Fiscal policy and its role in reducing income inequality: A CGE analysis for Pakistan

Transcription

1 Fisal poliy and its role in reduing inome inequality: A CGE analysis for Pakistan Dr.Arsad Ali Batti 1 Dr. Hasnain A. Naqvi 2 Zakia Batool 3 Abstrat Tis Study aims at analyzing te link between fisal poliy and inome distribution. Te model adapted was te simple Computable General Equilibrium model (CGEM- Pak) wi was developed in aordane wit te stati model struture onstruted by Lofgren et al. (2001). CGE model takes into aount market interation, tat is, te effets of priing outomes of one market in oter markets, and its effets, in turn, reating ripples trougout te wole eonomy, peraps even to te extent of affeting te prie-quantity equilibrium in te original market. Due to some misalulations in Soial Aounting Matrix (SAM) 2007, tis study uses SAM 2002 developed by (Doros et al, 2006). To explore te impat of fisal poliy measures on inome inequality, simulation exerises are performed wile te budget defiit is not allowed to inrease in te set of simulations. Inequality effets are investigated using Teil T, Teil L, Teil S and Hoover s Index. Results ave sown tat a poliy mix of sales tax, inome tax and government expenditure elp to redue inome inequality wile at te same te lessen eonomy s finanial dependeny. Key Words: Computable General Equilibrium (CGE), Soial Aounting Matrix (SAM), Fisal Poliy, Inome inequality, Budget Defiit. 1 Assistant Professor and Head of Sool of Eonomis, IIIE, International Islami University, Islamabad. 2 Assistant Professor and Resear Assoiate, Department of Management Sienes, COMSATS institute of information Tenology, Islamabad. 3 Leturer, Eonomis Department, NUML, Islamabad. 1

2 1. Introdution Inome inequality is one of te ritial barriers in most of te developing ountries inluding Pakistan for growt and development. Every tird man in Pakistan falls in te ategory of poor, tat is, one tird of te wole population exists below te poverty line 4. Moreover, te budget defiit as also been a serious issue trougout te istory of Pakistan s eonomy. Tis persistent defiit is te onstant soure of inreasing poverty and deterioration of inome distribution. Hene, it is a dire need of te eonomy to ave a good publi poliy su tat it ould redue budget defiit, alleviate poverty and redistribute inome. Wile disussing te role of fisal poliy in inome distribution, Alauddin and Bilquess (1981) and Malik and Saqib (1985) suggest tat only troug appropriate anges in te tax system, resoures of te eonomy an be distributed equally; wile, Saultz (1963), Saint Paul and Vedier (1993) and Ralp (1996) believe tat te publi expenditures ave a strong impat in reduing te degree of inome inequality. Fisal poliy an ave a signifiant influene on removing te gap between aves and ave-nots bot diretly and indiretly. Te diret effet lies in effeting te disposable inome of individuals and indiretly by effeting future earning apaities. Te progressive tax system is needed to redue te gap between ri and poor, but in Pakistan, te ratio of sales tax is ig wi is regressive in nature. Bot te pattern of publi expenditures and tax system an be strutured effiiently to redue inome inequality. It is important to note tat tere is an obvious and signifiant trade-off between equity and effiieny. Te poliies fousing on equity, by itting te urrent and future inome of investors, may disourage tem from investment. For example, inome transfers may redue inequality wi results in diversifiation of sare resoures from investment to subsidization of onsumption; onsequently, it redues eonomi growt by negatively affeting investment. Terefore, it is neessary to onsider tat ow mu ost, te eonomy as to bear in te form of derease in eonomi growt. International Monetary Fund (IMF) and oter finanial institutions stress Pakistan on reduing fisal defiit. In , te fisal defiit remained more tan 8.5% of GDP wile te target was 4.7 % of GDP. Wit referene to inome distribution, an IMF 4 SDPI s study (2012) 2

3 poliy paper 5 igligts tat ig inome inequality results in impeding maroeonomi stability. Tus, poliies related to tax and expenditure sould be made in su a way tat te eonomy ould aieve bot te distributional and effiieny objetives during fisal onsolidation. Tis study is an attempt to find a poliy wi ould redue inome inequality wereas at te same time aieving te objetive of reduing te fisal defiit. Terefore, in te ligt of signifiane of good governane, te fous of tis study is to a. Analyze te impat of fisal poliy (taxes, transfers and government expenditure) on inome distribution, tat is, weter it deelerates inome inequality or not. b. Verify te existene of trade-off between inome distribution and eonomi growt, sine te appliation of fisal poliy may involve te issue of trade-off between equity and effiieny 6.. Reommend te most feasible mixture of taxes and transfers. Plan of Study: Tis apter introdues te problem. Te review of literature is given in seond apter. Tird apter disusses te metodology. Capter four provides results and disussion. Finally, onlusion and poliy impliations are provided in apter five. Referenes are also provided at te end of tis study. 5 IMF Poliy Paper, Fisal poliy and inome inequality January 23, Equity versus effiieny: Te elusive trade-off by J. Le Grand (1990) 3

