The government has finally constituted the 11th National Finance Commission (NFC) to propose a new NFC Award, replacing the 7th NFC Award, which was agreed upon in May 2010. While an NFC Award is intended to last for only five years, the existing one remains in effect until a new one is agreed upon. The 7th NFC Award, considered one of the most fiscally damaging to Pakistan’s federal health, has now been in place for 15 years. If this new commission fails to agree on a more rational award, it could be financially devastating for the country.
Under the 7th NFC Award, 57.5% of total federal tax revenues are transferred to the four provinces. An additional 1% is given to Khyber Pakhtunkhwa for its role in the war on terror, and an extra two-thirds of 1% of the divisible pool is allocated to Sindh for giving up Octroi in 1998. The federal government also bears the full cost of Gilgit Baltistan, AJK, and ex-FATA governments. Together, these expenditures amount to nearly 62% of the federal government’s revenues.
This arrangement means that a significant portion of citizens’ taxes goes to the provinces, making it nearly impossible to consider reducing income or sales tax rates without also reducing the provincial share in the NFC Award. Since the 7th NFC Award was implemented, Pakistan has experienced slower economic growth compared to most other developing countries, a trend that appears to be significantly influenced by the award. This is because, despite newer and higher taxes, the country has been running large fiscal deficits, which have put negative pressure on the current account and currency.
This constant pressure means that even a little economic growth can cause the current account deficit to skyrocket and the currency to crash, a pattern of “boom and quickly-bust” episodes that has occurred many times in the recent past. The federal government’s outlays are concentrated in three main areas: revenue sharing with the provinces, the federal government’s own expenses, and debt servicing. Since debt servicing is non-negotiable without risking a default, the only two areas where expenditures can be reduced are provincial transfers and the federal government’s own expenses.
For example, last year, the federal government collected about Rs12 trillion in taxes but still had a deficit of Rs8 trillion. To close this deficit, the government would have had to raise an additional Rs20 trillion in taxes, because the first Rs12 trillion of the new revenues would have to go to the provinces. This would bring the total tax revenue to Rs32 trillion, or more than 30% of GDP, an amount that is neither possible nor desirable.
How should the NFC Award be reformed? The biggest problem with the 7th Award is not the total amount of money transferred to the provinces, but the fact that for every new rupee collected by the federal government, the first 60 paisas must go to the provinces. Therefore, a proposed reform is to keep the existing amount and rate of money going to the provinces the same, but to allow the federal government to retain 80% of any increase in tax revenues. Additionally, the Benazir Income Support Programme (BISP) should either be transferred to the provinces or its budget should be sourced from them if the federal government continues to administer it.
At the same time, it is crucial that agricultural income be brought into the federal tax net. The commission also needs to clarify whether some provinces are legally allowed to tax international trade and whether customs duties should be part of the divisible pool. The provinces, on their part, are expected to argue that the petroleum levy should be included in the divisible pool. Finally, a new constitutional amendment will be necessary, as the 18th Amendment specifies that the next NFC Award can increase, but not decrease, provincial shares.
The new commission faces many critical issues. The hope is that national interests will prevail over parochial and political interests.
