Tax smoothing, tax tilting and fiscal sustainability in Pakistan

Abstract

Pakistan has a long history of running fiscal deficits. There are two broad considerations motivating a government to run a deficit — tax smoothing and tax tilting. Tax-smoothing behavior results in fiscal deficits because in the presence of non-lump-sum taxes, optimizing governments seek to minimize the distortionary effects of taxation by keeping tax rates smooth over time, rather than varying contemporaneously with expenditure. Even if we assume that expenditures will remain constant over time, obviating the need for tax smoothing, fiscal deficits may arise due to tax-tilting behavior if the government's discount rate differs from the effective interest rate, as then there is an incentive to shift (tilt) taxation across time. This paper tests a version of Barro's tax-smoothing model, using Pakistan data for the period 1956–1995. The empirical results indicate that Pakistan's fiscal behavior is consistent with tax smoothing, as taxes remained relatively constant in response to anticipated changes in expenditure, most likely due to the government's inability to raise revenue. In addition, its fiscal behavior has been dominated by the stagnation of revenues, large tax-tilting-induced deficits, and the consequent accumulation of excessive public liabilities. An analysis of the time-series characteristics of tax-tilting behavior indicates that the stock of public liabilities is unsustainable under unchanged fiscal policies.