March 24, 2012
Jamil Nasir

Weak fiscal structure is one of the major policy areas Pakistan seriously needs to concentrate on to strengthen public finances through revenue mobilisation and cuts in wasteful and low-priority expenditures. This has been recommended by the IMF Country Report released in February, 2012 in pursuance of Article IV consultation and post-programme monitoring with Pakistan. The IMF’s advice is not misplaced especially in the context of yawning fiscal deficit and low tax-to-GDP ratio. The fiscal deficit of Pakistan has widened to the unsustainable limit of 6.6 percent of the GDP, whereas the tax revenues constitute only 9-10 percent of the GDP, one of the lowest in the world.

Tax evasion is widespread. You will hardly come across a person in Pakistan who believes that tax collection is fair, or that he should pay due taxes for a larger purpose of state building, or that he can associate himself with the benefits dished out by the state in return of taxes paid by him. .

Due to low revenue collections, large fiscal deficits are hard to finance and the hammer of austerity always falls on the development budget. As pointed out by the IMF report, the budgetary management simply means containment of investment spending and borrowing from the banks. It is almost impossible to reinvigorate the weak fiscal structure unless a consensus is reached through renegotiation of the fiscal social contract among all the stakeholders for domestic revenue generation and its spending. Currently, the social fiscal contract, if at all it exists, is very weak due to a palpable absence of any relation between the revenue raising and spending preferences. This model serves the interests of the powerful groups where revenue collection and public spending are separate domains to the detriment of the citizenry at large. The present fiscal model can best be described as what is called ‘the state capture paradigm.’

In such a paradigm, the state becomes an instrument for furthering the interests of the elite and the powerful who use the state apparatus to enrich themselves. The revenue collection and public spending patterns are clearly determined by the vested interests of such groups and not the collective benefit of the citizenry at large. Consequently, the powerful and the rich do not pay due taxes. The tax machinery remains weak, and horizontal and vertical inequities get sharp. Tax evasion becomes rampant and compliance cost rises. In such a model, the taxation system does not work as an instrument of state building and redistribution of resources. What need redefine the fiscal social contract – an agreement between the state and the citizenry to the effect that the people will pay their taxes honestly and in return the state will provide good governance and public goods like education and health etc.

In order to reconstruct such a contract, we need to answer three basic questions. First, what will be the major sources of revenue to reduce fiscal deficit (aid, borrowing or domestic revenue mobilisation)? Second, what will be the priority areas of spending (butter versus guns tradeoff)? Third, how will it be ensured that the allocated budget is properly spent on priority areas and value of money is returned to the tax payers (ie control of corruption and good governance)?

Traditionally, Pakistan has remained heavily reliant on borrowing, foreign as well as domestic and aid to bridge the fiscal deficits. The efficacy of aid as development strategy is questionable on several grounds especially on the perverse incentives it generates for the recipient country. Even if we believe in the efficacy of aid as viable option, it will not be forthcoming liberally at least in the near future due to economic downturn in the US and Europe.

As for borrowing, it has got its own costs. The dollar denominated debt has severe balance sheet effects if the currency of the country is not strong. Depreciation/devaluation of the domestic currency against the dollar increases public debt besides the point that more funds are required for debt-servicing in future.

Excessive borrowing from domestic banks has at least three detrimental effects. First, it creates inflationary pressures. Second, it results in high debt servicing due to high domestic interest rates. Third, it crowds out the credit demands of the private sector. Heavy reliance on borrowing is not a sustainable solution to the problem. Without exploiting domestic resource mobilisation, solution of the large fiscal deficits is not possible on sustainable basis.

For domestic revenue mobilisation, the issue of horizontal and vertical inequities needs to be addressed. Taxation of the sectors of the economy which are still out of the tax net should become part of the debate while reconstructing a fresh fiscal social contract. New tax avenues need to be explored especially by the provinces after grant of autonomy through recent constitutional amendments. Taxation of land value improvements, and simplified taxation schemes for small businesses operating in the informal sector can be some of the potential areas for broad basing of taxation. Broadening of the tax base will not only enhance revenue but also contribute towards state building.

In order to reduce tax evasion and large tax gap, improving the quality of tax bureaucracy is another area deserving. The efficiency of public bureaucracy is determined by the fact as to how effectively it collects taxes and detects tax evaders. The empirical literature recognises the quality of tax bureaucracy as one of the major determinants for tax revenue. If the majority of the tax-payers do not repose their trust in the fiscal competence and fiscal integrity of the tax machinery, enforcing the tax compliance will remain a difficult endeavour.

Second ingredient of the social fiscal contract relates to the spending priorities. It is what economists call “butter versus guns tradeoff.” According to the IMF country report, subsidies especially electricity subsidies and interest payments consume almost half of the government’s revenues while security spending uses up another quarter. The portfolio of expenditures in our case has got two salient features: first, most of the revenue is consumed by non-developmental budget like interest payments and defence. Second, whatever is left is consumed by wasteful expenditures. Thus very little budget is allocated for sectors like education and health etc. Resultantly, a large number of the population is not a direct beneficiary of the fiscal choices. While negotiating the social fiscal contract, we need to resolve, once and for all, whether we should secure ourselves through guns or by investing in our people.

The third question relates to the control of corruption and good governance. It is a matter of common observation that whatever little is allocated for the human and infrastructure development does not reach the intended targets. According to the IMF report “patronage, weak management, poor service delivery and other governance issues have created fertile ground for rent-seeking and corruption in Pakistan”. Good governance is critical not only to growth and development but also to raising tax revenues. In order to collect the due taxes, legitimacy of the state is highly important, which the state derives from good governance. If the governance is poor, the level of trust in the state’s ability to spend wisely and efficiently will also be low. Consequently, people will have little incentive to pay taxes.

A big debate needs to be initiated to reconstruct a fresh fiscal social contract by seeking answers to the above questions and all the stakeholders, irrespective of their political, ethnic and religious affiliations, should come forward to steer the country out of the economic morass.

The writer is a graduate from Columbia University with a degree in Economic Policy Management. Email: jamilnasir1969@gmail.com

-The News