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Controlling budget deficits: tax increases versus spending cuts.

Pakistan is Rs. 1260,000,000,000 in debt and our government continues to borrow at a rate of Rs. 120,000,000,000 per year. More than 30 per cent of our budget is getting wasted in paying interest on the debt that successive Pakistan governments have taken in the past. This excessive debt and debt servicing burden has brought Pakistan on the verge of financial bankruptcy. On average, every Pakistani family is about Rs. 70,000 in debt. However, eight-nine per cent of Pakistani families can not even afford to own a TV set and will not be able to contribute much towards repayment of this debt. Therefore, a family that owns a TV set in Pakistan is about Rs. 632,000 in debt. Similarly, only 3 per cent of families in Pakistan own a car, therefore, a family that owns a car is Rs. 2,300,000 in debt. This huge ever growing debt is the biggest national security threat to Pakistan. Estimates show that if no dramatic efforts are made to reduce budget deficits, in a matter of about 5 years, Pakistani government will be forced to close down public schools and hospitals, and will fail to pay its own employees. Moreover, temporary power shortages might become permanent and the country will be in a chaos, somewhat similar to what recently happened in the former Soviet Union.

Pakistani government has the following options to control its budget deficit before things get out of hand - increase taxes, decrease its spending, or a combination of the two. Our bureaucrats at this time seem to be preferring the first option of increasing taxes. This is evident by the introduction and then increase of the sales tax and a significant increase in prices of goods and services such as petrol in the recent budget. I examine both these options of increasing taxes and reducing spending below.

Revenues collected by our government are about 19 per cent of the size of our economy (GDP). This is about the same as that in other developing countries. However, the composition of revenues is not consistent with other developing countries. Agriculture constitutes 26 per cent of our economy yet its contribution in the form of taxes is only 2 per cent of GDP. This is partly due to the enormous political influence and power that landlords enjoy in Pakistan. As a result other sectors, especially manufacturing and services, pay significantly higher taxes. There is a widely held belief among bureaucrats as well as the common person that the easy solution for our economic problems is to increase taxes and use that money to pay off the debt and provide the common man with social services such as education and health care etc. However, this is just a myth. There are drawbacks of excessive taxes and there is a need for the bureaucrats and the citizens of the country to have an understanding of the drawbacks as well.

First of all, people who are rich are so because they or their parents have invested in this country despite the bureaucratic problems and political risks. Rich people include businessmen, who provide jobs to the people and foreign exchange reserves and taxes to the government. Rich people also include the professionals - doctors, engineers, MBAs, architects, scientists etc. They have worked very hard to reach this status. By burdening these people with taxes a government sends a message to the people that there is no risk-reward or hardwork-reward relationship. Businessmen and professionals take huge risks and indulge in hard work to earn their living. If they are taxed very high they loose the incentive to do so and the country suffers as a result.

Burdened with huge taxes many professionals might decide to leave Pakistan and overseas professionals might decide not to return making the professional shortage problem worse. Excessive taxes will also discourage local and foreign businessmen from investing in Pakistan especially when there are so many other countries in the world that provide tax breaks and incentives to such businesses. Every time there has been an increase in the tax rate by our government, billions of rupees have moved out of Pakistan. This has resulted in a loss of millions of potential jobs, and billions of rupees worth of potential foreign exchange reserves and taxes. There is no record kept by the Pakistani government or private institutions as to the amount that has left the country at such times to my knowledge.

Third, excessive tax burden might force a perfect healthy business to collapse. As a result the business might be forced to lay off workers and a large number of people who are earning a decent living might fall into poverty. Thus, taxes may increase poverty instead of decreasing it. Again no statistics are available in Pakistan of how many people lose jobs following tax increases. I will provide an example from U.S. In 1990 president Bush imposed a luxury tax on people buying expensive cars and yachts. The general understanding was that more taxes will be collected from the rich. However, the result was very unexpected. Rich people stopped buying luxury items to avoid luxury tax. As a result over thirty-five thousand workers lost jobs in the auto and yacht industries. The tax that was intended to effect the rich cost the poor their jobs.

Businessmen have a tendency to reinvest a major portion of their earnings after maintaining a certain standard of living. This reinvestment in the economy create more productive jobs in the future. Any time taxes reach a point that they do not leave much in the hands of the businessmen to reinvest, job growth and productivity of the country suffers.

Fourth, taxes are treated as a cost of doing business by the businesses. And this cost is generally added to the price of the product. Thus every time taxes increase the price of products and services also increase and it is the ordinary people - the customers - who end up paying these taxes. There is a saying that businesses have never paid taxes and never will. It is always the consumers who pay taxes.

Fifth, the belief that our government spends taxes to improve the standard of living of ordinary people, provide education to children, and health care to families, is flawed. Less than 20 per cent of budget has traditionally been spend on the people of the country. In the hands of the businessmen this capital is spent a lot more productively due to personal incentive, and creates millions of jobs in the process. Poor people can in turn use their salaries from these jobs to send their children to school and provide health care to their families.

