NFC yay or nay? Dissecting the debate around the award

Every few years the debate crops up, but is it truly the reason behind Pakistan's economic woes?
Published April 6, 2024

The National Financial Commission (NFC) award sparked debate recently after there was social media chatter that the International Monetary Fund (IMF) urged the country to revisit the award. Every few years, the debate crops up.

But what is the NFC? According to Article 160 of the Constitution, the NFC Award is the allocation of revenues between the federation and the provinces “through an Order (the NFC Award), on the recommendation of the National Finance Commission (NFC)”.

The current NFC award’s recommendations were given legal cover from July 1, 2010, and it came hand-in-hand with the 18th Amendment which transformed the contentious relationship between the Centre and the provinces by devolving a number of subjects to the provinces.

To put it simply, the award is a financial agreement. The government collects taxes from all over the country. The NFC award decides how much of that money goes to the federal government and how much goes to each province.

Imagine it like a big pie. The NFC award decides how many slices each part the federal or provincial governments get. This award is supposed to be fair and give each province enough money to function.

On X (formerly Twitter), some have argued why there is a need to reassess the NFC award with regard to the alleged poor performances of the provinces when it comes to taxing sectors such as agriculture, retail, wholesale and property, in addition to the debt servicing burden carried by the federal government.

Of course, this subject invited much fury. Some politicians, such Senator Sherry Rehman of the PPP, questioned as to why would the IMF want to put itself in the middle of changing the NFC formula in the country.

Sindh Chief Minister Murad Ali Shah also discussed the constitutional importance of the award, adding that it did not allow the provincial share to be decreased.

Pakistan is on its seventh NFC award in its 76 year history, with the seventh award reaching a consensus in 2009-2010. One of the most distinguishing features of this award is that it takes into account the human development level of the provinces rather than just population and land size.

The arguments against the present NFC formula

Former finance minister Miftah Ismail argues that the current formula leaves much to be desired when it comes to tax collection of the provinces and the debt the federal government is left to deal with by itself.

Citing concerns over the allocation of revenue, the former finance minister points out: “After sharing about 60 per cent of the revenue with the provinces, the Centre is not left with enough to cover even its debt servicing (interest payments), so we have to borrow even to pay back interest and we have to borrow for other expenses.

“The federal government is teetering on the brink of bankruptcy while the provinces are flush with cash.”

Highlighting the financial strain on the federal government, Ismail explains that the Centre has to take out a large chunk of its revenue for the provinces. He gives the example of the previous year, where the Centre collected Rs7 trillion in tax revenue before the award, but was left with Rs3tr to cover its debt servicing and other expenses.

On the concept of fiscal federalism, Ismail remarks: “The true sense of fiscal federalism means that when you give them the authority, you give responsibility as well.

Former finance minister Miftah Ismail.—Reuters/file
Former finance minister Miftah Ismail.—Reuters/file

“When you’re giving them authority over so many taxes and spending money, they should also have the responsibility to collect taxes such as property, agriculture, sales tax on services and motor vehicle taxes to raise money that the provinces need.”

Addressing concerns about development expenditures, Ismail notes a whopping 342pc increase in 10 years on development expenditures.

“I am not disagreeing with the fact that they have money to spend on development expenditures, however, they should raise their own taxes too,” he says, adding that the provinces raised only Rs650 billion while they spent Rs5tr.

He also notes that all the provinces combined collected fewer than Rs126bn from property and agriculture income tax, adding that the rich “park their wealth in land and are not taxed fairly”.

Comparing international practices, Ismail states that no other place gives so much money unconditionally. “In India for instance, the federal government says to the local government that we’ll give you grants if you collect your own property taxes,” he says.

As for reforms needed in the NFC award, he suggests an alternative distribution, stating that rather than giving 57.5pc to the provinces, it can be reverted back to 40 to 45pc.

This, he asserts, can be done gradually overtime to offer the provinces enough time to raise their own funds.

In a separate post on X, he calls for strengthening the 18th Amendment and cutting wasteful expenses. “But have provinces raise more revenues from property and agriculture,” he says.

The argument to keep the current formula

On the flip side, former finance minister and economist Hafiz Pasha paints a different picture of the Centre-province tug of war.

