Fiscal federalism: Case for provincial accountability

The National Fiscal Pact seeks to address deep-rooted inefficiencies, but will it fix Pakistan's fiscal mismanagement

ISLAMABAD:

Pakistan's fiscal management has long been a barrier to economic stability, with poor revenue mobilisation coupled with unchecked government expenditure intensifying the crisis. The challenges are further exacerbated by the over-reliance of provincial governments on the federal government for revenues, with little effort to strengthen their own revenue collection authorities.

According to fiscal operations by the Ministry of Finance, the combined tax collection by all four provinces was Rs774.20 billion in FY24, against a whopping Rs2,683.88 billion in expenditures. With provinces contributing only 1% of the tax-to-GDP ratio, the federal government collects an overwhelming 90% of revenue.

Since 57% of the federal government's revenues are transferred to provinces following the 7th NFC Award passed in 2010, provincial governments have not collected revenues at their potential, causing the federal government to rely on domestic and foreign debt to bridge the deficit.

According to data from the Debt Management Office, Pakistan's public debt has surged dramatically since 2010, rising from Rs9 trillion to Rs67 trillion in 2024. This reflects a substantial increase in domestic and external debt over the past decade. A possible explanation is the NFC Award, which caused the country's debt to surge due to fiscal imbalances created by elevated expenditures while tax collection remained stagnant.

Considering the fiscal management—or mismanagement—at both levels of government, it is unsurprising that the International Monetary Fund (IMF) included the National Fiscal Pact (NFP) in its programme, binding provincial governments to raise tax collection and thus contribute more to overall revenue collection.

As reported, the NFP aims to redistribute revenues and align provincial and federal taxation policies. The pact will also prevent provincial governments from setting agriculture support prices, which is a positive development. The transfer of some fiscal responsibilities to provinces will compel them to contribute more to revenue generation.

While the pact is ambitious and has been signed by all the provinces, certain caveats exist that could undermine the credibility of the NFP. Firstly, aligned with the 18th Amendment, the NFP focuses on tax revenue generation by provincial governments, specifically from historically under-taxed sectors like agriculture. While revenue collection is critical for economic growth and to prevent reliance on debt, expenditure reduction is equally, if not more, crucial.

Without effectively addressing expenditure control at the provincial level, the perpetual risk of fiscal indiscipline will remain. Focusing only on revenue collection will burden taxpayers without effective expenditure rationalisation. A benchmark should be provided to provinces to manage their spending within the revenue collection domain. Similarly, the federal government should provide performance-based grants to provinces to enhance accountability and incentivise adherence to benchmarks.

Another inefficiency in the expenditure framework is the duplicity in spending in certain areas, including the Public Sector Development Programme (PSDP). Following the 7th NFC Award, sectors like education, health, and agricultural subsidies were devolved to provincial domains, requiring their financing by provincial governments. However, the federal government continues to fund health and education projects, creating inefficiencies and overlaps. This acts as a double-edged sword, increasing fiscal deficits and contributing to mounting debts when expenditures are financed through borrowing. According to the World Bank, the federal government spent Rs328 billion in FY22 on devolved subjects such as education and health. Redefining roles to eliminate these redundancies is crucial to enhancing federal-provincial coordination and phasing out federal spending on devolved sectors.

Similar to education and health, the social protection sector is also a provincial domain. However, as per the FY25 budget, there has been an increase in the Benazir Income Support Programme (BISP) allocation from Rs466 billion to Rs592 billion. Being a devolved subject, hefty federal spending on social protection can be curtailed by transferring the responsibility entirely to the respective provincial governments.

A legitimate concern is the lack of transparency regarding the NFP, as it has not been made public. This secrecy prevents meaningful debate on the topic and questions the credibility of the pact. The non-disclosure raises scepticism and concerns that provincial governments may inequitably raise tax revenues.

The National Fiscal Pact revisits the National Finance Award to address the lack of provincial capacities that hinder the country's effective fiscal management. The current arrangement, which requires the federal government to transfer 57% of revenue to provinces, is unsustainable, especially when it bears the burden of debt servicing and defence, which consume around 75% of revenues. To ensure a balanced fiscal approach, either the NFC distribution formula must be revised to reduce federal transfers below 50%, or some expenses must be shifted to provinces while encouraging them to significantly increase tax collections. Otherwise, Pakistan's fiscal federalism will falter.

THE WRITERS ARE AFFILIATED WITH THE POLICY RESEARCH INSTITUTE OF MARKET ECONOMY (PRIME), AN INDEPENDENT ECONOMIC POLICY THINK TANK