To beg, borrow or steal?

In 2017, Nepal held its first local election after two decades. A generation of Nepalis had grown up without any experience of electing mayors or ward chairs. Bureaucrats were appointed to municipalities.

Those were not just any local elections, they were the first under a federal structure. Hopes were high, and expectations higher. But how to make fiscal federalism work, and particularly municipal financing? What has been the experience of the past two years?

There are two schools of thought about how municipalities should fund themselves. The first is that they have limited resources to invest in socio-economic development, and even added fiscal transfers from the federal and provincial governments on top of local revenues, are not enough for infrastructure and service delivery.

The second is that local governments are unable to use available resources due to lack of technical and financial capacity, and that financial deficit is irrelevant when local governments are not even able to spend their allotted budget.

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While both these narratives ring true, the challenges are not faced in isolation and are cyclical in nature -- they feed into each other. The lack of capacity of local governments has led to underutilisation of funds available through the market and the federal government. Administrative and policy restraints set by the federal government also limits local governments’ access to finance.

However, lack of spending capacity or lack of financing is not a challenge unique to local governments.  It is in fact part and parcel, a hereditary defect passed on from Kathmandu to rest of the country.

Under the federal structure, significant power has been devolved to local governments than previously imagined. However, the expenditure responsibilities of local governments do not match their ability to generate revenues -- their power to govern through constitutional mandate has been restricted by their financial ability to govern.

The revenue municipalities raise from taxes and levies is insufficient to cover operational expenses, let alone finance infrastructure or service delivery. Local governments are criticised for bloated operational expenses, but while this may be  justified, municipalities will still not be able to finance big ticket infrastructure and service delivery projects with merely internally generated revenues.

Local governments therefore have fewer avenues to raise funds. To decrease their finance deficit, they can either steal, beg, or borrow to meet their requirements. In the crudest sense, local governments can either raise taxes, or utilise federal government transfers, or borrow from banks.

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An obvious mechanism to increase the funding base of municipalities is to increase their own source revenue generated through property taxes and business registrations, among others. However, municipalities already have a smaller tax base which restricts their revenue-generation capacity. They also cannot increase tax rates twice within their 5-year term limit, as it would be politically unpopular. The other mechanisms to access finance are largely dependent on local governments’ ability to raise revenue locally.

Another option is to use the four intergovernmental transfers (grants)

provided by the federal government. Fiscal equalisation grants disbursed to local governments is generally inadequate to cover municipal expenses which drives local governments turn to conditional grants.

However, this reliance on conditional grants can only support piecemeal projects that do not always meet local needs and priorities. With Covid-19, the ability of the federal government to generate revenue have been hit, and subsequently, transfers to local governments.

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Local governments can also take internal loans through Nepal’s banks

and financial institutions to cover their deficit. As of this fiscal year, municipalities can borrow up to 12% (a two-percentage point increase from last fiscal) of its revenue and revenue distribution from the federal and provincial governments.

For instance, a larger municipality like Bharatpur could borrow up to Rs130 million in internal loans in the last fiscal year. Smaller municipalities like Birendranagar and Damak could borrow only up to Rs50 million. The minor increase in the debt ceiling does not increase their borrowing limit significantly. Considering the infrastructure and services delivery needs of growing urban centres that requires billions in investment, this amount seems grossly inadequate.

There are regulatory and institutional restraints and reluctance to empower local governments to finance their capital deficits. However, the lack of technical capacity of  local governments contributes equally to this problem. Nowhere is this more obvious than in their inability to spend their annual budgets.

This is also evident in the underutilisation of some of their federal grants, mostly because applying for these grants require project planning skills that are absent at the local level. Lack of capacity to plan, execute and monitor large scale projects is fuelling their inability to proactively seek federal grants to increase the revenue.

This limitation has been amplified due to restrictive banking and financial practices in Nepal. Financial institutions are inclined to provide collateral backed lending, which allows banks to sell the land (commonly used as collateral) if a project fails to deliver.

However, financing institutions are reluctant to lend to municipalities as municipal land cannot be used as collateral. While non-collateral based lending is an alternative, they are rare and limited to projects with guaranteed revenue streams such as hydropower projects with signed Power Purchasing Agreements with Nepal Electricity Authority.

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These are not just structural challenges, municipalities also face a crisis of confidence. Most municipalities are averse to borrowing and have not utilised the 12% internal borrowing threshold. Current borrowing, on average, comprises only 0.85% of municipal total revenue. Several municipalities say that despite their growing financial needs, they are less likely to take internal loans. Even if they do borrow, loans are used to manage working capital deficits rather than to finance municipal projects.

In absence of long-term vision and prior plans, costly projects that may exceed the allotted fiscal transfers are not included within municipal plans and budget. Plans are limited to short to medium term projects and larger infrastructure or service delivery improvements which could potentially increase local governments revenues are ignored. The crux of the matter is, rather than municipal needs informing the budget, fiscal transfers dictate policy priorities of local governments.

Local governments are locked in this vicious cycle. The federal government’s reluctance to ease up its fiscal hold on municipal finances constricts their capacity to deliver on their constitutional responsibilities. In parallel, limited institutional capacity of municipalities to deliver on their budget drives the federal government to maintain its regulatory and administrative hold.

These constraints subsequently limit municipalities access to adequate finance. Unless this cycle is broken, local governments, much to our disappointment will only end up delivering short sighted piecemeal projects.

The effectiveness of federalism rests on enabling municipalities and the leadership to identify, create, plan, and implement sustainable long-term projects. Despite the authority provided by the Constitution to local governments, their heavy reliance on fiscal transfers and inability to seek internal loans as an alternative for financing projects weakens their autonomy and governing power.

After all, adequate fiscal autonomy is a key tenet of effective decentralisation which should not be undermined by poorly designed federal controls.

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Anna S Gautam and Nishu Baral are analysts with Infrastructure Development and Financial Sustainability project supported by The Asia Foundation at VRock and Company.