Performance based allocation: Missing the differences of local governments

This article was originally published in on August 15, 2023 by Yatindra K.C. Mr. K.C ​​is a researcher at Samriddhi Foundation, an economic policy think tank based in Kathmandu. The views expressed in this article are the author’s own and do not represent the views of the organization. Author can be reached at [email protected]

A lot has already been said about Nepal’s fiscal architecture. The common consensus at least amongst those that have a keen interest in Nepal’s fiscal federalism is that some fine tuning is required. The over-dependence of sub-national governments on federal grants, the rising share of conditional grants as opposed to fiscal equalization grants, and weak performance of subnational governments in terms of internal revenue collection are the issues that have been raised multiple times. Indeed, these are important issues and as a country that still (realistically speaking) has not completed its transition process, it is important to address these problems at least to avoid a precedent being set in.

Some efforts have been made to incentivize better performance at the sub-national level. Most notably, the National Natural Resources and Fiscal Commission (NNRFC) has started allocating funds based on performance indicators. The seventeen indicators designed by the NNRFC (for local governments) capture, among other things, revenue utilization, planning and budgeting and service delivery. To the NNRFC’s credit, it has tried its best to design a system that will evaluate sub-national governments based on available data. Rather than opting for self-assessment (which is the predominant strategy used in most government agencies), the commission is focused on making a true assessment. Yet the share of performance-based grants is negligible enough to be of any incentive for sub-national governments. Currently, they range from 0.03 percent to 0.1 percent of the total budget size of local governments. There is at least some reluctance to design any grant system that will either reward or punish.

As the OAG report highlights, very few local governments have focused on utilizing their internal source of revenue. Among those that have been successful in mobilizing their internal sources a common thread is present. Either they have a sizable population and industrial presence, or they were bequeathed with structural endowments when the country’s governance structure changed.

Local governments are not an entirely new concept for Nepal, their existence sans autonomy was a feature of the unitary state. Naturally the absence of substantial autonomy meant that some local governments would receive more attention than others. In today’s context, this means some local governments were better off when the country finally adopted the federal system, they had a larger revenue base and most importantly they already had structures that were experienced enough to easily adapt to the new system.

Today’s debate about the weak performance of local governments in terms of their revenue mobilization misses this crucial aspect. Local governments did not start off on the same footing. Their strengths and weaknesses vary, and fine-tuning Nepal’s fiscal architecture will require acknowledgement of this. Efforts to incentivize performance whether it be service delivery or revenue mobilization too fail to recognize the fact that some local governments can already build on their experiences within the unitary governance structure whereas others cannot. Take, for instance, the nominal share of performance based fiscal equalization grants. The evaluation criteria, among others, focuses on things such as timely budgeting, adequate projections of revenue and expenditure, retention rate of students in community school, school enrollment rates among others. These are the areas where rural municipalities and municipalities lack technical capacities. With some exceptions, sub-metropolitans and metropolitans outperform rural municipalities and municipalities on most of the evaluation criteria.

Whether by design or in the lack of a better alternative thereof, the current system of administration of performance-based grants regards all local governments as the same. At least for now, fiscal equalization grants in Nepal are simultaneously looking to achieve three goals–horizontal equalization, vertical equalization and performance incentivization. One must also look at how other grants–such as special and complimentary grants–incentivize the performance of local governments. During the initial days of the intergovernmental transfer system in Nepal, performance incentive function was believed to be better achieved by special, complementary and conditional grants. Yet as time came to pass, incentivizing function found its place in the fiscal equalization grant. It could either be the reluctance of agencies responsible for special, conditional and complimentary grants to do so or the problems of designing systems with imperfect data.

Those that are interested in Nepal’s fiscal federalism often take recourse to the performance-based grant system of the recent past. To their credit, it is a substantial knowledge base that must be utilized. Yet what is often missing from the debate of designing intergovernmental transfer systems is the need to take into account the differing conditions of local governments themselves. Previous systems did utilize a similar strategy, yet their efficacy has rarely been questioned.

On the other hand, we also need to consider equity, both horizontal and vertical. Designing a system that incentivizes performance is not an easy task. Above all, it will require looking at the entire apparatus of intergovernmental transfer systems and institutions involved. Some level of coordination and cooperation, which seems to be missing, will also be required moving forward. But most importantly, we must acknowledge that not all local governments are the same, they have differing capacities and these need to be worked into any system of allocation.