the CBR. A large number ofpeople interviewed, and even the officers at the CRO, were of the opinion that tax-relatedproblems were the most important reason why firms decided to stay away from formalization anddesired to continue to exist below the government radar level. This needs to be addressed onpriority basis.

There is also a need to consolidate and rationalize the current structure of local and provincialtaxation, in particular property tax, which is a major constraint on retail sector growth. Theprovincial and local governments need to take a close look at these.


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Vocational training for workers, and training of middle management, as well as quality of traininghas to be improved. This becomes a major constraint for firms that want to grow. In the Punjab,TEVTA, which is re-organizing technical training, has to work with SMEDA and SME clusters tomake it more relevant to the industry. Similarly other provinces have to do the same. But there isno serious attempt to look at the management training aspect for working middle management.

Existing business schools are too few and expensive to take on the job for the entire country. Astrategy for human resource development, from this angle, has to be worked out.

3. General RecommendationsTax reforms will have to include: a) rationalization of tax rates, b) streamlining of sales taxrefunds, c) extension of sales tax coverage to most sectors, d) documentation of entire value chainsacross most areas, and e) reduction in interface between taxpayer and tax officials to reducetransaction costs in terms of time consumed, paperwork required as well as reducing rent-seekingopportunities. It should be born in mind that c) above can only be recommended if e) is

implemented. Otherwise c) could cause even more problems for businesses.

WAPDA rates are a federal subject and work on large dams and other mega projects needs to beundertaken to see if rates can be brought down at least to levels that are prevalent in the region.

There is definitely need to harmonize some of the rules that apply to SMEs. But before this can beaddressed the government needs to publicly announce at the federal level, with concurrence fromthe provinces and the various departments, that it wants to enhance the role of SMEs in theeconomy. Then it needs to undertake detailed studies of how specific rules and institutionalstructures for the SMEs can be created in various areas such as access to financing, infrastructure,technology, and marketing; and how other rules which are not SME-specific can be made SMEneutral at least.

Interestingly, a lot of SME activity is already organized in some cluster form. On themanufacturing side the Gujrat-Gujranwala area, Faisalabad and Silakot are already well-identifiedand developed clusters. On the trade side too there are many well-defined clusters (Azam ClothMarket, Hall Road, and so on). It should be possible, for the government or as private-publicpartnership, to come up with cluster-specific institutional structures that can help address theconstraints mentioned above. The task for studying these issues can be entrusted to cross-departmental teams that are given logistic support through SMEDA. To give a concrete example,we could have a couple of representatives of banks and SBP, a couple of academics, and a fewSMEDA staff looking at the access to finance issue for SMEs. The recommendations of that groupcould go into policy initiatives at the SBP.

The most difficult reform to conceptualize is the one regarding legal and judicial reform. We havealready stated that a lot of department specific problems too have to do with lack of access tojustice, lack of fairness in the system and lack of speedy enforcement and resolution. It is beyondthe scope of this study to suggest reforms in the area, but the importance of these reforms shouldbe stressed.


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Having lists of pre-qualified consultants on their website and in printed brochures, with

representation from most cities, that could help businesses complete the incorporation

process as quickly as possible and with the minimum of hassle29

.Having facilitation officers at CROs that could help individual applicants go through the

different steps needed for incorporation. These facilitation officers, no more than two of three in

number for even the busiest CROs, would ensure that the number of mistakes are low - this couldreduce the pressure on the officers that check documents for mistakes and missing information. Itwould reduce the time of registration as well as hurdles in the documentation.

Initiation of Online Facilities30

The facility of online registration and incorporation could not only save time of the

enterprises but it could also help access those enterprises which are located in distant areas .This would also increase the outreach of the SECP beyond the eight CROs that they

currently have. Online registration could reduce the time needed by officers to scrutinize data andmove it around. It would reduce the number of visits that firms need to make to the CRO office as

well. But online systems have to be carefully designed, and this should only be done after morecareful study of the costs and benefits from it. Even if an online system is introduced the currentpaper- based system will go on functioning as it does for some years and given our literacy rates,continue to handle the bulk of the traffic.

