Fiscal decentralization and local public services delivery

Abstract from a NBER working paper by Bianchi et al (2021): Fiscal decentralization reduced local spending but expanded municipal services, and it also increased female labor supply in Italy. 

---

This paper studies how fiscal decentralization affects local services. It explores a 1993 reform that increased the fiscal autonomy of Italian municipalities by replacing government transfers with revenues from a local property tax. Our identification leverages cross-municipal variation in the degree of decentralization that stems from differences in the average age of buildings caused by bombings during WWII. Decentralization reduced local spending but expanded municipal services, such as nursery schools. These effects are larger in areas with greater political competition. The paper also investigates how the reform affected labor markets. Decentralization increased female labor supply—probably through expanded availability of nursery schools—thereby reducing the gender gap in employment.

---

Briefly, in 1993, Italian municipalities saw fiscal decentralization increase when the central government replaced government grants with revenue from a newly established local property tax. Local revenue (from local taxes and service fees) increased by more than 50% relative to 1992 in just a year's time and replaced central government transfers as the major source of municipal revenues. This boosted accountability as local politicians had to be more accountable to residents for any mismanagement of funds. 

• They find that decentralization induced local politicians to cut waste and increase efficiency. After the reform measure, local administrators decreased the size of government (both expenditure and revenue), but also rebalanced spending in favor of revenue-generating and customer-facing services, thus reducing administrative processes and associated costs. 
• They also find that municipalities that raised more revenues through the local property tax dedicated a larger share of their budget to nursery schools (+18%) and had more public nursery schools (+20%). The number of pupils in nursery schools increased by an additional 24% after the reform in the same cities.
• They document that municipalities that raised more revenues through the local property tax experienced a larger increase in female participation in the labor market. Women's LFPR increased by up to 20%, leading to reduction in preexisting gender gap in employment.  

Agriculture productivity shocks and nonagricultural employment in India

Abstract from Jonathan Colmer's published paper in American Economic Journal: Applied Economics, 13(4):101-24

---

To what degree can labor reallocation mitigate the economic consequences of weather-driven agricultural productivity shocks? I estimate that temperature-driven reductions in the demand for agricultural labor in India are associated with increases in nonagricultural employment. This suggests that the ability of nonagricultural sectors to absorb workers may play a key role in attenuating the economic consequences of agricultural productivity shocks. Exploiting firm-level variation in the propensity to absorb workers, I estimate relative expansions in manufacturing output in more flexible labor markets. Estimates suggest that, in the absence of labor reallocation, local economic losses could be up to 69 percent higher. 

---

Short-term priorities for the economy

It was published in The Kathmandu Post, 09 August 2021.

---

Short-term priorities for the economy

The focus now should be on executing the budget and curtailing wasteful spending.

The current coalition government led by Prime Minister Sher Bahadur Deuba has inherited a challenging economic situation that continues to be affected by the Covid-19 pandemic and related lockdowns. Finance Minister Janardan Sharma faces an uphill task to revive economic activities, which remain subdued with little likelihood of a convincing rebound beyond the base effect after a contraction in fiscal 2019-20. Specifically, a short-term economic recovery strategy to reap 'low hanging fruits' has to be rolled out and implemented in such a way that it does not deviate much from the 2021-22 budget ordinance and 15th Five-Year Plan.

The major constraint here is the availability of resources amidst unprecedented expenditure pressure while the country stares at a third wave of the pandemic. The government cannot drastically increase expenditure, both actuals and allocations, due to its implementation capacity and funding constraints. The latest data shows that the government fell short of targets in pretty much all fiscal indicators. In 2020-21, while recurrent spending was about 90 percent of the target, capital spending was just 65 percent. Tax revenue mobilisation was about 95 percent of the target, but foreign grants just 34 percent. A relatively slower pace of spending compared to revenue mobilisation meant that the fiscal deficit decreased to 4.8 percent of the gross domestic product (GDP) from 5.5 percent in 2019-20. In the 2021-22 budget, a large increase in expenditure compared to receipts is set to provisionally widen the fiscal deficit to about 6 percent of GDP.

Low-hanging fruits

Against the backdrop of slow economic activities, tight fiscal space, inflationary pressures and deteriorating external sector, the new finance minister faces a challenging task of stimulating broad-based and inclusive economic activity. He perhaps wants to deliver visible results in a short period of time given financing and implementation constraints. Unfortunately, the options are limited.

First, ensuring availability of funds, as and when needed, to respond effectively to the healthcare crisis should be the utmost priority. The most visible outcome for the government right now is an orderly process of testing, tracing and treatment; availability of vital medicines used for the treatment of the coronavirus; and widespread vaccination in the shortest time possible.

Second, the pandemic-hit industry and services sectors need continuous support—be it in the form of tax concessions or utility discounts or direct wage subsidy or social security contribution—until the situation stabilises. A third wave of infections and related mobility restrictions will further affect cash flows. It may actually permanently cut off the struggling small and medium enterprise from production networks. This will have long-term economic consequences as gaps in supply chains cannot be filled immediately. So, the government could prop up aggregate demand not only by increasing public spending, but also by supporting the private sector wade through the crisis so that they can achieve at least pre-pandemic levels of capacity utilisation.

Third, given fiscal and time constraints, a supplementary budget or major amendment to the budget ordinance is not ideal. The focus now should be on executing the budget and, if possible, curtailing some of the wasteful spending and ad hoc projects and programmes included in the budget. With earnest efforts, Sharma could make a difference by prioritising operation and maintenance of dilapidated roads and bridges, water supply and drainage system, electricity distribution lines, school and hospital buildings and other public infrastructure. These initiatives yield quick, visible results, and help to enhance productive efficiency of public spending. Funding for additional operation and maintenance expenses could be arranged through reprioritising and repurposing of existing budget allocations.

The finance minister could also prioritise public investment management by instituting a mechanism whereby only well vetted and prioritised projects are included in the budget and medium-term plan. This means reworking on the existing National Project Bank, which has guidelines for identification, appraisal, selection and prioritisation of projects but are hardly adhered to during implementation. This will aid in allocative efficiency of public spending.

