THE federal ministry of finance and the departments of finance in the four provincial capitals are currently engaged in formu-lating proposals for the budgets of 2012-13.

This exercise is being undertaken at a particularly difficult moment in the country’s economic history. This is for three reasons.

The first concerns policymakers’ seeming inability to generate the needed resources for investing in the economy. This is a complex matter. It goes beyond increasing the dismally low tax-to-GDP ratio that has fallen to 8.6 per cent. Low levels of tax revenue generation are also tied to the problem on the side of external finance.

Pakistan seems headed towards another external payments crisis. To deal with it the country will need a sizeable flow of external resources — the payment needs for the 2012-13 have been estimated at $10 billion, well beyond the current capacity to pay. While workers’ remittances have done very well this year, they are not enough to finance the external deficit. Other sources of finance — in particular official development assistance from the United States — cannot be relied upon.

The World Bank and the Asian Development Bank have indicated their willingness to finance large development programmes and projects but these won’t do much to help with the balance of payments situation.

Given Pakistan’s poor record of implementing donor-financed projects, the actual amounts disbursed from the commitments made by the development agencies will not be very large. This leaves the IMF as the only viable source of large and quick flow of foreign funds.

But the Fund is not likely to rush in this time as it did in 2008.

It will not be forthcoming unless it can assure its board of directors that Islamabad will comply with the conditions it did not meet to remain current with the Standby Agreement (SBA) it had negotiated last time around.

Given that the 2012-2013 financial year will coincide with the last year of the current coalition government, it will make it doubly difficult to bring about a structural change in the tax system.

The country now has a well developed culture of tax avoidance. This has been promoted by two factors. First, the tax authorities don’t have the wherewithal to ensure compliance. Second, the failure of the government to provide adequate services to potential tax payers has reduced the incentive to pay taxes.

“Why should we pay taxes if the government does not deliver the services we need” is an argument one often hears from the people who are not inclined to pay into the official treasury.

In order to raise government revenues, budgets, both federal and provincial, must do more than levy new taxes or increase the incidence of those that are already on the books. They must change the structure of incentives that will bring new tax payers into the system.

One example of this is from Turkey where some decades ago Prime Minister Turgut Ozal made the payment of taxes not just a legal requirement or a civic duty. He created an environment in which income earners were prepared to document their transactions. This involved increasing both incentives as well as awareness.

The second difficult situation the budget makers must deal with the impact of the Seventh National Finance Award taken together with the 18th Amendment. These two near-revolutionary developments have brought provincial finance under the spotlight. However, the records of the provincial governments have been as poor as that of the federal administration. Tax revenues of the provincial governments have fallen from one per cent to only 0.5 per cent GDP. This was the result of the large and growing dependence of the provinces on their share in the federal divisible pool as well as grants from Islamabad. But balancing this are the additional responsibilities the provinces must shoulder because of the 18th Amendment. This will require a considerably larger tax effort on their part.

The Lahore-based Institute of Public Policy in its 2012 annual report provides some ideas about what can be done by Punjab in improving the province’s tax base. It recommends increasing the incidence and scope of three provincial taxes: agriculture income tax (AIT), urban immovable property tax (UIPT) and generalised sales tax on services (GST).

The AIT currently yields only Rs1 billion in Punjab; it could yield as much as Rs10-15 billion with justifiable increase in its incidence from Rs150 to Rs750 per acre on a progressive basis. The holdings below 12 acres of irrigated lands or equivalent could be exempted. Tax collection from UIPT could be tripled from the current low level of Rs8 billion. The GST could provide even larger amounts.

These adjustments could increase the combined tax-to-GDP ratio for the four provinces back to one per cent with subsequent adjustments taking the total to three to four per cent in four to five years.

The third problem the budgets must address relates to the worrying decline in both public and private investment. As a percentage of GDP, fixed investment declined from 18.4 to only 13.3 in the last three years. Taking into account the normal depreciation of capital, the net addition to the nation’s capital stock is only two per cent a year. This is an incredibly low amount for an economy that needs to grow at a much higher rate.

All five budgets must provide for incentives so that the rates of investments begin to increase. This must happen in both public and private sectors. The state has to reverse the deterioration that has taken place in the irrigation infrastructure in order to realize the country’s enormous agricultural potential. The private sector must increase investment in industry and modern services.

Investment in large scale manufacturing has declined from 2.7 per cent of GDP in 2006-07 to only 0.9 per cent in 2010-11 and there are several other problems that budget-makers in the five capitals must be fully cognizant of. Although in a pre-election year policymakers will not want to ask for sacrifices, it must be realised at the same time that the country’s current economic situation is precarious. Action on a number of vital fronts cannot be postponed any longer.