Fiscal Federalism, Governance, Macroeconomic Performance and Economic Growth: An Analysis with Special Reference to Pakistan

Abstract

This dissertation consists of the analysis of the evolution, structure and practices of fiscal federalism in Pakistan and develops a framework for analyzing the impact of fiscal decentralization on economic growth in the presence of macroeconomic stability and quality of governance institutions. In addition, the dissertation aims to determine the optimal choice of taxes/transfers for Pakistan and to investigate budget spillover and fiscal policy interdependence at the provincial level for Pakistan economy. To achieve the abovementioned objectives, the dissertation is divided into four independent studies. The first study deals with the federalist politics and local government reforms for Pakistan. The study also highlights the fiscal performance of the country during the past few years. The analysis shows that provinces are now exerting considerable fiscal efforts along with improvement in tax collection. Provincial governments are performing a major role in development activities and variation in preferences of the sub-national governments for development expenditure is the outcome of provincial fiscal autonomy. The outcome of this study will help the policy makers and researchers to identify the existing status of the decentralized fiscal practices in Pakistan and to design better future policies for sub-national governments. The second study analyzes the impact of fiscal decentralization on economic growth and broadens the scope of assessment by allowing the impact of fiscal decentralization on economic growth to depend on nation’s macroeconomic stability and quality of governance institutions. The study uses a panel dataset of 33 developed and 20 developing countries over the period of 1996-2014. The study finds that fiscal decentralization is growth enhancing when supported by sound institutional structure in terms of rule of law, low corruption in government institutions, high bureaucratic quality and democratic accountability. Further, the results show that the effect of fiscal decentralization on per capita GDP growth rate is positive when it is complemented by stable macroeconomic conditions in terms of stability in prices, budget deficit and exchange rate. Therefore, in the absence of good governance and macroeconomic stability, decentralization is harmful to growth, however, decentralization can become growth enhancing if macroeconomic stability and quality of governance institutions exceed certain critical levels. All these conclusions hold for developed as well as developing countries. The third study follows the endogenous growth model developed by Barro (1990) and extended by Gong and Zou (2002) to understand how tax and expenditure assignments between federal and provincial government affect the choice of public policy, welfare and economic growth for Pakistan economy. The analysis shows that, an increase in federal income tax will boost the rate of growth as long as the income tax rate is less than or equal to 10% with given provincial taxes, preferences, technology and federal transfers. However critical level of provincial income tax rate that corresponds to maximum growth is estimated to be 5%. The analysis depicts that higher federal and consumption taxes improve the welfare of citizens, up to a certain level, through their positive impact on the rate of economic growth, however, provincial property tax entails larger distortionary effects for raising revenue relative to other taxes. The analysis shows that federal transfers for provincial spending have positive influence on growth rate, up to a certain level, although the effect of increase in the rate of federal transfers is not much significant. The result depicts that growth maximizing policy choices of income, consumption and property taxes are also consistent with welfare maximizing policy choices of taxation. The fourth study investigates fiscal policy interdependence at the provincial level for Pakistan by using time-space set of spending data and alternative measures to define neighborliness. The study estimated a kind of spatial lag/durbin model within seemingly unrelated regression framework to investigate whether variables observed in one unit affect the other units. The result shows that expenditure preferences of provincial governments are influenced by the expenditure choices of their neighboring provinces. In addition, provincial expenditure on law and order, health, education and economic services also seems to be influenced by the spending choices of neighboring provinces. Therefore, inter provincial spillover effects for aggregate and disaggregated provincial spending may requires a different composition for federal grants to provinces and an analysis of these spillover effects will provide innovative insights for federal and provincial budget formulation.