Scholarly article on topic 'An Analysis of Debt Sustainability in the Economy of Pakistan'

An Analysis of Debt Sustainability in the Economy of Pakistan Academic research paper on "Economics and business"

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Abstract of research paper on Economics and business, author of scientific article — Khurram Ejaz Chandia, Attiya Y. Javid

Abstract The study provides a detailed analysis of debt sustainability in the economy of Pakistan. Literature on the issue of public debt considers it sustainable if the growth of debt is not greater than growth of GDP. Debt sustainability in the economy of Pakistan is tested by estimating fiscal reaction function where a positive relationship is found between surplus-to-GDP ratio and lag debt-to-GDP ratio. The small coefficient of debt-to-GDP indicates an existence of sustainability in its weak form. Afterwards, extended fiscal reaction function is estimated and results show that the value of coefficient of lag surplus-to-GDP ratio is positive and marginally significant which confirms the role of past surpluses in future. Debt dynamics is also analyzed. To analyze the effects of expenditure and revenue adjustment to debt, revenue and expenditure reaction functions are estimated and results are in support to inter temporal budget constraint as government has its role in fiscal adjustments by working on both the aspects i.e. revenue and expenditure. The dynamic analysis of affects of government spending and revenue shocks on debt-to-GDP ratio and other macro-economic variables through Vector Autoregressive (VAR) model is also the part of this study for period 1971-2008 and results indicate that consumption and output reacts negatively to the innovations in government spending refers to the similarity with Ricardian behavior. Lastly, the long run relationship between surplus-to-GDP ratio and debt-to-GDP ratio is estimated through Johansen co integration to confirm sustainability and results suggest the existence of long run association among the two series.

Academic research paper on topic "An Analysis of Debt Sustainability in the Economy of Pakistan"

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Economics and Finance

ELSEVIER Procedia Economics and Financc 5 (2013) 133 - 142

www.elsevier.com/locate/procedia

International Conference on Applied Economics (ICOAE) 2013

An Analysis of Debt Sustainability in the Economy of Pakistan

Khurram Ejaz Chandiaa, Attiya Y. Javidb

aLecturer (Management Sciences),COMSATSInstitute of Information Technology, Sahiwal, Pakistan _bProfessor (Economics), Pakistan Institute of Development Economics, Islamabad, Pakistan_

Abstract

The study provides a detailed analysis of debt sustainability in the economy of Pakistan. Literature on the issue of public debt considers it sustainable if the growth of debt is not greater than growth of GDP. Debt sustainability in the economy of Pakistan is tested by estimating fiscal reaction function where a positive relationship is found between surplus-to-GDP ratio and lag debt-to-GDP ratio. The small coefficient of debt-to-GDP indicates an existence of sustainability in its weak form. Afterwards, extended fiscal reaction function is estimated and results show that the value of coefficient of lag surplus-to-GDP ratio is positive and marginally significant which confirms the role of past surpluses in future. Debt dynamics is also analyzed. To analyze the effects of expenditure and revenue adjustment to debt, revenue and expenditure reaction functions are estimated and results are in support to inter temporal budget constraint as government has its role in fiscal adjustments by working on both the aspects i.e. revenue and expenditure. The dynamic analysis of affects of government spending and revenue shocks on debt-to-GDP ratio and other macro-economic variables through Vector Autoregressive (VAR) model is also the part of this study for period 1971-2008 and results indicate that consumption and output reacts negatively to the innovations in government spending refers to the similarity with Ricardian behavior. Lastly, the long run relationship between surplus-to-GDP ratio and debt-to-GDP ratio is estimated through Johansen co integration to confirm sustainability and results suggest the existence of long run association among the two series.

© 2013TheAuthors.Publishedby ElsevierB.V.

Selectionand/orpeer-reviewunder responsibilityoftheOrganising CommitteeofICOAE2013 Keywords: Debt sustainability; government expenditure; Economy of Pakistan

1. Introduction

The situation of foreign debt has possibly become most alarming problem for developing nations of the world after the problem poverty and surety of human resource development at the start of this millennium. It has been observed that poorest countries of the world are heavily indebted. In these highly indebted poor countries (HIPCs), revenue resources and earnings generated from exports are being used for debt servicing as a replacement for being utilized for health, education and population welfare. Neither the resources are used to spend for investments and growth of economy or for scientific research and development (Aslam, 2001). The term 'debt sustainability' refers to the level of debt which permits a country to fulfill its present and

2212-5671 © 2013 The Authors. Published by Elsevier B.V.

