April 13, 2022


Austerity and Renewables

A new IMF-approved tax regime is crippling Pakistan’s green energy sector

After weeks of rising domestic pressure, a spiraling economic crisis, and the swift loss of crucial military support, Pakistan’s Prime Minister Imran Khan was removed from office last weekend following a vote of no confidence. The political turmoil is the latest in a worrisome series of events in the country—the price of food has risen sharply in recent months, along with gas and other essentials. And Pakistan’s rupee plummeted against the dollar, raising concern that higher bills for basic imports may deplete its dollar reserves.

Khan’s erratic style went from being seen as an asset—bucking pressures from Western lenders—to a liability, ​​as the government reversed course on key policies and contributed to heightened economic instability. In a speech following his election, Khan’s successor, interim Prime Minister Shehbaz Sharif, said the former cricket player and socialite had run a government that was “corrupt, incompetent and laid-back.”

His dismissal comes as the war in Ukraine and rate hikes by the US Federal Reserve pose immense challenges for heavily dollar-indebted developing countries. A late January poll found that two-thirds of Pakistanis considered double-digit inflation to be the biggest problem facing the country. But tens of thousands protested across the streets of major cities on Sunday night, showing their support of Khan and echoing his unsubstantiated claim that the ouster was a result of US meddling.

In the months leading up to the current crisis, wrangling with the International Monetary Fund (IMF) hastened Khan’s waning popularity in Parliament. Earlier this year, the IMF released part of a long-delayed loan conditional on Pakistan’s passage of a new budget measure raising sales taxes on imports, energy, and ordinary consumer items. 

Entwined in tense negotiations over financing, Khan’s government agreed in January to impose those unpopular tax hikes in order to win the loan installment, including, crucially, taxes on renewables that critics warned could damage its nascent solar and wind markets. Khan then reversed course, announcing that he would break with some pledges by cutting petrol and diesel prices as a short-term relief measure. New taxes on the fledgling renewable sector, however, remained. The result of the negotiations is that the IMF has reimposed loan conditions that directly contradict its own stated aims of upping the cost of carbon and fostering renewable energy.

Pakistan is not the only country where IMF assistance could undermine the clean energy transition. In Mozambique and Indonesia, for example, IMF policy advice opened the door to greater investment in the coal sector and left the domestic power sector more exposed to climate-linked financial risk. But the situation is particularly severe in Pakistan, where the IMF-approved budget cuts development spending and imposes a greater burden on the country’s narrow and inflation-battered tax base. The new taxes on renewable equipment could weaken investor confidence and delay growth in the country’s markets for solar, wind and electric cars, according to several analysts including Pervez Tahir, Pakistan’s former chief economist.

The new tax regime is already driving up solar panel costs for vulnerable energy customers like farmers in the province of Sindh, who rely on solar energy in rural areas with spotty access to electricity. Since the passage of the budget, the cost of solar panels is estimated to have spiked by 30 percent. The rising costs, alongside fresh taxes on agricultural materials, contributed to anger at the Khan government. In February, farmers staged protests against the administration, gaining the backing of opposition parties. Environmental groups have taken aim at both Khan and the IMF, arguing that the Fund is undermining its new stated focus on climate-linked risk. 

IMF-backed austerity

On World Environment Day in June 2021, Khan delivered a speech demanding that richer nations take more action to combat climate change, given the inequalities of carbon emissions and climate risk. Domestically, Khan, the founder of the centrist Pakistan Tehreek-e-Insaf Party (PTI), pledged in 2020 to produce 60 percent of the nation’s energy from renewables by 2030, end coal projects in favor of hydroelectricity, and convert 30 percent of the nation’s cars to electric vehicles.

January’s new budget followed nine months of deadlock during which the Fund denied Pakistan access to a $6 billion Extended Fund Facility (EFF), a loan program, over its refusal to adopt belt-tightening measures and hit higher tax collection targets. Talks became more promising in June, as the US prepared to pull out of Afghanistan. The Biden administration reportedly used IMF funding as a bargaining chip to push for greater cooperation with Islamabad for its Afghan operations. But Khan, who campaigned against overreliance on international aid, held off for several months before agreeing to raise taxes.

The IMF has for years criticized Pakistan’s tax regime, arguing that its many exemptions undermine growth and create distortions. To foster a more competitive business environment, it has pushed for a simpler system and a widespread policy of what it calls tax “harmonization.” 

