Opinion Forum

The role:

Fiscal federalism involves the equitable distribution of financial resources, including responsibilities. A fundamental principle is that tasks should be accompanied by their associated costs. Whether under a unitary or federal system, every function requires funding to be completed. Revenue is typically generated through taxes, service charges, royalties from natural resources, financial transfers, and loans.There are four aspects of fiscal federalism.

Figure no 1:

The four aspects of fiscal federalism include the distribution of expenditure responsibilities, which specifies the work to be performed by each level of government; revenue authority, which determines the allocation of tax revenues to different government levels; intergovernmental financial transfers, which outline the grants provided to lower-level governments; and internal debt, which establishes the borrowing limits for each level of government. In the context of Nepal, revenue distribution specifically, the allocation of value-added tax and the distribution of excise duties generated from domestic production along with the mobilization and distribution of natural resources (determining which levels of government are permitted to mobilize natural resources and in what form) are integral components of fiscal federalism. Additionally, understanding audit management is crucial within the framework of financial federalism. This article focuses on financial transfers, which represent a significant aspect of financial federalism.

Intergovernmental Financial Transfer

Intergovernmental financial transfer, or grant distribution, refers to financial resources (grants) allocated from one level of government to another, typically from the central government to lower-level governments. These transfers are essential for addressing the fiscal imbalance between domestic revenue and expenditure needs. In principle, every job responsibility should be accompanied by the necessary financial support. It is often stated that responsibility without financial resources is like putting the ‘horse before the carriage.’ In Nepal, the constitution guarantees intergovernmental financial transfers, recognizing that internal resource rights are limited at the provincial and local levels. To facilitate these transfers, the constitution establishes four types of grants: equalization, conditional, special, and supplementary. Additionally, there is a constitutional provision that mandates financial transfers not only from the central government to the provincial and local levels but also from the provincial to the local level. Similarly, there is a legal provision to distribute 15% of the value-added tax and excise duty collected from domestic production to the provincial and local levels. This revenue distribution amount is to be received by the provinces and local levels by the 15th of every month. Additionally, 25% of the royalties from internal natural resources are also allocated to the provinces and local levels. A brief description of the grant as mentioned in the picture along with the distribution of revenue is as per the schedule.

(a) Fiscal Equalization Grant: A fiscal equalization grant is a financial allocation provided by the Government of Nepal to provincial and local levels based on their expenditure needs and revenue capacities. Provinces transfer these grants, received from the Government of Nepal and their own generated revenues, to local levels within the province according to their specific expenditure requirements and revenue-generating abilities, as recommended by the National Natural Resources and Fiscal Commission.

(b) Conditional Grants: Conditional grants are funds provided by the Government of Nepal to the provincial or local levels, as well as from the provincial government to the local level, for the implementation of plans that align with national policies, programs, standards, and infrastructure conditions.

(c) Supplementary Subsidy: The supplementary subsidy is the subsidy provided by the Government of Nepal to the provincial and local levels to implement any plan related to infrastructure development. Provinces may provide supplementary grants to local levels in accordance with provincial laws.

(D) Special Grants: Special grants are funds provided by the Government of Nepal for specific projects aimed at developing and supplying essential services such as education, health, and drinking water. These grants also support balanced development between provinces or local levels and aim to uplift or develop groups or communities that have faced economic, social, or other forms of discrimination. Provinces may also provide special grants to local levels in accordance with provincial laws.

Revenue Distribution

In the constitution, there is a provision for distributing revenue from the federal reserve fund to the federal, provincial, and local levels, as well as from the provincial reserve fund to the provincial and local levels. According to the Intergovernmental Finance Management Act 2017, the value-added tax and excise duty collected from domestic production in the Federal Dividend Fund are to be shared between the Government of Nepal, provinces, and local levels at 70%, 15%, and 15%, respectively. Similarly, according to the National Natural Resources and Finance Commission Act 2017, while distributing revenue between provinces and local levels, the commission considers factors such as population and demographic details, area, human development index, expenditure needs, revenue collection efforts, infrastructure development, and special conditions in Nepal. The commission is required to recommend these allocations to the government. The law also states that the detailed basis and framework set by the commission is valid for five years and can be reviewed every five years.

