REFORMS FOR A BRIGHTER FUTURE: TIME TO DECIDE Policy Notes: Fundamental Policy Shifts for Pakistan’s Sustainable Economic Development 1 1 Table of Contents: About the “Reforms for a Brighter Future” Policy Notes 3 Time to Decide 4 Overview and Summary 6 Reducing Child Stunting 20 Ghazala Mansuri and Ziauddin Hyder Improving Learning Outcomes 30 Izza Farrakh, Koen Geven, Toby Linden and Saher Asad k ’ Transforming Pa istan s Private Sector 38 q Tobias Ha ue, Gonzalo Varela, Fahad Hasan, Rafay Khan, Qurat ul Ain Hadi and Amjad Bashir Unleashing the Agri-Food Sector 48 Olivier Durand and Basharat Saeed Achieving Sustainable Energy 56 Teuta Kacaniku, Oliver Knight and Mohammad Anis Strengthening Government Revenues 65 Lucy Pan with inputs from Irum Touqeer and Tobias Haque Rationali ing z Government Expenditures 73 Derek Chen with inputs from Qurat ul Ain Hadi Strengthening Institutions for Effective Implementatio n 8 1 q with inputs from Ishrat Husain and Akmal Minallah Tobias Ha ue 31 About the “reforms for a brighter future” Policy notes: “Reforms for a Brighter Future” is an initiative of the World Bank, aimed at fostering debate and dialogue on critical economic development policy issues facing Pakistan. Further information is available from the World Bank Pakistan website at https://www.worldbank.org/en/country/pakistan/brief/reforms-for-a-brighter- future-time-to-decide. These policy notes were prepared by Tobias Haque (Lead Economist), Derek Chen (Senior Economist), Lucy Pan (Senior Economist), Irum Touqeer (Public Sector Specialist), Gonzalo Varela (Lead Economist), Fahad Hasan (Financial Sector Specialist), Amjad Bashir (Senior Operations Officer), Qurat ul Ain Hadi (Financial Management Specialist), Teuta Kacaniku (Senior Energy Sector Specialist), Olivier Durand (Lead Agriculture Specialist), Basharat Saeed (Water Resources Specialist), Ghazala Mansuri (Lead Economist), Izza Farrakh (Senior Education Specialist), Toby Linden (Lead Economist), Jon Jellema (Senior Economist), Christina Wieser (Senior Economist), Moritz Meyer (Senior Economist), Akmal Minallah (Senior Financial Management Specialist), Rafay Khan (Senior Financial Sector Specialist), Ziauddin Hyder, (Senior Health Specialist), Naz Khan, (Principal Country Officer), Puteri Watson (Senior Operations Officer), and Ishrat Husain (Consultant). 41 TIME TO DECIDE: Pakistan is at a critical decision point. “Muddling through” the current economic crisis, and continuing to avoid urgent, fundamental, and long overdue policy shifts will bring major costs and risks. If the political will for once-in-a-generation changes does not materialize, this crisis could “go to waste”, as many have before. The same old pattern of slow development and recurrent crises would be repeated, as climate and other shocks mount in severity and frequency. Alternatively, the current crisis could be a turning point, if it leads stakeholders and decision makers to realize that the current model of development has failed, leaving a large proportion of the population behind. At this critical juncture, and as a long-standing partner of Pakistan, the World Bank has a responsibility to recommend a set of fundamental policy shifts that we believe are required to durably change Pakistan’s development course. These policy notes outline required policy shifts and are intended to steer debate and build consensus around the urgent adoption of a new development framework. Recommended policy shifts would require those who have gained from the status quo to give up undue benefits, through eliminating distortions that favor a minority while muting broad-based growth, and mobilizing resources from the wealthy to finance much needed expansions of basic services for those most deprived (including education, health, and access to water). These changes would ultimately benefit all, leading to faster and more sustainable and inclusive growth and development, and allowing Pakistan to realize its potential to reach upper-middle income status by its centennial in 2047. The World Bank, December 2023. 1 6 REFORMS FOR A BRIGHTER FUTURE: OVERVIEW AND SUMMARY Policy Notes: Fundamental Policy Shifts for Pakistan’s Sustainable Economic Development 7 3 Background Pakistan is at a critical decision point. While there have been recent important examples of reform progress, economic policies over past years and decades have had overall negative impacts on sustainability, productivity, and investment. As Pakistan has fallen behind its peers, progress with poverty reduction has ceased. Human development outcomes remain dire, while the benefits of growth have accrued disproportionately to a narrow elite. Amid continued rapid population growth and a youth bulge, a growing number of young Pakistanis are frustrated by the lack of opportunities, with prospects for young women especially bleak. Pakistan is among the countries most impacted by climate change, and recent events, including the 2022 floods, have highlighted the urgent need for investment in climate resilience. The economy is now, again, sustained by a short-term IMF program, inflation is at record highs, the rupee has depreciated sharply, while foreign exchange reserves remain at uncomfortably low levels. Recent policy measures (including the restoration of exchange rate flexibility, subsidy reforms, and movements towards fiscal constraint) have supported economic stabilization, but the underpinning drivers of Pakistan’s economic fragility remain to be addressed. Many countries, including Indonesia, India, and Vietnam, have taken the opportunities presented by crisis to pursue deep economic reforms, driving step changes in growth and substantial and sustainable improvements in living standards. It is now time for Pakistan to decide whether to maintain the patterns of the past or boldly move towards strong, sustainable, and inclusive growth. This note presents critical policy shifts required to move beyond the current low equilibrium towards sustainable and inclusive economic development and poverty reduction. As outlined in the table below, Pakistan must move From underfunded, inefficient, and fragmented service delivery and social protection systems towards coordinated, efficient, and adequately financed service delivery, targeting the most vulnerable From wasteful and rigid expenditure financed by high levels of debt and a narrow, distortive, and inequitable tax system towards prioritized public investments that support growth and development, financed by a broad-based, efficient, and equitable tax system From a protected, stagnant, and unproductive economy with a large state presence towards a dynamic open economy driven by private investment and exports From agriculture sector policy settings that lock farmers into a low-value, low-productivity farming system towards a market-driven, productive agricultural system that is resilient to climate change impacts From energy sector policies that drive high energy costs, environmental harms, and unsustainable accumulation of debt towards efficient, sustainable, and resilient generation and distribution, based on accurate price signals and strengthened private participation From a public sector that is inefficient, often ineffective, and vulnerable to capture by vested interests towards accountable, efficient, and transparent government. This note summarizes the accompanying series of policy notes. It i) outlines Pakistan’s current development challenge; ii) identifies the critical constraints to faster development progress; iii) describes the major policy shifts that would be required to address current constraints; and iv) proposes broad principles to guide implementation of required reforms. These policy shifts, what they should entail, and the potential benefits they would provide are summarized in the following table. 8 3 Table : Required Poli y Shi ts 1 c f From To Through Potential Gains Underfunded and C oordinated, efficient, D eveloping and implementing a national 32 per ent in rease c c inefficient service and adequately strategy for coordinated action to address in G P er a ita by D p c p delivery and social financed service stunting; progressively increasing budgetary 2047 from closing protection systems delivery, targeting the allocations to stunting, health, education, and human capital gaps with with fragmented and most vulnerable. social protection, as fiscal space becomes peers unclear available; strengthening support to family accountabilities. planning; increasing the number of schools and quality of teaching; enhancing the efficiency of social protection spending. Wasteful and rigid P rioritized investments Reducing subsidy spending; realigning federal 2.1 per ent o G P in c f D expenditure financed that support growth spending with constitutional mandates; sa ings from v by high levels of debt and development divesting or reforming OEs; reducing tax S expenditure measure and a narrow, financed by a broad- expenditures; introducing new excises on 2 per ent o G P c f D distortive, and based, efficient, and harmful products; introducing new taxes on in rease in re enues c v inequitable tax system. equitable tax system. property and agriculture. from closing tax expenditures, new excises, and reforms to income ta 3 per ent o G P c f D in rease in re enues c v from new taxes on land and agriculture A heavily regulated, A dynamic open Maintaining a flexible, market-based exchange US$88 billion export protected, stagnant, economy driven by rate; reducing fiscal deficits to increase potentia and unproductive private investment and availability of credit to the private sector; economy with a large exports. pursuing business regulatory simplification US$2.8 billion FDI state presence. through coordinated federal and provincial potentia processes; reducing the presence of the state 7-8% G P growth by D in the economy; eliminating the anti-export raising investment to bias of trade policy through major tariff 25% of G DP reform. Agriculture sector A market-driven Repurposing public spending from inefficient Up to US$4.9 billion policy settings that agricultural system and inequitable subsidies (including for sa ings from reducing v lock farmers into a supported by public fertilizer and tube-wells) and price support subsidy support to low-value, low- interventions that measures towards investments in core public agriculture ( unjab and P productivity farming enable productivity goods, including agronomic research, animal Sindh) system. and resilience. health, food safety, sanitary and phytosanitary standards, early warning and monitoring systems, and rural infrastructure. Energy sector policy Efficient, sustainable, Maintaining progress with reducing energy 6.5 percent of GDP in settings that drive high and resilient subsidies; avoided economic losses energy costs, generation and implementing measures to improve the from unreliable environmental harms, distribution, based on efficiency of distribution companies and electricit and unsustainable accurate price signals transmission, including through the accumulation of debt. and strengthened introduction of private sector participation; Around US$ billion 2 private participation. moving towards increased use of renewable in a oided interest v energy sources over time to reduce c osts from eliminating generation costs. circular debt A public sector that is Open, accountable, Strengthening institutions for coordination inefficient, often efficient, and between different levels of government; ineffective, and transparent progressing digitization and e-government; vulnerable to capture government. increasing transparency, including through by vested interests. performance standards; reforming public sector recruitment, training, and performance; and progressing the devolution agenda. 9 3 Pakistan’s development challenge Pakistan’s current economic development model provides few benefits to most citizens. Pakistan achieved rapid poverty reduction between 2001 and 2018, with the poverty rate at the international lower- middle income poverty line declining from nearly 80 percent to around 40 percent. Poverty reduction was driven by urbanization and the movement of agricultural workers into higher productivity informal service employment and construction, and outmigration and associated remittances. With low economic growth, and in the context of several recent shocks (including the COVID-19 pandemic, the 2022 floods, and high food inflation), progress with poverty reduction has since ceased. The poverty rate in 2023 is estimated at around 39 percent, only slightly below the poverty rate of 40 percent in 2018. When accounting for population growth, there could be almost three million more Pakistanis living below the poverty line than in 2018. Little progress has been achieved in closing gaps in poverty between urban and rural areas (the rural poverty rate is more than double the urban poverty rate). Broader metrics of welfare and opportunity show similarly negative trends. As Pakistan’s population grows rapidly, access to high quality jobs remains heavily constrained, with 83 percent of all wageworkers informally employed (and earning significantly less than the few able to access formal sector employment). Amid a youth bulge, youth unemployment is much higher than a decade ago, especially in urban areas (7.4 percentage points for males, and 10.4 percentage points for females). Access to and quality of public services is lacking, leaving many Pakistanis without adequate health, education, sanitation, or nutrition (see below). Amid rapid urbanization without sufficient public investment, 47 percent of urban households live in overcrowded housing units in informal settlements with inadequate infrastructure and services. Without comprehensive and responsive social protection systems, Pakistanis are heavily exposed to climate shocks and natural disasters. This was vividly illustrated by the human costs of the 2022 flooding, where substantial damage to health and education infrastructure led to deepening of social disparities. In the context of regional and domestic instability, fragility risks remain high in some areas. Women and girls continue to face widespread exclusion from access to services and opportunities. In a recent Pakistan Institute of Development Economics survey, nearly four in ten Pakistanis reported that they would like to leave the country if given the opportunity to do so, including more than six in ten young males (aged 15-34). Inadequate development progress is underpinned by slowing growth. Between 2000 and 2020, Pakistan’s average real per capita growth rate was just 1.7 percent. This is less than half of the average per capital growth rate for South Asian countries over the period (four percent), and well below the average per capita growth rate of comparator countries with similar economic structures, including India (6.1 percent) and Ethiopia (5.8 percent). As a result of slow growth, Pakistan’s per capita incomes have also fallen behind. While Pakistan’s per capita income was among the highest in South Asia during the 1980s, it is now among the lowest in the region. Figure 1: Real Per Capita Growth 2000-2020 Figure 2: Real GDP Per Capita 7 5.8 6.1 4500 6 5.3 4000 4.7 4.8 5 Percent 4 3.6 3.3 4.0 3.2 3500 3 2.3 3000 1.7 2 2500 USD 1 0.2 2000 0 1500 Turkey Pakistan Ethiopia Bangladesh India Egypt Vietnam Indonesia Mexico South Asia Low & middle income Upper middle income 1000 500 0 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2022 Pakistan Bangladesh Bhutan Structural Aspirational Groups India Srilanka Nepal 10 3 Recurrent macroeconomic instability reflects the unsustainability of the current growth model. Pakistan’s economic growth has not only been slow, but also volatile, with Pakistan experiencing periodic macroeconomic crises. Periods of rapid growth have been driven by high government spending, fueling consumption and imports rather than investment. Private consumption has accounted for around 71 percent of total aggregate demand over the past two decades and most GDP growth. Private investment has averaged only around 11 percent of GDP and been steadily declining (compared to 20-25 percent in India and Bangladesh). Exports have fallen as a share of GDP, from around 16 percent of GDP during the 1990s, to around nine percent today. Periodic balance of payments crises driven by unsustainable fiscal and current account deficits have necessitated subsequent painful contractionary adjustments, slowing growth, reducing certainty, and undermining investment. Pakistan’s current growth model is both harmful to the environment and leaves Pakistanis vulnerable to climate and other shocks. Pakistan is one of the countries most exposed to the impacts of climate change. Alongside increasing temperatures, Pakistan is experiencing increased climate variability and extreme weather events, including flooding, drought, cyclones, and landslides. The current model of economic development leads to overuse of key natural resources, especially water, while production practices impose major environmental damage including through pollution. Air pollution already shortens the average Pakistani's life expectancy by 4.3 years. The combined risks from the intensification of climate change and environmental degradation, unless addressed, will further aggravate Pakistan's economic fragility and could ultimately reduce annual GDP by 18 to 20 percent per year by 2050. Poor and marginalized communities are likely to bear a disproportionate burden, as they are more heavily exposed to climate risks and have fewer resources with which to mitigate impacts of adapt. Key constraints Several interrelated factors underpin Pakistan’s inadequate development progress. First, and above all, Pakistan faces a human capital crisis. Low human capital and weak utilization of available human capital heavily constrains productivity, growth, and development. Pakistan’s human development outcomes lag well behind the rest of South Asia and are roughly equivalent to those in many Sub-Saharan African countries, with the costs disproportionately borne by girls and women. Close to 40 percent of children under the age of five are stunted. Pakistan has the largest number of out-of- school children in the world (20.3 million), including 37 percent of girls and 27 percent of boys, with boys expected to receive 1.4 years more education than girls on average. 79 percent of ten-year-old children are unable to read and understand a short age-appropriate text. Nearly seven percent of children do not survive until their fifth birthday, compared to 0.7 percent in Sri Lanka. Weaknesses in human capital reflect constraints to access and poor quality of services, arising from a range of policy and institutional dysfunctions. Public investment of about 2.5 percent of GDP in education and 0.9 percent on health is much lower than the global average and the average for similar economies. High fertility rates and rapid population growth place additional pressure on services. Along with the obvious human costs, poor human development outcomes impose large economic costs. If Pakistan’s human capital outcomes and utilization improved to the level of its peers, per capita GDP growth could almost double (from a projected 18 percent to 32 percent) over the next 25 years. Second, Pakistan faces large and unsustainable fiscal deficits. Pakistan’s fiscal deficit has been persistently large and growing, driving debt to unsustainable levels. High government consumption, often driven by the political cycle, has increased demand for imports, contributing to current account deficits and periodic balance of payments crises. Post-2010 annual average deficits have been significantly larger than the pre-2010 average, and the general government deficit reached a 22-year high at 7.9 percent of GDP at end- FY22. Debt reached 78.0 percent of GDP in FY22, in breach of the fiscal rules stipulated by the Fiscal Responsibility and Debt Limitation Act (FRDLA). While external debt is not high by international standards,upcoming external debt amortizations contribute to current high external financing needs and associated risks, in the context of low exports and depleted foreign exchange reserves. Large domestic financing 11 3 financing needs are crowding out private sector lending, with the government absorbing most available credit from the banking sector, leading to high banking sector exposure to the government and associated increases in financial sector risks. Large fiscal deficits reflect weaknesses in expenditure and revenue policies. Expenditures are rigid, with 80 percent of federal expenditure allocated to interest payments, transfers and subsidies, and payments to civil servants, contributing little to equity or growth. Revenues remain low by international standards, with a regressive tax system dependent on indirect taxes and substantial exemptions disproportionately benefiting the better-off. Third, market distortions deter investment and exports. Pakistan suffers from low productivity and investment because policies distort markets, preventing resources from being allocated to their most efficient use. Inefficiency in social resource allocation is reflected in Pakistan’s labor productivity increasing by just 40 percent over the past three decades, compared to 170 percent in Bangladesh, and 330 percent in Vietnam. Critical policy distortions include i) periodic overvaluation of the exchange rate, imposing an implicit tax on exporters while subsidizing imports; ii) protectionist trade policies that increase the relative profitability of selling in the domestic market and discourage exports; iii) tax policies (such as under-taxation of land and agriculture) that encourage investment in low-productivity sectors of the economy; iv) a business regulatory environment that imposes substantial transaction costs on domestic investment and curtails foreign direct investment; v) a large state presence in the economy, with unproductive State-Owned Enterprises (SOEs) operating in commercial sectors and crowding out private activity (federal commercial SOEs had a combined output of 12 percent of GDP and combined assets valued at 48 percent of GDP in fiscal year FY2020); vi) limited capacity of the financial sector to effectively channel savings into private sector investment, due to limited access to finance (only around 21 percent of Pakistanis have a bank account) and high-levels of government borrowing from domestic banks crowding out private borrowing (around 70 percent of total bank lending is to the public sector). Low female labor force participation represents an additional major misallocation of social resources, with fewer than one in four (23 percent) women participating in the labor force (compared with four in five men), with many educated women excluded from employment opportunities. Fourth, the agriculture sector is unproductive and stagnant. The agri-food sector is critical to the Pakistan economy and employs many of the poor. It accounts for around 23 percent of GDP and employs around 40 percent of the labor force. Government interventions in the agri-food sector include input subsidies (including for water, fertilizer, and electricity), minimum guaranteed prices, and import and export restrictions. These interventions, intended to stimulate staple production and stabilize prices, have proven extremely costly1 and ineffective while imposing important perverse impacts. They have locked smallholder farmers into a low-value farming system; encouraged resource-intensive and environmentally damaging production practices; and weakened innovation, diversification, and productivity. As a result, agricultural output per worker in Pakistan has grown at around a quarter of the pace of the average for South Asia between 1991 and 2019. Water productivity in Pakistan stands at 130 grams of crop output per cubic meter of water, as compared to 390 grams in India, 800 grams in China and 1,560 in the USA. Fifth, energy is expensive and unreliable, while mounting energy sector debt contributes to fiscal challenges. In the energy sector, current policies have generated large fiscal and economic costs. Major weaknesses in the current policy framework include continued price subsidies that impose fiscal costs, create economic distortions, and disincentivize energy efficiency; high costs of generation, including due to poor choice of power generation technology, and expensive power purchase contracts signed when risks were very high and needs acute; increasing costs of imported fuels, exacerbated by the depreciation of the Rupee; and large distribution losses, including technical and collection losses of up to 30 percent, arising from inefficiency and mismanagement of state-owned distribution companies. Persistent gaps between the costs of providing power and tariffs charged to consumers continue to impose large fiscal costs, while starving the 1 Direct and indirect subsidy support to agriculture and irrigation in Punjab and Sindh has accounted for about US$2.2 and US$2.7 billion of public spending per year, including tax relief for inputs, import and export subsidies and revenue gap financing 12 3 sector of revenues required for maintenance and new investment and fueling the accumulation or arrears and debt (total power sector circular debt is currently estimated at US$8.95 billion, or four percent of GDP). Economic losses arising from lack of access to reliably electricity for firms and households were estimated at US$15 billion in 2015. Finally, Pakistan’s public sector is inefficient, often ineffective, and vulnerable to elite capture due to important institutional and governance deficits. Policy decisions are heavily influenced by strong vested interests, including those of military, political, and business leaders (Kaplan, 2013; Husain, 2018; Hasnain 2008; Ahmad 2010). The devolution agenda remains incomplete, posing challenges to efficiency and accountability. The 18th Constitutional Amendment saw a major devolution of service delivery responsibilities to provinces, presenting opportunities for stronger accountability, but federal government continues to deliver many devolved functions, creating overlaps in service delivery, increasing fiscal costs, and blurring accountabilities. Local government appointments and budgets remain controlled by the provincial governments, leaving decision-making centralized in provincial capitals and Islamabad. The structure of government is extremely complex and unwieldy, while the performance of public sector staff is undermined by inadequate recruitment of staff with key skills, weak performance incentives, and the short tenure of staff in many important decision-making roles. Time to Decide – a Framework for Reform Pakistan has enormous untapped development potential which must now be realized. Constraints to growth described above can be resolved through bold and decisive policy reform. Previous World Bank analysis has shown that, with the right policies in place, Pakistan could leverage its young and fast-growing working age population, natural resource endowments, and geographical location in a fast- growing region to achieve upper-middle income status by 2047 (after one hundred years of independence). Many other countries have taken the opportunity presented by economic crisis to implement major reforms to successfully drive step-changes in growth. These countries include India and Indonesia in the 1990s and Vietnam in the 1980s. As it faces yet another macroeconomic emergency, it is time for Pakistan to decide between two paths: reform and inclusive growth, or stagnation and recurrent crisis. Achieving Pakistan’s development potential will require major and wide-ranging policy shifts across six key policy areas. Major policy shifts are required to 1) address the human capital crisis; 2) achieve sustainability in public finances; 3) build a competitive and outward-oriented private sector; 4) realize Pakistan’s agri-food potential; 5) achieve sustainability in the energy sector; and 6) strengthen institutions for effective reform implementation. The table below outlines the key constraints to Pakistan’s development; required policy shifts; and potential gains. The table lists the relevant World Bank discussion notes and additional analytical work providing detailed reform recommendations within each area. The following sections provide a summary of required reorientations in policy. 