Pakistan’s fiscal woes

Huzaima Bukhari & Dr. Ikramul Haq

“….the debt servicing relief of US$ 2.7 billion (equivalent to 1 percent of GDP) provided to Pakistan under the G-20’s Debt Servicing Suspension Initiative will help create expenditure space for Covid-related spending” —State Bank of Pakistan’s Annual Report 2019-20—The State of Pakistan’s Economy

The coalition federal and provincial governments of Pakistan Tehreek-i- Insaf (PTI) in three provinces (asked to support the Centre by showing surplus) have failed to overcome fiscal deficit and resultantly debt burden and debt servicing are creating a daunting challenge coupled with alarming debt-to-GDP ratio of 88% . The fiscal deficit was 8.1% of GDP in the last fiscal year against the target of 7%.  In the first six months of the current fiscal year, the fiscal deficit reached Rs. 1.4 trillion. The total expenditure of 10% of GDP (Rs. 4.9 trillion) against total revenue collection of 7.4% of GDP [taxes only 5.4%] is more than distressing. There is no will to end wasteful expenses and reduce tax expenditure that at federal level in two years was Rs. 2.1 trillion—see details in Fiscal deficit and tax expenditure, TNS, [Political Economy] The News, September 20, 2020.   

During the first half of the current fiscal year from July to December 2020 out of total tax revenue collected by Federal Board of Revenue (FBR) of Rs. 2.2 trillion,  Rs. 1280 billion) was  transferred to the provinces under 7th National Finance Commission (NFC) Award. The net amount available with Federal Government after including non-tax revenues of Rs. 861.6 billion), was Rs. 1.79 trillion that could not even meet the two major heads, debt servicing (Rs. 1475 billion: domesticRs. 1357 billion andforeign Rs. 118 billion) and defence (Rs. 486.5 billion). All the facts and figures relating to the single most disturbing factor that even Rs. 171 billion were borrowed for defence needs, were highlighted in Challenges on fiscal front, TNS, [Political Economy] The News, February 14, 2021.

SBP in its Annual Report 2019-20—The State of Pakistan’s Economy admits that “the federal PSDP was significantly compromised due to the shortfall of more than Rs 1,500 billion in FBR taxes as compared to the budgeted target, along with urgent, additional expenditures incurred amid the Covid-19 pandemic”. The SBP and Ministry of Finance in their publications are not raising a red flag as they should do about the rising quantum of debt servicing.

It is a fact that the provinces fulfilled partly their commitment in the last fiscal year and during the first half of the fiscal year [see details in Challenges on fiscal front, TNS, [Political Economy] The News, February 14, 2021] to help the Centre in fiscal consolidation by showing “a combined surplus of Rs 224.9 billion during FY20 as per SBP’s Annual Report 2019-20—The State of Pakistan’s Economy . But at the same time, it says that “this surplus was only 53 percent of the target (Rs 423 billion) set for the year”. The expectation of surplus from provinces shows the vulnerability of the federal government on fiscal front, for which no out-of-the-box solution is suggested till today. During the last fiscal year, the total provincial expenditures went up to 10.7% after declining by 3.5% in fiscal year 2018-19.

In its Annual Report 2019-20—The State of Pakistan’s Economy, SBPhas rightly raised the crux of the issue:

However, cross-country examination reveals that high fiscal deficits and higher allocation of bank liquidity for budgetary lending cannot entirely explain such a low private credit to GDP ratio. For instance, India, Sri Lanka, Egypt, Turkey and Malaysia ran persistently high fiscal deficits over the past 15 years, yet their credit growth through all these years was also substantially higher than Pakistan. More importantly, India, Egypt and Brazil even have a higher level of bank claims on government; still, their banks managed to contribute meaningfully to private sector growth, especially when compared to Pakistan

In the way of growth of private sector, among many factors, is complicated and fragmented tax system as well as low collection despite high rates and over 70 withholding tax provision under the federal and provincial tax codes—both direct and indirect taxes. This area has been touched by SBP in ‘Annual Report 2019-20—The State of Pakistan’s Economy stressing that “a more sustainable solution to correct the country’s fiscal vulnerabilities is needed, which requires more than just increasing tax rates. Documentation, reducing informality, and harmonizing the tax regime, are all needed to broaden the tax base and reduce reliance on non-tax revenues”.

