World Bank urges NFC overhaul to fix Pakistan’s fiscal imbalance

The World Bank has urged Pakistan to overhaul its fiscal federalism framework, warning that the current National Finance Commission (NFC) arrangement has created a structural imbalance between federal spending responsibilities and available revenues.

In its report titled Strengthening Fiscal Federalism in Pakistan, released during a media briefing on Wednesday, the World Bank said the 18th Constitutional Amendment and the 7th NFC Award were major steps towards decentralisation, but their financing and institutional arrangements remain incomplete.

The report said the existing system continues to weaken fiscal discipline, limit revenue mobilisation and affect service delivery, as spending responsibilities, taxation powers and accountability mechanisms remain misaligned.

The lender said reverse grants included in the federal budget for FY2026-27 may offer short-term relief, but broader reforms are needed to place the fiscal framework on a sustainable footing.

According to the report, Punjab has allocated more than Rs546 billion and Sindh Rs260 billion in reverse grants for the federal government. However, Khyber Pakhtunkhwa and Balochistan did not show any such allocation in their budget documents.

The combined allocation by Punjab and Sindh comes to Rs806 billion, which is Rs229 billion, or 22%, below the federal government’s estimate of Rs1.035 trillion in grants and receipts from provinces under Article 164 for FY2026-27.

Jaffer Askari, an economist working with the World Bank, said Khyber Pakhtunkhwa and Balochistan had not allocated any amount for reverse grants in their budgets.

The report was launched days after provinces agreed to provide Rs1.035 trillion in grants to support national security, large dams and a mechanism to stabilise fuel prices during crises.

Tobias Haque, Lead Country Economist at the World Bank, said reverse grants could help address vertical imbalances in the short term, but wider reforms would be required to resolve fiscal federalism challenges within the constitutional framework.

The World Bank said the federal government continues to spend in areas that fall under provincial responsibility after devolution, creating duplication, waste and blurred accountability.

It noted that total federal expenditure increased from an average of 11.2% of GDP during FY2002-09 to 13% during FY2010-24. Federal spending on devolved subjects rose from 0.5% to 0.7% of GDP during FY2008-24, including 0.5% of GDP spent on BISP by FY2024.

The report said the current NFC framework reduced federal resources without a corresponding reduction in federal expenditure responsibilities, contributing to a structural federal fiscal deficit and accumulation of public debt.

It also said weak revenue performance, macroeconomic pressures and the mismatch between federal financing and functional needs have contributed materially to Pakistan’s fiscal deficit.

The World Bank recommended that the federal government reduce spending that overlaps with provincial mandates. It said savings should first be identified, after which an assessment of federal revenue potential should determine whether further vertical rebalancing is required.

The report proposed function-specific deductions from the divisible pool to share the cost of federal spending on national public goods, including national transport infrastructure, certain security expenditures, debt servicing, social protection, environmental programmes, strategic interprovincial water infrastructure and national policy coordination.

It said the government could also consider changes to the composition of the divisible pool or temporary reductions in the provincial revenue share, if agreed by all parties, to address urgent fiscal needs, such as a reduction in outstanding debt.

The lender also highlighted spending patterns in the provinces, saying additional transfers after the 18th Amendment did not sufficiently improve social services.

While provincial spending on basic services increased, the largest single rise was in administrative expenses. Around 80% of consolidated provincial expenditure continues to be absorbed by recurrent costs, with much of the increase going to general public services and administrative costs rather than education or health.

The report said current expenditure absorbed about 82% of the incremental resources transferred to provinces during FY2009-23. Real provincial spending on salaries increased by 250% during the period, while spending on pensions rose by 330%.

Additional salary expenditure on education accounted for 36% of the incremental wage bill, while health accounted for 18%.

The report also pointed to continued growth in civil service employment despite devolution. It said the number of civil servants working in devolved functions remained unchanged through FY2024, while federal employment in non-devolved sectors rose by 191,004 employees, or 85%, between FY2009 and FY2024.

The increase was largely linked to expansion in non-military security personnel. According to the report, units originally set up for border security are now performing domestic policing functions, which are constitutionally devolved to provinces.

The World Bank said these forces operate at the provincial level, but their salaries are 70% federally funded, while provinces contribute only 30% as a special allowance.

Bolormaa Amgaabazar, Country Director of the World Bank, said some adjustments could be made in the NFC formula without politicising the issue. She said the first phase of devolution had not achieved the intended objective of improving social services.

The report recommended replacing the current complex multi-factor NFC formula with a transparent fiscal gap approach. Under this model, divisible pool resources would be allocated on the basis of standardised assessments of expenditure needs and own-source revenue capacity.

The World Bank said such a system would avoid disincentives to revenue collection and prevent provinces from being penalised for fiscal efficiency.

It also recommended conditional transfers linked to measurable service delivery outcomes in devolved sectors such as education and health. These transfers, it said, should be verified by an independent third party and supported by stronger federal and provincial statistical systems.