4 2. Literature Review Inome inequality remains a ore issue in designing an effetive fisal poliy. In ase of Pakistan, Suleman (1973) observes te inome inequalities to be inreasing over te period of , wereas Kandkar (1973) sows tat te trend in inome inequality is dereasing over te period of In 1980s, most of te studies foused only on measuring inome inequality using different indies (Mamood, 1984), wile merely few studies were based on making redistribution strategies (Ceema and Malik, 1985). Ayub (1977) and Kandkar (1973) sow tat in Pakistan te inequalities in inome are signifiantly iger tan te inequalities in onsumption. Tere are many fators wi an affet inome distribution. Many studies ave been done in developed and developing ountries to find out te effetive poliy measures to redue te inequality in inome distribution 2.1 Tax and Transfer for te Redution in Inome Inequality A fine poliy mix of tax and transfers an signifiantly improve te distribution [Leubker (2011)]. Cubero and Hollar (2010) prove in teir study tat government an give any sape to te inome distribution pattern by using tax and transfers. Te nature of tax plays a very ritial role in poliy making. Joumard et al (2012) work on te same ground and find tat a ountry aving relatively small tax and transfer seme attains te same redistribution effets as a ountry wit iger tax rate and transfers if tey rely on inome tax wi are progressive in nature. Engel et al. (1999) measure te diret effet of taxation on te inome of ouseolds and tus its effet on te distribution of inome. Furter, tey suggest tat, to aieve equal distribution, proportional tax system must be introdued instead of low-yield progressive taxation. Martinez-Vazquez et al. (2011) studies tat if an eonomy prefers diret taxes to indiret taxes, ten inome distribution improves gradually over time. Alesina and Ardagna (1998) and Park (2012) observe tat a fisal adjustment mainly based on inreases in tax rate is sort-lived wile redution in government wages and publi employment transfers is long-lived. Tere is also a lot of disussion on te effetiveness of government spending over tax on inome distribution. Martinez-Vazquez (2008), Bird and Zolt (2005) and Harberger (2006) argue tat fisal adjustment based on tax system does not affet te distribution pattern. Cubero and Hollar (2010) analyze te impat of tax and spending deision on te distribution of inome and find tat government spending as more potential in orreting 4

5 distribution, but progressive tax system ombined wit inreased soial spending may furter improve te distribution. 2.2 Trade-Off between Equity and Effiieny In evaluating te impat of fisal poliy, many researers find a visible trade-off between equity and effiieny due to wi many poliy makers and politiians are seen relutant in using fisal poliy for fair distribution of inome. Bertola and Allan (1993), Dollar and Aart (2000), Perugini and Martino (2008), Mulas-Granados (2005) and Lambert (1990) disuss te trade-off issue and onlude tat any ange in fisal poliy requires a detail analysis of its effet on bot equity and effiieny. Alesina, and Rodrik (1984) sow tat te growt oriented poliies are favored by a government tat onerns apitalists only. Teir empirial findings sow tat tere exists a negative relationsip between eonomi growt and Inome distribution. Afonso et al. (2005), Moreno-Dodson (2008) and Bayraktar and Moreno-Dodson (2010) analyze te impat of publi spending on growt and onlude tat publi spendings negatively affets te quality and quantity of eonomi growt wi onseutively affets te inome distribution. Wile, Deininger and Squire (1996) and Ravallion and Cen (1997) see no relationsip between growt and inequality. 2.3 Analysis of Fisal Poliy Using CGE Computable General Equilibrium (CGE) model as a distinguising feature: it identifies te impat of any small exogenous ange on te overall eonomi system. Adelman and Robinson (1978) and MLure (1977) argue tat te general equilibrium models an assess te eonomi beavior in an interesting dimension tat annot be viewed in partial equilibrium studies. Lofgren et al. (2003) wile explaining te merits of CGE examine tat it laks denseness beause in addition to SAM, only estimated set of parameters for witin-group distribution is required to run te exogenous simulations. On te oter and, tis approa as a drawbak tat it assumes tat witin-group distribution is fixed. Lofgren, Robinson et al. (2003) furter suggest tat to overome tis drawbak, te ouseolds in te CGE model an be disaggregated into more setions. Tus in tis way we an find out te witin group differene in inome. Wile Dal et al. (1986), Dal and Mitra (1989) and Mitra (1992) used CGE approa to study te maroeonomi impats of fisal ange witout onsidering setoral details tat is tey did not disaggregated ouseolds and oter aounts into large groups. Using CGE model for te eonomy of 5

6 Canada, Cury, Pedrozo and Coelo (2010) onfirm te effetive role of government transfers in reduing inome inequality. In Pakistan, Iqbal and Siddique (1999) undergo a omplete and desriptive study using CGE approa to analyze te impat of fisal adjustments on inome distribution and it is sown tat redution in onsumption subsidies and expenditures on ealt and eduation adversely affet inome distribution. In teir study, Iqbal and Siddique (1999) observe tat earnings of fators of prodution from prodution ativities are an important fator of inome distribution beause poor ouseolds obtain teir sare from wage inome and ri lass gets most of teir sare from inome of apital. Siddique and Iqbal (2001), in teir later work, examine te impat of tariffs on inome distribution using CGE model and onlude tat redution in tariff elps to redue te gap between ri and poor. Kemal et al. (2001) use CGE model and SAM for and analyze te impat of redution in import tariffs on inome distribution. Tey suggest tat redution in tariff auses te pries of imported ommodities to derease, wi in turn affets te fores of demand and supply in te ommodity market. Tese anges in te fores of demand and supply furter worsen te distribution pattern beause su poliies affets te onsumption as well as inome of ri more positively tan tat of poor. Naqvi et al. (2011) use CGE model for Pakistan to study te impat of agriulture taxes on inome distribution and welfare of ouseolds. Tey use SAM 2001 and onlude tat a ombination of redution in sales tax and imposition of taxes on agriulture is an effetive distribution poliy tool. It is observed tat agriulture tax orrets te distribution pattern and auses te government revenue to inrease in su a way tat government as a situation of budget surplus. On te oter and, budget surplus enables government to make redution in sales tax, due to wi prodution ativities inrease and at te same time, te welfare of te ouseolds also improves. Overall, te above literature sows tat fisal poliy an play an effetive role in reduing inome inequality. However, in te framework of omputable general equilibrium (CGE) model, te above literature ignores te deterioration in budget defiit wile analyzing te impat of different tools of fisal poliy on te distribution of inome. In tis study, we take up tis issue and onsidering te budget defiit, investigate te impat of ouseold inome tax and subsidies on te distribution pattern using CGE framework. 6

