NEPAL FISCAL FEDERALISM UPDATE, 2024: DOWNLOAD THE REPORT
The World Bank Nepal Fiscal Federalism Update (NFFU) aims to report annually on the progress of fiscal federalism in Nepal and identify implementation gaps. This second update reviews the progress on fiscal federalism since the publication of the first report and provides an update on economic conditions across provinces and local governments in 2023. Considering their important role in fiscal federalism and the recent growth of public debate on the role of provincial governments, this edition gives special emphasis to the provincial level of government.
Growth has been slow and deficits have manifested across provinces and most local governments.
In fiscal year (FY) 23, Nepal's provinces saw their slowest growth since FY20, ranging from 1.4 percent in Bagmati to 3.3 percent in Gandaki, driven by a decline in wholesale and retail trade and manufacturing. Import restrictions implemented by the federal government in the first half of FY23 to manage external pressures resulted in a significant decline in the wholesale and trade sub-sector across all provinces, while manufacturing and construction sub-sectors also contracted, in part due to the elevated prices of manufactured goods and construction materials. Bagmati, which has the largest services sector, contributed to the slowdown in national growth.
The slowdown in growth along with import restrictions led to a decline in federal revenue from 23.1 percent of gross domestic product (GDP) in FY22 to 19.2 percent of GDP in FY23. This, in turn, caused a decrease of 1.3 percentage points of GDP in fiscal transfers (including revenue sharing) to sub-national governments. Consequently, in 2023, provincial revenue and grants plunged by 0.9 percentage points of GDP to a record low of 3.5 percent, and local government revenue and grants fell by 1 percentage point to 8 percent of GDP. While all provinces and municipality types experienced this decline, Sudurpashchim Province and urban municipalities saw the largest decrease.
With spending remaining relatively unchanged at around 12 percent of GDP, lower revenue and grants in FY23 led to a deficit for both provincial and local governments, the first time since FY19. Provincial deficits reached 0.3 percent of GDP in FY23, while local government deficits stood at 0.4 percent of GDP. These deficits were financed using the opening cash and bank balances, reflecting unspent unconditional fiscal equalization grants (FEGs) and revenue sharing from previous fiscal years. The severity of the deficit varies significantly across provinces and municipality types, with Sudurpashchim Province and urban municipalities experiencing the largest deficits.
Sub-national governments in Nepal consistently underspent their budgets in FY23. Provincial governments underspent at a rate of 34 percent, while local governments underspent at a rate of 24.4 percent. Program expenses (recurrent expenditure) and public construction (capital expenditure) were the common drivers of underspending for sub-national government. Underspending at the provincial level continues to be explained by lack of alignment between periodic development plans, the medium-term expenditure framework (MTEF), and the budget, as well as the allocation of a significant portion of the budget to the category of ‘Economic Miscellaneous’.
Progress on the regulatory framework for fiscal federalism and institutional development has been slow, and urgent action is needed on reinforcing expenditure and revenue assignments, as well as upgrading the Inter-Governmental Fiscal Transfers System.
Nepal’s legal and institutional reform under fiscal federalism has been progressing moderately.
At the institutional and strategic levels, the Fiscal Federalism Coordination Division (FFCD) at the Ministry of Finance (MoF) has the mandate to coordinate fiscal federalism implementation, including for development of fiscal federalism strategies. In addition, FFCD has also been designated as the unit responsible for coordinating public financial management (PFM) strategies since November 2023. Proactive reviews on regulatory frameworks, such as the Local Government Operations Act (2017) and Inter-Governmental Fiscal Arrangement Act (2017), together with the review of the Unbundling Report led by the Office of the Prime Minister and Council of Ministers (OPMCM), are underway to further clarify the division of responsibilities among the three tiers of government.
The enabling environment for fiscal federalism and PFM at the provincial level is slowly advancing. Following federal-level institutional developments, provincial-level institutions responsible for fiscal federalism and PFM are in the process of developing their core building blocks. By December 2023, all seven provinces had enacted their Provincial Civil Service Acts (PSCA), paving the way for the recruitment of sub-national civil servants. The dependence of provincial governments on conditional grants (CG) as a share of their total revenue decreased from 19.6 percent in FY22 to 17.3 percent in FY23, which indicates a marginal increase in the fiscal autonomy of provincial governments. Enhancing the capacity for revenue administration at the provincial level ought to be encouraged to further empower provincial fiscal autonomy.
