Fiscal policy and economic growth

Fiscal policy is an important tool of modern governments to steer economy in right direction. All governments, specially in emerging markets, endeavour to align their fiscal policies in the manner that (i) there are sufficient revenues available for fixed non-developmental expenses and ever expanding development expenses and (ii) that there is enough ‘disposable’ personal income with individuals and corporates generating enough savings/funds for investment by the private sector. These are essentially two conflicting objectives. Striking a balance is a difficult challenge. Maintaining that balance is the beauty of policy governance. Both objectives are independent in character; nevertheless there are intricate underlying inter-dependencies. This is the subject of political economy and the subject matter of discussion of this paper. In the following paragraphs this subject will be discussed with a particular reference to Pakistan’s economy.

We are living in a world that is dominated by economic philosophies developed in the post-Second World War scenario. In essence, economic policy is the subject of the West. Our role is executor or implementer only. Notwithstanding all the rhetoric for independence and non-aligned approach, we all have to agree that, now in 2017, there is only one universal guideline for developing fiscal policy essentially designed to favour economies in the west. China, however, is the sole exception. A summary of this universal policy, in the ‘pre’-Trump Era, is (a) smaller governments, (b) a universal tax rate of around 25-30 percent on corporate income and personal income, (c) lower tariff to promote global trade, a disguised protection for ‘tax havens’ essentially for shifting ‘wealth’ from east to west. These policies have resulted in increasing ‘income disparities’ between states and people within the state, even in developed countries. This universal fiscal policy coupled with ‘free trade’ regime around the world with minimum tariff restrictions has resulted in accumulation of huge reserves with Multinational Corporations (MNCs) whereas almost all the governments including the USA’s are running in huge deficits and accumulation of insurmountable debts. Herein also China is an exception. Less than one percent of the global population holds more than 80 percent of the wealth of the world. This raises the fundamental question, whether or not fiscal policies in post-Second World War era have failed to deliver. Pakistan is a diligent follower of these universal dictations, at least for the last two to three decades. A discussion in the following paragraphs reveals that universal generic propositions in fiscal policies with reference to its relationship with growth do not interact scientifically and mathematically in our country. There are many reasons for the same, however, negative attributes arise due to the prevalence of a high proportion for undocumented/unorganized sector of economy. ‘The Economist’ of London in a very recent article has compared the traffic flow at the Lahore-Islamabad Motorways with the GT Road. The conclusion from overall economic viewpoint is that it is service for upper middle class only. This raises many questions for economic policy environment in Pakistan.

As a result of the constant failure of these generic fiscal policies, there is a view that increase in ‘tax revenue’ is essentially a disincentive for economic growth. There is a belief that the sum available with the government which should have been used for infrastructure and human development, is essentially ‘wasted’, therefore if the same is available to the private sector, the same will contribute better for economic growth. There are reasons and bases for the validity of this view, however, this short term limited approach is not desired for the developing countries like Pakistan. It is highly unfortunate that reasonably well informed circles promote this idea for various reasons. In the following paragraph it will be endeavored that these perceptions are diluted to a possible extent.

In Pakistan, we collect around Rs 3,500 billion rupees under various heads of taxes. Out of the same, at least Rs 1000 billion are theoretically available for ‘development’ expenses in the hands of ‘ineffective governments’. It is generally believed, and rightly so, that this sum which amounts to around 5 percent of the reported GDP of the country does not contribute ‘equally’ in real terms if the same is left with the persons who by force are required to pay for the same. The resultant alternative proposition is that if the same Rs 1000 billion is left with the organized sector that effectively pays such taxes, then whether or not that sector will contribute more to the economic growth by reinvesting the same. In other words government jobs is done by the private sector. There is general acceptability of the view that growth momentum will improve as the present structure for the use of this Rs 1000 billion development expense leads to corruption, nepotism and wastage. We may agree with this ‘financial’ conclusion, on the first count, however, a detailed analysis as made in the following paragraphs leads to a different conclusion. That conclusion is based on socio-political dynamics being the ultimate objective of any state rather than financial management. Economics is not financial management. The right term is ‘political economy’. Social equity is not similar of generic ‘socialism’ as well being of society cannot be left to desires of a few individuals.