On domestic resource mobilisation, the bulk of the work needs to be in improving revenue administration so that leakages are plugged. Note that new policy measures related to revenue are expected to contribute only 7 percent of the total estimated revenue for this fiscal. The rest 93 percent is planned to be generated from existing measures, which means increasing the taxpayer base and improving compliance. Harmonisation of IT systems of various tax wings, active risk-based audit for taxpayer compliance, and a monetisation strategy for idle public sector assets will be helpful. Furthermore, assisting sub-national governments in revenue administration as well as public investment management will also be important. On deficit financing, since the cost of external borrowing is lower than that of internal borrowing, the former may be prioritised for the interim period. However, this will require sectoral policy and institutional reform commitments, or improved budget execution capacity.

Fourth, fiscal and monetary policies have to be synced with an objective to ensure demand and supply stabilisation, and an eventual economic recovery. Moderate inflationary pressures are okay during the interim period, but a medium-term plan to tame inflationary expectations, which are trending upward, should not be overlooked. There could also be cooperation in ensuring that the existing support measures related to refinancing schemes, subsidised credit and regulatory forbearance are not prematurely withdrawn. That said, the authorities will have to carefully rein in excessive credit growth that is not consistent with indicators such as GDP growth and deposit growth. An unjustifiably bullish stock market and rising real estate and housing prices are not good signs at the moment for the sound health of the financial system.

Minimal physical interface

Fifth, external sector needs to be monitored carefully, especially the direction of remittance inflows amidst a decline in the number of outgoing migrant workers as well as weak demand for them in the destination countries. This, along with widening trade and current account deficits, could put external sector stability at risk. Adjusting import tariffs and tightening bank financing to dissuade demand for expensive foreign vehicles and gold could be considered.

Finally, the finance minister can push for new measures that could have an immediate impact on struggling households and businesses, and aid the recovery process. For instance, a partial credit guarantee scheme with an umbrella framework to cover all guarantees, including credit subsidy to various sectors is helpful. Similarly, digitisation of public services so that there is minimal physical interface between the public and businesses and bureaucrats is another promising area for quick results. Addressing youth unemployment through reskilling, vocational training and temporary employment guarantee schemes is also going to be fruitful.

Brief highlights from IPCC's Sixth Assessment Report

AR6 Climate Change 2021: The Physical Science Basis, the IPCC’s Sixth Assessment Report submitted by Working Group I is out now. The report includes the most updated physical understanding of the climate system and climate change, and includes regional climate simulations as well. It provides evidence on how and why climate has changed and the effects attributable to human actions. 

Excerpts from the report:

The evidence regarding human influence on warming of atmosphere, ocean and land is unequivocal. Widespread and rapid changes in the atmosphere, ocean, cryosphere and biosphere have occurred.  Observed increases in well-mixed greenhouse gas (GHG) concentrations since around 1750 are unequivocally caused by human activities. Each of the last four decades has been successively warmer than any decade that preceded it since 1850. Global surface temperature in the first two decades of the 21st century (2001-2020) was 0.99 [0.84-1.10] °C higher than 1850-1900. Global surface temperature was 1.09 [0.95 to 1.20] °C higher in 2011–2020 than 1850–1900. 

The likely range of total human-caused global surface temperature increase from 1850–1900 to 2010–2019 is 0.8°C to 1.3°C, with a best estimate of 1.07°C.

Globally averaged precipitation over land has likely increased since 1950, with a faster rate of increase since the 1980s (medium confidence). It is likely that human influence contributed to the pattern of observed precipitation changes since the mid-20th century, and extremely likely that human influence contributed to the pattern of observed changes in near-surface ocean salinity.

Human influence is very likely the main driver of the global retreat of glaciers since the 1990s and the decrease in Arctic sea ice area between 1979–1988 and 2010–2019 (about 40% in September and about 10% in March).

It is virtually certain that the global upper ocean (0–700 m) has warmed since the 1970s and extremely likely that human influence is the main driver. It is virtually certain that human-caused CO2 emissions are the main driver of current global acidification of the surface open ocean.

Global mean sea level increased by 0.20 [0.15 to 0.25] m between 1901 and 2018. It increased by .7 [3.2 to 4.2] mm yr–1 between 2006 and 2018 (high confidence). Human influence was very likely the main driver of these increases since at least 1971.

Global surface temperature has increased faster since 1970 than in any other 50-year period over at least the last 2000 years (high confidence). Temperatures during the most recent decade (2011–2020) exceed those of the most recent multi-century warm period, around 6500 years ago13 [0.2°C to 1°C relative to 1850–1900] (medium confidence).

Human-induced climate change is already affecting many weather and climate extremes in every region across the globe. Evidence of observed changes in extremes such as heatwaves, heavy precipitation, droughts, and tropical cyclones, and, in particular, their attribution to human influence, has strengthened since AR5. It is virtually certain that hot extremes (including heatwaves) have become more frequent and more intense across most land regions since the 1950s, while cold extremes (including cold waves) have become less frequent and less severe, with high confidence that human-induced climate change is the main driver of these changes.

The frequency and intensity of heavy precipitation events have increased since the 1950s over most land area for which observational data are sufficient for trend analysis (high confidence), and human-induced climate change is likely the main driver. Human-induced climate change has contributed to increases in agricultural and ecological droughts15 in some regions due to increased land evapotranspiration (medium confidence).

Decreases in global land monsoon precipitation from the 1950s to the 1980s are partly attributed to human-caused Northern Hemisphere aerosol emissions, but increases since then have resulted from rising GHG concentrations and decadal to multi-decadal internal variability (medium confidence). Over South Asia, East Asia and West Africa increases in monsoon precipitation due to warming from GHG emissions were counteracted by decreases in monsoon precipitation due to cooling from human-caused aerosol emissions over the 20th century (high confidence).

Heating of the climate system has caused global mean sea level rise through ice loss on land and thermal expansion from ocean warming. Thermal expansion explained 50% of sea level rise during 1971–2018, while ice loss from glaciers contributed 22%, ice sheets 20% and changes in land water storage 8%. The rate of ice sheet loss increased by a factor of four between 1992–1999 and 2010–2019. Together, ice sheet and glacier mass loss were the dominant contributors to global mean sea level rise during 2006-2018.

