A fragile federal budget — I

The Budget for 2021-22 has been presented and awaits parliamentary approval. This article is in two parts and analyzes the budgetary proposals, estimates of revenues, expenditures, overall budget deficits, and the macroeconomic impact. As a starting point it reviews the budgetary outcome for the year just ending.

The budget deficit of the Federal Government has been derived from the revised estimates presented in the budget documents of 2021-22 as Rs 3,577 billion, equivalent to 7.5 percent of the GDP. Net Federal receipts are reported at Rs 3,691 billion, showing a growth rate of under 13 percent. Total Federal expenditure is estimated at Rs 7,268 billion, with a growth rate of only 7 percent over the previous year’s level.

However, the examination of the revised estimates reveals both some overstatement of revenues and understatement of expenditures. First, there is overstatement of the revenue from the petroleum levy of Rs 83 billion; second, there is understatement of debt servicing of Rs 80 billion; third, understatement of revenue transfers to Provinces from the Federal divisible pool of Rs 220 billion, by deferral to next year; and fourth, PSDP spending is over reported by almost Rs 100 billion. As compared to the annual target of Rs 650 billion, the spending in the first three quarters was only Rs 264 billion. The motivation of showing higher development expenditure is to avoid too high a growth in the budgeted level of Rs 900 billion next year.

Overall, net Federal revenues are likely to be Rs 303 billion lower than the revised estimate for 2020-21. However, total expenditure could be Rs 20 billion lower than reported. This implies that the Federal deficit will be Rs 283 billion higher and reach Rs 3,860 billion, equivalent to 8.1 percent of the GDP.

The target for 2020-21 for the Federal budget deficit was 7.5 percent of the GDP. This is likely to be exceeded by 0.6 percent of the GDP. Last year the Federal deficit was close to 8.6 percent of the GDP. Therefore, there will be only marginal success in bringing down the size of the fiscal deficit in 2020-21.

Our analysis of the budget estimates for 2021-22 also reveals a likely large understatement of the level of the consolidated budget deficit of the federal and provincial governments, because revenues have again been substantially overstated while current expenditures significantly understated.

The tax revenue estimate looks rather ambitious. FBR revenues are expected to show a growth rate of 24 percent, with an absolute increase of Rs 1,138 billion, and reach Rs 5938 billion. The growth rate of 24 percent has never been achieved before. The sales tax, in particular, is expected to show phenomenal growth of 30 percent. Overall, the tax system will tend to shift towards indirect taxes, with almost 70 percent of the additional revenues from these taxes.

The envisaged strategy is that the policy measures will spur growth, which will generate the needed revenues. To this end, it is estimated that there will additional revenues of Rs.506 billion of which Rs.264 billion will come from additional policy measures.

The revenue strategy seems to lay great store on mobilizing sales tax and income tax revenues by getting more retailers into the net through the installation of 500,000 point of sale machines/registers, supporting it with award schemes for sales tax paid receipt holders. This will be the biggest and most challenging test of this government’s resolve to expand the tax base. If they can pull it off by initially installing 50,000 such registers this year, it will be a remarkable achievement.

Administrative measures without the FBR using its predatory discretionary powers, are expected to generate Rs 242 billion, employing the usual rhetoric of the broadening of tax net using data and technology. Past evidence of such strategies, however, provides little comfort on likely outcomes.

The set of documents on the Federal Budget for 2021-22 include a report on Evidence-based Revenue Forecasting. Based on the methodology developed in this report the normal growth in revenues is projected at Rs 5,336 billion. However, the historical data of tax revenues used for making the projection are actual revenues and include the impact of discretionary changes. Therefore, the projected FBR revenues of Rs 5,336 billion include the average historical level of discretionary additional revenues as a percentage of the GDP. The proposed taxation proposals in 2021-22 are relatively small in magnitude. Therefore, a projection of Rs 5400 billion is taken as the full FBR revenues inclusive of the taxation measures for 2021-22.

The key finding is that the budget estimate of Rs 5,829 billion revenues from FBR is highly unlikely to be realized. There will be a shortfall in the revenue projection of Rs 429 billion, and this estimate does not factor in the revenue loss of Rs.100 billion from the withdrawal of the enhanced excise duty on the usage of mobiles and internet. It is likely, therefore, that sizeable additional taxation proposals will be required during the year to achieve the target.

Turning to non-tax revenues, the petroleum levy (PL) is no longer classified as a tax and has been transferred to non-tax revenues. An ambitious target of Rs 610 billion has been set as the revenue from petroleum levy. As of June 1, 2021, the levy per litre is in the range of Rs 4 to Rs 5 per litre. It will lead to revenues of less than Rs 150 billion, implying a shortfall of Rs 460 billion. The levy will have to be raised to almost Rs 30 per litre early next year, if this big shortfall is to be avoided, a politically daunting move.

Overall, given the current state of the budget the total shortfall of revenues is likely to be as much as Rs 889 billion, equivalent to almost 1.7 percent of the projected GDP.

