In Search Of Prudent Economics – Dr Muhammad Yaqub

Prime Minister Nawaz Sharif is a well-intentioned leader and seems to be genuinely interested in taking the economy out of its existing state of stagflation, which has made the economic lives of the majority of the people miserable. However, his publically stated diagnosis of economic problems and proposed solutions are mostly misplaced, except the energy policy which is on the right track, and the initiative for reform/privatisation of loss-making public sector enterprises.

The prime minister’s views on the economy, particularly those relating to taxation and mega investment projects in the public sector, may have been influenced by his business background, political instincts and pressures of vested interest groups.

In the circumstances, a heavy responsibility rests on the shoulders of the PM’s economic team to explain the real state of the economy, come up with sound policy options and take the courage to lay bare before the prime minister what is required to be done to pull the budget and the balance of payments out of the present crisis and restore healthy growth with inflation coming down to a single digit.

It is not an easy task to develop such a policy package in a situation that has many constraints and it is even more difficult to sell it to politicians by neutralising their preconceived ideas and the hold that vested interest groups have on them. But there is no short cut to the goal post.

Technocrats and bureaucrats on an economic team, whose jobs depend on the pleasure of the chief executive, are always tempted to first try to read the prime minister’s mind and then tailor their advice so that it is received well by him. Such has been a common occurrence during the past two governments with disastrous consequences. They used cooked up data and indulged in temporary patchwork to make the political leadership believe that all was well till such time as the economy began to unravel.

However, the current finance minister has a better understanding of the economy and has political clout in the party to lead his colleagues on a prudent economic path even if it becomes a personally thankless job to give professionally correct but politically difficult-to-accept economic policy advice. But for the sake of the country, it is important for the finance minister to be forthcoming in presenting to the political leadership a roadmap for economic management that can produce the intended results.

We all understand that motorways, bullet trains and modern airports are symbols of progress and we all wish to take Pakistan there as soon as possible. It is also recognised that the private sector has to play a key role in accelerating investment and economic growth. But it is equally important to recognise the complexities of managing an economy in a crisis and to use the private sector in the current difficult economic and security situation as the engine of growth. It requires a carefully crafted national development strategy in which the role of the private sector is clearly defined and public sector investment priorities are properly identified.

The first step for sound economic management is to have a proper understanding of the state of the economy based on genuine economic and social data. The past practice of data fudging to make the situation look better should be permanently finished.

The correct economic statistics would show that the biggest economic problem faced by the country is that of the budget which is in a terrible shape. Right now, the public sector is a net dis-saver to the extent of two to four percent of the GDP. What this means in practice is that government revenue is just about adequate to take care of defence expenditure and public sector debt servicing liabilities and most of the other current and all development expenditure is being financed by internal and external borrowing. Internal borrowing has led to high inflation and external borrowing to mortgaging the future of the economy and the country’s sovereignty to foreigners.

In the circumstances, the priority of the present government should not be to identify mega projects in the public sector for additional spending but to abandon the practice of note printing and borrowing from abroad by taking policy action to consolidate the tax base and modernise the tax administration in order to mobilise more tax revenue and increase the tax-to-GDP ratio to reduce the level of government borrowing.

In restructuring the taxation system, there should be a fundamental shift from taxing the poor through indirect taxes to direct taxation of the richer segments of the population who currently escape income tax payments. Simply put, landlords, the business community, large traders, real-estate and stock market speculators, underground operators, professional groups and other tax evaders and tax thieves should all be effectively brought under the direct tax net.

Nobody pays income taxes voluntarily, not even in developed countries, unless they know they will be caught and ounished or penalised. For this purpose, it is important to move towards the modernisation of the taxation system including documentation of transactions, improvements in record keeping and reporting requirements and development of a database for cross-checking income flows. The tax laws also need to be amended to include an all-inclusive definition of income for tax purposes and to consolidate the income tax base to improve its revenue productivity and elasticity.

The government, however, seems to be moving in the opposite direction. In a meeting with the business community on November 28 the prime minister announced a new tax concession package for them. It includes amnesty from scrutiny for the source of income of those making a certain amount of investment in some sectors. Certain categories of taxpayers are exempt from tax audit and some are given the option to pay a modest amount of tax and escape income scrutiny. While the tax amnesty, tax concessions, tax exemptions and freedom from tax audit have pleased the business community but will not serve the interests of the country.

The prime minister’s concession package has eroded the tax base further. The tax accountability mechanism has been weakened rather than being strengthened. Opportunities have been created for unscrupulous elements to escape the income tax net and reduce the potential of the system to increase the tax-to-GDP ratio. The perception that tax evaders stand rewarded and honest taxpayers remain at a disadvantage has been confirmed.

Additionally, this package is a hindrance in improving the horizontal and vertical equity of income tax. It would be interesting to see the reaction of the fiscal economists of the IMF in the context of the forthcoming review of the EFF arrangement. Quite obviously, it is a major setback to tax reforms.

If the purpose was to increase private-sector investment, it could be better encouraged by exposing it to a competitive environment under a legal and regulatory framework that is transparent and effective and geared to protect property rights. A subsidy-pampered and tax-exempted private sector is bound to degenerate into a ‘rentier’ class unable to compete in the global markets.

What could also help private-sector investment is a policy initiative in which savings are rewarded and consumption is penalised. Introduction of a Value Added Tax will be very effective in this context. An interest rate policy that ensures a positive real rate of return to financial savers would help promote savings/investment more than interest subsidy to borrowers or tax exemptions on the incomes of tax dodgers.

An efficient and coercion-free banking system that mobilises domestic savings and channels them to productive private-sector trade and investment activities would accelerate economic growth and generate employment more effectively than any subsidised loan scheme for unemployed youth. A State Bank of Pakistan that is de facto independent and conducts a prudent monetary policy to control inflation will serve the country better that an incompetent and subservient SBP subordinating monetary policy to the financing needs of the fiscal policy.

In brief, the government needs to abandon failed past approaches and adopt a new strategy of economic management based on good governance practices and a sound macroeconomic framework to pull the economy out of its present quagmire.