Fiscal Policy

PAKISTAN ECONOMIC POLICY
INTRODUCTION
FISCAL DEFICIT IN PAKISTAN

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FISCAL POLICY
The central objective of government’s economic policy is to build a strong economy with
a view to creating employment opportunities for all and improve the standards of living
of the people of Pakistan. The policies pursued thus far have injected fiscal discipline,
reduced the country’s debt burden, created a stable macroeconomic environment, revived
economic activity and most importantly have created a strong platform of economic
stability which is vital for building prosperity and achieving social justice. Economic
stability allows businesses, individuals and the government to plan more effectively for
the long term improvement in the quantity and quality of investment. The Government is
committed to locking in stability and investing in the country’s future, enabling it to meet
the challenges and rise to the opportunities of the global economy.
Fiscal policy is the economic term that defines the set of principles and decisions of a
government in setting the level of public expenditure and how that expenditure is funded.
Fiscal policy and monetary policy are the macroeconomic tools that governments have at
their disposal to manage the economy. Fiscal policy is the deliberate and thought out
change in government spending, government borrowing or taxes to stimulate or slow
down the economy. It contrasts with monetary policy, which describes policies
concerning the supply of money to the economy. Fiscal policy is described as being
neutral, expansionary, or contractionary. An expansionary fiscal policy occurs when the
government lowers taxes and/or increases spending; thus expanding output (national
income). An increase in government spending or a cut in taxes shifts the aggregate
demand curve to the right. An expansionary fiscal policy will expand the economy's
growth. A contractionary fiscal policy occurs when the government raises taxes and/or
lowers spending; thus lowering output (national income). A decrease in government
purchases or an increase in taxes shifts the aggregate demand curve to the left. A
contractionary fiscal policy will constrict the economy's overall growth.

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ECONOMIC EFFECTS OF FISCAL

POLICY
Fiscal policy is used by governments to influence the level of aggregate demand in the
economy, in an effort to achieve economic objectives of price stability, full employment
and economic growth.
Keynesian economics suggest that adjusting government spending and tax rates, are the
best ways to stimulate aggregate demand. This can be used in times of recession or low
economic activity as an essential tool in providing the framework for strong economic
growth and working toward full employment. The government can implement these
deficit-spending policies due to its size and prestige and stimulate trade. In theory, these
deficits would be repaid for by an expanded economy during the boom that would follow,
the basis for the New Deal.
During periods of high economic growth, a budget surplus can be used to decrease
activity in the economy. A budget surplus will be implemented in the economy if
inflation is high, in order to achieve the objective of price stability. The removal of funds
from the economy will, by Keynesian Theory, reduce levels of aggregate demand in the
economy and contract it, bringing about price stability.
Despite the importance of fiscal policy, a paradox exists. In the case of a government
running a budget deficit, funds will need to come from public borrowing (the issue of
government bonds), overseas borrowing or the printing of new money. When
governments fund a deficit with the release of government bonds, an increase in interest
rates across the market can occur. This is because government borrowing creates higher

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demand for credit in the financial markets, causing a higher aggregate demand (AD) due
to the lack of disposable income, contrary to the objective of a budget deficit. This
concept is called crowding out. Alternatively, governments may increase government
spending by funding major construction projects. This can also cause crowding out
because of the lost opportunity for a private investor to undertake the same project.
However, the effects of crowding out are usually not as large as the increase in GDP
stemming from increased government spending.
Another problem is the time lag between the implementation of the policy, and visible
effects seen in the economy. It is often contended that when an expansionary Fiscal
policy is implemented, by way of decrease in taxes, or increased consumption (keeping
taxes at old level), it leads to increase in aggregate demand; however, an unchecked spiral
in aggregate demand will lead to inflation. Hence, checks need to be kept in place.

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FISCAL DEFICIT

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FISCAL DEFICIT
Fiscal deficit occurs when an entity (often a government) spends more money than it
takes in. An accumulated deficit over several years (or centuries) is referred to as the
government debt. Often, a certain part of spending is dedicated to paying of debt with
certain maturity, which can be refinanced by issuing new government bonds. That is, a
fiscal deficit leads to an increase in an entity's debt to others. A deficit is a flow. And a
debt is a stock.
Fiscal deficit = total expenditure – total receipts.
The elements of the fiscal deficit are:

(a) The revenue deficit, which is the difference between the government’s
current (or revenue) expenditure and total current receipts (that is,
excluding borrowing)
(b) Capital expenditure.
TYPES OF FISCAL DEFICIT

Different figures for the budget deficit are quoted by different people due to the different
definitions in use and also because of problems of measurement. There are three different
figures that can be generated and used, depending on expediency.
 Revenue Budget Surplus/ Deficit

 Overall Budget Deficit
 The Primary Budget Deficit

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REVENUE BUDGET SURPLUS/DEFICIT

A revenue surplus or deficit of the budget is equal to the difference between net revenue
receipts and current expenditure minus the repayment of foreign debt. Net revenue
receipts are equal to the gross revenues of the federal government minus the transfer to
the provinces. The revenue surplus shows the extent of public sector savings, where a
surplus implies positive saving by the government, and a deficit negative saving. This
revenue surplus or deficit is the bridge between the revenue and capital account of the
government.
In case of Pakistan, public saving has been negative for many years, thus a revenue
deficit of the budget. An increase in revenue budget deficit shows that the government is
using its borrowings increasingly to meet current expenditure, especially the salaries of
government employees.
OVERALL BUDGET DEFICIT

This is the most commonly used indicator to refer to the state of a country’s public
finances, and measures the difference between the total expenditure of the government
and its resources. It measures current expenditure plus development expenditure minus
repayment of foreign debt minus net revenue receipts minus the contribution by
autonomous bodies minus the amount earned by disinvestment of shares.
THE PRIMARY BUDGET DEFICIT

The primary budget deficit measures the impact of all discretionary changes of the
government in any year. It is calculated by subtracting the interest payments on domestic
and foreign debt from the overall budget deficit.

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FINANCING THE
FISCAL DEFICIT
The on going debate on the growing trade and current account deficits and fiscal
deficit needs to be encouraged as it creates awareness of economic issues among the
general public and puts pressures on the policy makers to take corrective actions.
However, this debate has so far been dominated by a superficial or highly perfunctory
analysis perpetuated by two extreme positions. Those who wish to criticize and find fault
with the government paint a doom and gloom day scenario and argue that deficits are a
result of mismanagement and wrong economic policies pursued and pose a serious threat
to macroeconomic stability and future growth. Those supporting the government, on the
other hand, convey a sense of complacency that may lull us to believe that there is
nothing to worry about because these deficits can be financed at present. We are neither
faced with a doom and gloom scenario nor is the availability of finances to meet the
deficit in the short term a guarantee that these deficits can be easily filled in the future.
Unless serious efforts are made to mobilize resources in a way that does not damage the
country’s productive capacity it would become increasingly difficult to meet these gaps.

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Financing fiscal deficit

• External borrowing
o Debt flow
o Non debt flow
• Domestic borrowing
o debt
 Bank borrowing
 Non-bank borrowing
o Equity
o Privatization proceeds
FOREIGN SAVINGS/EXTERNAL BORROWING

Foreign savings can take the form of debt or non-debt creating flows. As a matter
of prudence, the preference is always to minimize debt and maximize non-debt creating
flows. The logic behind this proposition is simple – debt creates a fixed income charge.
Whether the economy or the project for which debt has been contracted makes a surplus
or not the fixed installment has to be paid under all circumstances. Most Pakistanis, not
well versed in economics, are genuinely apprehensive that foreign borrowings may
plunge us into a debt trap from which we have only recently gotten out. These
apprehensions are justified if the proceeds from these borrowings are misallocated and
misutilised. If the borrowings are not likely to contribute to expansion of the economy or

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do not fulfill economic and social objectives it is better to avoid them. But as long as the
rate of return on the project is higher than the interest rate on which debt is contracted
borrowing is justified.
NON-DEBT FLOWS
1. FDI
2. REMMITANCES
3. PRIVITIZATION PROCEEDS REALIZED FROM FOREIGN
CURRENCY
Non-debt flows – mostly equity-will result in a payment as dividend only when
the economy or the project is earning profits. So dividend outflows are dependent on
positive income generation. Foreign direct investment not only brings foreign capital but
also new technology, managerial skills and links with international markets etc. The
economy thus benefits a great deal in many ways than is possible under borrowing.
Therefore FDI or equity flows should be encouraged.
Another major source of non debt flows is the remittances of overseas nationals.
These are simply exchange of foreign currency they remit from abroad with the local
currency paid to their families or other beneficiaries in the country. These flows do not
create any liability in form of foreign exchange payments in the future. That is why they
are termed as unrequited transfers and are very helpful in filling in the trade gap and
meeting current account deficit.

