Band-aid or real reform?

Although past IMF support prevented serious foreign exchange shortages, their ‘band-aid’ conditions enabled Pakistan’s irresponsible rulers to postpone fundamental reforms. The IMF became a willing lender of first resort.

This time around, the IMF must act as lender of last resort, supporting the ‘first best’ reforms that Pakistan needs. The programme must aim to reduce the current account and fiscal deficits to sustainable levels in 2-3 years; overhaul tax administration; and privatise all commercial state enterprises in 3-4 years, and reduction of their losses while they are in the process of privatisation. There should also be deep governance reforms of energy-sector enterprises, and elimination of circular debt as well as a reduction in the anti-export bias – including actions so that exporters get raw materials free of all taxes, refunds on time, and energy at the same price as their competitors. The programme could also aggressively improve the ‘doing business’ eco-system and minimise risks of reform reversibility .

In tax reforms, the crucial issue that needs examination is why all past reforms have failed. Apart from lack of political commitment, another reason was the excessive focus on collections from those already in the tax net, and too little attention on non-filers and on improving quality of service.

Proper sequencing of reform actions would enhance the success of the programme. Thus in the first 12-18 months, the reform initiatives should comprise identifying, and taxing, non-filers. The aim should be to raise most additional taxes, needed for fiscal adjustment, from this group. An aggressive effort, where virtually the entire FBR staff and management are pursuing non-filers, can yield a substantial quantum of taxes. The tax administration should be made “rule based, non-discretionary and customer friendly”. Without the huge trust deficit between the FBR and existing taxpayers being bridged, non-filers will use every trick to stay out of the net, Also: there is a need to eliminate taxpayers’ hassles resulting from overlap between the FBR and provincial tax authorities.

The FBR’s internal culture is to treat taxpayers as cheats, rather than as customers. Because FBR staff are both judge and jury, and corruption is endemic, taxpayers have no recourse but to succumb to extortion or pursue the tortuous legal route. Virtually every corporate has litigation with the FBR, mostly because of frivolous tax demands. Several reforms should be considered. For example: there is a need to rewrite all tax laws and revise business processes to reduce discretion and introduce transparency and predictability. There should be a swift mechanism , independent of the FBR, to overturn frivolous notices of ITOs and to withdraw the thousands of cases in court.

Tax forms need to be simplified, and require only disclosure of income and eliminate the other very intrusive requirements, as they increase opportunities for extortion. There is also a need to restrict ITO’s power to seal bank accounts. This power is one of the most extortionary and anti-business feature of our tax system. Further, the policy of individual staff targets for collections needs to be done away with. It has led to extortion in the absence of internal accountability for wrongdoing.

In addition, the programme must seriously consider the following three key institutional and policy levers that could act as roadblocks to reckless fiscal and monetary mismanagement once the programme is completed.

First, the present NFC Award, and the process for determining awards, needs to reformed. While no one can disagree that the provinces must get the bulk of resources, distribution should be consistent with sound fiscal management. The present NFC is deeply flawed and has been the main driver of high deficits and excessive debt. It is designed as though Pakistan comprises five states, and not one country. Changing it will be contentious, but the following must be considered: (i) establishing a full-time NFC Commission; (ii) introducing ‘circuit breakers’ in the award, so that agreed distribution is automatically changed in the event fiscal deficit exceeds desirable levels; and (iii) introducing as a criterion provincial performance on ‘own revenues’. Provincial tax collection is abysmal. For example, last year per capita provincial tax collection in Sindh and Punjab was Rs4,500 and Rs2,000, respectively. In comparison, it was Rs32,000 in Indian Punjab and Rs26,000 in Maharashtra.

Second, the SBP needs to be made fiercely independent of the Ministry of Finance. The SBP’s dismal performance on management of exchange rate and monetary policy has been a major reason for Pakistan’s repeated balance of payments crisis. The following actions must be considered: (i) fundamentally change the appointment process for the SBP governor and board members. One way to introduce merit is to entrust an independent search committee of experts with providing the government a short list for board members and governor, and to have a cooling-off period before retired government servants become eligible for these positions. Also, there is a need to amend the SBP Act and Banking Companies law to put a legally binding cap on lending to the government – so that all new credit goes to the private sector. Among emerging markets, Pakistan has one of the lowest levels of credit to the private sector. And, finally, legally prohibit the SBP from mandating directed credit.

Third, the Fiscal Responsibility and Debt Limitation (FRDL) law should be amended to make it more difficult to violate. In a country where the sanctity of the constitution is not sacrosanct, it is not so obvious what actions would prevent violations of this law. Nevertheless the FRDL provides a powerful lever to rein in reckless borrowing. Two changes to the law should be considered, the first being including penalties for key policymakers – finance minister and finance secretary – who abet and approve violations of the law. If these two officials are held accountable through some form of legal sanctions, the risks of imprudent fiscal management could be dramatically reduced. While such personal penalties are not the norm, it merits serious consideration given the past behaviour of people who occupied these offices.

Another change would be changing the target from debt-to-GDP, which is only understood by economists, to debt service-to-tax revenues. Citizens are more likely to be shocked and demand corrective action if told that 40 percent of tax revenues are used for debt service , than if told that debt is 70 percent of GDP. Also: GDP numbers are more susceptible to manipulations.

The above programme will be difficult and unpopular. But Pakistan has no choice if it has to put itself on a permanent path of growth and stability. The IMF will fail the people of Pakistan if its next programme is yet another band-aid bailout.

The writer is a former adviser to the World Bank.