Fiscal Decentralization and Economic Growth in Pakistan

pecuniary DECENTRALIZATION AND ECONOMIC GROWTH IN PAKITAN A Thesis Submitted to the Faculty of Institute of Management Sciences, Peshawar In Partial Fulfilment of the Requirements for the Degree of MBA ( pay) (2009-2011) Institute of Management Sciences, Peshawar Chapter 1 Introduction agree to James Edwin Kee, pecuniary decentalisation is the devolvement of certain administrative and monetary powers and functions to the hired gun-national g all overnments.It worrywise room the shifty of responsibility to the dependent governments with concomitant accountability. The extent of pecuniary devolution stooge be mensural in endpoints of the powers of low-level governments to raise taxation or to incur expenditures. pecuniary devolution in the public sector has acquire capacious attention during the subsist two decades for many reasons. The implications of monetary self-reliance on the execution of instrument of sub level government and sparingal exploitation h as been canvas widely both for the developing and the veri give in world.In revolution countries, with the disinteg dimensionn of primevalized form, fiscal federal official officialism emerged and in many developing countries, like India, Brazil and Argentina, fiscal decentralization was debated regarding its heart and souls on economic stabilization. Some studies opinion as, how constantly, suggested that the consanguinity among the two has non been conclusive. financial devolution is reckoned as a key policy tool that ensures economic capacity and good disposal done pecuniary autonomy of the federating units.It drags to the integproportionn of provinces and enhances their participatory role in the economic development of a country. It relieves the central government from compensable attention to the details of monetary matters, in that locationby enabling it to nethertake the tasks at national level in a more eventive and efficient manner. Also, if the centra l government for some reasons becomes inefficient, then devolution can be a possible solution. It accele drifts suppuration and empowers the low-level governments by dint of financial autonomy and administrative empowerment.The devolution t on the wholeys the federating units more responsible as it brings the government closer to the sight. decentralisation policy has a positive effect on economic harvest- sequence as it helps implement social policies in a smash manner. In decentralized set ups, the lower tiers of governments know more ab egress the necessities and developmental needs of the people, which leads to economic faculty in improvement sales talk, at that placeby accelerating the egression rate at national and regional levels. This is to a fault callight-emitting diode the Oats Decentralization Theorem.It says that if the people in one municipality ar not provided with adequate public services, they may opt for shifting to opposite municipalities having mo re facilities. Financial autonomy reduces the wasteful utilization of resources by the central government. According to fowl and Smart (2002), for effective service delivery it is spellant that the recipient of coin has all the way mandate, sufficient resources and powers to energize decisions. Through decentralization, responsibilities as well as resources are devolved to the lower level governments (Rondinelli,1981).In this way , the federating units are empowered which enable them to use the resources to good effect , raise living standard of the people and distri notwithstandinge the piss load (Gordin, 2004). In Pakistans case, the significance of monetary devolution cannot be overemphasized. Pakistan is a federation having a centralized taxation system. The study chunk of tax tax revenue is get togethered by the central government, which is then distri provideded among the provinces to subvert financial disparities. hold 160 of the constitution empowers the presi dent that he shall constitute National Finance Commission later every five years for the dispersal of funds, taxes and opposite monetary assets among the federating units. The decision of the commission is called National Finance Commission Award. The commission is comp deck upd of the finance ministers of the federation and the provinces and such other persons as may be constitute by the president in consultation with the governors of the respective provinces. So far, seven NFC Awards subscribe to been announced, the latest be the 7th NFC Award of 2010.Except for the 1974 Award, there has been a growing tendency in the exile of revenue from the subject matter to the provinces. The 4th NFC Award was a meaning(a) move forward towards fiscal decentralization as it heighten the share of the provinces by 18% and accepted their right over hydel profit, developmental imbue and excise avocation on crude oil. The 7th NFC Award accepted the demands of Baluchistan, KPK, Sindh by d evising a legislation, wherein poverty, inverse universe of discourse density and under development pay also been given due weightage.Moreover, the idyl share has been compound from the previous 47. 