The State of Domestic Commerce in Pakistan Study 3 - Subsidies and Incentive Regimes

THE STATE OF DOMESTIC COMMERCE IN
PAKISTAN
STUDY 3
SUBSIDIES AND INCENTIVE REGIMES
For
The Ministry of Commerce
Government of Pakistan
November 2007
By
Innovative Development Strategies (Pvt.) Ltd.
House No. 2, Street 44, F-8/1, Islamabad

Table of Contents
List of Abbreviations ............................................................................................................... i
Acknowledgments ................................................................................................................ iv
Executive Summary ............................................................................................................ 3
Section 1: Introduction .................................................................................................. 6
1.1. Subsidies and Incentive Regimes .............................................................................. 6
1.2. Scoping the Study ..................................................................................................... 7
Section 2: Subsidies for Domestic Commerce ............................................................ 9
2.1 Cross Subsidization in the Energy Sector .................................................................. 9
2.1.1 Cross Subsidization in Electricity and Natural Gas Tariffs .............................. 9
2.1.2 Cross Subsidization in Fuel Pricing .............................................................. 13
2.2 Financial Incentives ................................................................................................. 14
2.3 Policy Package for Developing Storage Facilities .................................................... 15
2.4 Subsidy on Freight Transport .................................................................................. 15
2.4.1 The National Logistics Cell (NLC) ................................................................ 15
2.4.2 Pakistan National Shipping Corporation (PNSC) .......................................... 16
2.5 Incentives in Construction........................................................................................ 17
2.5.1 Khuda Ki Basti and the IHDS ....................................................................... 17
2.5.2 Defense Housing Authorities ........................................................................ 18
Section 3: Agricultural and Trade Subsidies ............................................................. 19
3.1 Agricultural Subsidies .............................................................................................. 19
3.2 Trade Subsidies and Incentives ............................................................................... 20
3.2.1 Export Finance Scheme ............................................................................... 20
3.2.2 Long Term Financing of Export Oriented Projects (LTF-EOP) ..................... 20
3.2.3 Scheme for Locally Manufactured Machinery ............................................... 20
3.2.4 Scheme for pre and post Shipment Under FE25 .......................................... 21
3.2.5 Freight Subsidy Scheme .............................................................................. 21
3.2.6 Skill Development and R&D Support for the Textile Sector .......................... 21
3.2.7 Quality Standards Certification ..................................................................... 21
3.2.8 Financial Incentives ..................................................................................... 22
3.2.9 Support for Participation in Trade Fairs ........................................................ 22
3.2.10 Support for Certification ............................................................................... 22
3.2.11 Support for Establishment of Retail Outlets Abroad ..................................... 22
3.3 Impact on Domestic Commerce............................................................................... 22
Section 4: Conclusions and Recommendations ....................................................... 24
4.1 Policy Recommendations ........................................................................................ 24

List of Tables
Table 2.1: Schedule of Electricity Tariffs ....................................................................... 11
Table 2.2: Schedule of Natural Gas Prices ................................................................... 12
Table 2.3: Breakdown of Sale Prices of Petroleum Products ........................................ 13
Table 3.1: Green Box Subsidy Outlays (Million US $) ................................................... 19

Innovative Development Strategies (Pvt) i
List of Abbreviations
ABAD Association of Builders and Developers
ADB Asian Development Bank
ADBI Asian Development Bank Institute
APCA All Pakistan Contractors Association
ATT Afghan Trade Transit
BAF Bank AlFalah
BCI Business Competitiveness Index
BOR Board of Revenue
CAA Civil Aviation Authority
CBM Cubic meter
CBR Central Board of Revenue
CDA Capital Development Authority
CIB Credit information bureau
CMR Contract for the International Carriage of Goods by Road
CPI Corruption Perceptions Index
CPIA Country Policy and Institutional Assessment
DFID Department for International Development
DHA Defense Housing authority
EDF Export Development Fund
EIU Economist Intelligence Unit
EOS Executive Opinion Survey
EPB Export Promotion Bureau
ESCAP Economic and Social Development in Asia and the Pacific
FBS Federal Bureau of Statistics
FCL Full Container Load
FDI Foreign Direct Investment
FIAS Foreign Investment Advisory Service
Ft Foot
FY Fiscal Year
GCI Global Competitiveness Index
GCR Global Competitiveness Report
GD Goods Declaration
GDP Gross Domestic Product
GoP Government of Pakistan
GOR Government Officials Residences
GRT Gross Register Tonnage
GST General Sales Tax
HBFC Housing Building Finance Corporation
HBL Habib Bank Limited
HDR Human Development Report
HFIs Housing Finance Institutions
IFC International Finance Corporation
IFS International Financial Statistics
IMF International Monetary Fund
ISAL Informal Subdivision of Agricultural Land
ISO International Standards Organization
IT Information Technology
ITU International Telecommunications Union

Survey Report on Domestic Commerce
Innovative Development Strategies (Pvt) ii
KBCA Karachi Building Control Authority
KDA Karachi Development Authority
KESC Karachi Electric Supply Corporation
KM(s) Kilometer(s)
KPT Karachi Port Trust
KSE Karachi Stock Exchange
LCL Less Than Container Load
LOA Length Overall
MCB Muslim Commercial Bank
MENA Middle East and North Africa
MOC Ministry of Commerce
MOD Ministry of Defense
MTDF Medium Term Development Framework
NBP National Bank of Pakistan
NCS National Conservation Strategy
NER Net Primary School Enrollment Rate
NHA National Highway Authority
NIE Newly industrialized economy
NIT National Institute of Transport
NLC National Logistics Cell
NTN National Tax Number
NTRC National Transportation Research Center
NTTFC National Trade and Transport Facilitation Committee
NWFP North West Frontier Province
PASSCO Pakistan Agricultural Storage and Services Corporation
PEC Pakistan Engineering Council
PHDEB Pakistan Horticulture Development and Export Board
PIAC Pakistan International Airlines Corporation
PIDE Pakistan Institute Of Development Economists
PIHS Pakistan Integrated Household Survey
PKR Pakistani Rupee
PQA Port Qasim Authority
PR Pakistan Railways
PREF Pakistan Real Estate Federation
PSDP Public Sector Development Program
R&D Research and Development
REER Real Effective Exchange Rate
REITs Real Estate Investment Trusts
RICS Royal Institute of Chartered Surveyors
SAI Social Accountability International
SBP State Bank of Pakistan
SKAA Sindh Katchi Abadis Authority
SME Small and Medium Enterprises
SPS Sanitary and Phytosanitary
SRO Statutory Regulation Order
Std Standard
TEP Total Factor Productivity
TEU Twenty-Foot Equivalent Units
TI Transparency International
TOR Terms of Reference

iii
TSDI Transport Sector Development Initiative
TTFP Trade and Transportation Facilitation Program
UK United Kingdom
UNDP United Nations Development Program
US United States
USA United States of America
USC Utility Stores Corporation
USD United States Dollars
WAPDA Water and Power Development Authority
WDI World Development Indicators
WEF World Economic Forum
WGI Worldwide Governance Indicators
WTO World Trade Organization