He states: “In our Constitution, and in the principles of policy, we have enunciated this principle that over time, we must reduce inequity among the various provincial jurisdiction.”

One of the seventh NFC award’s main distinguishing features is the fact that it really goes out of its way to include in its horizontal sharing formula the provinces which were considered to be neglected, namely Balochistan and Khyber Pakhtunkhwa. It attempts to “link distribution of resources to poverty level to offer a more multifaceted approach to distribution of resources”.

“The end result [for the NFC award],” says Hafiz Pasha, “is to enable the process of fiscal equalisation as the federal government transfers on a per capita basis somewhat more the underdeveloped provinces”.

When its comes to international practices, Dr Pasha notes that countries like India give much more leeway to its states when it comes fiscal responsibility.

Economist Hafiz Pasha.—Arif Ali/White Star/file
Economist Hafiz Pasha.—Arif Ali/White Star/file

He says: “The states of India have been given the power to borrow and create their own debt and they engage in large borrowings. While in Pakistan, the Constitution has not allowed the provinces to borrow.”

“The provinces, therefore, do not incur any debt of their own,” he points out, “The entire debt of the government today is the debt incurred by the federal government and, without any contribution to it, the provincial governments generate surpluses which are used to reduce the deficits.”

Drawing comparisons to India, Dr Pasha points out that despite claims of India outperforming Pakistan in economic indicators, its budget deficit was larger than Pakistan as a percentage of its GDP. (India’s fiscal deficit is 5.8pc of its GDP, while Pakistan’s is 4.6pc as of Jul-Apr FY2023.)

“And the main reason is that in Pakistan there is no provision for the provinces to borrow so they don’t create any debt and therefore are not liable to carry any debt-to-servicing liabilities,” he asserts.

Reflecting on the provincial role in governance, Dr Pasha notes, “Quite frankly, the federal government’s governance performance is not necessarily better.”

Dr Pasha emphasises the importance of provincial spending on human development, stating, “The real function of the provincial governments is improving the lives of the people.”

“The prime responsibility of the federal government is, of course, defence and so on, but the main responsibility of the provinces is to improve the lives of the people, which basically means they have to invest and spend on education and health,” he says.

Regardless, the former finance minister points out that federal transfers had in fact declined in the last five years to the provinces as a percentage of the GDP.

“And the reason for that decline is because the overall tax-to-GDP ratio at the federal level has declined,” he said.

This can be reflected in the fact that the current tax-to-GDP ratio witnessed a drop of 0.4 points in the first half of the current fiscal to 4.4pc from 4.8pc last year.

The decline, a recurring trend, reinforces concerns that the Federal Board of Revenue (FBR) will not be able to attain even the low target tax-to-GDP ratio of nearly 9pc for the year.

‘NFC not the problem’

Yousuf Nazar, an economist and former head of equities and investments at Citigroup, backed this statement: “The tax collection performance of the FBR from 2017-18 to 2020-21 was poor. The FBR tax collection declined in real terms — adjusted for inflation — for the three successive years after 2017-18.”

Nazar elaborates the main issue to be of the ruling elites and their inability to tax property, agriculture, retailers and wholesalers.

“This is not an NFC issue but rather the question of politics,” he says, “Tax-to-GDP ratio declined at the FBR level and no progress was made to increase tax collection from property and agriculture. It is misleading to paint it as a federation versus the provinces issue.”

“Consequently, domestic borrowings hit record levels. From 2013 to 2023, the markup payments in the federal budget went up by 396pc to Rs5.7tr.”

Can’t ignore human development

Dr Hafiz Pasha points out that ultimately Pakistan now spends much less on human development. Consequently, Pakistan ranks 165th on a list of 193 countries on the UN Human Development Index in a report which factors in standard of living, education and life expectancy.

Furthermore, Dr Pasha argues that the Petroleum levy is already rerouting money from the provinces to the government as it is counted as a non-tax item and is not treated as a divisible pool item, noting that the provinces will already receive Rs500bn less this year.

