FISCAL POLICY FOR INCLUSIVE GROWTH

Author(s): Kalsoom Zulfiqar

Source: Pakistan Economic and Social Review , Summer 2018, Vol. 56, No. 1 (Summer 2018),
pp. 21-46
Published by: Department of Economics, University of the Punjab

Stable URL: https://www.jstor.org/stable/10.2307/26616731

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 21

Pakistan Economic and Social Review

Volume 56, No. 1 (Summer 2018), pp. 21-46

FISCAL POLICY FOR INCLUSIVE GROWTH: A

CASE STUDY OF PAKISTAN

KALSOOM ZULFIQAR*

Abstract. Fiscal policy plays a significant role in achieving

inclusive economic growth as it can reduce inequalities, mitigate
poverty and generate productive employment opportunities by
regulating public expenditures and taxes. Current research
examines the role of fiscal policy in plummeting poverty,
reducing inequality, generating productive employment and last
but not the least in attaining broad based inclusive economic
growth for Pakistan. Various components of government
expenditure and taxes are evaluated by estimating multiple
vector autoregressive (VAR) models and by computing
elasticities on the basis of cumulative impulse response
functions (IRFs). The analysis suggests that fiscal policy is not
playing an effective role in promoting broad-based inclusive
economic growth. The frail linkage between fiscal policy and
inclusive economic growth is countermand to very essence and
spirit of the former in a developing country like Pakistan.

Keywords: Fiscal policy, Income inequalities, Inclusive growth, Productive

employment, Poverty, VAR estimation, Impulse response
functions

JEL Classification: C22, D31, O12, O43, D63

*The author is Assistant Professor/Incharge at Department of Economics, University of

the Punjab, Lahore. This paper is based on the PhD research work of the author.
Corresponding author e-mail: sakoang@yahoo.ca

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22 Pakistan Economic and Social Review

I. INTRODUCTION
The notion of inclusive economic growth has gained remarkable attention
in developing Asia due to prevalence of widespread income and non-
income disparities. Macroeconomic policies are vital in pursuing poverty
alleviation, reducing income inequalities, fostering economic growth and
generating productive employment opportunities. Birdsall (2007)
concluded that macroeconomic policies can shape the environment and
incentives for inclusive growth in three important areas: fiscal discipline-
the more rule-based the better, a “fair” fiscal policy with respect to
revenues and expenditures, and a business-friendly exchange rate.
Although these policies are not underlying causes of growth, they can
control and alter growth outcomes in many ways. These policies can be
used to achieve economic growth with a human face. Khatiwada (2013)
observed that “Over time macroeconomic policies have evolved as
faceless policy measures……and can be given a human face. We can cite
several areas of macroeconomic policies with human face they are linked
with Inequality, poverty, gender, and inclusion”.
It is suggested that nurturing inclusive growth, creating decent jobs
and endorsing equality should be important pillars of macroeconomic
policy. Fiscal policy, in pursuit of inclusive growth, becomes particularly
relevant. Lopez et al (2010) concluded that “Fiscal policy is one of the
most powerful instruments that governments use to maintain
macroeconomic stability for growth, as well as for intra and
intergenerational transfers of wealth. Governments often have at their
disposal between 25% and 40% of GDP for spending, including
redistribution across social groups.” Hence, composition of government
spending can have remarkable effects on level and outcomes of economic
growth. For example, government spending on public goods has a strong
association with poverty alleviation and reduction in inequalities. In
contrast government spending on private goods has negative implications
for both growth and equity. Similarly, tax policies directly affect
households and their consumption and saving behavior and have
inferences for income distribution and economic growth.
Asian Development outlook (2014) proposed that “One important
instrument available to the government for bringing about a more
inclusive society is fiscal policy. Governments can design spending

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 ZULFIQAR: Fiscal Policy for Inclusive Growth 23

programs and tap revenue sources in ways that reduce inequality”.

Fiscal policy can play an important role in regulating aggregate demand,
the distribution of income and economy’s capacity to produce goods and
services (Musgrave, 1959). Therefore, correct choice of composition and
combination of these policies has become crucial in achieving a broad-
based path of economic growth across countries. Estrada et al (2014)
highlighted the important role governments can play in achieving goal of
inclusive economic growth through well devised fiscal policy. Public
spending on infrastructure development enhances productivity of whole
economy and public spending on education leads to human capital
formation and helps reduce inequalities. The reduction in economic
disparities has assumed more importance due to increased focus on
Inclusive growth. It is in this background that there is a need to explore
role of government policies in reducing economic inequalities, alleviating
poverty, creating productive employment opportunities and maintaining
desired economic growth rate (see Benabou; 2000, Seshadri & Yuki;
2004).

