FISCAL REVIEW 2011 - How effective is foreign assistance?

Like many other developing counties, Pakistan stands dependent upon foreign assistance particularly for its development needs due to low domestic resource mobilization. Flows of savings from developed to non-developed economies have traditionally taken the form of grants and loans.
The aid injection, in theory, brings rapid economic growth; successful aid experiences suggest countries achieving, faster physical and human capital accumulation -- and in some instances improved welfare levels. However, there are also negative effects of foreign aid in aid recipient countries, which divert large part of their funds (foreign assistance) to non-development public administration, defence expenditure and debt servicing.
Also, political instability, frequent changes in policies, misalign public sector priorities and inefficiency of institutions neutralises the effect of aid on growth -- thereby having less-than-expected impact on poverty reduction. Pakistan has a long way to go before it can have a well-established taxation system, instruments for promotion of private savings and taping international markets for capital inflows.
During 1980s and 1990s, tax revenue as percentage of GDP was 13.8 percent and 13.4 percent on average, which slid to 10.5 percent by 2011, as agriculture and many services sectors still remain out of the tax net. The large informal economy also poses high tax administration and compliance costs and, according to an estimate, the tax gap in Pakistan is currently over Rs 600 billion. In order to finance the twin deficits government has remained dependent on foreign assistance, which in later years was procured on harsher terms.
Pakistan's debt stock has also ballooned over time. In 1980s and 1990s the external debt was $8.7 billion and $15.2 billion respectively, whereas the domestic debt was $6.4 and $17.7 billion. Overall debt stock has shown a rising trend with external debt soaring to $54.4 billion and domestic debt to $65.2 billion by March 2011. In recent times the threat to fiscal sustainability comes from servicing of domestic debt, which the government has been obtaining to finance losses of public sector enterprises, untargeted subsidies and a generous public sector investment program with main focus on infrastructure financing.
External and internal threat to national security forced the government to run a high security and defence budget that led to the slippage of fiscal deficit targets set with the IMF in 2010. This also contributed to a higher inflation, despite a generally depressed demand.
The accumulation of high debt stock is mainly due to deficit financing which includes high current expenditures by government, particularly those related to security, law and order and defence. The graph here shows the overall government expenditures, which highlight that the proportion of development expenditures is significantly low as compared to current expenditures.
In 1980s and 1990s the current expenditure was 17.6 and 19.6 as percentage of GDP, respectively, whereas development expenditure was 7.3 and 4.7 as percentage of GDP. In other regional economies the ratio of development expenditures to GDP has been maintained at relatively higher levels. The focus is usually on those public sector investments that can provide a level playing field for the private sector and, in doing so; such public sector investments can crowd-in foreign and domestic private investment.
Foreign assistance in the absence of structural reforms has been ineffective in contributing positively towards economic growth for Pakistan. The preoccupation with macroeconomic crises and stabilisation has not allowed the economic managers to look beyond the short term.
Besides, the proportion of grants in total foreign assistance has significantly declined as compared to loans over the course of year - thus imposing substantial debt servicing costs. During the first five year plan the share of grants in total foreign assistance was 77.2 percent as percentage of total foreign assistance, which declined to 29.6 percent during 1999-2009. (See table for details)
The conditionalities associated with loans in terms of interest payments and repayment period were translated from softer to harsher terms. For instance interest payments during 1960s on loans were 3.3 percent, which rose to 4.8 percent in 1980s. Similarly, the loans procured during 1960s were supposed to payback within the time frame of 30 years with the grace period of 7 years, which later, in 1990s, reduced to 21 years with the grace period of 6 years.
In the light of above, there is an urgent need for improving domestic resource mobilization ensuring macroeconomic stability and reducing reliance on foreign loans. There is a need to increase the tax base of the country by bringing the presently exempt agriculture and services sectors in the tax net, bringing automation in tax system to avoid tax evasion, encouraging the tax payers through innovative incentives.
The government's current expenditure needs should not be financed through any mode of foreign investment. Pakistani markets are still heavily regulated and sector picking prevails through a distortive tax and subsidy culture. In the medium to long-run government may device a plan to limit its role to policymaking and regulation; leaving ownership, financing and management of productive sectors to the market. The writers are economists and currently work at the Planning Commission of Pakistan. Their views do not necessarily represent that of the institution. They can be reached at wahab907@gmail.com and vahmed@gmail.com.

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LOANS & GRANTS (AS PERCENTAGE OF TOTAL FOREIGN ASSISTANCE)

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Year                                 Loans          Grants

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Up to 30-06-1960                      22.8            77.2

2nd Plan (1961-65)                    51.5            48.5

3rd Plan (1966-70)                    76.4            23.6

Non-Plan (1971-78)                    88.9            11.1

5th Plan (1979-83)                    76.3            23.7

6th Plan(1984-88)                     71.8            28.2

7th Plan (1989-93)                      79              21

8th Plan (1994-98)                    90.4             9.6

Non-Plan (1999-2009)                  70.4            29.6

Grand Total                           76.9            23.1

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