Global surface temperature will continue to increase until at least the mid-century under all emissions scenarios considered. Global warming of 1.5°C and 2°C will be exceeded during the 21st century unless deep reductions in CO2 and other greenhouse gas emissions occur in the coming decades. Global warming of 1.5°C relative to 1850-1900 would be exceeded during the 21st century under the intermediate, high and very high scenarios considered in this report (SSP2-4.5, SSP3-7.0 and SSP5-8.5, respectively).

Many changes in the climate system become larger in direct relation to increasing global warming. They include increases in the frequency and intensity of hot extremes, marine heatwaves, and heavy precipitation, agricultural and ecological droughts in some regions, and proportion of intense tropical cyclones, as well as reductions in Arctic sea ice, snow cover and permafrost. Every additional 0.5°C of global warming causes clearly discernible increases in the intensity and frequency of hot extremes, including heatwaves (very likely), and heavy precipitation (high confidence), as well as agricultural and ecological droughts in some regions (high confidence).

Monsoon precipitation is projected to increase in the mid- to long term at global scale, particularly over South and Southeast Asia, East Asia and West Africa apart from the far west Sahel (high confidence). A warmer climate will intensify very wet and very dry weather and climate events and seasons, with implications for flooding or drought (high confidence). It is very likely that rainfall variability related to the El Niño–Southern Oscillation is projected to be amplified by the second half of the 21st century.

From a physical science perspective, limiting human-induced global warming to a specific level requires limiting cumulative CO2 emissions, reaching at least net zero CO2 emissions, along with strong reductions in other greenhouse gas emissions. Strong, rapid and sustained reductions in CH4 emissions would also limit the warming effect resulting from declining aerosol pollution and would improve air quality.

The likelihood of an outcome is expressed in the following way: virtually certain 99–100% probability, very likely 90–100%, likely 66–100%, about as likely as not 33–66%, unlikely 0–33%, very unlikely 0–10%, exceptionally unlikely 0–1%. Additional terms such as extremely likely 95–100%, more likely than not >50–100%, and extremely unlikely 0–5% are also used. A level of confidence is expressed using five qualifiers: very low, low, medium, high and very high.

South Asia

• Heatwaves and humid heat stress will be more intense and frequent during the 21st century (medium confidence)
• Both annual and summer monsoon precipitation will increase during the 21st
• century, with enhanced interannual variability (medium confidence).
• Over most of the Hindu Kush Himalayan region, snow cover has reduced since the early 21st century, and glaciers have retreated and lost mass since the 1970s.
• The Karakoram glaciers have remained either in a balanced state or slightly gained mass. During the 21st century, snowcovered areas and snow volumes will decrease in most of the Hindu Kush Himalayan, and snowline elevations will rise and glacier volumes will decline (high confidence).
• A general wetting across the whole Tibetan Plateau and the Himalaya is projected, with increases in heavy precipitation in the 21st century.
• Extreme precipitation is projected to increase in major mountainous regions (medium to high confidence, depending on location), with potential cascading consequences of floods, landslides and lake outbursts in all scenarios (medium confidence).
• With few exceptions, mountain glaciers have retreated since the second half of the 19th century (very high confidence). This retreat has occurred at increased rates since the 1990s, with human influence very likely being the main driver. This behaviour is unprecedented in at least the last 2,000 years (medium confidence). Furthermore, glaciers will continue to lose mass at least for several decades even if global temperature is stabilized (very high confidence).
• Mountain glaciers will continue to shrink and permafrost to thaw in all regions where they are present (high confidence). Mountain glaciers are projected to lose more mass in higher greenhouse gas emissions scenario over the 21st century (medium confidence).
• It is virtually certain that snow cover will decline over most land regions during the 21st century, in terms of water equivalent, extent and annual duration.

Conditional or unconditional convergence

In their latest NBER working paper on economic convergence, Kremer, Willis and You (2021) argue that there was a trend towards unconditional convergence (GDP per capita today depends on its GDP per capita in the past) since 1990 and absolute convergence since 2000 owing to broad faster catch-up growth and slower growth of the frontier economies. They also show that many of the correlates of growth such as human capital, policies, institutions, and culture also showed convergence with higher income country groups.  As both correlates and growth have changed, their relationships (coefficients of growth regressions) have also changed. The shrinkage of growth regression coefficients has led to the narrowing of the gap between unconditional and conditional convergence. Absolute convergence has converged towards conditional convergence.

Major highlights from the working paper:

There was a steady trend towards unconditional convergence since the late 1980s and absolute convergence since 2000. Between 1985 and 1995, income per capita diverged by an average 0.5% annually, but between 2005 and 2015, it converged at a rate of 0.7%. The richest quartile of countries had the fastest growth in the 1980s, but the slowest growth since then as it became flat in the 1990s and then declined since 2000. However, the three other quartiles all experienced accelerating growth through 1990s and early 2000s. 

They argue that the conditional convergence could be due to (i) faster spread of technologies due to globalization as well as greater capital and labor mobility (accelerates convergence), and (ii) convergence in growth correlates themselves such as human capital, policies, institutions and culture (these could narrow the gap between unconditional and conditional convergence). 

The authors also explore whether growth correlates have changed over time by looking at four groups. First, enhanced Solow fundamentals, namely investment rate, population growth and human capital, which are fundamental determinants of steady state income. Second, short-run correlates, namely policies (political and financial institutions, fiscal policy) that can change in relatively short period of time. Third, long-run correlates, namely historical determinants of institutions and geography that change slowly, if at all. Fourth, culture (they consider 10 cultural variables such as views on inequality, political participation, the importance of family, traditions, work ethics, etc). They find that these correlates have not been highly persistent as many have undergone large changes and themselves converged substantially across countries, especially towards those of rich countries.

Establishing relationship between two trends -- towards convergence in income and the convergence of many of the correlates of growth itself-- is a bit challenging because causality can run both ways (for instance, converging income causes policies, institutions and culture to converge or it could be the other way round). By using omitted variable bias formula, they decompose the gap between absolute convergence (convergence across countries without conditioning on determinants of steady state income) and conditional convergence by looking at the product of the slopes of two relationships: correlate-income slopes and growth-correlate slopes. 

They find that while cross-sectional relationships between income and the correlates have changed in levels, their slopes have mostly remained stable. However, growth-correlates regression coefficients have shrunk substantially and show little autocorrelation for correlates (institutional homogenization) except for Solow model fundamentals (investment rate, population growth, and human capital), which have remained stable. This flattening of growth-correlates relationship suggest that absolute convergence converged towards conditional convergence. 

