A Growth Promoting Fiscal Policy For Pakistan

Remarks by Henri Lorie, Senior Resident Representative

of the IMF in Pakistan at the Pre-Budget Seminar of The Nation newspaper
May 16, 2006, Lahore

The views expressed in this paper are those of the author and should not be attributed to the International
Monetary Fund, its Executive Board, or its management.

It is a pleasure for me to participate in this pre-budget seminar organized by The Nation. I am

told that this might be the first time that an IMF resident representative in Pakistan ventures

in such territory.

Under the Poverty Reduction and Growth Facility (PRGF) program of 2001-2004, the IMF

was able to support financially a comprehensive reform program for which the Pakistani

government took full-ownership. With its successful conclusion at end-2004, Pakistan parted

with any remaining IMF conditionality, hopefully as definitely as the Economist magazine

has placed Pakistan on its list of emerging market economies, with the likes of China and

India.

As member of the IMF, Pakistan continues to receive IMF policy advice under the

“surveillance” responsibilities assigned by the international financial community to the IMF.

Macroeconomic policy advice and technical assistance in the IMF’s areas of expertise (fiscal

and money and banking) have become the focus of this new relationship. May I add, in

parenthesis here, that the recent Spring Meetings of the IMF and the World Bank have again

brought to the forefront the “surveillance” responsibilities of the IMF, not only in the case of

emerging markets, but also for the industrial countries, broadening them in fact to include

new initiatives in the area of multilateral surveillance. A hot topic in this regard, as you
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know, has been the growing global current account imbalances, in particular among the

United States, East Asia, and the oil exporting countries.

I’ll share with you my views on (1) a growth promoting fiscal policy stance, as represented in

particular by the overall fiscal deficit and its financing; (2) the need to increase growth-

enhancing government spending; and, therefore, (3) the need to significantly increase the tax

revenue effort in ways which also support growth.

1. A growth promoting fiscal policy stance

Let me state at the outset that Pakistan has come a long way in reducing the size of its

overall fiscal deficit. From an average of about 5.5 percent of GDP in the 1990s, the deficit

steadily declined to less than 3.5 percent of GDP in 2004-05. Excluding spending related to

the earthquake relief and reconstruction, the deficit outcome for 2005-06 is also likely to be

around this number.

The fiscal performance of recent years has allowed a significant decline in the burden of

the public debt, with a reduction in the overall public debt/ GDP ratio to just above 60

percent of GDP by end 2004/05, from a peak of almost 90 percent of GDP in 2000/01.

Within this aggregate, external debt is about half. A courageous fiscal consolidation process

under the reform program of the government, in addition to other factors contributing to

favorable debt dynamics (such as high GDP growth, low external and domestic interest rates,

and debt restructuring), was key to that remarkable achievement.

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Nevertheless, the public debt remains a large burden on the budget and the balance of

payments, with the interest bill alone still absorbing a full 1/3 of tax revenue.

Under the recently passed Fiscal Responsibility Law, the Pakistani government is

expected to further reduce the debt/ GDP ratio by 2.5 percentage points of GDP every

year for some time. Some of the contributing factors mentioned above have become less

favorable. In particular, domestic and external interest rates have increased significantly over

the last 18 months. Adherence to the mandate stipulated in the Fiscal Responsibility Law is

likely, I believe, to require some further reduction in the fiscal deficit over the medium-term.

Exactly by how much would depend on the assumptions one makes regarding various

macroeconomic variables, which I will not get into here. Clearly, earthquake reconstruction

will increase the pressures on the budget for a number of years. And this makes it the more

important to adopt a full-fledged Medium-Term Budget Framework.

The general point I would like to make here, is my belief that, whatever the legal

mandate, further fiscal consolidation from where we are now would in fact be beneficial

to Pakistan’s long term growth prospects. Again, the timeframe I have in mind is the

medium term, and I will not dwell on the question of how fast Pakistan should, or indeed can,

move in that direction.

Research at the IMF and elsewhere has found that there are strong non-linearities in

the relationship between key fiscal aggregates and GDP growth, suggesting the

existence of threshold levels. Specifically, while further reducing the fiscal deficit below a
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threshold level (in percent of GDP) might be counterproductive from the point of view of

long term growth prospects, moving towards the threshold from a higher actual deficit level

would be beneficial. And the same would be true with regard to a debt-to-GDP threshold.

Estimates of these thresholds vary greatly, but the more careful empirical studies suggest

thresholds of about 2 percent of GDP for the fiscal deficit and 15-20 percent of GDP (or 80-

85 percent of exports) for the (external) debt stock in present value terms.

