Fiscal Decentralisation and Economic Growth in Pakistan
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ABSTRACT: One strand of endogenous-growth models assumes constant returns to a broad concept of capital. The author extends these models to include tax-financed government services that affect production or utility. Growth and saving rates fall with an increase in utility-type expenditures; the two rates rise initially with productive government expenditures, but subsequently decline. With an income tax, the decentralized choices of growth and saving are "too low," but if the production function is Cobb-Douglas, the optimizing government still satisfies a natural condition for productive efficiency. Empirical evidence across countries supports some of the hypotheses about government and growth. Copyright 1990 by University of Chicago Press.Journal of Political Economy. 02/1990; 98(5):103-26.
- Federalism, Decentralisation, and Economic Growth..
The Pakistan Development Review
45 : 4 Part II (Winter 2006) pp. 845–854
Fiscal Decentralisation and Economic
Growth in Pakistan
SHAHNAWAZ MALIK, MAHMOOD-UL-HASSAN, and SHAHZAD HUSSAIN*
Fiscal decentralisation is seen as a means to enhance the economic efficiency of
the government and also promote economic growth. Fiscal decentralisation is the
empowerment of fiscal responsibilities to the sub-national governments, involving
devolution of powers to tax and spend along with arrangements for correcting the
imbalances between resources and obligations. The effectiveness of fiscal
decentralisation depends upon: (a) appropriate expenditure assignments—with division of
functions among different levels of government depending upon their comparative
advantage (called the principle of subsidiarity); (b) appropriate tax or revenue
assignments; and (c) the efficient design of a system of transfers and its proper
implementation [Kardar (2006)].
Many developing countries are turning to different forms of fiscal
decentralisation because it is a possible way to get rid of the traps of ineffective and
inefficient governance, macroeconomic instability and inadequate economic growth.
Economists and policy-makers are of the view that the decentralisation of a nation’s
fiscal structure is an effective strategy to promote economic growth and
development. However, it is surprising that some existing studies found negative
association between economic growth and fiscal decentralisation in cross country
study as well as a country case study. In spite of this negative association between
economic growth and fiscal decentralisation, developed and developing countries are
reviving their debates on fiscal decentralisation.
The primary propose of this study is to analyse the impact of fiscal decentralisation
on economic growth of Pakistan. The rest of the paper is constructed as follows. Section
II will take brief review of previous studies on the subject. In Section III, we will
summarise the trends in fiscal allocation between central and provincial governments.
Section IV will describe the model and methodology. Estimation results will be presented
in Section V. Section VI will conclude the study.
Shahnawaz Malik <email@example.com> is Professor of Economics, and Mahmood-ul-Hassan
<firstname.lastname@example.org> and Shahzad
postgraduate students at the Department of Economics, Bahauddin Zakariya University, Multan.
Authors’ Note: We are thankful to Dr Imran Sharif Chaudhry for his valuable suggestions and
guidance for the preparation of this paper. We are also thankful to Mr Tony Venables, Professor of International
Economics, London School of Economics and Political Science, UK, for his comments as a discussant of this
paper in 22nd AGM and Conference of the PSDE (Lahore, 2006).
Hussain <email@example.com> are
Malik, Hassan, and Hussain
II. LITERATURE REVIEW
There is extensive literature on the relationship between fiscal decentralisation and
economic growth. Different studies found different results for developing as well as
developed countries but no study found on the same relationship in the context of
Pakistan. Phillips and Woller (1997) suggested that there exists a statistically significant
though trivial inverse relationship between the level of revenue decentralisation and
economic growth in sample of developed countries. They failed to find any relationship
between fiscal decentralisation and economic growth in sample of less developed
countries. Their data set consists of annual observations on twenty-three less developed
and seventeen developed countries for the years 1974 through 1991.