3 13 Table 2: Policy shift framework Constraints From To Potential Gains Relevant Analytics An ongoing Underfunded and Coordinated, efficient, and 32 percent increase in Policy ote educing N : R human capital inefficient service adequately financed GDP per capital by Child tuntin S crisis delivery and service delivery, targeting from closing olicy ote Improving 2047 social protection the most vulnerable. human capital gaps with P N : systems with peers Learning Outcome fragmented and Human Capital eview R unclear accountabilities. Large and Wasteful and Prioriti ed investments z . percent of 2 1 in GDP Policy ote N : unsustainable rigid expenditure that support growth and savings from Rationali ing z fiscal deficits financed by high development financed by expenditure measure G overnment levels of debt and a broad-based, efficient, 2 percent of in GDP Expenditure a narrow, and equitable tax system. revenues from closing distortive, and Policy ote N : tax expenditures, new trengthening inequitable tax excises, and reforms S system. G overnment evenue R to income ta percent of in Federal ublic P Expenditure eview 3 GDP revenues from new R taxes on land and agriculture Insufficient A heavily A dynamic open economy U $88 billion export S D iscussion oteN : productivity, regulated, driven by private potentia Transforming the rivate P investment, protected, investment and exports. ecto U $ .8 billion I S and exports stagnant, and S 2 FD unproductive potentia Country Economic economy with a emorandu -8% growth by M 7 GDP large state raising investment to Public Expenditure presence. 25% of GDP Revie Pakistan @100 An Agriculture A market-driven Up to U $ .9 billion S 4 D iscussion oteN : unproductive sector policy agricultural system savings from reducing Unleashing the Agri- and stagnant settings that lock supported by public subsidy support to Food ecto S agricultural farmers into a interventions that enable agriculture ( unjab Country Climate and P sector low-value, low- productivity and resilience and indh) evelopment epor S productivity D R farming system Pakistan @100 Unreliable Energy sector Efficient, sustainable, and 13 percent reduction in D iscussion oteN : and high-cost policy settings resilient generation and generation costs from Achieving Energy energy, with that drive high distribution, based on renewable energ Sustainabilit mounting energy costs, accurate price signals and energy sector environmental strengthened private U $ billion in savings S 2 Country Climate and debt harms, and participation. from energy efficienc D evelopment eport R unsustainable U $ billion in S 13 accumulation of potential avoided debt imports Weaknesses A public sector Open, accountable, D iscussion ote N : in institutions that is inefficient, efficient, and transparent Strengthening and often ineffective, government. Institutions for Effective governance and vulnerable to Implementatio capture by vested interests. P akistan @100 14 3 Policy Shift #1: Addressing the human capital crisis To move from underfunded and inefficient service delivery and social protection systems with fragmented and unclear accountabilities towards coordinated, efficient, and adequately financed service delivery, targeting the most vulnerable, Pakistan must: i) develop and implement a national strategy for coordinated action to address child stunting (Policy Note #1); ii) progressively increase budgetary allocations to health, education, and social protection, as fiscal space becomes available; iii) strengthen support to family planning, including through awareness and education campaigns; iv) increase the number of schools (especially for girls) and female teachers (Policy Note #2); v) ensure teachers have the rights skills and use effective teaching practices (Policy Note #2); vi) enhance the efficiency of social protection spending, enhance coordination between social protection programs, and ensure benefits reach the intended population. Policy Shift #2: Achieving sustainability in public finances To move from wasteful and rigid public expenditures towards tightly prioritized public spending that supports growth and development, Pakistan must immediately: i) reduce energy and commodity subsidies (these cost around 1.8 percent of GDP in FY22 for federal government alone and primarily benefited those in the top three deciles of the income distribution); ii) fully implement the Treasury Single Account to reduce the carrying costs of large cash balances in government accounts; iii) impose temporary austerity measures, including through a stringent review of operational costs, development projects, a government-wide hiring freeze (and wage freeze for upper echelons), a halt to vehicle purchases, and limiting allowances for representation, travel, and petrol. Over the medium-term, reforms should be introduced to: i) realign federal recurrent and development spending with constitutional mandates, reducing federal spending on provincial mandates through ministries, agencies, and vertical programs; ii) reduce the fiscal drain of SOEs through discontinuing subsidies, imposing restrictions on SOE loans, selective divestment, increased private participation, and improved governance; and iii) reform pensions including through indexation to inflation subject to a cap, instituting a minimum retirement age to receive benefits and circumscribing dependents eligible for survivorship benefits. To move from a narrow, distortive, and inequitable tax system towards a system that is broad- based, efficient, and equitable, Pakistan must i) reduce or eliminate costly and often regressive duty and sales tax exemptions; ii) increase excises on socially harmful goods, including tobacco; iii) expand the base for personal income tax by simplifying the structure, merging the schedules for salaried and non-salaried workers, and lowering the tax-free threshold; iv) increase, improve, or implement progressive taxation on property, retail, and agriculture income, particularly at the provincial level; and v) introduce new environmental taxes and user charges, including on carbon emissions or other pollutants. Policy Shift #3: Building a competitive and outward-oriented private sector To move from a protected, stagnant, and unproductive economy with a large state presence towards a dynamic open economy driven by private investment and exports, Pakistan must Maintain a market-based exchange rate, aligned with fundamentals Improve firms’ access to finance, including through i) reducing the fiscal deficit and reversing government’s increasing monopolization of domestic financial sector resources; ii) strengthening insolvency and creditor rights; iii) reforming development finance; an iv) developing capital markets Pursue business regulatory simplification and digitalization through coordinated provincial and federal processes, beginning with revisions to the Investment Act to facilitate new foreign investment Reduce the presence of the state in the economy by i) divesting SOEs operating in purely commercial sectors; ii) improving the governance and financial management of retained SOEs; and iii) divesting other state property and assets that could be effectively managed by the private sector. 15 3 Eliminate the anti-export bias in trade policy by i) developing and implement a long-term tariff rationalization strategy; ii) phasing out regulatory and additional customs duties; and iii) reforming export support schemes to benefit a broader range of new exporting firms. Policy Shift #4: Realizing Pakistan’s agri-food potential To move from agriculture sector policy settings that lock farmers into a low-value, low- productivity farming system towards a market-driven agricultural system supported by public interventions that enable productivity and resilience, Pakistan must: i) repurpose public spending from inefficient and inequitable subsidies (including for fertilizer and tube-wells) and price support measures towards investments in core public goods, including agronomic research, animal health, food safety, sanitary and phytosanitary standards, early warning and monitoring systems, and rural infrastructure; ii) simplify the policy and regulatory framework at both the federal and provincial government levels to facilitate private investment; iii) support small farmers by facilitating adoption of climate-smart and regenerative agriculture practices, facilitating access to input and output markets, reducing information asymmetries, and rebalancing bargaining power along agri-food value chains; and iv) reform the wheat sector by reallocating resources from the wheat purchase program towards improving seed quality and improving storage and marketing through farmers’ organizations. Policy Shift #5: Achieving sustainability in energy To move from energy sector policy settings that drive high energy costs, environmental harms, and unsustainable accumulation of debt towards efficient, sustainable, and resilient generation and distribution, based on accurate price signals and strengthened private participation, Pakistan must: i) maintain progress with reducing electricity subsidies including through rapid implementation of required tariff adjustments and avoidance of new subsidy measures and elimination of tube-well subsidies; ii) implement end-user gas tariff reforms to align tariffs with the cost of supply to constrain unsustainable gas demand and reduce mounting gas sector circular debt; iii) implement measures to improve the efficiency of distribution companies, including through the introduction of private sector participation; iv) move towards increased use of renewable energy sources over time, reducing generation costs; and v) support improvements in energy efficiency including through information campaigns and building and product standards. Policy Shift #6: Strengthening institutions for effective implementation To move from a public sector that is inefficient, often ineffective, and vulnerable to capture by vested interests towards open, accountable, efficient, and transparent government, Pakistan must: i) revive and strengthen institutions for effective national policy coordination between federal and provincial governments (including the Council of Common Interest and National Economic Council) to ensure policy coherence and effective policy implementation; ii) improve processes for public sector appointment, performance management, and tenure to enhance incentives for delivery; iii) enhance digitalization and e- government to improve efficiency and reduce opportunities for corruption; and iv) increase government transparency through improved availability of information and the establishment of performance targets for key government entities. In parallel, the incomplete devolution agenda should be further progressed to strengthen local-level accountability. A clear vision for effective devolution should be developed and implemented, including through reforms to government financing and structure. 16 3 Implementation,Tradeoffs, and Sequencing Implementation of the reform priorities identified above will present important challenges. The proposed reform agenda is expansive, and full implementation may not be immediately feasible with available administrative capacity and fiscal space. Some proposed reforms involve short-term costs for longer-term benefit, and would therefore be likely to encounter political opposition, including from the public or special interests. Several key issues will need to be taken into account for effective reform implementation. Phasing and Prioritization The above reforms would not all need to be implemented immediately. Fiscal pressures and implementation constraints could be managed through a sequenced approach. In the current fiscal context, immediate priorities would include i) maintenance of a sound macroeconomic framework including a flexible exchange rate and maintenance of tight monetary policy; ii) measures to consolidate government spending, including subsidy reforms, austerity measures, and a program for SOE divestment or private participation (including for DISCOs); iii) reforms to improve revenue collections, including closing exemptions and simplifying tax schedules; iv) reforms to restore business confidence, including through immediate steps to ease the business regulatory environment and ease foreign investment; v) decisive but gradual measures to reduce import duties and encourage exports; and vi) increased allocations to the BISP program, along with a cost-sharing plan with the provinces, to support the poor during a period of economic adjustment. With progress towards economic stabilization, debt on a sustainable trajectory, and some recovery of fiscal space, subsequent priorities could include: i) broader increases in allocations to critical social services and for public interventions to enhance female labor force participation; ii) expanded provision of public goods to support key productive sectors, including agriculture, including for enhanced climate resilience; and iii) fiscal and structural reform measures to progress the devolution agenda. Figure 3: A framework for Reform sequencing Private sector, business environment, and SOE Increased investment in public goods required to reforms to improve social resource allocation strengthen human capital, productivity, and resilience High impact and visible measures to improve efficiency in service delivery Fiscal consolidation (expenditure and revenue) to reduce debt and move financing needs to a sustainable trajectory Gradual and phased implementation of trade reforms, moving towards openness while managing fiscal costs of reduced tariffs, and temporary private sector dislocation Macroeconomic stability through a flexible exchange rate and independent monetary policy with inflation targeting Improved investor and public confidence through clear communication of reform plan and objectives Monitoring and evaluation, public dialogue, and transparency Increasing confidence and investment, growth recovery, restoration of fiscal space 17 3 Box: Top reforms for the first year of a new government A new government could immediately progress the following reforms to stabilize the economy, restore confidence, and establish the foundations for improvements in service delivery and governance Develop and implement a national strategy for coordinated action to address child stunting Reduce energy and commodity subsidies in the budget (including for fertilizer and tube-wells) and reallocate spending towards critical public goods and increased social protection spending to shield the poor from any negative short-term reform impacts Impose temporary austerity measures, including through a stringent review of operational costs and development projects, and a government-wide hiring freeze Divest, restructure, or introduce private participation in the operation of several large SOEs (including energy sector distribution companies) in accordance with the recommendations of recent government analysis Implement an ambitious package of tax reforms including, reductions in duty and sales tax exemptions, increased excises on socially harmful goods, including tobacco, and new taxes on land and agriculture Initiate a coordinated federal-provincial process for business regulatory simplification and digitalization with clear targets, beginning with revisions to the Investment Act to facilitate new foreign investment Develop, publicize, and implement a long-term trade tariff rationalization strategy, including immediate reductions in protectionist tariffs Implement end-user gas tariff reforms to align tariffs with the cost of supply to constrain unsustainable gas demand and reduce mounting gas sector circular debt Through a consultative nationwide process led by the Council of Common Interest, develop a clear vision for effective devolution and a roadmap for implementation through reforms to government financing and structure. Consensus and Communication Sustaining political momentum will require clear communication regarding the scope, nature, and medium-term objectives of reform. A clear medium-term implementation strategy for economic reform and recovery should be developed and publicly disseminated, ideally with broad political support. This strategy should i) clearly articulate the inevitability of major reforms to escape the current equilibrium of low growth and periodic crisis; ii) explain how short-term economic costs are expected to translate into longer- term economic benefits for much of the population; and iii) bundle reforms that are likely to impose economic hardship on segments of the population with mitigation measures, especially focused on protection of the poor or those vulnerable to falling into poverty. Public engagement sessions should be undertaken to discuss the distributional impacts of reforms, and how the poor will be protected from negative impacts, including through enhanced access to social protection. Accountability and Transparency A clear monitoring and evaluation framework should be established against which to measure and monitor the impact of the reform program. This will allow the gains from economic reforms to be measured and communicated. It will also allow for course adjustments in the case of unexpected outcomes or slower-than-expected progress. This should be accompanied by broader measures to improve public sector governance, accountability, and transparency, to build public confidence and ensure responsiveness of policy to public preferences (see Discussion Note 7: Strengthening Institutions for Effective 18 3 Implementation). This should include improvements in ex ante assessment of new public expenditure programs and PSDP projects, further improvements in budget and fiscal transparency, and improved public reporting against policy agendas and objectives, supported by enhanced use of digital technologies (including implementation of e-Procurement systems, Citizen Portals, e-Khidmat centers, and similar innovations). 3 20 POlicy NOTE 1 REDUCING CHILD STUNTING Sustainable and Climate-Resilient Solutions to Child Stunting 21 The Problem of Child Stunting Forty percent of children under five suffer from stunted growth in Pakistan and there has been little progress in reducing child stunting over the past three decades. Stunting has crippling impacts that are largely irreversible, damaging a child’s cognitive and physical capacity, leading to lower educational attainment, lower economic productivity, and reduced income earning potential. Failure to address this human development crisis on an urgent basis is limiting Pakistan’s growth prospects as well as its ability to reduce poverty and improve equality of opportunity. Accelerated progress on child stunting requires a major shift in both policy design and policy implementation. Policy design needs to expand beyond narrow interventions focusing only on nutrition and health to include the critical environmental factors that underly the biological drivers of stunting. The most urgent of these is the reduction of exposure to human and animal fecal waste, especially for infants, through the provision of safe water, sanitation and animal waste management, and comprehensive behaviour change. Pakistan’s exceptionally high fertility rate is another neglected but critical driver of the intergenerational transmission of child stunting. Finally, child stunting cannot be reduced sustainably without addressing food and water security and dietary quality and diversity. A transformation of the Agri-food system is needed to tackle the compound risks to food and water security from environmental degradation and a rapidly changing climate. Progress across these multiple dimensions will require an integrated cross-sectoral effort, led by empowered federal and provincial bodies, with a clear mandate, adequate resources and a sharp focus on areas and populations that are most deprived. Potential costs and benefits of accelerating a reduction in child stunting Impacts on Growth and Poverty (By reducing child stunting levels to under 5% and reducing fertility to replacement levels by 2035) 30 Poverty Real GDP GDP per capita 25.81 % change from baseline Impact of HC 20 13.96 12.27 10 6.93 2.44 0.43 0.43 0.41 0 -0.03 -0.83 -5.39 -4.60 -10 2025 2030 2040 2050 The Cost to Do this ~1% of current GDP for 15 years [USD 3-4 billion per year] Source: Policy simulation conducted for the Pakistan Country Climate and Development Report (2022) 22 3 The Problem Forty percent of children under five suffer from stunted growth in Pakistan.1 Pakistan is among the few remaining countries in the world where stunting rates remain this high2 and where there has been virtually no progress in reducing child stunting over the past three decades.3 Given the rapid growth in population, the number of stunted children in Pakistan has been rising substantially over the past few decades. Figure 1: Stunting rates across countries over time 80 60 Pakistan Pakistan (NNS) India 40 Bangladesh China Peru 20 0 1986 1991 1996 2001 2006 2011 2016 2021 Year Source: World Bank-World Health Organization. National Nutrition Surveys (Orange line, Pakistan) Child stunting is a condition or ‘syndrome’ in which multiple pathological changes occur in the first 1000 days of a child’s life, from conception to age 2, that are largely irreversible and have crippling impacts on the children who survive and the societies they live in. Child malnutrition, in all its forms, underlies 45% of all child deaths among children less than 5 years, but malnutrition related mortality is just the tip of the iceberg. Eighty percent of brain development occurs in the first 1000 days and stunting can severely compromise this. The many millions of infants that survive, but are stunted, are thus left with neural damage, reduced physical capacity and immune dysfunction along with a height deficit. This reduces lifelong learning ability and quality of life and results in low economic productivity and income earning potential as an adult, reinforcing the cycle of poverty and inequality. 1 A child is considered stunted if his/her height-for-age is more than two standard deviations below the World Health Organization’s (WHO) Child Growth Standards median. WHO. Nutrition Landscape Information System, Country Profile: Interpretation Guide. WHO, Geneva 2010. 2 In some provinces like Sindh, one in two children is stunted, and in rural Sindh this number rises to nearly two out of three children. 3 Pakistan ranks 15th from the bottom among countries. It ranks just above Afghanistan, Sudan, Libya, and Angola, all countries which have been severely conflict affected over the past few decades and of which some, like Angola are among the most unequal countries in the world. 233 Failure to address this public health crisis on an urgent basis is limiting Pakistan’s growth prospects as well as its ability to reduce poverty and improve equality of opportunity. Pakistan ranks 141 out of 174 on the World Bank’s Human Capital Index (HCI), implying that a child born in Pakistan today is expected to be only 40 percent as productive as they could be by age 18 unless there are significant improvements in human capital outcomes. The risk of metabolic conditions, like diabetes, blood pressure and cardiovascular disease, is also significantly elevated throughout life, further reducing income earning potential and increasing household 4and societal healthcare costs. Estimates suggest losses in per capita income of around 5 to 7 percent. And the impacts are intergenerational. Women who are stunted in childhood tend to have stunted children, many of whom are born stunted, further reinforcing the cycle of poverty and inequality of opportunity. In the end, this limits the developmental potential of an entire society. To accelerate progress on child stunting, major shifts in both policy design and policy implementation are needed—a comprehensive approach is needed, as narrowly focusing on nutrition and health interventions has proven to be ineffective. Policy design needs to include attention to critical environmental factors that underlie the biological drivers of stunting, and the key factors that adversely impact the physical and mental health of young women. The focus of interventions aimed at addressing stunting in Pakistan has been on dietary and nutrition related interventions targeted to pregnant and lactating women and children under age 2. These include exclusive and early breast feeding, complementary feeding after weaning, dietary and micronutrient supplementation for mothers and infants, and health interventions to manage moderate acute- or severe acute malnutrition and anemia. In some cases, family planning programs aimed at reducing fertility and encouraging child spacing have been included. In others, social transfers have been included to enable the poorest households to improve food security and dietary adequacy.5 These interventions are clearly important and correctly focus on the first one thousand days from conception to age 2, the only clear window of opportunity to prevent child stunting. However, implementation of even these agreed interventions has been weak and scattershot. This needs to change. What has been missing almost entirely, however, is the inclusion of critical environmental factors that contribute to neural damage and cognitive impairment and reduce the effectiveness of dietary and nutrition related interventions. The most immediate of these is environmental enteric dysfunction (EED), systemic infection and inflammation. EED is a subclinical often asymptomatic disease of the small intestine which alters gut structure due to chronic pathogen contact and ingestion, restricting the body’s ability to absorb and use nutrients through the small intestine. Along with chronic nutritional deficiencies, EED and related inflammation impairs immune function, causes neural damage and consequent cognitive impairment. The pathways through which pathogen contact and ingestion lead to EED and immune impairment start with inadequate sanitation provision. This allows fecal–oral pathogen transmission to occur through the consumption of infected fluids, food, and soil. And is reinforced by adverse hygiene behaviors like feeding a child without washing hands, the disposal of child feces in open waste piles, poor food storage and reheating and exposure of infants to animal waste. Infants are particularly susceptible because their immune systems are underdeveloped and geophagy, the practice of eating soil, is common infant behavior, increasing the likelihood of protozoan ingestion particularly where children are exposed to animal feces. The environment that exposes a child to EED and chronic infection and inflammation is endemic across Pakistan. There has been virtually no public investment in sanitation, particularly in rural areas. 4 See Wellesley L et al. The business case for investment in nutrition. Chatham House, The Royal Institute of International Affairs, 2020. 5 The national Nashonuma program is a case in point. 24 3 There has been a massive decline in open defecation, from 29 percent to under 12 percent between 2001 and 2018, but this occurred almost entirely through household investment in low quality toilets from which untreated fecal waste is emptied into open drains that run through narrow streets in rural villages and urban low-income neighborhoods. There has also been no investment in the provision of safe drinking water. Water testing results show that at least a third, and in some provinces like Sindh, up to one-half of drinking water is bacterially contaminated at its source (at the tap, handpump etc.) and the rate of bacterial contamination nearly doubles when water is tested at its point of use, usually a storage container, indicating the important additive role of poor hygiene behaviors.6 Animal exposure is also common, particularly in rural areas where food animals routinely live in close proximity to humans, and infants are readily exposed to animal waste through crawling and mouthing behaviors as well as through the mother’s hands.7 Exposure of infants to nitrates in drinking water, through excessive use of chemical fertilizers and to aflatoxin in stored grains used to prepare key complementary infant food has further exacerbated environmental conditions. The wide-ranging impact of environmental contamination and rapid population rise are also evident in the levels of diarrhea and stunting prevalent in the wealthiest urban areas of the country. Income and urban location provide far less protection in Pakistan than in many other countries. Levels of stunting and the prevalence of diarrhea remaining surprisingly high even among the highest income quintiles and there is very little difference between urban and rural areas (see Figure 2). Figure 2: Stunting, Underweight, Wasting, and Diarrhea in Children Under Five by Income Levels Punjab & Sindh, Rural-Urban and Expenditure Quintiles, 2014) Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5 Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5 Punjab Sindh 75 60 45 30 15 0 Stunting Wasting Diarrhea Underweight Underweight Stunting Wasting Diarrhea Diarrhea Underweight Stunting Wasting Stunting Wasting Underweight Diarrhea Rural Urban Rural Urban Source: Mansuri et al. (2018) ,Figure 3.6. ibid, footnote 6. 