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Pakistan's Financing Conundrum

Out of Pakistan’s national budget of 14.46 trillion rupees for 2023-24, total revenue amounts to 6.9 trillion rupees. A substantial 7.3 trillion is earmarked solely for interest payments, equivalent to 5.7% of GDP. An additional 7.56 trillion rupees is designated for financing further debt. What strategies might the government consider to reduce this debt burden? If the government chooses to increase taxes, what would be the impact on citizens’ purchasing power? Conversely, if taxes are not increased, how does the government plan to finance its spending? In the pursuit of sustainability, which specific expenditures might the government consider reducing or eliminating?

Options for increasing taxes include raising indirect taxes, which constitute 60% of total tax revenue, or direct taxes (40% of revenue), approximately 70% of which is derived from withholding taxes. These withholding taxes can indirectly affect consumers. Such a move could trigger further inflation which has averaged 25% over the last two year, and is rising. According to the Pakistan Bureau of Statistics, consumer price inflation surged to 31.5% in February 2023, the highest since June 1974.

However, the government's implementation of a contractionary monetary policy has been unsatisfactory, a result that can be attributed to the absence of demand-pull inflation, with cost-push inflation prevailing instead. Rising business costs have resulted in price hikes independent of demand dynamics. Regrettably, heightened interest rates have compounded this situation by stifling business operations and increasing operating expenses.

High inflation has eroded consumers’ purchasing power, contributing to a projected poverty rate of 37.2%. Exorbitant food costs led to a 38% decline in consumers’ purchasing power in 2023. A tax increase could amplify inflation, raise living expenses, intensify poverty, and further reduce purchasing power.

A government that relies excessively on debt financing heightens its financial vulnerabilities. By June 2023, Pakistan's external debt surged to $124.3 billion compared to a mere $37.2 billion in June 2006. Over half of the budget is allocated to servicing this debt, an amount equivalent to 105 percent of total tax revenue. This leaves limited resources for spending on public welfare and other developmental priorities after tax collections are channeled into debt obligations.

Continued reliance on this pattern could hinder the government's ability to secure additional loans from both local sources and foreign financial institutions, given Pakistan’s elevated debt-to-GDP ratio and limited repayment capacity. This scenario would compromise various spending obligations and priorities, including salaries, pensions, defense expenditures, and other outlays. Pakistan faces external debt repayments of $73 billion between 2023 and 2025. Over the past seven years, external debt has doubled from $65 billion in 2015 (24% of GDP) to $130 billion (40% of GDP) in the current year.

Anticipating this challenge, Pakistan may initiate debt rescheduling, particularly with key bilateral lenders like China, which constitutes nearly one-third of the government's external debt. This challenge is not unique to Pakistan. However, Pakistan's capacity to address its huge debt burden is constrained by the absence of an effective debt management strategy as well as the country’s massive debt servicing obligations which surpass its overall tax revenue. Rescheduling debt is only a temporary solution, as the frequency and duration of such actions are limited. Ultimately, outstanding debt must be repaid to prevent the government’s insolvency or the forfeiture of strategic assets.

What are some possible solutions? On the revenue front, the government could broaden the tax base rather than raising tax rates. It is imperative to bring individuals from various income levels and the informal sector into the tax net. Neglecting this could exacerbate poverty, social fragmentation, and hinder formal sector growth. Additionally, the government should curtail non-essential expenditures. Following the 2009 National Finance Commission Award, redundant federal agencies or institutes can be dissolved. Public sector entities grappling with mounting deficits could be privatized or operated via public-private partnerships to enhance efficiency and reduce deficits.

The allocation of subsidies and tax incentives should be minimized. A United Nations Development Programme report highlights substantial economic privileges – around $17.4 billion annually – allocated to specific groups in Pakistan. Instead, the focus should shift towards cultivating a favorable local business ecosystem with minimal statutory approvals, no objection certificates (NOCs), and other barriers, thus bolstering global competitiveness. Now is the time for the government to consider radical measures, including expanding the tax base, trimming unproductive expenditures, dismantling redundant public enterprises, and reducing extravagant outlays. Failure to do so could lead to worsened poverty rates, a heightened risk of state instability, and increased societal unrest.

Failure to tackle Pakistan’s rising debt crisis could lead to inflation, economic instability and worsened poverty rates..