In Pakistan the budget deficits have consistently at increasing trend from 1995 to onwards which is being financed by the governments of now and then through external and domestic borrowing which are resulting a high debt levels due to high interest cost associated with it and this all pave the way for an increase in forthcoming taxes levy by the government time to time. This paper is an empirical investigation of the proposition that Fiscal deficit cannot be reduced by increasing taxes. The finding reveals that an increase in taxes is not the better choice for tackling the jinni of fiscal deficit.Fiscal deficit, Tax Collection, Error correction model (ECM), ADF unit root test

Hasan, Syed Akif

Osman, Ms. Amber

Subhani, Muhammad Imtiaz

English

Research Papers in Economics

__________________________________________________________________________________________ 
Accepted in  
American Journal of Scientific Research (AJSR), 2012 
Fiscal Deficit cannot be reduced by increasing Taxes  
(A point to ponder from Pakistan) 
 
Muhammad Imtiaz Subhani  
Iqra University Research Centre-IURC, Iqra University,  
Defence View, Shaheed-e-Millat Road (Ext.), Karachi-75500, Pakistan 
E-mail: drsubhani@yahoo.co.uk 
Tel: +92(21) 111 264 264 (Ext. 2010) ; Fax: +92(21) 5894806 
 
Syed Akif Hasan 
 Iqra University, Defence View, Shaheed-e-Millat Road (Ext.) 
Karachi-75500, Pakistan 
E-mail: drakifhasan@gmail.com 
Tel: +92(21) 111 264 264 (Ext.1509) ; Fax: +92(21) 5894806 
 
Amber Osman 
Iqra University Research Centre-IURC, Iqra University,  
Defence View, Shaheed-e-Millat Road (Ext.),Karachi-75500, Pakistan 
E-mail: amber.osman@yahoo.com 
Tel: +92(21) 111 264 264 (Ext. 2010) ; Fax: +92(21) 5894806 
 
Muhammad Nayaz 
Iqra University Research Centre-IURC, Iqra University, Defence View, 
 Shaheed-e-Millat Road (Ext.),Karachi-75500, Pakistan 
Email: muhammadnayaz@yahoo.com 
Tel: +92(21) 111 264 264 (Ext.2024) ; Fax: +92(21) 5894806 
 
 
 
Abstract 
 
  In Pakistan the budget deficits have consistently at increasing trend from 1995 to 
onwards which is being financed by the governments of now and then through external 
and domestic borrowing which are resulting a high debt levels due to high interest cost 
associated with it and this all pave the way for an increase in forthcoming taxes levy by 
the government time to time. This paper is an empirical investigation of the proposition 
that Fiscal deficit cannot be reduced by  increasing taxes. The  finding reveals that an 
increase  in  taxes  is  not  the  better  choice  for  tackling  the  jinni  of  fiscal  deficit. 
 
Keywords: Fiscal deficit, Tax Collection, Error correction model (ECM), ADF unit root  
                    test. 
 1. Introduction 
Fiscal deficit in Pakistan is a major issue as the various findings indicate that the fiscal deficit is 
remained at the same level even the tax collections are increased for all of the fiscal years after 
1994 and to compensate this deficit government increases its debt financing from domestic and 
foreign sources which leads towards inflation and high interest rates. This paper is an empirical 
attempt to interrogate that whether or not an increase in tax collection is a better and logical 
option to reduce the size of fiscal deficit for the economy of Pakistan? 
 