Selection and/or peer-review under responsibility of the Organising Committee of ICOAE 2013 doi: 10.1016/S2212-5671 (13)00019-1

upcoming servicing obligations without any rescheduling or accumulation of accruals. Sustainable debt is a level of debt where debt ratio turns down or remained unaffected, and the fiscal deficit is not necessarily to be at zero but it should not push the debt ratio to boost or move faster than growth rate of GDP. Literature on issue of public debt does not consider it a dilemma rather it consider mismanagement and unsustainable character of public debt as a trouble (Fan, 2007).

The primary objective and aim of this study is to test the long-run relationship between surplus-to-GDP and public liabilities-to-GDP.

> To test for debt sustainability in Pakistan through fiscal reaction function and extended fiscal reaction function.

> To test for debt sustainability in Pakistan through analyzing debt dynamics.

> To test for fiscal adjustments in Pakistan through revenue and expenditure reaction functions (revenue and expenditure adjustments to debt).

> To examine the dynamic effect of government spending and revenue shocks on debt-to-GDP ratio and other macroeconomic variables through Vector Autoregressive (VAR) model.

> To test for debt sustainability through applying co integration to surpluses and public liabilities.

2. Methodology

This section lays down the methodology adopted for the analysis of debt sustainability in Pakistan and also discusses about data collection and data sources.

The sustainability of debt emerged as a crucial phenomenon as large deficit and rising debt are held by most of developing countries including Pakistan. This scenario has endangered the solvency of the government and give rise to concerns about the precision of the budgetary polices. The sustainability tells whether budgetary polices are taking government away from solvency or towards solvency. Therefore sustainability implies that fiscal policies are adopted in a way that inter temporal budget constraint are satisfied or not. This implies that present market value of the public liabilities is equal to the discounted sum of upcoming expected primary surpluses. 2.1 Models

Inter temporal budget constraint (IBC) can be obtained from budget identity as follows:

PL, - PL= rtPLt_l + Gt - Rt (2.1)

PLt is the public liabilities called stock of debt at time t Gt are primary public expenditure (net of interest) Rt is government revenues rt is interest rate on public liabilities in period t-1.

Gt — Rt and PLt + Gt are defined as primary deficit and total public expenditure respectively. Following

Quintos (1995), Gatak and Sanchez-Fung (2006) by simplifying the budget constraint the following relationship is obtained:

PSt =a + pPLt +st (2.2)

PS = primary budget surplus-to-GDP ratio. PLt = debt-to-GDP ratio.

Bohn (1998) derives a policy rule or reaction function which is consistent with the rational behavior. Bohn's (1998) test of debt sustainability determines whether government is taking suitable measures of confirm inter temporal budget constraint by surplus-to-GDP ratio and debt-to-GDP ratio or not. The following equation was estimated by Bohn (1998) to test debt sustainability.

PSt = a0 + a1PLt-1 + e t (2.3)

PSt = Surplus-to-GDP ratio net of interest (alternatively deficit-to-GDP ratio with negative sign). PLt-1 = debt-to-GDP ratio during period t-1.

To determine fiscal stability, it implies to test significance of a1 in above equation. If a1 turns out to be statistically significant against alternative hypothesis i.e. a1<0 will indicate that government is on the trajectory of achieving debt sustainability. The theoretical rationale working in the concept is that the debt sustainability cannot be achieved unless the previous accumulation of debt is offset by large surplus in current period to pay off previous debt which is a positive and significant condition for debt sustainability. The estimation of above equation requires PSt (surplus-to-GDP ratio) and PLt (debt-to-GDP ratio) to be stationary. If PSt and PLt are non-stationary, than relationship can be established in co integration or long-run relationship provided et is stationary.

