Is a Permanent National Finance Commission the Answer?

The 7th NFC Award has drawn criticism from diverse quarters ever since it became effective, including from  IMF, who IMF termed this Award unbalanced and inflexible and making the country’s macroeconomic management difficult with serious consequences for overall socio-economic outcomes.

It is generally argued that if no correction is made to the Award that came into force on 1 July 2010, Pakistan will continue to experience large fiscal imbalances leading to the acceleration of public debt. The present government is trying to address the challenges posed by the Award.

An effective system of intergovernmental fiscal transfers is the cornerstone of strong and stable public finances in a country.

The purpose of having a sound fiscal transfer mechanism is twofold. First, to minimise the vertical imbalances caused by the inadequacy of revenues of provincial governments to meet their expenditure requirements. Second, to alleviate horizontal imbalances caused by disparities in the revenue capacity of the constituent units of the federation – viz., provinces – so as to enable them to provide basic public services to their citizens at a reasonable level.

In recognition of the need to redress these two imbalances in a fair and orderly fashion, Article 160 of the Constitution of Pakistan provides for the establishment of a National Finance Commission (NFC) at intervals not exceeding five years.

The NFC provides recommendations to the President of Pakistan on the distribution of resources between the federal and the provincial governments and among the provinces. These recommendations are implemented through a Presidential Order.

In Pakistan, over 90 percent of taxes are collected at the federal level, and less than 10 percent at the provincial level. Provinces thus rely heavily on federal resources to meet their expenditure requirements.

In a federal state like Pakistan, fiscal decentralisation is essential to improving quality of services provided to the masses. However, badly managed fiscal decentralisation can create serious difficulties for the provinces and the federal government.

Let us examine the salient features of the 7th NFC Award. Firstly, during the first five years of the Award, a sum of PKR 6,671 billion was transferred to the provinces as against PKR 2613 billion during the five years under the previous (6th) Award — 2.6 times more resources.

Second, the share of the divisible pool as a percentage of the total tax collected increased from 41 percent in 2008-09 (the last year of the previous Award) to 58 percent by 2012-13.

Third, in order to address the issue of horizontal imbalances, inter-provincial resources were also adjusted. If we look at provincial shares, Balochistan appears as the main beneficiary of the 7th NFC Award with its share increasing from 5.11 per cent to 9.09 per cent – an increase of 3.98 percentage points.

Also gainers were Sindh and Khyber Pakhtunkhwa (KP) although marginally. Punjab, on the other hand, witnessed its share decline from 57.36 percent to 51.74 percent — a decline of 5.62 percentage points.

Fourth, while population used to be the sole criterion for revenue sharing prior to the 7th NFC Award, the current Award is based on multiple criteria. This is one of the most significant features of the 7th NFC Award. These criteria include population (82%), poverty or backwardness (10.3%), revenue collection or generation (5.0%) and inverse population density (2.7%).

Fifth, special attention has been given to improving the financial health of Balochistan for its socioeconomic devel- opment.

Sixth, recognising the role of the KP as a frontline province in the war against terror, the Award provided an additional one percent of the net divisible pool to KP to meet its expenses.

WHAT WENT WRONG IN THIS AWARD?

To begin with, it was finalised in haste by holding a few meetings in a short span of four to five months. Therefore, no proper homework was carried out and it lacked a sound economic foundation. Revenue projections for the duration of the Award were grossly unrealistic and as such created serious difficulties for subsequent macroeconomic management.

The scope of the Award was too extensive and its implementation too rapid to manage fiscal decentralisation in an orderly manner. Massive resources were transferred to the provinces in a short period without giving due consideration to their capacity to spend huge amounts of money prudently.

Thus, it not only compounded macroeconomic instability, but also adversely affected the provision of public goods and services in the provinces. For example, net enrolment at the primary level, the overall literacy rate, and various health indicators, instead of improving, have deteriorated in the provinces.

The timing of the 7th NFC Award was also inappropriate. Pakistan was already facing serious fiscal challenges; interest payment (a budgetary item) was rising at an unsustainable rate, doubling in just three years; the security environment was deterio- rating due to the war on terror, which required more resources; power sector subsidies were rising at a greater pace and the public sector enterprises were bleeding profusely.

All these subjects fall under the domain of the federal government and require large resources. At a time when financial requirements of the federal government were accelerating, the 7th NFC Award drastically cut its resources, increasing Pakistan’s reliance on borrowing.

The provinces, on the other hand, were given so much resources that they were encouraged to pursue lax expenditure policies, thus contributing immensely to the rise of the overall fiscal deficit (the fiscal deficit rose from 6.2 percent of GDP in 2009-10 to 8.8 percent in 2011-12 and remained at 8.2 percent in 2012-13.)

None of the growing financial needs of the federal government were taken into account when determining the shares between the federal and provincial governments.

It is strange that the bulk of the taxes collected from across Pakistan were transferred to the provinces and yet the responsibility to maintain financial discipline remained vested in the federal government.

In other words, a federal government controlling only 40 percent of resources from the divisible pool cannot possibly maintain financial discipline in the country all by itself, nor be answerable to the IMF for achieving revenue and deficit targets.

Because of the imbalances in the resources and responsibility of the federal government, it was forced to indulge in ingenious accounting. For example, the federal government was not releasing resources to the provinces on time; it gave perverse incentives to the provinces to not spend money; started holding back refunds/rebates to show higher revenue collection and treating privatisation proceeds and foreign grants as non-tax revenue instead of as financing items.

How can this Award be salvaged without violating the Constitution?

First, it must be kept in mind that the present Award should not weaken the federal government’s ability to reduce the fiscal deficit and public debt. Provincial governments need to improve either their own revenues and curtail unnecessary expenditure.

Second, the revenue collection charges should be reverted to 5 percent from the current level of 1 percent. This will immediately increase resources for the federal government.

Third, under the 7th NFC, almost three times more resources are being transferred to the provinces. Why then should the federal government with its depleted resources undertake federal projects in the provinces? Let the provincial governments finance develop- ment projects on their own.

Fourth, interest payments or public debt and defence spending are currently the responsibility of the federal government. Public debt is not incurred by the federal government alone, and similarly defence should be the responsibility of the entire country. Provinces should therefore be asked to share the burden of interest payments and defence to the extent of their shares in the divisible pool.

Fifth, in the case of federal projects executed in the provinces and any debt so acquired, the respective provincial governments may share debt servicing costs with the federal government.

Sixth, in order to achieve fiscal deficit targets without resorting to accounting tricks, some hard binding constraints may be put in place. Provincial governments should be bound to deliver surpluses to meet the consolidated fiscal deficit. The Council of Common Interest (CCI) or the National Economic Council (NEC) look like promising forums to decide the level of surplus that the provinces need to generate.

Seventh, we may consider a Permanent National Finance Commis- sion headed by a renowned economist, with representation from each province. The purpose of the Commission would be to conduct research with a view to improving the fiscal decentralisa- tion process; to monitor the specific fiscal reforms at the provin- cial level and to ensure service delivery in each province.

Eighth, a performance-based revenue transfer mechanism needs to be developed. 75 percent of the divisible pool can be released to the provinces on the basis of the NFC formula and the remaining 25 percent of the divisible pool may be linked with the perfor- mance of the provinces in service delivery. The high-powered PNFC should set up a mechanism, with provinces duly represent- ed, to monitor performance.

Lastly, the provinces should set up Provincial Finance Commis- sions to make fiscal decentralisation a success.