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The views expressed in this paper are those of the author and should not be attributed to the International
Monetary Fund, its Executive Board, or its management.
told that this might be the first time that an IMF resident representative in Pakistan ventures
in such territory.
Under the Poverty Reduction and Growth Facility (PRGF) program of 2001-2004, the IMF
was able to support financially a comprehensive reform program for which the Pakistani
government took full-ownership. With its successful conclusion at end-2004, Pakistan parted
with any remaining IMF conditionality, hopefully as definitely as the Economist magazine
has placed Pakistan on its list of emerging market economies, with the likes of China and
India.
As member of the IMF, Pakistan continues to receive IMF policy advice under the
Macroeconomic policy advice and technical assistance in the IMF’s areas of expertise (fiscal
and money and banking) have become the focus of this new relationship. May I add, in
parenthesis here, that the recent Spring Meetings of the IMF and the World Bank have again
brought to the forefront the “surveillance” responsibilities of the IMF, not only in the case of
emerging markets, but also for the industrial countries, broadening them in fact to include
new initiatives in the area of multilateral surveillance. A hot topic in this regard, as you
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know, has been the growing global current account imbalances, in particular among the
I’ll share with you my views on (1) a growth promoting fiscal policy stance, as represented in
particular by the overall fiscal deficit and its financing; (2) the need to increase growth-
enhancing government spending; and, therefore, (3) the need to significantly increase the tax
Let me state at the outset that Pakistan has come a long way in reducing the size of its
overall fiscal deficit. From an average of about 5.5 percent of GDP in the 1990s, the deficit
steadily declined to less than 3.5 percent of GDP in 2004-05. Excluding spending related to
the earthquake relief and reconstruction, the deficit outcome for 2005-06 is also likely to be
The fiscal performance of recent years has allowed a significant decline in the burden of
the public debt, with a reduction in the overall public debt/ GDP ratio to just above 60
percent of GDP by end 2004/05, from a peak of almost 90 percent of GDP in 2000/01.
Within this aggregate, external debt is about half. A courageous fiscal consolidation process
under the reform program of the government, in addition to other factors contributing to
favorable debt dynamics (such as high GDP growth, low external and domestic interest rates,
Nevertheless, the public debt remains a large burden on the budget and the balance of
payments, with the interest bill alone still absorbing a full 1/3 of tax revenue.
Under the recently passed Fiscal Responsibility Law, the Pakistani government is
expected to further reduce the debt/ GDP ratio by 2.5 percentage points of GDP every
year for some time. Some of the contributing factors mentioned above have become less
favorable. In particular, domestic and external interest rates have increased significantly over
the last 18 months. Adherence to the mandate stipulated in the Fiscal Responsibility Law is
likely, I believe, to require some further reduction in the fiscal deficit over the medium-term.
Exactly by how much would depend on the assumptions one makes regarding various
macroeconomic variables, which I will not get into here. Clearly, earthquake reconstruction
will increase the pressures on the budget for a number of years. And this makes it the more
The general point I would like to make here, is my belief that, whatever the legal
mandate, further fiscal consolidation from where we are now would in fact be beneficial
to Pakistan’s long term growth prospects. Again, the timeframe I have in mind is the
medium term, and I will not dwell on the question of how fast Pakistan should, or indeed can,
Research at the IMF and elsewhere has found that there are strong non-linearities in
the relationship between key fiscal aggregates and GDP growth, suggesting the
existence of threshold levels. Specifically, while further reducing the fiscal deficit below a
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threshold level (in percent of GDP) might be counterproductive from the point of view of
long term growth prospects, moving towards the threshold from a higher actual deficit level
would be beneficial. And the same would be true with regard to a debt-to-GDP threshold.
Estimates of these thresholds vary greatly, but the more careful empirical studies suggest
thresholds of about 2 percent of GDP for the fiscal deficit and 15-20 percent of GDP (or 80-
85 percent of exports) for the (external) debt stock in present value terms.
Taking these estimates as reference points, Pakistan would currently still be on the
“wrong” side of the deficit and debt thresholds. The implication would be that further
A main reason for these findings is the “crowding-out” effect that the domestic financing
of the fiscal deficit exerts on the amount of domestic savings available to support private
sector activity and investment. Had it not been for a (renewed) reliance on external
financing, financing of the 2004-05 budget deficit entirely with domestic resources would
still have absorbed more than 20 percent of private national savings. Although not dramatic,
this amount is significant. Access to external savings cut this absorption to less than half.
In fact, most of the domestic financing of the budget in 2004-05 [and also in 2005-06]
was provided by the State Bank of Pakistan (SBP) through seigniorage, essentially
because the government was not ready to see domestic interest rates rising to levels that
would have made its debt attractive for banks and others to hold. While this alleviated in
the short-run the “crowding-out” of the private sector, it contributed to inflationary pressures,
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and to the widening of the external account deficit which we have been observing. Without
the direct SBP financing of the budget contributing to reserve money growth, the banks
would not have had the liquidity that has allowed credit (and imports) to grow so rapidly, or
at least, other (external) sources of financing would have had to be attracted to satisfy the
Phasing out of the direct recourse of the budget to SBP financing, in my mind, will go a
stability, and therefore promote sustainable growth. I am glad to see that the economic
While financing through external borrowing does not exert a direct crowding-out effect,
the resulting increase in the debt stock (in proportion to GDP) does tend to have an
adverse effect on growth, at least when the external debt exceeds a threshold level. This
is so for various reasons; I’ll mention one here: the servicing of the higher debt stock tends to
increase the share of non-productive expenditures within the budget, at the expense of
Now, as far as how further fiscal consolidation would be achieved to move closer to the
threshold levels for the deficit and debt, recent empirical evidence supports the view
that cuts in transfers (subsidies) and an increase in the revenue effort are best ways to
Before turning to tax revenue mobilization issues, let me now say a few words on the
private sector’ s productivity. From this perspective, it is easy to see why government
spending on physical infrastructure (roads, ports, dams, etc.), as well as on education and
infrastructure, law and order, and security should also be viewed as “productive”. That is, to
the extent that they impact positively on the business environment and investment climate.
