Analysing a budget can be a little bit like unravelling a mystery – some things are obvious, others are not quite what they seem, and you always discover new things as you delve deeper.
In the days leading up to its release, the federal Budget, 2006-07 was being touted as one that would be pro-poor and provide relief to the common man. In some ways it has lived up to this hype, which is the good part. In particular, the size of the public sector development programme (PSDP) has been increased 60 per cent, from Rs272 billion to Rs435 billion, including Rs50 billion for the Earthquake Relief and Reconstruction Authority (ERRA).
And reportedly, 44 per cent of the non earthquake-related federal component of the PSDP is earmarked for much-needed public infrastructure development and another 44 per cent for the social sector. These allocations are definitely pro-poor, with the important proviso that the delivery, monitoring, and utilization mechanisms of the PSDP need to be vastly improved for this programme to become more effective.
Another good thing about the budget is that there are at least some relief and subsidy measures provided for the betterment of the common man. Besides, the dearness allowance and the increase in pensions for government employees, there is also an increase in the minimum wage from Rs3,000 to Rs4,000 per month, an increase in the tax exempt level of income from Rs100,000 per annum to Rs150,000 per annum and a decrease in the effective tax rates of lower income salaried workers. The government has also increased subsidies on the imports of fertilizer and sugar and has decided to provide daal (lentils) at subsidized prices at utility stores.
If properly implemented and conducted in a transparent manner, some of these and other relief measures should help the common man and woman. However, it is questionable how effective controlled prices of essential food items at utility stores will be in making food more affordable to the vast majority of the low-income people. Will those in most need of relief have adequate access to these stores and, even if they do, how will it be ensured that they are given priority for purchasing the limited quantity of the goods that are available at subsidised prices?
Although there are relief measures in the budget, their importance should not be exaggerated, as their size is somewhat modest. Not counting the tax relief, the government’s relief and subsidy measures are estimated to be Rs109 billion, or about 1.2 per cent of projected GDP for 2006-07. It should be noted that this is only slightly higher than the 1.1 per cent of GDP they are estimated to be in the current fiscal year.
Turning to concerns about the budget, it represents a substantially expansionary stance of fiscal policy and, therefore, puts further pressures on the growing macroeconomic imbalances. One imbalance, of course, is the fiscal deficit itself, which is targeted to be 4.2 per cent of GDP. By increasing the government’s dissavings, a larger fiscal deficit decreases domestic national savings and thus increases the gap between investment and national savings. This increases external financing requirements.
Another way to look at this is that the domestic demand that is created by the increased government spending – unless it is met by a commensurate increase in domestic production – has to be satisfied by importing more. This puts pressure on the external current account deficit to widen further; already it has increased to $4.7 billion during July-March, 2005-06 from $1.2 billion during the same nine months of the previous fiscal year.
The fiscal deficit can also further fuel inflationary pressures, both directly because it can increase domestic demand relative to domestic production as well as indirectly through the expectation that it will partly be financed by money creation, in effect by borrowing from the State Bank of Pakistan (SBP).
The government will argue that although the fiscal deficit-to-GDP ratio target of 4.2 per cent exceeds their own recommended ceiling of four per cent, this is due to the unanticipated expenditures related to earthquake relief and reconstruction activities; without these expenditures the deficit is expected to be 3.7 per cent of GDP. However, under the prevailing conditions of growing macroeconomic imbalances and high inflation, it would have been more prudent to target a lower fiscal deficit-to-GDP ratio to better safeguard the hard-earned macroeconomic stability and policy credibility.
This proposition highlights an important dilemma that the government faces. The allocated development expenditures and earthquake-related spending are essential. But the unprecedented increase in the PSDP also creates pressures on fiscal imbalances. The dilemma is how to ward off those pressures without compromising the development expenditures.
The answer: expenditure switching and raising a lot more tax revenue in a manner that preserves or even increases the progressivity of the tax system. (The progressivity measures the extent to which the rich bear a higher burden of taxes.) And, it is in these dimensions that the budget is lacking.
True, current expenditures are estimated to fall about four per cent to Rs880 billion, relative to the revised estimates of this year’s spending. But, according to these revised figures, the target for this year will overshoot by 11 per cent.
In the two main components of current expenditure, General Public Service and Defence Affairs and Services, the revised figures indicate that the targets for this year will be exceeded by 12 per cent and nearly eight per cent, respectively. This continues the tendency, which has been going on year after year for current expenditures to exceed their targets by significant amounts.
Thus, relative to the budgeted amount for 2005-06, current expenditures are still projected to rise by about 6½ per cent. This is the same as the target for the inflation rate, so that even in real terms (after adjusting for inflation) expenditure switching is not occurring.
However, it is the case that, even not counting the earthquake-related spending of Rs50 billion, development expenditures are at least slated to increase as a share of total government outlays (if the projections are realized) to about 29 per cent from this year’s share of 23 per cent based on revised data.
The tax initiatives in the latest budget fall well below expectations. A lot more tax revenue needs to be generated for the budget to be pro-poor on a sustainable basis. Tax receipts for this fiscal year are estimated to exceed the target by a little more than two per cent, but this is partly because inflation, and therefore nominal income, is higher than was originally envisaged.
For 2006-07, tax revenues are projected to rise a further 17½ per cent, but it should be noted that nominal income is also projected to rise about 13½ per cent, based on the government’s economic growth target of seven per cent and inflation target of 6½ per cent.
The implication is that tax revenues as a share of GDP will rise only very modestly from 9.3 to 9.6 per cent, which is very low even by developing country standards. Moreover, the share of direct taxes in total taxes will fall slightly from 32.8 to 32.3 per cent. A pro-poor fiscal policy should target an increase in this share, since direct taxes are more progressive.
The government has lost an opportunity for widening the tax net through such measures as greater taxes on services, capital gains of stocks and real estate, and agricultural incomes. Although some new taxes, such as the CVT on property deals have been introduced, the estimated revenues from these taxes are reportedly only Rs25 billion, which is just 0.3 per cent of projected GDP.
The change in the existing income tax structure also leaves something to be desired. The exact provisions – under which the income tax rates have declined but will now be applicable to gross salary (including house rent and utility allowances) rather than basic salary only – will render the tax system less progressive than before. While these measures provide some tax relief to lower-income groups, they raise the effective tax rates on middle-income groups.
More notably, they provide substantial tax relief to the rich because, given the limits of exemptions on allowances, most of the benefits of the rich were already getting taxed. The high-salary groups will thus enjoy the lower tax rates without much increase in their taxable incomes.
In sum, there are some measures in the budget on the expenditure side that are strongly pro-poor and are to be lauded. At the same time, not enough has been done by way of expenditure switching and especially by way of raising tax revenues. In the end, this results in a budget that is quite expansionary.
This, in turn, increases the risks that inflationary pressures will not dissipate and that macroeconomic imbalances will reach unsustainable proportions and force a correction in the form of a sharp slowdown in economic growth. Were such a risk to be realised, it would not be in the interest of the common man in the long run.
(The writer is Acting Managing Director, Social Policy and Development Centre, Karachi)