The federal budget for 2006/07 has been presented in a difficult context -both political as well as macroeconomic. In our view, the policy response to these challenges, as set out in the budgetary proposals, is inadequate and/or inappropriate.
Even on the political front, a large part of the measures designed to consolidate the government's position prior to the next election may fail to deliver to the extent hoped for.
RE-CAP: As widely expected, the government has adopted an expansionary fiscal stance in the just-released budget for 2006/07. Total outlay has been projected to rise by 20%, while development spending has been ramped up by 58%, to 32% of total expenditure (4.7% of projected GDP). A fiscal deficit target of 4.2% of GDP has been set (Rs 374 bn), while the primary balance is budgeted to widen to a deficit equal to 1.5% of GDP (from an estimated 1.1% of GDP in FY06).
BUDGET CONTEXT: Set in a context of "rich" policy settings and rising imbalances, one of the key challenges of the budget was to contain aggregate demand, without derailing the overall growth momentum. In our view, this called for meaningful tax measures to deflate private consumption spending in the economy, with taxation of speculative activities in the asset markets (real estate, equities) leading the way.
On the other hand, two other principal challenges facing policymakers were the lowering of business costs and improving the competitiveness of industry, and raising substantially the allocation for social sector spending. Finally, providing "relief" from rising inflation was deemed a political imperative.
POSITIVE AREAS: Marked by good intentions in many areas, the principal salient of the budgetary measures is on the "relief" side. Salaries and pensions of government servants have risen 15-20%, subsidies have been budgeted to rise to Rs 109 bn (1.2% of GDP), and the minimum threshold income for tax exemption has been raised to Rs 150,000 (from Rs 100k).
Revenue mobilisation through increased documentation is relatively weak, though a 2% levy (CVT) has been imposed on real estate transactions, while the withholding tax rate on cash withdrawals from banks has also gone up. Taxes on equity market transactions and broker commissions have also been raised. New measures are expected to yield around Rs 25 billion, while exemptions are projected to cost Rs 16 billion. Hence, in net terms, CBR receipts are budgeted to rise by around Rs 8-9 billion.
The agriculture sector has also received due emphasis, with sizeable allocations for lining of water courses and building of mega-dams. In addition, budgetary measures also focus on promoting livestock farming and the development of the dairy sector.
MISSING ELEMENTS: High business costs, especially in the export sector, have not been addressed directly or adequately. In the face of an overvalued exchange rate and rising input costs, a time-bound subsidy (next 12 months) on electricity and gas tariffs for exporters could have been considered.
2. A major factor currently impeding capital formation or the sluggishness in construction is the high cost of land. In concept, the levy of a 2% CVT on real estate was meant to dissuade speculation and hence lower prices. In reality, by excluding property transactions in cantonment areas (according to one interpretation), and by not tackling the issue of declared value versus actual market value, the levy will not achieve its objective.
3. Allocations for improving crop productivity via improved research and better extension services does not appear to have been given the required attention (admittedly, agriculture is a provincial subject but sub-national resources are stretched and provinces have systematically ignored this area).
4. A measure of fiscal rectitude. While on paper, current expenditures are budgeted to decline 4% in FY07, they have been on a strong rising trend over the past 2-3 years. The numbers for FY06 are hardly comforting. Estimated outturn viz current expenditure was Rs 919 bn versus budget of Rs 827 bn (an over-run of 11%).
ASSUMPTIONS:
The budget's critical assumptions are:
- CBR tax revenue to rise 19% to Rs 835 billion. - Total expenditures to increase by nearly 20%, with current expenditures to decline by 4% in nominal terms. - Import growth of 16% in FY07. - GDP growth of 7%. - Inflation at 6.5%.
SOME CRITICAL ISSUES:
USE OF SUBSIDIES: Generally, the use of blanket subsidies covering all users (such as on petroleum products, on sugar, or to absorb the losses of Wapda, for example) is bad policy considering the inability to target those most in need. A large part of the allocation on subsidies wll be consumed by less-deserving segments of society.
A better approach would have been to perhaps expand the definition of "life-line" users of electricity and gas, and target them for subsidised rates. In addition, GST rates could have been lowered for those items that make up a larger proportion of household budgets of low-income segments.
In any case, the large bulk of the allocation on subsidies (electricity, PDL) will protect consumers from further rate increases, without providing relief from existing prices. This could prove to be politically ill-conceived.
Size (and quality) of PSDP: Similarly, aside from the critical issues of project selection and quality of implementation, extracting political mileage from the record PSDP allocation may prove to be elusive.
Almost by definition, the PSDP is spent mainly on "mega-projects". With long gestation periods, and a longer time-line in terms of spillover effects becoming "visible", the PSDP allocation should not be counted upon to deliver political capital within an election cycle. Here, the higher allocation for a more "micro"-level program, Khushaal Pakistan, is a positive step.
BOTTOM-LINE: The budget is not sufficiently aligned with macroeconomic realities. By stoking aggregate demand further - rather than reining-in private consumption spending - the fiscal stance will potentially aggravate imbalances in the economy. As noted by S&P and other analysts, and as pointed out in our research notes in December 2005 and in May this year, the stimulatory fiscal stance will continue to provide a strong underpinning to rapid import growth, leading to larger trade and current account deficits.
In addition, an expansionary fiscal deficit is likely to be inflationary, especially in the context of several consecutive years of economic growth that is likely to have been higher than the economy's potential output. How the government chooses to finance the fiscal deficit, especially with regard to recourse to the central bank, will also exert a substantial influence on the inflation outcome.
(The writer is Chief Economist, Pakistan Unit ABN Amro Bank.)