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The third avenue is the privatization proceeds realized in foreign currency.
Although these are non-recurring in nature, they have the double advantage of filling in
the current account gap as well as the fiscal gap. To the extent, these proceeds reduce the
demand for new debt the country is better off.
Financial integration is spurring many developing countries to raise equity by
selling GDRs/ ADRs of their companies on foreign stock exchanges. This mode of
financing is relatively stable and enjoys many of the features inherent in FDI.
DEBT FLOW
• Official creditors
o Multilateral Financial Institutions (MFIs)
o Bilateral creditors
• Private credit markets
On the debt side the country has several choices – either to approach the official creditors
or private credit markets. Among the official sources the main suppliers are the
Multilateral Financial Institutions (MFIs) and Bilateral Creditors. MFIs offer
concessional and non-concessional loans to developing countries. Bilateral countries
increasingly provide grants to low income countries while their export credit agencies are
interested in extending suppliers and buyers credit to support their businesses.
Consessional loans and grants should be channelized to the maximum extent possible as
they have only a mild burden on debt servicing capacity.

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Bilateral agencies
Multilateral and Bilateral Agencies provide project and non-project financing. Project
financing for infrastructure and human capital development is to be welcomed as it
supplements domestic investment in meeting critical deficiencies and shortages in the
economy, introduces new knowledge and technical expertise and benchmarks the country
to international best practices. Non-project financing provided mainly for budgetary
support comes loaded with donor conditionalities. In case these conditionalities put limit
on exercise of autonomy in decision making these loans should be taken only as a last
resort and to avert crisis situations. Export credit has to be scrutinized more thoroughly to
un-bundle its implicit or hidden costs such as tied procurement from explicit costs.
Private credit markets
Private credit markets offer a much wider range of products such as Islamic Sukuk,
bonds, syndicated loans etc. Access to these markets is limited to about 25 emerging
economies in the world, which are graded by the credit rating agencies and found to be
creditworthy. Pricing of these instruments depends upon the sovereign rating, the track
record and assessment of economic prospects. Sovereign bonds act as the benchmark for
corporates of the country to raise funds in the International Capital Markets. Care should
be taken in accessing International Capital Markets as they penalize mismanagement and

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weak policies more severely than the official creditors do. Countries that do not practise
good governance or are habitually indulgent in excesses should not access these markets
DOMESTIC BORROWING
Now we will discuss the domestic borrowing and official transfers options. Equity can be
raised by floating shares of state enterprise on stock exchanges or selling to private equity
companies or through private placements. As these modes are similar in nature to
privatization proceeds they can be considered together. They ought to be preferred for
exactly the same reasons as FDI.
DOMESTIC DEBT
Domestic borrowing can take the form of bank or non-bank borrowing.
Bank borrowing
Bank borrowing can be further divided into Central Bank and Commercial Bank
borrowing. Central Bank borrowing for meeting fiscal deficit or losses of public
corporations is not desirable as it affects high powered money creation and therefore
generates inflationary pressures. Excessive Commercial Bank borrowing by the
Government crowds out private sector credit within the target imposed by money supply
targets and should also be discouraged.
Non bank borrowing
The two main channels for non-bank borrowing are Pakistan Investment Bonds (PIBs)
and National Savings Schemes (NSS). PIBs are issues of medium and long term duration

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and mobilize institutional savings while NSS is targeted at individual or retail investors.
As long as these instruments do not entail substitution or diversion from other financial
sector savings they bring in additional household savings to the formal sector and should
be encouraged. Remunerative but competitive rates of return should be offered to the
savers under the NSS. Institutional savings should not be allowed to flow into NSS as this
is bound to stifle the growth of Private Equity Funds, Venture Capital Funds, Pension and
Provident Funds, Mutual Funds, Real Estate Investment Trusts, Long Term Mortgage
Market and Corporate Bond Market.

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Foreign savings vs domestic savings

Deficits, by themselves, are not necessarily undesirable nor something to be
shunned like plague. What they signify in simple and very broad layman terms is that the
domestic savings of a country are not enough to meet its investment requirements.
Developing countries are characterized by low per-capita incomes and widespread
prevalence of poverty. They cannot generate sufficient savings from their own incomes
after meeting basic consumption needs of their population to undertake required
investment for expanding production, building infrastructure and strengthening human
capital. Policy makers have two choices – either they limit investment to the exact level
of domestic savings or they mobilize additional savings from outside the country and
increase investment to a higher level than what is possible if only domestic savings were
available. As public expectations from their governments are becoming quite heightened
and the incidence of poverty needs to be lowered sooner than later developing countries
have used foreign savings to augment their domestic savings and achieve a higher rate of
economic growth. Let us illustrate this with a simple example. Under the first scenario if
the domestic savings of a country is 12% of GDP then investment rate of 12% will
generate annual growth rate of 4% annually. If the population growth rate is 2% and per-
capita income is $ 500 it will take 35 years to double the per-capita incomes to $ 1000.

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How many political governments can afford to wait that long? Is it morally defensible
that many countries may have per-capita incomes over $ 70,000 by then while a
developing country is stuck with such a low per-capita income level? Now suppose that
the government raises foreign savings equivalent to 3% of GDP every year the
investment rate of 15% (domestic savings rate 12% + foreign savings rate 3%) will
generate annual growth rate of 5% annually. With the same parameters per-capita income
in this scenario will double within 24 years. Although this period is still too long but
higher growth rates will also result in pushing domestic savings rate higher, which, in
turn, will further reduce this period of 24 years. So it becomes clear that mobilizing
foreign resources is an activity which a poor country such as Pakistan should not shirk
away.
The above analysis indicates that resort to foreign savings and contracting debt can help
the developing countries in improving the living standards of their population more
rapidly by attaining higher rates of economic growth. But the main focus should be on the
management and utilization of these resources. A menu of options approach outlined in
the chart can be helpful in examining and determining the relative costs and benefits of
each of these options. The annual financing requirement including domestic and external
borrowing should then flow from this examination and guide the policy makers in
approaching the various creditors and equity markets etc. They can then carve out the
slices or trenches from each source and negotiate the terms and conditions of each
individual transaction.

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The generalized dismissal of deficits and borrowing on one hand or an automatic
and mechanical approach whereby all forms of financing are welcomed and accepted
irrespective of their costs and benefits are the positions both of which should be
discouraged.. The smart countries have used foreign savings and debt to their advantage
and scrupulously avoided the pitfalls and blind alleys. Deficits are a natural outcome of
the process of economic development. The trick is how to put these deficits to work in a
way that accelerates the process of economic development and poverty reduction.
Menu of Financing Options
External Domestic
Debt creating flows Non-debt creating flows
Debt Equity
Transfers Privatization
proceeds
Official Private FDI GDRs Portfolio

Official Private
Bonds Islamic Syndicated

Sukuk Loans
Multilateral Bilateral
Concessional Non-Concessional Grants Loans

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Market based Concession

A sound fiscal policy is essential for preventing macroeconomic imbalances and realizing
the full growth potential. Pakistan has witnessed serious macroeconomic imbalances in
the 1990s mainly on account of its fiscal decadence. Persistence of large fiscal deficit
resulted in unsustainable levels of public debt, adversely affecting the country’s
macroeconomic environment. Pakistan accordingly paid a heavy price for its fiscal
indiscipline in terms of deceleration in economic growth and investment, and the
associated rise in the levels of poverty. Considerable efforts have been made over the last
six years to beat financial discipline by pursuing a sound fiscal policy. Pakistan’s hard
earned macroeconomic stability is underpinned by fiscal discipline.
It is a well established fact that the decade of the 1990s was the lost decade for Pakistan.
While many developing nations made substantial progress, Pakistan lurched from one
economic crisis to another mainly of its own making. Weak macroeconomic management
and the lack of commitment to undertake difficult structural reforms were typical of the
quality of governance. Appalling economic decisions hyped on populist slogans were
symbolic of the freewheeling decision making that led to the incurring of huge public
debt. Commercial banks and other financial institutions became the instruments of
political patronage and profit for certain sub-sections of society. The gross
mismanagement of public sector enterprises (PSEs) like WAPDA, KESC, the Railways,
the Pakistan Steel Mills, PNSC and PIA, further added to the problems. The freezing of

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foreign currency accounts shattered the confidence of investors and expatriate Pakistanis
vis-à-vis the management of the country.
The persistence of large fiscal and current account deficits (7% and 5% of GDP,
respectively) and the associated build up of public and external debt (over 100% of GDP
and 335% of Foreign Exchange Earnings, respectively) emerged as the major source of
macroeconomic imbalances in the 1990s. Failure in enhancing revenues consistent with
growing expenditure requirements, stagnation in exports (stagnated at $ 8 billion for six
years in the 1990s) and in overall foreign exchange earnings (stagnated at $ 11-12 billion
range for six years in a row in the 1990s) exacerbated these imbalances and vitiated a
stable macroeconomic environment. Such a state of affairs had a far reaching impact on
the country’s economic well-being. There was despondency among all, as many began to
talk of Pakistan as a failed state. Indeed Pakistan witnessed economic growth slowing
(from an average of over 6% per annum in the 1980s to 4% by the end of the 1990s);
investment rate decelerating (from an average of over 19% of GDP to 15.6% by 1999);
the country’s debt burden reaching alarming proportions (public debt as a percent of
GDP was over 100% of GDP and external debt and liabilities reaching $ 38 billion or
335% of Foreign Exchange Earnings – worse than many Highly Indebted Poor
Countries (HIPCs)), foreign exchange reserves plummeting to a level ($ 415 million on
November 12, 1998) hardly sufficient to finance two weeks of imports; poor governance
beginning to be the norm; the country loosing its financial sovereignty; more and more
people falling below the poverty line; and above all, the country was lurching from one
crisis to another.
The massive cost of debt servicing (almost two – thirds of the country’s revenue were
consumed by debt servicing alone) rendered fiscal policy instruments ineffective and the
country’s physical and human infrastructure began to show signs of buckling under the
combination of a fiscal crunch, rising poverty and poor governance. A weak and fragile
economy became the cause as well as the effect of the poor law and order situation in the
country. This was the background of the state of the economy that existed in 1999.

