After the promulgation of the Constitution of Nepal 2072, Nepal has been transformed from a unitary to a federal system of government, and there are three levels of government namely union, state and local government. All three levels have single and common rights. Residual authority rests with the federal government. According to the federal law, there is also a provision in the constitution that special, protected or autonomous areas can be established for social, cultural protection or economic development.

Federalism is based on three main dimensions political, administrative and financial. Among these, stability in the political dimension, issuance of the Federal Civil Service Act in the administrative dimension and financial transfer in the financial dimension have been the main challenges.

State of fiscal federalism 

Financial federalism is the blood circulation of federalism. Its main objective is to reduce regional inequality and provide equal development opportunities. In the context of Nepal, financial federalism is considered as a means of economic empowerment of ordinary citizens by efficiently distributing financial resources, power and responsibility between the Government of Nepal, the provincial government and the local government.

Article 60 of the Constitution provides that all three levels of government can levy taxes and collect revenue on matters within their respective jurisdictions, and the revenue collected by the Government of Nepal should be distributed transparently and balanced at the union, state and local levels. Likewise, there is a provision that the amount of financial transfers received by the provinces and local levels will be in accordance with the recommendations of the National Natural Resources and Finance Commission, financial equalization grants will be available based on the need for expenditure and revenue capacity, and the provision of conditional, supplementary and special grants will be in accordance with federal laws.

The government of Nepal provides 4 types of grants to the provincial and local levels, and the provincial government to the local level: financial equalization grants, conditional grants, supplementary grants and special grants. 

Financial equalization grants are regularly transferred from the Union to the state and local levels and from the state to the local level. This grant attempts to equalize development opportunities by providing financial assistance to economically weaker regions or provinces. Its main objective is to reduce inequality.

Special grants are awarded for conducting special programs. Complementary grants are grants given for specific projects or development programs. A conditional grant is a grant provided by a higher level government to a lower level government to carry out a specific activity or program.

After the implementation of federalism, an important trend of inter-governmental financial transfer is evident in Nepal. Other grants, especially conditional grants, have increased significantly compared to equalization grants. There are some reasons for the increase in the proportion of other subsidies compared to the equalization subsidy:

1. A mentality of central control and directive tendencies prevails. The federal government seems still reluctant to grant full fiscal autonomy to local and provincial governments. Through conditional grants, the central government wants to implement its priorities and policy goals at the local and provincial levels. This reflects the tendency of the federal government to maintain central control.

2. Lack of institutional capacity and lack of trust. Even if the federal government tries to pretend that it is natural to prioritize conditional grants over equalization grants when the federal government is not sure about the financial discipline and priorities of the local and provincial levels, that is not true. Currently, even with the presence of elected representatives at the local level and the availability of sufficient technical manpower, it is contrary to the spirit of the constitution for the federal government to increase the tendency to set policy directives, priorities and spending patterns. 

3. There is a need for expansion and coordination of development projects. Major infrastructure development projects, such as roads, bridges, irrigation, electrification, etc., are often of a nature that crosses local and regional boundaries. It seems that the proportion of other grants has increased because complementary and special grants are effective in maintaining coordination and consistency in such multi-sectoral projects.

4. The issue of international aid and foreign loan influence and mobilization is also linked to it. Financial assistance and loans provided by international development partners and multilateral financial institutions are often conditional in nature and the mobilization of these resources is mainly through conditional grants. For example, grants and loans from organizations such as the World Bank, Asian Development Bank, and the International Monetary Fund are often directed toward specific projects and programs. Transferred as conditional grants to local and regional governments.

Currently, the federal government has used more special grants and conditional grants while adopting new financial grant structures. The proportion of other grants is increasing compared to equalization grants. This can create challenges in implementing federalism. In order to improve the effectiveness of federalism implementation, it is necessary to put more emphasis on the increase of equalization grants.

Impact of other grants 

The purpose of implementing federalism is to adequately address various regional, cultural and social needs. Although the initial situation looks positive, the increase in the proportion of other subsidies compared to the equalization subsidy seems to be continuously shrinking the autonomy of the local levels.