The Khan government passed the latest budget—actually a Supplementary Finance Bill or “mini-budget,” outside the regular fiscal cycle—to address the IMF’s concerns and access renewed financing. It promised dramatically higher fiscal revenues from sales taxes including on renewables by imposing a 20 percent tax on solar and wind and a 12 percent higher sales tax for imported electric vehicles—effectively crippling the renewable energy sector, which relies heavily on imports.

As expected, the new taxes have raised upfront capital costs and made renewable energy developers more reluctant to enter the market. “We made our financial conclusions based on the numbers when there was no sales tax,” said one renewable energy developer backing a utility-scale wind and solar project in the country. (The developer asked not to be named, since the project is under active review.) He added, “we won’t say that we won’t make any kind of investment, but of course we will be reassessing our choices.”

Under the new budget, debt servicing is also predicted to increase. Debt servicing remains a consistent barrier to green energy transitions across much of the Global South, including sub-Saharan Africa and Latin America, but the case of Pakistan is especially dire. From 2012 to 2022, out of total net revenue receipts of Rs100, Rs85 went towards debt servicing, compared to Rs51 and Rs20 for India and Bangladesh, respectively. The nation’s debt-to-GDP ratio ranks 151st in the world, and economists have warned of a coming debt trap, with harsher conditionalities and an even greater dependence on borrowing for funding the nation’s civil service salaries, pensions and defense spending. 

Broadening the tax base

Pakistan has one of the world’s lowest tax-to-GDP ratios, partly owing to low state capacity and high informality. The IMF frequently cites that ratio in pressing for greater discipline on granting tax concessions. The Fund argues that Pakistan’s complex fiscal federalism model—with multiple tax administrations and different tax systems for goods and services—lead to revenue administration fraught with “fragmentation and inefficiencies.”

“You hear it all the time: ‘tax exemptions lead to distortions,’” said attorney Zain Moulvi. Liberal civil society groups like Moulvi’s organization, the Alliance for Climate Justice and Clean Energy, share the overall goal of broadening the tax base in order to distribute the burden more widely. But they say that in practice, the IMF’s ideological insistence on revenue-raising and closing loopholes has led to regressive taxes that strangle smaller sectors and the existing tax base. “They always go for easy money,” said Ikramul Haq, a Lahore-based tax expert. The IMF and Pakistan’s Federal Board of Revenue (FBR), he said, typically withdraw the lowest-hanging sales tax exemptions, while leaving in place tax breaks for powerful groups.

Meanwhile, untaxed perks for the powerful persist. The new budget originally would have taxed goods imported by foreign diplomats and top government officials, including the president and prime minister, but those changes were subsequently withdrawn. Judges who sit on the country’s top courts have long enjoyed tax-free allotments of phone calls, water, and gas for electricity, and 200 liters of gasoline each month. The Chiefs of Staff of the armed forces are given an untaxed “sumptuary allowance” for entertainment. A 2011 report by Pakistan’s Center for Investigative Reporting found that nearly 70 percent of federal lawmakers didn’t file a tax return.

But under pressure to raise revenue, the government has instead opted to close loopholes for smaller and less politically powerful sectors—a tactic that frequently proves ineffective, since those sectors often don’t generate high taxable profits. Proponents of the new budget have made a similar ideological case for closing tax exemptions on all sectors including renewable energy. “But if cigarettes are used in the president’s house,” Haq said, “they are tax free.”

The IMF this month announced a push for steeper taxes on high-earning professionals. Critics like Moulvi say that this move does little to patrol oligarchs such as the real estate tycoon Malik Riaz, or to reverse sweeping tax exemptions for industry. Customs duties and corporate income taxes remain relaxed in special economic zones set up for Chinese contractors. 

Ultimately, the focus on closing a few, highly visible tax breaks for the rich may be something of a distraction. All told, the exemptions for official perks cost the country Rs30 billion or around $164 million in 2019, according to a report from the Federal Board of Revenue (FBR). Tax exemptions for “rich and mighty” classes are not unique to developing countries like Pakistan. Though NGOs have focused on elite tax-skirting, even the United States, the biggest voting bloc in the IMF, allows the richest Americans to pay almost no taxes

Even so, the problem of eliminating tax exemptions bears scrutiny—not least since it’s cited by multilateral institutions at politically opportune moments and used, in practice, to impose regressive fiscal policy. Instead of advocating for tax “harmonization” to fund development initiatives, many civil society groups favor a focus on debt forgiveness and green financing tools such as debt-for-nature swaps.

Renewables omitted from essential goods

Even the IMF selectively invokes the principle of removing all tax breaks. In a 2019 report, it acknowledged that efforts to reduce distortions in the tax system should exclude “basic food and medicines.” In its February review of the EFF loan program, the IMF again made allowances on tax concessions for “basic food, live animals for human consumption, and health- and education-related goods.”

