The article written by me in Business Recorder on Monday 21st of January 2019 had speculated that the primary motive for presentation of the Mini-Budget was to control the burgeoning budget deficit in the on-going fiscal year, 2018-19. The first six months had witnessed a runaway tendency in the size of the budget deficit. Based on estimates of borrowing from different sources, the deficit had approached the magnitude of almost Rs 1100 billion by end-December, 2018, almost 2.9 percent of the projected GDP for the year. If this trend continues, there is the unpleasant prospect that the fiscal deficit can approach almost 7 percent of the GDP by the end of the year. This will be not only higher than last year's deficit of 6.6 percent of the GDP but also larger by a colossal Rs 700 billion over the deficit target set by the PTI Government in the (Revised) Budget for 2018-19, presented in September 2018.
Instead, the mini-Budget has come as a complete surprise. The path chosen is not one of presenting proposals to directly mobilize more revenues to achieve significant reduction in the budget deficit in the remaining five months of the fiscal year. Instead, the Finance Minister has opted to present an 'economic reform package'. The objective is apparently to provide a fiscal stimulus to the real economy which has tended to slow down visibly. During the last six months, industrial production has declined and exports have shown little growth. The level of investment, especially public, has probably come down. There also has been hardly any containment of imports and the current account deficit.
The Government, therefore, appears to have opted for a vintage brand of 'supply-side' economics. The strategy involves the granting of tax breaks and fiscal incentives to stimulate economic activity leading to an upsurge in the 'real economy', especially of exports and investment, thereby also contributing to higher employment generation. The objective is to expand the tax base and thereby generate more tax revenues to reduce the fiscal deficit. Simultaneously, larger exports could contribute to lowering the trade deficit. This is in sharp contrast to the conventional view, especially of the IMF that stabilization of the economy must precede higher growth. In effect, the Finance Minister has hoped that stabilization will be achieved through faster growth. This way all groups in the economy could be simultaneously satisfied.
A number of questions arise with regard to the strategy adopted: Will the tax breaks and fiscal incentives lead to higher export- and investment- led growth? Will the tax bases expand rapidly enough to not only compensate for the revenue loss due to reduction in tax rates but actually lead to increased revenues and thereby restrain the fiscal deficit? Clearly, the assessment hinges on the precise nature of the proposals in the so-called 'economic reform package'.
The first priority is to assess the impact of the measures in the reform package on exports. Already, the year, 2018, has witnessed a number of moves to bring down the value of the rupee, leading thereby to a cumulative devaluation of 32 percent. This ought to have stimulated exports but unfortunately this has not happened. The diagnosis is that the gain in price competitiveness has been watered down due to the rise in domestic prices of imported inputs and utility prices.
Consequently, some measures needed to be taken to make inputs cheaper in production of goods for export. First, the import duties on key inputs of raw materials and intermediate goods into exports have been substantially reduced. Earlier, in the last ECC a decision was taken to make the imports of cotton tax free. Second, the Finance Minister has also announced a policy of pricing electricity for exports at 7.5 cents per kwh, almost 25 percent below the prevailing tariff for industry thereby implying a significant subsidy. Third, and importantly, a scheme has been introduced of giving promissory notes to exporters against the outstanding refunds so as to help in improving substantially their liquidity.
These are big moves with the potential of providing a strong impetus to exports but with significant negative implications on the exchequer. Based presumably on the above-mentioned moves and some quid pro quo from China, the Advisor to the Prime Minister on Commerce has indicated that exports will reach $27 billion by end-June 2019. This implies that the growth rate of exports in the second half of 2018-19 will be as high as 17 percent. We hope that the exporters will not disappoint the Government after the substantial support provided to them in the reform package.
The strategy to promote private investment leading to higher production is based on enhancing profitability and the rate of return by a number of steps. First, the super tax is being withdrawn from July 2019. Second, the tax on retained earnings above a certain level has been removed. Third, the income tax rate on bank advances to key real sectors like agriculture, SMEs and housing has been halved. This should expand the supply of credit to these sectors for investment at a lower cost. A number of fiscal incentives have also been announced for investment down the road in projects in the SEZs. The tax on cash withdrawals by filersfrom banks has been withdrawn. This should increase the flow of deposits into the banking system and enhance the availability of credit for investment.
Overall, a somewhat ingenious and bold approach has been adopted in fundamental contradiction with conventional wisdom. What are the prospects for this somewhat high-risk strategy?The implication first on the budget deficit are worked out.
There are, in fact, a number of measures in the reform package which could have negative implications on the budgetary position. First, there are significant revenue losses associated with no advance tax on cash withdrawals from banks by filers, elimination of taxes on imported raw materials and intermediate goods for exports, withdrawal of the advance tax on share transactions and reduction in the income tax rate on bank advances to special sectors. A first order estimate of the revenue foregone is Rs 30 billion by end-June 2019. Down the road, the carry forward of capital gains losses for up to three years could imply sacrifice of revenues if the market does not recover quickly and sufficiently. The FBR has grossly understated the net revenue loss at Rs 6.8 billion.
Second, there is the cost of the gas and electricity subsidies. These could add up to Rs 35 billion in the second half of the financial year. Third, the crucial question is what the impact on the budget will be of the sizeable amount of Rs 250 billion issued as promissory rates against refunds due. In the short-run there is no cash outflow from the Budget but there is accrual of a big deferred liability. In the discussions with the IMF it will be necessary to arrive at an understanding as to how this liability will be treated in the budgetary framework. Encashment of these promissory notes by exporters could lead to some spurt in demand for goods and services in the economy.
The Government will need to take some actions to minimize the budgetary impact of the reforms package. There are already indications that an effort will be made to arrive at a settlement on the dues pending of GIDC and generate higher revenues from petroleum products to at least partially recover shortfall in FBR revenues already of over Rs 170 billion in the last six months. Also, stronger efforts will be required to contain current expenditure especially in view of the fact that cost of debt servicing could rise by over Rs 400 billion in 2018-19 due to the hike in interest rates and the need to refinance a large stock of MTBs.
The revenue loss and the cost of subsidies of Rs 65 billion will need an expansion in the GDP by over Rs 400 billion or by 1 percent, over the growth projected in the absence of the reform package. Achievement of this through exports will require their growth to be at least 12 percent in the second half of 2018-19.
The real concern is that with additional growth in the GDP, if achieved, will lead to higher aggregate demand and, consequently, higher imports generally. In addition, the upsurge in exports and investment will lead directly to a larger level of imports of inputs and machinery. Commercial importers may also be induced to increase their volume of imports now that the minimum tax on them has been replaced by a fixed tax at the same rate as the minimum tax. A first estimate of the increased imports is $2.5to $3 billion. This could exceed the increase in the exports and lead to some worsening of the current account.
Overall, the Government has embarked on ahigh-risk strategy of trying to achieve more growth and greater stabilization simultaneously. The key risk factors include failure to arrive an out of the court settlement on the GIDC, substantial encashment of the promissory notes in the short run and a rise in oil prices in coming months.
The negotiations with the IMF are likely to take a new twist. The Staff Mission will, of course, subscribe to the mantra of 'stabilization first and growth later'. We hope that the vested interests who have received significant largesse in the mini-budget will continue to back the Government if it runs into some heavy weather in coming months.
(The writer is Professor Emeritus and former Federal Minister)