Attacks on the NFC Award

There have recently been some attacks on the 7th NFC award relating to the distribution of federal tax revenues between the federal and provincial governments. This process of distribution is the natural outcome of fiscal federalism. Both India and Pakistan are federations and have a similar arrangement of revenue sharing between the federal government and the federating units.

The primary focus of the attacks has been the apparently large share of the four provincial governments combined of 57.5% from the divisible pool of federal taxes. This has had, according to the detractors from the Award, some negative consequences. More recently, the IMF Staff Mission to Pakistan for the second review of the Stand-by Facility has also expressed similar negative views on the impact of the 7th NFC Award.

The first negative consequence that has been highlighted is that the large share of the provincial governments in the divisible pool has left the federal government with inadequate revenues. Currently, the net revenue receipts are not even enough to cover the costs of debt servicing, and this has led to large federal budget deficits.

The second negative consequence that has been projected is that the large federal transfers have created a ‘moral hazard’ situation. The provincial governments have had little incentive to develop their own-revenue sources in the presence of access to large transfers.

Consequently, the tax-to-GDP ratio of the four provincial governments is low at only 0.8% of the GDP. This is despite the fiscal powers to levy taxes with big tax bases like the sales tax on services, agricultural income tax and the urban immoveable property tax. In fact, not only is the provincial tax-to-GDP ratio low, but it has also been declining from over 1% of GDP in 2017-18 to 0.8% of the GDP in 2022-23.

There is also a need to recognize that if the federal government was under pressure, then it should also have made efforts to raise its tax-to-GDP ratio. Instead, it has fallen to 8.5% of the GDP in 2022-23 from 10.4% of the GDP in 2017-18.

The critics of the 7th NFC Award and the high share of 57.5% of the provincial governments in the divisible pool have probably failed to note a special provision in the Constitution of Pakistan, brought in with the 18th Amendment. This clause, 160(3A), states:

“The share of the Provinces, in each Award of the National Finance Commission shall not be less than the share given to the Provinces in the previous Award.”

Therefore, there is no scope for reduction of the provincial share of 57.5% in the divisible pool, unless the above clause is withdrawn by a constitutional amendment.

The only other feasible option is to reduce the size of the divisible pool. The 7th NFC Award recognized this option and permitted some withdrawals from the divisible pool, prior to its distribution. These are as follows:

(i) 1% of the divisible pool to the province of Khyber-Pakhtunkhwa for the war on terror.

(ii) 1% of the divisible pool to the federal government to cover the administrative costs of tax collection by the FBR.

(iii) 0.66% of the divisible pool the province of Sindh for withdrawal of octroi.

More recently, efforts are being made to reduce the size of the divisible pool by exclusion of some revenues from the divisible pool. The prime example of this is the petroleum levy which has been raised to Rs 60 per litre, partly as a substitute for the sales tax.

The petroleum levy has been classified as a non-tax revenue source and, therefore, its revenues are not included in the divisible pool. The estimated reduction to the provinces of the diversion of sales tax revenues to the petroleum levy is already significant at almost Rs 500 billion in 2023-24.

There is also a need for introducing a fiscal incentive for greater fiscal effort by the provincial governments. Already, the horizontal sharing formula in the 7th NFC Award among the provinces has one indicator of revenue collection/generation, with a weight of 5%. The revenues are the collections of the federal taxes from within the respective provincial boundaries. The result was the following allocation of the 5% of the divisible pool as follows by province in the 7th NFC Award:

Punjab 44%

Sindh 50%

Khyber-Pakhtunkhwa 5%

Balochistan 1%

This allocation has remained unchanged since 2010-11.

The proposed alternative is for the distribution not to be based on collection of federal taxes by province but for allocation based on collection of the own taxes by the provincial governments. Accordingly, the share in 2022-23 would have been as follows:

Punjab 46%

Sindh 44%

Khyber-Pakhtunkhwa 5%

Balochistan 4%

This share can be changed annually based on the previous year’s share in the collection of provincial taxes in Pakistan. Clearly, this will provide an incentive for the provincial governments to develop their own tax systems.

The other mechanism that can be put in place for inducing greater fiscal effort by the provincial governments was included in the 1997 NFC Award but withdrawn in the 7th NFC Award. The commitment was that a matching grant will be given by the federal government to a provincial government equal to the amount raised through taxation proposals. This scheme can be brought back, and the matching grant financed from the divisible pool prior to its distribution.

There is need to recognize that the federating units in Pakistan face a more constrained policy environment than those in India. Borrowing powers of the former are extremely limited and special permission is required even in emergencies. As compared to this position, the states in India have large access to borrowing. In 2022-23 the total borrowing by these states was as much as 3% of the GDP.

Not only is there little scope for borrowing, but provincial governments in Pakistan are expected also to generate provincial cash surpluses. The target for 2023-24 is Rs 650 billion. This can substantially contribute to the expected generation of a combined primary surplus of 0.4% of the GDP.

There is need also to emphasise that the size of federal transfers to the provincial governments has been declining since 2017-18, due to the decline in the federal tax-to-GDP ratio. It has fallen to 5% of the GDP from 5.7% of the GDP in 2017-18. Consequently, the expenditure on basic social services like education and health has declined from 3.2% of the GDP in 2017-18 to 2.9% of the GDP in 2021-22. This is one of the basic reasons for the fall in the UNDP Human Development Index of Pakistan from medium to low level.

Therefore, efforts should not be made to reducing the size of the divisible pool by admitting other claims to the pool or by converting revenue sources from tax to non-tax revenues. Instead, the prime responsibility of the federal government must be to undertake progressive tax reforms and at the minimum restore in the next two years the tax-to-GDP ratio to the 2017-18 level. Provincial governments should be given an incentive to develop their own revenue sources as highlighted above. These measures will contribute to strengthening the federation of Pakistan.

Also, there is need for a new NFC Award. The 7th NFC Award has been operative for nine more years than it should have. The 8th, 9th and 10th NFCs have failed to arrive at a consensus on a new award. The new government may constitute the new 11th NFC and expedite the process of a new award, which better reflects the prevailing economic conditions rather than a fourteen-year-old award.

Copyright Business Recorder, 2024