Expenditure Asymmetry & Budget Execution, Challenges of Fiscal Federalism

As Nepal transitions to a federal system and as political stability returns to the country with the completion of three tiers of election, people's aspiration for economic growth and prosperity is high under the new structure. However, the government is likely to face tough times ahead financing and maintaining federalism as it is expected to be a costly affair. Economists have pointed out to the expenditure asymmetry and budget execution as two major challenges to be faced by all three tiers of the government.

Expenditure Asymmetry

The expenditure asymmetry in fiscal policy is the gap between revenue and expenditure. In other words, it is a mismatch between resources and expenses to be incurred. Looking at the government's target of collecting Rs 730 billion as revenue for the annual budget of Rs 1278 billion in the current fiscal year, the revenue target for the next fiscal year can be beefed up to Rs 800 billion. However, the constitution allows provincial and local governments a share in the national revenue which leaves the central government's coffer will only 80% of such revenue. The annual budget of the central government, on the other hand, is likely to go up significantly, although the finance minister including officials of finance ministry are yet silent about the size of the annual budget for the next fiscal year. The responsibility to allocate and disburse grants to provincial and local governments is with the central government. The Intergovernmental Fiscal Management Act, ratified by Parliament in October 2017, has envisaged four types of grants: fiscal equalisation, conditional, matching and special, for states and local bodies. The central government will provide these grants annually. Even if the central government limits the budget's size to Rs 1300 billion, there will be sizable deficit as it can only collect less than Rs 650 billion as revenue which is less than 50% of the annual budget. The government can cover an additional Rs 325 billion which is around 25% of the budget through foreign aid and international and domestic borrowing. Still the deficit is sizable. In this context, the central government is under immense pressure to increase revenue. This can be achieved by either increasing tax rates or increasing the tax net by bringing larger mass into the tax bracket and plugging the revenue leakage. Early indication suggests that government will choose the second option. The new Finance Minister Yuba Raj Khatiwada has also assured the private sector that the government will not increase tax rates to fund the budget deficit, instead it will plug the revenue leakage and bring more individuals and businesses into the tax bracket. Khatiwada is already taking stringent measures at the customs in order to curb under-invoicing which is rampant across the key custom points. Under invoicing is a practice of reducingthe price of a goods on an invoice than the price actually paid in order to pay lower custom duty. Due to such practice by importers at major custom points, the government's revenue collection is negatively affected. In a bid to check this practice, Finance Minister Khatiwada has ordered custom officials to follow reference price of imported goods instead of price mentioned on the invoice. Speaking at a recently organised programme in the Finance Ministry for the mid-term review of the budget for the current fiscal year, Khatiwada instructed customs officials to revise the reference price of goods and ensure proper valuation in order to boost import duty collection. Apart from the central government, the provincial and local governments will also be under immense pressure to increase their revenues to meet their financial needs. Such pressure coupled with unclear laws may allow immature moves with negative long term implications. Recently, Shailung Rural Municipality of Dolakha district decided to impose hydroelectricity tax worth Rs one million on Nepal Hydro Developer Limited which is operating a medium sized hydropower project in the district. The local body's decision to impose tax under separate heading when the developers are already paying all types of royalty and taxes to the central government will discourage the private sector. Likewise, Khumbu Pasang Lhamu Rural Municipality of Solukhumbu district has started charging a tourism fee from foreign trekkers despite objections from travel trade entrepreneurs. Economist Chandan Sapkota said such things will become more common in the future unless the central government brings out laws and clarity on such issues. "The central government must introduce acts or amend existing acts to clarify jurisdiction of each tier of government when it comes to fiscal federalism," said Sapkota. Apart from imposing fees and taxes on businesses and individuals in a haphazard manner, the provincial and local governments will want more of the revenue pie which can lead to confusion and unrest. The subnational governments share of the revenue pie will be based on a formula for the distribution of excise duty and value added tax (VAT) devised by National Natural Resource and Fiscal Commission (NNRFC), a constitutional body. As per the Intergovernmental Fiscal Management Act, the central government is required to give 15% of VAT and excise duty collected from domestic products to local bodies, and another 15% to the states from the next fiscal year. The central government also needs to distribute 25% of royalties generated from the use of natural resources like mountaineering, electricity, forests, mines and minerals to the local bodies and another 25% to the states from the next fiscal year. The commission will devise a formula based on parameters such as geographic area, population, cost of service delivery, incidence of poverty and ability to generate financial resources to distribute such taxes, duties and royalties among subnational governments. "The NNRFC's resources distribution formula must be transparent in order to minimise internal strife among subnational governments," said Sapkota.

Budget Execution

Another major challenge that all three tiers of governments are likely to face, according to Sapkota, is budget execution which includes preparation of the budget and its implementation specially capital expenditure. The newly established subnational governments don't have expertise of preparing an annual budget. With government officials reluctant to take their posting at the provincial and local levels and rather opting for retirement, the subnational government will face difficulties in preparing and executing the budget. Similarly, the problem of low fund absorptive capacity which has been chronic in the past is likely to be seen under the new structure. Following the shift from unitary to federal system, the central government earmarked adequate funds to the newly formed local bodies only to see low fund absorption capacity at such level. By March, the local bodies have spent just over 20% out of the total budget of Rs 225 billion allocated to them. Each rural municipality received a grant ranging from Rs 100 million to Rs 390 million, while each municipality received grant ranging from Rs 150 million to Rs 430 million. Each sub-metropolitan city, on the other hand, received a minimum of Rs 400 million and a maximum of Rs 630 million, while every metropolitan city received grant ranging from Rs 560 million to Rs 1.2 billion. But local bodies cite lack of qualified human resources and proper laws for having barely spent the grant allocated to them. When it comes to capital expenditure, the performance of the central government is also poor. Over the first eight months of the current fiscal year, only 28.28% of the capital expenditure has been spent. Out of Rs 335.17 billion allocated for capital spending for the current fiscal year, only Rs 94.79 billion has been spent. The funds allocated for the development of large infrastructure projects have remained unused and it has been cited as one of the major reasons behind low capital spending.