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REASONS FOR PAKISTAN’S FISCAL DEFICIT

Pakistan’s public finances and fiscal deficit as follows:
 Total expenditure exceeds total revenue, and the growth in expenditure

is greater than that in revenue.
 Current expenditure alone exceeds total revenue.
 Development expenditure has been falling, while current expenditure has grown.
 Defense expenditure has been very high, and much higher than even development
expenditure.
 Interest payments along with defense expenditure constitute more than half of
annual expenditure.
 The main source for financing the fiscal deficit has been non-bank borrowing,
rather then bank borrowing.
 Domestic debt is greater than foreign debt.
 The financing of the deficit is very substantially from domestic sources rather than
from foreign sources.
 The fiscal deficit of the government of Pakistan has been around 8 percent of GDP
for much of the 1980’s.
Moreover some interesting trends since 1980, which are also worth highlighting.

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 Total revenue has remained, with some variations over time, more or less the same
in 22years, despite reforms of different sorts.
 Total expenditure has fallen, since 1980/1 to relatively lower levels since 1999.
 Although total expenditure has fallen, current expenditure has risen in the 1990’s
and has not as yet, fallen significantly since 1999.
 Since a high degree of debt was accumulated in the 1980’s, debt servicing has
increased overtime. The highest proportion ever, 8.3 percent of GDP, was paid out
in 1999/2000.
 Defense expenditure has fallen over time, although due to changes in the
composition of what constitutes defense expenditure, one needs to be cautious
about making absolute claims.
 Development expenditure has been fallen very dramatically from a high 9.3
percent of GDP in 1980/1 to around 3 percent currently; it was a mere 2.1 percent
in 2000/1 perhaps the lowest ever.
 The budget deficit has been brought down to early 1980 levels.
There is complete agreement over the claim that the federal budget deficit is the most
important threat facing Pakistan’s economy.
Fiscal policy has been identified as “critical failure” in the context of Pakistan, and as one
of Pakistan’s key macroeconomic problems, threatening price stability, balance of

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payments, “constraining essential government investment in economic and social

infrastructure, and thereby, endangering growth prospects”.
The IMF following the conventional wisdom which it has helped frame, would, in all
likelihood, hold the deficit in Pakistan responsible for some, if not all, of the following
consequences: growing inflation, crowding out of private investment, a falling growth
rate, and the twin of the budget deficit, the continuing deterioration of the current account
deficit. The ‘very high’, ‘escalating’ budget deficit, according to IMF theory of causality,
should have had severe repercussions on the growth of the economy. This is clearly not
the case. Pakistan has faced very high growth rates compared to other developing
countries and averaged well over 6.5 percent per annum in the 1980’s. This is no mean
achievement given the huge budget deficit, which has averaged 7 percent in the same
period. Surely, the numbers must give pause for thought.
The inflation rate is another key variable that should have exploded given the high budget
deficit. An average of only 7 percent inflation over a decade is quite creditable.
Moreover, only 9 of the 23 years since 1980 have seen double-digit inflation, with a
maximum of 13.9 percent. According to estimates, Pakistan’s inflation rate should have
averaged in excess of 50 percent, given the high and unsustainable budget deficit. With
Latin American deficits, Pakistan has continued to have South Asian rates of inflation.
Interestingly, however, in the early 1990s when the budget deficit was 8.7 percent, after
which it fell, inflation actually rose in the period. It seems that there might even be an
inverse relationship between the two, at least in the case of Pakistan.
The crowding-out phenomenon is a key favorite of orthodoxy and neoclassicists, given

their penchant for the private sector. The theory suggests that the government, in its
financing of the deficit, would have pushed up interest rates to such an extent that the
private sector would have found it unaffordable to invest, and thus would have crowded
out. This would have implied a growth rate of far less than the hugely impressive 15
percent per annum experienced by the private sectors in the 1980s. Moreover, with the

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even greater ‘burgeoning of the budget deficit’ in 1990/1(8.7 percent), 19911/2(7.5), and
1992/3(7.9), one would have not expected the 19, 30 and 13 percent growth in the private
sector over the same years. Clearly, there seems to be little truth in the claim that the
private sector has been crowded out due to government policies or the budget deficit. The
evidence, no matter how superficial, points to different conclusion. Moreover, in the
period since 1988 when the deficit has been particularly high, so much so that the
structural adjustment program of 1988 emphasized the need to cut the deficit drastically,
the economy has behaved even more unconventionally with respect to IMF theory: real
per capita GDP rose by 10.4 percent between 1988 and 1992; merchandise exports
expanded by an average of 14 percent per annum in volume; private sector gross fixed
capital formation gradually expanded from 7.7 to 9.4 percent of GDP; and even domestic
savings rose from 10.5 to 12.2percent. Furthermore, even the current account deficit
behaved quite contrary to IMF theory. With this evidence, one is forced to re-examine the
questions: does the budget deficit matter in the context of Pakistan and how does the
IMF/World Bank feel about this issue?

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DOES FISCAL DEFICIT MATTER

IN THE CONTEXT OF
PAKISTAN?
Given its repeated concern over the issue of the budget deficit, one is led to believe that
the IMF has views on Pakistan’s budget deficit consistent with its theoretical construct.
Not so. The IMF/World Bank admit that:
“The macro consequences of fiscal deficits in Pakistan have apparently been quite
dissimilar from those in other developing countries with fiscal deficits of comparable
magnitude. Specifically Pakistan has experienced neither hyperinflation nor debt
rescheduling.. Growth has remained quite strong through the last two decades, inflation
has not been high, and the current account deficit has averaged about 2 percent of GNP,
remaining largely financial and not posing debt servicing problems for the country.”
These institutions, despite their insistence on the need to lower the deficit, admit that the
deficits have been ‘quite benign’ and that, despite the presence of fiscal deficits ‘ that are
very high by international standards, the country’s macroeconomic performance has been
relatively good. There is no evidence in Pakistan of the chronic acute macroeconomic
crises- manifest in extended periods of negative per capita income growth, hyperinflation,
and inability to service external debt- that have characterized many other developing
countries with comparable fiscal performance.

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The institutions that insist on cutting down the deficit admit that ‘initial performance in
Pakistan appears to have been remarkably good… At the same time economic growth has
been robust’, and real GNP per capita between 1972 and 1987 has shown a cumulative
increase of more than percent. Additionally, even the crowding out argument seems to
have been rejected, albeit reluctantly, with the IMF/World Bank admitting that public and
private investment seem to be positively correlated and ‘infrastructural build up that
result from government investment appears to facilitate private investment’. Public
investment was reduced drastically after 1996/7 as a consequence of privatization and
with restraints on government spending, while private investment turned negative after
the 1998 nuclear tests.
A study conducted by the IMF on determinants of private investment in Pakistan argued

that aggregate government investment had a significant positive impact on private
investment, implying ‘that the crowding out effect was not strong enough to balance the
crowding-in effect in the period [1972-1988]’. The government investment in
infrastructure was ‘estimated to be the most important positive determinant’ of private
investment in the period covered.
IMF believes that the deficit has not behaved in Pakistan as it should have in this period,
for several reasons:
 There was very high growth of real output (6 percent per annum) which
permitted a fairly rapid expansion of both interest-bearing and non-
interest-bearing debt without recourse to inflationary finance.
 The equilibrium deficit was quite high – 5.5 percent of GNP – despite a
low inflation rate because of a very high underlying rate of growth of
real output.

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 The government of Pakistan was able to borrow, both domestically and

externally, at rates below the marginal cost of funds in the international
private capital markets.
 Throughout the 1980s, the budget deficit was not monetized and
external funds and non-bank borrowings were the main sources of
funds to finance the deficit, so inflation remained low.
According to the observations of Pakistan, the impact of budget deficit on key

macroeconomic variables question the economic orthodoxy with respect to Pakistan, as
do the observations of IMF. While the monetarist neoclassical assumptions and
predictions regarding the behavior of the budget deficit are clearly spurious, if not out
rightly rejected the Keynesian interpretations, where public spending causes an increase
in aggregate demand and, subsequently, growth, given the less than full capacity of the
economy, seem somewhat closer to reality. Moreover, since there was no crowding out
through the mechanism of interest rate as predicted by the theory, one is led to believe
that there were ample loanable funds available at a given interest rate.
Given the nature and robustness of the economy, a fact conceded even by IMF, seems
quite clear that, in conventional orthodox framework, the budget deficit may not be the
real culprit after all.
RE-EXAMINING CRITICAL CONCERNS
The obsession that policy makers in Pakistan have with the budget deficit detracts
attention from the really important issues. The focus should not be on asking the
question: how high is the budget deficit, and is it sustainable? The real concern regarding
the deficit is the issue of spending and redistribution, i.e. who is being taxed and how is
public expenditure managed.

