How the ADR tax distorts the financial sector

The tax on Advance-to-Deposit Ratio (ADR) was introduced through the Finance Acts of 2021 and 2022 approved by Pakistan’s National Assembly and these provisions are being enforced by the Federal Board of Revenue (FBR) for the tax year 2025, ostensibly aimed at increasing bank’s lending to the private sector.

By imposing an additional tax of up to 16 per cent on income from government securities for banks with ADR below 50 per cent, the policy effectively penalises banks for failing to meet this threshold. In essence, it is not a tax on income but a penalty on the balance sheet structure of banks as of December 31, 2024. Unsurprisingly, banks are taking short-term measures to modify their balance sheets to avoid this hugely punitive tax.

While banks have made large profits during the last two years, they are also the largest tax-paying sector in the country. Therefore, this tax is being imposed on an industry already paying the highest tax in the country, with an aggregate tax rate on banks, including the super tax, around 50 per cent. The ADR tax pushes this rate to an exorbitant 66 per cent. Such excessive taxation does not merely affect the profitability of banks; it distorts the broader financial system.

At the root of the problem lies the government’s unsustainable fiscal policies and management which result in enormous about of bank borrowing. Fiscal deficits in Pakistan have consistently exceeded 6.0 per cent of GDP, and in recent years, surged beyond 8.0 per cent. With limited access to external financing due to the country’s high-risk profile, approximately 85 per cent of the federal government’s borrowing needs are now financed by the banking sector, facilitated by the State Bank of Pakistan (SBP). This over-reliance government on bank financing has crowded out private sector credit – the very lending the ADR tax purports to promote.

In response, banks are engaging in short-term strategies to meet the ADR threshold by year-end. These include issuing large loans at below-market rates to both public and private entities, with the borrowed funds often reinvested into government securities. This cycle generates a risk-free spread for borrowers while helping the banks improve their ADRs. October 2024 witnessed an unprecedented Rs1.1 trillion surge in bank lending, a figure driven not by genuine economic activity or private sector expansion, but by efforts to sidestep punitive taxation.

Compounding the strain is the requirement for banks to provide minimum deposit rates at 1.5 per cent below the policy rate savings deposits. At the current policy rate of 15 per cent, the minimum return that banks are required to pay to the deposit holders is 13.5 per cent – almost the same as the KIBOR rate around which banks do the lending, effectively matching the deposit rate.

In this situation, banks are not recovering their operational costs and clearly incurring losses in their conventional banking deposits other than current accounts. To mitigate losses and manage ADRs, banks have resorted to discouraging large deposits through penalties and imposing limits on daily balances. Between September 30 and October 25, 2024, total deposits fell sharply from Rs31.14 trillion to Rs30.4 trillion. This trend, which is likely to escalate in a declining interest rates environment for depositors, jeopardises a country already struggling with one of the world’s lowest savings rates, further curtailing funds available for investment and economic growth.

The ADR tax also raises serious constitutional and legal questions. Banks argue that regulating ADRs falls exclusively under the purview of the SBP, as mandated by the Banking Companies Ordinance, 1962, and the SBP Act. Parliament’s legislation imposing penalties based on the banks’ balance sheet structures, enforced through the FBR, effectively usurps the SBP’s regulatory authority. This overreach violates Article 142 of the constitution and the fundamental rights enshrined in Articles 18 and 25. Courts have already granted injunctions to a few banks against this tax, and it is highly likely that these provisions will ultimately be deemed unconstitutional, rendering the entire exercise futile – rather counterproductive for both the banking industry and the economy.

The policy also undermines its stated objectives. By taxing balance sheet ratios instead of income, the ADR tax penalises banks’ investment and lending strategies irrespective of their profitability. Even banks incurring net losses will be subjected to this tax on income from government securities. The resulting financial strain exacerbates challenges for an already heavily taxed sector, discouraging deposit mobilization and distorting credit markets.

Systemic issues further complicate private-sector lending in Pakistan. Over half of the economy remains undocumented, depriving banks of reliable data to assess creditworthiness. Additionally, the government’s excessive borrowing from the banking sector leaves limited resources for private enterprises. This contradiction between fiscal strategies and policy goals negates the rationale behind the ADR tax. The very policies that necessitate heavy government borrowing are the ones crowding out private-sector credit.

The ADR tax epitomises the misalignment in Pakistan’s economic policies. While ostensibly aimed at boosting private sector credit, it discourages deposit mobilisation, promotes unsustainable lending practices, and destabilises the financial sector – all without achieving meaningful tax revenue gains. With courts likely to nullify its provisions, the tax is poised to fail in delivering any significant fiscal or economic impact.

The most effective way to channel credit to the private sector is through systemic reforms entailing a reduction in the size of governments and their unusually large expenditure, not arbitrary taxation. Addressing fiscal mismanagement is paramount, including reducing the fiscal deficit and curbing government reliance on banking sector borrowing. In fact, for promoting demand for private sector growth and documentation of the economy, it is imperative that tax rates, which are currently one of the highest in the world, are reduced substantially. Also, the policy of increasing loans to the private sector should be monitored through the banking regulator rather than through the tax authorities.

The ADR tax, though well-intentioned, has proven counterproductive. Its unintended consequences threaten the stability of Pakistan’s banking sector and undermine broader economic objectives like savings and investment growth. This tax should be withdrawn immediately to avert a brewing crisis in the financial system.

The government must prioritise fiscal discipline and create a balanced financial ecosystem that fosters private sector growth. Only then can Pakistan achieve sustainable economic progress without resorting to counterproductive measures like the ADR tax.

The writer is a former managing partner of a leading professional services firm and has done extensive work on governance in the public and private sectors. He tweets/posts @Asad_Ashah