Provincial budgets of 2025-26
There is generally a greater focus on the prospects for and likely features of the federal budget in the days before its presentation. This is increased by the lobbying, against or for, particular taxation proposals.
Undoubtedly, the macroeconomic implications of the impending federal budget are significant in terms of the impact on the rate of inflation due to higher indirect taxes, extent of 'crowding out' of the private sector from bank credit due to government borrowing and development impact of the spending on infrastructure projects and services.
However, there is need also to recognize that the four provincial budgets, both individually and collectively, also have important implications on economic and social development in the country.
First, as per the Constitutional allocation of services after the 18th Amendment, the provincial governments are responsible for the provision of basic social services like education, health, water supply and sanitation, and economic services like roads, bridges and highways, rural development and irrigation.
Second, the four provincial governments combined engage in much more development spending than the federal government. During the first three quarters of 2024-25, the national development expenditure was Rs 1536 billion. The share of provincial governments was as much as 80 percent.
Third, the provincial governments make a significant contribution to reducing the overall consolidated budget deficit. For example, the federal budget deficit in the period, July to March, 2024-25, was Rs 4023 billion. The consolidated deficit was brought down to Rs 2970 billion, by the generation of a cash surplus by the four provincial governments combined of Rs 1,053 billion.
The forthcoming provincial budgets must also be examined from the viewpoint of the substantial revenue raising potential of provincial taxes and the extent of their exploitation. Currently, the provincial tax-to-GDP ratio is only 0.7 percent of the GDP.
There are a number of provincial taxes with large 'tax gaps' currently. The agricultural income tax can yield an additional 0.8 percent of the GDP if the new tax law is implemented effectively. The revenue potential is enhanced by the highly inequitable distribution of farm area in the country. Only 1 percent of the farmers own 22 percent of the farm land.
The provincial governments also have access to a number of property-related taxes. This includes the urban immoveable property tax, stamp duty and the capital value tax on property. These taxes are also grossly underexploited currently and the potential additional revenue could approach 0.5 percent of the GDP. This will require listing of all properties above a minimum size and proper valuation of these properties.
The largest source of tax revenue currently of the provincial governments is the sales tax on services. There is need for proper documentation of transactions and full integration with the federal sales tax on goods. These measures could increase the revenues from the tax by almost 0.5 percent of the GDP.
Therefore, the overall revenue potential from provincial taxes is 1.8 percent of the GDP. The time has come to stop tinkering around with federal taxes and focus more on fundamental reforms in provincial taxes to raise substantially more revenues.
The IMF Programme is attaching for the first time more focus on provincial revenues. In particular, emphasis has been laid on development of the agricultural income tax.
There is need to look at the projections of finances in 2025-26 of the four provincial governments combined in the IMF Staff Report of 17th of May. This report was released after the successful completion of the first review of the IMF Extended Fund Facility.
The growth rate in provincial tax revenues is projected at 24 percent in 2025-26. With the nominal GDP expected to rise by 12 percent, the incremental fiscal effort in collection of the agricultural income tax is expected to be only Rs 120 billion, equivalent to hardly 0.1 percent of the GDP. Clearly, a more ambitious target needs to be set.
The level of provincial non-tax revenues is actually expected to decline from Rs 307 billion in 2024-25 to Rs 260 billion in 2025-26, for reasons which are not clear. The provincial governments have significant sources of non-tax revenue. The best example is of irrigation charges. These are extremely low currently and recover only 14 percent of the operations and maintenance costs incurred on the irrigation system, especially in Punjab and Sindh.
Turning to expenditures, the IMF Staff Report expects provincial current expenditure to rise by 15 percent in 2025-26. This is double the likely rate of inflation next year. Also, the current expenditure, excluding debt servicing, of the federal government is projected to rise by only 8 percent. As such, from the viewpoint of economizing on day-to-day expenditures the same target growth rate should be set for the increase in current expenditure of provincial governments.
Provincial development expenditure is expected to be higher by 12 percent, equivalent to the increase in the nominal GDP. Here again there is a bias. Federal development spending is anticipated to rise here also by 8 percent only. This is at the time when the federal PSDP must allocate substantially more funds for water resources projects as an insurance against diversion of water by India.
Overall, the implied provincial cash surplus is close to Rs 1500 billion, compared to the likely outcome of Rs 1000 billion in 2024-25. This will hinge on achievement of 22 percent growth in federal NFC fiscal transfers, which will only be possible if taxation proposals in federal taxes
raise an additional Rs 1100 billion in 2025-26.
In conclusion, the time has come for much more focus on provincial finances. The 'tax gap' in provincial taxes is very large and needs to be exploited on a high priority basis, especially since the incidence of these taxes is likely to be more progressive. The outcome should be the generation of substantially larger provincial cash surpluses, which ought to reach over 30% of the federal budget deficit in the next three years.
Copyright Business Recorder, 2025
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