Necessary, not sufficient - Dr Maleeha Lodhi - Tuesday, March 22, 2011

Source :

The writer is special adviser to the Jang Group/Geo and a former envoy to the US and the UK.

After months of indecision, vacillation and policy reversals, the PPP-led coalition has announced a number of measures aimed at containing the budget deficit. Belatedly the government’s economic team was able to persuade its leadership to take minimal action to control the runaway deficit – in a challenging political environment.

These stopgap measures will not address the structural fiscal problems accumulated over time but they do signal a desire to take the necessary first steps and reassure increasingly sceptical donor countries and international lenders that the government is serious about dealing with the country’s dire economic state.

The new tax and expenditure measures will help limit government borrowing from the State Bank for the remainder of the fiscal year. The measures include a one-time flood surcharge of 15 percent on income tax payable for fiscal 2010-11, an increase in the rate of special excise duty, and a sales tax on agricultural inputs. Having failed to implement the reformed general sales tax (RGST) the government has removed the exemptions from the sales tax of five ‘zero-rated’ export-oriented sectors, textiles, carpets, leather, sports and surgical goods.

These measures are expected to raise Rs53 billion in additional revenue. Together with the envisaged spending cuts – through slashing development expenditure – the combined impact of what has widely been billed as a supplementary budget is expected to be Rs120 billion.

The new taxes have been imposed through presidential ordinances while the removal of the GST exemptions has been effected through SROs (statutory regulatory orders). This may have been the only course available to the government after the collapse of its talks with the PML-N and resistance from its coalition partners.

But it nevertheless points to a telling political weakness: a government in power unable to take its measures to parliament. This is also not promising for stronger structural action required later this year to address the fundamental budget disequilibrium especially as the political clock starts being set for elections.

Imposing tax measures through presidential ordinances also exposes them to challenge in the courts. A key question therefore is whether the government will be able to overcome these challenges if they are mounted. Will the government stay the course when its hallmark has been governing-by-’U’ turns?

Predictably, affected interests are already voicing opposition to the removal of sales tax exemptions. This however is offset by the helpful environment created by the recent initiative taken by the Pakistan Business Council, which called for a number of steps including fiscal reform to stabilise the economy. In an unprecedented move, Pakistan’s captains of business and industry issued a joint call urging the government to act to lead an economy recovery.

But if an unfavourable reaction develops to the measures in the coming weeks it will test the government’s ability to stand its ground particularly on steps that also affect its own rural constituency. The effort to contain a serious fiscal deficit will face another critical test ahead: in implementation. History suggests that even when governments are pushed into taking much-needed steps, poor tax compliance thwarts the effort. What is collected is what matters not aspirational and elusive revenue targets.

The government might be expecting too much while doing too little. The expectation of raising 53 billion in just the few remaining months of the current fiscal year seems a tall order given the record of chronic underperformance by the Federal Board of Revenue.

The effort is too little because half of the measures announced are temporary whose fiscal impact is limited to the end of this financial year. If the government was prepared to expend political capital to push through these measures it might as well have undertaken longer term, structural measures and also inject equity into its fiscal policy. The PPP coalition will have to use this capital all over again and surmount similar political pressures in selling its budget proposals in three months time. Was it therefore not prudent to expand the tax net – as the government had earlier vowed to do – and take more lasting steps rather than rely on one-time inflows?

As for the cuts in expenditure, too much of the axe has again fallen on the development budget, which has obvious and adverse implications for growth, and too little on untargeted subsidies, which remain the big drain on the exchequer. The huge quasi-fiscal deficit of the public sector has yet to be touched. The expenditure cuts would have been more meaningful and durable if they had a) reduced poorly targeted subsidies; b) addressed the huge subsidies given to the failing and mostly insolvent Public Sector Enterprises (PSEs), from which it is the financially well-off sections of society that derive the greatest benefit and c) created a demonstration effect by visible cuts in current expenditures.

Of the PSEs the power sector makes the biggest hole in the budget. This year Rs200 billion will be spent on subsidies to keep electricity tariffs lower than their actual cost, and Rs100 billion for payments towards settling the circular debt, which in the absence of structural reform, will re-emerge again.

Meanwhile the reversal on the fuel price increase means the government continues to incur a cost of Rs5 billion a month. The inability to pass through international prices to the domestic market will cost the exchequer Rs18-20 billion in the first three months of this year alone. World commodity prices are moving upwards and if an acceptable formula for price adjustment is not adopted, subsidy costs may become an unbearable burden for the budget.

These are not politically easy decisions to take. But the costs of deferred action are even higher. These pile up to exacerbate an already grave fiscal position – widening the budget deficit, leading to greater government borrowing and printing of currency notes and fuelling higher inflation, the most regressive tax of all.

The new measures leave most underlying economic problems to be addressed in the future. Raising more revenue principally by placing an additional burden on those who already pay tax, postponing a broadening of the tax base through the RGST and an agricultural income tax and cutting already squeezed development expenditure, does not add up to structural reform even though extending the sales tax to agricultural inputs is a way of bringing that sector into the tax net.

Pakistan’s macroeconomic vulnerabilities are such that it has no cushion to withstand a shock – whether external, (a sudden and sustained increase in oil prices) or internal (a major security incident, prolonged political paralysis or instability). The current turmoil in the Middle East has already seen oil prices rise and added to the country’s oil import bill. This will put increased pressure on the Balance of Payments (BOP).

Pakistan’s foreign exchange reserves appear to be at a comfortable level helped by record remittances from overseas Pakistanis, a sharp rise in world commodity prices and substantial inflows in the form of short term lending from the IMF and bilateral donors. But these factors are unrelated to economic policies and reversible in their character. They provide no room for complacency. Nor do they obviate the need for sound measures to ensure BOP viability without heavy reliance on exogenous and unpredictable factors. Controlling the budget deficit within prudent limits is the essential first move to achieve this.

The latest steps taken by the government may help reduce borrowing from the central bank in the remaining months of the current fiscal year. But to institute fiscal discipline, contain inflation or protect the BOP in the context of a huge overhang of liquidity in the economy fuelled by heavy borrowing in past years, these steps will have to be followed by determined action in the next budget to reinforce and augment the effort by more substantial and real structural adjustment – not temporary expedients. Without this effort the prospect of any stabilisation will remain bleak and that of a sustainable economic recovery even more distant.

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