Cash Accounting and Budget Deficit

Budget is not just a book-keeping exercise for recording government receipts and expenditure. It is a significant instrument of economic management and has important basic functions of stabilisation, allocation, distribution and resolution of conflict.

The way funds are raised and spent has far-reaching implications for the economy and the society at large. From that angle, budget should be very transparent so that all stakeholders may be able to understand and respond rationally to the proposed measures.

It has been customary for the finance minister, to sum up, while presenting the annual budget, the financial impact of the proposed measures. This vital information is conspicuously missing in the Federal Budget for 2010-11 with the result that the size of the budget deficit– a crucial element for fiscal and economic management-, cannot be determined by an outsider.

The fiscal deficit-GDP ratio has assumed added importance because of the conditionalities of the current standby arrangement with the IMF. Compliance with this condition has been a sticky issue. In the past, all sorts of devices to show compliance on the due date were used such as advancing receipts, and postponement of payments. If this did not do, there was no hesitation in resorting to figure fudging even at the risk of being detected and fined.

In this connection, it must be remembered that the US is a major shareholder of international financial institutions including the IMF. In case a borrowing country is on the right side of the US, the Fund, like its other sister institutions, will be very soft and more than willing to grant waiver after waiver. For this, the attitude of the US authorities needs to be watched very carefully. This has been the experience of Pakistan, which is being repeated in case of the current standby facility.

The concept of GDP embraces goods and services produced in a year. There is no problem with budget deficit-GDP ratio, if the goods and services acquired by the public sector are paid off during the same year. If not, the relationship will be distorted to the extent these are not paid or those acquired in the previous year are paid.

In Pakistan, budget accounting is on “cash basis” and only payments during the year are taken into account regardless of the date of transaction. As a result, there are huge arrears because of slack financial discipline, to say the least, and also deliberate efforts to show a better fiscal position for reasons mentioned above. Recently huge arrears of electricity charges due from the federal government departments, including the Presidency have appeared in the press.

The massive circular debt, which is primarily responsible for energy crisis is a glaring demonstration of the phenomenon. The same should be the case regarding other charges and that can be an endless story. The total amount involved could be staggering. To that extent, the ratio understates the expansionary impact, and its contribution to inflation, of fiscal policy. As a matter of fact, no one in government knows the total outstanding liabilities of the public sector.

A very low tax-GDP ratio is bemoaned and there is demand to increase it to a reasonable level commensurate with other similar developing countries. One effective step in this direction, which is also a condition of the IMF standby, is the imposition of value added tax (VAT). How the matter is proceeding makes an interesting case study. In any shape, VAT or revised GST is going to be an indirect tax adding to the already very heavy burden on the common man who also ultimately bears the cost of rampant corruption.

The real problem is not low tax-GDP ratio but the nominal direct tax-GDP ratio. Direct tax revenue at the federal level is shown as 36.4 of tax revenue and 4.2 per cent of GDP. Even this is artificial as some indirect taxes are, without any justification, included in Income Tax and treated as direct taxes. Budget documents do not give any details about income tax.

The State Bank in its Annual Report FY 2009 gives this detail for the first time, which is quite revealing. The components of income tax collections during FY09 were Call on demand- Rs77 billion, Voluntary- Rs142 billion, Withholding- Rs2 41 billion, adding to Gross Income Tax- Rs460 billion. Withholding tax collections were more than half of income tax and consisted of imports- Rs30 billion, salaries- Rs27 billion, dividends-Rs7 billion, bank interest- Rs12 billion, contracts-Rs83 billion, exports-Rs14 billion, cash withdrawals- Rs12 billion, electricity bills- Rs13 billion, telephones- Rs22 billion, Others- Rs23 billion, adding to Gross- Rs241 billion.

The basic distinction between direct and indirect tax is that the former is imposed on income and wealth while the latter is on goods and services. By this definition, of withholding tax only salaries, dividends, and bank interest qualify as direct tax and they accounted for Rs64 billion. If this is adjusted, income tax collections (net) fall to Rs244 billion and direct tax revenue to Rs363 billion. The ratio of direct taxes to GDP would come down from 4.2 to meagre 2.8 per cent– one of the lowest in the world.

As pointed out, information in budget documents has to serve several analytical purposes and this makes the accounting classification of crucial importance. The first basic revision of the classification was made in mid-1970s when functional-cum-economic classification was adopted. Even prior to that special effort was made to prepare an economic analysis of budget, and this was released with other budget document at the time of presentation of the federal budget.

The new classification facilitated that task but was discontinued after some time. Now another functional-cum-object classification has been introduced. However, that leaves much to be desired. For instance, the legislature, the judiciary and the executive are important state functions and their individual fiscal position should be given.

Functional classification 011 reads, “Executive and Legislative Organs, Financial and Fiscal Affairs, External Affairs.” Budget-in-Brief is of common interest but does not contain functional classification. Budget in Brief needs to be improved to serve its basic purpose of educating the ordinary citizen. Economic analysis of budget should be resumed as this will also serve the economic managers.

Economic managers need to realise that devious ways can at best help them gain some time but can never alter the harsh economic realities. Honesty has been and will ever remain the best policy. For a proper grip on public finance, the “accrual basis” of accounting should be adopted like in many other countries.

The article was originally published in the Daily Dawn.