Budget: flaws and omissions

IN an environment marked by judicial and political turmoil, a beleaguered government with its popularity (if it ever had any) in negative territory, and faced with what seems an unavoidable election, has unveiled a populist budget that it desperately hopes will help it at the hustings.

After its tirade against former civilian governments, the spin on the increase in development expenditure (while people continue to suffer long hours of loadshedding), claims of a sharp reduction in poverty and generous pro-poor relief measures announced in the budget, the government must now be scratching its head, wondering why it has merely succeeded in generating a negative reaction.

The key challenges confronting the economy that the budget was supposed to attempt to tackle are inflation, the growing budgetary and external trade deficits, continuing high rates of unemployment in parts of the country and the widening disparities of incomes and wealth.

Meeting competing demands for resources, while maintaining fiscal discipline, required the government to walk a tight rope on budgetary allocations and taking decisions on trade-offs between short and medium term goals and objectives. However, with the election looming on the horizon, the government decided to throw caution to the winds. It has chosen not to make the tough choice to raise the tax-to-GDP ratio to narrow the growing gap in this indicator (already two to three percentage points) between ourselves and our South Asian neighbours.

The most worrying feature of the budget is the likely impact on the fiscal deficit, which, given the lack of effort to raise additional resources and continuation of exemptions, and even new reliefs, is likely to grow, especially considering some of the unknowns, like the subsidy for electricity consumption of tubewells.

This could have serious adverse implications for inflation (which is likely to increase if expenditure is not reined in), which will further erode the purchasing power of those trying to eke out a living. Macroeconomic stability achieved after a long and hard struggle (in fact by this government) with a fair sprinkling of luck thrown in by the events of 9/11, has been lost. In 2003/04 the fiscal deficit was 2.4 per cent of GDP and inflation three per cent. These numbers have officially risen to 4.2 per cent and eight per cent respectively.

These macroeconomic imbalances are inducing pressures and new challenges for sustaining the present healthy rates of economic growth.

In this connection it is worth pointing out that while we are being assured that the gradual reduction of the fiscal deficit is as per the course laid out in the Fiscal Responsibility Act, there is reason to be concerned about hidden deficits in the shape of huge accumulated losses of public sector enterprises like Wapda, KESC (even after privatisation based on written agreements with the private owner and operator), the Railways and PIA to which there are large additions on an annual basis, around one per cent of the GDP.

In other words, there are hidden deficits because of losses of public sector enterprises that have not been accounted for in fiscal deficit. Such "creative accounting" has resulted in the reporting of lower fiscal deficits. These will eventually have to be either borne by consumers through higher tariffs, or will have to be bankrolled through the budget.

The bulk of the budget will be financed, including the modest pro-poor expenditures (despite the official hype created about the subsidies for food items the increase in allocations for all subsidies over the last year (including for electricity and fertiliser) is only Rs6.3 billion, with a mere Rs200 million set aside for pulses), by largely taxing the not-so-affluent instead of those who have the wherewithal to bear the burden of the expansion being planned for 2006/07.

A number of measures could have been taken to broaden the tax base and achieve horizontal equity among different interest and income groups, instead of selectively choosing some sectors for special treatment. Pakistan is in many ways a unique country where a principal source of income and wealth creation in the last two to three years — capital markets — continues to escape serious taxation.

Just in the last two years, the stock market index has jumped from around 6,000 points to over 13,000 this month with market capitalisation shooting up to reflect a capital gain of more than two trillion rupees accruing to holders of listed shares, which escaped taxation because of a specific tax exemption for capital gains arising from trading in listed securities. If these gains had been taxed at close to the same rate as dividends, then far more would have been raised than through the much-touted CVT on transactions in shares.

Hence, the decision of the government to continue to extend the tax exemption on capital gains arising from trading in listed securities has once again demonstrated that economic policies are not just skewed in favour of the rich but are also speculator friendly, disincentivising investments in the real sectors of the economy.

In a country where the distribution of assets is heavily skewed compared with the distribution of incomes and where there are no taxes on either deaths or gifts (wealth tax has also been withdrawn) the continuing exemption from taxation of massive capital gains in recent years from trading in shares has huge implications for widening inequalities between the affluent and the less privileged segments of the population.

This budget provides more shelter to inefficient assemblers of motor vehicles and motor-cycles — the means of transportation of the less privileged segments of the population — who already enjoy an extraordinarily high level of protection through the import tariff structure. They will continue to pocket, as private profits, what would have been tax revenues.

The government has also been shy of broadening the base of GST on services largely because the main beneficiaries of revenues from this source would have been the provinces.