The four aspects of fiscal federalism include the distribution of expenditure responsibilities, which specifies the work to be performed by each level of government; revenue authority, which determines the allocation of tax revenues to different government levels; intergovernmental financial transfers, which outline the grants provided to lower-level governments; and internal debt, which establishes the borrowing limits for each level of government. In the context of Nepal, revenue distribution specifically, the allocation of value-added tax and the distribution of excise duties generated from domestic production along with the mobilization and distribution of natural resources (determining which levels of government are permitted to mobilize natural resources and in what form) are integral components of fiscal federalism. Additionally, understanding audit management is crucial within the framework of financial federalism. This article focuses on financial transfers, which represent a significant aspect of financial federalism.

Intergovernmental Financial Transfer

Intergovernmental financial transfer, or grant distribution, refers to financial resources (grants) allocated from one level of government to another, typically from the central government to lower-level governments. These transfers are essential for addressing the fiscal imbalance between domestic revenue and expenditure needs. In principle, every job responsibility should be accompanied by the necessary financial support. It is often stated that responsibility without financial resources is like putting the ‘horse before the carriage.’ In Nepal, the constitution guarantees intergovernmental financial transfers, recognizing that internal resource rights are limited at the provincial and local levels. To facilitate these transfers, the constitution establishes four types of grants: equalization, conditional, special, and supplementary. Additionally, there is a constitutional provision that mandates financial transfers not only from the central government to the provincial and local levels but also from the provincial to the local level. Similarly, there is a legal provision to distribute 15% of the value-added tax and excise duty collected from domestic production to the provincial and local levels. This revenue distribution amount is to be received by the provinces and local levels by the 15th of every month. Additionally, 25% of the royalties from internal natural resources are also allocated to the provinces and local levels.  A brief description of the grant as mentioned in the picture along with the distribution of revenue is as per the schedule.

(a) Fiscal Equalization Grant: A fiscal equalization grant is a financial allocation provided by the Government of Nepal to provincial and local levels based on their expenditure needs and revenue capacities. Provinces transfer these grants, received from the Government of Nepal and their own generated revenues, to local levels within the province according to their specific expenditure requirements and revenue-generating abilities, as recommended by the National Natural Resources and Fiscal Commission.

(b) Conditional Grants: Conditional grants are funds provided by the Government of Nepal to the provincial or local levels, as well as from the provincial government to the local level, for the implementation of plans that align with national policies, programs, standards, and infrastructure conditions.

(c) Supplementary Subsidy: The supplementary subsidy is the subsidy provided by the Government of Nepal to the provincial and local levels to implement any plan related to infrastructure development. Provinces may provide supplementary grants to local levels in accordance with provincial laws.

(D) Special Grants: Special grants are funds provided by the Government of Nepal for specific projects aimed at developing and supplying essential services such as education, health, and drinking water. These grants also support balanced development between provinces or local levels and aim to uplift or develop groups or communities that have faced economic, social, or other forms of discrimination. Provinces may also provide special grants to local levels in accordance with provincial laws.

Revenue Distribution

In the constitution, there is a provision for distributing revenue from the federal reserve fund to the federal, provincial, and local levels, as well as from the provincial reserve fund to the provincial and local levels. According to the Intergovernmental Finance Management Act 2017, the value-added tax and excise duty collected from domestic production in the Federal Dividend Fund are to be shared between the Government of Nepal, provinces, and local levels at 70%, 15%, and 15%, respectively. Similarly, according to the National Natural Resources and Finance Commission Act 2017, while distributing revenue between provinces and local levels, the commission considers factors such as population and demographic details, area, human development index, expenditure needs, revenue collection efforts, infrastructure development, and special conditions in Nepal. The commission is required to recommend these allocations to the government. The law also states that the detailed basis and framework set by the commission is valid for five years and can be reviewed every five years.

Analysis of Financial Transfers

The details of the financial transfers from the Government of Nepal to the provincial and local levels for the past seven financial years (from 2018/2019 to 2023/2024) are in Table 1 and 2. Table 1 shows the details of financial transfer to the province and table 2 to the local level. The details mentioned in the table are outlined in the budget speech. In the fiscal year 2018/2019, the province received a total subsidy of NPR 123 billion. In the fiscal year 2024/2025, the province’s subsidy has been reduced to only NPR 96 billion. This is unfortunate in the matter of grant transfer of the province. Details, including revenue sharing, have also been reduced. In the financial year 2018/2019, it was NPR 1.80 billion, while in the financial year 2024/2025, it has decreased to NPR 1.76 billion. The total financial transfer from the budget of the Government of Nepal was 13.72 percent in the financial year 2018/2019, but it has dropped to 9.46 percent in the financial year 2024/2025. Overall, the financial transfer to the province is disappointing.

