Pakistan’s banking sector is like a rich patriarch who’s expected to bail out distant relatives falling on hard times every now and then. Yet everyone resents the same patriarch for his high status and vast wealth that they believe is undeserved and acquired through dubious means.

A glance at recent federal budgets, including 2023-24, shows the government is quick to pile too much tax on the banking sector. But why should the government not raise taxes on banks given that they’ve uniquely positioned themselves to benefit from bad fiscal management by the federal government?

The country runs on debt. The federal government will be short of Rs7.6 trillion to run its affairs in 2023-24. So it’ll finance two-thirds or Rs5tr of this deficit through domestic borrowing. Within domestic borrowing, the share of bank borrowing will be 62.5pc or Rs3.1tr.

In simpler words, the government’s failure to balance its books leads to heavier reliance on bank loans by Islamabad. In turn, banks make money hand over fist, especially because the benchmark interest rate remains at an all-time high amid unprecedented inflation. Banks win, everyone else loses, or so the logic goes.

A new windfall tax of up to 50pc on extraordinary gains because of exogenous factors is the ‘most negative feature’ of the 2023-24 budget

So when the budget time comes, and the government is looking for ways to increase its revenue, the taxpayer of choice is invariably the banking sector. The latest budget is no exception.

There’re five major proposed tax measures for the banking sector. Four of them are negative and one is positive.

First of all, the tax rate on the banking sector is set to increase from 43pc to 49pc in 2023-24. Even though the income tax rate will still be 39pc as before, the rate of super tax for banks earning more than Rs500 million will increase to 10pc from the existing rate of 4pc.

So relatively profitable banks will be required to part ways with 49pc of their pre-tax earnings for the calendar year 2023. “This will erode the overall profitability of the sector by an average of 11pc,” said Arif Habib Ltd in a research note issued to clients on Saturday.

Another major blow to banking income in the budget is in the form of a new windfall tax of up to 50pc on “extraordinary gains” that banks made in the last five years owing to “exogenous factors”. In other words, the government will tax banks for their windfall earnings caused by foreign exchange gains/currency depreciation.

Banks’ collective “income from dealing in foreign currencies” amounted to Rs80 billion in the October-December 2022 quarter, up 2.3 times from Rs34bn a year ago, according to AKD Securities. This windfall tax is the “most negative feature” of the proposed budget, the brokerage said.

The third negative measure for the banking sector is the re-imposition of a 0.6pc adjustable withholding tax on cash withdrawals above Rs50,000 a day by non-filers. Like in the past, analysts expect this move to drive down the growth in deposits by non-filers. This will leave banks with smaller liquidity to deploy in assets like loans and investments in government papers.

The fourth negative tax measure for banks is the proposed increase in the withholding tax rate from 1pc to 5pc on payments to non-residents through debit/credit or prepaid cards. The proposed range is 2pc to 10pc for non-filers.

Meanwhile, the additional tax imposed last year on the basis of a bank’s advance-to-deposit ratio — ostensibly to encourage private-sector lending — remains in place this year too.

The only positive measure for banks is the two-year extension in the concessionary tax rate of 20pc on banking income realised through additional loans to low-cost housing, agriculture and small and medium enterprises — a move aimed at nudging banks towards extending credit to these underserved sectors.

Having gone through all the negatives and one positive for banks in the budget, what’s the takeaway for the shareholders of commercial lenders?

The surprising verdict by Arif Habib Ltd is that banking shares still constitute a “good buy”. Of course, the overall profitability of banks will be adversely affected. But stock market investors make (or lose) money based on the price at which they buy a share, not the absolute profit figure that appears on a company’s income statement.

The price-to-earnings (P/E) ratio, which measures a bank’s current share price relative to its per-share earnings, is 2.8. Given that the 10-year average P/E ratio is 7.8, the banking sector appears to offer investors a significant upside going forward.

Published in Dawn, The Business and Finance Weekly, June 12th, 2023