6 This evidence is reviewed in detail in: Mansuri et al, 2018. “When Water Becomes a Hazard: A Diagnostic Report on the State of Water Supply, Sanitation and Poverty in Pakistan and its Impact on Child Stunting.” WASH Poverty Diagnostic Report, World Bank Group, Washington, DC. 7 Research has shown up to 5 pathogens in the small intestines of exclusively breast-fed babies. 8 Waller et al, 2020, Multiple and complex links between babyWASH and stunting: an evidence synthesis, Journal of Water, Sanitation and Hygiene for Development. 25 3 Sustained and broad-based behavior change is necessary to ensure that all pathways through which infants are exposed to pathogens are closed. The set of interventions related to hygiene, health, child feeding and care practices, and the prevention of infant contact with animal feces is now labeled 8 babyWASH. Neglect of the environmental drivers of child stunting significantly constrains the efficacy of critical nutrition specific interventions. Nutritional and cash transfer interventions generally produce weak impacts on child stunting even where there is considerable success in reducing diarrhea and diarrhea induced mortality. The underlying mechanism for this is now understood to be impaired gut health and inability to absorb nutrients. This can also help explain why there has been virtually no reduction in child 9 stunting over the past two decades in Pakistan, despite a sharp decline in monetary poverty. Pakistan’s exceptionally high fertility rate is an important driver of the intergenerational transmission of child stunting. The total fertility rate in Pakistan is still at 3.3, while the rest of the region is already at or below replacement fertility levels. There is now a dearth of evidence that children born to young mothers and higher birth order children are more likely to be stunted. There is also growing evidence that stunting can begin in utero with birth length highly predictive of length at age 2. Stunting in utero is characterized by high levels of inflammatory markers like CRP and low Insulin like growth factor-1 (IGF-1) levels and is also associated with low maternal IGF-1 levels at birth. This points to the critical importance of pre-conception maternal health, and attention to the health and nutritional status of young women more generally, including their exposure to EED, chronic inflammation or infection. A decline in overall fertility and delayed motherhood are essential for this. Many studies have shown that a decline in fertility is accompanied by an increase in the educational attainment of girls and increased participation by women in income- generating activities, with beneficial impacts on household income and investments in children’s education and health and improvements in gender equity. Sustained progress on child stunting and on human capital more broadly is now also at significant risk from repeated extreme weather events due to climate change and environmental degradation. The combined impact of climate change and environmental degradation is already compromising food and water security. This will make it difficult to sustain progress on child stunting unless early action is taken to safeguard the agri-food system by a shift towards more sustainable and regenerative practices. Pakistan is among the countries at the highest risk for climate change related extreme weather events that are projected to intensify heat waves, change monsoon and rainfall patterns, and accelerate glacial melt. It is also among the countries that face the largest threats to natural capital and biodiversity loss due to environmental degradation. Modeling done for the Pakistan 10 Country Climate and Development Report 2022 found that even a very partial assessment of potential damages from extreme weather events could reduce GDP by 10-15 percent by 2050 and bring poverty reduction to a virtual standstill. A fuller assessment that includes damages to critical health, water, sanitation, and education services and infrastructure would intensify these impacts and make progress on child stunting much harder to sustain. 9 Using the national poverty line, monetary poverty fell from 64 percent to under 25 percent. Using global poverty monitoring metrics, extreme poverty, measured as US$1.90 or less per person per day, was virtually eliminated over this period, decreasing from 28.2 percent to about 3 percent. Over the same period, poverty at the lower middle-income line of US$3.20 per person per day also declined from 73.5 percent to 34.3 percent by 2018. 10 World Bank. 2022. Pakistan Country Climate and Development Report. Washington, DC. http://hdl.handle.net/10986/38277 26 1 4 Recommendations Synergistic multi-sectoral action will be required to shift the current equilibrium, combined with comprehensive and sustained behavior change communication at all levels. This is not a trivial ask and it cannot be the exclusive responsibility of any single government department or ministry. It is important therefore to address both the theory of change and the potential implementation challenges upfront. Recommendation #1 – Adopt a revised theory of change that includes all the critical drivers of stunting and put it through an intensive process of socialization within government. Expand the set of interventions from the more familiar actions referred to as ‘nutrition specific’ in frameworks like the 2021 Lancet Maternal and Child Nutrition Framework,11 to include the critical environmental factors that drive a large part of the biological process underlying stunting. These include, in particular, access to safe water and sanitation and the safe management of animal and solid waste, to reduce EED. The 2021 Lancet update on Maternal and Child Undernutrition12 acknowledges this by noting that “New evidence on the causes of poor growth points towards subclinical inflammation and environmental enteric dysfunction.” In addition, urgent attention will also be needed to: (i) expand the quality and availability of family planning services to reduce fertility and improve birth outcomes, and (ii) safeguard food and water security and dietary quality and diversity, through a shift to a more sustainable and climate resilient food system. This will also help reduce infant exposure to nitrates in drinking water and aflatoxin in stored grains and prepared infant foods. Additionally, attention to early childhood education will be needed to moderate cognition losses to protect the generations of young children who are, or soon will be, past the age where reversal is feasible. The labeling of interventions, such as in the Lancet framework, has led to an unintended hierarchization in which dietary and nutrition related interventions, labeled ‘nutrition specific’, have become the near exclusive focus of most efforts to reduce stunting. This needs to end. Finally, it will require much greater focus on sustained and comprehensive community and household behavior change. Recommendation #2 – Operationalize and adequately empower federal and provincial bodies charged with addressing child stunting. To enable these bodies to deliver at the necessary quality and scale, the following will be needed Strong political and administrative backing at the highest levels of government with a clear mandate to assign sectoral responsibilities with well-defined metrics of success, and time-bound and measurable outcomes An implementation plan that lays out precisely what needs to be done, who is responsible, and the resources allocated to support each targeted outcome. To enable this. The assignment of decision-making powers will need to be commensurate with responsibility, especially for implementation-level bodies, and technical and operational capacity will need to be built in all relevant sectors A transparent and public system for tracking resource flows and outcomes. Available finance data does not allow for a credible tracking of resource flows and is entirely unlinked to any results framework. For a high-level focus on stunting to be actionable, much better resource flow data will be needed, which is tagged to specific actions and outcomes, and is at the level of detail needed for monitoring against agreed results A monitoring and evaluation system to enable third party verification of implementation quality and achievement of agreed targets and outcomes. 11 Emily et al. 2021. Effective interventions to address maternal and child malnutrition: an update of the evidence. Lancet Child Adolesc. 12 Cesar et al. 2021. Revisiting maternal and child undernutrition in low-income and middle-income countries: variable progress towards an unfinished agenda. Lancet Volume 397. https://doi.org/10.1016/S0140-6736(21)00394-9 27 1 4 Recommendation #3 – Focus sharply on areas and populations that are most deprived and move towards geographical and sectoral convergence at scale. A multi-sectoral synergistic approach will require the geographic convergence of interventions in WASH, nutrition, population and health, social protection, agriculture, and early childhood education, and these interventions will need to be done at sufficient scale to interrupt the cycle of deprivation that leads to stunting. A convergence approach has been very successful in countries that are achieving a sustained and accelerated reduction in child stunting. Given both resource and capacity constraints, areas with the worst stunting levels will need to be prioritized for action. Recommendation #4 – Implement a sustained, high visibility nationwide behavior change campaign, aligned with the revised theory of change, to create mass public awareness. The campaign will need to highlight the enormous costs of child stunting, its key drivers, the actions that government is taking, and the actions that households and communities need to take to protect infants, young children, and mothers. This will require a reach out through all channels of communication (television, radio, billboards/posters as well as print and social media platforms and push messaging to mobile phones etc.), with content designed for audiences with varying levels of literacy and customized for rural and urban contexts. It will also need the active participation of NGOs and CSOs to mainstream messages and support behavior change at the grass roots level. Recommendation #5 – Address the following critical implementation bottleneck There is no department at the provincial level with a clear mandate for the delivery of safe water and sanitation or waste management in rural areas. While specific solutions may vary by province, two things are clear. The responsibility for rural and urban water and sanitation services should not reside in one entity and the delivery of such services will remain unsustainable without a shift to a utility model, where a publicly owned utility (or a utility with a public private partnership) has a clear mandate and responsibility to provide safe water, sanitation, and waste management services against a sustainable tariff.13 Given the cost of providing services in rural and remote areas with small scattered settlements, innovative solutions for the provision of safe water and sanitation will also be needed The implementation of nutrition interventions that have been included in the Universal Health Coverage Benefit Package (UHC-BP) needs strengthening.14 There is a severe shortage of knowledgeable, skilled, and motivated health personnel in the primary health system, as well as a lack of nutrition related training and essential medicines and specialized nutrition commodities. Pakistan has a 1.45 ratio of health professionals (physicians, nurses, midwives and LHWs) per 1,000 people, just one- third of the health workforce goal of 4.45. Shortages of qualified personnel are even more acute in Balochistan and Sindh, which have the highest rates of stunting, and things are far worse in rural areas, due to absenteeism, low staff retention, weak support mechanisms and poor-quality and ill-coordinated supervision. The availability of essential medicines, particularly specialized nutrition commodities, and other supplies at PHC facilities also remains a key impediment to delivering health and nutrition care of adequate quality at sufficient scale The situation is considerably worse in rural and hard-to-reach areas. This will need to be remedied through capacity building, the hiring of qualified staff, and the adequate stocking of medical supplies and nutritional commodities. A transparent resource tracking system will be invaluable for this. 13 Such utilities have been successfully set up in many countries, including in neighboring countries like India. In Pakistan, the government of Punjab has taken the first step in this direction by setting up the Punjab Rural Municipal Services Company (PRMSC) along the same lines. 14 UHC-BP, also called the Essential Package of Health Services (EPHS), is to be implemented through the District First Level Hospitals and Primary Healthcare Centers (i.e., Basic Health Units and Rural Health Centers) and Lady Health Workers in accordance with the Health Sector National Action Plan (2019-2023). 28 4 1 The institutional arrangements for the provision of family planning services need to be overhauled. The two departments mandated to deliver family planning services, the Population Welfare Department (PWD) and the Department of Health, have largely failed in the provision of even basic services at an adequate scale. A big part of the problem has been a reluctance in recent decades to prioritize this aspect of maternal and child health. As a result, the Department of Health, despite its extensive network, and its focus on other maternal and child health services, has done almost nothing to integrate family planning into its core maternal health services. This must be redressed. As part of this, changes may be needed in the functions of the PWD and the Health Department to avoid duplication and weak programs. In addition, the availability of contraceptive commodities needs to be expanded. 4 1 30 Policy NOTE 2 IMPROVING LEARNING OUTCOMES Sustainable and Resilient Solutions to Pakistan’s Learning Crisis 31 2 1 Sustainable and Resilient Solutions to Pakistan’s Learning Crisis More than three-quarters of 10-year-old children in Pakistan are unable to read and understand an age-appropriate paragraph – a phenomenon that has been termed Learning Poverty. Investment in education has been low, despite a growing population, while inefficiency and a lack of prioritization have meant that the limited investment in education is not used effectively. Special attention is needed to get girls into school and learning. Immediate actions should be taken to build school capacity (particularly for girls), prioritize foundational skills including reading in all schools, embrace multigrading, and adopt data driven decisions. Within the next five years, priority actions are to support teachers to have the right skills, invest in early childhood education, teach children in a language they understand, and significantly increase the amount and efficiency of the education budget. These investments will put Pakistan on the right track to substantially reducing Learning Poverty within the next ten years. The Problem Pakistan is Facing a Long-standing Learning Crisis More than three out of every four (78%) of Pakistan’s ten-year old children cannot read and understand a simple text by the age of 10. ‘Learning Poverty’, as this phenomenon is called, is high in Pakistan for two reasons. First, about 20 million children remain out of school. With an estimated 73% of children enrolled in school, Pakistan is behind other countries in the region, and even behind the average low- income country (Figure 1). Second, even when enrolled in school about two-thirds of children do not learn to read with comprehension by the end of primary school primary school.1 These low levels of learning outcomes are evident in subjects such as science and mathematics as well: in the latest internationally comparable data, Pakistan ranked 57 out of 58 participating countries in these subjects.2 Girls in Pakistan face special challenges in their access to and retention in schools. Far more girls (12 million) than boys (8 million) are not in school, particularly because many girls never make it to school. Key challenges for girls’ education include long distances to the nearest school, a lack of (female) teachers, overcrowding in schooling, a lack of adequate, functional toilets at schools, as well as social norms restricting girls’ education. And the challenge keeps increasing as Pakistan’s population continues to grow quickly, in part because girls drop out of school and start having children at an early age. 1 Minimum proficiency levels are set globally by the Global Alliance for Monitoring of Learning led by the UNESCO Institute of Statistics. https://gaml.uis.unesco.org/ 2 Trends in International Mathematics and Science Study, IEA, 2019. 32 3 1 Figure 1: Net Enrollment Ratio, Primary, Both Sexes Cross Country Comparison 100 Srilanka 90 Nepal Bangladesh 80 India Pakistan Low Income 70 60 2001 2004 2007 2010 2013 2016 2019 2022 Source: Pakistan data from household surveys (PSLM, HIES), other countries from UNESCO Institute for Statistics School closures during COVID-19 pandemic and the 2022 floods have deepened the learning crisis, signaling that the school system remains vulnerable to future shocks. During the COVID-19 pandemic, all schools were closed for 18 months, prompting dropouts and learning losses. One common reason for dropouts was parents’ views that their children would not be able to catch up with learning. And in 2022, over 17,000 schools were damaged by the floods, impacting over 2.6 million enrolled children who were out of school for seven weeks on average.3 Six months on, one-third of households expected that their children would need to be taken out of school to work.4 Concerted effort is needed to re-enroll students who have dropped out; and to introduce remedial learning to cover learning losses.5 Pakistan cannot achieve sustained economic growth without addressing the learning crisis. Pakistan’s Human Capital Index (HCI) value of 0.416 is lower than the South Asia average of 0.48, comparable more to Sub- Saharan Africa average (0.40). Increases in human capital, essential for development, cannot be achieved without equitable access to quality education. Education confers a broad range of economic benefits: it helps people get jobs especially in the formal sector, increases people’s incomes and employability, improves economic mobility, and enables families to escape poverty. It also increases individuals’ and families’ resilience to shocks. The skills that students obtain are associated with greater productivity, technology adoption, and innovation, and education – and the skills it confers – contributes to higher growth. 3 Government of Pakistan et al., (2022) Pakistan Post-Disaster Needs Assessment (PDNA) 4 Dahlin, Lauren; Barón, Juan D., (2023) Children and Their Families Six Months After Pakistan’s Floods. Special Note; July 2023. Washington, DC: World Bank. http://hdl.handle.net/10986/39978 License: CC BY-NC 3.0 IGO. 5 See Geven, K., Fazili, S., Tahir, A. and Fasih, T., (2022) SMS Girl Data Insights: 2, for an overview of pandemic impact in Pakistan. See Baron, J., Bend, M., Roseo, E., and Farrakh, I., (2022) Floods in Pakistan: Human Development at Risk, for data on flood impact. 6 This means that a child born today will only attain 41% of the human capital she could attain by age 18 if she had access to the complete education and full health. This figure does not take into account further loss of human capital from the recent floods. 33 3 1 Returns to schooling are higher for women and are the highest for lower income countries7. However, at the current pace of progress and population growth, it will take Pakistan at least 50 years and 31 years just to enroll all girls and boys into school, respectively8. Recommendations Pakistan has the knowledge and ability to tackle the learning crisis, even if the scale of this problem is large. There are eight key priorities,9 four priorities to be addressed in the first year, and four priorities to be addressed within five years. First Year Priorities: (i) increase access to school, especially for girls, (ii) prioritize mandatory reading lessons in all schools, (iii) provide instructional support for multigrading, and (iv) adopt data driven decisions, especially to closely monitor learning outcomes Plan to bring every child into school, particularly focusing on girls. Pakistan has had periods of expanding schooling quickly through the elimination of school fees in the public sector and engaging in public-private partnerships. However, there is still a considerable shortage of schools and classrooms, along with safety risks both enroute to school and in school, especially for girls. Public funds for new classrooms, teachers and schools are needed but remain scarce. As a complementary short-term solution, provinces should continue to scale up public-private partnerships, with clear guidelines on establishing government subsidized low-fee private schools in areas where there are no public schools. Public campaigns to promote enrollment, highlighting the benefits of schooling, have proven to be highly cost- effective. Conditional cash transfers for girls to attend schools have also proven effective for increased enrolment and retention Make a daily literacy/reading lesson mandatory in all schools across the country. The ability to read and comprehend text impacts a student’s learning ability in all other learning areas. Schools therefore need to focus on developing reading skills from the earliest grades, by dedicating at least 90 minutes per day to reading activities, focusing first on teaching children to read, and then on reinforcing reading fluency through routine reading practice. Policy makers can build on initiatives that have proven to work in Pakistan, at scale, like the Pakistan Reading Project,10 or the Room-to-Read11 project. These projects have shown that all children can learn to read with the right materials and continuous support for teachers Recognize the reality of multigrade teaching and provide support to teachers, building on successful experiments that group students by their actual levels of learning. Many schools do not have enough teachers for every grade. For example, 44% of schools in Sindh have two classrooms or less. This situation is likely to continue for decades, given the growing student population. Teachers need support for multigrade teaching, so that they can target teaching appropriately to students’ needs. This means specific training, appropriate materials, and support that focuses on whether children are learning, not on whether the textbook has been used. Many schools do not have enough teachers for every grade. For example, 44% of schools in Sindh have two classrooms or less, requiring multigrading. This situation is likely to continue for the immediate future, given the growing student population. Teachers need support for multigrade teaching, so that they can target teaching appropriately to students’ needs. 7 https://blogs.worldbank.org/education/50-years-after-landmark-study-returns-education-remain-strong 8 https://blogs.worldbank.org/education/facing-challenges-girls-education-pakistan 9 Beyond education, Pakistan should find ways to tackle its population growth as it requires public services like education to constantly expand to provide coverage for all. 10 The Pakistan Reading Project was a USAID-funded project, implemented by all four provinces to help improve reading instruction in public schools. 11 The Room-to-Read project is an international project to create low-cost reading material, which has been implemented in Pakistan by ITA to produce low-cost multi-language reading material. 34 4 1 This means specific training, appropriate materials, and support that focuses on whether children are learning, not on whether the textbook has been used. Implementation approaches that group children for all or part of the day based on their learning level rather than their age – referred to as Targeted Instruction or Teach at the Right Level (TaRL) – have proven to be effective and can be adapted to multigrade settings Invest in collecting and using data by setting performance targets, particularly to closely track improvements in learning outcomes. All provinces have established data systems, with regular monitoring of schools by administrators and collection of data for decision making. Some provinces are also introducing unique identifiers for students, so that students can be tracked as they move between grades and public schools. This data needs to be used by administrators at all levels to set targets and to track progress, adapting policy when there is no improvement. Importantly, systems to monitor student learning outcomes need to be improved across all levels and this data used to target support to teachers and schools. At a minimum, foundational learning levels should be assessed across all provinces and at national level at least every two years, in a form that enables comparisons between student groups and tracking of outcomes across years. The recently established Pakistan Institute for Education (PIE) has made strides forward in the measurement of learning outcomes, its data will need to be used by policy-makers to set targets and improve learning levels, while also safeguarding the credibility of data collection efforts. Five Year Priorities: (v) support teachers to have the right skills, (vi) invest in early childhood education, (vi) teach children in a language they understand and (viii) increase the amount and efficiency of the education budget Ensure teachers have the right skills and knowledge and are equitably distributed among schools. Good progress has been made, for instance, by introducing classroom-based teacher coaching12, setting targets for districts and schools, and recruiting teachers based on merit. The next steps are to ensure all teachers know the subjects they are teaching and use effective teaching practices, through introducing an objective examination of subject content for new teachers and for re-certification of existing teachers. In addition, transparent rules and expectations on career progression and incentives are needed to ensure adequate teachers are assigned to and teach in rural schools Increase the supply of high-quality early children education and parenting programs. The net enrollment ratio in primary education has been increasing since 2015, but is still at 73%, as many children start school late and are overage for primary school. Even when early childhood education (ECE) is offered in school, rates of enrollment–ranging from 16% in rural areas to 26% in urban areas –mean children are not ready to start school on time. Children in Pakistan who enroll in early childhood education (ECE) are more likely to be developmentally on track at age 3 and 4 than children who never enroll. In Punjab, for instance where the province sets quality standards for ECE and monitors these actively, 74% of children aged 3 and 4 who attended an ECE program were rated as developmentally on track compared with 52% of children not enrolled Teach children in a language they understand. There is strong evidence from Pakistan and around the world that learning should be in a language that students understand best, usually their mother tongue.13 Limited comprehension of the language of instruction encourages rote learning, instead of learning for understanding and application. Conversely, learning in the mother tongue provides a more solid foundation to learn multiple languages from an early age. Provincial governments should consider changing the medium of instruction, textbooks, teacher guides and assessments to regional languages, and develop more effective strategies to transition to a national or international language for instruction at an appropriate age. 12 The Classroom Observation Tool, based on the World Bank’s Teach model, was implemented in Punjab to mentor teachers based on 11 pedagogical practices. 