More progress needs to be made on revenue and expenditure assignments across the three levels of government. For instance, some of the sectoral legal and regulatory frameworks, such as the Water Supply and Sanitation Regulations and the Education Bill (currently under review by Parliament), should provide further clarity on expenditure assignment in the sectors, determining which tier of government holds what spending power. On revenue assignment, the Construction Materials Management and Regulation Bill was submitted to Parliament in November 2023 and is expected to provide clarity on the division of revenue rights and responsibilities between provincial and local governments (PLGs) regarding natural resources. It is important to enact these regulatory frameworks without delay to give clarity on concurrent responsibilities among the three tiers of government.
The Inter-Governmental Fiscal Transfers (IGFTs) System requires upgraded institutional arrangements for effective management. The reliance of local governments on the four types of IGFTs is still high – 74.3 percent of total local government revenue in FY23, which is slightly less than the 76.1 percent in FY20 – while CGs to local governments have increased slightly over the same period, from 43.5 percent to 46.5 percent of total revenue. The overall trend of IGFTs has remained unchanged, with the largest proportion of resources for local governments being transferred through CGs.
CGs could be decreased and FEGs increased to enable planning and decision-making by PLGs according to bottom-up needs. Furthermore, the design of CGs can be improved by establishing a transparent, consultative process and a technical methodology to increase the predictability of financial resources, as well as by adopting mechanisms to increase the flexibility of PLGs in the programming and use of these grants.
Progress has been made on public financial management at the provincial and local government level, although challenges persist.
Local governments are making strides in planning and budgeting practices. For example, (a) more local governments are preparing periodic development plans, MTEFs, and annual programs; (b) almost all local governments have established the required committees for budget preparation; (c) thematic budget ceilings are increasingly being determined based on legal guidelines; and (d) most local governments delegate spending authority as required by law. However, challenges remain in terms of preparing MTEFs and annual programs based on spatial based periodic plans.
Local governments largely complied with accounting standards, but budget transparency remains low. While some types of budget information like revenue and spending estimates are becoming more publicly available for the budget year, problems with comparability and transparency persist in budget speeches, despite the adoption of the Sub-National Treasury Regulatory Application (SuTRA) by almost all local governments. For example, unlike federal and provincial governments, more than 90 percent of sampled local governments did not present three sets of figures (estimates for the upcoming year, revised estimates for the current year, and actual figures from the previous year) or consistent documentation on budgets based on administrative, economic, and functional classifications. This prevents comparisons between budgets and execution.
There has been progress in terms of procurement capacity and internal control systems at the local level, although there is ample room for improvement. The number of local governments preparing and fully implementing master and annual procurement plans increased from FY22 to FY23. According to LISA data, 44.1 percent of 444 local governments prepared and fully implemented these plans in FY23, marking a considerable increase from 29.1 percent of local governments in FY22. There was also a considerable increase in the number of local governments that prepared, fully implemented, and regularly monitored internal control systems. Despite this progress, close to half of the local governments sampled in FY23 did not prepare any procurement-related plan, and more than half did not have an internal control system.
Despite a decrease in audit irregularities and an increase in public hearings, fewer local governments are complying with legal deadlines for financial reporting. Local governments are increasingly failing to prepare and publish their annual budget execution reports within the mandated timeframe of three months after the fiscal year ends. This decline in adherence to the legal requirement is widespread across all municipality types. The compliance rates in FY23 ranged from a low of 17 percent in metropolitan cities to a high of 22 percent in rural municipalities.
Progress in the uptake of recommendations contained in the NFFU 2023 has been moderate.
Moderate progress has been made against the six key recommendations highlighted by NFFU 2023. Since the first edition of the NFFU in 2023 (with a data cut-off date of March 2023), some progress has been made in the actions recommended by the report in terms of the enabling legal, policy, and institutional frameworks and the PFM implementation status of PLGs. Among these are the decision by the government to prepare a Fiscal Federalism Roadmap for Nepal, led by the FFCD under the MoF, and the ongoing process to review the Unbundling Report through an exercise led by the OPMCM to give further clarity on expenditure and revenue assignments among the three tiers of governments. However, there has been limited progress on some other key recommendations, such as the important reforms needed on the assignment and management of conditional grants (for details, see the recommendation matrix in the report).
The key recommendations of this report build on the progress achieved since the last NFFU and the remaining gaps. They refer to reforms or amendments in the legal framework, reinforcement of the IGFT system, facilitating economic and PFM-related data production and access, reform of the procurement system, strengthening PFM and procurement capacity, and reinforcement of PLGs’ budget credibility. The recommendations are summarized in the following table , along with a proposed level of priority (short and medium term) based on their feasibility, impact, and sequencing.