Fragile state of public finances

The information on fiscal operations by the federal and provincial governments in the first nine months of 2022-23 has been released recently by the federal ministry of finance. They depict a significant deterioration in the state of public finances in the country.

The consolidated budget deficit from July to March 2022-23 stands at 3.7 percent of the GDP. This is only marginally smaller than the deficit in the corresponding period of 2021-22 of 3.8 percent of the GDP. The last quarter of 2021-22 saw a large deficit of 4.1 percent of the GDP, which took the annual deficit to the highest ever level of 7.9 percent of the GDP. There is the risk that there will also be a big deficit in the last quarter of 2022-23, which will take the annual deficit to at above 7 percent of the GDP.

The financial year started following the presentation of the annual budget in the National Assembly. The federal budget as presented was markedly ambitious in nature under the umbrella of the IMF program. The consolidated budget deficit was targeted at 4.9 percent of the GDP. This represented an unprecedented reduction in the deficit by 3 percent of the GDP in relation to the level in the previous year. Simultaneously, there was the expectation of a primary deficit of only 0.2 percent of the GDP, as compared to the extremely large primary deficit of 3.1 percent of the GDP in 2021-22.

The fundamental question is why the budget deficit in 2022-23 is going to be much larger than the initially targeted level in the federal budget for the year? The paragraphs below show that this has happened on both sides of public finances. There will simultaneously be a shortfall in revenues and higher expenditure under various heads in relation to the targeted amounts.

Total revenues of the federal and provincial governments combined have aggregated to 5.6 percent of the GDP in the first quarters. This is significantly lower than the level of fiscal effort last year of 7.2 percent of the GDP. However, direct tax revenues have shown extraordinary growth of over 46 percent. The failure is in indirect tax revenues, with only marginal growth of less than 2 percent. Consequently, the overall growth in FBR revenues up to March 2023 has been under 18 percent, as compared to the target growth rate of 23 percent.

The absence of buoyancy in indirect tax revenues is attributable to lack of growth in both the import and domestic tax bases. The efforts at restricting imports to sharply bring down the current account deficit in the face of very low foreign exchange reserves have resulted in an increase of only 1 percent increase in the rupee value of imports, despite a large depreciation in the value of the rupee. High revenue yielding imports like transport equipment have virtually ceased.

Domestic sales tax and excise duty revenues have been severely constrained by the fall in the level of industrial production by over 6 percent. Big revenue spinners like the tobacco, cement, automobile, and petroleum refining industries have shown very big declines in output. The relatively high rate of inflation and increase in tax rates have not been adequate to yield a big increase in revenues. Nevertheless, the efforts of FBR (Federal Board of Revenue) at raising direct tax revenues must be recognized. Now the share of direct taxes in FBR revenues is almost 45 percent, as compared to 36 percent last year.

There have also been other major shortfalls. First, following the enhancement of the Petroleum Levy to Rs 50 per liter, the expectation was that it would yield Rs 855 billion in 2022-23. Instead, the revenue generated is Rs362 billion in the first three quarters. This is due to the substantial drop in sales of Motor Spirit of 16 percent and of 25 percent in HSD oil.

Second, given a rapid growth in FBR revenues and consequently in revenue transfers to provincial governments the projection of the combined provincial cash surplus was Rs750 billion in 2022-23. The actual surplus as of end-March 2023 is Rs 456 billion. The end of the third quarter is usually the peak time of this surplus. Therefore, there will be a shortfall by the end of the year of significantly above Rs300 billion.

The other major negative development is the quantum jump in interest rates which has raised the cost of debt servicing from 3.2 percent of the GDP in the first three quarters of 2021-22, to 4.3 percent of the GDP in the corresponding period of 2022-23. The policy rate of the SBP now stands at 21 percent. The moves from 13.75 percent in June 2022 to 21 percent in early April 2023 have come under strong pressure from the IMF (International Monetary Fund) with the stated objective of curbing inflation. This has not happened, but the burden of debt servicing is likely to be higher by Rs 1300 billion over the initially targeted level and reach the highest ever level of Rs 5200 billion, equivalent to 6.2 percent of the GDP by the end of 2022-23.

The negative development last year was the unprecedented increase in the magnitude of subsidies and grants of as much as Rs 1417 billion, equivalent to an unbelievable growth rate of 113 percent. The expectation was that these payments, especially subsidies, will be reduced by Rs 832 billion this year. Up to March 2023, the reduction achieved is Rs 354 billion.

Development spending has continued to decline as a percentage of the GDP. It is the first casualty of the extraordinary jump in the outlay on debt servicing. The level of PSDP (Public Sector Development Programme)-related expenditure has fallen from the already low 1.6 percent of the GDP in the first three quarters of 2021-22 to 1.3 percent of the GDP up to March 23. Gone are the days when the annual level of development spending used to approach 4 percent of the GDP. The underinvestment in infrastructure does not auger well for the future GDP growth rate.

There is also a very unusual pattern of financing of the budget deficit. The sharp decline in external financing due to very negative perceptions of the economy has implied that repayment of government external debt has exceeded the gross inflow by as much as Rs 682 billion. Consequently, the budget deficit of Rs 3079 billion has been financed by a peak in domestic borrowing of Rs 3761 billion. This has put even more pressure on the high interest rates.

The IMF has in its projections of the economy of Pakistan in the latest World Economic Outlook estimated that the budget deficit in 2022-23 will be 6.8 percent of the GDP. However, there is apparently an error in the forecast. Based on the actual nine-month magnitudes, the IMF has projected a 63.1 percent increase in total revenues in the last quarter of 2022-23. This is well beyond the realm of possibilities.

Therefore, the budget deficit projected by the IMF of 6.8 percent of the GDP is likely to be significantly higher at 7.7 percent of the GDP in 2022-23. The expectation of the IMF that there will be a primary deficit of 0.5 percent of the GDP will now be a more likely primary deficit of 1.4 percent of the GDP.

Overall, the expectation that the state of public finances of Pakistan will be stabilised within the framework of the IMF will not be realized this year. The year had started with the target of a consolidated budget deficit of 4.9 percent of the GDP. Instead, it is likely to be closer to 7.7 percent of the GDP, higher by almost Rs 2300 billion. We await the presentation in mid-June of the federal budget of 2023-24, probably with the same unrealistic targets as of 2022-23 in an effort to keep the IMF on board.

Copyright Business Recorder, 2023