Federal-Provincial Revenue Sharing

Draft for Discussion Only

Federal-Provincial-Local Fiscal Transfers in Pakistan

Anwar Shah, World Bank

December 6. 2003

Matching revenue means as closely as possible to expenditure needs of the various levels of government serves to strengthen accountability in a federal system. Allowing sub-national government greater access to own tax bases accompanied by stronger tax collection performance and better attention to cost recovery policies will help in this task. In Pakistan, in view of the very large vertical imbalances – gap between expenditure needs and revenue means at provincial and local levels – and the associated implications for weak accountability, tax decentralization options require serious consideration to narrow these imbalances without eliminating them entirely. This is because, it is desirable in federal systems for higher level governments to have access to more revenues than those dictated by their direct program responsibilities alone. These additional revenues can be used to support national and provincial economic objectives such as setting national standards, securing economic union and ensuring inter-regional and inter-local fiscal equity. The design of these transfers is however, critical to achieving the objectives sought. The issues pertaining to the design of these transfers are critical to achieving the objectives sought. This note reviews the design of existing fiscal transfers in Pakistan for their consistency in achieving the objectives being pursued.

Vertical fiscal imbalance in a federation reflects the revenues raised by the federal government that are made available to provinces to finance their expenditures. There are two broad ways this transfer of funds can take place. One is by assigning a pre-determined share of federal revenues to the provinces, while the other is by making federal-provincial transfers whose magnitude is based on criteria other than federal revenues. The first is revenue sharing while the second falls under the general rubric of federal-provincial transfers. The distinction is a conceptual one only, since both amount to a transfer of funds and both share some common characteristics. In Pakistan, revenue sharing is the dominant form of federal-provincial fiscal relations for financing operating expenditures. Conditional grant programs are practiced primarily for capital projects that are typically designed and determined at the federal level and local governments implement these projects on behalf of their provincial governments.

Current Practice of Federal-Provincial Revenue Sharing in Pakistan

The task of the distribution of revenues between the federation and the provinces have been assigned by Pakistan Constitution (article 160) to an intergovernmental, inter-legislative cum civil society body, the so-called National Finance Commission (NFC). The NFC comprises of the Finance Minister of the Federal Government as chair and Provincial Finance Ministers and other persons (from provincial legislatures, experts, academia, think tanks) appointed by the President after consultations with the provincial Governors. The constitution mandates convening of National Finance Commission every five years to decide (make awards) on (a) the proportion of the constitutionally specified federal revenues that should go to the provinces; and (b) the criteria for the distribution of these revenues among provinces. Previous quinquennial awards stay in force in the event a consensus is not reached on the new award. Due to a lack of consensus on the 2002 award, the 1997 NFC award remains in vogue at the present time but efforts are currently underway to reach a new consensus. For this purpose, a newly constituted National Finance Commission is starting deliberations in December 2003.

The 1997 NFC Award

The 1997 NFC award (renewed in 2002) consisted of three components : (a) revenue sharing component – distribution of a pool of federal revenues to provinces by formula; (b) returning to the province of origin resource royalties, charges and excises after deducting a 2% federal collection fee; and (c) special lumpsum transfers to NWFP and Balochistan provinces. These are described as follows:

(a) Revenue Sharing Component

Taxes on income, wealth, capital value taxes, sales taxes on goods, federal excises (excluding natural gas) and the customs duties, i.e. nearly all of federal consolidated revenues ( after retaining a 5% collection charge) excluding income taxes on federal employees constituted the divisible pool for the 1997 award. The NFC mandated transfer of 37.5% of the divisible pool to the provinces on the basis of provincial share of the national population. In addition, to these revenues, provinces currently receive an additional 2.5% of general sales tax (GST) revenues as a pass-through funds for local governments in lieu of their elimination of octroi tax. For FY2002-2003 total divisible pool comprised of 448.5 billion Pak Rupees and provinces received 150 billion rupees as revenue sharing transfers (see Table 1 for details).

