Towards fiscal & digital reforms

Pakistan has faced significant challenges in balancing the distribution of power and fiscal responsibilities between its federal and provincial governments.

The landmark Constitution (Eighteenth Amendment) Act, 2010 [18th Amendment] effective from April 19, 2010, was aimed at decentralizing governance by devolving more powers to provincial governments.

It sought to promote provincial autonomy, enhance democratic governance, and allow establishment of local governments with political, administrative and financial powers for addressing residents’ socio-economic needs at grass-root level. While the devolution of power was an important step towards empowering provinces, its financial implications have drawn substantial criticism.**

The legitimate expectation behind the 18th Amendment was that provinces would gradually reduce their financial dependency on the federal government by strengthening their local revenue sources.

The idea was that with greater autonomy, provinces would be able to generate enough revenue to cover their expenses without relying on federal government’s contributions.

However, over a decade later, this goal remains unfulfilled. Instead of reducing their reliance on federal transfers, the provinces continue to depend heavily on funds allocated through National Finance Commission (NFC), a body designed to ensure an equitable distribution of fiscal resources. This situation leaves the federal government with insufficient resources to meet its obligations, leading to enormous borrowing and an unsustainable fiscal path.

This growing financial disparity between the federal and provincial governments has sparked a wider debate on the need for comprehensive institutional and structural reforms.

As the current distribution of fiscal powers and responsibilities remains lopsided, there is an urgent need to recalibrate the system to ensure a fairer, more sustainable arrangement.

For addressing these issues, the government of Pakistan is now working on the National Fiscal Pact (NFP), a framework designed to reform the fiscal relationship between the federal and provincial governments.

NFP aims at creating clearer guidelines for fiscal responsibility, revenue sharing, and resource allocation, ultimately improving the provinces’ ability to mobilize revenue and contribute to fiscal consolidation efforts.

Under the terms of Pakistan’s US$7 billion 37-month extended fund facility (EFF) agreement with the International Monetary Fund (IMF), the government has made several commitments that will guide this reform. One key aspect of NFP is the redistribution of fiscal responsibilities between the federal and provincial governments.

The federal government has agreed to develop certain spending responsibilities to the provinces, in line with the spending allocations set out in the 18th Amendment. This includes additional contributions to areas such as higher education, health, social protection, and regional infrastructure investments.

At the same time, the provinces have pledged to increase their efforts to collect taxes, particularly agricultural income, property taxes, and sales tax on services.

NFP has two broad objectives, which includes improving revenue generation and rationalizing spending. On the revenue side, provinces are expected to reform the taxation of agricultural income, a sector that has largely remained outside the tax net.

This is expected to boost provincial revenues and help meet fiscal consolidation targets. By implementing a more comprehensive and standardized system of agricultural taxation, provinces can ensure that tax policies reflect the economic value of agricultural production.

While there may be concerns that such reforms could place an undue burden on small farmers, the aim is to ensure that the tax system is fair and does not allow for exploitation or tax evasion.

A key challenge in implementing agricultural taxation reforms is the informal nature of this sector. To address this issue, provinces must invest in improving tax administration, increasing transparency, and leveraging technology to better track income and integrate farmers into the formal tax system.

Simplifying registration processes and creating incentives for farmers to participate in the formal economy could significantly increase tax compliance in this sector.

Indeed, broadening the tax base will be critical to increasing overall revenues through which Pakistan can ensure that tax burdens are distributed more equitably and that more sectors of the economy contribute to public finances. Alongside agricultural taxes, the provinces could expand the sales tax regime to include a wider range of services, capturing more economic activity and ensuring that higher-growth sectors are taxed appropriately.

On the expenditure side, NFP encourages provinces to increase their contributions to federally supported programmes, such as the Higher Education Commission (HEC).

NFP also envisions a gradual increase in spending on health and education, which would require both the federal and provincial governments to work together to align resources more effectively. Furthermore, the NFP advocates for a review of social protection programmes to identify and eliminate redundancies, ensuring that public funds are used efficiently to address the needs of vulnerable populations.

As part of these fiscal reforms, both the federal and provincial governments will need to ensure that spending aligns with broader fiscal objectives and resources are allocated in a way that maximizes social welfare.

NFP will require a strong political commitment to succeed. The process will not be easy, as it requires overcoming entrenched political interests and building consensus across various levels of government. There will also be the need to pay attention to the political economy of fiscal decentralization, especially in provinces where political instability or poor governance may hinder effective revenue mobilization and public spending.

Finally, fiscal reform will require the identification and streamlining of redundant ministries or functions. Where responsibilities have been devolved to the provinces, it is important to ensure that services are localized and managed effectively; otherwise, redundant functions should be eliminated.

Alongside fiscal reforms, Pakistan is also considering the legalization of digital currency, a move that could potentially transform the country’s financial system. In the past, State Bank of Pakistan (SBP) had resisted the idea of digital currencies, expressing concerns about their volatility and their potential to facilitate illegal activities.

Virtual currencies were explicitly warned against by the SBP, which argued that these currencies lacked legal protection and could expose consumers to financial risks. SBP also highlighted concerns regarding the anonymity of virtual transactions, which could make it easier to launder money or fund illicit activities.

However, in a significant shift, the proposed amendments to the State Bank of Pakistan Act, 1961 now introduce the concept of digital currency defined as a “digital form of currency issued by the bank under section 24 as legal tender under section 25” into the country’s financial system granting SBP the authority to issue digital currency.

This would effectively allow SBP’s currency in both physical and digital forms. SBP also plans to establish a subsidiary to develop and operate digital payment systems, signaling a new direction in Pakistan’s financial sector.

These proposed amendments that have the potential to modernize Pakistan’s monetary system have also sparked significant criticism. One major concern is the lack of a clear regulatory framework for digital currencies. Critics argue that Pakistan’s financial infrastructure is not yet ready to handle the complexities of digital currencies, and that the risks—such as cybersecurity threats, fraud, and potential money laundering—could outweigh the benefits.

On the other hand, proponents argue that legalization of digital currencies could offer significant advantages, such as increased financial inclusion, lower transaction costs, and more efficient payment systems. Digital currencies could provide greater access to secure financial services, particularly in rural areas where traditional banking infrastructure is limited.

Additionally, well-implemented virtual currency regulations could help reduce reliance on cash and streamline the flow of money within the economy. By embracing digital currency, Pakistan could position itself as a leader in financial innovation, potentially attracting new investment and fostering greater economic integration.

The legal introduction of digital currency also presents an opportunity to enhance the transparency of financial transactions, which could help combat issues like corruption and tax evasion. A well-regulated digital currency could serve as a powerful tool for improving monetary policy management, reducing inflation, and strengthening the central bank’s control over economy.

However, in order to fully realize these benefits, Pakistan would need to develop a robust regulatory framework, address concerns about security, and ensure that digital currencies do not exclude marginalized populations who may lack access to the necessary technology.

Pakistan’s proposed fiscal and digital reforms represent vital steps towards modernizing the country’s economic and financial systems. While NFP offers the potential for improved fiscal management and revenue generation, it faces political and logistical hurdles that must be overcome.

Similarly, legalization of digital currency could transform Pakistan’s financial environment, while at the same time, it requires careful planning and regulation to mitigate associated risks.

Ultimately, the success of these reforms will depend on the government’s ability to navigate complex political, economic, and technological challenges, ensuring that both fiscal and digital innovations contribute to the long-term stability and prosperity of Pakistan.

Copyright Business Recorder, 2024