5

Public Finance and Fiscal Policy

5.1 Overview Deceleration in revenue growth coupled with a strong rise in total expenditures, driven by exceptionally large interest payments and current subsidies, caused serious deterioration in all key fiscal performance indicators during FY08 (see Figure 5.1). In particular, fiscal deficit in FY08 finished at 7.4 percent of GDP, a level not observed since FY99, against budget target of 4.0 percent of GDP for the year and compared to 4.3 percent of GDP witnessed in the preceding year. Also, primary and revenue balances, measured as a percentage of GDP, moved solidly into deficit during FY08, after hovering around zero in the preceding years. A quarter-by-quarter accumulation of budget deficit reveals a particularly large imbalance in Q4-FY08 (see Figure 5.2). However, a substantial part of this oversized addition to fiscal deficit in Q4-FY08 represents the recognition of the liability accrued during all three preceding quarters of FY08 on account of unpaid price differential claims. 1

Figure 5.1: Re venues and Expenditure s Interest payments Current subsidies Revenue growth (rhs) Expenditure growth (rhs) 38 500 400 billion rupees 300 200 100 0 FY05 FY06 FY07 FY08 30 23 15 8 0 percent

Figure 5.2: Contribution to Fiscal De ficit FY06 3.0 2.4 percent of GDP 1.8 1.2 FY07 FY08

Even though tax revenues increased by a 0.6 respectable 18.1 percent during FY08, as compare to the growth recorded in FY07, the 0.0 rise lagged behind 23.1 percent growth Q1 Q2 Q3 Q4 budgeted for the year. This was mainly caused by a substantial shortfall in collection under direct taxes. Also, collection of surcharges on oil and gas witnessed considerable declines, (due to non-adjustment of domestic energy prices with rises in international oil prices) leading to significant deceleration in non-tax receipts. Consequently, total revenues rose to Rs 1,499.4 billion during FY08, up by 15.5 percent compared to 20.6 percent growth realized in FY07. The deceleration in total revenues, combined with a rise of 35.9 percent in total expenditures dictated a large jump in fiscal deficit during FY08 (see Table 5.1). The increase in total expenditure during FY08 was fueled by excessive current spending owing to interest payments, subsidies and defence expenditures. The three heads combined constituted nearly 63 percent of total current expenditures in FY08.

Till March 2008, only Rs 17 billion was disbursed to refineries and OMCs on account of price differential claims. The new government inherited the accumulated liability and has, during April-June 2008, disbursed Rs 148.9 billion to refineries and OMCs. Also, see SBPs Second Quarterly Report for 2007-08 on the State of Pakistans Economy.

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Table 5.1: Summary of Consolidated Public Finance billion rupees Budget FY04 Total revenue Tax revenue Non-tax Receipts Total expenditure Current Development and net lending Unidentified Revenue surplus (+) / deficit (-) Overall deficit Financing through: External resources Internal resources Banking system Non-bank Privatization proceeds 794.1 550.1 244.0 923.6 778.4 181.0 -35.8 15.7 -129.4 129.4 -6.5 124.7 63.7 61 11.2 FY05 900.0 632.6 267.4 1,117.0 943.1 252.5 -78.5 -43 -217.0 217.0 120.4 68.2 60.2 8.1 28.3 FY06 1,076.6 753 323.6 1,401.8 1,121.0 367.1 -86.3 -44.4 -325.2 325.2 148.9 79.1 70.9 8.1 97.3 FY07 1,298.0 889.7 408.3 1,675.5 1,375.3 424.7 -124.5 -77.4 -377.5 377.5 147.2 158.9 102 56.9 71.5 FY08 1,475.9 1,095.5 380.4 1,874.7 1,378.2 496.5 97.7 -398.8 398.8 193.1 130.7 80.9 49.7 75 Actual FY08 1,499.4 1,050.7 448.7 2,276.5 1,857.6 423.4 -4.4 -358.2 -777.2 777.2 151.3 624.2 519.9 104.3 1.7 Budget FY09 1,809.2 1,308.5 500.8 2,391.5 1,875.8 515.7 -66.6 -582.3 582.3 165.2 391.9 149 242.9 25.1

Source: Economic Survey 2007-08 and www.finance.gov.pk

5.2 Fiscal Performance Indicators All the balance indicators of fiscal performance depict a sudden deterioration in FY08 (see Figure 5.3). Fiscal deficit recorded more than double increase during the year, rising from Rs 377.5 billion in FY07 to Rs 777.2 billion in FY08. The outgoing fiscal year saw the fiscal deficit, as a percentage of GDP, rise to 7.4 percent, the highest level of budget deficit since FY99. The growth of deficit reflected a fall in revenue growth as well as an acceleration in total expenditures.

