After eight long years of deliberations, Nepali people have finally received a constitution written by a Constituent Assembly. The people of the Federal Democratic Republic of Nepal now expect enduring peace, good governance, development and prosperity through the implementation of the new

constitution.

Devil in details

The implementation of the constitution, however, is going to be challenging in the context of fiscal federalism. Experts argue that tensions between the federal, state and local governments are unavoidable mainly due to an asymmetrical distribution of responsibilities and fiscal resources among them. The incipient institutional capability to mobilise sufficient resources could further exacerbate the situation. The perceived vertical and horizontal fiscal gaps between different governments could also undermine socio-economic development and service delivery. Constitutionally, the federal government controls enormous fiscal resources, and state and local governments are also saddled with unavoidable responsibilities. Hence, inter-governmental conflict and chaos is inevitable. The promises made by leaders which are difficult to fulfil and the thorny issues of federalism could also frustrate the people.

The subtleties of fiscal federalism have been hardly discussed, hence it is little understood. The federal structure of the government will need a sufficient amount of human, physical and fiscal resources in the days to come. State and local public expenditure will undoubtedly rise due to the necessary physical infrastructure like office buildings, furniture and vehicles and overhead expenses. Moreover, other constitutional commitments such as free education, health services and social security, among others, will also increase public expenditure. The mammoth and lethargic bureaucracy will likely devour scarce financial resources at the cost of development and public services.

Fiscal gaps

The constitution has mandated the federal government to levy value added tax (VAT), income tax, customs duty, excise duty and a number of other taxes. These taxes accounted for around 85 percent of the total revenue in the fiscal year 2014-15. But the state and local governments are only authorised to levy property taxes, user fees and charges that make up a paltry 15 percent of the total revenue. Therefore, state and local governments will largely depend on the federal government to fund routine functional assignments.

The tepid behaviour of the political elite and various turpitudes of the bureaucracy could exacerbate the fiscal gap between the federal, state and local governments. It could eventually become the soft underbelly of fiscal federalism. Federalism, as practised in other countries, shows that over-dependency on the federal government can undermine the autonomy of state and local governments in decision making. Resource-strapped state and local governments will have to compromise on development and service delivery issues.

However, fiscal gaps can be managed by husbanding overlapping expenses, cutting non-essential services, increasing service provisions proportionate with increased

service fees and charges and optimising the size of the bureaucracy. State and local governments should enhance their revenue-generating capability to spur interdependency with the centre. The people should also be ready to pay high taxes and compliance costs. Tax officials will have to cope with the dissatisfaction of the people in having to pay taxes and user fees to the federal, state and local governments.

Tax administration

The role of the federal tax administration will bemost important. Developing the institutional capability of the tax administration should be an overarching mission of the government. The federal tax administration should help develop knowledge, share experiences and organise functions of the coming state and local tax administrations; focus on simplifying procedures; foster automation; empower taxpayers and enforce laws to enhance normative compliance with the rules. The law requires taxpayers to be registered with the tax system, file tax returns, pay tax dues, maintain books of accounts and be ready to face sanctions against deviant behaviour including tax assessment with penalties.

The current tax administration has many mediocre and less professional staff; most of them lack the required skill and competency to prevent tax avoidance and evasion. So the tax administration should reorient its focus to develop an efficient, professional and service-oriented tax system not only to lure taxpayers but also to boost revenue to reduce the vertical revenue gap between the central, state and local governments.

The crux of the problem of the federal tax administration currently functioning in the country is the dearth of a comprehensive and integrated information and database. The tax authorities should develop a robust Tax Information Network (TIN), like the one in India, without delay. Such a network is an institutional framework that helps gather, store, process and analyse economic and financial information and data of taxpayers. It can provide access to veritable information about the income, consumption and the real estate, financial and other physical assets of taxpayers so that the tax administration can use the data while assessing tax liabilities. It can assist in developing the institutional capability of the tax administration. TIN can be structured by developing a policy and creating legal and institutional mechanism for the automatic sharing of the information collected by different governmental and non-governmental organisations.

Furthermore, the excessively exemption-riddled tax policies should be revisited to expand the tax base. Additionally, it is urgent to seriously think about issues of under-invoicing, transfer pricing and offshore businesses that can siphon off the tax base. Legal provisions relating to safe harbours could be instrumental in not only attracting multinational companies but also reducing potential legal conflicts with those companies. Moreover, the government should duly invoke double taxation avoidance agreements for the automatic sharing of information between governments.

No doubt, fiscal consolidation deserves the utmost priority. The political and bureaucratic elites should show prudence and prowess to deal with fiscal consolidation and make the constitution effective in letter and spirit. The self-fulfilling prophecy of the political and bureaucratic elite towards federalism will be a dead duck unless state and local governments enhance extractive and distributive capabilities.

Koirala is Chief Tax Officer at Inland Revenue Office, Bhairahawa