The rationale of this study is to look for logical relationship between debt-income ratio, primary surplus and a set of all other determinants of the primary budget surplus.

PSt = ao + a1PLt-1 + a2Zt + e t (2.4)

Zt is a set of other determinants of primary surplus, and Bohn (1998) include this set of other determinants in error terms.

2.1.1 Fiscal Reaction Function

Barro (1979) and Barro (1986) in his tax-smoothing model, suggests some important features of optimal fiscal policy which depends on permanent government expenditure and on level of debt. Bohn (1998) model is used in this study to estimate a regression, by including other determinants of surplus-to-GDP ratio which were earlier suggested by Barro (1979) and Barro (1986). The relationship takes following form of fiscal reaction function.

PSt =a0 + a1PLt1 + a2Gt + a3GAPt +st (2.5)

PSt = St = Primary budget surplus-to-GDP ratio.

PLt-1 = dt-1 = Debt-to-GDP ratio.

G = Government spending in Pakistan

GAP = Difference between actual and potential GDP of Pakistan.

GDP GAP is defined in literature by standard definition as a difference between actual and potential GDP. GDP is regressed on time and obtain the fitted values and then take the difference between actual and fitted GDP and got GDP GAP.

It is expected that surplus-to-GDP ratio and debt-to-GDP ratio must have positive relationship and government spending and output gap must have negative relationship with surplus because increased government spending reduces surplus and more output gap leads to reduction in surplus.

2.1.2 Extended Fiscal Reaction Function

Since surplus in particular period depends on the surplus in previous period, therefore equation of fiscal reaction function is extended by including lag surplus on the set of explanatory variables.

PSt =a0 + axPLt_j + a2Gt + a3GAPt + a4PS,_X + st (2.6)

PS t-1 = lag of surplus-to-GDP ratio

4.1.3 Debt Dynamics

For assessing debt sustainability, debt dynamics is analyzed by following Bohn (1998). This dynamics is based on the short run relationship of surplus-to-GDP and debt-to-GDP ratio. So if temporarily two series moves away from each other in the short run, there is adjustment and debt-to-GDP ratio revert to its mean. The short run relationship becomes:

APS = a0 + a1APLt_1 + a2AGt + a3AGAPt + st (2.7)

All the variables used in this relationship of debt dynamics are same as defined above. This relationship equation suggests that that government is taking measures to satisfy inter temporal budget constraint or not.

2.1.4 Government Revenue and Expenditure Adjustments to Debt

The effects of expenditure and revenue on debt sustainability are investigated along with how these fiscal adjustments are transmitted to the economic activity in context of Pakistan. To analyze fiscal adjustments, following Blanchard and Perotti (2002), revenue and expenditure reaction function are estimated. The relationships are given below:

2.1.4(A) Government Expenditure Adjustment to Debt

Gt =a0 + a1PLt_1 + a2GAPt + s, (2.8)

This implies that government spending (G) in any economy depends on public liabilities or public debt and

the gap of actual and potential GDP.

2.1.4(B) Government Revenue Adjustment to Debt

Rt =a0 + a1PLt_1 + a2GAPt + st (2.9)

This implies the dependence of government revenues (R) in any economy on public debt or public liabilities and the gap of actual and potential GDP.

2.1.5 Impulse Response Functions using Vector Autoregressive (VAR) Model

As public debt piles-up with fiscal expansion (raising expenditure) or less revenue generation, this effects consumption per capita, interest rate, inflation, exchange rate and etc. To analyze the transmission mechanism of dynamic effect of government spending and revenue innovations, Vector Autoregressive (VAR) model is estimated. Following Blanchard and Perotti (2002) and Favero and Giavazzi (2007), this study applies unrestricted VAR analysis. Let yt be vector of private consumption per capita (CON), interest rate (INT), real exchange rate (ER), along with ratio of debt-to-GDP.

To examine the dynamic effect of government spending and revenue innovations on debt-to-GDP ratio and other macro-economic variables, the following VAR model is estimated.

yt = E cyt + e t (2.10)

yt vector consist of government spending (gt) consumption per capita (CON), interest rate (INT), exchange rate (ER), and debt-to-GDP ratio (PL).

