Does Fiscal Policy Really Matter? Estimating the Optimal Government Size

Abstract

Pakistan, a developing nation grappling with significant economic challenges, faces persistent issues related to budgetary deficits and escalating external debt. This study explores and estimates the optimal size of government and taxation system in Pakistan by employing the Ordinary Least Squares (OLS) method on annual data from 2000 to 2024. After performing diagnostic tests to ensure stationarity, the study utilizes the Engle-Granger cointegration analysis to uncover the long-term relationships between key economic variables. The Scully model is applied to determine the optimal size of government under both balanced and unbalanced budget scenarios, offering valuable insights into fiscal policy alignment. The results show that the short-run optimal size of government is 18.87%, while the long-run optimal size, derived through cointegration analysis, is 16.71%. Additionally, the study finds that the optimal level of government spending is 22.18%, while the optimal tax rate in an unbalanced budget scenario is 16.27(1-θ)%, with θ representing the fiscal deficit. The findings reveal a widening gap between the optimal taxation level and actual tax receipts, suggesting the need for Pakistan to shift from an indirect tax structure to a more direct tax system. Furthermore, expanding the tax net to include untaxed sectors and implementing stronger enforcement measures to reduce tax evasion and avoidance are crucial to improving tax compliance. Failure to achieve an optimal government size could lead to inefficient public spending, increased fiscal deficits, and underperformance in key sectors of the economy, ultimately hindering sustainable economic growth and development.