A pro-growth strategy without fiscal stimulus

For Pakistan to be competitive in world economy, its private sector needs to be able to compete on its own strength

The lively public debate around the federal budget has served as a reminder of the importance of getting economic and financial policies right. In the public discourse, there appears to be a broad consensus about what Pakistan has already achieved, particularly in the area of economic stabilisation and the main economic goals going forward are higher growth, employment, exports and investment. But there has been a notable diversity of views on how these goals can be achieved and what this should imply for the budget.

We have heard many voices in the public debate calling for further stimulating economic growth with a more expansionary budget, either by reducing taxes or increasing public investment spending. These calls were clearly made against the backdrop of the significant reduction of the budget deficit in the past two years in the context of Pakistan’s IMF-supported programme. While the impatience to see a faster acceleration of economic growth is understandable, expansionary fiscal policy is not the right tool at this juncture. In fact, there is a strong case for continued reduction of the budget deficit, at a measured pace, so that the debt can be reduced, the private sector supported and higher growth achieved.

Firstly, at over 60 per cent of GDP, public debt in Pakistan remains high. That debt needs to be serviced, and thus nearly 40 per cent of federal spending is devoted to interest payments. While the fiscal situation has already improved significantly, this is still an important vulnerability today. Further, reducing debt and the interest bill will, over time, free significant amounts of resources that can then be directed towards spending priorities such as public investment or health, education and other social spending.

Secondly, a more expansionary budget would, arithmetically, increase budget financing needs. With commercial bank balance sheets already dominated by loans to the public sector, additional borrowing by the government would likely come at the expense of lower access to finance and thus investment by the private sector. But private investment needs to rise significantly to bring about the much-needed impulse for growth and job creation. Finally, current constraints to Pakistan’s growth are mostly of a structural nature. Until structural reforms bear fruit in the form of higher productivity, any fiscal boosts to economic growth are likely to be short-lived and leave an even larger debt burden to deal with in the aftermath. There is thus a need to continue addressing important structural bottlenecks to growth. This will require higher public investment, and continued and sustained efforts in widening the tax net will be needed to generate the necessary resources for this. Addressing bottlenecks to growth will also need to entail continued efforts on important structural reforms to improve the ailing power sector, poorly performing public sector enterprises and the business climate.

Coming to tax exemptions, much of the budget discussion in the media focused on how phasing out of these exemptions will adversely affect various parts of the economy and whether other forms of tax relief would be provided. But what is most important in assessing the utility of tax exemptions is the economic benefit they have brought to Pakistan’s economy. Tax exemptions are costly, and not only for the budget: they provide benefit to some economic groups at the expense of other taxpayers, some of whom also end up being disadvantaged by competition from businesses facing a lower tax burden. Tax exemptions should be regarded as exceptional and temporary support, typically limited to just a few cases in exceptional circumstances. If tax exemptions become entrenched and some businesses depend on continued tax relief for their survival, there are symptoms of misallocation of economic resources and impaired fairness of the tax system.

For Pakistan to be competitive in the world economy, its private sector needs to be able to compete on the strength of its balance sheets and business models and not on preferential tax treatment. A favourable business environment and a friendly investment climate will be critical for this, but special tax breaks also need to come off. By restricting the legal authorisation for the government to issue new exemptions and gradually eliminating old ones, this issue is being addressed.

Pakistan’s broader economic goals can only be achieved in a durable way in conjunction with gradual reductions in the budget deficit and financing needs, as targeted under the 2015-16 budget. The budget reduces untargeted energy subsidies, which disproportionately benefit the wealthier segments of society, and raises tax revenue — mostly on account of continued removal of tax exemptions and stronger disincentives for non-filers of tax returns. At the same time, the budget increases allocations for social assistance and development expenditure. If sustained over time and supported by enabling structural reforms — including widening the tax net, restructuring public enterprises, reforming the energy sector and improving the business climate — a fiscal strategy based on these pillars will make Pakistan less vulnerable while supporting sustainable and inclusive growth and improving the social safety net for the poor.

Published in The Express Tribune, July 18^th, 2015.

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