CHAPTER 1:

INTRODUCTION

1.1 Overview

The relationship between government revenue and expenditure is a very important topic and has been an essential issue for many economists and policy makers as it represents budget deficit, government expenditure Plans and taxation structure of a country. Since the main objective of every government is to improve economic growth with low debt levels, better education system, development of infrastructure and job opportunities better fiscal policy is needed to achieve these goals. From a short term perspective fiscal policy is said to be expansionary when government expenditures exceeds the total revenue and the resulting deficit is then financed by the government, However if these expenditures contributes in economic growth then there is a long term relationship exist between government expenditure and economic growth. In addition different studies indicate that the determination of Economic growth is depended on tax levels. Whereas many believe that the most significant factor that contributes in economic growth is tax level as the collection for development purposes of most developed and developing countries depend on tax revenue.

1.2 Research Problem

In Pakistan the level of budget deficits have consistently increasing from 2005 which is then financed by the government through external and domestic borrowing resulting in a higher debt levels due to high interest cost associated with it and leads to more future tax expectations. Thus the financing by the government for the compensation of deficit is an important variable, several studies have put light on the outcome of fiscal deficit but very few have tried to find the reasons and causes of these deficits which is why the nexus between government revenue and expenditure is still an unsolved issue. Therefore the main purpose of this research is to study the causal relationship between government revenue and expenditure.

1.3 Hypotheses

H1: Tax Revenue causes Government Expenditure.

H2: Government Expenditure causes Tax Revenue.

H3: Tax Revenue and Government Expenditure bidirectionally cause to each other.

1.4 Outline of the Study

The research studies the causal relationship between government expenditure and tax revenue to see the reasons for the consistent budget deficits in Pakistan from many years. In addition time series analyses have been done to forecast the trend of government expenditure and revenue based on the leading variable.

CHAPTER 2:

LITERATURE REVIEW

Nanthakumar and Taha (2007) have found a stable relationship between spending and revenue. Furthermore there is a long-term impact exist expenditures that enter as input into the production function and those that enter as inputs in investment technologies.

Koch, Schoeman, and Tonder (2005) found that there is an association between burden of taxes and economic growth according to the findings based on the data of 1960-2002 if tax burden decreases economic growth increases significantly.

Friedman (1982) explains expenditure of the government depends on total revenue because as taxes increases expenditure increases by which deficit remains at the same level, therefore the level of fiscal deficit cannot be reduced by increasing taxes.

Buchanan and Wagner (1977) on the other hand have presented an alternative hypothesis that increase in taxes does not lead towards low expenditures because taxes creates higher price of goods for the public due to high interest cost associated with it Buchanan and Wagner suggest that in order to restore deficit government should limit its financing ability.

Sobhee (2004) tested the causality from tax to expenditure and from expenditure to taxes by using the data of public finance and founded that for the utilization of public expenditure in a small economy government first accommodate the necessary funds, therefore to avoid the situation of fiscal deficit the government must carefully monitor and control its spending programs.

Fasano and Wang (2002) in a research on GCC countries founded that the primary Source of revenue is oil and due to the economic fluctuations medium-term expenditure strategy should be adopted according to which expenditure should not exceed the non-oil revenue so that in recessions to compensate expenditures oil revenues can be injected by short-term accommodations.

Second hypothesis where causality runs from expenditure to revenue the government first spend and then to accommodate the required level of expenditure adjusts tax policy.

Peacock and Wiseman (1979) argue that due to economic crises government expenditure increases and remain at the same level even when the crises is over. In other words government expenditure is driven by strong economic crises which is able to change public perception about the size of the government.

Gounder, Narayan, and Prasad (2007) find compatibility with the second hypothesis that the increase in taxes for the accommodation of government spending affects on the capital investment by investors due to the fear of paying higher taxes in future.

The third hypothesis is fiscal synchronization according to which expenditure and revenue decisions are independent and bilaterally cause to each other. Reflecting the traditional theories for the demand for public goods.

Meltzer and Richard (1981), the demand of public expenditures and taxes need to compensate these expenditures are compared with many alternative spending programs for cost benefit analysis, therefore the practical implication of this hypothesis is bidirectional causality.

