Selected Issues


Selected Issues

Managing Effective Fiscal Federalism1

Nepal has been undergoing a swift transition to fiscal federalism in recent years. The new paradigm holds the promise of improved delivery of public services. However, the rapid transition to the new structure of government and government finances also carries pitfalls and complicates fiscal and macroeconomic management. Indeed, the introduction of fiscal federalism has been associated with a sharp deterioration of fiscal performance. The design of intergovernmental fiscal relations and the ambitious timetable to implement fiscal federalism have been shaped importantly by political-economy considerations that are outside the scope of this note. Instead, the focus is on analyzing Nepal’s newly-established fiscal federalism framework, highlight gaps in the current structure and the potential economic impact, and discuss policy recommendations. Managing effective fiscal federalism in Nepal will require strong efforts to strengthen public financial management and enhance the implementation capacity at all levels of government to mitigate risks to fiscal sustainability and achieve allocative efficiency gains.

A. Nepal’s Fiscal Federalism Structure

1. Nepal is transforming itself from a unitarian state into a federal democratic republic as mandated by the 2015 Constitution. The transition to a federal system could help make policies more inclusive and improve the delivery of government services to people across Nepal. The new federal state structure comprises federal, provincial, and local governments (Figure 1).

Figure 1.
Figure 1.

Nepal: Transition to Federal Structure

Citation: IMF Staff Country Reports 2019, 061; 10.5089/9781484399781.002.A002

Number of corresponding units is shown in parentheses.

2. Fiscal and institutional arrangements have been re-designed and implemented to support the new federal structure. A key objective is to create allocative efficiency gains and improve the delivery of public services, with local governments responsible for basic services including education, health, local transportation, and water and sanitation. The 2015 constitution sets out the provisions that govern the fiscal federalism framework, in particular the revenue and expenditure assignments. The Parliament has also approved the Local Government Operations Act (2017) which will govern the operation and management of local governments. Under this Act, in the future, all financial resources allocated for local governments are to be deposited into the Local Consolidated Fund, which will enable the municipalities to manage their fiscal affairs. The Inter-Government Fiscal Transfers Act (2018) specifies the framework for public financial management. The National Natural Resources and Fiscal Commission (NNRFC) has been established per the constitution to recommend the arrangements related to inter-governmental fiscal transfers, internal borrowing, and natural resources utilization.

3. With the current setup, Nepal’s fiscal federalism is special in a number of aspects. For instance, most spending assignments are handed down to the lowest level of government—local government, with limited roles for the central and provincial governments. Furthermore, the subnational levels have vast legislative powers which could create coordination challenges. The transition to fiscal federalism is being implemented over a short time span, rather than in a calibrated and sequenced manner, which adds to the transition challenges.

4. Provincial and local governments’ financial resources comprise of four key elements:

  • Four categories of fiscal transfers:

    • (i) Equalization grants: transfers of resources to the provincial and local governments based on population, development status, and the gap between expenditure needs and revenue potential. Transfers are effected in four installments (10th August, 19th October, 16th January, and 15th April);

    • (ii) Conditional grants: transfer of funds to provincial and local governments to implement projects related to national policies and standards. A quarter of the total budgeted amount is to be transferred on July 17. The rest is to be transferred on the first day of each trimester depending on implementation progress;

    • (iii) Complementary grants: transfer of funds to provincial and local governments to match the resources; and

    • (iv) Special grants: transfer of funds to provincial and local governments to support any special project related to the supply of services, emergency needs, and activities related to national development priorities.

  • Revenue-sharing: VAT and internal excise tax revenues will be shared among federal, provincial, and local governments at the ratio of 70:15:15. Royalties will be shared at the ratio of 50:25:25.

  • Local revenue collection: Taxes on property, rent and lease income, and vehicle registration fees will be collected by local governments for their own source revenues.

