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Fiscal Policy and Economic Growth

Fiscal policy is an important tool for modern governments to steer the economy in the right direction. All governments endeavour to align their fiscal policies in a manner that ensures there are sufficient revenues available to the government for fixed, non-developmental expenses and ever-expanding development expenses.

Furthermore, governments seek adequate disposable personal income, generating enough savings for investment by the private sector.

It is a very difficult balance to maintain. Both objectives are independent in character, nevertheless, there are significant inter-dependencies in character.

We are living in a world dominated by economic philosophies developed in the West. Economy is their subject, not ours. Notwithstanding all our desire for independence and a non-aligned approach, we all have to agree that now, in 2017, there is only one universal guideline for developing fiscal policy essentially designed in the West. China is the only exception.

The summary of this universal policy, in the pre-Trump era, is smaller governments, a universal tax rate of around 25-30 percent on corporate income and around the same rate for personal income. A disguised protection for tax havens essentially for bringing wealth from the East to the West.

These policies have resulted in increasing income disparities even in developed countries. This universal fiscal policy, coupled with free trade regimes around the world with minimum tariff restrictions, have resulted in accumulation of huge reserves with multinational corporations (MNCs).

Virtually all governments including that of the United States are running in huge deficits and accumulating insurmountable debts. Once again, China seems to be the only exception. Less than one percent of the global population holds more than 80 percent of the world’s wealth. Have our fiscal policies failed? Or are we in a different phase of economic history?

Pakistan has been a diligent follower of this universal order for two to three decades. A universal generic proposition for fiscal policies do not interact scientifically and mathematically in our country.

There are many reasons for this, however, such as the heavy negative contributions made by the undocumented sector. The Economist magazine of the UK, in a recent article, compared the traffic flow on the Lahore-Islamabad Motorway with that on GT Road.

Policy makers remain vague when questioned and inaccurately maintain that high disposal income in the hands of the traders will be reinvested and accelerate growth. This presumption is flawed for the reason that such savings are again invested in trading activities or investments in real estate and existing shares in stock exchanges. We are in a fiscal trap designed to promote trade

The conclusion from an overall economic perspective is that the motorway is a service for the upper-middle class. This raises many questions about Pakistan’s priorities.

As a result of the consistent failure of generic fiscal policy, there is a view that an increase in tax revenue is essentially a disincentive for economic growth. There is a belief that the money available with the government is essentially wasted, therefore if the same money could be made available to the private sector, it would be utilised efficiently for economic growth.

But this short-term and limited approach is not beneficial for developing countries like Pakistan. In Pakistan, we collect around Rs3,500 billion under various heads of taxes. Out of this, at least Rs1,000 billion is theoretically available for developmental expenses in the hands of ineffective governments.

This huge sum, which amounts to around five percent of the reported GDP of the country, does not contribute equally to the GDP in terms of value.

The proposition is that if the same Rs1,000 billion is left with the organised sector, that effectively pays such taxes, then will that sector contribute more to economic growth by reinvesting it.

There is a universal acceptability of the view that growth momentum will improve as the present structure for the use of this Rs1,000 billion development expense leads to corruption, nepotism and wastage. We may agree with this conclusion, on the first count, but a detailed analysis leads to a different conclusion.

That conclusion is based on socio-political dynamics rather than financial management. Economics is not financial management. The right usage is political economy.

In order to understand the subject we would have to go back to the basic feature identified right at the outset, in effect, the basic philosophy of taxing the right people for generating enough funds for development expense that benefits all of society. This encapsulates the concept of ‘tax is the cost of civilisation’.

Less than one percent of the global population holds more than 80 percent of the world’s wealth. Have our fiscal policies failed? Or are we in a different phase of economic history

In a society like Pakistan there is a dire need for huge developmental expenditure, both on soft and hard sides, whereas in economies like Greece and Spain, the existing infrastructure is sufficient to serve the society for a long time. Unfortunately in traditional economic theories, which we follow very diligently, these two diagonally opposite situations are 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.

On the other hand, any higher tax recovery in a particular society should not make the market non-competitive in this new world.

In Greece, there are sufficient roads and schools in the rural areas, which are necessary for the minimum support for people living in those areas. Greece’s main problem is an aging population and availability of exportable surplus, be it product or people.

In contrast, there is a dire shortage and need for affordable public sector schools, clean drinking water, transport and other basics in our society. Unless we invest in these areas, there cannot be sustainable development in our society and the youth will resort to unproductive and destructive activities.

The role of fiscal policy is to provide sufficient funds for development that has a varied dimension depending on the economic status of that society.

In the last five or six decades, in the post-colonisation era,  the 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. There are many reasons for this.

However, it cannot be ignored that, in the practical sense, it was political independence only and economic tentacles were never severed. GATTS, followed by WTO, consolidated such limitations. Nevertheless we should not be ashamed to admit that, for a very long time, there was little realisation for good governance-based independent economic policies. Whether or not there is any such realisation is a subject of judgment.

A regulatory regime without adequate corrections at home are essentially meaningless. In post-1990s Pakistan, we had an almost free foreign exchange regime, whereas in India there were serious prohibitive restrictions.

