Pakistan’s convulsed fiscal deficit - Dr Maleeha Lodhi (Issues) 21 April 2011

The Pakistan government still lacks a credible action plan to control the nation’s budget deficit. It has balked from taking tough decisions that can confront the scale of the fiscal problem and resorted instead to temporary, stopgap measures that do little to address the underlying causes.

The situation may aggravate due to a confluence of two new factors. Together they indicate that in the absence of reform the fiscal deficit could grow even larger in the foreseeable future because these developments have underlying structural characteristics.
The Governor of Pakistan’s State Bank has sounded a timely warning about the first of these trends in a Reuters interview earlier this month. The erudite governor said he was worried by a “structural shift” of incomes towards the non-tax paying or lightly taxed sectors from tax paying ones. This shift of incomes especially to the agriculture sector, he said, means that the tax to GDP ratio is “structurally destined to hover at lower levels”.
Pakistan has one of the lowest tax to GDP ratios in the world and Shahid Kardar’s prognosis suggests that additional structural factors will further fuel the fiscal deficit crisis. He reiterated the call to broaden the tax base and address this structural shift in the next budget.
At a time of severe economic hardship for much of urban Pakistan and for the industrial and manufacturing sector, the agricultural economy has – in spite of the 2010 floods – benefited from higher global commodity prices and domestic support prices which together have shifted the terms of trade in favour of the untaxed agriculture sector. Agriculture accounts for 22 per cent of GDP but contributes little more than one per cent of all revenue. The rise in international commodity prices and the government’s setting of procurement prices well above their import parity price in the past two years has led to an increase in farm incomes. But this has not been accompanied by any commensurate obligation to pay tax.
A GST has formally been in place for 20 years but its fiscal impact has been greatly diluted by many exemptions. Add to this the rampant evasion of income tax by the services sector and its successful effort to thwart a value added tax and an even more dismal picture emerges. The net result is what Governor Kardar has drawn attention to – a structural shift within the economy with serious fiscal implications.
As Mr. Kardar has alluded, if the two sectors that contribute 74 per cent of GDP have seen incomes grow but remain largely outside the tax net, it is hard to see how the tax to GDP ratio can improve. Without fundamental reforms and a tax regime that is fair and equitable, the tax to GDP ratio cannot much exceed 10 percent.
A key reason for a culture hostile to revenue collection is the lack of equity in the tax regime with the burden falling disproportionately on the same people. To inject equity into the system the agriculture and services sector must be brought fully into the tax net.
The federal government has been additionally burdened with rising security related expenditures and a growing debt burden, whose servicing is now absorbing over 45 per cent of its share of tax revenues. The situation has been worsened by its inability to downsize government, cut back huge subsidies on energy, and stop the hemorrhaging of public sector enterprises by
their restructuring and eventual privatisation.
Unless a bold policy plan is devised to deal with the structural sources of the runaway budget deficit the country’s economic future will be imperiled by an unsustainable and serious fiscal situation being compounded now by emerging trends and more enduring unresolved issues.
Dr Maleeha Lodhi served as Pakistan’s  ambassador to the United States and the United Kingdom

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