Innovative Development Strategies (Pvt) iv
Acknowledgment
The IDS team owes a debt of gratitude to the officers of the Ministry of Commerce for their guidance, assistance and feedback during the course of this study. Our special thanks go out, in particular, to Syed Asif Ali Shah, Secretary; Mr. Naseem Qureshi and Mr. Ashraf Khan, Additional Secretaries; Mr. Abrar Hussian, Joint Secretary; Syed Irtiqa Zaidi, Consultant and Mr. Qaseem Subhani, Section Officer, for sparing their precious time and efforts for the study.
We feel a deep sense of gratitude for the Minister for Commerce. Mr. Humayun Akhtar Khan, who took out considerable time from his busy schedule to guide us. It was his sincere and deep conviction which enabled us to conduct and compile this detailed and comprehensive study on Domestic Commerce of our country. His apt guidance and keen analytical oversight were extremely helpful in finalizing the study and formulating the policy recommendations.
This study has benefited from comments received from the following:
1. State Bank of Pakistan, Karachi.
2. Federal Board of Revenue, Government of Pakistan, Islamabad.
3. Planning and Development Division, Government of Pakistan, Islamabad.
4. Trade Development Authority, Government of Pakistan, Karachi.
5. (Management Consultants) Establishment Division, Government of Pakistan, Islamabad.
6. Finance Division, Government of Pakistan, Islamabad.
7. Pakistan Institute of Development Economics, Islamabad.
8. NTTFC, Karachi.
9. FPCCI, Karachi.
10. Planning and Development Board, Government of Punjab, Lahore.
11. Planning and Development Board, Government of NWFP, Peshawar.
12. Planning and Development Board, Government of Sindh, Karachi.
13. Planning and Development Board, Government of Balochistan, Quetta.
14. Investment and Commerce Department, Government of Punjab, Lahore.
15. Ministry of Communications, Government of Pakistan, Islamabad.
16. Housing and Works, Government of Pakistan, Islamabad.
17. Ministry of Food, Agriculture and Livestock, Government of Pakistan, Islamabad.
18. Ministry of Water and Power, Government of Pakistan, Islamabad.
19. Ministry of Petroleum, Government of Pakistan, Islamabad.
20. Statistics Division, Government of Pakistan, Islamabad.
21. Ministry of Commerce, Government of Pakistan, Islamabad.
22. Agriculture Department, Government of Punjab, Lahore.
23. Local Government and Rural Development Division, Government of Punjab, Lahore.
24. Statistics Division, Government of Pakistan, Islamabad.

1
SUBSIDIES AND INCENTIVE REGIMES*
by
SAFIYA AFTAB
DR. GEORGE BATTESE
DR. SOHAIL J. MALIK
* For a detailed analysis of the regulatory environment, please see the accompanying study “Regulatory Issues in Domestic Commerce”.

Innovative Development Strategies (Pvt) 3
Executive Summary
1. The Agreement on Subsidies and Countervailing measures negotiated as part of the Uruguay Round of the General Agreement on Tariffs and Trade (GATT) defines a subsidy as ‘a financial contribution by a government or any public body’. According to a study by Peters and Fisher incentives are of two kinds: tax and non tax incentives1. Tax incentives include measures such as property tax abatements, tax increment financing, sales tax exemptions and credits, corporate income tax exemptions and credits for investment or jobs, while non-tax incentives include business grants, loans, and loan guarantees.
2. The categories of subsidies and incentives analyzed in this report are cross subsidization in energy pricing, financial incentives and incentives for development of facilities (storage, warehousing etc.), subsidy on freight transport, incentives in the real estate sector, agricultural and export subsidies. The objective of this report is to see how these subsidies and incentive regimes affect domestic commerce and possible policy measures that can be adopted to promote domestic commercial activity.
Subsidies for Domestic Commerce
3. There are two major forms of cross subsidization in the energy sector, which can affect domestic commerce. The first is cross subsidization in electricity and natural gas pricing, with commercial and industrial sectors subsidizing households. The purpose behind cross subsidization is to make essential infrastructure and services available to all sections of society. Subsidies in the energy sector can have distorting effects on consumption, leading to wastages in sectors where costs are kept low, and a decrease of competitiveness in sectors where energy is priced at higher rates. The second cross subsidization in the energy sector relates to the cross subsidization in the pricing of fuels, with diesel being priced below gasoline to facilitate freight transportation. The subsidy on diesel ensures that road freight transport charges in Pakistan are amongst the lowest in the world. While retailers and wholesalers on the whole benefit from this strategy (although experience low quality of service), there are dual effects for the transport sector. On the one hand, possibilities for expansion of the sector are considerable as the economy grows, but on the other hand, the sector generates relatively low profits on a per unit basis. There are a number of quasi- subsidies in the energy sector also, which can impact domestic commerce. These mainly take the form of domestic crude transport to refineries at subsidized rates (using the National Logistics Cell (NLC)), and a long term freight contract with the Pakistan National Shipping Corporation (PNSC) for transportation of imported crude oil, again at subsidized rates – thus a transport sector subsidy which allows two state owned enterprises to benefit.
4. With regard to financial incentives, Pakistan’s financial sector has witnessed extensive liberalization since reforms began in 1991, and the system of provision of subsidized credit for priority sectors has largely been done away with. However, the commercial sector is at a disadvantage when it comes to formal sector financing options, as banks have little experience of lending to commercial enterprises, and such enterprises often cannot meet the collateral requirements of formal sector financial enterprises.
5. To develop storage facilities the government provides subsidized credit for the establishment of cold storage facilities, and for the cost of obtaining international certifications such as the ISO certifications. Although the terms of the package being offered were broadly outlined in the trade policy, the storage owners contacted during the focus group meetings were unaware of this facility, and the survey data, particularly data on
1 Peters, Alan and Peter Fisher. 2004. The Failures of Economic Development Incentives. Journal of the American Planning Association, Vol. 70, No. 1., pp 27-37.

financing does not indicate any use of such a facility. Moreover the Ministry of Commerce itself does not appear to have developed the scheme further or made any attempt to operationalize it as yet.
6. The government has provided targeted subsidies to certain public sector freight enterprises by disallowing the entry of private competitors in some fields, such as transport of crude oil. This policy is meant to control prices of essential commodities, but has resulted in the creation of near-monopolies in some forms of freight transport.
7. Construction is acknowledged to be a sector with strong backward and forward linkages, and significant growth in this sector can have a remarkable impact on growth of incomes. Given the buoyancy of the sector, and the unmet demand in the housing sector, the government has been keen to introduce incentives in the housing and construction industries. Since FY2002, the government has progressively introduced financial incentives in the housing sector, allowing a proportion of the markup on housing loans to be tax deductible, and introducing measures to encourage housing finance including increasing the maximum lending limit and the loan period for loans given by the House Building Finance Corporation (HBFC). Financial incentives, as announced by the government in successive budgets, cannot have a major impact in a construction market where housing finance is practically unheard of. However, the clear definition of property rights and transparency in procedures regarding the sale and transfer of property, as well as the efficient supply of facilities and infrastructure to housing estates would have a much greater impact in promoting the sector.
Agriculture and Trade Subsidies
8. Pakistan provides support to agriculture through subsidization of research, storage and marketing, extension services, and infrastructure and flood protection services. Infrastructure and flood protection services (which include primarily the construction and maintenance of the irrigation infrastructure) account for the bulk of subsidy payments for the sector, with only nominal expenditure on research and development, extension and storage and marketing. Agricultural subsidies in general have little direct impact on these sectors beyond the residual effects they may have based on their effects on production. The only area of domestic commerce directly affected by agricultural subsidies is storage, given the federal government’s support for the Pakistan Agricultural Storage and Services Corporation (PASSCO), the prime public sector agency responsible for the storage of grains, particularly wheat.
9. Pakistan cannot provide direct export subsidies as it used to prior to its inclusion in the WTO regime, but can subsidize the cost of marketing and transportation of exports. The government employs a range of incentive systems for exporters, mostly in the form of financial incentives. Trade incentives offered by the SBP take a variety of forms including concessionary credit for exporting industries and concessionary trade financing. With regard to trade subsidies, the key impacts on domestic commerce come through the effects of subsidies on production.
Conclusions and Recommendations
10. Utility and fuel pricing regimes need to be carefully reviewed as part of the ongoing restructuring of the energy sector. There is a need for some degree of cross-subsidization keeping in mind equity considerations and the need to supply basic services to low income households. The commercial sector should not be expected to pay a price for the lack of efficiency and mismanagement in utility providers.

Subsidies and Incentive Regimes
11. The subsidization of freight prices may benefit the commercial sector in terms of ensuring cheap transport, but there are environmental costs involved and they hinder the adoption of fuel efficient technology and better maintenance practices in road transport.
12. The performance of the NLC and the PNSC needs to be reviewed in addition to PASSCO, to assess the feasibility of allowing the public sector to operate in areas where private sector capability is increasingly available. While it is true that the role of the NLC has been substantially reduced in recent years, the PNSC has not been subjected to similar scrutiny.
13. In the real estate sector, an effort must be made to provide a level playing field to developers with transparent systems for provision of infrastructure.

