Pakistan's Fiscal Free-Ride: Tying Provincial Funds to Local Taxes

The Problem, Stated Plainly

Pakistan's fiscal federalism, as currently structured by the 7th National Finance Commission (NFC) Award, has become a primary enabler of provincial fiscal irresponsibility and a significant contributor to the federal government's burgeoning debt crisis. While the 2010 Award was lauded for enhancing provincial autonomy by increasing their share of the divisible pool to 57.5 percent, it inadvertently created a perverse incentive structure: provinces receive substantial federal transfers without commensurate pressure to mobilize their own revenue. This fiscal free-riding has allowed provincial governments to neglect vast, undertaxed sectors like agriculture and real estate, perpetuating an inequitable tax system that disproportionately burdens the formal economy and salaried class. The federal government, meanwhile, is left to shoulder an ever-increasing debt burden, with debt servicing consuming a staggering portion of its net revenue. This imbalance is not merely an accounting anomaly; it is a structural flaw that undermines national fiscal stability, stifles development, and entrenches the power of untaxed elites at the provincial level. The time for polite debate is over; Pakistan needs a bold renegotiation of the NFC Award that ties provincial funding directly to their performance in local tax mobilization.

Tying Provincial Transfers to Tax Effort is Not an Option, It's a Necessity

The current fiscal arrangement in Pakistan, enshrined in the 7th NFC Award, has inadvertently fostered a culture of dependency among provinces. With 57.5 percent of the federal divisible pool automatically transferred to them, provinces have little incentive to broaden their own tax base, particularly in politically sensitive sectors like agriculture and real estate. This is not a theoretical concern; the numbers paint a stark picture. In fiscal year 2026, the total agricultural income tax base was estimated at a staggering Rs. 3.7 trillion, yet provincial collections amounted to a mere Rs. 8.4 billion. This represents an abysmal collection rate, highlighting a profound failure in provincial fiscal governance. Similarly, property tax collection in Pakistan stands at a dismal 0.08 percent of GDP, a stark contrast to 5 percent in Malaysia, 3 percent in Indonesia, and 2 percent in India. These figures are not indicative of a lack of potential, but rather a lack of political will and robust enforcement mechanisms at the provincial level. The federal government, meanwhile, is left grappling with a massive fiscal deficit, projected at 5.9% for FY 2024-25, and a public debt-to-GDP ratio of 70.39 percent in 2024. A significant portion of federal revenue is consumed by debt servicing, leaving limited fiscal space for critical development expenditures. This vertical fiscal imbalance, where the federal government bears the brunt of revenue generation and debt, while provinces enjoy a substantial share of transfers without reciprocal effort, is simply unsustainable. The next NFC Award must fundamentally alter this dynamic by introducing a performance-based component, directly linking provincial transfers to their success in mobilizing own-source revenues. This would not only incentivize fiscal responsibility but also unlock significant untapped revenue potential, contributing to overall national fiscal health. The argument that this infringes on provincial autonomy is a red herring; true autonomy comes with responsibility, and the current system allows provinces to shirk the latter while enjoying the former.

Learning from Others: Performance-Based Transfers in Federations

Pakistan is not unique in its struggle with fiscal federalism, but it can certainly learn from other federations that have successfully implemented performance-based fiscal transfers. India, for instance, through its Finance Commissions, has increasingly incorporated incentives for states to improve their fiscal performance, including revenue mobilization and expenditure efficiency. While population remains a significant factor, indicators like tax effort and fiscal discipline are gaining prominence in allocation formulas. This encourages states to not merely rely on central transfers but to actively pursue their own revenue streams. Similarly, countries like Brazil have experimented with mechanisms that link federal transfers to states' and municipalities' adherence to fiscal responsibility laws and their performance in delivering public services. These models demonstrate that a balance can be struck between ensuring equitable resource distribution and incentivizing fiscal prudence. The World Bank, in its analysis of Pakistan's fiscal decentralization, has also highlighted the need for improved incentives for local revenue mobilization and reduced dependence on unpredictable transfers. The current 7th NFC Award, while a step towards greater provincial autonomy, has remained stagnant for fifteen years, despite a constitutional mandate for revisions every five years. This prolonged adherence to an outdated formula, largely driven by political economy considerations and a unanimity rule, has compromised the dynamic nature of resource distribution. The lack of a dedicated NFC secretariat and insufficient research support further exacerbate the problem, hindering the development of an efficient and equitable formula that balances need with performance. By incorporating a robust performance-based component, Pakistan can move towards a more mature fiscal federalism, where provinces are empowered not just by receiving funds, but by actively generating them, fostering a stronger sense of ownership and accountability.

