GTZ Report on Proposal for Nepal Grant Formula - LGCDP

Urban Development through Local Efforts ProgrammeA joint programme of the Ministry of Local Development (MLD) andthe German Technical Cooperation (<strong>GTZ</strong>) Proposal for a new localgovernment taxation systemand intergovernmentaltransfersDecember 2009

<strong>Report</strong> submitted by Dr Alexander Wegener,interpublic consultancy,Alexander.Wegener@interpublic-consultancyon behalf of <strong>GTZ</strong> for <strong>GTZ</strong>/udle

Proposal for a municipal grant allocation formulaiTable of Content1 Preconditions for and assumptions on a local government system in a federal Nepal.............................................................................................................................................11.1 Principle of subsidiarity and congruence...............................................................................................................21.2 Principle of equivalence................................................................................................................................................31.3 Principle of connectivity...............................................................................................................................................32 Proposal for a new local government taxation system in a federal Nepal.............52.1 Replacement of the Local Development Fee.........................................................................................................52.2 A local taxation system acknowledging the design principles of congruence, equivalence and connectivity...............................................................................................................................................................................62.2.1 An optimal set of local government taxes.....................................................................................................72.2.2 A reasonable sharing of taxes between levels of government..............................................................92.2.3 A cost-­‐recovery approach in the calculation of user charges............................................................103 Proposal for a future grant allocation scheme for municipalities in a federal Nepal...........................................................................................................................................113.1 Total gross fund deoinition.........................................................................................................................................113.2 Preference for unconditional grants instead of conditional grants...........................................................123.3 The proposed grants....................................................................................................................................................133.3.1 Unconditional grants..........................................................................................................................................133.3.2 Conditional grants...............................................................................................................................................134 Formulae de[inition for unconditional grants..............................................................154.1 Basic grant formula deoinition.................................................................................................................................154.1.1 Population..............................................................................................................................................................154.1.2 Own Source Revenue.........................................................................................................................................164.1.3 Socio-­‐economic condition................................................................................................................................174.2 Minimum Conditions and Performance Measurement formula deoinition............................................174.2.1 Minimum condition fuloilment.......................................................................................................................184.2.2 Honouring local performance........................................................................................................................184.2.3 Grant assignments during a oiscal year.......................................................................................................185 Formula de[inition for conditional grants (capital investment grants)...............196 References..................................................................................................................................20

Proposal for a municipal grant allocation formulaiiList of [igures and tablesFigure 1: Institutional symmetry in local government oinance...................................................................................4Figure 2: The importance of LDF in the past oiscal years for municipalities in Nepal.......................................6Figure 3: Revenue types and design criteria......................................................................................................................7Figure 4: The grant allocation scheme...............................................................................................................................14Figure 5: Unit cost of service delivery in dependency to population.....................................................................16

Proposal for a municipal grant allocation formula 1Preconditions for and assumptions on a local government system in a federal Nepal1 Preconditions for and assumptions on a local government system in a federal NepalThis report on behalf of gtz/udle aims to open the discussion on a future local government oinance sys-­tem. The current system of local government oinance has to be changed for a number of reasons:• First, Nepal's accession to the World Trade Organisation requires the abolishment of taxes that dis-­criminate imports. The main source of income for municipalities in Nepal is the Local Development Fee, which needs to be replaced until 2011.• Second, Nepal's development towards a federal system will create a new level between local govern-­ment and the federal government, and thus, the local government oinance system will have to reolect the new state restructuring.