Medium-term budget strategy

The Federal Ministry of Finance has released the Medium-Term Budget Strategy Statement for the period, 2024-25 to 2026-27.

The Fiscal Responsibility and Debt Limitation Act of 2005 states that the Federal Government will prepare such a statement, consistent with the principles of sound fiscal and debt management. It should be included in the annual budget statement to be laid before the National Assembly not later than the thirtieth day of each financial year.

There is one serious problem this year. The budgetary magnitudes for the on-going financial year, 2024-25, in the Medium-Term Budget Strategy diverge from those presented earlier in the budget session. In particular, the 2024-25 Budget-in-Brief statement had presented in Table-3 on page 7 that the federal budget deficit is estimated to be Rs 8500 billion, equivalent to 5.9% of the projected GDP in 2024-25.

The Medium-Term Budget Strategy has increased the size of the targeted budget deficit in 2024-25 to Rs 9758 billion, equivalent to 6.9% of the GDP. In effect, the targeted budget deficit has been raised by 1% of the GDP.

What explains the divergence? It is due to a big downward adjustment in the magnitude of the inflow of the SBP profits from Rs 2500 billion to Rs 1242 billion. This is tantamount to a reduction in Federal non-tax revenues of 1% of the GDP, leading thereby to a corresponding increase in the Federal budget deficit by 1% of the GDP.

The fundamental question is whether the 2024-25 amended Finance Bill (Federal budget) should be presented to the Parliament once again given the significant increase in the targeted fiscal deficit? The Speaker of the National Assembly needs to decide on this issue.

The Medium-Term Budget Strategy otherwise demonstrates a very positive perspective on the national economy. The GDP growth rate is expected to show buoyancy. It is projected to increase from 2.4% only in 2023-24 to 3.6% in 2024-25, to 4.8% in 2025-26 and to 5.5% in 2026-27. Simultaneously, the rate of inflation is expected to drop from 24.3% in 2023-24 to only 12% in 2024-25 and thereafter to single-digit rates of 7.5% in 2025-26 and 7.0% in 2026-27.

The presumption here is that Pakistan will quickly emerge from a position of extreme financial vulnerability, with low foreign exchange reserves in relation to the external financial requirements. Presumably, this will be facilitated by the impending three-year IMF Extended Fund Facility (EFF).

However, IMF Programs generally tend to focus much more on stabilization of the economy of the borrowing country rather than on supporting expansionary policies for achieving faster growth. The last IMF EFF of Pakistan envisaged the GDP growth rate to rise to 4.5% in the third year of the Program. Therefore, the targeted growth rate of 5.5% in 2026-27 appears unduly optimistic.

A perhaps even more serious problem is with the projections of the rate of inflation. The sharp moderation of the rate of inflation to just 12.2% in the last two months of 2023-24 and to 11.1% in July was due to the stability in the nominal value of the rupee and thereby no further imported inflation. Also; bumper crops, especially of wheat, have facilitated a fall in food prices.

However, there has already been a substantial increase in the electricity tariff in the first month of 2024-25. The budget for 2024-25 has included heavy new indirect taxation, even on basic consumer items. As the year proceeds there will be pressure from the IMF to follow a market-based exchange rate policy, which will lead to more imported inflation. Already, the May 10 Staff Report of the IMF, at the end of the Stand-by Facility, projects 16% devaluation of the rupee in 2024-25.

Therefore, the projected rates of inflation are likely to be higher. The BNU Macroeconometric Model estimates the inflation rate at 16% in 2024-25, 10% in 2025-26 and 8% in 2026-27.

The Medium-Term Budget Strategy also projects the size of the current account deficit, exports, imports and worker’s remittances. These projections for 2024-25 are taken from the Annual Plan for 2024-25 prepared by the Planning Commission. Given the critical importance of the external balance of payments position of Pakistan, it would have been appropriate to also project the likely position in the financial account and the resulting magnitude of foreign exchange reserves. Perhaps these projections will be finalized in the forthcoming IMF EFF.