Renewable energy infrastructure is not on this list of basic goods. Alongside renewables, mobile phones, laptops, agricultural machinery and flavored dairy products will face steep taxes, affecting broad swaths of Pakistan’s population.

The omission of renewables from the IMF’s list of goods not only disregards Pakistan’s domestic clean energy goals, it also cuts against the Fund’s growing emphasis on climate risk metrics in global lending. In the latest Comprehensive Surveillance Review—a document that updates the Fund’s strategic direction every five years—officials pledged to consider financial stability risks from climate in their influential Article IV surveillance reports on member countries. The taxes on renewables reveal a disjunct between these high-level aims and the IMF’s insistence on austere tax policy, which in practice biases the energy sector towards fossil fuels. 

To greenlight the latest loan disbursal, the IMF accepted dubious promises from the Khan government on the speed at which it could raise tax revenue. In a letter to the IMF Director, the central bank governor and finance minister project that in the coming year, federal tax revenue would grow by more than 25 percent. That jump in tax collection would be highly unlikely, said Haq, given Pakistan’s ongoing struggle to build state capacity for tax enforcement.

In the review, the IMF and Pakistan said that the dramatic surge in tax collection would be achieved by raising the petroleum development levy, a tax on gas and diesel. The IMF has for several years urged wider adoption of carbon taxes by member countries to discourage fossil fuel use. But carbon taxes are politically unpopular, and just a month after the letter from top finance officials, Khan reversed course and cut gas and electricity prices. If the IMF were consulting more with local groups, several critics said, they could have anticipated that reversal.

Entrenched interests

Renewables enjoyed their brief moment in the sun starting in 2019, when Pakistan waived the recently reimposed taxes on solar and wind equipment to spur growth in the sector. That same year, the provinces of Sindh and Balochistan saw massive power failures, a frequent occurrence despite sprees of energy infrastructure building. Millions of Pakistanis still lack access to grid electricity—a challenge that could be quickly addressed with distributed solar panels. 

“Sindh is massively in support of wind and solar because it’s rich in those resources, it’s free, the people are so far-flung, and it’s hard to get gridding into the region,” Moulvi said. Solar panels in particular could provide cheaper distributed access to electricity for small-scale uses like water purification systems and wells, but distributed solar is less popular with the World Bank, which sets the agenda for much of Pakistan’s foreign energy investment.

Under criticism for financing coal and fossil fuel development, the World Bank has pivoted to large-scale hydropower, where it is easier to attract private sector financing. For instance, IndiGrid, a prominent developer in the Himalayas, is backed by American private equity group KKR. These projects employ a small army of consultants and contractors, from environmental impact assessors to developers, but their rapid construction, often in the seismically active Himalayas, has been hazardous. Despite those risks, environmental advocates think the World Bank’s hydropower favoritism could also help explain IMF’s willingness to see higher taxes on equipment for solar and wind.

Further crowding out renewables, Khan’s government inherited a large pipeline of fossil fuel projects, which the government says shrinks the space for new renewables by creating surplus capacity and little demand for new projects. The nation’s energy has been snarled in geopolitics—a major deal for a Russian-built gas pipeline was set to be finalized this year.

There is still some domestic support for replacing existing fossil fuel power with cleaner alternatives. Pakistan’s Alternative and Renewable Energy Policy of 2019 is explicitly geared at “displacing” existing fuel sources, not merely leveling the playing field. To achieve that, it could be necessary to keep some tax breaks for the young sector.

“Even if you did have an Animal Farm taxation regime—everything is taxed equally, there’s no preferential treatment, no exemptions, period—you would still be, in effect, discriminating against renewables, given where they’re starting off in the market,” Moulvi said. “There are entrenched interests that need to be displaced.”

How Pakistan’s renewables will fare under Khan’s successor remains to be seen. As chief minister of Punjab, Sharif earned a pro-business reputation as a developer of several mega-infrastructure projects. He’s presented himself as a moderate interested in fixing relations with the United States, while also deepening economic ties with China. Sharif now faces talks with the IMF over remaining $3 billion from the EFF program. The rupee soared on Monday following the announcement of his political ascendance, buoyed by optimism at obtaining the loan. 

Meanwhile, there is a final, painful irony to the IMF undermining its new rhetorical support for clean energy. Even as international financial institutions have stymied greater uptake of renewables, Pakistani advocates of green investment find themselves fighting off claims that there is low domestic support for clean energy. Despite widespread support for cheap renewables, Tahir said, “there’s the perception that solar—and anything civil society is after—is Western agenda.”

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