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The authors are grateful to Mohsin S. Khan, Malcolm Knight, Mohamed El-Erian, and Kal Wajid for their comments and suggestions on an earlier version of the paper, which was presented at a seminar on “Financing Pakistan’s development in the 1990s” sponsored by the Lahore University of Management Sciences in December 1991. Any errors that remain are our own.
In Pakistan the fiscal year runs from July 1 to June 30, and the consolidated fiscal deficit includes all current and development expenditures and all tax and non-tax revenues of the central and provincial governments, as well as the operating surplus of certain autonomous bodies. Almost all data used were taken from several issues of the Pakistan Economic Survey.
Public sector investment was devoted to the development of the chemical industry, as well as to cement, fertilizers, engineering, I petroleum, steel, and vegetable ‘ghee’.
Indirect taxes account for about 80 percent of total tax revenues in Pakistan, and foreign trade taxes represent about half of total indirect tax revenue. Administrative problems have hampered the collection of direct taxes, and the taxation of agricultural incomes has not been politically feasible.
The previous government, however, had already achieved a substantial reduction in public consumption during its last year in office.
Development expenditures consist of investment expenditures of the federal and provincial governments and those of relevant autonomous bodies (Water and Power Development Authority, Oil and Gas Development Corporation, Pakistan Television Corporation, and Pakistan Telecommunications Corporation).
This is not to say, of course, that fiscal deficits of the magnitudes observed exerted no harmful effects, or that performance could not have been improved with lower fiscal deficits, but rather that there is no evidence in Pakistan of the chronic acute macroeconomic crises—typically manifested- in extended periods of negative per capita income growth, rapid inflation, and inability to, service external debt—that have characterized many other developing countries with comparable fiscal performance.
Strictly speaking, these fiscal deficits may not be comparable, since the definitions of fiscal variables can differ quite significantly across countries.
This is not to deny that Pakistan has had its share of external financing problems. Indeed, since 1970 Pakistan has experienced several episodes of balance of payments difficulties that required exceptional financing. Concurrent with periodic exceptional financing, Pakistan also undertook several, episodes of adjustment which may also explain the relatively better macroeconomic performance.
In popular discussions, the link between fiscal deficits and inflation in developing countries is typically seen as being quite direct. In the absence of secondary securities markets, government borrowing from the central bank expands the supply of base money. Hence, the rate of growth of the money supply is taken to depend primarily on the size of the fiscal deficit. With the rate of inflation in turn being determined by the rate of growth of the money supply, the link between fiscal deficits and inflation follows. In reality, however; matters are much more complicated than this for a number of reasons such as the cyclical behavior of velocity and the government’s ability to borrow (See Haque and Montiel (1991) for a fuller discussion).
Since the model does not incorporate rational expectations there is no feedback from price expectations.
For some additional information on the influence of foreign financing on fiscal policy in Pakistan, see Haque, Husain and Montiel (1991).
Other underlying assumptions are: growth of real GNP constant at 5.8 percent, approximately the growth rate in 1991; inflation at 6 percent; LIBOR at 7 percent; and exchange rate depreciation at 10 percent per annum, the average annual rate that actually occurred during the eighties.
In any case, Haque and Montiel (1991 a, b) have shown that capital restrictions do not hold in most developing countries; capital tends to be mobile internationally.
If a further assumption is made on the maturity structure of the debt stock held at end-1991, then a certain percentage of that debt stock would have to be rolled over at higher market interest rates through the years 1992-96. Expenditures would be further increased in each year, and the fiscal deficit to GNP ratio would be higher. On the assumption of a five-year maturity structure, our calculations show the deficit/GNP ratio rising to more than 8 percent.
For a fuller, discussion of the theoretical underpinnings of this section, see Haque and Montiel (1991).
A dot (•) over a variable denotes a time derivative, whereas a hat (^) denotes a proportional rate of change.
As noted earlier, all the projections presented in the paper are illustrative based on various assumptions, and are in no way intended to forecast the future behavior of either the economy or economic policy.
See Haque and Montiel (1991) for an extensive discussion of the issue of the effect of “willingly held” debt on the sustainability calculation.
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 partly 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.
This assumes, implicitly, that tax rates are adjusted to offset deviations in the tax base from baseline values.
For the simulation exercises interest rates are treated as endogenous variables and the nominal exchange rate as a policy instrument.
The expected rate of inflation is treated as an exogenous variable in these simulations.