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(b) Revenues returned by origin

Royalty on crude oil, royalty, excise duty and surcharge on natural gas and general sales tax on services are returned by origin to the provinces after deducting a 2% federal collection charge. In FY2003-2004, provinces received 33.4 billion rupees on account of these revenues/

The NFC mandated payments of special lumpsum grants to NWFP and Balochistan provinces in recognition of their special needs. In FY2002-2003, Rs. 20 billion in federal revenues were transferred to the two provinces.

(d) Federal Transfers in lieu of Octroi and Zila Taxes (OZT)

Until 1998, taxes on inter-municipal trade represented major source of revenues for district and tehsil governments in Pakistan. Octroi tax was imposed by urban governments (current equivalent of Tehsil governments) goods and services imported from other jurisdictions and the Zila tax was levied by rural governments (current equivalent of district governments). In 1998 , these taxes were abolished at the direction of federal government with a promise to compensate local governments for loss of revenues through a federal transfer program that passed funds through provincial governments to local governments. Currently 2.5% of revenues from the federal goods and services tax are transferred to provincial governments for distribution to local governments. In FY2002-2003, provinces received 14.5 billion rupees or 5.8% of total transfers from the federal government as the OZT transfers.

Conditional Grant Programs

Federal government provides financing mostly for capital projects that are centrally sponsored either using federal revenues or grants received from foreign governments and agencies. In FY2002-2003, these transfers amounted to 15.6 billion rupees or 6.3% of total transfers. Foreign grants comprise 75% of such financing (see Table 1). The following grants programs were in vogue in FY2002-2003:

Conditional Capital Assistance Programs

Khushhal Pakistan Program (KPP): Under KPP, funds are made available to local governments through provincial governments for small local capital projects. The federal government specifies the criteria for project selection and a negative list for the use of funds. The district governments decide on the project selection and implementation. In FY 2002-2003, XX billion rupees were made available for this program.

Tameer-Watan Program (TWP).: Federal Government provides members of national parliament (National Assembly) and the provincial governments entitle members of provincial assembly, ten million rupees each to be spent on any project in their electoral districts. These programs are implemented through district governments. In FY2002-2003, XX billion rupees were made available for this purpose.

Education Sector Reform Program (ESRP): This program makes available federal financing primarily for rehabilitation of school facilities. The funds are made available to the provinces as development grants who in turn allocate these to the district governments. In FY2002-2003, X billion rupeeeswere transferred to the provinces on this account.

The Extended Immunization Program (EIP): For the childhood immunization program, the federal government provides in-kind contributions in the form of vaccines, vehicles and other equipment. In FY2002-2003, xx million rupees were spent on this program by the Federal Government.

Conditional Operating Assistance

Lady Health Worker Program (LHWP): Under the National Program for Family Planning and Primary Health Care, thre federal government finances the salaries of lady health workers jointly recruited by the provinces and the districts. In FY2002-2003, this program cost the federal government xx million rupees.

The Pros and Cons of Pakistan’s System of Federal-Provincial Fiscal Relations

As noted earlier, Pakistan’s system of federal resource transfer to the provinces is predominantly a revenue sharing system having important merits of a transparent fiscal system as well as lacking important levers a well designed fiscal transfer system can potentially offer. The smaller conditional grant programs employ less transparent criteria. These arguments are discussed below:

Merits of the Existing Revenue Sharing System

Pakistan’s fiscal system is laudable on several counts.

The constitutionally mandated structure of the National Finance Commission represents an excellent model of a federal-provincial participatory decision making body with all the key stakeholders represented . The consensus decision rule further offers opportunity for political compromise and accommodation. This model is superior to so-called independent and largely academic grants commissions in India and Australia as the decision makers are not represented on latter bodies. The practical merits of such an institutional arrangements are borne out by the simplicity and transparency of the commission awards.

