Fiscal federalism is considered the lifeblood of any federal system. Nepal has been implementing it for more than seven years now. Over the years, the country has made substantial progress in a few fiscal decentralization indicators, registering itself as one of the world's decentralized countries.
Between fiscal years 2018/19-2022/23, the province and local governments (PLGs) accounted for more than 38 percent of the general government (all three levels of government combined) expenditure. This is close to the Organization for Economic Cooperation and Development (OECD) average (39.5 percent) and much higher than the Asia Pacific average (26 percent).
Similarly, the PLGs spent almost half of the total general government revenue during the same period. This is way higher than the Asia Pacific and OECD averages.
Over a relatively short period, Nepal has activated all the mechanisms of fiscal federalism as envisaged by the Constitution. The country should pride itself on managing the transition toward a federal governance system smoothly without major disruptions in public service delivery. There has been a massive expansion of the physical infrastructure, and PLGs have been able to show their presence before their constituencies. Fiscal federalism is believed to have played a critical role in this.
That said, however, the application of fiscal federalism has not been without challenges.
Federalism implementation has not been expenditure-neutral, meaning that it is being implemented by substantially increasing government expenditure. The general government expenditure (excluding the expenditure related to the reconstruction and rehabilitation after the Gorkha earthquake in 2015) as a percentage of gross domestic product (GDP) had been around 21 percent, on average, during the five years preceding the federal system, which rose to almost 30 percent during the fiscal years between 2018/19-2022/23.
During the same period, however, general government revenue performance did not keep up with the increase in expenditures. Consequently, the general government budget deficit, which had been around six percent, on average, during the five years before the federal system, rose to more than 19 percent, on average, between 2018/19 and 2022/23.
The federal government is meeting the deficit through borrowing, mainly domestic borrowing. Except for a minuscule portion passed on to the local governments, the federal government is liable for repaying the loan. By the end of 2022/23, the total outstanding loans reached 43 percent of the GDP. Though this is not historically the highest, the pace at which the share of loans in the budget is increasing raises concerns about the sustainability of the current fiscal system.
Likewise, though the PLGs have been spending about half of the general government revenue, and an overwhelming part of it is coming from the federal government, they are not happy with the current fiscal transfer arrangement, including revenue sharing out of the proceeds of the value added tax and internal excise duty. They complain that the federal government has transferred too little while retaining a major part of its revenue.
Moreover, there are serious concerns about the efficiency and effectiveness of the expenditure being made by all three levels of government. Although there are some signs that PLGs are more responsive than the federal government in delivering services and infrastructure, it is unclear if the increase in expenditure leads to commensurate enhancement in inclusive access to services and sustainable infrastructures.
These beg a question: What is wrong with the current fiscal federal system?
Lack of well-thought-through implementation strategy: Fiscal federalism implementation is currently not based on a strategy that provides a roadmap on how to roll it out from the immediate to long-term. Such a roadmap should have included clearer guidance on how to delineate roles and responsibilities among all three levels of government, maintain macro-fiscal stability, ensure accountability, optimize resource mobilization, etc. Without such a strategy, the implementation has been ad hoc.
Unclear roles and responsibilities: Except for a few areas exercised by the federal government (such as defense, international relations, etc.), all government levels are working in the same areas, leading to a significant level of inefficiencies and weak accountability. Duplication and even triplication of funding are quite common which is, perhaps, the weakest aspect of Nepal's fiscal federal system. This is mainly because federal government ministries do not want to give up their power over functions that can be better delivered by the PLGs, and to some extent, the provincial governments are working on the functions that are better performed by the local governments.
Finance did not follow function: Contrary to the finance-follows-functions principle, the federal government followed a 'finance-first' model and is said to be more generous in transferring funds compared to functions and functionaries. In addition to 30 percent of revenue sharing, the federal government has been transferring 45 percent, on average, of its total revenue to the PLGs. This is possibly because the fund is the easiest thing to transfer of all the components. The federal government 'cheated' in the name of personnel adjustment by retaining more than constitutionally mandated structures and personnel, leaving the PLGs heavily understaffed. One of the key roles of the federal government should be developing standards and ensuring that all levels of government follow them. On the contrary, it is competing with the PLGs even to fund micro-level schemes.
Unclear objectives of different grants: Constitutionally, own-source revenue and the equalization grant are the major sources to fund the PLG expenditures. Given the differences among the PLGs in revenue capacity and expenditure needs, the equalization grant is supposed to meet the gap (between own-source revenue and expenditure needs) in such a way that all citizens receive the basic public services in a minimally equal manner irrespective of their residence. The other three grant windows (namely, conditional, complementary, and special grants), have their specific objectives. In practice, however, the conditional grant has become the main source of funding for basic services such as education, health, etc. Since the basic services are funded by the conditional grant, it is not clear what exactly the equalization grant is 'equalizing'. Against this, the PLGs have been using the equalization grant to fund almost any activities they want. In this regard, the Inter-governmental Fiscal Management Act did not define the objectives of different grant windows in line with the letter and spirit of the Constitution.
Weak Accountability of the PLGs: The degree of fiscal decentralization as mentioned above overstates the degree of actual control that PLGs have over the uses of funds. An overwhelming part of the expenditure of the PLGs is federally designed, mainly through conditional grant, leaving little space for sub-national planning. Through the conditional grant, the PLGs have been relegated to the implementing agents of the federal government. This, together with the federal control of the key PLG personnel, limits their scope of accountability. To the extent the PLGs are under federal control, the federal government should be accountable for the (lack of) outcomes, not the PLGs. Furthermore, there is no effective mechanism for monitoring the performance of the PLGs, preventing citizens from holding PLGs accountable for their (lack of) performance.
Fewer incentives to the local governments to generate revenue: The revenue base of the local governments, particularly that of urban-based municipalities, is quite strong, unlike that of the provincial governments. However, the current transfer system does not incentivize them to put their sincere effort into optimizing own-source revenue as it treats all the local governments equally. Moreover, before fiscal year 2022/23, the PLGs as a whole had a significant amount of unspent revenue balance at the end of fiscal years despite their competition to spend as much as they could, leaving little incentive to capitalize on their revenue potential.
The role of the National Natural Resources and Fiscal Commission minimized: The Constitution stipulates that the amount of fiscal transfer to be received by the PLGs shall be as recommended by the Commission. The reason behind this stipulation is that an independent and professional entity is better positioned to recommend the amount of transfer compared to the federal government. Again, the Intergovernmental Fiscal Management Act deviated from the constitutional provision and empowered the federal government. Consequently, the Commission's role has been confined to revenue sharing, royalty from natural resources, and equalization grant which has been a source of many anomalies in the current transfer system.
To conclude, while the country has made notable progress in fiscal federalism in a short time, challenges abound. Though it is not uncommon to have such challenges during the transitional years, they need to be addressed without delay if the political leadership of all political parties is serious about effectively implementing the federal system.
(The author has worked as an expert in the Natural Resources, Economic Rights, and Revenue Distribution Committee of the Constituent Assembly. He has a keen interest in federalism, local governance, and intergovernmental relations)
