Given the sluggish progress in institutional arrangements for advancing fiscal federalism in Nepal, immediate measures are needed to strengthen expenditure and revenue allocations and enhance the Intergovernmental Fiscal Transfers System. These steps are crucial to fostering self-reliance and efficacy in sub-national governments.

 NewBiz Report

Nepal has been practising fiscal federalism for seven years now. Since sub-national governments are functioning normally and presenting budgets regularly, it may seem that everything is working as expected. However, the journey has been far from smooth, as governments in provinces and local units have often expressed frustration over the federal government's alleged overreach into their jurisdictions. With the development of the regulatory framework for fiscal federalism and related institutional reforms progressing at a sluggish pace, friction between sub-national governments and the federal government has begun to emerge, raising questions about the effectiveness of federalism.

A recent World Bank report has highlighted the slow pace of institutional arrangements for advancing fiscal federalism in Nepal. The report has called for immediate measures to strengthen expenditure and revenue allocations and enhancement of the Intergovernmental Fiscal Transfers System. As institutional arrangements for fiscal federalism are still in progress, sub-national governments have questioned the centre's move to curb the ability of the local units to practise the true spirit of federalism. This includes the federal government's decision to reduce grants allocated to local units.

The federal and provincial governments allocate funds to local units under the Financial Equalisation Grant. The National Natural Resources and Fiscal Commission recommends grants based on seven different indicators. The cabinet meeting held on January 9 decided to reduce the grant amount from the third instalment based on revenue collection. Additionally, the Financial Comptroller General Office (FCGO) sent a letter to all Financial Comptroller Offices instructing them to transfer no more than 74.11% of the allocated budget.

"The federal government's move to cut down resources for local governments is unjust and unacceptable. Such actions have undermined the federal system itself. We are nearing the end of the fiscal year, and this is the time to make payments for completed work and projects," said Bhim Prasad Dhungana, president of the Municipal Association of Nepal.

According to federalism expert Rudra Sharma, Nepal, as the youngest federal nation, needs to learn from practices abroad, and implement what is best for the country. “In a federal structure, sub-national governments should be allowed to practise the true spirit of federalism. But this has not been the case in Nepal. While local governments look active, provincial governments are not taking the lead,” he added. This, according to Sharma, is happening because political leadership has deputed third or fourth tier leaders in provincial levels. “Neither can they work in the spirit of federalism, nor can question top-tier leaders to work as per the constitutional mandate,” said Sharma. 

The federal government keeps 50% of the royalty on natural resources, while provincial and local levels receive 25% each, as per the The Intergovernmental Financial Management Act. However, since the royalty is not being distributed proportionately, this is increasing inequality between the local units. According to the World Bank report, key regulatory frameworks, such as the Local Government Operations Act, 2017 and the Intergovernmental Fiscal Arrangement Act, 2017, are under review to clarify responsibilities among government tiers. Provincial-level institutions are developing essential infrastructure, with all seven provinces enacting their Provincial Civil Service Acts by December 2023, paving the way for recruitment of civil servants.

However, revenue and expenditure assignments need further clarification across government levels. For example, sectoral frameworks like the Water Supply and Sanitation Regulations and the Education Bill are under review to define expenditure responsibilities. The Construction Materials Management and Regulation Bill, submitted in November 2023, has tried to clarify revenue rights and responsibilities between provincial and local governments regarding natural resources.

"The Intergovernmental Fiscal Transfer (IGFT) system needs upgraded institutional arrangements for effective management, as local governments heavily rely on IGFTs," states the report.

Concerted efforts are needed to reduce reliance on conditional grants (CGs) and increase flexible expenditure grants (FEGs), enabling bottom-up planning and decision-making. Improving the design of CGs with a transparent, consultative process and technical methodology is crucial to enhance the predictability and flexibility of financial resources.

Provincial and local governments have made progress in public finance management (PFM), with improvements in planning, budgeting, procurement capacity and internal control systems. However, challenges persist, particularly in budget transparency and compliance with legal reporting deadlines. Most local governments have adopted the Sub-National Treasury Regulatory Application (SuTRA), but issues with comparability and transparency of budget information continue to plague them.

While there has been some progress in terms of procurement capacity and internal control systems at the local level, there is ample room for improvement.

