Mar 2, 2010

Fiscal consolidation

The government needs to balance the economy rather than the budget

By Hussain H. Zaidi

According to the Fiscal Policy Statement 2009-10, recently issued by the Federal Finance Ministry, fiscal consolidation remains at top of the government’s macro-economic stabilisation efforts. Fiscal consolidation is a euphemism for reducing fiscal deficit, which during last two years has been a major macro-economic challenge for the PPP government.

Contrary to popular view, fiscal deficit is not inherently a vice. Whether the government should have fiscal deficit or surplus depends on the state of economy. As famous economist Lord Keynes remarked, "The government should seek to balance the economy rather than the budget. In case of widespread unemployment and deficiency of aggregate demand, fiscal deficit should stimulate the economy, whereas in case of inflationary boom, fiscal surplus should be preferred. However, at any rate fiscal deficit needs to be kept within manageable limits, otherwise it can destabilise the economy."

Though both developed and developing economies face fiscal deficit, the problem is more serious in case of the latter. This is for more than one reason. Whereas for developed countries, the major economic problem is to maintain a steady growth rate, for developing countries it is both to accelerate the growth rate and maintain economic stability. Hence, developing countries need a higher investment-GDP ratio to add to the capital stock and accelerate the rate of capital formation. The government also needs to create the social capital — education, health, public utilities — and physical infrastructure, which make an expansionary fiscal policy necessary. On the other hand, due to low level of business activity and income and a culture of tax evasion, it is difficult for public revenue to match public spending.

Coming to Pakistan, fiscal deficit rose dramatically to 7.6 percent of GDP in financial year (FY) 08 from 4.3 percent of GDP in FY07. During FY09, fiscal deficit was reduced to 5.2 percent of GDP though the budgetary target was 4.3 percent. For FY10, the current fiscal year, the fiscal deficit target is 4.9 percent of GDP. This envisages expenditure-GDP ratio of 19.4 percent (compared with 19.3 percent during FY09) and revenue-GDP ratio of 14.5 percent (compared with 14.1 percent during FY09). The GDP growth target for FY10 as set out in the budget was 3.3 percent. However, as per State Bank of Pakistan (SBP) projections, the economy will grow at 3 percent.

It may be mentioned that during 1990s, average fiscal deficit-GDP ratio was 7 percent, well above the current level of around 5 percent. However, decline in fiscal deficit has more to do with fall in expenditure than increase in revenue. During 1990s, average expenditure-GDP ratio was 23.6 percent, while revenue GDP ratio was 16.8 percent, well above the current levels of expenditure (19.3 percent) and revenue (14.1 percent).

In theory, the simple way to contain the fiscal deficit is to reduce expenditure or increase revenue. However, this is easier said than done. Given the political economy of Pakistan together with the war on terror, which is consuming a sizable portion of public resources, if there are to be any drastic cuts in public spending, these have to be on development expenditure or subsidies. Development spending for FY08 (including both federal and provincial) was Rs 452 billion. The FY09 budgetary estimates for development spending were Rs 516.6 billion; however, actual spending was Rs 448.8 billion. For FY10, development spending estimates were Rs 763.1 billion, which were revised to Rs 616 billion and are now projected to be only Rs 510 billion. During the first half of FY10, the actual development spending was Rs 116 billion, which suggests that even Rs 510 billion projections are on the higher side.

On the other hand, current expenditure in FY08 was Rs 1.86 trillion. The actual expenditure during FY09 was Rs 2.04 trillion against the budget estimates of Rs 1.86 trillion. For FY10, budgetary current spending estimates were Rs 2.10 trillion, which were revised upward to Rs 2.26 trillion and are projected to be 2.40 trillion.

Now we come to the other side of fiscal deficit — public revenue. Total revenue in FY08 was Rs 1.50 trillion including tax revenue of 1.05 trillion and non-tax revenue of Rs 414 billion. The revenue collected during FY09 was Rs 1.85 trillion (including tax and non tax revenue of Rs 1.20 trillion and Rs 646 billion respectively) against the budget estimates of Rs 1.80 trillion. For FY10, budgetary revenue estimates were Rs 2.15 trillion, and are projected to be 2.18 trillion. During the first half of FY10, revenue collected was Rs 427 billion.

Though public revenue is on the increase in absolute terms, in relative terms i.e. as part of the GDP it has come down. For instance, revenue-GDP ratio in FY07 was 14.9 percent, which came down to 14.6 percent in FY08 and further to 14.1 percent in FY09. For FY10, the revenue-GDP target is 14.5 percent. In particular, Pakistan has one of the lowest tax-GDP ratios in the region, which came down to 9.2 percent in FY09 from 10.6 percent in FY08. Even during robust economic growth of 7 percent on average from FY03-FY07, the revenue GDP ration stuck around 14 percent. In fact during FY05 when the economy grew at 9 percent, arguably the fastest ever in the country’s history, revenue-GDP ratio was only 13.8 percent — one of the lowest ever.

Thus the GDP growth has not been matched by revenue growth, particularly that of tax revenue. According to the Fiscal Policy Statement 2009-2010, in real terms tax revenue has registered sluggish growth of 1.4 percent during last five years (FY05-FY09) compared with fairly healthy average GDP growth of 5.5 percent during this period. The reason, as the statement itself points out, is that major contributors to economic growth — services and agriculture — are outside the tax net.

In order to increase tax revenue, either direct or indirect receipts will have to be increased. Any increase in indirect taxes shifts the burden to the consumer and results in price increase. Moreover, indirect taxes are essentially regressive as the burden is shifted equally regardless of income. Another problem with indirect taxes is the elasticity of demand. Since demand for essential goods is inelastic and that for luxuries elastic, increase in taxes on luxuries may reduce revenue while that on essential goods increase revenue. Though economically it may be a better option to increase taxes on essential goods, socially and politically such a move is difficult as it will further reduce disposable real income of low income groups, who spend a major portion of their budget on such goods. Thus, any increase in taxes has to be in direct taxes. However, the problem with direct taxes is that these are easier to evade and require an efficient tax collection machinery and tax culture.

At the behest of the International Monetary Fund (IMF), the government is planning to introduce value-added tax (VAT) from the next financial year. The VAT will be levied on both goods and services to be collected by the federal government and the provinces respectively.

Pakistan needs an expansionary fiscal policy to stimulate the economy and maintain healthy growth momentum. However, to avoid serious fiscal and other macro-economic imbalances, such as inflation, public revenue needs substantial appreciation. Economic growth feeds on itself. Growth creates jobs, revenue and additional incomes, which in turn spur growth.

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