SECP should also consider the issue of extending the working hours of the CROs. If the onlineregistration systems are efficient, longer office hours, theoretically, are not needed. But given theliteracy and other issues mentioned above, facilitation might require longer hours in practice.

5. Final Word: SECP LeadershipIn many ways the last two chapters have made it clear that the SECPs objective of increasingincorporation rate, with the aim of documenting various sectors, binging enterprises in to theformal framework and net, and introducing them to some documentation discipline - a worthy aim- is fundamentally tied with firm growth. Of course, this in no way suggests that CRO functioningand gains in efficiency there are not important or that marketing strategies should not be made orimplemented. But it does imply that even with efficient CRO functioning and SECP rules andregulations for incorporation, businesses might not incorporate if other factors, identified anddiscussed above, make incorporation too expensive or undesirable in any way.

A significant number of these other factors and constraints have nothing to do with the SECP.But they are constraints to firm growth and in many cases are binding constraints. So, they doaffect the SECP aim for increasing the incorporation rate. SECP then can play a leading role inidentifying these constraints, on behalf of the various businesses, for the various ministries anddepartments to address. It can also, through its research wing in Islamabad, suggest viable policyoptions and changes and can also monitor the progress on addressing the impediments. To an

29 SECP officials feel that since they are regulatory authority and not a rating agency, they cannot have pre-qualification. We do notbelieve that their being a regulator precludes pre-qualifying facilitators.30 SECP has started implementing the process for introducing on-line incorporation, and the possibility of filing of returns on-line isalso being looked into.


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extent, unless SECP gets involved in this sort of leadership role, onetime studies that identifyconstraints will not be enough to bring out the changes that SECP hopes to make.


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Chapter V. Action Items

1. IntroductionIn the last chapter, on policy framework and recommendations, we have already discussed some ofthe broader details of what needs to be achieved, in the various sectors, to facilitate SME growthand hence incorporation. In this chapter, we will discuss some Action Items that the SECP coulddiscuss with the relevant agencies for immediate or early action, and on the CRO front, undertakeitself to facilitate SME growth, corporatization and incorporation. In the former case SECP canonly initiate a dialogue with the relevant agencies, and facilitate a discussion that could lead todesirable policy and environmental changes leading to a more conducive atmosphere for SMEgrowth. In the latter case of CROs functioning, SECP can affect the changes itself. But as wediscussed in the previous chapters as well, the bulk of the work, in terms of removing hassles,hurdles and impediments, needs to be done by the other departments.

2. Policy InitiativesFinancial Reforms

Lending on cash-flow basis has to be introduced, so that reliance on heavy collateralization andpersonal guarantees (eroding limited liability), which tend to hurt SME access more than largefirms, can be reduced. But this requires not only specialized changes in prudential regulations,(SBP domain), it also requires credible removal of information asymmetries for banks. The banksneed to have credible information on the larger economic environment, the particular industriesthey have exposure in and the particular firms they are or will be dealing with. For the largerenvironment and large-scale industry information banks can generate their on research, but forfirm specific information, banks need specialized credit rating agencies to provide information.This area is nascent in Pakistan and needs to be developed more.

Where SMEs are concerned banks face two sorts of information asymmetries in the context givenabove. They do not have sufficient information on the individual SMEs and they, often, do nothave information on the SME specific industries as well. The latter part is easier to remedy.SMEDAs research department can generate reliable industry specific information for the bankingsector that reveals the potential of SMEs in particular industries, the scope for expansion, exportand development. The former, regarding information of specific firms, is harder. Mainstreambanks, given the larger SME numbers, find individual vigilance and monitoring, to be too costly.SMEs also need to be rated by credit agencies, but given their less transparent financial and legalstructures, this is not going to be easy. SME Bank could take the lead here and jumpstartdevelopment of databases on SMEs willing to get credit, and willing to develop a stablerelationship with a lender. SMEDA has formed a taskforce on finance related issues of SMEs.SECP could request the taskforce to attend to this issue too.