7 3. Estimation Metodology In order to assess te impat of fisal poliy measures on inome distribution, omputable general equilibrium model of Pakistan (ereinafter CGEM-Pak) is used. Tis model is in aordane wit te stati model struture onstruted by Lofgren et al. (2001). CGE is a quantitative model in wi all te fators and setors wi an affet te eonomy are inorporated. Te CGEM-Pak is a domesti model and it aptures te eonomi ativities of ountry. Tis model follows te SAM (Doros et al, 2006), segregation of ativities, ommodities, fators and institutions. Equations in te model are onstruted in su a way tat it ould satisfy miro and maroeonomi onstraints. Wit few amendments in te model, different senarios are presented to sow te net impat of fisal adjustments on te eonomy under onsideration. Tese amendments inlude te desegregation of agriulture ativities and servies. Table 3.1 demonstrates te disaggregation of ativities, institution, fators of prodution and ouseolds. TABLE 3.1: Sets and Elements of CGEM-Pak Model Set Element Disaggregation Institutions - Houseold, Government, Entrepreneur, Rest of te world Houseold Rural Large, medium, small and landless farmer, poor non-agriultural labor, poor non-farm labor, ri non-farm labor Urban poor labor, ri labor Ativity Agriulture - Nonagriulture Mining, Food manufaturing, yarn, Textiles, leater, Oter Manufaturing. Servies - Fators of - Own large farm labor, own medium farm labor, own small farm labor, Prodution agriulture wage labor, non-agriulture unskilled labor, skilled labor, large farm land, irrigated medium farm land, irrigated small farm land, nonirrigated small farm land and apital. Tere are four bloks of equations in te model Prie Blok Te model is onstruted wit te framework tat ea ativity produes one ommodity only. Export prie (PE) is alulated by multiplying ommodity s produer prie by exange rate and ten subtrating te export tax from it. 7 Soial Aounting Matix 7

8 PE PWE ( 1te ) EXR (3.1) were PE is domesti prie of exported goods, te is export tax rate, EXR is nominal exange rate, PWE World prie of Exports (Foreign urreny units), subsript is ommodities. Domesti onsumers pay prie of te imports to te rest of te world. Tey pay tariff on tese imports, so import prie (PM) is determined by adding te tariff in te import prie. PM ( 1tm PWM EXR (3.2) ) Were PM =domesti prie of imported goods tm = Import tariff rate EXR=exange rate (nominal) PWM =World prie of imports (Foreign urreny units) Te demand prie of domesti goods (PX) is determined by adding te domesti supply prie and ost of trade inputs per unit of domesti sales. Te final supply prie (Ps) for te domesti ommodity is obtained by te interation of produer and export prie. PX QX PD QD PE QE PD = Domesti prie of domesti output QD C = Domesti sales quantity PE =domesti prie of exported goods QE C =Quantity of exported ommodities (3.3) Te final supply prie (Ps) for te non exported ommodity is PX QX PD QD (3.4) Composite ommodity s prie (PQ) is determined by adding import and domesti pries. Te final market prie is ten determined by adding sales tax to te Composite ommodity s prie. PQ ( PD QD PM QM)(1 tq ) (3.5) PD = Domesti prie of domesti output QD C = Domesti sales quantity PM =domesti prie of imported goods QM C =Quantity of imported ommodities tq = Rate of sales tax 8

9 Te final market prie of omposite non-imported ommodity s prie is PQ QQ PD QD 1tq ) (3.6) ( Gross revenue per ativity (ativity prie) is alulated as PA a a, PX (3.7) C Were a, is Yield of output per unit of ativity a Prie of value added (fator inome per unit of ativity) is determined by PVA a PAa ir, C a PQ (3.8) Were ir, a is Quantity of as intermediate input per unit of ativity a Prodution and Commodity Blok Te model inludes nine prodution ativities 8 using primary and intermediate inputs. Tese ativities ollet teir revenue from selling te produts tey produe. Tey ten use te revenue for te purase of te required inputs to arryout prodution. Eleven fators are involved in prodution wi inludes six labor types, four types of land and apital. Primarily inome distribution is determined by measuring ow mu value added flows from te setor of prodution to fators of prodution. Tis distribution depends on te ouseold s ownersip of different fators of prodution. Houseolds differ in skills so tey get different inome aordingly. Constant elastiity of substitution (CES) funtion is used to apture te prodution pattern at different level. Subjet to onstant returns to sale, te produers are assumed to maximize teir profit. Tis implies tat te fators of prodution reeive teir inome, were marginal ost equals marginal revenue. Leontief tenology is used to ombine fators wit fixed sare intermediates. Tus, te output from tese ativities using primary fator under Cobb-Douglas funtion is measured as QA a ad a f QF f, a f, a (3.9) QA a= Quantity (level) of ativity a QF f,a = Quantity demanded of fator f from ativity a ad a = Ativity parameter of prodution funtion 8 Details of ativities and fators of prodution is given in table1 9

10 α f, a = Value added sare for fator f in ativity a Tese ativities also use intermediate inputs QINT, a ir, a QAa (3.10) Were ir, a is Quantity of as intermediate input per unit of ativity a. Tus, ea domesti ommodity an be defined as QX a, QAa (3.11) aa θ a = Yield of output per unit of ativity a Model inludes te foreign trade wit te assumption tat tis trade is based on imperfet substitutability between domesti and imported goods. Tis substitution is governed by CET 9 funtion. Tus, wen te ommodity is exported it takes te following form; QX ax [( 1x ) QD x x QE x ] 1/ Te optimal ombination of tese two goods must satisfy x (3.12) QD / QE x 1/( x [( x 1) 0 /1x )( PD / PE )] x, (3.13) Energy is te only produt in tis model wi is produed and onsumed domestially tat is prodution of energy setor is neiter exported nor imported. Tus, te nonexported ommodity is defined as QX QD (3.14) Te final omposite good wi is te ombination of imported and domesti goods is supplied to meet te final and intermediate demand. Tus te quantity of omposite ommodity supplied to domesti ommodity demander is QQ aq [(1 q ) QD q q QM q ] 1/ Te optimal ombination of tese two goods must satisfy q (3.15) QM / QD [( q /1 q )( PD / PM )] q 1/ (1 q ) 0 q (3.16) Te quantity of non-imported ommodity supplied to domesti ommodity demander is 9 Constant elastiity of transformation 10

