Nepal promulgated a new constitution under which the country will be restructured in a federal republican setup. However, it is doubtful whether this will happen considering the contradictory messages coming from some political parties and leaders. Federalism is a complex political, social and economic phenomenon. If it is not implemented with a strong commitment, it will create more social chaos and unrest. There are many contentious issues that need to be resolved to smooth the transformation, including the economic aspects of federalism which is known as fiscal federalism.

Federalism is the devolution of power to lower tier units or structures. Proponents of devolution argue that decisions should be made closer to the people and not by a government situated far away. Self-rule and shared rule are the main thrust of federalism with locally accountable governing entities. Federalism does not mean just geographical and political delineation of the states. The whole concept of federalism is to have constitutionally autonomous political units to fulfil the requirements of the people.

Accommodating diversity

It is important to understand that political autonomy is directly related to economic autonomy. Fiscal federalism is about autonomy in terms of raising and mobilising revenue. There is no general consensus on the modality of fiscal federalism. Different countries have adopted different fiscal structures. However, the basic guideline remains the same. Nepal has very distinct features of diversity in terms of culture, language, geography and income. Accommodating this diversity within the parameters of self-sustaining provinces is the main challenge of fiscal federalism.

Even though the constitution has clearly identified revenue sources for all three tiers of the government, the main revenue sources like customs duty, value added tax, excise duty, corporate income tax, personal income tax, payroll tax, passport fee, and visa fee remain with the central government exclusively. They account for approximately 80 percent of the total revenue collection. State and local governments have been allowed to collect entertainment tax, advertisement tax and property registration charges.

Likewise, property tax, land revenue, vehicle tax, business tax and house rent tax is to be collected by the local level. Under this model, the federal government will pocket 90 percent of the revenue leaving the rest to state and local governments. This modality is common in the developing countries. It is clear from this that sub-national governments will face severe financial constraints. The vertical imbalance between the central and the sub-nation remains large. To fill this vertical imbalance gap, the sub-nation will have to rely heavily on intergovernmental grants and transfers.

Vertical and horizontal imbalances

In Nepal’s context, horizontal imbalance, or economic inequality between the provinces, is also very large. A large proportion of the taxes are collected in a few districts. Seven districts account for 85 percent of the revenue and the remaining 68 districts get less than 15 percent of the total revenue. So fiscal arrangements have to consider both vertical and horizontal imbalances. The constitution states that revenue sources will be distributed between the centre and sub-national units, but it does not say how intergovernmental transfers will be done. According to the constitution, transfers will be made by the Natural Resource and Fiscal Commission. It will be a huge challenge for the commission to create an equitable and adequate transfer mechanism.

Transfers can be specific, conditional, non-conditional, discretionary or adhoc. Perhaps the most suitable fiscal transfer would be based on a simple formula rather than on discretion and negotiation. Conditional and non-conditional transfers depend on the nature of the assignment. Earmarked transfers with conditions are necessary where the minimum national standard has to be ensured while conditional transfers are preferred to promote greater accountability. An adequate and effective equalisation formula needs to be designed by including a sunset clause, or a deadline after which it will become ineffective.The formula should be based on social and economic indicators with population size as the main basis.

Complex and contentious

Apart from fiscal transfers, sub-national borrowing is also another significant source of revenue. Many developing countries prohibit external borrowing. Part 19 of the constitution has unambiguously mentioned local financial provisions including loans. Article 228 says that local governments can generate income through tax and also access loans from fiscal institutions subject to the provision of the law. The provision further empowers local governments to levy tax on subjects of competencies as long as they do not have adverse effects on the national fiscal policy, free movement of goods and services, capital and labour market and fiscal policies of neighbouring provinces. Central governments rarely allow their sub-national governments to borrow without limit. Some countries prohibit borrowing by sub-national governments, and it is common to find controls or rules on their borrowing and sometimes their expenditure, even though these infringe on their fiscal autonomy.

Although the new constitution has interpreted the basic thrust of fiscal federalism, sub-national governments will have to depend on the centre for funding due to the obvious inadequacy of their internal revenue sources. The main challenge for the Natural Resource and Fiscal Commission is designing a more equitable formula based on the equalisation transfer model. The fiscal commission which currently consists of three members has to be expanded matching the number of provinces, with each member assigned to look after one province. Since fiscal arrangements for fiscal federalism are a very complex and contentious issue, a high level of expertise, research and caution is required. Failure to implement a successful fiscal federal policy may lead to the failure of the country.

Prasai is a chartered certified accountant pursuing a Master’s in Public Policy at the University of London