#pakistan’s fiscal woes: Budget-making in an economic crisis

The budget for the current fiscal year exudes an air of complacency. There have been a number of critical commentaries, including by Messrs Abid Hasan, Sakib Sherani and Ashfaque Khan. There also was a spirited defence by Farahnaz Isphani in this paper. But, as the finance minister has correctly stated, the budget document is less important than the overall strategy to address the difficulties facing the nation.

Critical in determining the policy stance is an assessment of where the country finds itself and its medium-term prospects. In 2007/8, there was an unsustainable fiscal position and a collapse in reserves. The IMF provided a bridging loan of over $8 billion (later raised to $11.5 billion) because of the administration’s promise to raise the tax/GDP ratio from 9% towards 14% to address repayments coming due from 2012. But the government’s medium-term strategy paper now targets a tax/GDP ratio of 10.1% over the next three years. And the target for 2011/12 is 9.1% of GDP, which several commentators suggest is not achievable. Like Alice in Wonderland, FBR has to run faster to stand still. We are more vulnerable than in 2007. How will we repay the IMF, and address our now growing unsustainable total debt? Who will ride to our rescue this time?

In addition, the new tax revenue targets will mean that much of the current spending being devolved under the 18th Amendment will become unfunded mandates, with serious consequences for basic health care and education — especially for the poor. Expecting a provincial surplus under these circumstances is naïve at best.

While some of the sentiments in the budget about widening the tax base are to be welcomed, the approach to tax policy in the budget is baffling, especially the decision to eliminate excises and reduce the existing GST, in the presence of mounting security and social pressures and in the middle of a full-blown economic crisis and a failed IMF program.

Excises are used in most countries in order to meet multiple objectives: taxing “bads” on health grounds (eg, tobacco and other items); for environmental protection; and for distributional purposes (to tax more heavily items consumed by the rich–e.g., cars and luxury items). This permits the proper “arms-length” functioning of a single rate GST, need to reform the FBR so that it does not require special SROs (which are really only to the advantage of vested interests, or well to do consumers). So why are excises being eliminated by a party that claims the legacy of Zulfikar Ali Bhutto?

Despite the talk about removing exemptions, SRO283 of April 1, 2011 still stands, and it is not clear which items are “protected”. A lower GST rate on luxury carpets or textiles does not protect the industry, but provides a benefit to the consumers of such goods. A cascading and lower rate for some sectors makes nonsense of the talk about “fixing the GST”. Continuation of the SRO culture, together with the planned merger of the FBR IT with NADRA, without a completely reformed bureaucracy and tight safeguards, will provide ample opportunities for new rent-seeking.

Together, the government’s proposals appear to put greater weight on the extra rupee that goes to the rich as opposed to the poor. The situation is compounded by the unspoken “I” tax – the elephant in the room — or the “inflation tax.” The strategy appears to be increasingly to keep borrowing from the banking system (external loans are now going to be hard to find, given Pakistan’s credit ratings), and then inflate out of the liabilities. Such a policy proved disastrous in Latin America. The inflation tax is the most regressive instrument, attractive though it may be to a cash-strapped government. The poorest and the middle classes pay it, given that the rich are fully hedged with domestic and external assets.

The government missed a chance to start to rationalise direct taxation, together with a more efficient assignment of responsibilities and the creation of an arms’ length tax administration that would be trusted by the provinces as well as taxpayers.

It may be possible to rationalise this approach to tax policy on the grounds of expediency, but it can hardly represent the preferences of a government committed to the welfare of the poor.

The writer has served as Executive Director on the IMF for Pakistan and as adviser to the Finance Minister on tax reforms. He teaches at the London School of Economics