Section 1
Introduction
1. Most of the available literature on subsidies in Pakistan deals with export subsidies and agricultural subsidies, with the more recent studies focusing on the impacts of the gradual phase-out of subsidies in the last decade. The TORs are not specific about the proposed scope of the study, and refer in very general terms to a need to make an inventory of all prevailing subsidies. This is, however, not a useful exercise unless we are clear about the policy arena that we are operating in. Our first task therefore, is to specify how we define subsidies and incentives, and than to scope out the proposed study.
1.1. Subsidies and Incentive Regimes
2. A commonly accepted legal definition of a subsidy is that given in the Agreement on Subsidies and Countervailing Measures negotiated as part of the Uruguay Round of the General Agreement on Tariffs and Trade (GATT).2 The Agreement (commonly known as the Subsidies Agreement) defines a subsidy as “a financial contribution by a government or any public body.” Financial contributions are defined as direct transfers or potential direct transfers of funds (grants, equity infusions, or government guarantees), non-collection of government revenue that is otherwise due (for example, tax credits), government provision of goods and services (other than infrastructure), and government purchases of goods for provision at below market rates.
3. Incentives are more difficult to define, but a recent paper by Peters and Fisher gives a workable classification.3 The paper divides incentives into two kinds: tax and non tax incentives. Tax incentives include measures such as property tax abatements, tax increment financing, sales tax exemptions and credits, corporate income tax exemptions and credits for investment or jobs, while non-tax incentives include business grants, loans, and loan guarantees.
4. The general argument for subsidies and incentives needs careful consideration, and the case for/against each subsidy or incentive also needs to be very carefully delineated. The political economy of subsidies/incentives suggests that these are relatively easy to institute and extend, especially where potential beneficiaries are concentrated and those who are to bear the cost are larger in number and more scattered. Take the hypothetical case where government wants to impose a levy of Rs. 1 per person per month on the larger population and pass this on as a subsidy to X industry of the country, constituting 50 manufacturers of that good. The additional cost to a family of 8, per month, is only Rs. 8. But the benefit to the 50 manufacturers would be Rs. 150 million (assuming that to be the population) per month,
2 See http://www.wto.org/english/docs_e/legal_e/ursum_e.htm#kAgreement
3 Peters, Alan and Peter Fisher. 2004. The Failures of Economic Development Incentives. Journal of the American Planning Association, Vol. 70, No. 1., pp 27-37.

or Rs. 3 million per manufacturer per month and Rs. 36 million over a year. The additional cost to each family or individual is so low that it would be hard for the larger population to mount a campaign against such a levy4. But for each manufacturer it would make sense to lobby for a subsidy of this kind. In fact, they would be, individually and collectively, willing to spend a substantial amount, as side payment, bribes and gifts, to lobby for such a subsidy. And if such a subsidy is once given, in the limit, the manufacturers should be willing to spend up to the extent of the subsidy to ensure that the subsidy continues. So once granted, the subsidy would be hard to remove. Furthermore, the manufacturers can come up with other explanations, about employment, industrial development, export potential and so on, to ‘justify’ the subsidy as well. One would require rigorous analysis and research to a) thwart attempts to lobby for such subsidies, and b) decide whether any subsidy should continue or not. Thus, in general, the political economy of subsidies/incentives would suggest that the government and people need to be very wary of arguments for subsidies and need to set strict standards for giving any subsidies, and the onus for making the case should be on the group lobbying for it. Subsidies and incentive schemes can be an important and sometimes necessary way of correcting market failures, defraying first mover disadvantages, subsidizing fixed and sunk costs, and for ensuring certain types of redistributions. But they are market distorting and they are costly. So, we need to have solid, well researched and well established reasons for extending any subsidies. Furthermore, there should be time table for phasing out of the subsidy accompanied with the arguments for extending the subsidy, and the time table should be strictly adhered to, unless there are good reasons not to. Finally, there should be, for all subsidies/incentive schemes, frequent and in-depth studies to figure out a) if the subsidy is indeed serving the purpose for which it was offered, and b) if it is time to phase it out.
1.2. Scoping the Study
5. Subsidies and incentive regimes take a variety of forms in Pakistan. Given that our focus in this set of reports is on domestic commerce, the limits of this study have to be delineated very carefully, to maintain the required focus. A review of available literature on subsidies as well as on key sectors of domestic commerce suggests that we scope out the study, so as to relate it to domestic commerce, to include the following categories of subsidies and incentives:
 Cross subsidization in energy pricing
 Financial incentives and incentives for development of facilities (storage, warehousing etc.)
 Subsidy on freight transport
 Incentives in the real estate sector
6. Each of the above sectors has a strong link with other sectors of domestic commerce we will be analyzing as part of our compendium of studies. Our objective in this exercise will be to see how these subsidies and incentive regimes affect domestic commerce, and what are the policy measures that can be adopted, in terms of possible changes to these subsidies and incentives, to promote domestic commercial activity.
4 See Mancur Olson’s ‘The Logic of Collective Action’ for detailed arguments regarding why larger more dispersed groups are at a disadvantage, usually, against smaller, better identified and better knitted groups when it comes to organizing collective action. The main points have to do with a) lower costs of organization in smaller groups, b) higher possibility of avoiding ‘shirking’ and being able to impose punishment on defectors, and c) the higher benefits, of any successful action, per capita, that members of a smaller group are likely to accrue.

7. In addition to the subsidies listed above that have a direct bearing on domestic commerce, we will also be looking at agricultural and export subsidies to the extent that these can generate production in key sectors, which will in turn have a bearing on domestic commerce. The report is structured as follows. Section 2 describes the nature of subsidies directly affecting domestic commercial activity. Section 3 analyzes agricultural and trade subsidies and discusses how these affect domestic commerce. Section 4 is the concluding section which also includes recommendations for the subsidies and incentives regime.

Section 2
Subsidies for Domestic Commerce
2.1 Cross Subsidization in the Energy Sector
8. There are two major forms of cross subsidization in the energy sector, which can affect domestic commerce. The first is cross subsidization in electricity and natural gas pricing, with commercial and industrial sectors subsidizing households; the second relates to the cross subsidization in the pricing of fuels, with diesel being priced below gasoline to facilitate freight transportation. In addition, there are a number of quasi-subsidies in the energy sector also, which can impact domestic commerce. These mainly take the form of domestic crude transport to refineries at subsidized rates (using the National Logistics Cell (NLC)), and a long term freight contract with the Pakistan National Shipping Corporation (PNSC) for transportation of imported crude oil, again at subsidized rates – thus a transport sector subsidy which allows two state owned enterprises to benefit. These different forms of subsidy are discussed in more detail below.
2.1.1 Cross Subsidization in Electricity and Natural Gas Tariffs
9. Energy pricing policies all over the world seek to achieve a balance between considerations of financial viability, and the need to extend service, and make basic infrastructure services available to all sections of the population. In Pakistan, equity considerations have given rise to a pricing policy wherein energy prices are skewed in favor of households (and agricultural users), at the expense of industrial and commercial consumers.
10. Power tariff determination was the sole preserve of the public sector utilities, the Water and Power Development Authority (WAPDA) and the Karachi Electric Supply Corporation (KESC) until the late 1990s. The tariff structure was complex, with a relatively low base tariff, and a number of surcharges.5 There was little or no determination of actual costs of supply, but tariffs for low voltage consumers (households and agricultural tubewell users) were estimated to be below cost. After the negative experiences with Independent Power Producers (IPPs) in the mid 1990s, the government decided to establish a regulatory authority to oversee the planned unbundling of WAPDA, and to create a level playing field for private companies envisaged to enter the power generation and distribution sectors. The National Electric Power Regulatory Authority (NEPRA) was established through an Act in 1997, with the mandate to determine tariffs for the generation, transmission and distribution of electric power, in addition to powers of licensing etc. Although the structure of the power tariff has been simplified over the past six years, with higher base rates, and a reduction in the
5 See Haider, Syed Waqar. 2004. Energy Pricing Policy in Pakistan: Existing Prices and a Proposed Framework. LEAD Pakistan Occasional Paper No. 17.

