Federalism can thrive and conflict can be avoided only when all levels of government share the available resources in an appropriate manner. Even though fair distribution of wealth and income is fundamental to the success of a federal system, often devolution of power is not followed by devolution of finance. For example, once the responsibility for running health or education programmes has been transferred to local governments, the resources required to execute these functions should be made instantly available to them. However, our central government is not able to adhere to this principle, which consequently leads to tensions between the central and local governments. A possible conflict can be avoided by making resources (law, money and authority) available to local governments to implement their mandates.

Often the sources of funds for local government are taxes, duties and fees; their own (public) property; grants and transfers; borrowings and their own commercial activities. Income tax, property tax, value added tax, inheritance tax, corporate tax, customs duty and service fee paid by citizens and enterprises are important sources of income. Local governments own assets such as natural resources (oil, mineral deposits, forests or water), infrastructure (roads and telecommunications) and cultural heritage sites from which they can generate income. Grants and transfers are usually payments obtained from the central government. Grants and transfers can either be earmarked or conditional (how the funds are used is specified) or they can be non-earmarked or unconditional (the federal units have discretion over how the funds are used). Further, local government can also borrow money. 

Four aspects

Our local governments have different financial capacities and requirements, and therefore need standard principles and formulas to determine the amount of financial allocation. Every level of government wants to maximise the amount of revenue allocated to it. This requires a revenue sharing agreement, but Nepal has not yet established the National Natural Resources and Fiscal Commission (NNRFC) which is supposed to be constitutionally responsible for revenue sharing and dealing with natural resources.  

The NNRFC has to consider four aspects for sharing revenue: Attribution of revenue source (who can raise royalties from natural resources or taxes), the determination of the rate (who determines the tax rate and scale, or the amount of royalties), collection of revenue (who can collect revenue and grant exemptions) and the distribution of revenue (how revenue will be calculated and distributed). These four areas are common sources of conflict in a federal system, and therefore the NNRFC must address this issue. 

Conflict has also been observed while sharing revenue between different levels of government using the origin principle, under which revenue is allocated to the location where it originated, as it creates imbalances in financial capacity. Pooling revenue and redistributing it as per general principles such as per capita basis or financial need has been observed to avoid conflict. 

Uneven distribution of revenue from the centre is a source of conflict between the central and local governments. But locally available natural resources have great potential for generating wealth and income and addressing revenue-related conflict. However, it can be a perennial source of conflict when irrationally exploited or unevenly distributed. Hence, the NNRFC should define clear criteria and principles. Further, natural resources, especially water, land and forests, are important sources of livelihood and common sources of revenue for the government. There is a possibility of over-exploitation leading to conflict and tension. 

Financial equalisation is important to create a balance between weak and strong federal units. Financial capacities and special needs should be taken into account when determining equalisation payments. Conflict and tensions are inevitable when poor federal units are not able to raise enough revenue to carry out their their mandates and rich federal units provide more and better services to their citizens, or if residents in poor federal units have to pay extra to receive comparable services.

Credible, competent, independent

Urbanised municipalities and rural municipalities have different needs. All these concerns have to be addressed to avoid conflict. Hence, the NNRFC should develop principles, mechanisms and criteria for financial equalisation (redistribution of funds from the centre or from richer to poorer federal units) to avoid conflict and ensure the capacity of federal units to provide a minimum level of services.

Revenue capacity and needs are often the common criteria used for financial equalisation. For instance, Brazil, India, Nigeria, Spain and South Africa rely predominately on these criteria. In contrast, Malaysia relies mainly on a per capita redistribution scheme. In almost all federal countries, funds come from the central budget to create financial equalisation. 

Newly elected municipalities can properly operate as per their mandate when they have access to resources. And their access to resources will become possible only after the NNRFC is established and functional. Therefore, the success or failure of the newly elected local governments in fulfilling their constitutional mandates depends on the central government’s cooperation in establishing a credible, competent and independent NNRFC immediately.

Upreti is associated with the Nepal Centre for Contemporary Research, a Kathmandu-based not-for-profit research organisation