13 https://learningportal.iiep.unesco.org/en/issue-briefs/improve-learning/language-of-instruction 35 4 1 Amplify the education budget and maximize the efficiency of spending. Pakistan spends much less public money on education than other countries (Figure 2), only 2.4% of its Gross Domestic Product (GDP) and only 14.5% of total government expenditure. That leaves a greater cost-of-education burden for households with school-age children and leads to inequalities in children’s access to school and ability to learn as rich households spend three times as much as poor households.14 Along with spending more on education, the government needs to improve the efficiency of that spending, and the best way to this is to improve teachers’ capacity to teach, as teachers are the largest expenditure category15 and the most important educational input to student learning. Guaranteeing that funds reach their designated accounts on time and that audit and accountability procedures enable need-based spending, allowing for timely and effective spending, is also critical. Figure 2: Government Expenditure on Education, Total (% GDP) World 4.3% (2020) Bhutan 7.0% (2021) Maldives 5.8% (2020) India 4.5% (2020) Nepal 4.2% (2020) South Asia Afghanistan 2.9% (2020) Pakistan 2.4% (2021) Bangladesh 2.1% (2021) Upper Middle Income 4.1% (2020) Lower Middle Income 3.9% (2020) Income Categories Low & Middle Income 3.8% (2020) Low Income 3.0% (2020) Source: WDI 14 According to data from the Pakistan Bureau of Statistics (PBS) 2018-19, the richest quintile of households spends 12,000 rupees per family member compared to 4,000 rupees for the poorest quintile. 15 While education budgets account for a large portion of provincial spending, a substantial amount is allocated to salaries and recurrent expenditures. In Punjab, Sindh, and Khyber Pakhtunkhwa, only 11-12% was allocated to development expenditures, which include construction of new schools, support to teachers and public-private partnerships. 36 5 What Will it Take? A political consensus will be needed to develop a strategic investment plan for the country’s education system. The deep problems in the education system will not be rooted out in one political cycle but will need policy makers’ efforts over several decades. This requires and alignment of technical and political priorities, and targeted, data-driven actions, supported by all political parties, civil society, and development partners. The government will also need to recognize, and address more directly, the heterogeneity across and within provinces, so that investment of resources and prioritization of interventions to improve access, equity and quality respond to local conditions. This can be achieved, in part, by empowering local administrative units with greater capacity, autonomy and authority for decision making. Previous experiments have been successful: Punjab and Khyber Pakhtunkhwa experienced increased in participation and retention rates, especially among girls, during their respective District Steering Committee and District Performance Management regimes, led by Deputy Commissioners and District Education Officers. However, these were of short duration and focused more on delegation of responsibility rather than power and budget: for such routines to sustain and have long term impact, efforts to decentralize decision making need to be formalized by delegation of human and financial resource management powers to local administrative units. In parallel, the technical capacity of central institutions needs to be strengthened so they can support education delivery more effectively at the local level. Textbook, teacher and assessment development institutions, and data collection and monitoring units need to adopt technology to introduce greater efficiency to their services, recruit resources with the right skills, motivate them with career management and growth incentives, and introduce routine feedback loops with schools so that their services are aligned with the needs of students. Pakistan needs to gradually increase its education spending to 5.4 percent of GDP from its current base of 2.4 percent. The World Bank has estimated that bringing every child in school and ensuring that all children learn the basics would require an additional 3 percent of GDP on top of what is currently spent – bringing the needed education expenditure to 5.4 percent. While increasing educational expenditure is of crucial importance for Pakistan, the investments need to be based on evidence of what works. The actions proposed above are all backed by evidence of their effectiveness16 and by examples of practices that have proven effective in Pakistan. 16See also the latest report from the Global Education Evidence Advisory Panel, ‘Cost-Effective Approaches to Improve Global Learning. 5 38 Policy NOTE 3 TRANSFORMING PAKISTAN’S PRIVATE SECTOR Facilitating a Dynamic, Productive, and Environmentally Sustainable Economy 39 Facilitating a Dynamic, Productive, and Environmentally Sustainable Economy Pakistan’s current consumption-driven, import-intensive growth model is unsustainable. Red tape imposes a heavy compliance burden on firms, access to finance is limited, a large state presence in the economy distorts markets and competition, while heavy trade protections benefit large incumbent firms at the cost of new firms and exporters. As a result, productivity and investment is low and declining, economic growth is slowing, formal sector employment opportunities are scarce, progress with poverty reduction is inadequate, and the economy is subject to periodic macroeconomic crises. Women face major constraints to labor force participation. A comprehensive program of reforms is required to unleash the productive potential of Pakistan’s private sector, including through increasing competition and outward orientation. This reform program should include measures to Improve firms’ access to finance by limiting government borrowing from the domestic financial sector and improving institutions for credit market development Simplify the business environment through coordinated federal and provincial regulatory reform and digitalization processes, focusing on constraints faced by small and medium sized firms Reduce the heavy state presence in the economy through a program of SOE reform and selective divestment Rationalize trade tariffs to reduce disincentives to exporting Ensure the rigorous maintenance of a flexible and market-determined exchange rate; an Address supply- and demand-side constraints to women’s labor force participation. As a conducive broader policy environment is established, government should also overhaul existing export subsidy schemes, pursue improved market access, and support firms’ adoption of green technologies and products. Potential from Transforming Pakistan’s Private Sector: US$88 billion US$2.8 billion 7-8% GDP growth Export potential Foreign Direct With investment increased Investment Potential to 25 percent of GDP The Problem Pakistan’s private sector and export performance H igher private investment and improved export performance are critical to improving living standards. Pakistan’s recent growth has been driven by unsustainable booms in consumption, underpinned by fiscal expansions aligned with the political cycle. This has led to high fiscal and current account deficits and periodic macroeconomic crises, with little improvements in economy-wide productivity. igher private sector H investment can help Pakistan escape this cycle, generating new and higher paying jobs for Pakistan’s young and 40 3 growing population, and the revenues required to fill critical public service deficits, including in health and education. In many countries, exports have provided a critical foundation for increased private investment, allowing firms to access a much larger global market for products that Pakistan can produce efficiently, generating critical foreign exchange to finance the import of products that are costly to produce domestically, and providing economy-wide improvements in productivity through exporting firms’ exposure to international innovations and competition (see Box 1). Private investment in Pakistan is low and declining. Pakistan has very low rates of private investment relative to regional and comparator countries (around one-third of the South Asia average). Private investment declined from an average of 13.7 percent of GDP in the 2000s to around 10 percent in FY21.Foreign direct investment (FDI) has also remained minimal, at around 0.6 percent in FY21, before declining to negligible levels amid recent macroeconomic instability and political uncertainty. This represents a major lost opportunity when FDI performance is compared against regional peers and estimated FDI potential of around US$2.8 billion per year (Figure 2). Figure 1: Private Investment as % GDP Figure 2: Foreign Direct Investment as % GDP 30 6 25 5 20 4 3 % of GDP % of GDP 15 2 10 1 5 0 0 -1 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Pakistan India Bangladesh Malaysia Egypt, Arab Rep. Pakistan India Bangladesh 2000 2005 2010 2015 2020 Malaysia Egypt, Arab Rep. Source: World Development Indicators Pakistan’s export performance is weak, and the private sector increasingly inwardly oriented. As a share of GDP, Pakistan’s exports fell from 16 percent in 1999 to 9 percent in 2021, an exceptionally low level among middle-income countries (Figure 1). In 2000, US$14 out of every US$10,000 worth of goods and services exported worldwide originated in Pakistan. This has fallen to only US$11 in 2021 (in contrast, Vietnam increased its export market share from US$23 to US$123 over the same period) (Figure 4). Declining export performance is generalized across sectors, with Pakistan’s share of the global textile and apparel market shrinking from 2.3 percent to 1.8 percent over the past two decades. Pakistan has also made little progress in diversifying its exports. It is in the bottom half of countries in terms of the diversity of exported products, and the bottom third of countries in terms of the diversity of its export markets, with both measures showing deterioration over the past decade. Export performance is likely to be increasingly constrained without improving the sustainability of production practices and the quality and availability of certification services. Pakistan’s exports are often produced using environmentally unsustainable processes, reflecting the widespread use of implicit and explicit subsidies (including for electricity, water, and fertilizers). Critical exports products that do not meet international sustainability standards are likely to face increasing constraints 41 3 to market access amid changing consumer preferences and policy responses to climate change1. Figure 3: Exports of Goods AND Services Figure 4: Global Market Shares (Exports per (Percentage of GDP, 2021) $10,000 of world’s exports) 250 140 123 120 200 100 150 VNM: 93 PAK: 9 80 100 60 47 BGD: 10.7 40 50 EGY: 11 23 13 11 20 14 0 0 2001 2011 2021 Vietnam Pakistan Source: World Development Indicators Box 1: Why is exporting associated with higher productivity? Evidence for Pakistan and the world suggests trade and productivity are closely linked. Firm-level analysis shows that Pakistani exporters are substantially more productive than comparable domestic- oriented firms (similarly, foreign-owned firms are more productive than domestic-owned ones). The productivity premium for exporters holds across sectors, and it is explained both by selection into the export markets (it is firms that are most productive in the first place that get to export) and by learning from exporting (firms’ productivity grows as they export more systematically). Indeed, in Pakistan, systematic exporters are, on average, 23 percent more productive than new exporters, suggesting a virtuous circle where productivity drives export participation, and exposure to the export market further improves productivity. Drivers of poor private sector and export performance Low private investment and weak export performance largely reflect distortions and resource misallocations arising from current policies. Existing policy settings constrain access to finance, impose high regulatory compliance costs, and disincentivize exports. Private firms, particularly SMEs, are subject to unfair competition from state-owned entities undertaking commercial operations and receive little support when seeking to access new overseas markets. Firms lack access to finance. Pakistan’s financial sector is failing to effectively deliver on its critical intermediation role of channeling savings into productive investment. Credit to the private sector has dropped from a high of 29 percent of GDP in 2008 to 13.8 percent in 2022, below half the SAR average and significantly lower than Pakistan’s aspirational peers. 1 In the textiles sector, for instance, adoption of standards has become increasingly important for firms to access high-earning markets. For example, the Sustainable Apparel Coalition (SAC) developed the Higg Index – a set of modules to measure the environmental impact of a product’s entire value-chain – as a voluntary platform in 2011. With stricter standards becoming the norm, however, the tool has now become an industry standard for large brands, retailers, and manufacturers. 42 3 Figure 5: Constraints to private sector investment and exports Excessive state presence within the economy A complex Anti-export business bias in trade regulatory policy environment Low private Lack of access investment and Periodic to finance weak export exchange rate performance overvaluation Source: Author Access to credit is also highly uneven with 56 percent of outstanding credit to the private sector held by the corporate and manufacturing sector, compared to just 5.4 percent to small and medium enterprises (SMEs), which make up the vast majority of firms in Pakistan. In the recent 2022 Business Enterprise Survey, firms cited lack of access to finance as the second most important constraint to doing business (medium-sized firms employing 20-99 employees cited lack of access to finance as the most important constraint).2 While the microfinance sector has 9.2 million active borrowers, it accounts for only four percent of lending and the balance sheets of micro-finance institutions have been heavily impacted by the COVID-19 crisis and 2022 floods. The most important constraint to private sector credit is high levels of government borrowing from commercial banks, which crowds out the private sector (73.4 percent of all bank lending is now to government, up from 43 percent in 2010). In the presence of a dominant and theoretically ‘risk-free’ borrower, the banking sector has few incentives to design innovative financial products and institute robust risk management practices to extend finance to underserved sectors. Additional constraints include: i) a weak insolvency and creditor-right regime, providing banks with limited options for recourse in the case of defaults; ii) low domestic savings driven by limited financial inclusion and low financial literacy; iii) uncoordinated and ineffective development financing programs, with a diverse array of development finance instruments (ranging from direct allocation of funding in the fiscal budget, to public ownership of financial institutions to the very expensive provision of subsidies and guarantees) showing very limited impact in real terms. The business environment is complex, creating high compliance costs (especially for SMEs), and discouraging foreign investment. Regulatory bottlenecks and onerous and discretionary regulatory enforcement discourage businesses from entering the formal economy and impose substantial compliance costs. It also compounds regulatory risks to investment creating incentives to avoid and evade compliance. Dealing with business regulations (registrations, licenses, permits, certificates, standards, and inspections) in Pakistan is complex, costly, and overlaps across the federal, provincial, and municipal boundaries. Over 40 federal, provincial, and local agencies in Pakistan regulate investment and business activities in an uncoordinated manner. 2 Firms reported financing only one percent of fixed asset purchases through bank loans, compared to 12 percent for South Asia, and 13 percent for middle income countries. 43 3 The passage of the 18th Amendment to the Constitution of Pakistan in April 2010 that aimed to devolve power from the center to provinces has further complicated the regulatory environment, creating five regulatory markets – four provinces and the capital territory – in the presence of long-standing federal- provincial coordination challenges. FDI is deterred by a lack of consistency between the legal framework for investment. The Foreign Private Investment Act of 1976 stipulates that foreign investment is subject to Government’s clearance and is only allowed if it meets the development priorities of the Government or if the activity does not exist in the country. Challenges to repatriating profits, as reported by existing multinational firms in Pakistan, coupled with a relatively limited network of free trade agreements are also deterrents to greater FDI inflows. In the absence of a country-wide digital land titling systems, there is opaqueness around land ownership with implications for land-use, the cost and time required to acquire land for productive purposes, and use of land as collateral for loans. The state plays a large, intrusive, and distortive role within the economy. The federal government owns more than 200 State-Owned Enterprises (SOEs), while provincial governments own many more. Total assets of SOEs and other state entities are very significant, with the value of SOE assets estimated at around 48 percent of GDP. Many SOEs and other state entities are engaged in commercial activities, crowding out private sector activity competing on uneven terms, due to their preferential access to finance, subsidies, and in-kind benefits (such as subsidized or fixed price inputs). SOEs’ preferential access to loan financing crowds out financing to the private sector, undermining private investment. Subsidies to SOEs and other state entities in the energy, food, and trade sectors are highly distortive, impeding efficiency and competition across entire value chains. Protectionist tariff policies disincentivize exports. Protectionist trade policies, initially intended to facilitate import substitution, are instead disincentivizing exports, worsening Pakistan’s trade position. Import tariffs benefit firms selling to the local market by protecting them from import competition (a one percent increase in tariffs on a given output increases markups from selling in the domestic market by 4 percent). Protectionist trade policies therefore act as an implicit export tax, discouraging domestic or foreign investment in exporting firms. In addition, when import duties are applied on intermediates, raw materials and capital equipment, and duty drawback schemes for exporters do not work efficiently, they increase production costs, harming economy-wide productivity. Costly tax expenditures are incurred as various exemptions are granted on import duties for inward oriented firms under the 5th Schedule of the Tariff Code.3 Pakistan’s recent history of exchange rate intervention and manipulation has also harmed export performance. A weaker real exchange rates boosts export competitiveness as it reduces the dollar-value of domestic value added. When instead, the exchange rate is artificially kept overvalued, the export sector is negatively affected, and its structure is tilted towards low value-added activities. Evidence for Pakistan shows that, on average, a real depreciation of the PKR by 10 percent increases exports by 5 percent. Women’s opportunities for private sector participation are highly constrained. Pakistan’s productive and private sector potential is heavily constrained by low levels of female labor force participation. Pakistan is an outlier among lower-middle income countries with only around one in four (23 percent) of women participating in the labor market. Female labor force participation is constrained by several complex and overlapping factors, including social norms; weaker educational outcomes for females (only 35 percent of working-age women in Pakistan have completed primary education or above, compared with 52 percent of working-age men); lack of access to safe transport; and limited access to digital connectivity for women (only 15 percent of women regularly access an internet connected computer compared to 28 percent of men, while only 30 percent of working age women have mobile phones, compared with 80 percent of working 3 According to the latest data available, these exemptions reached 168.7 billion PKR in FY22, more than three times as much as the exemptions due to export-related duty remission schemes (51 billion PKR) or Preferential Trade Agreements (46 billion PKR). 44 3 age men). Firms are often also reluctant to hire women due to perceptions that this may cause workplace disruptions, for example including the need to establish gender disaggregated facilities. Economic modeling suggests Pakistan could achieve major employment and output gains by improving female labor force participation. Increasing the proportion of women participating in the labor force between Pakistan and the average lower-middle income country could lead to the generation of 19.3 million jobs and increase economic output by up to 23 percent. Recommendations Addressing constraints to private investment and export growth will require development and implementation of a bold reform agenda. Highest priority reforms are summarized in the following figure. Figure 6: Reforms for private sector investment and exports Constrain fiscal deficit Lack of access Strengthen insolvency and creditor rights regime to finance Reform development financ Develop capital markets A complex Reform the Investment Ac business regulatory Pursue simplification and digitalization through coordinated environment provincial and federal processes Excessive state Implement the triage proces presence in the Divest SOEs operating in purely commercial sector economy Improve SOE governance and financial management Implement a long-term tariff rationalization strateg Anti-export bias Phase out regulatory and additional customs dutie in trade policy Reform export support schemes Periodic exchange rate overvaluation Maintain a market-determined and flexible exchange rate Constraints to Improve education quality and acces female labor force Address constraints to transport and connectivit participation Consider interventions to address firm level market failures Source: Author A range of reforms are required to strengthen private sector access to finance. Government should: i) reduce the fiscal deficit and government’s increasing monopolization of domestic financial sector resources, encouraging stronger flows to the private sector ; ii) increase outreach, investor awareness, and financial literacy to equip businesses and households with the information required to access the financial sector and the products offered by it; iii) pursue financial inclusion policies to tap into the informal savings of the population, particularly by leveraging newly developed digital channels; iv) address legal, policy, and 45 3 institutional hurdles that currently limit the development of the market for credit information (including data sharing, data privacy, integration of platforms etc.); v) enhance the effectiveness of the court system in resolving credit-related disputes and insolvency proceedings; vi) strengthen the supervisory and crisis management framework; and vii) strengthen banks’ capital base to provide space for enhanced lending to riskier segments. Over the longer-term, the government should: i) develop capital markets through promoting listing for large companies with significant debt requirements and reducing tax driven distortions between asset classes; and ii) consolidate and harmonize development financing instruments and institutions based on a review of their mandates, governance, and rules of engagement. Critical reforms are needed to radically simplify the business environment Firstly, Pakistan should immediately revise the Investment Act to align it with the new Investment Policy, addressing unnecessary constraints to foreign investment, and clearly signaling commitment to investment reforms. Revised legislation should mandate establishment of an investor grievance redressal system through which investors’ grievances with the state can be addressed before they become legal disputes or limit further investment. Formal and informal constraints to the repatriation of profits should be removed Secondly, government should establish a National Regulatory Delivery Office reporting directly to the prime minister, in line with international good practices. This office would consolidate and lead efforts (including under the Pakistan Regulatory Modernization Initiative) to ease of investing and doing business in Pakistan, for both domestic and foreign investors. The office would ensure a risk-based approach to regulatory delivery for targeted and effective enforcement minimizing the cost of compliance for businesses Thirdly, equivalent offices with similar mandates should be established at the provincial level (Provincial Regulatory Delivery Units). The usefulness of such an approach has been demonstrated in Punjab where a Doing Business Reform Unit within the provincial Ministry of Planning and Development has worked effectively to drive substantial regulatory reforms. Across the board, business climate reform initiatives should maximize the use of digital solutions and involve strong links to the private sector. Pakistan should establish a national business portal which can integrate federal and provincial regulatory agencies into an online interface for business licensing, and for receiving, reviewing, and processing regulatory approvals efficiently without unnecessary face-to-face interactions. The portal should also facilitate ongoing compliance with business regulation including inspections, gather feedback from the private sector on the quality of regulations and associated administrative procedures, and provide an online complaint registration and management system. While progressing critical reforms, Pakistan should seek to offer stability in the regulatory and tax environment over time, to provide certainty to investors. Digitalization of land records should be progressed nationwide. Drastic measures are needed to reduce the presence of the state in the economy. Firstly, government should pursue a program of ambitious SOE reforms based on the 2020-2021 triage exercise. Government should quickly divest viable SOEs operating in commercial sectors. For other SOEs, government should curtail subsidies that are not associated with the provision of public goods, and phase out preferential access to financing, bailouts, guarantees, and loans, while introducing private participation, enhanced performance monitoring, and strengthened governance practices. These reforms combined should improve commercial discipline and curtail unfair competition with the private sector. Secondly, government should curtail distortionary and costly subsidy schemes in energy and agriculture, improvements in productivity and sustainability. Finally, government should review state asset holdings, allowing the private sector to take on 46 3 management of assets that are not critical to the provision of core public goods (especially state controlled commercial operations). Trade policies should be comprehensively overhauled to eliminate the current anti-export bias. Government should: i) design and implement a long-term tariff rationalization strategy; ii) gradually reduce import duties and tariff cascading, identifying potentially affected sectors and providing time-bound support to displaced workers; iii) phase out regulatory and additional customs duties; iv) digitalize and automate duty remission schemes for exporters, relying on trust-based systems and risk-based audits, and time-bound approval processes; v) gradually phase out import duty exemptions under the Fifth Schedule of the Tariff Code, to level the playing field, and reduce tax expenditures; and vi) equip the National Tariff Board to make evidence-based policy decisions, building capacity in the National Tariff Commission. To curtail entrenched patterns of elite capture, changes to tariffs should be fully transparent and subject to publication and consultation. Pakistan should maintain a flexible, market-determined exchange rate. Avoidance of further exchange rate intervention or manipulation is critical to ensure that the exchange rate reflects market fundamentals and does not present an additional artificial constraint to exports. Interventions should be mobilized to support increased women’s labor force participation. Improving access to and quality of education for girls will be critical to closing labor market gaps (as discussed in Policy Note #6). In addition, public interventions are required to ease women’s access to work opportunities, including through investments in safe public transport and expanded access to the internet and associated online work opportunities. There may be scope for experimental interventions, potentially financed by development partners, to help firms meet the initial fixed costs of accommodating female employees (such as gender disaggregated facilities). As a conducive broader policy environment is established, government could also consider options to improve support to export development. Existing export financing schemes should be reformed to focus on long-term financing and supporting new exporters, with subsidy eligibility and amounts subject to rigorous cost-benefit analysis. Trade portals should be consolidated under the Pakistan Single Window, complying with the WTO Trade Facilitation Agreement. Government should consider pursuing double taxation agreements to reduce the tax burden on exports of modern services., and seek to expand access to international markets through negotiated trade agreements. Government should also improve the enabling environment to increase the quality and availability of certification services and business advisory services – especially to small businesses – to allow exporting firms to meet international sustainability standards. 