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The table below provides a very brief overview of what our observers feel is the central
issue regarding the budget deficit.

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The contrast in the patterns of defense expenditure and development expenditure is the
key concern regarding the budget deficit and public spending. In fact, Pakistan is the only
underdeveloped country where defense spending outweighs development expenditure.
Since 1980, development expenditure has fallen far sharply than the small reduction in
defense expenditure. Moreover, between 1985-1995, defense spending increased by 150
percent compared to 89 percent increase n development expenditure. Ironically, prior to
1985-86 when there was military government in power and Pakistan was under martial
law for most of the time, defense expenditure was considerably less than development
expenditure. After the advent of democracy in Pakistan, in 1988-99 defense expenditure
was higher than development expenditure in every single year, except one! There are two
possible explanations for this pattern:
 According to one view, during military rule, not only was the military making
use of the defense budget, but also due to its status as ‘the government’, it
acquired a large share in the civilian side of the economy.

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 A second explanation for this trend was that in the post-martial law period,
while the military was not in government, it is considered that military
continued to be in power. Pakistan was unable to deal with the given
democracy due to which military played more overt policing role.
Therefore, if budget deficit is ‘the number one problem of Pakistan’s economy”, as most
observers believe, it is for reasons connected with the role and distribution of public
expenditure, and is not dependant on the fetish of an abstract, arbitrary, badly calculated
statistic. The question of governance, or how public money is utilized, allocated,
managed, and siphoned off, is of critical importance.
FROM PERIL TO STABILITY
In this backdrop of a grave macroeconomic crisis, President General Pervez Musharraf

invited Mr. Shaukat Aziz to take charge of the Ministry of Finance in November, 1999.
He very quickly assembled a team of highly trained economists and extremely talented
civil servants. To address the issue of the severe macroeconomic crisis and place the
economy on a path of sustained higher growth, financial stability, and improved external
balance of payments, the economic team launched a comprehensive set of economic
stabilization and structural reform measures. Stabilization policies were needed to stop
the economic hemorrhage and dispel the gloom about Pakistan’s future. The government
believed that macroeconomic stability was vital for achieving higher and sustained
economic growth, creating employment opportunities and preventing people from falling
below the poverty-line.

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While accepting this challenge, the government set forward four major policy objectives
on economic front.
 First, to stabilize the country’s debt situation with a view to restoring

macroeconomic stability.
 Second, to revive economic growth and restore investor confidence.
 Third, to arrest the rising trends in poverty and
 Fourth, to improve governance.
These four-policy objectives were all interconnected. For example, a rising debt burden,
which consumed almost two-thirds of government revenues on account of debt servicing
forced public sector development programs to decline over the years. Being
complementary in nature, private sector investment also declined. This decline in overall
investment caused economic growth to decelerate with a corresponding rise in
unemployment and poverty. Poor governance also contributed to the slowing of
Pakistan’s economic growth and the rising levels of unemployment and poverty. It is
obvious that declining investment and economic growth in the 1990s was the mirror
image of the prevalent political and macroeconomic environment at that time.
Given the nature of the challenges, the government had two options. The first, was to
implement the four objectives simultaneously, that is, stabilize the debt situation, promote
investment and growth, reduce poverty and improve governance. The second option was
to prioritize these objectives and address the core issues first. After extensive
deliberations, the economic team opted for the second option for the following reasons:
First, Pakistan did not have the capacity to address all these issues simultaneously.
Second, to address all the issues simultaneously we had to use instruments whose
outcomes were conflicting in nature. For example, the root cause of the rising debt

- 30 -
burden had been the persistence of large fiscal and current account deficits, causing rapid
accumulation of debt and consequent deterioration of macroeconomic environment. In
such an unstable environment one could not expect the private sector to come forward
and increase investment. A stable macroeconomic environment was an absolute pre-
requisite for promoting private sector investment and spurring economic growth.
Stabilizing the country’s debt situation was considered to be the core issue and was
addressed first with lot of vigour and ingenuity. Wide-ranging structural reforms in
almost all the key sectors of the economy were also needed to enhance economic
incentives, improve resource allocation, and remove impediments to private sector
development. The Finance Minister felt that Pakistan’s economic problems were
structural in nature and the objectives of sustaining high growth, low inflation; external
payment viability and improving the lives of the common man could not be achieved
without removing these structural bottlenecks. It is with this view that a series of
structural reform measures were initiated in such areas as privatization and deregulation,
trade liberalization, banking sector reform, capital market reform, tax system and tax
administration reform, agriculture sector reform etc.
The fruits of the policies and reforms that were introduced by the government in early
2000 started yielding dividends. It has become a fashion among critiques to attribute all
the successes on economic front to the events of 9/11 and that the economic team had no
role in these successes. For them, dollars have been dropped from the helicopter and
accordingly all economic indicators have improved thereafter. We Pakistanis have been
so disillusioned by the governments and representatives of the past that, rightly or
wrongly, we fail to realize success even if it is staring us in the face.
It is a fact that Pakistan’s economy started showing signs of improvement by 2000-01

well before 9/11. Can any one dispute the facts that large-scale manufacturing grew by
11.0% in 2000-01 against 3.6% in 1998-99; inflation declined to 4.4% from 5.7%;
revenue collection increased to Rs.396 billion against Rs.308 billion; debt servicing as a
percentage of total revenue declined from 64% to 57%; exports increased from $ 7.8

- 31 -
billion to $ 9.2 billion; the current account deficit was reduced from $ 2429 million to $
513 million; foreign exchange reserves increased from $ 1.7 billion to $ 3.27 billion and
external debt and liabilities as a percentage of foreign exchange earnings declined from
335.4% to $ 259.5%? These are undeniable facts and well-documented in official
publications. These improvements had taken place much before 9/11.
Pakistan’s fiscal policy position remained focused on sustained economic growth in
unison with declining debt services, alleviating poverty and investing in physical and
human infrastructure. The last seven years (2001-07) saw Pakistan improve its fiscal
position considerably, given that the overall fiscal deficit, that averaged nearly 7.0
percent of GDP in the 1990s, had declined to an average of 3.8 percent (including
earthquake spending). The underlying fiscal deficit targeted at 4.0 percent of GDP for
2007-08 is most likely to be surpassed owing to a variety of factors stated earlier.
A study of Table discloses a change in pattern of both government revenues as well as
expenditures over the last 17 years. Under revenues, tax-to-GDP and hence revenue-to-
GDP ratios have shown a declining trend, owing mainly to structural deficiencies in the
tax collection system. The expenditures of the government follow a similar pattern, with
total expenditures showing an overall decline since the beginning of the 1990s. It should
be pointed out that despite an overall decrease in total expenditures; it is heartening to see
that development expenditure has shown a steady increase in recent years. Fiscal deficit
as percent of GDP has steadily declined during the same period, picking up slightly in the
last two fiscal years, mainly on account of earthquake spending. The declining pattern of
the fiscal deficit was more to do with falling expenditures than rising revenues. Since
1999-2000, the fiscal deficit has been contained primarily due to an improvement in total
revenues and also partly due to the rationalization of expenditure. The shifting of
expenditure from current to development while leaving total expenditures stagnant at
around 18 percent of GDP has helped improve the fiscal position while maintaining the
focus of the government’s developmental needs for the country.

- 32 -
The table below shows the fiscal indicators as percentage of GDP.
A cursory look at Table reveals important structural shift in patterns of revenue and
expenditures. On the revenue side, the tax-to-GDP or revenue –to-GDP exhibits a secular
decline over the last one and a half decade. On the expenditure side, total expenditure and
its components also exhibit a secular decline as percentage of GDP.

- 33 -
Fiscal deficit as percent of GDP also declined substantially during the period. However,
reduction in fiscal deficit owes mainly to sharper reduction in expenditure – more so to
development expenditure – rather than improvement in revenue effort. Reduction in fiscal
deficit since 1999-2000 owes partly to the improvement in revenue side and partly to the
rationalization of expenditure – particularly in the shifting of expenditure from current to
development and leaving the total expenditure to remain stagnant at around 18 percent of
GDP. Going forward, a further reduction in fiscal deficit must come from improvement
in revenue. The improvement in tax effort should not be limited to Federal Government
alone. The Provincial Governments will have to do much more to enhance their
provincial tax-to-GDP ratio from the current stagnant level of 0.5 percent to at least 1.0
percent of GDP in the medium-term.