II. LITERATURE REVIEW

There are many studies which pronounce effective fiscal policy and
focused government spending as viable policy options in reducing
inequalities and promoting inclusive growth. Bastagli et al. (2012) stated
that fiscal policy can influence income distribution by affecting current
disposable incomes and impacting future earnings of individuals. A
government may utilize public expenditure for provision of public
services or to attain equitable income distribution. Claus et al. (2014)
concluded that public spending on education & health are the two most
effective means of reducing inequality in developing Asia.
Thomas, et al. (1999) concluded that fiscal policy is vital for
allocation of resources and maintaining equilibrium between various
types of assets of an economy. Their growth or reduction is dependent on
encouragements generated by tax policies and allocation of resources
through public spending policies. Widmalm (2001) explained that
different types of taxes have different growth effects. Taxes which distort
consumption patterns and discourage investment are harmful for
economic growth. Similarly, taxes can be effectively used to attain
equitable income distribution. Kneller et al. (1999) propounded that

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24 Pakistan Economic and Social Review

public expenditure, financed by non-distorting taxes, increases growth in

a small public sector while an increase in distorting taxation will reduce
economic growth. The benefits of tax exemptions and subsidies are
mostly grabbed by the influential high income individuals, which has
undesirable implications for economic growth and income equality.
Ahmed (2007) highlighted the importance of composition of public
expenditures for economic growth and poverty alleviation. Expenditure
on health, education and infrastructure has positive impact on economic
growth when controlled for other factors. Several studies have explained
the significance of fiscal policies in shaping pattern of economic growth
via two types of public spending i.e. spending on public & private goods
and on subsidies. Roberts (2003) concluded that if public spending is
increased on education it may create opportunities for poor to get
education, however demand side factors may reduce this effect. Such
factors may include perceptions regarding paybacks of education, income
of the household and other costs to parents for sending their children to
educational institutions.
Chu et al. (2000) surveyed studies for a large set of developing
economies and concluded that in most economies, government spending
on education sector helped the poor more as compared to rich. Public
spending on primary education was comparatively well directed in a way
that share of advantages going to lowest quintile were higher than the
benefits accruing to the richest quintile. David & Petri (2013) used the
data based on various surveys for analysis and suggested that there is a
need to divert public spending towards the areas that are more helpful in
attaining inclusive economic growth. It is also suggested in literature that
public spending can be productive only if it develops infrastructure that is
used as an input for private investment (Devarajan, et al. 1996). There are
numerous studies which confirm that well directed public spending on
human capital enhances economic growth. (Guellec & Pottelsberghe;
1997, Diamond;1999, De la Fuente & Doménech; 2006, Heitger; 2001).
Public spending on consumption and social security either have no effect
or negative impact on economic growth (Aschauer; 1989, Barro & Sala-i-
Martin 1990; Grier & Tullock 1989).
Habito (2009) examined the reasons why poverty reduction patterns
accompanying economic growth have varied so widely across Asia. It

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 ZULFIQAR: Fiscal Policy for Inclusive Growth 25

suggested that sectoral composition of economy, nature, size and patterns

of public investments (particularly on social services and agriculture);
and quality of governance affect poverty reduction and pattern of
economic growth. Results confirmed the role of governance, public
expenditure on social services and contribution of agriculture to GDP
growth. Similarly, it also highlighted the important role manufacturing
sector can play in attainting inclusive economic growth and
recommended to take a broader view of poverty for policy prescription.
There are many existing studies (see Khan& Hashmi; 2015, Arif &
Farooq; 2011, Irfan & Baber; 2014, Sherani; 2006, Faridi &Nazar; 2013,
and Mahmood &Sadiq; 2010) which have evaluated the effectiveness of
macroeconomic policies in motivating economic growth in Pakistan.
Most of the empirical evidence about macroeconomic effects of fiscal
policies is based on separately estimated regressions, analyzing the
growth effects, the distributive effects or role of fiscal policy in poverty
reduction. Besides that, most of previous studies consider public
expenditure and tax revenue as a whole ignoring the fact that different
components of revenues and expenditures can have varied impact on
growth, income distribution, poverty and employment. For example,
current expenditure, due to its non-productive nature, has different
consequences for poverty, inequality, employment and economic growth
as compared to development expenditure. Similarly, direct and indirect
taxes influence income distribution, economic growth and employment
generation differently. Government expenditure on health and education
facilities can determine access level of these facilities. If major portion of
expenditures is non-productive it can lead to lack of provision for
necessities of life. Well directed public expenditure stimulates economy,
generates productive employment and contributes to inclusive growth.
Similarly, taxation structure is no less important in affecting equity,
poverty reduction and income redistribution all of which constitute
Inclusive growth.
However, despite its demonstrated relevance, the joint response of
economic growth, income inequality, poverty, employment and inclusive
growth to different measures of fiscal policies has largely been
overlooked in Pakistan. It is astonishing to find that there is not even a
single study which focuses the impact of fiscal policy on Inclusive
growth in Pakistan. It is in this background that present study aims at

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26 Pakistan Economic and Social Review

filling this significant gap in existing literature. The study provides an in-
depth evaluation of the role of fiscal policy in attaining a broad based,
inclusive growth in Pakistan.

