Fiscal Article

Paradigm Shift on Fiscal Front in Nepal

In the federal set up of government, the focus should be on balancing (a) public sector efficiency and growth, (b) redistribution of income/wealth and (c) macro-economic stability.

KATHMANDU: Significant political reforms have taken place in Nepal lately. The shift from the unitary to the federal form of the government has ushered in fiscal reforms in Nepal. The Constitution of 2015 has formalized the political change of political and fiscal federalism witnessed in Nepal.

The unitary system can also have a fiscal decentralization, but fiscal federalism is associated with political federalism. With the adoption of the federal system of governance, Nepal has one federal government, 7 provincial governments, and 753 local level governments with 6743 ward committees. Altogether, there are 761 governments in the country with nearly 135 ministers and 884 members of parliament.

Naturally, recurrent expenses tend to rise to support these political structures and the growing size of the bureaucracy. However, expenses will not go up as hyped in the mainstream. A case in point is the large size of constituent assembly in the past. There were 601 seats back then, now there are 885, which is just 284 more. Also, as a least developed country, Nepal’s development trajectory is bound to grow and consequently, the size of the economy is also expected to expand. The expanding economy will have no problems in supporting the increased size of the government and the public sector.


Fiscal federalism has three popularly cited objectives. They include (a) addressing the problem of chronic poverty, (b) mitigating uneven regional development pattern, i.e. addressing the issue of horizontal inequalities, and (c) improving the efficiency of public resource utilization.

The Issue

One issue of fiscal federalism is the effect of the relative size of the public sector on the national economy. The concern relates to the private sector development and the crowding-out effect of the public sector expenses. Therefore, in the federal set up of government, the focus should be on balancing (a) public sector efficiency and growth, (b) redistribution of income/wealth and (c) macro-economic stability.

Fiscal Model in Nepal

Legislative developments so far suggest that Nepal has adopted fiscal federalism model of (a) expenditure decentralization, (b) revenue centralization, and (c) fiscal transfers aimed at addressing horizontal imbalances.
Expenditure decentralization means the decentralization of the allocative functions – the provision of public goods across the provinces. The focus of revenue centralization is to protect the common market – capital, labor, and commodities. The idea of revenue centralization is not to distort capital, labor, and goods markets. Rather the objective is to ensure a free mobility of resources and goods.

The Macro Picture

The macro picture of fiscal federalism is shaped by how responsible the federal government is in stabilizing macroeconomy and redistributing income and how efficient the sub-national authorities are in ensuring public goods provision within their jurisdiction.

The current size of the budget is 32% of GDP (2017/18). Gross domestic saving is 18.1% of GDP. Gross national saving to GDP ratio is at 46.0%. The gross capital formation to GDP ratio is at 50.2%. The gross fixed capital formation is at 28.1%. These macro indicators are encouraging for the national economy going forward.

However, Nepal will have to push up the gross capital formation ratio to 45% of GDP. For that, the government will have to increase the revenue ratio to 32% of GDP from the current level of 22.3% and domestic borrowing to 5% of GDP. The government will have to raise foreign aid of nearly 8% of GDP. These initiatives are key to put the economy on a higher growth trajectory.

How to manage public finance of this magnitude

To manage federal finance of this magnitude, the government should do a couple of things.

First, the government will have to reduce the size of the informal economy. The World Bank estimates the size of the informal economy in Nepal as 37% of GDP. According to the Ministry of Finance, Government of India’s study report on ‘Measures to Tackle Black Money in India and Abroad 2012’, the size of Nepal’s informal economy is 40.8% of GDP. An NRB study estimates 35% of international trade (especially imports) as informal.

Second, efforts should be made to maintain the current level of remittances. Remittances are subdued not due to the fall in demand for Nepalese workers, but rather due to less supply of Nepalese workers relative to demand in the wake of COVID-19. This finding of NRB’s recent study on “Free Visa and Free Ticket” has implications for informal transfers of remittances as well. The COVID-19 has also shed light on the magnitude of informal transfer of remittances. The relative pickup in remittances amid the COVID-19 situation is due to the decline in informal transfer of remittances.