- 34 -
FISCAL POLICY
DEVELOPMENT
2007-2008

- 35 -
FISCAL POLICY DEVELOPMENTS

DURING 2007-2008
Fiscal year 2007-08 proved to be a difficult year for Pakistan, with several political and
economic events transpiring unexpectedly. These events include heightened political
tensions, soaring global oil prices, the international and domestic food inflation
phenomena, a slowdown in global economic activity, and the troubled law and order
situation prevalent in the country. However, the most important aspect was the non-
responsive stance on account of political expediency, that is, not responding to the policy
challenges emerging on Pakistan’s economic scene during most part of the fiscal year
2007-08. All these events have had adverse consequences for fiscal discipline. Because of
the instability experienced at the onset of 2007- 08, the fiscal deficit is expected to miss
the target of 4.0 percent of GDP this year by a wide margin. The hard earned
macroeconomic stability underpinned by fiscal discipline appears to have been
evaporated. In other words, financial indiscipline during the outgoing fiscal year has
already caused severe macroeconomic imbalances, for which, Pakistan is likely to pay a
heavy price in terms of deceleration in growth and investment, and the associated rise in
the levels of poverty; widening of current account deficit and the attendant rise in public
and external debt; a loss of foreign exchange reserves and the associated pressure on the
exchange rate; and most importantly, higher inflation and the associated rise in interest
rates.
A sound fiscal position is vital for achieving macroeconomic stability, which is

increasingly recognized as being critical for sustained economic growth and poverty
reduction. The sooner Pakistan improves its fiscal position by making sharp fiscal
adjustments, the lesser the price it is likely to pay for its fiscal indiscipline. A sharp fiscal
adjustment can reduce large external current account imbalances, restore the confidence
of global investors, ease financing constraints, support growth and contain inflation. With

- 36 -
a new government coming to power late in the fiscal year 2007-08, the need to adjust
policies and counter the burden on the fiscal position has become a challenging task.
Reforms in Tax Policy and Tax Administration

An adequate level of revenue generation is a sine quo non for public policy to meet
expenditure obligations. Conversely, inadequacy of revenue generation directly affects
the government’s resource position and the availability of socially desirable public goods.
In Pakistan’s economic history, the mismatch between revenue collections and budgetary
requirements was a norm rather than an exception. The reform efforts remained
ineffective due to the inherent weaknesses in the tax system and an ineffective tax
administration.
Moving forward, an additional reduction in fiscal deficit in the future should be largely
driven from improvements in total revenue, more specifically, through the taxation
system. The improvement in the tax collection effort should not just be the responsibility
of the Federal Government but also the Provincial Governments, who must contribute
their share by enhancing their provincial tax-to- GDP ratio from the current stagnant level
of 0.5 percent to at least 1.0 percent of GDP in the medium-term.

- 37 -
Major Reforms in Direct Taxes:

Major reforms introduced in the Direct Tax structure include the promulgation of the
Income Tax Ordinance, 2001, which came into effect from 13th September 2001. The
objective was to simplify the language of the Ordinance by removing ambiguities for
ensuring uniformity in treatment of various categories of taxpayers, reduce the
dependency on withholding taxes, encourage voluntary compliance backed by strong
audit, and minimum tax exemption. The introduction of Universal Self Assessment
Scheme (USAS) for all categories of taxpayers, without any conditionality, has been a
major breakthrough. The basic threshold of income tax is continuously being raised and
the removal of a large number of income tax exemptions have been put in place. A two
tier agricultural income tax was initiated during the same period. A self assessment
scheme for filing of corporate tax was introduced. Some revenue reducing measures,
principally cuts in corporate income tax rates have been put in place in recent years. This
also ensured parity between the rates applicable to private, public and banking
companies.Wealth tax was also abolished.
Major Reforms in Indirect Taxes:

a) The enactment of the Sales Tax Act, 1990 introduced its value added
version renamed as General Sales Tax (GST).1 This was levied on goods
only (with many exemptions) and that too at the manufacturing and import
stages. A major leap forward was taken in 1995-96 when GST was
converted into a full-fledged VAT mode tax with all its basic features;
self-assessment, functional distribution, input tax credit facility and audit
based procedures. To further increase its base, its coverage was extended
to importers in 1997 and to wholesalers and retailers in 1998. With the
expansion of service sector in 1990s, the anomaly that goods are being
taxed but not the services was removed and the scope of GST was
extended in 2000.

- 38 -
b) b) The major policy change introduced in the 2005 budget regarding

Federal Excise was the system of self-assessment by withdrawal of federal
excise staff from the manufacturing units. The idea was to improve the
confidence of the taxpayers which should promote voluntary compliance.
Similarly, the Federal Excise Act was transformed in conformity with the
Sales Tax Act and the registration procedure was changed. The sales tax
registration number will also be sufficient for the federal excise taxpayers.
The mode of payment was rationalized to provide relief to the taxpayers.
On some services and goods FED is payable in VAT mode i.e. in the same
manner as provided in the Sales Tax Act of 1990.
c) Pakistan has made significant efforts in liberalizing its trade regime during
the last two decades. The maximum tariff rate had declined from 225
percent in 1990-91 to 45 percent by 1996-97. It was further reduced to a
maximum tariff rate of 25 percent (barring automobile sector) during
fiscal year 2007-08. The average tariff rate stood at just 6 percent in fiscal
year 2007-08 as compared to 65 percent in 1990-91. The number of tariff
slabs was reduced from 13 to 4 during the same period. Quantitative
import restrictions have already been eliminated except those relating to
security, health, religious and cultural concerns.
Tax Administration Reform

The tax administration reform strategy stresses upon Policy, Administrative and
Organizational reforms. This includes the simplification of laws, introduction of universal
self-assessment, elimination of exemptions, reducing dependence on withholding taxes,
and an effective dispute resolution mechanism. This includes the transformation of the
income tax organization on more functional lines, the re-engineering of manual processes
of all taxes, increasing the effectiveness of FBR, and improving skills and integrity of the
workforce. This includes reorganization of FBR headquarters, reductions in the number
of tiers, and the reduction in workforce from existing levels with enhanced financial
packages. Simultaneously, the Government has constituted a Cabinet Committee for

- 39 -
Federal Revenue (CCFR) to provide functional autonomy to the FBR. The aim of these
reforms is to have a fully integrated tax management system. There is a strong realization
in the FBR that, apart from customs, other tax wings i.e. Sales Tax and Income Tax
should be developed on similar standards so that at the end, FBR has one comprehensive
integrated system. The change in name of the revenue board from CBR to FBR signifies
a complete paradigm shift from an adversarial relationship between the taxpayers and
collectors, to taxpayers’ facilitation and education to mobilize resources. The government
has also approved a medium-term program for reforming tax administration in November
2001. Since then, major efforts have been made to improve tax administration.
Outcomes of Reforms
The structure of taxation in Pakistan has changed considerably following a number of tax
and tariff reforms that started in the 1990s and were intensified during the recent decade.
With a gradual reduction on the dependence on foreign trade taxes (collected through
customs) and a concurrent increase in GST and direct tax collections, the composition of
tax collections has been successfully modernized.
Excise duties accounted for about a fifth of FBR’s collection until 1998/99, targeting
levies on utility services, bank advances, and other goods and services at the point of
production. Since then, gradual cuts in excise duties, as well as removal of selected items
from the excise net, have led to a sharp decline in collection, with excises comprising of
only 8.8% of total FBR revenues or 0.8 percent of GDP in FY07-08.
Pakistan’s tax revenue-to-GDP ratio stood at only 10 percent of GDP during 2007/08
compared to an average of 18 percent for other developing countries indicating that
substantial tax policy measures are still needed to broaden the tax base.
The buoyancy and elasticity of the taxation system does not exhibit the desired
improvements and needs to be focused upon. The country’s tax regime resembles the one
generally practiced throughout Latin American countries, where indirect tax, in particular

- 40 -
sales tax, occupies a relatively high share within the overall tax revenues. The indirect
tax-to-GDP ratio stood at around 6 percent, and direct tax-to-GDP ratio was calculated to
be 4 percent and less than 2 percent if withholding taxes are excluded. The government
recognizes the need to broaden the tax base and reduce marginal tax rates which would
stimulate investment and production. This would also promote voluntary tax compliance.
Broadening of the tax base will also ensure the fair distribution of the tax burden among
various sectors of the economy. The overall services sector including wholesale and retail
trade as well as agriculture, are potential candidates for broadening of the tax bases.
During the decade ending in 1999-2000, the average growth of FBR tax collections stood
at 12 percent. This growth rate was calculated at 14.5 percent during the period 2000-
2008. The slight increase from 12 to 14.5 percent confirms the positive impact of reforms
but also reveals that more defined efforts are required to enhance overall collections. It is
however encouraging to know that during the last few years the growth in revenue
collection has been impressive at close to 20 percent.
The share of Direct Taxes in federal tax receipts has increased from around 18 percent in
the early 1990s to 32 percent in 2000-01. It further increased to 39.6 percent in 2007-08.
One of the implications of this change is that direct taxes have now emerged as the
leading revenue contributors to federal taxation receipts – a transition that has always

- 41 -
been desired on equity and efficiency grounds. Consequently, the direct-tax-to-GDP ratio
continues to increase from 3.8% in FY06-07 to 4.1% in FY07-08. It is distressing
however, that direct taxation in Pakistan accounts for only 4% of GDP whereas in other
competing developing countries this ratio is as high as 7%.2 Indirect taxes currently
account for 62 percent of the total revenues. The largest among these is the GST, which
accounts for 39 percent of the total tax collections and its share in indirect taxes stood at
60.3 percent for FY07-08. VAT or GST in Pakistan is a recent phenomenon.
Nonetheless, its growth has been faster than any other tax. It has increased sharply both at
domestic and import stage, from Rs. 16.0 billion in FY90-91 to Rs. 375 billion in FY07-
08. Induced largely by trade liberalization, the customs collection declined sharply over
the past decade, but rose sharply from FY02-03 because of higher imports. As a share of
GDP, customs collections declined from 3.4 percent in FY94 to 1.1 percent in FY02.
During the last few years, imports were growing in excess of 30 percent due to an
unprecedented surge in domestic demand. Consequently, the current fiscal year witnessed
an increase in gross and net collection from Rs. 132.2 billion in FY06-07 to 154 billion in
FY07-08. Custom duties accounted for 24.7 percent of the total indirect taxes for the
current year as compared to 25.5 percent last year.

