GTZ Report on Future Nepal Municipal Finance

Urban Development through Local Efforts Programme

A joint programme of the Ministry of Local Development (MLD) andthe German Technical Cooperation (GTZ)

Local government finance in Nepal

Current situation, challenges and future policy

June 2008

2

Report submitted by Dr Alexander Wegener,

interpublic consultancy,

[email protected]

on behalf of GTZ for GTZ/udle

mailto:[email protected]

iii

Table of Content

1 Introduction: What this document is about...........................................1

2 Municipal Finance at the crossroads.....................................................1

2.1 Revenue composition...........................................................................................32.1.1 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...................................................112.1.3 Tax review reveals inconsistencies and potentials..................................14

(a) Value added tax.................................................................................14(b) Land and property taxes....................................................................14

2.2 Per Capita Revenue............................................................................................152.3 Grant and LDF allocation....................................................................................18

2.3.1 WTO accession requires abolition of local development fee..................182.3.2 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...................................................................................223.2 Intergovernmental fiscal transfers.......................................................................233.3 Accounting and financial management practice.................................................24

4 References..............................................................................................25

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List of TablesFigure 1: Factors influencing the situation of local government finance in Nepal.............2Table 2: Revenue titles for municipalities..........................................................................3Figure 3: Municipal revenue composition in Nepal............................................................5Figure 4: Municipal tax revenue composition in Nepal......................................................6Figure 5: Municipal tax revenue composition in Nepal (excluding LDF and former octroi)

.............................................................................................................................7Figure 6: Municipal revenue composition in Nepal as a share of annual total revenue..10Figure 7: Growth rates of selected municipal revenues to previous year.......................12Figure 8: Growth rates of selected municipal revenues to previous year.......................13Figure 9: Total revenue and total population in the fiscal year 2005/2006......................16Figure 10: Per capita revenue and total population (excluding Kathmandu) in the fiscal

year 2005/2006..................................................................................................17Figure 11: Grants allocated to municipalities...................................................................19Figure 12: Grants by type allocated to municipalities......................................................20Figure 13: Design principles of local taxation..................................................................22

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interpublic berlinDr. Alexander Wegener

interpublic berlin Wegener & Wegener GbRSundgauer Straße 100

D-14169 Berlin (Zehlendorf)Tel.: (030) 939 555 90Fax: (030) 939 555 [email protected]

mailto:[email protected]

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 op-portunities to design a political system that fits most the ethnic diversity and the urgent need of so-cial 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 adminis-trative system, and the design of the judiciary systemThis 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 ma-jor strategic decisions have to be taken, and they are embedded within the current political de-cision-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

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 repres-ents 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-coordin-ated. 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)

Local Government Finance

Political System

Status of local government in afederal state

VDCs and municipalitiesFiscal System

revenues, revenue allocationand revenue sharing in a federal

state

Urbanisation

exogenous and endogenousgrowth of urban areas

cities as economic centresof the regions

Globalisation

Abolition requirement of LDFby WTO

growing international economicacitivity in Nepal

Funding

growing Government fundsgrowing international donor

support


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, construc-tion and structure of the house and area covered by the house, as ap-proved by the Municipal Council.

Land revenue and 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 categor-ies on the basis of residential and commercial importance of land.

Integrated property tax

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 en-tertainment 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 muni-cipality-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 - regis-tration, renewal and lump sum

Municipalities are authorized to levy an annual vehicle tax on the spe-cified 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 con-structed by them or transferred to them from other organisations. Muni-


Revenue Title Short description

cipalities can levy registration tax on carts, riksha and tanga at rates ranging from Rs 15 to Rs 50.

Commercial video tax

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.

Service Charges

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 re-commendation fee

Approval of building design fee

Attestation of maps fee

Commercial activities

Bahal (rent) Municipalities act as commercial entrepreneurs in developing sites ren-ted out to private natural or legal persons

Grant Unconditional grants are available forAdministrative GrantDevelopment GrantMatching GrantResource Mobilisation GrantSocial Mobilisation GrantGrant for Landfill SitesFire Fighting Vehicle GrantGuest House GrantNot 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 pro-jects like bus parks and commercial centres. Commercial activities may play a growing role if fund-ing of municipalities is not adequate to their needs and might harm private sector investments or even activities.


Figure 3: Municipal revenue composition in Nepal

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 FY05/060

500.000.000

1.000.000.000

1.500.000.000

2.000.000.000

2.500.000.000

3.000.000.000

3.500.000.000

Local TaxesFees and FinesProperty RentalLoansGrantsOther IncomeMiscellenous IncomeOther RevenuesBalance forw arded


Figure 4: Municipal tax revenue composition in Nepal

Note: Until FY 99/00, some municipalities did not differ between revenues from octroi and vehicle tax.

