Nigeria is a federation. In practice, this means that the Nigerian government operates at three levels; federal, state, and local, with each responsible for different functions and responsibilities. For example, the Federal Government (FG) has sole responsibility for printing money and maintaining the peace, while the State Governments share responsibility for health and education with the Federal Government.
How is the Nigerian Government funded?
Oil revenues account for nearly all government revenue – 69% in 2017. Corporation taxes, VAT, customs, and other levies make up the rest. States are financed in two ways: with the funds they generate through personal income taxes and other levies – known as Internally Generated Revenue (IGR), or the money they receive from the FG every month from the Federation Account Allocation Committee (FAAC). The local governments are also financed through a mix of allocations from the FG and IGR.
How Is The Money Shared?
At the end of every month, the FG gathers all the money it has generated from crude oil sales, customs and taxes, and so on. 13% of any revenue made from natural resources is returned to the origin state of those resources, in line with the derivation principle. Other deductions are made for the costs associated with collecting revenues, and the rest of the funds are shared across the three tiers of government. The FG keeps 52.68% for its budget (goes to the FCT), the states share 26.72%, and local governments get 20.60%.
Each state receives a proportion of federal revenues based on a "Horizontal Allocation Formula". The first 40% of revenues is shared equally across the states. The rest is determined by population (30%), landmass (10%), IGR (10%) and social development factors (10%), which include things like school enrollment, number of hospital beds and most peculiarly, the amount of rainfall in the state.
Bankrupt States and Skewed Incentives
Many Nigerian states are funded mainly from federal allocations, with as many as 14 states funding at least 90% of their budgets with their FAAC allocations. This poses two problems. First, because most federal revenue comes from oil, volatile oil prices make it hard for states to plan their financial futures. It is common to see states expand their civil service during oil price booms and struggle to pay salaries or fire workers when oil prices slump. The federal government bailed out states in 2015 for this reason.
The second problem with this revenue sharing system is a little more nuanced. When states generate their revenue from taxing citizens, the incentives of the state align with the economic benefits of its citizens. The state needs its economy to grow so that government's tax income can increase. However, in a system where revenue is gotten mostly from federal allocations which have no relationship with the economic performance of the state, the state government stops caring about the economy of the state. Instead, they turn their attention to matters in Abuja as they try and preserve their FAAC allocations.
What Do We Do?
There are simple solutions to these problems, but it is unlikely any will be implemented as the people that currently benefit from this system are also the ones with the ability to change it. Oil price volatility can be tackled by saving for a rainy day, as is the purpose of the Excess Crude Account, which has been drained from a peak of $22 billion to just $2 billion today.
The potential solutions for the principal-agent problem are a lot more complicated. The allocation formula can be tweaked to promote better incentives. Most of the current criteria relate to factors outside a state's direct control (population, landmass, rainfall), with too little emphasis placed on fiscal management.
For example, federal allocations can be matched with state expenditure, where for every naira the states spend on a sector, the FG provides matching funds. Or we could set limits that prevent states from accessing their FAAC allocations if their debt rises beyond a certain level. The FG attached similar conditions (e.g. timing of budget passage, transparency of accounts, etc.) to their 2015 bailout of state governments. Unsurprisingly, many states have violated these conditions, but there have been no real consequences. It is one thing to set targets or tie revenues to metrics, and it is another thing to enforce. Alternatively, FAAC allocations could be explicitly tied to performance in health or education , ensuring that state governments have an interest in investing in the human capital of their states.
The current system of funding the government is plagued with issues such as being prone to oil shocks and misaligned incentives between state governments and their citizens. The potential solutions are tough and require enormous political will in the face of vested interests. But as long as we continue with this system, we would have bankrupt states and state governments that are more about federal allocations than the economic performance of their state.