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Fiscal Adjustment in Pakistan: Some Simulation Results

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1993
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PAKISTAN HAS experienced large fiscal deficits over the past two decades. The consolidated fiscal deficit of the federal and provincial governments averaged about 6.5 percent of GNP during the 1980s and fell only slightly in 1990-91.1 A comparison of Pakistan’s fiscal performance with those of other developing countries is provided in Table 1. The table shows that, as a percentage of GDP, Pakistan’s fiscal deficit has been higher than the average among developing countries.

Table 1.Macroeconomic Performance and Fiscal Policy Across Various Countries
Fiscal deficit/GDPInflation ratesGrowthCurrent account/GDP
Average,1983-8919901991Average,1983-8919901991Average,1983-8919901991Average,1983-8919901991
Developing countries-5.26-3.09-5.2239.4991.0358.731.70-0.38-4.91-0.44-0.45-1.87
Africa-6.29-2.84-0.6417.8915.3618.44-0.96-2.08-1.20-2.20-0.64-1.90
Asia-3.14-2.82-2.329.037.968.715.633.784.100.02-0.10-0.65
Europe-3.63-4.45-11.0512.0735.81109.862.46-2.99-1.650.51-1.42-1.63
Western hemisphere-5.070.06-0.84203.65769.77154.29-0.42-2.120.79-0.87-0.59-1.43
Net debtor countries-5.01-3.25-4.8244.29104.2565.712.27-1.06-6.19-0.68-0.92-1.43
Small low-income countries-6.88-6.32-5.4933.7031.4729.180.680.400.48-4.62-5.15-4.70
Heavily indebted countries-4.86-0.67-1.30180.58628.81135.81-0.44-2.44-1.38-0.76-0.30-1.60
Pakistan-7.60-6.06-7.065.379.3512.073.012.852.43-2.68-4.06-4.06
Source:IMF, International Finance Statistics (various years).
Source:IMF, International Finance Statistics (various years).

The fiscal deficit has remained high in Pakistan because of the government’s inability to mobilize additional resources or to cut current expenditures. Weaknesses in the tax system have led to an inelastic tax structure and a heavy reliance on international trade taxes for revenues. Moreover, with defense expenditures constituting about 25 percent of expenditures, interest payments about 15 percent, and administration (including social services) another 15 percent, the structure of expenditures has not been amenable to large cuts.

Despite its poor fiscal performance, Pakistan’s macroeconomic performance compares favorably with those of most other developing countries. For example, as shown in Table 1, Pakistan’s annual average growth rate is not only higher than that for all other developing countries but also higher than the average for Asian developing countries. This does not imply that high fiscal deficits have had no adverse effects on Pakistan— macroeconomic performance may have been better had the deficits been smaller. To study the possible macroeconomic effects of future deficit reduction, we conduct several simulation experiments comparing the effects of alternative methods of deficit reduction. We use an empirical macroeconomic model for Pakistan, which is presented in the Appendix but briefly described below.2

I. Simulation Model

The exogenous fiscal policy variables used to analyze Pakistan’s deficit reduction are public sector consumption, investment, and tax revenues.3 In addition, public external borrowing is treated as an exogenous variable. Exogenous monetary policy variables include the supply of base money, public sector borrowing from commercial banks, lending by the central bank to commercial banks, and the required reserve ratio. The selection of these variables implies that domestic nonbank borrowing is the residual mode of financing for the public sector, an assumption that accurately describes the situation in Pakistan during the past decade.

The model incorporates several direct channels through which fiscal policy may affect macroeconomic performance. For example, the estimated parameters are consistent with a mild form of Ricardian equivalence and also suggest some direct substitutability between private and public consumption. More conventionally, for non-Ricardian consumers, taxes reduce household disposable income and hence negatively affect private consumption and saving. The accumulation of public capital, through government investment, is both directly and indirectly productive, since it enters the production function as a direct input and is complementary to private investment.4

The solution of the model can be described as follows. Since full employment is assumed, real output is determined before the beginning of each period (as a function of the inherited private and public capital stocks). Beginning-of-period asset stocks are also predetermined, since they are given by the previous period’s government financing decisions and private sector portfolio allocations. The domestic currency value of the private sector’s stock of foreign assets is affected, in addition, by the current period’s official exchange rate. For the assets to be willingly held, the price level (which affects the demand for currency), the interest rate on public sector securities, and the deposit interest rate all adjust endogenously to achieve equilibrium levels.5 The interest rate on public sector securities, in turn, determines the rental rate on capital.6 These factors, together with public consumption and investment decisions, as well as other contemporaneous exogenous determinants of private disposable income, determine private consumption, investment, and saving, as well as the fiscal deficit and the trade balance.

