Vital signs

  • Whether country practices federal or unitary system of governance, efficient arrangement of finances is fundamental

Jan 22, 2018-

With the new federal structure in place, most outcomes will depend on the type of policies the lawmakers, bureaucrats and concerned political parties are going to endorse. As of now, they all seem to be taking help from a number of international organisations, but it would be interesting to know what sort of process and techniques they are following to get the policies onto paper and implement them. Moreover, proper checks and balances, accountability, transparency and sustainability of policies are yet to be witnessed.

One of the major concerns of the public in relation to the federal set-up is inflation. In order to keep inflation in check, both in the centralised and decentralised fiscal system, an independent central bank should focus on price stability. Taking into account the duration of the election phase, high government expenditure has caused imbalances in the aggregate supply and demand, thereby inflicting demand-side inflation. Such inflation caused by abnormal government spending is harmful to the economy as it might dampen the real Gross Domestic Product (GDP). The series of government spending on different phases of local and federal elections resulted in a fluctuation of the inflation rate while the elections were taking place. However, the overall trend of inflation shows an increment of the inflation rate. Now that we are in the post-election scenario, it depends on the economic policies that the concerned parties are going to endorse.

The basics of inflation would say that with the federal structures in place, it is likely that the provinces will fight for resources and budget. States are not going to get more resources by simply demanding them. The state does not have these resources at hand, so simply demanding more resources would not help much. If the provinces have to make do with the constraint on resources, a mild or low level of inflation can be expected. However, if the regions which seemed to be traditionally ignored by the centre in terms of budget allocation receive a more generous package, then we might see greater activity from the government’s side—this surge in spending is likely to set an increasing inflationary trend.

A surge in spending

Government expenditure has increased, especially due to a transition to a new federal structure, the earthquake and the aftermath of the flood. With increased government spending, the fiscal deficit is expected to widen in fiscal year (FY) 2018 to 4.3 percent of GDP as per the report of the World Bank. Financing is not expected be a problem given ample fiscal space with a low debt-to-GDP ratio and a large cash balance at hand. On the other hand, the current account had turned into a marginal deficit in FY 2017, but is expected to widen as import growth is expected to remain high, while remittances and exports growth are expected to surge gradually. Customs duty, value added tax (VAT), corporate income tax, excise duty and personal income tax are the major sources of revenue. These comprise approximately 80 percent of the total tax revenue and are assigned to be collected by the central government, whereas service charges, punishment and fines and tourism charges are assigned to be collected concurrently by all three levels of government. Considering this modality, around 90 percent of the total tax revenue will fall under the jurisdiction of the central government. This seems to be incompatible with global fiscal federalism practices. Customs duties by nature have to be collected by the federal government. Therefore, VAT and income tax will have to be collected concurrently at both the central and sub-national levels. The central government and the federal states may share power over taxes and cooperate in tax administration, but tax rivalry is likely to take place as each federal state may impose specific variations of local taxes. Other taxes including excise duty will have to be collected by the sub-national governments which will support their expenditure responsibilities adequately. 

Suppressing inflation

Cooperation in tax administration and tax rivalry at the local level can be a challenge to entrepreneurs as the process is very likely to add yet another level of bureaucracy, and entrepreneurs and business people would have to critically consider the local laws and policies of each state. Nonetheless, there will be a number of opportunities as every state will have to provide a competitive environment and incentives to attract investment. Non-tax revenues derived from the activities of the central government like corporate debt servicing will go to the central government, whereas non-tax revenues collected from user charges will have to be assigned to the local governments. Decentralisation on the revenue side is likely to prevent inflation only in a dynamic framework, and hence its dissuasive quality is not as compelling; while on the expenditure side, it is likely to foster it, confirming that devolving expenditure functions to sub-national levels of government may generate conditions for greater inflation. Consistently, GDP per capita, government expenditures, foreign direct investment (FDI), and remittances are likely to suppress inflation, while the impact of the other variables do not seem certain. 

Hydropower resources and power plants are highly concentrated in a small number of hills and mountain areas. Not every state is endowed with hydro resources due to diversity in geography and natural resources. Revenue sharing from hydropower could be a controversial issue in Nepal, creating conflict if the revenues generated from this source are not shared by wide discussion and after national consensus. Royalties from hydroelectricity could be shared by the sub-national governments and the local level. Profits and taxes of hydropower will go to the central government which will then be disseminated to other regions accordingly. Problems might also arise during dissemination of the revenue as regions affected by hydropower plants are likely to demand a greater share. 

Whether the country practices a federal or unitary system of governance, proper and efficient arrangement of its finances is a fundamental factor for the country to function. It is a more contentious and complicated process when it comes to federal system of governance. Banks and financial institutions (BFIs) should be ready to face a number of challenges and opportunities considering the federal set-up. They should be willing to support the private sector if they want to diversify their portfolio. It is necessary to establish bank branches in rural areas and foster access to finance. Likewise, BFIs should also encourage small and medium scale enterprises (SMEs) and generate a value chain. Moreover, banks should focus on the people who prefer cooperatives over banks, especially in deprived sector lending, and make them familiar with the banking modality in order to channelise finance.  

Dhital is a graduate from the University of Delhi

Published: 22-01-2018 07:36

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