Local Government Finance in Nepal - LGCDP

Urban Development through Local Efforts Programme
A joint programme of the Ministry of Local Development (MLD) and
the German Technical Cooperation (GTZ)
Local government finance in
Nepal
Current situation, challenges and future policy
June 2008

Report submitted by Dr Alexander Wegener,
interpublic consultancy,
Alexander.Wegener@interpublic-consultancy.de
on behalf of GTZ for GTZ/udle
2

Table of Content
1 Introduction: What this document is about...........................................1
2 Municipal Finance at the crossroads.....................................................1
2.1 Revenue composition...........................................................................................3
2.1.1 Revenue composition and trends..............................................................8
(a) Tax revenue composition.....................................................................8
(b) Non-tax revenue composition..............................................................9
2.1.2 Growth rates of selected revenue titles...................................................11
2.1.3 Tax review reveals inconsistencies and potentials..................................14
(a) Value added tax.................................................................................14
(b) Land and property taxes....................................................................14
2.2 Per Capita Revenue............................................................................................15
2.3 Grant and LDF allocation....................................................................................18
2.3.1 WTO accession requires abolition of local development fee..................18
2.3.2 Competing grants reduce capacity building efforts.................................18
3 Policy recommendations for gtz/udle in promoting local government
finance in Nepal......................................................................................21
3.1 Local government finance...................................................................................22
3.2 Intergovernmental fiscal transfers.......................................................................23
3.3 Accounting and financial management practice.................................................24
4 References..............................................................................................25
iii

List of Tables
Figure 1: Factors influencing the situation of local government finance in Nepal.............2
Table 2: Revenue titles for municipalities..........................................................................3
Figure 3: Municipal revenue composition in Nepal............................................................5
Figure 4: Municipal tax revenue composition in Nepal......................................................6
Figure 5: Municipal tax revenue composition in Nepal (excluding LDF and former octroi)
.............................................................................................................................7
Figure 6: Municipal revenue composition in Nepal as a share of annual total revenue..10
Figure 7: Growth rates of selected municipal revenues to previous year.......................12
Figure 8: Growth rates of selected municipal revenues to previous year.......................13
Figure 9: Total revenue and total population in the fiscal year 2005/2006......................16
Figure 10: Per capita revenue and total population (excluding Kathmandu) in the fiscal
year 2005/2006..................................................................................................17
Figure 11: Grants allocated to municipalities...................................................................19
Figure 12: Grants by type allocated to municipalities......................................................20
Figure 13: Design principles of local taxation..................................................................22
iv

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v
interpublic berlin
Dr. Alexander Wegener
interpublic berlin Wegener & Wegener GbR
Sundgauer Straße 100
D-14169 Berlin (Zehlendorf)
Tel.: (030) 939 555 90
Fax: (030) 939 555 91
info@interpublic-berlin.de

Introduction: What this document is about 1
1 Introduction: What this document is about
The declaration of the Republic of Nepal marked the end of a long-lasting monarchy and gives opportunities
to design a political system that fits most the ethnic diversity and the urgent need of social
inclusion and participation in Nepal. However, the functionality of a political system is heavily
dependent on the design of public finance and intergovernmental transfers, apart from the administrative
system, and the design of the judiciary system
This report points out
• the need for a re-design of local government finance, taking into account the experiences made,
• proposes an optimal revenue composition of local government
• deals with the need for a LDF replacement
• summarises policy recommendations on
– optimal revenue composition for local government
– optimal local taxation
– grant allocation scheme
2 Municipal Finance at the crossroads
Municipal, as well as local government finance in general in Nepal is at the crossroads. Some major
strategic decisions have to be taken, and they are embedded within the current political decision-making
process on the type of federalism the newly born Republic of Nepal will establish.
Given the large ethnic diversity, the ongoing problem of social inclusion, and the need to establish
sound participation opportunities, local government finance in Nepal is an important issue that will
determine the functionality of federalism and the chance of empowerment of local people.
Local government finance in Nepal will be confronted in the near future with five major challenges
1. Given the population growth and the urbanisation rate as well as the urbanisation growth rate,
the number of urban areas will increase in the next years.
2. Given the WTO membership of Nepal, the LDF is not compatible with the concept of free
trade and must be out-phased within some years (WTO 2003).
3. Given the growth of revenues collected, the Government of Nepal has been increasing funds
for municipalities in the last and probably in the upcoming fiscal years (see → figure 3, p. 5). It
is expected that local areas will benefit to comply with the demand for participation and inclusion
(MLD and GTZ/udle 2006)
4. The discretionary style of grant allocation by MLD and MPPW harm efforts on the local level
for better exploiting taxes and may have a negative impact on long-term financial planning if
grants are easily accessible. Grants allocated through at arm's length organisations such as
TDF are decreasing (see → figure 11, p. 19), partially because of less easy accessible grants
(conditions and restrictions apply in contrast to funds allocated by ministries).
5. The growing political stability in Nepal will unleash funds from international donors that
have been retained during the conflict period.