• Third, the current system of local government funding is based predominantly on a high share of federal support. However, a decentralised system would require strong local governments – not only legally, but also oinancially – to balance the idea of local self-­‐governance (legal autonomy) with oiscal autonomy.The design of a local revenue system includes three central dimensions: the assignment of revenue sources among types of government, the degree of autonomy with which subnational governments can exercise their assigned authority, and the efoiciency of the revenue administration system (Taliercio 2006, 107). This paper describes the design of a system of local government oinance in a future federal Nepal considering the legal authority and the assignment of revenues. • First, this chapter outlines key preconditions and assumptions of state structuring and the import-­ance of the local level within a federal structure. Key assumptions are the further deepening of local self-governance of local communities, the principle of subsidiarity and the principle of congruence (chapter 1.1 hereafter), and the principle of equivalence (chapter 1.2 on page 3f.) in oinan-­cing local services. The principle of connectivity relates to oiscal relations between levels of govern-­ment, federal, regional and local (chapter 1.3 on page 3f.). Altogether, these assumptions favor strong local governments within a federal structure. Key reason for proposing strong local govern-­ments is the empirical evidence from federal states in industrialised and developing countries, in which often the local government level is weakest in relation to the federal and regional level.• Second, the chapter titled Proposal for a new local government taxation system in a federal Nepal on page 5f. describes the future funding sources of local government in a federal Nepal, taking into ac-­count the undisputed end of the Local Development Fee, a centrally collected import tax redistrib-­uted to municipalities based on a historical municipal revenue source, the octroi. There is currently no single tax source that may replace the yields from the Local Development Fee, therefore new sources have to be identioied which should empower local government, but also guide them to en-­hanced responsiveness and accountability to the local communities. Shared taxes and supplements to existing non-­‐local taxes may fulloil this requirement. Based on three principles presented in chapter 1 an optimal set of local government taxes and user charges is presented.• Third, the chapter titled Proposal for a future grant allocation scheme for municipalities in a federalNepal on page 11f. outlines the fund olows between levels of government.• Finally, the forth and oifth chapter specioically address design question on allocation formulae for Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 2Preconditions for and assumptions on a local government system in a federal Nepalconditional and unconditional grants.gtz/udle hopes to support the discussion process on a new local government oinance system in a feder-­al Nepal and welcomes comments on this paper.1.1 Principle of subsidiarity and congruenceIt may be regarded as success of decentralisation efforts that publications not only refer to local gov-­ernment structure and functions as in the 1970s and 1980s (for example Stamp 1986), but also on loc-­al government oinance since the 1990s, and that local governments are much more important in ser-­vice delivery than they were until the 1990s (for example Tordorff and Young 1994, Wunsch 2000). Local governments in a federal state may have very different constitutional, legal and oinancial rights, and often, their position in a federal state is threatened (Gboyega 1991).The oirst assumption of this paper is that within a future federal Nepal, there is local self-­‐governance for local communities. Although the precise structure of local units has not been decided yet, the as-­sumption is made that there is a unioied legislation on local government that addresses both the cur-­rent municipalities and rural communities. The assumption is that there will be no district councils in the future.Local self-­‐governance is the corner stone of a new local governance oinance system:“It is quite plausible to argue that in the matter of service deliveries as well as in local busi-­ness development, control rights in governance structures should be assigned to people who have the requisite information and incentives and at the same time will bear respons-­ibility for the (political and economic) consequences of their decisions. In many situations, this insight calls for more devolution of power to local authorities and communities” (Bardhan 2002, 202). The principle of subsidiarity encourages local self-­‐governance for all local affairs.“Until the late 1980s, decentralisation experiments in sub-­‐Saharan Africa tended in the majority of states to reinforce central control rather than enhance local autonomy” (Tor-­dorff 1994, 555). Key lesson from decentralisation reform in Commonwealth Sub-­‐Saharan Africa is “that if representative authorities are to have more than a symbolic development role, they must be strengthened in both stafoing and oinancial resources” (Tordorff 1994, 579). And this is deoinitely true for all decentralisation efforts in any country, regardless whether industrial-­ised, developing, or in transition.“After all, the logic behind decentralization is not just about weakening the central author-­ity, nor is it about preferring local elites to central authority, but it is fundamentally about making governance at the local level more responsive to the felt needs of the large majority of the population” (Bardhan 2002, 202). The principle of subsidiarity indicates that only those services and public functions should be operated by higher levels of government if the regulation, production and delivery of these services on the local level would result in either very low efoiciency of effectiveness. The principle of congruence demands Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 3Preconditions for and assumptions on a local government system in a federal Nepalthat a local government body should be responsible for those tasks which are used by or beneoit mostly the local residents in its administrative boundaries. There should be a spatial identity between de-­cision-­‐makers and user or beneoiciaries.Together, the principle of subsidiarity embedded within idea of local self-governance and the principle of congruence should form one key design criterion for a future local government [inance system in Nepal.1.2 Principle of equivalenceThere is a vast amount of literature on public oinance theory, whereby the underlying principles of tax-­ation and spending are assumed to be same for unitary and federal states (Bhargava 1953).This principle of equivalence demands, that the beneoiciaries of locally produced services should also pay for these services. In consequence, this principle demands that local services should be funded by the local community. This community is set up by natural and legal persons. By that principle, it be-­comes evident, that funding for local government should be balanced between all beneoiciaries of the local government, citizens and businesses.Therefore, a sound local government oinance system must allow and give legal authority to local gov-­ernment bodies to have, set and change taxes, whereby the taxes should comply with the principle of equivalence, and where necessary, to group-­‐related equivalence.In a developing country context, local taxation should also take into account the ability to pay espe-­cially of the poor or potentially marginalised groups. One larger attempt to tax all individuals within a local government unit was undertaken in the late 1980s in the United Kingdom. The so-­‐called “poll tax” would have meant that every citizen regardless of income would have to fund the local government services. Strong opposition, and the apparent inequalities created if no other funding sources are avail-­able not only led that the Government gave up the plan, but also ended the political career of Prime Minister Margaret Thatcher. In most countries, group-­‐related equivalence is used to legitimate taxes such as• local taxes on land and buildings, and• local taxes on businesses.It is important that local taxes have broader tax bases covering all most of potential and active users of local government infrastructure and services. Local government tax bases should comprise natural and legal persons (citizens and businesses) that actually or potentially bene[it from local government infrastructure and services.1.3 Principle of connectivityThis principle demands, that decision-­‐makers that decide on an issue that affects budgets should also be responsible to fund this decision by their own means. For example, a federal government should not decide on a law which incurs costs on sub-­‐national governments without accompanying funding.Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 4Preconditions for and assumptions on a local government system in a federal NepalThe principle of connectivity is more important for the design of a local government oinance system in general, and contributes little to the actual design of local taxes and tariffs. Figure 1: Institutional symmetry in local government [inanceDecision-MakersPrinciple of congruencePrinciple of connectivityInstitutional SymmetryBeneficiaries, UsersResponsible funding bodyPrinciple of fiscal equivalanceDr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 5Proposal for a new local government taxation system in a federal Nepal2 Proposal for a new local government taxation system in a federal NepalThis chapter deals with options on how to redesign the local taxation system in Nepal under two major changes that will affect local government:• First, the section 2.1 on “Replacement of the Local Development Fee“ shows the major implication on municipal oinance in Nepal if the LDF is being abolished, • Second, section 2.2 titled “A local taxation system acknowledging the design principles of congru-­ence, equivalence and connectivity“ outlines the key principles after which a local taxation system should be designed.• Sub-­‐section 2.2.1 titled “An optimal set of local government taxes“ applies the principles to taxes typically assigned to local governments,• Sub-­‐section 2.2.2 titled “A reasonable sharing of taxes between levels of government“ discusses the need to tax sharing arrangements in a federal structure, and• Sub-­‐section 2.2.3 titled “A cost-­‐recovery approach in the calculation of user charges“ determines the key design criteria for the calculation of prices for user charges and fees.The options discussed are based on Public Finance Theory and experiences in federal states such as Germany, Austria, Switzerland, and others. 2.1 Replacement of the Local Development FeeThe Local Development Fee (LDF) plays a major role in local government funding in Nepal for the mu-­nicipalities. The LDF' predecessor, the octroi, was replaced by a centrally collected import duty and has been redistributed to the municipalities. However, the formulae for the allocation is based on previous octroi collection, and although modioied – guaranteeing minimum amounts to all municipalities – the LDF is far beyond a fair distribution. The LDF is regarded as “own source revenue”, although the LDF in practice is more similar to an uncon-­ditional grant without a clear formula. Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 6Proposal for a new local government taxation system in a federal NepalFigure 2: The importance of LDF in the past [iscal years for municipalities in Nepal12000000001000000000800000000Nepalese Rupees6000000004000000002000000000FY91/92FY93/93FY93/94FY94/95FY94/96FY96/97FY97/98FY98/99FY99/00FY00/01FY01/02FY02/03FY03/04FY04/05FY05/06Annual BreakdownSince Nepal's ratioication to accede the World Trade Organisation it is clear that duties have to be abol-­ished to foster free markets, and this would in consequence result in a dramatic oinancial loss of the re-­ceiving municipalities. The importance of LDF is extraordinary high (see oigure 2 on page 6). Revenue from LDF has been growing for years and since some years, around one billion Nepalese Rupees are redistributed to muni-­cipalities.The design of a new local government oinance system for Nepal has thus to oind• alternatives to the LDF – in the amount of roughly one billion Nepalese Rupees, and• to design a local government oinance system in a future federal Nepal based on the above mentioned principles of congruence, equivalence and connectivity.2.2 A local taxation system acknowledging the design principles of congruence, equivalence and connectivityAssignment of reasonable taxing powers helps give a government control over its oiscal destiny. It al-­lows the government, acting for its citizens, choice over its level of spending and how that spending will be oinanced from segments of its economy. That is an important element for oiscal autonomy. Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 7Proposal for a new local government taxation system in a federal NepalFrom the revenue side of the public economy, oiscal autonomy (and responsibility) is greatest when the subnational government chooses what taxes it will levy, deoines the bases it will use, sets the rate and preference structure for those bases, and administers the taxes that have been adopted (Mikesell 2003).Figure 3 on page 7 summarises the optimal design of three major types of income for local government bodies if the three guiding principles of congruence, equivalence and connectivity would be applied to the three main sources of income of local governments:• User charges (usually for utilities) and fees (usually for administrative services)• Local taxes• Grants.Figure 3: Revenue types and design criteriaSourceFees and user chargesLocal taxesGrantsBasisLocal services where the individual consumption is measurable and politic-­ally desired (such as water, electricity, solid waste collection, etc.).Local fees and user charges should be designed that the services provided can be founded (full cost recovery).Local services, where the individual consumption is either not measurable, or not desirable.Local taxes, however, should follow the principle of equivalence. Therefore, the principle of equivalence is extended to local groups beneoitting from loc-­al services such as house-­‐ and land owners, businesses, or citizens.In an ideal world, grants do fuloil two functions only: The serve to guarantee a minimum oinancial basis of local bodies (oiscal function) and to internalise external spatial effects. after Friedrich 2005Based on this optimal design, the following sub-­‐sections deal with• An optimal set of local government taxes (section 2.2.1 on page 9f.),• A reasonable sharing of taxes between levels of government (section 2.2.2 on page 9f.),• An optimal set of local government taxes (section 2.2.3 on page 10f.).2.2.1 An optimal set of local government taxesProperty taxes are regarded often as an “optimal” local tax, especially when taking into account Anglo-­‐Saxon literature. However, this type of tax affect only a specioic group of the local citizenry and not ne-­cessarily the whole community. This tax is an example of a group-­‐related equivalence, whereby the as-­sumption is made that property owner beneoit in general from local government decision-­‐making and service delivery beyond user-­‐charge based service delivery. Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 8Proposal for a new local government taxation system in a federal NepalAn optimal set of local government taxes should embrace different groups within the local community. These groups should comprise both citizens and businesses. Therefore, an optimal set of local government taxes results in at least one tax per group targeting• citizens (local income or property related tax) and • businesses (local business tax)This, in consequence, would require that local government bodies in the context of Nepal have the legal authority to tax• citizens through the integrated property tax, and to tax• businesses through the business tax.Typically, upper levels of government collect income taxes such as personal income tax or corporate in-­come tax. Business taxes and corporate income tax do often tax the same tax base. To avoid double tax-­ation, the amount paid by a local business to the local taxing authority (business tax) must be deduct-­ible from the corporate income tax payable to upper levels of government. The number of businesses subject to business tax should be larger than the number of businesses subject to corporate income tax. A local business tax should cover all businesses, small-­‐scale and even informal businesses. In prac-­tice, this requires an assessment process that can deal with the informal sector, too. Tax information in this case may even provide very helpful information on the economic development of a community. The amount of high-­‐yielding local taxes is limited in most countries of the world. Typically, the follow-­ing taxes are the most important to local government funding:• personal income tax (in Nordic countries only, Denmark, Sweden, Norway)• land tax on unbuilt areas• building tax on buit-­‐up areas, often land tax and building tax are connected (Anglo-­‐Saxon property taxation), and • business taxA surtax system on the major national taxes, such as income tax (non-­‐progressive), is widely used to oinance local budgets from international perspectives. Local governments can piggyback extra rates on the stable national taxes using the same tax base. With the development of local taxes, a surtax system can be applied using the existing tax collection channel of the General Taxation Department, which will reduce administrative costs. A ceiling should be put on surcharge rates to limit the wide difference in surcharge rates among jurisdictions. The merit of a surtax system lies in guaranteeing stable revenue resources for local governments with fewer administration efforts. “In the longer term, a surcharge or piggy-­‐back on personal income taxation is the best op-­tion. It would allow subnational governments to set their own tax rates on a centrally deoined tax base and within limits set up by the central government” (Ahmad and Brosio 2008).However, piggybacking has some downfalls, too:“While surcharges on central tax bases can give a considerable degree of oiscal autonomy without some of the problems that full autonomy can create, subnational governments may not agree, if given the choice, that the autonomy thus given is adequate. In particular, Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 9Proposal for a new local government taxation system in a federal Nepalthey may be concerned that a government not receiving the revenue from a tax that it ad-­ministers is likely to feel less urgency in collection of or for reform of that tax than are those using the revenue to oinance their operations. They may feel that administration in practice is inextricably intertwined with tax policy and that, without having choice over administrative decisions, they lack appropriate oiscal autonomy” (Mikesell 2003).In the context of Nepal, the number of taxpayers for high-­‐yielding taxes such as individual or corporate income tax, value-­‐added tax or others is still low. However, Government might consider surcharges to increase the overall revenues from these taxes, as there are still a large number of potential taxpayers de facto “exempted” from tax invoices.2.2.2 A reasonable sharing of taxes between levels of governmentThe large importance of the LDF to local government funding in Nepal (at the moment limited to muni-­cipalities) raises the question which income might replace the LDF when abolished. It is rather evident that given the relatively large number of revenue titles that are assigned to Nepalese municipalities no single additional “new” tax can be created to replace the high-­‐yielding LDF.An alternative and more efoicient way to equip local governments with revenue is to better exploit the shared revenue between central and local governments. We can expect beneoits of tax sharing such as reduced tax competition among local governments, economies of scale in tax administration and collection, and the maintenance of revenue stability over the business cycle etc. However, there are also downsides of the tax sharing scheme, due to disadvantages such as a reduction in local autonomy and the breaking of the link between the beneoits and costs of local public expenditure (Mikesell 2003).This fact is an argument to broaden the tax bases of the current taxes (see the section above). However, even with a broadening of the tax bases of the current local taxes in Nepal – especially the integrated property tax and the business tax as the potentially most important local taxes in the future – there is a need to replace the current grant allocation scheme and the LDF redistribution through a system of shared taxes.Shared taxes are very common in federal states. In Germany, for example, there are a number of taxes which are shared between the federal level and the state level, and there are provision that guarantee local governments a share. This is the case for the distribution of the value-­‐added tax, the personal in-­come tax and tax on capital gains. Local governments in Switzerland levy supplements to canton individual income taxes (see Mikesell 2003). Each of the twenty-­‐six Swiss cantons has its own tax system and local governments are entitled to levy taxes to the extent authorized by the canton. The communal tax is levied as a percentage or multiple of the basic canton tax rate. A federal law requires cantons to harmonize their income tax concept and deductions with the federal base, but they may set the amount of deductions and their rate schedules. Each of the cantons has a separate administrative body for collection of its taxes. The communal tax is piggybacked on the canton tax and federal tax is reported on the canton return. Thus, the canton is responsible for assessing and collecting federal, canton, and communal income tax – cent-­ralization down from the canton but decentralized administration up to the federal level. In contrast to the case in many nations, subnational – canton and municipal – Swiss governments receive the bulk of income tax collections, not the federal government. And, again in contrast to most international exper-­ience, the income tax is a relatively modest revenue source for the federal level. But because the tax is collected across all cantons, it is important that the base and deductions be standardized in order that Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 10Proposal for a new local government taxation system in a federal Nepala uniform effective federal rate can be imposed on taxpayers without regard to their location.At the current stage of the discussion process of state restructuring it is not possible to recommend specioic taxes to be shared until there is a decision on task assignment between the federal, the new re-­gional and the existent local level with a high degree of local self-­‐governance is taken. However, the future funding mechanism will have to rely on shared taxes to meet the funding requirements of the local level, and most probably, tax sharing agreements usually refer to income taxes or taxes on consumption.Therefore, an “optimal set” of taxes and fees includes:• a stable and predictable tax revenue source• such as a property tax based on land and buildings, if the valuation is kept simple and complies with the standard institutional capacity of local governments units in Nepal.• a tax revenue sensitive to economic development• such as a business tax on prooits of all business activities (formal and informal sector, blue-­‐collar and white collar, including freelancers, regardless of size and branch of activity) that create in-­centives for local government units to promote economic development within their boundaries. The local business tax for businesses already paying corporate taxes should be deductible from the corporate tax.• Such as a local share of personal income tax for all natural persons• cost recovering user charges for fee-based technical services such as water, sewerage, solida waste collection and other services. Local councils may subsidise fees with general funds, if a full cost recovery approach is not feasible.In addition, the proposed basic grants should be based on population data and thus are encouraging local government units to create housing and job opportunities. The basic grant should be stable and predictable to enable local government oinancial planning.2.2.3 A cost-recovery approach in the calculation of user chargesAlthough user charges are by no means taxes, and typically, user charges are common for services which are consumed individually or per household and where a person-­‐ or household-­‐related charging is appreciated. User charges should not be considered as general funds, but specioically aimed to cover the costs of that specioic services, such as water consumption and waste water, street cleaning, electri-­city consumption, abattoir services, and others.The user charges should not exceed the full cost of the service, and the council is due to make political decisions which services should achieve which level of cost recovery. Any cost recovery below full cost recovery will then require support from the general fund and thus reducing the local possibilities for decision-­‐making.Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 11Proposal for a future grant allocation scheme for municipalities in a federal Nepal3 Proposal for a future grant allocation scheme for municipalities in a federal Nepal“We oind that developing countries have more centralized oiscal structures and argue that this is consistent with the theory of oiscal federalism. Economic development, however, does push the advantage toward decentralization. We also show that developing countries use a wide variety of transfer instruments to fund local governments, and that these in-­struments give the national government varying degrees of control over local government oinances” (Bahl and Linn 1994, 1)Economic theory assigns the functions of general purpose grants to address vertical imbalance between central and local budgets and to adjust horizontal imbalances among local budgets. The the-­ory also assigns specioic purpose grants to correct spillovers and to implement national goals through local expenditure. Grant allocation should support local self-­‐governance in promoting social, economic and democratic progress on the local level. Grants are not to be misused to tighten control over local government, neither by federal level, nor by regional level.Regarding the design of equalization and specioic purpose grants, Bird and Smart (2002) set out the following principles of international lessons. These are: • Both general purpose and special purpose matching grants should be managed on the basis of rules. • The funding pool of general purpose grants should be set in a stable but olexible way. • The allocation of general purpose grants should take account of both need and capacity. The formula should be as simple, reliable, and transparent as possible. • Specioic incentive features to encourage additional tax effort are not necessary, if the general pur-­pose grants are designed properly and if some tax policy discretion is guaranteed for local govern-­ments.• On the use of general purpose grants, no conditions should be imposed. • Matching conditions according to the expenditure type and oiscal capacity of recipient government should vary in the provision of specioic purpose grants. • In oinancing infrastructure by specioic purpose grants, recipient governments should satisfy technic-­al conditions, which ensure that money is properly spent. • The management of local public oinance of all local governments should follow standard procedures, to maintain adequate and current accounts, and be audited regularly and publicly. 3.1 Total gross fund de[initionIn a federal Nepal, it is assumed that local government is deoined as one of three state levels next to the federal level and the regional level. This is necessary to ensure that federal government has a stake in local government oinance. If local government would be regarded as an internal affair of the regional states, the federal government would possibly violate the constitution if they would directly address Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 12Proposal for a future grant allocation scheme for municipalities in a federal Nepallocal governments. Therefore, the gross fund deoinition for funds to be allocated to local governments – here municipalities – should be a fund that should be oilled by the federal government and should be open for regional governments for funding, too. There are two options• First, all regions could use the total gross fund as an equalisation element: All regions pay in accord-­ing to a formula to be agreed upon, and the funds are distributed across the nation. The funding to a gross fund is an equalisation element, as there might be regions that pay more in the fund than the municipalities are receiving in that region. However, this is depending on the revenue assignment to the regions. • Second, if regions are not willing to use the gross fund as an equalisation element, they could top up the federal grant anticipated for the municipalities within their region. What should be avoided and what should be limited by law is a multitude of different funding schemes, different grant allocation schemes that would encourage imbalances in local government funding rather than to create a fair and equal funding options for all urban areas in Nepal.3.2 Preference for unconditional grants instead of conditional grantsOne key question is designing local government oinance system is the need for federal or regional fund-­ing of local governments in general, and thereafter the question, whether this federal or regional fund-­ing should be unconditional or conditional.In principle, the local government oinance system in a federal state with strong local governments in terms of legal autonomy, oiscal autonomy and relevance for the service delivery, should always seek to ensure sufoicient funding from own sources of revenue. As explained above, own sources of revenue are unlikely to be enough to fund for all functions assigned to local governments, therefore tax sharing agreements are essential in Nepal. However, even with the combination of own source revenues and shared taxes, oiscal imbalances might occur. Fiscal imbalances are typical for those state systems which grant local government oiscal autonomy. The more income of local government is dependent on own source revenues, the more likely are imbalances in terms of per capita income, especially in a country with large differences between municipalities in terms of geographical setting and economic activity such as Nepal.Unconditional grants do have the function to guarantee the function of local government regardless where the local government is located and regardless the socio-­‐economic condition. However, uncondi-­tional grants may contain equalization elements to reduce vertical oiscal imbalances.Conditional grants should be small in number and small in amounts allocated. The main reason is that conditional grants are designed by deoinition to support specioic policy objectives of the Government. The Government has – through the instrument of conditional grants – large opportunities to guide loc-­al council decisions, as conditional grants reduce the cost of service delivery or capital investments. There is no problem in having conditional grants, however, there share of unconditional grants should be much larger to enable local councils to fund local services according to the needs of the local people, while the share of conditional grants should be much smaller to offer incentives for local councils to fund local services according to the political programme of the Government.Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 13Proposal for a future grant allocation scheme for municipalities in a federal Nepal3.3 The proposed grantsUnconditional grants should ensure the operation of local government tasks and functions assigned, if local sources of income are too small or too volatile.Conditional grants should be kept small in number, and may be used to promote federal or regional policy objectives.3.3.1 Unconditional grantsThere should be only one unconditional grant to be allocated to local government units based on com-­mon criteria, which are available to the Government and ensure an equal distribution according to population, socio-­‐economic condition and should be altered by local government performance in key areas.3.3.2 Conditional grantsThere may be some selected conditional grants available to local government. The conditional grants• must be limited in amount,• must be limited in relation to the amount of the unconditional grants, not exceeding 20% of the total funds available to local governments,• should not given through the various line ministeries, but• should be channelled through the Ministry of Local Development, the Ministry of Physical Planning or the Town Development Fund.Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 14Proposal for a future grant allocation scheme for municipalities in a federal NepalFigure 4: The grant allocation schemeFederal GovernmentRegional GovernmentsTotal Gross FundUnconditional Grants(80%)Conditional Grants(20%)Basic Grant(50%)MCPM Grant(50%)Allocation Formula(a) population(b) area(c) poverty(d) own source revenueAllocation Formula(a) supplement or(b) chargeto basic grantAllocation Formula(a) by proposal(b) co-funding only(c) TDF processing(d) technical feasibilityConditional grants should be used to promote federal (or regional) policy objectives. Conditional grants are by no means meant to tighten oinancial control over local government, they always should either to• fund for services provided by local government which under regulatory control of the federal gov-­ernment or the regional government, but performed by local government. The underlying assump-­tion is the rule of the principle of connectivity, which states that delegated functions must not re-­main unfunded. Delegated functions hereby means that the function is formally assigned to a differ-­ent level than the level the assigned function is actually performed.Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 15Formulae deoinition for unconditional grants4 Formulae de[inition for unconditional grantsThis chapter outlines the proposed formula deoinition for unconditional grants, while chapter 5 on page 19f. describes the formula to be used for conditional grants. This chapter is structured as follows:• section 4.1 discusses the Basic grant formula deoinition, and• section 4.2 shows the relations to the Minimum Conditions and Performance Measurement formuladeoinition (page 17f.).4.1 Basic grant formula de[initionThis section shortly describes the criteria to be used:• Population• Own Source Revenue• Socio-­‐economic condition4.1.1 PopulationThe basic grant formula deoinition is kept simple and is mainly based on population data. Population data is available and reliable, and all basic grant formulae in the world rely on population as a key in-­dicator for grant allocation. The general assumption in using population data is that population also re-­olects the costs of delivering a service to the public. However, some problems have to be addressed:• smaller local governments in terms of population may require a minimum amount allocated, as there are minimum per unit costs for service delivery.• The more densely populated an area is, the less are the per unit costs of service delivery (i.e. water supply, sewerage, and others), while the demand for infrastructure may be higher in more densely populated local governments compared to sparsly populated local governments (i.e., less demand for piped sewerage systems in sparsly populated local governments as open ditch systems may already satisfy the need, thus meaning that service infrastructure costs may be much lower in sparsely populated local governments compared to agglomerations).While population is widely used in the design of intergovernmental oiscal relations, the design of a pop-­ulation based criterion must be more complex if there is a large difference in population between local government units. This is the case in Nepal, where the local governments in the Kathmandu Valley are largest in terms in population, and they are in addition very close and open further efoiciency gains in service delivery through joint service production. Thus, the criterion on population should take into account• unit cost considerations• demand for service is often not linear, but starts with a crucial number of inhabitantsDr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 16Formulae deoinition for unconditional grants• unit costs are dependent on technical standards which may vary depending on the number of total population, and• unit costs tend to decrease with larger number of beneoiciaries, especially when they are offered in densely populated areas such as agglomerations.• deviations from average size of local government unit and/or agglomerationsFigure 5: Unit cost of service delivery in dependency to populationUnit pricePopulationFigure 5 shows a oictive decrease of unit cost per service produced with an increasing number of popu-­lation until to a minimum cost recovery. It should be noted, however, that some services such as waste water require a minimum number of inhabitants to change, for example, from septic tanks to piped sewerage systems, or from open ditches for stormwater to piped systems, and so on. A population based criterion in a basic grant should therefore• consider from which minimum number of inhabitants what services are required• consider decreasing unit costs for at least capital intensive infrastructure.4.1.2 Own Source RevenueThe second main basic indicator is related to the own source revenue of a local jurisdiction. This indic-­ator is much more complex and requires a more sensitive approach than using population data. The in-­dicator is aimed toDr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 17Formulae deoinition for unconditional grants• favour those local governments that exploit best their local tax bases and achieve full cost recovery of services rendered on a fee-­‐basis to citizens.• encourage local governments to invest more in better tax coverage rates and in better tax collection rates. Tax coverage rates show the amount of potential exploitation of a given revenue title, while tax collection rate refers only to the collection of receivables from registered and assessed tax payers.The key problem is to estimate the "tax capacity" within a local government. A report of the Australian Government on Assessing Local Government Revenue Raising Capacity of 2008 stated that “ultimately the observed revenue-­‐raising efforts of local governments are driven by the demands of their com-­munities for local government services. However, there are reasons why it is difoicult to estimate dir-­ectly the extent to which various characteristics of communities ‘explain’ differences in observed rev-­enue-­‐raising efforts. Among other things, this is because of:• the difoiculty in linking the rates paid by local residents to the services they use, which means there is no observable price for each of the services used• the substantial variation in the mixes and levels of goods and services provided by councils• the complexity and variation across councils in the system of rates, and of user fees and charges, levied by councils• the limitations of the data available.”For Nepal, these limitations are valid in principle, yet less important, as the four main issues raised do not apply as such or as much as in industrialised countries. The efforts local councils may take to in-­crease revenue may be limited due to low ability or willingness to pay, whereby willingness can be ad-­dressed politically, and low ability would result into no supplement to the basic amount allocated. The more per capita revenue is raised in selected taxes, which are at the same rate throughout the country, indicates local efforts. However, this holds true for non-­‐volatile taxes only such as land and building taxes. More economically active local governments, or those that are close to the main trade routes in Nepal, may have higher per capita revenues as compared to those with very little economic and taxable activities. Therefore, a systems has to be found that balances the tax capacity and the actual tax per capita income of local governments.4.1.3 Socio-economic conditionIn 2009, the grant allocation formulae used by Government relied on the Human Development Index. There are fundamental critics how the HDI is being used and especially, how the subsequent allocation occurs (see Steffensen 2009). The critics are strongly supported here. For municipalities, there is no HDI data available, and the use of district data instead is not regarded as feasible. As long as there is no consistent and reliable data base, the Government should refrain from using this and similar indicators to avoid severe imbalances or inequalities. 4.2 Minimum Conditions and Performance Measurement formula de[initionThe MCPM grant is unconditional and is oixed to 50% of the available gross funds for unconditional grants. Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 18Formulae deoinition for unconditional grantsThe amount allocated to local government bodies is dependent on the fuloilment of the minimum con-­ditions and the relative performance of a distinctive local government body:• If minimum conditions are not met, the respective local government body is not entitled to beneoit from the MCPM grant.• The relative performance of a local government body decides whether a local government body would receive a supplement honouring the relative better results in comparison to the average, or a charge to discriminate local bodies which are below average or least performers.This approach requires:• The gross allocation is based on the same criteria as the unconditional grant.• The intended allocation for those local bodies not fuloilling the minimum conditions are allocated to all local bodies which have met the minimum conditions.4.2.1 Minimum condition fulHilmentCurrently, the MC/PM system for municipalities requires the fuloilment of the minimum conditions to become eligible for the topping up of the government grant funded by LGCDP.The DDC/VDC system knows similar arrangements.The arrangement should not be changed, however, a number of minimum conditions and performance measures may be changed after some years to set new minimum conditions and to shift policy object-­ives that me be reolected in enhanced, changed or new performance measures.4.2.2 Honouring local performanceThe MCPM mechanism in honouring performance is currently based on the relative performance of an individual municipality against all other municipalities based on the overall performance assessment across all topics covered in the MCPM questionnaire. It is recommended to further analyse the available data to oind out differences in the thematic areas covered in the performance measurement assessment.4.2.3 Grant assignments during a Hiscal yearThe actual payment of grants through central (and regional) governments should follow a clear timetable. There should be no more than one approval of assignment within a year, and this informa-­tion should include the tentative payment schedule to local governments to avoid illiquidity and cash olow problems on the local level.Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 19Formula deoinition for conditional grants (capital investment grants)5 Formula de[inition for conditional grants (capital investment grants)Conditional grants should be limited in number and should be channelled through a very limited number of institutions to avoid local government picking of “cheap” funds. It is recommended to use the Town Development Fund (TDF) as a distributing entity to ensure technical expertise, a single face of central (and regional) government to local government, and to free ministerial work from day-­to-­‐day oinancial monitoring and reporting of grants.Conditional grants should follow clear rules under which circumstances local governments may apply for conditional grants or under which the federal or regional governments allocate conditional grants. The total fund for central government grants should always be much smaller than the fund for uncon-­ditional grants (see oigure 4 on page 14) and conditional grants should always be co-funded by the bene[itting local government. Local governments should have the authority to force main consumers of capital investments to contribute to the investment (i.e. road construction, side walks, etc.).Conditional grants should reolect the large differences in taxing power of local government in Nepal. A system in which disadvantaged local governments need less own sources than those with better taxing powers should be established. The Town Development Fund currently uses only a system by size of local government, however, this systems tells nothing on the need and the ability of the local govern-­ment to co-­‐fund a higher share of large-­‐scale local infrastructure projects. It is recommended to use a similar criterion as the “own source criterion” described further above (see chapter 4.1.2 Own SourceRevenue on page 16f.).Capital investment grants should be made available for• Water and waste water management, including water supply, distribution, disposal, treatment and stormwater management, including construction works and equipment.• Local roads and bridges, and sidewalks, including street lightning, including construction works and equipment.• Solid waste collection, including collection, and disposal, construction works and equipment.• Educational facilities, including museums• Heritage, mainly restoration.Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de

Proposal for a municipal grant allocation formula 20References6 ReferencesAlmy, Richard R. (2000): Property Tax Policies and Administrative Practices in Canada and the United States: Executive Summary, in: Assessors Journal (2000)7, pp. 41 – 57.Baer, Katherine et al. (2002): Improving Large Taxpayer Compliance: A Review of Country Experience, IMF Occasional Paper 215. Washington, D. C.: International Monetary Fund.Bahl, Roy and Johannes Linn (1994): Fiscal Decentralization and Intergovernmental Transfers in Less Developed Countries; in: Publius 24(1994)1, pp. 1-­‐19.Bardhan, Ranab (2002): Decentralization of Governance and Development; in: The Journal of Economic Perspectives 16(2002)4, pp. 185-­‐205 Bell, Michael E. (1999): An Optimal Property Tax: Concepts and Practices, Washington, D. C.: Economic Development Institute, World Bank.Bhargava, R. N. (1953): The Theory of Federal Finance; in: The Economic Journal 63(1953)249, pp. 84-­‐97Bird, R. M. and Smart (2002) ‘Intergovernmental Fiscal Transfers: International Lessons for DevelopingCountries’, World Development, Vol. 30, No. 6, pp. 899-912Fjeldstad, Odd-­‐Helge (2001): Fiscal Decentralisation in Tanzania: For better or for worse? CMI Working Paper 2001:10. Bergen, Norway: Chr. Michelsen Institute.Fjeldstad, Odd-­‐Helge (2001): Taxation, Coercion and Donors: Local Government Tax Enforcement in Tanzania; in: The Journal of Modern African Studies 39(2001)2, pp. 289-­‐306.Gboyega, Alex (1991): Protecting Local Governments from Arbitrary State and Federal Interference: What Prospects for the 1990s? In: Publius 21(1991)4, pp. 45-­‐59.Hemming, Richard, Neven Mates, and Barry Potter (1997): India, in: Teresa Ter-­‐Minassian, ed., Fiscal Federalism in Theory and Practice. Washington, D. C.: International Monetary Fund.OECD (2000): The OECD 1999 Survey on Fiscal Design Across Levels of Government: Summary Note. Paris: OECD.Stamp, Patricia (1986): Local Government in Kenya: Ideology and Political Practice, 1895-­‐1974; in: African Studies Review 29(1986)4, pp. 17-­‐42.Tordoff, William (1994): Decentralisation: Comparative Experience in Commonwealth Africa; in: The Journal of Modern African Studies 32(1994)4, pp. 555-­‐580.Tordoff, William and Ralph A. Young (1994): Decentralisation and Public Sector Reform in Zambia; in: Journal of Southern African Studies 20(1994)2, pp. 285-­‐299.Veehorn, Charles and Ehtisham Ahmad (1997): Tax Administration, in: Teresa Ter-­‐Minassian, ed. Fiscal Federalism in Theory and Practice. Washington, D. C.: International Monetary Fund. Wunsch, James S. (2000): Refounding the African State and Local Self-­‐Governance: The Neglected Foundation; in: The Journal of Modern African Studies 38(2000)3, pp. 487-­‐509.Dr Alexander Wegener interpublic consultancywww.interpublic-­‐berlin.de