number of surcharges, the differentiation in tariff rates by consumer category remains. NEPRA has issued tariff determinations for all the eight distribution companies (DISCOs) servicing Pakistan, and for KESC. Although there are minor variations across the DISCOs, the range of rate differentials is fairly narrow, and an examination of average tariffs serves our purpose.
11. As can be seen from Table 2.1, for residential consumers (or the General Supply Tariff A-1 category), tariffs are determined at Rs. 2.41 per Kwh for the first 100 units of consumption. Commercial tariffs, on the other hand, are determined at Rs. 6.80 per Kwh (see the General Supply Tariff A-2 category). The maximum tariff for residential users is Rs. 6.74 per Kwh which becomes applicable for users who use more than 1000 units of electricity. Similarly, fixed minimum monthly charges are determined at Rs. 45 per month (for single phase connections) and Rs. 100 per month (for three phase connections) for households, whereas the comparable charges for commercial users are Rs. 150 and Rs. 300 respectively – a three fold increase. Industrial tariffs, though not comparable in the exact sense as the scale determination is different, nevertheless work out to be higher than residential, but lower than commercial tariffs.
12. The same structure of cross subsidization is apparent in natural gas pricing also (see Table 2.2), where rates for domestic consumers start at Rs. 80.98 per million cubic feet (mmcft), rising to a maximum of Rs. 306.79 per mmcft, while rates for commercial use average Rs. 271.07 per mmcft. Natural gas prices were historically fixed at rates lower than fuel oil, particularly for domestic consumers and fertilizer producers, a policy that caused inter-fuel substitution and increased the use of gas as a fuel both in the domestic and industrial sectors. However, as concerns about the depletion of domestic gas supplies has increased, and industrial consumers have had to face shortages and load-shedding in winter months as supplies are re-directed to domestic use, gas prices have been on the rise, increasing by almost 66 percent between 2002 and 2006.
13. The argument behind cross subsidization is rooted in the need to make essential infrastructure and services available to all sections of society, and to set tariffs in accordance with estimates of “ability of pay” for different income groups. Nevertheless, subsidies can have distorting effects on consumption, leading to wastages in sectors where costs are kept low, and a decrease of competitiveness in sectors where energy is priced at higher rates. While there has been a significant outlay of research on household and industrial energy demand and its relation with prices, there is no parallel research for the commercial sector, and little information on how electricity pricing in particular affects wholesale and retail trade, as well as storage (particularly cold storage).
14. Information from the domestic commerce survey indicates that the mean monthly expenditure on electricity on retail establishments is Rs. 3662, while the median expenditure is Rs. 1200. In contrast, the Household Income and Expenditure Survey (HIES) for 2001-02 reports average household expenditure on fuel and lighting as Rs. 529 per month, of which 46 percent is spent on electricity. Even the highest income quintile in the HIES survey, expenditure on fuel and lighting is just Rs. 730, with 56 percent of this, or Rs. 408 spent on electricity. For urban areas, average monthly expenditure on fuel and lighting for the highest income quintile was Rs. 844, and average monthly expenditure on electricity was Rs. 472. While the HIES is a nationwide survey, and even the highest quintile in the survey may not represent the middle class urban consumers, there is little doubt that average monthly expenditure on energy is likely to be significantly higher for commercial enterprises than for households, for a given level of energy consumption.
15. There are too many questions that need to be answered in this area before we can come to a more informed decision on whether the current tariff structures and cross subsidization levels make economic sense or not. It is not clear, so far, if the tariff rates being imposed on any

of the customer categories are optimal or if they are a result of many years of cost plus thinking. If the latter is the case, NEPRA needs to have an exercise to determine optimal tariffs and then decide whether WAPDA/KESC should deviate from these tariffs or not. Charging higher rates to industry and commercial activity, on the margin, does raise their cost of business. In fact most surveys, including ours, has pointed out that the cost of electricity is one of the major concerns for people in both manufacturing as well as trade. It constitutes one of the major input costs for most manufacturing processes. At the same time we know it is cheaper to supply electricity to larger clients (industry) than physically dispersed domestic users, and it is easier to collect bills from commercial/industrial clients as well. More importantly, the government needs to decide if the higher charge to industry and trade is raising their costs to the extent that it is having a significant distortionary effect on their current business, growth prospects and future investment plans6. If there is a significant effect of these, the government needs to decide whether the cross subsidization should continue as it is, or it would be better to fund WAPDA and KESC losses from domestic consumers through another source. The current tariff structure might also be diluting WAPDA/KESC incentives for achieving higher levels of efficiency and delivery of better quality service (both issues have been flagged in our survey), the subsidy needs to be restructured to ensure such dilution does not occur. Most of the responsibility for undertaking the research and analysis mentioned above lies with NEPRA. Currently, NEPRA does not have the experience and expertise needed for such analyses and significant investments need to be made in human and technical resources at NEPRA before they will be able to carry out the required work.
Table 2.1: Schedule of Electricity Tariffs
Effective 1-07-2005
Tariff Category/
Fixed/Min
Energy
F.A.S.
Additional
Surcharges
Total
Particulars
Charges
Charges
Subsidized
Surcharge
@ 10.4%
Avg-Rate
(Rs/KwM)
(Rs/Kwh)
(Rs/Kwh)
(Rs/Kwh)
(Rs/Kwh)
(Rs/Kwh)
GENERAL SUPPLY TARIFF A-1( including FATA)
Upto 50 Units
-
0.61
0.73
0.06
1.40
For Consumption > 50 units upto 1000 units
0.00
0.00
0.00
For First 100 units
-
0.41
0.43
1.48
0.09
2.41
For next 200 units
-
0.58
0.43
2.19
0.11
2.31
(101-300)
For next 700 units
-
1.51
0.43
3.45
0.20
5.59
(301-1000)
Above 1000 units
-
1.88
0.31
4.32
0.23
6.74
Minimum Monthly Charges:
a) Single Phase Connections Rs 45/-
b) Three Phase Connection: Rs 100/-
GENERAL SUPPLY TARRIF A-2( including FATA)
For first 100 units
-
2.70
0.00
3.82
0.28
6.80
Above 100 Units
-
2.94
0.00
3.67
0.31
6.92
For peak load requirement above 20kv
220
1.09
0.12
2.83
0.23
5.27
Minimum Monthly Charges:
a) Single Phase Connections Rs 150/-
b) Three Phase Connection: Rs 300/-
Continued…
6 Many other countries have their tariffs structured the other way. Industry pays lower rates. The argument for such tariffs is that lower rates for industry encourage competitiveness, industrial activity, expansion and investment. The benefits accruing from such an expansion, in terms of more jobs and national income, would in the long run not only allow people to have higher incomes, they would make further growth possible as well. For achieving the positive outcome, if current domestic consumers have to sacrifice a little, in terms of paying a little more, it would make sense to do that at a national level and even at individual level customers might eventually be better off, due to higher incomes, than if they were currently subsidized at the cost of future industrial growth.

