A risky Pakistan Budget – II


ARTICLE (June 27 2008): FINANCING OF THE BUDGET DEFICIT: An important reason why the country is in the grip of high inflation is that a large proportion of the deficit was financed by borrowing from the State Bank of Pakistan.
In 2007-08 government borrowing from SBP will reach 455 billion, approaching 4.3 per cent of GDP. This type of financing does not crowd out the private sector through preemption of capital and therefore, is considered more conducive to growth, but by adding to the stock of reserve money strongly expands money supply and increases inflationary pressures.

What is the proposed deficit financing strategy in the 2008-09 budget? Initial indications are that the government proposes to adopt a more balanced strategy of financing in 2008-09.

Subject to containment of the deficit to 4.7 percent of the GDP, it has budgeted a decline in borrowings from SBP to Rs 149 billion in 2008-09. Simultaneously the government has announced an enhancement in the return on National Saving Schemes (NSS) of 2 percentage points to increase inflow to almost 2 percent of the GDP, from the current level of Rs 116 billion to Rs 259 billion in 2008-09.

Therefore, if the fiscal deficit is successfully brought down sharply, then borrowing proposed from SBP is within “safe limits” of just over 1 percent of GDP, and this level of deficit financing will not be significantly inflationary in nature.

However, if the budget deficit is substantially higher as projected in the previous section, as per IPP’s estimates, then borrowing from SBP could once again approach 4 percent of GDP, thereby perpetuating and even intensifying inflationary pressures in the economy. Also, a roughly 20 percent increase in the return on NSS is expected to induce more than doubling of inflows, which appears optimistic.

The returns on NSS will have to be reviewed periodically in 2008-09 to determine if further enhancement in returns is necessary or not. We turn next to the two key areas of action in the Budget, first, the proposed big reduction in the subsidy bill and, second, the incremental resource mobilisation effort.

THE REDUCTION IN SUBSIDY BILL As mentioned earlier, the linchpin of government’s fiscal adjustment strategy is the reduction in subsidies. Altogether, the subsidy bill is projected to fall by over Rs 105 billion.

The government’s commitment to reduce subsidies is reflected in the Finance Minister’s budget speech, which states “there is an unbearable burden of subsidies currently carried by the budget.

Much of it is unintended and benefiting such groups who are neither needy nor should they be subsidised. It is estimated that at present more than Rs 400 billion are provided in subsidies of all kinds from the budget. A detailed pruning of subsidies is, therefore, necessary and inevitable to preserve country’s finances.”

Which are the subsidies that the government is proposing to prune and what are the likely implications on prices? The government proposes to reduce subsidy to oil refineries/ oil marketing companies (OMCs) from Rs 175 billion to Rs 140 billion, a decline of 20 percent.

If such a decline was not proposed, the oil subsidy for 2008-09 is projected to be Rs 350 billion. 95 percent of subsidy is on high speed diesel (HSD) and 5 percent on kerosene and light diesel oil (LDO).

Since the budget proposes to bring down the oil subsidy bill to Rs 140 billion, this will require a decrease in subsidy of Rs 210 billion from the projected level, which will tantamount to an increase early in 2008-09 of over Rs 20 per litre in price of HSD (on the assumption that price of kerosene & LDO is unchanged).

This implies an increase of 40 percent in HSD price on the back of 33 per cent increase since March 1, 2008. Overall, therefore, the price may have to raised by almost 86 percent from Rs 37.73 to 70.13 per liter during the calendar year, 2008.

A big increase in the price of HSD will raise transport costs and consequently the prices of food items and construction materials as well as road and railway fares. Obviously, the measure is likely to hit the lower income groups disproportionately, and therefore, will be regressive in incidence.

Reactions to higher fuel prices are currently being witnessed both in developed and developing countries in the form of strikes and street protests.

The big question is whether the government will be able to successfully orchestrate such a big price hike, especially in HSD. It appears more likely that a modest price increase will be implemented gradually in 2008-09. This will make it difficult to achieve the large target of oil subsidy reduction.

The implications of other reductions in subsidy bill are also likely to be inflationary in character. The subsidy on import of wheat is being halved from Rs 40 billion in 2007-08.

This implies a reduction in subsidy of Rs 15 per kg on imported wheat, with the likelihood of an impact on the retail price. Likewise, the proposed reduction in WAPDA and KESC subsidies is 34 per cent and 30 percent respectively. These reductions imply electricity tariff increases in 2008-09 of 25 to 30 percent. The budget also assumes no R&D support to textile sector.

Is this being withdrawn? There is no clear policy statement by the government on the export promotion strategy in the Budget. Altogether the strategy of large subsidy reduction is fraught with political and economic risks. This will be a crucial element in determining the degree of success in attaining the budgetary targets in 2008-09.

7. RESOURCE MOBILIZATION STRATEGYIn the 2008-09 Budget, government proposes to significantly raise its revenues from Rs 1000 billion to Rs 1250 billion, implying an increase of about 25 percent. As compared to this, growth in revenues last year was 18 percent. Clearly the government intends to make a big effort at additional resource mobilisation this year.

The government estimate of enhancement in direct taxes in the coming year is of Rs 111 billion. Our assessment is that this is an ambitious target and may not materialise. As compared to this, targeted revenue increase from sales tax of about Rs 97 billion appears achievable, so do the targets for customs and excise duties.

The Budget proposes a significant additional resource mobilisation effort. The revenue generating potential of the taxation proposals is estimated at about Rs 75 billion. The big revenue proposals are the enhancement in import duty rates on luxury items and the sales tax rate from 15 to 16 percent. Both proposals can potentially raise Rs 25 billion each. Enhancement in excise duty rates on goods and services and in withholding income tax rates together can mop up an additional Rs 25 billion.

