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The promise of fiscal federalism
With the promulgation of the 2015 constitution, Nepal embarked on its federalism journey . It established three tiers of government: one federal, seven provinces, and 753 local levels in 2017.
The provincial and local levels are at the heart of service delivery as envisioned by the constitution, including the provision of better education for children, enhanced maternal healthcare, and improved road connectivity to facilitate mobility and access to markets, among others.
Delivering these services effectively and efficiently to all Nepalis while ensuring inclusion and equity is the core promise of fiscal federalism. For example, data shows that service delivery in the health sector has been improving when compared to the pre-fiscal federalism period or the period before intergovernmental fiscal transfers, defined as the transfers of funds between the three different levels of government, were initiated.
Demographic Health Surveys show improvements in access to and coverage of health services through the increase in the number of institutional deliveries amongst the poorest quintile, from 33.9 percent in 2016 to 65.8 percent in 2022. Overall, the improvements in service delivery have translated to better health outcomes as indicated by under-5 mortality rates, which improved from 39 to 33 per 1000 live births between 2016 and 2022, and stunting in under-5 children, which improved from 36 percent to 25 percent over the same time.
Fiscal federalism is the engine of good governance that helps ensure the availability of required resources and builds accountability of the subnational governments.
Fiscal federalism is the engine of good governance that helps ensure the availability of required resources and builds accountability of the subnational governments.
Implementing fiscal federalism requires supporting legislation, institutional and operational mechanisms to generate revenue, opportune distribution of fiscal transfers, and, most importantly, the processes and capacities to spend those resources in an efficient manner.
Progress and challenges in fiscal federalism in Nepal
With federalism taking root in Nepal, some important foundations of fiscal federalism have been successfully built. Four key legislations related to financial procedures and intergovernmental fiscal transfers have been enacted for the last three years.
To support fiscal federalism, the Natural Resources and Fiscal Commission (NNRFC), the Fiscal Federalism Coordination Division at the Ministry of Finance, and seven Provincial Planning Commissions have been established, with the latter being responsible for provincial development plans and three-year rolling medium-term expenditure frameworks (MTEFs) in coordination with the provincial ministries of finance.
The formation of four types of grants that are designed to address different local and provincial needs in the intergovernmental fiscal transfer system has enabled provincial and local governments to receive nearly 36.7 percent of the federal budget, amounting to 64.8 percent of their revenue in FY2021 to execute important functions. In FY2021, the share of conditional and equalization grants in the overall federal intergovernmental transfer was 95 percent.
While conditional grants are earmarked for specific activities and complement untied resources to be utilized for service delivery, equalization grants are untied to equalize the resources available across provincial and local governments. The other two grants are complementary grants, which are for national priority infrastructure projects, and the special grants that are intended to support regionally and sectoral-confined special projects.
Medium-term expenditure frameworks for the federal government and provincial and local governments have been further formulated to improve planning at the subnational level, and we are seeing improvements in fiscal and regulatory structures at the provincial level.
At the same time, challenges remain in operationalizing fiscal federalism and public financial management at the subnational level . Gaps remain in maintaining accounting records across the public financial management cycle and in publicizing financial reports. Most local governments’ periodic development plans and medium-term expenditure frameworks were not publicly available in FY2021.
Challenges remain in operationalizing fiscal federalism and public financial management at the subnational level.
There is also a lack of strong internal control systems to address the rising number of irregularities detected through the audit process, and a lack of ways to engage citizens and beneficiaries in planning, budgeting, and monitoring of spending in local governments. Available funds are being underspent, which hinders the efficient delivery of public services.
Governance experts and stakeholders attribute these challenges to weak technical and human resource capacity in planning and budget execution at the provincial and municipal levels. Monitoring progress in these areas is also challenging due to insufficient publicly available data on subnational governments’ performance in public financial management.
A roadmap to strengthen fiscal federalism
The World Bank’s Nepal Fiscal Federalism Update (NFFU) recommends four ways Nepal can strengthen fiscal federalism in light of the progress and challenges in the sector, and building on the findings of the 2019 Federalism Capacity Needs Assessment.
The first step is to develop a fiscal federalism roadmap. In the short term, a key priority is to develop a fiscal federalism roadmap that provides a middle and long-term vision of Nepal’s fiscal federalism , complements other strategies and action plans (e.g., the Public Financial Management Reform Strategy currently in the making), and builds an inclusive approach to forge broader ownership among the stakeholders to boost implementation of federalism.
Secondly, it will be key to reinforce the current inter-governmental fiscal transfer system by making the transfers more flexible, clear, and timely, as well as increasingly performance-based. The coordination among federal fiscal institutions needs to be strengthened if the current system is to be improved.
It will also be important to establish a consolidated public financial management performance database at the federal level to enhance the monitoring and evaluation of the overall performance of provincial and local governments’ resource management.
Finally, amendments to the legal framework are needed to help clarify the concurrent and shared responsibilities among the three tiers of government, as well as additional efforts in strengthening the capacity of human resources at the subnational level.
The Fiscal Federalism Update serves as a basis to further engage with stakeholders at the federal and subnational levels on these recommendations towards improving the capacity of provincial and local governments in fiscal federalism, strengthening service delivery for all Nepalis, and contributing to Nepal’s green, resilient, and inclusive development.
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