Why are Nigerian states not financially independent?

Like the United States, Nigeria operates a federal system of government, wherein power is decentralised among the federal and state governments. The state governments have the authority under the constitution to enact laws, collect taxes and undertake other fiscal responsibilities to benefit their state and its citizens. 

Although the same federalism rules that work in the US apply to Nigeria, some disparities raise eyebrows about the financial independence of state governments in Nigeria. For example, most states in Nigeria are dependent on the monthly federal accounts allocation (FAAC) for administrative expenses like salary payments. According to  BudgIT’s fiscal performance index of 2021, only three states (Lagos, Rivers and Anambra) can comfortably meet their internal obligations like salary payments and capital expenditure without FAAC—the monthly allocations shared by the federal government to state governments. It's interesting because it means that 92% (33 states) of Nigeria’s states are revenue-strapped if they do not receive monthly payments from the federal government.

When we consider that oil income, which used to make up a significant chunk of these payments, has recently stopped flowing in, there are reasons to be worried.

For context, the Nigerian National Petroleum Company (NNPC) is to remit oil revenue to the federation account every month, which adds to the total amount shared by the federal accounts allocation committee to state governments. However, so far, in 2022, the remittance from NNPC has been zero due to higher fuel subsidy payments. Basically, the NNPC has had to forgo its FAAC remittance to pay for fuel subsidies. We will delve deeper into this, but for now, it's crucial to highlight that the lower the remittance, especially from oil revenue, the lower the revenue to be shared with the state governments. And this makes state governors jittery because they have become so reliant on FAAC disbursements. 

Today, we will examine why state governments need to reduce their reliance on FAAC. And to do this, we will first discuss how they generate revenue and where they spend it.
 

State governments and FAAC

Every month, the federal allocation accounts committee disburses funds to all 36 states based on a revenue-sharing formula. The money shared is gotten from different sources like oil revenue, value-added tax (VAT), company income tax (CIT), petroleum profit tax (PPT), exchange rate gains, custom & excise duties and import duties, amongst others.

If you look at this through the lens of a mathematical equation, you would say that FAAC (the amount shared to state governments by the federal government) is a function of all these sources of income (oil revenue, CIT, VAT, PPT etc.). In economic theory, we’d simply explain a direct or positive relationship between the dependent variable (FAAC) and the independent variables (sources of income). If any of these income sources decline, so will FAAC.

The primary source of revenue for the federation account is crude oil. Therefore, if anything happens to Nigeria’s revenue from crude oil, the amount of money to be shared (FAAC) would also be affected. Lately, Nigeria’s crude oil revenues have been going downhill. This year, oil theft and vandalism have been recurrent themes affecting Nigeria’s ability to produce more crude oil. The county’s average oil production is 1.3 million barrels per day (mmbpd). For context, this is 19% below the 1.6mmbpd in the revised 2022 budget and 27% lower than Nigeria’s new OPEC quota of 1.79mmbpd.

Meanwhile, the global price of crude oil has remained bullish, around $100 per barrel. But, Nigeria cannot take advantage of the higher oil prices despite being an exporting country. This continues to limit oil revenue, affecting the total amount remitted to the federation account. Instead, the government spends more on importing refined petroleum products and fuel subsidies due to higher oil prices. To explain this, we look at the NNPC’s remittance to the federation account so far in the year. The graph shows that the NNPC’s remittance is either low or non-existent because of fuel subsidy payments. Unfortunately, this is likely to continue as the International Monetary Fund predicts that Nigeria’s subsidy payments could climb to ₦6 trillion from the estimated ₦4 trillion this year. 

If oil revenues decline, so will the amount to be shared with state governments, making states highly vulnerable to oil prices and production changes. 

The same applies to other income sources like VAT and CIT. When people are impoverished and spending power is low, value-added tax (tax attached to goods and services) will decline. And the biggest thief of value to consumer disposable income is inflation, which has increased sharply to its highest level in the last eight months to 16.8%. A popular analysis by Stears is that if inflation is around 15%, the value of income halves every six years. So, VAT revenues could decline if aggregate consumption or demand levels are low due to higher inflation and falling consumer disposable income. For instance, the gross revenue generated from VAT in April (to be shared with states in May) fell by 19% to ₦178.8 billion from ₦219.5 billion in March.   

For CIT, if companies operate in a hostile environment, where operating expenses continue to climb and limit their revenue, the tax to be remitted to the government will also fall.

With this, it becomes easy to picture how state governments interact with the amount they receive from the federal government. In summary, as the sources of FAAC’s income fall, so does the amount states receive. Sadly, the ripple effect is often mass salary cuts, delays, and layoffs from different state governments.
 

