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Two different pieces on Pakistan’s economic troubles:

Meekal A. Ahmed, in The Express-Tribune, warns against putting off fiscal reform due to misplaced comfort in the fleetingly good balance of payments situation:

“Experience teaches, however, that a seemingly comfortable cushion of reserves can vanish with astonishing speed. Global prices for food and oil are beginning to surge, reminding us of Pakistan’s last balance of payments crisis in 2008. With no agreement on a pass-through mechanism for oil prices in Pakistan and oil prices in world markets headed higher, Pakistan’s fiscal deficit and import bill are set to soar, the former because of oil subsidies and the latter due to the rising unit price of oil. It is true that exports and workers’ remittances have performed exceptionally well so far and reimbursements from the Coalition Support Fund have also helped shore up the external position. However, it is not clear whether these favourable developments will be sustained in the remaining five months of 2010-11 and beyond, and/or whether they will be overwhelmed by adverse developments on the fiscal and import front.”

In his piece in Dawn, Sakib Sherani argues that Pakistan’s economic difficulties stem from a structural problem. The economic elite, having captured the corridors of power, are largely exempt from the tax system:

“The biggest challenge for those discussing agendas to bring the economy back to health is how to incentivise their own political class to think beyond an election cycle. The manifestation of this malady — state capture by an elite with its attendant atrophy of institutions — and its pernicious effects are everywhere.

“The most egregious example is found, of course, in our tax who’s who. With around 2.5 million income tax filers (not necessarily all payers), a large portion of who are salaried, it is hardly surprising that direct taxes on income constitute a meagre 3.6 per cent of GDP. Hence, of the abysmally low — and declining — tax-to-GDP ratio, 60 per cent comes from taxing the consumption of every Pakistani, irrespective of income.”

You can read Ahmed’s piece here and Sherani’s here.

A version of this article was published in Dawn on February 8, 2011

In introductory economics courses, economic systems are explained by using the two extreme (and mostly theoretical) examples of the “command economy” and the “laissez-faire economy”. The former is fully controlled by the state and the latter has no state interference at all. Most economies in the world today (except, perhaps, for North Korea) exist somewhere between these two extremes: the mixed economy. Some mixed economies are more planned than others, however. For example, Cuba’s is a heavily planned economy. Production decisions (what to produce and how much of it to produce) and price decisions (how much to sell for) are directly or indirectly determined by the state.

Alternatively, Japan, South Korea, Singapore and India, which had strongly state-guided economies during the 1960’s and 70’s, have liberalized over time. In each one of these cases the state has gradually surrendered the more intrusive levers of economic control in favor of less direct tools. This has allowed a more market based economy, where production and price decisions are determined by the market forces of demand and supply. There are exceptions, of course (India recently banned the export of onions; Japan limits rice imports; etc.).

Pakistan’s is a mixed economy also. It is unclear, however, what the political consensus is on the role of the state. Do we want a market-based economy or a state-driven economy? Is the state’s role regulatory or should it micro-manage economic activity? Have we even bothered having a debate on the matter? Historically, the Pakistani state has always directed the economy aggressively. This began with the import-substituting industrialization of the 1960s and reached its heights in the 70’s with nationalization. Today state involvement in the economy continues to exist in the much less intrusive form of subsidies, tariff protections, export quotas and price controls.

Here are some examples. In the textile sector, yarn manufacturers are not free to sell their product to the highest bidder (whether local or international). There is an upper limit to the amount of yarn that is allowed to be sold to international buyers: an export quota. The rest of Pakistan’s manufactured yarn has to be sold to Pakistani textile manufacturers. The reason for this policy is that the state would like to enhance “the value added” of Pakistani exports by allowing local textile manufacturers to access local cotton yarn at lower prices (since they are not competing with foreign buyers for it). This has the effect of keeping costs for textile manufacturers down (which is a good thing) but it also keeps profits for yarn manufacturers lower (which is a bad thing). At the same time, the state does not allow textile manufacturers to import yarn from abroad.

When it comes to household goods (sugar, flour, etc.), the state controls the amount of these goods to be exported in order to guarantee local supply. But it also controls the amount that is imported in order to protect local suppliers from foreign competition. At the same time, the government tries to guarantee farmers some income by creating price floors: minimum prices that sugar and flour manufacturers must pay per ton of sugar cane or wheat, respectively. It also tries to create a price ceiling at which sugar or flour must be sold to the end consumer to protect consumers from price hikes for basic staples.