III. DATA AND ECONOMETRIC METHODOLOGY

This section provides a brief description of data used in present study.
Annual data for the period 1980-2015 on various variables is collected
from different sources including Economic Survey of Pakistan, Labor
Force Survey (LFS) of Pakistan, International Financial Statistic (IFS)
and World Development Indicators (WDI). Time series data on poverty
was extracted from various publications of Social policy and
development center (SPDC), and the data base Knoema supported by
World Bank indicators. Data on inequality (Gini-coefficient) is taken
from Standardized World Income Inequality Database (SWIID) version
3.1. Table 1 provides a description of variables used in this study. All
variables are used in log form.
TABLE 1
Description of the Variables
Variables Description
GDP Growth rate of Gross Domestic Product
IG1 Inclusive Economic Growth
GINI Gini Coefficient
POV Poverty head count ratio
CE Current Expenditure as percentage of GDP
DE Development Expenditure as percentage of GDP
EE Education Expenditure as percentage of GDP
HE Health Expenditure as percentage of GDP
DT Direct taxes as percentage of GDP

1
Inclusive growth is measured by composite inclusive growth variable consisting of
poverty, inequality and inverse of employment to population ratio following Ramos et al
(2013). IG is interpreted opposite of its sign.as fall in poverty, inequality and inverse of
employment ratio imply a higher level of inclusive growth.

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 ZULFIQAR: Fiscal Policy for Inclusive Growth 27

Variables Description
IT Indirect Taxes as percentage of GDP
GDPE GDP per person employed
GFCF Gross fixed Capital Formation as percentage of GDP

ECONOMETRIC METHODOLOGY
Vector Autoregressive (VAR) models are extensively used to estimate
effects of monetary policy. However, many recent studies on
macroeconomic effects of fiscal policy have also used this approach (see
Capet; 2004, Kamps; 2005, Marcelino;2006, Perotti; 2005). Ramos &
Roca-Sagales (2008) supported the use of VAR approach to analyze the
effects fiscal policy as follows
“VAR models are particularly appropriate to estimate the
medium and long term impact of public policy for at least three
reasons. Firstly, they take due account of the dynamic feedback
between variables as well as their effect on other variables both
in the short and long term. Second, VAR models are especially
suitable when the variables of interest are endogenous Finally
VAR models are not too demanding on the data, which has surely
contributed to the recent proliferation of empirical research on
the macroeconomic effects of fiscal policy”
Hamilton (1994) advocated that even with co-integrated relations
among key variables, use of basic VAR can be feasible because
parameters are estimated consistently and the estimates have same
asymptotic distribution as those of differenced data. The VAR
methodology utilized in present study, developed by Sims (1980), is an
ad hoc dynamic multivariate model, treating simultaneous set of variables
equally, in which each endogenous variable is regressed on its own lags
and of other variables in a finite order system. The objective of the
approach is to examine dynamic response of system to shocks without
having to depend on incredible identification restrictions inherent in
structural models. Following Christiano et al (2005), Bernanke & Blinder
(1992) a representative reduced form VAR can be written as:
+ +

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28 Pakistan Economic and Social Review

Where k-dimensional vector of endogenous variables

A (L) = an auto-regressive lag polynomial, and
 t = The vector containing reduced -form residuals, which in general will
have non-zero correlations.
In current study six different VAR models are estimated to cover
various dimensions of Inclusive growth. Existing literature advocates that
reduction of income inequality; poverty alleviation and generation of
productive employment are important pillars of Inclusive Economic
growth. (see Ali &Son; 2007, McKinley; 2010, Anand et al.; 2013,
Bhorat et. al.; 2015). In order to analyze the role of fiscal policy in
attaining Inclusive growth present study has utilized framework proposed
by Hur (2014). This model is extended to add more dimensions of
inclusive growth particularly poverty and productive employment in
Pakistan.