3 48 Policy NOTE 4 Unleashing the Agri-Food Sector Towards Productive and Climate-Resilient Agriculture 49 Towards Productive and Climate-resilient Agriculture The agri-food sector in Pakistan receives generous public support in various forms but performs far below its potential. Because the sector remains vital to the economy, employment, food security and rural livelihoods, the Federal and Provincial Governments each year aim to stimulate agriculture production through the distribution of generous subsidies and minimum guaranteed prices to farmers. Yet, agri-food sector growth remains low, Pakistan’s wheat productivity is stagnating, and agri-food production is poorly diversified, despite significant agro-ecological potential. Meanwhile Pakistan’s imports of pulses and vegetable oils keep increasing, and the diverse and vibrant livestock production potential is ignored. The current agri-food policy framework is heavily distortionary, and public spending are costly and not benefiting to small land-holding farmers where the highest substantive growth potential lies. Public interventions are pushing the agri-food production system beyond a sustainable use of natural resources and are not driving its adaptation to climate change, which is projected to decrease yields for some crops by 14 to 50 percent and increase demand for irrigation water by 10 to 25 billion cubic meters (BCM). Pakistan can become an agri-food powerhouse but this requires an urgent and thorough repurposing of public policy and spending. Reforms are required to establish proper incentives; attract private investments to improve access to markets, finance and innovations; and support climate change adaptation. A revamped policy framework could more vigorously help address the structural challenges of smallholder producers, stimulate crop and livestock diversification, and modernize the wheat value chain to make Pakistan wheat competitive and reduce its fiscal burden. More investments in high potential subsectors (livestock, fruits and vegetables, etc.) and core public goods (research and extension, farmers organizations, marketing infrastructure, etc.) could yield significant improvements in growth, employment, rural incomes, nutrition, and environmental outcomes. Potential benefits from unleashing the agri-food sector US$2.2 to 2.7 billion per year US$700 million per year Of public finance released from wasteful and From increased production of fruits poorly targeted subsidies and vegetables 50 3 The Problem The agri-food sector performs under its potential despite receiving large public support The agri-food system remains vital to Pakistan’s economy and the main source of income for a large share of the rural population. The agriculture sector contributes 23 percent of the country’s GDP and its contribution remained stable over the past three decades. The sector generates a quarter of total export earnings. Close to 40 percent of Pakistan's labor force is still engaged in agriculture. More than 61 percent of Pakistan's people reside in rural areas and are largely dependent on crop and livestock productions. Overall, two out of three employed women work in the agri-food sector. For the last 50 to 60 years, the agri-food sector has benefited from large and generous public spending and support in various forms. The Federal and Provincial Governments have been extensively supporting agriculture production to ensure food security and provide affordable food. Public support to farmers includes a wide variety of instruments ranging from input subsidies, subsidized tariffs on water and electricity for irrigation, and minimum guaranteed prices. Agricultural trade policies also impose import quotas or regulate commodity exports, with the intention of protecting domestic markets and local production. Poor irrigation pricing and inefficient tariff collection necessitate provincial budgetary allocations to cover the shortfall in cost recovery, representing about 94 percent of Operation and Maintenance (O&M) costs in Sindh, and 70-75 percent in Punjab. All these measures represent a significant drain on Governments’ budgets. In recent years, direct and indirect subsidy support to agriculture and irrigation in Punjab and Sindh has accounted for about US$2.2 to US$2.7 billion of public spending per year, including tax relief for inputs, import and export subsidies and revenue gap financing.1 Despite extensive support, Pakistan’s agri-food sector underperforms in comparison with peer countries. Pakistan has a substantial comparative advantage in agriculture, stemming from its abundance of arable land spread across a diverse set of agro-ecological zones, fresh-water resources managed through the biggest contiguous irrigation system in the world, and a large rural labor force that is predominantly agrarian. The governance framework guiding public support to the agriculture-food system has prevented the full benefits of these assets from being realized. Following undeniable progress during the Green Revolution, annual agricultural growth rates slowed from over four percent between 1970 and 2000 to below three percent thereafter. Between 1991 and 2019, agricultural output per worker grew at an annual rate of 0.7 percent in Pakistan, significantly below the South Asia average of 2.8 percent over the same period. The average wheat yields in Pakistan are almost half of those in China and 15 percent lower than in India. Cotton yields in China and Bangladesh are 2.3 and 1.7 times higher than those of Pakistan, respectively.2 Pakistan’s use of water in agriculture puts it among the 10 percent worst performing countries on agricultural water productivity.3 The agri-food sector also underperforms when assessed against its own potential, with yields of major crops 1.5 to 4.2 times below field potential. Distortive and costly public interventions undermine performance and progress Public support (policies, interventions, and expenditures) in the agri-food sector is costly, inefficient, heavily distortionary, poorly targeted, and makes the system vulnerable to climate change impacts. To ensure food security, public spending has been focused on stimulating domestic staple production, especially by small farmers, to stabilize prices and provide affordable flour to consumers. 1 The World Bank Group. 2022. Pakistan Country Climate and Development Report. 2 FAO statistics 3 Young, William J.; Anwar, Arif; Bhatti, Tousif; Borgomeo, Edoardo; Davies, Stephen; Garthwaite III, William R.; Gilmont, E. Michael; Leb, Christina; Lytton, Lucy; Makin, Ian; Saeed, Basharat. 2019. Pakistan: Getting More from Water. © World Bank, Washington, DC. http:// hdl.handle.net/10986/31160 License: CC BY 3.0 IGO 51 6 3 This narrow objective has distorted decision making towards locking smallholder farmers in a low value farming system, making them miss out on growing demand for higher value products in domestic and international markets. The most illustrative distortions are as follows The traditional farming system remains subsistence oriented and reliant on a few crops, yet is resource-intensive and vulnerable to shocks. Public incentives are skewed towards four crops that use 85 percent of the cultivated land: wheat (48 percent), rice (15 percent), cotton (15 percent), and sugarcane (7 percent). Sugarcane and rice are water intensive crops which, alone, consume 50 percent of the irrigation water.4 Wheat and rice alone receive around 75 percent of the fertilizer and water subsidies. In addition, the support to wheat prices above international market prices further distorts cropping choices by farmers. This notably encourages monocropping practices by most smallholder farmers, which makes them more sensitive to economic, climate and environmental shocks, and prevents diversification toward higher value, more nutritious, and less resource intensive crops. These policies also limit agriculture to provide a path out of poverty as higher-value crops and more efficient and sustainable techniques remain out of reach Domestic food production is not responsive to dietary changes and does not capture diversification and value addition opportunities. The focus on food security ignores the growing demand both on domestic and international markets for higher value and more nutritious products, such as fruits, vegetables, and animal sourced food. Pakistan has an immense potential in this regard thanks to its diverse agro-ecological conditions and rich genetic resources. The International Trade Center estimates this untapped potential in fruits and vegetables to represent over US$700 million per year for Pakistan. The imports of pulses and vegetable oils cost close to US$3 billion per year,5 almost equivalent to the average annual costs of Punjab or Sindh agriculture subsidies. Moreover, except for cotton and sugar, there are limited post-harvest operations of domestic production (storage, logistics, processing, packaging, etc.) to add value and enhance quality standards The relative contribution of the livestock sub-sector to the economy and to smallholders’ incomes is far larger than public spending dedicated to it. Livestock production is a core element of the farming system, especially for smallholders, as an essential source of resilience (savings), nutrition (proteins and lipids from by-products), energy (land preparation and transport), and nutrition transfer to crops (manure). However, while the livestock sector represents 60 percent of the agricultural GDP, it receives less than one percent of public investments. There is untapped potential for dairy and meat on domestic and export markets through quality improvement and processing Public support also underinvests in core public goods, such as agronomic research and extension that are indispensable to generate and disseminate innovation and support climate change adaptation. Pakistan’s public investment in agricultural research was at 0.37 percent of agricultural GDP in 1996 and has declined to 0.12 percent in 2016. India, Bangladesh, and Sri Lanka are spending between 0.3 to 0.60 percent. Most agricultural research expenditures still go to food grains, sugarcane, and cotton, rather than to high-value crops and livestock products, and to developing climate- smart and market-based innovations and improving post-harvest technologies for value-addition. More investment is needed to stimulate the local production of high-quality seeds to ensure better suitability to local conditions and reduce reliance on imported seeds. The vast majority of the farming community is not benefitting from the generous subsidies Public support is also not adequately supporting smallholder farmers who are the vast majority of farmers and have a huge potential for productivity increases. Land distribution remains highly inequitable with 2 percent of farmers owning 45 percent of the cultivated land. Farmers with less than 12.5 acres (5ha) of land represent close to 90 percent of the farming community. Yet, they receive a limited fraction of public subsidies, as many subsidies, especially acreage-based ones, primarily benefit bigger farmers. 4 Based on water requirements and areas under cultivation. Source: Davies S.Young W. 2021 5 International Trade Center (https://exportpotential.intracen.org/en/) 52 6 3 Large farms are at least nine times more productive than small farms.6 In sum, the current public support system is not only more favorable to large farmers, but it is also not designed to help smallholder farmers overcome the specific market failures they are facing in terms of: (i) limited scale of production and low productivity due to lack of inputs, equipment, and knowledge of good production practices; (ii) market aggregation failures limiting economies of scale; (iii) coordination failures along the value chain leading to information asymmetries and preventing stable market relationships; (iv) inequality in bargaining power with buyers and input providers to obtain better prices and services; and (v) producers’ undercapitalization and challenging access to finance curbing their ability to invest in equipment, innovation, production, and marketing upgrading. Regulatory frameworks governing agriculture and water lead to natural resources degradation and undermine adaptation to climate change The existing water sector governance framework provides no incentive for water conservation, crop specific subsidies retain farmers in low value and high water-consumptive production systems, and the lack of groundwater regulation coupled with perverse energy subsidies for electric tube-wells encourage over-extraction. Water productivity in Pakistan stands at 130 grams of crop output per cubic meter of water, as compared to 390 grams in India, 800 grams in China and 1,560 in the USA. The economic productivity of water use in agriculture is among the lowest 10 percent of countries, globally. The abiana system serves none of the key purposes associated with natural resource pricing – it does not reflect the scarcity value of water; it does not cover the cost of providing public irrigation services; and it does not incentivize private sector to participate and increase quality of services. Low fiscal space leads to poor O&M and leaves little room to modernize irrigation services and make them responsive to farmer needs. Many farmers are overcoming these shortcomings through tubewells, leading to the overexploitation of groundwater and deterioration of its quality. Where tube-wells are electric (roughly 10 percent in Punjab), the electricity subsidy exacerbates the problem of groundwater depletion which affects everyone dependent on the resource, while the benefits accrue to a handful of farmers. Where they are diesel operated (about 90 percent in Punjab), it leads to high spending on energy and to high carbon emissions. The current policy framework is pushing the agri-food production system beyond a sustainable use of natural resources. The irrigation policy leads to high surface water withdrawals. More than 35 percent of irrigated land is waterlogged and 30 percent highly saline, making it unfit for agriculture production. Polluted return flows affect river ecology and the downstream water users. Fertilizer subsidies lead to uneven, inefficient, and excessive use of synthetic fertilizer resulting in severe soil degradation, while excessive pesticide usage harms biodiversity. There is no policy incentive to stimulate the adoption of more environmentally sustainable practices, especially chemical fertilizers application based on actual crop requirements and alternative options of biofertilization. The policy framework is also not conducive to the adoption of climate-smart agriculture practices, while climate change is already materializing through heat waves and more intense and variable rainfall. Production of key crops is projected to be 14 to 50 percent lower under climate change than under the no-change benchmark.7 Changes in the monsoon, winter precipitation, snow, and ice melt patterns, may alter the spatial and temporal distribution of water available for irrigation. Climate change is also expected to further impair livestock productivity through reduced water availability, changes in fodder and feed quality and quantity, increased risk of disease epidemics, and the increased cost of feed, water, energy and cooling systems. Moreover, the risk of hydro-climatic disasters (floods and droughts), as observed in 2022, constitutes an increasing threat to agricultural production and food security. While existing policies acknowledge climate-related vulnerabilities, policy-induced market distortions and structural constraints impede the transition towards a greener and more climate resilient agri-food system. 6 The World Bank Group. 2022. ‘From Swimming in Sand to High and Sustainable Growth - A roadmap to reduce distortions in the allocation of resources and talent in the Pakistani economy. Pakistan’s Country Economic Memorandum 2022’. 7 International Center for Tropical Agriculture, the World Bank Group. 2017. Climate-Smart Agriculture in Pakistan. CSA Country Profiles for Asia Series. Climate impact modelling with IMPACT model. 53 6 3 Recommendations An in-depth revision of the policy framework is urgently needed to realize the full growth potential of the agri-food sector, and strengthen its climate resilience The agri-food policy framework needs to be adjusted to today’s market and climate realities. The overall public support program relies on an outdated vision that restrains the role of the agri-food sector to ensuring food security and self-sufficiency, complemented by few specific agri-exports. A renewed long-term vision for the agri-food sector should be much more ambitious to make Pakistan an agri-food power. The agri-food sector offers tangible opportunities to generate growth and employment; and reduce rural poverty and malnutrition, while strengthening the resilience of smallholder producers to shocks. The overarching goal should be to develop a diversified, competitive and resilient agri-food sector that creates growth, jobs, and nutritious outcomes, preserves the natural resources and the productive potential and is inclusive of smallholder farmers and their mixed crop-livestock farming systems, while capturing domestic and export market shares for diverse produce. A consensus needs to emerge on the key steps needed to progressively adjust policies. The Federal and Provincial Governments need to hold consultations with farmers and private sector representatives on the directions for changes and ensure harmonization of policy measures and instruments. The objective of a revamped policy framework should be to establish the right incentives (in terms of land and water use, adoption of climate-smart agriculture, nutritive diets, and so on), deliver differentiated and equitable support to different categories of farmers, stimulate private investment and competition, and harmonize regulations among Provinces. Multi-stakeholder consultations on sector modernization could be organized around the following priority recommendations Repurpose public spending from inefficient and inequitable subsidies and price support measures towards investments in core public goods and neglected subsectors (livestock, horticulture, pulses, and oilseeds). Public investments are urgently needed to strengthen agronomic research, animal health, food safety, sanitary and phytosanitary standards, early warning and monitoring systems, rural infrastructure such as storage facilities closer to rural producers, cold chains to improve agri-food quality and food safety,8 feeder roads to ensure the last mile access to markets, and so on. This would also give space to and attract private sector investments towards higher value production. Simplifying and harmonizing the policy and regulatory framework among the Federal and Provincial Governments could also attract more private investments. These reforms would allow all farmers – regardless of size or income level – more and better opportunities to generate productivity gains Invest in sustainable land and water management to increase natural resource conservation and productivity. Improving irrigation service and adopting conjunctive management of canal water and groundwater would reduce environmental degradation linked with waterlogging and salinity and facilitate productivity gains while also ensuring reliable and demand-driven access of all farmers to water for irrigation. Better on-farm land preparation and management practices would increase both land and water sustainability. Enforcing existing land planning to prevent the loss of fertile agriculture land in the face of sprawling urbanization and establishing proper land use taxation could also help stimulate sustainable agriculture investments Address the structural challenges of smallholder producers. Inefficient and inequitable subsidies should be replaced by differentiated support to different categories of farmers, targeting primarily smallholder farmers and encouraging the adoption of climate-smart and regenerative agriculture practices. Public support should help organize small farmers to facilitate their access to input and output 8Not detailed in this note, over US$1.5 billion of productivity could have been lost in 2016 in Pakistan from foodborne disease, and Pakistan has high rejection rates for various fresh agri-produce exports to the EU according to the 2019 World Bank report “The Safe Food Imperative”. 54 6 3 markets, reduce information asymmetries, and rebalance bargaining power along the agri-food value chains. Promoting innovative financing instruments such as the electronic warehouse receipt system should facilitate access to finance for smallholder farmers. Exploring options to secure the land and water use rights of tenants and sharecroppers, as well as registering them for direct access to subsidies, would stimulate longer- term investments in productivity increase and diversification, and climate-smart soil and water management practices Modernize the overall wheat value chain to make Pakistan wheat competitive and reduce its fiscal burden, while stimulating crop and livestock diversification. Wheat remains at the core of the traditional farming system and Pakistani diet, but the wheat value chain can be made more efficient by improving agronomic performances with better quality seeds, establishing an efficient storage and marketing system through private operators and farmers’ organizations, and gradually removing the costly and distortive procurement program. Current resources spent on wheat could be repurposed to such objectives, as well as to support higher value and more nutritious crops, which would improve not only small farmers’ incomes, but also the nutrition status of rural children. 6 3 56 Policy NOTE 5 ACHIEVING SUSTAINABLE ENERGY Towards Affordable, Reliable, and Sustainable Energy 57 Towards Affordable, Reliable, and Sustainable Energy Energy is a critical enabler of economic development and poverty reduction in Pakistan. However, the sector is not adequately fulfilling this role as a result of persistent fiscal, reliability, and energy security challenges. Inefficiencies and an incapacity to recover costs have led to the accumulation of around US$8.3 billion of circular debt in the electricity sector and US$6.3 billion in the gas sector, imposing substantial fiscal costs and risks. It is estimated that power shortages result in lost economic output of more than US$8 billion a year. Additionally, the country imports around 43 percent of its total energy supply, requiring around US$13 billion of foreign currency per year, which is likely to increase over time based on current trends. There is significant use of imported coal, especially in industry, and the country suffers from relatively high energy intensity of GDP. Furthermore, there are major gaps in the provision of universal access to modern energy and energy sector emissions are the largest contributor to GHG emissions and air pollution in Pakistan. A major policy shift is required to move towards more secure, environmentally sustainable, lower- cost sources of energy that take advantage of Pakistan’s hydropower, solar and wind resources. This should involve: i) maintaining progress with reducing electricity subsidies, while protecting the poor, including through rapid implementation of required tariff adjustments and avoidance of new subsidy measures and elimination of tube-well subsidies; ii) implementing end-user gas tariff reforms to align tariffs with the cost of supply to constrain unsustainable gas demand and reduce mounting gas sector circular debt; iii) implementing measures to improve network efficiency, including through the introduction of private sector participation in both distribution and transmission; iv) moving towards increased use of renewable energy sources over time, reducing generation costs; and v) supporting improvements in energy efficiency including through information campaigns and building and product standards. Potential benefits from sustainable energy 13% Reduction US$2 Billion US$13 Billion in generation costs in savings potential potential savings in from mobilizing from energy efficiency avoided imports renewable energy 1 This excludes highly uncertain estimates of the use of traditional biomass and waste. 2 The issues include theft, losses (including methane leakage from the gas network), inaccurate consumer billing, and incomplete collections and arrears. 3 Some consumers systematically do not pay their bills, and the distribution companies respond to this by providing limited supply to those consumer groups to try and stem their losses. 58 The Problem Pakistan’s energy sector cannot currently provide affordable, reliable, sustainable, and modern energy for all (SDG7). Key challenges include Heavy dependence on fossil fuels. Fossil fuels comprise 86 percent of the primary commercial energy supply1, exposing Pakistan to high prices, energy insecurity (including price shocks and supply disruptions), and generating air pollution and greenhouse gas (GHG) emissions Growing financial deficits due to energy prices that do not reflect costs, misaligned subsidies, and the poor performance and inefficiency of electricity and gas distribution companies.2 Large financial losses place a heavy fiscal burden on the government and disincentivize private investment in the sector Electricity and gas supply interruptions that stem from electricity transmission bottlenecks, aging equipment, and managed load-shedding of electricity and gas (undertaken for commercial reasons).3 Unreliable supply generates additional costs to households and firms in lost productivity and heat stress. It also increases incentives for firms and households to generate their own electricity, depriving utilities of paying customers. The limited transmission infrastructure and difficulties in maintaining system stability; significant obstacles to the expansion of renewable energy Relatively high energy intensity of GDP, with low rates of improvement. This places additional cost burdens on households and businesses and further exacerbates energy insecurity Persistent gaps in the provision of universal energy access, with significant rural-urban and regional disparities. Heavy reliance on fossil fuels, combined with the expected growth in demand, threatens to exacerbate many of the current challenges of the energy sector. Although considerable focus is given to the electricity sector, only 17 percent of Pakistan’s energy consumption is in the form of electricity, with the balance coming primarily from the direct consumption of coal, gas, and oil in the domestic, industrial, and transport sectors (see Figures 1 & 2). Total energy supply is likely to increase from 84 million tons of oil equivalent (MTOE)5 in 2019 to 115 MTOE in 2025, at an annual growth rate of 5.8 percent under a BAU scenario, much of which will come from fossil fuels under the current policies. 