Lecture Business economics - Lecture 32: Monetary and fiscal policy

In this chapter you will learn the theory of liquidity preference as a short-run theory of the interest rate, analyze how monetary policy affects interest rates and aggregate demand, analyze how fiscal policy affects interest rates and aggregate demand, discuss the debate over whether policymakers should try to stabilize the economy.

Lecture 32

Monetary and Fiscal Policy

Instructor: Prof.Dr.Qaisar Abbas

Course code: ECO 400

Lecture Outline

A. Monetary Policy

B Fiscal Policy

Monetary Policy

• Monetary policy is concerned with regulation of quantity, cost and allocation

of money and credit in the economy It is a mechanism, which has serious implication for economic development It helps individuals decide the amount and place of investment, rate of savings and spending

Monetary Policy

Definition of Monetary Policy

• The actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates Monetary policy is maintained through actions such as increasing the interest rate, or changing the amount of money

banks need to keep in the vault

• http://www.investopedia.com

• Money policy in many countries has been kept away from direct arena of government The government only establishes basic rules and eventual targets However, in Pakistan many policy has been a much more

government controlled and influenced tool

Monetary Policy

– Interest rates have been pre-determined

– Sector credit targets are defined

– Market has not played an influential role

The monetary management may be divided into two periods

• pre-1991 period

• Post-1991 period

Monetary Policy

Pre- 1991 Period

• Pre-1991 period

– Before the 1991 financial sector reforms, the government’s management program was considered to be a loosely managed, highly unorganized system In 1972, when the banking reforms were taken, a National Credit Consultative Council (NCCC) was established to determine the distribution of credit in the economy

– An annual credit was and still is devised each year to determine the extent of monetary expansion for the year The government administered all rates of return and the whole economy had to accept

them It is far to say that Money Policy prior to 1991 worked fairly

well and government had pursued an economic growth strategy :

• By controlling interest rates

• Directing credit to priority sectors

• Obtaining cheap credit from banking sector

• Post-1991

– From 1991 till today the financial sector has been in the throes of

major transformation The impetus to these drastic reforms is the World bank and International Monetary Fund

Recent Monetary Policy Framework in Pakistan

• Objective(s) of SBP’s monetary policy is to strike a delicate balance on inflation containment and maintaining/supporting economic growth

• Change in the monetary policy stance is communicated through adjustment in the policy rate – the overnight rate at which SBP provides collateralized cash to bank(s) If required, changes in the Cash Reserve Requirement (CRR) and Statutory Liquid Reserve requirement (SLR) are also made

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Inherited Macroeconomics Imbalances

• Government inherited large macroeconomic imbalances owing to expansionary monetary and fiscal policies, with them having spillover effects on the current account but without adjustment of the exchange rate because of large capital inflows

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FY 05

FY 06

FY 07

FY 08

FY 09

FY 10

Recent experiences with monetary management:

• The resurgence in inflation is attributable to a number of factors

• Reform measures (to dismantle past distortion/suppression of energy and oil prices) whose impact is being felt in the short-term

ü Reduction in energy related subsidies

ü Automatic pass through of increase in international prices of oil in electricity tariffs

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Recent experiences with monetary management:

Overall 20.8 11.7 13.1 15.3

Household Furniture and

Source: Federal Bureau of Statistics

Recent experiences with monetary management: InflationMultiple Shocks/Factors

edible oil, wheat, rice, corn, etc

• Food inflation (Prices of perishables increased by 48 percent during Aug-Sep,10 and have declined by only 6.7 percentage points in October) after floods (supply chain issues)

• Crop Losses

• Damage to communication infrastructure

• Increase in transportation costs

• Hoarding and cartelization

• Impact of expansionary fiscal operations to finance relief expenditures

• Government borrowings from SBP (Rs 184 billion since 1st July) owing

to security & flood related expenditures and delayed receipt of external assistance and re-imbursements

• To contain inflationary pressures SBP has raised the policy rate twice since the beginning of FY11 (in July and September 2010), by 50 bps each

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Recent Policy and Administrative Monetary Policy

• Establishment of a Monetary Policy Committee (MPC)

- A 9 member MPC chaired by Governor SBP with two external academic experts

- Minutes of MPC meetings along with votes of members (without names) on monetary policy decisions posted on SBP’s website, increasing transparency of monetary policy formulation process and SBP’s credibility