IV. EMPIRICAL IMPLEMENTATION

STATIONARITY TESTS
In terms of empirical implementation, the first step is to determine
the order of Integration of each variable. For this purpose, Augmented
Dicky Fuller (ADF) test and Phillip-Perron (PP) tests are used. Akaike
Information Criterion (AIC) and Schwartz Information Criterion (SIC)
are used for optimal lag selection. Test results suggest that all the
variables are integrated of Order one which means non-stationary in
levels but stationary in first difference. The VAR models are therefore
estimated in first differences of log-levels or growth rates following
Ramos & Sagales (2008), and Gallo & Sagales (2014).

VAR MODELS AND IMPULSE RESPONSE FUNCTIONS (IRFS)

The study has estimated six different VAR models and an effort is
made to include most of the relevant variables to avoid omitted variable
bias. The analysis is primarily based on impulse Response Functions
(IRF) derived from these models considering the effects on income
inequalities, poverty, productive employment and inclusive growth of a
one-off one percentage point shock in the growth rate of fiscal policy
variable. Impulse response analysis in time series analysis is important in

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 ZULFIQAR: Fiscal Policy for Inclusive Growth 29

determining the effects of external shocks on variables of the system.

Simply put, an Impulse Response Function (IRF) shows how an
unexpected change in one variable in the initial time period affects
another variable over time. It should be emphasized that we are not
looking at how one variable affects another variable. In most of the
analysis the impulse response functions converge within first 5 or 6 years
implying that long-term effect on income equality, poverty, Productive
employment and Inclusive economic growth are zero. In levels, however,
such shocks cause lasting changes in inequality, poverty, productive
employment and inclusive growth due to permanent changes in the level
of fiscal variables. We are looking at shocks coming from the error term
related to fiscal variables (various components of expenditure and
taxation in case of present study).

CHOLESKY DECOMPOSITION AND ORDERING OF

VARIABLES
In literature, the standard procedure to accommodate
contemporaneous correlations among shocks in different variables is the
Cholesky decomposition of Variance-Covariance matrix of estimated
residuals. (See Kamps;2005, Fatas & Mihov; 2001, Favero & Rovelli;
2003). The same procedure is adopted in present study. It is important to
choose right ordering of the variables as it may have greater impacts on
estimated policy responses. In present analysis, economic relationships
and logic are used to order the variables. Government Spending, both
current and development, is assumed to be exogenous following
Blanchard & Perotti (2002) and De Castro (2006). It implies that
Inclusive Growth, income inequality, Poverty and productive
employment react to variations in Public spending but not vice versa. It
can also be interpreted that policy is implemented at one point in time but
its effects take place with a time lag. It is assumed that tax revenue reacts
contemporaneously to inequality, unemployment, poverty and output
shocks. This assumption is in line with Bernanke & Mihov (1998) and
Blanchard & Perotti (2002). Another assumption is that indirect taxes do
not contemporaneously affect direct taxes and current spending does lead
development spending. Keeping in view this economic background and
logic, to estimate impulse response functions variables are considered in
the order current expenditure, development expenditure, inclusive

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 30 Pakistan Economic and Social Review

growth, inequality, poverty, employment, direct taxes, and Indirect tax

revenue as per the requirement of each model.

V. EMPIRICAL RESULTS
The results of empirical estimation are presented in this section.

UNIT ROOT TESTS

Table 2 summarizes the results of Augmented Dicky Fuller (ADF)
and Phillip-Perron (PP) test. These tests are conducted on all the
variables used in various models to determine the order of integration of
each variable. For both tests, null hypothesis is that the series is non-
stationary or contains a unit-root and the rejection of null hypothesis is
based on MacKinnon critical values. The results of both ADF and PP
tests suggest that all variables are stationary in first difference or in other
words integrated of order one.
TABLE 2
Unit Root Analysis (ADF and PP test)
ADF Test PP test
Variables
Level 1st difference Conclusion Level 1st difference Conclusion
IG -0.1254 -6.3257 I(1) -0.1033 -6.915 I(1)
GDP -1.101 -7.783 I(1) -0.936 -7.824 I(1)
Gini 3.104 -8.256 I(1) 0.443 -8.974 I(1)
POV -2.946 -4.614 I(1) -2.103 -3.553 I(1)
CE -2.754 -5.570 I(1) -2.729 -6.074 I(1)
DE -1.617 -6.359 I(1) -1.577 -6.421 I(1)
EE -0.730 -9.298 I(1) -1.015 -23.114 I(1)
HE -1.114 -6.213 I(1) -2.775 -11.707 I(1)
DT -2.110 -4.944 I(1) -2.223 -4.953 I(1)
IT -2.430 -6.658 I(1) -2.356 -6.666 I(1)
GDPE -2.366 -5.490 I(1) -2.366 -5.490 I(1)
GCFC -1.946 -4.827 I(1) -2.146 -4.774 I(1)
EMPM -1.592 -5.964 I(1) -1.620 -5.963 I(1)

