4 Public Finance and Fiscal Policy

4.1 Overview

 

Quite unlike FY02, when a one-time expenditure jump had reversed the fiscal consolidation, FY03 saw a decisive fall in the fiscal deficit to 4.4 percent of GDP. The year therefore marks an important watershed in the government's efforts to cut the fiscal deficit, in that: (1) this is the first time in decades that the annual fiscal deficit target has been met (or exceeded); and also (2) the first time in over 25 years that the fiscal deficit has moved below 5 percent of GDP (see Figure 4.1).

 

Also, it is quite heartening to note that the greater part of the improvement stems from a sharp jump in revenues - consolidated tax receipts in particular depicted a 16.2 percent YoY increase during FY03, considerably higher than the 8.3 percent growth recorded in FY02.

 

While the fiscal adjustment efforts deserve credit, there are a couple of issues that merit further consideration:

 

1) Firstly, a glance at Figure 4.2 shows that over the years the decline in the fiscal deficit was at least partially due to a reduction in developmental expenditures relative to the economy.

 

The fall in FY03 development expenditures to GDP ratio was therefore particularly disappointing. The government appears to have recognized this problem, as evident in the increased FY04 developmental outlays.

 

2) Secondly, a significant contribution to the reduction in the fiscal deficit during FY03 is through a strong growth in defense receipts.

 

Therefore, at face value it would appear that the reduction in the fiscal deficit might not be sustainable in future, as these non-structural receipts would not flow in the future. To the extent that these receipts financed increased defense spending incurred in providing logistic support etc. to international forces in Afghanistan, there is no cause of concern. But, if for some reason they did set up some recurring demands the domestic receipts would have to foot the bill.

Notwithstanding the satisfactory fiscal performance witnessed in FY03, it is important to recall that Pakistan still remains heavily burdened by the debt incurred in the past, and needs to generate sustained primary fiscal surpluses for years to come.¹ Moreover, it is imperative that the requisite fiscal prudence be evident in current rather than developmental spending (which needs to accelerate) if the economy's ability to carry debt is to improve.

 

To this end, therefore, the government should hasten to send a strong signal to investors and businessmen through the passage of the draft Fiscal Responsibility Law. At the same time it must ensure that the resulting fiscal space, in coming years, is used to increase investments in human development and infrastructure.

 

4.2 Fiscal Performance Indicators

 

The broad improvement in the Pakistan fiscal profile during FY03 is mirrored in the changes in most of the key fiscal indicators during FY03.

 

4.2.1 Fiscal Balance Indicators

 

In aggregate, fiscal balance indicators show that the broad recovery in Pakistan's fiscal position since FY98 continued into FY03 as well (see Figure 4.3). While the overall balance remains negative in FY03 (i.e., the budget deficit persisted), a trend improvement is clearly evident. This not only reflects the FY03 reduction in the budget deficit, in absolute terms, but also the increased capacity of the growing economy to service the debt.

 

However, a large amount of contingent liabilities, both implicit and explicit, remains a matter of concern.² In fact, contingent liabilities are estimated to be around Rs 75 billion (1.3 percent of GDP). The revenue balance, which measures the share of revenues captured by non-development expenditures, also improved in FY03. Here too, the deficit fell from 2.1 percent of GDP in FY02 to 1.6 percent of GDP in FY03 (its lowest level during last five years). The reduction in the revenue deficit was primarily achieved on the back of a strong increase in revenues coupled with a decline in debt servicing costs. It is imperative that the revenue should be able to finance non-development expenditure in totality and borrowed funds are used only for productive development expenditures. Tax revenue to GDP ratio needs to be raised to at least eliminate revenue deficit.

 

Contrary to the improvement in overall and revenue balances, the primary balance saw a marginal deterioration during FY03 due to a more pronounced decline in interest payment compared to the decline in the budget deficit. Thus, the primary balance fell from 2.0 percent of GDP in FY02 to 1.6 percent of GDP in FY03.

4.2.2 Revenue Indicators

Pakistan's revenue indicators for FY03 depict some modest improvement over the corresponding FY02 figures. The total-revemie-to-GDP ratio rose to a ten-year high of 17.7 percent in FY03 compared with 17.2 percent in FY02 (see Table 4.1 & Figure 4.4).

 

This improvement, and the related rise in the tax-to-GDP ratio primarily reflects the success of the government's efforts to widen the tax base and improve tax administration, due to which tax growth has outstripped the growth in the economy. However, improvement witnessed in non-tax-revenue to-GDP ratio in FY03, despite a sharp fall in SBP profits was mainly due to a rise in defense receipts.

4.2.3 Expenditure Indicators

 

On an aggregate level, the focus on lowering the fiscal deficit through lower development spending over the years is quite evident in Figure 4.6.

 

Clearly, there has been an across the board improvement in the current expenditure profile by FY01, with a sharp reduction in interest payments, a decline in defense spending and in general administration. In fact, the only segment that saw an increase in spending was general subsidies, which essentially reflected the impact of the deterioration in the financial position of the two power utilities, WAPDA and KESC.