In summary, excessive taxes and regulations make life miserable for the middle and poor class, force investors to take their funds to foreign countries, increase inflation, reduce foreign investments, and slow down the economy. Our government needs to be very careful in increasing taxes any further. The private sector has just got its first chance in decades to improve and build. It needs some breathing room. To start recovering too quickly form the private sector, what our bureaucrats have lost by decades of mismanagement and inefficiencies, will backfire. Excessive taxes at this stage can take off all the initiative and momentum. Large businesses, due to their sophisticated management skills and various alternatives available for investing, will find ways to avoid taxes. This might be accomplished by reducing or eliminating reinvestment and moving capital out of the country where it can earn higher after-tax returns. The small business sector in Pakistan, which is the back bone of the Pakistan economy and creates a majority of jobs, will feel the pinch of higher taxes and might be forced to lay off employees and limit their business activities to maintain their profit margins. Ordinary people will experience an increase in hardships as they see an increase in their water, electricity, telephone, and other bills. The overall impact will be a reduction in investment and economic growth and an increase in unemployment and inflation. The reduction in government revenues as a result of slower economic growth and investments will outweigh any increase in the revenues base from higher taxes. What is needed is to increase the size of the pie and not to take more from the same pie.

On the expenditure side, our government spending of about 26 per cent of GDP is somewhat higher than other developing countries, however, of greater concern is the distribution of spending priorities. Over 30 per cent of our budget is wasted in paying interest on debt that successive governments have taken in the past. Twenty six per cent is spend on defence while over 10 per cent is spend on civilian government and to cover losses on government-owned industries. Our government education spending of less than 2 per cent of the budget and health spending of less than 1 per cent is one of the lowest in the world. Our government spending on clean drinking water, women development, rural development, population planning, and science and technology, totals less than 3 per cent of the budget. This lack of investment in the people is the biggest reason for our failure to solve the country's problems and move towards prosperity.

It is obvious from the above statistics that our government needs to reduce its non-productive spending. However, there are signs that our bureaucrats have decided to further reduce investment in important issues in an attempt to reduce budget deficits. In the 1993-94 budget, instead of reducing waste, inefficiencies, and corruption, that runs into billions of dollars, our bureaucrats have reduced the education budget by over 20 per cent and the science and technology budget by over 50 per cent. Now our science and technology spending constitutes 0.05 per cent of the budget ($6m) - not exactly the best preparation to enter the 21st century. This reduction in productive investments will severely hurt us in the medium and long-run.

The solution to Pakistan's economic crises is obvious. We need to reduce non-productive spending, increase productive spending, reduce the size and powers of our bureaucrats, deregulate and privatize the economy, and let the free market system show its magic as it has done in the case of many other countries. However, our country's history is full of lost opportunities. The 1950s and 1960s were lost as revenues were not spend on educating and training people and building the infrastructure. The 1970s were wasted because nationalization and the resultant exit of the private sector from the development of the country, especially large-scale industries, reduced the potential for increased government revenues, jobs in the private sector, exports, and foreign exchange, and resulted in huge inefficiencies and losses in the nationalized industries. The 1980s were wasted because huge foreign remittances from Pakistanis working overseas, and loans and grants from international donor agencies and countries, were not put to productive use but spend mostly on non-productive factors and to subsidize the inefficient state-owned industries. Today, from what we hear of bureaucrats in private and public, by their actions and words, all indications are that the 1990s will be wasted by making an attempt to reduce deficits by (1) increasing taxes and thus burdening the private sector and slowing the economy; and (2) reducing productive rather than non-productive spending. My only hope is that this time there will be rational people in government and the private sector that will not let this happen.

The biggest lesson that our bureaucrats can learn is the story of the hen that laid the golden egg. It was lack of this understanding that led our leaders to nationalize private industries in the early 1970s to get all the eggs at once rather than receiving them gradually (as the private sector flourished). It is the same lack of understanding that led our leaders to spend such huge portion of the economy on non-productive spending, especially defence. And now again, our bureaucrats are convinced on increasing taxes without understanding that this would actually result in less and not more revenues for them, in the long run.

Moving from the "borrow and spend" policy to "tax and spend" policy will only move Pakistan into an even deeper economic crises. The best policies that our government can follow at this stage are:

1. Increase investment in the people of Pakistan with increase in spending for education, health care, clean drinking water, population planning, and infrastructure development (roads, bridges, etc.).

2. Reduce non-productive government spending by reducing waste, corruption, and inefficiencies in various departments of the government and reducing defence spending.

3. Reduce the huge debt of Pakistan by a combination of:

a) an introduction of an agricultural tax on the landlord class in Pakistan;

b) reduction of non-productive government spending, and

c) utilization of the proceeds from privatization of state-owned industries to pay off the debt.
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Author:Waheed, Amjad
Publication:Economic Review
Date:Aug 1, 1993
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