They argue that their results are consistent with neoclassical growth models, particularly after 1990. While conditional convergence held throughout the period (1985-2015), absolute convergence did not initially but as human capital, policies and, institutions improved in poorer countries, their explanatory power with respect to growth and convergence have declined. So, "the world has converged to absolute convergence because absolute convergence has converged to conditional convergence". Policies and institutions used to matter, but that they have converged, they matter less (and their effects are non-linear). Evidence support convergence in policies and institutions, but divergence in income over 1960-1990 (inconsistent with neoclassical growth model). However, convergence changed since 1990 and the outcome is consistent with neoclassical growth models (but not AK models such as endogenous growth models or poverty trap models that predict divergence). 

*******

Meanwhile, Acemoglu and Molina (2021), in a follow up comment, argue that the results of  Kremer, Willis and You (2021) working paper are driven by the lack of country fixed effects controlling for unobserved determinants of GDP per capita across countries. This "create a bias in convergence coefficients towards zero and this bias can be time-varying, even when the underlying country-level parameters are stable." They find no evidence of major changes in patterns of convergence and no flattening of the relationship between institutional variables and economic growth. 

Pande and Enevoldsen (2021) argue that convergence towards development-favored policies that drove the trend outlined by Kremer, Willis and You (2021) also mean that this has happened with rising within-country inequality, resulting in more of the world's poor clustering in (lower) middle-income countries. 

Entry and exit of informal firms

In a latest NBER working paper, McCaig and Pavcnik (2021) present several stylized facts about entry and exit of informal firms using a nationally representative panel data from Vietnam. 

Most informal firms are often operated only by the owner. Lower wealth and aggregate productivity tend to correlate with smaller average firm size. With economic development, average firm size also increases as self-employed entrepreneurs seek wage opportunities (so informal business is a necessity in part affected by lack of other employment opportunities). It indicates that self-employment decreases and size of firms increases with economic development. Other causes of smaller firms include imperfections in capital markets, barriers to hiring labor, cost of registration and formalization, and lack of business training. 

Major highlights/excerpts from the working paper:

First, informal businesses exhibit rates of entry and exit around 14-18% annually. Entry and exit rates are similar and highly correlated at a point in time, within industries, and within regions. They both decline over time and across space with economic development. 

Second, although market selection influences which firms survive, entry and exit has little net effect on aggregate (revenue) productivity or hiring of workers outside the household. This owes to overlapping labor productivity of entering and exiting firms and low subsequent productivity growth and hiring among the surviving entrants.  Almost half of the entrants exit within two years and the surviving entrants do not significantly improve their performance over time or begin to hire paid workers. This could be due to market-selection, but also due to owner-specific characteristics and shocks, alternative employment options, and household-specific shocks. Business exit and entry is associated with large decreases and increases, respectively, in individual and household income.

Third, the large overlap in revenue of entering and exiting informal businesses and the high correlation between entry and exit rates are related to the education and economic activities (self-employment, wage work or just outside of the workforce) of business owners prior to starting, or after closing down, an informal business. Informal business owners are less educated on average than wage workers in the formal sector, but more educated than agricultural workers. Entering and exiting owners have very similar levels of education. 

Fourth, the transitions in and out of operating an informal business reflect the underlying structure of economic activities of the working age population, with education gaps also playing a role. About one-third of informal non-farm business entrants and exiters transition to and from self-employment in agriculture.  However, the likelihood of this transition declines with economic development, highlighting the role of net entry from agriculture into informal non-farm businesses in structural change.

Nepal's largest hydropower project starts operation

Nepal's 456 MW Upper Tamakoshi Hydropower Project started operation on July 5, 2021 from one of its six 76-MW units. Nepal will likely have surplus power for now when all the six units start generating power at full capacity (around mid-October 2021). Even during the dry season (December-February), the project can generate electricity at full capacity for five hours. It is a run-of-the-river hydropower project financed through domestic resources. The project incurred huge time and cost overruns (5 years and NRs50 billion, respectively).

Excerpts from The Kathmandu Post:

---

Energy Minister Bishnu Paudel, speaking during the inauguration, said the full operation of the project is expected to contribute around 1 percent to the GDP. “It will help boost industrial production,” he said. “This project shows that we can collect the fragmented capital within the country and invest in projects like Upper Tamakoshi.”

The majority share (51 percent) of the Upper Tamakoshi Hydropower Limited is held by four public entities, namely, Nepal Electricity Authority, Nepal Telecom, Citizen Investment Trust and Rastriya Beema Sansthan. “The project has boosted our confidence,” said Prime Minister Oli. “We can now develop these types of projects through our own resources and manpower. We ended the loadshedding in 2017 but that was by importing power.” In May 2018, the Nepal Electricity Authority had officially announced elimination of load-shedding for the industrial sector, a year after relieving residential customers who had suffered never-ending power cuts for decades.

[...]The six years project began in 2011 to end the power shortage. But like other projects of national importance, this too suffered, resulting in massive cost and time overruns. Its price tag has swelled, or more than doubled, to Rs85 billion. Bigyan Prasad Shrestha, chief executive officer of the Upper Tamakoshi Hydropower Project, said that the initial cost of the project was Rs35 billion [without interest]. “Now, the cost of the project [without interest] has reached Rs53 billion. According to him, initially, the interest to be paid was estimated at Rs14 billion. “Now, the bank interest alone stands at Rs32 billion. So, the overall cost is around Rs85 billion.” The annual interest rate has been set at 11 percent.

[..]Nepal, currently, has an installed capacity of 1,385 MW of electricity. According to Timilsina, the country’s peak demand stands at 1,350 MW. This means, when all units of Upper Tamakoshi start production, the country will have nearly 500 MW of surplus energy in the wet season. Around 300 MW of power is currently being imported from India.

[...]“With the average power purchase agreement (PPA) rate of Rs4.06 per unit, it is the cheapest price of electricity for Nepal Electricity Authority,” said Ghising. “So, it is beneficial for the power utility. Even after paying back the loans within a few years, it can generate a good amount of income and more power projects can be developed with it.”

