Writing about the macroeconomic impact of fiscal deficit, James Tobin, the Nobel laureate in Economics in 1981, observed: “Few issues of economic theory and fact evoke such polar disagreement. The contesting views carry relatively divergent implications for public fiscal and financial policy” (Asset Accumulation and Economic Activity).
There is a sharp divergence of views on how fiscal deficit affects the economy. The conventional view, embodied in the Washington Consensus and held by the international financial institutions (IFIs), is that fiscal deficit, particularly in the context of developing countries, represents the most important policy variable affecting the rest of the economy.
According to this view, the relationship between fiscal deficit and other macroeconomic variables is set to depend on how the deficit is financed. It stipulates that money creation leads to inflation, government borrowing crowds out private investment and external debt leads to balance of payments crises (Easterly and Schmidt, Fiscal Deficit and Macroeconomic Performance in Developing Countries, World Bank Research Observer, 1993).
On the contrary, many economists question the validity of the view that budgets should always be balanced. James Tobin is of the view that what is really important is appropriate fiscal policy which may or may not balance the budget. He argues that there are built-in stabilisers in the fiscal system and that deficit performs a useful function in absorbing savings that would otherwise be wasted in unemployment, excess capacity or lower output. This view is shared by Willem Buiter who maintains that even in the long- run equilibrium, zero is not a uniquely interesting figure for the budget deficit (Principles of Budgetary and Financial Policy).
A more balanced view considers fiscal deficit as a useful indicator of overall economic performance and many analysts find a significant statistical relationship between deficit and many, though not all, macroeconomic performance variables.
The debate about fiscal deficit reverberates in the analysis of Pakistan’s economy, particularly in the context of the IMF and the World Bank conditionality. It is generally believed that fiscal deficit and consequential sustainability of domestic and particularly external debt obligations are the most important issues facing Pakistan’s economy.
The dissenting view, however, is that fiscal deficit has, until recently, continued to remain benign and has not disrupted the positive trends in the economy. According to this view, budget deficit can be problematic for reasons pertaining to the distribution and management of public expenditure and is not dependent upon the fetish of an abstract, arbitrary, badly calculated statistic (S. Akbar Zaidi, Issues in Pakistan’s Economy).
Where does the truth lie? There is a paucity of fiscal research in general and empirical analysis in particular in the context of Pakistan. This article seeks to explore, on the basis of fiscal and macroeconomic data, the macroeconomic impact of fiscal deficit.
The table provides a comparative look at the key fiscal and macroeconomic indicators over time. It is evident that a chronic and large fiscal deficit since the early 1970s has been the main source of macroeconomic imbalance , creating unsustainable debt and balance of payments problems on the one hand and adversely affecting savings, investment and growth on the other. The resultant loss of growth momentum in the economy and lack of fiscal space for social and human development also had profound implications for poverty.
Despite earlier efforts at fiscal stabilisation, it was not until recently that a reasonable degree of fiscal consolidation has been achieved by successfully implementing a stabilisation programme which, coupled with a broad range of structural reforms, has put the economy back on the track of sustainable growth.
Despite a large fiscal deficit, Pakistan performed relatively well in the macroeconomic sense during the 1980s, with high growth, low inflation and absence of major external imbalance. An enigma though to analysts, the availability of cheap foreign and domestic financing created a statistical illusion and allowed sustainable deficit without the ignition of an inflationary episode. The economic outturn, however, could have been better had fiscal deficit been controlled (Nadeem ul Haque and Peter J. Montiel, Fiscal Policy Choices and Macroeconomic Performance in the 1990s).
It was during the 1990s that adverse fallout of these fiscal policy choices became manifest. Non-bank financing during the 1980s made interest payments the largest item of current expenditure. Large recourse to domestic bank financing during the 1990s triggered double-digit inflation. Demand pressures created by large fiscal deficit showed up in current account deficit, increasing the economy’s external vulnerability at a time of squeeze in the availability of foreign financing.
Large and persistent fiscal and current account deficits led to a huge build-up of public and external debt. Public debt stood at 92 per cent of GDP and 627 per cent of government revenue and external debt at 48 per cent of GDP and 364 per cent of foreign exchange earnings (inclusive of FC liabilities) at the end of the 1990s. These ratios clearly suggested that Pakistan’s debt had become unsustainable. The macroeconomic impact during the 1990s has been well documented: low growth, declining investment, increasing poverty, social sector spending crowded out by debt service, high inflation, and external liquidity problems.
As a result of stabilisation policy and structural reforms undertaken by the government since 2000, fiscal deficit and public debt have been brought down to sustainable levels; growth and investment have picked up; reduction of debt service burden has created fiscal space for social sector and infrastructure development; and overall balance on the external account, despite a widening trade deficit, remains surplus.
Economic growth during the last four years has averaged 7.5 per cent of GDP and is likely to continue its momentum. Important challenges, however, remain: poverty, recent surge in food inflation, low tax to GDP ratio and, above all, sustaining long-term growth and ensuring continuity of structural and governance reform.
Fiscal consolidation is the key to macroeconomic stability. In order to ensure fiscal sustainability, it is important to address the structural issues on both revenue and expenditure side. Low tax to GDP ratio, narrow tax base, taxation of services and agriculture sectors, a large informal economy, documentation and enforcement, and revamping tax administration constitute major challenges on the revenue side.
On the expenditure side, creating fiscal space for human and infrastructure development, low effectiveness of public expenditure and financial and public sector management remain major structural issues.