Figure 5.3: Fiscal Pe rformance Indicators Fiscal balance Revenue balance Primary balance 2 0 -2 -4 -6

Revenue balance2 moved firmly into deficit -8 during FY08, reaching 3.4 percent of GDP FY03 FY04 FY05 FY06 FY07 FY08 against a budgeted surplus of 1.0 percent of GDP. This is truly troubling since the Fiscal Responsibility and Debt Limitation (FRDL) Act requires the revenue balance to be at least zero, as a percent of GDP, by FY08 and beyond. Primary balance3, as a share of GDP, recorded a deficit of 2.7 percent in FY08 compared to a deficit of 0.1 percent in FY07. Despite large amount of interest payments, the worsening of primary balance is mainly attributable to high current expenditures. 5.3 Revenues After staging a modest recovery in preceding two years, total revenues, as percent of GDP, showed signs of weakening during FY08 as growth in tax revenues came to a standstill while non-tax receipts
2

Revenue balance measures the saving capacity of the government and is calculated as the difference between total revenues and current expenditures. Primary balance helps assess the sustainability of the fiscal deficit. It highlights the current discretionary budgetary stance by excluding the impact of interest payments (that are caused by past policies).

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percent of GDP

Public Finance and Fiscal Policy

decelerated noticeably (see Figure 5.4). Tax revenues increased by 18.1 percent in Figure 5.4 : Re ve nue Ratios FY08, slightly lower than 18.2 percent T ax revenue Non-tax revenue recorded in FY07, reaching to Rs 1050.7 T otal revenue 15 billion. An unexpectedly poor performance of direct taxes during FY08 more than offset a 12 fine showing by taxes on international trade as well as taxes on goods and services (see 9 Table 5.2). Consequently, total tax-to-GDP ratio saw a marginal fall to 10.0 percent in 6 FY08 from 10.2 percent in FY07. A regional comparison of tax revenues, as percent of 3 GDP, reveals that Pakistan stands far behind most of the regional countries (see Figure 0 5.5). In fact, Pakistans tax to GDP ratio stands below the regions average and is the second lowest in the region, with Bangladesh at the bottom. Thailand and Malaysia, with tax revenues at 16.3 percent of GDP, stand out at the top in the region.
percent of GDP FY03 FY04 FY05 FY06 FY07
Table 5.2: Composition of Tax and Non-Tax Revenues billion rupees YoY change (%) FY05 Tax revenues Direct taxes Taxes on property Taxes on goods and services Taxes on international trade Other taxes Non-tax revenues Profits from PTA/Post Office Dept Interest (PSE and others) Dividends SBP profits Defence Surcharges Petroleum Gas Royalty on oil/gas Discount retained on crude oil Others Total revenue Source: Ministry of Finance 632.6 176.9 9.5 296.3 117.2 32.5 267.4 17.7 34.3 56.8 10.0 52.5 26.8 10.6 16.2 19.5 49.9 900.0 FY06 753.0 215.0 9.1 352.0 138.2 38.7 323.6 11.0 13.8 64.2 13.9 67.5 50.8 24.5 26.3 24.8 77.7 1076.6 FY07 889.7 334.2 3.5 383.3 132.2 36.6 408.3 5.8 19.6 60.0 69.2 79.6 64.5 29.7 34.9 28.5 81.1 1298.0 FY08 1050.7 387.9 4.1 472.0 150.5 36.1 448.7 5.0 40.4 76.0 87.3 47.5 35.2 14.5 20.7 34.9 18.6 103.9 1499.4 FY07 18.2 55.5 -62.1 8.9 -4.4 -5.4 26.2 -47.3 41.7 -6.6 397.8 17.9 27.2 21.1 32.9 15.1 4.3 20.6 FY08 18.1 16.1 18.1 23.2 13.9 -1.3 9.9 -13.2 106.1 26.7 26.2 -40.3 -45.5 -51.2 -40.6 22.4 28.1 15.5