---

Emerging consensus on minimum global corporate tax rate

The Economist on global corporate tax:

---

Officials signed up to a five-page statement with two main elements: a new minimum tax rate on multinationals’ profits; and a reallocation of the right to tax those of the largest, away from places where they register their assets and towards where they make their sales. In return for those new tax rights, governments would refrain from some unilateral measures, notably taxes on giant technology companies. Securing agreement from so many countries on such a touchy issue is a remarkable feat. Even so, there is more work to do before the future of corporate taxation is settled.

[...]The deal is structured to affect more companies as time goes by. At first the reallocation of taxing rights will apply to those with global turnover above €20bn ($24bn). But if all goes well, that threshold could fall to €10bn. To address the common complaint that digital companies can make profits somewhere without registering the physical presence often necessary to tax them, governments will be able to levy some tax if local revenues exceed just €1m. In small, poor countries with GDP of less than €40bn the threshold will be only €250,000.

[...]Having secured a high-level agreement, negotiators have agreed on a deadline of October to settle important details. Some countries are pushing for a minimum tax rate of 15%; others want the floor to be higher. The base of profits subject to the minimum tax, the precise amount of taxing rights to be reallocated and the precise scope of unilateral measures to be withdrawn also have to be hammered out.

After that, in 2022 governments must draw up an international treaty to reallocate taxing rights, to be implemented in 2023. The deal also envisages that minimum taxes might be legislated for in 2022 and implemented in 2023, though countries could do that without waiting for a treaty. The agreement is a big step forward. But plenty of taxing work still lies ahead.

---

Big budget, big promises

It was published in The Kathmandu Post, 02 June 2021. A detailed blog on the same issue here..

---

Big budget, big promises

Given that the pandemic is affecting economies everywhere, Nepal’s budget is exceptionally far-fetched.

Finance Minister Bishnu Prasad Poudel presented the 2021-22 budget on May 29 through an ordinance, owing to the dissolution of the federal Parliament and the announcement of fresh elections scheduled for November. The bloated budget includes big promises on expenditure, revenue mobilisation and deficit financing that are challenging to implement if elections are held—that too without fully vaccinating a sizable share of the population.

Nevertheless, the finance minister has rightly prioritised the most pressing challenge right now, i.e., testing, tracing, treatment, vaccination and upgrading healthcare infrastructure. The strategy seems to be the stabilisation and recovery of economic activities by addressing healthcare challenges, continuation of existing projects and relief measures for individuals and businesses, and propping up aggregate demand as well as the voter base by increasing allowances.

Large outlay, large deficit

The total expenditure outlay for 2021-22 is Rs1.65 trillion, which is 30.1 percent higher than 2020-21 revised estimate. Recurrent and capital spending allocations constitute 61 percent and 26 percent of the budget. Notably, the government started reporting recurrent and capital grants to subnational governments (SNGs) separately from the next fiscal. This gives a better picture of actual capital spending, because earlier the government used to argue that reported capital spending underestimates the actual figure as some fiscal transfers recorded under recurrent spending are used for financing capital projects by SNGs.

Total federal receipts (federal government’s share of revenue plus foreign grants) are estimated to be Rs1.09 trillion. The revenue mobilisation growth target is set at 20 percent. Considering the federal government’s expenditure and its share of revenue in total revenue mobilisation, the budget deficit turns out to be Rs559.3 billion, which is to be financed by foreign loans and domestic borrowing. The government expects foreign aid (grants and loans) to cover about a quarter of its expenditure needs. Overall, the fiscal deficit is projected to increase to about 7 percent of the GDP in 2021-22, up from about 5 percent in 2020-21.

About 45.1 percent of the planned recurrent budget is earmarked for SNGs in the form of recurrent fiscal transfer and unconditional recurrent grants. The other big-ticket item is social security, which takes up about a quarter of the recurrent budget. Social security includes allowances, social assistance (scholarship; rescue, relief and rehabilitation, medical assistance); and social benefit of employees (pension and disability allowances, retirees related gratuity and medical assistance). The increase in allowances by 33 percent, including for 70 years and above elderly people, has drastically increased allocation under this heading by 50 percent. Meanwhile, about 58 percent of the planned capital budget is going for civil works and 14 percent as capital grants to SNGs.

Major takeaways

The budget has been rolled out when the country is at a critical juncture. In fact, economic activities are estimated to have contracted by 2.1 percent in 2019-20 and will likely grow at around 2 percent in 2020-21, most of which will be due to a base effect anyway. Increase in social security allowances, the allocation for free vaccination, the continuation of refinancing facility and business continuity funding, and income tax relief for individuals and businesses are some of the notable features of the budget.

Without ascertaining resources, it is also redistributive in nature, particularly aimed at influencing the voter base ahead of the planned federal parliamentary elections. A larger increase in federal expenditure (30.1 percent) than an increase in federal receipts (14.5 percent) points to a challenging fiscal management task going forward. Against this backdrop, there six specific macroeconomic takeaways.

First, since the budget deficit is widening, and outstanding public debt and interest payments are increasing, it would have been good to anchor expenditure and revenue on medium-term expenditure and revenue frameworks. Outstanding public debt is also rising fast, particularly after 2014-15, reaching about 37 percent of GDP in 2019-20 from 22 percent barely five years ago. One also needs to tally how this budget falls in line with the 15th five-year plan and to what extent it includes projects listed in the National Project Bank.

Second, the revenue mobilisation growth target of 20 percent compared to the 2020-21 revised estimate is a bit ambitious at the moment. In fact, revenue growth has been consistently below 20 percent since 2016. Increasing excise duties on ‘sin’ goods and tinkering with administration reforms may not yield many benefits without an increase in the taxpayer base and better compliance. Large-scale, ad hoc tax exemptions are not helpful.

Third, most of the projected foreign loans may not be realised if project implementation is not drastically overhauled. Compared to the revised estimate for 2020-21, foreign loans are projected to increase by 87 percent, which is not realistic given the poor budget execution capacity and the fact that if elections happen in November, it will disrupt development activities. Meanwhile, domestic borrowing is projected to cross 5 percent of the GDP. Large domestic borrowing may sound okay, given the ample liquidity in the banking system and lack of investment opportunities for pension funds and institutional investors. However, as the situation normalises and capacity utilisation of firms improve along with demand for credit by individuals and businesses, there may be pressure on liquidity, leading to a rise in the inter-bank rate and then retail interest rates.

