Fiscal deficit: Government expenditure is not the problem

Why reducing the size of government ministries will not solve the fiscal deficit.

The efforts by the federal and provincial governments to reduce their expenditures, while admirable, will do no appreciable damage to the size of the fiscal deficit. Despite the high prevalence of corruption and inefficiency, the government does not actually spend too much money. Its fiscal deficit stems from not collecting enough taxes from its citizens.

On a theoretical level, the fiscal problem facing Pakistan is easier than that facing the United States and Europe: their governments promised too many services and did not levy enough taxes and so, in order to restore fiscal balance, they need to reduce services as well as raise taxes. In Pakistan, reducing services is neither an option nor will it do anything to solve the problem and hence the only way to restore fiscal balance is by raising taxes. This, of course, is far easier said than done.

Any assessment of the government’s fiscal outlays demonstrates that cutting expenditures appreciably is not really possible. Once that reality is accepted, the only sensible debate is finding the right balance between three approaches: increase existing tax rates, levy new taxes, and crack down on tax evasion. None of these is optional.

Spending and possible cuts

Half of the federal budget is consumed by just two items: defence expenditures and debt servicing. Since debt servicing is impossible to cut without declaring national bankruptcy and defence expenditures would be difficult to cut when the country is in a state of war within its borders, that means that whatever cuts are made they must come from the remaining half of the budget.

Another one-fifth of the budget is development expenditure, which could be cut except that the country faces a devastating blow to its infrastructure and needs to rebuild as fast as possible. About five per cent of the budget is subsidies, the easiest item to justify cutting, except that it would also raise a hue and cry from unthinking populists, both in the media and in the halls of parliament. About another five per cent is spent on education, health and law enforcement – three areas where the government spends far too little. The above calculus shows that only about 20 per cent of the budget can actually be cut. But that 20 per cent includes such institutions as the ministries of agriculture, environment, livestock, etc.

Each of those performs a necessary function, albeit highly inefficiently. Yet even if one were to eliminate that spending entirely, the budget deficit would still only be cut by half!

Simply put, while the government is highly inefficient and corrupt, it does not actually spend too much money. It needs every penny that is allocated to be spent better. But it cannot, and should not, make do with less money.

Levy new taxes or raise old rates?

Once it has been established that the government cannot actually do with less money, there is only one remaining question: how can it raise more? There are three different ways, two of which involve tinkering with the tax system. In terms of actual tax rates, Pakistanis are not really heavily taxed. The highest bracket of those making Rs700,000 a month or more must pay only 20 per cent in federal income taxes. There are, of course, other taxes, but by and large, the actual rates are not particularly high. So, in theory, the government could raise the rates without burdening the people too much.

However, the problem in practice is that nearly all taxes are paid by a very small segment of society that constitutes no more than three per cent of the adult population. Hence raising rates on these folks would be patently unfair. The only way to really raise rates, therefore, is to make sure that more people pay taxes, including those who are currently exempt. That includes services, textile exporters as well as agriculture, though I must warn the most fervent advocates of the agriculture tax that it will yield very little in revenues.

In this regard, the most important reform the government needs to push through is the value added tax (VAT), now called the reformed general sales tax. It will not only help document the economy but will also remove most of the exemptions that currently exist, making the tax system fairer.

Yet even the removal of exemptions and the implementation of VAT will increase the government’s revenue by an amount that will cover only about 40 per cent of the deficit, according to the FBR. In short, none of these measures comes close to solving the problem. There is one course of action that does, and it calls for a massive government crackdown on tax evasion.

Tax evaders: where the real money lies

If there are not massive riots against the government, if every trader and industrialist does not hate every senior government official with the very core of their being, if FBR is not the most reviled acronym in the country, then the government’s efforts against tax evasion have not gone far enough. For that is what it will take: the government must risk – nay, provoke – a massive insurrection against it in order to ensure fiscal balance. According to a 2007 study by the World Bank, tax evasion costs the government in excess of Rs700 billion a year. That figure is undoubtedly higher today. In other words, if the government were to crack down and remove 100 per cent of tax evasion, the federal fiscal deficit would turn into a surplus.

Of course, every country has a certain amount of tax evasion, but if it is minimised to a relatively small level, the government can cover the rest of its deficit through minor increases in tax rates or removal of exemptions.  The problem, in short, is not the government. It is us and our tax evasion.

The writer can be contacted at [e-mail]

Published in The Express Tribune, January 24^th, 2011.