Experience has shown that cutting expenditure has generally yielded better results than raising taxes.

Naween A. Mangi
Dec 14 - 20, 1996

As the caretaker government’s reform slogans begin to wear thin on our markets, the business community continues to wait for something more solid than just tide-over packages and reassurances, to put our long term economic fundamentals back on track. And in this regard, our primary concern remains the country’s chronic fiscal deficit, now at 6.3% of GDP.

While it is, no doubt clear, as the experiences of several parts of the developing world have shown, that international donor agencies like the World Bank and the IMF do generally speaking represent the interests of the industrialized world, their persistent call to reduce the fiscal deficit does have its merits. But it is not a question of what we are to do, but more one of how we are to do it.

What does economic theory suggest? Textbook definitions will suggest that a government runs a budget deficit if government purchases of goods and services (G) (like defense expenditure, government employees, building roads etc.) exceed the net of tax revenues minus transfer payments (T) like welfare, social security payments etc. If this is the case, i.e. G exceeds T the government would fund the deficit by borrowing from financial markets and issuing government debt.

In Pakistan persistent fiscal imbalances have contributed to low national saving and investment, impeding growth performance. Many developing countries have managed to sustain relatively large fiscal deficits, but such deficits are unlikely to be sustainable because government debt cannot grow faster than the economy in the long run. During the 1980's the fiscal deficit in Pakistan averaged over 7% of GDP and was financed largely through extensive controls on financial markets, relatively strong monetary growth and external borrowing; growth also averaged 6% a year in the 1980s. But in the early 1990s adverse supply conditions increased the fiscal deficit to over 9% of GDP and the growing external debt burden eventually led to a financial and exchange market crisis in 1993, followed by a sharp decline in growth to about 2.5%.

Seven or eight years ago, the country's fiscal deficit averaged 10% of GDP and this is now at 6.3%. How can a 20-year average deficit of 7% of GDP be financed? Either through borrowing from donor agencies, domestic borrowing or by borrowing from the banking sector. On average we finance 2.5% of GDP from international donors, 3-4% from money creation and 1-2% from domestic borrowing. We therefore end up with a growing level of debt. Now with slowing GDP growth, and an acceleration of foreign debt, our debt as a percentage of GDP is now close to 46%. Our total debt:GDP ratio as been estimated at 90-95%. So we are in a situation of larger deficits, less GDP growth, and higher debt payments . With an exploding debt to GDP ratio, our only option is to reduce our debt levels and accelerate GDP growth.

If we finance the fiscal deficit by external financing, this will cause our external debt to grow and this will not only exacerbate our balance of payments problems but increase the interest payments on external debt which in turn worsens the fiscal deficit problem. If we finance from bank borrowing, we have to print money which leads to inflation and our domestic debt will also be higher leading to increased interest payments on domestic debt and back to the fiscal deficit. And if the deficit is financed by nonbank borrowing, this will lead to the crowding out problem and increase domestic debt as well.

Assuming we are going by the traditional and not the Ricardian view of government debt, it is understood that a tax cut and no change in government spending, will stimulate consumer spending, reduce national savings which will raise the interest rate and crowd out investment.

Of course deficit reduction is also the hard and virtuous road to debt stabilization, and at the same time, it is politically the most difficult decision to implement. Public spending gives rise to interest groups that resist cuts, of which the best example is government employees. And this is particularly relevant in our context, where a burgeoning bureaucracy with relatively generous allowances would be an especially difficult group to justify the virtues of a spending cut to. Raising taxes is, of course, universally unpopular. And yet, deficit reduction has been the solution chosen and achieved in several European countries. For European Union countries to qualify for Economic and Monetary Union, deficits have to be cut to 3% of GDP and debts below 60%. The reward for such self denial, politicians hope, will be lower ratios of government debt to GDP. Of course debt need not be a worry; if countries grow quickly enough to provide the tax revenues needed to meet the interest payments on time, then there is no crisis, but the bigger the debt, the harder this task, as in our case. And even if countries rarely default, high debts burn holes in tax payers pockets. And in Pakistan, as the recent downgrading by Moody’s Investors Services affirms, default will not come as a surprise.

Furthermore, if interest payments are high as a percentage of GDP, financial markets will fear that deeply indebted governments may be tempted to default or to cut the real value of their debts through a burst of inflation. Thus they demand higher interest rates from debt-ridden governments and make fiscal woes worse.

So is a tight fiscal policy the solution? The real question is that does a tighter fiscal policy necessarily lead to a lower debt-to-GDP ratio? In a study early this year by economists Alesina and Perotti, the conclusion was reached that it does not. The ultimate effect of a smaller fiscal deficit on government debt depends on the composition of a cut in the deficit, and not its size. This research also concluded that the tight policies that worked were those based on spending cuts and not those that tended to rely on higher taxes. In successful episodes expenditure fell by 2.2% of GDP while taxes rose by a mere 0.4%; in the rest taxes rose by 1.3% while expenditure was cut by 0.5%. When a tighter fiscal stance successfully led to a smaller debt burden, about half of the cuts came from cuts in current expenditure. But tighter policies that failed to peg debts back, left these expenses virtually untouched. Successful policies, it appears, require politically difficult spending cuts.

And of course the ratio of debt to GDP is more likely to fall in economies that are growing quickly.

So if you want to cut your debt burden, tight fiscal policy is not enough--a little tightening will stunt growth without lowering interest rates. And so far the most successful debt cutters have been those who are bold enough not to raise taxes but rather to cut expenditure.

This could prove a valuable lesson for Pakistan's economic managers. As has been typical, the federal budget of 1996 and the subsequent minibudget of October 22, sought to cut the deficit by raising taxes. The budget for 1996-97 envisaged a budget deficit of Rs 100.9 billion, or 4% of GDP, as revenue receipts were to increase by 21.6%. Additional tax revenues were to raise Rs 40.8 billion. However several measures were readjusted after the budget and in the minibudget of Oct 22, not only was development expenditure by Rs 20 billion and current expenditure by just Rs 7 billion but additional taxes of Rs 13 billion were also imposed. Even in 1995 for example, the budget provided for a reduction in the fiscal deficit from 5.9% to 4% through substantial increases in tax revenue through new tax measures and improvements in tax administration. The actual budget outturn resulted in a 6% deficit mainly as a result of a shortfall in revenue collection owing to budget concessions and tax roll backs and unsatisfactory collection.

Cutting current expenditure has always remained politically virtually impossible, and when spending cuts have been made, development has always received a serious blow. Most independent economists are unanimous on the view that unless the interim government is able to take some tough decisions, not only on making the tax base more equitable by bringing the agricultural sector into the tax net and improving tax collection, but also by drastic spending cuts from current expenditure, the fiscal deficit problem will not go away. And with the short time period that the caretakers have, plus the fact that they have no political mandate to take such decisions, compounded by the reality that even if they were able to institute change, there are simply no guarantees that the next government will follow through on them, no sustainable solution seems likely in the foreseeable future. And such decisions simply have not been the stuff of elected, political governments.