 

The sharp fall in the expenditure share of interest payments and defense is particularly heartening given that these two heads alone had accounted for over two thirds of the government expenditures by FYOO and made the structure of expenditure highly inflexible. So expenditure reduction was achieved in the 1990s at the cost of development expenditure (see Figure 4.6).

 

As government's own investments in infrastructure and human development have an important role in "crowding in" private investments, a sustained reduction in development expenditure is clearly counter­productive.

 

4.3 Fiscal Developments at Federal Level

 

The revised federal budget revenue receipts stood at Rs 701.6 billion, up by 13.3 percent during FY03 over FY02. This figure is also 4.0 percent higher than the budget target for the year. The improvement is contributed by, both tax and non-tax revenues (see Table 4.2). The revised federal expenditures on the revenue account were Rs 709.2 billion in FY03,2.1 percent higher than in the previous year. Thus on revenue account, the Federal Government's own budget was almost in balance in FY03. This represents an acceleration of a trend, which began in FYO1.

 

4.3.1 CBR Tax Performance

 

Helped by a realistic tax target, a broad improvement in the economy and rising imports, as well as various administrative measures, the CBR turned in an exceptional performance during FY03, comfortably exceeding the annual 13.6 percent target growth for the period (see Figure 4.7). The growth represents a significant improvement over the insipid 3 percent increase witnessed in FY02 (see Table 4.3).

 

This the first time in the past 10 years that the annual tax target has been achieved, and it is all the more impressive given that the tax increase target for FY03 was quite robust, in comparison with recent years.

As evident from Table 4.3, indirect taxes accounted for approximately 67 percent of the aggregate net tax receipts, with approximately half being accounted for by sales tax alone. However, in terms of the annual target, indirect taxes fell short of the mark due to under performance by both sales tax and excise duty, but this was almost offset by the above-target performance of direct taxes and customs receipts.

 

Despite the strong FY03 performance, the overall CBR tax to GDP ratio has seen only a small up tick from 11.0 in FY02 to 11.3 percent in FY03. In fact, as seen in Figure 4.8, this ratio has remained in the 10.5 percent and 11.5 percent range since FY98, which is lower than average of 11.9 percent for preceding 6 years. Clearly, while the tax reforms have helped raise (and stabilize) direct tax receipts by about 2.0 percent of GDP, the limited revenue yield from indirect taxes continues to be a drag on the aggregate tax performance.

 Table 4.3: Actual Tax Collections (Net) by CBR

4.3.2 Refunds and Gross Collections

There have been some views that the strong FY03 net tax receipts may, in part, reflect that accrued tax refunds were withheld to inflate the annual (net) tax collections.

One reason behind this concern is that the 10.9 percent growth in gross tax receipts for FY03 is substantially lower than the 13.9 percent growth in the corresponding net receipts. However, on closer scrutiny this is easily explained by fact that in FY02 exceptionally high refunds were disbursed to clear the accumulated arrears. Thus the FY02 net collections were much lower than trend. Following this large adjustment, the FY03 net collections resumed their normal growth path (see Table 4.3).

 

Table 4.4: Gross Collections

 

 

The disbursed refunds declined from Rs 79.3 billion in FY02 to Rs 75.6 billion in FY03, even though exports were higher in the latteryear (which would be expected to translate into higher refunds). In fact, the FY03 refunds are only Rs 3.7 billion lower than that paid in FY02 (despite the absence of any arrears and also the fact that the duty drawback rates were cut down). As a result, refunds as a share of tax collected reached 14.1 percent (see Table 4.4 and Figure 4.9). Thus, the unexpectedly strong payments may be attributed to the robust growth in the exports and the greater transparency in the refund repayment system due to the introduction of the Sales and Automated Refund Repository (STARR) network.

 

However, there is a sharp drop in refund payments in the final months of FY03 (see Figure 4.10). Given that exports usual surge during this period, the decline in refund payments is certainly surprising, particularly given the CBR claim that the time lag between the filing of the refund claim and its payment (after verification) has been sharply curtailed. Interestingly, the fall in refund payments is visible in both July FY02 as well as the corresponding month of FY03, leaving the relative performance in the two years roughly unaffected.

 

Direct Taxes

After under-performing on targets during much of FY03, direct taxes surged strongly during Q4-FY03 to reach Rs 151.3 billion by end-June FY03; 2.2 percent over the target and 6.2 percent over the FY02 collections (see Table 4.3). The above-target growth of the direct taxes appears to be a result of increasing economic activity as well as growth in the taxpayer base,³ and withdrawal of exemptions in the FY02 budget.

 

Withholding taxes (WHT) remained the biggest source of direct tax collections, accounting for approximately 76.4 percent of the aggregate direct taxes in FY03. The breakup of the withholding tax receipts (available only for the July-May period), suggest that three of the five major sub-categories: salaries, contracts and imports (all indicating a rise in economic activity) strongly contributed to the FY03 growth in withholding tax receipts.

 

The fall in the withholding tax receipts from the other two categories, interest income and income from securities probably reflects the steep drop in interest rates in the economy (see Table 4.5).

 

Table 4.6: A Comparison of Voluntary Payments and Collection on Demand (July-May)