A Debt Reduction And Economic Stimulus Plan

Pakistan's debt levels are unsustainable, given slowing growth and a faltering economy. The country is in need of governance and fiscal reforms that reduce the size of the government and overhaul the tax system to encourage productivity.

A Debt Reduction And Economic Stimulus Plan

According to former British prime minister Tony Blair, Singapore’s legendary founder Lee Kuan Yew made three important decisions right after the country’s independence, that played a critical role in transforming the country from a poor fishing village to one of the richest countries in the world. “Each one of them now seems obvious. Each one at the time was deeply contested”, said Tony Blair, who acknowledged that he learnt a lot from Lee Kuan Yew. Chinese leader Deng Xiaoping was also a great admirer of Singapore’s founder.

Those decisions were: adopting the English language, attracting the best intellectual and management capital in the world regardless of national origin, and paying public servants generously while showing zero tolerance for corruption.

We keep hearing mantras about political stability, consensus building, and homegrown plans, but the moral of this story is that a highly indebted and dysfunctional economy cannot be revived by mediocre public officials with a myopic worldview, who continue to walk down the beaten path and are incapable of doing anything except borrowing more. The country’s ruling elites must introduce major governance and economic reforms to avoid sinking deeper into the debt quagmire. Otherwise, they have the most to lose because they cannot compete and thrive anywhere else outside Pakistan.

Current Situation

The government does not repay principal loans from its budget, but contracts more debt to repay maturing loans. Pakistan needs around Rs 33.8 trillion (about 32% of GDP) next year to refinance its debt and pay interest on loans. The crushing debt and debt servicing levels have left no fiscal space for the government to spend on infrastructure and development. The total spending on education dropped to 1.5% of the GDP last year from 2% just four years ago.

The country’s future has been mortgaged due to an inefficient and incompetent public sector, excessive regulation, and extravagant colonial-style government spending. These factors have contributed to the country’s persistently higher structural inflation and ballooning debt. The federal government’s debt continues to climb at the rate of $2.3 billion a month. It has nearly doubled in the past four years, rising from Rs 38.8 trillion in June 2020 to Rs 74.3 trillion in April 2024. The federal government debt-to-GDP ratio rose from 58.6% in 2013-14 to nearly 75% in 2023. The interest cost climbed from 54% of net federal revenues (total revenues less transfers to provinces) in 2014 to 113% in 2024.

Pakistan’s debt levels are unsustainable given its slowing growth and faltering economy, while the country is slowly getting de-industrialized. The share of the livestock sector (about 14% of the GDP) in the economy is rising, manufacturing is declining, and low-skilled services underpinned by a consumption-driven economy (supported by about $30 billion in remittances from overseas) characterize the economy of the sick man of Asia.

State-Owned Enterprises and the banking sector

State-owned enterprises (SOEs) continued to bleed government finances in 2023, costing Rs 1,021 billion in government support in just one year. Aggregate losses of the SOEs in the power sector totalled Rs 304 billion in 2023, despite Rs 759 billion spent by the government supporting this sector.

Capacity payments to the independent power plans (IPPs) totalled Rs2.1 trillion in FY 2023 and continued to be a major reason for the rising power sector circular debt.

The aggregate losses of the SOE infrastructure sector, including entities like the National Highway Authority and Railways, reached Rs5,595 billion over the past ten years.

The government borrows locally to support the loss-making SOEs but lacks a clear roadmap to reduce the federal government debt, which stood at around $267 billion in April 2024. About 61% of the federal government debt is domestic, mostly held by banks. Commercial banks lent Rs 28.92 trillion to the government during FY 2023, representing a record 98.55% of their total deposits by the end of May 2024, according to the State Bank of Pakistan. This scenario represents a major drag on private sector investment, while the banks have made easy money, boosting their stock market valuations.

External Debt

According to the IMF, Pakistan’s official external debt stood at around $102 billion in December 2023, with around 45% owed to multilateral institutions, which are the largest creditors as a group. The IMF accounted for just 7.4% of the total public foreign debt. Pakistan owes nearly $30 billion to China, which is the single largest creditor.

Government Spending and Fiscal Deficit

On top of the Rs4 trillion federal government spending (defence, pensions, civilian government), the budget projects a staggering Rs9.8 trillion (Rs8.2 trillion or 7.7% of the GDP in 2023) to be paid in interest costs. The government plans an increase of 45% in total revenues to reduce the fiscal deficit. However, the people are paying for the losses and blunders of the government, whose motto seems to be tax, spend, and lose money.

During the ten years from 2013-14 to 2023-24, the real GDP growth was 3.5% per annum, but the total revenues grew by only 2.42% per annum because the revenues-to-GDP ratio fell from 12.8% in 2013-14 to 11.5% in 2023-24.

Analysis of Revenues

It is important to analyse based on total federal revenues because the petroleum development levy (PDL) was reclassified as non-tax revenue in the fiscal year 2019-20 and has since been reported as such. Contrary to some claims, the transfers to the provinces under the NFC award fell to 40.1% in 2023-24 from 48.9% of the total revenues in 2018-19. In sharp contrast, the markup payments that accounted for 39.5% of total revenues in 2018-19 rose to a staggering 67.6% of total revenues in 2023-24.