Besides mobilising additional revenues, the budget also proposes some tax breaks, especially fiscal incentives to promote agriculture and provide relief to lower income salary earners. These will cost the exchequer Rs 9 billion. Therefore, overall the net additional resource mobilisation effort proposed is Rs 66 billion, close to 0.5 percent of the GDP.

A look at the resource mobilisation strategy proposed in the budget leads to some conclusions. First, 86 per cent of the additional revenue is proposed to be generated from indirect taxes – 33 percent from import duty, 33 percent from sales tax, and 20 percent from excise duty. Second, virtually all the additional revenue mobilisation is from enhancement in tax rates, rather than broadening of tax bases.

Finally, most of the additional revenue in income tax is from enhancement in withholding tax rates. This represents a retreat from promotion of voluntary compliance by taxpayers.

The resource mobilisation strategy adopted by the government, as such has some clear implications. While the government deserves credit for proposing a significant fiscal effort, of about 0.5 percent of GDP, its strategy is not only regressive, but also inflationary. In a period of spiralling inflation and rising inequality, the government may have demonstrated more sensitivity to the potential impact of the taxation proposals and focused more on taxing the undertaxed sectors and tax payers with greater ability-to-pay.

OVERALL ASSESSMENT OF BUDGETARY IMPACTBased on the above, we are in a position to make an initial assessment of the impact of the proposed budget on the key objectives enunciated earlier, as follows:

STABILISATION: The government proposes to bring down the fiscal deficit from 7 percent of the GDP in 2007-08 to 4.7 percent in 2008-09. This represents a sizeable adjustment of over 2 percent of the GDP. But the budgetary outcome is characterised by a high level of risk and uncertainty. Not only are the revenue targets ambitious in the context of an economy which has slowed down perceptibly but the sharp containment required in expenditure, especially on subsidies, will be difficult to achieve politically and otherwise. There is a fairly high probability that the budget deficit could be significantly higher, even approaching 7.5 percent of the GDP. If this happens then the level of aggregate demand will remain high, if not compensated for by an even more draconian monetary policy, and pressure will persist on the external balance of payments of the country, leading to a further drawdown of the foreign exchange reserves and exchange rate depreciation.

INFLATION: If the target of fiscal deficit of 4.7 percent of the GDP is achieved then the degree of ‘monetisation’ of the deficit and the inflationary consequences thereof are limited. But if the deficit rises significantly then there is the likelihood that at the margin there will have to be increased resort once again to borrowings from SBP, thereby putting pressure on monetary aggregates and fuelling inflation further.

Also, the direct consequences of the budget on the price level in the form of the hike in indirect tax rates and withdrawal of subsidies are substantial. The rise in salaries and allowances will contribute to the wage-price spiral. It appears that while inflation historically has been due more to ‘demand-pull’ factors, it will increasingly acquire a ‘cost-push’ character, especially due to higher fuel and energy prices. The government recognises the possibility and has targeted for an even higher rate of inflation in 2008-09 of 12 percent.

GROWTH: It is reassuring that at least in the initial Budget statement the federal and provincial governments are proposing substantially larger PSDPs than in 2007-08. This will not only preserve the growth momentum but provide for sustained growth in the medium run. But if there is failure during 2008-09 in containing current expenditure then there is every likelihood that the PSDPs will be slashed by perhaps as much as 25 to 30 percent.

The strong positive aspect of the budget is the high priority being attached to revival of the growth process in the agricultural sector, especially through cheapening the cost and improving access to inputs. These measures could be instrumental, along with higher prices, in helping the sector achieve a growth rate of 4 percent in 2008-09.

However, the industrial sector and manufactured exports appear to have been largely ignored in the budget, although some incentives have been provided for investments in power to alleviate the existing energy constraint on production. The implicit decision to withdraw the R&D support to the textile sector at this time is problematic in character.

Although export profitability has probably improved significantly due to the sizeable depreciation of the rupee, textile exporters face stiff competition in international markets and are operating with a series of handicaps like relatively high interest rates, power load shedding, import margin requirements, etc.

At a time when Pakistan desperately needs to boost exports to contain the large trade deficit, withdrawal of the R&D support may be an ill-advised move. A better strategy might have been to gradually phase out the withdrawal over a period of, say, three years.

Therefore, success in achieving the manufacturing sector growth targets of over 8 PERCENT IN 2008-09 WILL HINGE ON HOW WELL THE TEXTILE SECTOR PERFORMS.

REDISTRIBUTION: The government must be complimented for presenting a substantial relief package in the budget for the poor. This includes the introduction of a cash transfer of Rs 1000 per month per household through the Benazir Income Support Program, initially to about 3 million households.

In addition, the government proposes to initiate or continue with other programs like the People’s Works Program, National Internship Program and People’s Rozgar Program. However, it is important to ensure that there are enough financial resources and that targeting of the poor through these programs is done efficiently.

But while some redistribution is being attempted on the expenditure side, the taxation system is moving in a regressive direction. Of particular concern is the decision to raise the standard GST rate from 15 percent to 16 percent which will increase the burden of taxation on basic consumer goods like sugar, ghee, tea, etc.

A better option would have been to tax undertaxed sectors, especially rapidly growing services consumed by the well-to-do and corporate entitles. Overall, the budgetary impact on key macroeconomic magnitudes is unclear at this time due to the considerable uncertainty that exists about successful implementation of policies proposed in the budget.

In the best case scenario, we could see significant stabilisation of the economy but in the more plausible scenario the deficit could remain high, inflationary pressures could even intensify in the economy and Pakistan could move to the brink of a financial crisis, especially if political stability remains elusive over the next few months.



Source: Business Recorder, 28/6/2008

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