Re-aligning NFC: coalition govt faces a challenge from within

Reportedly, the IMF (International Monetary Fund) has requested resumption of dialogue on the National Finance Commission (NFC) award to address the imbalances in the distribution of fiscal resources between the federal government and provinces. It’s a much-needed debate the country needs to have as the federation of Pakistan has increasingly become fiscally unsustainable due to the debt trap it finds itself in.

In its country report published in 2017, the IMF pointed out that Pakistan’s fiscal arrangement is unique compared to other countries. The usual practice in many countries is that the share of subnational governments (provinces in case of Pakistan) in revenues is lower than their share in expenditure, and the resulting gap is covered in the forms of various transfers.

It is the other way round in Pakistan where provinces’ share in revenues is significantly higher than their share in expenditure. The lopsidedness was present even before the 7th NFC award, as in 2010 the provinces’ share in expenditure was 30 percent while they received 42 percent of the revenues. Thereafter, due to higher share of divisible tax pool going to provinces (from 47.5% in FY10 to 57.5% from FY12 onwards), the provinces’ share in expenditure averaged at 34 percent during FY11-23 while average share in revenues stood at 53 percent.

The vertical asymmetry got uglier, as many functions of devolved subjects from federal jurisdictions to provinces despite the 18th Amendment stayed with Islamabad, while provinces built their own capacities. This has resulted in duplication in consumption of resources.

Nonetheless, the issue is much bigger than the redundancy of a few devolved subjects at the federal level. The rollout of fiscal decentralization in the 7th NFC Award has been unbalanced in several important areas.

The incentives are misaligned – both at the federal and provincial levels. The provinces while getting a higher share do not have any incentive to enhance their tax base – as there is minuscule tax collection on agriculture income, land, and other areas. Why would provincial legislatures dominated by agri landlords and urban landholders, tax themselves (and their vote base) when they are receiving sufficient revenue from divisible pool to run expansionary fiscal management?

Yes, the provinces have shown good progress in imposing GST on services, which was one of the functions devolved after the 18th amendment. The provincial governments formed their own tax authorities and their collection increased at a CAGR of 17 percent from FY16 to FY23. However, its share in total GST on goods and services stood at a mere 14 percent during last year whereas services accounts for over 50 percent of GDP.

There is still much room to enhance the GST on services as it is a provincial subject and by having multiple tax collection authorities, this has issues of its own. There are confusions on origination and destination on services. There are complications due to varying rates in provinces and filing of returns to multiple authorities. It is a nightmare for honest taxpayers, as ideally should be one countrywide tax authority to collect GST.

Then the incentive for the federal government to impose new taxes (within divisible pool) lowers as the lion’s share goes to provinces. The point is that federal government’s control over spending from taxes is falling. To counter that, the federal government is imposing levies outside the divisible pool – such as petroleum levy, which is currently at Rs60/litre even as the GST on petroleum has dropped to zero.

The third issue is that provinces increased resources went disproportionately into current spending, which increased at a CAGR of 15 percent from FY10 to FY23 while the development spending grew at a CAGR of 13 percent. The provincial share of current expenditure in total expenditure was 71 percent in FY10, and after 7th NFC award, it has averaged at 75 percent during FY11-23 – barring Baluchistan, current spending outpaced the development in all other provinces. And the provincial development spending marginally fell in terms of GDP — from an average of 1.8 percent during FY06-10 to 1.7 percent during FY11-23.

Another problem is that political parties have extensively used the enhanced provincial resources for patronage by inducting a large number of provincial employees. Back in the day, SOEs (such as PIA and PSM) were the places to employ political workers and supporters. However, with these turning into loss- making elephants, provincial resources are now being used towards workers. Then there are divergent policies on public sector penetration in businesses — for example, the federal government is consistently pursuing privatization of SOEs even as provinces (especially Punjab) have created numerous ‘Section 42 Companies’ in public domain.

Lastly, the spirit of devolution could never materialize as local government system is almost dysfunctional in Pakistan. Provincial cabinets control the local government jurisdictions, and the service delivery is poor. Provinces, after getting financial power from the federation, do not want to lose it, by passing it on to the third tier. That limits the ability to collect local council taxes and improve service delivery based on the same

That is the stock of the situation. The federal fiscal system is almost bankrupt due to the lopsidedness of the NFC award, redundancy of devolved subjects at federal level, misaligned incentives, lack of transparency on expenditure by provinces and absence of devolution to third tier. There is an urgent need to rethink the whole framework to restore the sustainability of the fiscal house.

The IMF noted in its report that the NFC award is largely silent about sharing the burden of financing joint responsibility. The provinces are required to bear responsibility along with the federal government on areas such as public debt and energy sector, yet somehow it is assumed that these would be financed by the federal government. Now, the capacity of the federal government to bear these losses on its own has been maxed out. The costs ought to be shared by provinces too, going forward.

Moreover, a share of Benazir Income Support Programme (or Ehsaas programme) must be transferred to the provinces, as due to unprecedented inflation, the poverty levels are on the rise while the federal government’s ability to enhance cash and other transfers has been exhausted.

Sharing is caring. Provinces must share the burden to keep the country fiscally afloat. And by doing so, they would be compelled to raise revenues in their own jurisdiction – such as agriculture income tax, land based taxes, and other municipal revenues. Moreover, provinces should raise financing by issuing municipality bonds and using other avenues.

Most importantly, they must work on developing effective local bodies. Provinces in Pakistan are too big in size. There are only nine countries (other than Pakistan) that are larger than Punjab in terms of population. And the province mainly enjoys revenues with little in responsibility. Meanwhile, Karachi, one of the top ten populous cities in the world, has been treated as an orphan by the provincial government in Sindh.

Fiscal federalism in Pakistan needs to be revisited as the provinces must share responsibility and there should be smaller and manageable administrative units. However, it is easier said than done. The federal government and military establishment have a desire to revisit 7th NFC award, but PPP (Pakistan People’s Party) has no interest in it at all, as the party has little incentive to share responsibility of federation and to spend enough on Karachi, as it is content with cementing its voter base in interior Sindh. Similarly, the PTI (Pakistan Tehreek-e-Insaf) government in KP is in no mood to budge.

That is why the powers that be are underscoring the need for forming a unity government to address the issues of federation and federating units, since in making any change in NFC award a two-thirds majority is required along with all four provinces on board. If the PPP can veto the appointment of chairman IRSA by the prime minister, why would they agree on any amendments to the current NFC arrangement. The challenge is to bring everyone, including PTI, on board.

Copyright Business Recorder, 2024