A response from the level of public liabilities and government spending is necessary for firmness of debt unless the growth rate of economy is exactly equal to the average cost of financing public debt. The interest rate is an essential variable in transmission of fiscal shocks, depending on future expected monetary policy and risk premium, both can be affected by debt dynamics. It is expected that the implications of a particular fiscal shock of interest rate will be different depending, whether the shock produces a stable or unstable path for public debt (Favero and Giavazzi 2007). Call money rate is used for interest rate. It is short term interest rate between banks mostly used in the studies.

2.1.6 Co integration

PSt =a + pPLt +et (2.11)

PS = primary budget surplus-to-GDP ratio. PLt = debt-to-GDP ratio.

Co integration is applied to confirm the long run relationship between the variables which is indicated from the results of above models and equations.

2.2 Data

The figures and statistics for this study are obtained from International Financial Statistics (IFS) CD-ROM (2008) issued by International Monetary Fund, Pakistan Economic Survey (various issues), and Pakistan Statistical Year Book 2008. The data includes statistics and figures for government expenditure, government revenue, primary surplus/deficit, consumption of private sector, real interest rate and real exchange rate; tax

and public debt scaled by GDP for the time period of 1971 to 2008. 3. Analysis and Discussion of Results

The econometric analysis consists of several estimation techniques. The analysis begins with stationarity test. Then sustainability of debt is analyzed through fiscal reaction function, extended fiscal reaction function and debt dynamics. Afterwards, fiscal adjustments are investigated. The debt dynamics is also explained by including other macro variables through impulse response functions. Finally to confirm the analysis co integration test is applied. 3.1 Unit Root Test

For estimation of required models, first step is to test for the stationarity of variables included in study for analysis. The augmented Dickey-Fuller (ADF) test with a constant and a trend is applied to test the stationarity of variables. The result of this test for unit root indicate the acceptance of unit root in all series, so the variables are made stationary by taking first difference and are integrated of order one before moving towards any further analysis. The results for the unit root test are reported in the table given below. Table 3.1 The Unit Root Test Results

Variables Level First Difference

PS -0.13 -5.73*

PL -0.23 -5.49*

G -1.62 -4.64*

R -2.17 -5.80*

GAP -0.48 -5.08*

ER -1.45 -3.95**

INT -0.16 -4.77*

Note: * indicate the significance at 1% level, ** indicate the significance at 5% level and *** indicate the significance at 10% level respectively.

3.2 Fiscal Reaction Function

The equation for fiscal reaction function is estimated by using ordinary least square and standard errors are adjusted for autocorrelation and heteroscedasticity. The results show that fiscal policy in Pakistan is sustainable as there exists a positive relationship between PS and lag PL or alternatively negative relationship between budget deficit-to-GDP ratio and debt-to-GDP ratio as it was previously explained by (Bohn 1998). The small magnitude of the co-efficient indicates the existence of sustainability in weak from. These results are in correspondence with inter temporal budget constraint. This result supports Bohn predication that surplus (deficit) should respond negatively (positively) to change in government expenditure. Table 3.2

Variables Coefficient Std. Error t-Statistics Prob.

C 0.0227 0.0230 0.9871 0.3310

PL(-1) 0.0737 0.0232 3.1787 0.0033

G -0.2385 0.1220 -1.9544 0.0594

GAP -1.24 5.44 -2.2768 0.0296

R-square = 0.5415 Adj. R-square = 0.4992 F-statistic = 12.6310 3.3 Extended Fiscal Reaction Function

Table 3.3

Variables Coefficient Std. Error t-Statistics A.1. Prob.

C 0.0677 0.0218 3.0985 A.2. 0.0041

PL(-1) 0.0370 0.0176 2.0963 A.3. 0.0443

G -0.1644 0.1290 -1.2745 A.4. 0.2119

GAP PS(-1) -8.16 0.2450 5.96 0.1812 -1.3706 1.3519 A.5. 0.1803 0.1862

R-square = 0.5847 Adj. R-square = 0.5311 F-statistic = 10.9134

This equation for extended fiscal reaction functions is also estimated by Ordinary Least Square and results are same for the variables included in previous equation, however their level of significance is reduced for this time. The lag value of co-efficient for lag surplus-to-GDP ratio is positive however marginally significant. 3.4 Debt Dynamics Table 3.4

Variables Coefficient Std. Error t-Statistics Prob.

