Emphasising development

[VetDoctor]

Emphasising development
Dr Ashfaque H Khan

Five years of economic mismanagement and poor governance by the previous regime have not only damaged the economy but also severely weakened key institutions of the country like the State Bank of Pakistan, the Ministry of Finance, the Planning Commission and the Federal Board of Revenue.
Economic growth has slowed to an average of 3.0 percent per annum over the last five years, failing to create enough jobs for new entrants each year and thereby increasing unemployment. Budget deficit averaged over 7 percent of GDP, reaching as high as 8.8 percent last year. The persistence of a large fiscal deficit along with sharp depreciation of the exchange rate caused public debt to rise at an unprecedented pace. Inflation persisted at high double digits for most of the previous regime’s tenure.
In sum, Pakistan is currently experiencing low economic growth, higher budget deficit, rising inflation, and an unprecedented surge in public debt. How can these challenges be addressed? Pakistan has sought, and rightly so, assistance from the IMF to stabilise the economy. The IMF, using conventional macroeconomic policies, has emphasised stabilisation in the narrow sense of reducing the budget deficit, controlling debt and keeping inflation low. From the IMF’s perspective, Pakistan needs to focus on stabilisation first to create the conditions for growth and employment.
The conventional macroeconomic policies focusing on stabilisation first have lost their charm, particularly after the recent experience of several European countries. The sharp fiscal adjustments to stabilise the economy were found to be associated with enormous social cost and human suffering, which postponed economic recovery in the euro zone areas. Such developments have forced global leaders to rethink stabilisation first and growth later. In a recent meeting of the G-20 in Moscow, the global leaders have agreed to take measures to put their economies on the job-rich growth path. In their perspective, budget consolidation is necessary in the medium-term but growth promotion is necessary in the short-term.
World leaders have come to believe that macroeconomic policies should not focus narrowly on reducing budget deficit, debt stabilisation and curbing inflation but should be supportive of growth and employment generation. Such macroeconomic policies do not in any way advocate lax fiscal policy or encourage fiscal indiscipline. Rather they give greater emphasis to domestic resource mobilisation, on the one hand, and to the quality and composition of expenditure, on the other. This new financial ethos is perhaps yet to reach the corridors of the IMF. Consequently, the embattled Pakistani authorities are under IMF pressure to continue relying on conventional macroeconomic policies to remedy this country’s economic woes.
How would I design the fiscal policy to achieve developmental goals of macroeconomic policies? In a developmental context, the fiscal policy serves as both an instrument of stabilisation policy and as an instrument to achieve growth and poverty reduction objectives. Owing to the persistence of large fiscal deficit, rising debt and bouts of inflation which Pakistan experienced for decades, fiscal policy here has largely focused on the goal of stabilisation. Accordingly, the developmental role of fiscal policy for promoting growth and reducing poverty has remained underemphasised.
Although stability is necessary for growth, it is not sufficient. At the aggregate level, budget deficit or public debt may serve as a useful indicator of short-term macroeconomic stability; however, these offer little indication of their long-term effects on economic growth which ultimately determines the sustainability of debt.
For the purpose of development, what matters is where and how the fiscal deficit is being spent. Is it spent on education and health to enhance human capital which would improve productivity and hence growth? Or is it being spent on building and strengthening the country’s physical infrastructure that would contribute to employment generation and promoting growth. If the answer is yes, then public debt, even though it is high and rising in the short term, would be sustainable. As long as fiscal deficit is being used to enhance debt-carrying capacity, higher and rising public debt is not a burden on the economy.
It may also be noted that public debt does not contribute positively to growth contemporaneously; its contribution to growth comes with a lag and in the meantime, debt-to-GDP ratio may rise in the short-term. Furthermore, the design of fiscal policy needs to identify and also incorporate the transmission channels through which fiscal policy influences long-term growth. A fiscal policy that neglects these efforts runs the risk of achieving stability but at the cost of long-term growth and poverty reduction.
Many developing countries including Pakistan used fiscal policy for stabilisation purpose by cutting public spending in growth critical areas to the detriment of development. Historically, public spending has played a significant role in structural transformation in the Asia-Pacific region and elsewhere. It is within this perspective that the question of public investment crowding in or crowding out private sector investment has been widely examined in many developing countries.
Empirical evidence overwhelmingly supports the ‘crowd-in’ effect of public investment on the ground that public investment in infrastructure is lumpy investment with long gestation lags and relatively low profits, which discourages the private sector from investing in those areas. Unless these infrastructural gaps are closed with public investment, the process of growth can run up against a number of infrastructural constraints.
The successful economies of the Asia-Pacific region invested heavily in infrastructure in several key industries such as steel, machine tools and basic chemicals as well as in education and health. All these investments contributed significantly to sustaining the growth momentum, reducing poverty and building human capital.
It is in this context that the composition of public spending, instead of overall fiscal deficits or debts, matters for growth. Public debt problems that affected many developing countries, including India and Pakistan, in the 1980s, 1990s and even today (in the case of Pakistan) arose primarily due to the inability to raise revenue despite improvements in growth rates. Developing countries, which failed to enhance their tax-to-GDP ratios and scrutinise the composition of public spending, have experienced high and rising debt burden, leading to balance of payment difficulties with an inevitable tumble into the IMF programme.
These countries had to go with the conventional prescription of stabilisation first. Such conventional prescription brought nothing but suffering especially in many European countries in recent years. This forced world leaders to advocate striking a balance between stabilisation and the developmental roles of macroeconomic policies.
In sum, though the overall fiscal deficit or public debt matters for short-term macroeconomic stability, what matters most for development purposes is where the deficit is being spent. In this perspective, the composition and quality of expenditure attain the greatest significance. At the same time, the low tax-to-GDP ratio in many developing countries is the biggest constraint in using fiscal policy for development.
Accordingly, measures such as broadening tax bases, making tax structures more progressive, improving the efficiency of tax administration and tightening regulations on tax havens could raise the required funding to support the developmental roles of fiscal policy. Is Pakistan ready to implement the above-stated fiscal policy?
The writer is principal and dean of NUST Business School, Islamabad.
Email: ahkhan @nbs.edu.pk

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