Fourth, the projection of foreign grants seems ambitious as sources of grants are drying up. For example, Asian Development Bank and World Bank now provide loans only, although technical assistance is principally a grant. And that most bilateral donors may not increase aid allocations given their priority to boost domestic economies ravaged by the pandemic. The government is projecting to receive a 134 percent growth in foreign grants over the 2020-21 revised estimate, which is unrealistic.

Fifth, the non-contributory allowance for the elderly, a sort of a guaranteed universal basic income, hopes to support individual or household consumption demand. However, it directly increases the government’s liability as well, because it needs to be continued for years to come. Normally, such schemes are reasonable when the economic pie is growing and there are enough resources to fund populist schemes. Increasing social protection liability by borrowing or by cutting down capital spending is not a good policy.

Finally, the real GDP growth target of 6.5 percent of GDP may a bit optimistic, given that the pandemic will continue to affect lives, livelihoods and economic activities well into the next year. There is no likelihood of sharp V-shaped recovery. Agricultural output growth might be higher than in 2020-21 with a forecast for a normal monsoon and the availability of inputs such as chemical fertilisers. Industrial output may not fully recover because capacity utilisation will not drastically increase amidst subdued demand and investment. Travel and tourism activities are unlikely to recover anytime soon without adequate healthcare measures and mass vaccination. Elections-related spending, if it happens, will add to consumption demand. Overall, GDP growth may hover around 4 to 5 percent in 2021-22.

Quick thoughts on Nepal’s FY2022 budget

On 29 May 2021, Finance Minister Bishnu Prasad Paudel presented FY2022 budget (mid-July 2021 to mid-July 2022). The FY2022 budget is introduced through an ordinance since the parliament was dissolved and fresh federal elections were announced for November 2021. The budget focuses on addressing healthcare challenges due to the Covid-19 pandemic— particularly testing, vaccination, and healthcare infrastructure—, social security, elections, infrastructure investment, and pandemic-related relief measures for individuals and businesses. The priority is stabilization and recovery of economic activities by addressing the immediate healthcare challenges, continuation of existing projects, and tax relief for individuals and businesses.

The budget is rolled out when the country at a critical juncture that has widely disrupted lives, livelihoods, and economic activities. In fact, economic activities are estimated to have contracted by 2.1% in FY2020 and will likely grow at around 2% (lower than 4% CBS’s provisional estimate) in FY2021, most of which will be base effect anyway. 

Much of the focus is on stabilization measures, especially for households and businesses. Increase in allowance by 33% including those for 70 and plus years old, allocation for free vaccination, continuation of refinancing facility and business continuity fund for businesses, scrapping of constituency development fund (or local infrastructure partnership program) and poverty alleviation fund, income tax relief for individuals and businesses, and promotion of electrical vehicles are some of the notable features of the budget. Some of these measures are continuation of last year’s budget. However, there are also signs of redistributive nature of the budget, without ascertaining resources, with a view of influencing voter base ahead of the federal parliamentary elections. Resources have also been allocated for preparation of detailed project reviews or feasibility studies of prospective projects such as hydropower projects and river diversion projects. That said, larger increase in federal budget (30.1%) than the increase in federal receipts (14.5%) point to a challenging fiscal management task going forward, especially fiscal consolidation and higher revenue mobilization to lower widening fiscal deficit. 

More on these later. But, let us first look at the macro-fiscal specifics:

Expenditure outlay

The total expenditure outlay for FY2022 is NRs 1647.6 billion, which is 30.1% higher than FY2021 revised estimate and 11.7% higher than FY2021 budget estimate. The government expects to spend 85.9% of NRs 1474.6 billion allocated in FY2021. However, given the expenditure trend so far, it is highly unlikely as public works have also been affected by the pandemic, especially in the last quarter of FY2021—the time when most of the work accelerates. 

FY2022 expenditure outlay comprises of NRs 1004.4 billion as recurrent expenditures (61% of the total outlay), NRs435.2 billion as capital expenditures (26.4%), and NRs208 billion as financial provision. From this year’s budget the government started reporting recurrent and capital grants to subnational governments (SNGs) separately. The earmarked recurrent and capital transfers to SNGs are NRs325.7 billion and NRs 60.9 billion, respectively. If the previous accounting was followed, i.e. all transfers in recurrent heading, then recurrent and capital expenditure in FY2021 are estimated at NRs 867.5 billion and NRs 251.2 billion, respectively. It means recurrent budget is up by 15.8% and capital budget by 73.1% over the revised estimate for FY2021. Without previous accounting (capital transfers being a part of recurrent spending), then recurrent and capital expenditures are estimated to increase by 17.1% and 48.8%, respectively. In any case, there is a large increase in capital budget. However, without a viable implementation plan and the effect of lockdowns on labor mobility and availability of supplies, it is most likely to be underspent as before.

As a share of GDP, total budget amounts to 35.1%, including 21.4% of GDP as recurrent spending and 9.3% of GDP as capital spending. As per FY2020 revised estimates, the government now expects to spend just 81.9% of planned recurrent budget and 71.3% of planned capital budget. 

FY2022 budget overview
GDP growth target (%)				6.5
Inflation target (%)
Budget allocation for FY2022				Rs billion	%
Projected total expenditure	1647.6
Recurrent	1004.4				61.0
Capital	435.2				26.4
Financial provision	208.0				12.6
Projected total receipts		1088.3
Revenue		1024.9			94.2
Foreign grants		63.4			5.8
Projected budget surplus (+)/deficit (-)		-559.3
Projected deficit financing			559.3
Foreign loans			309.3		55.3
Domestic borrowing			250.0		44.7

Receipts

A total revenue target of NRs 1025 billion (21.8% of GDP) has been set for FY2022 (or NRs 1151 billion if revenue sharing with subnational governments is included—24.5% of GDP). Foreign grants are expected to be NRs 63.4 billion (1.4% of GDP). Total federal receipts (total revenue plus foreign grants less sharing of revenue with subnational governments) turns out to be NRs 1088 billion (23.2% of GDP). The central government shares, based on monthly collections, 30% of VAT and internal excise duty, and 50% of royalties from natural resources with subnational governments. The revised estimate for federal revenue mobilization (including grants) in FY2021 is 22.3% of GDP. 

