FISCAL FEDERALISM OR FISCAL FOOLISHNESS?

UNCLAS SECTION 01 OF 02 ISLAMABAD 003077 SIPDIS SENSITIVE E.O. 12958: N/A TAGS: ECON EFIN EAID PGOV PK SUBJECT: FISCAL FEDERALISM OR FISCAL FOOLISHNESS? REFTEL: A) PESHAWAR 214 B) ISLAMABAD 2829 ¶1. (SBU) Summary: In a move heralded in the Pakistani press as a "historical shift to provincial autonomy" and a "victory for democracy," the National Finance Commission (NFC) reached a consensus on the formula for revenue division between the federal and provincial governments on December 11. Agreed upon unanimously by the NFC after four months of active negotiations (and seven years of deadlock),the formula awards a significantly expanded percentage of the pool of GOP funds to the provinces. What remains to be seen, however, is whether the provincial governments have the capacity to deliver needed social services and the fiscal responsibility to stay within their newly expanded budget parameters. If the provinces overspend or spend poorly, the federal government will be hard pressed to avoid budget-busting assistance, to the detriment of IMF-agreed spending targets. End Summary. - - - - - - Background - - - - - - ¶2. (SBU) The federal and provincial governments reached consensus on the National Finance Commission (NFC) award on December 11, setting the formula for the division of the country's financial resources through the Commission for the first time since 1997 (Ref B). The Constitution of Pakistan mandates that the NFC examine and agree upon the division of tax revenue between the federal government and the provinces of Pakistan every five years. However, attempts to find consensus through an NFC have failed since 2002. In the absence of an NFC award under the Musharraf administration, the division of resources was announced through executive order. This latest award is the seventh in the history of Pakistan. - - - - - - - - - - - - - - The Structure of the Award - - - - - - - - - - - - - - ¶3. (SBU) Under the new award, the provinces will receive 56 percent of the total pool during the first year of the award (Pakistani FY10-11) and 57.5 percent of the total funds for the four remaining years of the award. This "vertical" distribution between federal and provincial funds currently gives the provinces 47.5 percent of the divisible pool. ¶4. (SBU) For the first time in Pakistan's history, the provinces agreed to divide the pool of funds on the basis of multiple criteria, instead of solely on population. The less populous provinces of NWFP and Balochistan had been lobbying for the inclusion of more criteria since the 1980s and Dr. Gulfaraz Ahmed, Balochistan NFC representative, reported that from the earliest meetings of this NFC, the group had agreed that the new formula must be more comprehensive. The final award was based upon the following criteria, weighted to percentages agreed to by the group: population (82 percent),poverty (10.3 percent),revenue collection (5 percent),and low population density (2.7 percent). ¶5. (SBU) Representatives from Sindh, home of business hub Karachi, were eager to have collection of revenue be one of the criteria included in the formula. As revenue collection is credited to a business's headquarters no matter where in the country transactions take place, Sindh would have by far the greatest share of revenue collection among the provinces. In order to create a more equitable division, the NFC allocated an equal weight to revenue generation and revenue collection under the "revenue collection" criteria. In exchange, Sindh was awarded a one-time transfer of $71.2 million (at a rate of 84 Pakistani Rupee to the dollar) from the federal government. ¶6. (SBU) Based upon the weighted criteria, the final shares of the divisible pool for the various provinces will be as follows: Punjab 51.74 percent, Sindh 24.55 percent, NWFP 14.62 percent and Balochistan 9.09 percent. - - - - - - - - - - - - - - - - Tax Collection: A Welcome Chore - - - - - - -- - - - - - - - - - ¶7. (SBU) Shaukat Tarin, Federal Finance Minister and NFC Chairman, announced that the fee currently charged by the federal government to collect the general sales tax on behalf of for the provinces would be reduced from five percent of the total pool to one percent, ISLAMABAD 00003077 002 OF 002 increasing the divisible pie by four percent. The federal government also agreed to the provinces' demand to implement their constitutional right to collect a sales tax on services, essentially allowing each province direct access to a revenue stream previously controlled by the federal government. - - - - - - - - - - - - - - - - Special Packages Seal the Deals - - - - - - - - - - - - - - - - ¶8. (SBU) The new award recognizes the NWFP's fiscal burden due to the ongoing conflict by providing the province an additional one percent of the entire, undivided pool of resources. Dr. Gulfaraz remarked to EconOff that with this formula, each of the three other provinces and the federal government are giving the NWFP a portion of their funds, thus sharing the burden of the war on terror, borne by NWFP alone up until now. ¶9. (SBU) Although the agreed-upon formula awarded Balochistan 7.17 percent of the divisible pool, the federal government and provinces agreed that Balochistan's special development needs warranted a share of 9.09 percent. Indeed, Finance Minister Tarin announced Balochistan would receive at minimum $985 million (roughly equivalent to the 9.09 percent) for every year of the award, and if resources were not available from the divisible pool, the federal government would make up the difference from its own resources. Net profits owed the provinces by the parastatal Water and Power Development Authority (WAPDA) for hydro-electric power generation were also paid out by the federal government before the third round of NFC negotiations (Refs A and B). - - - - - - - - - - - - - - - - - - - With Resources Comes Responsibility... - - - - - - - - - - - - - - - - - - - ¶10. (SBU) Dr. Gulfaraz proudly reported to EconOff that all federal grants to the provinces, which had equaled around 10 percent of the federal share of the divisible pool under the previous award, would be done away with in this NFC award on the unanimous demand of the provinces. "The provinces need funds to stabilize their governments," he said. "This is a long-term project and the provinces should not have to continuously look to the federal government for money." Dr. Gulfaraz applauded this move towards fiscal federalism and said he looks forward to greater prosperity and governmental effectiveness for the provinces under the new award. ¶11. (SBU) However, Safdar Parvez, an economist at the Asian Development Bank, expressed concern about the distribution of such a large percentage of the divisible pool to provincial governments that have limited experience effectively spending large sums of money on development. The provinces have a history of over-spending and now will be given full rein to spend without oversight from the federal level. More money to the provinces will likely lead to a waste of resources Pakistan can ill-afford, Parvez postulated. ¶12. (SBU) Furthermore, the federal government must now meet its financial obligations with less money, Parvez added. Of primary concern are obligations such as interest payments on domestic and international debt, which the GOP must meet in order to retain its good standing with the IMF. Military spending and large-scale public sector development projects could also be squeezed. ¶13. (SBU) Comment: This is fundamentally a good news story, given the history of failure on the part of the predecessor governments to work out an equitable distribution of funds. Even the ADB's skeptical Safdar Parvez admitted that the NFC's ability to come to amicable (if hard-won) consensus was "the best news we've seen in the papers for a long time." Nevertheless, the award could pose long-term risks as well. Past performance indicates that the provinces may well spend the country's carefully divided money with a recklessness Pakistan can ill-afford. If the provinces do come back to the hard-pressed federal government for additional funds and the GOP cannot muster the political will to resist, they could drive Pakistan into further debt to either the State or commercial banks. PATTERSON