Abstract

The fiscal sector of Pakistan has faced complex challenges for long, characterized by unproductive, inflexible public expenditures and inadequate tax revenues. Developing nations often struggle to implement effective fiscal policies due to these constraints. An ideal fiscal policy is believed to encompass counter-cyclical properties, yet, Pakistan typically prioritizes addressing its persistently high fiscal deficit by resorting to austerity measures, rather than leveraging these cyclical. This study explores Pakistan’s fiscal policy issues under three main themes, with significant implications for policy development.

The first essay examines the cyclical behavior of federal government expenditures and taxes in Pakistan from 1984 to 2019. It investigates whether financial constraints and institutional quality can help guide fiscal policy in a more appropriate direction. Functional heads of expenditure (current, development, and overall) and taxes (direct and indirect) are analyzed using a nonparametric econometric technique, Multivariate Adaptive Regression Splines (MARS). The findings indicate that Pakistan’s fiscal policy demonstrates a mixed cyclical pattern, with a nonlinear relationship to business cycles. While the social sector (including health, education, and social protection) exhibits no cyclical behavior, other categories of expenditure display a combination of cyclical tendencies. Regarding tax policy, sales tax demonstrates pro-cyclical behavior, while other direct and indirect taxes remain acyclical.

The second essay evaluates the Expansionary Fiscal Contraction (EFC) hypothesis by identifying fiscal contraction episodes through the growth rates of public expenditure. Utilizing the MARS technique again, the results contradict the EFC hypothesis, indicating that spending on education, health, and social protection has a positive influence on private sector activity during austerity periods. From a policy perspective, the findings suggest that to mitigate the negative effects of austerity, spending growth in social sectors should be maintained or increased, ensuring that cuts in these areas can potentially harm the economic recovery.

The third essay is a narrative analysis of the motivation behind tax adjustments in the country from 1973 to 2021. The narratives have been taken from the sayings of the finance ministers in the budget speeches during different political regimes. Based on the motivations it has been determined whether the tax policy is exogenously determined or has any cyclical considerations 2 on its back. The overall outcome in the end is that there are a few instances where the tax adjustments are targeted at the economic revival of the country. In most of the instances the target of the extra revenue generation is to fill in the budget deficit gap. There a few instances where the reason was to fulfil the defence needs of the country. Thus, most of the time the tax adjustments are exogenously determined.

The third essay provides a narrative analysis of the motivations behind tax adjustments in Pakistan from 1973 to 2021, drawing from finance ministers’ budget speeches across various political regimes. This analysis explores whether tax policies were driven by exogenous factors or cyclical considerations. The results reveal that, in most instances, tax adjustments were aimed at closing the budget deficit rather than stimulating economic growth. Although there were occasional tax measures targeted at economic revival or defense funding, tax policies were largely exogenously determined.

The study certainly holds importance regarding Pakistan’s fiscal policy framework. The findings advocate for aligning fiscal policy on counter-cyclical grounds to address long-standing economic challenges. Additionally, social sector expenditures (education, health, and social protection) should be prioritized during austerity to soften its adverse effects. Finally, tax policy should transcend revenue generation and focus on broader objectives such as growth, equity, and welfare. These policy recommendations offer valuable guidance for reforming Pakistan’s fiscal framework to achieve more sustainable and equitable economic outcomes.