Pitfalls of budget-making
The federal and provincial governments have begun to develop blueprints of their budgets for FY16. An examination of the vast deviation in the past original budget estimates and their ultimate outcomes shows that the budget-making exercise is not done with the care and professionalism that it deserves. Consequently, the budgetary outcome for every fiscal year turned out to be quite different from what was promised in the original budget.
In the years when the government had an operational programme with the IMF, the desired aggregate outcome was produced to the satisfaction of the IMF through statistical trickery or patchwork of ad hoc measures but the underlying budgetary situation did not improve. As soon as an IMF programme became non-operational or was completed, the budget deficit ballooned back to the previous levels. Accordingly, the IMF programmes in the last thirty years have not been of much help in resolving the budgetary difficulties from a longer term perspective.
One of the main reasons for a mismatch between budgetary promises and performance in the past has been that both the federal and the provincial governments overestimated revenue receipts and understated expenditures in their original budgets every year to make them look good. Moreover, in the recent past, the Ministry of Finance either did not seek, or ignored, the professional input of the Planning Commission for development expenditure, of the State Bank of Pakistan for government bank borrowing and of the Federal Board of Revenue for revenue estimates. It developed its own scenarios based on administrative considerations and political expediency.
There being no professional input from other agencies and ministries and no checks and balances on the Ministry of Finance, and given the lack of professional competence within the ministry, the budgets set unrealistic targets for revenue collection and relied on excessive internal and external borrowing without taking into account the interlinkages and side effects of particular solutions.
In fact, a major flaw in the preparation of the budget has been that the Ministry of Finance did not formulate its budgets in the context of a consistent macroeconomic policy framework. In particular, it used interest rate and exchange rate policies to meet the budgetary requirements rather than to create a sound macroeconomic policy framework.
It kept the exchange rate overvalued to contain the rupee counterpart of foreign debt servicing and low real interest rates to keep public domestic debt servicing manageable. Such an exchange rate policy lost its potency as an instrument of correcting the fundamental disequilibrium in the balance of payments and interest rate policy lost its relevance in monetary management because the level of government bank borrowing, rather than the SBP, determined the reserve money base.
Unrealistic original estimates of tax revenue and foreign receipts set in motion a chain reaction of decision-making on the expenditure side that was difficult to reverse and landed the budgets in larger than the original budget deficits necessitating excessive government borrowing from the banking system that fuelled inflation, crowded out the private sector and inhibited productive activity in the private sector. The budget mismanagement pushed the economy to a state of stagflation.
Additionally, there were a large number of public sector enterprises that incurred huge losses year after year which were funded by the government in one way or the other – but mostly outside the budgetary process to depict a better picture of recorded public finances. Similarly, there was usually under provisioning for the cost of subsidies included in the budgets.
The provinces mainly depended on their share in the pool of federal taxes in preparation of their budgets and they got caught in a difficult fiscal situation when the actual revenue receipts fell short of the estimates made by the federal government in the beginning of the year. Being unwilling to impose their own taxes, the axe of provincial governments fell on expenditure on health, education and other social sectors.
Notwithstanding the tall claims made by the Ministry of Finance and the IMF about the consolidation of the fiscal situation in the last two years, the underlying structure of the budget has not improved, and cannot improve, without a major reform of the budgetary process on the following lines:
First, instead of imposing its own will on the professional agencies, the Ministry of Finance should rely on the FBR for estimates of revenue both from the existing taxes and any new tax proposals. The scope of government borrowing from the banking system should be based on the SBP estimates derived from the projected rate of monetary expansion that is consistent with the inflation target. As a matter of prudence, budget financing by borrowing from abroad should be gradually phased out starting with FY16.
Second, based on realistic estimates of the availability of resources to finance the budget from existing sources, the Ministry of Finance should either scale back expenditure or propose additional taxation to fill the gap. Excessive foreign borrowing only hurts the balance of payments and excessive money creation promotes monetary instability. Imposing more taxes on the already heavily taxed sector and people will take the budget nowhere. The tax-to-GDP ratio should be increased by expanding the tax base, taxing the untaxed sectors and undertaxed people, dismantling the underground economy and improving tax administration.
Third, the IMF is about to hold discussions for the completion of the next review of the EFF and to reach an agreement with the targets and benchmarks for the budget for FY16. Its past preoccupation with numbers has taken the budget and the economy nowhere from a long-term perspective. Learning from its past performance, the IMF should shift its focus from setting quantitative budget targets to structural budgetary reforms.
Fourth, the cabinet should examine the budget documents carefully rather than rubber stamping without critical evaluation what is produced by the Ministry of Finance. Moreover, as is the case in most democratic countries, the budget estimates made and presented by the executive branch should be scrutinised by a budget committee of the National Assembly with the help of professional staff. The present practice of blind approval of what is presented to it by the Ministry of Finance should be discarded permanently.
Fifth, as long as the public-sector enterprises are not privatised or restructured to eliminate their losses, the budget should make an explicit provision for financing of their losses. Similarly, the cost of subsidy should be calculated accurately and provided for fully in the original budget.
Sixth, the provinces should be made to impose their own taxes under their jurisdiction and increase their expenditure on health, education and social sectors to bring it at par with other developing countries.
Seventh, the budget should be framed in a macroeconomic framework that is internally consistent and can help achieve macroeconomic objectives. Its preparation in a macroeconomic framework will help explain the policy linkages and side effects of budgetary policies.
In short, if the government is serious about addressing the macroeconomic imbalances in the country it not only needs to broaden the tax base, document economic transactions, dismantle the underground economy and improve tax administration but also needs to move on a more professional path of budget-making in the context of an internally consistent macroeconomic policy framework.
There is also a need to impart some integrity to fiscal statistics, prepare estimates on a professional basis and put in place a monitoring and accountability mechanism both in the executive and the legislative branches of government. Failure to do so will continue to keep the economy hostage to fiscal mismanagement.
The writer is a former governor of the State Bank of Pakistan.
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