5% to 56%. The provinces were also given the powers to turn around sales Tax on their declare. by-line this decision, the Sindh Province has already underinterpreted this task and claims to prolong collected 50% more Sales Tax in the first five months of the financial year compared to the corresponding consummation last year Dawn, Dec 10, 2011. The eighth Financial Award is scheduled to be held on 16th Dec, 2011.Apart from the resource dissemination Through NFC Award, Article 161 of the Constitution provides for exaltation of Royalty on natural resources to the respective provinces in the shape of surcharge on gas and crude oil. This will lead to greater transfer of funds from the effect to the provinces. With the 18th inbuilt amendment, the concurrent list has been abolis hed, and with it entry No. 49 in the 4th Schedule to the Federal legislative list has also been amended. As a result, the GST Services in Federal Excise mode have been assigned to the provinces.Despite the presence of this constitutional mechanism for resource distri only ifion, the smooth allocation of funds was interrupted due to deadlocks among the provinces over the distri stillion formula, and, resultantly, the NFC Award failed to narrow down the vertical and horizontal resource gaps. At the territorial dominion level, The National Reconstruction Bureau launched a decentralization programmed through Government Plan 2000, wherein it was acknowledged that without pecuniary Decentralization no authority is devolved, which gain emphasizes the importance of transfer of funds to the lower tiers of government.The above paragraphs introduce only one side of the picture. There are many studies which suggest that there is no contract relationship among fiscal devolution and economi c fruit and efficiency at the level of sub-national governments. As a matter of particular, there is also a strong case against the Fiscal federalism. It may lead to social inequalities as for instance, incomes and taxes may not be equitably distributed among the various regions of a country. Also, fixed be are associated with running administrations of low-level governments.So, in low-income countries it may not be justified to spend firm amount of the available funds on these expenses (Homme,1995). The relationship of Fiscal devolution and economic growth has been analyze extensively in recent years. So, large volume of literature is available on the topic. Different relationships were examine to establish any clear relationship amid Fiscal devolution and economic growth, but at odds(predicate) results were obtained both for the developed and the developing economies.Some studies have shown positive relationship, others negative and equable others no relationship at all be tween economic growth and fiscal autonomy. For Pakistan, too, studies have yet to find any clear relationship between financial decentralization and economic growth. Important contributions on this subject have been make by Zang and Zou(1998) ,Xie , Zou and Davoodi (1999) , Lin and Liu (2000) , Thieben (2001) , Martinez-Vazquez , McNab(2001) , Felenstine & Iwata (2005) and Kardar (2006) etc.This study identifies strengths and weaknesses of the existing Resource Distribution System (RDS) through historical review. It is chiefly believed that that square-toed information about the existing RDS will lead to better policy formulation, which will ultimately perplex the country on the road to prosperity. In this connection, it is also worthwhile to analyze the implications of the current resource distribution policies on the economic growth of the country. Thus, this study helps underwrite the extent of financial autonomy of the provinces and measures its long term benefits.Rest of th e study is arranged as follows Chapter 2 pertains to Literature review i. e. study conducted antecedently by other researchers on this topic In chapter 3 theoretical background and econometric methodology for our estimation is be debateed chapter 4 discusses sources of our info and construction of proteans chapter 5 covers results and interpretation thereof results and chapter 6 is about the mop up of research. Chapter 2 Literature Review 2. 1 IntroductionIn this chapter, we discuss the empirical studies related to our study i. e. sour done previously by other researchers on this topic. 2. 2 Previous empirical studies The significance of relationship between the financial autonomy and economic growth can be gauged from the volume of literature available on this topic. versatile important relationships were analyse to establish clear relationship between the two, but inconsistent results were obtained both for the developed and the developing economies.For Pakistan too stud ies have yet to find any clear relationship between financial decentralization and economic growth. On leafing through the pages of available literature, one comes across valuable work on the topic, some of which is discussed in the following paras Davoodi and Zou (1998) developed a theoretical perplex for studying the relationship between Fiscal autonomy and economic growth on the basis of averaged panel entropy of 46 countries. The study showed a negative relationship between the two for developing countries.Zhang and Zou (1998), while using mainland mainland Chinas provincial panel data for the accomplishment 1978-1992, found a negative association between provincial economic growth and the degree of financial autonomy over the past fifteen years. Philips and Woller (1997) studied the above referred relationship for seventeen developed and twenty three less(prenominal) developed countries on the data collected for the period 1974 to 1991. A negative weakly significant relatio nship was found for the developed world. However, no such relationship could be proved between the two variables for the less developed countries.Xie , Zou and Davoodi (1999) observed that there is a highly insignificant relationship between Fiscal Decentralization and economic growth for the coupled States, which the authors attributed to the fact that the country had already reached optimal level of fiscal autonomy and thus no further progress on this line was possible. Thieban (2001) made use of OECD countries cross sectional data for the period 1975 to 1995, but the study failed to establish any link between revenue decentralization of the low-level governments and economic growth