11 QQ QD (3.17) Institution Blok Institutions obtain teir inome from fators of prodution after teir involvement in te value added. Nine ouseold groups 10 are inluded in te model. Inome of apital is distributed among te nine types of ouseolds, enterprises and government. Tus YF sry FPD PF QF i, f i, f f, a f f, a aa (3.18) sry i,f = Sare for institutions i in inome of fator f FPD f,a = Fator prie distortion for fator f in ativity a PF f = Rate of return to fator f QF f,a =Quantity demanded of fator f from ativity a Houseold s inome is alulated as YH YF, f TR, g CPI EXR TR, r TR, f F s (3.19) YF,f = Transfers of fator inome to ouseold TR,g = transfer payment from government to ouseolds TR,r = transfer payment from rest of te world to ouseolds TR,s = transfer payment from firm to ouseolds CPI=onsumer prie index Transfers of government to ouseolds are CPI indexed, tat is, tey an be fixed in nominal terms. After tax saving of tese ouseolds an be written matematially as MPS HTS 1 ty YH (3.20) Were marginal propensity to save of any ouseold is MPS MPSIN 1 MPSADJ MPSDUM (3.21) MPSIN = Initial marginal propensity to save MPSADJ= MPS adjustment fator MPSDUM = 0-1 dummy: 1= for tose H wose saving anges, 0 oterwise Te ouseolds utility funtion an be written as UH QH,,, (3.22) 10 Large farm, Medium farm, Small farm, Landless farmers, Rural agriulture landless, Rural non-farm nonpoor, Rural non-farm poor, Urban non-poor, Urban poor 11

12 QH, = quantity onsumed of ommodity by ouseolds β, = sare of onsumption spending of ouseold on ommodity Were QH,, EH PQ (3.23) EH = onsumption expenditure of ouseold. And 1 1 EH MPS ty YH (3.24) ty = ouseold inome tax rate. Te quantity of investment demand for ommodities is alulated by multiplying base year investment demand by investment adjustment fator wi is exogenous. QINV INV IADJ (3.25) Te government setor ollets inome from diret (inome tax from ouseolds) and indiret taxes and also from apital (YF g,f ) and uses it on onsumption expenditure and transfers to ouseolds. Bot of tese payments are fixed in real terms. In tis model, Government is onsidered as a onsumer and its onsumption for ea of te ommodity is exogenously fixed. Tus, te government budget surplus (GBS) is determined by subtrating government expenditures from government revenue. H GBS tyyh EXR TRg, r tqpdqd tq PM QM YFg, f CM tm EXR PWM QM CM C CM te EXR PWE QE TR s, g TR, g CPI PQQG (3.26) H C Were ty =inome tax tq =sales tax rate tm =import tariff rate te =sales tax rate on exports Entrepreneurs reeive teir inome only from apital. Tey ten make transfers to ouseolds and savings. Teir saving is alulated as te differene between teir inome 12

13 and expenditures. It is also assumed tat tey do not onsume ommodities. Tus, inome of entrepreneurs is written matematially as YFRM YF s, k (3.27) And teir saving is YFRMTS YF s, k TR, s (3.28) Rest of te world is taken beause te model assumes open eonomy. Tus, ountry exports its produt to and imports produt from rest of te world System Constrained Blok Tis blok ontains te equations sowing te onstraints in te model. In fator market, te quantity of fators supplied must be equal to te sum of quantity demanded from ativities and te unused supply of fator f (QFU f ). Tus aa QF f, a QFU f QFS f (3.29) Market of omposite ommodity also involves te onstraint tat quantity supplied must be equal to te quantity demanded. Tus matematially QQ aa QINT QH QG QINV, a, (3.30) H QQ =supply of omposite ommodity QINT,a =quantity of ommodity used as intermediate input QH, = quantity onsumed of ommodity by ouseolds QG = quantity of onsumption of ommodity by government g. QINV = base year investment demand Te onstraint related to urrent aount balane expressed in foreign urreny imposes tat tere must be equality between foreign exange earnings of te ountry and its spending CE FS PWE QE TRi, r PWM QM TRr, i ii FS= foreign saving PWE QE =Export revenue CM ii (3.31) 13

14 TR i,r =transfer payment from rest of te world to oter institutions PWM QM =Import Revenue TR r,i =transfer payments from institutions to rest of te world Finally saving of institution must be equal to te quantity of investment demand for ommodities. Tus H MPS (1 ty ) YH C PQ YFRMTS GBS EXR BOP QINV (3.32) 3.2 Model Closure Te losure presents te maroeonomi assumptions to ondut simulations wi are usually done by anging te value of poliy variables tat are exogenous. Ten te impat of tese simulations on equilibrium values of endogenous variable is measured. Te losure in tis model assumes fixed Foreign Savings (FS) and ene a flexible exange rate (EXR) lears te urrent aount. For savings/investment aount, savingsdriven investment is assumed, terefore savings are fixed, and Investment adjustment fator (IADJ) is flexible, permitting investment to adjust. For apital market, it is assumed tat apital is ativity-speifi and fully employed. Tis means tat te prie of apital is fixed and fator prie distortion adjusts to lear te market. Note tat apital is te only fator wi is used in all types of ativities. Tere are four types of land in our model 11 and all types are being used in agriulture setor, wi as only one ativity (agriulture). For land market, it is assumed tat all types of land are fully employed and ene prie of land will lear te market. Tere are four types of agriulture 12 and two types of nonagriulture labor 13 in te labor market of te model. Tey are mutually exlusive and tere is no mobility of labor aross tese setors. Te assumption of four types of agriulture labor is tat tey are fully employed and ene prie of labor (wage rate) will lear te market. In CGEM-Pak, non- agriulture setor as eigt types of ativities and ea type of ativity uses two types of labor (non-agriulture labor; skilled and unskilled). Full 11 Large farm land, irrigated small farm land, irrigated medium farm land, non-irrigated small farm land 12 Own large farm labor, own medium farm labor, own small farm labor, agriulture wage labor 13 Skilled labor, non-agriulture unskilled labor 14

