A budget with mixed signals

The end of the on-going EFF program with the IMF in September 2016 was expected to lead to a fundamental change in the budget strategy. The program had focused exclusively on stabilisation over the last three years. The fiscal deficit had been brought down to 5.3 per cent of the GDP last year and projected at 4.3 per cent of the GDP in 2015-16.
The process of fiscal stabilisation was achieved by additional taxation and big cutbacks in development spending in relation to initially budgeted levels. The withholding tax regime was expanded and GST tax rates enhanced. Little attempt was made to contain current expenditure or broad-base the tax system. Consequently along with the impact of other negative trends the GDP growth remained relatively low.
The budget of 2016-17 was expected to make a transition to a growth-oriented strategy to take the GDP growth beyond 5 per cent. But the budget as presented gives mixed signals. The fiscal deficit is to be brought down further to 3.8 per cent of the GDP, with significant additional taxation, thereby highlighting the continued emphasis on stabilisation.
Simultaneously, on the positive side, a number of incentive packages have been proposed for revival of agriculture, exports and investment respectively. The combined PSDP of the Federal and Provincial Governments is to be raised significantly by 20 per cent in 2016-17. A fundamental question arises. How can further stabilisation and revival to growth be simultaneously achieved?
This report highlights, first, the budgetary outcome of 2015-16 and, second, the salient features of the budget of 2016-17.
BUDGETARY OUTCOME IN 2015-16
Revised estimates for 2015-16 of federal revenues are optimistic
The growth rate of gross federal revenue receipts was only 9 per cent in the first nine months of 2015-16. While the exceptional performance of tax revenues, especially of FBR, has been commended, a new structural problem has emerged. Non-tax revenues have plummeted by almost 25 per cent. State Bank of Pakistan profits have fallen due to lower mark-up rates. Receipts from the Coalition Support Fund of the USA have been lower. Revenues in the form of dividends and royalties from the domestic oil sector have dipped due to lower prices.
However, there is expected to be a phenomenal recovery in federal revenues in the last quarter of 2015-16 by as much as 38 per cent in relation to the level in corresponding quarter of the previous year. Non-tax receipts, in particular, are projected to rise by a phenomenal 81 per cent. Consequently, the annual gross revenue receipts are likely to be higher by 18 per cent, double the growth rate in the first nine months.
This exaggeration of revenues in the last quarter of a financial year is consistent with past practice. Last year also federal revenues were overstated by Rs 289 billion in the revised estimates. This enabled the reporting to the Parliament of a 58 per cent higher level of development spending than the actual level observed. This year, federal PSDP expenditure may be exaggerated by over Rs 300 billion, while appearing to adhere to the deficit target of 4.3 per cent of the GDP.
FBR revenues have shown exceptional buoyancy
For the first time in many years, FBR appears to be on track to achieve the target of Rs 3104 billion for 2015-16. In the first nine months the growth rate of direct taxes is 15 per cent, while that of indirect taxes is relatively high at 21 per cent. This implies an overall growth rate of almost 19 per cent. Apparently, revenues have shown even higher growth in the last two months.
What explains the dynamism in FBR revenues in 2015-16? First, there is the large windfall gain from the lower oil price. This enabled the GST rates on POL products to be raised substantially, simultaneously with a perceptible fall in retail prices. For example, the GST rate on High Speed Diesel rose to a peak of 51 per cent during the year, as compared to the standard rate of 17 per cent. In the first nine months, revenues from POL products rose by almost 24 per cent. Their contribution to total indirect tax revenues has now gone up to 31 per cent.
Second, the expansion in the withholding tax regime and enhancement in rates has also yielded results. Total revenues from withholding taxes have risen by 17 per cent in the first nine months. These deductions at source now constitute over 71 per cent of total revenue from direct taxes as compared to 59 per cent in 2012-13.
Third, it is perhaps not so well known that the fastest growing source of revenue in 2015-16 will be customs duty. The growth rate could exceed 32 per cent. A minimum duty regime was introduced on imports of 1 per cent in 2014-15. This was raised to 2 per cent in the budget of 2015-16 and further to 3 per cent in the mini budget of November 2015. In addition, given substantially lower import prices, regulatory duties have been introduced on a large number of items.