Taking these estimates as reference points, Pakistan would currently still be on the

“wrong” side of the deficit and debt thresholds. The implication would be that further

fiscal consolidation would be beneficial for long-term growth.

A main reason for these findings is the “crowding-out” effect that the domestic financing

of the fiscal deficit exerts on the amount of domestic savings available to support private

sector activity and investment. Had it not been for a (renewed) reliance on external

financing, financing of the 2004-05 budget deficit entirely with domestic resources would

still have absorbed more than 20 percent of private national savings. Although not dramatic,

this amount is significant. Access to external savings cut this absorption to less than half.

In fact, most of the domestic financing of the budget in 2004-05 [and also in 2005-06]

was provided by the State Bank of Pakistan (SBP) through seigniorage, essentially

because the government was not ready to see domestic interest rates rising to levels that

would have made its debt attractive for banks and others to hold. While this alleviated in

the short-run the “crowding-out” of the private sector, it contributed to inflationary pressures,
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and to the widening of the external account deficit which we have been observing. Without

the direct SBP financing of the budget contributing to reserve money growth, the banks

would not have had the liquidity that has allowed credit (and imports) to grow so rapidly, or

at least, other (external) sources of financing would have had to be attracted to satisfy the

demand for credit.

Phasing out of the direct recourse of the budget to SBP financing, in my mind, will go a

long way in strengthening the monetary policy framework to maintain macroeconomic

stability, and therefore promote sustainable growth. I am glad to see that the economic

managers have began the debate on this important reform.

While financing through external borrowing does not exert a direct crowding-out effect,

the resulting increase in the debt stock (in proportion to GDP) does tend to have an

adverse effect on growth, at least when the external debt exceeds a threshold level. This

is so for various reasons; I’ll mention one here: the servicing of the higher debt stock tends to

increase the share of non-productive expenditures within the budget, at the expense of

productive expenditures (including public investment).

Now, as far as how further fiscal consolidation would be achieved to move closer to the

threshold levels for the deficit and debt, recent empirical evidence supports the view

that cuts in transfers (subsidies) and an increase in the revenue effort are best ways to

secure a lasting positive impact on growth.

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Before turning to tax revenue mobilization issues, let me now say a few words on the

challenge of raising productive public expenditures in Pakistan.

2. More productive public expenditure

Productive government expenditure can be defined as those which “enhance” the

private sector’ s productivity. From this perspective, it is easy to see why government

spending on physical infrastructure (roads, ports, dams, etc.), as well as on education and

health are “productive”. Besides these outlays, expenditures on the administrative

infrastructure, law and order, and security should also be viewed as “productive”. That is, to

the extent that they impact positively on the business environment and investment climate.

Expenditure on subsidies and transfers, on the other hand, are not genuinely productive, even

if they improve the financial position and well- being of beneficiary enterprises and

households. In fact, subsidies tend to distort the allocation of resources, and thus to reduce

overall efficiency, potential output, and growth.

Typically, the level of public expenditure is assessed in terms of the amount of money

spent on different categories, rather than in terms of the “quality” or “productivity” of

the expenditure undertaken. This can be misleading. Ultimately, the assessment of the

“productivity” of government spending must be based on the “outcomes”, of what that

spending has actually delivered (e.g. graduates well versed in mathematics and sciences, or

accounting, healthy mothers and children, etc…).

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In Pakistan, the widespread perception seems to be that government expenditure are

not particularly efficient in delivering positive “outcomes”. For instance, red-tape and

even corruption is seen as reducing the effectiveness of any given amount of rupees spent on

general administration. Standards in education and health also appear to be fairly low. Recent

studies found that teachers and medical workers are, on average, absent from work 20-40

percent of the time in developing countries such as India and Indonesia; similar service

delivery problems may exist in Pakistan as well. Therefore, a growth-promoting public

expenditures policy must critically focus on improving efficiency and outcomes, not just

increasing the amount of money spent. I believe that the Pakistani government understands

this well, witness for instance the recent creation of a Civil Service Reform Commission. We

look forward to further progress in this important area.

On the other hand, the rising trend in subsidy and net lending to the energy sector in

recent years needs to be reversed, through commercialization, restructuring, and

privatization of state-owned enterprises concerned, and adjustment in prices to reflect

the true costs. Let me just suggest here that well targeted cash subsidies to the poor, as far as

the households are concerned, and regional development grants, as far as the industrial and

commercial enterprises located in remote areas are concerned, would be less distortionary

and potentially more cost effective than general tariff subsidies and/or tariff cross-

subsidization among various groups of users.