15 employment is assumed for non-agriulture labor. Moreover, labor is fully mobile witin te setor and a unique wage lears te labor market. 3.3 Inequality Measures Due to te limitation of our data, only inequality between ouseold groups is aptured. To alulate inequality, Teil-L, Teil-T and Teil-S indies are used. Te Range of Teil-T index from 0 (lowest inequality) to ln(n) (igest inequality). Conversely, te Teil-L index ranges from 0 to infinity and te iger te value of Teil-L, te iger te inequality is. Matematially, te indies are written as TT ln N YH YH N ln YH YH (3.34) and Teil-L an be written as: TL ln YH N N YH ln N N (3.35) Were YH = Total inome of te population YH = Inome of subgroup N = Total population N = Population in te subgroup symmetrized Teil index an be alulated as: 1 TS 2 TT TL. Substituting values of TT and TL in above equation 1 TS 2 YH ln N YH YH N N (3.36) 15

16 3.4 Data and Model Calibration Due to some misalulations in SAM , it is not used in tis study. Tis study uses te available Soial Aounting Matrix (ereinafter SAM) developed by Doros, Niazi and Nazili (2006), for te year as benmark dataset. SAM represents all te transation between te agents of te eonomy witin a partiular period. Te SAM used in tis study was developed for te year Tis square matrix (SAM) reflets te reeipts and payments of different transations done by different agents of te eonomy and satisfies all equilibrium onditions and properties of CGEM-Pak Struture of SAM ( ) SAM onsists of 5 major aounts, namely ativities, ommodities, fators of prodution and institutions and savings. Institution aount inludes ouseold, enterprises, government and rest of te world. Te basi struture of maro SAM is presented in Table 3.2 wi explains te features of maro SAM, wile Table 3.3 presents te maro SAM of Pakistan for te year Miro SAM explains te disaggregation of aounts in maro SAM. Te original miro SAM inludes 34 ativities, 33 ommodities and 27 fators. Te aount ouseolds ave been disaggregated into 9 sub-aounts, out wi 7 are rural type and 2 urban types. Te original SAM as many ategories of agriulture and servie setor as te objetive was to ek te impat of agriulture growt on poverty. But in tis study, a modified miro SAM is used wi aggregates te servie and agriulture ativities into only one ategory ea beause tere is no need to inlude details of agriulture and servie setors. Te remaining ativities are aggregated into 6 ategories tat is mining, food manufaturing, yarn, textiles, leater, oter manufaturing. Tis SAM onsists of 9 ommodities, 11 fators of prodution, 9 ouseolds and tree oter institutions. Ideally, trade elastiities sould be estimated eonometrially from ross setion and time series data. Given limited resoures as well as data onstraints, it is not possible to estimate elastiity parameters for tis study. Terefore, elastiity parameters employed by different studies examining similar questions for omparable developing eonomies ave been used. Tese trade elastiities are sown in Table 1 in Appendix. 16

17 TABLE 3.2: Struture of Maro Soial Aounting Matrix Ativity Commodity Fator Houseolds Govt. Enterprise ROW Saving Total Ativity Gross output Gross output Commodity Intermediate Demand Houseold s Consumption Govt. onsumption Exports Invest. Expenditures Agg. Demand Fator Value added Fator inome Houseolds Fator Inome Y f Operating surplus Remittanes From abroad Houseold Inome Govt. Enterprise Tariff, diret and indiret tax Fator inome Y KE Inome Tax ROW Imports Transfers to ROW (TR HR ) Saving Depreiation Houseold Saving Total Cost of Agg. Supply Fator Houseold Prodution Expenditure Expenditure Govt. transfers To ouseold Interest payment (TR GE) Govt. Saving Govt. Expenditure Profit tax TR EG TR ER Enterprise Saving Enterprise expenditure Soure: Derived from transforming maro SAM struture developed by Nielsen (2001) for Vietnam. Foreign saving Foreign Exange Expenses Investment Govt. Revenue Enterprise inome Foreign Exange outflow Saving 17

18 TABLE 3.3: Maro SAM Pakistan (Million Rs) ACTIVITY COMMODITY FACTOR HOUSEHOLD GOVT ENTERPRENUER ROW SAVING TOTAL ACTIVITY COMMODITY FACTOR HOUSEHOLDS GOVT ENTERPRENUER ROW SAVING TOTAL Soure: SAM for Pakistan 18

19 Te equations of te model explained above sow ativities of maro eonomy, wile troug te alibration proess te SAM gives atual values for te oeffiients in tese equations. Te model is solved primarily for equilibrium to make sure tat te base year dataset is reprodued. Afterwards, we give a sok to te model by anging te value of one of te exogenous variables. Te model is ten re-solved for equilibrium (as before) and anges in te values of te endogenous variables. Tese values are ten ompared wit te base-year equilibrium to establis te impat of exogenous soks. Te distributional impat of exogenous soks (maro variable) is determined by te indiators, tat is, Teil T, Teil L, and Teil S. At te same time, te impat of tese poliy measures on eonomi growt and oter maroeonomi variables su as exports, imports, investment et. is analyzed to ek te trade-off between equity and effiieny, wi is supposed to be involved in te implementation of fisal poliy. 3.5 Simulation Design Different simulations are designed to run on te model of study, CGEM-PAK. Tese simulation exerises are arried out by inreasing or dereasing te values of suggested poliy tools until te inome inequality measures sow a deline in inequality. For te simulation exerise any perentage number an be taken, but sould be attested wit various sensitivity analysis [Israel (2006)]. Te proposed simulation strategies are sown in Tables 3.4 and 3.5 Simulations in Table 3.4 test te signifiane of government transfers to ouseolds, inome tax and sales tax in reduing inequality witout suggesting any measure to inrease revenues to over te resulting budget defiit. Simulation 1 tests te impat of an inrease in government transfers to ouseolds on inome distribution. As sales tax as a regressive nature, simulation 2 disusses te impat of a derease in sales tax and simulation 3 disusses te impat of an inrease in inome tax wit te assumption tat it as a progressive nature. Simulations in table 3.5 inlude different poliy mix in order to redue te gap between aves and ave-nots by onsidering its impat on budget defiits. Tese simulations are designed in su a way tat we ould ave a signifiant redution in budget defiit. Simulation 4 introdues tax and transfer seme. In tis simulation, sales tax is redued to derease te eonomi burden of poor and transfers from 19