Compared to the revised estimate, revenue growth target for FY2022 is about 20%, which is ambitious in the first place due to the expected low nominal GDP growth. The government missed revenue target in FY2018, FY2019 and FY2020. In FY2021, it is expecting revenue growth of 20.9% as economic activities partially normalized and imports recovered. With an assumption of 10% nominal GDP growth for FY2022, revenue buoyancy comes to be about 2.

Given that the GDP growth target itself is a bit optimistic, and revenue administration reforms along with tinkering of excise duty on tobacco, alcohol, beer, and petroleum fuel has its own limits, it needs to be seen how this government plans to achieve the revenue target. 

Nepal’s revenue mobilization is already one of the highest among low-income countries and about 45% of it comes from taxes on international trade (primarily imports). Tax revenue is projected to be around 22.1% of GDP in FY2022, up from an estimated 20.4% of GDP in FY2021. Non-tax revenue is projected to be 2.4% of GDP. The government expects to mobilize 95% of tax revenue target for FY2021. In FY2020 it was just 75.5%.

Deficit financing

Considering the federal government’s expenditure and its share of revenue in total revenue mobilization, budget deficit turns out to be NRs 559.3 billion, which is to be financed by foreign loans equivalent to NRs 309.3 billion and domestic borrowing of NRs 250 billion. So, government’s projected revenue is able to fund only 66% of its projected expenditure for FY2022. The government expects foreign aid (grants and loans) to cover about a quarter of its expenditure needs. Domestic borrowing will cover 15% of its financing needs. 

Large domestic borrowing tends to affect market liquidity and interest rates if the government borrows aggressively to fund expenditure commitments just when economic activities start to normalize after the ebbing of infections from the second wave. The government had a plan to raise NRs 225 billion internally and NRs 299.5 billion externally in FY2021. The latest estimates show that while the goal of domestic borrowing will be met, only 55.1% of the external borrowing target will likely be realized. 

Compared to the revised estimate for FY2021, the government is planning to double net foreign borrowing (5.8% of GDP) and net domestic borrowing by 27% (4.3% of GDP). Again, without substantial improvement in budget execution capacity, it is unlikely that the government will be able to borrow the targeted amount. 

Overall, fiscal deficit (revenue incl grants minus expenditure incl net lending) is projected to increase to about 7% of GDP in FY2022, up from about 5% in FY2021. Primary deficit (fiscal deficit before interest payments) is projected to about 4% of GDP. The FY2021 budget estimate put fiscal deficit at around 7% of GDP in FY2021, but lower budget execution (both recurrent and capital spending) and near-target revenue mobilization resulted in lower deficit. When actual numbers are reported, it will probably be revised down further.

Where is recurrent budget going?

About 45.1% of planned recurrent budget of NRs 1004.4 billion is going to subnational governments (SNGs) in the form of recurrent fiscal transfer (fiscal equalization, conditional, complementary and special grants) and unconditional recurrent grants. The other big-ticket item is social security, which takes up about a quarter of the recurrent budget. Social security includes allowances, social assistance (scholarship; rescue, relief and rehabilitation, medical); social benefit of employees (pension and disability allowances, retirees related gratuity and medical assistance). The increase in allowances for 70 years and above elderly people by NRs 1000 to NRs 4000 has drastically increased allocation under this heading. Allocations for social security has been increased by 50%. About 15% of recurrent spending is earmarked for compensation of employees. Interest payments on foreign and domestic debt has drastically increased in recent years as borrowings increase to plug in widening fiscal deficit. Allocations for it increased by 27% and is estimated to be about 1% of GDP. Given the high fiscal deficit and accumulation of outstanding public debt due to the 2015 earthquake and fiscal profligacy during elections time, interest payments have been rising fast. Interest payments have more than tripled since FY2015.

The government has earmarked NRs 64.8 billion (1.4% of GDP) for use of goods and services, which also includes some of the pet projects of politicians and government. Use of goods and services consists of (i) rent & services; (ii) operation and maintenance of capital assets; (iii) office materials and services; (iv) consultancy and other services fee;(v) program expenses; (vi) monitoring, evaluation and travel expenses; (vii) recurrent contingencies; and (viii) miscellaneous. 

Where is capital budget going?

Almost 58% of the planned capital budget of NRs 435.2 billion is going for civil works, 14% as capital grants to SNGs, 13.4% for construction or purchase of buildings, and 4.1% for land acquisition. Compared to the FY2020 revised estimate, capital budget has been increased by 48% (including capital grants, it will be about 67%). 

Major takeaways from FY2022 budget

First, the budget has been designed keeping in mind two objectives: (i) addressing the immediate health crisis, particularly testing, treatment and vaccination, and (ii) upcoming parliamentary elections. The validity of the budget itself is contested by other political parties and constitutional experts as it a full-fledged budget was unveiled through an ordinance. If the Supreme Court reinstates the house of representatives again, then the fate of this budget is undecided. The new government could either adopt it or bring out a new budget. But for now, since the budget was announced just before the elections, it includes several pork-and-barrel type projects and programs to woe voters including elderly vote through increase in allowance without ascertaining resources. The budget also has allocation for projects that probably won’t be completed till the medium-term. These include Lumbini development masterplan, industrial zones, smart and mega cities, etc. So, it has both populist as well as distributive flavor. It does not spell out overall governing macroeconomic framework.

Second, since budget deficit is widening, and outstanding public debt and interest payments are increasing, it would have been good to anchor expenditure and revenue to medium-term expenditure and revenue frameworks. It is missing in the budget. Note that outstanding public debt is rising fast in Nepal, especially after FY2015. It reached 37% of GDP in FY2020, up from 23.9% of GDP in FY2015. External debt comprises of 58% of outstanding public debt. Both internal and external debt have been rising rapidly. One also needs to tally how this budget falls in line with the 15th five-year plan and to what extent projects includes in National Project Bank are incorporated. Some projects such as tunnels in highways and industrial parks have been included without much due diligence. There has to be a fiscal consolidation strategy as a part of a medium-term budget framework. 

