Runaway budget deficit

The information on Fiscal Operations by the Federal and Provincial Governments for the first nine months of 2017-18 has been released recently by the Ministry of Finance (MoF). The bottom line is worrying. Already, in nine months, the fiscal deficit has reached 4.3 percent of the GDP, in excess of the annual target of 4.1 percent of the GDP, and higher than the deficit in the corresponding period of 2016-17 of 3.9 percent of the GDP. Usually, the largest quarterly deficit is incurred in the last quarter of the fiscal year. Last year the deficit in the fourth quarter was 1.9 percent of the GDP. Therefore, the budget deficit is well on the way to crossing 6 percent of the GDP for the first time in five years.

Last year, the fiscal deficit was 5.8 percent of the GDP against the target of 3.8 percent of the GDP. Therefore, are we seeing a pattern developing here? First, budgets being presented for approval by the Parliament are increasingly divorced from reality. Second, deficits are now in the range of 6 percent of the GDP. This may well be termed as the new ‘natural deficit’ in public finances.

What are the implications of such persistent large deficits? They will continue, first, to put pressure on the public debt to GDP ratio which was already at 67 percent of the GDP by end 2016-17. This is well above the limit set by the Fiscal Responsibility and Debt Limitation Act of 60 percent of the GDP. An annual deficit in the range of 6 percent of GDP implies that the public debt to GDP ratio will rise by 1 to 1.5 percentage points during each year.

Second, with constraints increasingly to net external borrowing there will be pressure for more borrowing from domestic sources, especially from the banking system. There are two options here. If there is large-scale resort to deficit financing by printing of money by the SBP then this will have downstream inflationary implications. Already, by March 2018, borrowing from the SBP has exceeded Rs 2.1 trillion. Alternatively, commercial banks may be induced to pick up more government paper. This will tend to ‘crowd out’ the private sector and negatively impact on the process of investment and growth in the economy.

Third, a high persistent fiscal deficit will constrain the size of the national PSDP and other development expenditure. Already, in the revised estimates for 2017-18, the MoF has envisaged that the Federal PSDP will be cut by 25 percent by the end of the year and the combined Provincial PSDP by 27 percent. An indication of the magnitude of the problem is given by the fact that if the development spending had been at the level of the original targets for 2017-18 then the fiscal deficit would have approached a mammoth 8 percent of the GDP, an all-time record in absolute size.

The central issue is why the deficit target is likely to be violated by such a large margin this year? There are three reasons. First, the growth in net revenue receipts of the federal government is likely to be very small. Second, the level of current expenditure will be substantially higher than originally budgeted by the MoF. Third, in a pre-election year provincial governments are unlikely to opt for a big cut in development spending and instead generate a sizeable cash surplus to support the efforts at restricting the size of the consolidated fiscal deficit.

Gross revenue receipts of the federal government have shown modest growth of 11 percent in the first months. FBR revenues have performed relatively well with growth of 16 percent, although still somewhat below target. The real debacle is in the performance of non-tax and other tax revenues. The former are down by 3 percent in relation to the level last year. The MOF expects, as per the revised estimates for 2017-18, that they will fall by over 6 percent by the end of the year. Clearly, the cessation of CSF inflows has not helped. Also, there are no major one-time receipts like the proceeds from privatization.

There is need to highlight here that, as opposed to Federal non-taxes, Provincial non-tax receipts have demonstrated truly exceptional growth of 227 percent in the first nine months. ‘Other’ non-tax revenues are reported at a very large Rs 148.9 billion. This is completely unprecedented. The MOF needs to explain what the source of this large revenue is. Otherwise, this will imply that revenues have been bloated and that the actual deficit in the first nine months is even higher at 4.7 percent of the GDP, as compared to the reported deficit of 4.3 percent of the GDP.

The reason Federal other tax revenues have fallen is the 46 percent decline in revenue from the Gas Infrastructure Development Cess (GIDC) and the Gas Development Surcharge combined. The budgeted figure for the year is Rs 153 billion, whereas the actual revenue in the first nine months is only Rs 28 billion. Perhaps the recent passage of the new GIDC Ordinance will help in at least partially restoring revenue from this source. However, this revenue is earmarked and should not accrue to the Federal Consolidated Fund.

Provinces have generated a large cash surplus of Rs 191 billion in the first nine months. This has made a significant contribution to restricting the size of the consolidated fiscal deficit. However, by the middle of May it had come down to Rs 74 billion. There is the likelihood that like last year there will be little surplus by the end of June.

The MoF consciously understated the projected level of current expenditure in the budget documents for 2017-18. It is indeed remarkable that virtually zero growth was anticipated, so as to show a big deficit reduction. Needless to say, this has not happened. In the first nine months total current expenditure of the Federal Government has increased by 9 percent. According to the revised estimates for 2017-18, this growth is expected to go up to 11 percent. Consequently, the actual level is likely to be almost Rs 400 billion above the level projected at the start of the year.

The higher spending is primarily in two heads. Debt servicing is up by 7 percent already in the first nine months. It is expected to exceed the budget estimate for 2017-18 by Rs 162 billion. The level of defense expenditure is higher by 16 percent. However, in this case the original budget estimate had not made a provision for the rise in salaries and pensions in the Budget speech of 2017-18.

What is the outlook for 2018-19? The Achilles heel of the Federal Budget will be the level of revenues. Optimistic projections have been made of 18 percent growth in tax revenues. However, a drop of 9 percent is expected in non-tax revenues, FBR revenues are expected to show growth of almost 13 percent, despite the large income tax concessions granted to individuals and to companies in the Finance Bill of 2018-19.

Other taxes revenue growth is projected at 114 percent, led by the unprecedented growth of 76 percent in the Petroleum Levy and a seven times increase in revenue from GIDC. However, in a period of rising oil prices, the sales tax on POL products will have to be simultaneously brought down if the burden on consumers is to be kept at a tolerable level.

The MoF has shown more realism and projected some growth in current expenditure of 8 percent in 2018-19. Increases anticipated in debt servicing and defence are 6 percent and 10 percent respectively. However, this does not allow for the additional cost of Rs 70 billion due to the salary and pension hike announced in the Budget Speech.

Overall, the incoming Government after the elections will face a formidable task of managing the public finances of the country. The present Government leaves at a time when the underlying deficit is close to 6 percent of the GDP for various structural reasons. As such, major reforms will have to be taken on both the revenue and expenditure fronts in the first few months after takeover. Otherwise, the deficit target of 4.9 percent of the GDP for 2018-19 will remain very elusive and yet again the deficit will go beyond 6 percent of the GDP.