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Ideas for fiscal efficiency by Salim Raza

The former Governor State Bank of Pakistan, poses key questions on Pakistan’s crisis-ridden economic trajectory and points to a path forward for embedding the model in sustained macro stability.

The question has become rhetorical: given Pakistan’s abundant manpower and natural resources, bilateral donors and the IMF over the years, why has the country not been able to build a deeper, more diversified economy than one marked by recurring fiscal excess leading to balance of payment pressures. It is a legitimate question, because despite all the attention it receives globally, Pakistan’s growth prospects have drifted into long-term decline.

Successive governments have shown little stamina for reform. Liberalization has been half-hearted, and uncoordinated government intervention across the economy has compromised long-term investment decisions. This has stymied the growth momentum fundamental for macroeconomic stability. The current IMF programme is a bold attempt to once again try and entrench economic reform. Yet once again the challenges to its success will be more political than technical. Despite the promising start, the model will need continued ‘hands-on’ strategic leadership if the economy is to be brought back on track.

However, this time around, the country is on a tight leash. Unlike the 2008 IMF programme, which gave Pakistan greater space by up-front disbursement of about $3 billion, without associated preconditions, the current programme is designed with less width.

The new IMF extended fund facility of $ 6.6 billion is available in 12 quarterly installments. Significant prior actions have been built-in before each installment is released. These include a steep reduction in power subsidies, privatization of 65 Public Sector Enterprises (PSE), autonomy for the State Bank in monetary policy and preconditions for provincial governments to run budget surpluses among others.

Prior actions already announced will, over the life of the programme, account for 45% of the full fiscal adjustment targeted at 4.2% of GDP. Based on the achievement of given targets, indicative projections by the IMF envisage Pakistan’s foreign reserves growing to $20 billion, inflation stabilizing at 6%, and GDP growth reaching 5% annually by 2018.

In contrast, if reform is stalled, the baseline case for 2018 will see foreign reserves plummet to less than two weeks of imports, inflation reaching 12% and GDP growth stagnating at 3% annually.

Predictably, the IMF notes that risks to the medium-term outlook are tilted to the downside, implying that without significant policy reform and help from the international community the macroeconomic outcomes would likely be worse than the baseline projections.

If the programme’s goals are implemented, both in terms of policy reform and quantitative outputs, they would “embed” within the economy much needed macroeconomic operational balance essential for sustainable growth.

A Stagnating Economy

However, Pakistan’s past record with the IMF has been poor, with 10 out of the 11 programmes since the late 1980s abandoned well before completion. There clearly has been little realization that falling out of a programme has knock-on effects. Not only does the country lose the undrawn part of the IMF commitment, but other incremental funding is also jeopardized.

An even more damaging fallout of abandoned programmes is the steady erosion in the state’s credibility as holder of fiscal authority. Reversals in reform measures announced after each successive IMF programme have also undermined the government’s credentials as an economic manager.

Despite setbacks, some past reforms initiated under IMF regimes have stuck, often cited as exemplars of positive outcomes. Prominent in this are measures for economic liberalization, which include privatization, financial sector liberalization, and the relaxation of foreign exchange controls – all of which stimulated domestic investment and Foreign Direct Investment (FDI) levels.

Paradoxically, the relationship between economic liberalization and tax revenue in Pakistan has been an inverse one. Despite achieving a 9% GDP growth rate in the mid-2000’s, Pakistan’s fiscal results have actually deteriorated.

In the mid 1990s, total revenue was 18% of GDP, while tax receipts accounted for 13.5%. Today, total revenue has shrunk to 13% of GDP and tax receipts to just 9% of GDP – among the lowest ratios in the world.

Two factors have contributed towards declining tax revenues – a drastic cut in custom duties under trade liberalization of the mid 1990s, and decreasing direct taxation during the early 2000s. The cut in direct taxes has been based on the supply-side assumption that lower taxes spur more investment. Liberalization and lower tax levels were expected to propel investment and increase production, generating higher incomes and higher taxes.

Despite expectations that a decline in direct taxes would be offset by the imposition of an integrated VAT over time, almost two decades later, the issue still hangs fire. A truncated GST remains a moribund first step towards VAT, and direct taxes have actually fallen in real terms. As a result, shrinking real revenues have led to a decline in government budgetary expenditure from 24% of GDP in the mid-1990s to 20% of GDP today.

Simultaneously, stubborn budget deficits dominated by power subsidies, PSE losses and financing cost of government debt, coupled with a decline in public development expenditure in real terms, have all led to economic stagnation bottoming to a five-year average GDP growth rate of 3% – the longest spell of low growth since the 1950’s.

Arresting this spell of low growth is essential for Pakistan. Realigning the compass of economic governance requires significant macroeconomic stabilization. One path to this stabilization can be through the implementation of structural reforms under the current IMF programme.

What are the three core drags on Pakistan’s stabilization? They are of course, weak tax mobilization, loss making PSEs, and the swelling volume of domestic debt.

Tax Mobilization

At the outset, our traditional national income tax policy effectively excludes more of the productive economy than it covers. Furthermore, exemptions, exceptions and concessions to a good part of the taxable economy have resulted in a thriving unregistered economy.

