World Bank flags gaps in Pakistan’s fiscal federalism despite progress

ISLAMABAD: Pakistan has made meaningful headway on fiscal federalism since 2010, but important departures from international standards and accepted practices still persist, the World Bank said in a report released on Tuesday.

In its report, Strengthening Fiscal Federalism in Pakistan, the World Bank identified four major weaknesses in the country’s fiscal framework. Expenditure responsibilities remain only partly carried out and are not clearly defined in some sectors, noting that the federal government continues to function in areas devolved under the 18th Constitutional Amendment. This overlap has led to waste and weakened accountability, while local governments still do not have clearly defined functions or adequate resources.

The 18th Amendment led to fragmentation in the tax system. While provincial powers over taxation were strengthened, particularly in relation to general sales tax on services, the World Bank said the tax base was split across five competing jurisdictions. This complexity increased compliance costs, discouraged trade between provinces and weakened overall revenue collection. It further noted that major tax bases, especially agricultural income and property, remain significantly underused.

The World Bank said federal-provincial transfer arrangements, including the National Finance Commission, have not met key policy goals. While the NFC has ensured predictability and protected provincial revenue shares, has not translated into better functional outcomes. The current arrangement reduced federal resources without a matching shift in spending responsibilities, contributing to a structural fiscal deficit at the federal level.

“The current framework reduced federal resources without a commensurate adjustment in expenditure responsibilities, driving a structural federal fiscal deficit,” the report read.

The NFC’s horizontal distribution mechanism has also fallen short of achieving genuine fiscal equalisation. The formula offers no meaningful incentives for provinces to improve revenue collection or service delivery performance, and may also discourage federal revenue effort because a large portion of collected revenues is automatically transferred to provinces.

On local government, the World Bank said that despite the constitutional recognition of Article 140A, local bodies remain fiscally dependent, institutionally unstable and effectively subject to provincial discretion. Provincial Finance Commission awards are infrequent and non-binding, transfers are made on an ad hoc basis and local governments generate little revenue of their own. The report concluded that devolution has not meaningfully extended below the provincial level.

Impact on deficits, revenues and service delivery

These departures from good practice have produced several negative outcomes, including a structural federal fiscal deficit, weak revenue performance, limited success in aligning spending and services with actual needs, and weak institutional protection for the fiscal federalism system.

According to the World Bank, provincial revenues, including federal transfers, rose from less than 4 per cent of gross domestic product in fiscal year 2010 to an average of 6.5pc over FY10 to FY24, while federal expenditures did not decline in line with this shift. The loss in federal revenues from transfers, estimated at 1.9pc of GDP, was roughly equal to the increase in post-devolution federal primary deficits of 1.7pc of GDP. A mismatch between federal financing and functional needs had contributed to Pakistan’s fiscal deficit and growing public debt.

On revenue performance, the World Bank said the division of the tax base across five jurisdictions had distorted incentives, raised compliance burdens and created room for avoidance. Federal revenues have continued to underperform significantly and that despite expanded tax assignments for provinces, own-source tax revenue has scarcely risen. Agricultural income tax remains largely uncollected even though agriculture accounts for more than 20pc of GDP, while urban immovable property tax yields only 0.13pc of GDP compared to 0.3 to 0.6pc in comparable countries.

The World Bank also said fiscal federalism has had only a limited effect in matching public spending and service delivery to actual requirements, contrary to the expected benefits of devolution. Although provinces increased spending on basic services after the 18th Amendment, the biggest single rise was in administrative expenses. About 80pc of total provincial expenditure went to recurrent costs, with most incremental spending absorbed by general public services and administration rather than health or education.

Spending patterns remain geographically unequal, with district allocations continuing to reflect historical precedent instead of poverty levels or service delivery gaps. For local governments, total government spending declined from 10pc in 2005 to 4.7pc in 2024.

The World Bank said institutions meant to support fiscal federalism have also underperformed in monitoring and coordination. The Council of Common Interests held only 11 meetings between 1973 and 2010 despite a constitutional requirement to meet every quarter, while a successor NFC Award has been delayed for more than a decade and a half.

Reform priorities outlined

The report proposed a number of reforms to make the fiscal federalism framework more effective. The first priority should be to correct the mismatch between the financing and functions of the federal and provincial governments. The World Bank said the ongoing federal rightsizing exercise aimed at cutting wasteful spending that overlaps with provincial mandates should be prioritised regardless of broader reforms, and said international examples should be used in shaping the process.

Once achievable savings are secured, a federal revenue potential assessment should be used to decide whether more vertical rebalancing is necessary and to what extent. Remaining gaps could then be addressed through tools such as function-specific deductions from the divisible pool to share the burden of federal spending on national public goods, including transport infrastructure, some security expenditure, debt servicing, social protection, environmental programmes, strategic interprovincial water infrastructure and national policy coordination.

For horizontal distribution, the World Bank recommended an approach that achieves equalisation while also encouraging sound fiscal behaviour. It proposed a transparent fiscal gap model in place of the current multi-factor formula, under which divisible pool resources would be distributed on the basis of standardised estimates of spending needs against each province’s own-source revenue capacity. This would remove disincentives to revenue effort and avoid penalising provinces for fiscal efficiency while preserving provincial fiscal autonomy. It cited Australia, Canada, China, Nigeria and South Africa as examples of countries using similar systems.