-This article was originally published by Dinesh Karki in The Himalayan Times on June 19, 2016.
The end of May saw federal Nepal’s first annual budget after the promulgation of the new constitution. The USD 10 billion-budget, among other things, focuses on implementation of the constitution — ushering Nepal towards federalism. While the budget is ambitious in size and scope, the prospect of proper implementation is utterly bleak. If we look at the previous year’s capital expenditure, the government has only spent 25 per cent of the allotted budget. That can be attributed to bureaucratic inefficiency and structural bottlenecks. A pertinent question then would be how could federalism enhance the spending capacity of the government? Devolution of revenue collection and expenditure power to lower levels of government could offer one alternative. Empirical studies (concerning Nepal) have shown that fiscal decentralisation exercised in the past had a positive effect on district economic growth. It is imperative for Nepal to institutionalise fiscal decentralisation to garner the benefits of federalism.
Budget and fiscal decentralisation
Though Nepal has adopted federalism officially, this budget still continues the traditional approach. The budget is laden with centrally planned public goods around the country. It follows a model of revenue-sharing through transfers to local bodies. As local governments can be more responsive to diverse local preferences, they would be more efficient than the federal government in providing local public goods. Moreover, local governments would have incentives to be fiscally sound if they support their expenditures through local revenue, as they need to be accountable to their constituents. Under the federal structure, Nepal will have three tiers of government — federal, provincial and local governments. The constitution has defined the scope of authorities of different levels, some of which are concurrent. The federal structure is an improvement to the previous model of decentralisation with development regions as it requires elected governments in all three tiers. Another shortcoming of the previous model is dependence on central transfer or grants. The new provision requires delegation of authorities of taxation and expenditures to lower levels of government. However, the laws of taxation to guide delegation of such authorities are yet to be formulated. Further, concurrent powers of taxation and expenditures could undermine accountability and affect incentives of different tiers of government. It should be guaranteed that the roles and responsibilities of each institution should be clearly defined. Autonomy of decentralised subnational governments is essential for the success of fiscal federalism. In particular, sub-national autonomy is important to limit the discretionary powers of the federal government. As a step towards adopting federal structure, the government has allocated budget for holding local elections, which is critical for strengthening local governance. The budget has also doubled the grants for Village Development Committees and municipalities. Though local governments could be empowered through grants, they could become transfer-dependent and undermine fiscal accountability. Moreover, these grants are arbitrary and not based on well-defined criteria; for instance, on the basis of need or performance.
The challenge to fiscal discipline
This year’s budget increased by 28 per cent over last year’s reaching as high as half of Nepal’s Gross Domestic Product. It has been widely condemned for jeopardising fiscal discipline as it is well beyond available resources. On one hand, autonomy is desirable in terms of enhancing allocative efficiency, while on the other, it comes at the cost of opportunistic behaviour from autonomous entities. Subnational governments may have incentives to spend resources recklessly to win favour of their constituents. In countries with federalism, there have been instances of vertical fiscal imbalance when a sub-national government cannot fully cover its expenditures with own resources. When such imbalances are adjusted through transfers from the central government or public borrowing, cost shifting behaviour manifests. One problem with soft-budget constraints is that it generates incentives to be profligate in their expenditures and influences expectations during times of financial distress. Further, such transfers would impose negative externalities on residents of other jurisdictions in the form of increase in taxes or decrease in spending. Are there any mechanisms in the constitution to prevent such behaviour? Sub-national governments might be allowed to raise loans from the public through the credit market. They will also receive grants from the central government under fiscal-equalisation principle. The constitution has made the provision for Natural Resources and Fiscal Commission that will set the parameters for conditional grants and recommend a ceiling of internal loans for all tiers of government. In addition, factor mobility and political competition would promote fiscal discipline. Further, strong markets for credit and land, electoral system, credible judiciary and administrative fiat are required to further harden the budget constraint.
Road to prosperity
It is important to explore how fiscal decentralisation and fiscal discipline enhance economic growth. When powers are devolved to elected sub-national governments, the discretionary powers of the government to influence markets will be limited. Moreover, expenditure and revenue assignments to lower level governments will limit the funds available for government to support certain industries or provide subsidies. A fiscally sound government would curtail expansionary programmes allowing enough space for private investment. All in all, a fiscally decentralised government that is fiscally sound would preserve market characteristics leading to economic growth.