"The current NFC Award has become a shield for provincial fiscal inertia, allowing elites to evade their fair share while the federal government drowns in debt."

The Counterargument — And Why It Fails

The most vocal counterargument against renegotiating the NFC Award, particularly to tie transfers to provincial tax mobilization, centers on the sanctity of provincial autonomy and the fear that such a move would roll back the gains of devolution. Defenders argue that the 18th Amendment and the 7th NFC Award were landmark achievements, granting provinces much-needed fiscal space and decision-making power over devolved subjects like health, education, and infrastructure. They contend that any attempt to link transfers to tax effort would be perceived as federal overreach, potentially leading to political instability and undermining the cooperative spirit of federalism. Furthermore, some argue that provinces face unique challenges in tax collection, including administrative capacity gaps, political sensitivities, and the inherent difficulty of taxing informal sectors. They might also point to the fact that the 7th NFC Award's horizontal distribution formula already includes a 5% weightage for revenue generation, suggesting that incentives already exist.

However, this defense, while appealing in its commitment to devolution, fundamentally misinterprets the nature of true autonomy and ignores the dire fiscal realities. Autonomy without accountability is a recipe for inefficiency and inequity. The current system, far from fostering robust provincial governance, has enabled a reliance on federal transfers that has stifled genuine efforts at local resource mobilization. The argument of administrative capacity is often a convenient excuse; the sheer magnitude of the 'tax gap' in agriculture (Rs. 880 billion in 2023-24 against Rs. 10 billion collected) and the abysmal property tax collection rates demonstrate a systemic failure of political will, not merely technical limitations. Moreover, the existing 5% weightage for revenue generation in the horizontal formula is demonstrably insufficient to incentivize meaningful change. The IMF, in its 2024 program, explicitly mandated bringing historically untaxed elite sectors like agriculture and property into the tax net, recognizing the domestic elite's subversion of tax efforts. Economist Savail Hussain rightly points out that despite rising federal transfers, human development outcomes have remained below par in most provinces, indicating a disconnect between fiscal transfers and effective service delivery. The federal government's fiscal space is severely constrained, with debt servicing consuming a disproportionate share of its budget. To ignore this reality in the name of an idealized, yet functionally flawed, notion of provincial autonomy is to condemn Pakistan to perpetual fiscal instability and underdevelopment. The revision is not an assault on devolution; it is a necessary evolution towards a more responsible and sustainable federal system.

What Must Actually Happen — A Concrete Agenda

To steer Pakistan away from its current fiscal precipice, a fundamental and courageous renegotiation of the NFC Award is imperative. This is not about stripping provinces of their constitutional rights, but about equipping them with the tools and incentives to become fiscally responsible partners in national development. The following concrete steps must form the agenda for the next NFC Award:

Conclusion

Pakistan stands at a critical juncture, where the long-term sustainability of its fiscal framework hinges on a courageous re-evaluation of the NFC Award. The current model, while intended to foster provincial autonomy, has inadvertently created a system of fiscal dependency and inequity, allowing powerful elites to remain largely untaxed while the federal government grapples with an escalating debt crisis. The evidence is undeniable: provinces are failing to mobilize their own revenue potential, particularly from agriculture and real estate, despite possessing the constitutional mandate to do so. This is not a failure of devolution itself, but a failure of accountability within the devolved framework.

The path forward is clear, albeit politically challenging. A renegotiated NFC Award that explicitly links provincial transfers to their performance in local tax mobilization is not an attack on provincial autonomy; it is an essential step towards strengthening it. True autonomy demands responsibility, and it is time for provinces to shoulder their fair share of the national fiscal burden. By adopting a performance-based approach, harmonizing tax laws, modernizing collection mechanisms, and establishing a robust, independent NFC Secretariat, Pakistan can unlock immense untapped revenue, foster a more equitable tax system, and build a fiscally resilient federation. The alternative is a continued slide into deeper debt and economic instability, a price too high for the nation to pay for the fiscal inertia of its federating units. The time for action is now, to forge a new fiscal compact that serves all Pakistanis, not just a privileged few.