Notwithstanding what I have just said about the “quality” or “productivity” dimension,

studies have shown that for some categories of expenditures there is in fact a
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relationship between growth supporting outcomes in terms, for instance, of school

enrollment rates and lower mother/ infant mortality, and the level of spending on

education and health. And in these critical categories of expenditure, Pakistan continues to

lag behind despite recent progress. The 2004-05 PRSP report shows education and health

expenditure at 1.8 and 0.5 percent of GDP, respectively, while on average developing

countries spend 3.8 and 2.3 percent, respectively, on these expenditure.

Therefore, increasing budget spending on education and health must continue to be a

key priority for Pakistan.

Let me add in this regard that private spending on education and health does not

appear to be a substitute for government intervention in these areas, since the key is to

make those services available to the entire population. This does not mean that the private

sector cannot have a role in the delivery of these services; for instance, the government could

give vouchers to enable the poor to have access to private education and health institutions.

3. A more efficient tax system

A relatively poor revenue performance limiting available resources is a main reason why

Pakistan lags many other countries in providing for productive expenditure.

Even compared with low income countries, the tax revenue effort in Pakistan is more

than 2 percentage point of GDP lower. And, as a low middle income emerging market
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economy, Pakistan should be expected to mobilize almost 5 percentage points of GDP

additional tax revenue, just to be among the average performers. This is clearly a daunting

task.

Improving the tax revenue/GDP ratio is key for success in pursuing a growth

promoting fiscal policy in Pakistan. Yet, tax policy itself could have a direct impact on

growth. Any taxation of output generally reduces the rate of return on capital, and thus

investment and growth. It is therefore important to limit as much as possible the

distortionary/ disincentive effect of taxation; and, simply put, the way of doing this is to

apply relatively low tax rates on large tax bases.

The breakdown of tax revenue also suggests that:

1) the underperformance of Pakistan’s tax revenue is the greatest in the

individual income tax, including the taxation of the non-corporate business sector (less

than 0.5 percent of GDP, compared to 2 percent of GDP in low income countries alone).

2) while Pakistan collects amounts of VAT revenue that are similar to those raised

by low income countries, it collects significantly less than low middle income countries.

3) revenue from excises and import duties are even lower than those raised by low

income countries, owing to the low excises on beverages and petroleum products (including

PDLs) and the relatively low import duty rates plus the extensive system of exemptions.

The relatively poor performance of the income and VAT is not due to particularly low

statutory tax rates. In fact, Pakistan’s statutory corporate profit tax rate of 35 percent is
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about the same as the average statutory tax rate in low income countries, and is a bit higher

than the average statutory corporate profit tax rate in lower middle income countries, as well

as in the East and South Asia region (about 30 percent). And the VAT rate in Pakistan, at 15

percent, is higher than the average rate prevailing in the East and South Asia region (about 11

percent), though just below the average prevailing in the Middle East and Central Asia region

(about 16 percent).

Pakistan endemic revenue underperformance is mostly a result of a weak tax

administration and a narrow tax base. It is on these areas that all efforts need to be

focused.

My main points here are three:

1) self-assessment is a step in the right direction that must be accompanied by

stronger tax enforcement, including through measures to identify non-filers. The CBR

should further mine various data bases for this purpose, and work out an effective exchange

of information between the income tax, VAT, and customs services. There also needs to be a

clearly defined risk-based audit policy based on transparent criteria. The increase in the

number of income tax returns from 1 million to 1.3 million since 2003 as a result of CBR’ s

recent efforts is encouraging in this regard, but this is still a very small number in a country

of this size.

2) tax bases must be broaden. On the income tax side, sectors not meaningfully

covered (agriculture, real estate and financial services and transactions) must be brought into

the tax net once and for all. Capital gains taxation alone, be it on real property or financial
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assets sales, has the potential to add significantly to income tax receipts in Pakistan, in my

opinion. In terms of the VAT, it is important to further reduce exemptions, as well as to

further bring retail trade and services within the tax net. The higher threshold VAT

registration introduced in 2004/05 may also need to be reconsidered. The zero-rating of the

VAT for pretty much the whole supply chain of the export oriented sectors has made it even

more urgent to improve the VAT collection at the domestic retail level. Once an effective and

efficient VAT tax credit and refund mechanism can be put in place, I would expect to see the

CBR reverting back to a more orthodox implementation of this tax.

3) in terms of supporting an early quantum increase in tax revenue, there seems to

be room for some increase in excises (including PDLs).

Above all, there needs to be a “grand bargain” between the private sector and government. In

exchange for greater compliance by the private sector, promoted by a fair and transparent

taxation system, the government would provide quality public services that enhance growth

and welfare. Pakistan is moving in this direction. I look forward to further progress.

Thank you for your attention.

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