Fiscal Policy for Inclusive Growth: A Case Study of Pakistan

Author:KALSOOM ZULFIQAR
 
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Abstract

Fiscal policy plays a significant role in achieving inclusive economic growth as it can reduce inequalities, mitigate poverty and generate productive employment opportunities by regulating public expenditures and taxes. Current research examines the role of fiscal policy in plummeting poverty, reducing inequality, generating productive employment and last but not the least in attaining broad based inclusive economic growth for Pakistan. Various components of government expenditure and taxes are evaluated by estimating multiple vector autoregressive (VAR) models and by computing elasticities on the basis of cumulative impulse response functions (IRFs). The analysis suggests that fiscal policy is not playing an effective role in promoting broad-based inclusive economic growth. The frail linkage between fiscal policy and inclusive economic growth is countermand to very essence and spirit of the former in a developing country like Pakistan.

Keywords: Fiscal policy, Income inequalities, Inclusive growth, Productive employment, Poverty, VAR estimation, Impulse response functions

  1. INTRODUCTION

    The notion of inclusive economic growth has gained remarkable attention in developing Asia due to prevalence of widespread income and non-income disparities. Macroeconomic policies are vital in pursuing poverty alleviation, reducing income inequalities, fostering economic growth and generating productive employment opportunities. Birdsall (2007) concluded that macroeconomic policies can shape the environment and incentives for inclusive growth in three important areas: fiscal discipline - the more rule-based the better, a “fair” fiscal policy with respect to revenues and expenditures, and a business-friendly exchange rate.

    Although these policies are not underlying causes of growth, they can control and alter growth outcomes in many ways. These policies can be used to achieve economic growth with a human face. Khatiwada (2013) observed that “Over time macroeconomic policies have evolved as faceless policy measures……and can be given a human face. We can cite several areas of macroeconomic policies with human face they are linked with Inequality, poverty, gender, and inclusion”.

    It is suggested that nurturing inclusive growth, creating decent jobs and endorsing equality should be important pillars of macroeconomic policy. Fiscal policy, in pursuit of inclusive growth, becomes particularly relevant. Lopez et al (2010) concluded that “Fiscal policy is one of the most powerful instruments that governments use to maintain macroeconomic stability for growth, as well as for intra and intergenerational transfers of wealth. Governments often have at their disposal between 25% and 40% of GDP for spending, including redistribution across social groups.” Hence, composition of government spending can have remarkable effects on level and outcomes of economic growth. For example, government spending on public goods has a strong association with poverty alleviation and reduction in inequalities. In contrast government spending on private goods has negative implications for both growth and equity.

    Similarly, tax policies directly affect households and their consumption and saving behavior and have inferences for income distribution and economic growth.

    Asian Development outlook (2014) proposed that “One important instrument available to the government for bringing about a more inclusive society is fiscal policy. Governments can design spending programs and tap revenue sources in ways that reduce inequality”.

    Fiscal policy can play an important role in regulating aggregate demand, the distribution of income and economy’s capacity to produce goods and services (Musgrave, 1959). Therefore, correct choice of composition and combination of these policies has become crucial in achieving a broad-based path of economic growth across countries. Estrada et al (2014) highlighted the important role governments can play in achieving goal of inclusive economic growth through well devised fiscal policy. Public spending on infrastructure development enhances productivity of whole economy and public spending on education leads to human capital formation and helps reduce inequalities. The reduction in economic disparities has assumed more importance due to increased focus on Inclusive growth.

    It is in this background that there is a need to explore role of government policies in reducing economic inequalities, alleviating poverty, creating productive employment opportunities and maintaining desired economic growth rate (see Benabou; 2000, Seshadri and Yuki; 2004).

