The objective of incurring sovereign debt is to extricate a nation from existing crises and fund investments for growth and development. However, reliance on debt should be prudent and not excessive. When a nation fails to manage its debts effectively, it can enter a state of debt distress — a challenging and painful process.

In such cases, the debt itself becomes a crisis, often exacerbating the initial problems that prompted the borrowing. As of 2023, the total debt and liabilities-to-GDP ratio stood at 89.9 per cent, accompanied by an annual deficit exceeding 6.9pc of GDP. Should this trend persist, what fiscal challenges will Pakistan face in the short and long term, and how might these be overcome?

Similarly, Pakistan is facing dual debt challenges: First, it borrows heavily from international financial institutions — total external debt and liabilities are 42.1pc. This necessitates significant dollar expenditures to repay these debts, putting pressure on the country’s fiscal outlook and compelling further borrowing from international financial institutions.

Simultaneously, the country owes substantial amounts to its own financial institutions, about 47pc of its GDP. Most of this debt comes from local banks, constituting more than 87pc of the money these banks lend to the government.

Consequently, a significant portion of the budget — specifically, debt servicing payments amounting to Rs9.8 trillion, up from Rs7.3tr the previous year, nearly equal to government revenues — is allocated to this end in fiscal year 2024-25.

Failure to address fiscal risks has aggravated poverty levels and hindered economic development

To fulfil other obligations, the state plans to procure an additional Rs5.1tr, up from Rs3.1tr, in loans from banks along with non-bank borrowing expected at Rs2.7tr. This cycle of external and internal debt fosters a fiscal trap, progressively engendering vulnerabilities for the state, market, and society.

The persistent depreciation of the exchange rate has resulted in a significant increase in the cost of imported goods, contributing to a trade deficit of $13.9 billion in 2023-24. Elevated interest rates, coupled with the depreciating exchange rate, have precipitated a surge in inflationary pressures.

Additionally, the cost associated with climate change has emerged as an ongoing catastrophe for affected individuals, particularly highlighted by the recent floods in Pakistan, which resulted in substantial losses, including the destruction of homes and the loss of valuable assets such as livestock and precious metals.

This escalation in inflation, along with the cost of natural disasters and fiscal mismanagement, has substantially eroded consumer purchasing power, leading to an anticipated persistence of the 40pc poverty rate according to the World Bank and a 38pc diminution in purchasing power, particularly exacerbated by the escalating costs of food in 2023. Given these challenges, how can the government still provide essential services and care for its people?

To address this, let us examine how the government can augment its revenue while concurrently curbing expenditures. On the revenue front, Pakistan’s tax collection rate fell from 14pc of GDP in the 1980s to only 10.5pc in 2023. This decline is compounded by the regressive nature of the existing tax structure, which is heavily reliant on indirect taxes. Only one-third of tax revenues are sourced from income tax, primarily stemming from just eight million registered employees out of a workforce of 114m individuals.

The agricultural sector, in particular, experiences minimal taxation, with approximately 90pc of farmers enjoying tax exemptions for land holdings of up to 12.5 acres. Influential players dominate the real estate sector and are among the least taxed areas in Pakistan’s economy, highlighting an opportunity for increased fiscal contributions.

Likewise, tax exemptions granted to various energy sector projects and production sectors favour affluent and influential landholders. Such exemptions cumulatively amount to approximately $17.4bn during 2022-23, equivalent to roughly 6pc of GDP.

By reforming these exemptions and concurrently broadening the tax base, the government could increase the tax-to-GDP ratio from its current 10.5pc to 13pc in the short term and up to 18pc over the long term.

Approximately 80pc of government spending is essentially pre-committed, especially budget allocations for salaries, pensions, interest payments, and defence expenditures. Spending equivalent to a mere 2.5pc of GDP is earmarked for developmental initiatives.

Conversely, spending on subsidies in the fiscal year 2024-25 totalled Rs1.4tr and Rs1.01tr was allocated to pensions. Over 80pc of these subsidies were allocated to the energy sector, most of which benefit independent power producers due to vague agreements based on full-capacity payments.

In Pakistan, there are currently more than 210 state-owned enterprises (SOEs), managed by either the federal or provincial governments, which play a crucial role in the economy by contributing 44pc to the nation’s GDP — a significant increase from 31pc in 2015.

However, these SOEs pose ongoing fiscal challenges, as evidenced by the top 14 enterprises incurring losses of Rs458bn and amassing circular debts that burden the national economy. Adopting a strategy that includes private-public partnerships and privatisation could improve operational efficiency and alleviate fiscal deficits.

The failure to address significant fiscal risks has aggravated poverty levels, intensified social disparities, and hindered economic development. Implementing the Treasury Single Account system, enacting comprehensive tax reforms, and methodically phasing out subsidies could result in considerable financial savings, exceeding Rs850bn in the near term and surpassing Rs1,400bn over an extended period.

It is imperative for Pakistan to embrace inclusive and equitable fiscal governance measures to eliminate subsidies, bring pension reforms and privatise the loss-making SOEs. Such strategic implementations are essential for steering Pakistan towards a trajectory of prosperity, robust growth, and sustainable financial stability. Otherwise, relying solely on debt is itself a crisis that can lead to social fraction, frustration, and financial crunch.

The writer is an Assistant Professor (PhD Financial Economics) at the National University of Modern Languages, Islamabad

Published in Dawn, The Business and Finance Weekly, August 19th, 2024