of these countries.Martinez Vazquez and Mc Nab (2001) concluded that the relationship between fiscal decentralization and economic growth is still unclear, and that little attention has been paid to in subscribe factors through which fiscal devolution may influence economic growth. In contrast to the above findings, Lin and Liu (2000), while using panel data of 28 provinces for the period 1970 to 1993, arrived at the conclusion that there exists a positive relationship between fiscal decentralization and economic growth in China. The authors noted that the impressive growth of china for the last twenty years can be linked to fiscal reforms.Ebel and Yilmaz (2001), observed that Fiscal design of OECD countries is unable to explain Fiscal decentralization in true sense. Martinez Vazquez and Mc Nab (2003), on the basis of panel data, covering the period 1972-1997, studied the direct and indirect relationship between fiscal decentralization, economic growth and macroeconomic stability . They arrived at the conclusion that devolution minimizes the inflation rate, has no direct influence on economic growth, and has positive indirect effect on growth as it results in on macroeconomic stability.Justin Yifu and Zhiqiang (2000), investigated the implications of fiscal decentralization of e conomic growth in China, and found that it has made remarkable contribution to economic growth. This finding is in conformity with the possibleness that Fiscal devolution enhances economic efficiency. Fielstentein and Iwata (2005), while using VAR (Vector Auto regressive) example found that there is a relationship between decentralization and macro economic performance in China. They concluded that Fiscal decentralization is positively related to growth in the period after the war, and has negative effects on the inflation rate after the 1970s.While using the cross country data for 78 countries, Mello and Barenstein (2001) observed that as the share of receipts, including non-tax revenue, grants and transfer of funds, from the federal government ontogenys in the total provincial revenues, the relationship between financial devolution and governance grows stronger. Shah (1991) pointed out that poor performance in most of the developing countries in the last 40 years can be attribu ted to highly centralized regimes.Huther and Shah (1998) noted that good governance and fiscal decentralization are positively related, which in turn may enhance economic growth. Akai and Sakata (2002) used integrity country data and predicted that fiscal decentralization plays a role in economic development. They pointed out that in the United States, high government spending was required in the initial phases of economic development, therefore, any digest that took into consideration this period is bound to ove stay putimate the role of central government in the economic development.This led Xie et al (1999) to declare that decentralization has adverse effect on economic development. Jorge Martinez-Vazquez and Mark Rider (2006) pointed out the structure of financial system plays a pivotal role in determining the conduct and performance of low-level governments, which indirectly influence economic growth of a country. According to them, though both China and India show great fina ncial decentralization, the central governments restrict the fiscal autonomy of the sub-national governments through conditional grants and piteous powers to raise revenue.Thus, the regional governments are forced to use extra budgetary allocations to overcome their financial constraints, which results in waste of resources. These structural infirmities in the financial systems entail profligacy and unproductive expenditure policies, which may stymie the growth rate in the future in both the countries. Nobuo Akai, Yukihiro Nishimura and Masayo Sakata (2007), while using panel data of the fifty states of the US, showed that fiscal decentralization minimizes the variance of GDP growth due to decentralization among various levels of government.They also observed that there exists a negative relationship between fiscal devolution and economic volatility. Hiroko Uchimora and Yurika Suzuki (2009) studied Fiscal Decentralization in the Philippines after the promulgation of Local Governme nt code (1991) . This study examined the fiscal relationship between the central and sub national governments by using the indicators of Fiscal decentralization. According to their findings, in the Philippines, the responsibility to incur expenditures by the local anesthetic anaesthetic governments is not accompanied by corresponding strengthening of the fiscal capacity.As a result, local governments rely heavily on fiscal transfers from the central government and Internal Revenues aloneotment, which point the local finance unstable. Atushi Alimi(2004) Although , in theory, decentralization promises efficient provision of public services at local level, empirical evidence gives a mixed picture regarding its implications on economic growth. They attempted to resolve this contrariety by using instrumental technique on the data for the period 1997 to 2001.In this study, fiscal decentralization is measured in hurt of the ratio between local expenditure to total government expenditu re. The result showed a significant positive relationship between per capita growth rate and Fiscal decentralization. Perraton, J. and Wells, p. (2003), in their makeup, Multi level governance and Economic cohesion noted three general trends in economic policy reservation the transfer of powers to supranational institution in economic policy formulation, e. g. he formation of the European Union and realness Trade Organization secondly, almost all developed countries have established regional organizations, to