Pakistan’s economy has been in a chokehold for the past two years. The problem is that there are too many elephants in the room. The slowly tightening grip began with the reckless borrowing and exchange rate manipulation of the previous Pakistan Muslim League Nawaz (PML-N) government, particularly in their last couple of years in power.
The resulting bulging current account deficit was followed by the ill-placed economic priorities of the incumbent Pakistan Tehreek Insaaf government. On top of all this, a monetary policy in flux has meant general economic hardships causing great strife to businesses and families. However, if one were to try and spot the largest of the elephants, which has caused such deep rooted, lingering economic chaos, it would have to be the current government’s misplaced fiscal policy.
At a time when the government should have been bending over backwards to encourage economic growth and activity, it chose instead to squeeze the economy for all it is worth through excessive taxation on incomes, utilities, and other goods and services.
And while the current government’s policies have been a catalyst for the existing chaos, the fiscal crisis has been a decade in the making. The problem first began when foreign financing that was being used to cover for state expenses, particularly civil and military US aid, was suspended. The state was then faced with the first signs of a fiscal deficit that was rapidly ballooning.
The solution that the PML-N government resorted to was to borrow from other sources. They bridged the gap in the budget through forex-denominated borrowing, which then gave birth to the still persistent current account deficit. When the PTI inherited these crises, as they never fail to remind the public, they found themselves clueless.
The Prime Minister had been banking of the billions of dollars that expat Pakistanis were asked to send on, but surprise surprise, the plan flattered miserably and the government continued to squeeze the economy, putting further strain on revenue collection, and increasing the budget deficit.
It took time for the PTI to wake up to reality, but by the time they did, the only possible course of action was to opt for a short-term solution by engaging in deposit-borrowing from friendly countries like the U.A.E., Saudi Arabia, and China. Despite the mad dash to shore up reserves through friendly countries, Pakistan still ended up having to go to the International Monetary Fund (IMF). But by the time we did, it was already too late.
The economic meltdown could not be avoided, and has led to the epic deterioration of fiscal deficit with the rupee taking its historic plunge. The government’s initial throes to save its sinking ship have now allowed the IMF to be in a very strong negotiating position. Because of how bad things have gotten, the IMF has been able to demand radical reforms on the fiscal side by the government. The IMF insisted that the government limit its prime deficit (the deficit excluding developmental spending), to ensure spending in development heads. To control such a deficit, any government only really has two options: to cut spending or to increase revenue. The PTI opted for the predictable latter alternative.
And here lies the hamartia. Policymakers in Pakistan and economic experts consider the country’s revenue collection to be very poor. The measure often used is tax to GDP, where Pakistan’s tax to GDP stands at 11.6% compared to India, which is north of 16%.
Going by this measure, increasing revenue seemed an obvious choice for the government to make. To this end, the government chose to pursue a two-pronged strategy: increasing tax rates on salaried individuals, on utilities, and on goods and services, and of intimidating individuals and businesses through tax notices and other compliance requirements. The bulk of the tax focus was on indirect taxation and an atmosphere of fear was fostered, causing the business community to retreat into a shell, paralyzing economic activity in the country. We are still reeling from the consequences.
What policymakers fail to realise, however, is that while Pakistan’s tax to GDP is low and has potential of improvement, such radical changes cannot come to fruition overnight. For Pakistan fixing this is doubly difficult. Back in the late 90s, the country had taken the easy but lazy route of indirect taxation. This has meant that not only is the tax establishment unable to collect effectively, any aggressive revenue collection drive is likely to impact the salaried and lower-classes the most, draining their disposable income. This drainage, then leads to a collapse in spending, in turn leading to an economic halt.
To understand this, consider a household that has a monthly income of PKR 40,000 through two earners. With this income, let us say the household spends PKR 10,000 on non-essential groceries and other spend, after paying for rent, utilities and other necessities. Now, as the government increases indirect taxes on utilities, and goods and services; this drains this amount, and thus their spending shrinks, leading to lower sales for businesses, who then have to do cost-cutting, thus throwing the economy in a downward spiral.
If the income is taxable and the tax rate increases, this further squeezes the household and in-turn the economy. With economy squeezing, increasing taxation, in turn further squeezes the revenue collection for the government, pushing fiscal deficit to record heights – something that we are facing right now in the form of a more than PKR 800 billion shortfall in revenue target.
Just when tax-driven spending squeeze was not enough, the government’s fear tactics further pushed investors and businesses to hold spending and hold on to their capital. And so, a year and a half into the PTI government, economic activity is still way below potential. If there is any lesson that the government can learn, it is that statistics without understanding of underlying reality are more harmful than helpful. The obsessive focus on tax to GDP has proven to be a farce. Tax to GDP should be improved but turns out the measure is an effect not a cause. And unless the underlying causes are not addressed, without hampering economic activity, increased taxation will fail to control fiscal deficit, as is evident.
The government needs to wake up to the fact that in the short-to-middle term, the only solution out of this crisis is to reduce the size of government and cut spending on non-developmental spending to control the fiscal deficit. Unless the government focuses on it, the economic meltdown will continue, and any aid or foreign debt driven solutions will make the collapse even worse. Does the government understand this? And does it have the resolve to fix this? Because these questions will determine the economic future of Pakistan.