20 government to ouseolds are inreased to inrease te welfare of ouseolds. On te oter and, te resulting defiit in budget is finaned by raising inome tax. Simulation 5 and 6 test te effet of different mixtures of sales tax, inome tax and government expenditure on inome equality and overall eonomy. In ea of tese simulations, we redue te sales tax to orret te inome distribution wile to over te resulting defiit in budget we ut te government expenditures and inrease te inome tax rate. TABLE 3.4: Simulation Senarios (Budget defiit is allowed to ange) Simulation Base senario 1 35% inrease in government transfers to ouseolds 2 6 % derease in sales tax % inrease in inome tax TABLE 3.5: Simulation Senarios (Budget defiit is not allowed to inrease) Simulation Base senario % derease in sales tax, 26.2% inrease in government transfers to ouseolds and 10.25% inrease in inome tax % ut in government expenditures, 7% redution in sales tax and 3.65% inrease in inome tax % ut in government expenditures, 7.01% redution in sales tax and 2.5% inrease in inome tax 20

21 4. Results and Disussion Our main simulation results of assessing te impat of different fisal poliy instruments are sown in Tables 4.1 troug 4.4. In tese tables, negative sign wit government budget surplus sows government budget defiit. GDPFC sows GDP at fator pries, GDPMP1 sows GDP from spending side at market prie wile GDPMP2 presents inome side GDP at market prie. GDPMP1 and GDPMP2 must be equal. GOVCON sows government onsumption and PRVCON presents private onsumption. 4.1 Simulation Results Allowing te Cange in Budget Defiit. Tese simulation exerises are arried out by inreasing or dereasing te values of suggested poliy tools until te inequality measures sow a deline in inequality wile we did not suggest any measure to over te resulting defiit in budget Government Budget Surplus, Inome distribution Eonomi poliies affet inome distribution troug tree meanisms. Firstly, tey diretly affet te inome of ouseolds by anging te return to primary fators. Seondly, a ange in inome tax or subsidies affet te disposable inome of ouseolds and lastly tese eonomi poliies affets te prie level tus te prie effet bring anges in te ouseold s real inome. Simulation 1 examines te impat of 35 % inrease in transfers on inome inequality. Te transfers from government to ouseolds are made to redue te inequality. In Table 4.1, te inome inequality index Teil T sows a derease in its value interpreting an improvement in inome distribution. Teil T responds to variations in te upper expenditure ategory. Tis poliy of inreasing transfers to ouseold auses budget defiit to inrease from 8457 to millions in Pakistani Rupees. Tis is beause in tis poliy, transfers ause an inrease in expenditure and no measure as been taken to raise revenue to over te osts. Simulation 2, in wi sales tax is redued by 6%, presents a similar result. Te value of Teil T dereases to but, oter inequality indiators remain unanged. A drastially negative effet on budget defiit is observed wi auses % ange in defiit wen ompared to its benmark value, tat is, budget defiit inreases from 8457 to million Rupees. 21

22 TABLE 4.1: Government Budget Surplus and Inequality Variables Base SIM1 SIM2 SIM3 Government budget surplus Teil T Teil L Teil S Result of Simulation 3 sows te impat of 5.81% inrease in inome tax. An inrease of more tan 5.9% in te inome tax rate leaves an adverse effet on inome distribution. In developing ountries, inome tax is souldered by middle lass and te tax ats are full of tax exemptions and te orruption fator makes tax evasion easy for ri 14. In Pakistan, majority of tax payers belong to middle or upper middle inome group 15. Terefore, a 5.81% inrease in te tax rate does not affet te inome distribution pattern. At te same time, te revenue raised by inome tax auses budget defiit to redue and a surplus of Rs million is observed. Tus, in Pakistan s eonomy inome tax poliy fails to serve as a tool for reduing inequality Maroeonomi Effets of Poliies Table 4.2 presents te maroeonomi effets of distribution poliies as disussed above. Te 35% inrease in transfers auses te GDP at fator prie to deline. GDP at market pries (bot from expenditure and inome side) sows a deline. A little improvement in equity is aieved at te ost of 0.016% (Rs million) redution in GDP at fator prie and 0.023% redution in GDP at market prie. It is beause te government transfers to ouseolds leave fewer funds wit te private investors, terefore investment dereases tat ause te eonomi growt to slow down. Furter, investment dereases by %, imports by 0.23%, and exports by 0.29%. We alulate net indiret taxes by subtrating subsidies and transfers from te total tax olletions. As in tis simulation transfers ave been made, terefore te index of net indiret tax presents a deline in its value relative to te base year tat is 14 Tapan, K.S (2006) Contrary to laims: Tax burden grows eavier for salaried people Report by Sabaz Rana in Te Express Tribune. 2. Murtaza, N (2012). 22

