ABSTRACT

In  Pakistan,  energy subsidy remains  an  important  subject  but  at the cost  of high  fiscal imbalances. This study investigates the nexus between energy subsidies and fiscal deficit in Pakistan, addressing a critical policy concern amid ongoing macroeconomic instability. The primary objective is to assess how energy subsidies and the other macroeconomic variables influence the fiscal deficit, and to identify an optimal energy subsidy path that minimizes the fiscal imbalances. The study employs the Two-Stage Least Squares (2SLS) technique on simultaneous models for the time series data spanning 1981-2023. Building upon this structural model, the study applies optimal control theory, specifically the Linear Quadratic Regulator (LQR), to simulate fiscal policy scenarios over the period 2024-2028. The simulation results reveal that while higher subsidies initially help reduce public debt, and interest rates, however, sustained reduction in subsidies over time improve macroeconomic stability by lowering fiscal deficit, public debt, and inflation without severely compromising social support. The policy gap addressed by this research is the absence of an optimization framework for energy subsidy reform in Pakistan, a gap largely overlooked in existing literature. Findings also underscore the importance of targeted and phased subsidy rationalization coupled with macro-fiscal coordination. The study recommends integrating subsidy policies within a broader fiscal framework, institutionalizing data-driven planning, and adopting green technologies to ensure fiscal sustainability and inclusive economic growth.