The Medium-Term Budget Strategy makes the required detailed projection of the state of public finances from 2024-25 to 2026-27. The Federal tax-to-GDP is targeted to increase from 8.7% of the GDP in 2023-24 to 11.5% of the GDP by 2026-27. This increase is close to the 3% of GDP, as highlighted by the Finance Minister. However, over 50% of the increase in the tax-to-GDP ratio is to be achieved in 2024-25. This will require the generation of over Rs 2 trillion of revenues from the taxation proposals included in the Federal budget of 2024-25. This quantum of additional revenue is unlikely to be achieved.

There is need to highlight that out of 2.8% of the GDP targeted increase in the Federal tax-to-GDP ratio, the increase in net federal revenues, after NFC transfers, will be only 1.1% of the GDP. This will create a problem of ‘moral hazard’. With an increase of almost 1.7% of the GDP in transfers from the Federal government, the Provincial governments will have little motivation to develop their own tax system. For example, it remains to be seen what efforts will be made to raise AIT revenues significantly later this year.

Turning to the level of different types of expenditure projected in the strategy, there appears to be very limited economy proposed in Federal current expenditure. With the expectation of declining interest rates from the peak in 2022-23, the level of debt servicing is projected to come down from 7.8% of the GDP to 6.5% of the GDP by 2026-27. However, the level of other current expenditures is expected to remain unchanged at 6.6% of the GDP.

The lack of focus on cutting other current expenditure implies that enough ‘fiscal space’ will not be created for sharply raising the level of Federal development spending. The PSDP is targeted to increase modestly from 0.6% of the GDP in 2023-24 to 1.1% of the GDP in 2026-27. Only five years ago the size of the Federal PSDP was over 2.5% of the GDP.

There is consequently an inherent inconsistency in the medium-term budget strategy. The target GDP growth rate in the terminal year, 2026-27, of the strategy is a relatively high: 5.5%. This will only be possible if the level of fixed investment in the economy rises sharply from 11.4% of the GDP in 2023-24, which was the lowest level in the last fifty years.

There is a need to take back the size of the federal PSDP to at least 2.5% of the GDP by 2026-27. This is essential not only for faster completion of on-going projects but also for inclusion of major new projects in water resources, power transmission and distribution, mitigation of adverse impacts of climate change, etc.

The bottom line in the strategy is the targeted reduction in the federal budget deficit from 7.9% of the GDP in 2023-24 to 6.0% of the GDP in 2026-27. In fact, there is a likely increase in 2024-25 in the federal budget deficit. It is projected at7.9% of the GDP as compared to the actual deficit of 7.3%of the GDP in 2023-24. It is truly surprising to see a budget strategy which targets an increase in the federal budget deficit in the first year of its operation.

The Provincial governments are expected to generate a combined cash surplus of 1% of the GDP in 2024-25, equivalent to Rs 1250 billion. The problem is that examination of the four Provincial budgets for 2024-25 reveals that the proposed combined cash surplus is below Rs 750 billion. Consequently, this will add 0.4% of the GDP to the overall fiscal deficit in 2024-25 and raise it to 7.3% of the GDP. This will also imply a primary deficit.

The fundamental question is whether the Medium-Term Budget Strategy has been shared with the IMF. If so, then it is reassuring to see the acceptance of the likelihood that the consolidated budget deficit in 2024-25 may even be larger than that in 2023-24 as a percentage of the GDP.

Overall, there are some problems with the medium-term budget strategy. It has raised the targeted budget deficit for 2024-25 to above the actual level in 2023-24. There is also a need to have a new NFC Award.

The provincial governments must be motivated to raise more their own revenues. Federal current expenditures should be curtailed to provide fiscal space for a quantum jump in development spending to facilitate faster growth. The 40% growth in FBR revenues must be achieved if mini-budgets are to be avoided.

Copyright Business Recorder, 2024