1 This excludes highly uncertain estimates of the use of traditional biomass and waste. 2 The issues include theft, losses (including methane leakage from the gas network), inaccurate consumer billing, and incomplete collections and arrears. 3 Some consumers systematically do not pay their bills, and the distribution companies respond to this by providing limited supply to those consumer groups to try and stem their losses. 4 Some consumers find it cheaper and more efficient to generate their own electricity. The loss of such profitable, paying consumers can create a spiraling problem for the DISCOs because the less revenue they are able to collect, the less electricity they are able to supply, and the more erratic the electricity service becomes, which compels more customers to leave the grid, which further diminishes the revenue of the DISCOs. 5 Million tons of oil equivalent. 59 Figure 1: Final Energy Consumption Figure 2: Energy Consumption by Sector: 2019–20 2020-2021 Agriculture LPG 1% 2% Electricity 17% Transport Oil 30% 31% Industrial 40% Energy Consumption Coal 19% Domestic Gas 21% Commercial 31% Other Govt 3% 5% Structural issues, poor planning, and substantial subsidies have resulted in huge inefficiencies across the energy sector, affecting the reliability of supply and generating huge fiscal deficits (referred to as “circular debt”).6 Pakistan has the highest subsidies on energy products in South Asia. Energy subsidies in 2020 accounted for 2.6 percent of the country’s GDP, two-thirds of which were for electricity consumption, with the remainder for natural gas.7 The notified tariff remains below the cost- recovery level. 62 percent of residential and all agriculture consumers are subsidized. While the progressivity of the subsidy to residential consumers has improved with recent tariff notifications (July 2022 and July 2023), the subsidy to electric tube-wells continues to be regressive, benefiting primarily large and wealthy farmers8. As a result of the absence of cost-reflective tariffs, combined with operational and technical inefficiencies within the state-owned electricity and gas distribution companies, revenue collection does not fully cover the cost of energy supply, which leads to deficits. The circular debt has continued to accumulate, especially in the last few years. As of the end of June 2023, circular debt stood at roughly US$8.3 billion in the electricity sector and US$6.3 billion in the gas sector, creating barriers to future investment9. The situation has been exacerbated by the recent addition of large coal and imported gas power plants with “take-or-pay” contracts that have increased capacity payments by 50 percent and increased the country’s exposure to international fossil fuel price volatility—as witnessed over 2022.The inefficiencies in the electricity and gas distribution companies include outdated metering practices, low collection rates, high technical losses, rampant theft, and gas leakages as a result of old and poorly maintained pipelines and sabotage10. 6 The reference to circularity captures the fact that the arrears keep getting passed from one energy sector entity to the next. In the power sector the deficits cascade from the distribution sector to the central power purchaser, and then to the power producers and fuel suppliers. 7 IMF, Fossil Fuel Subsidies Database (Washington, DC: International Monetary Fund, 2022), https://www.imf.org/en/Topics/climate- change/energy-subsidies. Note that this figure includes only “explicit subsidies.” The IMF also provides an estimate for “implicit subsidies” that takes account of the underpricing of externalities. Total energy subsidies, including both explicit and implicit, are estimated at 11.9 percent for 2020. For further details about the IMF’s research, see Ian Parry, Simon Black, and Nate Vernon, Still Not Getting Energy Prices Right: A Global and Country Update of Fossil Fuel Subsidies (Washington, DC: International Monetary Fund, 2021), https://www.imf.org/en/Publications/WP/Issues/2021/09/23/Still-Not-Getting-Energy-Prices-Right-A-Global-and- Country-Update-of-Fossil-Fuel-Subsidies-466004. 8 Of the 1.5 million tubewells across the country, merely 21% are linked to the power grid and therefore receive the advantage of subsidized tariffs. The remaining ones rely on unsubsidized diesel, creating an uneven playing field for farmers. 9 At the end of FY2023, Pakistan’s total circular debt was PKR 2,374 billion in the electricity sector and PKR 1,800 billion in the gas sector. The exchange rate: 1 US$ = 285 PKR. 10 In the gas sector these issues are often collectively referred to as “unaccounted-for gas.” Although the portion due to leakages is hard to estimate, this is a further source of avoidable GHG emissions in the country. 60 The gas sector has also been facing structural challenges. Heavily subsidized price of indigenous gas delivered to a handful of fertilizer manufacturers is not passed on fully to farmers—the main end-consumers of fertilizer. Meanwhile an estimated 15% of urea manufactured using this subsidized gas is smuggled out of the country to countries where urea sells at the global market price. The delivery of underpriced indigenous gas for in-house generation of electricity by factory owners (called ‘captive power plants’) captures this benefit for the few. Export-oriented industries regularly succeed in lobbying the government to subsidize the gas and electricity used by them. A shortage of domestic gas supply combined with increasing demand, has contributed to rising imports of Re-gasified Liquified Natural Gas (R-LNG). Today, R-LNG is used to supply 45 percent of demand.11 While the increase in share of imported gas has come at a higher cost, gas tariffs for end-consumers have remained constant. The latest tariff increase in February 2023 was the first in three years. Nevertheless, and the gas tariff is still below cost recovery level as it does not include the cost of imported gas. Diversion of expensive R-LNG to the two lowest paying consumer categories - domestic and fertilizers –, and subsidized R-LNG to export industries, has accelerated the buildup of the gas circular debt. The deep discounts offered to the fertilizers and domestic consumers has driven up prices for other consumers, in particular power plants, which increases the cost of electricity generation. Persistent circular debt curtails investment in the gas and power distribution networks, undermines the ability of both sectors to operate at full capacity due to fuel shortages, and increases the difficulty of attracting investors to support future power sector requirements. Recommendations The government must maintain its commitment to comprehensive reform, including transition away from fossil fuels. For the power sector, this requires reducing the cost of generation and overdependence on imported fossil fuels, bringing end-consumer tariffs closer to the cost recovery level, and improving supply-side efficiency and collections, and strengthening regulatory capacity and oversight. For the gas sector, tariff reforms are required to eliminate cross-subsidies and contain the increase in gas demand, especially of domestic consumers. Bringing the tariff to a cost reflective level, allocating scarce gas resources to the most efficient gas-based power plants, while also unbundling the sector (i.e. delinking the role of gas transporter and downstream supplier),12 while allowing third party access for both pipelines and terminals, will be critical. For the first time, the government’s reform program covers all aspects of the sector, focusing strongly on reducing current and future power costs, reducing reliance on imported fossil fuel, scaling up RE, addressing inefficiencies within the electricity distribution companies (DISCOs), and lowering subsidies in both electricity and gas sectors by better targeting them to those most in need. Pakistan has huge hydro, solar and wind power potential, but this has not so far been utilized. Several factors have contributed to slow deployment of renewable energy (RE), ranging from political economy to the technical ones. Large variations of the seasonal peak demand create some challenges for deployment of RE which requires simultaneous expansion and strengthening of the grid. Of the 43 GW of current installed capacity, 40.5 GW is classed as “dependable”, and yet the “peak capability”13 of the National Transmission & Despatch Company (NTDC) system is just under 28 GW, against a peak summertime demand of over 30 GW.14 11For SNGPL network the share of RLNG is 58%. 12 Currently, the two SUIs companies have three functions, transporting, distributing and selling gas to end-users. 13 The total “dependable capacity” consists of all the available capacity on the NTDC network assuming that all plants are generating at full output, with no fuel or hydrological constraints, but taking account of plant deratings due to age and inefficiencies. In practice this is virtually impossible to achieve, even if the current fuel cost and CD issues were addressed, due to the seasonal and daily availability schedules for large hydropower, scheduled and unscheduled maintenance, fuel shortages at individual plants, and the variability of solar and wind. “Peak capability” takes account of these constraints, and will vary throughout the year. 14 NEPRA. 2022. State of Industry Report 2022. Available at: https://nepra.org.pk/publications/State%20of%20Industry%20Reports/ State%20of%20Industry%20Report%202022.pdf 61 This, along with the unwillingness of the government to operate all available capacity due to high fuel prices, and the incur the large commercial losses involved in supplying non-paying consumer segments, drove widespread scheduled power cuts during 2022. Development of additional RE capacity is necessary to meet the current supply deficit in the summer. and reduce the cost of generation by moving away from fossil fuels. According to a World Bank study, utilizing just 0.071 percent of the country’s available area for solar photovoltaics (PVs) would meet Pakistan’s current total electricity demand15. The wind resource is also considerable, especially in Balochistan and Sindh. The Indicative Generation Capacity Expansion Plan 2021– 203016. (IGCEP) has a target to reach 60 percent of electricity generation by 2030, which consist of expansion of hydro, wind, and solar. There are currently few large hydropower projects under construction that once commissioned, will contribute to cost reduction and greening the mix. It would further require a significant build-out of 13.6 GW of additional solar and wind capacity based on current projections, but this has yet to begin. Achieving this objective will require introducing competitive bidding for new power generation projects and ending the old practice of direct contracting and cost-plus tariffs that have led to high power costs and an over-reliance on fossil fuels. This should be done in an organized/programmatic manner followed by annual rounds of procurement to meet the government’s targets. Strengthening and expanding the transmission network is key for successful integration of RE. Transmission represents a critical requirement in the energy sector as articulated in various scenarios in several government policy documents. The improvement of transmission infrastructure has been captured in National Energy (NE) Policy, National Energy (NE) Plan and a key part of IGCEP to meet demand scenarios. Transmission requirement has been made more pronounced with the increased installed generation capacity, with growing demand and curtailed generation from RE, especially from the southern part of the country. Government’s focus, therefore, has now shifted to improve the transmission network for reliable supply of electricity. Given the urgency to eliminate curtailment and operate a stable grid through strengthening and expanding the transmission network, private sector participation (PSP) should be considered. The government has expanded the role of PSP from generation to transmission pursuant to its Transmission Policy of 2015. Under Clause 5.2 of the NE Policy, taken together with government’s strategic directive under the NE Plan, the government has also now directed that the Transmission Policy of 2015 should be revised so as to promote integrated development in transmission at all voltage levels at 132 kV and above, to help achieve the goal of a competitive national energy market. NTDC should expedite development the integrated Transmission System Expansion Plan (TSEP) and IGECEP, while updating various governance instruments, such as Transmission Service Agreement, transmission policy framework e.t.c. focusing on incentivizing private participation in the transmission sector. A key aspect of the approved TSEP is that it serves as the basis for various investment programs for both transmission and distribution facilities, to be developed by the respective facility licensees, both private and public sector. For instance, the phase-I TSEP overlooking the network needs until 2026, has estimated that the transmission sector would require over additional $700m by 2026 to meet the projected demand and a stable operational grid. This suggests the dire need for external capital mobilization to help build out Pakistan transmission grid that meet its goals of transitioning to the 60% RE based system. The energy intensity of GDP is relatively high in Pakistan compared to other countries in the region, and there is substantial potential for improvement in demand-side efficiency. Pakistan’s energy intensity—the amount of energy needed to produce US$1 of GDP and a measure of energy efficiency —was 4.6 megajoules (million joules, MJ) per dollar in 2018, compared to 4.4 MJ/$ in India, 2.6 MJ/$ in Türkiye, 2.5 MJ/$ in Bangladesh, and just 1.8 MJ/$ in Sri Lanka. Moreover, the rate of energy efficiency improvement was only 1.2 percent over 2000–2018 (declining in more recent years), which is well short of the SDG7 global target of 2.6 percent. 15 World Bank, “Solar Photovoltaic Power Potential by Country,” World Bank Understanding Poverty website, July 23, 2020, https:// www.worldbank.org/en/topic/energy/publication/solar-photovoltaic-power-potential-by-country. 16 Syed Safeer Hussain, “Submission of Revised Indicative Generation Capacity Expansion Plan (IGCEP) 2021–30),” National Electric Power Regulatory Authority (NEPRA), Managing Director’s Letter to National Transmission & Despatch Co. Ltd (NTDC), September 24, 2021, Republic of Pakistan, https://nepra.org.pk/licensing/Licences/LAT-01%20IGCEP%2024-09-2021%2037702-29.pdf. 62 High energy intensity, combined with rapidly growing energy consumption, adversely affects energy security by further adding to the country’s dependence on imported fuel for meeting its energy needs, and by increasing peak demand requirements in the electricity and gas sectors. For example, a large and growing source of electricity demand, especially during summer peak periods, is cooling. usage of air conditioning, combined with poor levels of building energy efficiency and rising temperatures, will place huge pressures on the electricity network and could increase annual cooling-related GHG emissions from 23 million MtCO2e in 2020 to over 50 million MtCO2e by 2030.17 Furthermore, there are over 175 million electric fans in Pakistan, most of which are inefficient models that consume over twice as much electricity as highly efficient fans with direct current (DC) motors that can be manufactured domestically.18 Reducing industry’s use of coal (imported and domestic) would have significant benefits for Pakistan’s balance of payments and GHG emissions. The industrial sector has the highest share of energy use. Combined with its heavy reliance on coal, the sector makes a disproportionate contribution to air pollution and GHG emissions. In 2020, industry represented 37 percent of total energy consumption and 73 percent of coal consumption (mostly imported). Electricity generation represents a smaller share of total coal consumption, albeit one that has grown rapidly in recent years due to a number of new coal-fired power plants. Industrial coal consumption is dominated by the brick kiln and cement industries, leading to both energy use and process emissions, with air pollution impacts. These industries are economically significant contributors to GDP and employment and have important linkages to other sectors. But since much of the coal consumption in the industrial sector uses imported coal, there would be wider economic benefits to implementing efficiency and decarbonization measures, in addition to the significant environmental benefits. Figure 3: Energy Consumption by Sector (above) and by Fuel Type in the Industrial Sector (below) (2019–2020) 2% Agriculture 3% Commercial Transport Industry Domestic 4% Other gov’t 30% 37% 24% 51.4% 31.3% 10.9% 6.4% Coal Gas Electricity Oil To achieve sustainability in energy, government should immediately implement the following policy shifts. Improve supply side efficiency (DISCOs). Improving supply-side efficiency is critical for stemming - commercial and technical losses and introducing greater financial discipline and transparency. This will involve a politically difficult restructuring of tariffs and state-owned distribution companies. Without this, the sector 17Green Cooling Initiative Country Data, last accessed September 5, 2022, https://www.green-cooling-initiative.org. 18World Bank. 2022. Supporting the Manufacture in Pakistan of High-Quality DC Fans. https://openknowledge.worldbank.org/ handle/10986/ 63 will continue to bleed resources and provide poor services to households and firms. Improving efficiency of the DISCOSs is critical for stemming commercial and technical losses and introducing greater financial discipline and transparency. This will involve a politically difficult restructuring of tariffs and state-owned distribution companies, without which the sector will continue to bleed resources and provide poor services to households and firms. Key recommendations include: (i) introduce private-sector participation in the management of the power distribution companies in order to improve efficiency, quality of service, and consumer satisfaction (this could include privatization or long-term concession contracts for selected DISCOs); (ii) fully implement tariff and subsidy reforms to ensure full cost recovery in the electricity and gas sectors. Significant progress has been made on rationalizing the subsidies for both, gas and electricity domestic consumers. This has enabled better targeting of the poor. However, it’s important the reform continues to ultimately protect the poor through social safety net, ensuring a better targeting; and (iii) ensure the successful introduction of a competitive wholesale power market to bring greater transparency to future contracting. Enhance demand-side efficiency. Reducing the country’s reliance on imported fuels and mitigating the impact of high prices on consumers can be made much easier by pursuing demand-side efficiency. Measures should be taken to reduce peak demand for electricity and gas. Pakistan should: (i) target quick wins to generate national support and build early momentum, such as setting minimum performance standards for mass-market appliances and improving the energy efficiency of existing and new buildings in the commercial and residential sectors; (ii) shift to electricity where economically and technically feasible, such as for space and water heating; (iii) launch commercially driven replacement or exchange programs for inefficient older appliances, such as fans and incandescent lighting; and (iv) develop the market for energy service companies to mobilize private-sector investment. Improve efficiency in the gas sector. Domestic gas resources are depleting at a rate of 10% annually. This exposes the country to an increased dependence on the imported LNG to meet existing and future demand. To mitigate against this risk, the government should undertake a number of reforms on the gas sector that would improve efficiency. Some of the key actions include: (i) undertake gas tariff reforms that will direct scarce gas resources to the most efficient power plants, thus limiting the need for imports, while also removing the cross-subsidies, especially to the fertilizers and domestic consumers. These reforms will be critical for decarbonizing the gas supply by providing the right signals for demand and supply; (ii) introduce the third party access for the LNG terminal that would allow large industrial consumers to import their own LNG; and (iii) no further development of fossil fuel power plants, reflecting the conclusions of the government’s own least-cost plan and building on the moratorium on plants using imported coal. Decarbonize the industrial sector. The industrial sector has many economically beneficial opportunities for raising energy efficiency and adopting technological improvements. Achieving deeper decarbonization, however, will require fuel switching where this is feasible, process changes (for example, in cement manufacture) and the potential deployment of carbon-capture technology. Concessional climate finance will be required to help pilot and scale up interventions that are not yet commercially viable, supported by regulation and private sector investment. Key recommendations include: (i) Incentivizing decarbonization and efficiency improvements in industrial energy use through regulations, fiscal incentives, and improved access to financing; (ii) Supporting the electrification of the industrial sector, and fuel switching from coal where feasible, including to green hydrogen and bioenergy. 64 Ensure a “just” energy transition. Any national development transition of this magnitude will likely face resistance, not only from vested interests but also because it could result in lost jobs and livelihoods as industrial, commercial, and public sector organizations modernize and adapt. It is important that Pakistan ensures a just energy transition, which will include efforts to tackle remaining gaps in access to modern energy services. Pakistan should: (i) develop a clear understanding of those who might stand to lose politically and financially and avoid disproportionately favouring some interest groups over others; (ii) protect the poor and vulnerable through targeted retraining and financial support; and (iii) achieve universal access to modern energy by 2030, with a particular focus on rural households and on the uptake of off-grid electrification and clean-cooking solutions. 65 Policy NOTE 6 Strengthening Government Revenues Towards an Equitable, Efficient, and Sustainable Tax System 266 1 Towards an Equitable, Efficient, and Sustainable Tax System Pakistan’s fiscal deficit has been persistently large and growing, posing risks to fiscal sustainability. Relatively low tax collections, extracted from a small number of taxpayers, contribute to fiscal sustainability challenges, and constrain resources available for priority investments, including in human capital. Potential to raise further revenues from increasing rates for the major current tax instruments is limited and would likely exacerbate inequities and distortions. Instead, a major change in approach is needed, with federal and provincial governments working together to expand the tax base. This approach should include Closing distortionary and regressive exemptions Improving the functionality of the GST (including through base and rate harmonization and administrative improvements) as a means of raising revenues and encouraging formalization—particularly in the retail sector that remains largely untaxed Supporting compliance through simplification of tax structures and the closing of income tax loopholes Substantially increasing the taxation of both agriculture income and property; an Introducing new taxes on environmentally and socially harmful products. Effective implementation of such a strategy would require coordinated action between federal and provincial governments, potentially involving a broader revision of fiscal federalism arrangements. These efforts could help increase revenues from around 10.5 percent of GDP in FY22, to the range of 15-18 percent of GDP. Potential benefits from strengthening revenues ~3.7% of GDP Up to 2% GDP 1% of GDP in revenues from federal in revenues from in revenues from tax reforms to reduce tax reforming taxes on land reforming taxes expenditures, increase and property. on agriculture excises, and harmonize the GST. 267 1 The Problem Pakistan’s tax-to-GDP ratio has been declining, with revenues well short of what could be expected under an optimal tax system. Pakistan’s tax capacity (overall capacity of the economy to generate revenues) has remained largely unchanged at a little over 22 percent of GDP over the past decade. Despite this, there has been a longer-term trend of declining collections, with taxes falling from around 14 percent of GDP in the 1980’s to around 10 – 12 percent of GDP today. Tax collected in FY22 was only 10.4 percent of GDP. This decline in tax-to-GDP is associated with rising tax expenditures, which at the federal level, rose from 1.3 percent of GDP in FY16 to 2.7 percent of GDP in FY22. Figure 1: Tax expenditures by type (PKR billion and % of GDP) Income Tax Sales Tax Customs Duty (Total as Percent of GDP at start of FY) 3.0 1600 1400 2.5 Percent of GDP 1200 PKR Billions 2.0 1000 1.5 800 1.0 600 400 0.5 200 0.0 0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Source: Federal Board of Revenue tax expenditure reports Revenues are collected overwhelmingly at the federal level. In FY16, 92.3 percent of tax revenues were collected by the federal government. The proportion of taxes collected by the federal government has fallen marginally to 91.2 percent by FY22, partly due to increased taxation of services by provincial governments. Despite this increase, total provincial revenue collection remains less than one percent of GDP. Instead, provincial governments rely heavily on revenues transferred from federal government, in the form of general transfers, in accordance with the National Financing Commission (NFC) award. A large portion of the tax base is not captured. For example, of the approximately 114 million people employed, just under 8 million people are registered for personal income taxes due to widespread informality. Agricultural income tax revenues remain very small, as over 90 percent of farmers in some large provinces are untaxed due to their land holdings falling below the acreage exemption threshold1. Similarly, the number of active CIT filers is 27,334 out of more than 60,000 companies registered for CIT. This represents a mere 0.8 percent of commercial / industrial electricity users (an illustrative pool of potential entities liable for taxation). 1 Agricultural income is subject to a minimum tax based on the size of land holdings according to a fixed schedule of per acre rates. In some large provinces, farmers with land of less than 12½ acres are exempted from taxation, while those owning up to 25 acres of land pay PRs 100 per acre and the per acre rate increases to PRs 250 for land holdings between 26 and 50 acres and to PRs 300 for over 50 acres of land. Farmers with over 50 acres of irrigated land are also required to file for income tax. Estimates suggest that over 90 percent of farmers appear to have land holdings less than 12½ acres, thus agricultural income remains largely untaxed. Additionally, agricultural land used for non-agricultural purposes continues to be taxed under the agricultural income tax scheme. 