2. Literature Review 
Friedman (1982) concluded that an increase in taxes (revenue collections by government) does not 
tackle  the  budget  deficit  because  they  believed  that  the  level  of  fiscal  deficit  is  not  reduced  by 
increasing taxes/ revenue collections, infact, government goes for borrowing to tackle the deficit and as 
the result debt servicing is increased. In addition, Koch, Schoeman, and Tonder (2005) found that there 
is an association between the burden of taxes and economic growth according to their findings based 
on  the  data  of  1960-2002  if  tax  burden  decreases  economic  growth  increases  significantly. 
Baharumshah and Lau (2007) Found two sets of different results where the fiscal policy of Korea, 
Singapore and Thailand  is driven  by expenditures where the government  finances revenue  for the 
planned expenditures  according to the  limit of the balanced  budget which  facilitate the  long term 
sustainable budget position. However the taxation system should be implemented by taking care of the 
overall smooth  fiscal policy.  According to Baharumshah  and Lau (2007)  in case of  Malaysia and 
Philippines  expenditures and revenues are  independent of each other and the  level of government 
expenditures and revenues is determined through fiscal policy. Furthermore they confirmed that in 
order to achieve long-term economic growth fiscal consolidation is necessary to reduce deficits and 
debt  levels which  lead a country to fulfill expenditure priorities  better and provide  funds to more 
productive sectors. 
  Griffin and McKinley (1992) believes that in order to reduce the fiscal deficit, the expenditure 
policies of the government should be directed towards long-term future growth and for the well being 
of the people, in addition the activities that contribute more on socio economic development should be 
increased instead of using resources and funds to military defense projects. Similarly, King and Rebelo 
(1990) also confirmed that the taxation has a very important role in the long run growth process of a 
country  where  growth  is  not  affected  by  indirect taxation,  however  direct  taxation  is  harmful  for 
growth. Furthermore, Narayan and Narayan (2006) confirmed that if the proper implementation on 
policies is taken into consideration regarding tax/ revenue collections the fiscal deficit can be avoided 
in the countries like Pakistan, they further stressed that if the expenditure rises faster than revenue then 
this can create huge budget/ fiscal deficits. 
  While  investigating  fiscal  deficit  for  Greece,  Hondroyiannis  and  Papapetrou  (1996)  found 
unidirectional  causality  running  from  government  expenditure  to  revenues  in  Greece  and  the  odd 
government spending decisions were found as the pivot reasons for fiscal deficit for long run. They 
further  confirmed  that the  government  spending  to  GDP  is  very  high  in  Greece  which  results  an 
operating inefficiency for the economy and any attempt for reducing fiscal deficit without reducing the 
government expenditure leads to failure. 
  Ahiakpor and Amirkhalkhali (1989) Based on the analysis for Canadian economy proposed that 
when government increases taxes in order to fully control over fiscal deficit the government must 
reduce or limit its expenditures instead of finding ways to increase tax revenue which is just a burden 
on public. Baghestani (2004) in a study of Egypt and Jordan claimed that to promote domestic savings 
and private investment it is necessary to eliminate budget deficit for both the counties and the increase 
is tax collection is not the solution of tackling the budget deficit. They further stressed that the process 
of privatization since, facilitates high domestic saving and investment can be a good player to reduce 
fiscal deficit. Neyapti (2008) also supported the view point of Baghestani (2004) and he studied and confirmed that the privatization and decentralization improve the quality of governance which leads to 
decrease budget deficit and launch a stable economic condition.  
 
 
 
3. Research Methodology & Econometrical Models 
To explore and investigate the effects of an increasing change is taxes on the fiscal deficit, the non-
stationarities in the collected taxes and the fiscal deficit are interrogated first as explained in equation 1 
and 2, while, using the annual data of the outlined series for period from 1995 to 2011.The data for 
both the series was taken from the publically available source (website of State Bank of Pakistan). 
Error correction model (ECM) in the frame of ARDL is used as shown in equation 3, to investigate the 
impact of increasing change in collected tax on the fiscal deficit of Pakistan for the last 16 years. Both 
the previous lags of collected taxes and the fiscal deficit have been deployed in the ECM model to 
analyze the data. 
 
 TXt = αTXt – 1 + x΄t + β1 TXt – 1 + ……… βp TXt – p + ETt   ---Equation 1 
 FDt = αFDt – 1 + x΄t + β2 FDt – 1 + ……… βp FDt – p + ETt   ---Equation 2 
 FDt = C + β3 TXt +β4 TXt – 1 + β5 TXt – 2 + β6 FDt – 1 + β7 FDt – 2 + ETt 
                  ---Equation 3 
Where, TX= Collected Taxes and FD= Fiscal Deficit. 
 
4. Findings and Results 
 
Table 1: Findings of ADF Unit Root Test 
H: There is a non-stationarity in Collected 
Taxes. 
H: There is a non-stationarity in Fiscal Deficit. 
At Level    T-Stats  Prob. *  At Level    T-Stats  Prob. * 
ADF Test  -1.67912  0.9887  ADF Test  -1.57343  0.9691 
Test 
Critical 
1%  -3.23161    Test 
Critical 
1%  -3.21982   
5%  -2.96482    5%  -3.11871   
10%  -2.75391    10%  -2.68829   
 
 TXt = α TXt – 1 +  x΄t +   β1 TXt – 1 + ……… βp TXt – p + ETt    ---Equation 4 
  -0.02179    1.60891  0.55323 
  [-1.6791]   [1.8721]  [7.3211] 
 