State governments and their revenue

It’s worth noting that FAAC is currently the first but not the only source of income for most states in Nigeria.

They also generate revenue (IGR). However, in most cases, they generate far less than they spend. Imagine a situation where a state that produces the most negligible revenue internally has a civil servant workforce of over 3,000 people coupled with pensioners of, say, 1,000 and existing governors' salaries and allowances that are never reduced even in the face of rising inflation and costs. These expenses will be paid, and that’s where the FAAC they receive cushions the impact of their already low internally generated revenue. So, in this case, no FAAC, no salary. And remember, the priority staff often get paid first, leaving the lower class employees to scramble for the rest.

The revenue generated by various states is often negatively impacted by several factors like population, insecurity, inflation, class of individuals living in the states and the number of businesses that operate within the state, among other state-specific issues. For example, a state like Lagos would generate more revenue from “PAYE” than a Bayelsa state. And a likely reason is that Lagos is more populated with a high number of working-class individuals to tax. Insecurity also plays a significant role in that some northern states are plagued with high levels of insecurity, hence unfavourable for business investment compared to southern states. This would also affect their ability to generate revenue from taxes and possibly rent on government properties. States with a high level of inflation that negatively impacts purchasing power and reduces consumption would also be unable to generate more revenue from VAT compared to states with lower inflation rates. Finally, with some states mainly having low-income earners as a large part of their population, revenue from taxes will also be low. A good comparison here will be a state like Rivers with oil companies, rich workers, and Zamfara state. 

Currently, the percentage contribution of internally generated revenue (IGR) of all 36 states to their total revenue is 28%, compared to FAAC, which is 72%. As I mentioned earlier, as of 2021, only Lagos, Rivers and Anambra states could comfortably meet their internal obligations without FAAC. And this is worrisome! For Lagos—the commercial hub of Nigeria, income increased due to higher tax revenue, reduced operating expenses and substantial capital investments. Meanwhile, Rivers and Anambra cut operating expenses and prioritised capital expenditure to stay afloat.



 

The internally generated revenue (IGR) of states comprises income obtained from taxes (PAYE, road tax, VAT), levies (land), charges and fines, rent on government properties and income from the various ministries, departments and agencies (MDAs). 

And the same rule that applies to FAAC follows through with the IGR. If the revenue generated from the various sources is low, so will their IGR.

We know that various factors affect some states’ ability to generate more income than others. 

Now, it is also essential to see how they (states) spend their money because it provides a glimpse into what they prioritise and subtly highlights why they are dependent on FAAC. If a state’s total revenue is low (IGR + FAAC), and most of it is spent on non-revenue generating expenses instead of capital projects, it would likely remain in the constant loop of financial dependency on the federal government.

Several state governments spend a large chunk of their income on salaries, loan repayments, other operating expenses and capital expenditure. While it is not easy to categorically say what percentage of their income goes to what, according to this state-by-state breakdown, you’d see that salaries and other administrative expenses come before capital expenditure for most states. This brings to mind what happens at the federal government level as well. The budget prioritises recurrent costs (non-revenue generating) before capital expenditure (revenue-generating). In fact, the government borrows to plug administrative expenses. In the 2022 budget, 40% of the estimated expenditure (₦17.12 trillion) was allocated to recurrent expenses (₦6.9 trillion) compared to 32% for capital expenditure (₦5.46 trillion).

How state governments spend and whether they generate enough revenue affects the nation. I say this because, if you look at the chain of development inductively you will see that a country is not only affected by what happens at the top that trickles down to the masses, but it is also affected by what happens at the bottom that then scales to the top. The latter is the core of this story. Individuals make up a family, the family makes up society, society makes up a state, and states make up a country.
 

The case for state governments being independent

It will be challenging and improbable that state governments will be completely independent of the money they receive from the federal government. Several states understand FAAC's volatility and try to improve their revenue generation, and the challenge for each state varies. Think of Kaduna; despite its growing IGR, FAAC is still a huge contributor.

So far, the main issue I have highlighted is that state governments depend on FAAC and generate low revenues. And the situation is unlikely to improve because they spend more on recurring non-revenue generating expenses, which shouldn’t be the case. 

Instead, the FAAC received could be additional income. Think of it as a business with multiple channels of income. There would be the primary source of revenue which would be more stable and controlled. In contrast, other sources are tagged as “additional”, and sometimes volatile. 