Narayan and Narayan (2006) suggest three reasons regarding the importance of nexus between government revenue and expenditure first if proper implementation on policies is taken into consideration regarding government revenue fiscal deficit can be avoided, second if causality runs from expenditure to revenue outflow increases due to the fear that government spends first and pay for it later by increasing taxes. Third in case of bidirectional causality expenditure can rise faster than revenue which can create huge budget deficits because revenue and expenditure decisions are independent of each other.

Baharumshah and Lau (2007) Find 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. Whereas 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 based on marginal cost and revenue. Furthermore the findings indicate 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 the expenditure policies of the government should be directed towards long-term future growth and for the well being of the people, Therefore activities that contribute more on socio economic development should be increased instead of using resources and funds to military defense projects.

King and Rebelo (1990) 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.

Nanthakumar and Taha (2008) found in an analysis of Malaysia that the major part of taxes is direct taxes and reducing direct and indirect taxes leads to reduce in government expenditures, In addition non-tax revenue does not contribute much in economy’s growth.

Hondroyiannis and Papapetrou (1996) find unidirectional causality running from government expenditure to revenues in Greece where the reason of fiscal deficit from a long period of time was government spending decisions. The government spending to GDP is very high in Greece which results an operating inefficiency for the economy. Furthermore the results indicated that reducing fiscal deficit without reducing the government expenditure leads to failure.

Ahiakpor and Amirkhalkhali (1989) Based on the analysis of Canada found that to show the relevant results of fiscal policy government increase taxes which is a temporary and incomplete act in order to fully take control over fiscal deficit the government must reduce or limit its expenditures instead of finding ways to increase tax revenue burden on public.

Baghestani and McNown (2004) in a study of Egypt and Jordan claim that to promote domestic savings and private investment it is necessary to eliminate budget deficit for both the counties. Baghestani supported the causality from tax revenue to expenditure in case of Egypt and bi-lateral causality in case Jordan. Furthermore promoted the process of privatization because it facilitate high domestic saving and investment and at the same time helps to reduce fiscal deficit.

Neyapti (2008) studied the influence of fiscal decentralization on government revenue and expenditure and indicated that decentralization improves quality of governance which leads to decrease in budget deficit and stable economic condition. However the efficiency of fiscal decentralization increases in case of large population.

Keho (2010) Study the data fo 1660 to 2005 to analyses the causal relationship between government expenditure and tax revenue to see which expenditure and revenue items plays a part in the reduction of budget deficit and found that GDP has significant effect on government expenditure. Furthermore the findings of granger causality test indicate unidirectional causality from government revenue to expenditure according to the findings the implementation for the elimination of fiscal deficit should not be made by just increasing revenues. Thus for the beneficial results spending cuts are necessary. In other words tax system should be made with proper spending control system.

Brennan and Buchanan (1980) suggest that in order to reduce fiscal deficit constitutional limits should be imposed on post-constitutional government to reduce the revenue collection by latter governments so that position of maximum financing of goods demanded by public and minimum revenue collection can be achieved.

Baffes and Anwar (1990) conducted the research for the countries Argentina, Brazil, Chile, Mexico, and Pakistan to determine the behavior of government towards revenue and expenditures for the alignment of fiscal deficit. The results found to be positive for Mexico, Brazil and Pakistan while the similar findings haven’t been found for Argentina and Chile. For Brazil, Mexico and Pakistan causality runs in both ways in other words bidirectional causality where decisions for the government spending and revenue are taken simultaneously. However in case of Argentina and Chile causality runs from expenditure to revenue. The results indicates that to control budget deficit the government should increase revenue collection and restrain expenditure whereas public expenditures should be reduced in Argentina and Chile.

Stoian (2008) founded in case of Romania by applying Johansen cointegration and Error Correction model that the long run relationship between government revenue and expenditure do not affect major fiscal imbalances.

CHAPTER 3:

RESEARCH METHODS

3.1 Method of Data Collection

Data of the two variables Government Expenditure and Total Revenue is taken from secondary sources with the help of multiple sources which includes (Ministry of Finance), (State bank of Pakistan) and (Hand book of Statistics on Pakistan Economy).