Effective 1-07-2005
Tariff Category/
Fixed/Min
Energy
F.A.S.
Additional
Surcharges
Total
Particulars
Charges
Charges
Subsidized
Surcharge
@ 10.4%
Avg-Rate
(Rs/KwM)
(Rs/Kwh)
(Rs/Kwh)
(Rs/Kwh)
(Rs/Kwh)
(Rs/Kwh)
INDUSTRIAL SUPPLY
B-1 upto 40 kw
-
1.81
0.13
2.97
0.20
5.11
There shall be minimum monthly charges of Rs 70/Kw for first 20 Kilowatts of load and Rs 90/Kw for rest load between 21 - 40 kw
B-2 (>41-500 kw)
300
1.30
0.13
1.99
0.26
4.76
B-2 TOD ( Peak)
300
1.98
0.13
2.22
0.36
6.01
B-2 TOD (Off Peak)
300
1.20
0.13
2.07
0.24
4.57
B-3 (Normal) 11&33 kv not exceeding 5000 kw
290
1.29
0.13
2.01
0.22
4.38
B-3 TOD (Peak)
290
1.97
0.13
2.68
0.28
4.61
B-3 TOD (off Peak)
290
1.15
0.13
1.60
0.19
3.62
B-4 Normal 66/132/220 kv - All loads
280
1.24
0.13
1.86
0.23
4.29
B-4 TOD (Peak)
280
1.87
0.13
1.69
0.27
4.57
B-4 TOD (off Peak)
280
1.11
0.13
1.49
0.19
3.50
Source: Government of Pakistan. 2006. Economic Survey, 2005-06. Economic Advisors Wing. Finance Division.
Note: 1) The above figures cover some portion of the tariffs schedule. For full details, WAPDA may be consulted.
2) The above tariffs are inlusive of GOP subsidy in FAS and discount in addl. Surcharges
Table 2.2: Schedule of Natural Gas Prices
(Rs/mcft)
Date / Category
20-8- 2002
25-10- 2002
21-3- 2002
20-8- 2002
1-7- 2003
1-7- 2004
2-2- 2005
1-7- 2005
1-1- 2006
DOMESTIC (Slab)
I
Upto 3.55
66.86
67.95
67.95
67.95
69.31
73.95
73.95
73.95
80.98
II
3.55 to 7.1
100.73
102.37
102.37
102.37
104.42
111.42
111.42
127.92
147.41
III
7.1 to 10.64
161.16
163.78
163.78
163.78
167.06
178.25
192.96
204.17
235.84
IV
10.64 to 14.20 (MCFT/M)
201.45
213.06
213.06
213.06
217.32
231.88
251.01
265.59
306.79
V
All over 14.20
217.85
COMMERCIAL
186.98
190.02
190.02
190.02
193.82
204.88
221.78
234.67
271.07
General
166.18
168.88
168.88
168.88
172.26
182.09
197.11
208.56
240.91
Cement
222.32
222.32
222.32
222.32
209.78
209.78
227.09
240.28
277.55
CNG Station
166.18
168.88
168.88
168.88
172.26
182.09
197.11
208.56
240.91
Pakistan Steel
208.56
Captive Power
208.56
240.91
FERTILIZER
SNGPL'S SYSTEM
(i)For Feed Stock
Pak.Americal Fertilizer Ltd.PAFL
36.77
36.77
36.77
36.77
36.77
36.77
36.77
36.77
36.77
F.F.C Jorden
36.77
36.77
36.77
36.77
36.77
36.77
36.77
36.77
36.77
Dadoud/ Pak Arab
62.57
62.57
62.57
62.57
67.26
73.99
73.99
83.24
83.24
Pak china/ Hazara
66.40
66.40
66.40
66.40
71.38
78.52
78.52
88.34
88.34
(ii)For Fuel Generation
166.18
168.88
168.88
166.88
172.26
182.09
197.11
208.56
240.91
Daood and Pak Arab
168.88
168.88
168.88
FOR MARI GAS CO. SYSTEM
(i)For Feed Stock
FFC Engro Chemical(New)
13.09
13.09
61.68
61.68
66.31
72.94
72.94
82.06
82.06
Continued…

(Rs/mcft)
Date / Category
20-8- 2002
25-10- 2002
21-3- 2002
20-8- 2002
1-7- 2003
1-7- 2004
2-2- 2005
1-7- 2005
1-1- 2006
FFC Engro Chemical(Old)
61.68
61.68
61.68
61.68
66.31
72.94
72.94
82.06
82.06
Pak Saudi
61.68
61.68
61.68
61.68
66.31
72.94
72.94
82.06
(ii)For Fuel Generation(Power)
166.18
166.88
168.88
168.88
172.26
182.09
182.09
208.56
SNGPL & SSGCL'S SYSTEM
166.18
168.88
168.88
168.88
172.26
182.09
197.11
208.56
Liberty Power Ltd.
190.80
190.80
190.80
222.89
235.77
234.33
262.03
303.25
303.25
GAS DIRECTLY SOLD TO
WAPDA'S GUDDU POWER STATION
SUI FIELD (917 BTU)
145.51
KANDHKOT FIELD (866 BTU)
160.54
163.15
163.15
163.15
166.41
175.90
190.41
201.47
232.72
MARI FIELD (754 BTU)
156.14
158.86
158.68
158.68
161.85
171.08
185.19
195.95
226.34
SARA/SURI FIELD
156.14
158.68
158.68
158.68
161.85
171.08
185.19
195.95
Source: Government of Pakistan. 2006. Economic Survey, 2005-06. Economic Advisors Wing. Finance Division.
2.1.2 Cross Subsidization in Fuel Pricing
16. The transportation of finished petroleum products from the refineries to supply stations all over the country is regulated under the Equalized Prices and Freight Pool system. As the name suggests, the system ensures that product prices are the same throughout the country, and prices are determined on a cost plus formula, wherein average freight cost, government levies, distributor and dealer margins (at 3.5 percent and 4 percent respectively) and sales tax (at 15 percent) is added to the ex-refinery price to determine the end-product price. In July 2001, government gave the responsibility for consumer price determination of petroleum products to the Oil Prices Advisory Committee (OCAC) which revised product prices fortnightly in accordance with international prices of crude oil, and which determines the ex-refinery price on the basis of “import parity,” or the landed price of crude oil.7 Since May 2006, this task has been carried out by the Oil and Gas Regulatory Authority (OGRA).
17. While deregulation has thus taken place to some extent (as import price follows the trends in the international market), the surcharges and levies on petroleum products give the government the opportunity to maneuver within the price mechanism and maintain differential pricing. The government has consistently followed a policy of keeping the prices of diesel below the prices of different forms of gasoline (as shown in Table 2.3 below). As the table illustrates, diesel is exempted from export duty, petroleum levy and dealer margins, and charged significantly less for inland freight and OMC margin, resulting in a sale price that is almost 50 percent less than the price of motor spirit.
Table 2.3: Breakdown of Sale Prices of Petroleum Products
Price Breakdown as of 1 December 2006
Ex-refinery / IPD
Excise Duty
Petroleum Levy
Inland Freight
OMC Margin
Dealer Margin
Sales Tax
Sale Price
Motor spirit
26.87
0.88
17.79
1.13
1.63
1.87
7.53
57.70
HOBC
27.60
0.88
22.43
1.57
1.84
2.10
8.46
64.88
High Speed Diesel
25.51
0
0
1.85
0.96
0
4.25
32.57
Source: OGRA website
7 See www.ocac.org.pk/ex_refinery5.asp for the detailed pricing formula.

18. The subsidy on diesel is estimated at about Rs. 5 per liter. Given that about 8 million tonnes of diesel are consumed annually in Pakistan in the road transport sector, the subsidy on diesel is estimated to cost the government about Rs. 60 billion.8 Fuel costs are estimated to constitute about 65 percent of freight costs on any given route.9 The substantial subsidy on diesel thus ensures that road freight transport charges in Pakistan are amongst the lowest in the world.10 While retailers and wholesalers on the whole benefit from this strategy (although experience low quality of service), the transport sector itself sees it as a double- edged sword. On the one hand, possibilities for expansion of the sector are considerable as the economy grows, but on the other hand, the sector generates relatively low profits on a per unit basis. The environmental costs, in terms of pollution, are also higher for diesel than petrol or CNG. But this cost has not been estimated and added to the overall cost of the subsidization policy. In fact, there seems to be a clash of subsidies here as well. The government has announced, a number of times, that they would like public transport, especially intra-city passenger transport, to shift to CNG instead of diesel due to the high pollution costs, and has even announced some incentives for helping with the conversion. But if diesel prices are also subsidized, the subsidy on CNG would have to be higher to make the conversion possible. The diesel subsidy thus needs to be revisited in light of the estimates of the pollution costs.
2.2 Financial Incentives
19. Pakistan’s financial sector has witnessed extensive liberalization since reforms began in 1991, and the system of provision of subsidized credit for priority sectors has largely been done away with. However, the commercial sector is at a disadvantage when it comes to formal sector financing options, as banks have little experience of lending to commercial enterprises, and such enterprises often cannot meet the collateral requirements of formal sector financial enterprises. There is little published data on the banking sector’s lending to commercial enterprises - the State Bank’s Annual Report gives data for growth in private sector credit by type of business, and reports a growth of 43.5 percent in credit to Commerce and Trade in FY200611, but this is surmised to be primarily growth in trade financing.12 However, there are some tax incentives offered to the commercial sector which are listed as follows.
20. Withdrawal of Excise Duty on Travel by Train: Excise duty on train travel (on second and third class coaches) has been withdrawn with effect from June 2006, a measure which was anticipated to ease the load on road transport13 and provide some benefit to the lower income commuters and travellers.
21. Zero Rating of Sales Tax on Import and Supply of Trucks and Dumpers: In another measure announced in June 2006, sales tax on import of heavy vehicles (5 tonnes and above) and on the inputs used in manufacture of such vehicles was withdrawn to facilitate use of such equipment, mainly in construction and allied industries.
8 Using a measure of 1.42 kg to a liter.
9 See report on Transport, which is part of the compendium of reports on domestic commerce.
10 See chapter on Transport in the Interim Progress Report for a discussion on this.
11 For a more detailed discussion of the regulatory issues involved in this area, see the chapter on regulatory issues in domestic commerce.
12 See State Bank of Pakistan. 2006. Annual Report. Table 5.5, pp 99.
13 Though this is not likely to result in a major shift. Railway carries only about 10 percent of the overall inter- city passenger traffic, and the popular routes are usually over crowded. So even with the incentive, the passenger shift that can be expected can only be small.