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 05/060

200.000.000

400.000.000

600.000.000

800.000.000

1.000.000.000

1.200.000.000

1.400.000.000

1.600.000.000

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


Figure 5: Municipal tax revenue composition in Nepal (excluding LDF and former octroi)

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 05/060%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

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


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 in-cluded are the revenues from octroi. Without octroi, the picture is very different1, 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 land-related taxes has not yet been exploited, there are still many municipalities that have not imple-mented 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 develop-ment 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.


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 muni-

cipalities - 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 muni-

cipalities

(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 expendit-ure projects. Whereas there may be some explications for large amounts of balances brought for-ward 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.


Figure 6: Municipal revenue composition in Nepal as a share of annual total revenue

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 05/060%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

25,7%28,7%

24,3%

12,5%10,2% 10,2% 8,8% 10,6%

6,2%9,3% 8,6% 7,3%

14,5%11,6%

6,6%

4,3%

5,2%

7,6%

5,8%6,8%

7,5% 14,5%

14,1%

16,0%14,0%

15,4%

10,6%

11,2%22,2%

22,5%

60,3%

54,6% 54,2%

64,7% 65,1%60,9%

52,6%49,3% 49,2%

46,4%

56,9% 56,7%

47,9%

42,4%45,1%

Local TaxesFees and FinesProperty RentalLoansGrantsOther IncomeMiscellenous IncomeOther RevenuesBalance forw arded


2.1.2 Growth rates of selected revenue titles

Growth rates range between minus 40% and plus 220%, indicating large volatility that can-not 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 dif-ference between tax and LDF growth rate until the fiscal year 1999/2000 is mainly due to account-ing 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 abso-lute 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 oth-er 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 ex-plained 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).


Figure 7: Growth rates of selected municipal revenues to previous year

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 05/06-50,00%

0,00%

50,00%

100,00%

150,00%

200,00%

250,00%

Tax Grow th RateLDF Grow th RateOw n Source Revenue Grow th RateGrant Grow th Rate


Figure 8: Growth rates of selected municipal revenues to previous year

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 05/06-150,00%

-125,00%

-100,00%

-75,00%

-50,00%

-25,00%

0,00%

25,00%

50,00%

75,00%

100,00%

125,00%

150,00%

175,00%

200,00%

Vehicle Tax Professional Tax Roof Top Tax House Rent Tax Contract Tax Local Market Tax Sales Tax: Cattle/Fish Unclaimed Land Tax


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 de-partments 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 intro-duced 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 import-ant 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-


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 (ex-cluding 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 municipalit-ies excluding Kathmandu and the total revenue in a logarithmic grid.

0 20000000 40000000 60000000 80000000 100000000 120000000 140000000 16000000010000

30000

50000

70000

90000

110000

130000

150000

170000

190000

BAGLUNGBANEPA

BHADRAPURBHAKTAPUR

BHARATPUR

BHIMESHOR

BIDUR BIRATNAGAR

BIRENDRANAGAR

BIRGUNJ

BUTWAL

BYAS

DAMAK

DASARATHCHAND

DHANGADHI

DHANKUTA

DHARAN

DHULIKHEL

DIPAYAL-SILGADHI

GAUR GULERIYA

HETAUDA

ILAM

INARUWA

ITAHARI

JALESWOR

JANAKPUR

KALAIYA

KAMALAMAIKAPILVASTU

KHADBARI

KIRTIPUR

LAHAN

LALITPUR

LEKHANATH

MADHYAPUR THIMI

MAHENDRANAGAR

MALANGAWA

MECHINAGAR

NARAYAN

NEPALGUNJ

PANAUTI

POKHARA

PRITHABINARAYAN

PUTALIBAZARRAJBIRAJ

RAMGRAM

RATNANAGAR

SIDDHARTHANAGAR

SIRAHA

TANSEN TIKAPUR

TRIBHUVANNAGAR

TRIYUGA

TULSHIPUR

WALING

Total Revenue

Tota

l Pop

ulat

ion


Figure 9: Total revenue and total population in the fiscal year 2005/2006

200 20001000000

10000000

100000000

1000000000

AMARGADHI

BAGLUNG

BANEPA

BHADRAPUR

BHAKTAPUR

BHARATPUR

BHIMESHOR

BIDUR

BIRATNAGAR

BIRENDRANAGAR

BIRGUNJ

BUTWAL

BYAS

DAMAK

DASARATHCHAND

DHANGADHIDHANKUTA

DHARAN

DHULIKHEL

DIPAYAL-SILGADHI

GAUR

GULERIYA

HETAUDA

ILAMINARUWA

ITAHARI

JALESWOR

JANAKPUR

KALAIYA

KAMALAMAI

KAPILVASTU

KHADBARILAHAN

LALITPUR

LEKHANATH

MADHYAPUR THIMI

MAHENDRANAGAR

MALANGAWA

MECHINAGAR

NARAYAN

NEPALGUNJ

PANAUTI

POKHARA

PRITHABINARAYAN

PUTALIBAZARRAJBIRAJ

RAMGRAM

RATNANAGAR

SIDDHARTHANAGAR

SIRAHA

TANSEN

TIKAPURTRIBHUVANNAGAR

TRIYUGA TULSHIPUR

WALING


Figure 10: Per capita revenue and total population (excluding Kathmandu) in the fiscal year 2005/2006

scale from 200 NRS. per capita upwards (logarithm)

average per capita revenue Nrs. 761,60in the fiscal year 2005/2006

regression (logarithm)

popu

latio

n (lo

garit

hm)