which powers of economic policy-making have been devolved. In the transition states, there is a growing tendency towards decentralization to curtail expenditures and to make the governments more accountable thirdly, the governments are now inclined to reduce their sizes and make alternate arrangements for governance through NGOs. This concept of governance is referred to as multi-level governance.In Pakistans case, Fiscal Federalism has been studied in detail. According to A nwar Shah, World depone (Dec, 2006), there are two ways of transferring funds from the Centre to the provinces assigning share of the federal revenues to the provinces at a pre-determined rate and direct transfer of funds (other than revenue) from the Centre to the provinces. According to him, the revenue manduction system in Pakistan affects the transfers in a lump sum and predictable manner to the federating units, which are at shore leave to use these funds the way they choose.The author further argues that NFC places greater responsibility of revenue ingathering on the Federal government, thereby making the tax machinery efficient and tax compliance cost effective. The Revenue sharing system may have its merits, but it is also associated with certain demerits. For example, the provinces enjoy vast discretion in the utilization of funds, but have no control over the amount of funds they acquire from the union the federal government cannot influence the provinces to set pri orities for achieving uniform standards in reas like health and Education the provinces receive the funds without any strings attached to it , therefore, they feel less accountable while spending the funds the share received by the provinces have no relation with the expenditures they incur, as usually the expenditures outgrow the rate at which the Federal revenue grows. Nighat Bilgrami and Mahpara Sadaqat (2006) have given an account of evolution and working of NFC Award ever since its introduction in 1951. According to the authors, with the providedion of 1974 Award, there is a growing tendency in increase of revenue transfer to the provinces.The study step forward in this direction was the 1991 NFC Award, wherein new taxes were included in the divisible pool. In addition, as envisaged in Article 161 of the Constitution, royalty on crude oil and surcharge on gas were also transferred to the provinces. This caused greater decentralization of funds, which over a period of time co mpete a pivotal role in improving service delivery in health, education and irrigation etc sectors. The newsprint identifies various forms of fund transfers from the Federal government to the provinces.These include Revenue Sharing grafts, Straight transfers, Recurring Grants, knowledge Grants and loans. The authors have also elucidated that how resources are transferred in Pakistan from the federal government to the provinces in four ways from the centre to the provinces, from provincial to local governments, from the federal government to the local governments and from local to local governments. The paper also gives a rationale for transfers of resources from the federal to provincial and municipal governments.At the end of the paper, the authors have suggested that littler provinces be provided with soft loans and factors like backwardness and poverty be also considered while allocating the resources. Moreover, the provinces should be allowed to generate revenues that fall wi thin their domain. Iftikhar Ahmed, Usman Mustafa and Mahmood Khalid (2007) have dilated upon the evolution of resource distribution over time. According to them the divisible pool has been expanded by the inclusion body of more taxes.However, as tribe is the sole criteria for the distribution of resources through NFC awards, it has given birth to serious discrepancys among the provinces. The paper says that resources are transferred from the centre to the provinces in two ways Systematic or Formula Based transfer, comprising of revenue sharing and Random transfer, including grants, executive discretionary funds and Parliamentarian funds etc. According to the authors, with the passage of time the federal government has become more centralized, thereby adversely affecting the efficiency of the provincial governments.The federal government has got engaged in activities that purely fall within the purview of provinces. These include irrigation, roads, culture, tourism, youth persona l matters etc. This has increased the burden on federal government. The Federal government collects 93 % of the revenue but expends only 72%, whereas the provinces generate just 7% but spend 28%. The argument shtup greater revenue collection by the centre is that it is more efficient in revenue collection than the provinces. nevertheless this argument is flawed as the provincial and local governments are left with lesser opportunities to collect revenue.This results in the dependency of the provinces on the federal government for transfer of resources. In this paper, NFC Award has also been criticized in that the criteria for resource distribution are mainly population. Elsewhere in the world, other factors like backwardness, population density, and revenue generation are also considered while devising a formula for distribution of resources. According to the authors, the major shift towards fiscal decentralization appeared in the 1996 NFC Award, whereby all duties and taxes were included in the divisible pool.By so doing enhancer and predictability in resource distribution was though enhanced, yet the resource distribution formula between the federal and provincial governments changed little. The paper says that resources distribution has never been taken seriously. Only one criterion, that is population, has been