Fiscal policy and public debt - I

The following are excerpts from SBP's quarterly report 2015-16 - The State of Economy:
The budget deficit in the first quarter of FY16 was 1.1 percent of GDP, showing a marginal improvement over the same period last year. Though tax collection remained below expectations amid lower inflation, the reduction in the budget deficit was primarily due to moderate growth in current expenditures. The expenditure control also helped improve primary balance another key indicator of fiscal performance (Figure 4.1).
The tax collection by FBR was about Rs 40 billion less than expected during the first quarter, which was mainly due to sluggishness in sales tax. The direct taxes, on the other hand, showed significant growth on the back of new measures taken in the federal budget FY16 (Box 4.1). There was also no support from non-tax revenues, which remained at last year's level.
Therefore, the burden of fiscal consolidation fell on government expenditures. On a positive note, the government managed a moderate growth in current expenditures and directed the flow of funds towards various development works. However, the expenditure should be further rationalised through minimising expenses relating to loss-making PSEs and circular debt, in order to contain the fiscal deficit.
Meanwhile, the financing pattern of the budget deficit saw heavy reliance on commercial bank borrowings which increased to Rs 443 billion during the quarter. On a positive note, the government retired some of its debt with the central bank. Similarly, deficit financing through external resources also increased, which was largely derived from issuance of Eurobonds in the international market.
Box 4.1: Key taxation measures announced in Federal Budget FY16: In federal budget for FY16, the government targeting the tax to GDP ratio of 11.1 percent and to contain the deficit to 4.3 percent of the GDP. The budget envisaged a growth of 17.5 percent in taxes during the year, and introduced a number of new tax measures. The key proposals are given below:
New taxes/rate increases A one-time tax of 3 percent on individuals at income in excess of Rs 500 million, and 4 percent on associations, companies and banks, for the rehabilitation of Temporarily Displaced Persons (TDPs);
Expansion in the coverage of differential taxation scheme for filers and non-filers in order to encourage tax filing: eg, tax rate on dividend is increased from 10 percent to 12.5 percent for tax filers and 17.5 percent for non-filers; Income tax of 0.6 percent on all banking instruments levied on non-filers of tax returns, which was later reduced to 0.3 percent after negotiations with the stakeholders;
Increase in Capital Gains Tax from 12.5 percent to 15 percent for 1st year, and 10 percent to 12.5 percent for next year; A uniform rate of 35 percent on all sources of banking companies' income to remove tax arbitrage; Reduction in various exemptions (under SROs) equivalent to Rs 120 billion.
Tax rate reduction/concessions Reduction in the number of slabs of customs duty to 4 for simplification, and reduction in duty rates from 25 percent to 20 percent; A plan for reducing the corporate income tax rate by 1 percent annually to bring it down from 35 percent to 30 percent during the next 6 years.
Reduction in income tax rate from 5 percent to 2 percent for salaried taxpayers with income less than 0.5 million and in excess of 0.4 million; Reduction in customs duty on imported construction machinery from 30 percent to 20 percent. Introduction of a reduced sales tax (non-adjustable) of 7 percent instead of 17 percent to encourage farm mechanisation. Similarly, the customs duty, sales tax, and withholding tax rates on imports of agricultural machinery were also proposed to be reduced.
In order to promote certain sectors, the government has announced tax holidays. These include Halal food production which is tax exempted for four years and rice mills for one year. The government has declared a 10-year tax exemption on projects on developing and setting of electricity transmission lines in the country and 5-year tax exemption for projects for manufacturing equipments for solar and wind energy.
4.2 Revenues The revenue collection improved by 11.6 percent against a dismal growth of 1.2 percent a year ago. While the non-tax revenues showed virtually no growth, the tax collection picked up by 15.4 percent. The pace of tax collection, though encouraging, is still lower than what it should be: tax collection in Q1-FY16 is 19.3 percent of the full year target; however, according to past seasonal pattern, it should be about 21 percent of the annual revenues (Figure 4.2).
The shortfall witnessed in first quarter implies that much higher growth is required in subsequent quarters to achieve the annual target. For instance, a growth of 24.6 percent in tax collection will be needed in Q2, given the full year target of Rs 3,729 billion and the fact that around 25 percent of annual tax is collected in Q2 (Figure 4.2).
FBR taxes The tax collection by FBR posted 11.6 percent growth during the quarter (Table 4.2). Encouragingly, the direct taxes yet again witnessed a robust growth of 26.3 percent which has also increased its share in total tax collection from 35.3 percent in Q1-FY15 to 39.9 percent in Q1-FY16. The increase in direct taxes is largely due to enhanced coverage of the withholding taxes (Box 4.2).