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 ZULFIQAR: Fiscal Policy for Inclusive Growth 31

SPECIFICATION TESTS
It is important to ensure that models are correctly specified and
model residuals are free from first order auto-correlation,
heteroscedasticity or non-normality. In this regard, VAR residual LM test
for autocorrelation, VAR residual heteroscedasticity test and Jarque- Bera
test for normality are applied. The results of specification tests are
summarized in Table 3.
TABLE 3
Specification Tests (p-values)*
Model 1 Model 2 Model 3 Model 4 Model 5 Model 6

Autocorrelation 0.7175 0.6777 0.4707 0.9255 0.6102 0.5081

Heteroscedasticity 0.2495 0.1216 0.2702 0.4377 0.3179 0.2118
Normality 0.3140 0.0763 0.3627 0.3011 0.5327 0.7139
*specification tests are based on the residuals from the estimation of unrestricted VAR
for each model. AR residual LM test is used to test for autocorrelation. If value of LM
statistic is greater than the critical Value, the errors have auto- correlation. (If p ≥ 0.05,
the error terms have no auto correlation) VAR residual heteroscedasticity test. For
normality, Jarque-Bera test (Lutkepohl, 1991) was applied. Under the null of normally
distributed residuals the test statistic is asymptotically distributed χ2 with 2 degrees of
freedom.

It is clear from the results of various tests that all the models are
correctly specified and free of auto-correlation, heteroscedasticity and
non-normality. Inverse roots of AR characteristic polynomial were also
calculated to investigate stability of the models. For all the models values
of roots are less than unity and lie within the unit circle hence confirming
that estimated VAR models are stable.

FISCAL ELASTICITIES
Following table summarizes estimated elasticities derived from
accumulated impulse response functions (IRFs) [see Appendix I)]
obtained by using Choleski decomposition. These elasticities measure
long-term accumulated effects of one percentage point initial shock to
relevant fiscal variable on income inequality, poverty, productive
employment and inclusive growth in Pakistan. The sum of significant
responses is provided in the brackets.

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 32 Pakistan Economic and Social Review

FISCAL POLICY AND INCOME INEQUALITY

This section presents fiscal elasticities which are derived from the
accumulated impulse response functions which are obtained from
Choleski decomposition. These elasticities provide an assessment of long
term accumulated effect on various dimensions of inclusive growth
(inequality, poverty, productive employment) of a one percentage point
initial shock to the pertinent fiscal variable. The first two columns of
table present estimated Inequality elasticities derived from accumulated
impulse response functions (IRFs). The sum of significant responses is
provided in the brackets.
TABLE 4
Inequality, Poverty, Productive Employment and
Inclusive Growth Elasticities
(Range of results)
Inequality Elasticities Poverty Productive Employment Inclusive Growth
Fiscal Elasticities Elasticities Elasticities
Variable
Model 1 Model 2 Model 3 Model 4 Model 5 Model 6
GDP 0.042 -0.1086 -0.1031 0.0621 -0.0452
(0.042) -0.0361) (-0.010) (0.0501) (-0.0314)
GFCF 0.039 -0.0331
(0.039) (-0.0201)
CE 0.064 0.1602 -0.1320 (-0.0354)
(0.064) (0.000) (0.000) (0.0000)
DE 0.0040 -0.0221 0.0245
(0.000) (0.000) (0.000)
EE -0.042 -0.2345 -0.0764
(-0.042) (-0.1523) (-0.0721)
HE 0.019 -0.0521 -0.0456
(0.006) (0.000) (0.000)
DT 0.0453 -0.2123 -0.0564 -0.0523 0.0012
(0.0453) (-0.083) (-0.0061) (-0.0362) (0.0012)
IT 0.0086 0.0321 0.0457 0.0435 0.01741
(0.000) (0.000) (0.0162) (0.0171) (0.0102)
Source: Calculated and compiled by the author

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 ZULFIQAR: Fiscal Policy for Inclusive Growth 33