  2. LITERATURE REVIEW

    There are many studies which pronounce effective fiscal policy and focused government spending as viable policy options in reducing inequalities and promoting inclusive growth. Bastagli et al. (2012) stated that fiscal policy can influence income distribution by affecting current disposable incomes and impacting future earnings of individuals. A government may utilize public expenditure for provision of public services or to attain equitable income distribution. Claus et al. (2014) concluded that public spending on education and health are the two most effective means of reducing inequality in developing Asia.

    Thomas, et al. (1999) concluded that fiscal policy is vital for allocation of resources and maintaining equilibrium between various types of assets of an economy. Their growth or reduction is dependent on encouragements generated by tax policies and allocation of resources through public spending policies. Widmalm (2001) explained that different types of taxes have different growth effects. Taxes which distort consumption patterns and discourage investment are harmful for economic growth. Similarly, taxes can be effectively used to attain equitable income distribution. Kneller et al. (1999) propounded that public expenditure, financed by non-distorting taxes, increases growth in a small public sector while an increase in distorting taxation will reduce economic growth. The benefits of tax exemptions and subsidies are mostly grabbed by the influential high income individuals, which has undesirable implications for economic growth and income equality.

    Ahmed (2007) highlighted the importance of composition of public expenditures for economic growth and poverty alleviation. Expenditure on health, education and infrastructure has positive impact on economic growth when controlled for other factors. Several studies have explained the significance of fiscal policies in shaping pattern of economic growth via two types of public spending i.e. spending on public and private goods and on subsidies. Roberts (2003) concluded that if public spending is increased on education it may create opportunities for poor to get education, however demand side factors may reduce this effect. Such factors may include perceptions regarding paybacks of education, income of the household and other costs to parents for sending their children to educational institutions.

    Chu et al. (2000) surveyed studies for a large set of developing economies and concluded that in most economies, government spending on education sector helped the poor more as compared to rich. Public spending on primary education was comparatively well directed in a way that share of advantages going to lowest quintile were higher than the benefits accruing to the richest quintile. David and Petri (2013) used the data based on various surveys for analysis and suggested that there is a need to divert public spending towards the areas that are more helpful in attaining inclusive economic growth. It is also suggested in literature that public spending can be productive only if it develops infrastructure that is used as an input for private investment (Devarajan, et al. 1996).

    There are numerous studies which confirm that well directed public spending on human capital enhances economic growth. (Guellec and Pottelsberghe; 1997, Diamond;1999, De la Fuente and Domenech; 2006, Heitger; 2001). Public spending on consumption and social security either have no effect or negative impact on economic growth (Aschauer; 1989, Barro and Sala-i-Martin 1990; Grier and Tullock 1989).

    Habito (2009) examined the reasons why poverty reduction patterns accompanying economic growth have varied so widely across Asia. It suggested that sectoral composition of economy, nature, size and patterns of public investments (particularly on social services and agriculture); and quality of governance affect poverty reduction and pattern of economic growth. Results confirmed the role of governance, public expenditure on social services and contribution of agriculture to GDP growth. Similarly, it also highlighted the important role manufacturing sector can play in attainting inclusive economic growth and recommended to take a broader view of poverty for policy prescription.

    There are many existing studies (see Khanand Hashmi; 2015, Arif and Farooq; 2011, Irfan and Baber; 2014, Sherani; 2006, Faridi andNazar; 2013, and Mahmood andSadiq; 2010) which have evaluated the effectiveness of macroeconomic policies in motivating economic growth in Pakistan. Most of the empirical evidence about macroeconomic effects of fiscal policies is based on separately estimated regressions, analyzing the growth effects, the distributive effects or role of fiscal policy in poverty reduction. Besides that, most of previous studies consider public expenditure and tax revenue as a whole ignoring the fact that different components of revenues and expenditures can have varied impact on growth, income distribution, poverty and employment. For example, current expenditure, due to its non-productive nature, has different consequences for poverty, inequality, employment and economic growth as compared to development expenditure.

    Similarly, direct and indirect taxes influence income distribution, economic growth and employment generation differently. Government expenditure on health...

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