followed for resource distribution, thats wherefore the NFC Award has failed to resolve the difficulty of Fiscal Decentralization. Usman Mustafa (2011) has highlighted the importance of federal form of government and has argued that even European Union has the characteristics of federalism.While referring to works of notable authors on the subject, it has been argued that Fiscal Decentralization increases efficiency, transparency and accountability. According to the author, in Pakistans case, there are pre-federalism (from 1947-71) and post federalism (from 1973 onwards) periods. In the first perid, the authority was centralized (one unit), whe reas the second period is characterized by the march towards decentralization of powers from the centre to the provinces. In this context, the author argues that NFC Award is a step forward towards decentralization.He, however, criticizes population being suitable criteria for resource distribution between the centre and the provinces. In order to remove the grievances of the little provinces, a historical decision was taken in the 7th NFC Award on Dec, 2009 at Gawadar, to which all the provinces concord. In this award, the demands of the small provinces were accepted, and a multifactor formula was devised. In the formula, factors like poverty, underdevelopment and inverse population density were also included for resource distribution. Moreover, the Federation sacrificed more that 10% of its share in favour of the provinces.It was also agreed that collection charges received by the Federal government on revenue would be curtailed from the existing 5% to 1%. This will increase th e volume of net transfer of revenue from the federal to the provincial governments. All these decisions taken in the 7th NFC Award will contribute favourably towards Fiscal Decentralization in Pakistan. According to Kardar (2006), local governments have significance both in the context of Devolution plan and calamity of central and provincial governments to deliver quality services to the masses ever since the emergence of Pakistan.He further argued that though legislation on devolution is a landmark achievement, the biggest challenge is to settle the row over powers between the provinces and district governments. Dr. Shahnawaz Malik, Mahmood-ul-Hassan and Shahzad Hussein analyzed the relationship between Fiscal decentralization and economic growth for the period 1971-2005. They obtained mixed results on the basis of unalike variables used in analysis. The study further showed that with the continuous rise in the share of provincial government revenues and expenditures, economic g rowth slows down.Naeem-ur-Rehman Khattak, Iftikhar Ahmed and Jangraiz Khan, while using time serial publication data, for the period 1980 to 2007, analyzed the resource distribution, and studied the impact of financial decentralization on the economic growth of Pakistan. According to them, the divisible pool has expanded over the years by the inclusion of more taxes in it. They pointed out that the resource distribution mechanism failed to affect economic growth positively, and suggested that the distribution formula be revisited, having regard to factors like tax collection and backwardness of the provinces.They further suggested that more powers be delegated to the provinces to raise their own revenues. Chapter 3 THEORETICAL BACKGROUND AND ECONMETRIC METHODOLOGY 3. 1 Introduction In this chapter we discuss the theory which guides our research, variables of our model, persona of statistical relationship and the model we will use for estimation. 3. 2 THEORETICAL BACKGROUND Various forms of Decentralization. It refers to the direction of powers and functions from the central to low-level governments. There are three main forms of decentralization (JICA 2008) . 2. 1. Decentralization It is the weakest type of decentralization, and refers to the transfer of decision making powers along with financial and management responsibilities from the officials in the centre to those serving in the local /regional offices. 3. 2. 2. Delegation Here the powers are delegated to the autonomous bodies, including corporations, housing authorities etc. , working under the supervision of the central government. These organizations enjoy vast discretion and decision making powers. 3. 2. 3.Devolution It is the gradual transfer of administrative, financial and political authority to the local bodies, which exercise their powers and functions within certain geographical confines. It has three main constituents, as discussed below a) Political decentralization It refers to the shiftin g of powers and authority to local bodies, run by local political representatives. It has a well-established system of political decision-making and accountability at the local level. b) Administrative decentralizationIt is the form of devolution whereby stave of line ministry is dissociated from their corresponding ministries and brought under the control of the local administration. This is done through establishing local pay roll, which empowers them to support and punish the staff. c) Fiscal decentralization It refers to the shifting of authority and responsibility to the sub-level governments with regard to decision-making on distribution of financial resources. This also includes the powers to raise local revenue.Fiscal decentralization has attracted great attention, among the economic circles, especially for improving service delivery at the local level. The main objectives of Fiscal decentralization include efficient utilization of resources, effective service delivery, mac roeconomic stability and economic growth. With these objectives in view, the developing world is following the principle of Subsidiarity, which emphasizes that authority should rest with the lower tiers of government for effective use, and that the responsibility of incurring expenditures should match with adequate financing.Decentralization leads to efficient utilization of funds through improvement in governance, as lower strata of government can better assess peoples line of works and know their priorities. Decentralization enhances participation of local population as the beneficiaries are directly baffling in planning the allocation of funds. Increased decentralization gives birth to democratization, which keeps the government close to the masses, thereby making it more accountable. 