Recommendations for Fiscal Deficit Reduction

The fiscal deficit can be reduced by cutting federal government spending, withdrawing some of the Rs 3.9 trillion in subsidies that benefit mainly the elites, expanding the tax net with a focus on high-income groups, and privatizing and reorganizing state-owned enterprises.

Some actions required are obvious, but the governments have shown little determination or intention to reform. Vested interests, including the bureaucracy, have resisted and even sabotaged reforms. On the other hand, the provincial governments have not made much progress in collecting more taxes from affluent urban property owners or rich agriculturists.

Debt Reduction Strategy

The country must plan to reduce debt through a combination of governance and fiscal reforms. It must reduce the size of its government, overhaul its tax system to encourage investments in productive sectors.

The government must demonstrate commitment to fiscal discipline by setting the following as key goals: reduce the fiscal deficit to 3% of the GDP, total debt to under 60% of the GDP, and interest cost to less than 40% of total revenues within the next five years.

Governance Reforms

A financial emergency must be imposed, and the federal government must assume the powers to tax income from agriculture and property through a constitutional amendment. The incomes of small farmers should be exempt from income tax, but there is no reason to provide exemption to large landlords earning millions. The government must provide legislative cover to maintain these reforms for the next five years to ensure stability and investor confidence.

The management of all SOEs must be transferred to a sovereign wealth fund managed by professionals with private sector experience and given complete autonomy from ministry control. The board of directors of the sovereign wealth fund should have the Prime Minister as its chairman and board members should include professionals and experts from relevant fields. The involvement of bureaucrats should be minimized and eliminated as soon as possible. Privatisation can take years but the governance reforms must start immediately to stop the bleeding.  

Policy-making functions should be taken away from the Federal Bureau of Revenue (FBR), and its discretionary powers to make changes in rules and regulations must be abolished. FBR officials must be restricted to electronic means only to contact taxpayers, and the physical presence of taxpayers should not be required without prior approval of the relevant income tax commissioner and only in cases where the potential tax liability is Rs 1 million or more.

Fiscal Reforms

The main objectives of fiscal reforms should be ensuring horizontal and vertical tax equity. All those with incomes above the exemption limit should pay tax regardless of the source of income, and higher income groups should pay higher rates of tax. They should seek to encourage investment in productive and export-oriented sectors through the tax code, and supporting trade liberalisation by reducing tariffs on raw materials and intermediate goods while imposing relatively higher tariffs on finished products.

Stabilization and Stimulus Measures

The following steps should be taken for stabilization. The interest rate should be cut by 300 basis points to save over a trillion rupees. Domestic debt should be restructured to cut coupon rates and extend tenors, saving another trillion rupees. A flat import duty of zero or 10% on all imports should be introduced, with zero on raw materials and intermediate products and 10% on all others.

All capacity payments on IPPs and request restructuring should be suspended, emphasizing to China that the current terms are unsustainable. Government expenditures should be cut and federal government employment must be reduced by 20%. The federal government’s pension bill has crossed Rs 1 trillion or $3.5 billion. The pensions of all government servants who retired at grade 19 or above and were also allotted a plot of land should be cut by 20%. A tax of 10% should be imposed where the pension exceeds Rs 150,000 per month.

The financial system should be linked to the extent of information on interest paid to the CNIC and increase the withholding tax to 25% where the gross interest paid exceeds Rs300,000 per year. This information should be used to require all deposit holders whose interest earnings exceed Rs100,000 per year to file tax returns. Currently, the interest income of individuals is subject to a final tax of 15% where the total income earned in a tax year does not exceed Rs 5 million. The distinction between filers and non-filers should be abolished as this measure can increase the tax base to at least 15 million using the currently available information.

Importantly, the government should withdraw increases in taxes on salaries and new taxes on essential items like stationery, books, pulses, milk, and other groceries.

All publicly listed IT companies should be exempt from income tax for 10 years and the highest income tax rate for publicly listed companies (except financial institutions) should be cut to 15%.

A non-utilization excise duty should be imposed on holdings of more than one plot by a family, and subject the sale of any plot or house to capital gains tax at market values determined by an independent agency other than the FBR.

Tax measures relating to exporters should be reversed to avoid adversely impacting the balance of trade and foreign exchange reserves.

All development expenditures allocated to members of parliament should be cancelled. All compensation and other facilities paid to members of Parliament and the Senate should be reduced by 30%.

All restrictions on the import or export of crops should be lifted and the prices of petroleum products should be deregulated.

The allotment of land for sale or lease for housing societies, government, clubs, public servants, land developers, etc., should be banned, except through public auctions.

The sales or transfers of immovable property by an ex-serviceman and serving personnel of armed forces or ex-employees or serving personnel of federal and provincial government have been exempted from tax by the budget amendments made after the budget speech. This shows a double standard - one for the rulers and another for the others- and is extremely discriminatory. This must be reversed.

The proposed measures will reduce the fiscal deficit, a major IMF condition, and strengthen Pakistan’s case for securing a new IMF program. This plan must be properly presented to the IMF and should be supported by irreversible governance reforms to make it look credible.

The writer is former head of Citigroup’s emerging markets investments, and was responsible for managing investments and macro-economic strategy across 40 countries in the emerging markets, covering Asia, Latin America, Eastern Europe, Middle East and Africa.