With a steadily declining direct tax base, taxation levels on consumption have widened. As a result, Pakistan’s tax framework has become regressive over the years and lower and middle class income earners now perceive tax policies to be discriminatory. Without equity in the incidence of tax, a precondition for gaining social consensus on tax compliance, more and more people ask why they should pay taxes.

Fuelling this growing sense of a remote state is the widening gap between government spending on social and physical infrastructure. Despite the recent rise in direct budgetary transfers to low income groups under social protection programmes, the diminished role of the state as an agency for development is creating rifts in the “social contract.”

What is needed is a change of ground rules so that discrimination in fiscal management is removed and a more egalitarian tax system guaranteed. All income, regardless of source, needs to be progressively taxed, and subsidies provided to only the lowest-income groups, through direct transfers.

With, 82% of tax revenue effectively coming from indirect taxes, Pakistan’s tax profile is increasingly becoming unviable, which is why a concentrated attempt at increasing direct taxes is essential for maintaining a semblance of fiscal sustainability. Simultaneously, the practice of using Statutory Regulatory Orders (SRO) to provide fiscal concessions should be reduced substantially to only unavoidable exigencies, subordinate to the approval of Parliament.

Economic Liberalization

Apart from making a visible embrace of egalitarianism and transparency in fiscal governance, the government must equally be willing to step back from its tight control over economic management. In its role as a maker of policy, a regulator, a buyer and seller of services, the government’s grip on the economy runs deeper than its ownership of PSEs.

The underlying problem is one of mind-set. Economic liberalization requires government to move on to a “light touch” management of the economy within a regulatory framework. This will allow investment and planning decisions to be made by professionals in response to market needs and market conditions. It will also slash the recurrent interface with politicians and bureaucracy for approvals and clearances.

The present government has made the commendable decision of privatizing a large number of PSEs. From a national perspective, the more value additive option to the outright divestiture of state ownership, as planned, would be to first transfer control over strategy, management and goal-setting of PSEs outside government ministries.

The blueprint for what to privatize and how to privatize, would then be a function of independent boards for respective PSEs. This process would ensure transparency and result in a more market driven privatization process.

Similarly, an equally essential element of economic liberalization is the need for devolution of fiscal expenditure, from higher to lower tiers of government. Social and development expenditure is best planned and incurred by provincial or local governments. In this context, the size of federal revenue transfers to provincial governments, which has been enhanced through the 2010 National Finance Commission (NFC) award, needs to be used more effectively by provincial governments. Development expenditure by respective provinces should also be increased substantially by raising further revenue from sectors under provincial domain i.e. agriculture, property, and VAT on services. In Pakistan, provincial tax revenues only form 5% of national revenues compared to 40% in India.

Debt Management

Finally, a major fiscal flashpoint is Pakistan’s rapidly growing government debt which now constitutes almost 64% of GDP today (42% domestic, 22% foreign). As a benchmark for sustained affordability, governments usually refer to a cap of 60% debt-to-GDP ratio.

Following this premise it would seem that Pakistan’s economy is not so “over borrowed,” but in reality, the 60% benchmark has little significance for Pakistan. A country’s capacity for debt is entirely dependent on the depth of resources available to service it. These consist of domestic tax revenue and the domestic banking system. Measured against these, Pakistan’s government debt is huge. Last year, debt servicing accounted for 35% of our total budgetary revenues and 50% of tax revenues. Similarly, government debt is already almost twice the size of our banking system ( 64% OF GDP VS. 33%). The problem is largely with the size and cost of domestic debt. Last year, domestic debt accounted for nearly 90% of servicing cost alone.

With private sector credit falling last year, the government actually borrowed the entire volume of credit created by the SBP and commercial banks. Lending to government today represents 55% of commercial bank credit, up from 30% six years ago. The strain on the banking sector has meant that commercial banks have reduced new lending to the private sector with lending to Small and Medium Enterprises (SME) falling to 7% of banks’ portfolios from 17% in 2007. This ‘credit squeeze’ has been regressive for growth because SMEs are the dominant source of new jobs in the country.

In this context, a professionally managed debt management function is long overdue at the Ministry of Finance. The mandate of such a debt management function should be to extend the untenably short tenor (2 years) of domestic debt and lower its cost by broadening distribution through escalating mutual fund activity within Pakistan and extending its marketing to international fixed income and index managers.

Good debt management, if institutionalized, may succeed in providing much needed fiscal space, but a long term solution is to progressively reduce the build-up of debt by reducing the budget deficit.

In its goals for fiscal rebalance and liberalization, the state risks opposition from powerful social and financial groups, and from politicians and sections of the bureaucracy. The issue of how to turn the pressure up on provincial governments to galvanize their own tax potential is also a tight rope politically. However, now more than ever, these structural challenges to the economy have to be faced. Democracy will not consolidate as a national system while the elected state is seen as only one part of an oligarchic power-sharing arrangement. The future of Pakistan’s social stability rests on the success of economic stabilization and the government’s ability to attain economic sovereignty. Without embedding macroeconomic stability through equitable revenue collection, sustainable liberalization and fiscal space through debt management, Pakistan cannot realize its economic potential and step out of its half a decade of economic stagnation.

The writer is Former Governor, State Bank of Pakistan and Member Board of Governors, Jinnah Institute.

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