For economists, the most suitable reason for state intervention in the markets is market failure (a situation where the forces of demand and supply lead to an inefficient economic outcome). Such market failures may occur in some parts of the economy, but they cannot justify the web of subsidies, quotas and price controls that pervade throughout our economy.

These trade quotas, tariffs and price controls are changed frequently in response to political pressures from consumers (voters) and producer groups. Just recently, the current administration in Islamabad withdrew planned changes in electricity and oil prices under political pressure. It also announced a lifting of the import limits on raw sugar late last year to alleviate the pain of increased sugar prices on consumers, only to be publicly chastised by the Pakistan Sugar Mills Association (PSMA). The Sindh government just announced its intentions to delegate ‘magisterial powers’ to local district officers to implement price controls as public unrest at inflation is mounting. This will, undoubtedly, lead to many traders selling their goods in the informal market, further shrinking the taxable base.

If you are confused by the web of limitations and constraints that govern commerce in the country, you’re not the only one. Picture a circus clown balancing precariously on a plank on a large ball, juggling a dozen daggers, while simultaneously being pelted from all sides by bananas and hand grenades and you will barely begin to understand the absurdity of the ad hoc nature of economic policy practiced by the state for most of Pakistan’s history.

This balancing act, performed by each new government, in order to appease voters and special interests and achieve narrowly defined goals such as export targets, comes at the price of economic efficiency. Each distorted price distorts future consumption and production decisions. This in turn distorts investment decisions. All the while the economy becomes more and more inefficient. Farmers grow crops that they would not grow but for guaranteed prices; manufacturers that should have shut down years ago because of inefficiency are rewarded instead; and new more efficient businesses that should have cropped up in their place never materialize. In the final analysis, decades of price controls, trade quotas and subsidies have not protected consumers from higher prices and inefficient producers from going under. All along consumers and producers have learned to expect the state to protect them from the normal ebbs and flows of the economy, instead of making the appropriate economic adjustments. We are left with an economy (with the notable exception of a couple of sectors) devoid of innovation and full of rent-seekers.

Now, though, the circus tent is about to collapse on the clown’s head. The state is faced with fiscal constraints that threaten the entire apparatus of subsidies, price controls and trade protections. In order to remain solvent it has to keep borrowing from international donors and in order to do so it will have to implement economic reform. So, as the Pakistani state’s ability to guide the economy through incentives and controls declines, the choice of which kind of economy we want to be, may increasingly be out of our hands.

I posted S. Akbar Zaidi’s piece from Dawn, here yesterday, in which he questioned the doomsayers predicting imminent economic collapse in Pakistan. Following quickly on the heals of that article is Ishrat Hussain‘s piece in today’s Dawn: Disconnects and mismatches:

“Popular discourse pertaining to Pakistan`s economic problems usually takes place at a highly superficial level, looking merely at symptoms. It is essential to go beyond generalisations and diagnose the real sources of the malignancy affecting the economy.

“Several disconnects and mismatches of various kinds are sapping the economy`s energy and vitality. These need to be fixed as part of a medium-term consensus agenda.”

Both Zaidi and Hussain have tried to draw attention to the misconceptions and hyperbole present in the current discourse on Pakistan’s economy. Interestingly, they have both highlighted the improvement (defined by aggregate income gains and not by improvements in income inequality) in the rural economy, while the urban economy has struggled.

Hussain’s article is not limited to this point, however. He goes on to paint a picture of the various sections of economy and how changes in the economic structure (rural/urban, external/internal and formal/informal) is affecting public finances.

You can read Hussain’s article here and Zaidi’s here.

A version of this article was published in Dawn on January 21, 2011.

The government’s financial squeeze continues unabated after recent attempts by the Pakistan Peoples Party (PPP) led administration to alleviate pressure on the public coffers came to naught. The ruling party was left isolated by opposition parties as well as its own coalition partners as one after another proposed tax reforms and increases in power tariffs and oil prices were withdrawn in the face of intense political opposition. In effect, political reality defeated economic reality.

