Addressing Pakistan’s Fiscal Deficit and Debt Trap: Challenges, Governance Reforms, and Taxation Solutions
Last year, our budget deficit was estimated to exceed Rs13 trillion, and this year it is projected to be around Rs11 trillion, significantly higher than the government’s initial estimate of Rs6.5 trillion to Rs7 trillion.
The government is supposed to keep the budget deficit between 5% and 6% of GDP and achieve a primary surplus to satisfy the International Monetary Fund’s (IMF) requirements for the 24th IMF programme. However, actual deficits have exceeded 8% to 10% of GDP.
These deficits are financed through loans, increasing the country’s total debt to over Rs81 trillion, nearly 80% of GDP.
Pakistan is trapped in a cycle of debt, avoiding sovereign default by rolling over loans from friendly countries and using new loans to service existing debt. This cycle continues with the aid of IMF bailout programmes.
Ronald Reagan once said, “There are simple answers to our nation’s problems but not easy ones.”
Despite numerous suggestions to cut expenditures and increase revenue, significant progress in reducing large fiscal deficits has been lacking.
The main issue with our governments (both federal and provincial) is their tendency to maintain the status quo and their lack of political will to adopt new and innovative approaches.
As a result, there has been much talk of reforms but no substantial progress.
The second major problem is poor governance at all levels, which undermines good decision-making, the adoption of appropriate macro-economic policies, and their implementation.
Governance quality depends on the people at the top — the cabinet, bureaucracy, and key institutions. As someone said, “Who is more important than how.”
Without changing our mindset and improving governance by appointing competent and honest individuals rather than those loyal and obedient, significant improvement is unlikely.
Regarding reducing the budget deficit, the bigger issue is very high unproductive expenditure due to the continuous expansion of government.
For instance, comparing Pakistan’s economy with Bangladesh, the tax-to-GDP ratio is similar at around 11%. Our major problem is huge expenditure, with government expenditure to GDP ratio over 22% compared to around 15% in Bangladesh, leading to a fiscal deficit of 10%.
We have too many ministries, departments, and government agencies, resulting in wasted resources without productive outcomes.
We need to drastically reduce the size of government, closing at least one-third of ministries, departments, and agencies at both federal and provincial levels.
After the 18th Amendment and the 7th National Finance Commission (NFC) Award in 2010, significant functions and resources were transferred from the federal government to the provinces.
Consequently, at least 15 federal ministries should have been closed, a point recognised by the finance minister in his initial statement after taking office a few months ago.
Similarly, funds transferred to the provinces under the NFC in 2010 have been largely wasted without improving outcomes in education, health, population planning, agriculture, and other areas.
There is a need for effective accountability and outcome-based governance at both federal and provincial levels.
The largest expenditure in the budget (about 80% of revenue) is debt servicing due to the accumulation of substantial government debt and very high interest rates set by the State Bank of Pakistan (SBP) to control inflation.
High interest rates increase the fiscal deficit as they escalate government expenditure because the government is the largest borrower from banks.
According to a recent publication on the banking sector’s financial position, banks’ investments in government securities (government borrowing from the banking system) increased by Rs7.6 trillion last year until April 2024, compared to a total increase in deposits of Rs5 trillion in the same period.
In contrast, banks’ lending to the private sector actually decreased, indicating that virtually all domestic savings mobilised through the banking system are used by the government to finance unproductive expenditures instead of being used by the private sector to produce goods, services, and increase employment.
This explains why Pakistan’s productivity is declining.
The SBP must significantly reduce the policy rate, especially since inflation has dropped steeply in recent months to less than 11% in May 2024 compared to over 36% in May 2023.
While the SBP has announced a 150 basis points cut, I believe there is a need to cut rates by at least 300 basis points immediately, and further decrease them to around 12% in the next few months as inflation is likely to decelerate to 7% to 8%, according to IMF projections next year.
This will massively reduce the government’s interest costs and overall expenditure.
Another major area of leakage is the energy sector and the poor governance of state-owned entities (SOEs), which have created huge circular debt and liabilities.
Major privatisation and reforms are required to reduce energy costs, significantly reduce government subsidies, and improve the governance and management of SOEs.
To improve revenue, the most critical reforms needed are improving the governance of the Federal Board of Revenue (FBR) and provincial revenue departments by inducting more competent people at the top.
An independent policy board for the FBR is needed to oversee policy-making, ensure effective oversight, and hold the FBR accountable.
There is also a serious need to restructure the taxation system by simplifying laws and procedures, reducing tax rates, and making the system fair and equitable.
We have one of the highest tax rates in the world, which incentivises tax evasion and poor enforcement.
By cutting tax rates, making the tax system fair, and promoting business, we can significantly increase tax collections and boost the economy.
Our tax-to-GDP ratio is less than 12%, one of the lowest primarily due to high tax rates and flawed policies that undermine businesses. We can only increase tax collection by promoting business, reducing tax rates, and making the tax system fair.
Continuously increasing tax rates is counterproductive for both the economy and tax collections because you cannot increase tax collection by harming the economy.