Moving on to other announcements in the budget, public sector employees whose salaries and pensions have been raised by 15 per cent and those whose basic payscales will be upgraded (both these measures will place a huge budgetary burden on the provincial governments) represent roughly seven per cent of the total workforce, while EOBI and the minimum wage (raised to Rs.4,600) related proposals will cover less than five per cent of the remaining workforce.

Considering that the government has not been able to implement even the former, it is not quite clear how it will enforce the revised legislated figure for the minimum, especially considering its own inability to force contractors, executing its construction schemes to pay their workers the minimum wage.

As for the much larger number of unprotected, self-employed people or those working in the informal sector or as landless agricultural labourers, the curse of inflation will continue to plague them in the foreseeable future.

The benefits of the huge continuing subsidy on electricity and fertiliser and the new subsidies on consumption of electricity by agriculture tubewells and some commodities like ghee, pulses and sugar to be sold through utility stores (whose number is to be increased by 4,000 over the next four months!) instead of being meant specifically for the poor, will also be available to more affluent households/farmers.

Moreover, the introduction of subsidies is a bad idea, as, they eat into the vitals of the economic body. Once introduced they become difficult to withdraw. A better strategy to keep prices in check would be to reduce the cost of doing business and control government spending that fuels consumption expenditure beyond the productive capacity of the economy.

The route to provide cheap essential consumption items through utility stores has been used repeatedly with little effect. This is a failed model because it serves only a small proportion of the intended population with much of its success in the enrichment of the private coffers of the employees of the corporation. That some of the goods are likely to find their way to neighbouring countries where prices of the same items are higher is also a possibility that cannot be ruled out.

Furthermore, the decision to pick up 25 per cent of the electricity cost of tubewells, will not only be painful for provincial budgets which are expected to bear half the cost, the proposal is also not sound because it disincentivises the conservation of energy and extraction of groundwater both important national needs.

Moreover, the subsidy, the principal beneficiaries of which will be the large farmers, is open-ended, there being no ceiling on the level of subsidy per tubewell. The proposal also provides Wapda with an opportunity to mask its distribution losses as electricity consumption by tubewells. Even if a subsidy had to be provided it would have been far better to agree to pay a lump sum per month per tubewell, as that would have provided an incentive to farmers to save on electricity to reduce production costs.

Similarly, to ensure a wider distribution of the subsidy on fertiliser (instead of it being principally appropriated by the large farmers) it would have made more economic sense to reduce the GST on it.

Islamabad continues to be determined to keep more and more resources for itself, and not share them with the provinces. The skewed distribution of resources will ensure that the federal government implements more than 70 per cent of the development programme. Islamabad resists giving the provinces more money through the NFC award by pleading that it is squeezed for funds, since it has a number of obligations relating to defence, debt servicing and administration.

The reality is that our rulers are simply unwilling to give up activities that the Constitution places squarely in the provincial domain. We now have an absurd situation of Islamabad constructing provincial roads and implementing schemes in rural areas (for instance under the Khushaal Pakistan Programme employing non-formula based transfers) simply because it is not prepared to share with the provinces a portion of the increasingly larger share of the cake that it is keeping for itself.

This execution of schemes at the local level also has significant implications for service delivery and accountability since it will be the lower levels of government that will eventually be responsible for maintaining in good working condition the assets created under these programmes. While the federal government denies provincial governments and local populations any direct participation either in identifying and prioritising their needs or in the execution of the schemes that it has designed, it naively expresses surprise, if not contempt, at the Baloch not being happy with all the development work being done for them by Islamabad.

Moving on to the areas that the budget speech chose not to dwell upon, it is noticeable that it was silent on what the government plans to do with the deficit on the external trade account. The decision to levy an additional one per cent surcharge on most imports ostensibly to discourage imports will make little difference to the import bill, although it will raise the private sector's cost of doing business, particularly pushing up the cost curve of exporters whose duty drawbacks are not likely to be raised to neutralise their resultantly worsened cost competitiveness.

Finally, even if we accept the government's claim that the budget is investor friendly the prevailing political instability (which will only exacerbate after Musharraf's announcement that he will contest the presidential election in uniform) can hardly expected to titillate the discerning senses of private investors .

To sum up, this budget may well leave a legacy and a trail of financial mismanagement that a future government will have to be grapple with on assuming office. This writer for one would not envy their position.

The writer is a former finance minister of Punjab.

Iran’s stabilising role in ME

WITH the UN Security Council due to consider further sanctions against Iran, the previous consensus among its permanent members may be difficult to maintain as the US justifies its Ballistic Missile Defence installations in Eastern Europe that are being targeted at Iran.

As a signatory of the Nuclear Non Proliferation Treaty, Iran has not only accepted inspection by the IAEA but has also signed an additional protocol permitting further visits to specific sites. Alarmist opinions aside, the general assessment among experts is that Iran is at least five years away from acquiring military nuclear capability. The only known nuclear power in the region, Israel, not only has its own capability but also enjoys full US guarantees. The basic problem in the current crisis is that the US remains committed to its goal of a regime change in Iran.

