In the fiscal year 2024-25, the government allocated Rs88 billion in fiscal equalisation grants for local governments and Rs60 billion for provincial governments. However, on February 10, the Office of the Comptroller General issued a circular stating that provinces and local governments would receive only 13.24 percent of their third instalment. This decision followed the Ministry of Finance directive on February 5, instructing the Comptroller General office to reduce grants due to revenue shortfalls.

Sub-federal governments receive equalisation grants in four instalments. Under normal circumstances, the third instalment should have provided Rs15 billion to provinces and Rs22 billion to local governments. However, due to the cuts, provinces will receive only Rs2 billion and local governments only Rs3 billion. This means Rs32 billion will not be disbursed, significantly impacting sub-federal governance.

This cutback has raised serious concerns regarding the implementation of fiscal federalism. Local and provincial governments, which rely heavily on these grants for service delivery and development projects, now face financial uncertainty. Many projects were initiated with budget assurance, and with some projects already 50 percent completed, the sudden budget reduction has placed local and provincial authorities in a financial dilemma.

Such reductions contradict the principles of fiscal federalism, which emphasise fiscal autonomy and predictability. Repeated grant reductions not only disrupt planning and execution but also raise questions about the federal government’s commitment to upholding the constitutional provisions of federalisation. Concerns arise over how ongoing projects will be completed and how payments will be managed.

According to the Appropriation Act 2081, the Office of the Comptroller General must transfer equalisation grants to the consolidated funds of provinces and local governments in four equal instalments. However, the Act also stipulates that grant amounts be determined based on revenue collection up to the end of Poush (mid-January) (which influences the third instalment, and revenue collection up to the end of Chaitra (mid-April), which affects the fourth instalment. The government has used this provision to justify reducing equalisation grants. Sources within the Ministry of Finance suggest revenue collection is unlikely to meet expectations by mid-April, making further cuts to the fourth instalment almost certain.

This provision in the Appropriation Act is flawed and should be reconsidered. While the government can make budgetary adjustments when revenue falls short, cutting constitutionally guaranteed equalisation grants instead of reducing other expenditures contradicts the principles of federalism and equitable fiscal distribution.

Fiscal resources and institutional structures must align with assigned responsibilities. Without sufficient fiscal resources, responsibilities remain unfulfilled. The Constitution has transferred over 60 percent of the previous unitary government’s duties to sub-federal governments, including critical sectors such as education, health, roads, drinking water, agriculture and livestock development. To manage these responsibilities effectively, these governments need taxation and revenue rights. However, their revenue generation remains extremely limited, particularly for provinces. Given this reality, fiscal transfers from the federal government are essential for them to function effectively.

The Constitution mandates that fiscal transfers be based on the principles of equity and need. The Federalism Special Committee of the National Assembly and the National Natural Resources and Fiscal Commission have classified equalisation grants as a fiscal guarantee provided by the federal government. They have recommended that if reductions are necessary, they should come from lower-priority projects rather than constitutionally guaranteed funds like the equalisation grant. By cutting these grants, the federal government is contradicting its fiscal commitments and jeopardising service delivery and development activities at the local and provincial levels.

Fiscal transfers help decentralise centralised revenues, ensuring that resources reach sub-federal governments. The Constitution recognises four types of grants: fiscal equalisation grants, conditional grants, special grants and matching grants. Among these, fiscal equalisation grants are unconditional and crucial for sub-federal autonomy. In the previous unitary system, local bodies received unconditional grants, and international best practices support the principle that equalisation grants should remain unrestricted. Conditional grants, on the other hand, are tied to specific projects and cannot be used flexibly. Equalisation grants enable provinces and local governments to plan and implement projects based on their needs. Ideally, their share in GDP or the national budget should increase over time, not decrease. The parliamentary special committee on federalism has also instructed the government to adhere to this principle.

Special grants are allocated to address sectoral imbalances in education, health and drinking water and mitigate inter-regional and inter-provincial disparities. They are designed to be need-based and integrated into mainstream development planning. The allocation criteria for special and fiscal equalisation grants are nearly identical, with only minor differences.

Matching grants are allocated based on specific project requests from provincial and local governments. In the fiscal year 2024-25, these grants comprised only 2.25 percent of total local government grants. In addition to these four types of grants, sub-federal governments also receive revenue-sharing transfers, including 15 percent each from Value Added Tax (VAT), excise duty on domestically produced goods and royalties from natural resources. Collectively, these mechanisms constitute Nepal’s fiscal transfer system.

Article 60(3) of the Constitution stipulates that the volume of fiscal transfers to provinces and local governments must be determined based on recommendations from the National Natural Resources and Fiscal Commission (NNRFC). However, the NNRFC has no role in allocating special and matching grants and has limited influence over conditional grants beyond setting general criteria. Its primary function is to allocate equalisation grants and oversee revenue sharing. Once the NNRFC determines the basis and framework for revenue sharing, the structure remains in place for five years.

Studies on fiscal transfers indicate that equalisation grants, as unconditional grants, are the most crucial component of fiscal federalism. Grant allocation should prioritise increasing the share of unconditional grants while reducing conditional grants. International best practices also support this approach. Allocation criteria typically consider expenditure and fiscal needs, revenue-generating capacity, poverty levels, accessibility and remoteness, regional and provincial disparities, infrastructure development status, financial discipline, governance and social composition. These factors are also incorporated into the legal framework.

In the first federal budget (FY 2018-19), local government equalisation grants accounted for 6.44 percent of the total budget. This declined to 5.87 percent in FY 2019-20, 4.99 percent in FY 2023-24 and 4.73 percent in FY 2024-25. For provinces, the share was 3.83 percent in FY 2018-19, dropping to 3.23 percent in FY 2024-25. This continuous decline contradicts the National Assembly’s Federalism Implementation Monitoring and Parliamentary Special Committee recommendations and the National Natural Resources and Fiscal Commission.

The current trend indicates that fiscal federalism is being weakened by prioritising conditional grants over equalisation grants, thereby centralising control rather than allowing sub-federal governments to function independently. If this continues, the fundamental principles of federalism—cooperation, coordination and coexistence—will be compromised. To safeguard federalism, equalisation grants must be protected and provided unconditionally, as envisioned by the Constitution.

The government must revisit the Appropriation Act and fiscal transfer policies to ensure equalisation grants remain protected, predictable and aligned with the long-term goals of federalisation and equitable development.