The amount of money the business gets from the latter (additional) is beyond their control, but that does not obliterate it from being a source of income. Another way to look at it is like an individual who receives a monthly salary and allowance from a parent or guardian. Assuming everything else is held constant (economic downturn that could lead to job loss, death, etc.)., the salary is what is controlled by the individual. If you work, you get paid. But the allowance, which could vary per month depending on the pocket of the guardian is beyond the individual’s control.

So, making plans, or as the states do it, a whole year’s budget based on expected revenue (that is beyond your control), is a ticking time bomb. And that is why most states might need to consider FAAC as additional revenue and not the primary source of income the state will run with. 

How can states be financially independent?

As I mentioned earlier, it is unlikely that state governments will be completely independent of FAAC allocations soon. The important thing is that they are motivated to increase their IGR substantially so they can comfortably cushion the impact of volatile FAAC disbursements. We have spoken extensively about how some states like Oyo, Ogun, Kaduna and Anambra are stepping up their game in revenue despite their challenges. In this regard, here are a few options state governments can consider.

First, the core here is analysing the benefit of trade through comparative advantage. The concept of comparative advantage explains a country or industry’s ability to produce a particular good or service at a lower opportunity cost than its trading partners. And this can only happen when the cost of production is lower compared to other countries or industries. Invariably, the country needs to have abundant resources (or get them at a very low price) and then sell them to other countries to make a profit. In this case, we are looking at it on a state level. There is no doubt that Nigeria is a resource-endowed country, with many states possessing various commodities in large and tradeable quantities.

For example, southwestern states like Ondo and Oyo are famous for their cocoa production, and copper is found in northern states like Plateau and Kano. Suppose these states look inward to boost the output of the various commodities they possess, be it agricultural or mineral. In that case, they can increase their revenue. The focus is not only to sell the raw materials but improve the value chain of the various commodities. Anecdotally,  businesses or countries make more money from the sales of finished products than raw materials. 

To make this happen, public-private partnerships are relevant, and there also have to be favourable regulations and policies in place to support stakeholders like farmers, business owners and investors. 

What if a state does not have so many natural resources?

The solution here is to be commercially attractive to businesses and investors. Lagos is not the most resource-endowed state in Nigeria. Still, it is Nigeria's commercial hub—accounting for 26.7% of the country’s GDP and 31% of the total IGR generated (₦267.2 billion) in the first half of 2021 (₦849.1 billion). Lagos state is also the top destination for capital imports into Nigeria, accounting for 71% of the total in Q1’2022. Businesses look forward to setting up headquarters in Lagos, and small, and medium-scale enterprises have Lagos offices. In summary, the state has a brand reputation for supporting businesses compared to other states.

But it doesn’t have to be only Lagos state. According to the latest capital imports report by the NBS, Ogun state is steadily moving up the chain, but states can do more. The crux of this point is that when state governments make their business environment friendly for business owners, business activities will increase. This will boost the state's economic productivity as more jobs are created. The states can then generate revenue from company income tax (as more businesses set up shop) and personal income tax—PAYE (as more people are employed). States can also generate revenue from the sales of government-owned lands and VAT (if a state is buoyant and comfortable to live in, people will naturally migrate, and the more they are, the more consumer spending and consumption levels). 

A thriving business environment is also a good incentive for investors. Therefore, if investor sentiments towards a state are positive, they will increase their capital investments which are currently very low among Nigerian states. However, insecurity is a major defining factor that could undermine investment inflows into states. From farmers-herdsmen clash to Boko Haram attacks, train bombings, unknown gunmen attacks and kidnapping incidents, investors will favour states with low insecurity problems over states embattled with insecurity.

As capital investments to several states rise, so will the total to the country. The focus here for the states is to attract foreign direct investments. Infrastructure-led or driven states will always thrive. An increase in FDI means better roads and improved health and education infrastructure, which will, in turn, enhance human capital development and economic growth.

From this, we see that state governments have much to benefit if they are motivated to improve their revenue rather than depend on FAAC. This level of independence is expected to keep states accountable and revenue-focused.

A caveat here is that some argue that the current revenue-sharing structure minimises inequality (i.e. some states are comparatively better at making money than others because they are more endowed with human capital, proximity to ports etc.). So, if we leave states to be independent, that might lead to high levels of inequality. But on the flip side, even with the current revenue set-up, we haven't seen inequality improve significantly.  Therefore, even if we accept that we need to solve inequality, the current set-up of giving states money does not work efficiently. A good solution is for states to start seeing FAAC as a secondary (additional) income.


NB: Chart on IGR and FAAC updated to reflect Imo state's previously omitted FAAC data