Vertical Fiscal Imbalance, Economic Growth and Decentralization

Abstract

Irrespective of the degree of tax and expenditure decentralization, every federation and unitary state face the problem of Vertical Fiscal Imbalance (VFI). The transfer dependency of subnational governments led them to substitute central transfers over their own revenue effort and this is historically evident in Pakistan. The contribution of provincial own revenues to the provincial expenditures is not much decent, which led to higher magnitude of VFIs. This paper is an empirical investigation of VFI, and its determinants. Based on a strongly balanced panel data at provincial (subnational) level from 1971 to 2021, we studied the effect of economic growth, tax decentralization, expenditure decentralization, and Eighteenth Amendment to the Constitution on VFIs. One of the key distinctions of this paper is modelling economic growth using per capita energy consumption which includes electricity, natural gas and set of petroleum products. Economic growth proxied through per capita energy consumption has negative association with VFI which means a corrective effect on VFI. Similarly, tax decentralization is also negatively associated with VFI, which obviously means corrective effect and less transfer dependency on federal government. To the contrary a positive association between expenditure decentralization and VFI is indicative that increase in government size/budget outlay are broadly financed through federal transfers thereby creating larger vertical fiscal imbalances. This also give policy prescription for future, that tax decentralization has disproportionality higher benefits compared to expenditure decentralization in terms of magnitude of VFIs. Based on different model specifications, we found that Eighteenth Amendment to the Constitution has both corrective and expansionary effect on VFIs.