GDP growth has a positive effect on income inequality i.e. Income

inequality increases with economic growth. If there is a 1% shock to
GDP growth it increases income inequality by 0.04%. Economic growth
does not seem to promote equity and Inclusive growth. The inequality
elasticities suggest that expansionary fiscal policy has adverse effect on
income inequality. Current expenditure has positive effect on income
inequality. With a 1% shock to current expenditure income inequality
increases by 0.06%. Development expenditure has no significant impact
on income inequality in case of Pakistan. This negative government
spending elasticity is in line with many previous studies. (see Ali &
Ahmad; 2010, Gallo & Sagales; 2014). Gross fixed capital formation
(GFCF) is also adversely impacting income distribution in Pakistan.
Brennenman & Kerf (2002) suggested that ideally GFCF should reduce
income disparities, as it helps in connecting to markets, enhances access
to employment, health and educational opportunities. But this has not
happened in Pakistan where GFCF has led to increased income
inequalities. In Pakistan, GCFC, particularly public investment in
physical infrastructure, is concentrated in some specific areas which is
promoting regional and spatial income inequalities. This unequal
distribution of public spending has resulted in unequal access to various
opportunities and has negative implications for inclusive growth. These
findings are in line with Hur (2014).
Education spending however has positive contribution regarding
reduction in inequality i.e. a 1% shock to education expenditure leads to
0.021% reduction in income inequalities. Health expenditure does not
significantly income distribution. Inequality effect of direct taxes is
positive, 1% percentage shock in direct taxes leads to 0.045% increase in
income inequality. This finding suggests that taxation structure is
regressive in nature. Ramos &. Sagales (2008) suggested that taxes
deteriorate income distribution in a country and public expenditures have
a greater potential to reduce income inequalities. Indirect taxes have a
negative but insignificant impact on income distribution. These results
are in line with Khan and Hashmi (2015) who also concluded that
indirect taxes have no significant impact on income inequalities in
Pakistan. Based on these findings it can be concluded that fiscal policy
tools are not effective in reducing income inequalities in Pakistan.

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34 Pakistan Economic and Social Review

FISCAL POLICY AND POVERTY REDUCTION

Habito (2009) defined inclusiveness of economic growth as GDP
growth that leads to significant poverty reduction. Poverty reduction is an
important pre-condition for achieving Inclusive growth. In order to
access the contribution of Fiscal policy in poverty reduction, poverty is
incorporated in VAR Model 3 along with various fiscal variables and
these elasticities are presented in Table 4. The sum of significant
responses is provided in the brackets. The results suggest that GDP
growth leads to poverty reduction i.e. poverty decreases with growth. If
there is a 1% shock to GDP growth it reduces poverty by 0.10% if all
responses are considered. However, it is difficult to conclude that
economic growth is pro-poor in Pakistan particularly if we take into
account only significant responses where response of poverty reduction is
just 0.03%.
This finding is supported by many previous studies in literature like
Omer & Jafferi (2008,). Current expenditure has positive effect on
poverty. If there is a 1% shock to current expenditure poverty increases
by 0.16%. It might be attributed to the non-productive nature of current
expenditures. However current expenditure has no significant effect on
poverty level in long-run. Expenditure on education not only increases
productivity of available work force but also increases their chances of
employment and helps reduce poverty. This linkage is confirmed by
present analysis; if there is a 1% point shock to education expenditure it
reduces poverty by 0.234%. These results are supported by many
previous studies. (See Ahmad & Batul; 2013 Khan et al; 2010, Riasat et
al ;2011, Janjua & Kamal; 2011). Health expenditure also reduces
poverty but its impact is relatively smaller as compared to education
expenditure. If there is 1% shock to health expenditure poverty reduces
by 0.05% however, this impact is not significant in long run.
Direct taxes are found to reduce poverty significantly, if there is 1%-
point shock to direct taxes poverty reduces by 0.21%, if all responses are
considered, and reduces by 0.08% if only significant responses are
considered. Indirect taxes lead to increase in poverty; however, this
impact is not significant. These results are in line with economic theory
as indirect taxes are regressive in nature and add to the miseries of poor
people who are mostly exempted from direct taxes. The analysis implies

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 ZULFIQAR: Fiscal Policy for Inclusive Growth 35

that only expenditure on education has significant poverty reduction

impact in Pakistan. All other components of government spending either
increase poverty or, have no significant implications for poverty
reduction and Inclusive growth.

FISCAL POLICY AND PRODUCTIVE EMPLOYMENT

Productive employment is an important pillar of Inclusive growth.
Many developing countries have shown tremendous economic growth
but unfortunately this growth has not created sufficient productive
employment to lift large number of people out of poverty. (see Kapsos;
2005, McKinsey;2012; Fox & Gaal; 2008). Access to productive
employment is vital for Inclusive economic growth. Szirmai et al (2013,
pp.03) suggested that “Access to productive employment is essential for
inclusion of the poor in society. Productive employment does not only
provide the poor with better incomes it also stimulates learning and skill
acquisition and participation in society”. Hence, poverty reduction and
social inclusion are linked to economic development through the channel
of productive employment. (Kremer et al.;2009).
ILO (2012, pp.03) defined productive employment “as employment
yielding sufficient returns to labor to permit workers and their
dependents a level of consumption above the poverty line”. Productive
employment can be generated through rapid economic growth, optimal
utilization of under-employed labor force and technical change. In
empirical literature, various indicators of productive employment are
proposed i.e. share of total employment in industry, share of own account
and family workers in total employment (McKinley;2010) and
employment to working age population, average wage growth, sector
specific wage growth, and whether workers are more productively
employed (Hansen & Sperling; 2013).
However, the main problem is availability of requisite data on these
indicators making it difficult to quantify the idea. In present study
employment in industry, as percentage of total Employment and labor
productivity growth2 (measured as an annual change in GDP per person

2
According to ILO (2009) the labor productivity growth rate is measured as the annual
change in Gross Domestic Product (GDP) per person employed.

