"Fiscal Decentralization Needs A Formula, Not Ad Hoc Decision"

Professor Jan Werner is the executive director of Institute of Local Public Finance of Germany. At a time when Nepal has been having a debate on fiscal federalism, the world renowned German expert, who was recently in Kathmandu, spoke to KESHAB POUD

March 22, 2015, 5:45 p.m. Published in Magazine Issue: Vol. : 08 No.- 18 March. 20 - 2015 (chaitra 6, 2071)

How do you describe the decentralization pattern?

As per classification, there are three kinds of decentralization. The first is political decentralization where the center transfers more political rights to the people or to the regional entities. Fiscal decentralization is a little different. In fiscal decentralization, the center transfers financial resources to sub-regional and local levels of government to enable them to finance their respective spending. You have also administrative decentralization. Don’t underestimate this as this is also very important. Under administrative decentralization, the central government gives regional and local authorities the right to provide and manage public goods under their own full responsibility. For example, the local units or elected mayors are allowed to hire and fire their employees. Mayors can hire teachers and other administrative staff as per their wishes.

What is the purpose of your visit to Nepal?

I am here as I was invited by the Inland Revenue Department and Federation of Nepalese Chamber of Commerce and Industry (FNCCI). A federal Nepal will have different state levels. Thus, business sectors have certain concerns.

What will be the consequences of the transformation of a state from a unitary to federal model?

There will be new institutions and new institutions also need taxes. A new tier of government also needs new taxes. Federalism is a political story board and I am here as an independent academic advisor. Political decision lies on Nepalese as you have to finalize the constitution according  to geographical definition of sub-regional and national levels.

Who should do what? The question of expenditure assignment?

Based on the local self governance act of 1999, the local units are generally spoken currently as responsible for basic needs like drinking water, waste management and electricity, local infrastructure such as  roads and bridges, education like pre schools and elementary schools and health like health centers, hospitals or programs for child care and nutrition.

How do you view the local bodies?

The local units are also extremely dependent on the central government, because 85 percent of their revenue comes from transfer grants and only 15 percent from their own sources of revenue (taxes and fees). From international perspective, it would make sense in the future if basic needs and primary and secondary education was not the responsibility of central government. However, in Belgium, Canada, Denmark, France, Germany, Italy, Spain, Switzerland, the United Kingdom and the United States, for example, central government is not responsible for education.

How do you see the property tax in Nepal?

A house tax is generally a good tax for local units in Nepal. But the tax base for property tax is not updated  regularly in Nepal. Combined with an inflation rate of around 9 percent this leads to a situation in which the current system generates only a small  revenue  flow (less than 1.8 percent of GDP).

What do you propose for Nepal?

My proposal seeks to introduce a broader, new property tax for the local level as a  tax sharing system for value added tax VAT in Nepal with 80 percent for central government and 10 each for regional and local level.

What system do you propose?

When designing an equalization system, a formula-based system with a fixed sunset clause should be given preference over the adhoc decisions. In terms of accountability, unconditional block grants make more sense than earmarked grants. But if you want to ensure national minimum standards of public goods, on the other hand, earmarked grants are preferable. It will be a political hot potato because the national MOF and central line ministries lose power to the sub national entities if the equalization system is formula-based and mainly unconditional.

What do you suggest for equalization system in Nepal?

Use mainly a revenue equalization system which is based on the population figure. Preference should be for unconditional block grants to strengthen local accountability and royalties and revenues from hydro power should be included in the equalization formula, as this is an area I feel could potentially generate major tension in Nepal. Use sunset clause for the equalization formula. Ask for international support because an international expert is independent of the daily political process in Nepal.

What is fiscal federalism?

Fiscal federalism, in contrast to decentralization, is concerned not with the transfer of sovereign rights, but with the following six questions.  It is about the question of expenditure assignment, the question of revenue assignment including who should levy which taxes. This also involves the question of vertical imbalance like any imbalance between the revenues and expenditures of sub national governments. There is also the need to see to what extent should fiscal institutions attempt to adjust for the differences in needs and capacities between different governmental units as the same level of government -- the question of horizontal imbalance, or equalization. And, finally what, if any, rules should exist with respect to sub-national borrowing?

What is important here?

Among them, this country needs a democratic election of sub-national tires of government. Otherwise, there will be questions of accountability. Whether it is unitary or federal, the local unit is under the elected representatives. Even in unitary countries like Sweden, United Kingdom and Norway, the people are elected at local level. However, you don’t have democratically elected representatives right now.

How do you see the tax morale?

In federal states, the tax morale is very high. For example in the United States and Canada, they have federal structures and tax morale is very high. However, in centralized countries like Greece and Luxemburg, the tax morale is low as people are not happy with this system.

How do you view the issue of fiscal federalism in Nepal compared with others?

The institutional arrangements and the responsibility for fiscal transfer and their respective equalization differ between countries. Different countries have different modalities. The central government agency model is known as ‘sink or swim’ and is followed by Poland, Italy and China. National Legislature or model known as a cobbler should stick to his last the Brazilian Constitution fixed the senate of Brazil. Another model is intergovernmental forum to avoid a toothless paper tiger and is followed by Canada, Indonesia, Germany and Montenegro. Similarly, Australia, India, South Africa and Uganda practice Independent agency or grant commission which is like political outsourcing.

What is needed in general in order to implement a sound intergovernmental finance system?

The constitution fixes the distribution of tax revenues between the different tires of government. Own assigned revenues versus and revenues sharing and local property tax versus value added tax VAT. Depending on how the respective constitution is structured, there may be a legal claim or the extent of the equalization system with regard to sub-national governments may be fixed. A constitution can avoid or lower fiscal conflicts, mainly in taxation in the areas of natural resources.

A sound intergovernmental finance system is essential for good service delivery in Nepal.  An all embracing constitution can avoid future conflicts between the different tiers of governments. Even for the best taxation system together with an integer tax administration, it is impossible to improve a tax collection rate without any political willpower.

What do you suggest for fiscal federalism in Nepal?

Most important thing is the finalization of the constitution including a geographical definition of the sub-national entities, assignment of expenditure responsibilities, and assignment of fiscal resources for each tire of government. As it is said, finance follows function, that is, democratic election of the sub-national tires of government or the local bodies including village, municipalities and districts.

When there will be three tires of government, there will be the likelihood of more conflict. How can we reduce the institutional conflicts in Nepal?

Institutional arrangements can reduce fiscal conflicts, e.g. with an intergovernmental forum in Nepal.  However, fiscal equalization and fiscal conflicts are mostly like the chicken or egg -- which came first -- question.

How do you see the establishment of independent commission?

My experiences of traveling to different parts of the world shows that the independent commission is never independent because even the very selection of the members of such a commission is a political decision and not an independent decision. To what extent should fiscal institutions attempt to adjust for the differences in needs to capacities between different governmental units at the same level of government? – The question of horizontal imbalance, or equalization; and finally, what, if any rules should exist with respect to sub-national borrowing?

How do you describe yourself?

I am an independent consultant and the Federation of Nepalese Chamber of Commerce and Industries asked me to come to Nepal. I have to admit the fact that I am not an official representative of GIZ or any other German government organization.

How was your experience sharing in Nepal?

I really enjoyed my program in Nepal. I have interacted with different levels of people including staff at IRD, secretary of Ministry of Federal Affairs and Local Development Dr. Som Lal Subedi, senior officials, FNCCI office bearers. It is good to know secretary Dr. Subedi, who heads the Ministry to deal with local bodies, is knowledgeable.

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