68 3 Only 178,190 entities are GST registered, from about 1.4 million retailers and 3.4 million commercial and industrial electricity users2. Under taxation of urban land leads to revenue loss and economic distortions. Significant potential exists to improve taxation of urban land. The current tax rate creates several market distortions and raises equity issues: (i) lower tax rates make it more profitable to invest in real estate relative to manufacturing or tradable services, thereby distorting the allocation of capital and reducing growth potential; (ii) lower effective tax rates for the Urban Immobile Property Tax (UIPT) on vacant plots rewards unproductive holding of land and speculative investments in real estate, thereby distorting land and housing markets; (iii) large differences in effective tax rates between rented and owner-occupied properties distort housing and rental markets; (iv) inadequate progressivity in land taxes benefits owners of high value properties at the expense of equity. Tax administration also remains complex and hinders revenue mobilization efforts. Revenue in Pakistan is managed by the Federal Board of Revenue (FBR) as well as 12 provincial revenue entities (three for each of the four provinces). Overlapping jurisdictions, multiple regulatory and tax requirements, and regular changes make the Pakistan tax system difficult to navigate for individuals and firms. The multiplicity of taxes and rates, and jurisdictional overlaps increase compliance and administrative costs. This complexity also provides opportunities for rate shopping and rent seeking, including by tax collectors. In the context of overall very low compliance and weak enforcement, government has relied heavily on the withholding tax regime. Withholding taxes on income are overall an efficient and progressive means of raising revenues. However, withholding on non-income transactions, including telecommunication and energy payments is highly regressive. Recommendations A new tax strategy is needed. Pakistan has typically sought to meet revenue shortfalls by increasing tax rates imposed on the relatively narrow compliant base. Continuing with this approach is likely to yield limited revenues, while increasing inequities and distortions in the tax system. Instead, federal and provincial governments should work together to broaden the tax base and raise revenue from undertaxed activities. This approach should include: i) closing distortionary and regressive exemptions; ii) improving the functionality of the GST (including through base and rate harmonization and administrative improvements) as a means of raising revenues and encouraging formalization; iii) supporting compliance through simplification of tax structures and the closing of income tax loopholes; and iv) substantially increasing the taxation of both agricultural and urban land. Improving federal-provincial coordination is critical. Tax administration and policy reforms should be immediately pursued to ease compliance and mitigate constraints arising from the current fragmented structure. Within the current constitutional framework, efforts should continue towards coordination of tax bases, creating a single tax market, and reducing the number of required interactions between taxpayers and revenue authorities (important gains have recently been achieved on harmonization of GST rules and definitions, including through coordination at federal-provincial revenue roundtables). Ongoing digitization efforts should be accelerated to reduce compliance costs and minimize the need for interactions between taxpayers and collectors. This should include faster progress with: (i) data sharing between tax agencies; (ii) making mandatory use of Computerized National Identity Cards (CNIC) for transactions, particularly of assets; (iii) development of a single portal for the sales tax; and (iv) digitization of land records and digital imagery of urban and rural lands. 2 IMF Working Paper, Unlocking Pakistan’s Revenue Potential, Serhan Cevik, August 2016. 69 3 At the federal level, reform efforts should focus on closing exemptions, simplifying the tax structure, and raising new revenues through excises. The following reforms should be undertaken Close corporate tax exemptions. Revenues equivalent to around 0.1 percent of GDP could be generated by closing regressive corporate tax exemptions that impose large fiscal costs while bringing few economic benefits. Specifically, this could include exemptions for power generation projects, which amounted to PKR 37 billion in FY21 and exemptions for real estate investments, which amounted to PKR 26 billion. Savings would be sufficient to fund 35,000 teachers on the average public sector salary, over two-thirds of Balochistan’s teacher population Reduce tax expenditures in the energy sector and for COVID-19 response. Tax exemptions and concessions resulted in tax expenditures of 2.7 percent of GDP in FY21. Government should wind back exemptions and other concessionary rates in the petroleum sector (PKR 280 billion); close exemptions on machinery imports to power generation and transmission (PKR 100 billion); and close costly exemptions introduced during the COVID-19 pandemic in the pharmaceuticals and energy sectors and for specific food items (PKR 40 billion on imports and PKR 100 billion on local supplies) Close exemptions for basic household items. Removing exemptions for food items including oil, pulses, animal, fruit, and dairy, could save PKR100 billion in revenues. Current concessionary rates on fertilizer impose fiscal costs of PKR 90 billion To encourage compliance and close loopholes, the personal income tax should be simplified. This should include harmonizing the tax schedule between salaried and non-salaried individuals, and reducing the number of tax brackets To both raise revenues and bring health and environmental benefits, excise duties should be increased on socially harmful goods. Excise duties on cigarettes could be applied with a uniform rate for all brands and an automatic inflation adjustment. This, in combination with strengthened enforcement to close the collection gap through the effective roll-out of a digitized stamp system, could raise up to 0.4 percent of GDP in additional revenue. Additional excises could be considered in future on other goods that are associated with environmental damage or negative health outcomes The poor should be protected from the price impacts of closing tax exemptions. Untargeted social relief through tax expenditures is regressive, with the bulk of the benefits flowing to the better off who consume and spend more. Poor households could be shielded from the impact of price increases associated with tax reform through increased temporary transfers or tax rebates via existing social protection programs, such as the Benazir Income Support Program (BISP). The poor would also benefit from a gradual phasing out of withholding taxes on non-income transactions, including telecommunication and electricity payments. At the provincial level, reform efforts should focus on improving own source revenue and accountability, including taxation of land and agriculture income. Provincial governments can significantly increase revenues through more progressive agricultural income taxation. Reforms should immediately be pursued to: (i) reduce or refine the current 12 ½ acre tax exemption threshold to bring more agricultural land into the tax net and reduce incentives for tax evasion through breaking up land holdings; and (ii) ensure appropriate categorization of land—taking account of size, location irrigation status, and area-based productivity aspects into tax rates. Simulations of an acreage-based tax indicated potential to generate additional provincial revenues of around one percent of GDP. 70 4 3 Provincial governments can significantly increase taxation of land. The following actions should be immediately pursued, generating up to two percent of GDP in revenues: i) continue or complete the establishment of reliable records of land ownership linked to NCICs and TINs; ii) harmonize the three valuation systems being used for different land related taxes, with taxable values based on capital values and equivalent to market prices3; iii) increase property tax rates to match those applied in peer economies (in Punjab, for example, the UIPT rate is currently set at 5 percent of the ARV, which translates into a Capital Value-based tax rate of 0.07 percent, compared to 0.5 percent in many low-income countries); and iv) improve the policy and legal framework to ensure that sizable and growing peri-urban settlements outside current notified municipal boundaries are also subject to appropriate land taxation. Reforms to current fiscal institutional arrangements should be pursued over the medium-term. Over the medium-term, further GST harmonization could bring substantial revenue gains. Pakistan is now one of the only federated states where the GST base remains fragmented, creating leakages and complexities for taxpayers4. A recent World Bank estimate suggest that further rate and base harmonization complemented by administration reforms could yield up to 1¾ percent of GDP. GST administration responsibilities should be consolidated with a comprehensive agency. Federal and provincial governments could agree to the establishment of a comprehensive administration, with a board of directors representing all federating entities. This, together with further IT advancements (e.g., data integration, single filing portal and e-invoicing) would radically ease compliance costs and foster further harmonization. Revenues collected by the comprehensive tax authority would continue to be distributed according to the 18th Amendment. Current fiscal federalism arrangements under the National Finance Commission and 18th Constitutional Amendment should also be reviewed for consistency with core principles of public finance. Federating units should be provided with the access to resources commensurate with their service delivery responsibilities and expenditure needs. The current system of federal transfers and assignment of tax responsibilities (GST on goods, and personal and corporate income taxation with the Federal Government; GST on services, property tax, and agricultural tax with the provinces) does not achieve this objective. The mismatch between available financing and formal service delivery responsibilities leads to de facto overlaps in service provision, undermining accountability and weakening incentives for efficiency in spending and revenue mobilization. Further, the current division of taxing powers creates opportunities for tax arbitrage and tax evasion, and enormous complexity for business compliance. Following a detailed review and appropriate consultations, institutional and/or constitutional reforms should be pursued to align revenue generation capacities with expenditure needs, considering administration and compliance factors (see Policy Note 8: Strengthening Institutions for Effective Implementation). Reforms to grow the economy and encourage formalization will also support sustainably higher revenues. Pakistan’s revenue potential is limited by the current structure of its economy. Revenue potential is ultimately constrained by Pakistan’s relatively low levels of income, large agricultural sector, and widespread informality. 3 The FBR and BoR currently use capital value as the basis, which is updated annually. The ENTD’s rental valuation tables use plot size and covered area as inputs and are required to be updated every five years. Basing all land-related transfer and recurring taxes on a single base value (BoR valuation tables) would promote harmonization. In parallel, actions taken over the medium term to bring the BoR valuation at par with market values would also improve other revenues that use these as a valuation basis, such as stamp duties, TTIP, and conversion fees. For recurrent taxation of non-commercial property, ongoing work to establish property values by the FBR can be used to establish a simple area-based system of imputed property value bands based on location and size, with provinces collecting rates applied against these estimated values. 4 India’s GST reforms, involving harmonization of the GST base and rates together with administration simplifications resulted in the c-efficiency ratio rising from under 0.4 in 2017 to around 0.6 in 2020 (Revenue Performance Assessment of Indian GST, Sacchidananda Mukherjee, NIPFP Working Paper Series 392). 71 3 5 While the measures discussed in this discussion note can bring major benefits, attempts to extract increasing revenue from a stagnant economy can eventually become counterproductive if they lead to a heavy tax burden being imposed on a limited tax base. Revenue policy and administration reforms should therefore be combined with broader measures to encourage investment, economic growth, and formalization, including through reforms to improve the business enabling environment, remove the anti-export bias in trade policies, and reduce the presence of the state within the economy (see Policy Note 3: Transforming the Private Sector). Pakistan’s fiscal system is uniquely regressive Findings from the Pakistan Commitment to Equity (CEQ) Assessment fiscal incidence analysis demonstrate that households (except those in the very poorest decile) are net payers into the fiscal system (Figure 2), which means that they pay more in cash terms in taxes than they receive in either subsidy or direct transfer benefits. The CEQ Assessment also revealed that in cash terms and relative to pre-tax incomes, the poorest 10 percent of the population in Pakistan pays a greater share of income in taxes than the richest 10 percent5. That poor households in Pakistan can expect a larger total tax burden (relative to pre-tax incomes) than rich households is unique among the set of countries that have undertaken a CEQ Assessment and points to the deleterious social and welfare impact of Pakistan’s current domestic revenue mobilization efforts6. Figure 2: Net Cash Position of Households by Decile 25.0% 20.0% Tax or transfer as a % of market 15.0% income plus pensions 10.0% 5.0% 0.0% Poorest 2 3 4 5 6 7 8 9 Richest -5.0% -10.0% Deciles by market income plus pensions, real, per adult equivalent Total in-kind education benefits Total in-kind health benefits Total indirect subsidies Total indirect taxes Total direct transfers Total direct taxes Source: World Bank calculations based on HIES 2018-19 and fiscal administrative data 5 This can be attributable to: (i) people whose circumstances are the same, not paying equal taxes given narrow tax base and multitude of exemptions; and (ii) higher tax burden not being placed on individuals with a greater capacity to pay, partly linked to political economy challenges. According to ILO estimates, of the approximately 114 million people employed, just under 8 million people are registered for personal income taxes. Furthermore, 90 percent of agriculture landowners do not pay taxes due to the 12½ acres exemption and the Urban Immovable Taxes and Sales Taxes are riddled with exemptions 6 Net payers and net recipients as well as absolute and relative tax burdens for most countries that have undertaken a CEQ Assessment are available for comparison at CEQ Data Center: https://commitmentoequity.org/datavisualization/country/IND 5 3 73 Policy NOTE 7 RATIONALIZING GOVERNMENT EXPENDITURES Prioritizing Spending to Support Macroeconomic Sustainability, Investment in People, and Climate-Resilience Rs. Rs. Rs. Rs. Rs. 74 1 Prioritizing Spending to Support Macroeconomic Sustainability, Investment in People, and Climate-resilience Pakistan’s large and persistent fiscal deficit has been an important driver of the country’s macroeconomic instability. Reducing expenditures that do little to support economic growth and development will play a central role in reducing the deficit. A narrow deficit will gradually create space for more public investment over time, including in physical and human capital and climate adaptation, to preserve and expand the productive capacity of the economy. However, containing the deficit while minimizing the negative impacts on development and the poor will be a critical challenge as Pakistan seeks to restore fiscal and macroeconomic sustainability over coming years. Measures that are immediately implementable for rationalizing fiscal expenditures includ Reducing poorly targeted energy and commodity subsidies Implementing the Treasury Single Account (TSA) Reforming Pensions, an Imposing temporary austerity measures. Over the medium-term, additional fiscal savings can be achieved by reducing the fiscal drain from poorly performing State-Owned Enterprises (SOEs) and improving the quality of development project spending. The fiscal deficit could also be reduced over time through improving alignment between federal and provincial spending. Duplication between provincial and federal governments should be eliminated. Provinces should meet additional financing responsibilities under the 18th constitutional amendment through enhanced provincial revenue collection and efficiency savings, reducing the need for federal spending in these areas (see Policy Note 6). Potential Gains From Expenditure Reforms Pakistan could achieve PKR876 billion potential savings from short-term expenditure measures Pakistan could achieve PKR458 billion potential savings from SOE reform and divestment Substantial progress in reducing the deficit and improving accountability could be achieved by gradually transferring the current PKR953 billion of federal spending in devolved areas to provinces, with provincial governments financing new spending from increased revenue collections and efficiency improvements. Figure: Average fiscal deficit and potential savings from short-term and medium-term expenditure reforms 3 75 The Problem Pakistan’s fiscal deficit has been persistently large and growing, posing risks to fiscal and debt sustainability. In FY22, Pakistan’s general government deficit stood at a 22-year high at 7.9 percent of GDP. The fiscal deficit has been growing, with the post-2010 annual average significantly larger than its pre-2010 average. Large recurrent budget shortfalls have led to a rapid accumulation of public debt, which reached 78.0 percent of GDP in FY22, slightly lower than the record high of 81.1 percent of GDP in FY20. Deficit and debt levels are now in breach of fiscal rules under the Fiscal Responsibility and Debt Limitation Act (FRDLA). Rationalizing and reducing Pakistan’s federal expenditure is critical to regaining fiscal and debt sustainability. Figure 1: Federal government Spending Figure 2: Federal government spending, (by current and development spending) economic classification (% of GDP) 16% 0% 5% 10% 15% FY12 13.6% 14% 1.6% FY13 12.7% 1.1% 2.1% 2.3% 1.5% 12% 1.9 % 2.2% FY14 13.1% 2.2% 2.8% 2.5% 2.5% FY15 12.6% 10% FY16 12.6% 13.1% 12.4% 8% 11.5% 12.5% 10.3% FY17 10.4% 10.0% 11.2% 11.9% 10.8% 10.3% 9.9% FY18 12.5% 6% FY19 13.5% 4% FY20 14.7% 2% FY21 13.4% FY22 13.5% 0% Loans and Advances Interest FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21 FY22 Grants, Subsidies, Writeoffs, Advances and Transfers Current Development Total Operating Expenses Capital Salaries, pensions and other benefits Total Expenditure and Loans Source: World Bank Staff calculations based on PIFRA data Pakistan’s federal fiscal spending is particularly rigid. In FY22, combined federal and provincial expenditure stood just above PKR 13 trillion, around 19.7 percent of GDP. The federal government accounted for about two-thirds of expenditure (13.5 percent of GDP). While not high by international standards, spending is strikingly rigid, with almost 80 percent of total spending annually being allocated to pre- committed areas such as interest payments, transfers and subsidies, and payments to public sector staff (Figures 1 and 2). This is much higher than regional peers. For instance, Nepal’s share of rigid federal government expenditure is less than 60 percent. Despite its importance, public development spending is low. With a substantial share of fiscal spending being pre-committed, there is little fiscal space for public investment. Consolidated development spending in Pakistan stood at 2.5 percent of GDP in FY22, of which the federal government contributed about 84 percent. These levels are very modest and lower than that of regional peers; India’s general government capital spending in FY21 stood at 6.7 percent of GDP. Low levels of physical and human capital investment have contributed to low growth in productivity, potential output, and employment, and therefore contributed to Pakistan’s recurrent boom-bust cycles. Development expenditure needs are expected to rapidly increase over coming years, as Pakistan is forced to confront and adapt to the impacts of climate change. 4 76 Spending on energy and commodity subsidies is poorly targeted, distortive, and wasteful. Between FY12 and FY22, subsidy spending averaged 1.1 percent of GDP and increased significantly to 1.8 percent of GDP in FY22. Over 80 percent of recurrent subsidy spending between FY13 and FY22 benefited the electricity sector (Figure 3), with a large share being tariff differential subsidies, accounting for 15 percent of total subsidies in FY22 (0.27 percent of GDP). These subsides are regressive with large shares of the benefits accruing to the non-poor: in FY19, 77 percent of the subsidy spending benefited households in the top 3 quintiles of the income distribution (Figure 4). By contrast, the bottom 40 percent only benefited from 23 percent of total spending. With recent tariff reforms, targeting had greatly improved. By FY22, 64 percent of the subsidy benefits accrued to the bottom 40 percent and only 36 percent of the benefits accrued to the top 3 quintiles of the income distribution. However, with one-third of benefits still accruing to relatively more affluent households, targeting can be further improved. Figure 3: Cumulative federal spending on Figure 4: Distribution of benefits of different subsidies between FY13 and FY22, by type programs by quintile 
 (% of total spending) (% of total benefits of a given subsidy) Utility Store Corp 3% 70 Electricity Electricity 65.4 TCP Subsidy Subsidy (2019) (2022) PASSCO 0% 3% Others 60 BISP 3% 53.8 BISP (Unconditional (Conditional Cash Transfers) Cash Transfers) Petroleum 50 11% % of total benefits 40 36.2 32.1 30 28 26.9 22.4 24.5 19.1 20 16.1 Electricity 14.2 14.8 - SOEs 13.7 Electricity - Private Company 68% 9.8 10 8. 12% 4.9 1 4.7 3.7 0.90.4 Electricity - SOEs Electricity - Private Company Petroleum 0 PASSCO Utility Store Corp TCP Others Poorest 2 3 4 Richest Source: Subsidies Table, Federal Budget in Brief, Ministry of Source: World Bank Staff calculations based on HIES 2018-19. Finance. Weak management of SOEs is a major drain on fiscal resources. The federal SOE portfolio has been incurring net losses since FY16 that average around 0.5 percent of GDP annually, with the top 14 loss making SOEs incurring an annual fiscal cost of 0.8 percent of GDP (PKR 458 billion).1 As a result, federal annual fiscal support to the SOEs, in the form of equity injections, subsidies and loans, has been substantial and growing, reaching 1.4 percent of GDP in FY21. In addition, many government loans to SOEs are overdue and not being serviced. The stock of outstanding government domestic loans to SOEs stood at 3.5 percent of GDP in FY21, of which nearly a third was overdue. Moreover, contingent liabilities, in the form of loan guarantees provided by the federal government for SOEs to contract commercial loans, have been rapidly rising, reaching almost 4.5 percent of GDP at end-FY21. Information on tax and dividend arrears is not readily available but taxes and dividends from SOEs averaged just 0.4 percent of GDP over the FY16-FY21, significantly lower than government direct transfers to the SOEs (1.3 percent of GDP). 1 Excluding health and education institutions, the federal SOE portfolio comprises 207 enterprises, of which 87 are commercial enterprises operating in various economic sectors, and 47 are non-commercial enterprises. Punjab has 224 SOEs (including 49 PSCs) and KP has 121 SOEs (including 6 PSCs). No information is available regarding the SOE portfolios of Sindh and Balochistan. 77 4 Incomplete fiscal devolution has led to duplicative and misaligned spending between federal and provincial governments. The 18th amendment transferred substantial spending responsibilities from the federal to provincial governments, including in core service delivery areas such as health, education, and some infrastructure. Provincial governments were expected to meet these responsibilities through federal transfers and provincial revenues. However, the federal government continues to spend on areas that have been devolved to the provinces, leading to duplication and a structural increase in the fiscal deficit. Examples of duplication and misalignment include: Spending on federal ministries focused on devolved subject areas, such as those for health and education, amounted to PKR 328 billion (0.5 percent of GDP) in FY22 Federal spending on devolved subjects through semi-autonomous bodies that focus on devolved service delivery areas. The federal government currently spends around 0.6 percent of GDP annually on devolved ministries and semi-autonomous programs bodies Federal government spending on vertical programs, such BISP, that directly provide services in the provincial domain. Federal spending on BISP was approximate PKR 240 billion (0.4 percent of GDP) in FY22 Federal development spending on devolved areas, which amount to PKR 315 billion in FY22. Recommendations The following immediate measures should be implemented to reduce overall fiscal expenditures: 1. Reduce energy and commodity subsidies. Reallocating spending away from costly, inefficient, and regressive subsidies, such as those on natural gas, petroleum, tube-wells, wheat, and fertilizers towards a targeted transfer program such as the Benazir Income Support Programme (BISP), can help to realize fiscal savings, reduce excessive consumption of imported fuels, and improve social outcomes. Well-targeted transfers prioritize public resources towards those who are most in need, while providing a boost to purchasing power that allows households to choose the highest value goods and services relevant to improving their welfare. 2. Adopt the TSA. The adoption of the TSA can improve the effectiveness of government cash management practices. It will enable proper monitoring and accounting of the Government’s available cash balances and reduce public borrowing needs. In June 2022, total federal government deposits at commercial banks amounted to PKR2,020 billion. By proper accounting and use of these idle cash balances, the amount of required sovereign borrowing can be reduced, generating interest cost savings of up to PKR 424 billion annually.2 3. Impose temporary austerity measures, while protecting infrastructure maintenance expenditures. The temporary imposition of stringent review requirements over staff and operational costs, as well as development spending, can generate immediate cost savings. The Government could consider setting a recurrent expenditure reduction target of 10 percent and implement a government-wide hiring freeze, wage freezes for the mid to upper echelons, and conservative salary increases (if any) for the lower echelons. These should be complemented by other measures, such as halting vehicle purchases and limiting 2 This assumes that new government borrowings incur interest rates that are equivalent to the policy rate, currently at 21 percent at the time of writing. 