C 0.3118 0.1281 2.4331 0.0207

PL(-1) -0.3223 0.1361 -2.3681 0.0241

G -9.67 5.53 -1.7479 0.0901

GAP -4.19 2.58 -1.6247 0.1140

R-square = 0.2091 Adj. R-square = 0.1349 F-statistic = 3.8202

The debt sustainability is further analyzed by investigating debt dynamics, through the equation derived from Bohn (1998). This indicates an unsustainable nature of public debt of Pakistan in short run. The mean reversion of debt-to-GDP ratio is revealed by the negative sign of the co-efficient of lag debt-to-GDP ratio. The output gap has a negative sign and is marginally significant. The government spending has negative sign showing procyclicality of debt dynamics with respect to shock in government spending.

3.5 Government Revenue and Expenditure Adjustments to Debt 3.5(A) Government Revenue Adjustments to Debt

After analyzing debt dynamics, next step is to evaluate policy question that which component of fiscal policy is adjusting against debt accumulation to make debt and fiscal policy sustainable. The objective of this step is to investigate, whether revenues or expenditures or both are playing their role in making adjustments. Revenue-to-GDP ratio is regressed on lag public debt and an output gap. The results indicate that adjustments come from revenue side. Table 3.5

Variables Coefficient Std. Error t-Statistics Prob.

C 10.5784 0.3911 27.0444 0.0000

PL(-1) GAP 1.9949 -0.0012 0.5131 4.98 3.8873 -24.7466 0.0005 0.0000

R-square = 0.9743 Adj. R-square = 0.9727 F-statistic = 607.4571 3.5(B) Government Expenditure Adjustments to Debt

The results for expenditures are also showing significance in making adjustment as the co-efficient appeared to be highly significant. The results are in support to the concept of inter temporal budget constraint and provides and an evidence that revenue can be generated and raised but the number of ways or channels are limited because it is not socially acceptable to raise revenue by increasing tax rates. In addition government has role in fiscal adjustments on the other side through working on its expenditures. Table 3.6

Variables Coefficient Std. Error t-Statistics Prob.

C 0.0083 0.0068 1.2154 0.2328

PL(-1) 4.54 3.30 13.7626 0.0000

GAP -7.42 2.46 -3.0162 0.0049

R-square = 0.9827 Adj. R-square = 0.9816 F-statistic = 938.2444

3.6 Impulse Response Functions using Vector Autoregressive (VAR) Model

For analyzing the effect of fiscal shocks of government spending and taxes on debt-to-GDP ratio and other macro-economic variables i.e. Output, interest rate, private consumption and exchange rate are estimated by unrestricted Vector Autoregressive (VAR) model. The benefit of the methodology is that it allows estimating small number of parameters and it does not enforce any type of restrictions on the economy. The VAR models are characterized without any prior distribution between endogenous and exogenous variables. To analyze the effect of fiscal shocks and government spending charges, methodology suggested by Blanchard and Perotti

(2007) and Favero and Giavazzi (20007) is adopted for data of Pakistan for period 1971-2008. The two VAR models are estimated, one includes government spending, output, private consumption, interest rate, exchange rate and debt. The other model takes revenues instead of government spending while other variables remain the same. The lag length of VAR selected three based on Akikia information Criteria (AIC) and Schwartz Bayesian Criterion (SBC). The first model also replaces debt and use tax, as VAR methodology reveals the possibility of different results in different cases. Figure 1 indicates the impulse response function using VAR model that gives an evidence of fiscal contraction. In figure 2, the impulse response functions are displayed when tax-to-GDP ratio is included. The tax shows a positive response towards government spending. The positive response of expansionary shock towards tax and negative response towards debt seems to indicate that increased tax revenue signals a reduction in future government obligations and suggests a positive wealth effect. On the other side, an increased in public debt causes a decrease in the present value of future revenues and reduced present consumption.