Overall, while achieving higher growth, the tax system has moved more in the direction of indirect taxes. Almost 80 per cent of FBR revenue now effectively comes from indirect taxes and withholding taxes of an indirect nature. This has implied that the tax burden has become substantially more regressive.
The big failure is in development of the direct tax system, especially by broad-basing and increasing the number of tax payers. An apparently well designed voluntary tax compliance scheme, with both a carrot and a stick, failed. This reveals the extreme distrust of FBR. The target growth of direct taxes in 2015-16 is 22 per cent. The actual growth rate is unlikely to exceed 15 per cent. A key indicator of failure is the decline in collection on demand by 31 per cent, following audit of returns, in the first nine months of 2015-16.
Cost of domestic debt servicing exceeds projections
The mark-up costs on domestic debt are expected to show zero growth due to the expected big fall in interest rates during 2015-16. However, the actual increase in the first nine months is 10 per cent. The higher growth of cost of debt servicing is due to the `lock in` effect of a big stock of outstanding PIBs, amounting to almost 37 per cent of Federal domestic debt. Under IMF advise, almost Rs 2 trillion of PIBs were purchased in 2013-14 and 2014-15 to avoid the problem of roll -over of short term floating debt. Unfortunately, this was done when interest rates were high, but fell precipitously soon after.
Pakistan is in a `debt trap`. This is demonstrated by the extent to which the cost of debt servicing eats up net revenue receipts of the Federal Government. This was 50 per cent in 2007-08, rising to 64 per cent in 2012-13 and probably reaching 73 per cent in 2015-16. The time is not very far away when mark up costs could consume bulk of the net revenues of the Federal government.
External borrowing will reach a peak in 2015-16
Gross external borrowing for financing the Federal budget deficit is expected to reach a record level of almost $8 billion in 2015-16. Almost 40 per cent of the borrowing is in the form of program loans from international development agencies. Another 40 per cent is project funding within the Federal PSDP.
In fact, gross external borrowing has been exceptionally high in the three years of the PML (N) government. The cumulative borrowing in these three years is $21 billion. This is in comparison to the external borrowing of $17 billion in the five year tenure of the PPP government from 2008-09 to 2012-13.
The issue of external debt sustainability has inevitably become more serious. In 2007-08, amortisation of external debt was equivalent to 11 per cent of exports. This had risen to 12 per cent by 2012-13 and is expected to reach 22 per cent by 2015-16. This is a reflection not only of the rapid growth in external debt repayment and interest payments but also of the relatively slow growth of exports.
Implementation Constraints have emerged in Federal Agencies
Almost two thirds of the Federal PSDP is being executed by agencies like WAPDA, DISCOs, National Highway Authority, Pakistan Atomic Energy Commission, Ports and Shipping, SUPARCO, Higher Education Commission and others. The constraints in capacity for implementation of PSDP projects of these agencies is demonstrated by the fact that total releases by the Planning Commission were Rs 401 billion by end-March 2016. However, the actual expenditure incurred is Rs 251 billion, representing a utilisation rate of only 63 per cent. This is significantly less than the utilisation rate on the same date last year of 77 per cent. Clearly, if the size of the PSDP is to be scaled up as part of the pro-growth strategy, then most agencies will need major augmentation of human resources and improvement in management systems.
Implementation of CPEC infrastructure projects is also proceeding at a slow pace. On-going portfolio of CPEC projects in the Federal PSDP has a total cost of Rs 367 billion. Only 10 per cent of the cost has been incurred up to 2015-16 and another 12 per cent expected in 2016-17. Clearly, much greater priority has to be attached to execution of CPEC infrastructure projects.
Fiscal Deficit may rise well above 4.3 per cent of the GDP in 2015-16
The likely shortfall in the net revenue receipts of the Federal Government in relation to the revised estimates has been highlighted above. Part of this may be compensated for by cutback in the national PSDP before the year ends.
