It was published in The Kathmandu Post, 07 August 2018.
An emerging but entirely predictable major headache for federal government is the tendency of subnational governments to engage in a race-to-the-bottom revenue policy. Provincial and local governments have introduced overlapping tax regimes and are openly sparring with the federal government to assert their rights as per their own understating of power mentioned in the constitution.
The uncertainty over tax regime and the subnational government’s jurisdiction with respect to mobilizing certain type of taxes have unnerved business community and potential investors. A competitive populism instead of cooperative and competitive federalism will have negative consequences on budget execution and investor sentiment. Note that this has happened even when the ruling Nepal Communist Party has two-thirds majority at federal as well as subnational levels.
All seven provinces as well a majority of local governments have introduced fiscal year 2018/19 (FY2019) budget, the first under the federal set up. Federal transfers (fiscal equalization, conditional, special and matching grants) and revenue sharing form the basis for their budget. In fact, total federal fiscal transfer and revenue sharing account for over 90% of provincial budget. They plan to cover remaining budget gap by raising revenue (province 2 and Karnali governments plan to borrow one billion rupees internally as well). Provincial and federal budget together tops Rs1552 billion, of which about 28.6% consists of capital budget. Similarly, a majority of the 753 local governments have presented FY2019 budget in line with federal and provincial fiscal transfers and revenue sharing. They plan to raise revenue by imposing local taxes when their expenditure plan is in excess of fiscal transfers and revenue sharing.
The whole process of designing expenditure priorities and revenue policy is supposed to be cooperative and competitive so that all tiers of government have synchronized and coherent plans to boost economic activities (and probably help the government realized its overarching motto “Prosperous Nepal, Happy Nepali”, irrespective of how that is measured or what is means!). This appears not to be the case right now. Several provincial and local governments are at loggerheads with the federal government over their jurisdiction in designing revenue policy. Note that they don’t have much say over expenditure priorities owing to the fact that the constitution is clear on what public services they must provide and how federal transfers are to be utilized for that purpose.
The subnational governments are aspirational and want to do more with larger budgets, which require more and bigger sources of revenue. Besides fiscal transfers and revenue sharing, they have limited options: internal loan, raising taxes and widening tax net as well as taxable economic or social activities. Currently there is a lack of clarity on procedures and regulatory framework to raise internal loans. So, most of the subnational governments have resorted to either raising taxes and/or including any economic activities under the tax net. This has pitted the subnational governments against the federal government, leading to a regulatory regime that looks like a race to the bottom and especially damaging to improving investment climate.
For instance, province one has imposed district export tax on agricultural and forest items against the spirit of the constitution. Upon a challenge by the federal government that intra and inter province movement of goods should be free, province one government renamed it sales tax. All they did was to change the name of tax but keeping its distortive nature intact. Similarly, province two is imposing natural resources tax, province five is charging entry fee to Indian vehicles, province seven is imposing a fee on registration and renewal of industries, province three is imposing export tax, and Karnali province is imposing taxes on inter-district export of mining and quarrying items. Meanwhile, several local governments have drastically increased or introduced taxes on tourism, transport and small business activities— the lifeline of local economies and employment.
This kind of uncertainty and tax policy disarray kills the spirit of federalism rooted in cooperative and competitive interaction among the three tiers of government. Two course corrections are important going forward.
First, the federal government should immediately work to resolve this matter as this kind of uncooperative federalism harms local businesses and potential investment. Ministry of Finance, Prime Minister’s Office, National Planning commission and Ministry of Federal Affairs and General Administration need to work together with subnational governments to create not only a coherent and consistent expenditure plan, but also a revenue policy that is unambiguous to business community and one that is geared toward boosting local economic activities. Unfortunately, the federal government itself is weak in fiscal management and governance exercise, evidenced by the dismal capital budget execution record and its singular focus on mobilizing revenue. The subnational governments are thinking that their success lies in raising more revenue to fund more recurrent spending type commitments they made to voters before the elections. Alas, this is fiscally fatal, kills entrepreneurship and harms investment prospects. Confusion is also cropping up due to the delay by the federal government to introduce laws and policies to implement the constitution.
Second, the federal government should facilitate competitive federalism between provincial and local governments to boost investment and commerce. They should be focusing on attracting investment in their region by rolling out regulations that eases cost of doing business, provides tax and land concessions, and raises productivity by supplying necessary infrastructure. Furthermore, the subnational governments should compete to attract more fiscal transfers by improving budget execution as more meaningful and efficient projects of subnational governments tend to attract more fiscal transfers.
The subnational governments must compete to attract more investment and to boost growth instead of competing on regulatory regimes that sets them on a path to the bottom.