3. 3 Various theories regarding decentralizationThe above narrated advantages, and many more not discussed here, emphasize the importance of Fiscal decentralization. But it was since the publishin g of Tiebouts article, A pure theory of local Expenditure that this concept has gained great popularity among the theorists, and the volume of literature on this topic has increased tremendously. According to Tibeout (1956), Fiscal decentralization improves production efficiency through greater mass mobilization. In 1959 Musgrave pointed out that the role of government is to bring stability to the foodstuff and effect the redistribution of income.He further argued that efficient utilization of resources can be secured only when local tastes and choices are taken into consideration. Oates (1972) pointed out that people living in different localities have peculiar tastes and preferences for public service, therefore, local governments, as against central government, being better informed, will provide better services to its citizens. This concept is called Oates Decentralization Theorem, agree to which economic efficiency can be enhanced by decentralizing the availability of public goods and services.Thus, the central government should be responsible for devising a national policy and providing efficient levels of government for distribution of goods . (Oates,2005) So, equipped with the requisite paraphernalia , the sub-national governments are in a better position to put in place welfare-maximizing policies. Cremer, Estach and Seebright (1994), stated that government at the centre cannot reach the information about local tastes and choices. Thus, it is through Fiscal Decentralization that local agents can bring about efficient supply of goods and services to their constituencies.Almost superposable views were evince by Qian and Weingast (1997), who opined that decentralization puts a check on budget expansion by promoting argument and strengthening accountability, which effects supply of goods and services in an efficient manner. Having said this, there is always a tendency among the local political agents to enlarge the scope of public goods and services at the cost of other jurisdictions. Rodden (2003) attributed this predilection to the type of decentralization being followed.If decentralization is dependent on self-generated tax revenue, smaller governments emerge and if transfer of funds occurs from the centre, it results in budget expansion. Though from economic and political point of view there are many benefits of Fiscal decentralization, yet it is not a cure for all ills. For instance, Fiscal Decentralization entails loss of Economies of Scale and loosens control over scarce resources. From it follows that centralization and Decentralization are not alternatives, rather the countries should find a balance between the two as per their requirements. . 4. Rationale for Fiscal Transfer in Pakistan The first reason is the general perception that the federal government is better equipped to collect major taxes, but is inefficient to collect smaller taxes. Also, the federal government may undertake major projects, but fail to deliv er on smaller projects. Hence, the efficiency criteria moldiness be followed while decision making allocation of meat and responsibilities. The second reason for resource transfer from the centre to the provinces is that the latter lack the resources to finance the provision of even basic services.In the last ten years, the average revenue generated by the centre, provinces and municipalities stand at 89%, 5% and 6% respectively. As against the revenue generation, the share in recurring expenditure of the federal, provincial and municipal governments is 74%, 23% and 4% respectively. As regards developmental expenditure, the share of these governments is as follows Federal government 65%, provincial government 25% and municipal governments 6%. These figures indicate that the provinces have limited resources opposite number the amount of expenditure they incur.This necessitates the transfer of resources from federal to lower-tiers of government. Another reason that can be attribute d to the allocation of resources among the different levels of government is Adequacy of Revenue. This concept refers to the capability of government not only to generate the initial revenue required to start a project but also to its ability to sustain it. In Pakistans case, Adequacy of revenue does not exist hence transfer of resources to the lower tiers of government is necessary if they are to undertake any such projects.The fourth reason of transfer funds from the centre to the provinces is that there are taxes which though provincial in nature but is collected by the federal government, for example Sales Tax. Another rationale for transfer of funds is that federal government uses certain taxes for the overall stabilization of the thriftiness hence they should be under the control of the federal government. NFC AWARDS Commentary and Agenda, Nighat Bilagarami, Jaffery and Mahpara Sadaqat (2006). 3. 5 ECONMETRIC METHODOLOGY 3. 5. 