Reports on the on-going negotiations between the Ministry of Finance (MOF) and the IMF reveal that among the many steps and reforms being discussed a heavy emphasis is being placed by the IMF on improvement in the state of public finances of the country. Consequently, a reduction in the size of the fiscal deficit has emerged as one of the primary goals of the reform agenda. The motivation is clearly to enable containment of the level of aggregate demand in the economy so as to depress the level of imports and thereby bring down the current account deficit in the balance of payments.
However, this time, the approach being adopted is somewhat different from those taken in the past. Apparently, the Fund is focusing more in the negotiations on elimination of the primary deficit rather than on reduction in the size of the overall fiscal deficit. The former is the difference for the Federal and provincial governments combined between total revenues and total expenditure, excluding interest payments.
This raises a number of questions: What is the significance of reduction or elimination of the primary deficit? What impact does this have on the strategy for stabilizing the public finances of the country? The primary deficit or surplus is, in fact, a key indicator of whether or not a country is falling into the 'debt trap'. If there is a primary surplus this means that the country has enough revenues to cover all its non-interest expenditure obligations and partly finance the interest payments on public debt. In this case, the rise in the public debt to GDP ratio is restricted. As opposed to this, if there is a primary deficit then it means that borrowing is taking place even to finance interest payments. This increases the risk of faster accumulation of public debt and a big increase in the public debt to GDP ratio.
The revenue side of the primary deficit consists of tax and non-tax revenues of the Federal and provincial governments combined. Tax revenues are the dominant source with a share of 86 percent in total revenues. On the expenditure side, the major components are, first, the expenditure, excluding debt servicing, of the Federal Government and total combined current and development expenditure of the four provincial governments.
The relative importance of the different components can be determined from the latest data on Fiscal Operations for 2017-18. The largest component is the current expenditure on administration and on economic and social services by the Federal and provincial governments combined. The share of this component was 34 percent in 2017-18 in total public expenditure, excluding interest payments. The second largest component is security related spending. It had a share of 29 percent and consists of the expenditure on defense services (including military pensions) and on public order and safety at the Federal level plus the outlay on maintenance of law and order by the provincial governments.
The third major component is development spending, including the capital expenditure on projects in the Federal and provincial PSDPs. The share of this component was 27 percent in 2017-18. Therefore, the three major components collectively had a share of 90 percent in total non-interest expenditure in 2017-18. The remainder, 10 percent was mostly accounted for by Federal grants and subsidies.
What has been the trend in the size of the primary deficit in recent years? In 2015-16, the third and last year of the previous IMF program, the primary deficit was near zero and total revenues virtually matched the public expenditure, excluding interest payments. It has grown rapidly in the last two years to 1.6 percent of the GDP in 2016-17 and to 2.2 percent of the GDP in 2017-18. Combined with debt servicing outlay of 4.4 percent of the GDP the overall budget deficit reached a peak level of 6.6 percent of the GDP last year.
Clearly, the primary deficit has to be contained otherwise not only will the fiscal deficit be large but the public debt to GDP ratio will also rise rapidly, well beyond the limit specified by the Fiscal Responsibility and Limitation Act of 2005. As part of the adjustment program, with or without the IMF, the primary deficit needs to be eliminated within a maximum of three years and ideally in two years.
Before the strategy for primary deficit elimination is developed, there is need to identify the reasons for the big jump in the deficit from 2015-16 to 2017-18. Revenues performed relatively well with an increase of 0.2 percent of the GDP. The tax to GDP ratio has risen to 13 percent. The problem is on the expenditure side. The biggest increase of over 0.9 percent of the GDP has been in Federal (excluding interest payments and security) and provincial current expenditure on civil administration and services. The next big increase of 0.6 percent of the GDP is in total security spending, followed by an additional almost 0.5 percent of the GDP in development spending by the provincial governments. Additional cost of 0.2 percent of the GDP was observed in other expenditures.
The Federal and provincial budgets for 2018-19 envisage a reduction in the consolidated budget deficit from 6.6 percent of the GDP in 2017-18 to 5.1 percent of the GDP. This is based on a big decline in the primary deficit to only 0.3 percent of the GDP as interest payments will go up in the presence of substantially higher interest rates.
Unfortunately, these projections are based on very optimistic assumptions. The performance in the first quarter reveals that revenues are not showing the expected buoyancy and both non-interest current expenditure on civil administration and services and defense expenditure have shown rapid growth of 21 percent and 23 percent respectively. The only area where there will be a big cut is on development spending of almost 0.8 percent of the GDP in 2018-19.
Therefore, on current trends, the primary deficit in 2018-19 is unlikely to change significantly from the level of 2.2 percent of the GDP observed in 2017-18. The saving in development spending is likely to be neutralized by the fall in the overall revenues-to-GDP ratio, especially due to slow growth in FBR revenues.
There is need to develop a strategy for halving the primary deficit this year to 1.1 percent of the GDP by various measures, including probably a mini-budget early in 2019 with a number of taxation proposals. This should include measures for raising the tax-to-GDP ratio by 0.36 percent of the GDP and to implement measures for achieving containment in current expenditure of 0.74 percent of the GDP. This means that one third of the adjustment will be on the revenue side and two thirds in expenditure. The downward adjustment in development spending has already been made.
Therefore, the revenue target for FBR has to be raised from Rs 4398 billion to Rs 4523 billion by implementing taxation proposals yielding Rs 125 billion in approximately six months. The Business Recorder has already published articles by various authors on tax reforms for raising more revenues.
The required cutback in current expenditure is Rs 250 billion. This needs to be distributed between the Federal and provincial governments, more or less, equally. For example, this implies a cut of 6 percent in each component of expenditure. Surely, this is attainable given the strong commitment to economy in expenditure of the PTI Government. The defence establishment may wish to voluntarily make the cut of 6 percent.
Overall, elimination of the primary deficit in two years appears to be a feasible goal. The IMF must be made to realize that an even faster rate of adjustment will unleash severe 'stagflation' in Pakistan and could lead to public or political disorder as has happened recently in Argentina and earlier in Greece and Tunisia in the process of implementing their respective Fund programs. Not only will there be more unemployment but the number of poor will rise sharply. Fortunately, the Fund has already expressed the need for more social protection coverage of the poor.
(The author is Professor Emeritus at BNU and former Federal Minister for Commerce, Planning and Finance)
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