A fiscal quagmire: genesis

In the last article, many readers felt that there was no explanation as to how we came to this pass and what remedial actions would be required to extricate the nation from this quagmire.

We would give an account of the causes responsible for this situation and suggest, in a follow-up article, the remedial measures to correct it. Although, figures would be minimized but the reference period is 2008-09 to 2021 with brief mention of 2021-22.

Fiscal deficit: As they say, fiscal deficit is the mother of all economic ills. Though there is a 5000-year history of debt, mostly public, the peculiar manner in which debt is created is a modern phenomenon. It simply means spending more than your income with no need (or intention) to pay back. Pakistan, like all other countries, also does so.

Are there some safe limits to such profligacy or it can go unchecked. During 2008-2021, fiscal deficit has averaged around 6.36% but with a very high variability.

FY12 saw the highest deficit of 8.53% and FY16 saw the lowest deficit at 4.12. More recently, during 2018-19 to 2020-21, deficit averaged at 7.03% and FY22 is projected to equal the 8.5%, last seen in FY22. By prudential standards these are high fiscal deficits. Fund would recommend 3.5% as maximum deficit for emerging market economies.

Tax revenues: The foremost cause of deficit is inadequate tax collections. During 2008-21, the average FBR taxes have been 9%, with small variation around this average. This is woefully inadequate for an economy of 250 million people. In FY22, tax collection is likely to be in the high 9%.

Gross revenues, including other taxes and non-tax revenues, improves only to 12.52%. There is virtual stagnation in revenues despite huge tax efforts routinely undertaken on the occasion of each budget.

Provincial transfers: Pakistan works through a system of fiscal federalism. Most of the taxes are collected at the federal level and then distributed through National Finance Commission (NFC) among the federation and provinces. The current NFC has led to severe imbalance in resources distribution as 57.5% revenues are transferred to provinces.

The imbalance is evident from the fact that in 2008-09, the year before the current NFC came into effect, only 28.4% of gross revenues were transferred to provinces and thereafter this has averaged at 42.8% with a high of 54.1 in FY19. In terms of percentage of GDP, provincial transfers on average amounted to 5.18% of GDP with a high of 5.66% in FY18.

Net revenues: What is available to the federal government after provincial transfers is net revenues. As percentage of GDP, net revenues averaged at 7.34% with a high of 9.14% in the first year of NFC in FY10. As we would see, this is utterly insufficient to support continuing high expenditures.

Expenditures: Now let’s see how much do we spend against the net revenues of the federal government. On average, federal expenditures amounted to 14% of GDP. Therefore, given the net revenue of 7.34%, the average deficit is 6.66% or say 7%. But as we noted earlier, the average is accompanied with significant variation or more so in recent years, where it is exceeding 8%.

Interest payments: Nothing explains the precarious nature of our fiscal state than the burden of debt servicing and interest payments we carry in our budgets. On average, interest payments as percentage of GDP were 4.42% with a high of 5.51% in FY20 and are likely to exceed significantly in FY22 and FY23 because of high interest rates.

Net revenues after interest payments: It would be highly instructive to ask how much of net revenues are left for meeting other expenditures after making interest payments. Clearly, on average, net revenues were 7.34% whereas interest payments averaged 4.42%.

But in view of deteriorating trends in recent fiscal years, this positive margin has virtually eroded as against 5.97% of net revenues in 2019-21, interest payments were 5.08% leaving less than 1% of GDP for all other expenditures including defence, civil administration, pensions, development, social safety-net and uncontrollable subsidies.

Development spending: It should not be surprising that in view of the precarious fiscal finances, the hardest hit expenditure has been the development spending. From a high of 6% of GDP, development spending has constantly declined to 2.81% in FY21.

With such level of spending it is impossible to hope for high level of growth. Curiously, the development spending budgeted at Rs.900 billion has already seen a cut of one-third or Rs.300 billion to contain the deficit within the Fund programme. Unfortunately, however, this is a trend whenever a Fund programme is done, the first casualty is development spending.

Leveraged consumption (LC): A measure that captures the size of unsustainable fiscal burden is the notion of leveraged consumption. This is defined as the difference between fiscal deficit and development spending, both taken as percentages of GDP.

The idea is that if the leverage (borrowing) is used for development spending, there is hope that such borrowings would create productive assets capable to liquidate the future debt servicing.

A zero value of leveraged consumption precisely means leverage is limited to development spending and a positive value shows how much borrowings are for consumption which creates no income earning assets.

Evidently, during the last IMF programme (2013-16), LC was brought down to zero as part of the completion of the IMF program in FY2016. This was partially compromised in next two years but was moderate at 1.22% of GDP.

Subsequently, it shot up to 4.89% before improving in last two year to 3.32%. As we noted earlier, in FY22, fiscal deficit would cross 8.5% while development spending has already contracted by a one-third. Therefore, in all likelihood the level of leveraged consumption would easily cross 5%.

This, then, is the picture of a precarious fiscal state and how it has been brought upon us. We have practiced profligacy without paying the bills. Clearly, it is not sustainable. Frankly, the fiscal finances have broken down.

There are no easy solutions nor would any of the standard approaches having applied from inside or outside work. This is now a huge political programme. There are acute distributional consequences associated with this policy and unfortunately acting against the ordinary people and in favor of the wealthy groups.

Copyright Business Recorder, 2022