The SBP has noted that although many exemptions and concessions in some sectors were “phased out in the FY20 budget, they still prevail in other sectors (such as those included in 5th, 6th and 8th Schedules of Sales Tax Act) and contribute to below-potential revenue collections”.

It is hearting to note that in its report, the SBP has suggested what we have been saying for the last 25 years, “Simplification and harmonization of the tax base as well as rates for agricultural income tax and sales tax on services”. SBP conceded that “these are also unfinished reform agendas”.

However, the SBP has failed to mention that tax reforms, including World Bank-funded six-year-long Tax Administration Reforms Project (TARP), failed to encourage people towards voluntary tax compliance. The number of tax filers has fallen since 2003 (excluding those filing income below taxable limit or paying negligible amount to become part of Active Taxpayers List to avoid higher incidence of withholding taxes).

Recently, the Federal Government obtained loan of US$400 million for Pakistan Raises Revenue (PRR) Project. The total cost of PRR Project is estimated at US $1.6 billion, of which counterpart contribution is $1.2 billion and IDA financing is US$400 million. Following in the footsteps of the Federal Government, the Punjab Government also decided to borrow US$304 million from the World Bank for tax reforms and it was approved by Planning Commission on September 16, 2020. Like earlier programmes, these are also bound to miscarry.

The only viable option for meaningful change is to replace the existing tax system with lower, flat and a predictable tax system that is simple, pragmatic, growth-oriented, and broad-based as suggested in ‘Towards Flat, Low-rate, Broad and Predictable Taxes’ (PRIME Institute, Islamabad, 2016, its revised and enlarged version of December 2020 is available free at: https://primeinstitute.org/towards-flat-low-rate-broad-and-predictable-taxes/). With such a system in place, those who are not into the tax net or who avoid true disclosures would be induced to pay due taxes voluntarily. This should be coupled with transparent and quality spending of taxpayers’ money for welfare of society as a whole and incentivizing growth and economic well-being of every individual.

In the wake of Constitution (Eighteenth Amendment) Act, 2010 [commonly called the “18th Amendment”) the fiscal management, both at federal and provincial levels, needs fresh thinking. The federal government, having all buoyant and broad-based taxes is not tapping the real tax potential even though the country is heavily indebted. On the other hand, provinces, which are almost entirely dependent on the NFC Award, have failed to raise sufficient resources of their own for increasing needs of the ever-growing population. The provinces must participate in national tax policy and collection apparatus as their share in NFC Award is larger than the federal government and Article 156(2) requires federalized, and not centralised economic planning. There is a dire need for a new tax model entailing harmonised sales tax on goods and services and its collection through a single national agency as well as low tax rates on broader base, though distribution would be strictly through Article 160—all participating in retiring debt burden that would ultimately eliminate fiscal deficit and boost growth.

After 18th Amendment, right to levy wealth tax and inheritance tax is with provinces but they are not ready to levy such taxes on the rich and mighty. This is a problem of political will at federal and provincial levels to collect income tax from the rich classes—the meagre collection of agricultural income tax—less than Rs. 3 billion by all provinces and Centre in Islamabad Capital Territory in fiscal year 2019-20—is lamentable. It is imperative that right to levy tax on income, including agricultural income, should be given to the Centre. In return, the Centre should hand over sales tax on goods to the provinces. This would help FBR to collect income tax of Rs. 5 trillion as per actual potential, and provinces by levying sales tax on goods and services would generate sufficient funds for their needs. This is the only way to achieve fiscal stabilisation.

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The writer, lawyers and authors, are visiting faculty at Lahore University of Management Sciences (LUMS).