1Augmented Dicky chockablock(predicate) (ADF) Tes t In this study a time series data is being used.Since this kind of data is usually non-stationary in nature, we first test it for stationarity or non-stationarity. For this purpose, an enhanced version of Dicky fuller Test, know as Augmented Dicky Fuller Test, is being employed. The ADF includes extra lagged terms of the dependant variable so as to remove auto-correlation. The following equations denote the three possible forms of ADF Test. i) Without any constant and trend ?yt=? *yt-1+i=1p? i? yt-i+et ii) Constant with non trend ?yt=a+? *yt-1i=1p? i+? yt-1+et iii) Constant with trend ?yt=a+? t+? *yt-1+i=1p? i+? yt-1+etOf the above equations, (iii) represents a more generalized form of ADF Test. Mackinnon(1991) gave fine foster for the DF test The critical values for the ADF Test are the same as those for Dickey Fuller Test. If the DF Statistical value is smaller than the critical value, Null hypothesis of a unit root is rejected, which suggests that the yt is stationary process or the variables are stationary. If on running the ADF Test the variables are found non-stationary in their original levels of series, the variables are made stationary in their first difference level of the series. . 5. 2 Ordinary least square model (OLS) formerly the variables are made stationary, estimation is made by employing Ordinary least square model (OLS). This model is suitable for ascertaining linear interdependencies in a time series data. Here it is also worthwhile to discuss Regression model. A multiple linear regression model estimates value of dependant variable (also called reply variable) on the basis of independent variables (also called explanatory variables). But there is always a difference in estimated and observed values.Therefore, a Regression model also possess unexplained variable, also called error term, which measures the difference between observed and estimated values. y= b+b1 x1+ b2 x2+ b x3 +ei A regression model will be best fit if the difference between observed and estimated value is minimum. We cannot take error term by simply adding all the difference between observed and estimated value because it may contain both positive and negative values which can cancel the effect of each other. So, we take the square of error terms which leads us to OLS . i. e. minimum squared difference.OLS is useful for structural inference and policy analysis. For the purpose of Structural digest of data, certain assumptions regarding the causality of data are made. These are error term (i) is normally distributed (ii) has zero pass judgment value of mean (iii) has constant variance in each time period and for all values of X and (iv) its value in one time period is unrelated to its value in some other time period. OLS is a very simple technique by which we can calculate the coefficient of each variable in other words it gives us the impact of one variable on another variable, which is summarized by impulse response function. Chapter 4 DATA AND VARIABLE 4. 1 INTRODUCTION This chapter covers how data is collected, what are sources of our data and how variables have been constructed variables for our estimation. 4. 2 Data type For the purpose of studying the relationship between Fiscal decentralization and economic growth, secondary data is being utilized. 4. 3 Sources of data For the purpose of this study the following sources have been utilized. i) Issues of Economic survey of Pakistan ii)World Development Indicators iii)Ten years in Pakistan Statistics (1983) iv)UNDP Human Development Report, 2007. )Hand book of Statistics on Pakistan frugality (2005) 4. 4 Construction of variables Economic growth of the country is taken as dependant variable. It is measured in terms of per capita Log of per capita gross domestic product (LYP), which is rebased by the year 2000 market prices. The variable is expressed in real terms using GDP deflator to ascertain the pattern of economic growth over the years. The Fiscal decen tralization is captured on the ratio of Provincial share in list Revenue to the Total Revenue (PRFR). The data source for these variables is Economic survey of Pakistan and covers the period from 1964 to 2008.As regards investment, it is captured by the Gross Fixed crownwork Formation (GFCF) and data is taken from Pakistan Economic Survey Moreover, a variable for conduct openness (OPN) is also used in the estimation model. This variable is obtained by adding imports and exports and dividing the same by LYP (at market prices). Here, too, the source of data is Economic Survey of Pakistan Other variables in the estimation model are Tax to GDP ratio (TGDP) and GINI co-efficient, the latter being used to calculate income equality and its source is UNDP Human Development Report. Chapter 5 RESULTS AND password . 1 INTRODUCTION The section consists of results and their interpretation. In para 5. 1, 5. 2 and 5. 3 Stationarity of data, Autocorrelation and the results of OLS model respecti vely have been discussed. 5. 2 Unit Root test In a time series data, the major problem is the non-stationarity of variables. So, before estimation, a test is applied to make the variables stationary. For this purpose various tests can be employed, but in our case we have used Augmented Dickey Fuller test, the results of which are shown in table 5. 1 below. plug-in 5. 1 UNIT ROOT demonstrate Non stationary variables ADF-value 5% Critical value Gfcf -1. 693492 -2. 9303 Gini -2. 462911 -2. 9303 Lpy 0. 863730 -2. 9303 PRFR -2. 206432 -2. 9303 TGDP 0. 158213 -2. 9303 Stationary variables ADF-value Critical value Gfcf -3. 997577 -2. 9320 Gini -4. 766215 -2. 9320 Lpy -4. 632922 -2. 9320 OPN -3. 453532 -2. 9303 PRFR -3. 662186 -2. 9320 TGDP -3. 01612 -2. 