Expenditure on subsidies and transfers, on the other hand, are not genuinely productive, even
if they improve the financial position and well- being of beneficiary enterprises and
households. In fact, subsidies tend to distort the allocation of resources, and thus to reduce
Typically, the level of public expenditure is assessed in terms of the amount of money
the expenditure undertaken. This can be misleading. Ultimately, the assessment of the
spending has actually delivered (e.g. graduates well versed in mathematics and sciences, or
not particularly efficient in delivering positive “outcomes”. For instance, red-tape and
even corruption is seen as reducing the effectiveness of any given amount of rupees spent on
general administration. Standards in education and health also appear to be fairly low. Recent
studies found that teachers and medical workers are, on average, absent from work 20-40
percent of the time in developing countries such as India and Indonesia; similar service
expenditures policy must critically focus on improving efficiency and outcomes, not just
increasing the amount of money spent. I believe that the Pakistani government understands
this well, witness for instance the recent creation of a Civil Service Reform Commission. We
On the other hand, the rising trend in subsidy and net lending to the energy sector in
the true costs. Let me just suggest here that well targeted cash subsidies to the poor, as far as
the households are concerned, and regional development grants, as far as the industrial and
commercial enterprises located in remote areas are concerned, would be less distortionary
and potentially more cost effective than general tariff subsidies and/or tariff cross-
Notwithstanding what I have just said about the “quality” or “productivity” dimension,
studies have shown that for some categories of expenditures there is in fact a
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enrollment rates and lower mother/ infant mortality, and the level of spending on
education and health. And in these critical categories of expenditure, Pakistan continues to
lag behind despite recent progress. The 2004-05 PRSP report shows education and health
expenditure at 1.8 and 0.5 percent of GDP, respectively, while on average developing
Let me add in this regard that private spending on education and health does not
appear to be a substitute for government intervention in these areas, since the key is to
make those services available to the entire population. This does not mean that the private
sector cannot have a role in the delivery of these services; for instance, the government could
give vouchers to enable the poor to have access to private education and health institutions.
A relatively poor revenue performance limiting available resources is a main reason why
Even compared with low income countries, the tax revenue effort in Pakistan is more
than 2 percentage point of GDP lower. And, as a low middle income emerging market
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additional tax revenue, just to be among the average performers. This is clearly a daunting
task.
Improving the tax revenue/GDP ratio is key for success in pursuing a growth
promoting fiscal policy in Pakistan. Yet, tax policy itself could have a direct impact on
growth. Any taxation of output generally reduces the rate of return on capital, and thus
distortionary/ disincentive effect of taxation; and, simply put, the way of doing this is to
individual income tax, including the taxation of the non-corporate business sector (less
than 0.5 percent of GDP, compared to 2 percent of GDP in low income countries alone).
2) while Pakistan collects amounts of VAT revenue that are similar to those raised
by low income countries, it collects significantly less than low middle income countries.
3) revenue from excises and import duties are even lower than those raised by low
income countries, owing to the low excises on beverages and petroleum products (including
PDLs) and the relatively low import duty rates plus the extensive system of exemptions.
The relatively poor performance of the income and VAT is not due to particularly low
statutory tax rates. In fact, Pakistan’s statutory corporate profit tax rate of 35 percent is
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about the same as the average statutory tax rate in low income countries, and is a bit higher
than the average statutory corporate profit tax rate in lower middle income countries, as well
as in the East and South Asia region (about 30 percent). And the VAT rate in Pakistan, at 15
percent, is higher than the average rate prevailing in the East and South Asia region (about 11
percent), though just below the average prevailing in the Middle East and Central Asia region
(about 16 percent).
administration and a narrow tax base. It is on these areas that all efforts need to be
focused.
stronger tax enforcement, including through measures to identify non-filers. The CBR
should further mine various data bases for this purpose, and work out an effective exchange
of information between the income tax, VAT, and customs services. There also needs to be a
clearly defined risk-based audit policy based on transparent criteria. The increase in the
number of income tax returns from 1 million to 1.3 million since 2003 as a result of CBR’ s
recent efforts is encouraging in this regard, but this is still a very small number in a country
of this size.
2) tax bases must be broaden. On the income tax side, sectors not meaningfully
covered (agriculture, real estate and financial services and transactions) must be brought into
the tax net once and for all. Capital gains taxation alone, be it on real property or financial
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assets sales, has the potential to add significantly to income tax receipts in Pakistan, in my
further bring retail trade and services within the tax net. The higher threshold VAT
registration introduced in 2004/05 may also need to be reconsidered. The zero-rating of the
VAT for pretty much the whole supply chain of the export oriented sectors has made it even
more urgent to improve the VAT collection at the domestic retail level. Once an effective and
efficient VAT tax credit and refund mechanism can be put in place, I would expect to see the
Above all, there needs to be a “grand bargain” between the private sector and government. In
exchange for greater compliance by the private sector, promoted by a fair and transparent
taxation system, the government would provide quality public services that enhance growth
and welfare. Pakistan is moving in this direction. I look forward to further progress.
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