Equalization grants have fallen from about 35 percent to 28 percent over the past five years, reducing local decision-making capacity by about 20 percent, according to one study. According to international standards, in a successful federal system, 40 percent of the total subsidy should be conditional, and it is decreasing in Nepal. As the share of conditional grants has increased by more than 15 percent in the last seven years, the tendency towards centralization is evident.

80 percent of provincial and 65 percent of local level plans are influenced or directed by the center, according to a study by the Administrative Training Institute. The ratio of conditional grants to the total grants received by the local level has increased from about 46 percent in 2074/75 to 61 percent in 2080/81, which limits the freedom of local levels to set their own priorities.

Unequal distribution of revenue sources is another major problem. Local level internal revenue is only 12 percent of the total budget on average. It can be seen in various statistics that the ratio of revenue distribution has decreased by about 8 percent in the last 5 years. 

Regional or regional disparity is also increasing, where the development index of Bagmati Province is 0.65 while that of Karnali Province is only 0.41. Similarly, in terms of infrastructure development, the Himalayan and hilly districts have 40 percent less infrastructure than the Terai districts.

The increasing use of grants of a conditional nature adds to the challenge of building the capacity of provincial and local levels in planning, implementation and monitoring. When provincial and local levels have little opportunity to formulate and implement their own plans, their institutional learning and capacity cannot be developed. The growth rate of conditional grants is about 333 percent, i.e. much higher than the growth rate of equalization grants from the federal government to local levels, which limits the opportunity for autonomous learning and development of local levels.

The increasing proportion of conditional, special and complementary grants compared to equalization grants increases the financial interdependence of states and local governments with the federal government. For example, the ratio of conditional, special and complementary grants to the total grants to the provinces seems to have increased from about 36 percent in 2074/75 to 75 percent in 2080/81, which makes it difficult for the provinces to formulate and implement independent development plans, it added.

The increased use of conditional grants also affects the balance of political and administrative power between federal, provincial and local governments. It increases the dominance of the federal government, limiting the ability of states and local levels to implement programs based on their own political preferences and manifestos.

Various studies have shown that increasing conditional grants and to some extent a lack of ownership increases the likelihood of corruption complaints and audit failures. Along with this, the fact that public hearings at the local level have declined by about 35 to 40 percent in the last 3 years raises questions about governance and accountability.

One of the main reasons behind this is the lack of local government's participation in other grants or emergency grants. Similarly, there is duplication in nearly 60 percent of the projects and due to the duplicated decision-making process between the three tiers of government, important infrastructure development projects are being delayed.

The social development budget has decreased by about 20 percent in the last 5 years. Various study reports have shown that more than 30 percent of programs have been affected by the reduction in equalization grants for women, Dalits, tribals and other marginalized groups. 

solution

As the experience of implementing federalism and the institutional capacity of the provincial and local levels develop, the ratio of equalization grants should be gradually increased. It gives autonomy to local and regional governments to formulate and implement plans based on their needs and priorities. According to the data, the growth rate of equalization grants to provinces is very low compared to other grants. It seems that it should be increased.

The internal revenue collection capacity of local and regional governments should be developed and self-reliance should be increased. This will reduce dependence on federal grants and increase fiscal autonomy. State and local level planning, implementation, monitoring and evaluation capacity should be developed. For this, technical manpower development, training, study research and experience exchange programs should be conducted.

This will help reduce dependence on conditional grants. The National Natural Resources and Finance Commission may make scientific, transparent and equitable recommendations regarding inter-governmental financial transfers. The Commission shall make independent, impartial and fact-based recommendations in determining the type and proportion of subsidy. This will help maintain balance of power and strengthen fiscal federalism.

The significant increase in the proportion of conditional, special and supplementary grants compared to equalization grants has added some challenges to the essence and spirit of federalism. In a federal system of governance, it is important to provide lower level governments with the autonomy to spend according to their needs and priorities. But the increasing use of grants of a conditional nature in Nepal's current subsidy system seems to limit this autonomy to some extent. For the healthy development of fiscal federalism in the long term, it is necessary to gradually increase the proportion of equalization grants and provide more financial autonomy to local and regional governments.