ISLAMABAD: Pakistan’s economy is making a gradual shift to cash as protection against the government’s taxation policies – a structural change that, according to experts, would lead to low economic productivity and high inflation.

During fiscal year 2015-16, growth in banking sector deposits was far lower than in the previous year while the currency in circulation increased at a much rapid pace, revealed minutes of the last Monetary Policy Committee (MPC) meeting.

In 2015-16, “the currency in circulation expanded 30.5% as compared to 17.3% a year before, which reflects that private businesses are using cash to settle their transactions,” according to the MPC.

In absolute terms, the currency outside scheduled banks increased from Rs2.555 trillion in 2014-15 to Rs3.334 trillion last year – a net addition of Rs779 billion in a single year.

In the last fiscal year, the federal government imposed a 0.6% withholding tax on all banking transactions worth over Rs50,000 carried out by non-filers of income tax returns in a single day, aimed at increasing revenue collection but without analysing its impacts on the economy. After protests, the government lowered the rate to 0.4%, but people still remain more reliant on cash.

The MPC noted that factors contributing to this trend include “low rate of return on deposits and imposition of withholding tax on banking transactions”.

The growing reliance on cash may dent global efforts, backed by the United Kingdom, to enhance financial inclusion in Pakistan, which remains one of the lowest in the world particularly among women.

The low return on deposits due to low interest rate environment somehow affected the deposits but the real damage was done by the government’s decision to impose the withholding tax, said Dr Hafiz Pasha, former finance minister. He said that increase in money circulation would lead to high inflation and banks would face problems in lending money to the private sector for expansion.

The currency in circulation-to-deposits ratio, which was 29.3% two years ago, increased to 35.1% last year, according to the International Monetary Fund (IMF) report. This ratio further increased to 37.1% as of September 9, underscoring the economy’s gradual shift towards cash.

The MPC noted that growth in deposits was just 8.7% in the last fiscal year as compared to 12% in fiscal year 2015. However, the deposits of private sector businesses grew by only 1.2% in the last fiscal year, which is considerably low as compared to 9.4% in fiscal year 2015, according to the MPC. The low growth in deposits may also be an indication that households savings are down due to low incomes, said Dr Pasha.

This decline in the deposits of private sector businesses has resulted in the deterioration of the currency in circulation to GDP ratio from 9.3% to 11.3% in just one year.

“The withholding tax on cash withdrawals has led to higher-than-usual demand for currency in circulation and lower growth in bank deposits than would otherwise have been the case,” said IMF Resident Representative Tokhir Mirzoev in an emailed response to The Banker Pakistan.

“This highlights the difficulty of widening the tax net in Pakistan. Tax collection, despite witnessing significant improvements over the last three years, is still much below Pakistan’s potential and continued efforts are needed to bring potential taxpayers into the tax net,” he added.

The withholding tax on banking transactions has nullified the efforts towards documentation of the economy, said Dr Ikramul Haq, who is a leading tax expert. He said that people have started avoiding the tax through different means.

While imposing the tax the government had hoped that it would compel the people to file their annual income tax returns. However, the number of filers remained below 1.1 million people, although more than seven million people are paying direct taxes by virtue of over 70 types of withholding taxes.

However, the Federal Board of Revenue earned Rs23 billion by charging 0.4% withholding tax last year – a gain that appears negligible when compared with the adverse implications of cash economy.

“The implementation of the withholding tax, which led to an increase in cash holding, will lead to lower documentation and lower revenues in the longer run,” said M. Ali Kemal, who is an Islamabad-based research economist at Pakistan Institute of Development Economics.

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