In order to understand the subject we would have to go back to the basic feature identified in the first paragraph. This takes us back to basic philosophy of taxing the right people for generating enough funds for development expense for the benefits of society as a whole. This is what is described as ‘tax is the cost of civilization’.

The relationship and the need for developmental expenditure and fiscal policies measures to boost the same have attained a different direction for the two sets of societies being the ‘developed world'(‘developed in this sense does not necessarily mean rich) and emerging countries like Pakistan. In one society, like Pakistan, there is a dire and irresistible need for substantial developmental expenditure, both on soft and hard sides. Whereas, for example, in economies like Greece and Spain, existing infrastructure, such as roads, hospitals and schools are sufficient to serve society for a very long time. Unfortunately in traditional economic theories, which we follow very diligently, these two diagonally opposite situations, are handled through a common generic theory. The mantra of ‘lesser role of government’ which essentially means ‘tax cuts’, is a measure for a society that has achieved a particular level of development, not for all. However, on the other hand, any higher tax recovery in a particular society should not make the market non-competitive in this new world. This is the problem which Trump will face against China as effective tax rate in China is substantially lower than USA. The sentences, as referred above, do not mean increase in tax rates. It represent equal tax for all segments of society at the same rate.

The aforesaid subject can be further explained by another example. In Greece, even in rural areas there are sufficient roads and schools which are necessary to provide minimum social support to rural people. Their problem is aging population with limited earning capability and availability of exportable surplus, be it product or people. As against that, in our society, there is a dire shortage and need for affordable public sector schools, clean drinking water, transport etc. If such inputs are available the ‘raw material’ – young human resource – will be able to generate enough disposable surplus income. Unless, such expenses are incurred there cannot be sustainable development in society and the youth living in such societies may resort to unproductive and destructive activities. For spending, we need tax revenues. So our objectives and situation is different. In summary, role of fiscal policy to provide sufficient funds for ‘development’ has varied dimensions depending on the economic status of that particular society. There is no generic policy. In other words, the needs of a youngster are different from a person passing through old age. The ‘house’ is to be accordingly designed. No readymade model is available.

In the last five or six decades, in post colonization era, economic and political governance of the countries that attained independence after the Second World War could not, except with some exceptions like Singapore, meet the expectations of the people who gained a ‘perceptional’ independence after 1945. There are many reasons for the same. However, it cannot be ignored that, in practical sense, it was a political independence only. ‘Economic tentacles’ were never severed. The GATTS, followed by the WTO consolidated such tentacles. Nevertheless we should have no hesitation in admitting that, for a very long time, there was very little realization for ‘good governance’ based on independent economic policies. We were fighting ideological wars for others. Whether or not there is any such realization ‘now’ is a subject of judgement. Nevertheless, Narendra Modi in India and Nawaz Sharif in Pakistan are signals for the desire of economic revival with a new model. In Pakistan, in the field of fiscal policies the results are not impressive.

Two examples, identified in this paragraph may be helpful in appreciating the subject that ‘regulatory regime’ without adequate corrections are essentially meaningless. In Pakistan, in the post-1990s we had an almost free foreign exchange regime, whereas in India there were serious prohibitive restrictions. Nevertheless, in both the cases it has now been revealed that citizens of both the countries have accumulated huge offshore assets notwithstanding two totally different regimes in force. This shows that both the rules of governance have not been able to achieve the desired results. The conclusion that can be drawn here is that lack of ‘good governance’ does not mean reducing the size of governments and the developmental expenses in the societies like us. This is a suicidal approach. This one basic principle can never be ignored anywhere be it society in the US or Botswana. The uncompromising principle is that the provision of basic education, health, transport and security is the responsibility of the state and will always remain so. States are there only to provide the same. If such facilities are outsourced, in any sense, then we will go back to the tribal system. Now the ‘Chief’ will not be the person, who is physically strong. But he will be a person who has gathered more wealth without any contribution to other fellow beings. This re-emergence of tribal society is not acceptable to humanity and we cannot destroy the results of our over thousand years’ journey of civilized society that brought us to this point of civilization.