It is worth mentioning that the the government has already achieved Rs60 per litre petroleum levy — with sources stating the IMF may want to hike it up to Rs100. The government had set a budget target to collect Rs869bn as petroleum levy on petroleum products during the current fiscal year under the commitments made with the IMF.

‘If anything needs to be changed, it’s the FBR’ also reached out to a political leader and former minister for poverty alleviation Shazia Marri who points out that a lot of subjects — like education, health, climate change — had been devolved to the provinces.

She says the stance of her party, the Pakistan’s Peoples Party (her party was one of the major proponents of the 18th Amendment) is: “If it’s a matter of money and if each time we hear there’s less money left for the federal government, they should look into their own expenditure, which is a duplication currently after the 18th Amendment.”

“The argument should not be whether the NFC should be the revisited,” she says. “The argument should be whether the federal government is seriously looking into the money spent on subjects that were devolved under the 18th Amendment.”

PPP’s Shazia Marri.—APP/file
PPP’s Shazia Marri.—APP/file

Marri gave the example of the money spent in 17 ministries, citing the number to be around Rs328bn, she asserts that those ministries are a financial burden to the Centre and “rather purposeless”.

She says: “The record of [tax] collection by provinces is better than FBR. If anything, it is the FBR that needs to undergo reforms.”

On whether sectors such as agriculture are taxed, she tells that the “sector is taxed; maybe not the kind of taxes one wants to apply — that is debatable”.

It should be noted that the agriculture sector is not entirely out of the tax bracket, its income is charged like any other income under the Income Tax Ordinance, 2001.

The sector also accounts for about one-fifth of the country’s economy. It is said that if the sector contributed its fair share, a fifth of the current year’s tax collection target of Rs9,415bn would be coming from farm output.

“There’s also the fact that agriculture sector is a very vulnerable sector, yet the most important one when it comes to the bread and butter of Pakistan,” she said.

“We have not given enough incentives to the agriculture sector, but we want to tax them just like a corporate sector company where the profits are insured, where the profits are calculated and received. A farmer is not sure of the crop or the rate of the crop that he is going to receive in the market,” she says.

She also suggests that federal government needs to revisit the subsidies it has in place for “people who do not necessarily require subsidies” such as preference that was given to the cement sector in 2018-2019.

Where do we go from here?

“In this world nothing can be said to be certain, except death and taxes.” — Benjamin Franklin.

All of these arguments can be brought back to one thing: taxes. Both sides agree that something needs to be done regarding the poor performances of the taxing institutions.

The lack of incentive to tax more sectors, for one side of the debate, poses major challenges for the imbalance in the federal-provincial relationship. While revisiting the NFC award’s share — which is cemented in the Constitution — and the lack of implementation of tax reforms at federal level seem to be a thorn at the side of the other.

Admittedly, both the federal and provincial governments have failed in increasing their tax net. To absolve the provinces or the Centre of their poor revenue performance would be unfair to the argument.

Earlier, Senator Sherry Rehman had made the point that provinces performed better as they has they had raised their tax-to-GDP ratio from 0.3pc to 1pc, however it would be wrong to attribute it to fiscal improvement.

To say that the provinces outperformed the federal government when it came governance and revenue would lack nuance needed to understand the complicated nature of the debate.

Dr Pasha notes the growth is due an additional tax which was devolved to provinces in the seventh award; the sales tax on services. The remaining sectors have not been developed.

So what is the answer? Experts provided several ways to incentivise the provinces to increase their tax net instead of over-burdening one segment. Dr Pasha suggests reverting back to the 1996 award which had an incentive for the provinces to generate more revenue.

However, most parties note that decreasing the share size of the current NFC award would require revisiting the Constitution itself. Moreover, the NFC award plays a critical role of strengthening the federation and cementing fiscal equalisation so that inequality regionally is reduced over time.

We must consider that Pakistan is already lagging behind in human development indicators as noted by World Bank’s 2023 Human Capital Index which expressed concern over the country’s failure to deliver on human development, noting alarming figures of child stunting and out-of-school youth.

Perhaps a special grant system in place may encourage those responsible to expand their horizons to raise more revenue. A step along the winding road to bring back fiscal effort by the provinces and the federal government all the while making sure just one segment of the society is not burdened with the load.

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