2.3 Grant and LDF allocation

Several studies (see synopsis in Wang and Davis 2005) showed that local government expendit-ures on highway, public safety, and utilities have positive relations with growth. Larger capital in-vestments 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 char-acter 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 abol-ished the local transit tax called octroi and replaced it by the local development fee (LDF). For reas-ons related to local development, health and education, including the need to generate fiscal reven-ue 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 aboli-tion. 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 adminis-tration, 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 mu-nicipalities 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.


Figure 11: Grants allocated to municipalities

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 05/060

100.000.000

200.000.000

300.000.000

400.000.000

500.000.000

600.000.000

700.000.000

800.000.000

TDF GrantOther GrantsDevelopment GrantAdministrative Grant


However, the practice of grant allocation has been criticised for a rather long time. Main point of cri-tique 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 report-

ing, 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

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 Reserve Fund 107,1

Administrative Grant 35,7

Development Grant 216,5

TDF Grants 9,0

RUPP Grants 12,0HRD Grant 2,0Resource Mobilisation Grant 2,0Social Mobilisation Grant 12,0Grant for Landfill Sites 5,0

Fire Fighting Vehicle Grant 13,0

Guest House Grant 4,2

Government Buildings 4,9

Social Infrastructure 83,3

Conservation Measures 1,2Land Pooling 4,6Municipal Planning 14,7Other DUDBC support 2,0


– 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 ad-dressing 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 sug-gests 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 Ter-minassian 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 econom-ic integration. Commonly emphasized criteria are as follows: • Local taxes should be independent from national policy goals such as income redistribution ob-

jectives 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 ad-equate to meet the cost of the ser-vices and infrastructure they are in-tended to finance.

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.

Local revenues need to be buoyant (the tax base should grow auto-matically when prices rise, popula-tion grows or the economy ex-pands) to meet expanding de-mands for service delivery. Reven-ue collections need to be stable and predictable to facilitate plan-ning and budgeting. Collection and administration costs

The local tax system needs to be fair and equitable in both design and administration. • Everyone should pay

something. • The tax burden should be pro-

portionate to ability to pay (ver-tical equity).

• Taxes should be applied con-sistently for individuals at the

• All enterprises pay something. • Similarly situated businesses

pay similar taxes.

Local taxes need to support a con-ducive business environment. • Taxes should not distort eco-

nomic activity (efficiency). • Taxes should minimize barriers


Local Authorities Citizens and Residents Businesses

need to be minimized. same income level (horizontal equity).

• Intensive users of municipal ser-vices should pay more (benefits principle).

Local revenues should enhance accountability and strengthen the social contract at the local level.

to enterprise development, es-pecially for small and medium-size enterprises.

Local revenue autonomy and flex-ibility need to be reinforced.

Local taxes need to be linked to services provided.

Local taxes need to be linked to services provided.

Tax instruments need to be politic-ally acceptable.

Compliance costs for taxpayers need to be minimized.

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 taxesThis 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 supple-mentary 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.


Tax sharing arrangements might include• VAT• income tax

whereby also other alternatives are feasible (such as local or regional supplements to centrally col-lected 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 ac-cepted 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 sec-tor accounting policies and practices. The poor standards in public sector accounting do have mul-tiple 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 in-

ternational 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 generat-ing assets.

References 25

4 References

Boadway, R., S. Roberts, A. Shah (1994) Fiscal Federalism Dimensions of Tax Reform in Developing Coun-tries, 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, 2002McLure, 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), Kath-mandu

Ray, Ranian (1993): Optimal demogrants and taxes in a federal welfare state; in: Journal of Population Eco-nomics, 6(1993)3, p. 199-214

Rodden, J. A. (2002) The dilemma of fiscal federalism: grants and fiscal performance around the world, Amer-ican 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. 81-84Wang, Lu and Otto A. Davis (2005): The Composition of State and Local Government Expenditures and Eco-

nomic Growth, http://www.pubchoicesoc.org/papers2005/Wang_Davis.pdfWorld 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/16Sharma, Kishor (1997): Impact of Policy Reforms on Manufacturing Growth in Nepal, in: Asian Survey,

37(1997)6, pp. 550-560

Documents

GTZ Report on Future Nepal Municipal Finance