The indirect taxes, on the other hand, posted a sluggish growth of 3.6 percent against a moderate 11.0 percent improvement in the same period last year. The overall deceleration in fuel prices and subsequently the inflation rate severely impacted the sales tax collection, which has shown negative growth during the quarter. Meanwhile the customs duty witnessed 23.4 percent growth owing to increased tariffs on imported items as well as inclusion of new items under the customs levy.
Box 4.2: Growing reliance on withholding taxes The withholding tax (WHT) is levied by the governments, across the globe, on sources of income, and purchase of goods and services. Pakistan inherited WHT on salary and interest income under British Income Tax Ordinance (ITO) 1922, which was repealed by the Income Tax Ordinance, 1979.
During 1990s, the withholding tax coverage was expanded substantially on various transactions and making most of them presumptive. Recently, its scope has been further enhanced to increase tax net and to address the issue of low and declining tax-to-GDP ratio. In the presence of large informal economy and poor culture of voluntary tax payments on one hand, and structural issues in tax administration on the other, the WHT has become a highly dependable means of generating revenues.
The WHT does have its merits. It is considered as low cost tool to raise revenues with the possibility of less leakages and minimum contact between the payers and tax official. It is therefore easy to broaden its coverage by including it on various services and income sources. Recently, the FBR has introduced a WHT mechanism, which separates out filers of income tax returns and non-filers. This mechanism is a tool to document the economy, whereby filers of tax returns pay lower tax rates than non-filers, thus incentivizing the tax filing.
As a result of enhanced coverage and differential rates on filers and non-filers, the share of WHT in direct taxes increased to 67.1 percent in FY15, compared with less than 60 percent three years back (Figure 4.2.1). Further, the contribution of WHT in total tax collection surpassed 26 percent in FY15 making it as the most reliable tax resource. During the last three years, WHT collection from all sources witnessed a compound annual growth rate (CAGR) of 24.5 percent, compared with the growth of 8.9 percent in overall FBR taxes.
The key sources of the withholding tax are contracts and international trade, which together make half of the total collection. Tax deducted from salaries constitutes 11.5 percent of the total WHT. Other important sources are bank interest and securities and cash withdrawal.
The coverage of WHT on banking transactions has been further enhanced in FY16 budget with higher rates for non-filers. The measure is expected to generate additional revenue as well as to curtail undocumented flow of funds from the banking channels. Although there are some adverse implications for banking sector, as people may opt out of the banking channel, we believe it will be short-lived; in the long-run this tax may help documentation of the economic transactions.
But there are also some demerits of WHT; (a) it carries a substantial compliance cost for withholding tax agents. This requires more human resource, I.T. infrastructure and other overheads to manage the collection mechanism and deposit with the FBR; (b) withholding tax on utilities (telephone bills, electricity bills, education fee, etc) may create additional burden on tax payers as it, though adjustable for tax filers, involves time lags for refunds; and (c) its incidence is regressive, like indirect taxes, particularly when applied on transactions.
Non-tax revenues The non-tax revenues posted a minimal growth of 0.3 percent (Rs 0.6 billion) due to absence of any significant one-time inflow that boosted the revenues in previous years. Moreover, due to lower international petroleum prices that continued to prevail, the revenue collected vide discount retained on crude oil and windfall levy contributed less than the same quarter last year and is expected to miss the budgetary targets (Table 4.3). Similarly, the royalties on gas and oil also declined due to price effect. Meanwhile, other major components such as SBP profits, CSF inflows and dividend earnings continued to support the non-tax revenues.
4.3 Expenditures The consolidated fiscal spending witnessed 7.2 percent growth during the quarter under review which is much lower than 12.7 percent increase in same quarter last year. This slowdown was broad-based; however, sharp reduction in growth was witnessed in interest payments the highest item in the current expenditure (Table 4.4).
The interest payments showed a modest growth of 5.4 percent in Q1-F16. This was mainly on account of lower growth in PIB coupon payments during the quarter. Both low interest rates and less borrowing through PIBs during FY15 were responsible for this lower growth.
The sluggish growth in the current expenditures paved way for the government to increase its development spending. As a result, the federal PSDP increased by 80 percent during the quarter which was also complemented by 40.6 percent rise in provincial PSDP. The federal government directed significant resources towards improving transport infrastructure, revamping of railways and improving water resources and distribution network. Moreover, PSDP disbursements were also made towards the Higher Education Commission (HEC), National Highway Authority (NHA) as well as rehabilitation of the IDPs. Likewise, the provinces also focused on developing physical infrastructure by laying road networks and development spending on public welfare.

