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In defence of the provinces

In recent months, the provinces have become the favourite punching bags of Islamabad, donors and commentators alike. They are being chastised for failing to generate adequate resources to fund their constitutional responsibilities to provide social and economic services such as law and order, education, health, water, sanitation, etc. This article examines the fairness of this censure without getting into the merits of the last National Finance Commission (NFC) Award that has given provinces close to 60pc of the national divisible resource pool, although they currently meet less than 40pc of the expenditure burden.

Let us, to begin with, recognise that on the grounds of equity, greater efficiency and administrative convenience, taxes in a federal system are levied and collected by the central government with expenditure responsibilities assigned to lower formations of government. The resultant vertical imbalance requires transfers of resources from the centre to the provinces through the NFC Award.

A highly centralised tax structure, a depressed tax-to-GDP ratio of the country, a low level of provincial effort to mobilise revenues and frequent upward revisions in salary and pension payments that have a ripple effect on provincial budgets are structural factors that had contributed to the deterioration in the fiscal situation of the provinces until the last NFC Award.

The provinces have made some decent effort in recent years to mobilise additional revenues. Moreover, the revenue-raising capacity of the provinces is limited because of the taxation powers enshrined in the Constitution and the structure (general sales tax, or GST, in VAT mode) put in place under an earlier IMF programme. The federal government has also pre-empted and exploited the revenue base of the provinces. For instance, it has levied a variety of silly withholding and other taxes on motor vehicles and property transfers, important revenue bases/instruments for the provinces.

The provinces have made some decent effort in recent years to mobilise additional revenues. Moreover, the revenue-raising capacity of the provinces is limited because of the taxation powers enshrined in the Constitution and the structure (general sales tax, or GST, in VAT mode) put in place under an earlier IMF programme. The federal government has also pre-empted and exploited the revenue base of the provinces. For instance, it has levied a variety of silly withholding and other taxes on motor vehicles and property transfers, important revenue bases/instruments for the provinces.

There is no denying that the provinces have not done enough to collect taxes on incomes derived from agriculture (making it worse by treating land rented out also as agricultural income) or by making urban property tax more progressive and robust. But they have made some decent effort in recent years to mobilise additional revenues by widening the base of GST on services. Unfortunately, however, some of the federal government’s taxation initiatives have encroached on provincial tax bases, narrowing their options to exploit the full potential of GST on services. To illustrate, by what twisted logic can Islamabad levy GST on hotels and restaurants and distribution of utilities like electricity and gas, etc and a conceptually bizarre GST on retail outlets. All these entities are providing services, and a GST on services is a provincial tax under the Constitution, with no federal role.

As for the strident criticism of the provinces one would like to understand why any government anywhere in the universe would commit the politically unpopular act of imposing or increasing a tax, provoking the ire of its constituents, to muster additional resources which it would be required to save so that a higher entity (the federal government) could spend this surplus? Under the ongoing IMF programme, the provinces are required to produce surpluses — budgeted at Rs289 billion for the new year. Why on earth would they accede to a demand to levy more taxes simply to generate surpluses for Islamabad to spend?

Examining the expenditure profile of provincial governments, the biggest chunk is taken up by salaries and pensions. The federal government has contributed to the rapid growth in allocations for this component. Whereas Islamabad does not have a well-conceived policy to regulate the size of its workforce it periodically revises salaries and pensions. The resulting increases, which are lumpy, are introduced in an ‘ad hoc’ manner. They impose a massive burden on the provinces (who employ close to 80pc of the civilian workforce in the public sector), without regard to the size of the employee base of a province, its capacity to pay and the general level of wages outside the government. And it is politically impossible for the provinces to deny their employees pay hikes even if they cannot so afford.

There are other recurrent expenditures of the provinces that have resulted from a variety of decisions imposed on them by the federal government. Until the 18th Amendment agricultural income, the federal government was fully empowered to determine both the level and the terms at which the provinces could borrow from any source.

Islamabad used this provision to lend to them at interest rates substantially higher than what it itself was paying. Until a decade ago, it even profited from the loans given by multilateral donors to the provinces by levying a hefty service fee on the concessional interest rates charged by donors.

In the past provinces were induced to borrow on the basis of population ratios without regard to their capability to service the debt, creating an incentive for financial imprudence. However, in a dramatic move in 1999/2000, without addressing the issue of the burden of the large stock of debt, the federal government ceased lending to provincial governments, expecting them to fund their own recurrent expenditures and development programmes from the transfers under the NFC Award.

Until this abrupt decision the debt burden of the smaller provinces was already high — some of which resulted from the pressure put on them by Islamabad to spend money on federal programmes or to accept foreign loans for projects of dubious value because the federal government needed foreign exchange to discharge its external liabilities.

To summarise, it is easy to run down the provinces for not marshalling adequate resources, without factoring in the context in which they are operating, the baggage they are already either carrying, or that is being placed on them, on account of federal decisions and programmes which impact their budgets and for being expected to launch politically harsh initiatives to increase the tax burden on their citizens so that savings are generated purely for Islamabad’s use.

The writer is a former governor of the State Bank of Pakistan.

Shahid Kardar, "In defence of the provinces," Dawn. 2014-07-08.
Keywords: Economics , Economic issues , Economic needs , Economic aspects , Social services , Electricity issues , Foreign debt , Economic growth , Agricultural income , 18th amendment , Taxation policy , NFC Award , Sales tax , Economy-Pakistan , Taxes , Gas , Pakistan , GST , GDP , IMF