- 42 -
FEDERAL BUDGET 2007-08

The total outlay of the federal budget 2006-07 is Rs.1314.8 billion which is 6.7 percent
higher than revised estimates of last year. Current expenditure is budgeted at Rs.879.8
billion— lower by 4.2 percent over last year whereas development expenditure is
budgeted at Rs.435 billion which is higher by 38.7 percent over last year. Total resource
availability is budgeted at Rs.1099.7 billion or 2.2 percent higher over revised estimates
of last year. Net revenue receipts are budgeted to fall by 2.3 percent on account of higher
transfers to provinces as well as fall in non-tax revenue receipts. Provinces are financing
greater amount of PSDP in the current year and at the same time generating more cash
balances which are budgeted to almost double from Rs.27 billion to Rs.53.8 billion.
Provincial cash balances are contributing to overall fiscal prudence in the economy.
Federal Budget is making all out effort to reduce nonproductive current expenditures
which is reflected in the lower level of current expenditure.

- 43 -
The following table highlights the salient features of Federal Budget 2007-08 and a
comparative budgetary position of 2006-07.
Public Debt

- 44 -
Public debt is the outcome of the developments taking place on the fiscal and current
account deficits. A larger gap in these two deficits would cause the public debt to grow at
a faster pace. Exchange rate depreciation would also cause the public debt to grow even if
the government does not borrow a single dollar. Low fiscal and current account deficits,
along with stability in the exchange rate, are critical in keeping the public debt at a
sustainable level. Large fiscal and current account deficits lead to an accumulation of
domestic and external debt which increases the country’s vulnerability to external shocks
while reducing investments and the consequent slowdown in economic growth.
Public debt as a percentage of GDP (a critical indicator of the country’s debt burden),
which stood at 85 percent in end-June 2000, has declined to 55.2 percent by end-June
2007 – a reduction of almost 30 percentage points of GDP in seven years. The declining
trend in public debt is likely to be reversed in 2007-08, mainly on account of a widening
of the fiscal and current account deficits and a sharp depreciation of the rupee vis-à-vis
the US dollar. By end-March 2008 the public debt as percentage of full year GDP stood
at 53.5 percent. More damage has however, been done to public debt in the last quarter
(April- June) of the current fiscal year, that is, a further widening of the fiscal and current
account deficits, increased borrowing from domestic and external sources to finance the
deficits, and a sharper adjustment to the exchange rate. The year 2007-08 is likely to end

- 45 -
with public debt at around 56 percent of GDP – marking the first time in a decade to see a
reversal in trends. Public debt in rupee terms has increased by 15.8 percent in the first
nine months (July-March) of the fiscal year 2007-08. Public debt is a charge on the
budget and therefore, it must be viewed in relation to government revenues. Public debt
stood at 589 percent of total revenues by end-June 2000 but declined to 363 percent by
end-March 2008 – a reduction of 226 percentage points of revenue. Going forward, the
key to the success of reducing public debt burden includes: a reduction in fiscal and
current account deficits and maintaining stability in the exchange rate. A declining public
debt would release government resources for public sector investment, would enable
private sector to borrow more (crowding-in) for investment and thus promoting growth.
The rising stock of public debt has serious implications for debt service obligations. The
debt servicing liabilities have declined sharply from 65.0 percent of total revenue in
1999-2000 to 28.5 percent of revenue in 2007-08 and from 53.5 percent of current
expenditure to 31.7 percent of current expenditure during the same period. The
subsequent fiscal space created by bridging the revenue-expenditure gap and low debt
servicing cost has enabled the Government to increase poverty and social sector related
expenditures from Rs. 89.8 billion or 2.2% of GDP in 2000-01 to a target level of Rs.
628.69 billion or 6.0% of GDP for 2007-08.

- 46 -
Domestic Debt
Most developing countries have a relatively small banking sector which limits the
availability of loan able funds. Borrowing from domestic financial sources has several
advantages including: avoidance of exchange rate risk, lower liquidity risk and ability to
deflate debt through higher inflation. However, excessive borrowing by the public sector
could lead to crowding out of the private sector as well as high interest rates and
inflation. With the expansion of the financial sector in Pakistan, the government has
relied more on borrowings from the domestic sector in recent years, reflecting in an
increase in the share of domestic debt in total debt, standing in at 53.8 percent up to
March 2008. By end-June 2007 total domestic debt stood at Rs. 2610.2 billion which was
estimated at 30 percent of GDP. The outstanding stock of domestic debt rose by Rs 409.9
billion and stood at Rs. 3020.1 billion by end-March 2008 or 30.3 percent of GDP.
The domestic debt has increased by 15.7 percent by end-March 2008 over end-June 2007
This growth in domestic debt when viewed at the back of an average growth of 8.1
percent of the last five years suggest that though the economy’s debt carrying capacity
has improved in recent years, the current rise in debt burden was witnessed mainly due to

- 47 -
the excessive borrowing of the government from the central bank as well as from non-
bank sources to finance a large budget deficit. The increase in domestic debt mainly
emanates from floating debt (27.1%) while the other two components, unfunded and
permanent, witnessed a modest growth of 6.1 percent and 9.4 percent, respectively.
Composition of Domestic Debt
Pakistan’s domestic debt has undergone considerable change in its composition in recent
years. The share of floating debt (a short-term instrument) in total domestic debt
increased from 36 percent in end-June 2005 to 46.6 percent in end- March 2008 – more
than a 10 percentage points in the last four years. The shape of long-term debt
instruments (unfunded debt) decline from almost 40 percent to 33 percent in the same period.
More reliance on short-term instruments to finance the fiscal deficit involves risks as
more resources will be required in quick succession. Going forward, attempts should be
made to rely as little as possible on short-term instruments, particularly borrowing from
the SBP to finance the fiscal deficit.
The following table provide a summary of outstanding domestic debt and domestic debt
service requirements for the periods indicated.

- 48 -
i - Unfunded Debt
The stock of unfunded debt has witnessed an increase for a third year running. Having
fallen from a stock of 909.5 billion in 2002-03 to Rs 854 billion in 2004-05, unfunded
debt has risen to Rs 997.2 billion by the end of March 2008, an increase of 6 percent from
last year or Rs 57.2 billion. This type of debt includes the various instruments that fall
under the National Saving Schemes (NSS). In response to various reforms in the NSS, the
unfunded debt saw a substantial increase starting in the first nine months of FY 2006-07
and the trend has continued into the current fiscal year.
ii - Floating Debt and Permanent Debt
The share of floating debt, which was undergoing a substantial decline since the 1990s,
increased by 27 percent or Rs 299.5 billion amounting to Rs 1407.2 billion by end-March
2008 see Table. The stock of permanent debt also exhibited a moderate increase of Rs
53.2 billion or 9.4 percent and stood at Rs 615.7 billion by end March 2008. The increase
in permanent debt is associated with efforts made by the Government to access funds
from auctions of the PIBs to satiate appetite for long-term paper and to promote the idea
of secondary market development. The administration has made an effort to balance
between long-term and short-term securities. The trade-off between short-run and longer
run maturity is intricately designed to keep debt servicing cost lower.
The figure below shows domestic debt from fiscal year 2000 to fiscal year 2008.

- 49 -
The major reason for the weak performance of these long term instruments can be
attributed to firstly increased market depth, providing diversified investment
opportunities and secondly the rigidities in profit payment structure of these instruments
that penalizes investors by denying them profit on the broken period. During July-Mar
FY08 period, debt servicing cost of the domestic debt increased by 52.1 percent, and
stood at Rs 328 billion mainly due to increase in unfunded debt servicing cost.

- 50 -
DEBT CRISIS

- 51 -
THE DOMESTIC AND FOREIGN

DEBT CRISIS
When General Pervez Musharraf came into power, he set up a Debt Management and
Reduction Committee in January 200, to tackle Pakistan’s serious problem of external
and internal debt, which had grown to a size greater than that of the GDP. As a
consequence, the committee released a report called Debt Reduction and Management
Strategy which laid down the cause of excessive debt. Pakistan was in the category which
faced debt problem on both domestic and foreign fronts. The reasons for this high debt
are summarized below:
 Large and persistent fiscal and current account balance of deficits.
 Imprudent use of borrowed resources.
 Weakening debt carrying capacity in terms of stagnant or declining real

government revenues and exports.
 Rising real cost of government borrowing, both domestic and foreign.
According to Debt Reduction and Management Strategy, the debt crisis was essentially
triggered by the un-sustainability of the level of current account balance of payment
deficits and the pattern of their financing in the 1999s. The report argued that it was this
current account problem which caused accumulation of both types of debt.