In Pakistan, there is effectively no direction to fiscal measures. There is general political rhetoric that the tax-to-GDP ratio should be at least 12.5 percent. Unfortunately even serious and senior people in this field measure the same in terms of money

Nevertheless in both the cases it has now been revealed that citizens of both the countries have accumulated huge sums outside their countries notwithstanding different regimes in force. This shows that both the manners of governance had failed. Nonetheless, lack of good governance is not the right reason for reducing the size of governments and developmental expenses in the societies like ours. That would be a suicidal approach.

A basic principle that should never be ignored, be it the US or Botswana, that the provision of basic education, health, transport and security is the responsibility of the state. If such facilities are outsourced, then essentially we will go back to the tribal system.

Now the ‘Chief’ will not be the person, who is physically strong. He will be a person who has gathered more wealth without any contribution to other fellow beings. That kind of tribal society is not acceptable to humanity and we cannot destroy the results of an over thousand-year journey that brought us to this point.

Fiscal policies for developing countries in this perspective require:

  1. Availability of adequate resources for the governments for development expenditure on education, health, infrastructure and security;
  2. Competitive rate of taxation for corporates and non-corporate sectors to stop outflow of investment to other countries;
  3. Reasonable proportion of collection through direct taxation measures in order to provide equity in allocation of wealth;
  4. Equity in incidence between citizens;
  5. Economic policies to override priorities.

Fiscal policy does not seem to be a reason for impairment of momentum for economic growth in the Pakistan. This essentially means that the fiscal policy of the government has become meaningless as far as growth strategy is concerned.

If appears, shamefully, that very senior and serious people consider taxation as the measure to collect revenue ignoring the fundamental and cardinal principle of equity, equitable distribution of wealth and effective mobilisation 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 means that we collect USD 30 billion from those who earn USD 150 billion.

This is a very high and, in effect, rate of around 25 percent. This rate should be halved. This means that people fulfilling their tax obligations are burdened to the extent that their businesses have become unviable.

Furthermore, this double incidence has eroded the disposal income of the masses as a large portion is collected through indirect taxes. This requires bringing USD 250 billion in the system with a substantial cut in the rates of indirect taxes to increase disposable income for the lower income segment of the society.

There is no doubt regarding the arithmetic given above. However it would remain arithmetic by accountants if our economist and policymakers do not realise the importance and relevance of an effective fiscal policy. States run on a system. Fiscal and monetary policies are tools to steer the state towards common benefits.

If such tools become irrelevant then it is the first sign of the failure of a state and the way towards chaos.

In Pakistan, there is effectively no direction to fiscal measures. There is general political rhetoric that the tax-to-GDP ratio should be at least 12.5 percent. Unfortunately even serious and senior people in this field measure the same in terms of money.

Who bears the incidence of that tax liability and what are the effects of such disproportionate and inequitable collection on the people, should be a concern for the State. This has eroded the trust of the people on the State apparatus and confidence whether or not our decision makers have the capacity and the will to steer the country away from this fiscal mess.

Empirical evidence reveals that no concrete effort has been undertaken on this important subject.

A critical analysis reveals there is a method to this madness. Pakistan, with a population of over 200 million people, where agriculture is now not able to provide employment to 30 percent of the labour force.

But if we examine the economic policies of this country for the last 70 years, including Ayub Khan’s industrialisation, the focus has never been on providing reasonable employment to the workforce in Pakistan. The policies were essentially ‘trade-oriented’. Fiscal policy was the first tool used to provide ‘protection’ to people engaged in such activities.

This is a unique feature in Pakistan. There is a class, comprising around seven to eight percent of population, which is getting richer without any effective taxation whereas 90 percent of the population is provided neither adequate employment nor infrastructure by the government. So there are islands of prosperity within the sea of misery

In the post-1990 era, the pendulum totally shifted towards a ‘Dubai Model Trade Policy’. In the 1990s, we introduced ‘presumptive basis of taxation’ for almost all activities related to trade such as imports, exports, etc. Now all trading activities are virtually exempt from direct taxation.

A sum collected at the import or export stage ranging from one to six percent of the value is deemed to be the tax liability of the person engaged in such activities. This indirect tax, in every practical sense, is transferred to the consumer. The profit or loss for the business falls outside the tax regime.

This innovative and creative tax scheme can only operate in Pakistan as governments are too weak to take on what is literally the traders’ mafia.

Against that, any industrial activity is subject to an effective tax rate of 35 percent with seven percent labour levies. In short, the present fiscal policies of Pakistan are effectively anti-growth in the real sense.

Policy makers remain vague when questioned and inaccurately maintain that high disposal income in the hands of the traders will be reinvested and accelerate growth. This presumption is flawed for the reason that such savings are again invested in trading activities or investments in real estate and existing shares in stock exchanges.

We are in a fiscal trap designed to promote trade.

This is a unique feature in Pakistan. There is a class, comprising around seven to eight percent of population, which is getting richer without any effective taxation whereas 90 percent of the population is provided neither adequate employment nor infrastructure by the government. So there are islands of prosperity within the sea of misery.

We need an economic growth of over 10 percent over the next three 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 of the GDP.

But this 12.5 is not a sum. The beauty lies in the composition. If around six to seven 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.

There cannot be islands of protection and safe havens for importers, real estate developers, exporters, and other protected cliques.