Fiscal trap: is it time to end the cycle of endless consolidation?

Business Recorder

16 hours ago

In the context of Pakistan, conduct of macroeconomic policy rests on two broad pillars: an increasingly independent monetary policy and a persistently constrained fiscal policy.
Over the past two decades, the SBP has gradually acquired operational and legal autonomy, helping it to steer monetary policy with a degree of institutional discipline.
By contrast, fiscal policy remains hostage to entrenched political bargains, rigid structural arrangements, and an ever-expanding government footprint that now threatens to push the upper taxation and public debt limits of what the economy — and its citizens — can bear.
At the heart of this dilemma is Pakistan's mounting dependence on predatory taxation and borrowings for federal deficit financing. Limited access to external capital markets — largely due to weak external credit ratings and recurrent balance of payments crises — has forced successive governments to lean heavily on domestic borrowing. But with local banks already saturated with government paper, the room for even higher domestic borrowings has shrunk dramatically.
The result is an endless cycle of fiscal consolidation — tightening budgets year after year, squeezing the after-tax profitability of businesses and disposable income of households, that ultimately results in suppression of investments and growth recovery. The FY26 federal budget, shaped under the latest IMF-supported EFF arrangement, starkly illustrates how deeply this pattern is now entrenched.
Headline numbers may suggest progress: the government pledges to shrink the overall deficit from 5.6 percent to 3.9 percent of GDP, while nudging the primary surplus up slightly to 2.4 percent. Yet beneath these surface figures lies a troubling reality: nearly all the adjustment burden falls on over-ambitious revenue targets and suppressed primary spending, not on a genuine structural rebalancing of fiscal architecture.
The revenue side alone tells the story. Tax collections are budgeted to grow by nearly 19 percent in FY26, which is on the back of 29 percent growth in actual tax collection in FY25. If history is any guide, continued mobilization of additional predatory taxation will prove exceedingly difficult to achieve without intensifying the pressure on an already burdened formal sector.
As per the IMF's First EFF Report (published in May 2025), the baseline medium-term macroeconomic framework projects real growth to increase modestly from 3.6 percent in FY26 to 4.1 percent in FY27, and then stabilizing around 4.5 percent through FY30. Despite official claims regarding the implementation of structural reforms, projected baseline growth remains constrained by the persistent imperative to avert balance of payments crises.
The tenuous nature of the current fiscal consolidation strategy is underscored by the EFF baseline macroeconomic projections. Specifically, the growth rate of tax revenues is projected to decline progressively, from 17 percent in FY26 to 12 percent in FY27, 10 percent in FY28, and stabilizing at approximately 11 percent in both FY29 and FY30—corresponding to an estimated 12 percent of GDP.
Concurrently, primary expenditure (excluding debt servicing) is projected to increase from 10 percent of GDP in FY26 to 12 percent in FY27, peak at 13 percent in FY28, and revert to 11 percent in FY29 and FY30—equivalent to roughly 14 percent of GDP. Predictably, under this fiscal framework, debt servicing obligations are projected to gradually decline from 8 percent of GDP in FY25 to 5 percent by FY30.
Nevertheless, the First EFF Report classifies the overall risk of sovereign stress as 'high' in both the short and medium term, while the long-term risk is assessed as 'moderate,' despite the projected stabilization of debt servicing within the baseline scenario. This 'high' sovereign stress is mainly due to elevated gross external financing needs, low fiscal and forex buffers.
One cannot understand Pakistan's fiscal trap without examining the legacy of the 7th National Finance Commission (NFC) Award of 2010. This constitutional arrangement mandates that 57.5 percent of federal tax revenues be transferred to the provinces—a well-intentioned federalist constitutional design to devolve functional responsibility and spending.
In theory, this should have allowed the federal government to shrink its own footprint. In practice, however, the federal government has only grown larger. Federal expenditures have risen at an average annual rate exceeding 14 percent since 2010, leaving a gaping hole between net federal revenues and ever-growing debt servicing costs.
Each fiscal year now begins with a stark arithmetic: once transfers to the provinces are made, the federal government must borrow—domestically and at increasingly high cost—just to cover current expenditures, let alone development spending. Half of all federal spending now goes to service debt. The cycle sustains itself through more borrowing, higher taxes, and a steady erosion of fiscal credibility.
To bridge this gap, the ongoing EFF programme stitched a National Fiscal Pact (NFP), committing provinces to run surpluses. But these provincial surpluses are retained and reinvested locally, not flowing back as revenues to narrow the federal deficit.
For FY26 budget, this leaves the federal government with an estimated standalone deficit of over PKR 6.5 trillion—even as the consolidated national deficit appears moderate on paper.
The EFF baseline projections suggest that headline debt-to-GDP ratios to decline from 78 percent to 64 percent by FY30, assuming tight adherence to primary surplus targets. But such headline improvements disguise the deeper malaise: the ratio of public debt to tax revenue will remain among the highest in comparable economies, and the underlying fiscal asymmetry between federal obligations and available net revenues will persist.
What, then, is the alternative? Incremental tinkering—shaving a few percentage points off expenditure here, tweaking taxes there—has failed to break the cycle for over a decade.
A more credible pathway would start with an interim recalibration of the NFC Award. By treating debt servicing and defence spending as first charges on federal revenue, and adjusting the vertical revenue share in the centre's favour, the structural imbalance can be narrowed over the medium term.
Equally critical is the question of domestic debt restructuring. Both provincial budgets and well-capitalised domestic banks can absorb carefully managed adjustment costs of debt restructuring. Such domestic debt restructuring must be underpinned by robust legal safeguards and vigilant oversight to protect financial sector stability.
The goal of domestic debt restructuring must be to free up fiscal space and then to lower the tax burden on businesses and improve disposable incomes that will help to revive private investment.
But these measures alone would not suffice without durable institutional guardrails. Pakistan needs a fiscal charter that binds governments to prudent borrowing and spending ratios, closes avenues for regressive and predatory taxation, and enforces broadening of tax base and mandatory tax compliance.
A permanent parliamentary fiscal oversight mechanism could further strengthen accountability, ensuring that borrowing decisions and contingent liabilities are subject to transparent scrutiny.
None of this will be politically easy. Rebalancing the NFC Award is a deeply sensitive undertaking in a federation where provincial autonomy is jealously guarded. Domestic debt restructuring invites resistance from powerful stakeholders.
Yet the stakes could hardly be clearer: without structural recalibration, Pakistan's fiscal policy will remain shackled to a perpetual cycle of consolidation that neither restores' macroeconomic stability nor unlocks the country's latent growth potential.
The broader aim must be to free fiscal policy from its reactive, debt-driven posture and enable it to function alongside monetary policy as a genuine countercyclical tool. In the absence of this, macroeconomic stability will remain elusive, private investment will remain stifled, and the promise of inclusive growth will remain perpetually deferred.
The depressing social and economic outturns during FY23-FY25 should serve as a wake-up call, the next FY27 budget must not be yet another missed opportunity. The time for halfway measures is long gone. Pakistan's political leadership must decide whether they wish to continue administering the same palliative year after year—or whether they are finally prepared to confront the structural roots of the fiscal trap that has held the economy back for far too long.
Copyright Business Recorder, 2025