State of public finances

The previous financial year closed with the largest ever budget deficit. The magnitude was Rs 3,445 billion, equivalent to 8.9 percent of the GDP. The increase in relation to 2017-18 was 2.3 percent of the GDP. This severe deterioration in the state of public finances was due to an absolute decline in FBR tax revenues combined with a big jump in the cost of debt servicing. The outcome would have been even worse if there had not been a big cut of Rs 650 billion in development spending in relation to the initially budgeted level.

The year, 2018-19, also witnessed an unprecedented development. Net revenue receipts of the Federal Government were not even enough to cover the outlay on debt servicing. Consequently, defense expenditure, costs of civil administration, subsidies and grants all were effectively financed by borrowing either domestically or externally. Clearly, this is not a sustainable situation.

The on-going financial year is expected to be a year of reform and transformation of the fiscal operations of the country, under the umbrella of an IMF Extended Fund Facility (EFF). The objective is to bring down the budget and primary deficits to more manageable levels. As such, the target for the budget deficit was set at 7.1 percent and the primary deficit at 0.6 percent of the GDP at the time of presentation of the Federal budget in the National Assembly.

The budget for 2019-20 included a number of very ambitious targets. The FBR revenues were expected to show a growth rate of 43percent and reach Rs 5,503 billion, with an absolute increase of as much as Rs 1661 billion. Non-tax revenues were projected to increase manifold from the extremely depressed level in 2018-19. Simultaneously, big increases of 31 percent and 58 percent were targeted for in current expenditure and in development spending respectively.

The first half of the year has been completed and information on fiscal operations for this period has been released recently by the Ministry of Finance. There has been significant improvement in the state of public finances. The fiscal deficit from July to December 2019 is 2.3 percent of the GDP, while there is actually a primary surplus of 0.6 percent of the GDP.

There are a number of questions which arise about the sustainability of this improvement and the likelihood of the containment of the annual fiscal deficit from 8.9 percent to 7.1 percent of the GDP. In particular, there is need to assess if the performance criterion in the IMF Program on the size of the primary deficit will continue to be achieved up to end of June 2020.

The first area of focus has to be the performance of FBR revenues. As compared to last year, there is significant buoyancy in these revenues. A growth rate of 16.6 percent has been shown in the first six months. However, this is woefully short of the target growth rate of 43 percent.

The growth in revenues of FBR has come primarily from the taxation measures included in the 2019-20 Budget. The taxation proposals put together represent additional taxation of over Rs 700 billion. Consequently, following their implementation, the minimum growth in FBR revenues on the base year level of Rs 3842 billion should be 18 percent. The actual growth is even lower than this, implying that the underlying tax bases are not demonstrating any growth.

This is confirmed by the severe import compression whereby from July to December the rupee value of imports has increased by only 1 percent. Similarly, the other major tax base of large-scale manufacturing sector value added in real terms has actually demonstrated negative growth of 3 percent up to December. Therefore, the growth of tax revenues has been constrained by the big slowdown in the economy.

The first review of the IMF program led to a scaling down of the FBR revenue target for 2019-20 by Rs 265 billion. Despite this there has been a shortfall of Rs 105 billion by December. This implies that there will have to be an increase of 54 percent in FBR revenues in the second half of the year if the annual target is to be met. This is clearly impossible.

The attainment of the primary deficit target for the first half of the year has been greatly facilitated by the extraordinary growth in non-tax revenues, cutback in development spending and a large cash surplus with the Provincial Governments. However, higher non-tax revenues are more of a one-off jump in the form of lumpy SBP profits and telecom license fees. Sustaining the growth of non-tax revenues will be difficult. Only 28 percent of the combined PSDP of the Federal and Provincial Governments has been utilized on projects up to December. This has also contributed to a cash surplus of Rs 358 billion with the latter Governments.

What is the outlook for the second half of 2019-20? The biggest concern is the potentially large shortfall in FBR revenues. If the growth rate remains, more or less, unchanged then the shortfall could be as large as Rs 750 billion. On top of this, the cost of debt servicing continues to show exponential growth. It increased by 39 percent in 2018-19 and now by 46 percent in the first half of 2019-20. There is likely to be even some acceleration in the second half of the year unless interest rates come down. Almost 60 percent of the absolute increase in domestic debt servicing will be due to the substantially higher interest rates. Any further cut in development spending will eliminate one of the few residual sources of growth in the economy.

Therefore, the fundamental question is what should be the fiscal policy for the second half of 2019-20? On the basis of the trends identified above the budget deficit could approach 8.5 to 9 percent of the GDP. This is likely to affect fundamentally the implementation of the IMF program. The performance criterion on the size of the primary deficit will most likely not be met in the third review and thereafter. Already, IMF staff agreement with the Authorities was left pending after the second review, thereby creating uncertainty about the steps necessary for successful completion of this review.

There is need to avoid a suspension or termination of the IMF Program when foreign exchange reserves are not sufficiently large, especially in the presence of over $3 billion of 'hot money' which could exit rapidly. Therefore, there is no other option but to focus on further fiscal consolidation.

The government will need to announce its budget strategy for the second half of 2019-20. This should include introduction of significant reforms in direct taxes in which the tax expenditure is over Rs 800 billion due to lower tax rates and exemptions. In addition there will be need for scaling back non-salary operating costs and development spending. Also, the debt servicing burden will need to be reduced by bringing down interest rates. These measures will be necessary not only from the viewpoint of bringing down the budget deficit to the revised target level agreed with the IMF of 7.6 percent of the GDP after the first review but also to ensure that the current account deficit does not start rising once again to due to the increase in aggregate demand in the economy caused by a rise in the budget deficit.

The budgetary framework agreed with the IMF from 2019-20 to 2021-22 requires even more fiscal effort in mobilizing tax revenues in 2020-21. The agreed increase is 1.8 percent of the GDP in 2020-21. Consequently, the Budget for 2020-21, due in three and half months, will need to include new taxation proposals and reforms for generating additional tax revenues by the FBR of almost Rs 900 billion. Perhaps the team which initially negotiated the Program with the IMF will find truly ingenious ways to generate this incredibly large quantum of additional tax revenues and hopefully for the first time the Federal and Provincial Governments will withdraw the special tax privileges given to the elite of the country.

(The writer is Professor Emeritus at BNU and former Federal Minister)