Non-tax revenues, on the other hand, witnessed a more pronounced deceleration during FY08. Specifically, non-tax receipts increased to Rs 488.7 billion in FY08, up by 9.9 percent against 26.2 percent strong rise in FY07. By and large, this dismal performance of non-tax revenues results from non-adjustment of domestic energy prices with historic rises in international oil prices and the consequent fall in surcharge receipts on oil and gas. Revenue receipts on account of petroleum 87

FY08

State Bank of Pakistan Annual Report 2007-2008

development levy (PDL) and development surcharge on gas reached at Rs 35.2 billion during FY08, down by 45.5 percent against a rise of 27.2 percent in FY07.

Figure 5.5: Tax Reve nue 17 14 percent of GDP

Region's average = 13.5 percent

10 5.3.1 FBR Tax Performance After three consecutive years of successfully 7 meeting the budgeted tax revenue target, FBR fell short in FY08. An unexpectedly poor 3 collection of direct taxes constitutes the principal factor in falling short of original tax 0 collection target for FY08. Even with this shortfall, FBR was able to cross the 1 trillion mark in tax revenue collection during FY08. FBR contributed Rs 1007.1 billion in total revenue receipts during FY08 against a revised target of Rs 1000 billion for the year, showing a growth of 18.9 percent YoY, compared to a rise of 18.8 percent in the preceding year (see Table 5.3). However, FBR tax to GDP ratio dropped slightly to 9.6 percent in FY08 from 9.7 percent in FY07. Singapore
Table 5.3: FBR Tax Collection (net) billion rupees FY08 target Original Direct taxes Indirect taxes Sales tax Federal excise duty Customs Total collection Source: Federal Board of Revenue 405.0 620.0 375.0 91.0 154.0 1025.0 Revised 385.0 615.0 375.0 92.0 148.0 1000.0 Net collection FY07 333.7 513.5 309.4 71.8 132.3 847.2 FY08 388.4 618.7 375.8 92.2 150.7 1007.1 Collection as % of target YoY change (%) Original 95.9 99.8 100.2 101.3 97.9 98.3 Revised 100.9 100.6 100.2 100.2 101.8 100.7 FY07 48.3 5.1 5.0 29.9 -4.4 18.8 FY08 16.4 20.5 21.5 28.4 13.9 18.9

5.3.1.1 Direct Taxes With accumulation of Rs 388.4 billion, direct taxes registered a growth of 16.4 percent compared to exceptional growth of 48.3 percent in FY07. Signs of trouble in direct tax collection appeared as early as September 2007 when growth in direct tax receipts collapsed to 6.9 percent. It was very clear after the dramatic fall of direct tax receipts by 32.9 percent in December 2007 that the direct tax target of Rs 405 billion for FY08 will be hard to achieve. A breakup of direct tax collection for FY08 reveals a substantial deceleration in gross income tax receipts despite 283.1 percent increase in collection on demand (see Table 5.4). Voluntary payments dropped by 12.1 percent in FY08 as compared to the incredible 89.5 percent rise in FY07. However, it is important to remember that voluntary payments in FY07 were exceptionally high due to large profits booked by banks, telecommunication, and oil & gas sector. Though complete financial accounts for FY08 are yet not available for most corporate, there are clear indications that the situation has reversed in FY08 for at least banking sector and the PTCL (the largest tax contributor in telecommunication sector). While decline in profits reported by banks contain accounting adjustments for change in forced-sale value regulation, PTCL actually booked a net loss (before tax) of Rs 8.3 billion for Jul-Mar FY08 due to huge expenses incurred on voluntary separation scheme (VSS). In

