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The financing of budget deficit has remained a fiscal dilemma for the various governments in Pakistan

By Dr. M. Hanif Akhtar,
Department of Economics, B.Z, University, Multan
 Jul 03 - 09, 2000

The macroeconomic discipline is considered to have a positive impact on the business climate in an economy. One of the indicators of such discipline is the fiscal deficit. Fiscal record of Pakistan has not been impressive over the last two decades of development. Larger budget deficits have persisted since 1970s, manifesting a lack of proper management of the economy. Persisting fiscal imbalances have undermined the performance of real sectors of the economy, increasing strain on the balance of payments and unleashing inflationary pressures as well. The deterioration in budgetary disciplines has also made the economy dependent on large-scale borrowings resulting in ever-increasing burden of debt servicing.

Despite the fact that repeated efforts have been made by the government to clear up the fiscal mess in Pakistan yet there seems to be no signs of success. Heavy defense outlays, over-generous non-development expenditures, large payments on account of debt-servicing and lower incidence of taxation have dominated the scene of fiscal management. Given the fact that the economy has a potential to generate additional revenues for the government, this potential has not been utilized fully. For instance, agriculture sector, a major contributor to GDP (25% in 1998), is exempt from tax in addition to tax evasion by the professionals, businessmen and non-salaried persons. Tax structure of the economy is narrow-based, less elastic and depends more on indirect rather than direct taxes. According to the State Bank of Pakistanís (SBP) annual report 1998-99, direct taxes form 35% of total tax revenue and comprise mainly of income and corporate taxes, while the indirect taxes comprising of sales tax, custom and excise duties etc. form a major portion (65%) of the tax revenues. Factors like dependence on few taxes and lack of elasticity in the tax structure has resulted in poor resource mobilization. Time and again the country has resorted to deficit financing or borrowings from various channels to bridge the fiscal deficit. A summary of public finance in Pakistan is provided in table below.

Summary of Public Finance in Pakistan

(% of GDP)
.

1980

1990

1994

1999

Total expenditure

23.0

25.7

24.5

20.3

Current

15.0

19.3

19.8

17.5

Development

8.0

6.5

4.6

3.0

Total revenue

16.2

18.6

17.3

16.9

Tax revenue

13.7

14.0

13.3

13.4

Non-tax revenue

2.5

4.6

4.0

3.6

Fiscal balance

-6.2

-6.5

-5.9

-3.4

Financing the deficit through: (% of deficit)

 . . . .

I. External sources

47.4

40.9

26.7

56.6

II. Domestic non-bank sources

9.6

52.8

59.7

105.4

III. Domestic bank sources/ Deficit financing

43.0

6.3

13.6

-62.0
Source: 1- GoP, Economic Survey, Various Issues. 2- SBP, Annual Report 1998-99.

During the first two decades of development, fiscal performance remained exceptionally good as in most of the years fiscal balance was in surplus. Even the years with fiscal deficits witnessed only negligible amount of deficit (less than 1 percent of GDP). The government tried to maintain fiscal balance by increasing the tax rates (mainly of indirect taxes) on various commodities in the early sixties. Indirect taxes formed a share of 70.3% of total tax revenue in 1961 and 75.6% in 1968.

With the increasing trend of public sector investment during the seventies and the nationalization of industry and finance in 1972, the role of public sector became significantly larger by middle of the decade. There was a substantial increase in public expenditures from 3.0% of GDP in 1970 to 24.5% of the same in 1976 while revenues increased from 2.6% to only 14.6% of GDP during the same period. This resulted in a fiscal deficit of 9.9% of GDP in the year 1976. During the end of 1970s, an attempt was made to reduce the fiscal deficit through expenditure cuts and revenue generation. But the government failed to control the deficit, being 9.2% of GDP in 1979, mainly on account of increases in the level of subsidies. Because of greater availability of foreign loans on concessional terms, most part of the deficit was financed through such borrowings. A short-term stabilization program, supported by the IMF, was also initiated reducing the deficit to 5.2% of GDP in 1981. Flow of external funds at concessional rates and the availability of domestic non-bank loans helped the economy to mitigate adverse effects of fiscal deficits that could have been higher otherwise.

Heavy defence expenditures, inflationary pressures and debt crisis in the early eighties increased budget deficit to 8.5% of GDP in 1988, forcing the government to resort to domestic non-bank borrowings. As a result of this policy measure, domestic interest payments increased from 0.9% of GDP in 1979 to 4.3% in 1989. This resulted in crowding out of the private sector investment as interest rates mounted up and the scope for credit to this sector became limited. Lack of revenue-generating efforts and continued growth in recurrent expenditures deteriorated the fiscal performance significantly during this period.