 FDt = α FDt – 1 +  x΄t +   β1 FDt – 1 + ……… βp FDt – p + ETt     ---Equation 5   -1.0013      0.00311   0.90013 
  [-1.5734]   [1.9347]  [5.7323] 
  The primary objective of this paper is to find an effect of change in taxes on the change in fiscal 
deficit of Pakistan, since both the outlined series are time series therefore, to interrogate the stated 
objective, the non-stationarities in both the series are investigated first by deploying the ADF unit root 
test. The  empirical  findings  as  reported  in  the  table  1,  reveal  that  at  zero order there  is  the  non- 
stationarities in both the series. Since, The ADF t-statistics are -1.167912 and -1.57343 respectively for 
both the collected taxes and fiscal deficit. And each ADF t-stats for both the series are more than for all 
corresponding critical values at 1%, 5% and 10% which imply the significant presence of Shocks in 
collected taxes and fiscal deficit. Since the root (alpha) is less than 1 for the series of collected thus we 
can conclude that the observed shocks in taxes are for short run. Whereas, for the series of fiscal deficit 
the root (alpha) is 1, thus it can be concluded that the series of fiscal deficit has the shocks for long run. 
As  Subhani  &  Osman  (2011)  confirmed  that  the  alpha/root  of  ADF  unit  root  test  explains  the 
short/long run shocks in the time series if the shocks are found present.  In the above equations 4 and 5, 
xt are optional exogenous regressors which gives the prediction of application of ECM model, since 
the t-stats for exogenous repressors are more than 1.5 thus the ADF model predicts also the application 
of error correction model, that is, the ECM model can further be applied to conclude the co movements 
between the stated series. 
Table 2: Findings of Error Correction Model (ECM) 
Error Correction   (Fiscal deficit) 
Co integrating Equation   0.012345 
(0.03281) 
[1.53680] 
 (Taxes (-1))  0.723599 
(1.2E+08) 
[1.93211] 
 (Taxes (-2))  0.236718 
(1.5E+09) 
[0.63464] 
 (Fiscal deficit(-1))  0.576453 
(9.46982) 
[2.98535] 
 (Fiscal deficit(-2))  0.321772 
(0.63221) 
[0.65238] 
C  0.088674 
(0.18978) 
[0.23548] R Squared 
Adjusted R Squared 
F- Statistics 
Akaike AIC 
Schwarz SC 
0.603311 
0.397665 
5.241287 
52.67570 
53.21198 
 
 FDt = C + β3 TXt + β4 TXt – 1 + β5 TXt – 2 + β6 FDt – 1 + β7 FDt – 2 + ETt 
       0.0886   0.0123      0.723    0.236     0.576             0.321    Equation 6 
       [0.235]  [1.536]     [1.932]  [0.634]   [2.985]           [0.652] 
  The findings of error correction model as they are shown in the table 2 and also by the equation 
6 reveal that there is the fiscal deficit for the current period is not controlled by the taxes collection for 
same period (current lag) and for the previous period (lag1), as the increase in tax collection for both 
the current and previous lag translates the increase in fiscal deficit significantly (at t> 1.5) . While, the 
increase in fiscal deficit for previous lag (lag1) also affects positively to the fiscal deficit for current lag 
(at t> 1.5) that is the fiscal deficit for current lag gets increased. table 2  also confirms that the applied 
ECM model explains the fiscal deficit 39.766 % significantly as Adjusted R Squared is 0.39766 at F = 
5.241 > 3.384. 
 
5. Discussion and Conclusion 
Fiscal deficit in Pakistan is a major issue because, as tax/revenue collection gets increased expenditure 
increases as a result and due an increase in govt. expenditures, fiscal deficit either remains at the same 
level  or  also  increased  as  confirmed  by  the  findings  of  this  paper.  To  compensate  this  deficit 
government  increases  its  debt  financing  from  domestic  and  foreign  sources  which  leads  towards 
inflation and high interest rates. Thence, to reduce the fiscal deficit, an increase in tax collection has 
never been proven as an smart idea for Pakistan. 
  Hondroyiannis and Papapetrou (1996) also confirmed that an attempt for reducing fiscal deficit 
by  an  increase  in  tax  collection  without  reducing  the  government  expenditure  leads  to  failure. 
 
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An Examination of the Causal Relationship between Government Spending and Revenue: A Cointegration analysis.

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Government revenue and government expenditure nexus: evidence from developing countries.

Monetary Shocks or Real Shocks, Which matters the most for Share Prices.

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Public Policy and Economic Growth: Developing Neoclassical Implications.

The Causal Relation between Government Revenue and Spending: Evidence from Egypt and Jordan.

Towards a Human Development Strategy,

Fiscal Deficit cannot be reduced by increasing Taxes (A point to ponder from Pakistan)

Fiscal Deficit cannot be reduced by increasing Taxes (A point to ponder from Pakistan)

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