Municipal Finance at the crossroads 2
Figure 1: Factors influencing the situation of local government finance in Nepal
Political System
Status of local government in a
federal state
VDCs and municipalities
Globalisation
Abolition requirement of LDF
by WTO
growing international economic
acitivity in Nepal
These developments will result, if no change of policy occurs, in
1. a growing number of urban areas within DDCs/VDCs, especially along major economic roads
(spatial economic development) under the existing legal framework of VDCs and DDCs
2. a sharp decline in own source of revenues when LDF must be pahsed-out, as LDF represents
a major share of revenue for the municipalities, and there is no strategic discussion on how
LDF is substituted.
3. continued arbitrary allocation of Government grants, creating negative incentives to improve
capacity building in tax and revenue administration and financial management, especially if
growing Government funds and direct and indirect international donor support are non-coordinated.
The share of coordinated grant allocation under clearly defined programmes, i.e. by the
Town Development Fund, is decreasing further.
The following sections of this chapter describes the current situation of municipal finance
• revenue composition,
– tax and non-tax income (→ section 2.1.1)
– growth rates (→ section 2.1.2)
– tax inconsistencies (→ section 2.1.3)
• per capita revenue analysis (→ section 2.2)
• LDF and grant allocation (→ section 2.3)
Fiscal System
revenues, revenue allocation
and revenue sharing in a federal
state
Local Government Finance
Funding
growing Government funds
growing international donor
support
Urbanisation
exogenous and endogenous
growth of urban areas
cities as economic centres
of the regions

Municipal Finance at the crossroads 3
2.1 Revenue composition
Currently, municipalities in Nepal benefit from a large variety of revenue titles that are listed in the
respective law, the Local Self-Governance Act of 1989. Some of the revenue titles are not collected
by municipalities because their yields are very low. Revenues vary largely in terms of per capita (for
details, see MLD/gtz 2008).
Table 2: Revenue titles for municipalities
Revenue Title Short description
Taxes House and land tax Municipalities may levy house and land tax on each house and land
within their jurisdiction on the basis of the size, type, design, construction
and structure of the house and area covered by the house, as approved
by the Municipal Council.
Land revenue and
tax
Integrated property
tax
For the purpose of land revenue, land is divided into four categories, on
the basis of the productivity of land (Abal, Doyam, Seem and Chahar).
For the purpose of the Bhumi Kar, urban land is divided into six categories
on the basis of residential and commercial importance of land.
For the purpose of this tax, a municipality shall have to stratify its area
as per necessity, and a separate statement of integrated property of the
residents or such stratification of each ward shall be prepared in the
specified format. The value fixed by the municipality and the rate of the
tax fixed by the Municipal Council to be levied thereon shall have to be
published and the municipality shall have to send a bill. The tax must be
paid as per the bill by the concerned taxpayer to the municipality within
the same fiscal year. No land revenue and house and land tax is levied
on the property subject to the integrated property tax.
Entertainment tax Municipalities may levy entertainment tax at the rate of 2 to 5 percent of
entrance fees on the means of entertainment such as cinema halls,
video halls and cultural show halls. Similarly, municipalities can levy entertainment
tax on the circus and magic shows at the rate of Rs 200 to
Rs 500 per day.
Advertisement tax Municipalities can levy an advertisement tax at rates ranging from Rs
200 to Rs 1000 on signboards, globe boards, stall etc permitted to be
placed by roads, junctions, public places etc. under their jurisdiction.
Rent tax Municipalities are empowered to levy a rent tax on the amount of rent in
cases where any house, shop, garage, godown, stall, shed, factory,
land or pond is rented wholly or partly within their jurisdiction. The rent
tax may be levied at a rate not exceeding 2 percent of rent.
On the other hand, municipalities can also levy a tenancy tax on municipality-operated
shops or permission given to operate temporary shops
in public places, unregistered land (Aailani) or roadsides at the rate of
Rs 2 to Rs 20 per square feet.
Professional tax Municipalities are empowered to levy a professional tax on the specified
industry, trade, profession or occupation. Minimum and maximum rates
for each category of profession are fixed and the municipalities can fix
rates according to their local conditions within these limits.
Vehicle tax - registration,
renewal and
lump sum
Municipalities are authorized to levy an annual vehicle tax on the specified
vehicles within their areas of jurisdiction and a per entry tax on all
kinds of vehicles entering into their area.
Municipalities can also levy per entry tax on the use of the road constructed
by them or transferred to them from other organisations. Muni-

Municipal Finance at the crossroads 4
Service
Charges
Revenue Title Short description
Commercial video
tax
cipalities can levy registration tax on carts, riksha and tanga at rates
ranging from Rs 15 to Rs 50.
Municipalities may levy tax at the rate of Rs 200 to Rs 500 per annum
on per video, projector, cable etc used by any person or organization for
commercial purpose.
parking fee, electricity, water, public telephone fee, solid waste, sanitation, public lavatories,
park, bath room, swimming pool, gymnasium, guest house, tourist site, hostel, haat bazaar,
sewerage fee slaughter house, crematorium, valuation of real estate (fixed assets), use of
washing space, street light, road, drainage maintenance
Fees Approval and recommendation
fee
Commercial
activities
Approval of building
design fee
Attestation of maps
fee
Bahal (rent) Municipalities act as commercial entrepreneurs in developing sites rented
out to private natural or legal persons
Grant Unconditional grants are available for
Administrative Grant
Development Grant
Matching Grant
Resource Mobilisation Grant
Social Mobilisation Grant
Grant for Landfill Sites
Fire Fighting Vehicle Grant
Guest House Grant
Not all grants are available for all municipalities.
Loan Loans are available from the TDF especially for urban infrastructure
after Local Self-Governance Act 1989:113-115, Khadka 2003
In recent years, municipalities are also trying to generate income through large infrastructure projects
like bus parks and commercial centres. Commercial activities may play a growing role if funding
of municipalities is not adequate to their needs and might harm private sector investments or
even activities.