Zhang and Zou (1998) using the provincial panel data for the period 1978-1992 for
China, found that a higher degree of fiscal decentralisation of government spending is
associated with lower provincial economic growth over the past fifteen years. This
consistently significant and robust result in their empirical examinations is surprising in
light of the argument that fiscal decentralisation usually makes a positive contribution to
local economic growth.
Jin and Zou used the panel data set for China’s 30 provinces for the time period
from 1979 to 1993 and 1994 to 1999 separately. The results suggested that in both time
periods, expenditure and revenue decentralisation levels should further diverge to benefit
Xie, Zou and Davoodi (1999) found for the high-income country United States
(covering the period since 1949) a highly insignificant effect of fiscal decentralisation on
economic growth. They argue that the degree of fiscal decentralisation in this country may be
at an optimal level so that benefits from a further rise of fiscal decentralisation are unlikely.
Lin and Liu (2000) used the province-level panel data of 28 provinces of China for
the period 1970-1993. They examined the effect of fiscal decentralisation on economic
growth by using a production-function-based regression analysis framework. They
suggested that fiscal decentralisation has made a positive contribution to growth process.
They also concluded that rural reform, the non-state sector and capital accumulation
along with fiscal reform are the key deriving forces of China’s impressive growth over
the past 20 or so years.
Thieben (2001) reviewed the benefits and shortcomings of fiscal decentralisation
for OECD countries for the period of 1975–1995. He used the pure cross-sectional
technique for analysis. He concluded that there is no relationship between economic
performance of high-income OECD countries and reliance of sub-national governments
on own revenue sources to finance their expenditures. Although it appears that increasing
self-reliance and capital formation are positively related, the associations between self-
reliance, on the one hand, and TFP growth and economic growth, on the other, are
Martinez-Vazquez and McNab (2001) concluded that it is still an open question
for empirical search for a direct relationship between fiscal decentralisation and
economic growth. Much less attention has been devoted in the literature to the indirect
channels through which fiscal decentralisation may effect economic growth, through the
impact of fiscal decentralisation on economic efficiency, the regional distribution of
resources, and macroeconomic stability.
Fiscal Decentralisation and Economic Growth
Ebel and Yilmaz discussed the topic of measurement of decentralisation and
different models on the relationship between fiscal decentralisation and economic
growth. Discussing the fiscal designs of OECD countries, they concluded that
decentralisation is surprisingly difficult to estimate and data, used by different authors, in
spite of many merits, falls short of providing full picture of fiscal decentralisation.
Mello and Barenstein (2001) used the cross-country data for up to 78 countries for
the period 1980-1992 and concluded that the higher the share in total sub-national
revenues of non-tax revenues and grants and transfers from higher levels of government,
the stronger the association between decentralisation and governance.
Martinez-Vazquez and McNab (2003) using panel data set for 52 developing and
developed countries for the period 1972-1997, examined the direct and indirect relationship
between fiscal decentralisation and economic growth and macroeconomic stability. They
found that decentralisation appears to reduce the rate of inflation in the sample countries,
does not appear to directly influence economic growth, and has an indirect, positive effect
on growth through its positive influence on macroeconomic stability.
Feltenstein and Iwata (2005) give an empirical examination of the impact of fiscal
and economic decentralisation in China on the country’s economic growth and inflation,
using a vector autoregressive (VAR) model with latent variables. Their econometric
investigation offers strong evidence that there is a connection between decentralisation
and macroeconomic performance in China. Economic decentralisation appears to be
positively related to growth in real output for the entire postwar period in China. Fiscal
decentralisation seems to have adverse implications for the rate of inflation, especially
after the late 1970s. Decentralisation would therefore seem to be good for growth and bad
for price stability.
III. TRENDS IN FISCAL ALLOCATION BETWEEN THE CENTRAL AND
PROVINCIAL GOVERNMENTS IN PAKISTAN
(a) Overall Fiscal Status
We analyse the fiscal stance of Pakistan which has two sides to balance the budget,
namely revenues and expenditures. Fig. 1 shows that total expenditures accounted for
25.7 percent of GDP in 1990-91 compared to 17.6 percent of GDP in 2005-06. Total
expenditure in the National Accounts is divided into current and development
expenditures (as in Fig. 1). Throughout 1990s’ current expenditures have a lion’s share of
total expenditures i.e. 19.3 percent in 1990-91 and 16.5 percent in 1999-00. Current
expenditures have decreasing trend now i.e. 16.3 percent in 2002-03 compared to 13.4
percent in 2005-06. Although the change is not much significant but it is a positive start
which should be continued. Development expenditures decreased consistently during
1992–2001 from 5.7 percent in 1992–93 to 1.7 percent in 2000-01 and then increased
during 2001-2006 from 1.7 percent in 2000-01 to 4.2 percent in 2005-06. This shows the
overall Government expenditures as a share of GDP.
Total revenues are divided into two tax revenues and non-tax revenues. Total
revenues are 16.9 percent of GDP in 1990-91 and 14.2 percent in 2005-06 (as shown in
Fig. 2). There is no significant increase or decline in revenues. Tax and non-tax revenues
have also insignificant fluctuations.
Malik, Hassan, and Hussain
Fig. 1. Share of Expenditures Relative to the GDP
90 92949698 000204
As % of GDP
Source: Pakistan Economic Survey (Various Issues).
Fig. 2. Share of Revenues Relative to the GDP
90929496 980002 04
TAX REVNON TAX REVTOTAL REV
As % of GDP
Source: Pakistan Economic Survey (Various Issues).
(b) Relative Fiscal Status between the Central and Provincial Governments
Fiscal decentralisation can be measured by the relative sizes of central spending
and revenue collection and provincial spending and revenue collection. Pakistan has a
highly centralised structure, characterised by the constitutional assignment of powers and
the political, administration and fiscal systems [Kardar (2006)]. The Constitution of
Pakistan gives the power to the Federal Government to levy the most productive taxes
Fiscal Decentralisation and Economic Growth
under present conditions-taxes on non-agricultural incomes, taxes on import, production
or excise duties and sales taxes. Once collected, these taxes are then shared between the
federal government and the provinces and between the provinces and local governments
while the expenditure responsibilities are assigned to the sub-national governments. So,
the revenue side is not a good indicator of decentralisation compared to expenditure side.
Revenues are allocated between Federal and Provincial governments with help of
National Finance Commission which is formed by the President of Pakistan after every
five years. Since 1997, the share of the Government in the divisible pool has been fixed at
62.5 percent while the share of the provincial governments has been fixed at 37.5 percent.
Beginning 2006-07, the share of the provincial governments in the divisible pool will rise
annually to 41.5 percent, 42.5 percent, 43.75 percent, 45.0 percent and 46.25 percent
thereafter in coming years (Economic Survey, 2005-06).
Fig. 3 shows some evidence about the relative fiscal status of central and
provincial governments. In 1971-72, provincial governments had .29 percent of total
federal government expenditures as compared to 43.62 percent in 2005-06. So, there is an
increasing trend of fiscal decentralisation on the expenditure side. On the revenue side,
29 percent in 1971-72 as compared to 44.73 percent in 2005-06. Although, it is
increasing trend on the revenue side but still unsatisfactory. There are no significant
changes in the ratio of expenditures and revenues which is poor picture of
decentralisation of fiscal status from last 8 years in spite of increasing interest of present
government towards fiscal decentralisation and devolution of powers.
Fig. 3. Ratio of Provincial and Federal Expenditures and Revenues
Source: State Bank of Pakistan.
IV. METHODOLOGY AND MODEL
The present study is based on secondary source of data consisting annual
observations on Pakistan and all four provinces for the period of 1971–2005. We have
taken the real Gross Domestic Product at current factor cost as dependent proxy variable
to analyse the impact of fiscal decentralisation on economic growth of Pakistan. Lin and