Third, there is a need to increase financial access, i.e. the need for increase monetization of the economy. According to the World Bank, only 45% of the total adult population has financial access. The Fin scope study report suggests 40% adults in Nepal have access to financial services. Commercial banks’ presence in all 753 local levels is yet to be ensured. The point is that financial development has the potential to mobilize resources needed for federal Nepal.

Fourth, concerted efforts should be made to attract FDI. The FDI stock reached Rs 200 billion including reserves in 2018. The paid capital FDI stock is only Rs. 77 billion. The FDI stock is low in Nepal. There is a need to initiate FDI related reforms. Deregulation is the need of the hour. There is also a need for private sector development such that the public sector does not crowd out the private sector.

Fifth, Nepal needs to reduce corruption. The Transparency International identifies Nepal as a highly corrupt country ranking it 113 of 180 countries. When corruption declines, public resources increase.


The first challenge is to move Nepal’s federal fiscal arrangements from the first-generation theory (GFT) to the second-generation theory (SGT) of fiscal federalism. The FGT of fiscal federalism is associated with decentralization of expenditure responsibilities and centralization of revenue responsibilities to achieve efficiency and equity in the federation.

Assuming federal and sub-national decision-makers are benevolent and maximize the social welfare, the FGT emphasizes the importance of transfers for addressing the problems of vertical and horizontal imbalances. However, the FGT ignores the macro-stability objective of federal finance and trade-off between political and economic objectives.

The SGT is based on the theory of market-preserving federalism. The goals of political institutions may often diverge from maximizing citizen’s welfare. The SGT emphasizes on inter-jurisdictional competition, a common market/protection of markets, hard budget constraints, leading role to the monetary policy. The SGT discusses the issue of crowding ut effect of public finance.

The second challenge is to ameliorate elite capture and reduce corruption. Nepal’s state machinery is largely in the hands of elites. Policies designed by elites are less effective for the poorer section of the society. The corruption is still at a high level which disproportionately affects the poorer sections of the society.

The third challenge is of fiscal populism. Very often, the governments tend to opt for cheap fiscal populism at the cost of infrastructure building measures meant for poor people. The route of fiscal populism is easier for it requires minimal efforts on the part of the government and maximizes the gains for those closer to the power centre. For instance, political party workers are monopolizing agricultural subsidies while leaving the poor farmers high and dry. The government should emphasize on building roads aimed at connecting the remote areas, health, sanitation and education.

The fourth challenge is avoiding the soft budget constraints. This risks macroeconomic stability. Nepal needs to adopt hard budget constraints at both national and sub-national levels. A feasible option is for Nepal to adopt the Fiscal Responsibility and Budget Management (FRBM) Act which requires fiscal rules.

The fifth challenge is of ensuring fiscal sustainability. For this, many countries are adopting fiscal rules. For example, India has set a medium-term fiscal plan of fiscal deficit at 3% of GDP for the central government and 3% of state GDP for state governments. The combined general government fiscal deficit target is set at 6% of GDP. Likewise, the general government public debt target is set at 60 %, which is decomposed to 40% for the central government and 20% for state governments.

The sixth challenge is of removing fiscal impediment for the effective conduct of monetary policy. The central government should preserve the central bank’s autonomy in formulating and implementing monetary policy. Fiscal policy should not dominate monetary policy. This is important for ensuring efficient credit market and developing a mature banking system.

The seventh challenge is of avoiding the bailing out sub-national government going forward. Statutorily, subnational governments can borrow internally. We should be positive about it for efficiency and equity. This is one way to bridge the vertical fiscal imbalance. However, we need to place in a borrowing regime which ensures market discipline as well.

Summing up

Fiscal federalism is good for the country as it has the potential to promote economic growth, efficiency, and equity. The greatest advantage is of promoting the general welfare of the people across regions of the country by holding the governments closer to the people accountable for meeting the needs of the people. However, bridging the vertical fiscal imbalance between the expenditure responsibility and revenue rights remains a challenge. We need to reform the fiscal federalism further so that subnational governments have enhanced revenue rights along with revenue sharing and fiscal transfers. The resource gap should be bridged further by making suitable arrangement for subnational borrowing.

-Nara Bahadur Thapa, Former Executive Director, Nepal Rastra Bank

Nara Bahadur Thapa |
Friday January 8, 2021, 11:08:27 AM |

Leave a Reply

Your email address will not be published. Required fields are marked *