9320 Gfcf- Gross fixed capital formation, Gini- Income inequality, Lpy- Log of GDP, OPN- Openness to trade (export+import/GDP), PRFR- Ratio of provincial shares in total revenue to total revenue, TGDP- Tax to GDP ratio.At the level, all the variables except OPN were found non-stationary, and were, therefore, stationarized at First difference level by using ADF Test. 5 . 3 TEST FOR AUTOCORRELATION Autocorrelation tells about the relationship between two or more error terms in the model. For innocent estimation, autocorrelation must be zero. If there exists problem of autocorrelation, it has to be removed. For this purpose, two hypothesis are constructed one, H0 Co-Var(u,u+1)=0,there is no autocorrelation between the error terms and second, Ha Co-Var(u,u+1)not equal to zero, meaning there is a problem of autocorrelation.To check autocorrelation in our model, we have used Breusch-Godfrey Serial Correlation LM Test (BG TEST), as shown in table 5. 2. According to the table, probability of F-statistic is significant at 5%, so we reject the hypothesis that cov (ut, ut+1) is equal to zero. In other words, there is autocorrelation problem in our model. In order to remove the autocorrelation problem, we have applied ARMA m odel with autocorrelation through AR (1), AR (3) and MA (2). Breusch-Godfrey Serial Correlation LM Test F-statistic 4. 781666 fortune 0. 001241 Obs*R-squared 20. 50376 Probability 0. 002252Probability of F-statistic is significant at 5%, so we reject the hypothesis that cov (ut, ut+1) is equal to zero. It means there is autocorrelation problem in our model. 5 . 4 ESTIMATION The results of the estimation with OLS are tabulated in Table 5. 3 below Dependent variableLPYMethod Least Squares Date 03/25/12 Time 1113 Variable Coefficient t-Statistic Prob. GFCF 0. 004693 3. 806074 0. 0006 GINI -0. 324275 -2. 919698 0. 0065 OPN 0. 000254 0. 468847 0. 6425 PRFR -0. 000173 -0. 517278 0. 6086 TGDP -0. 003194 -0. 809929 0. 4242 R-squared 0. 97793 Prob(F-statistic) 0. 000000 Adjusted R-squared 0. 997081 Durbin-Watson stat 1. 705104 In the model R2 shows strength of the regression line, which means how much important variables are covered by a model or how well renewing in independent variables explains the variation in dependent variable. For time series analysis R2 value must be greater than 0. 70 or 70%, which means the model must explain at least 70% of the total variation in dependent variable. In our results, R2=99% value is greater than 70%, so 99% of variation LPY is explained by our variables i. . GFCF, GINI, OPN, PRFR, TGDP. But the values in the 3rd column against each variable show t values. If the t value, in absolute form, is greater than 2, the relationship between the variables is significant. In our case, the financial autonomy is measured in terms of Ratio of Provincial share in Total Revenue (PRFR), whereas the Economic growth is captured on the variable LPY. It is evident from the table that the relationship between LPY (dependent) and PRFR (independent) is insignificant because the devalues, in absolute form, are less than 2.It implies that LPY is not influenced by PRFR. In other words, in Pakistans case, Fiscal decentralizatio n has no bearing on economic growth. The model shows that GFCF and GINI with variables have t value greater than 2 in absolute form affect economic growth. Durbin-watson value in the table tells us about the problem of auto-correlation in the model. If the value of Durbin-watson test is between 1. 7 and 2. 2 there will be no auto-correlation. In our table its value 1. 7, so we say that the problem of auto-correlation has been removed.CHAPTER NO 06 CONCLUSION This study focuses on identifying the impact of fiscal decentralization on economic growth through compilation of its historical trends. It is generally believed that that proper information about the existing fiscal decentralization system will lead to better policy formulation, which will ultimately put the country on the road to prosperity. In this regard, it is also worthwhile to analyze the implications of the current fiscal decentralization policy on the economic growth of the country.Thus, this study helps ascertain the e xtent of financial autonomy of the provinces and measures its long term benefits. In this study secondary data has been used, which covers the period from 1964 to 2008. Provincial share in total revenue (PRFR), GFCF- Gross fixed capital formation, Gini- Income inequality, OPN- Openness to trade (export+import/GDP), PRFR- Ratio of provincial shares in total revenue to total revenue, TGDP- Tax to GDP ratio are dependant variables, whereas LPY (Log of GDP) is dependent variable in the data.We used OLS model for our estimation, the results of which revealed that only GFCF and GINI have significant impact on GDP growth. On the other hand the influence of, OPN, TGDP and PRFR on economic growth (LPY) are insignificant. As PRFR and LPY measure the extent of fiscal decentralization and Economic growth respectively, we conclude that economic growth in Pakistan does not depend on fiscal decentralization. This may be due to the fact the Resource Distribution Formula has been mainly based on pop ulation. The results of other factors, included of late in the NFC Award, are yet to be seen.It is, therefore, proposed that not only the impact of population in the distribution formula be diluted by the inclusion of other factors, being emphasized by the smaller provinces, but also the powers of the provinces with regard to revenue generation be enhanced. 1 . The words, Financial devolution, financial autonomy and Financial /fiscal decentralization are being used interchangeably in this study. 2 . In this intelligence ,the words, federating unit, unit, province, sub-national government and low-level government will be used interchangeably.