Developmental Role of Fiscal Policy By Dr. Ashfaque H.

Khan Five years of economic mismanagement and poor governance by the previous regime have not only damaged the economy but also severely weakened the key institutions of the country like the State Bank of Pakistan, the Ministry of Finance, the Planning Commission and the Federal Board of Revenue. Economic growth has slowed to an average of 3.0 percent per annum over the last five years, failing to create enough jobs for new entrants each year and thereby increasing unemployment. Fiscal indiscipline has been the norm rather than the exception during the last five years. Budget deficit accordingly averaged over 7.0 percent of GDP and reaching as high as 8.8 percent last year. Persistence of a large fiscal deficit along with sharp depreciation of the exchange rate caused public debt to rise at an unprecedented pace. Inflation persisted at high double digits for majority mostof of the previous regimesthe. tenure of the previous regime. u In sum, Pakistan is currently experiencing low economic growth, higher budget deficit, rising inflation, and an unprecedented surge in public debt. How can these challenges be addressed? Pakistan has sought, and rightly so, the IMF assistance from the IMF to stabilize the economy. The IMF, using the conventional macroeconomic policies, has emphasized stabilization in the narrow sense of reducing the budget deficit, controlling debt and keeping inflation low. From the IMF perspective, Pakistan needs to focus on stabilization first to create the conditions for growth and employment. The conventional macroeconomic policies that focusedfocusing on stabilization first have lost their its charm particularly after the recent experiences of several European countries. The sharp fiscal adjustment to stabilize the economy was were found to be associated with enormous social cost and human sufferings, which not only postponed economic recovery in the Euro zone areas. but Ssome countries even had to battle battling youth unemployment of soaring to 60 percent with all itsattendant social consequences. Ssuch developments have forced the global leaders to re-think stabilization first and growth later. In the a recent meeting of the G-20 in Moscow, the global leaders have agreed to take measures to put their economies on the job-rich growth path. In their perspective, budget consolidation is necessary in the medium-term but growth promotion is absolutely necessary in the short-term. The world leaders have now recognized the importance of growth, job creation, equality, social development and environment. They have come to now believe that macroeconomic policies should not focus narrowly on reducing budget deficit, debt stabilization and curbing inflation but should be supportive of growth and employment generation. Such macroeconomic policies do not in any way advocate lax fiscal policy or encourage fiscal indiscipline. Rather they give greater emphasis to domestic resource mobilization on the one hand and to the quality and composition of expenditure on the other. This is now the new received wisdom to for achievinge robust and job-rich growth whichgrowth, which is inclusive, broad-based and sustainable. Thise new received financial ethoswisdom as advocated by the global leaders has perhaps has not yet reachedyet to reach to the corridors of the IMF. They have theConsequently, the embattled Pakistani authorities to are under IMF pressure to continue relying onpursue the conventional macroeconomic policies to remedy this countrys economic woes. How would I design the fiscal policy to achieve developmental goals of macroeconomic policies? In a developmental context, fiscal policy serves as both an instrument of stabilization policy and as an instrument to achieve growth and poverty reduction objectives. Owing to the persistence of large fiscal deficit, rising debt and bouts of inflation that Pakistan experienced for decades, fiscal policy here has largely focused on the goal of stabilization. Accordingly, the developmental role of fiscal policy forof promoting growth and reducing poverty has remained underemphasized.

Although stability is necessary for growth, it is not sufficient. At the aggregate level, budget deficit or public debt may serve as a useful indicator of short-term macroeconomic stability; however, thesethey offer little indication of their long-term effects on economic growth which ultimately determines the sustainability of debt. For the purpose of development, what matters is where and how the fiscal deficit is being spent. Is it spent on education and health to enhance human capital that would improve productivity and hence growth? Or is it being spent on building and strengthening the countrys physical infrastructure that would contribute to employment generation and promoting growth. If the answer is yes, then public debt, even though it is high and rising in the short term, would be sustainable. As long as fiscal deficit is being used to enhance debt carrying capacity, higher and rising public debt is not a burden onto the economy. It may also be noted that public debt does not contribute positively to growth contemporaneously; its contribution to growth comes with a lag and in the meantime, debt-to-GDP ratio may rise in the short-term. Furthermore, the design of fiscal policy needs to identify and also incorporate the transmission channels through which fiscal policy influences long-term growth. Attention must, therefore, be focused on public spending and taxation to achieve higher economic growth. Fiscal policy that neglects these efforts runs the risk to achieving stability but at the cost of long termlong-term growth and poverty reduction. Many developing countries including Pakistan used fiscal policy for stabilization purpose by cutting public spending in growth critical areas to the detriment of development. Historically, public spending has played a significant role in structural transformation in Asia-Pacific region and elsewhere. It is within this perspective that the question of whether public investment crowds-in or crowds-outcrowding in or crowding out private sector investment has been widely examined in many developing countries. Empirical evidence overwhelmingly supports the crowd-in effect of public investment on the ground that public investment in infrastructure is lumpy investment with long gestation lags and relatively low profits whichprofits, which discourages the private sector to investfrom investing in those areas. Unless these infrastructural gaps are closed with public investment, the process of growth can run up against a number of constraints, such as inadequate roads, poor communication, power shortages, poor shipping and air transportation. In the early phase of structural transformation of successful economies of Asia-Pacific region, the governments invested heavily in infrastructure, in several key industries such as steel, machine tools and basic chemicals as well as in education and health. All these investments contributed significantly to promoting and sustaining growth momentum, reducing poverty and building human capital. It is in this perspective context that the composition of public spending, instead of overall fiscal deficits or debts, matters for growth. Public debt problems that affected many developing countries, including India and Pakistan, in the 1980s, 1990s and even today (in the case of Pakistan) arose were primarily due to the inability to raise revenue despite improvements in growth rates. Developing countries that failed to enhance their tax-toGDP ratios and scrutinize the composition of public spending have experienced high and rising debt burden, leading to balance of payment difficulties and ultimately landingwith an inevitable tumble into the IMF program. These countries had to undergo with the conventional prescription of stabilization first to create the conditions of growth and employment. Such conventional prescription brought nothing but pain and human sufferings especially in many European countries in recent years. This which forced the world leaders to advocate for striking a balance between stabilization and the developmental roles of macroeconomic policies. In sum, though the overall fiscal deficit or public debt matters for short termshort-term macroeconomic stability, but for development purpose, what matters most is where the deficit is being spent. In this perspective, the composition and quality of expenditure attain the greatest significance. At the same time, the low tax-toGDP ratio in many developing countries is the biggest constraint in using fiscal policy for development purpose. Accordingly, measures such as broadening tax bases, making tax structures more progressive, improving the efficiency of tax administration and tightening regulations on tax heavens could raise the required funding to support the developmental roles of fiscal policy.

Is Pakistan ready to implement above stated fiscal policy? Do we have enough professional staff in the ministries of finance, planning, tax administration and the SBP to understand and practisce the new received wisdom? Should the government strengthen its economic team to handle the complex economic challenges facing the country? I leave this to the political leadership of Pakistan to answer these questions. The writer is Principal at NUST Business School (NBS) Islamabad. Email: ahkhan@nbs.edu.pk