THE federal budget has been presented last month in the most challenging macroeconomic context in the country’s recent history. To evaluate the policy intent behind the budgetary measures it is imperative to first understand the nature, magnitude and severity of the economic crisis that Pakistan is experiencing and how we got here.
Pakistan is in the throes of a ‘classic’ currency crisis, the likes of which it has not experienced in the past — but has been faced by a host of emerging markets at different points in time. Facing a $25 billion external financing gap (the sum of the current account deficit and debt repayments due), the country’s foreign exchange reserves have depleted sharply over the past two years — resulting in severe pressure on the rupee.
Two fundamental structural weaknesses have stalked Pakistan. On the external side, the country’s export base is not only small and narrow, but has halved in relation to the overall size of the economy in the past 15 years. Pakistan’s exports stand at 7.6 per cent of GDP — compared to 95pc for Vietnam, 20pc for India and 15pc for Bangladesh.
As a result of ill-conceived and misdirected policies (including maintaining an overvalued exchange rate for a protracted period), exports paid for only 38pc of imports in 2018, and far less as a percentage of imports and debt servicing combined. Little surprise then, that as cheaper imports surged, and foreign exchange earnings could pay for a smaller fraction, the country had to turn to external borrowing. A substantial part of this borrowing was short term and from commercial sources. A large part of this borrowing has become due and accounts for the hump in debt repayments Pakistan is experiencing since 2018. External debt servicing (interest plus principal repayments) has shot up from $ 5.3bn in fiscal year 2016 to an estimated $10bn to $11bn in 2019. Debt-servicing pressure is expected to remain elevated for the next few years.
The budget is part of a policy response to a difficult situation.
The stark picture is mirrored on the internal balance side, which is the more relevant backdrop for budget-makers. The mounting imbalance between expenditures and revenues had meant that the fiscal deficit had ballooned to 6.6pc of GDP in 2018. With interest payments soaring 32pc to Rs1,987bn in 2018-19, the momentum of the fiscal imbalance continued and the outgoing fiscal year probably ended with an estimated overall budget deficit of around 7.5pc of GDP. (Interest payments now account for 87pc of net federal revenue ie after transfer of resources to provinces, up from 60pc just two years ago.)
This extremely constrained and difficult context informed the budget-making exercise. Even though the budget had to be formulated within the stipulation of overall targets set under the IMF programme, to their credit, policymakers have found the room for some excellent steps and policy measures. Some of these are transformational, especially when viewed in the overall context of the introduction of the benami accounts law and the tax amnesty scheme. For example, the distinction between filers and non-filers, which legalised the option for a non-filer to continue staying outside the ambit of the tax regime, has been done away with. Documentation of transactions, incomes and assets has been a central focus, with accompanying measures such as the demonetisation of large denomination bearer bonds.
Income from debt and property is to be taxed at higher rates to dis-incentivise ‘non-productive’ sources of income, while the differential between DC and FBR valuation rates has been drastically narrowed. In addition, to protect domestic manufacturing, import duties on many tariff lines have been rationalised and a cascading duty structure introduced.
On the negative side, the zero rating of domestic sales of the export sector has been revoked, potentially hurting their cash flow in a very substantial manner. Additional customs duty rates have been enhanced, while the tax credit for BMR (expansion/modernisation) has been withdrawn. A move with significant adverse ramifications for parts of industry is the conversion of the final tax regime to minimum tax (except for exporters).
It is also not clear if, under pressure to achieve an ambitious revenue target, sovereign commitments to existing investors have been rolled back, reneged on or altered in any way. Without policy continuity there will be no credibility. And without credibility, incentives to investors will mean nothing.
Any serious and credible move towards greater documentation of economic sectors and transactions is going to be disruptive by definition. However, the demands of the IMF programme and the pressing requirements of economic stabilisation meant that the government’s hand was forced into ‘shock therapy’ and a ‘big bang’ approach to reforms. This approach is also magnifying the disruption as well as pain — and increasing the potential risk of not achieving desired results.
The FBR’s atrophied capacity is the biggest hurdle to the success of any serious and meaningful reform effort, and it is not likely to be any different this time unfortunately. As witnessed in the 2013 IMF programme, pressure of the revenue target is likely to compel policymakers to shift focus away from a wide-ranging and meaningful restructuring of the FBR — which is a necessary step in reducing the trust deficit of stakeholders and inspiring confidence in potential taxpayers.
The importance of correct sequencing in reform cannot be overstated. In this case, it is imperative to restructure tax administration first before tax policy reform is introduced. Otherwise, the recursive loop of past failures with regards to tax reform is likely to be repeated.
Finally, budget makers have demonstrated some misplaced policy priorities. Eliminating subsidies on the Metro bus or for Haj is completely unnecessary at a time when the average Pakistani is having to cope with severe price and income pressure. At the same time, finding resources to lavish on a coterie of rich stock brokers, a Rs20 billion taxpayer-funded ‘bailout’, is demonstrative of egregious policy capture and a lack of sensitivity — neither of which behoves this government.
The writer is a former member of the prime minister’s economic advisory council, and heads a macroeconomic consultancy in Islamabad.
Published in Dawn, July 5th, 2019