22. Sales Tax Exemption on Aircrafts of All Kinds: Such exemptions were earlier in place for heavy aircraft only, but since June 2006, have been extended to all aircraft to promote the growth of small cargo carriers14.
23. Input Tax Adjustment for Wholesalers/Retailers: Wholesalers and retailers importing in bulk have, since July 2006, been allowed to adjust input taxes against sales tax under the regular VAT regime. The measure is designed to encourage traders to pay sales tax at the standard rates.
2.3 Policy Package for Developing Storage Facilities
24. The trade policy for 2006-07 mentions the provision of subsidized credit for the establishment of cold storage facilities, and for the cost of obtaining international certifications such as the ISO certifications. In addition, the policy announced that any company setting up cold storage facilities would be eligible to use the Export Development Fund (EDF) to meet the first 6 percent of the mark-up of any credit obtained for the purpose. The key development here was that the facility was extended to all private sector entrepreneurs opening up cold storage facilities, and not just to those whose goods were explicitly marked for export. A recent report indicates that the capital expense of setting up a cold storage is Rs. 16.2 million, and the project would have an estimated financial internal rate of return (FIRR) of 16.8 percent.15
25. Although the terms of the package were broadly outlined in the trade policy, implementation has not begun in earnest. The storage owners contacted during the focus group meetings were unaware of this facility, and the survey data, particularly data on financing does not indicate any use of such a facility. Moreover the Ministry of Commerce itself does not appear to have developed the scheme further or made any attempt to operationalize it as yet16.
2.4 Subsidy on Freight Transport
26. In addition to the subsidization of freight transport through differential fuel pricing as mentioned in Section 2.1.2, the government also provides targeted subsidies to certain public sector freight enterprises by disallowing the entry of private competitors in some fields, such as transport of crude oil. This policy is meant to control prices of essential commodities, but has resulted in the creation of near-monopolies in some forms of freight transport as explained below.
2.4.1 The National Logistics Cell (NLC)
27. The NLC was formed in 1978 as a means of transporting essential commodities across the country, in an attempt to forestall hoarding. NLC assumed prominence particularly
14 This looks like a classic case of an incentive being given without any real justification for it. Domestic air transport of cargo is a negligible part of the overall market, and cost structures are such that it is likely to remain so in the future too. Air travel is a very small part of the total inter-city domestic travel as well. But the incentive has still been extended. It seems that this measure was more to facilitate import of smaller planes that some of the richer people in Pakistan had started to buy. But in that case the incentive was not needed. A rich person thinking of importing a plane is unlikely to be affected by sales tax if he/she is deciding whether to buy a plane or not.
15 See Asian Development Bank. 2005. Report and Recommendations of the President to the Board of Directors on a Proposed Loan to the Islamic Republic of Pakistan for the Agribusiness Development Project. Table A.12.1, pg 63.
16 For regulatory issues related to storage, and a justification of such a subsidy, see the chapter on regulatory issues.

after 1979, when it became the primary agency in charge of logistics for relief goods for the Afghan refugees. The company currently has a fleet of 1700 heavy duty trucks,17 500 units of earth moving equipment, as well as bowsers for transportation of liquids (mainly crude oil), and is now involved in construction (and has expanded its services to Afghanistan and Qatar), toll collection on specified routes, machinery renting, and even cultivation of mushrooms!18 The company is also expanding into development of port facilities, including installation of equipment for detection of trade in contraband; and in its last annual report, mentions moving into real estate development and private equity investment. Of its total revenue in FY2004, only 43 percent came from transport, while 39 percent was from construction, 12 percent from its dry ports facilities and the remaining from tolling and other enterprises.
28. In 2006, the NLC signed MOUs with the Government of Punjab for upgradation of buildings and other civil works in public sector schools, rural health centers and hospitals and police posts. The Corporation was given this responsibility because of allegations of rampant corruption in the award of contracts on the part of district level Departments of Civil Works. Although it will use the same method of awarding contracts and will probably use the services of the same contractors used by the district governments, NLC’s superior management practices are supposed to curb corruption. It is still too early to comment on the effects of this policy.
29. Although NLC manages less than 5 percent of the freight transport in the country, it has exclusive rights for road transportation in some areas. It is the only agency allowed to transport goods by road for Afghan Transit Trade (ATT), as it was the first company in Pakistan with bonded container facilities. Since 1994, private operators have entered the field, but the transport of commodities for the ATT remains an NLC preserve. Until the mid 1990s, the company was the sole transporter of domestic crude oil from the field to the refinery, but crude transport has since been opened up to private operators.19
2.4.2 Pakistan National Shipping Corporation (PNSC)
30. After nationalization of the shipping industry in 1971, the PNSC became the sole shipping company in Pakistan. Since the early 1990s, there have been attempts to encourage private sector shipping operations, but these have proved largely unsuccessful. PNSC has a fleet of 15 vessels (including 4 tankers), and in 2001 was awarded a ten year contract to carry all crude oil imports into Pakistan. In the same year (2001), the government again made an attempt to promote private shipping by offering a range of financial incentives for private shipping, but given PNSC’s monopoly in the transportation of crude oil, and the fact that private shipping companies had to obtain a “no-objection certificate” from PNSC if applying to transport government cargo, there was little chance of private operators entering the shipping business.
17 Recent newspaper reports indicate that the NLC may be allowed to import 300 used trucks duty free. The government has maintained a tariff on import of used trucks to protect domestic manufacturers, and has not waived this restriction in the face of repeated demands from private transporters.
18 See National Logistics Cell. Annual Report, 2005.
19 The World Bank’s Oil and Gas Sector Review, 2003, contends that NLC is the sole transporter of indigenous crude oil in Pakistan. The NLC counter claims that it transports on an average, only 40 percent of crude oil transport to Pakistan’s refineries (see letter to the editor in the News International, January 19, 2006).