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36 Pakistan Economic and Social Review

employed), is used as indicators of productive employment following

ILO (2009) and McKinley (2010).. Model 4 and 5 analyze the role of
fiscal policy in generating productive Employment in Pakistan. Model 4
is based on Indicator I (employment in industry as percentage of total
Employment) and Model 5 is based on Indicator II (Labor Productivity
Growth). The elasticities based on first indicator of productive
employment (employment in industry) show that GDP growth has
negative impact on productive employment generation. It implies that
employment opportunities generated by growth process are in less
productive sectors of economy and employment in productive sector is
shrinking instead of expanding. Similarly, none of government
expenditure items has significant impact on productive employment.
Direct taxes have negative but insignificant impact on productive
employment. However, 1% increases in indirect taxes lead to 0.045%
increase in productive employment. In case of model 5, none of the
expenditure items has a significant impact on productivity growth of
labor force. Direct taxes have negative and indirect taxes have positive
impact on GDP per person.
Productive employment is a vital ingredient of Inclusive growth. For
growth process to be inclusive it is critically important that sufficient
productive employment opportunities are generated to ensure mass
participation in growth process. Quality employment generation is key to
enhancing access and participation. The analysis submits that economic
growth in Pakistan can be termed as “jobless growth” as it is unable to
generate adequate employment opportunities in the productive sectors of
the economy. Fiscal policy does not seem to be very effective in
generating productive employment to ensure inclusiveness of growth
process.

FISCAL POLICY AND INCLUSIVE ECONOMIC GROWTH

An important contribution of present study is the analysis of the role
of fiscal policy in attaining a broad based inclusive economic growth for
Pakistan. As mentioned above Inclusive economic growth is measured by
utilizing the methodology proposed by Ramos et.al. (2013). Inclusive
economic growth variable is incorporated into VAR model 6 along with
GDP growth and various fiscal variables. The elasticities presented in last
column of the table show the long-term accumulated effects of one

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 ZULFIQAR: Fiscal Policy for Inclusive Growth 37

percentage point initial shock to GDP and relevant fiscal variable on

inclusive economic growth in Pakistan. The sum of significant responses
is provided in the brackets.
The connection between GDP growth and increase in level of
inclusiveness is weak. Although GDP growth increases the inclusiveness
but the magnitude is negligible i.e. as a 1% shock to GDP growth
increases inclusiveness just by 0.04%. It further reduces to 0.03% if only
significant responses are considered. This analysis suggests that
economic growth process in Pakistan is not inclusive as it is unable to
reduce poverty, mitigate inequalities and generate employment
opportunities. The connection between GDP and Inclusiveness is either
missing or too weak to make an impact.
Gross fixed Capital Formation (GFCF) has positive consequences for
inclusive economic growth. A 1% shock to GCFC increases
inclusiveness by 0.03% which is not very inspiring. Expenditure on
education leads to increase in inclusiveness of economic growth as 1%
shock to education expenditure leads to 0.07% reduction in inclusive
growth variable. This finding is in line with economic rationale as
education promotes inclusiveness through the channels of enhancing
productivity of labor, reducing income inequalities and by increasing
access to productive employment opportunities. Health expenditure does
not significantly impact the level of inclusiveness of economic growth.
Taxes both direct and indirect lead to reduction in inclusiveness. It might
be due to the fact that Pakistan relies heavily on indirect taxes which are
more regressive in nature. The tax system seems to promote inequalities
and is least effective in poverty reduction.

