# **1. Introduction**

Fiscal challenges are at the core of development challenges across South Asian countries. In Bangladesh, the energy mix is becoming increasingly expensive, at a time when demand for electricity is surging. Passing on the high costs to consumers is politically difficult, which results in an increasing subsidy burden. In Bhutan, exports of electricity from large hydropower projects are an important source of government revenue, but they are lumpy. Without a mechanism to smooth out public spending due to big investment projects, turbulence could arise as other large dams start operation. In India, fiscal discipline seems to be stronger at the center than in the states. And some states are a source of contingent liabilities, for example due to borrowing by utilities or due to waivers of bank debts for specific groups. In Nepal, low capacity prevents full spending of the budget. Compared to the federal level, capacity is even lower in the provinces and local governments and the move toward fiscal federalism may hence result in even stronger underspending. In Pakistan, the recent economic history is one of slow growth punctuated by recurrent macroeconomic adjustments. Adjustment programs brought in macroeconomic stability, but often at the cost of a temporary and substantial deceleration in economic activity. And once the economy was back on track, fiscal pressures mounted again, triggering the next boom-andbust cycle. Finally, in Sri Lanka population aging could make the country’s generous social programs unaffordable in a not-so-distant future.

The fiscal room to maneuver is limited, as tax revenues in South Asian countries are lower than could be anticipated given the region’s level of economic development. South Asian countries are not different from other developing countries in terms of the tax instruments they use, but their tax bases are small, tax exemptions are common, and tax evasion is widespread. Government spending is not as low as tax revenue and consequently fiscal deficits are larger than in most other regions. Fiscal deficits in several South Asian countries have been large for quite some time. The average deficit over the last three years has been around 5.5 percent in Pakistan and above 6 percent in India and Sri Lanka. Furthermore, public debt levels are remarkably high in some countries. South Asia’s public debt is projected to be above 55 percent of GDP in 2018 (World Bank 2018). Debt sustainability analysis jointly conducted by the World Bank and the IMF suggests that the public debt as percent of GDP of most South Asian countries should decline in the coming years.

Prudent fiscal policy ensuring macroeconomic stability is a key prerequisite for sustainable growth, determines the distributional effect of growth, and is crucial for external and currency stability (Easterly and Rebelo 1993; Mundle 1999, Park 2010, Gumus 2016, Badinger et al. 2017). In addition, fiscal policy should strive to smooth out business cycle fluctuations by strengthening the automatic adjustment of taxes and by adjusting government expenditures (Clements, Gupta, and Inchauste 2004). In other words, government spending should decrease during growth accelerations and increase in economic downturns. Good times ought to provide the fiscal space necessary to maneuver during downturns. This is especially important in South Asia, where the level of fiscal deficits is often affected by developments beyond the control of policy makers. Between 1980 and 2017, South Asian countries experienced over 100 downturns in key global and domestic variables.<sup>1</sup> During the troughs, fiscal

> 1 We considered global GDP growth, growth of world trade, international oil price, remittances, and terms of trade.

2