Fiscal realities: A case for NFC reform

SINCE the IMF reportedly asked the government to reconsider the NFC Award, a debate has started in Pakistan about it. Having been the finance minister of our country twice for short durations, I have seen how the 7th NFC Award has worsened our fiscal situation.

The National Finance Commission Award is a formula, reached by consensus between the federation and provinces, for the distribution of taxes collected by the federal government to various provinces. The award, nominally of a five-year duration, lasts until superseded by the next award. The latest, the 7th NFC Award, was concluded in May 2010.

This award gives 57.5 per cent of total federal taxes to the provinces. This share was 41.5 per cent in 2007 and 45 per cent in 2010. Under the current award, an additional 1.0 per cent is also given to Khyber Pakhtunkhwa for the war on terror and 0.38 per cent to Sindh in lieu of Octroi. Moreover, the money to run the governments of AJK, Gilgit-Baltistan and former Fata also comes from the federal government (but is not part of the award). The federal government also helps finance the Islamabad capital territory. In all, about 63 per cent of the federal taxes -- all the sales tax on goods, customs duty on imports, and the income taxes you pay -- goes to the provinces.

Last year, the federal government collected Rs7169 billion in taxes. Of this, Rs4223 billion was given to the four provinces, leaving the federal government with Rs2946 billion. The interest payment alone on government debt was Rs5696 billion, leaving the federal government with a deficit of Rs2760 billion, without spending a single paisa on the running of the civil government, pensions, defence, BISP, etc.

After all the expenses, we ended up with a federal deficit of Rs6676 billion or 7.9 per cent of GDP even while there was a provincial surplus of Rs157 billion. Thus, we again made another unsustainable increase in public debt, which is the main cause of inflation and devaluation.

Last year, the four provinces combined collected only Rs650 billion in taxes, against their total current and development expenditures of Rs5038 billion. They collected only 9.0 per cent of what the federation collected and only 12.9 per cent of what they spent. In other words, for every eight rupees the provinces spent, seven rupees were given to them by the financially distressed federation.

Of the Rs650 billion taxes the provinces collected, Rs417 billion came from sales tax on services, mostly mobile telephony. The total annual property taxes and agriculture income taxes were less than Rs126 billion. By comparison, Mumbai municipal authorities collected Rs180 billion in property taxes last year. (In India, the central government ties its grants to localities’ performance in property tax collection).

In terms of performance last year, Sindh did the best, collecting Rs285 billion, Balochistan collected Rs26 billion, KP collected only Rs41 billion and Punjab, the richest province with half the country’s population, collected a partly Rs297 billion.

In our constitutional scheme, only provinces can impose sales tax on services and taxes on property and agriculture income. The federation cannot touch these areas. But our provincial governments are not collecting much in taxes, especially from agriculture and property, and collect only a fraction of what they spend or what the federation collects.

The reason is misaligned incentives. In eleven out of the last 13 years, our provincial governments have run a surplus. So, there is no great need for or focus on additional revenues. Because land and property are the preferred sectors where declared and undeclared wealth is parked, it fortuitously turns out that rich Pakistanis are not inconvenienced by provinces trying to collect taxes.

Immediately after the passage of the 7th NFC Award, the newly rich provinces had difficulty spending their money. But as all parents know, kids always find a way to spend all their pocket money. Similarly, provinces have also found a way to spend the money, including a 455 per cent increase in payroll expenses during the first ten years after the award and a 480 per cent increase in ‘development’ spending in 13 years since the award.

Many well-meaning people object to a reduction in the NFC Award for the provinces, saying that we have 26.2 million kids out of school or that 58 per cent of our children under five years of age are wasted or stunted, and that provinces need more money not less. But that’s a misplaced argument. Giving more and more money to the provinces hasn’t moved the needle -- neither for health nor for education outcomes. For that we need effective local government, private school vouchers, parents and local residents being involved in school and hospital boards, population control, reproductive health clinics and more direct transfers to the poor.

More than anything else, to improve human development, we need to lift people out of poverty. This can only be done by bringing inflation under control and achieving sustainable growth. (In the last six years, inflation, low growth and high population growth combined have resulted in 40 million more people going into poverty).

However, inflation cannot be fully controlled as long as we have to finance our huge deficits with excessive borrowing and money printing. Only a disciplined fiscal regime will enable Pakistan to achieve growth with low inflation. This cannot be done until the budget deficit is brought under control.

An argument is made that the federal government should raise more taxes. Taking an extreme example, suppose last year the federal government had raised twice the tax revenue it actually did -- that is, Rs14,338 billion or 17 per cent of GDP. And suppose it would have given away only 60 per cent of the tax collected instead of the actual 63 per cent it has to give away. It would still have been left with net taxes of Rs5375 billion and would have run a federal deficit of Rs4247 billion or 5.0 per cent of GDP. The provinces, however, would have gone on a turbo-charged spending spree and our fiscal mess would have continued.

People have also rightly suggested that the federal government should get out of running devolved ministries and not provide subsidies (eg BISP or electricity) to consumers but let provinces do it. But taking these things out will have a devastating effect on the poor and will save no more than Rs1000 billion against an expected budget deficit of Rs8000 billion.

There is no fiscal solution without gradually bringing down the NFC Award from 57.5 per cent to somewhere between 40 and 45 per cent and possibly also giving the federal government the right to tax agricultural income. No other reform will succeed unless this issue is tackled.