2.5 Incentives in Construction
31. According to the National Housing Policy of 2001, there was a backlog of 4 million housing units in the country in that year, with the backlog growing at the rate of 300,000 units each year. Construction is acknowledged to be a sector with strong backward and forward linkages, and significant growth in this sector can have a remarkable impact on growth of incomes. Given the buoyancy of the sector, and the unmet demand in the housing sector, the government has been keen to introduce incentives in the housing and construction industries. Since FY2002, the government has progressively introduced financial incentives in the housing sector, allowing a proportion of the markup on housing loans to be tax deductible, and introducing measures to encourage housing finance including increasing the maximum lending limit and the loan period for loans given by the House Building Finance Corporation (HBFC). Nevertheless, the growth of housing has been hampered by uncertainties and the prevalence of fraudulent practices in the land titling and registration processes, and by delays in the development of basic infrastructure (mainly roads), obtaining utility connections20.
32. Financial incentives, as announced by the government in successive budgets, cannot have a major impact in a construction market where housing finance is practically unheard of. However, the clear definition of property rights and transparency in procedures regarding the sale and transfer of property, as well as the efficient supply of facilities and infrastructure to housing estates would have a much greater impact in promoting the sector. For low and medium cost housing, such incentives have been provided on a very limited scale, with NGO involvement in schemes such as the Khuda ki Basti and the Incremental Housing Development Schemes (IHDS) in Karachi and Hyderabad respectively. In high cost housing, schemes developed by the Defense Housing Authorities are the prime examples of such developments where the true incentives to construction come from clear legal processes for land ownership, and the provision of quality infrastructure. These schemes are discussed as follows.
2.5.1 Khuda Ki Basti and the IHDS
33. The IHDS (which was later replicated under the name Khuda ki Basti in eight areas in Karachi and Hyderabad) was the brainchild of the then head of the Hyderabad Development Authority (HDA), Tasneem Siddiqi. The first scheme was started on government land in 1986, and was developed using an “incremental” approach in that plots were allotted at affordable prices, and facilities were then developed incrementally as payments were made. Thus the scheme started out with just a communal water supply scheme, and public transport links to the city center, but as allottees continued to pay their monthly installments for ownership of the land, facilities were added till the full range of basic facilities, i.e. house to house water connections, electricity, roads etc were made available.
34. The scheme differs from other developments in low cost areas, because ownership rights were accorded to the allottees after payment of the initial amount, and facilities were added on after ownership had been established. This was in reverse to the practice usually followed in slum areas where basic facilities are provided at expensive rates, but land ownership is never established. The HAD devised a number of steps to discourage speculation in the scheme, including demarcating a large number of small plots, issuing ownership papers once allottees had started building shelters, and ensuring that families are being accommodated in the housing being built.
20 See chapter on regulatory issues as well.

35. The IHDS is an example of a government agency taking the lead to provide incentives to rightful owners to develop housing for their own use, rather than encourage speculation. However, the development of the scheme had more to do with the efforts of an individual, with a strong development ethos, rather than an entrenched process. The success of the schemes is expected to have results though, with the government considering the possibility of replicating the Karachi schemes in the form of “sasti bastis” all over the country. Sasti bastis are now functional in five districts in Sindh under the auspices of the Sindh Katchi Abadies Authority (SKAA). Similar proposals are under consideration in Punjab, possibly to be carried out by the proposed Punjab Urban Commission.
2.5.2 Defense Housing Authorities
36. For high income consumers, government incentives for housing and construction take the form of management of housing schemes in all major cities by the Defense Housing Authorities (DHAs) owned by the military, who acquire land, or develop housing estates on land owned by the military. The DHAs in Karachi and Lahore were originally formed as Cooperative Housing Societies (the Karachi society was formed as far back as 1953), but were later converted through Presidential Orders or Ordinances into Housing Authorities. Other DHAs, most recently in Islamabad/Rawalpindi have also been constituted under Ordinances. The practice of the military acquiring land to parcel out as part of a package of benefits to its personnel originated in British India, and was conceived as a way for the Crown to retain the loyalties of the armed forces in colonized lands. The practice has continued post partition, but has assumed complexity as development of real estate on military lands, or on state lands acquired by the military, and real estate transactions by military owned agencies have significantly increased in value.
37. DHAs have an upper hand in the housing market because of the security of land title once the scheme is announced, the relative ease of infrastructure provision, and good maintenance of infrastructure in the housing estates. However management and allotment systems in these schemes are typically opaque, and land acquisition for such schemes has invariably been at below market rates.21 The DHAs are essentially a distortion in the real estate market and represent a significant subsidy to military personnel who come to acquire the land as part of their package of benefits, and to real estate developers associated with the military who are provided opportunities to develop the land on favorable terms. While it is difficult to quantify the extent of the subsidy to DHA, it is likely to be exceptional – according to one estimate, 3375 acres of land were acquired for the Rawalpindi DHA at a cost of Rs. 11 billion, and the land was later sold for Rs. 135 billion.22
21 Land acquisition in the recently developed Lahore DHA and the Rawalpindi DHA is a case in point. In both cases, there are reports of original owners not being compensated adequately, or being pressurized to give up land.
22 See Agha, Ayesha Siddiqa. 2006. The New Land Barons? Article in Newsline, July.

Section 3
Agricultural and Trade Subsidies
3.1 Agricultural Subsidies
38. Pakistan’s accession to the WTO requires it to furnish the WTO Secretariat with details of subsidies given in agriculture. According to Annex 2 of the Agriculture Agreement under the WTO, permissible subsidies in the agriculture sector, also called “Green Box” subsidies, cannot distort trade and must cause minimal domestic distortion. In addition, price support of any kind is not permissible, and subsidies have to be funded out of government budgets and clearly identified in budgets as such, rather than be funded by passing on the burden of subsidization to the consumer. Pakistan provides support to agriculture through subsidization of research, storage and marketing, extension services, and infrastructure and flood protection services. The table below gives Pakistan’s outlays under the green box.
Table 3.1: Green Box Subsidy Outlays (Million US $)
Type of Measure
1986- 88
1995- 96
1996- 97
1997- 98
1998- 99
1999- 00
2000- 01
2001- 02
Total
General services on research
14.5
12.8
7.7
7.6
2.44
3.18
1.67
2.14
52.03
Storage facilities
4.8
0.8
0.3
0.2
0.00
0.08
0.19
0.04
6.41
Marketing services
0.1
0.1
0.1
0.0
0.11
0.00
0.02
2.32
2.75
Extension services
22.1
2.4
2.2
1.6
2.44
1.86
4.58
8.87
46.05
General services
0.3
0.5
0.0
0.0
0.70
0.01
0.06
0.30
1.87
Infrastructural services
147.5
335.0
312.6
266.1
235.76
213.07
203.59
140.94
1854.56
Flood protection services
7.9
34.6
15.9
22.8
7.94
7.18
7.38
1.17
104.87
Water supply services
31.3
53.7
53.9
14.1
14.43
13.04
7.71
0.82
189
Total
228.5
439.9
392.44
312.45
263.82
238.42
225.2
156.6
2257.54
Source: WTO Notifications
39. As the data shows, infrastructure and flood protection services (which include primarily the construction and maintenance of the irrigation infrastructure) account for the bulk of subsidy payments for the sector, with only nominal expenditure on research and development, extension and storage and marketing

3.2 Trade Subsidies and Incentives
40. Pakistan cannot provide direct export subsidies as it used to prior to its inclusion in the WTO regime, but can subsidize the cost of marketing and transportation of exports. The government employs a range of incentive systems for exporters, mostly in the form of financial incentives. Some of the key incentives in this regard are as follows.
41. Trade incentives offered by the SBP take a variety of forms including concessionary credit for exporting industries and concessionary trade financing. The four main schemes of the SBP are discussed below.
3.2.1 Export Finance Scheme
42. The Export Finance Scheme (EFS) was first sponsored by the SBP in 1973 to facilitate the provision of bank credit to exporters, and has undergone many transformations over the years as the government has faced pressure from international agencies on the provision of subsidized credit. Exporters are eligible (upon satisfaction of certain conditions) under the scheme to obtain export finance (post pre and post shipment) from commercial banks at a markup rate which is linked to the weighted average yields of T-bills and Pakistan Investment Bonds (PIBs).
43. Other related incentives include the establishment of the Pakistan Export Finance Guarantee Agency (PEFGA), which provides insurance against risk for exporters and thus covers the collateral requirements of banks. The PEFGA credit thus enables exporters to hedge against the financing risks of commercial banks.
3.2.2 Long Term Financing of Export Oriented Projects (LTF-EOP)
44. The second major scheme sponsored by the SBP, and initiated in 2004, enables financial institutions to provide credit at attractive terms to export oriented firms who require financing for imports of raw materials, machinery, plant and equipment not manufactured locally. The scheme was announced as a follow up to incentives for exporters announced in the Trade Policy for 2003-04. Under the scheme, the SBP provides refinance facilities for banks lending to manufacturers who export at least 50 percent of their output. Rates of refinancing are determined on the basis of the weighted average yields on 12 month T-bills and 3 to 5 years Pakistan Investment Bonds (PIBs). Banks are permitted to earn a maximum spread of 2 percent under the scheme.23
45. While banks make decisions on who to lend to, they are constrained to make choices from amongst clients who fulfill certain criteria, and who make specific requests for machinery import. The scheme is also supposed to encourage SME participation – initially 50 percent of funds allocated by the SBP to specific banks for refinancing purposes were supposed to be used for refinancing of loans given to SMEs. This condition has now been done away with, but banks are encouraged to prioritize the needs the SMEs. Funds loaned under the scheme can also be utilized to import equipment necessary to acquire a brand name or franchise.
3.2.3 Scheme for Locally Manufactured Machinery
46. The scheme was initiated in 1987 and provides concessionary finance for export of locally manufactured machinery. The scheme is applicable to “the manufacture of plant,
23 This was previously 3 percent, but was reduced by a percentage point in FY2007.