Municipal Finance at the crossroads 5
Figure 3: Municipal revenue composition in Nepal
3.500.000.000
3.000.000.000
2.500.000.000
2.000.000.000
1.500.000.000
1.000.000.000
500.000.000
0
FY91/92 FY93/93 FY93/94 FY94/95 FY94/96 FY96/97 FY97/98 FY98/99 FY99/00 FY00/01 FY01/02 FY02/03 FY03/04 FY04/05 FY05/06
Local Taxes
Fees and Fines
Property Rental
Loans
Grants
Other Income
Miscellenous Income
Other Revenues
Balance forw arded

Municipal Finance at the crossroads 6
Figure 4: Municipal tax revenue composition in Nepal
1.600.000.000
1.400.000.000
1.200.000.000
1.000.000.000
800.000.000
600.000.000
400.000.000
200.000.000
0
FY91/92 FY92/93 FY93/94 FY94/95 FY94/96 FY96/97 FY97/98 FY98/99 FY99/00 FY00/01 FY01/02 FY02/03 FY03/04 FY04/05 FY 05/06
Note: Until FY 99/00, some municipalities did not differ between revenues from octroi and vehicle tax.
Other Taxes
Tax Arrears
Unclaimed Land Tax
Sales Tax: Cattle/Fish
Local Market Tax
Contract Tax
House Rent Tax
Roof Top Tax
Professional Tax
Octroi and Vehicle Tax
Vehicle Tax
Octroi Tax

Municipal Finance at the crossroads 7
Figure 5: Municipal tax revenue composition in Nepal (excluding LDF and former octroi)
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
FY91/92 FY92/93 FY93/94 FY94/95 FY94/96 FY96/97 FY97/98 FY98/99 FY99/00 FY00/01 FY01/02 FY02/03 FY03/04 FY04/05 FY 05/06
Other Taxes
Tax Arrears
Unclaimed Land Tax
Sales Tax: Cattle/Fish
Local Market Tax
Contract Tax
House Rent Tax
Roof Top Tax
Professional Tax
Vehicle Tax

Municipal Finance at the crossroads 8
2.1.1 Revenue composition and trends
Municipalities in Nepal benefit from several sources of income:
• local taxes
• fees and fines
• property rental
• loans
• grants
• various income and revenue
• balance brought forward.
Revenues are increasing, but not constantly. The overall funds available to municipalities declined
from the fiscal year 2000/2001 to 2002/2003, and revenues in 2005/2006 were lower than in the
previous fiscal year 2004/2005 (see → figure 3, p. 5).
The following two sub-sections differ between
• tax revenues, including LDF
• non-tax revenues, including various income and revenue sources
(a) Tax revenue composition
The annual breakdown of municipal revenue and expenditure differs between the following revenue
titles (compare with the complete list of → revenue titles on p. 3)
• Local Development Fee (or former octroi)
• Vehicle Tax
• Octroi and Vehicle Tax (some municipalities did not differ between these revenue titles until fiscal
year 2000/2001)
• Professional Tax
• Roof Top Tax (or House and Land Tax, HALT, and Integrated Property Tax, IPT)
• House Rent Tax
• Contract Tax
• Local Market Tax
• Sales Tax: Cattle/Fish
• Unclaimed Land Tax
• Tax Arrears
• Other Taxes
Figure → 4 shows the composition of revenues in absolute terms for each year. In that figure included
are the revenues from octroi. Without octroi, the picture is very different 1 , especially since
the fiscal year 2000/2001:
Since the fiscal year 2001/2002 the composition of revenues has changed dramatically.
Land-based revenues, such as HALT, play a much larger role nowadays. The tax potential of landrelated
taxes has not yet been exploited, there are still many municipalities that have not implemented
the integrated property tax, and there are also options for further taxes, i.e. transfer taxes
on property.
The figure → 5 shows the same data, but excluding the former octroi and the later local development
fee (as well as mixed revenue titles like "vehicle tax and octroi"), and showing the relative per-
1 Please note that the figure excluded octroi as well as joint revenue titles, i.e. octroi and vehicle tax that
some municipalities combined until the fiscal year 2000/2001.

Municipal Finance at the crossroads 9
centage of tax revenue to the overall tax collection. Quite apparent is the sharp change of revenue
composition with beginning of the fiscal year 2000/2001. Key message since 2000/2001 is that
• property related taxes, i.e. IPT and HALT, are becoming the major original tax source for municipalities
- more than 50% on average since the fiscal year 2000/2001,
• the share of the professional tax remains rather stable - about 17% on average since the fiscal
year 2000/2001,
• the share of the vehicle tax is declining, about 12% on average since the fiscal year 2000/2001,
• while all other tax revenue titles contribute with less than 10% to the overall tax revenue of municipalities
(b) Non-tax revenue composition
Non-tax revenue include
• fees and fines
• property rental
• balance brought forward
• various income and revenue
• loans
• grants.
Municipalities cannot be blamed for overspending, in contrast, municipalities have considerable
amounts in their budgets that have been brought forward form the last fiscal year (see → figure 6,
p. 10). Most likely for balances brought forward are postponed or even not started capital expenditure
projects. Whereas there may be some explications for large amounts of balances brought forward
in the years of political instability and difficult local political decision-making, the share is still
rather large. The upcoming MCPM will therefore evaluate whether capital expenditure projects
have been completed in time to reduce these atypical revenue sources.
Income from
• fees and fines
• property rental
• various other income and revenues
have been rather stable in the last three years, while revenues from
• loans
• grants
• balance forwarded
showed a higher volatility.