23 by 0.123%. Tese transfers on te oter and indue an inrease in private onsumption. Simulation 2 (ut in sales tax by 6%) sows a different effet on overall maro eonomy. It makes GDP at fator ost to inrease from Rs million to Rs millions. Tis ange is reorded beause a redution in sales tax (by affeting prie) indues more onsumption tat auses te demand as well as output to inrease. An inrease in GDP is translated into more exports; raising te later by million Rupees. Wile, GDP at market pries indiate a derease in its value wi onfirms te tradeoff between equality and eonomi growt. Wen GDP is alulated at market pries, it inludes te taxes and subsidies (taxes enter in te equation of GDP wit positive and subsidies wit negative signs). A derease in sales tax redues te GDP measured at market pries. Te existing literature sows tat an inrease in te sales tax brings a boom in real investment, 16 tus a derease in investment is observed. Furter, government onsumption, imports and private onsumption also inrease beause redution in sales tax auses te pries to fall and inreases te purasing power wilst dereasing te value of net indiret taxes. Moreover, redution in sales tax indues more onsumption. Results of simulation 3 (inreased by 5.81%) sow tat GDP at fator pries as well as at market pries inreases. Table 4.1 sows tat tis poliy doesn t affet te distribution pattern but sows an inrease in eonomi growt rate. As te government s revenue from tax olletion inreases, more expenditure an be made tus government onsumption inreases. Furter, tis poliy doesn t affet te investment deisions of investor lass, te revenue raised may be used to inrease te investment level and tus te exports inreases by 0.24% wile imports also inrease by 0.19%. On te oter and, inrease in inome tax auses disposable inome to redue so te private onsumption sows a deline tat is it dereases by 0.23% Jorgenson, D.W. (1996), te impat of taxing onsumption, testimony before te ommittee on ways and means, U.S House of Representation, Mar Kotlikoff, Laurene J.(1993), Te Eonomi Impat of Replaing Federal Inome Taxes wit a Sales Tax, Cato Institute Poliy Analysis No. 193, April

24 TABLE 4.2: Maroeonomi Indiators Variable BASE SIM1 SIM2 SIM3 GDP FC GDPMP GDPMP GOVCON INVESTMENT EXPORTS IMPORTS E E E E6 NITAX PRVCON Notes: GDPFC (GDP at fator ost),gdpmp1 (GDP at market prie form expenditure side), GDPMP2 (GDP at market prie form inome side), GOVCON (government onsumption), NITAX (net indiret tax) and PRVCON (private onsumption) 4.2 Simulation Results Considering Budget Defiit. Tese simulation exerises are arried out to find te poliy measures wi are elpful in reduing inequality wile not deteriorating te existing defiit in budget. Poliies wi address only distributional issue may ause a uge gap in revenue and expenditures. It is already disussed in te literature review tat distribution measures involve effiieny ost, terefore poliy pakages sould be introdued in su a way tat tese measures ould remove or redue te effiieny osts wile orreting inome distribution Government Budget Surplus and Inome Distribution Table 4.3 sows te impat of poliy mix (tax and transfers) on inequality. Simulation 4 (SIM4) disusses te impat of 4.14% derease in sales tax, 26.2% inrease in government transfers to ouseolds and 10.25% inrease in inome tax. A derease in sales tax and inreased government transfers to ouseolds ause inequality to redue wi is evident from a derease in te value of Teil T. Te resulting defiit in budget is overed by inreasing te inome tax rate. Te overall inrease in budget defiit is million wi is mu less tan wat is observed in simulations 1 troug 3. 24

25 TABLE 4.3: Government Budget Surplus and Inequality Variables Base SIM4 SIM5 SIM6 Government budget surplus Teil T Teil L Teil S In simulation 5, Teil T and Teil S indies of inequality indiate improvement in inome distribution due to 7% redution in sales tax and 3.65% inrease in inome tax. Tese two inequality indies are sensitive to te anges in upper and lower expenditure ategories respetively. Tis poliy redues te budget defiit from 8457 million to million Rupees, were 3.62% ut in government expenditures ombined wit te inrease in inome tax rate is used to redue te budget defiit. Simulation 6 inludes 3.99% ut in government expenditures, 7.01% redution in sales tax and 2.5% inrease in inome tax. Te distributional effet of tis poliy is more signifiant tan te poliy disussed in simulation 5. All te Teil indies point out a redution in te gap between ri and poor. Tis simulation results in a onsiderable surplus of million Rupees in te budget Maroeonomi Effets of Poliies Table 4.4 sows te maroeonomi effets of simulated poliies. Simulation 4 positively affets te GDP at fator prie. Tis poliy involves a redution in sales tax wi affets te GDP at market prie positively but at te same time inrease in government transfers to ouseolds offsets tis positive effet, tus a sligt deline in te value of GDP (at market prie) is observed. Te government transfers ause government onsumption and private investment to inrease. A derease in sales tax auses te prie of goods to derease wi results in inreased demand for goods. Tis inreasing demand stimulates te investment, tus inreasing its level. Te inrease in private investment furter indues an inrease in te exports as well. A derease in sales tax leaves a positive effet on inome, tus private onsumption and onsumption of imported goods also inreases. A ut in te sales tax rate redues te net indiret taxes, and at te same time must ave a positive impat on private onsumption; but inrease in inome tax by 10.25% offsets tis positive effet on onsumption. 25

26 In simulation 5 and 6 (ut in sales tax and government spending and inrease in inome tax), we an observe an inrease in te value of GDP at fator prie and a derease in te value of GDP at market prie. Tis appens beause tese simulations inlude sales tax wi auses GDP (at market prie) to srink. Furter, due to a ut in te government expenditures, a deline in te value of government onsumption is observed wi elps to reover te defiit in budget aused by derease in sales tax. On te oter and, wit te derease in government expenditures, private investors will ave enoug funds to invest tus investment level inreases. Inrease in investment leads to more output, tus aving a positive effet on exports wi auses real GDP to inrease. Tis poliy involves te inome and substitution effet (aused by sales tax ), wi leaves a positive effet on te inome of ouseolds due to wi some ouseolds swit to imports, ausing an inrease in level of imports. Moreover, sales tax redution results in a derease in te net indiret tax olletion and enourages private onsumption but tis part of tis effet is offset by inrease in inome tax. TABLE 4.4: Maroeonomi Indiators VARIABLE BASE SIM4 SIM5 SIM6 GDP FC GDPMP GDPMP GOVCON INVESTMENT EXPORTS IMPORTS E E E E6 NITAX PRVCON Sensitivity Analysis In CGE models, te seletion of parameters takes te paramount importane. As tere is no readily available metod to estimate te parameters and elastiities of te model, terefore it is important to employ sensitivity analysis to ek te influene of elastiities and parameters used in te model 17. Te key idea is to replae te value of elastiities wit te values used in some oter studies or make anges witin a speified interval. If te anges in elastiities do not bring a signifiant ange in te 17 Domingues, E.P. and E.A. Haddad (2005) 26

