Intergovernmental Fiscal Transfers in a Federal Nepal

Nepal’s new federal constitution provides equal state power to each level of federal unit (that is, federal, provincial, and local governments). These governments’ functional responsibilities are enshrined in the schedules of the constitution, with expenditure responsibilities devolved to the subfederal units while revenue-raising rights remain highly centralized. To bridge the gap between revenue rights and expenditure needs, the constitution mandates fiscal transfers; subfederal units receive four grant types (fiscal equalization, conditional, special, and matching). The largest category of grant is fiscal equalization, which constitutionally must be distributed based on the expenditure need and revenue potential of the subfederal units, as processed by the independent National Natural Resources and Fiscal Commission (NNRFC), the body charged to make the fiscal transfer process balanced and transparent. In the short time since the implementation of federalism started in 2017, Nepal has done well with the fiscal transfers system. Subfederal units have received fiscal transfers amounting to 33 percent of the total federal budget and 11 percent of the country's GDP. Fiscal equalization grants alone account for about 3.4 percent of total GDP, indicating smooth vertical allocation of funds. However, the horizontal distribution of fiscal equalization grants has not been as successful, featuring an allocation formula and methodology that many consider unfair and meriting closer study. Accordingly, this paper examines current approaches and proposes alternate allocation formulae and methodologies, including recommendations for coordination and cooperation between the government and NNRFC on fiscal transfer issues.