Macro Bites

Macro Bite # 12

7 min read

Every year when the annual budget in Pakistan is released by the federal government, everyone becomes an economist and has something to say about it. Macro Pakistani wants to talk about important subjects like education and health, and the budgets allocated to them too. But in order to do that, it is important to understand who is responsible for what.

How does the government allocate funds to the budget in Pakistan?

After the 18th Amendment, Pakistan opted for a parliamentary form of government. This was supposed to devolve power to the provinces and their local bodies. Along with the amendment, the money sharing mechanism between the federal and provincial governments, called National Finance Commission (NFC) Award, also changed. With more subjects such as health and education handed to provinces, they required a higher share of revenue to be able to deliver. The new mechanism allowed provinces to receive 57.5% of the net divisible pool of revenues collected by the federal government. This was split across provinces using the following weights:

  • Population 82%
  • Poverty/backwardness 10.3%
  • Revenue collection 5%

Inverse population density 2.7%

Provinces need money

Source: Ministry of Finance

Before this new mechanism was introduced in 2010, provinces used to receive their share of revenue based on population alone, which unfairly disadvantaged Khyber Pakhtunkhwa (KPK) and Balochistan. While the largest share of the award is still based on population, the other metrics, though not perfect, have been a step in the right direction. The component of poverty/backwardness allowed provinces like KPK to catch up. The emphasis on revenue collection helped Sindh as it hosts a large tax-paying industry. The recognition of inverse population density allowed for a larger proportion of funds to flow to Balochistan with its low population but large land size.

The problem with over indexing on population is that it leads to perverse incentives. If Punjab knows it will keep receiving the largest share of revenue if its population keeps on increasing, it will not focus its energies on population control. India reduced the weight given to population in their finance commission to 25% and fixed the population to the shares in 1971. They did this to counter the perverse incentives and ensure no province gets to claim their populations were understated in the most recent census.

Federation needs money

Politicians and bureaucrats avoid ceding authority and relevance. Which is why the division of responsibilities between federal and provincial governments is still not clear. Islamabad still houses structures of a few devolved ministries such as Ministry for Federal Education and Training and Ministry of Food Security versus the provincial counterparts on education and agriculture

Source: Economic Survey of Pakistan 2019-20

In addition to the unclear devolution of power, the federal government has many responsibilities it needs to carry out as well. Think of subjects like military that have to be centralized. Because it only gets 42.5% of the revenue it generates now, the federal government has had to borrow heavily in the past few years from domestic and foreign sources to make ends meet.

Government causes inflation

So what happens when the government borrows heavily? We have discussed before how it crowds out private investment. We have also discussed how foreign loans, such as those we receive from the IMF regularly, have to be repaid in dollars. For this purpose, the country needs to generate dollars from exports, remittances or FDI in the country. In addition to these issues, government borrowing also causes inflation.

Source: State Bank of Pakistan (SBP)

More specifically, borrowing by the government from the Central Bank leads to inflation. You can see the inflation numbers at the bottom of the chart rise from 3.9% in September 2017 to 9.4% in March 2019, in tandem with share of SBP funding. This happened because SBP provided funds to the government by printing money. If you print money, you will have too much cash chasing too few goods. To simplify, think of two people wanting to buy the same shirt. The shirt costs PKR 1,000, both buyers have PKR 1,000 each but only one shirt is available. If all of a sudden, there is more cash available to both of them, they will each try to outbid the other and the price of the shirt will rise. Good news is that this practice of borrowing from the Central Bank has been restricted now so we can hope for these inflationary pressures to fade away.

Loans to pay off loans

Every new government comes in and blames the last one for taking on too many loans, which they have to repay by taking on even more loans. Close to 60% of the revenue collected by the federal government, goes to servicing old loans.

Source: Budget in Brief 2019-20; MP Analysis

In 2019, out of PKR 5 trillion revenue the federal government collected, almost PKR 2 trillion went out in interest payments alone. Another PKR 929 billion was used up in foreign loan repayments. This is after PKR 2.5 trillion had to be transferred to provinces to abide by the NFC Award. The federal government itself is left with no revenue after these expenditures and hence has to borrow. We will cover the other expenditures (e.g. military) that the federal government has to undertake, in later posts.

We reap what we sow

Apart from the resources transferred to provinces by the federal government, provinces also collect their own share of taxes (e.g. tax on services). However, resources are still limited for provinces and they are unable to carry out all the necessary expenditures they are responsible for.

Source: Economic Survey of Pakistan 2019-20; MP Analysis

This is specifically true for development expenditure. At Macro Pakistani, we have tried to drive home the importance of investment repeatedly. Provinces claim to not even have enough resources to cover their current expenditures and hence only 21% of total provincial expenditures are directed toward development or public investments. Other provinces, specifically Sindh, also claim to not get enough resources from the federal government due to an understated population. While the NFC Award covers 88% of all of Punjab’s expenses, it only covers 66% of Sindh’s burden. Hence, there seems to be merit in Sindh’s argument and will be explored in the new commission constituted recently.

Crazy Rich Karachi

One of the items that will be discussed by the new commission is grant-in-aids by the federal government to provinces for developmental projects. For those readers familiar with Karachi, this was the mechanism used to boost infrastructure development in the city back in the Musharraf era. This was the autocratic way of getting work done by giving funds to the smallest unit of local government and telling it exactly what to do.

Source: Karachi Budget; SAMAA

Most Pakistanis would have heard of the woes the city of Karachi has had to face in the last decade. Which is why it is a good example to use when explaining the benefits of appropriate devolution of power and allocation of budget in Pakistan. Read the full article if you want to understand how power is yet to be devolved to the smallest governing units in Pakistan. The country went from an autocracy, bypassing provinces, commanding local governments, to most provinces failing to effectively transfer autonomy to local governments today. We will discuss how the country has performed on the devolved subject of education next time, to better understand issues with allocation of budget in Pakistan

Read the full article in the link below

How are funds allocated to the budget in Pakistan?

Analysis of the division of government revenues between provinces, where budget in Pakistan is spent and why public debt has risen in the past.

Read more

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Faiz Ahmed

MBA Candidate at Harvard Business School with prior experience at Bain & Company, International Finance Corporation and State Bank of Pakistan. He is also the Founder of Macro Pakistani.

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