- 52 -
Table below gives key data for Pakistan’s domestic and external debt between 1993 and
2003. Total debt rose to 100% of GDP in 1998/9. Until the huge debt rescheduling of
2002, most indicators regarding debt as a percentage of total revenue, tax revenue,
current expenditure, were not particularly impressive, which just goes to reinforce the
observation that 9/11 has proven to be life saver for Pakistan. The period before the debt
rescheduling had exceptionally worrying statistics, with foreign debt more than 60
percent of GDP.
PROFILE OF DOMESTIC AND EXTERNAL DEBT

- 53 -
RATIO OF EXTERNAL DEBT SERVICING TO

EE 55.4 35.3 36.5 38.0 44.8 28.8
FEE 34.9 23.6 23.4 23.7 26.5 16.0
RATIO OF TOTAL PUBLIC DEBT SERVICING TO

- 54 -
tax revenue 78.4 87.8 90.3 77.1 90.2 54.8

Total 49.6 48.6 54.8 67.3 64.8 73.2 71.5 61.5 69.1 42.3
revenue
Total 36.8 36.4 39.0 47.8 43.9 53.0 51.7 47.4 52.2 33.9
expenditure
Current 45.8 44.6 47.6 56.8 .52.5 62.7 58.5 52.7 61.6 39.0
expenditure
As % of GDP
TD 92.2 84.4 85.9 90.2 99.8 104.7 106.0 113.5 104.3 95.1
DD 44.6 42.4 42.0 43.3 43.9 47.4 50.2 50.6 47.3 46.1
ED 47.6 41.7 43.9 46.9 55.4 54.9 53.5 60.2 55.3 48.0
EL 0.5 2.4 2.4 2.7 1.6 1.0
Parvez Hasan in his Pakistan’s Economy at the crossroads presented the fact that
Pakistan’s debt problem had emerged from the profligate 1980s, when General Zia-ul-
Haq’s government was spending far more money than it was receiving. He argued that
while there were very high growth rates in the 1980s; debt was being created which was
being transferred to future generations who would eventually have to pay the high cost
incurred in 1980s. The nominal public debt grew from around Rs.155 billion to Rs.802
billion in 1990 and further to 3,200 billion by 2000. The total debt burden was a mere 66
percent in 1980 and rose to over 100 percent by 1999. in 1980, the outstanding stock of
public debt rose from 400 percent of revenues to over 610 percent by the end of 1999.
Perhaps it was the 1996-99 period in which the public debt burden rose sharply, from 515
percent of government revenues to 625 percent, ‘which is considered as a more rapid
increase than 1980s’.
The reason why debt burden increased from 1996-99 are as follows:
 Growth rates had fallen in 1990s and so had revenue. In the 1980s, there
was real revenue growth of 8.2 percent per annum while it was 3.9

- 55 -
percent in 1996-1999 period. This implied that not only was debt
increasing , but it was becoming difficult to service debt.
 Interest rates increased from negligible levels in 1980s to very high

levels in 1996-99 period. This was mainly due to ‘liberalization of
interest rates’. While a huge debt overhang and with high amounts of
debt servicing at a time when the economy was doing noticeable poor in
the mid 1990s, and governments were being changed frequently , interest
rates were allowed to reach their ‘correct’ market price levels. The result
was that the Moeen Qureshi government, one of Pakistan’s many
caretaker governments, allowed interest rates to rise to ridiculous level of
20 percent per annum, despite the fact that there was debt to be repaid
and the economy was in poor situation.
 There was a serious upsetting of the balance between the defense and
development since early 1980s. the share of development in total
government spending, which was 40 percent in 1980 and 25 percent in
1990 declined to 13 percent in 2000, while defense spending more than
doubled in 1980-81 and 1999-2000.
 The debt crisis was also essentially triggered by the unsustainability of

the level of the current account balance of payments deficits and the
pattern of their financing.
 Exports and remittances had fallen to below par levels in this period and
there was a decline in foreign exchange earnings from 1996-1999.
 There was constant devaluation of Rupee which made it more expensive

to service foreign debt in rupee terms.

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There were certain deep seated structural factors and short term causes which led to
Pakistan’s high and increasing debt. These causes were as follows:
 National savings had been declining; there was a lack of fiscal discipline. Tax
revenue declined as percentage of GDP which indicated ‘ lower nominal
growth in tax collection as compared to the increase in GDP’.
 Foreign capital inflows had been used entirely to finance consumption.
Hence, it is not surprising that foreign debt and debt servicing kept increasing when the
economy was doing poorly, revenues were not rising and there was an overall investment
and confidence crisis in the country.

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WHAT HAPPENED TO DEBT CRISIS?
Even a cursory reading of any government document or academic study by economist at

any time during the 1990s immediately reveals that Pakistan was faced with a ‘crippling’,
‘devastating’ debt crisis for the entire duration of that decade. Both external and foreign
debt had reached astronomical, unsustainable levels, as had the budget deficit and interest
payments, which continued to give rise to further debt. The external debt and interest
payments had reached such astronomical positions that there was a real fear that Pakistan
would default on its international commitments and be declared bankrupt.
However, in December 2001, more specifically by 2002, the external debt crisis became
forgotten or ‘resolved’ and the Government of Pakistan had in fiscal year 2003/4 even
voluntarily retired $1.2 billion before its due date. This definitely gives a pause for
thinking that how this dramatic turnaround took place.
In order to gauge the extent of the crisis and the gravity of the situation, it is important to
know the amount of external debt owed and interest payment being made each year. The
table below presents the key ratios and data which give the clear picture.

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The table shows that by 1998/99, external debt was more than half the size of GDP and
with domestic debt around the same amount, the total debt of Pakistan was more than the
size of GDP. While Pakistan was paying back around a third in export earnings in the
form of debt servicing, it was still adding to the stock of overall external debt. The total
external debt to GDP was the highest in the fateful year 1998/99 after the nuclear test and
their repercussions.
Pakistan had been allowed to reschedule debt on numerous occasions in the past.
However, the scale of rescheduling in more recent years, particularly in December 2001,
largely payback to General Musharraf for his role backing US in their war against
Afghanistan, has been extraordinary.
In January 1999, following the foreign exchange problems that had been initiated after
Pakistan’s nuclear tests and the freeze on Foreign Currency Accounts and refusal of
many donors to lend to Pakistan, the Nawaz Sharif Government approached the Paris
Club members to reschedule its public and publicly guaranteed debt. The Paris club
agreed to reschedule some of the debt service payments due for the period January 1,

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1999 to December 31, 2000 in respect of the loans which were contracted prior to
September 30, 1997. As a result of this Pakistan ended up getting rescheduling worth
$3.1 billion in this period. At the end of first consolidation period in December 2000,
another round of rescheduling was sought from sovereign and commercial creditors.
Hence the Paris club, other bilateral and commercial creditors agreed to restructure debts
worth $1.8 billion.
However, the earlier debt rescheduling was minuscule compared to the $12.5 billion that
took place in December 2001. Not only was this amount far larger than any such
rescheduling in the past. Consequently, this provided an implied debt reduction without
having a ‘Heavily Indebted Poor Country (HIPC)’ status. Basically, the entire bilateral
debt of Consortium countries had been rescheduled, and this rescheduling had been for a
larger period than in the past; Official Development Assistance debt, which is 68% of the
total rescheduled, will be payable after 35 years, with 15 years grace period, and the Non
–ODA debt is to be repaid after 25 years period, with a five year grace period for other
loans. More over, there had been a re-profiling of debt in such a way that it took into
consideration the country’s capacity to pay. This rescheduling allowed a relief of between
$1.2 – 1.5 billion annually in payments of debt servicing on external debt during the
years 2001-05. To put the icing on the cake, add to this that Pakistan had not just had debt
rescheduling, but an actual debt write-offs by many friendly countries. Plus Pakistan had
an extraordinary fortuitous situation based on Pakistan’s support for the US invasion of
Afghanistan and its War on Terror.
Arshad Zaman argues that ‘the availability of external credit – and hence the ability to
incur external debt- has been determined by the status of Pakistan’s relations with the US.
In general, the availability of loans had spiked due to regional crises and has nose-divided
due to domestic developments… The availability of US military and economic loans has
always had a multiple effect in including bilateral and multilateral economic loans.

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However, despite the considerable rescheduling, it is important to emphasis that Pakistan

is still making substantial payments in the form of debt servicing to it creditors and
‘Pakistan’s external public debt will approach sustainable levels by FY2007’.