• Frequency of Monetary Policy reviews and decisions has been increased

- Instead of twice a year SBP now announces its monetary policy decisions six

times a year

- This has reduced uncertainty and increased SBP’s ability to influence market expectations and respond to changing economic conditions in a timely manner

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Policy Rate vs Inflation in Pakistan

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B Fiscal Policy

Objectives of Fiscal Policy

• Achievement of Full Employment

Other Objectives

• To increase exports and control unnecessary imports

• To minimize dependence on foreign aid and achieve self-sufficiency

• To provide inducement for saving and channel those savings into investment

• To increase per capita investment

Tools of Fiscal Policy

Fiscal Policy in Pakistan

• Fiscal policy relates to the government’s resource mobilization, collection and expenditure The government requires funds to finance public

investment and social development schemes and day to day running of the government machinery

• Taxes are levied on incomes, profits, goods and services, which enable the government to carry out their services Fiscal policy also provides

stabilization mechanism, which may be used to control and direct key

economic variables such as inflation and unemployment

Taxation system

• Taxes have a far-reaching effect on the economy They influence savings and investment decisions in both private and public sectors There are three major groups of taxes responsible for much of the revenue collected in Pakistan:

– Income tax

– Sales and excise tax

– Taxes on foreign trade

SOME SALIENT FEATURES OF PAKISTAN’S RECENT

TAX SYSTEM

Income Tax

•.Heavy Reliance (53%) on Withholding/Presumptive Taxes

•.Progressive Personal Income Tax (max rate: 20-25%)

•.Corporate Income Tax (35% rate)

•.Universal Self-Assessment Scheme

•.Advance Tax Regime

General Sales Tax

SOME SALIENT FEATURES OF PAKISTAN’S TAX

SYSTEM

Custom Duty

• Cascaded Tariff Structure (max rate: 25%; six slabs)

• Tariff Peaks in Automobiles and other luxury goods

• Share of Dutiable Imports (51%)

Excise Duties

• on few industries like cigarettes, beverages and cement

• on Services in VAT mode

• 1% Excise Duty across-the-board on manufacturing and imports

B PROVINCIAL

Taxes

• AIT, Land Revenue, Stamp Duty, Motor Vehicle Tax, Property Tax, Excises

• Sales Tax on Services

TAX-TO-GDP RATIO OF PAKISTAN

* On petroleum products and natural gas

Source: Ministry of Finance, Government of Pakistan.

THE IMBALANCED SECTORAL DISTRIBUTION

OF THE TAX BURDEN

• Till date the taxation system of Pakistan is criticized on the following grounds.

– There is wide spread tax evasion

– The proportion of indirect taxes in the total tax revenue is very high

– The tax system is not elastic i.e government revenues do not rise proportionally with rise in incomes

Taxation system of Pakistan

• The need for reform in the tax system has been passing in recent years at government expenditures have increased and budget deficit is rising.

RECENT REFORMS (2008-09 ONWARDS)

Carbon Tax

• Introduction of Fixed Levy on Petroleum Products as ‘Carbon Tax’ with large revenue yield of over Rs 110 billion ($1.3 billion)

Direct Taxes

• Taxation of (Short Term) Capital Gains on Shares

• Extension of the Withholding Tax Net (Bank Cash Withdrawals, Air Travel)

• Introduction of Minimum Tax on Turnover (of 1%)

• Random Ballot for Audit with Outsourcing to private Accounting Firms

• Detection of New Tax Payers through Collateral Evidence

PROPOSED REFORMS Introduction of Comprehensive VAT (or reformed GST)

• Objective is to broaden tax base and reduce tax rate (17% 15%)

• Elimination of exemptions on goods, except basic foodstuffs and life-saving drugs, could generate ¼% of GDP

• Enhanced coverage of services (excluding education and health) could increase tax revenues in the medium term by 1½ % of GDP

• Reduction in tax burden on industry

• Introduction delayed till 1st October 2010 due to

ü ~ issue of collection by provinces of the sales tax on services

ü ~ lobbies (especially the trading community)

PROPOSED REFORMS

Provincial Taxes

Areas of focus:

• Capital Gains Tax on Property

• Urban Immovable Property Tax

• Agricultural Income Tax

• The target in the on-going IMF Program is to raise the tax-to-GDP ratio by

3½ percentage points by 2012-13.