With the start of 1990s, need to contain the fiscal deficit resulted in macro-economic adjustment and structural reforms in the economy. The government adopted a long-term strategy for achieving much desired fiscal discipline through self-reliance policy. Controlling non-productive expenditures, withdrawing subsidies, downsizing the public sector through privatization of public enterprises, especially those running in losses, and better debt management were the principal tools of this strategy. During the recent years, the government has resorted to correction of fiscal imbalance via increased taxation and higher prices of public utility services under the directions of International Monetary Fund (IMF). However, such policies to minimize the deficit have resulted in higher inflation rates in the economy, heightening the social tension as well. The budget deficit still remaining high (6.2% of GDP on average for the period 1990-99), repeatedly overshooting the budgetary targets and commitments made to the IMF. This has also resulted in suspension of financial support from the IMF on various occasions. The government is striving for the fiscal adjustment through policy choices of both controlling the current expenditure and generating revenues through the mechanism of broadening the tax base and improving the revenue collection.

An analysis of the table above reveals that the efforts towards resource mobilisation do not seem to have materialised at all. This is reflected by the fact that the total revenues, as a percent of GDP, have stagnated around 17% since the last two decades. Part of the problem is directly related with the stagnation of tax revenues remaining almost around 14% since 1980 and onward. The scenario of current and development expenditures communicates a different story at the same time. The level of development expenditures has declined while that of current or the non-development expenditures has increased over time. The situation is converse to that expected. The decrease in deficit to the level of 3.4% of GDP during the year 1999 cannot be considered an achievement as compared to that 1980. An obvious factor in this regard is the decrease in level of development expenditures from 8% to 3% during the same period. Such a strategy of slashing the budget deficit might be considered as inconsistent with development aspirations of the economy.

The financing of budget deficit has remained a fiscal dilemma for the various governments in Pakistan. The eighties started with financing of the budget deficit mainly through external borrowings and bank sources. As a result of this strategy, not only external indebtedness increased, it also led to inflation in the economy (about 12.5% during the years 1981 and 1982). Hence, the government resorted to non-bank borrowings as a major source of financing the public deficit during the period 1983-90. The move was justified on account of debt crisis in the eighties and to prevent inflation as well. As a result of this policy-shift, inflation remained under control (6.0% on average) during the period 1983-90. Lack of domestic resource mobilization and the shortage of foreign loans forced the government to make a hesitant move for additional funds from the World Bank as a part of the structural adjustment loan (SAL) linked with stringent conditions. Resentment on part of the government has resulted in disruption of these funds, time and again.

During the 1990s, the government introduced various financial reforms through the market-based instruments of monetary management. Increase in reserve requirements, privatisation of commercial banks, license to establish private commercial banks, greater financial autonomy to the SBP, development of secondary markets in government securities, increase in commercial lending rates, credit control and capital market reforms etc. are the main features in this regard. Bank borrowings still appear as an important source of financing the budget deficit. Such a mode of financing the deficit not only affected the pace of monetary expansion but also accelerated the rate of inflation (10.6%), higher than annual average (7.3%) of the eighties. The bank borrowings soared up as a result of financial reforms and the government needs for retirement of the non-bank debt.

Fiscal imbalances that have been persistent since the last two decades still stand as a big challenge for policy makers in Pakistan. This has eroded credit-worthiness of the economy at international level by undermining the public finances. For obtaining more favourable growth, external and internal balances and lower rates of inflation, there stands a need for reducing current expenditures of the government and controlling wastage of resources on current and development outlays of the economy. There is also a need to reform the tariff structure in a way that results in minimum revenue losses and greater mobilization of resources to achieve macro-economic stability. In context of the present economic situation both at the regional and domestic levels, economic development of the country cannot be expected to be promising, at least in the short run. There is a need to adopt radical structural reforms in addition to the stabilization measures already in vogue, for the economic revival and stability.

The policy of financing the deficit through bank sources has led to greater monetary expansion and higher rates of inflation whenever the monetary authorities adhered to such a financing mode. This trend of financing the deficit needs to be changed to constrain and reduce inflation in the economy while rate of growth of output needs to be improved. The issue of containing the fiscal deficit is also important to the extent that prospects for financing the budget deficit through external borrowings, as has been in the past, are not promising. With the end of cold war and the loss of strategic position of Pakistan, the aid phenomenon faces an unsettled future.