VI. CONCLUSION AND POLICY IMPLICATIONS

Macroeconomic Policies, particularly fiscal Policy can play vital role in
reducing poverty and income inequality leading to coveted target of
Inclusive economic growth. Present study has analyzed the role of fiscal
policy in promoting a more broad-based inclusive economic growth in
Pakistan. The findings suggest weak linkage between fiscal policy and
inclusive economic growth in Pakistan. GDP growth reduces poverty up
to certain extent but falls short of mitigating inequalities and creating
productive employment opportunities. Government expenditures
particularly current expenditures are inversely affecting poverty

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38 Pakistan Economic and Social Review

reduction, income inequality and productive employment. Taxes are also

found not supportive to inclusive growth process.
A well-targeted and coordinated fiscal policy can play an important
role in reduction of poverty and inequality while stimulating productive
employment to ensure inclusive growth. Composition of government
expenditure should also be reviewed to achieve afore-mentioned targets.
There is a dire need to curtail non-productive current expenditures and
spend more on public goods, which will help attain more inclusive
economic growth through channels of employment and equity. Fiscal
policy should aim at reducing both income and non-income inequalities
and should promote access to education and health facilities as it has
direct implications for Inclusive growth. Gross fixed capital formation
should be equitably distributed to promote access and opportunities for
people living in backward areas. Hence, expenditure on education and
health and gross fixed capital formation should be particularly focused to
make the growth process more inclusive.
The current taxation system does not seem to play any significant
role in achieving inclusive growth in Pakistan. It should be over hauled to
promote equity in the society as taxes can play a very effective role
towards fair distribution of growth dividends. Pakistan, with low tax to
GDP ratio, large tax evasions and heavy reliance on indirect taxes, seem
to have all the ingredients for inequality to grow and inclusive growth to
retreat in society. Effective and broad based tax reforms are a key to pull
the country out of social and economic quagmire of unequal distribution
of wealth & resources.

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 ZULFIQAR: Fiscal Policy for Inclusive Growth 39

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 ZULFIQAR: Fiscal Policy for Inclusive Growth 45

APPENDIX
FIGURE 1
GINI Responses to Shocks in Current Expenditure, Development
Expenditure, Direct Taxes and Indirect Taxes
Response to Cholesky One S.D. Innovations ± 2 S.E.
Response of DLOG_GINI_ to DLOG__CE_ Response of DLOG_GINI_ to DLOG_DE_
.012 .012

.008 .008

.004 .004

.000 .000

-.004 -.004

-.008 -.008
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Response of DLOG_GINI_ to DLOG_DT_ Response of DLOG_GINI_ to DLOG_IT_

.012 .012

.008 .008

.004 .004

.000 .000

-.004 -.004

-.008 -.008
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

FIGURE 2
GINI Responses to Shocks in Gross Fixed Capital Formation,
Expenditure on Education and Expenditure on Health
Response to Cholesky One S.D. Innovations ± 2 S.E.
Response of D(LOGGINI) to D(LOGFC) Res pons e of D(LOGGINI) to D(LOGEGDP)
.004 .004

.002 .002

.000 .000

-.002 -.002

-.004 -.004

-.006 -.006
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Response of D(LOGGINI) to D(LOGHGDP) Res pons e of D(LOGGINI) to DLOG_Y_

.004 .004

.002 .002

.000 .000

-.002 -.002

-.004 -.004

-.006 -.006
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

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46 Pakistan Economic and Social Review

FIGURE 3
Poverty Responses to GDP, Current Expenditure, Education Expenditure,
Health Expenditure and Taxes
Response to Cholesky One S.D. Innovations ± 2 S.E.
Res pons e of D(LPOVERTY) to D(LOGCEX) Res pons e of D(LPOVERTY) to D(LOGEGDP)
.04 .04

.02 .02

.00 .00

-.02 -.02

-.04 -.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Res pons e of D(LPOVERTY) to D(LOGHGDP) Res pons e of D(LPOVERTY) to DLOG_Y_

.04 .04

.02 .02

.00 .00

-.02 -.02

-.04 -.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Res pons e of D(LPOVERTY) to D(LDTT) Res pons e of D(LPOVERTY) to D(LITX)

.04 .04

.02 .02

.00 .00

-.02 -.02

-.04 -.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

FIGURE 4
Productive Employment (Indicator 1) responses to Shocks in Current
Expenditure, Development expenditure, Direct Taxes and Indirect
Taxes
Response to Cholesky One S.D. Innovations ± 2 S.E.
Res pons e of D(LEMPM) to D(LOGCEX) Res pons e of D(LEMPM) to D(LOGDEX)
.04 .04

.03 .03

.02 .02

.01 .01

.00 .00

-.01 -.01

-.02 -.02
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Res pons e of D(LEMPM) to DLOG_Y_ Res pons e of D(LEMPM) to D(LEMPM)

.04 .04

.03 .03

.02 .02

.01 .01

.00 .00

-.01 -.01

-.02 -.02
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Res pons e of D(LEMPM) to D(LDTT) Res pons e of D(LEMPM) to D(LITX)

.04 .04

.03 .03

.02 .02

.01 .01

.00 .00

-.01 -.01

-.02 -.02
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

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