On Minimizing the Welfare Cost of Fiscal Policy:Pakistan’s Case

This study analyzes the continued and separate fiscal policy options regarding taxes, expenditures and public debt for Pakistan. It evaluates the plausibility of an important hypothesis that seeks to maintain a balance between raising resources, increasing expenditures and contracting public debt i.e., the tax smoothing hypothesis. The study determines whether Pakistan has adopted a tax smoothing policy to overcome fiscal deficit and if so, what forms such policy has taken. The Wavelet Transformation is used for the first time to decompose the expenditure rate series into the permanent and transitory parts. The graphical and empirical analyses presented here reveal that Pakistan has tried to minimize the welfare cost of taxation but these policies have not followed best practices in tax smoothing elsewhere. The paper also makes some useful recommendations in this regard. It shows that in order to minimize the welfare cost of taxation the government should finance its permanent expenditure by increasing the tax rate while transitory shocks to the expenditures or output should be financed by creating public debt. The debt, so incurred, should, however, be contingent upon an emergency situation and retired when that emergency ends. It is asserted that if Pakistan’s fiscal policies are reformed along the lines suggested in this study it would lead to efficient and equitable policies which are based on robust theoretical and empirical foundations.