NFC award and budget deficits

September 12,2018

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The 7th National Finance Commission (NFC) Award, approved in 2010, mandated that the federal government shall give 57.5 percent of its total tax intake – called the divisible pool – to the provinces.

In addition, it stipulated that Khyber Pakhtunkhwa be given an extra one percent of the pool for the war on terror and that Sindh should receive an extra 0.67 percent of the provincial share for the loss of octroi that it abolished in the 1990s. When taken together with the money the federation gives to Azad Jammu and Kashmir and Gilgit-Baltistan, and the vertical programmes, such as health, that it has to pay for in the provinces, the provincial share of federal taxes comes to around 62 percent. This, of course, means that for every Rs100 raised by the federal government in taxes, about Rs62 is handed over to the provinces.

There are three adverse effects of the NFC award and its largesse towards the provinces. First, it has increased the deficits incurred by the federal government and, indeed, by all the governments combined. Second, it has disincentivised the provinces from raising their own revenues. And third, it has given provinces a greater appetite to spend all the money they get from the federation, including on inefficient programmes and projects.

Let’s consider the first issue: how the NFC award has led to higher federal deficits. During the last fiscal year, the federal government took in about Rs4,600 billion in tax and non-tax revenues. The provinces raked in about Rs2,500 billion from this amount. Hence, the centre was left with only Rs2,100 billion, of which Rs1,500 was spent on interest on debt and another Rs300 billion on pensions. Both of these are legacy costs.

As a result, the federal government was only left with Rs300 billion and it still had to pay for civil administration, the public-sector development programme, defence and subsidies – which rounded off to about Rs2,800 billion. Hence, the government was left with no choice but to borrow. One can blame the PML-N government all one wants, but this heavy reliance on borrowing, which has now become the hallmark of our budgets, is actually a structural issue. And unless the NFC structure is addressed, the PTI-led government will also chalk up huge deficits, upwards of Rs2,000 billion annually.

The second problem with the NFC award is that it serves as a disincentive for the provinces to raise their own revenues. Just as parents who provide too much to their children end up spoiling them, the federal government is mollycoddling the provinces by handing them up to 90 percent of their revenues. And consequently, the provinces don’t try to raise much revenue on their own. Let’s take the example of the PTI government in Khyber Pakhtunkhwa. Despite its tall claims, it didn’t raise much revenue. Its agricultural income tax, for instance, was only a few crore rupees annually.

This is directly connected to the third hitch with the NFC: easy money encourages the provinces to spend freely. This is what we witnessed after 2013, when the PML-N government started raising more in tax revenues and sharing it with the provinces. Initially, the provinces couldn’t spend the money but quickly acquired an appetite for spending. The Sindh government, for instance, spent hundreds of billions of rupees in the last five years on lining the irrigation canals with questionable results.

The new PTI government has called a meeting for the new NFC award. The PML-N government also tried to do this. Unfortunately, we didn’t get any cooperation from the provinces governed by the PTI and the PPP. However, the PTI can be more successful since it controls three of the four provinces and the PPP’s priorities seem to be elsewhere these days. But unless the NFC award is altered, the PTI government will continue to run huge deficits, notwithstanding its fashionable but futile claims about austerity and higher revenues.

Even if we assume that the PTI will live up to its claim and double the tax revenues to Rs8,000 billion, after giving the provinces their share of nearly 62 percent they will only be left with Rs3,000 billion and will still run a huge deficit.

Reviewing the NFC award doesn’t in anyway mean that we do away with the 18th Amendment. The federalism brought about by the 18th Amendment is a step in the right direction – albeit an incomplete step. It now has to be augmented through the further delegation of power to the local governments. At the same time, allowances have to be made for uniformity across the country in a few subjects, such as educational standards or drug regulations.

Since the 18th Amendment stipulates that the NFC award for provinces can only be increased and not decreased, it may not be possible to change the award without amending the constitution. This seems unlikely, given the fractured and questionable mandate given to the PTI government. Therefore, a way to deal with the problem is to pay certain expenditures from the divisible pool before allocating it to the provinces. If this is done, the negative fiscal effects of the previous NFC award can be mitigated.

Unfortunately, the PTI has come into power without any plans. A month has gone by and we have seen no direction and policy. Their old habit of U-turns is still prevailing, whether it is in the Economic Advisory Council or gas or power tariff increases.

At some point, the PTI must stop blaming the PML-N and start delivering. And it has to have concrete and compelling proposals to alter the NFC award, and take the opposition and provinces into confidence. But this level of planning and maturity is perhaps asking too much of the PTI.

The writer has served as federal minister for finance, revenue and economic Affairs


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