Public sector financing decisions then determine the domestic components of the private sector’s asset portfolio that are to be carried over to the next period. The total size of the portfolio depends on private saving and the amount of lending that banks make available to the private sector after satisfying the public sector’s financing needs. Any discrepancy between the increase in the private sector’s portfolio and total new liabilities issued by the public sector and by the banks is accumulated by the private sector in the form of net foreign assets. With private and public capital stocks determined from the net investment by the respective sectors, the next period’s output is determined, and the model is ready to be solved again.

Table 2.Deficit Reduction Strategies—Simulation Result a(Annual average deviation from baseline projections)
GrowthInflationRatio of current account to GNP
Adjustment in public consumption
Short run (1992-94)0.3-1.3-0.5
Long run (1995-98)0.42.70.2
Adjustment in public investment
Short run (1992-94)-0.34.21.0
Long run (1995-98)-0.51.50.6
Adjustment in taxation
Short run (1992-94)0.12.10.4
Long run (1995-98)0.02.10.5

Ten percent annual reduction in the nominal deficit with the indicated variable adjusting to bring about the deficit reduction.

Ten percent annual reduction in the nominal deficit with the indicated variable adjusting to bring about the deficit reduction.

II. Deficit Reduction Strategies

To reduce the fiscal deficit, the government has to reduce expenditures or increase taxation, or both. In turn, expenditure reduction can fall on consumption or investment. In this section, we examine the effects of these alternatives—a reduction in government investment expenditures, a reduction in government consumption expenditures, or an increase in tax revenues—using the model described above. Specifically, we assume that, in each of the five years over which the simulation is run, the nominal fiscal deficit is reduced by 10 percent through an adjustment in the relevant fiscal variable.

The simulations are based on hypothetical data for the years 1991 to 1996. Given the inherent difficulties associated with such an exercise, no attempt to forecast the actual course of the economy over this period is implied.7 Instead, the baseline was established with the expectation that the economy would continue on current trends. The simulations are, therefore, only indicative of the qualitative direction in which the economy may be expected to move in response to a fiscal shock. For brevity, only the growth, inflation, and balance of payment outcomes are described, since these are the variables most likely to concern policymakers. The results are presented in Table 2.

Reduction in Government Consumption

As shown in Table 2, this mode of adjustment produces the most favorable inflationary outcome and the least reduction in growth but does not achieve as large an improvement in the current account as the other two approaches. The reduction in government consumption is partly offset by an increase in private consumption, in keeping with the model’s mild Ricardian features. Consequently, offsetting private sector behavior limits the extent of improvement in the current account. Reduced domestic demand serves to reduce the domestic price level and the rate of inflation. Given reduced government borrowing needs, domestic interest rates fall, inducing an increase in private investment and thus increasing output slightly over time.

Reduction in Government Investment

The preferred course for deficit reduction through much of the 1970s in Pakistan was a reduction in government investment, although this alternative has the least beneficial growth and inflation effects. Reducing the deficit by 10 percent in each year requires increasingly large reductions in public investment. This implies progressively larger reductions in real output, both because of the lower public capital stock and because of the induced decrease in the private capital stock. An increase in private investment through lower interest rates does not materialize because the lower public capital stock represents a negative supply shock, which raises prices and thus actually increases the domestic interest rate. Reduced output and higher prices both depress private consumption. The reductions in both public and private investment, together with that in private consumption, do improve the trade balance, however, despite lower output.

Increase in Taxation

Results are quite different when deficit reduction is brought about by an increase in tax revenue. In this case, government borrowing is reduced, and domestic interest rates fall, stimulating increased private investment. Because of the increase in the private capital stock, real GDP rises; yet, higher taxes also imply lower private consumption. Interestingly, prices rise in this scenario because higher taxes reduce private disposable income, which causes private saving to fall. Private wealth is therefore reduced, but, since money financing of the fiscal deficit is exogenous, the stock of currency increases markedly as a share of private portfolios. To absorb the currency willingly into private portfolios requires an increase in the price level. This, in turn, reinforces the effect of the tax increase by reducing private disposable income and consumption.

This decrease in private consumption again leads to an improvement in the trade balance. However, as domestic prices continue to rise, the interest rate reduction is eventually reversed, causing private investment to fall. While this magnifies the trade balance improvement, it reduces the positive deviation of real GDP from its projected value.

It appears, therefore, that reducing the deficit by cutting public investment, a favorite vehicle for deficit control in Pakistan, may improve the trade balance but at a cost to economic growth and with little payoff in terms of inflation. The alternative favored by many observers—an increase in tax revenues—could achieve a similar external adjustment and also mitigate the cost in forgone output. The preferred course may therefore be the containment of government consumption.

