Fiscal federalism in practice vs law

Federal share of resources has risen to 65% despite NFC formula

ISLAMABAD:

Two schools of thought have emerged in the recent debate on the 18th constitutional amendment, which brought a structural shift towards devolution. One school – let's call it centralists – has argued that the federal government is now structurally weak and in a perpetual fiscal crisis, since 57.5% of divisible resources are transferred to provinces whereas it must finance defence and debt servicing on its own, leaving hardly any resources for other heads. This school also argues that despite resource transfer, provincial governments have failed to bring any improvement in social spending – in education and health particularly. The other school – let's call it federalists – believes that the continued presence of the federal government in devolved subjects – including social protection, education, health, and agriculture – is unnecessary and has increased its fiscal burden. This school echoes the direction of the 18th amendment, demanding more devolution, including empowered local governments. Practically, there is a political stalemate on this debate, and this stalemate has not allowed discussion on the 11th NFC Award. The echo of the 28th constitutional amendment is largely in this background.

The World Bank's recent report on fiscal federalism in Pakistan – taken down from its website – has reignited debate on these issues, while it has not offered any fresh insights. It has equated federal transfers to provinces with the post-devolution federal primary deficits. The World Bank's country director has written that "the loss in federal revenues from transfers (around two trillion rupees today) was roughly matched by the increase in federal primary deficits post-devolution". The report has also blamed the NFC Award for a stagnant tax-to-GDP ratio – for failing in harmonising the tax base, especially in the case of GST. This report largely falls in the 'centralist' school, though it has also criticised the continued presence of the federal government in devolved subjects. This is a major shift in the Bank's narrative as noted by Shahid Kardar in a recent article. Historically, the World Bank has championed devolution.

The vertical distribution of the divisible pool of resources under the current NFC Award dictates that the federal government should get 42.5%, but it gets a much higher share in practice if all resources are accounted for. As former Chief Economist Muhammad Zubair notes, "FY27 budget does not amend the constitution, but it reconfigures fiscal federalism in practice."

I bring some numbers to argue the case that the NFC Award – and the 18th amendment – has largely become irrelevant.

For the last three years, the federal government has received 65% of all resources – combining tax and non-tax resources. The Article 164 grant to the federal government – about Rs800 billion – is a first-timer, but it just maintains the ratio. For reaching this conclusion, I have included provincial surplus of Rs1,794 billion, Article 164 transfer of Rs800 billion, and all non-tax resources in the federal share. Replacement of 18% GST on petrol in 2022 with a much higher – and discretionary – tax we call Petroleum Development Levy was the first major step towards re-writing of the NFC. This has continued.

Provincial governments do not receive 57.5% of national resources – they receive 35%.

With this number in view, the argument that the federal government does not receive adequate resources should be discarded.

The criticism of provincial governments for a lack of progress on social indicators still stands, and this brings me to make another important point.

It is true that the federal government continues to function in devolved functions. But in large-ticket items – including education, health and agriculture – its share is already very small. In education, it has 8% of budgetary resources; in health, it has 6%; and in agriculture, it has 7% of budgetary resources. Partly this is justified by the needs of spending in areas under the federal government, and partly it is justified for national harmony across regulatory frameworks. Regulatory fragmentation acts as a deterrence to investment.

As far as new tax bases are considered, provincial governments do not have much to bring to the table. Increasing agriculture income tax to 45%, where even previously existing concessionary rates had failed, was simply a non-starter and a recipe for failure.

Going forward, we need a two-pronged strategy. On one hand, the federal government must exit from all businesses. In 2024-25, it spent almost Rs2 trillion on maintaining these state-owned enterprises. This is roughly 40% of the current fiscal deficit. It must also minimise federal tax expenditure. This can shave off another 30-40% of the fiscal deficit. It should also re-assign social sector spending to provinces. This will bring the fiscal deficit to zero.

On the other hand, we need to increase spending as well as improve the quality of spending on social and human development. This must include a discussion on the defence budget. We need to maintain border security and meet present threats with full force. However, we must equally worry about human security and climate security, which threatens our future.

THE WRITER IS FOUNDER AND CEO OF POLICY RESEARCH INSTITUTE OF MARKET ECONOMY (PRIME)