Under Nepal's federal system, the constitution has given many functional responsibilities to the sub-national levels, but most of the revenue raising rights to the federal government. And to reduce the gap between functional responsibilities and revenue raising rights, the constitution has established the provision of intergovernmental fiscal transfers. This allows the sub-national levels to receive four types of grants from the federal government—fiscal equalisation, conditional, special and matching grants.

The sub-national levels have full autonomy in spending the fiscal equalisation grant while they have to spend conditional grants in specific sectors. Special grants are given to improve education, health and water supply, and reduce inter-local and inter-provincial imbalances.

The National Natural Resources and Fiscal Commission Act 2017 and the Intergovernmental Fiscal Arrangement Act 2017 have been passed to create legal provisions for fiscal transfers. These laws specify the definition and distribution criteria of grants and revenue sharing. The sub-national levels receive 15 percent of each fiscal resource from value added tax (VAT) and excise duty on domestic production.

Natural resources

Out of the total funds collected in the country, the federal government keeps 70 percent and distributes 15 percent each to the provinces and local units. Also, the provinces and local units each get 25 percent of the royalties from natural resources such as mountaineering, forestry, electricity generation, mining and so forth. The royalties from natural resources are given only to the sub-national government units that are located in the area where these revenues are collected. In the fiscal year 2018-19, the provinces and local units each received Rs47 billion under the revenue sharing arrangement while the allocation for fiscal 2022-23 has been increased to Rs81.5 billion. Including these amounts, the figures come to Rs442 billion in 2018-19 and Rs592 billion in 2022-23, equivalent to around one-third of the government budget for that year.

Nepal's federal system also requires the provinces to make fiscal transfers to the local units. The provinces started making fiscal transfers to the local units from their first full budget in fiscal 2018-19, moving about 6 percent of their total budgets. In 2022-23, the ratio increased to about 9 percent. This shows that the provinces have established a good practice of distributing grants to the local units from their own sources too.

As a percentage of their respective budgets, the provinces send more money to the local units than they receive from the federal government.

The constitution stipulates that fiscal equalisation grants should be distributed on the basis of expenditure needs and revenue capacity, making fiscal equalisation the most important grant type. But sub-national governments have been receiving more conditional grants than fiscal equalisation grants. In the budget for the fiscal year 2022-23, conditional grants make up 61 percent of the Rs299 billion in grants allocated by the federal government. According to the principles of grant distribution, fiscal equalisation grants should be increased and conditional grants should be reduced. But what has been happening is just the opposite. This needs to change.

The share of special and matching grants is also nominal. Special and matching grants each make up only 3.19 percent out of the Rs429 billion in grants allocated for the sub-national levels for fiscal 2022-23.

Development position

In terms of the overall development position of the provinces, Sudurpaschim, Karnali and Madhesh are lagging behind in most socioeconomic development indicators. The best way to bring these provinces into the mainstream of development is through special grants.

About 33 percent of the federal budget for fiscal 2021-22 was allocated for fiscal transfers to the sub-national levels. This is about 12 percent of the country's GDP. Fiscal equalisation grants alone account for about 3.4 percent of the GDP, indicating smooth vertical allocation of funds. When adding revenue sharing to the fiscal equalisation grants, the ratio goes up to 6.8 percent. The grants received by the sub-national levels within a short time of Nepal's becoming a federal republic should be taken positively. This shows that Nepal's fiscal federalism is not weaker than that of most federal countries of the world.

While analysing the nitty-gritty of fiscal transfers in Nepal, some aspects are found to be satisfactory. A quarter of the total budget of the Nepal government goes to the sub-national levels. But it is necessary to correct some issues found in the fiscal transfers. Further, it is important to pay attention to why and for whom the grants are being channelised.