III. Conclusions

In the coming years, the question of alternative modes of deficit reduction is likely to become an important issue for Pakistan. Simulation experiments suggest that of the three alternative strategies for deficit reduction—reducing current government expenditures, reducing government investment expenditures, and increasing taxation—the least desirable in terms of growth and inflation effects is a reduction of government investment. The most favorable is a reduction in government consumption. An increase in tax receipts yields intermediate results. Since it may be difficult to achieve meaningful deficit reduction solely by cutting public consumption, a combination of current expenditure control and revenue increases may be the most desirable policy choice to achieve a lasting fiscal adjustment. Without such an adjustment, money financing may increasingly be required—an alternative that would risk bringing Pakistan’s macroeconomic performance down to that of other high-fiscal deficit countries.

Equations of the Simulation Model

Permanent income

Consumption function (cointegrating form)

Consumption function (error correction form)

Investment function (cointegrating form)

Investment function (error correction form)

Output

Household financial wealth

Household financial assets

Household demand for currency

Household demand for government debt

Currency substitution

Uncovered parity

Public sector budget constraint

Public sector deficit

Public sector capital accumulation

High-powered money

Commercial banks’ balance sheer

Loan interest rate

Household disposable income

Household budget constraint

Private investment

Rental cost of capital

Relative price of capital

Equilibrium condition for government bonds

Trade balance

Definition of variables:

AH= Household stock of financial assets

B =Total government bonds outstanding

BC = Stock of government bonds held by commercial banks

BH = Household stock of government bonds

CG = Real government consumption per capita (logCG=cG)

CP = Real private consumption per capita (logCp=cp)

DH = Household stock of demand deposits

DEF = Government deficit

DUM = Dummy variable

ec = Error correction term

FG = Foreign debt of government

FH = Household stock of foreign currency assets

H = Stock of high-powered money

iB = Interest rate on government bonds

iD = Interest rate on deposits

iF = Interest rate on foreign debt

iL = Interest rate on loans

i* = Rate of return on foreign assets, in domestic currency

IG = Real public investment

IP = Real private investment

Lc = Central bank lending to commercial banks

KG = Stock of real public capital (logKG=kG)

LG = Commercial bank lending to the government

LH = Commercial bank lending to households

Kp = Stock of real private capital (logKP=kP)

MA(1) = Moving-average term

MH = Household stock of domestic currency

P = Aggregate price level

pk = Price of capital goods

rk = Rental cost of capital goods

rr = Reserve ratio

s = Official exchange rate

ŝ = Rate of depreciation of the official exchange rate

T = Real tax receipts

TB = Real trade balance

W = Nominal household wealth

Y = Real GDP (logY=y)

Yd = Real disposable income of households (logYd=yd)

YP = Real permanent income of households (logYp=yp)

Z = Real foreign remittance receipts

α = Relative price of capital

δP = Depreciation on private capital stock

δG = Depreciation on public capital stock

π = Rate of inflation

REFERENCES

    HaqueNadeern and PeterMontiel“The Macroeconomics of Public Sector Deficits: The Case of Pakistan,”World Bank Working Paper 673 (Washington: World Bank1991).

    LucasRobert E.Jr.“Econometric Policy Evaluation: A Critique,” in The Phillips Curve and Labour Markets,ed. byKarlBrunner and A.H.MeltzerCarnegie-Rochester Conference Series No. 1 (New York: North Holland1976) pp. 1946.

*

Nadeem U. Haque is currently on leave from the Research Department. He holds a Ph.D. from the University of Chicago. Peter J. Montiel is Professor of Economics at Oberlin College and was formerly a Deputy Division Chief in the IMF’s Research Department. He holds a Ph.D. from the Massachusetts Institute of Technology. The authors are grateful to Mohsin S. Khan, Malcolm Knight, Mohamed El-Erian, and Kai Wajid for their comments and suggestions on an earlier draft of the paper.

1

In Pakistan, the fiscal year runs from July 1 to June 30.

2

For a more complete description of the model, see Haque and Montiel (1991).

3

This assumes, implicitly, that tax rates are adjusted to offset deviations in the projected tax base.

4

The nature of these relationships suggests one set of reasons why fiscal deficits may not have greatly inhibited Pakistan’s growth performance—public dissaving in the form of consumption may have been partially offset by private saving, thereby limiting the claims of the former on resources for investment. Simultaneously, public investment has itself been directly productive and may have tended to stimulate private investment.

5

For the simulation exercises, interest rates are treated as endogenous variables and the nominal exchange rate as a policy instrument.

6

The expected rate of inflation is treated as an exogenous variable in these simulations.

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