When banks start demanding higher and higher returns on the government treasury bills and bonds, the government retaliates by imposing a higher tax on their income. This is exactly what the next fiscal year’s budget tells us.

And when banks continue to invest heavily in government debt securities taking and charging excessive returns knowing that the doors of government borrowing from the central bank are shut, the government reminds them that in so doing, banks are ignoring private sector credit demand.

And sometimes this reminder comes in the form of higher taxes imposed on the income from investment in the government debt securities of the banks that do not make enough loans to the private sector.

The next year’s budget also exposes this aspect of the government-bank relations. In the budget for 2022-23 starting July 1, the government has raised the total incidence of taxes to 47 per cent, inclusive of the newly-introduced 2pc poverty alleviation tax from currently 39pc.

Taxing banks at exorbitantly high rates at this stage requires a serious re-think

The corporate tax on banks alone has been increased to 45pc inclusive of 4pc supertax from 35pc corporate tax plus 4pc supertax or a total of 39pc. An additional 2pc poverty alleviation tax would naturally apply to banks — as most of them earn Rs300 million-plus income per year — the threshold for this new tax introduced to shift “the tax burden from the poor to the rich.”

To discourage over-exposure of banks in treasury bills and bonds that invest in them ignoring the private sector, the government has also raised from 39pc to 47pc the tax rate on income from their government securities. Even this elevated rate would apply to those banks that manage their advances to deposit ratio (ADR) — a measure of how generously they lend to the private sector — over 50pc.

For those banks that manage their ADR between 40pc-50pc, the tax rate has been increased from 41.5pc to 49pc. The highest tax rate on banks’ income is from government securities ie currently 44pc to 55pc.

Banks are not happy with these measures. They are protesting silently with the government besides lamenting before the central bank that such measures would depress their earnings too deeply and would prove counter-productive.

Whether the government would budge and provide some relief to banks is a different matter. But the fact remains that the government has levied higher taxes on banks on the premise that they have “earned windfall gains due to higher interest rates and risk-free investment in government securities,” as Finance Minister Miftah Ismail put it in his budget speech.

This approach is apparently faulty if the government believes in a market-driven interest rate regime which is, by the way, necessary to contain inflation. It also seems unfair to tax any industry at a higher rate only because it has been making windfall gains without resorting to cartel-making or indulging in unfair market practices.

More worryingly, this approach can backfire and prove counter-productive in two ways. First, some banks may prefer to limit their exposure to government bank securities thus depriving the government of the much-needed banking funds at low prices. And second, to improve their ADRs, some may start lending to high-risk sub-sectors of the private sector recklessly. In both scenarios, the government and the economy would suffer and even the banking industry’s base would shrink.

That said, banks need to reach out to the unserved and underserved segments of the private sector including agriculture and small and medium enterprises (SMEs). They also need to develop the necessary expertise for lending more to women-led SMEs and youth-led technology startups.

On the one hand, these measures would lay a good foundation for sustainable economic growth. And, on the other, they would also enable banks to grow systematically without taking undue risks and without depriving the government of reasonably-priced bank loans.

The government, meanwhile, needs to tighten fiscal belts to reduce its dependence on overall borrowing from banks. It also needs to generate more tax revenue which is possible only if banks continue to play a proactive role in promoting growth — and also explore innovative ways to increase non-bank borrowing in the overall mix of domestic borrowings at a cost lesser than the cost of bank borrowings.

The challenges for both the government and the banks are too serious to be ignored and both need to move in tandem without which neither the economy can grow at the targeted level of 5pc during the next fiscal year, nor can the financial sector can grow on a sustainable basis.

We should not forget that domestic debts have grown so huge that the government has set aside Rs4.439 trillion for domestic debt servicing in 2022-23. This amount is more than twice the size of the proposed defence and defence services’ combined budget of about Rs1.527tr.

And for banks, the challenge is to deliver financial intermediation services at affordable prices amidst the rising cost of doing business to improve cyber security, risk-profiling, risk management, upscaling of employees’ skills etc.

The recently initiated transfer of government funds from banks to the Treasury Single Account maintained with the central bank is already giving sleepless nights to top bankers. (But more on that later). Taxing banks at exorbitantly high rates at this stage requires a serious re-think.

Published in Dawn, The Business and Finance Weekly, June 20th, 2022