Progress has been moderate in implementing recommendations from the Nepal Fiscal Federalism Update, 2023, including developing a Fiscal Federalism Roadmap and reviewing the Unbundling Report. However, key areas, such as reforms in conditional grant management, require more attention. The report's recommendations focus on legal and policy reforms, strengthening the IGFT system, improving data production and access, and enhancing PFM and procurement capacities to reinforce budget credibility.

Krishna Prasad Sapkota, a former president of the Federation of District Development Committees, said all government bodies need to work properly rather than question each other. “For example, the local units have the right to work in agriculture and livestock. The provincial governments can work on finding domestic markets and linking farmers with these markets, while the central government can focus on finding international markets,” Sapkota said. “However, what is happening is that even the central government is working at the local level.”

Sapkota said that the distribution of natural resources, according to international practice, is the responsibility of local governments. “However, Nepal is failing in this. As the central government has control over natural resources, the sub-national governments do not receive the amounts that they deserve,” he added.

Likewise, the constitution has delegated the management of schools up to secondary level to local governments, while higher secondary education is under the purview of provincial governments. Despite this constitutional provision, the central government still wants to oversee the management, he added.

Some Progress in Internal Control Systems

While there has been some progress in terms of procurement capacity and internal control systems at the local level, there is ample room for improvement. The number of local governments preparing and fully implementing master plans and annual procurement plans has been on the rise. According to the report, 44.1% of 444 local governments prepared and fully implemented these plans in fiscal year 2022/23, marking a considerable increase from 29.1% in 2021/22.

There was also a significant increase in the number of local governments that prepared, fully implemented and regularly monitored internal control systems. "Despite this progress, close to half of the local governments studied in 2022/23 did not prepare any procurement-related plan, and more than half did not have an internal control system," the report states. Local governments are increasingly failing to prepare and publish their annual budget execution reports within the mandated time frame of three months after the fiscal year ends. This decline in adherence to the legal requirement is widespread across all municipality types.

Sub-national Governments in Deficit

Fiscal balances of provincial and local governments fell into deficit in 2022/23 for the first time since the implementation of fiscal federalism. Provincial governments recorded a consolidated fiscal balance deficit of 0.3% of GDP in the previous fiscal year. This was driven by lower revenue and grants, which decreased from 4.4% of GDP in 2021/22 to a record low of 3.5% of GDP in 2022/23.

According to the report, provincial deficits reached 0.3 percent of GDP in 2022/23, while local government deficits stood at 0.4% of GDP. These deficits were financed using opening cash and bank balances, reflecting unspent unconditional fiscal equalisation grants and revenue sharing from previous fiscal years. The severity of the deficits varies significantly across provinces and municipality types, with Sudurpashchim and urban municipalities experiencing the largest deficits. Provincial and local governments in Nepal underspent their budgets in 2022/23.

Provinces Log Slowest Growth

In 2022/23, province governments experienced their slowest economic growth since 2019/20, ranging from 1.4% in Bagmati to 3.3% in Gandaki, driven by a decline in wholesale and retail trade and manufacturing. Import restrictions implemented by the federal government in the first half of 2022/23 to manage external pressures resulted in a significant decline in the wholesale and trade sub-sector across all provinces. Additionally, the manufacturing and construction sub-sectors contracted, partly due to the elevated prices of manufactured goods and construction materials. Bagmati, which has the largest services sector, significantly contributed to the slowdown in national growth.

The slowdown in growth, coupled with import restrictions, led to a decline in federal revenue from 23.1% of GDP in 2021/22 to 19.2% of GDP in 2022/23. This subsequently caused a decrease of 1.3 percentage points of GDP in fiscal transfers (including revenue sharing) to sub-national governments. Consequently, in 2022/23, provincial revenue and grants plunged by 0.9 percentage points of GDP to a record low of 3.5 percent, and local government revenue and grants fell by one percentage point to 8% of GDP.

Underspending Continues

Provincial governments underspent at a rate of 34%, while local governments underspent at a rate of 24.4%. Program expenses (recurrent expenditure), public construction (capital expenditure), and contingencies (recurrent and capital components) were the common drivers of underspending for sub-national governments, according to the report. "Underspending at the provincial level continues to be explained by a lack of alignment between periodic development plans, the medium-term expenditure framework (MTEF) and the budget, as well as the allocation of a significant portion of the budget to the category of ‘Economic Miscellaneous'," states the report.