The withdrawal of proposed increases in power and oil prices can be directly attributed to their widespread unpopularity with the electorate. On the other hand the failure to implement the Reformed General Sales Tax (RGST) can be attributed to its unpopularity among the political bases of its most vociferous opponents: The Pakistan Muslim League-N (PMLN) and the Muttahida Qaumi Movement (MQM). This particular tax reform is vehemently opposed by the traders that form substantive parts of those two parties’ support base.

Moving forward, two questions need to be addressed. Why have we failed in implementing apparently necessary fiscal reforms? What are we to do next? Recent comment on the fiscal conundrum seems to split into two opposing groups. While the exact articulation of the two sets of perspectives may vary from commentator to commentator I will attempt here to delineate a common set of arguments, perceptions and underlying assumptions for each.

The first is the apparently dispassionate, economic realist school. They point to the inescapable economic crunch the state is in. Members of this group can be imagined in their living rooms, at editorial desks, donor agency offices and Pakistan desks at Western foreign offices, chastising the inept political class for their inability to make difficult decisions. They see no policy alternative to tax reform and slashing state subsidies to electricity and oil consumers. In this assessment of recent developments, much needed economic reform was sacrificed at the altar of short-term political expediency.

The second group is the more visceral, populist group. These folks, sitting on television talk shows and in tea shops around the country, are offended by the nerve that corrupt politicians display when they wish to raise power or fuel prices. They are the retailers and traders sitting in markets in Karachi and Lahore, who have noticed rising power tariffs and no relief from that dreaded load-shedding. They bristle at the idea of tax reform that will increase their tax liability to a state that provides them with nothing in return. In this reading, the economic reforms are less needed than tackling corruption. There is a strong set of assumptions inherent here. That corruption within the government represents a drain on public finances, which, were it to be tackled seriously, would deliver the state out of the current crisis without the need for price hikes and tax reform. Another assumption is that political corruption may even have created this fiscal crisis and that this administration is substantively more corrupt than previous administrations.

The realists do not deny the existence of rampant corruption. But they appear to believe that corruption is a relatively constant drain on the economy from administration to administration. It is part of the background which may be a long-term structural problem, and has long-term structural solutions. They also appear to think the current pressure on public finances is due to exogenous events. That is to say that it is caused by forces that are not under the economic control of the state, such as the floods from last summer, militancy and spikes in oil and food prices at source.

The answer to the first question (why have attempts at fiscal reform failed politically?) lies in the gap between these two perceptions of reality. Unfortunately, there is no quantitative method to determine the relative level of corruption from administration to administration. I do not claim to know whether this administration is the most corrupt ever, but there are those who claim so. These people always have an anecdote or ten handy when they are asked for evidence and they are steering the public discourse at the moment. And as long as this perception exists it would be difficult for an unstable coalition to implement drastic fiscal reforms.

So far the government has been covering itself by borrowing excessively from the financial markets and printing more money. This has pushed inflation up to 16%, public debt to well above 60% of GDP and the expected fiscal deficit for the current fiscal year to over 6% of GDP. While that public debt burden is lower than for many other countries, the kick in the teeth comes from how expensive the rate of borrowing is and how much it adds to future debt-servicing. At the same time, the International Monetary Fund has decided to call out the government on its failure to push through tax reform.

So, what is to be done? Fiscal reform is essential, but so is the survival of this administration until the next general election. The real question then is how can the administration make fiscal reform more politically palatable in an already frayed economic and political environment? Perhaps it can expand the scope of fiscal reform to incorporate some of the suggestions from political opponents. There are already some signs that tax evaders may be gone after more aggressively. The government can perhaps try to expand tax collection from the agriculture sector. It can reduce the size of the government by cutting non-essential expenditures. Above all, the government needs to make a coherent case for reform to the electorate. An honest appraisal of the situation, including the likely negative economic consequences of inaction, needs to be presented before the public.

None of this will be easy, but it can only be achieved by aligning perceptions of reality within the political forum with economic reality. The government must negotiate with those political parties that opposed the RGST and bring them back to the table. What it has to offer them remains to be seen. The template for this process exists within the negotiations for the 7^th National Finance Commission award from 2009 and the 18^th amendment to the constitution from last year. This is how democracies are supposed to work.