It’s a lesson the Mughals learned the hard way: if you cannot raise the revenues to pay for your government, your country won’t be yours to govern for very long.

If you look at the raw numbers alone, the story can be quite alarming. Pakistan’s stock of public debt has doubled since this government came into power, but that number can be misleading. When thinking about debt it’s better to look at the proportions, rather than the raw quantities.

“The debt to GDP ratio is not changing,” says Hafiz Pasha, who is a leading adviser to the government on revenue affairs, and is widely known as a fiscal hawk.

“In fact, over the past decade, the debt to GDP ratio has actually fallen very sharply, from about 80 per cent at the end of the 1990s to just over 60 per cent now.”

That proportion means that Pakistan is in fact much better off, in terms of its indebtedness, than many other countries that are living through a sovereign debt crisis. In Greece, for instance, the same ratio stands at 164 per cent, for Japan it’s at 229 per cent, for Singapore 100 per cent and so on.

But even proportions are not that straightforward. How much debt is appropriate for any given country to be carrying?

The answer to that question depends on the ability of the country in question to pay the costs of servicing the debt. And that is where Pakistan has a problem – in debt servicing payments.

“More than 60 per cent of net revenue receipts of the federal government go towards debt servicing,” says Dr Pasha, “which leaves hardly anything behind for other expenditures like health and education”.

For the other high income countries that are in the midst of a sovereign debt crisis these days, the problem is different from the one we’re facing here, and therefore their situation is not comparable. Those countries have documented economies, and they can raise additional tax revenue quickly by broadening their tax base or cutting their bloated entitlement expenditures.

Fiscal reform The main issue for them is not the mechanics of fiscal reform, since the revenue lines are there to be tapped. Their issue is building the consensus around the required adjustment, the politics of fiscal reform, which is tricky because all post-war generations in those countries have grown up in the shadow of the large welfare states that are eating up so much of their fiscal resources.

In Pakistan, however, both the mechanics and politics of fiscal adjustment are stacked against the reforms.

“Given flagging growth our revenue lines are pretty stretched out as they are, so additional tax revenue is going to be very difficult to generate,” says Salim Raza, former Governor of the State Bank of Pakistan. “From where will they pay the additional costs of all the new debt they are taking on today?”

Many economists seem to agree that Pakistan’s growing domestic debt wouldn’t be as much of a problem if it was accompanied by fiscal reforms that produced corresponding increases in revenues.

An economy the size of Pakistan, with GDP at official exchange rate estimated at just over $200 billion in 2011, should reasonably be able to carry a total public debt burden of $135 billion, provided that it is able to capture at least 15 per cent of this GDP in its tax net.

But Pakistan is borrowing precisely because it cannot capture more than nine per cent of its GDP in taxes, and additional taxes will take years to develop, since political will needs to be forged, followed by the mechanisms for collection and audit, and documentation of incomes through reform of the archaic revenue machinery. For comparison, consider that it took the country almost one full decade to develop one new revenue head in our fiscal machinery: the Sales Tax.

So the real problem is not the accumulation of debt, but rather the failure to develop the fiscal machinery which can help sustain the levels of public debt required by an economy facing the challenges of today's world. Since most of the domestic debt is held by a small group of large banks, this means the financial system is being used to fill in for the failure of the revenue machinery.

“The contours of a debt trap are now taking shape and if it's not tackled now, it will make the whole financial system very vulnerable” says Farid Khan, CEO of ABL Asset Management Company, one of the country’s largest mutual funds which invests heavily in government debt.

“As yet, we don't feel that sovereign risk is indigestible but the system's capacity to bail the government out is filling up fast.”

When you get to a point where your additional tax revenues are no longer sufficient to pay for the costs of servicing your debts, then the country enters what is known as a “debt trap”, when you start borrowing just to service the debt you took out yesterday.

The Mughals could tell you a lot about what happens after that, if only they had been paying attention to their fiscal health, but I don’t think they figured out their predicament until it was too late. - Concluded