The dependence of provincial governments on conditional grants as a share of their total revenue decreased from 19.6% in 2021/22 to 17.3% in 2022/23, which indicates a marginal increase in the fiscal autonomy of provincial governments. Enhancing the capacity for revenue administration at the provincial level should be encouraged to further empower provincial fiscal autonomy, the report added.

Provincial Spending Sees Moderate Growth

Provincial government spending went up slightly by 0.1 percentage point to 3.8% of GDP in the previous fiscal year. This increase was driven by a rise in capital spending, particularly for roads, bridges and other public construction projects. However, a decrease in recurrent spending (spending on salaries, goods and services, and fiscal transfers to local governments, typically around 40% of aggregate spending) partially offset the rise in capital expenditure. 

Nevertheless, there were significant differences in spending variations across provinces. For instance, Koshi, Karnali, and Lumbini witnessed a decline in overall spending, with recurrent expenditure driving the decrease in Koshi, capital spending in Karnali and both in Lumbini. Conversely, other provinces experienced an increase in overall spending, primarily led by capital spending, except for Gandaki, where recurrent spending fuelled the increase.

Local Government Spending Dips Slightly

In 2022/23, local government spending slightly decreased to 8.4% of GDP, marking a 0.2 percentage point decline compared to the previous fiscal year. This drop was driven by reduced capital spending, particularly in public construction activities, which represented over 25% of total expenditure. However, the decline was partially offset by an increase in recurrent spending, which accounted for an average of 63% of total local government expenditure.

Among municipality types, rural and urban municipalities saw a notable decrease in total spending, reflecting revenue and grant shortfalls. Together, they contributed to a 0.2 percentage point decline in overall spending as a share of GDP, mainly due to reduced capital spending, typically adjusted in the short term due to revenue shortages. Conversely, metropolitan cities experienced increased spending, fuelled by both recurrent and capital expenditure, partially counterbalancing the spending decrease seen in other municipality types.

Sub-national Fiscal Gap Widens

The gap between expenditure and revenue of sub-national governments remained significant in the study period. Only 8% of the own spending of provinces was financed by own revenue, with the vertical fiscal gap (VFG) slightly increasing in the last fiscal year. This gap, defined as the difference between own spending and own revenue, stayed close to the historic average of 93%, ranging from 85% in Bagmati to 99% in Sudurpashchim.

For local governments, the VFG widened to 94% in the previous fiscal year, surpassing that of provincial governments. This increase suggests a growing reliance on transfers from higher levels of government rather than generating own-source revenue.

According to Sharma, the concept of federalism was to strengthen provinces. “But after eight years, they are not economically strong. We, and even the provincial actors, talk about Kathmandu being dominant for administrative activities, but there has been less discussion on why provincial cities are failing behind when it comes to economic activities,” he added. 

Another significant issue, experts say, is the implementation of laws. For example, while the provincial government has enacted the Provincial Civil Service Act, its implementation faces substantial challenges. Civil servants sent by the federal government often lack full loyalty to the provincial government. “The provincial governments struggle to direct or take disciplinary action against them. These civil servants operate under provincial jurisdiction at their discretion and return to the federal government whenever they choose. Their primary allegiance remains with the federal government rather than the provincial authorities,” Sapkota said.

Experts also argue that provincial governments face powerlessness due to unfair funding distribution and excessive federal control. “They receive only 15% of the royalties, while the federal government keeps 70%. Despite this, the federal government retains control over projects at provincial and local levels, with most projects managed directly by federal authorities,” experts say. “This has led to repeated projects and long delays, as they must follow federal rules, which take months. As a result, provincial governments cannot work freely or effectively and remain dependent on federal directives.” 

• Fiscal balances of provincial and local governments fell into deficit in 2022/23 for the first time since the implementation of fiscal federalism. According to the report, provincial deficits reached 0.3 percent of GDP in 2022/23, while local government deficits stood at 0.4% of GDP. 
• Provincial government spending went up slightly by 0.1 percentage point to 3.8% of GDP in the previous fiscal year.
• In 2022/23, local government spending slightly decreased to 8.4% of GDP, marking a 0.2 percentage point decline compared to the previous fiscal year.
• The gap between expenditure and revenue of sub-national governments remained significant in the study period. Only 8% of the own spending of provinces was financed by own revenue, with the vertical fiscal gap (VFG) slightly increasing in the last fiscal year.
• Provincial governments underspent at a rate of 34%, while local governments underspent at a rate of 24.4%.