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CONCLUSION

- 62 -
CONCLUSION
Fiscal Year 2007-08 has been one of the most difficult years for Pakistan’s economy, as
several political and economic events transpired unexpectedly, adversely affecting the
country’s fiscal position. As a result, the overall fiscal deficit is likely to be 6.5 percent of
GDP against the budgeted number of 4 percent. Such a large slippage on the fiscal side
has already caused severe macroeconomic imbalances. The hard-earned macro economic
stability underpinned by fiscal discipline appears to have been lost and Pakistan is likely
to pay a heavy price in terms of deceleration in growth and investment, reversal in
poverty trends, widening of current account deficit, rise in public and external debt,
depletion of foreign exchange reserves and mounting pressures on the exchange rate.
A sound fiscal position is crucial for achieving macroeconomic stability, which is widely
accepted as being imperative for sustained economic growth and poverty reduction. The
sooner Pakistan improves its fiscal position by making decisive fiscal adjustments, the
lesser the price it is likely to pay for its fiscal indiscipline. A sharp fiscal adjustment can
reduce large external current account imbalances, restore the confidence of global
investors, ease financing constraints, support growth and contain inflation.

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FISCAL DEFICIT:
IS THERE
A
WAY OUT???

- 64 -
Recommendations for Expenditure side
• The tendency to incur debt without debate and discrimination must be curbed.
This should apply both to domestic and foreign debt. We should not take non-
concessionary loans and loans with too many cost-pushing strings short term
borrowings should in general be abandoned. Prospects of foreign debt swaps
and debt restructuring should be examined in depth in order to reduce the
burden of the existing foreign debt. In the case of domestic debt bank
borrowings budgetary support should be a residual financing item determined
by the safe limits of monetary expansion after full accommodation of the
genuine private sector credit requirements. Even government borrowings from
non-bank sources through various saving schemes and saving institutions should
be rationalized and reduced. Domestic non-bank borrowing also needs to be
harmonized with debt management and monetary policies in order to promote
integration of the capital and money market, reduce mark-up rate structure and
adopt a market based policy of monetary management. Moreover privatization
proceeds should be set aside to retire the outstanding domestic debt rather to
finance expenditures.
• Economy derive to reduce current expenditures should be intensified and closer

scrutiny of development projects based on stringent economic criteria is
warranted. Debt servicing capacity of the country and containment of inflation
may be two factors that should be taken into account in determining the size of
development expenditure. Moreover high cost and long gestation projects that
“lock-in” a large share of development expenditures for years should be
subjected to detailed institutional and legislative scrutiny. Pursuit of big prestige
projects of questionable economic justification should be abandoned.

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• Public corporations particularly those with large investment program, must be

made to generate their own resources and provide a reasonable economic rate of
return on past government investment. There is a need for a restructuring of
their managements, elimination of wastes and freeing of their output pricing
policies from government control.
Recommendations for Revenue side
• Widening the tax base:

Currently our tax base is narrow only 1.5 million pay tax while the potential is
high. If we first increase our number of tax payers then only there will be margin
of reducing the tax rates. Bringing all incomes, especially agricultural incomes, in
the tax net, can widen it. As it has been discussed before that various sectors of
our economy are under taxed. For e.g. only 5% of direct taxes come from non-
agriculture sector and out of this 5 % most of taxes are given by manufacturing
sector and services sector contribution is negligible. If steps are taken like
constant surveys, rewards for tax payment and subjecting individuals to
punishment for not reporting their income will help in collecting taxes from under
tax areas. Greater tax compliance can be ensured after the economy has been
documented.
• Improving administration:
Tax administration system cannot be improved until and unless a total
automated database system is provided to CBR .In the era of information
technology, everyone is stressing the need for automation but very few actually
know what automation in income tax entails. The CBR with the cooperation of
NBP should introduce a computerized and automated tax deposit system so that
no one escapes tax obligation.

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Simplification
The tax system administration, laws and regulations should be made simpler,
easier to operate and more convenient for taxpayers. Majority of people complain
about complex tax laws and procedure for tax payment .Our country with such
high illiteracy rate cannot afford to have complex tax system. For instance, the
practice of changing every year the procedures, format of tax form or extending
the last date for filing returns should be eliminated.
• Drop in number of taxes at all levels

A basic change in our three-tier tax system -- central, provincial and local, that
is fraught with multiplicity and complexity -- is needed. The number of taxes at
all levels needs to be reduced. Replacement of the current tax system with a fair,
simple and transparent one will certainly increase economic growth and national
productivity. At the same time, the governments at the federal and provincial
levels and all the concerned departments should reduce their expenditure by
enforcing strict financial discipline.
• Emphasize on direct taxes:

The government should also ensure that the burden of indirect taxes, which
usually falls across-the-board, is reduced and the ratio of direct taxes enhanced.
Under the tax and tariff reforms, the government should shift the incidence of
taxes from imports and investment to consumption and income. This would bring
much relief to the poor and middle classes in the society. At this level, Pakistan is
unlikely to attract any significant foreign direct investment. Why should one
invest in Pakistan, which is not an ideal country from the perspective of
availability of infrastructure and law and order, when there are several
jurisdictions offering lower tax rates, better living conditions and without such a
serious law and order problem? Therefore, in order to attract foreign direct

- 67 -
investment and even to induce local investment, the government should seriously
consider to reduce the tax rate, both for corporate as well as individuals.
• Punishing tax evaders:

One reason for increased tax evasion and corruption is that the culprits are not
subjected to punishments. People if caught for corruption or evasion are set free
by paying certain amount of fine. Hence these people are set free to commit same
crime again. Greater publicity should be given to cases of tax evasion in the hope
that public shame would serve as one of the deterrents to tax evasion. Government
alone cannot solve tax evasion but it needs strengthening of national, social and
political institutions, promoting rule of law and improving the living standards of
people.
• Educate the public

Voluntary tax compliance is essential for the broadening of the tax base to
reduce the burden on existing taxpayers. In spite of the ‘public awareness
campaign’ launched by CBR, the desired target is still to be achieved. Taxpayers’
education and Tax culture cannot flourish in Pakistan unless taxpayers get quality
service and facilities in return, which unfortunately do not exist at present.
Pakistan’s public has the image of tax corruption. To eradicate this image the
Government of Pakistan needs to provide them with improved social facilities.

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Fiscal Policy

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PAKISTAN ECONOMIC POLICY

FISCAL DEFICIT IN PAKISTAN

FISCAL DEFICIT IN PAKISTAN

ECONOMIC EFFECTS OF FISCAL

FISCAL DEFICIT IN PAKISTAN

FISCAL DEFICIT IN PAKISTAN

FISCAL DEFICIT IN PAKISTAN

Fiscal deficit = total expenditure – total receipts.

The elements of the fiscal deficit are:

TYPES OF FISCAL DEFICIT

 Revenue Budget Surplus/ Deficit

FISCAL DEFICIT IN PAKISTAN

REVENUE BUDGET SURPLUS/DEFICIT

OVERALL BUDGET DEFICIT

THE PRIMARY BUDGET DEFICIT

FISCAL DEFICIT IN PAKISTAN

deficit needs to be encouraged as it creates awareness of economic issues among the

FISCAL DEFICIT IN PAKISTAN

Financing fiscal deficit

o Non debt flow

FOREIGN SAVINGS/EXTERNAL BORROWING

FISCAL DEFICIT IN PAKISTAN

3. PRIVITIZATION PROCEEDS REALIZED FROM FOREIGN

Non-debt flows – mostly equity-will result in a payment as dividend only when

Therefore FDI or equity flows should be encouraged.

meeting current account deficit.

FISCAL DEFICIT IN PAKISTAN

The third avenue is the privatization proceeds realized in foreign currency.

demand for new debt the country is better off.

Financial integration is spurring many developing countries to raise equity by

o Multilateral Financial Institutions (MFIs)

• Private credit markets

Multilateral Financial Institutions (MFIs) and Bilateral Creditors. MFIs offer

concessional and non-concessional loans to developing countries. Bilateral countries

interested in extending suppliers and buyers credit to support their businesses.

they have only a mild burden on debt servicing capacity.

FISCAL DEFICIT IN PAKISTAN

financing for infrastructure and human capital development is to be welcomed as it

supplements domestic investment in meeting critical deficiencies and shortages in the

to international best practices. Non-project financing provided mainly for budgetary

Private credit markets

be taken in accessing International Capital Markets as they penalize mismanagement and

FISCAL DEFICIT IN PAKISTAN

companies or through private placements. As these modes are similar in nature to

exactly the same reasons as FDI.

Domestic borrowing can take the form of bank or non-bank borrowing.

generates inflationary pressures. Excessive Commercial Bank borrowing by the

targets and should also be discouraged.

Non bank borrowing

FISCAL DEFICIT IN PAKISTAN

be encouraged. Remunerative but competitive rates of return should be offered to the

Market and Corporate Bond Market.

FISCAL DEFICIT IN PAKISTAN

Foreign savings vs domestic savings

Developing countries are characterized by low per-capita incomes and widespread

after meeting basic consumption needs of their population to undertake required

investment for expanding production, building infrastructure and strengthening human

FISCAL DEFICIT IN PAKISTAN

management and utilization of these resources. A menu of options approach outlined in

FISCAL DEFICIT IN PAKISTAN

The generalized dismissal of deficits and borrowing on one hand or an automatic

Menu of Financing Options

Debt creating flows Non-debt creating flows

Official Private FDI GDRs Portfolio