Fiscal deficit

The fiscal deficit for last year overshot its target of around five per cent of the GDP.

KARACHI: Someone has to finance the government’s expenditures. The fiscal deficit for last year overshot its target of around five per cent of the Gross Domestic Product (GDP). Next year’s target of four per cent seems as realistic as Pakistan’s victory against England in the ongoing cricket series.

The nation braces itself for more accurate estimates of losses sustained during the floods while the government suffers from an absolute lack of ideas and funds.

Unfortunately, the current state of affairs has resulted in an uneasy equilibrium. Contrary to the situation in other economies, a rising fiscal deficit invites the prospect of a stagnating economy.

Traditionally, fiscal deficits are expected to spur economic activity. The government’s expenditure is an individual’s income. As income grows, individuals tend to spend more and economic activity receives a boost.

Indeed, India’s economy has sustained a gross fiscal deficit of close to 10 per cent over the past year and projects a fiscal deficit of around eight per cent for next year according to Reserve Bank of India reports.

Developed countries have sustained fiscal deficits in efforts to jump-start their respective economies following the collapse of international financial markets.

According to the IMF database, fiscal deficits for the both the US and the UK are around 11 per cent of GDP for fiscal 2010.

In most countries, fiscal deficits are inflicted upon the economy to drive the country out of recession.

Unfortunately, Pakistan’s fiscal deficit has not and probably will not serve as a stimulus to economic activity.

The problem may lie in the individual’s expectations of the government.

Since the individual may not believe that the government can finance its deficit through any other means but taxation, the individual may brace for a future, inevitable rise in taxation.

Thus, the consumer may cut back on current spending in order to save money for the upcoming rise in taxation.

In Pakistan’s case, the consumer may expect a rise in future prices due to the implementation of indirect taxes such as the reformed general sales tax or the value added tax and may consequently rein in current spending to save more for the future.

Here, instead of increased economic activity due to a rise in the government’s expenditure, a fiscal deficit may lead to a constriction of economic growth.

Coupled with expectations of rising prices, the economy may head towards a slowdown in growth and a rise in general price levels.

The theory that fiscal deficits and surpluses do not affect consumer spending was first put forward by noted 19th century economist David Ricardo and formalised by Robert J Barro in the 1970s under the Ricardian equivalence theorem.

However, it is unclear if the conditions necessary for the application of this theory exist in Pakistan.

The theory itself has received its fair share of criticism and has limited empirical support.

However, if consumers are reining in spending due to expected tax increases, the solution may lie in the government credibly convincing the individual of its ability to finance or sustain its current fiscal deficit successfully.

With consumers anticipating an imminent increase in indirect taxation, a larger fiscal deficit will lead to a tighter leash on spending.

Unfortunately, someone has to finance the government.

Published in The Express Tribune, August 23^rd, 2010.