27 result, we an onlude tat our results are reliable. In order to ondut te sensitivity analysis, tis study uses +50% to -50% anges in te armington elastiity and export elastiity used in te model. Different ombinations of tese elastiities are made wi are sown in Table 4.5. TABLE 4.5: Simulation parameters for Sensitivity analysis Experiment Cange in elastiity S0 Original Armington and CET elastiities S1 50% inrease in Armington elastiity S2 50% inrease in CET elastiity S3 50% derease in Armington elastiity S4 50% derease in CET elastiity S5 50% inrease in Armington and CET elastiity S6 50% derease in Armington and CET elastiity S7 50% inrease in Armington and 50% derease in CET elastiity S8 50% derease in Armington and 50% inrease in CET elastiity Te effet of anges in tese parameters on maroeonomi analysis is not signifiant, leading to te onlusion tat results are reliable. Te result of sensitivity analysis is sown in Table 2 and 3 in Appendix. 4.4 Conluding Remarks A brief analysis of simulations 1 troug 3 is presented in Table 4.6. Teil T is more sensitive to anges in expenditure tan te oter inequality indies, terefore only Teil T is sown in te table. To address te problem of inequality, it is important to sow tat tese poliies do not affet budget adversely. GDP at market prie measures money value of all goods and servies onsidering te government s role (tax and subsidies) tus, to disuss te tradeoff issue, GDP at market prie is used. Te positive sign wit tese indiators sows an inrease in teir value and te negative sign sows a derease. As in simulation 3, Teil T doesn t reord any ange, terefore te idea of inreasing inome tax to solve te problem of inequality doesn t work ere. Bot te simulations 1 and 2 verify te existene of a strong trade-off between equity and effiieny. In simulations 1 and 2, inequality is redued but in bot te senarios, it is observed tat budget defiit inreases and eonomi growt (GDPMP) dereases. Te government 27

28 budget defiit inreases drastially in simulation 2, wereas simulation 1 sows more adverse effet on eonomi growt wen ompared to simulation 2. Tus, as ost involved in tese two poliies is more tan te benefit, effiieny requires tat tese two poliies sould not be employed to orret te distribution pattern. TABLE 4.6: Cange in Inequality, Budget defiit and eonomi growt SIM 1 SIM 2 SIM 3 Teil T No ange GBD GDPMP GDPFC Note: GBD (Government budget defiit), GDPMP (GDP at market prie), GDPFC (GDP at fator prie) Table 4.7 disusses te anges in inequality, budget defiit and eonomi growt due to poliy pakages disussed in simulation 4 to 6. Te GDP reords a positive ange for all of tese simulations. Exept simulation 4, oter simulations sow a derease in budget defiit. In simulation 4, a negative ange is observed in eonomi growt. Wile in simulation 5, equality is aieved wit Rs million redutions in te defiit and at te ost million derease in GDP. In simulation 6, GDP dereases more tan wat is reorded in simulation 5. TABLE 4.7: Cange in Inequality, Budget defiit and Eonomi Growt SIM 4 SIM 5 SIM 6 Teil T GBD GDP MP GDP FC On te basis of above disussions, we an onlude tat among budget defiit and eonomi growt if we are more onerned towards budget defiit ten simulation 5 presents te best poliy pakage to overome inequality wereas simulation 4 is favorable only if we want equality wit minimum effiieny ost togeter wit a little positive ange in budget defiit 28

29 5. Conlusion and Poliy Impliation 5.1 Conlusion Inome inequality is one of te ritial barriers in most of te developing ountries inluding Pakistan for growt and development. Tese ountries ave low inomes aompanied by sky roketing ost of living and unemployment rate tat lead to inreased poverty level and unequal distribution of inome. Te persistent defiit in te eonomy s budget is also one of te auses of inreasing poverty and deterioration of inome distribution. Tis study aims at analyzing te role of fisal poliy in reduing budget defiit, alleviating poverty and redistribution of inome fairly. Tis study investigates te impat of fisal instruments on inome inequality in Pakistan using CGEM-Pak. Like oter developing ountries, a fall in inome of Pakistan aompanied by ig budget defiits, orruption and politial unrest auses a widening gap between te ri and poor. Tis study sows tat fisal instruments ave a potential role in orreting inome distribution. In tis resear, it is found tat te use of sales tax or transfers alone an affet inome distribution but it auses te budget defiit to deteriorate. Tus, it is onluded tat a mix of fisal instruments an ave a positive effet on inome distribution, GDP at fator ost, and budget surplus, wile GDP at market prie sows a sligt deline. As in te urrent senario, te fous of politiians and eonomists is to redue te finanial dependeny, terefore among simulation 4 and 5, simulation 5 (3.62% ut in government expenditures, 7% redution in sales tax and 3.65% inrease in inome tax) is te best possible poliy to redue te inreasing inequality. Redution in sales tax auses an inome and substitution effet on all ouseolds, exept te urban nonpoor ouseolds wo are te riest lass of tis ountry. Tese effets on ouseolds inome make tem better-off and redue inequality. 5.2 Poliy Impliation and Suggestions It is important to note ere tat government poliies implemented to remove inome inequality need a strong politial will and support to promote progressive sales in inome tax and to redue te government expenditures partiularly te nondevelopment expenditures so tat te redution in sales tax ould be made possible. A responsive government is needed to ave a proper ek and balane to make sure te 29