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Bangladesh

Sri Lanka

Philipines

Indonesia

Malaysia

China

India

Thailand

Taiwan

Pakistan

Public Finance and Fiscal Policy

addition, a procedural change in advance tax regime last year also contributed towards shortfall in
Table 5.4: Direct tax collection billion rupees Percentage change YoY FY06 Gross income tax Collection on demand Voluntary payments Withholding taxes Others Other direct taxes Gross direct taxes Refunds Net direct taxes Source: Federal Board of Revenue, Islamabad 243.6 16.8 87.4 139.2 0.2 15.1 258.7 34.0 224.7 FY07 346.1 11.2 165.6 168.9 0.5 9.7 366.0 32.2 333.7 FY08 395.2 42.9 145.5 206.6 0.2 12.1 414.3 25.8 388.4 FY07 42.1 -33.4 89.5 21.3 96.5 -35.8 41.4 -5.2 48.5 FY08 14.2 283.1 -12.1 22.3 -59.1 25.0 13.2 -19.9 16.4

collection under voluntary compliance. Collection on demand increased significantly to Rs 42.9 billion from Rs 11.2 billion in FY07. Receipts under arrear demand yielded a growth of 61.1 percent mainly due to tax drive initiatives by the Income Tax department against tax defaulters and the disposal of Brought Forward cases. In the backdrop of large declines in voluntary payments during FY08, FBR initiated audit of Figure 5.6: Share in Gross Income Tax select tax payers to ensure compliance with Withholding taxes Voluntary payments tax regulations. The process resulted in Collection on demand substantial creation of current demand. 100% Consequently, receipts under current demand rose by 398 percent to reach at Rs 36.7 billion 80% inFY08.
60%

Withholding tax receipts increased to Rs 206.6 billion during FY08, up by 22.3 percent compared to 21.3 percent rise in FY07. With actual decline in voluntary payments, a strong performance during FY08 led withholding taxes to reclaim its dominant share in gross income tax collection (see Figure 5.6).

40% 20% 0% FY05 FY06 FY07 FY08

A breakup of withholding taxes reveals a strong growth in receipts from contracts during FY08 (see Table 5.5). In fact, contracts now contribute 37 percent in withholding taxes, up from 34.7 percent share in FY07. The increase in the receipts from contracts mainly reflects impact of higher development spending in FY07. Other major heads contributing to withholding tax receipts include: imports, salaries, telephone, exports and bank interest. 5.3.1.2 Indirect tax collection Indirect tax receipts grew by a handsome 20.5 percent in FY08 compared to a meager 5.0 percent in FY07. Encouragingly, this particular performance was driven by strong growth in all the heads. Also, indirect tax receipts nearly covered the original revenue target for FY08, made possible by larger than target collection under sales tax and FED.

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State Bank of Pakistan Annual Report 2007-2008

Sales Tax With actual collection of Rs 375.8 billion, sales tax surpassed its revised target of Rs 375 billion showing a strong growth of 21.5 percent compared to 5.0 percent in FY07.However its share in total taxes surged slightly from 36.5 percent to 37.3 percent in FY08. Within sales tax, domestic-related component stood at Rs 180.4 billion registering a growth of 35.1 percent, compared to 8.2 percent in FY07 Table 5.5: Withholding Tax Collection while import-related sales tax increased by billion rupees 11.1 percent. The strong collection from Growth (%) domestic component was mainly due to zero FY06 FY07 FY08 FY07 FY08 rating of the crude oil at import stag which has Imports 26.9 26.1 27.7 -2.9 6.0 left positive impact on output tax. Of importSalaries 15.6 16.6 22.6 6.5 36.7 related sales tax major revenue came from Dividends 3.2 4.3 6.5 31.4 51.9 POL products (Rs74.3 billion), Edible oil and Bank interest 6.6 9.4 9.7 42.1 2.9 waxes (Rs 15.4 billion) and plastic products Contracts 46.7 58.7 76.5 25.6 30.4 (Rs 14.6 billion). With in the domestic sales Exports 10.0 10.9 11.5 8.9 5.1 tax prime contributors were POL products Cash withdrawal 2.3 5.0 6.2 115.5 23.5 (Rs60.5 billion), services (45.5 billion) and Electricity bills 5.1 5.4 5.9 5.4 9.3 Sugar (Rs 15.4 billion).
Telephone 7.6 15.1 139.2 13.1 19.5 168.9 18.1 21.8 206.6 72.5 28.5 21.3 38.8 12.3 22.3

Custom Duty The revenue collection from custom duty stood at Rs 150.7 billion, registering a growth of 13.9 percent, compared to a decline of 4.4 percent in the preceding year. These increased custom duty receipts were driven primarily by 27 percent rise in the dutiable imports in FY08 which outweighed the impact of a continuing decline in the tariff rate.

