What holds SMEs back?

Recent policy decisions in Pakistan signal a renewed drive to broaden financing possibilities and business assistance for SMEs. The Small and Medium Enterprises Development Authority (SMEDA) is set for reorganization, the State Bank of Pakistan (SBP) has introduced a digital financing portal, and expansion of export credit support is planned.

These steps signify a focus on increasing access to finance and institutional aid for micro, small, and medium-sized enterprises (MSMEs). However, the launch of these initiatives still raises the critical question: does the government genuinely comprehend what has hindered the sector all along?

An essential factor to consider is the extent of informality within the MSME sector. These businesses constitute about 99 percent of the country's enterprises and 78 percent of employment. Despite employing millions and forming the backbone of the economy, many informal MSMEs are excluded from formal banking finance due to the absence of documented accounts and verifiable financial records.

The policy discourse is dominated by discussions on improving access to finance, yet it often overlooks the fundamental question: why do numerous businesses remain informal to begin with?

For many enterprises, informality is not merely a choice but a reaction to a business environment where formalization incurs higher costs than perceived benefits. Factors such as high inflation, steep energy tariffs, expensive inputs, and low purchasing power hinder businesses' ability to maintain profitable margins. Formalization entails additional tax liabilities, labor regulations, social security contributions, and administrative tasks.

Policymakers should not assume that businesses will formalize their operations without addressing the economic and regulatory constraints that make formalization financially challenging.

The regulatory landscape also plays a significant role in deterring business expansion. Employing more than 10 workers triggers a host of labor laws, social security obligations, and Employees' Old-Age Benefits Institution requirements that impose considerable compliance costs on small businesses with limited administrative resources.

The introduction of multiple tax rates and withholding obligations at various stages of business transactions elevates compliance costs and strains working capital, disproportionately affecting smaller enterprises. This tax regime is partly a response to the country's fiscal challenges, with the Federal Board of Revenue (FBR) relying on withholding taxes to generate revenue, albeit at the expense of a business-friendly tax environment.

The inconsistency between the government's desire for businesses to formalize, access bank financing, create jobs, and contribute to tax revenues, while simultaneously maintaining a tax system that makes formal operations more burdensome and expensive, presents a contradiction at the heart of Pakistan's MSME policy. To truly support SMEs, policymakers must acknowledge the broader repressive business environment, shaped by an unfavorable macroeconomic context, high production costs, and an onerous regulatory burden that discourage formalization.

SMEDA's reorganization and other announced measures must be complemented by a thorough review of the laws, taxes, and economic policies that govern small businesses. Otherwise, institutional reform will remain ineffective, leaving the underlying barriers intact.