Rejoinder to the IMF

Harold Finger, the new IMF Mission Chief for Pakistan, has recently written an article in an English-language national daily on 'A Pro-Growth Strategy without Fiscal Stimulus'. This is an attempt at justifying the strategy of steep fiscal deficit reduction, which has largely determined the quantitative performance criteria and structural benchmarks in the on-going Extended Finance Facility (EFF) of Pakistan with IMF. By 2019-20, the IMF projects that Pakistan will need to bring down the fiscal deficit to a mere 2.5 percent of GDP.
The key element of the strategy is achieving big increases in the tax-to-GDP ratio by initially raising tax rates and broad-basing the tax system more recently. The former has involved raising the GST rate, enhancing the minimum tax on corporate income and introducing a minimum duty on non-dutiable imports. The latter has implied stronger enforcement to increase the number of taxpayers and introduction of new withholding taxes along with higher rates, especially on non-filers. In customs duty and sales tax the primary focus has been on withdrawal of SROs.
The objective is to bring down the public debt-to-GDP ratio, such that the heavy interest payments claim less of the revenues. The resulting, `fiscal space` can then be used for higher development spending and social protection. However, this strategy has met with very limited success. In the first two years of the Program there has been a large shortfall each year in achieving the FBR revenue target by over Rs 200 billion. This has resulted in a, more or less, corresponding cut in the PSDP in order to remain within the quarterly fiscal deficit target and qualify for the next IMF tranche release. Simultaneously, the Provincial Governments have been asked to generate large cash surpluses by also scaling down their expenditures, especially on development.
The heavy doses of additional taxation of over Rs 200 billion each year have negatively impacted on the tax bases. The cutbacks in an already low federal PSDP (less than 2 percent of the GDP) have affected the growth potential of the economy. The economy has remained stuck in the low growth trap. The Pakistan Bureau of Statistics has engaged in some overstatement of the GDP growth rate, to take it above 4 percent. The actual growth rate is closer to 3.5 percent in the last two years.
This strategy has, more or less, unravelled in 2014-15. Not only has the FBR revenue target proved very elusive, but also the Provincial Governments have not generated anywhere near the cash surplus required of almost Rs 300 billion. Despite some violation in accounting practices, like including receipts from privatisation in the SBP profits, it is likely that instead of a fiscal deficit of 4.9 percent of the GDP, the consolidated deficit will exceed the deficit in 2013-14 of 5.5 percent of GDP and approach 6% of the GDP.
The outcome next year is also likely to be a failure in achieving the further reduced target of 4.3 percent of the GDP, as it is based again on a high growth rate of 20 percent in FBR revenues and a Provincial cash surplus of Rs 297 billion. In a year when the next NFC award is being negotiated, the Provinces will strive for higher expenditure benchmarks. This precludes the generation of a large cash surpluses by these Governments.
Therefore, the experience by now is that the strategy followed has neither stabilised public finances nor helped in achieving some revival of the growth process in the economy. Further, contrary to Mr Finger, social safety nets have not been adequate to provide a cushion against poverty. The low rate of economic growth has implied employment in 2013-14 of an additional 510,000 workers only as compared to thrice the number of labour force entrants. Instead of coming down, the public debt to GDP ratio has remained at close to 64 percent of the GDP.
The fundamental reason for failure of the IMF recommended strategy is that heavy additional taxation is likely to be counterproductive when imposed on a weak economy. The sequencing of reform has been wrong. It is essential that the economy be allowed to breathe and grow first before it can bear the burden of heavy additional taxation. The worst hit is the large-scale manufacturing sector which has seen a significant decline in its growth rate in 2014-15.
The appropriate strategy involves an enhancement in the level of development expenditure, not only to provide a short run fiscal stimulus but also to remove some of the structural bottlenecks that have severely restricted growth in the economy. In particular, the allocations to WAPDA, for replacement and modernisation of the Gencos and to NTDC for rapidly improving the transmission system, should have been up to two times larger. Higher power generation from existing plants and improved transmission will facilitate the growth process relatively quickly. New generation plants could come in the next phase of development of the power sector.
The government has claimed that the size of the federal PSDP has been increased in 2015-16 to Rs 700 billion from Rs 540 billion last year. But Rs 580 billion will go into development projects and the rest for interventions outside the PSDP, implying a growth rate of only 7 percent. The Wapda (Power Sector) allocation at Rs 112 billion is even lower than that for highways of Rs 160 billion. The allocation for the water sector in a 'water-stressed' country like Pakistan is only Rs 30 billion, 35 percent less than last year. The Provincial governments have budgeted for a combined PSDP of over Rs 800 billion, but this will remain only a pipe dream in the presence of a large shortfall in transfers. Already, social indicators are beginning to falter due to expenditure cut backs. In 2013-14, for the first time, the literacy rate fell from 60 percent to 58 percent.
Finally, since the growth strategy without the fiscal stimulus is not working, there is need to also look at other stimuli. Fortunately, interest rates have come down sharply, following the precipitous decline in the rate of inflation, and there is scope now for also pursuing a more expansionary monetary policy. Further, an adjustment in the exchange rate has become essential if the process of export-led growth is to be initiated once again.
(The writer is the Managing Director of the Institute for Policy Reforms and a former Federal Minister)