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Pakistan's fiscal deficit was around eight per cent of GDP at the end of fiscal year 2013.
Such large deficits fan inflation, increase public debt, reduce private investment and expand external accounts gap.
More problematically, Pakistan is running such large deficits while critical public investment needs in healthcare, education, infrastructure development and disaster preparedness remain unmet.
Thus, resolving fiscal pressures through a systematic approach is crucial, even during this stagflationary period where public fiscal adjustments are made difficult by inadequate revenues, along with downwardly inelastic and even increasing expenses.
A systematic approach would be to first calculate the fiscal adjustment required based on the current fiscal deficit and the additional critical public investments needed to achieve sustainable development.
Secondly, policymakers should identify sources for increasing revenue and reducing expenditure, which would help achieve this fiscal adjustment but also work for growth, poverty reduction and administrative and political feasibility.
While the recent IMF agreement emphasises fiscal stability, it is unfortunately not based on such a systematic tailor-made approach, but on standard one-size-fits-all Fund prescriptions that it monotonously doles out to loan recipients.
To calculate the size of the fiscal adjustment, one must start with the current fiscal deficit. The annual fiscal deficit must be brought down to a level where Pakistan can start reducing its public debt, which already hovers around 60 per cent of GDP.
Since annual debt servicing currently consumes around 4.5 per cent of GDP, the fiscal deficit must be brought down from eight per cent to around three per cent of GDP in order to start reducing the outstanding debt.
To this five per cent annual fiscal adjustment, one must add at least another five per cent to address critical needs in healthcare, education, infrastructure development and disaster preparedness to ensure sustainable development. Thus, policymakers must essentially make annual fiscal adjustments of around 10 per cent of GDP through revenue increases and expenditure reductions immediately.
As stated above, such revenue increases and expenditure reductions must respect the critical goals of growth, inequality reduction and administrative and political feasibility. Common sense dictates that before increasing taxes, policymakers must reduce public expenditure waste, both on the civilian and the defence side, in order to increase its credibility and be in a stronger position to ask people to pay more taxes.
Estimates about government waste vary widely and are generally difficult to measure accurately. However, even conservative figures suggest that it should be possible to obtain public expenditure savings of at least one per cent of GDP by reducing such waste.
Cutting essential expenditures is difficult, especially during economic downturns where it can subdue economic growth even further. However, cuts in government waste, such as lavish expenditures on senior official entitlements, will have little impact on economic growth.
Secondly, common sense also dictates that before increasing taxes, the government should plug current leakages in the tax administration; otherwise even additional tax measures will experience significant leakages.
A joint Federal Bureau of Revenue (FBR), World Bank and Georgia State University review of Pakistan’s tax system in 2009 had conservatively calculated the federal tax gap, i.e. the amount of tax that goes uncollected due to non-compliance with the law, to be around 70 per cent of the actual taxes collected, or around eight per cent of GDP back then.
It may not be administratively feasible or cost-efficient to collect the whole of that tax gap. However, even collecting half of it would yield fiscal savings of around four per cent of GDP. Thus, about half of the required fiscal adjustment of around 10 per cent of GDP, which relates to bringing the fiscal deficit down to three per cent from eight per cent, can be met without any increases in taxes by reducing government waste and tax evasion.
The rest of the five per cent fiscal adjustment related to increasing expenditures on critical sectors would require collecting more difficult-to-collect taxes that are currently being evaded, and eventually levying additional taxes.
Increasing taxes even at the best of times is not easy politically, and is even more difficult when the economy is floundering. The focus during such times must be on increasing those taxes that have the least impact on overall economic growth and the poorer segments of the population.
This issue involves the question of the mix between direct and indirect taxes, which currently stands at around 39:61. Unfortunately, the bulk of the focus in the IMF agreement, and especially in the way that it has been implemented in practice, has been on increasing indirect taxes — more specifically sales taxes — and reducing subsidies on oil and electricity.
Overall, global reviews usually find that direct taxes are better for economic equality and during economic slowdowns, while indirect taxes are better for economic growth and foreign direct investment. Direct taxes are generally seen as being more progressive than indirect ones, i.e. they impact rich people proportionately more than the poorer people.
However, indirect taxes can be progressive and direct taxes can be regressive, based on the exact compositions and details. The 2009 joint study had found indirect taxes in the country to be progressive. Whether this is still true, and whether indirect taxes are as progressive as direct taxes, need to be reviewed carefully.
However, during economic slowdowns, it is better to first exhaust all untapped direct tax avenues before increasing indirect taxes.
So, the government’s decision to reduce corporate taxes without first improving the tax administration to ensure that the rate reduction actually yields higher absolute taxes is unjustified. Furthermore, the government should have first exhausted untapped direct tax avenues such as increasing taxes on large-scale agricultural income, capital gains and wealth.
Increases in sales tax and reductions in subsidies should have been delayed for 2-3 years until the economy had revived, given that better avenues, for e.g. reductions in government waste and tax evasions and increase in direct taxes cannot only bring the fiscal deficit to manageable levels, but also finance increased outlays in critical sectors.
Unfortunately, such pro-growth and pro-poor approaches to fiscal management are missing from the perspectives of both government officials and the IMF.
The writer is a political economist at UC Berkeley.