78 5 3 allowances for representation, meetings, travel, and petrol for all staff. Concurrently, the government could conduct review of PSDP development expenditure and cancel all projects that have not undergone proper project preparation, selection and prioritization and delay previously vetted projects that are unlikely to bring significant benefits to the poor. Such a consolidation of development expenditure could target a 20 percent reduction in near-term development spending.3 4. Reduce the fiscal drain of SOEs. The fiscal drain stemming from SOEs can be reduced by (i) discontinuing subsidies to SOEs that do not provide a public good benefit (ii) enforcing all SOE loan agreements and establishing stringent processes and criteria for evaluating SOE loan requests, including reviews of assets that can be collateralized for repayment capacity (iii) implementing the recommendations of the 2021 triage exercise (a Ministry of Finance review, which assigned SOEs to categories for retention, privatization, or liquidation), and preparing for the divestment of major loss making SOEs, especially those with no clear rationale for government involvement, (iv) pursuing opportunities for private participation across the SOE portfolio through management or concession contracts; and (v) strengthening SOE governance through implementation of the new SOE law and improving financial management and performance, including by strengthening the capacity of the SOE Central Monitoring Unit and institutionalizing SOE performance monitoring. Reforms for immediate fiscal expenditure reduction: Annual Fiscal Savings Potential Billions of PKR Eliminate spending on subsidies for: Electricity tariff-differential 167a Tube-wells 20a Minimum support price for wheat (Subsidies to PASSCO) 8a Fertilizers (Subsidies to farmers plus subsidies for urea manufacturing) 41a Gas (to LNG sector for subsidized gas supply to industry) 81b TSA interest cost savings 424 Austerity measures over government staff and operational costs (10 percent of 55c FY22 costs for the“Running of Civil Government”) Consolidation of PSDP allocations (20 percent of FY22 Federal PSDP expenditure) 80c T otal 876 (1.3 percent of FY22 GDP) Source: Controller General of Accounts and Ministry of Finance. Notes: aPIFRA data; bFY22 Revised Budget; cFiscal Operations 2021-22 data T he following medium-term measures should be pursued to rationalize overall fiscal expenditures: 5. Reform pensions to reduce pension costs. Fiscal costs for Pakistan’s federal and provincial civil servants’ pension schemes have dramatically grown. A recent study4 found that provincial pension expenditures grew from 1.6 percent of GDP in 2016-2017 to 2.2 percent of GDP in 2020-2021. Estimates indicate that overall pension spending as a share of tax revenue reached 18.7 percent as of FY20.5 3 However, maintenance spending for infrastructure should be protected to prevent deterioration of growth-enhancing assets and higher future repair or replacement costs. 4 The financing of semi-autonomous institutions can be subsequently taken up by the provinces in line with the constitutional mandates. 5 In order to protect access to essential social services in lower-capacity provinces, a phased devolution approach with appropriate safeguards and remedial actions should be planned and adopted. 79 6 3 Measures to constrain the growth of pensions spending include automatic indexation to inflation subject to a cap, instituting a minimum retirement age to receive benefits, and limiting dependents eligible for survivorship benefits. 6. Divest or restructure SOEs (including through increased private participation), in accordance with the recommendations of the triage exercise. After identifying and addressing binding constraints to divestment/restructuring, the government should proceed rapidly with required restructurings and transactions to divest those SOEs that engage in purely commercial activities. Subsequently, private participation can be introduced where this is likely to improve incentives and capacity for commercial performance. Implementation of triage could reduce fiscal expenditures by 0.8 percent of GDP. 7. Strengthen public investment management to improve the quality of development spending. Recommendations include to fully implement the PFM Act of 2019, including the use of economic and risk analysis for development projects and to establish an M&E system for public investment projects and programs. 8. Rationalize provincial expenditures. Opportunities should also be pursued to rationalize provincial expenditures. Important opportunities include reforms to Address provincial commodity subsidy and price support schemes that lead to high fiscal costs and the accumulation of commodity debt Reduce costs of the provincial SOE portfolio, mirroring efforts underway at the federal level; an Optimize human resource expenditures in basic service delivery, including civil service pay reform to ensure that compensation is aligned with market norms and based on adequate qualification and performance. Over the medium-term, fiscal consolidation should be further supported by addressing duplication and misalignment between spending by the federal and provincial governments: 9. Measures should be implemented to address current duplication in current provincial and federal government spending. This should involve identifying and eliminating direct overlaps between federal and provincial recurrent roles and spending (for example in the ministries of health and education), to reduce duplication and waste. This should be based on a detailed review and adequate consultation. 10. Further progress towards fiscal consolidation could be achieved by transferring increased financing responsibilities to provinces in accordance with the 18th constitutional amendment. Gradual transition of financing responsibilities for spending on devolved subjects to provinces could reduce the fiscal burden on the federal government. This could support overall fiscal consolidation if provincial governments were required to meet the costs of delivering the additional devolved functions through efficiency improvements and mobilizing new revenues through underutilized devolved revenue sources, including increased taxation of property, agriculture income, and services (as described in Policy Note 6). Alignment of spending responsibilities with constitutional mandates would improve accountability and strengthen incentives for provincial governments to maximize potential from devolved revenue sources. Federal spending in the following areas could be progressively devolved: Spending on ministries and through semi-autonomous bodies that focus on devolved service delivery areas Spending on the Benazir Income Support Program; an Federal government development project spending on devolved subjects. 80 7 3 Current Federal Spending Federal spending on devolved subjects Billions of PKR Operational spending on devolved ministries and semi-autonomous bodies 398 Benazir Income Support Program Expenditures 240 Federal development spending on provincial mandates 315 Total 953 (1.4 percent of FY22 GDP) Source: World Bank Pakistan Federal Public Expenditure Review 2023 A Roadmap for SOE Reform 1. Reduce fiscal exposure by i) instituting strict conditionalities and performance covenants for issuance of new fiscal support to SOEs; ii) enforcing loan contracts to ensure the timely recovery of overdue amounts, linking this to the performance contracts of Boards of Directors; iii) enforcing a legislated overall guaranteed limit; and iv) introducing a maximum cap on exposure as a percentage of SOE assets/liabilities. 2. Improve information on SOE performance by: i) improving the financial reporting framework and comprehensiveness of Government Financial statements; ii) defining a financial reporting framework for federal and commercial SOEs created by special enactment; iii) introducing disclosure requirement for corporate reporting for PSCs, including in relation to the adoption of sustainability standards; iv) incorporating SOE holdings onto the Government balance sheet; v) introducing a computerized database to provide portfolio-level information and entity-level exposure and performance information to the decision makers. 3. Introduce corporate governance reforms in line with the new Federal SOE Law (2023) including i) developing a state ownership policy and dividend policy; ii) ensuring competitive selection of professional and independent Boards of Directors; iv) developing a SOE performance monitoring and evaluation system; and v) transferring the SOE oversight function from line ministries to a strengthened Central Monitoring Unit. 4. Support improved commercial performance, including i) requiring SOE management to develop business plans to achieve commercial rates of return; and ii) monitor implementation through separately accounting for commercial and non-commercial activities and taking explicit account of subsidies paid to SOEs for the provision of public service obligations. 5. Pursue triage to quickly divest SOEs where there is no rationale for government ownership, through: i) identifying binding constraints to divestment/restructuring; ii) developing a reform roadmap to improve performance of the entities that will be retained and restructured; and iii) progressing transaction for those SOEs that can be quickly divested. 81 Policy NOTE 8 STRENGTHENING INSTITUTIONS FOR EFFECTIVE IMPLEMENTATION Towards Accountability and Transparency 82 1 Towards Accountability and Transparency Effective implementation of the reforms proposes in these policy notes will depend on addressing critical underlying institutional and governance constraints. These constraints include: i) perverse political economy incentives and elite capture, with policy decisions heavily influenced by vested interests, including those of military, political, and business leaders; ii) an incomplete devolution agenda that leads to overlaps and gaps in service delivery, increases fiscal costs, and blurs accountabilities; and iii) structural and institutional constraints in the public sector, including unclear or duplicative responsibilities and weak incentives for public sector performance. Institutional reform is a long-term challenge. Critical measures to strengthen accountability, counteract elite capture, and build the administrative capacity of government to deliver critical reforms and investments should be pursued. These includ Reviving and strengthening institutions for effective national policy coordination between federal and provincial governments (including the Council of Common Interest and National Economic Council) to ensure policy coherence and effective implementation Improving processes for public sector appointment, performance management, and tenure to enhance incentives for delivery Enhancing digitalization and e-government to improve efficiency and reduce opportunities for corruption; an Increasing e-government transparency through improved availability of information and the establishment of performance targets for key government entities. In parallel, the incomplete devolution agenda should be further progressed to strengthen local-level accountability. A clear vision for effective devolution should be developed and implemented, including through reforms to government financing and structure. The Problem Institutional constraints to implementation This series of policy notes recommends a broad range of critical reforms for sustainable economic development. Effective implementation of these reforms will present a major challenge, in the context of important governance and institutional constraints. These constraints include Perverse political economy incentives and elite capture. Pakistan’s politics remains dominated by patronage, with political elites mobilizing support through the direction of regulatory concessions, public sector rent flows, and private goods to constituents and allies, rather than through improved service delivery and economy performance. Policy decisions are heavily influenced by strong vested interests (Kaplan, 2013; Husain, 2018; Hasnain 2008; Ahmad 2010). Critical reforms have limited prospect of effective implementation in a context where many policymakers are accountable to special interests rather than the broader public. 83 1 An incomplete devolution agenda. Devolution can theoretically support effective reform implementation, by ensuring closer accountability linkages and feedback mechanisms between service providers and citizens. The 18th Constitutional Amendment saw a major devolution of service delivery responsibilities to provinces, presenting opportunities for stronger accountability. The devolution process has not been effectively implemented, however. Federal government continues to deliver many devolved functions, creating overlaps in service delivery, increasing fiscal costs, and blurring accountabilities. Financing arrangements are not informed by current service delivery responsibilities.1 Fiscal arrangements (under which provinces depend heavily on federal transfers and important tax bases are split between provinces and the center) weaken accountability for revenue collection and complicate tax administration. While protected under the constitution, local governments have limited power or resources in practice. Local government appointments and budgets remain controlled by the provincial governments, leaving decision-making centralized in provincial capitals and Islamabad Structural and institutional constraints in the public sector. The structure of government is extremely complex, while incentives for performance are often weak, limiting implementation capacity. Pakistan has around one million public servants across federal and provincial levels, spread across hundreds of departments, agencies, and State-Owned Enterprises (there are currently around 200 SOEs at the federal level alone, among around 340 autonomous agencies). The large number of government entities at federal, provincial, and local levels leads to continuous coordination problems, with unclear mandates causing overlaps and gaps in service delivery. Unclear or duplicative responsibilities undermine accountability. Performance management of staff is weak. Performance reviews are rare and incentives reward adherence to the rules rather than good operational performance. Promotions are largely based on seniority and informal networks, and do not ensure that those most qualified for leadership end up in senior positions. Rapid turnover of officials in senior government positions weakens institutional capacity and undermines continuity in reform implementation. Opportunities for change The current juncture presents potential for overdue reform. International evidence shows that institutional reform is a long-term process, heavily dependent on a conducive political context. While technocratic interventions are unlikely to transform Pakistan’s institutional environment in the short-term, current contextual factors may present some windows of opportunity for positive change. These factors include Deteriorating economic conditions. Current weak economic performance and the potential for continued macroeconomic crises present threats to the economic interests of elites. Recognition of the extent and severity of current challenges may broaden support for required economic and institutional reforms Demographic change. Pakistan has a young and fast-growing population, with among the largest proportional youth populations in the world. A growing share of the population is urban, relatively educated, and insulated from traditional rural patronage structures. Recent research has argued that young urban voters are more likely to vote based on the perceived performance of government in effective economic management and service delivery, potentially strengthening political incentives for improved policy (Mahar and Malik 2021). 1 The 18th Constitutional Amendment of 2010 allocated responsibility for almost all public services to provinces, along with control over all local government institutions. The center mostly retained functions relating to defense, foreign affairs, natural resources, electricity, communications, regulatory frameworks and cross border relationships of trade and finance. The Amendment also expanded the taxation powers of the provinces to include the sales tax on services, taxes on agricultural income, immovable property, estate and inheritance, and zakat and usher (religious taxes). The 7th National Finance Commission Award of 2009 increased the provincial revenue share from 47.5 percent to 56 percent in the first year of the award and 57.5 percent in the remaining years of the award. The NFC award also introduced a multifactor formula for horizontal distribution of resources to the provinces taking account of population, poverty, resource mobilization, and population density. 84 1 Emerging technologies. Pakistan has experienced rapid increases in access to digital technology and social media2. Social media has become an important site for political and policy discourse. Recent analysis shows that economic issues were among those most frequently discussed by actively political social media users in the lead-up to the 2018 elections (Mir, Mitts, and Staniland 2022). Digital technologies, including social media, have been posited as an important mechanism for political awareness and mobilization, and as a tool through which the public sector can be held to account for service delivery performance (World Bank 2018). Box: Pakistan’s institutional performance over time and in comparison International indicators highlight Pakistan’s overall poor institutional and governance performance. World Governance Indicators, derived from a range of surveys and benchmark measures, show Pakistan ranked below the average for South Asia and Upper Middle-Income countries against all indicators. Pakistan is ranked in the bottom 3rd of all countries against five of six indicators. There has been mixed progress over the past two decades. While Pakistan’s return to democracy has driven an improvement in percentile ranking against “Voice and Accountability”, there has been relatively minor improvement against only two of the remaining five indicators since 2001. Other indicators and sources paint a similar picture. The World Bank’s Country Policy and Institutional Assessment data shows Pakistan performing slightly worse than the average for lower middle-income countries, with deterioration against two of three governance indicators since 2005 (“protection of property rights and rules-based governance” and “quality of public administration”), and only slight improvements in scores for “transparency, accountability, and corruption in the public sector”. Pakistan is currently ranked 140 th of 180 countries in Transparency International’s Perceptions of Corruption Index, with continuous declines in performance and rank since 2018. Figure 1: World Governance Indicators – Percentile Rank for Pakistan and Comparators 60 50 40 30 20 10 0 South Asia Pakistan South Asia Pakistan South Asia Pakistan South Asia Pakistan South Asia Pakistan South Asia Pakistan Upper middle Upper middle Upper middle Upper middle Upper middle Upper middle income income income income income income Control of Government Political Stability Regulator y Quality Rule of Law Voice and Corruption Effectiveness and Absence of Accountability Voilence/Terrorism 2000 2011 2021 2 Pakistan now has over 194 million mobile phone subscribers and more than 124 million broadband subscribers (Pakistan Telecommunication Authority 2022). Pakistan had 37 million social media users in 2020. This included 36 million Facebook users and 1.26 million Twitter users. Users of social media tend to be younger, with 41% users are between (18 and 24) years and 36% people are between 25 and 34-years-old (Shafaq, Li, and Dong 2022). 85 1 Recommendations Several measures should be prioritized to strengthen institutions and support implementation of critical reforms. Immediate measures should be taken to improve coordination between different layers of government. Current constitutional arrangements require coordination on national policy between federal and provincial governments. Decisions made by the Economic Coordination Committee or the Federal Cabinet are no longer binding on the provinces. The Council of Common Interest and National Economic Council must therefore play a critical role in supporting national policy coordination and coherence. A National Council of Ministers, consisting of the Federal and Provincial Ministers working under the aegis of the Council for Common Interests (CCI) should formulate and monitor the implementation of key national policies, including in education, health, food security and agriculture, water and sanitation, and transport. Strengthened federal-provincial fiscal coordination should be pursued in parallel, including further efforts to harmonize tax policy and administration, and ensure the effective implementation of a national medium-term fiscal framework, in line with new federal and provincial fiscal responsibility legislation. Processes for public sector appointment, performance management, and tenure should be improved. Implementation of public sector reforms is being impeded by the vested interests of senior bureaucrats in maintaining the status quo. Strong political leadership will be required to change incentive structures within the public service. Firstly, a Performance Management System (PMS) should be implemented across the public sector, under which public servants are assessed against the achievement of agreed performance indicators (linked to ministry functions under the Rules of Business), with performance assessment feeding into career progression, salary increases, and (in cases of persistent poor performance) early retirement. Secondly, security of tenure should be strengthened for all government officers, including secretaries. Any decision to remove a government officer from their position before the end of an appointment term should require a written justification, with the affected person provided the right to challenge this decision through an independent, formal process. Thirdly, recently introduced processes for the open, competitive appointment of Chief Executives to public sector agencies with critical economic and social functions should be strengthened and maintained. Chief Executive appointments should be safeguarded from political interference. Chief Executives should be provided with operational autonomy and a fixed tenure and held accountable for results against a set of clearly defined objectives and goals. Finally, in-service training of government officers should be strengthened to close important skills gaps, while recruitment should be recalibrated to focus on key relevant skills and expertise, rather than strong performance against the public service exam. Digitalization should be implemented across government to increase efficiency and reduce opportunities for corruption. Digitalization should be pursued to increase efficiency and reduce opportunities for corruption. Pakistan has most of the prerequisites in place for an aggressive program of digitalization, including a national identity system covering nearly half of the adult population, significant penetration of smart mobile phones, many electronic data bases, computerized land records, automated banking apps, a vast fiber-optic network, and a burgeoning IT industry. Electronic platforms and e-service centers should be established to provide a single platform for all forms, clearances, NOCs, and seeking rulings. 86 1 Digital platforms should also be increasingly used for revenue administration, including the single GST portal, and to facilitate citizen feedback on government performance (e.g., teacher attendance) and submission and tracking of citizen grievances and complaints. E-government should be accelerated to improve efficiency and effectiveness. Existing efforts to introduce e-government at federal and provincial levels should be intensified and accelerated. Business processes should be revised to take maximum advantage of electronic systems and reduce the need for paper-based approvals. These revisions should empower secretaries, heads of departments, and district officers to take decisions without multiple clearances. Initiatives towards e-procurement should be pursued at provincial and federal levels. Transparency should be significantly improved. Transparency is a critical tool for increasing the accountability of policymakers to citizens. Government agencies should be required to establish and report against service standards and outputs, including in budget documentation. Audit capacities across government should be strengthened, including increased use of performance audits. Further progress should be made with the publication of government financial information, including in-year budget reports, external audit reports, reporting on guarantees and contingent liabilities, and the audited financial statements of SOEs. Revised manuals, rules, regulations, statutory orders, circulars, guidelines, and codes should be published on the websites of public sector entities. Cabinet meeting minutes and proceedings should be made public, except in specific cases where there is a strong public good rationale for confidentiality. Combined, these measures can help to strengthen accountability and counteract elite capture, while building the administrative capacity of government to deliver critical reforms and investments. These measures may also have important impacts on private sector confidence and investment, by improving the quality of public services, addressing policy instability and corruption, and better aligning policies with the interests of citizens and firms. In parallel, a clear vision for effective devolution should be developed and implemented, including through reforms to government financing and structure. The following steps should be taken Develop a clear vision for decentralization. The design of any decentralized system, including expenditure, tax and revenue assignments as well as transfer of functions and tax instruments, depends on the agreed objective of the reform process. The first step in reviving Pakistan’s decentralization agenda should be to develop a common/joint vision of decentralization, potentially including maintaining national unity, increasing accountability of service providers, or better tailoring service provision to the demands of citizens. This vision is required to inform the further decentralization process, including at the local government level Build consensus around technical implementation arrangements. An appropriate constitutional body (likely the Council of Common Interests) should develop an implementation plan based on the agreed vision, through a consultative process with broad public participation. This plan should provide: i) clear and mutually agreed division of responsibilities between federal, provincial, and local governments; ii) arrangements for tax devolution, grants, and subnational revenue collection to ensure that each level of government has adequate resources to finance its respective responsibilities (based on costing of service delivery responsibilities and assessment of revenue potential at each level, and likely necessitating revisions to the 7th NFC award); and iii) an assignment of functional responsibilities for implementation Empower local governments in accordance with assigned responsibilities. Devolving administrative autonomy, finances and expenditure responsibilities to elected local governments is necessary to enhance accountability. 87 1 A legal framework establishing LGAs and defining their functions needs to be developed. Provincial finance commissions must be strengthened ensure greater fiscal autonomy of LGAs including strengthened powers of resource allocation and revenue collection. Mechanisms to enhance local-level accountability must be established, for example through community-based consultations, deliberations, and participation in decision-making Restructure and streamline government agencies to address overlaps and redundancies. Federal and provincial departments that are already redundant or would become so under the proposed devolution to the local governments should be abolished. The recent exercise to rationalize federal autonomous bodies and attached departments, corporations, companies, councils, institutes, subordinate offices at the Federal Government should be repeated in line with newly delineated responsibilities and fully implemented; and duplicated at the provincial level. Federal spending on provincial mandates, including through the government ministries, vertical programs, and the development budget, should be ceased, delivering significant potential fiscal savings (see Policy Note 7: Rationalizing government expenditures).