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Summary of Fiscal Implications of the 18th Amendment: The Outlook for Provincial Finances

Core Content

The document Fiscal Implications of the 18th Amendment: The Outlook for Provincial Finances, authored by Aisha Ghaus Pasha and published by the World Bank in November 2011, examines the financial implications of the 18th Amendment to Pakistan's Constitution, which was ratified in April 2010. The Amendment significantly devolved powers and responsibilities from the federal government to the provinces, leading to a more decentralized structure of governance. It also enhanced provincial fiscal powers, including the ability to levy and collect taxes on services, real estate, and agricultural income. The report assesses the impact of these changes on provincial finances, outlines the mechanisms of devolution, and highlights the challenges and opportunities in the implementation process.

Main Points and Key Information

1. Overview of the 18th Amendment and Its Fiscal Implications

• The 18th Amendment restructured the distribution of powers between the federal and provincial governments by:
  • Abolishing the Concurrent Legislative List (CLL), transferring its functions to the provinces, except for electricity.
  • Reallocating some subjects from the Federal Legislative List (FLL) Part I to Part II, making them shared responsibilities between the federal and provincial governments under the Council of Common Interests (CCI).
• Fifteen ministries/seventeen divisions were devolved to the provinces in three phases:
  • Phase I (Dec 2010): Special Initiatives, Zakat and Ushr, Youth Affairs, Population Welfare, Local Government and Rural Development.
  • Phase II (Apr 2011): Education, Social Welfare and Special Education, Livestock and Dairy Development, Culture and Tourism.
  • Phase III (Jun 2011): Food and Agriculture, Health, Labour and Manpower, Women and Development, Sports, Environment and Minorities Affairs.
• The number of federal divisions was reduced from 50 to 33, and the total number of employees in these divisions was 35,566, with over 14,000 in education alone.

2. Fiscal Implications of the 18th Amendment

• Federal Expenditure on Devolved Divisions:
  • Rs 45 billion in current expenditure was transferred to the provinces in 2010-11, with the largest share (Rs 23 billion) going to the Higher Education Commission (HEC).
  • Development expenditure (PSDP) for devolved subjects was Rs 47 billion, with Rs 30 billion for vertical programs and Rs 17 billion for location-specific projects.
• Total Expenditure Transferred:
  • Ranges from Rs 67 billion to Rs 91 billion, depending on whether the HEC current budget is included.
• Provincial Budget Impact:
  • Punjab and Sindh saw a 6% and 5% increase in budgets, respectively.
  • K-PK and Balochistan saw smaller increases, with Balochistan expected to remain in deficit.
  • The federal government expected a large surplus from the provinces, but the actual impact was minimal, with a combined deficit of Rs 11 billion in 2010-11.

3. Financing of New Responsibilities

• Federal Government's Role:
  • The federal government initially assumed responsibility for financing vertical programs (e.g., health, population welfare, HEC) until 2014-15.
  • Location-specific projects are now primarily funded by the provinces.
• Provincial Absorption Strategy:
  • Most provinces absorbed the new functions into existing departments.
  • Only modest provisions were made in the Schedule of New Expenditure (SNE) for additional staff.
  • Federal employees were gradually absorbed into provincial departments, with no retrenchment planned.
• Autonomous Bodies:
  • Some bodies were retained at the federal level, such as the Drug Control Agency, PARC, and PASSCO.
  • Provincial governments have started streamlining their portfolios, with Punjab opting to execute only half of the devolved projects.

4. Outlook for Provincial Finances

• 2011-12 Budget Trends:
  • Revenue receipts are expected to grow by 18% (in line with inflation).
  • Current expenditure is projected to increase by 7%, with increased foreign aid for flood-related reconstruction.
  • The combined PSDP is targeted for Rs 477 billion, a 61% increase from the 2010-11 level.
• Budget Outcomes:
  • Punjab and K-PK are projected to have balanced budgets.
  • Sindh is expected to have a small surplus.
  • Balochistan is projected to remain in deficit.
• Fiscal Challenges:
  • Revenue transfers fell short of targets due to underperformance of the Federal Board of Revenue (FBR).
  • Increased salary and allowance costs pushed current expenditure beyond budget.
  • Over-optimistic assumptions about foreign assistance led to financial misalignment.

5. Development of Provincial Taxes

• New Tax Powers:
  • Provinces now have the authority to levy:
    • Sales tax on services.
    • Capital Value Tax (CVT), Capital Gains Tax (CGT), and Agricultural Income Tax (AIT).
  • These powers are expected to help raise the low tax-to-GDP ratio of Pakistan.
• Potential Revenue Sources:
  • AIT: Existing rates are low and enforcement is weak.
  • Urban Immovable Property Tax (UIPT): Can be expanded by removing exemptions and updating rental values.
  • Service Tax: Can be broadened to include more sectors like business services and private security.
  • Irrigation Charges (abiana): Currently insufficient to cover O&M costs; rationalization is needed for efficient water use.

6. Borrowing and Debt Levels

• Provincial Borrowing Powers:
  • Provinces now have greater access to domestic and foreign borrowing, but this must be monitored.
  • Combined provincial debt is about Rs 800 billion, less than 5% of GDP, mostly concessional foreign debt.
  • Interest payments range from 3% to 8% of current expenditure.
• Need for Fiscal Rules:
  • Experience from Latin America and India suggests the need for fiscal rules, including debt ceilings, to ensure sustainable borrowing.
  • A Provincial Fiscal Responsibility Act similar to the federal one (2005) is recommended.

7. Major Risks for Provincial Finances

• Key Risks Identified:
  • Shortfall in Revenue Transfers: Due to FBR's failure to meet targets.
  • Excess Current Expenditure: Driven by salary increases and flood relief costs.
  • Over-optimistic Foreign Assistance Projections: May lead to financial imbalances.
• Future Outlook (2012-13):
  • The 2012-13 budget is expected to see a surge in development spending, increased borrowing, and a rise in deficits.
  • Taxation measures may be delayed until after the elections.

8. Need for New Revenue Sharing System and Fiscal Rules

• Divisible Pool (DP):
  • A higher share for provinces in the DP may be justified due to the full financial liabilities of devolved functions.
• Fiscal Rules:
  • A system of fiscal rules, particularly debt ceilings, is needed to ensure financial sustainability.
  • The report recommends a mechanism similar to the 11th Finance Commission of India.

9. Other Emerging Issues

• Pending Issues:
  • Devolution of specific functions like drug control, inter-provincial wheat supplies, and agricultural research.
  • Distribution of assets/liabilities to entities like EOBI and WWF.
  • Joint ownership of natural resources between federal and provincial governments.
  • Impact of the 18th Amendment on the planning process.
  • Future role of local governments.
  • Overall implications of decentralization on economic growth.

10. Monitoring the Devolution Process

• Importance of Monitoring:
  • A robust monitoring system is essential to assess the quality of service delivery before and after the devolution.
  • It helps identify disruptions or breakdowns due to institutional or financial constraints.
• Recommendations:
  • Donors should provide technical assistance to help resolve issues in the devolution process.
  • Lessons from other countries' decentralization experiences should be applied.