Budget Blues

Pakistan’s public finances are in a strait-jacket

On June 12th, Pakistan’s finance minister, Muhammad Aurangzeb, placed the national budget for fiscal year 2024/25 before parliament. Much technical analysis of it has been published since, so I won’t go into the nitty-gritty in this week’s file. Instead, I will highlight four key issues that plague not only this specific budget, but Pakistan’s deteriorating fiscal situation more generally.

Before I get to that, here’s the big picture of the expenditure plan in 2024/25:

• 91.1% of the total budget is earmarked for current expenditure.
• This leaves only 8.9% for development spending, which given the track record, will actually end up being even less.

This split is quite unbelievable for a ‘developing’ country. Compare this with Bangladesh’s 2024/25 budget, a country that used to be the same country as Pakistan:

• 63.6% for current expenditure.
• 36.4% for development spending.

Let’s now turn to the four major (but by no means the only) reasons why Pakistan is being forced to starve itself, so to speak.

The banks own us ???

A combination of one of the world’s lowest tax/GDP ratios (less than 10%) and decades of politically motivated fiscal profligacy mean that the government is well and truly in a (largely domestic) debt trap. In simple terms: Pakistani banks own the state, and the latter has to spend most of its revenue on debt servicing.

• In 2024/25, more than half of total expenditure (51.8%) is planned for debt servicing.
• In the last seven years, the ratio of debt serving to total government expenditure has increased by 1.9 times, or 91%.

As the government is forced to, a) borrow more to meet persistently high budget deficits, and b) spend more each year on servicing the existing debt stock, there is little left for development spending. To make matters worse, there is also little left with banks (whose incentives are by now distorted) to lend to the private sector, which hinders growth, which lowers tax potential, which reinforces a high budget deficit and the need for ever-greater government borrowing, completing a vicious cycle.

Not even doing what we can

Low revenue generation and high spending on debt servicing (as well as on defence, to a lesser extent) leaves precious little to spend on more productive things. But Pakistan’s spending plans in this area are also warped. Let’s only compare spending on subsidies and development to elaborate the point.

As a fraction of total expenditure, since 2021/22, subsides have been higher than development spending by the federal government (PSDP).

Why is this bad? In the Pakistani context, there are several reasons.

• Both in the form of direct payments and tax breaks, subsidies are largely untargeted and fund vested interest groups, promoting a rent-seeking culture.
• A few salient industries include textiles, real estate, car assemblers, and fertilizer. The last one is an especially salient case, since fertilizer manufacturers (instead of farmers) are subsidized – a classic case of an untargeted subsidy. ??
• A large chunk of subsidies each year funds bad government policy and management, i.e. to cover huge losses in the publicly-run power production and distribution network. ??
• Subsidies usually make little economic sense, from a development perspective. For instance, no country ever achieved strong growth by exporting raw commodities. But for some mysterious reason, each year sugar producers in Pakistan are subsidized to export the item – as if they were exporting computer chips instead of sugar!
• Finally, the randomness of politics seeps into fiscal policy too easily, destroying any scope for long-term planning. Consider the year 2021/22 in the figure above. As a share of total expenditure, subsidies jumped from 6% (in 2020/21) to 16.6%, which was 0.4% higher than what was spent on defence that year! Why? Because in early 2022, the Prime Minister at the time, Imran Khan, decided to spend way more on fuel subsidies than budgeted (1,785% more!). He did this to counter an impending no-confidence vote against him in parliament by temporarily averting raising fuel prices, after the outbreak of the Russia-Ukraine war. Although he failed to save his seat, the massive (unplanned) spurt in government spending significantly contributed to higher budget deficits, higher government borrowing, and thus higher inflation in the subsequent two years.

How long can you milk the same cow?

The last two issues I want to discuss are on the revenue side. The first of these is Pakistan’s low tax/GDP ratio, as mentioned above. There are three broad reasons why the tax system is inefficient and regressive:

• A lazy policy of squeezing the salaried class and formal business sector.
• An unwillingness to expand the tax net by documenting the relatively large informal economy.
• An over-reliance on indirect taxation.

The 2024/25 budget contains virtually nothing to address any of these key issues. Quite the opposite, it will further burden those who already pay taxes, without making much of a dent in lowering the fiscal deficit:

• A re-adjustment of income slabs for salaried individuals will increase the income tax paid by most of the middle-class.
• Higher duties on fuel and imports will form the bulk of government revenues, along with sales taxes.
• Lower tax rates for politically powerful interest groups, such as real estate, have been maintained while the feudal class will continue to get away with paying no tax on agricultural income.
• There is no plan to bring retailers and wholesale suppliers, another politically powerful interest group, into the tax net.
• While some previous tax exemptions have been withdrawn, there is no broader plan of unifying tax rates across economic sectors to end politically-motivated distortions.

A lop-sided money-sharing formula ??

The second issue on the revenue side is that since the 18th amendment to the constitution, passed in 2010,?the federal government has to transfer a large portion of its tax revenues to the country’s four provinces. While the devolution of financial resources along with political devolution makes sense, it has to be matched by the provinces starting to generate more of their own resources.

But this has not happened, and while the provinces now have surplus budgets, the federal government’s deficit has widened over the years. Consider that, in 2024/25, the federal government will transfer 41.7% of its total revenue to the provinces. This is not an issue as such, but it becomes one since the many areas that are now supposed to be the exclusive policy domain of the provinces (such as education and health) continue to drain the federal exchequer. So in effect, the federal government has less money than it used to, but its expenditures have not reduced correspondingly. ?????

What to watch out for

• This budget has enough fiscal consolidation measures to win the IMF’s approval, and a new multi-year financial support package will likely be approved in July.
• The 2024/25 budget will achieve relative economic stabilisation, but there will be no meaningful reforms. ????
• The budget is inflationary. This means that while consumer inflation will decelerate this year, it is likely to remain high, in double-digits, for the rest of 2024.
• The forced austerity in the budget will dampen private consumption and investment, in turn keeping GDP growth depressed. My assessment is that it will be around 2.5% in 2024/25.

About the author

Waqas A. Rana is a development economist and founding partner at Shared Pathways, an international development consulting and advisory firm. His core area of interest is the study of economic growth strategies for developing countries. Outside of work, he likes to read literature from around the world, lift weights, run, and hike. He can be reached at: [email protected]