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High interest rates were a problem till a few years ago, but are no longer an issue. Creditor rightshave been strengthened recently (Ordinance No. XLVI of 2001). But these need betterenforcement. We will discuss the issue of judicial reforms below.

Judicial Reforms and Trust

Following on from the discussion in the last chapter, the main problem that results from inefficientcontract repudiation, judicial corruption and delays, and weakened property rights is that it reducesthe type and duration of contracts that businessmen can enter. Businessmen cannot make assetspecific investments in machinery and human resource development, and they cannot resort tolong-term contracting. And it sets incentives for expropriation and extra-economic coercionthrough breaking of contracts. These result on stunted or distorted growth (like force verticalintegration discussed earlier). At the micro level, communities and networks with high reciprocityrelationships can address the issue by creating trust institutions guaranteed by the reciprocityrelationships and credible threats of ostracization. This explains the development of MaghribiTrader networks of the 12-14th Century, and also explains the Rotating Savings and Credit

Associations (RoSCAs)

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of today. But these institutions are not generalizable and do notguarantee global optimality. These can only be acquired through an efficient and fair judicialsystem that guarantees enforcement or ensures compensation in reasonable time, and at areasonable cost.

This area requires the development of specialized changes that can only be done in consultationwith the judiciary, the legal profession and the businessmen. Asian Development Bank (ADB) hasa significant initiative, called Access to Justice that is supposed to tackle such issues. SECPcould refer the problem to the initiative for detailed scrutiny and development of specializedrecommendations. The outcome of the changes has to focus on the fairness of the process, andmaking the time and money costs for invoking the judicial system reasonable.

Tax Related Reforms

There have been very significant and detailed studies that have been conducted on tax reforms.These include various IMF and World Bank studies and most recently the Shahid Hussain report.CBR is undergoing reform, but the pace of reform has been frustratingly slow. We have discussedthe general pattern of what the reforms have to include in the last chapter. From SME perspective,the following areas need special attention:

a. Sales tax rate has to be reduced from 15 percentb. The number of sales tax rates, based on turnover or size, have to be reduced, and uniform,

lower rates need to be applied across the board. Different rates area creating thresholdeffects for SMEs that are distorting growth incentives and the incentive to incorporate. Butthis should only be done in tandem with reduction in the overall sales tax rate. Otherwisethe compliance burden on SMEs will increase.

c. Documentation requirements for sales tax have to be reduced and streamlined.

31 We call them committees in Pakistan. They are quite prevalent in business communities in the country, and especially in thetrader networks.


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d. Sales tax net has to expanded to all items (with exemptions for food, medicines and otherselected goods), through the value-chain, and to services as well. This will allow removalof other taxes (like professional tax on services rendered by professionals, and a number ofexcise duties), and will facilitate reduction of transaction cost. But the expansion requiredocumentation of value-chains and the economy, something that CBR has so far not been

very successful in doing.e. Sales tax refund procedure has to be restructured to allow early recovery and withoutpayment of speed-money (corruption).

f. Self-assessment system, for tax returns, has to be universally applied, with a randomselection for audit. This requires significant investments in building the capacity of theaudit wing of the CBR, but it will reduce harassment of the taxpayer and the corruption inthe system.

g. Import duties on raw materials have to be removed.h. Import duties on intermediate good need rationalization to provide incentives for local,

quality production of the final good.

Infrastructure Reforms

The main issues in infrastructure have to do with cost of power, the poor quality of service bypower companies, the high time and money cost of transportation, clearance at ports, and provisionof other infrastructure facilities like water and sewerage. The following steps are recommended.