Fiscal policies for developing countries in this perspective require: 

(i) Availability of adequate resources for the governments for developmental expenditure on education, health, infrastructure and security;

(ii) Competitive rate of taxation for corporates and non-corporate sectors to stop outflow of investment to other countries;

(iii) Reasonable proportion of collection through direct taxation measures in order to provide equity in allocation of wealth;

(iv) Equity in incidence between citizens; and

(v) Economic policies to override all other considerations.

‘Fiscal Policy’, for reasons identified below, has attained a totally different dimension in Pakistan. This essentially means that fiscal policy of the government has become ‘meaningless’ so far as growth strategy is concerned. It appears that very senior and serious people, consider taxation as the measure to collect revenue ‘only’ ignoring the fundamental and cardinal principle of (i) equity, (ii) equitable distribution of wealth and (iii) effective mobilization of saving for growth. In quantitative terms the GDP of USD 300 billion is unreported by at least USD 100 billion and effective GDP for tax purposes does not exceed USD 150 billion. This can be illustrated as:

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a) Real GDP                    US$     400

b) Reported GDP           US$    300

c) Taxed GDP                  US$     150

d) Tax to GDP on (c)       US$  30

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This means that we collect USD 30 billion from those who earn USD 150 billion. This is very high effective rate of around 20 percent. This rate should be halved. This means that people fulfilling their tax obligations are burdened to the extent that there businesses have become unviable. Furthermore, this double incidence has eroded the disposable income of the masses as a large portion is collected through indirect taxes. This requires bringing USD 250 billion (400 – 150 = 250) in the system with substantial cut in the rates for indirect taxes to increase disposable income for the lower income segment of the society. The arithmetic referred above is totally verifiable. However, it would remain an arithmetic by an accountant if our economists and policy makers do not realize the importance of having a fiscal policy that is ‘relevant’. States run on a system. Fiscal and monetary policies are tools to steer the state towards common benefits. If such tools become ‘irrelevant’ like ours, then it is the first sign of failure of a state and way towards chaos.

In Pakistan, fiscal policy is essentially a revenue collection measure only. There is a general political rhetoric that tax to GDP ratio should be at least 12.5 percent. Unfortunately even the serious and senior people in this field measure the same in terms of ‘money’ say Rs 3,500 billion etc. etc. Who bears the incidence of that tax liability and what the effects of such disproportionate and inequitable collection is not the subject of the society. This reflects complete departure from the basic principle of political economy and public finance. This has eroded the trust of the people on state machinery and the necessary confidence to the effect whether or not our decision makers have the capacity and the will to steer the country away from this fiscal mess. Empirical evidences reveal that no concrete effort has been undertaken on this important subject in the last 20 to 30 years. In fact we are working in reverse order.

A critical analysis of this situation reveal that there is sense in this madness. Pakistan, with a population of over 200 million people, where agriculture is now not able to sustain over 30 percent of labour force, requires an ‘industrial oriented economy’. Nevertheless, if we examine the economic policies of this country for the last 70 years, including Ayub Khan’s industrialization, the policy focus has never been in providing reasonable empowerment employment to workforce in Pakistan. In short, the policies were essentially ‘trade-oriented’. Fiscal policy is the foremost tool used to provide ‘protection’ to people engaged in such activities. In the post-1990 period, the pendulum totally tilted towards a ‘Trade-Oriented Policy’. It can be asked why and how such a categorical remark can be made. The answer is simple and short. In the 1990s we introduced ‘Presumptive Basis of Taxation’ for almost all the activities related to trade such as imports, exports, etc. Now all trading activities are virtually exempt from direct taxation.

A sum collected at import or export stage ranging from 1 to 6 percent of the value of imported or exported product is deemed to be the tax liability of the person engaged in such activities. This indirect tax, in every practical sense, is borne by the consumer. The income or loss from such transactions falls outside the tax regime. Only taxable activity subject to normal tax regime is now the ‘industrial production’ or documented service sector like banks etc. In such a situation, there are high incidences of internal transfer pricing in favour of trade of goods so produced to reduce direct taxation on industrial activity. Where such possibilities are not possible, manufacturing activities were disbanded as being non-competitive.

