Pakistan Institute of Development Economics


Fiscal Policy Effectiveness for Pakistan: A Structural VAR Approach

The role of fiscal policy in affecting economic activity has been on the theoretical and applied research agenda for both academicians and policy makers since the evolution of macroeconomics. Fiscal Policy can affect an economy dynamically; this impact could differ across economies depending on the structure of the economies. In the context of developing economies, such as Pakistan, where active fiscal policy or a non-Ricardian fiscal policy is practiced, large seinorage revenues exist and ratchet-up effects of expenditures are found [Khalid, et al. (2007)], it becomes crucial to ascertain the fiscal policy effectiveness. This paper attempts to identify the fiscal policy effectiveness with respect to different budgetary components towards aggregate economic activity in Pakistan. Here Structural VAR estimation using Blanchard and Roberto (2002) methodology is applied to identify the impact of fiscal policy instruments on the economy for Pakistan. In Pakistan’s case it is evident that fiscal policy has been playing a major role in providing policy options for the government throughout her history of economic management. It was observed that government expenditures at the aggregate level affect the economy in line with the theory, i.e. it affects the economic activity positively, whereas the tax variable shock affects economic activity opposite to the theory. This may be due to the fact that the tax elasticities are very low and government expenditures also behave in a ratchet up manner, as also pointed out by Khalid, et al. (2007) while estimating fiscal reaction function for Pakistan. Hence when revenues increase the government expenditures also increase instead of paying off the debt, which may lead to a positive impact on the economic activity. We also estimated separately, the fiscal policy effectiveness for fiscal policy instrument sub-components i.e. defense and interest payment expenditures. In our analysis it turns out that defense expenditures have positive impact on economic growth while interest payments negatively affects it which is comparable to a number of studies. Similarly disaggregated analysis for the revenue variable by splitting the tax revenues in the broad categories of direct taxes and indirect taxes were also made. From that analysis it appears that direct taxes affect economic activity negatively while indirect taxes ambiguously affect economic activity positively.

Mahmood Khalid And Ahsan Ul Haq Satti

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