Crumbling finances
Muhammad Yaqub | Opinion | From the Newspaper
10th Jan 2012

SEVERAL economists, the State Bank of Pakistan and the IMF have been sounding a warning for quite some time about the deteriorating situation of public finances and its implications for the economy. But this has fallen on deaf ears.

The budgetary situation of the federal and provincial governments and of public-sector enterprises (PSEs) in FY11 was very alarming and the data for the first half of FY12 indicates that matters are worsening.

In FY11, the federal government`s total revenue was 11.7 per cent of GDP, 47 per cent of which was transferred to the provincial governments under the NFC Award. Revenue remaining with the federal government amounted to 6.2 per cent. At the same time, federal government expenditure was 13.8 per cent of GDP in FYll, leaving an expenditure-revenue gap of 7.6 per cent. The PSEs were operating at huge losses, the gap becoming higher if their contingent liabilities were added.

The gap was financed through borrowing, mainly from domestic bank and non-bank sources.

Debt servicing was the biggest single item of expenditure in FY 11 48 per cent higher than the total defence expenditure and consuming 41 per cent of the total tax revenue. The consolidated development expenditure declined to 15 per cent of the total expenditure.

On the revenue side, federal tax revenue rose less than the nominal GDP in FY11 reducing further the tax-GDP ratio. It stood at 8.9 per cent of GDP, with indirect taxes accounting for 64 per cent of the total tax revenue, the bulk of it coming from the sales tax. The tax-GDP ratio is the lowest in the region and the taxation system is narrowly based and regressive.

Indirect taxes and excessive government bank borrowing ledto a sharp increase in prices impacting heavily on the poor. It is well known that inflation is the cruellest form of taxation.

Additionally, it distorts resource allocation, retards economic growth and adds to income inequality and poverty.

The latest monetary data indicates a sharp worsening of public finances in the first half of FY12.

Net government-sector bank borrowing up to Dec 23, 2011 was more than twice that in the same period the previous year. A new and alarming aspect was provincial borrowing of Rs23bn asagainst a retirement of Rs32bn in the same period last year.

The PSEs are by now financially almost bankrupt. The debt of loss-making PSEs had to be taken over by the government by issuing special treasury bills of about Rs400bn. The high cost of electricity purchased from rental power plants and theft in the distribution of electricity in general was partly passed on in higher prices and partly absorbed in budget subsidies, and even then people suffered from extensive loadshedding.

Notwithstanding a decline of Rs133bn in the net foreign assets of the banking system, public-sector bank borrowing and some pick-up in private-sector credit led to an expansion in money supply of nearly five per cent up to Dec 23, 2011.

If a major revenue mobilisation effort is not mounted, the fast-rising federal debt servicing and borrowing by provincial governments would widen the consolidated budget deficit.

With foreign budgetary support on the decline, it will mean more reliance on bank borrowing fuelling inflation.

The high rate of inflation put pressure on the exchange rate and also contributed to a sharp decline of nearly $2bn in foreign exchange reserves during July 1Dec 23, 2011. Depreciation of the exchange rate will increase the rupee cost of foreign debt servicing adding to the budget deficit.

Public finances are thus trapped in a vicious circle that, if not broken soon, will take down the economy with it. The only way to avert a financial crisis is by undertaking substantive fiscal reforms.

On the expenditure side, a large component of the foreign public debt is to the IFIs that cannot be rescheduled. Debt servicing is a contractual obligation and has to be met. However, further accumulation of debt can be slowed down by reducing the budget deficit.

Defence expenditure has fallen in real terms in recent years, and further reduction would require a change in national defence and foreign policy priorities, but some saving can be effected even there through improved efficiency and economy in the use of resources by the defence establishment.

There is also scope for reduction in the civilian no-debt servicing current expenditure which should be tapped starting with austerity and economy in spending at the higher echelons of the government. The PSEs have to be either privatised or completely restructured to operate on commercial basis.

But the major focus should be on raising steadily the taxGDP ratio based on the building up of a broad-based, progressive tax system.

Documentation of the economy, plugging of tax loopholes and improvement in tax collection can go a long way in raising more revenue from existing taxes. The coverage of income tax should be expanded to all incomes and all sectors and its exemption-punctured base should be consolidated. A low-rate mass-consumption tax applicable to all goods and services, other than food items and medicines, must be introduced. The provincial governments can mobilise their own resources by using their taxation authority.

A reorientation of the fiscal system on the above lines would require national consensus and a sincere effort by all stakeholders to agree on a national fiscal reform programme to be implemented by whichever government is in power. The budgetary problems need to be urgently resolved on a non-partisan basis in the same way as is done in the case of national security matters.

The writer is a former governor of the State Bank of Pakistan.