Fiscal federalism in Pakistan

The World Bank has recently published a report on Strengthening Fiscal Federalism in Pakistan. This report has come at an appropriate time when there is a lot of discussion on the federal structure in Pakistan. A particular view has been put forward that more effective governance will require an increase in the number of provinces in Pakistan.

The World Bank report recognises the 7th NFC Award of 2010 as a major step forward, but emphasises that there has not been effective implementation, especially of the18th Amendment, also of 2010.

The first failure is lack of full devolution of functions as per the 18th Amendment in two steps. First, according to the Federal Legislative List, a number of functions were to be transferred to the provincial governments, which has not happened.

Second, according to Articles 32 and 140A there ought to have been a further process of devolution from provincial governments to local governments with due representation of peasants, workers and women.

The second failure highlighted by the World Bank is that the 7th NFC gave too large a share of 57½ percent to the provincial governments from the federal divisible pool of taxes. This created two ‘negative’ incentive effects.

First, such a large transfer reduced the motivation of the provincial governments to develop their own potentially large revenue sources. Second, the federal government was less willing to bear the political costs of resource mobilization, when more than half the additional revenues were given to the provincial governments.

The other drawback highlighted in the World Bank report is that despite Article 140 of the Constitution, local governments remain adhoc in nature, fiscally dependent, institutionally unstable and fully subservient to provincial discretion. The provincial Finance Commissions have been set up infrequently and transfers from provincial governments to local governments are very adhoc in nature. In effect, the devolution process envisaged in the 18th Amendment in 2010 has not gone beyond the provincial tier.

The World Bank Report also highlights a problem which has not been identified much before. This is the fragmentation of the tax system, which is the consequence of the sales tax on goods being within federal fiscal powers and the sales tax on services handed over in 2015 to the provincial governments.

The sales tax is to be seen as a value-added tax, so as to have a neutral impact on economic activities in the country. Functioning of the value-added tax requires both industrial and service input costs to be charged against the sales tax on the value of sales by a producer. This is not happening in Pakistan.

The last major deficiency in fiscal federalism in Pakistan, according to the World Bank, is that the horizontal distribution formula among the provincial governments does not ensure adequate fiscal equalisation. There is need for assigning greater weight to poverty, backwardness and inverse population density. This implies that the weight assigned to the size of population needs to be significantly lower.

The World Bank report has duly respected the various Constitutional provisions on fiscal federalism in Pakistan. However, the report does not appear to fully recognize the nature of and extent of inter-governmental fiscal transactions in Pakistan.

There is no reference in the report to Article 160 (3A), which states that the combined share of the provincial governments, in each Award of the National Finance Commission, shall not be less than the share given in the previous Award.

This has been one of the main reasons for the failure of NFCs set up after 2014-15, the end of the five-year tenure of the 7th NFC Award. Currently, the Eleventh (11th) NFC is in place, but has apparently not made much progress. It was constituted in August 2025.

However, the federal government has found ‘back-door’ methods leading to big de facto reduction in net terms of transfers to the provincial governments.

This is best illustrated by the measures and targets in the 2026-27 budgets of the federal and provincial governments as follows:

(i) Targeted transfer of Rs 8,635 billion to the four provincial governments. The size of the Federal Divisible Pool is expected to be close to Rs 15,264 billion, net of 1 percent deduction due to costs of administering FBR. The provincial share is estimated at close to 57.5 percent.

(ii) The provincial governments are expected to generate a cash surplus of Rs 1,794 billion in 2026-27, and contribute significantly to reducing the consolidated budget deficit. This is effectively a partial return of transfers.

(iii) The size of the divisible pool has been reduced by converting the sales tax on petroleum products into a petroleum levy. This is expected to reduce the divisible pool by Rs 1,677 billion in 2026-27.

(iv) For the first time ever, the provincial governments have been asked to make a grant of Rs 1035 billion under Article 164 of the Constitution to the federal government.

Therefore, the de facto share of the provincial governments will be much less than 57.5 percent. The effective transfer will be Rs 5,806 billion, with the true size of the divisible pool at Rs 16,941 billion. The share of the provincial governments will effectively be down to as low as 34.3 percent, compared to the mandated level in the 7th NFC Award of 57.5 percent.

The ad hoc changes have enabled the Federal government to target for a big increase in development spending in 2026-27, while the provincial governments will reduce their development expenditure. There is need for formalization of these ad hoc arrangements through a new NFC Award.

The World Bank’s proposal for effective local governments is appreciated. The path to follow is not more provincial governments but elected and truly representative local governments. This will not only increase the provision of basic services, but also lead to greater accountability in service provision to the people.

There is need also for integration of the federal sales tax on goods with the provincial sales tax on services, to have a proper value added tax. Our large neighbouring country has a sales tax on services at the Union level and a sales tax on goods at the State level. Success has been achieved by a long process of reforms at creating a national value added tax. Perhaps the World Bank could obtain the details of the reform measures for examination of their feasibility in Pakistan.

Finally, the World Bank has rightly highlighted the defects in the horizontal sharing formula among provincial governments of federal transfers. There is clearly a case for reducing the share of population component from over 82 percent and increase it especially for higher inverse population density, which will compensate for higher costs of providing services. Also, an incentive may be created for promoting reforms in collecting more revenues from provincial taxes. Such an incentive was included in the 1996 Award.

There is no doubt that this is the appropriate time to strengthen fiscal federalism in Pakistan. The key direction must be in establishing effective duly elected local governments as per Article 140A of the Constitution and not by increasing the number of provincial governments. This will provide for more accountability, leading thereby to more effective delivery of services in the country.

Copyright Business Recorder, 2026