This innovative and creative tax scheme can only operate in countries like Pakistan as ‘governments’ are too weak to take on traders’ mafia. This includes all government – be it political system or military regime. As against that any industrial activity is subject to effective tax rate of 35 percent with a 7 percent labor levy. In short, the present fiscal policies of Pakistan are effectively anti-growth in real sense. When we discuss this matter with the policymakers the readymade answer is vague and based on a totally wrong concept in that high disposable income in the hands of the traders will be reinvested that will accelerate growth.

This presumption is flawed for the reason that such savings are again invested in trading activities or investments in real estates, existing shares in stock exchanges or transferred outside for assets outside Pakistan. We are in a ‘fiscal trap’ designed to promote ‘trade’. This is a unique feature in Pakistan. There is a class consisting of around 7 to 8 percent of population which is getting richer without any effective taxation whereas 90 percent of population is neither provided adequate employment nor infrastructure by the governments. So there are islands of prosperity within the sea of misery.

We need an economic growth of over 10 percent for over 3 decades to bring the country out of the current mess. For this we require an effective fiscal policy that is able to generate revenues equal to 12.5 percent of GDP or US$ 400 billion currently being

US$ 150 billion. Nevertheless, this 12.5 percent is not a sum. The beauty lies in the composition. If around 6 to 7 percent of the same is not generated from direct taxes then all other objectives will fail. Secondly, such 12.5 percent should be collected from every person having income over and above a certain limit.

Discussion in the aforesaid paragraph reveal the following: 

(i) In usual circumstances, a tight fiscal policy is anti-growth. However, in Pakistan, pendulum moves in a reverse order. A tight fiscal policy provides incentive for ‘selective/non-inclusive growth’. This non-inclusive growth leads to growth in undocumented, untaxed and un-organized sector. Resultantly, there is concentration of wealth in a few hands, non-availability of development resources for the government and deceleration of growth in the real sense;

(ii) The second feature is divergent results for different sectors of economy. Any correction in fiscal regime and tightening of fiscal structure disincentivise the organized sector in multiple sense. Firstly, it starts the tax or tariff burden and secondly, it provides the competitive business advantage for a very large size of economy that falls outside the orbit of any form of fiscal regime;

(iii) Presumptive tax regime, perpetual amnesty scheme and non-availability of asset database are few primary features of tax regime that has created these two islands within our economy;

(iv) The subject of fiscal policy and the subject of economic growth require tailor-made within the context of Pakistan’s economy.

The following are solutions and corrections: 

(i) All-inclusive growth, being a necessary need of our economy, requires re-establishment of relationship between effective fiscal policy and growth;

(ii) Documentation of asset and recording of assets and transaction should remain the foremost objective prior to development of any framework for fiscal regime. A gap in documentation, if it exceeds 5 to 10 percent of economy essentially results the situation being faced by us;

(iii) Once the certain level of documentation is achieved, the fiscal policies should focus on:

a) Achieving a Tax to GDP ratio of around 15 percent by 2025;

b) All sources of income to be taxed at the similar maximum rate of 20 to 25 percent on net income basis. Complete and uncompromising removal of all forms of presumptive taxation.

c) Effective rate of tax for all kinds of organization be it an individual or a firm or a company should be same. No concept of dual taxation on distribution in the form of dividend;

d) Exemption regime for certain sector to be replaced by zero rating regime;

e) Similar rate of sales tax on goods and services under the Federal and Provincial Government at a level of 7.5 to 10 percent.

In a summary our fiscal policy regime should focus on taxing the all at lower rate instead of a few at an exorbitant rate. This policy requires a larger government sector with reasonable resources to provide education, health, infrastructure and internal security to the people, not leaving such essential attributes of a civilized society to individual and relying on philanthropy for betterment of common. The biggest philanthropy in a civilized society is paying due taxes and ensuring their equitable utilization.