Power:a. Electricity tariffs need rationalization so that any existing subsidies from industrial and

commercial sector, to the domestic sector, are actually reversed.b. In the medium run, electricity providers have to bring power tariffs in line with other

countries with whom our producers need to compete with in a post-WTO globalized tradeenvironment.

c. Distributions Companies (DISCOs) have been formed and these allow for benchmarkcompetition, but the next step is to allow existing DISCOs to compete for customers ineach others territories, and to allow new distribution companies to enter the industry.Competition at the distribution level will help solve the quality of service and cost ofprovision issues as they have done in the telecommunications area.

d. GoP has allowed private investment in generation in both thermal and hydro projects, andPrivate Power and Infrastructure Board (PPIB) has done a commendable job of managingissues with the thermal power producers. The first private sector hydro project should beon-line next year, but it took an inordinate amount of time for this project to get allclearances from the GoP. This process, to facilitate private investment in hydro projects,needs to be streamlined.

Roads, Transport and Other Infrastructure:a. GoP PSDP was cut from around 8 percent of GDP in the early 1990s to a low of 2 percent

of GDP in the last couple of years. Expenditure on infrastructure also went down intandem. This has seen some reversal in this years budget. A large portion of the PSDP, andprovincial ADPs, has to be earmarked for road construction, maintenance, and up-gradation. Construction of inter-provincial highways is a federal subject, while intra-


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province maintenance and expansion needs to come from provincial ADPs. Sinceprovinces like Balochistan have small ADPs but large needs for infrastructure investment,special grants from the federation might be needed in this area.

b. The railway network also needs significant investment in track extension and maintenance.c. The Punjab has initiated a public-private sector initiative (PIEDMC) to facilitate the

development of new and maintenance/up-gradation of older industrial estates across theprovince. The provincial government realizes that it is not possible for them, currently, toprovide high quality infrastructure in all parts of the province, but they can provide highquality in some pockets. PIEDMC will facilitate this. Other provinces can look at andemulate the model. This can facilitate the provision of all services like high quality powerinfrastructure, water, sewerage, and roads. For some cases even a connection with the localrailway line could be facilitated.

Human Resources and Technology

Both human resource development and technology acquisition (whether through R&D or through

licensed transfer), by one firm, have significant positive externalities for other firms in a sector.Since these benefits cannot be captured by the firm making the initial expenditure, given theexternality, we will, inevitably have under-investment in human resource development and newtechnology acquisition (as well as any other activity that can be copied). Individual SMEs cannotaddress the issue. Furthermore, individual SMEs are too small to be able to afford fixedinvestments in R&D as well as training. In most countries governments play a role in both thesemarkets. SMEDA has recently setup task forces to formulate policy for these areas. SECP shouldrequest SMEDA to further request the relevant taskforce to study the issue in detail and come upwith sector specific proposals. We can be sure that vocational training institutes will have to becreated, in private-public sector partnership, and with reference to specific sectors, and similarlysuch research institutes will also need to be setup, but the detailed proposals can only be workedout by the dedicated taskforces. SECP can point out to SMEDA though, that without suchinterventions it would be hard for SMEs to grow and enter export markets even in areas whereclusters might be working at the level of local market (in medium or low quality product range).

The recent creation of a vocational training authority at the federal level is a step in the rightdirection. But the real success will be in the ability of this body to forge private-public partnershipswith the SME industries and clusters to specifically alleviate the human resource needs of thesegroups. General vocational training institutes, though helpful, cannot address the problems of theSMEs.

3. SECP and CRO Recommendations

As we have discussed in the last two chapters, CRO functioning has been streamlined significantlyin the last few years, as far as the incorporation process is concerned, and throughout ourinteraction with firms as well as CRO officials we were not able to identify barriers toincorporation, of the same or similar order of magnitude as the ones already identified above. Thelast chapter gives recommendations for improvements in CRO functioning based on these. But, to

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