The anomaly is that the predominantly young population of Iran would like to see improved relations with the West, but not at the cost of sacrificing their national identity and values. Former presidents Rafsanjani and Khatami reflect a pragmatic approach but President Mahmoud Ahmadinejad stands for the sovereignty and rights of an ancient land, which cannot be sacrificed. He also symbolises the aspirations of the Muslim world, which must be respected if the West wants security in the region.

While sticking stubbornly to its right to continue uranium enrichment, that is being exercised by many other signatories of NPT for peaceful purposes, Iran has participated in a security dialogue in Baghdad in which the US also took part. Iran has participated in IAEA consultations and is in contact with some EU countries on its nuclear programme. It has refuted allegations that it has sent arms to militants in Palestine or Lebanon and has condemned Israel’s resort to violence against Palestinians in Gaza and the West Bank, where it has arrested many elected representatives belonging to Hamas.

The Israeli attitude shows complete disdain for the peace process and the US has hardly shown any reaction, which bodes ill for durable peace in the region. On his recent tour of Europe, President George Bush tried to strike a conciliatory note with President Vladimir Putin of Russia by suggesting the installation of monitors in Azerbaijan for US and Russian missiles. The chairman of the Joint Chiefs of Staff in the US is being changed and a large US naval force has been steaming up and down the Persian Gulf.

The overall US posture in the Middle East is still aggressive, with Syria being accused of provoking conflict in Lebanon, while Iran’s nuclear ambitions are highlighted frequently. Though Secretary of State Condoleezza Rice keeps talking to Arab leaders the US is focusing on militants in Sudan and Somalia. The post 9/11 anti-Muslim rhetoric persists, and apart from the US pursuing regime change in Iran, ideas of redrawing the map of the region keep surfacing, and include the creation of Greater Balochistan.

As the election campaign picks up in the US, the Republicans continue to stress commitment to US forces fighting in Iraq and Afghanistan. As neighbours of Iran, Tehran would prefer to see foreign forces leave and internal peace and stability return. This does not look probable in the near future as the process of reconstruction in Iraq and Afghanistan has not gained momentum, and maintaining law and order remains the priority. The Democrats, on the other hand, are urging diplomacy and dialogue.

With Shia militias in Iraq stepping up attacks on Sunnis whom they outnumber three to one, the Arab rulers of adjoining lands to the south, headed by King Abdullah of Saudi Arabia, have made it clear to the US government that they will not remain indifferent if the widespread killing of Sunnis continues.

As Iran is allegedly aiding Shia militias in southern Iraq and supplying weapons to groups hostile to the US, there is increased pressure from Washington on Iran. But then, President Ahmadinejad paid an official visit to Saudi Arabia to assure the monarch that Iran stood for Muslim unity and had no desire to ignite sectarian passions.

Iran has defended its right to carry out uranium enrichment for peaceful purposes. But the powerful Jewish lobby in the US, joined by Israel, has stepped up pressure on the Bush administration to launch a pre-emptive attack on Iran for the purpose of destroying its nuclear installations and achieving a regime change.

Despite possessing the technical capability to attack Iran, the overall US predicament does not make a decision on the issue an easy one. The US is bogged down in Iraq and Afghanistan and its military resources are already overstretched. With the EU favouring a peaceful settlement and China and Russia lukewarm about additional sanctions against Iran, Washington will not only be defying world opinion but also ignoring new trends in the US itself where a majority favours diplomacy over bloodshed.

There are other elements that should make the US consider Iran as a regional power with a long history of a player of global significance. The Iranian empire stretched up to the Mediterranean 2,500 years ago. The country today boasts of a rich culture and a civilisation that influenced Central and South Asia as well as the Middle East. Its geo-strategic situation allows it to play an active role in a large region.

It may be recalled that following the overthrow of Mossadeq in 1953, the restored Shah became the most trusted ally of the US until he was toppled by the Islamic revolution in 1979. Except for the first decade when Imam Khomeini was in control, the US and Iran have coexisted without too much acrimony. Analysts point out that their interests have overlapped on many issues. Even now the Iranian attitude towards Iraq and Afghanistan may be harmonised with that of the US.

There is no love lost between the Iranians and the resurgent Taliban. The Iranian attitude over security issues in Iraq did not lead to controversy involving the US representative at the recent conference in Baghdad. Iran’s role as a major producer of oil and gas cannot be ignored. It is certain that if hostilities were launched, the price of these items would shoot up, causing hardship all round.

Any US show of force will further destabilise the region. Pakistan would experience serious disturbances with its substantial Shia population. One hopes that self-restraint prevails over arrogance.

The writer is a former ambassador.