Then there is the case of expenditures that have been under-budgeted. A subsidy of Rs.330 billion has been estimated for the power sector which, according to the post-budget statements of representatives of the Power Division, is under-stated by Rs.170 billion. This shortfall will have to be covered by raising utility tariffs (combined with tariffs on marginal costs basis to stimulate demand and thereby contribute to capacity payments of surplus power) otherwise it will get added to the stock of the circular debt. Also, as domestic borrowings are expected to go up by almost Rs.2.5 trillion over and above the existing stock of debt the interest on this debt is underestimated by roughly Rs.100 billion, which would be even more accounting for the higher level of deficit of Rs.1,285 billion, owing to the understatement of expenditures and overstatement of revenues (Table 1).

The above discussion implies that the budget deficit at the Federal level could be substantially higher by 2.4 percent of the GDP in 2021-22) than the magnitude implied by the budget estimates, as shown in Table 1.

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                          Table 1
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                 Budget Estimates for 2021-22
                                           (Rs in Billion)
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                                            2021-22
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                             Budget Estimates       Likely
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FEDERAL
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Total Revenues                     7,908             7,019
Transfers                          3,411             3,167
Net Revenues                       4,497             3,852
Total Expenditure                  8,487             8,757
Federal Budget Deficit            -3,990            -4,905
Provincial cash surplus              570               200
Overall Budget Deficit            -3,420            -4,705
Budget Deficit as % of GDP          -6.3              -8.7
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The current projection is that the Provincial cash surplus will increase by over 170 percent in 2021-22 to Rs 570 billion, equivalent to over 1 percent of the projected GDP. With elections not that far down the road will the provinces end the year with surpluses totaling Rs.570 billion? This is highly unlikely. Already, the Punjab Government has announced in its budget that it will be generating a surplus of only Rs 125 billion. The Sindh Government has presented a deficit in its budget of Rs 25 billion. Therefore, it is beyond the realm of possibility that the combined Provincial surplus will be more than Rs 200 billion, equivalent to 0.4 percent of the projected GDP.

Overall, in the current state of the Budgets of the Federal and Provincial Governments, the consolidated budget deficit is likely to be as high as 8.7 percent of the GDP (Table 1). This will be significantly higher than the likely deficit of 7.7 percent of the GDP in 2020-21. If the consolidated deficit is to be limited to 6.3 percent of the GDP in 2021-22 the prospects for mini-budgets later in the year are on the cards, unless there is a large cutback in development spending from the projected high level of Rs 2,100 billion,

Furthermore, one is left wondering about the relevance of the level of the fiscal deficit of a cash-based system, with contingent liabilities continuously building up (circular debt, losses of SOEs and huge tax refunds still to be paid) but do not get reflected in the budget documents.

To meet the additional requirement of almost Rs 1.3 trillion (Table 1) from the domestic market for financing the higher budget deficit (which could be even higher if the IMF were not to agree to its support-assuming it continues to be available- being used for budgetary financing) it may involve taking decisions that compromise the goals and objectives of the policy interventions built into the budget. For instance, if, for political economy reasons, there are no expenditure cuts, it could entail a crowding out of the private sector or the need for funds addressed through more injections by the SBP (which will fuel inflation from the demand side), necessitating a monetary policy response, the raising of the rate of interest; the latter to also serve as an instrument to attract savings to the banking sector. But the banks will find it difficult to mobilize deposits because of measures taken in the budget which incentivize trade in equities (capital gains to be taxed at 12.5%) as against the tax rate of roughly 35% on interest income exceeding Rs.5 million from deposits.

The most formidable challenge will be the financing of the external account and its medium-term sustainability. The budget documents reveal the expectation of a net increase of 25% in foreign funding to finance the budget and the balance of payments. For this hope to be realized the IMF would have to be converted to our viewpoint that the potential achievements of the adopted path will essentially be the same as envisaged under the Fund’s recommendations. Will we able to strike our own course and manage without the IMF, by ignoring its suggestions, because it is not that obvious how this good-feel bonanza can be financed?

Based on the income and price elasticities of our imports, accepting the government prediction of a real GDP growth rate of 4.8%, our projections suggest a growth in volume of imports by 4% and their dollar value by 16%, indicating a big risk of a jump in imports.

As regards exports, it remains to be seen if the increase in exports this year were the result of trade generation in new or existing markets on a sustainable basis or merely the temporary of diversion of global demand from other producers who were undergoing greater Covid-related stress. An indicator of this possibility is that the increased earnings have come from higher unit prices of our exports with sales volumes having experienced a reduction! However, in our projections we have accepted the estimates of Government. Employing these assumptions, we project the Current Account Deficit worsening by $5 billion in 2021-22.

The risks and fears are the tightening oil and global commodity prices, the revenue mobilization measures, the rising and biting costs of servicing of the domestic debt and commercial foreign debt, the hemorrhaging of the fiscal accounts caused by losses of SOEs and the complacency that may have slipped into the projected estimates for the year from the unexpected manna from heaven in the form of an exceptional growth in remittances, the temporary debt relief provided by the G-20 and cheap and additional support from the multilaterals for Covid-19, suggest the prospects for a somewhat lower GDP growth rate and a significantly higher rate of inflation than the projections of the Government for 2021-22.

(The authors are a former Federal Minister and a former Governor of the SBP, respectively. The second and last part of this series of articles will be carried in Thursday’s issue)

Copyright Business Recorder, 2021