3.2 Sample Size

Sample of 31 observations have been used by using the data of public finance from the year 1979-2010. Where the variable (Total Tax Revenue) has been created by adding indirect-tax, direct-tax, Non-tax revenue and surcharges and (Total Expenditure) has been calculated by adding Development and Non-Development Expenditures.

3.3 Research Model

Granger model is used to study the causality where TR is the total revenue and TE is total government expenditure.

TRt = �1 + δ1 + TEt-1 + TEt-2 + ET1

TEt = �2 + δ2 + TRt-1 + TEt-2 + ET2

The above two equation represents the hypothesis where the causality running from total expenditure to revenue in equation one and from revenue to expenditure in equation two. The rejection of any hypothesis concludes unidirectional causality between government expenditure to revenue. However, rejection of both the hypothesis concludes bidirectional causality in other words fiscal synchronization exists between government revenue and expenditure.

3.4 Statistical Technique

In this research granger causality test by Granger (1969) has been applied to study the causal relationship by comparing one time series with another (Government Expenditure with Government revenue) where one variable becomes the cause of the other variable to predict it significantly. In addition cross-correlation has been applied to assess the correlation between both time series variables.

CHAPTER 4:

RESULTS

4.1 Findings and Interpretation of the results

Table 4.1

The summary given in the table above shows that there is a unidirectional causality exist between total government expenditure and total revenue, as the value of F-Statistic is < 3.5 when the causality runs from expenditure to revenue due to which the null hypothesis (TOTAL_EX does not Granger Cause TOTAL_RE) is accepted. However, the causality is running from revenue to expenditures as F-Statistics > 3.5, Furthermore both lag 1 and lag 2 are tested to achieve better results as table 4.2 indicates therefore the null hypothesis (TOTAL_RE does not Granger Cause TOTAL_EX) is rejected.

Table 4.3

Figure 4.1

Total_Revenue with Total_Expenditure

Lag Number

The results of cross-correlation indicates total revenue as a leading time series variabler with a strong correlation of .994 with government expenditures at lag 0, furthermore correlation a positive correlation has been found from lag 1 to lag 11, However the correlation is decreasing and from 12 to 16 lags correlation in negative predicting that with the increase in total revenue, total government expenditure will decrease in future.

4.2 Hypotheses Assessment Summary

CHAPTER 5:

CONCLUSION, DISCUSSION, IMPLICATIONS AND FUTURE RESEARCH

5.1 Conclusion

The research studies the causal link between total government expenditure and total revenue in Pakistan using granger causality test and the supportive cross correlation from 1979-2010. The result from granger causality supports the hypothesis that tax revenue causes government expenditure in Pakistan. In addition cross correlation results have indicated long-term results that with the increase in revenue expenditures will increase. Therefore the major conclusion drawn from this research is that in order to eliminate the problem of fiscal deficit and sustainable economic growth government should focus on the policies which facilitate increasing revenue.

5.2 Discussion

Various studies have analyzed the causal relationship between government expenditure and revenue. Some supported with unidirectional causality occurring from revenue to spending and from expenditure to revenue whereas some have indicated the result of bidirectional causality. However, both the variables have significant impact on budget deficit and economic growth.

Fiscal deficit in Pakistan is a major issue as the findings of cross correlation indicates that the revenue and expenditures are correlated which means that as revenue increase expenditure increases and deficit remains at the same level and to compensate this deficit government increases its debt financing from domestic and foreign sources which leads towards inflation and high interest rates.

5.3 Implications and Recommendations

The model and analysis of this study is very useful for economists and policy makers as it helps in enhancing revenue by tax reform programs. In addition for the determination of optimal spending expenditure reform assessment can be done through cost and benefit analysis which will help in setting objectives for tax collections and better utilization of taxes.

5.4 Future Research

Future research possibilities could be as follows first variables like national income and debt financing could be included in the research. Second data sets of multiple countries would be interesting to analyze the causal relationship using the same model in comparison with this research.