The other area of uncertainty is the Provincial cash surplus. In the derivation of the consolidated fiscal deficit for 2015-16 it is assumed that the four Provinces combined will generate a cash surplus of Rs 336 billion, equivalent to almost 1.1 per cent of the GDP. As of 3rd June 2016, the SBP reports the surplus at Rs 81 billion. Therefore, it is highly unlikely that the target level of surplus will be generated.
Overall, a conservative estimate is that the overall fiscal deficit may reach 5 per cent of the GDP. This is of course, subject to accurate reporting of the budgetary magnitudes. Last year, for example, an all-time high statistical discrepancy of Rs 178 billion was reported to significantly bring down the deficit.
Public Debt is rising rapidly
According to the SBP, public debt was 65 per cent of the GDP at the time of assumption of power by the PML (N) Government. As of 31st March of 2016, SBP estimates are that is has reached 66 per cent of the GDP. By the end of the financial year, 2015-16, it may approach 67 per cent of the GDP. This is substantially higher than the limit of 60 per cent of the GDP imposed by the Fiscal Responsibility and Debt Limitation Act of 2005, from end-June 2013 onwards. As such, the government owes a detailed explanation to the Parliament for the large and growing divergence from the debt ceiling. Instead, in the Finance Bill an attempt is being made to narrow the definition of public debt.
BUDGET OF 2016-17
Budget targets a fiscal deficit of 3.8 % of the GDP
The Budget of 2016-17 aims to achieve a further reduction in the consolidated fiscal deficit of the Federal and Provincial Governments to below 4 per cent of the GDP. The target of 3.8 per cent of the GDP is the number agreed with the IMF following the last review.
How will the deficit target be achieved? The Federal deficit is projected at 4.8 per cent of the GDP, while the Provinces are expected jointly to produce a cash surplus of 1 per cent of the GDP.
Gross revenue receipts of the Federal Government are expected to rise by almost 16 per cent in 2016-17. FBR revenues are assumed to exhibit, more or less, the same dynamism as in 2015-16, with a growth rate close to 17 per cent. Following transfers to the Provinces, net revenues are expected to show growth of 12 per cent.
A significant feature of the Federal Budget of 2016-17 is a strong emphasis on limiting the growth of current expenditure to only 4 per cent, even below the projected rate of inflation of 6 per cent. As opposed to this, there is an ambitious target of growth in development expenditure (PSDP + other development expenditure + net lending) of over 22 per cent.
The key budgetary magnitudes are based on fragile assumptions
Within FBR taxes, the growth rate of sales tax is targeted at 17 per cent. This will hinge on the evolution of oil prices, which have shown a rising trend in recent months. If this continues, the windfall gains from higher GST rates on POL products may be largely eroded. Also, a commitment has been made to pay the refunds due to exporters.
The anticipated growth in non-tax revenues is also tenuous. The future of CSF inflows is still somewhat uncertain. The risk is that they may only partly materialise, thereby causing a resource gap of almost Rs 100 billion. Further, in a regime of an extremely low policy rate, it is doubtful if the SBP can generate profits of Rs 280 billion in 2016-17.
On the expenditure side, the big question relates to the assumption that mark-up payments on debt will rise by only 3 per cent. Also, reduction in subsidies, especially to the power sector, of 28 per cent is expected at a time when the price of furnace oil is rising.
The national PSDP has been set at Rs 1675 billion, with Rs 800 billion at the Federal level and Rs 875 billion by the four Provinces combined. However, in their budget speeches the latter have announced a combined developing expenditure target of over Rs 1 trillion. This increases the likelihood that the targeted Provincial cash surplus of Rs 339 billion will not be achieved. Already, in their budgets for 2016-17 three Provinces have announced deficit budgets and one Province a balanced budget.
Given the above risk factors, the fiscal deficit incurred may be substantially above the target of 3.8 per cent of the GDP. It could approach 5.5 per cent of the GDP.
Further, the budget estimates for 2016-17 do not fully incorporate the cost of the agriculture relief package and the salary/ pension increases. This adds over Rs 200 billion to consolidated expenditures.
More is required to revive agriculture
The PM's agriculture package announced in September 2015 was only partially implemented. The price of urea did not fall as much as targeted and agricultural credit is unlikely to reach the level of Rs 600 billion in 2015-16.