Others Gross

Source: Federal Board of Revenue

Table 5.6: Federal Excise Duty Collection billion rupees Major Heads Cigarettes & tobacco Cement FY07 28.4 15.2 FY08 28.5 15.1 YoY change Absolute 0.1 -0.1 Percent 0.4 -0.6

In fact, during FY08 the duty relief on various Services 4.4 12.4 8.0 181.3 commodities has increased the import value of Natural gases 6.2 6.1 -0.2 -2.8 certain commodities like POL products (up Beverages 4.4 4.1 -0.3 -5.8 66.4 percent), edible oil and waxes (up 90.4 Beverages concentrate 2.8 3.0 0.2 6.3 percent), iron and steel scrapes (up 30.4 Sub-total 61.5 69.3 7.8 12.7 percent), contributing to higher custom duty Others 5.6 8.6 2.9 52.5 collection. The volume of POL products Total (domestic) 67.1 77.8 10.7 16.0 imports also increased significantly due to Total (imports) 4.8 14.4 9.5 196.9 price factor. The POL products import were Total (gross) 71.9 92.2 20.3 28.2 budgeted by the government at US$ 65 per Refund & rebates 0.1 0.0 -0.1 -72.3 barrel for the full fiscal year but the Total (net) 71.8 92.2 20.4 28.4 unexpected increase in the POL prices Source: Federal Board of Revenue registered a 58.9 percent rise in custom duty from POL products. The import value of the vehicles declined due to change in the policy stance to restrict the import of used motorcars. Similarly this decline can also be linked by the restriction on the car financing due to the accumulation of bad debt. The break up of custom duty data reveals that considerable revenue came from vehicles (15.8 percent), POL products (14.7 percent), Edible oil and waxes (10.6 percent) and electrical machinery (8.3 percent).

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Federal Excise Duty (FED) The FED receipts totaled Rs 92.2 billion in FY08, 28.4 percent higher than in FY07, boosting its share in total taxes to 9.2 percent (see Table 5.6). In fact FED is the only category wherein tax collection target was revised upwards. The strong increase in FED receipts was mainly due to widening the tax base by inclusion of non-financial services as well as air travel into FED net, and imposition of 1 percent special excise duty on domestic production and imports. The revenue measures taken into federal budget FY09, such as enhancing the excise duty rates on telecommunication services, banking, insurance and franchise services and levying the FED on imports and local supply of cars, will definitely help maintain the upward trend in FED revenues. A break up of FED receipts reveals that major revenue contributions were made by cigarettes and tobacco (Rs 28.5 billion), cement (Rs 15.1 billion), services (Rs 12.4 billion) and natural gas (Rs 6.1 billion). 5.4 Expenditures The consolidated public expenditures rose to Rs 2276.5 billion, showing an increase of 35.9 percent (the biggest rise since FY75) compared with the growth of 19.5 percent in FY07. As a result, total expenditures-to-GDP ratio reached at 21.7 percent, the highest level attained in a decade (see Figure 5.7). Worryingly, the FY08 rise in total spending is almost exclusively driven by extraordinary growth in current expenditures as development spending was constrained to increase by only 4.2 percent. The particular upsurge in current expenditures witnessed during FY08 reflects: (1) interest payments on domestic debt showed no signs of letting up; the ratio of interest payments on domestic debt to GDP went up to 4.1 percent in FY08 from 3.7 percent in FY07; (2) though defence spending as a share of GDP declined by 0.2 percentage points during FY08, actual expenditures increased strongly compared to preceding year; and (3) current subsidies, which accounted for less than 1 percent of GDP in FY07, more than quadrupled to reach at 3.7 percent of GDP in FY08 (see Table 5.7). A large outlay on account of interest payments on domestic debt is chiefly attributed to financing raised against Defense Saving Certificates (DSCs) in late nineties at lucrative rates. Between November 1996 to May 1999 DSCs were sold at maximum rate of 18.04 percent. Those DSCs will continue to mature till May 2009 which means that debt servicing cost in terms of DSCs would be substantial in FY09 as well.
Figure 5.7: Expe nditure Ratios Development and net lending Current expenditures T otal expenditures 22 18 13 9 4 0 FY02 FY03 FY04 FY05 FY06 FY07 FY08

