The Fiscal Architecture of Subnational Governments in Federal Nepal

The formation of the three tiers of government represents a novel experiment in Nepal’s federal journey since the adoption of the new constitution in 2015. State power in the former unitary system, both rights and responsibilities, has been divided across federal, provincial and local tiers of government, with a mix of exclusive and concurrent powers for each. In matters within their jurisdiction, subnational governments can formulate laws on financial rights, set their own budgets, make decisions, devise plans and policies, implement those plans, levy taxes, and collect revenues. In the roughly three years since devolution went into effect, a few problems and uncertainties have cropped up, particularly in the exercise of power. Subnational governments complain that the center has not been very cooperative when it comes to the formulation of laws, allocation of resources, transfer of the institutional set-up, etc. However, there have been some achievements in the implementation of federalism. Institutional structures have formed at the subnational government levels, they have begun staffing, and their fiscal situations are gradually strengthening. Improvements have been made in almost all areas, including social, human development, economic, infrastructure and administrative sectors. A sense of positive competition has been created between different local and provincial governments. However, a continuing point of tension in Nepal’s federal devolution is shape of the fiscal architecture supporting the new rights and responsibilities of subnational governments. The constitution provides many functional responsibilities to provinces but only limited revenue rights. This structure conflicts with the “finance follows function” principle of effective decentralization, suggesting that initiatives are needed to review the fiscal space of the provincial level. The purpose of this paper is to analyze existing institutional structures and details of subnational government finance (“fiscal architecture”) in Nepal, primarily at the provincial level, and identify recommendations for improvement.