Figure 3 indicates an impulse response function using VAR model, introducing government revenue shock on macro-variable. The impulse response shows revenue shock has negative impact on output and exchange rate while has positive impact on consumption interest rate and debt. It implies that decreased revenue tends to impact the output of an economy and reduce it. As a result of the reduced output, the economy will have to import the goods which will no doubt negatively impacts the exchange rate and it will be depreciated. The deceased revenue will result in increase debt as government will finance its expenses through debt in case of revenue shock.

Figure 1: Dynamic Implication of Government Spending Shock on Macro Economic Variables

o Cholesky One S.D. Innovations ± 2 S.E.

of GPC to GPC

of CONPC to GPC

1 23456789

Response of BRL to GPC

123456789

Figure 2: Dynamic Implication of Government Spending Shock on Macro-Variables

Response to Cholesky One S.D. Innovations ± 2 S.E.

Response of GPC to GPC

Response of CONPC to GPC

123456789

23456789

23456789

Response of ER to GPC

Response of DEBT to GPC

1 23456789

Note: The VAR model is predicted with three lags and a constant.

Response of ER to GPC

23456789

Response of TAX to GPC

23456789

Note: The VAR model is predicted with three lags and a constant.

Figure 3: Dynamic Implication of Government Revenue Shock on Macro-Variables

Response to One S.D. Innovations ± 2 S.E.

Response of R to R

Response of CCNC to R

1 23456789 10

Response of GDP to R

1 2 3 4 5 6 7 8 9 10

Response of INT to R

1 2 3 4 5 6 7 8 9 10

Res pons e of ER to R

1 2 3 4 5 6 7 8 9 10

Response of DEBT to R

1 2 3 4 5 6 7 8 9 10

1 2 3 4 5 6 7 8 9 10

Note: The VAR model is predicted with three lags and a constant.

3.7 Co integration

To examine the long term association among surplus-to-GDP and debt-to-GDP Johansson (1991) co integration estimation technique in used, which is carried out by full information maximum likelihood procedure. The first step in applying co integration test is to estimate Vector Autoregressive model between the two variables and select lag length of VAR model. All criteria i.e. Akaike Information Criterion (AIC), likelihood Ratio (LR) and Schwarz information criterion (SIC) suggests one as suitable lag length therefore VAR of order one is estimated than in next step co integration test is applied.

The chart below reports the results based on Johansson Co integration test. Testing the restriction of no more than r co integrating vectors against the alternative of r < 0, the hypothesis cannot be rejected by both maximum eigon-value and trace statistic value at 95% level of significance. Based on the results obtained from Johansson co integration method, it is concluded that surpluses and public debt are co integrated. The results suggest that there exists a long run relationship between the two series. Further Vector Error Correction Model (VECM) is applied for investigation of long run connection among surplus and debt. Table 3.7

Evidence on Johanson Co integration (Trace Statistics)_

Hypothesis No of CE(s)

Eigon-value Trace Stat T-value p-value

None* At Most 1

0.46 0.003

21.33 0.11

15.49 3.84

0.00 0.07

Table 3.8

Evidence on Johanson Co integration (Max Eigon Statistics)_

Hypothesis No of CE(s) Eigon-value Max Eigon Stat

T-value p-value

None* At Most 1

0.46 0.003

21.22 0.11

15.49 3.84

0.00 0.07

3.7.1 Vector Error Correction Model

Vector Error Correction incorporates an error correction terms and confirms the stability of co integration relationship. VECM requires both series to be integrated of the same order and there exists a long run relationship between them which has been confirmed earlier. The results of normalized equation are reported in table below and the coefficient of debt in normalized co integrating equation show that if the government surplus increase by 1%, this will results in 0.04% accumulation of debt which is quite significant. The error correction term is showing that the adjustment is significant and it depicts the stability of long run connection. Since both the variables surplus-to-GDP and debt-to-GDP are co integrated, this result suggests the reaction of fiscal policy towards debt accordingly. Primary surpluses are predicted to increase in order to fulfill inter temporal budget constraint. Table 3.9 VECM Estimation

