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The fiscal challenge

20 April, 2011

By Dr Maleeha Lodhi


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The government still lacks a credible action plan to control the nation’s budget deficit. It has balked from taking tough decisions that can confront the scale of the fiscal problem and resorted instead to temporary, stopgap measures that do little to address the underlying causes. Confusion reigns about which of last month’s tax measures have been reversed or modified and which have survived resistance from affected interests.

With significant reform stalled the disarray in public finances continues to pose a threat to the country’s financial stability. The situation may aggravate due to a confluence of two new factors. Together they indicate that in the absence of reform the fiscal deficit could grow even larger in the foreseeable future because these developments have underlying structural characteristics.

The Governor of the State Bank has sounded a timely warning about the first of these trends in remarks that merit more attention than they have received. The insights offered by Mr Shahid Kardar in a Reuters interview earlier this month signal new risks for the country’s already precarious fiscal position.

The erudite governor said he was worried by a ‘structural shift’ of incomes towards the non-tax paying or lightly taxed sectors from tax paying ones. This shift of incomes especially to the agriculture sector, he said, means that the tax to GDP ratio is “structurally destined to hover at lower levels”.

Pakistan has one of the lowest tax to GDP ratios in the world, which is the source of all its fiscal problems. Mr Kardar’s prognosis suggests that additional structural factors will fortify or fuel the fiscal deficit crisis unless decisive measures are taken. He reiterated the call to broaden the tax base and address this structural shift in the next budget.

What exactly is the central bank governor referring to and why is it important? He is pointing to the fact that while the agriculture and service sectors have for a number of reasons been doing better than other tax-paying sectors they still contribute little revenue to the exchequer.

At a time of severe economic hardship for much of urban Pakistan and for the industrial and manufacturing sector, the agricultural economy has – in spite of the 2010 floods – benefited from higher global commodity prices and domestic support prices which together have shifted the terms of trade in favour of the untaxed agriculture sector. Agriculture accounts for 22 percent of GDP but contributes little more than one percent of all revenue. The rise in international commodity prices and the government’s setting of procurement prices well above their import parity price in the past two years has led to an increase in farm incomes. But this has not been accompanied by any commensurate obligation to pay tax.

Similarly, a major part of the services sector, which now accounts for 52 percent of GDP, remains exempt from any General Sales Tax. In recent years this sector has been growing at a much faster rate than the manufacturing and even the agricultural sector. Moreover this sector has also significantly benefited from the increased spending resulting from higher agricultural incomes. But it has failed to appreciably contribute to government revenue.

A GST has formally been in place for twenty years but its fiscal impact has been greatly diluted by many exemptions. Add to this the rampant evasion of income tax by the services sector and its successful effort to thwart a value added tax and an even more dismal picture emerges. The net result is what Governor Kardar has drawn attention to – a structural shift within the economy with serious fiscal implications which warrant urgent tax reforms.

As Mr Kardar has alluded, if the two sectors that contribute 74 percent of GDP have seen incomes grow but remain largely outside the tax net, it is hard to see how the tax to GDP ratio can improve. Without fundamental reforms and a tax regime that is fair and equitable, based on the ability of different sections of society to bear the burden, the tax to GDP ratio cannot much exceed 10 percent. Additional revenue can still however be raised through better enforcement and removal of exemptions to the GST.

A key reason for poor tax compliance and a culture hostile to revenue collection is the lack of equity in the tax regime with the burden falling disproportionately on the same people. To inject equity into the system the agriculture and services sector must be brought fully into the tax net however politically tough that may be. Without this, the country’s structural fiscal problem and chronic revenue shortfall cannot be addressed.

The agricultural sector continues to benefit from state help without being asked to pay its due. When the official wheat procurement price was set higher than its international market price this amounted to giving a producer subsidy. Although this year support and international prices are roughly the same the government is still intervening to buy several million tons of wheat to ‘protect’ farmers not able to sell their produce at the procurement price.

This producer subsidy together with a large subsidy on inputs like urea, are politically difficult to withdraw in view of the clout of the farm lobby in the national and provincial assemblies. The cost of this subsidy is now huge – more than Rs45 billion a year.

The shift in incomes to the non-tax paying sectors has been accompanied by a second development which will also fuel the budget deficit and, unless corrective action is taken now, become an additional ‘structural’ cause of a deepening fiscal crisis. This relates to the balance of resource distribution that was tilted in favour of the provinces under the December 2009 National Finance Commission award.

The redistribution of resources under the NFC award represented a missed opportunity that can prove costly in the future. When the share of provincial governments in the divisible pool was being enhanced no effort was made to persuade the provinces to accept reciprocal commitments to: a) mobilise resources from taxes in their provincial or local jurisdictions and b) assume the responsibility to absorb personnel and fund operational and development activities devolved to them under the Eighteenth Constitutional Amendment.

The spectre that now looms is for provinces, unaccustomed to expenditure restraint, to become a source of chronic federal financial frailty. Under the existing arrangement the provincial governments have no incentive to save and more efficiently use the increased resources transferred to them. Hence, they are unlikely to generate the ‘surpluses’ that the federal government will need to keep the fiscal situation within manageable limits.

A reduced share in scarce resources has meant that without a sharp growth in revenues or a commitment by the provinces to spending curbs the federal government will continue to have to borrow to meet its current expenditures. This is becoming starkly evident in the persistent rise in the revenue deficit – now about to cross 2.5 percent of GDP. This means a federal government revenue shortfall of over Rs300 billion of its annual current and non-development expenditures.

The federal government has been additionally burdened with rising security related expenditures and a growing debt burden, whose servicing is now absorbing over 45 percent of its share of tax revenues. The situation has been worsened by its inability to downsize government in consonance with the Eighteenth Constitutional Amendment, cut back huge subsidies on energy, and stop the haemorrhaging of public sector enterprises by their restructuring and eventual privatisation.

Unless a bold and coherent policy plan is devised to deal with the structural sources of the runaway budget deficit the country’s economic future will be imperilled by an unsustainable and serious fiscal situation being compounded now by emerging trends and more enduring unresolved issues.

 

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