The revenue sharing system practiced in Pakistan represents a simple, objective (formula based) and transparent way of reasonably secure and growing amount of revenues to the provinces. It provides transfers in a lumpsum, unconditional and predictable way to the provinces. The provinces are left with full discretion and complete autonomy over how to spend these funds. This facilitates the decentralization of fiscal responsibility and contributes to the efficiency of the federal system. The provinces remain accountable to their own constituents via the legislative process for the manner in which they provide services.

The NFC award also facilitates the preservation of a fully harmonized tax system in Pakistan. It has enabled the federal government to retain major revenue raising responsibilities to achieve greater efficiency in tax collection and administration and lower the compliance costs of the tax system. These arrangements have avoided tax jungles that continue to block the reform of sales taxes in India.

The NFC awards equalize to an uncertain standard the fiscal needs of the provinces as population represents a good proxy for fiscal needs.

The revenues returned by origin represents an acknowledgement by the federal government that resource royalties are provincial own source revenues and simply collected by the federal government.

The special grant program for NWFP and Balochistan provides additional unconditional assistance to the two smaller provinces with lower than average fiscal capacities and higher than average expenditure needs. This recognizes the differential needs arising from a dispersal of population over a large area to be serviced in Balochistan and the mountaineous terrain and influx of Afghan refugees in NWFP .

Drawbacks of the Existing System

For all its simplicity and effectiveness in getting funds into the hands of the provinces with a minimum of intrusion, revenue sharing has some drawbacks especially if relied on excessively as is the case in Pakistan. The main issue concerns the fact that provinces receive these funds like manna from heaven with no accountability to tax payers. They do not experience the pains of justifying additional taxes to their constituents while enjoying the pleasures of spending on their pet projects. Due to their unconditional nature, and rightly so, there is also no oversight requirements by the federal government.

A related concern is that while provinces are left with considerable discretion in the use of revenue sharing funds, they have virtually no discretion over the amount of funds they receive. If revenue sharing is seen as an alternative to other forms of federal-provincial transfers, this is no drawback. But revenue sharing in Pakistan leaves little revenue raising responsibilities with the provincial governments. In these circumstances tax decentralization options – such as tax base sharing might offer superior alternatives. Enhancing the ability of provinces to raise their own revenues can increase the accountability of provincial governments for their fiscal performance.

Another important drawback of revenue sharing system is that it does not permit fiscal capacity equalization to a national average standard. Such an equalization system fosters a sense of unity in the nation as citizens benefit from having reasonably comparable levels of public services at reasonably comparable levels of taxation across the nation. Please note that the proposals currently under discussion in Pakistan to include backwardness, tax effort and other indicators in the NFC formula would make the system complex without achieving fiscal equalization.

An additional important drawback of the revenue sharing system is that it deprives the federal government from having the lever to influence provincial priorities in order to achieve national objectives of say having national minimum standards in education and health to foster internal economic union. Such a system also works as an impediment to introducing an accountability for results and performance orientation culture in the public sector at the provincial level.

Another potential drawback of the existing system is that the formula determining a province’s revenue allocation bears little relation to province’s expenditure responsibilities. A province’s revenues grow at the rate of growth of federal revenues. This may differ considerably from the rate of growth of province’s expenditure responsibilities. Provincial expenditures on education, health, and infrastructure are likely to far outstrip growth in federal revenues.

Finally, the existing revenue sharing program exposes the provinces to risks associated with changes in federal tax bases and collection performance. Both these risks, however, may be quite small as almost all federal revenues are included in the base.

The program of returning resource royalties by origin seems also difficult to justify as the federal government collects revenues at centrally determined rates and then returns them to provinces on the basis of collection (see also Shah, 1996). While it can be argued that resource royalties as opposed to resource profit or rent taxes could be reasonably assigned to the provinces, but then provinces should be able to decide on the rates and structure of such royalties while collection could be either provincial or federal.

The special grant program for NWFP and Balochistan is also flawed as the size of these grants are determined in an ad hoc manner and both the size and duration is unrelated to any provincial fiscal capacities. This program weakens accountability of provincial governments to their taxpayers without dealing with regional equity concerns in a satisfactory manner.