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Table 4.1: Summary of Fiscal Operations

billion rupees ; growth in percent

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                                            Actual                  Growth

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                       Budget FY16   Q1-FY15   Q1-FY16   Q1-FY15   Q1-FY16

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A. Total revenue             4,688     839.7     937.0       1.2      11.6

Tax revenue                  3,729     626.9     723.5      11.7      15.4

Non-tax revenue                958     212.9     213.5     -20.8       0.3

B. Total expenditure         6,017    1176.5    1265.1       5.4       7.5

Total expenditure (booked)            1170.2    1254.0      12.7       7.2

Current1                     4,786    1050.1    1085.2      20.9       3.3

Of which

Interest payments            1,280     394.5     415.9        31       5.4

Development                  1,231     115.3     169.9      32.3      47.4

PSDP                         1,235      93.0     146.3      16.9      57.4

Others                                  22.3      23.6     193.3       5.7

Net lending                              4.8      -1.1

Statistical discrepancy                  6.4      11.1

Fiscal balance (A-B)        -1,305    -336.8    -328.2

Financing                    1,305     336.8     328.2

External sources               322     -13.5      55.3

Domestic sources               983     350.3     272.9

Banking system                 283     139.9     139.4

SBP                            -65     -39.0    -304.4

Scheduled banks                348     178.9     443.8

Non-bank                       650     210.4     133.5

% of GDP

Overall fiscal balance        -4.3      -1.2      -1.1

Revenue balance               -0.3      -0.7      -0.5

Primary balance               -0.2       0.2       0.3

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1.Includes pensions, grants, subsidies, and general government expenses.
Source: Ministry of Finance

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Table 4.2: FBR Tax Collection

billion rupees; Growth in percent

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                        Budget              Actual        Growth

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                    FY16   Q1-FY15   Q1-FY16   Q1-FY15   Q1-FY16

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Direct             1,348     189.7     239.7      17.3      26.3

Withholding tax       na     141.1     171.9      20.4      21.8

Indirect           1,756     348.1     360.5      11.0       3.6

Customs              299      64.5      79.6      23.1      23.4

Sales tax          1,250     258.2     253.4       9.5      -1.9

Federal excise       206      25.4      27.5       0.0       8.2

Total taxes        3,104     538.0     600.0      13.1      11.6

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Source: Federal Board of Revenue

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Table 4.3: Non-tax Revenues

billion rupees

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                                     Budget           Actual

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                                 FY16  Q1-FY14  Q1-FY15  Q1-FY16

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Mark-up (PSEs & others)            57     56.8      0.9      0.9

Dividend                           88      3.7     10.9     16.3

SBP profits                       280     80.0     67.5     67.6

Defence (incl. CSF)               154      2.0     77.3     75.7

Royalties on gas & oil             59     19.2       20     17.6

Passport & other fees              25      4.0      2.7      3.4

Discount retained on crude oil     21      3.9      2.3      2.1

Windfall levy against crude oil    18      3.8      5.3      1.0

Foreign grants                     40     10.1        8      7.1

Other federal                      53     74.6      5.5      7.2

Provincial                        168     10.7     12.4     14.9

Total non-tax revenue             963    268.8    212.9    213.5

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Source: Ministry of Finance

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Table 4.4: Analysis of (Consolidated) Fiscal Spending-Q1

billion rupees; growth in percent

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                                                     Growth

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                          FY15      FY16     FY15      FY16

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Total expenditure      1,176.5   1,265.1      5.4       7.5

Total

expenditure(booked)     1170.2    1254.0     12.7       7.2

Current                1,050.1   1,085.2     20.9       3.3

Federal                  772.1     768.2     20.7      -0.5

Interest payments        394.5     415.9     31.0       5.4

Domestic                 375.9     396.9     31.3       5.6

External                  18.6      19.0     24.8       2.2

Pension                   39.7      42.5      8.8       7.0

Grants                    52.8      56.7     26.3       7.3

Defence                  164.6     145.6     12.4     -11.5

Public order & safety     21.3      21.8     16.3       2.2

Health & education        12.7      16.5     -9.6      30.1

Others                    86.7      69.2      6.5     -20.1

Provincial                 278     317.0     21.5      14.0

Development              115.3     169.9     32.3      47.4

PSDP                      93.0     146.4     16.9      57.4

Federal                   39.6      71.3    -11.9      80.0

Provincial                53.4      75.1     54.4      40.6

Other dev. expenditure    22.3      23.6    193.3       5.8

Net lending                4.8      -1.2    -94.2    -124.0

Statistical Discrepancy    6.3      11.2    -91.9      75.7

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