equipment, transport equipment, cargo vessels, ships, fixtures, fittings, accessories and consumer durables which are to be used for industrial applications and which undergo processing in Pakistan for value addition.”24 The scheme does not cover machinery and equipment that uses more than 80 percent imported components, and it provides for both pre and post shipment finance.
3.2.4 Scheme for pre and post Shipment Under FE25
47. Foreign exchange deposits were made available for trade financing under the FE-25 scheme after the 1998 freezing of foreign currency accounts. The scheme started operating in August 2002, and works on a self-liquidating basis. Authorized foreign exchange dealers extend pre-shipment finance to exporters, and are then allowed to adjust the loan against the proceeds of the post-shipment facility, like discounting of foreign bills in foreign currency. The scheme was considered feasible in that it enabled banks to earn higher returns than they were earning by placing the funds in foreign countries at rates of barely 2 percent. It also facilitated exporters who could obtain finance at 4 percent interest rather than the 8 percent they were charged on local currency loans under even concessionary finance schemes. There was no currency risk involved as export proceeds were being used to pay off the loans.
48. The Ministry of Commerce offers a range of incentives to exporters including freight subsidy, support for marketing and research and development (R&D), as well as a range of fiscal incentives. These are discussed as follows.
3.2.5 Freight Subsidy Scheme
49. The scheme was announced in the trade policy for FY2003, and consisted of a 25 percent freight subsidy on export of new goods, and goods going to new markets. The scheme has since undergone some modifications, and is currently tenable for exports to Africa, Eastern Europe (non EU countries), Central Asia and the Pacific Islands. In addition, the subsidy is available to exports which fall in the “developmental” category, even if they are going to established export markets. The export of leather goods is also eligible for a 25 percent freight subsidy.
3.2.6 Skill Development and R&D Support for the Textile Sector
50. The Ministry of Commerce sponsored the establishment of the Textile Skill Development Board to facilitate training for workers in the textile industry. In 2005, the Government extended the facility of a 6 percent compensatory rebate to the garment and knitwear industry. The scheme has been extended to June 2008 at a lower rate of rebate.
3.2.7 Quality Standards Certification
51. The Ministry covers 50 percent of the costs of acquisition of certain quality standards by exporting firms. In addition to the ISO certifications, this scheme now covers eco labeling and certification of organic foods.
24 See the website of the Export Promotion Bureau, www.epb.gov.pk.

3.2.8 Financial Incentives
52. There are a number of financial incentives for exporters including taxing export proceeds at concessional rates of withholding tax; concessional corporate tax rates for SMEs; sales tax exemptions on gas and electricity for five export industries, as well as exemptions on imports of certain items of machinery and some kinds of plants; and sales tax exemption on purchase of raw materials for certain industries among other things.
53. The TDAP is the new face of the Export Promotion Bureau (EPB) – the Authority came into being as a result of a Presidential order issued in November 2006. As was the case with the EPB, the TDAP is mainly concerned with export marketing and facilitation. Some of the key incentives offered by the TDAP are as follows.
3.2.9 Support for Participation in Trade Fairs
54. The TDAP provides full funding for participation of women entrepreneurs in trade fairs abroad. This is in addition to the 50 percent subsidy on airfare and per diem given to business delegations.
3.2.10 Support for Certification
55. TDAP provides an interest subsidy on loans acquired for the establishment of certification and accreditation facilities, and also supports the full cost of consultancy services for the establishment of such facilities. It also bears 75 percent of the cost of product listing in a lab specified by a foreign importer, under a plan to provide financial support for mandatory certifications.
3.2.11 Support for Establishment of Retail Outlets Abroad
56. The TDAP provides financial support to meet rental costs of retail outlets established in other countries for a period of three years. For the first year, the TDAP meets 50 percent of rental cost, while in the second and third years 25 percent and 10 percent of rental costs are covered by TDAP.
3.3 Impact on Domestic Commerce
57. The purpose of the above listing is to assess the possible impacts of agricultural and trade subsidies on domestic commerce, particularly on retail and wholesale trade, transport, storage and real estate. Agricultural subsidies in general have little direct impact on these sectors beyond the residual effects they may have based on their effects on production. The only area of domestic commerce directly affected by agricultural subsidies is storage, given the federal government’s support for the Pakistan Agricultural Storage and Services Corporation (PASSCO), the prime public sector agency responsible for the storage of grains, particularly wheat. In addition to PASSCO, provincial Food Departments also manage public sector grain storage facilities. Until some years ago, grain storage was exclusively the preserve of the public sector, but in 2001, with the government increasingly under pressure from international agencies to deregulate the wheat market, the private sector was allowed to participate in the procurement and storage of wheat. However, in spite of the federal government agreeing to conditionalities of at least one multilateral donor, the Asian Development Bank (ADB), to phase out provincial food departments and restructure PASSCO and restrict its role, little progress has been made on either of these initiatives.

58. With regard to trade subsidies, the key impacts on domestic commerce come through the effects of subsidies on production. An analysis of whether trade subsidies do indeed boost local production and export is beyond the scope of this study. However, our hypothesis would be that if these effects are indeed observed, trade subsidies would indirectly boost the domestic commerce sector, particularly wholesale trade, storage and transport. Data limitations, however, do not permit us to quantify these effects.

Section 4
Conclusions and Recommendations
59. Compiling an exhaustive list of subsidies and incentives to domestic commerce is an arduous task given that there are few subsidies explicitly directed towards these sectors. The bulk of our study has concentrated on analyzing the effects of “hidden subsidies” given to certain institutions or sectors, many of which actually function as taxes on the domestic commerce sector. Thus, differential utility rates act as taxes on domestic commerce, as does preferential treatment given to certain public sector corporations. There is little by way of direct subsidization of commerce beyond the few financial incentives we have listed here. This is perhaps appropriate in a policy environment that is increasingly moving away from subsidization. However, in the same spirit, it is advisable to review policies which discriminate against the private sector in domestic commerce. Our recommendations are summarized as follows.
4.1 Policy Recommendations
60. Medium Term: In the medium term, there is a need to resolve issues of negative taxation in the commercial sector, in addition to a need to make subsidies explicit in budget documents.
 Utility and fuel pricing regimes need to be carefully reviewed as part of the ongoing restructuring of the energy sector. While the need for some degree of cross-subsidization may be necessary given equity considerations and the need to supply basic services to low income households, the commercial sector cannot pay a price for the lack of efficiency and mismanagement in utility providers.
 The subsidization of freight prices may benefit the commercial sector in terms of ensuring cheap transport, but entails environmental costs and hinders the adoption of fuel efficient technology and better maintenance practices in road transport. Given the recent meteoric increases in oil prices, it is not advisable to urge a rationalization of diesel prices at this stage, but the cost of the diesel subsidy should be clearly identified in budget documents to give the government a clear idea of its expenses in this regard, and to facilitate a possible review of the policy at a later stage, perhaps when more fuel efficient technologies gain prominence.
61. Long Term: In the long term, there is a need to ensure a level playing field for all stakeholders in the trade and commerce sector. The performance of the NLC and the PNSC needs to be reviewed in addition to PASSCO, to assess the feasibility of allowing the public sector to operate in areas where private sector capability is increasingly available. While it is true that the role of the NLC has been substantially reduced in recent years, the PNSC has not been subjected to similar scrutiny. In the real estate sector, an effort must be made to provide

a level playing field to developers with transparent systems for provision of infrastructure. There is also a need to develop an integrated model on the effects of trade subsidies on the domestic economy.

The State of Domestic Commerce in Pakistan Study 3 - Subsidies and Incentive Regimes

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The State of Domestic Commerce in Pakistan Study 3 - Subsidies and Incentive Regimes