Political economy of NFC

BY S A K I B S H E R A N I | 5/15/2015

THE eighth National Finance Commission (NFC) has been constituted and at least one preliminary meeting between the centre and provinces has been held. The NFC is designed to determine the envelope of fiscal transfers from the centre to the provinces from the federal divisible pool (vertical distribution), as well as the formula for distribution between the provinces (horizontal distribution).

From its inception to the seventh NFC Award, the share of the provinces in the federal divisible pool had not crossed 50pc, while a single criterion was used for horizontal distribution: population. From the perspective of the smaller provinces, this distribution basis skewed the fiscal resource transfer to the largest province in terms of population, while ignoring their development needs based on backwardness, land mass and population density, the impact of long running conflict etc.

The seventh NFC Award proved a landmark in countering the feeling of deprivation of the smaller provinces by changing the basis of inter-provincial distribution, solely from population to multiple criteria. The weight of population was reduced to 82pc, while three new criteria were introduced: backwardness (10.3pc), revenue collection (5pc), and inverse population density (2.7pc).

The credit for this landmark change goes largely to Punjab, since decisions at the NFC are unanimous, as well as to the PPP government and the political parties represented in one of the few successes notched up by the nascent `democratic` system.

Perhaps more importantly from a fiscal framework perspective, the seventh NFC also dramatically enlarged the size of the fiscal transfers to the provinces from the centre. From 50pc under the previous Award, the share of provinces rose to 57.5pc in the seventh NFC Award. Inclusive of the additional four percentage pointsconceded by the centre on account of `collection charges`, the total share of the pie for the provinces exceeded 60pc.

Inter-governmental fiscal transfers are not just about higher vertical distribution of resources from a national to sub-national governments, however. In addition to a transfer of fiscal resources, the other elements involve expenditure assignment as well as designing appropriate incentives for the provinces to engage in own-resource mobilisation.

Hence, the `grand design` that was supposed to underpin the seventh NFC Award and make it work was the transfer of expenditure assignment to the provinces under the 18th Amendment, in conjunction with agreement among all the parties involved on the need to increase tax revenue. One of the cornerstone measures under the latter was agreement by the provinces for an integrated value added tax to be leveled on goods as well as services to be collected by the Federal Board of Revenue. Work by the IMF and World Bank had suggested that an integrated VAT, if properly implemented, could increase tax revenue by around 3pc of GDP within three years.

The combination of measures on both the revenue as well as expenditure side would increase the fiscal resource pool available, while significantly mitigating the impact on the centre`s finances. However, the 18th Amendment was rushed through without proper thought or preparation and implemented in a ham-handed manner, while the agreement on an integrated VAT was not formalised. The spirit of political accommodation and consensus during the deliberations forged mainly by Shaukat Tarin as chairman NFC, dissipated when the finance ministry bureaucracy were suspected of having tinkered with the wording of the final award sent to the president for approval. The finance minister`s departure two months after finalising the seventh NFC Award, put paid to the integrated VAT and provinces decided to go it alone.

Nonetheless, the change in the NFC formula dramatically increased the quantum of fiscal resources available with the provinces. From Rs753 billion in 2009-10 (the final year of the previous award), the gross total transfers to provinces increased to Rs1,074bn in the first year of the seventh NFC Award, rising to a budgeted Rs1,720bn for the current fiscal year.

The flip side, however, has been that resources at the command of the federal government were squeezed equally dramatically at a time when spending on its main expenditure responsibilities, debt servicing and defence, was rising sharply. Hence, of the net revenue available with the federal government after transfers to provinces, 67pc will be taken up by interest payments alone in the current year. This will obviously leave little else for the other major expenditure heads, and compel the government to borrow even more.

The good news of sorts is that provincial expenditures on public service delivery have gone up sharply on paper at least. Hence, the combined spending on education and health by the provinces has increased from Rs243bn in 2009-10 (before the seventh NFC) to Rs618bn in 2013-14 a cumulative increase of 2.54 times in nominal terms.

The bad news and unequivocally so is that the impact on the ground of this supposed increased expenditure is not showing up everywhere. Take Sindh, for example. With budgetary spending on education purportedly increasing from a mere Rs 15bn to Rs106bn in a four-year period, its outcome indicators in education remain abysmal; in fact, by most credible reports and accounts, the situation in Sindh`s public educational institutions has worsened.

The lesson here: with greater resources comes greater responsibility. While the eighth NFC Award should incentivise even greater own-resource mobilisation by the provinces, where and how the money is spent and to what effect should not be beyond scrutiny. Hence, I propose that the eighth NFC Award should include an explicit set of outcomes that provinces will need to achieve with regards to education, health, provision of safe drinking water etc. by the end of the tenure of the award.

These outcomes should be monitored and audited independently at the halfway mark using indicators and benchmarks agreed by consensus. If a particular province is lagging significantly in achieving these, despite the additional resource transfer, its share in the following half of the duration of the NFC Award should be adjusted or withheld till such time progress is made.

The monitoring and accountability framework of the NFC Award has to be changed, and its incentives aligned with delivering outcomes rather than merely increased spending.
The writer is a former economic adviser to government, and currently heads a macroeconomic consultancy based in Islamabad.

Published in Dawn