The Vigilant steps towards Federalism- A case for fiscal stability

-This article has been originally published by Jai Venaik in The Himalayan Times on December 24, 2017.

As the election fiesta draws a success in forming the first federal government in Nepal, issues pertaining to the implementation of the new government design takes centre stage. A top priority would be to institute the Natural Resource and Fiscal Commission (NRFC), the body mandated by the Constitution to review the basis and modalities for the distribution of revenues between the three vertical orders of the governments. Fiscal federalism forms the bedrock of the functioning of a federation as they foster incentives for multiple orders of government to provide services to the citizenry in a competitive, efficient and responsible manner. The discourse in the public domain has addressed the vertical fiscal gaps, horizontal inequities as well as the appropriate tools of intergovernmental transfers, it hasn’t addressed the likelihood of a failure in macroeconomic management in Nepal.

Federal fiscal systems are adapted to aim at safeguarding the threat to central exploitation while also keeping a check and balance on the decentralised opportunistic behaviour constituent states might indulge in. The sub-regional units autonomously manage their finances which may pose certain risks to the macroeconomic stability of the country. The debt to GDP ratio in Nepal recorded in the year 2016 was 27.4 percent. With the aim of structural and decentralised development, sub-regional governments are bound to accrue debt. The basis and the guidelines though will be in accordance with the federal law as per the constitution. While intergovernmental transfers should adhere to meet the financial requirements of the states, lack of fiscal discipline on the part of sub-regional governments could potentially hamper macroeconomic stability.

The problem is not a new one and has been a matter of concern amongst most federal countries. Brazil and Mexico both have had a lack of fiscal discipline amongst the subregional governments. While legislated fiscal rules in the form of budgetary balance controls, debt restrictions and, tax/expenditure controls do aid in maintaining a sound fiscal discipline by avoiding pork-barrel politics. However, fiscal rules alone cannot ensure the resultant outcome if breaches go unchecked. The Indian fiscal prudence rules mandate a ceiling of about 3 percent but the same was breached in the fiscal year 2015-16 amounting to 3.6 percent in a period of 10 years. As reported, the Reserve Bank of India reported that the debt-to-state-GDP ratio for as many as 17 states (Uttar Pradesh 5.6% (up from 3.1% the previous year), Rajasthan 10% (up from 3.1%), Haryana 6.3 %(up from 2.9%), Bihar 6.9% (up from 3%), Madhya Pradesh 3.9% (up from 2.4%) and Goa 6.8% (up from 2.3%)  in India increased beyond the mandated threshold.

The money is often used as waivers instead of capital formation thus making it increasingly difficult to repay which furthers turns into a federal bailout jeopardising the economic stability of the country. This also greatly affects foreign investment in a country as investors tend to see combined economic heath of the national as well as the regional governments. While fiscal rules are one of the methods to establish a check and balance on fiscal discipline, a contingency fund (often termed as rainy-day funds) set aside during good times could act as ‘debt-brakes’ in terms of crisis. The constitution through article 124 foes create a federal contingency fund, the same is not extended to states and local governments.

While federalism allows subregional governments to develop in their own respective agendas, it also infuses a level of competition amongst the governments to improve their economic profiles. There are several ways through which the competition plays out: lobbying for employment by: generating federal or private sector jobs; encouraging domestic and foreign investment; providing incentives and subsidies for attracting capital and labour; supplying public infrastructure to facilitate business activity; providing a differentiated menu of public services; offering one-stop shop windows for licensing and registration and; pursuing  open-door policies for new capital and skilled labour. The Swiss, American, Australian and Canadian exemplify the benefits of competing jurisdictions to bolster economic capacities of the region as well as the country. Competition, thus essentially is proven to inculcate a healthy atmosphere of growth.

However, with competition as with anything else, the rule of law must ensure fair practises which prohibit policies affecting neighbouring jurisdictions (beggar-thy-neighbour policy). Such cases were witnessed in Spain and Brazil which are often remembered as ‘fiscal wars’ and ‘race to the bottom’ where unchecked jurisdictional competition created negative spillover effects in sub-regional jurisdictions. Imposto sobre Circulação de Mercadorias e Serviços (ICMS, or Tax on Circulation of Goods and Services) , a state tax, is considered one of the main causes of fiscal wars in Brazil. Some Brazilian states, like Espírito Santo and Santa Catarina defined that operations involving foreign products were subject to an ICMS exemption. For some time, if an operation happened in Santa Catarina instead of Minas Gerais, for example, companies would face a rate of 0% instead of 7% and take undue advantage creating a loss in government treasury. To solve this, the federal government established a unified 4% ICMS rate for all the interstate operations in the country. Similarly, the situation seen with Imposto Sobre Serviços (ISS, or Tax on Services), a municipal tax had similar effects with the problem of double taxation.

While the NRFC will be outlining the basis of transfers, it is also mandated by the constitution to the various disputes that might occur due to the above as enshrined in article 251 part (i). Thus, a careful review would be required to strengthen the foundation of Nepal’s federal democracy.