Variable Coefficient T-value

PSt-1 0.04 2.59

ECT(-1) -1.55 -3.84

4. Conclusion

Pakistan is suffering from accumulation of deficits which results in public debt of Pakistan. The roots of the cause lie in improper use and early neglection of domestic resources of Pakistan. Pakistan was inherited by financial shortages and lack of resources from India at the time of its establishment. The results of study conclude that fiscal policy in Pakistan is sustainable in its weak form as the positive relationship is found between surplus-to-GDP ratio and lag Debt-to-GDP ratio. The coefficient of public debt or public liabilities is small indicating an existence of sustainability in its weak form. The impact of government spending on budget surpluses is negative which support the prediction of Bohn(1998) which suggests the surplus (deficits) should respond negatively (positively) to change in government expenditure. The results for extended fiscal reaction function show the value of coefficient of lag surplus-to-GDP ratio is positive and marginally significant. This confirms the role of past surpluses in surpluses of present or alternatively past deficits matter in current deficits. Analysis of debt dynamics conclude that the mean reversion of debt-to-GDP ratio is indicated by negative sign of coefficient of lag debt-to-GDP ratio. Afterward, it has been analyzed that which component of fiscal policy is adjusting against debt accumulation to make debt sustainable. The results for revenue shows that adjustments come from revenue side as coefficient of both the variables i.e. lag public debt ratio and output gap, are highly significant. The results for expenditure are also indicating their part in adjustments as the coefficients of both the variables in this case are also highly significant. So it is concluded that results are in support to inter temporal budget constraint as government has its role in fiscal adjustments by working on both the aspects i.e. revenue and expenditure.

The dynamic analysis of affects of government spending and revenue on debt-to-GDP ratio and other macroeconomic variables through Vector Autoregressive (VAR) model is also the part of this study for period 1971-2008. To examine the transmission of innovations in government spending, impulse response functions are estimated for five following variables which include government spending per capita, GDP per capita, consumption per capita, debt-to-GDP ratio, interest rate and exchange rate. The consumption and output reacts negatively to the innovations in government spending. The interest rates increase with expansionary fiscal spending. The exchange rate tends to appreciate as a result of rise in government spending. The positive response of shock towards tax and negative response towards debt refers to the situation of its similarity with Ricardian behavior. An increase in tax revenue shows a probability of reduction in future government liabilities. On other hand, an increased government debt causes a decrease in the present value of future earnings.

Lastly, the study examines the long run association among surplus-to-GDP ratio and debt-to-GDP ratio through Johansson co integration technique to confirm sustainability. Based on the obtained results, it is concluded that surpluses and debt are co integrated. The results suggest the existence of long run association among the two series. Furthermore, VECM is applied for the investigation of stability of long run association among surplus and debt. The results confirm the stability of co integration relationship. So, it is concluded that variables, surplus-to-GDP and debt-to-GDP are co integrated and suggest that fiscal policy reacts to debt or public liabilities as needed and primary surpluses are likely to rise in order to assure inter temporal budget constraint.

6. Recommendations

The country, Pakistan can get rid of this situation of debt and deficit by mobilization of resources but mobilization of resources is not the only requirement but the requirement is the proper utilization of available resources. The misuse of available resources is deteriorating the situation as the resources have never been properly handled in Pakistan. The deficit can be controlled easily just by controlling non-development expenditures of the government which are burden on poor people of Pakistan. The Ministry of Commerce and Trade and Federal Board of Revenue (FBR) must layout rules and procedures to encourage investments and exports which will no doubt lead toward increased revenues.

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Bohn, H. (1998) 'The behavior of US public debt and deficits', The Quarterly Journal of Economics, 113(3), pp. 949-963.

Blanchard, o., Perotti, R. (2002) 'An empirical characterization of the dynamic effects of changes in government spending and taxes on

output', The Quarterly Journal of Economics, 117(4), pp. 1329-1368.

Fan, E. X. (2007) Pakistan's Public Debt: A brief overview. PRMPolicy Note Series, 1, pp. 1-15.

Favero, C.. Giavazzi, F. (2007) 'Debt and the effects of fiscal policy', NBER Working Paper Series, 12822, pp. 1-32.

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