The details of the financial transfers from the Government of Nepal to the provincial and local levels for the past seven financial years (from 2018/2019 to 2023/2024) are in Table 1 and 2. Table 1 shows the details of financial transfer to the province and table 2 to the local level. The details mentioned in the table are outlined in the budget speech. In the fiscal year 2018/2019, the province received a total subsidy of NPR 123 billion. In the fiscal year 2024/2025, the province’s subsidy has been reduced to only NPR 96 billion. This is unfortunate in the matter of grant transfer of the province. Details, including revenue sharing, have also been reduced. In the financial year 2018/2019, it was NPR 1.80 billion, while in the financial year 2024/2025, it has decreased to NPR 1.76 billion. The total financial transfer from the budget of the Government of Nepal was 13.72 percent in the financial year 2018/2019, but it has dropped to 9.46 percent in the financial year 2024/2025. Overall, the financial transfer to the province is disappointing.

Regarding the local level, a total subsidy of NPR 205 billion was received in the financial year 2018/2019. In the financial year 2023/2024, this subsidy has increased to NPR 312 billion. Although the total grant amount has risen, the burden of conditional grants on the total grant is high at the local level. In 2018/2019, the burden was 53.74 percent, while in 2023/2024, it has increased to 66.77 percent. The share of the equalization grant in the budget of the Government of Nepal was 6.44 percent in the financial year 2018/2019. However, in the financial year 2024/2025, it has decreased to 4.73 percent. While the overall financial transfer to the province has increased, the share of conditional grants in these transfers remains high. Additionally, the share of the equalization grant compared to the budget is weak. Similarly, the financial transfer at the local level is also unsatisfactory (see Table 2).

Based on the details mentioned in the table, the spirit of grant distribution and financial federalism is not favorable. In this context, The parliamentary special committee on federalism implementation study and monitoring of the National Assembly has given important suggestions on matters including financial transfer. The Committee’s recommendations are in Schedule 1. The recommendations of the committee have not been implemented.

Provinces and local levels lack autonomy in managing conditional grants. Under the conditions and standards established by the Government of Nepal, projects and programs selected by the central government must be implemented at these levels. The grants provided by the Government of Nepal to provincial and local governments, as well as those from provincial governments to local levels, are conditional grants designed to facilitate the implementation of plans in accordance with national policies, programs, standards, and infrastructure conditions. Even this definition of conditional grants specified in the law has not been accepted. It has been observed that conditional grants are being distributed without any established criteria or basis.

The overall financial transfer to the provincial and local levels is not considered satisfactory. Ideally, these transfers should have increased proportionally with the budget ratio. However, compared to the previous unitary system, there has been significant progress. In the past, local governments managed financial resources ranging from 2 to 3 million, but now they are handling billions. This shift has brought a wave of development in rural municipalities, which is attributed to financial transfers, and this progress should be viewed positively.

Conclusion/recommendation:

Nepal’s federalism operates as a pyramidal structure, guided by the rights and responsibilities outlined in the constitution. The local level requires more financial resources and support. The general principle that tasks should align with value and institutional structures has not yet been fully embraced. Additionally, the provincial and local levels have limited authority over tax revenue. The situation is critical when reviewing financial transfer and ministerial plans and programs from the perspective of federalism and provincial and local levels. For the strengthening of financial federalism, the recommendations of the National Assembly Federalism Implementation Monitoring Parliamentary Committee have not been implemented. It is necessary to implement the recommendations of the committee. Point by point conclusions and suggestions are as mentioned below:

• A thorough review of the entire financial transfer framework, especially from the financial year 2018/2019 to 2023/2024 is needed.
• The increase in financial equalization grants needs to be proportional to the budget. The local level is heavily burdened with conditional grants. It needs improvement.
• The method used to determine the amount of financial transfer (pool) received by the provincial and local levels is not considered fair. It is essential for the parliamentary committee to play an effective role in determining the pool.
• The National Natural Resources and Finance Commission should be allowed to work according to the powers given by the constitution. It is wrong to limit the Commission to just determining the criteria for distribution of equalization grants and revenue sharing. The commission also needs to be active.
• According to the report of the Office of the Auditor General, most ministries, contrary to the Government of Nepal’s Work Division Rules, have interfered in the jurisdiction of provincial and local levels through plans and programs, acting against the spirit of federalism. In a situation where local associations/federations and provincial governments share a similar stance, it is essential to review the role of the ministries.
• When the government of Nepal sends conditional grant projects to the provinces and local levels, it is necessary to have a system of sending lump sums by specifying sectoral conditions, targets and expected achievements, not in an operational manner but in a thematic manner.
• There is a need for a debate about the equalization grant distribution system (data used in the formula, formula determination method, etc.) transferred from the Nepal government to the province and local levels.
• To effectively implement the recommendations of the Parliamentary Special Committee on Federalization Implementation Study and Monitoring of the National Assembly particularly regarding financial federalism and financial transfers,it is essential to engage in ongoing discussions and consultations with the relevant agencies.
  Agenda: 1. Recommendations related to financial federalism from the Special Parliamentary Committee for the Study and Monitoring of Federalism Implementation of the National Assembly, 2022.
• Due to the lack of clarity in the division of responsibilities among government levels from the right list of the Constitution of Nepal and its elaboration/unbundling, the delineation of responsibilities will be revised based on five years of experience to establish greater clarity in the responsibilities among the levels of government.
• Determine what the minimum responsibilities that provincial and local levels must undertake for the delivery of public services are and how much financial resources are necessary for that.
• To identify the details of revenue collection and revenue potential of the province and local levels.
  Provincial and local levels should prioritize internal resource mobilization by making revenue improvement action plans.
• The collection of advertisement tax and entertainment tax listed in the single rights of the provincial and local levels is seen to be extremely low, including in major municipalities like Kathmandu, and therefore needs to be improved.
• Establishing a method of collecting real estate registration fees based on market value and improving the administrative aspects of land registry and land surveyor offices.
• Establish uniformity in the vehicle tax rates across all provinces. Create a policy framework to allocate a specific portion of this tax for the conservation and enhancement of forests and the environment.
• To improve the law to end the ambivalence in the collection and distribution of local natural resources and resources including mining and river resources, stone, gravel, sand, etc. which are in the list of common rights of the province and local level.
• Establish legal provisions that clearly outline the roles of all three levels of government regarding the collection, distribution, and regulation of mining and river-related materials, such as stones, gravel, and sand, as well as the operation and management of crusher industries. Additionally, remove crusher industries that are operating in violation of existing laws.
• Since interest groups dominate the exploitation of natural resources and environmental degradation is evident due to excessive extraction, necessary legal and policy arrangements should be made for prevention and control.
• Draft an integrated law to simplify the operation and management of natural resources.
• Develop a loan management system for provincial and local levels to regulate the operation of internal loans.
• The amount of financial transfers received by provincial and local levels should be based on the recommendations of the National Natural Resource and Finance Commission. However, laws that restrict the jurisdiction of the Commission regarding grants other than fiscal equalization grants should be amended, according to subsection (3) of Article 60 of the Constitution of Nepal.
• Ensure compliance with the method of increasing the share of fiscal equalization grants in the financial transfers from the Government of Nepal to the provincial and local levels, and from the province to the local levels, in accordance with the budget ratio.
• Make the statistical data and distribution used in fiscal equalization grant allocation transparent and reliable.
  When sending conditional projects from the federation to the provinces and local levels, and from the provinces to the local levels, ensure that they are sent in a consolidated manner, specifying thematic sectoral conditions, goals, and expected achievements, rather than in a fragmented manner based on activities.
• When distributing grants to the provincial and local levels, do not open/use any doors other than the four types of grant distribution mentioned in the Constitution (equalization, conditional, special, and complementary).
• Implement an incentive and performance-based grant system for at least 50% of the fiscal equalization grant to foster competition among local levels (municipalities) in service delivery and development activities.
• In situations where the Revenue Advisory Committee, Resource Estimation and Budget Limit Determination Committee, and Budget and Program Formulation Committee are not functioning in some local levels, ensure their activation as per the law.
  (Former MP Devkota is a financial federalism expert.)Source: Prachi Sanchetana Quarterly