Table 5.7: Composition of Current Expenditure billion rupees FY06 Current expenditures of which Interest payments Domestic Foreign Defence 237.1 195.0 42.1 242.0 368.8 318.9 49.9 249.9 489.7 430.2 59.5 285.1 1121.0 FY07 1375.3 FY08 1857.6

Notwithstanding an impressive 27.5 percent Subsidies 101.2 76.0 395.0 growth in development expenditures during Superannuation allowance 40.1 42.2 56.5 the first three quarters of FY08, the Provincial 332.7 402.2 437.1 government applied swift brakes in Q4-FY08 Source: Economic Survey: 2007-08 and Ministry of Finance to curtail the growth of development spending. In absolute terms, the federal government booked Rs 46.8 billion development spending in Q4-FY08 compared to Rs 101.3 billion 91

percent of GDP

State Bank of Pakistan Annual Report 2007-2008

in the corresponding quarter of FY07. As a result, growth in development outlays dropped to 4.2 percent in FY08 compared to 18.8 percent in FY07. 5.5 Provincial Fiscal Operations The consolidated as well as province wise overall balance improved significantly owing to both a large rise in revenue receipts as well as deceleration in total expenditures. In addition, the four provinces recorded revenue surpluses as well. Total revenue receipts of all provinces stood at Rs 667.2 billion during FY08, of which federal tax assignments contributed Rs 457.4 billion (see Table 5.8). However, the increase in revenue receipts of the provinces emanated largely from a better performance of non-tax revenues and Rs 42.7 billion federal grants for development expenditure.
Table 5.8: Summary of Consolidated Provincial Finance billion rupees FY06 Total revenue Provincial share in federal revenue Provincial taxes Property taxes of which: agriculture tax Excise duties Stamp duties Motor vehicle tax Other Provincial non-tax Interest Profits from hydro electricity Irrigation Others Federal loans and transfers/grants Loans (net) Grants Grant for dev. expenditure Total Expenditure Current expenditure Interest payments to federal government Other current expenditure Development expenditure Overall balance Source: Ministry of Finance 450.3 300.7 36.8 9.1 0.9 2.3 10.2 7.1 8.1 47.6 0.3 6.0 2.5 38.8 65.2 -0.1 65.3 496.6 355.6 22.9 332.7 141.0 -46.3 FY07 483.4 400.1 36.8 3.5 0.9 2.5 10.3 7.7 12.9 45.4 1.4 4.2 2.7 37.1 1.1 -28.4 29.5 602.9 420.3 18.1 402.2 182.6 -119.5 FY08 667.2 457.4 40.8 4.1 0.9 2.9 11.3 7.8 14.6 78.0 10.2 7.8 2.8 57.2 91.0 15.3 33.0 42.7 671.1 457.0 19.9 437.1 214.1 -3.9

Figure 5.8: Provincial Re venue Balance 110 90 70 billion rupees 50 30 10 -10 FY07 FY08 FY07 FY08 FY07 FY08 FY07 FY08 Punjab Sindh NWFP Balochistan

Province wise analysis shows that not only the four provinces experienced revenue surpluses in FY08 they also exhibited substantial improvements in their respective revenue balances over preceding year (see Figure 5.8). While the rise in revenue balance of the three provinces was directly associated 92

Public Finance and Fiscal Policy

with revenue inflow on account of provincial share in federal revenue and provincial non-tax receipts, improvement in Baluchistans revenue balance is attributable mainly to federal grants.

93