  • Internal borrowing and provision of loans by the center: The legal framework and monetary instruments related to internal borrowing have not yet been finalized. Nevertheless, the NNRFC’s administrative decision suggest an upper limit for internal borrowing at 5 percent of GDP per annum for the federal government. Provincial and local governments could borrow up to 10 percent of the sum of their share of VAT and excise revenue locally-collected revenue.

5, The first two budgets under fiscal federalism entailed sizeable financial resources transferred to sub-national governments, resulting in a sharply wider fiscal deficits (Table 1).

  • The operation of fiscal federalism commenced partially in FY2017/18, as the center began fiscal transfers to newly-established local governments. Transfers were limited to conditional and equalization grants and determined on an ad hoc basis by a simple formula.

  • Subsequently, the NNRFC developed a revenue sharing formula. The establishment of provincial governments further operationalized fiscal federalism and the FY2018/19 budget envisages total financial resources for subnational governments of 14 percent of GDP.

  • The transfer of a significant amount of resources to subnational governments has not been offset by an equivalent decline in central government spending. Therefore, the consolidated fiscal position has deteriorated sharply with the deficits reaching 6.5 percent of GDP in FY2017/18 and budgeted to expand further to about 8 percent of GDP in FY2018/19. As a result, even taking into account the likely under-implementation the budget, public debt is projected to rise to 33 percent of GDP in FY2018/19, up from 26 percent of GDP in FY2016/17.

Table 1.

Nepal: General Government Operations Under Fiscal Federalism

article image
Sources: Nepali authorities and IMF staff projection

Nepal: Fiscal Deficit and Public Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 061; 10.5089/9781484399781.002.A002

Sources: Nepali authorities and IMF Staff Calculations

B. Key Issues and Challenges

Macro-Fiscal Implications of Nepal’s Current Fiscal Federalism Structure

6. Fiscal strains could be exacerbated in the absence of further adjustment of central government spending and medium-term budget planning. A sizeable increase in the consolidated government’s budget envelope and the lack of realistic medium-term fiscal framework, if persists, could risk fiscal sustainability, as this could lead to an unsustainable fiscal path amid persistent budget deficit and rising public debt. At present, Nepal’s risk of debt distress remains low, but public debt is projected to rise sharply and reach 35 percent of GDP in the medium-term in the staff’s baseline scenario, up from 22 percent of GDP in the staff report for the 2017 Article IV Consultation.

7. The heavy reliance of the subnational governments on shared revenues and transfers from the center has put pressures on the fiscal balance and could risk fiscal sustainability. Nepal’s share of subnational spending in total general government spending of about 36 percent in the FY2018/19 Budget is not exceptionally high, but the share of the subnational governments’ own source revenue in their total revenue is very low, thus leading to very large vertical fiscal imbalance (VFI)—higher than in other countries (Figure 2). Cross¬country experience suggests that large VFIs are associated with worse fiscal performance, in terms of general government balance, as it could relax the fiscal discipline of subnational governments (Eyraud and Lusinyan, 2011). More specifically, sub-national governments’ dependency on shared revenues and transfers from the center may create incentive problems. The provincial and local governments face little incentive to raise revenue to finance their spending. Local authorities may fail to fully internalize the cost of local spending when they can finance their marginal expenditure with central transfers that are funded by taxpayers in other jurisdictions; therefore, this behavior can lead to overspending, relaxation of tax collection, low revenue, and weakening of fiscal balance (Sow and Razafimahefa, 2017).


Vertical Fiscal Imbalance and General Government Balance 1/

(In percent)

Citation: IMF Staff Country Reports 2019, 061; 10.5089/9781484399781.002.A002

Source: OECD, IMF World Economic Outlook, and staff calculations.1/ VFI is in percent of subnational own expenditure, as of 2015.GGB is in percent of GDP, and is the average value over 2011-2015.
Figure 2.
Figure 2.

