The rights of the three tiers of government are included in the schedule of the constitution. Functional and revenue rights, provision of fiscal transfers and borrowing of the provinces and local levels are enshrined in the constitution. In terms of functional responsibilities, Nepal’s constitution is devolved. Functional responsibilities are pyramidal from the bottom to the top (more expenditure responsibilities at the provincial and local levels, and lower at the federal).

The constitution has given many responsibilities to the sub-federal units (provincial and local governments), but the revenue-raising rights to fulfil these responsibilities are nominal. The constitution provides more revenue-raising rights to the federal government. Intergovernmental fiscal transfers can be mobilised to reduce the fiscal gap between functional responsibilities and revenue-raising rights. According to this arrangement, provincial and local governments receive four grants, namely fiscal equalisation grant, conditional grant, special grant and matching grant. After the country entered into federalism, all these four grants have been received by provincial and local governments.

The provinces and local levels are expecting more fiscal equalisation grants from the federal government. However, they are getting more funds under conditional headings. There are lots of problems with this grant. The schemes and programmes of this grant are small. In the current fiscal year 2020-21, the provinces received conditional grant funds amounting to Rs36.35 billion. The total number of conditional programmes is 13,256. The local levels received Rs161 billion in conditional grants for 84,000 programmes and projects. This analysis shows that the federal government still enjoys sending petty programmes and projects to the sub-federal levels.

Centralised revenue

Fiscal transfers are the main source of revenue for sub-federal units in most countries. In federal countries, revenue-raising rights are relatively more decentralised to sub-federal units, so fiscal transfers account for a smaller share of sub-federal budgets. A 2019 report of the World Observatory on Subnational Government Finance and Investment reveals that the share of transfers is 43 percent in federal countries and 53 percent in unitary countries. But in Nepal, around 80 percent of the income of sub-federal units comes through fiscal transfers including revenue sharing.

Whether in unitary countries or federal countries, revenue-raising powers are often centralised. In fact, fiscal transfers are the means to address the vertical fiscal imbalance stemming from centralised revenue-raising rights. In some countries, fiscal transfers are provided for in the constitution, while in others, they are provisioned for through other legal acts. The issue of determining the proper criteria for fiscal transfers, be it constitutional or legal, is very complex. In fact, the necessary condition of the fiscal transfer system is that it should address fiscal needs and be technically sound. Similarly, it must be politically acceptable. In Nepal, the grant allocation to the provinces for the current fiscal year 2020-21 has been politically questioned in Parliament. There may be dissatisfaction with the budget and programmes; but since the grant is allocated with standard norms and procedures, it is not good to raise questions over grant allocation.

Fiscal need

There is a provision in the constitution that the government should distribute fiscal equalisation grant to provincial and local governments based on fiscal needs and revenue capacity. However, the laws related to grant distribution have not defined and clarified the concept of expenditure needs. The wording of the constitution has been retained in the law as well. Taking the Covid-19 pandemic as an example, the cost of keeping 100 people in quarantine is very different from the cost of keeping 1,000 people. Due to specific locations and geographical complexity, food and medical supplies may cost a little more per person in certain areas over others. The first basis of the expenditure need is population size. If the sub-federal units have enough of their own resources, it will not be a problem. However, if they have little revenue, there is a problem. If their internal resources are scarce, grants may need to be increased.

This is a simple example in times of a pandemic. But even in normal conditions, if there is a larger population, a sub-federal unit will need more to cover costs related to basic services. For example, if the number of students is greater, the school building needs are likely to be large. A larger number of teachers and staff would also be needed. The expenses for textbooks and furniture, libraries and playgrounds increase with the population size. The expenditure needs would also be larger in other service delivery areas such as health, drinking water, sanitation, public toilets and transportation.

The same thing happens in jurisdictions with large land areas. Assuming everything is equal, a jurisdiction with a larger land area will typically have greater expenditure needs in order to provide the same level of services. In addition to the greater need for infrastructure, it is likely that the infrastructure (as well as the delivery of public services) will be more expensive. In many cases, a larger land area means higher costs of canals, irrigation, roads, transportation and electricity. There are many cases and examples (level of development, remoteness, and prices of consumers and producers goods) of fiscal needs. The most important and widely used criteria among countries are people and land area.

In the budget session of the fiscal year 2020-21, parliamentarians from Province 2 complained that the federal government had disregarded them by making less fiscal transfers including fiscal equalisation grant. The lawmakers talked about the non-transparent distribution of grants, and giving more grants to some provinces and less to others. According to them, out of the total matching grant of Rs5.19 billion, their province received the lowest amount of only 0.53 percent. They also talked about fiscal equalisation, conditional and special grants. In fact, the transfer of grants is to meet the real fiscal need for sub-federal levels.

If the fiscal need is not taken into consideration, problems will arise. Problems would not have arisen if the above-mentioned fiscal need tools had been taken seriously. Finally, the role of the National Natural Resources and Fiscal Commission is paramount in the distribution of grants. However, there have been attempts to weaken the commission. It is completely wrong and unfortunate for the fiscal federalism. It is also necessary to have a legal mechanism of implementing all kinds of grants including fiscal equalisation as per the recommendation of the commission.

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