Municipal Finance at the crossroads 10
Figure 6: Municipal revenue composition in Nepal as a share of annual total revenue
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
60,3%
4,3%
25,7%
54,6%
5,2%
28,7%
54,2%
7,6%
24,3%
64,7% 65,1%
5,8%
12,5%
6,8%
60,9%
7,5%
10,2% 10,2%
52,6%
14,5%
8,8%
49,3%
14,1%
10,6%
FY91/92 FY93/93 FY93/94 FY94/95 FY94/96 FY96/97 FY97/98 FY98/99 FY99/00 FY00/01 FY 01/02 FY 02/03 FY 03/04 FY 04/05 FY 05/06
49,2%
16,0%
6,2%
46,4%
14,0%
56,9% 56,7%
15,4%
10,6%
9,3% 8,6% 7,3%
47,9%
11,2%
14,5%
42,4%
22,2%
11,6%
45,1%
22,5%
6,6%
Local Taxes
Fees and Fines
Property Rental
Loans
Grants
Other Income
Miscellenous Income
Other Revenues
Balance forw arded

Municipal Finance at the crossroads 11
2.1.2 Growth rates of selected revenue titles
Growth rates range between minus 40% and plus 220%, indicating large volatility that cannot
be explained by dramatic changes of the revenue groups. Revenue collection capacity
might be dependent on political condition, expected revenues, and grant allocation.
Figure → 7 shows the growth rates of selected revenue titles:
• the tax growth rate shows the annual growth rate compared to the previous year from all local
taxes excluding octroi and the later LDF
• the LDF growth rate shows the annual growth rate compared to the previous year from octroi
(partially including the vehicle tax, see note) and the later LDF
• the own source revenue shows the annual growth rate compared to the previous year from all
own sources of revenue excluding LDF (and former octroi)
• the grant revenue growth rate shows the annual growth rate compared to the previous year from
government grants excluding LDF.
Quite apparent is the large volatility of Government grants allocated to municipalities. The small difference
between tax and LDF growth rate until the fiscal year 1999/2000 is mainly due to accounting
practice until that year: Many municipalities had only one revenue title for both revenues from
octroi and vehicle tax. Revenue from octroi and later LDF outweigh all other tax revenues in absolute
terms.
The only revenue that constantly improved over the last years were revenues from own sources
excluding the LDF.
Increases in Government grant allocation have a negative impact on growth rates of the other
revenue groups at least in the following fiscal year, if not already in the year the grant
was received. This indicated that tax capacity efforts will be less effective, i.e. taxpayer education
and performance improvement of revenue and tax departments if there are more "efficient" ways
for municipalities to receive funds with much lower transaction costs.
Figure → 8 shows the annual growth rates of selected tax revenues only. Revenues from the "roof
top tax" include HALT and IPT and volatility cannot be shown properly in this figure, because the
growth from fiscal year 2001/02 to 2002/2003 exceeded 1000%. What is apparent from that figure
is that growth rates are not correlating properly as this theory might suggest. This may be explained
by lower incentives for municipal tax administration to collect tax revenues with low yields.
Considerable lower loan approvals after the fiscal year 2000/2001 after a four year period of rather
stable and high income from loans led to an overall decline of funds available to municipalities in
the next fiscal year 2001/2002.
The decline was compensated only in the fiscal year 2004/2005, when considerable amounts in
grants were allocated to municipalities (see → figure 3, p. 5 and figure 7, p. 12).

Municipal Finance at the crossroads 12
Figure 7: Growth rates of selected municipal revenues to previous year
250,00%
200,00%
150,00%
100,00%
50,00%
0,00%
-50,00%
FY93/94 FY94/95 FY95/96 FY96/97 FY97/98 FY98/99 FY99/00 FY00/01 FY01/02 FY02/03 FY03/04 FY04/05 FY 05/06
Tax Grow th Rate
LDF Grow th Rate
Ow n Source Revenue Grow th Rate
Grant Grow th Rate

Municipal Finance at the crossroads 13
Figure 8: Growth rates of selected municipal revenues to previous year
200,00%
175,00%
150,00%
125,00%
100,00%
75,00%
50,00%
25,00%
0,00%
-25,00%
-50,00%
-75,00%
-100,00%
-125,00%
-150,00%
FY93/93 FY93/94 FY94/95 FY94/96 FY96/97 FY97/98 FY98/99 FY99/00 FY00/01 FY01/02 FY02/03 FY03/04 FY04/05 FY 05/06
Vehicle Tax
Professional Tax
Roof Top Tax
House Rent Tax
Contract Tax
Local Market Tax
Sales Tax: Cattle/Fish
Unclaimed Land Tax

Municipal Finance at the crossroads 14
2.1.3 Tax review reveals inconsistencies and potentials
There are still some revenue titles that are rather inconsistent with taxes that have been introduced
on central government level such as the value added tax.
• Sales tax is still existent on selected agricultural goods,
• as well as some specific services are taxed, although they are already taxed by other levels of
government
– like the contract tax and
– the entertainment tax,
– and local market taxes.
(a) Value added tax
The taxes levied by municipalities should fit into an overall sound taxation system. Value added tax,
or goods and services tax (GST), is tax on exchanges. It is levied on the added value that results
from each exchange. It differs from a sales tax because a sales tax is levied on the total value of
the exchange. For this reason, a value added tax is neutral with respect to the number of passages
that there are between the producer and the final consumer.
Value-added tax (VAT) system replaced sales tax regime in Nepal and a number of different taxes
were eliminated, among them Sales Tax, the Contract Tax, the Hotel Tax and the Entertainment
Tax. In order to implement these reforms, tax laws were drastically changed and three different departments
within the Ministry of Finance were all merged into one, Inland Revenue Department
(Dahal 2007).
(b) Land and property taxes
The history of the property tax started in 1962, when the first elected government in Nepal introduced
property tax. It had been applied in the major cities of Nepal adding one after another step
by step from 1962 to 1989, being replaced in 1990 by a property tax, and then again replaced by
the urban house and land tax in 1995/96. At that time tax used to be collected as central tax. After
the introduction of local self governance act in 1999, property tax was given to local bodies. Now
there are two forms of property tax:
• House and land tax and
• Unified property tax or integrated property tax (IPT)
For the purpose of house valuation, buildings are categorised into the four classes:
• Class A: Green (raw bricks) with mud mortar or made of wood (timber)
• Class B: Kiln bricks (stones) with mud mortar
• Class C: Kiln bricks (stones) with cement mortar.
• Class D: RCC frame structure.
The value of houses per square feet is fixed; for A class House currently Rs. 450, for B class
House Rs. 525, for C class House Rs. 575 and for D class House Rs. 625. Depreciation of Houses
can be subtracted. But its rate and years for respected houses are limited by act, which is as under
class A 3% over 25 years, class B 2% over 30 years, class C 1% over 70 years and for class D
0.75% over 100 years.
The experience with the IPT is limited so far, and there has been legislative interventions regarding
tax base, assessment and implementation. The coexistence of different taxation, HALT and IPT, is
confusing, and tax awareness campaigns should be aware that IPT might become later one important
part of local government taxation. Revenues from that tax, tax base as well tax rates have to be
increased to become an important revenue title for local government. In addition, there are other
opportunities, as they have been already discussed within gtz/udle such as a transfer tax to be col-

Municipal Finance at the crossroads 15
lected in case of property transfer based on the price of the property.
2.2 Per Capita Revenue
Per capita revenue is varying. → Figure 9, p. 16, shows the total revenue for 57 municipalities (excluding
Kathmandu) and the population for the fiscal year 20004/2005. The figure clearly shows
that
• the large majority of municipalities has less than 50,000 inhabitants,
• there is no clear correlation between number of inhabitants and total amount of funds
available.
In an unusual correlation, → figure 10 on page 17 shows the per capita revenue of 57 municipalities
excluding Kathmandu and the total revenue in a logarithmic grid.

Municipal Finance at the crossroads 16
Figure 9: Total revenue and total population in the fiscal year 2005/2006
Total Population
190000
170000
150000
130000
110000
90000
70000
50000
30000
MALANGAWA
DHANKUTA
TULSHIPUR
HETAUDA
PANAUTI
DASARATHCHAND
SIRAHA
MAHENDRANAGAR
NARAYAN
TRIYUGA
TRIBHUVANNAGAR
SIDDHARTHANAGAR
MADHYAPUR THIMI
LAHAN
JALESWOR
WALING KAMALAMAI
KAPILVASTU
BIRGUNJ
KHADBARI RAMGRAM
RAJBIRAJ LALITPUR DAMAK
PUTALIBAZAR GAUR POKHARA GULERIYA
ITAHARI
JANAKPUR TANSEN RATNANAGAR
BIDUR KIRTIPUR BANEPA TIKAPUR
NEPALGUNJ
DHARAN BIRATNAGAR
BAGLUNG
MECHINAGAR
DHANGADHI BHAKTAPUR
INARUWA
KALAIYA
BHADRAPUR
DIPAYAL-SILGADHI
DHULIKHEL
BHIMESHOR
BYAS
ILAM
PRITHABINARAYAN
LEKHANATH
BIRENDRANAGAR
BHARATPUR
10000
0 20000000 40000000 60000000 80000000 100000000 120000000 140000000 160000000
Total Revenue
BUTWAL

Municipal Finance at the crossroads 17
Figure 10: Per capita revenue and total population (excluding Kathmandu) in the fiscal year 2005/2006
population (logarithm)
1000000000
100000000
10000000
1000000
MAHENDRANAGAR
TRIYUGA
GULERIYA
DHANGADHI
DAMAK
JANAKPUR
BIRATNAGAR
LALITPUR
BHARATPUR
DHARAN BUTWAL
RATNANAGAR BIRENDRANAGAR
KAMALAMAI
TRIBHUVANNAGAR
BYAS
TIKAPUR
LAHAN PANAUTI BAGLUNG
TULSHIPUR
PRITHABINARAYAN
DIPAYAL-SILGADHI RAMGRAM
INARUWA
KHADBARI
PUTALIBAZAR
ILAM
BHIMESHOR
MALANGAWA
RAJBIRAJ
WALING
SIRAHA
DASARATHCHAND
KAPILVASTU
JALESWOR AMARGADHI
NARAYAN
POKHARA
NEPALGUNJ
TANSEN
GAUR
BIDUR
DHANKUTA
BHADRAPUR
BHAKTAPUR
200 2000
KALAIYA
HETAUDA
BIRGUNJ
SIDDHARTHANAGAR
MECHINAGAR ITAHARI
MADHYAPUR THIMI
LEKHANATH
scale from 200 NRS. per capita upwards (logarithm)
average per capita revenue Nrs. 761,60
in the fiscal year 2005/2006
regression (logarithm)
BANEPA
DHULIKHEL

Municipal Finance at the crossroads 18
2.3 Grant and LDF allocation
Several studies (see synopsis in Wang and Davis 2005) showed that local government expenditures
on highway, public safety, and utilities have positive relations with growth. Larger capital investments
face several problems:
• funding capacity and
• institutional capacity
Funding problems, because the overall revenue is in many municipalities just too small, despite
promising increases over the last years, to fund larger capital projects, especially multi-year capital
investments. In addition to the funding problems, many municipalities face institutional problems in
terms of limited knowledge in project design, preparation and feasibility, as well as later financial
management of assets and operations and maintenance of assets.
2.3.1 WTO accession requires abolition of local development fee
The local development fee is not a tax, nor it is a classical grant. However, the redistributive character
is more linked to classify the LDF as an unconditional grant rather than an own source tax
revenue for municipalities. There are, however, divergent opinions on the character of LDF. The
reasons why LDF is presented under the chapter of grants is the fact that there will be no single
local tax that can replace by volume the amount of funds collected by LDF.
→ Figure 4 (Municipal tax revenue composition in Nepal) clearly shows how important the former
octroi and the nowadays local development fee is. The Local Self Governance Act 1998 had abolished
the local transit tax called octroi and replaced it by the local development fee (LDF). For reasons
related to local development, health and education, including the need to generate fiscal revenue
earmarked to respond to critical local needs, the Local Development Fee of 1.5 per cent of the
value of imports had been set up.
The aggregated figures for the local development fee hide an important deficiency of the current
local development fee allocation. Like the former octroi, a municipal tax on imported and consumed
goods, the local development fee is not well allocated to all municipalities. For obvious reasons, tax
collection costs for collecting octroi in each and every jurisdiction was too complicated and
burdened importers.
The tax collection is now centralised and was transferred to customs, and revenues generated are
redistributed to municipalities on the basis of a three-year-average income from octroi before abolition.
Thus, the structural problem - the limited amount of beneficiaries, is still the same.
Nepal's accession to the World Trade Organisation WTO on April 23, 2004 and the preparatory
work resulted in Nepal's agreement to abolish the local development fee. Since then, however, no
discussion has started how to replace the LDF. Some areas of improvement have been identified,
mainly extensions of tax base for selected axes, and simplification of tax procedures and administration,
however, these potentials cannot replace in volume the amount of revenues that is being
collected by LDF.
2.3.2 Competing grants reduce capacity building efforts
The are not too many line ministries providing grants to municipalities. Nepal provides funds to municipalities
only via two ministries, the Ministry of Local Development (MLD) and the Ministry of
Physical Planning and Public Works (MPPW), which is the better choice compared to numerous
other countries, in which grant allocation is done separately and usually non-coordinated by each
and every line ministry.

Municipal Finance at the crossroads 19
Figure 11: Grants allocated to municipalities
800.000.000
700.000.000
600.000.000
500.000.000
400.000.000
300.000.000
200.000.000
100.000.000
0
FY91/92 FY93/93 FY93/94 FY94/95 FY94/96 FY96/97 FY97/98 FY98/99 FY99/00 FY00/01 FY01/02 FY02/03 FY03/04 FY04/05 FY 05/06
TDF Grant
Other Grants
Development Grant
Administrative Grant

Municipal Finance at the crossroads 20
However, the practice of grant allocation has been criticised for a rather long time. Main point of critique
is the arbitrary allocation, and the large number of competing funding opportunities. While
some grants have been administered by autonomous organisations like the Town Development
Fund under specific programs, such as matching grants or grants for municipalities that have fewer
funding opportunities from loans, some are given by MLD and MPPW. The policies, under which
grants are being allocated range from very low conditions (this is especially true for the Municipal
Reserve Fund, MRF administered by the Ministry of Local Development, MLD), to sector-specific
grants.
The competition of grants results in
• reduced likeliness that municipalities apply for loans, because alternative cheaper funds are
available,
• reduced likeliness that municipalities apply for grants if grants are conditional in terms of reporting,
feasibility studies or evaluation requirements,
• reduced likeliness to implement Government sectoral policies, if cheaper funds are available
Figure 12: Grants by type allocated to municipalities
Administrative Grant 35,7
Other DUDBC support 2,0
Municipal Reserve Fund 107,1
Figure 12 shows all type of grants excluding the large LDF, that accounted for almost one billion
NRs. in the last fiscal year. The grants listed here
• grants allocated to all municipalities (de facto unconditional)
– administrative grant (MLD)
– development grant (MLD)
• grants allocated only to selected municipalities (de facto conditional)
– TDF grants (matching grants distributed by TDF from MLD)
– RUPP grants (matching grants distributed by MLD)
– HRD grants (matching grants distributed by MLD)
– resource mobilisation grant
Municipal Planning 14,7
Development Grant 216,5
Land Pooling 4,6
Conservation Measures 1,2
Social Infrastructure 83,3
Government Buildings 4,9
Guest House Grant 4,2
Fire Fighting Vehicle Grant 13,0
Grant for Landfill Sites 5,0
Social Mobilisation Grant 12,0
Resource Mobilisation Grant 2,0
HRD Grant 2,0
RUPP Grants 12,0
TDF Grants 9,0

Municipal Finance at the crossroads 21
– social mobilisation grant
– landfill site grant
– fire fighting vehicle grant
– guest house grant
– government buildings (DUDBC of MPPW)
– social infrastructure (DUDBC of MPPW)
– conservation measures (DUDBC of MPPW)
– land pooling (DUDBC of MPPW)
– municipal planning (DUDBC of MPPW)
– other sources (DUDBC of MPPW)
• discretionary funds
– municipal reserve fund (MLD)
• international donor support
• local development fee (which is de facto not a grant, but a shared tax)
This listing clearly shows that there are too many grants and only few grants that are distributed to
all municipalities. In addition, the total amount of funds of the municipal reserve fund is somewhat
too large compared to the other funds available.
It should be mentioned that the road board of Nepal also funds road construction and maintenance.
Municipalities, however, cannot influence amount and schedules of road works, therefore, these
funds cannot be classified as grants.
To summarise:
• there are too many grants
• there are too many funds from additional grants like the municipal reserve fund with unclear
conditions, resulting in non-intended grant selection by municipalities,
• fewer dedicated grants have been allocated to municipalities in recent years by specialised
institutions such as the Town Development Fund.
• there is a need to redesign the grant system, but given the phasing-out of the LDF, a new
grant system must include a concept of tax sharing to compensate for the loss of income
3 Policy recommendations for gtz/udle in
promoting local government finance in Nepal
This chapter summarises key policy recommendations gtz/udle should follow to achieve objectives
in the area of local government finance. Local government finance comprises
• own sources of revenue versus allocated funds from regional entities or central government,
• taxes versus non-tax revenues
Sub sections are on:
• local government finance,
• intergovernmental fiscal transfers, including grant formula, and
• accounting policies and management.

Policy recommendations for gtz/udle in promoting local government finance in Nepal 22
3.1 Local government finance
gtz/udle should focus on designing a framework of local government finance before addressing
single revenue titles.
Local government revenues - tax and non-tax revenues, own sources and allocated funds - need to
be designed before individual revenue titles should be considered. Activities should include:
• optimal revenue composition for local governments in a federal state,
• optimal local taxes for local government in Nepal, thereby taking into account
– municipalities as well as
– village district councils as smallest local government unit
• optimal non-tax income for local government in Nepal, thereby taking into account
– income from commercial activities
– fees for services guaranteed or delivered by local governments
Regarding the tax assignment among different tiers of government, international experience suggests
that some taxes are better suited for local governments than others. International lessons
provide a number of economic rationales of taxation in a federal setting (McLure 1983 and Terminassian
1997). Maintaining efficiency is often emphasized for the assignment of local taxes. This
is because decentralizing tax systems can often interfere with the efficiency of nationwide economic
integration. Commonly emphasized criteria are as follows:
• Local taxes should be independent from national policy goals such as income redistribution objectives
and economic stability.
• The local tax base should exhibit low mobility between jurisdictions.
• Benefit taxes and user charges are appropriate to local taxes.
In addition to the aforementioned efficiency criteria, economic principles, such as national equity,
administrative costs, and fiscal needs are important for developing countries (Boadway, Roberts,
and Shah 1994). Thus,
• Sub-national engagement in perverse redistributive policies, using both taxes and transfers,
should be restrained.
• Rules to allocate tax revenue among jurisdictions, restricting tax evasion and avoidance, will be
required.
• Revenue means should be matched as closely as possible to revenue needs.
Figure 13: Design principles of local taxation
Local Authorities Citizens and Residents Businesses
Local revenues need to be adequate
to meet the cost of the services
and infrastructure they are intended
to finance.
Local revenues need to be buoyant
(the tax base should grow automatically
when prices rise, population
grows or the economy expands)
to meet expanding demands
for service delivery. Revenue
collections need to be stable
and predictable to facilitate planning
and budgeting.
Collection and administration costs
The framework for local taxation
needs to be simple, transparent
and easy to understand.
The local tax system needs to be
fair and equitable in both design
and administration.
• Everyone should pay
something.
• The tax burden should be proportionate
to ability to pay (vertical
equity).
• Taxes should be applied consistently
for individuals at the
The local tax system needs to be
fair and equitable in both design
and administration.
• All enterprises pay something.
• Similarly situated businesses
pay similar taxes.
Local taxes need to support a conducive
business environment.
• Taxes should not distort economic
activity (efficiency).
• Taxes should minimize barriers

Policy recommendations for gtz/udle in promoting local government finance in Nepal 23
Local Authorities Citizens and Residents Businesses
need to be minimized. same income level (horizontal
equity).
Local revenue autonomy and flexibility
need to be reinforced.
Tax instruments need to be politically
acceptable.
• Intensive users of municipal services
should pay more (benefits
principle).
Local revenues should enhance
accountability and strengthen the
social contract at the local level.
Local taxes need to be linked to
services provided.
Compliance costs for taxpayers
need to be minimized.
to enterprise development, especially
for small and mediumsize
enterprises.
Local taxes need to be linked to
services provided.
Compliance costs for taxpayers
need to be minimized.
after Sarzin 2007
A crucial suggestion which derives from the literature is that local taxation may play an important
role in curbing expectations of soft budget constraints. The threat by the central government not to
intervene ex post to solve local governments’ problems may simply be not credible ex ante, if the
local government has no sufficient resources of its own to take care of unpredictable events. And
as local expenditure tend to be fixed in the short run, these extra resources can only come from
local taxation. Interestingly, there is some robust empirical evidence (Rodden 2002, 2006), based
on both interregional and inter-countries comparison, which suggests that local governments which
are mostly financed by own resources tend to be less prone to soft budget constraints problems.
gtz/udle has already started to think about new income sources for local government, among them:
• property transfer tax
a tax on property sale by natural and legal persons based on the price of the property
• integrated property tax
further broadening of tax base and reducing complexity of tax. It is a widely assumption that
property taxes are "best" for local government, but tax management and tax assessment usually
burdens institutional capacity of local government very much.
• supplementary charge on central government taxes
This approach is being widely used in highly decentralised unitary states such as Scandinavian
countries on PIT and corporate income taxes. gtz/udle should evaluate the impacts of supplementary
charges on PIT and how to extend the PIT tax base.
3.2 Intergovernmental fiscal transfers
gtz/udle should first focus on the general design of intergovernmental fiscal transfers to be
established within the new federal system, and develop transition plans. Then, a redesigned
grant system with a replaced LDF should be developed.
There is little benefit in redesigning the current formula, which is not used anyway. It is apparent
that the LDF allocation criteria are misleading and that there is a need for revision. However, this
discussion should be closely linked with alternatives to the replacement of LDF. There is no single
other revenue title that is likely to replace the gross amount that is being allocated to municipalities,
therefore tax sharing arrangements as well as fund allocation needs to be addressed first. This is to
avoid a typical situation in a number of federal states, in which the most profitable revenue sources
have been allocated to central government and the regions, whereby local governments do have
limited access to own sources of revenue.

Policy recommendations for gtz/udle in promoting local government finance in Nepal 24
Tax sharing arrangements might include
• VAT
• income tax
whereby also other alternatives are feasible (such as local or regional supplements to centrally collected
taxes such as income tax on individuals and corporations)
3.3 Accounting and financial management practice
gtz/udle should further support local government in establishing a sound, international accepted
accounting system based on International Public Sector Accounting Standards.
Thereafter, individual support should be given to local government in developing good and best
practice in asset management, especially operations and maintenance.
Most of local governments in Nepal have accounting systems that are not capable to meet today's
requirements, and it is assumed that there are growing differences between public and private sector
accounting policies and practices. The poor standards in public sector accounting do have multiple
consequences, most obvious in the area of auditing and accountability. The gtz/udle has
already stared some years ago some project initiatives in the area of public sector accounting. It is
recommended that
• in co-operation with national chartered institutes of accounting and by taking into account the international
public sector accounting standards uniform framework for accounting (first product:
standardised chart of accounts) should be developed.
• gtz/udle devloped appropriate accounts for managing assets, especially infrastructure assets,
to support proper management of income and expenditure of revenue and non-revenue generating
assets.

References 25
4 References
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Policy Research Working Paper 1385, World Bank
Dahal , Chet Nath (2007): Tax Auditing System in Nepal: Comprehensive Analysis of Tax Auditing System in
Nepal, Kathmandu
Gold, Ronald B. and Edward Foster (1972): Measuring Equity in the Taxation of Agricultural Land: A Case
Study of Nepal, in: Land Economics, 48(1972)3, pp. 277-280
Gordon, Roger H. (1983): An Optimal Taxation Approach to Fiscal Federalism; in: The Quarterly Journal of
Economics, 98(1983)4, pp. 567-586
Khadka, Rup (2002): Existing structure of municipal taxes, in: The Kathmandu Post, March 21, 2002
McLure, Jr. C. E. (ed.) (1983) Tax assignment in federal countries, Centre for Research on Federal Financial
Relations, Australian National University, in association with the International Seminar in Public
Economics
Ministry of Local Development and GTZ/udle (2006): Detailed Revenue and Expenditure Breakdown with
Budget and Key Financial Indicators of 58 Municipalities (FY 2000/2001-FY 2004/2005), Kathmandu
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6(1993)3, p. 199-214
Rodden, J. A. (2002) The dilemma of fiscal federalism: grants and fiscal performance around the world, American
Journal of Political Science, 46, pp. 670-87
Rodden, J. A., (2006) Hamilton’s Paradox: The promise and peril of Fiscal federalism, New York, Cambridge
University Press
Sarzin, Zara (2007): Local government revenue policies and their impacts: a model for Tanzania and Uganda,
http://siteresources.worldbank.org/INTPSIA/Resources/490023-
1120841262639/psia_tanzania_uganda.pdf
Ter-Minassian, T. (1997) Fiscal Federalism in Theory and Practice, International Monetary Fund
Thapa, Ram Bahadur (2004): Financial Resource Mobilization in Pokhara Sub-Municipal Corporation; in: The
Journal of Nepalese Business Studies 1(2004)1, pp. 81-84
Wang, Lu and Otto A. Davis (2005): The Composition of State and Local Government Expenditures and Economic
Growth, http://www.pubchoicesoc.org/papers2005/Wang_Davis.pdf
World Trade Organisation (2003): Report of the working party on the accession of the Kingdom of Nepal to the
World Trade Organization, Report WT/ACC/NPL/16
Sharma, Kishor (1997): Impact of Policy Reforms on Manufacturing Growth in Nepal, in: Asian Survey,
37(1997)6, pp. 550-560