Cross-Country Subnational Government Operations

Citation: IMF Staff Country Reports 2019, 061; 10.5089/9781484399781.002.A002

8. Fiscal decentralization may impede the conduct and effectiveness of fiscal policy If a large share of taxes and spending is shifted to subnational governments, the central government’s fiscal policy levers become less powerful. This could be an important issue given also that policy priorities often differ across government levels. Ter-Minassian (1997) noted that revenue-sharing arrangements on a tax-by-tax basis with fixed distribution coefficients like in Nepal tends to make fiscal policy more pro-cyclical: increases in shared revenues during a boom period increase the availability of resources for sub-national governments, and vice versa. This will tend to limit the ability of the central government to conduct counter-cyclical stabilization policies. Indeed, Sow and Razafimahefa (2017) found fiscal decentralization to be associated with increased fiscal policy pro-cyclicality or reduced counter-cyclicality, thus suggesting that fiscal decentralization has a destabilizing effect on fiscal policy. This issue deserves attention in Nepal where fiscal policy in recent years tended to be pro-cyclical, and decentralization could further reduce the effectiveness of fiscal policies going forward.


Fiscal Decentralization and Cyclicality of Fiscal Policy 1/

Citation: IMF Staff Country Reports 2019, 061; 10.5089/9781484399781.002.A002

Sources: Sow and Razafimahefa (2017) and IMF staff calculations1/ Fiscal decentralization index is obtained as the inverse of the ratio of central government share over the general government expenditure. Cyclicality coefficients of fiscal policy are derived from the relationship between the change in government expenditure and output gap, where positive coefficient indicates pro-cyclicality. The coefficients are estimated using Aghion and Marinescu (2007) methodology, which are country-specific and time-varying. Sample includes 64 countries between 1990 and 2012. Red dot presents Nepal data as of 2018/19

Capacity Issues

9. Rapid devolvement of spending responsibilities and augmentation of resources to subnational governments could stretch the capacity at subnational levels, therefore limiting allocative efficiency gains. Decentralization of expenditure responsibilities could lead to allocative efficiency gains, for example by allowing for better alignment of expenditure priorities with preferences of citizens. However, these gains may be negated in practice by administrative weaknesses and the lack of capacity at the subnational level (Ter-Minassian, 1997). In the case of Nepal,

  • Rapid federalization carries the risk of disruption of public services. This could be exacerbated in case roles and responsibilities across the three levels of governments are not clearly defined.

  • Subnational governments appear to have limited implementation capacity to fully utilize their resources. A substantial share of the resources transferred to provincial and local governments is often kept in government deposit accounts, as evidenced by a surge of government deposits during the fiscal year.

  • The absence of well-developed public financial management systems at the subnational levels, including expenditure reporting and control systems, could raise the risk of misallocation and waste (Ahmad et al, 2006).


Nepal: Government Deposits

(NPR Billion)

Citation: IMF Staff Country Reports 2019, 061; 10.5089/9781484399781.002.A002

Source: NRB.

Framework and Institutional Design Issues

10. It is as yet unclear to what extent the current fiscal transfers and revenue-sharing will align with subnational governments’ actual cost of public service delivery. In principle, the design of revenue sharing2 and grants3 to subnational governments in Nepal appears to be broadly in line with practices in other countries. Nevertheless, the expected cost of service delivery remains unknown, as a comprehensive costing of subnational governments’ expenditure assignments has not yet been completed. Therefore, there is a need to review and refine subnational governments’ budget envelopes to bring them in line with the expected cost of service delivery.

11. Gaps in the existing framework remain to be filled. The framework for internal borrowing will need to be developed, with the criteria and borrowing limits to be set effectively. Cross-country experiences suggest such conditions will be crucial to enforce fiscal discipline and mitigate macro-fiscal risks arising from subnational levels.

C. Policy Implications

12. In sum, a rapid transition to fiscal federalism carries several pitfalls and can complicate fiscal and macroeconomic management. Nepal’s swift implementation of fiscal federalism has been associated with a marked deterioration of fiscal performance. At the same time, it is too soon to assess whether the new federal fiscal structure will help to improve the delivery of public services. Managing effective fiscal federalism in Nepal will require strong efforts to strengthen public financial management and enhance the implementation capacity at all levels of governments to mitigate risks to fiscal sustainability and improve allocative efficiency gains. These include:

Short-term priorities:

  • Subnational governments’ policy implementation capacity should be strengthened through training, standardization, and the use of technology.