Third, the plan of large domestic borrowing will have implications in the financial market, and most of the foreign loans may not be realized if project implementation is not drastically overhauled (well, except for policy-based lending, whose disbursement is conditional on fulfilling pre-agreed policy and institutional reforms). Budget execution has to be improved, with limited time and cost overruns, to ensure timely disbursement by multilateral donors. Compared to revised estimate for FY2021, foreign loans are expected to rise by 87% (net foreign loans by almost 100%), which is not realistic given the budget execution capacity and the fact that if elections do happen in November, it will disrupt development activities as most of the resources will be diverted to hold elections. Meanwhile, domestic borrowing is projected to cross 5% of GDP (net domestic borrowing of above 4% of GDP). Large domestic borrowing may sound okay as of now given the ample liquidity in the banking system and lack of investment opportunities for pension funds and institutional investors. However, as situation normalizes and capacity utilization of firms improves along with demand for credit by individuals and businesses, there may be a pressure on the financial market, leading to rise in inter-bank rate and then retail interest rates. 

Fourth, revenue mobilization growth target of 20% compared to FY2021 revised estimate is a bit ambitious at the moment. In fact, revenue growth has been consistently below 20% after FY2016. In FY2021, the revenue target was 22% over FY2020 revised estimate. The government has increased excise duty on sugar-based goods, tobacco, cigarettes, alcohol, beer, and petroleum fuel, among others. Just increasing rates on some non-essential goods without much efforts to reform tax administration for better services delivery and to increase tax base is not going to yield substantive results. The authorities should be thinking of new strategies to boost domestic resources mobilization: simplification of tax code, e-filing of taxes and digitization of services, improved taxpayer compliance to control leakages, proper enforcement of property tax, etc. 

To be fair, there is a sort of growth-enhancing tax policy as the budget commits to tax imported industrial inputs lower than imported final goods. Similarly, customs duty on equipment used by tea, jute, pashmina, and agricultural firms has been waived off. There are income tax exemptions of varying degree for new businesses established after the pandemic, startups, firms operating in special and industrial zones, etc. Similar exemption commitment was made in the past budgets as well, but they hardly get implemented. There are other tax rebates and concessions such as abolition of excise duty on import of electric vehicles and substantial reduction of customs duty (to encourage domestic consumption of electricity and to ensure environment-friendly transport network). Excise duty on electric vehicles ranged from 60% to 120%. 

Fifth, projection of foreign grants seem ambitious as sources of grants are drying up (ADB and WB now provide loans only although TA is principally a grant) and that most bilateral donors may not increase aid allocations given their country’s priority to boost their economies ravaged by the pandemic. The government is projecting to receive foreign grants of about NRs 63.4 billion in FY2022—a growth of 134% over FY2021 revised estimate— which has not happened in the last decade. The largest foreign grant it received was NRs 43 billion in FY2016 after the earthquakes. In FY2021, the government expected to received NRs 60.5 billion but has revised it down to NRs 27 billion. 

Sixth, cash allowance/pension (non-contributory) for 70 years and above and other allowances have been increased by 33%. Allowance to elderly is a part of social protection scheme to support individual or household consumption demand. This is like a guaranteed universal basic income for elderly people. However, it directly increases the government’s liability as well because it needs to be continued for years to come. Normally, such schemes are reasonable when the economic pie is growing and there are enough resources to fund such populist schemes. However, increasing social protection liability by borrowing loans or by cutting down capital spending is not a good policy. Against this backdrop, this tranche of increase in elderly allowance is probably aimed at influencing the voter base for the upcoming elections. In its political manifesto ahead of 2017 elections, the CPN(UML) party committed NRs5000 per month elderly allowance.

Seventh, grants or transfers to local bodies are reported under recurrent and capital grants. Earlier, grants were clubbed under recurrent expenditure only and the government used to argue that real capital spending is much higher than just capital spending because grants or transfers to local bodies under recurrent spending included conditional and unconditional capital grants as well. That said, there are still conditional and unconditional grants to government agencies, committees and boards under recurrent spending, but these are not that large (about 5% of recurrent expenditure). 

Eighth, revised budget estimate for FY2021 is optimistic given the setback in project implementation due to COVID-19 pandemic related restriction on mobility and economic activities after April 2021 (second wave) and in the first quarter of FY2021 (tail end of first wave). So, most of the numbers will be revised downward when the government presents actual numbers in the next budget.  

Ninth, real GDP growth target of 6.5% of GDP may a bit optimistic given that the pandemic will continue to affect lives, livelihoods and economic activities well into the next year. There is no likelihood of sharp V-shaped recovery. Agricultural output growth might be higher than in FY2021 given the forecast of a favorable monsoon and likely availability of inputs such as chemical fertilizers. Industrial output may not fully recover and capacity utilization may also not be drastically higher as both consumption demand and investment remain subdued. Mining and quarrying activities and construction will be slow to pick up, and manufacturing activities will also likely be at a modest pace. New addition of hydroelectricity to the national grid will jack up its growth rate. In the services sectors, travel and tourism activities are unlikely to recover anytime soon as both domestic and foreign visitors remain cautious of travel without adequate vaccination. International travel may continue to get disrupted in countries with less vaccination rates and rising covid-19 infections. Elections-related spending, if it happens, will add to consumption demand. Overall, GDP growth may hover around 4-5% in FY2022.  

Tenth, as in the previous years, the main challenge is budget execution. This will be a bit challenging during an election year, the risk of another wave of infections disrupting labor and capital mobility, slow vacation drive, and the apparent disconnect between MOF’s budget implementation directives to lines ministries and the latter’s pace and nature of work. For instance, several promises made in the previous budget were never realized. One such case is that the government promised a separate 300 bed infectious diseases hospital in Kathmandu, additional 250 intensive care unit beds at government hospitals in Kathmandu and provincial capitals, and separate infectious disease hospital in the provincial capitals. These were promised even before the deadly second wave hit the country. They remained unfulfilled. High staff turnover, political interference at management and operational levels, lack of consultant and contractor management capability, hurdles in inter-ministry and intra-ministry coordination, governance shortcomings, and a lack of project readiness will continue to impact capital spending.

So, a likely scenario at the end of the year will be that recurrent budget will be almost spent (over 90%), and capital budget will be under-spent. The government will try to borrow the full amount domestically. But, both foreign grant and loan will fall short of the target. Revenue mobilization growth will be short of target but still high enough. Eventually, fiscal deficit will be lower than projected and that the government will have treasury savings at the NRB. 

FYI, I have assumed FY2022 nominal GDP growth to be 10% and inflation to remain at around 5-6%.