The agriculture relief package announced by the Federal Government in the Budget Speech is welcome. It includes many desirable moves to support farmers at this difficult time like subsidy on urea/DAP, reduction in electricity tariff, initiation of a credit guarantee scheme, etc. In addition, the Government of Punjab has also announced a package for agriculture, which includes interest free loans for small farmers.
But these moves, although very tangible; may not be fully adequate. At a time of uncertainty about prices, it was important that support prices should also have been announced in advance for cotton and rice.
The principles of cost sharing adopted historically between Federal and Provincial Governments appear to have been violated. The fertiliser subsidy has always been financed fully by the Federal Government and shown as development expenditure. Further, the cost of reduction of mark-up rates should be borne by the SBP. The primary responsibility of Provincial Governments is commodity financing to operate a support/procurement price regime.
Also, an anomaly continues to persist. Fertiliser is the only commodity in Pakistan which is taxed and subsidised simultaneously. The 5 per cent sales tax on fertiliser ought to have been withdrawn, thereby implying a lower subsidy.
More is also required to revive exports
The Budget speech also focuses on incentives for revival of exports. The Finance Minister has made a commitment that all the pending sales tax refunds till 30th of April, whose RPOs have been approved will be paid by 31st August 2016, However, a similar commitment was made in the Budget Speech of 2015-16, but it was not honoured.
The big move proposed is zero rating of exports. The objective is to avoid the need for payment of refunds. But a 5 per cent sales tax has been imposed on textile local sales. How will this tax be zero rated along the textile value chain?
Revival of exports will also require a significant adjustment in the rupee parity with respect to US $. According to the SBP and IMF the currency is overvalued by 17 per cent to 20 per cent. A downward adjustment is essential to restore export competitiveness. During 2015-16, the Pakistani rupee has depreciated by only 3 per cent, as compared to 6 per cent by India, 6 per cent by China and 9 per cent by Turkey.
It is not surprising that while extra exports of $1 billion were made initially to the EU, following the granting of GSP plus, there has since been a drop of $600 million.
Unilateral tax moves in the Finance Bill put stress on the Federation
FBR has proposed some changes in the Finance Bill which should have been consulted earlier with the Provincial Governments. The first move is the proposed non- input tax invoicing of service inputs into manufacturing in the Federal GST. The Provincial Governments may react by not honouring manufactured goods input tax invoices in the sales tax on services. The result will be `cascading` of the GST rate from 17 per cent to almost 19 per cent in the case of goods. There will be an impact of a similar magnitude on services.
Perhaps even more importantly any such moves should have been approved by the Council of Common Interests (CCI) to preserve the spirit of the Federation, especially after the 18th Amendment. Further, the 7th NFC Award came to an end on 30th June 2015. No meeting has been convened in 2015-16, despite the nomination of members and preparation of background papers.
There are other many serious inter-governmental issues like the financing of vertical programs, determination of magnitude and payment of hydro-electricity profits, tax sharing from oil and gas revenues, avoidance of double taxation, etc which need to be resolved on a top priority basis to avoid undue stress on the Federation.
Right development priorities in the Federal PSDP, but more needed for water & CPEC
The Federal PSDP of 2016-17 has allocated 20 per cent for power generation and electricity transmission, 23 per cent for highways and 5 per cent for the railway. This is consistent with the implicit allocation of functions, whereby the Federal Government focuses primarily on development of physical infrastructure and the Provincial Governments on basic social and economic services. However, Pakistan is becoming a `water-scarce` country and there is need for development of water resources. The WAPDA (water sector) projects and the Dams (Dasu and Diamer-Basha) have received a combined allocation of only Rs 106 billion, equivalent to 13 per cent of the PSDP for 2016-17. The allocations for the two dams are only 5 per cent of the project costs.
In conclusion, as described above, the Federal Budget of 2016-17 coveys mixed signals. It does not do enough to promote higher growth to achieve the Annual Plan GDP growth target of 5.5 per cent. There is also the risk that the fiscal deficit may significantly exceed 3.8 per cent of the GDP. The year, 2015-16, promises to be a year characterised by uncertainty.
(The writer is Professor Emeritus and a former federal minister)