  • Public financial management systems at subnational levels should be established. Particularly, effective and transparent budgeting, accounting and reporting system at all levels should be developed. Nepal’s Financial Comptroller General Office is taking steps to improve financial reporting at the subnational levels, and it is important that these efforts be intensified. Local consolidated funds should also be established, to help monitor the financial transactions of subnational governments. Going forward, these funds should be made to act as stabilization funds—absorbing excess resources during boom while boosting spending during bust periods, in order to prevent more procyclical fiscal policy resulted from fiscal decentralization.

Medium-term priorities:

  • The expenditure allocation should gradually adjust to reconcile with the responsibilities and needs. Fiscal Responsibility and Budget Management Bill (FRBMB) should be adopted to ensure fiscal discipline and increase accountability. A realistic medium-term expenditure framework should be reinstated, and medium-term budget planning should be developed to ensure fiscal prudence and consistency with broader macroeconomic management. The annual budget planning should be guided by the medium-term framework. A periodic spending review should be conducted to provide inputs to refine the methodology and formulas for revenue sharing and fiscal transfers.

  • Fiscal discipline at subnational levels can be strengthened by better aligning subnational governments’ taxation powers with their spending obligations, thus narrowing the vertical fiscal imbalances (Eyraud and Lusinyan, 2011). State and local taxes should be carefully selected, based on feasibility and efficiency considerations.

  • The functional and revenue responsibilities should be clarified at all levels of government. It is crucial to ensure non-overlapping responsibilities between the center and local authorities, in order to avoid duplication and waste of public resources as well as to warrant better service quality (Ter-Minasian (1997) and Ahmad et al (2006)). A review of costs of delivering services in the federal structure should be conducted as a matter of priority.


  • Ahmad, E., G. Brosio, and M. Gonzalez, 2006, “Uganda: Managing More Effective Decentralization,” IMF Working Paper No. 06/279 (Washington: International Monetary Fund).

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  • Eyraud, L., and L. Lusinyan, 2011, “Decentralizing Spending More than Revenue: Does it Hurt Fiscal Performance?IMF Working Paper No. 11/226 (Washington: International Monetary Fund).

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  • International Monetary Fund, 2012, “Pakistan: 2011 Article IV Consultation and Proposal for Post Program Monitoring,” IMF Country Report No. 12/35 (Washington).

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  • National Natural Resources and Fiscal Commission, 2018, Fiscal Federalism in Nepal: Journey so Far, Official Presentation.

  • Sow., M., and I. Razafimahefa, 2017, “Fiscal Decentralization and Fiscal Policy Performance,” IMF Working Paper No. 17/64 (Washington: International Monetary Fund).

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  • Ter-Minasian, T. ed.,, 1997, Fiscal Federalism in Theory and Practice (Washington: World Bank).


Prepared by Piyaporn Sodsriwiboon (APD).


Revenue sharing criteria in Nepal is based on population, area, human development index, and under-development index factoring in infrastructure, cost of service delivery, and discrimination index. Similarly, India uses formulas that combine population, income per capita, state’s own tax effort and under-development index. Brazil uses a set of coefficients loosely linked to relative per capita income levels of the states. Germany applies redistributive criteria for sharing VAT on per capita basis entailing to less affluent states (Ter-Minassian, 1997).


Grant distribution in Nepal takes into account gaps between revenue potential and expenditure needs, cost of expenditure, human poverty index, and other dimension of poverty such as discrimination index and infrastructure index. As noted in Ter-Minassian (1997), Denmark, Japan, and Korea also use indicators of expenditure needs including demographic characteristics, population density, length of road, among others. In addition, countries such as the United States and Canada use block grant or special grant for the case of Nepal to close expenditure gaps.

Nepal: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept