IMPACTOFFISCALDECENTRALIZATIONONECONOMICGROWTHOFNEPAL

KhimLalDevkota1PreliminaryDraft:Commentsarewelcomeat:

devkotak@lgcdp.gov.np,devkotak@gmail.com

ABSTRACT

ThispaperanalyzestheimpactoffiscaldecentralizationonGDPpercapitainNepalusingan

ordinary leastsquare(OLS)modelovertheperiod19952009.Theempiricalfindingssuggest

thatfiscaldecentralizationhasapositivesignificantimpactonGDPpercapita.Inadditionto

theempiricalanalysis, the literatures relate toNepal,also illustrate the influencesof fiscal

decentralization to the local planning, infrastructure developments, resource mobilization,

servicedelivery,publichearing,auditingandgoodgovernance. Nodoubt,thesearethekey

variables foroverall localeconomicdevelopment.Finally,throughthemultiplierprocedures,

the fiscaldecentralizationaffects the country'sGDPper capitaand economicdevelopment

whichissupportedbyanempiricaltestaswell.

Keywords:fiscaldecentralization,GDPpercapita,Measurement,ordinaryleastsquare.

INTRODUCTION

Situated in the lap of the Himalaya, Nepal is a landlocked country, tucked between two

economicpowersofAsia,namelyChinaand India. Ithasapopulationof28millionand its

GDPgrowthrateis3%.ThepercapitaGDPofNepalis536USdollarandGDPisonly15billion

dollar(IMF2010).

MostoftheeconomicactivityinNepalisinagriculturewiththesectorcomprising33percent

oftheGDP.Manufacturing is6.25percent,electricityandwatercomprise1.49percentand

miningislessthan1percentofGDP(MOF2009/10).

1 Mr Devkota is working for the Local Governance and Community Development Programme (LGCDP), Ministry of LocalDevelopment ( MLD) as a fiscal decentralization and public finance management specialist. The empirical analysis andobservationsofthepaperisauthorspersonalwhichdonotnecessarilyreflecttheviewsofLGCDP/MLD.

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Fiscaldecentralization,ordevolvingtherevenuesourcesandexpenditurefunctionstolower

tiersofgovernment, isseenaspartofareformpackageto improveefficiency inthepublic

sector,toincreasecompetitionamonglocalgovernmentsindeliveringthepublicservices.By

bringing the government closer to the people, fiscal decentralization is expected to boost

public sectorefficiency, aswell as accountability and transparency inpolicymaking. Ithas

become a clear trend in government reform in both developed and developing countries

includingtheNepal.

ThecasestudyofNepal isvery interestingfortestingwhetherfiscaldecentralization indeed

leadstoimprovedproductionoflocalpublicgoodsandservices.Actually,theGovernmentof

Nepal(GON)iscommittedfortheeffectiveimplementationoffiscaldecentralizationsystem.

Everyyear thegovernmenthas increased thevolumeof fiscal transfers to the localbodies.

Increasedfiscaltransferstothe localbodieshasprovidedanopportunitytostrengthenand

improvethequalityof local infrastructure,servicedelivery,andempoweredthecommunity

(LGCDP2008).

As with most developing countries, Nepal has an extremely centralized system of public

finance.Thecentralgovernmentcurrentlyplaysthedominantroleinvirtuallyallexpenditure

and revenue decisions. The central government is responsible for macroeconomic

stabilization and distribution, and shoulders themajor allocation functions of government

(Kelly, 1999). Kelly's 10 years earlier statement is still valid. The local bodies are heavily

dependentonthecentralgrant.Outoftotalrevenue,theshareofownsourcerevenueisonly

30percent(LBFC2010)andfiscaldecentralizationindexcomparingtoGDPisverylow,just

aroundonepercent(Devkota2010,Subedi2010).

Nepal isoneof the fastestmovers in theHumanDevelopment Index (HDI)since1970.The

gapbetweenNepal'slifeexpectancyandtheworldaveragehasnarrowedby87percentover

thepast40years.Remarkablereduction in infantmortalityreflectsmoregeneralsuccess in

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healthfollowingtheextensionofprimaryhealthcarethroughcommunityparticipation, local

mobilizationofresourcesanddecentralization(UNDP2010).

ThequestionofwhetherthefiscaldecentralizationhascontributedtoNepal'seconomicgrowth

and development over the past couple of years is however, open to debate. If fiscal

decentralization influences the economic growth and development directly or indirectly (the

latter through the local economic development process), then the policy makers need to be

awareof these relationshipwhen formulating and implementing fiscaldecentralizationpolicy.

Therefore,theimpactoffiscaldecentralizationoneconomicgrowthanddevelopmentofNepalis

the central focus of this research which would address the evolving patterns of fiscal

decentralizationinNepal.ItwouldbebasedonGDPpercapitawhichhasbeentestedbyapplying

asimpleOrdinaryLeastSquare(OLS)model.

On this background, to ascertain a clearer picture concerning fiscal decentralization and

economic growth of Nepal, this paper begins with a literature review regarding fiscal

decentralizationand localeconomicdevelopmentofNepal. Thiswillbefollowedby literatures

andresearchonstudiesaboutfiscaldecentralizationandeconomicgrowthanddevelopmentas

wellascurrenttrends fromthe internationalperspective.The latterpartofthispaperexplains

themethodologyandtheempiricalresultsfollowedbytheconclusion.

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A BRIEF REVIEW OF FISCAL DECENTRALIZATION AND ITS IMPACT ON LOCAL ECONOMIC

DEVELOPMENT

Actually,thedecentralizationofgovernanceinNepalbeganin1960s.Sincethentheprocess

hasundergone significant changesover time.Post1990speriodmaybe consideredas the

landmark in the development of decentralization process in the country. Various reform

measureswereinitiatedtostrengthentheprocessofdecentralizationinthecountry.Amore

systematicattemptwithalegalbasewasfollowedsince1999afterthecirculationofLSGA.In

thedecentralizationhistoryofNepal,thepromulgationofLSGA,1999wasamilestone(LBFC

2005).

Thedecadeof1990'swasconsideredalandmarkinfurtheringtheprocessofDecentralization

in Nepal. The Constitution of Nepal, 1990 had adopted decentralization as the directive

principleof the stateandprovidesabroad frameworkof the systemofgovernanceof the

country(Subedi2009).

The local bodies have been conceived as institutional entities subservient to central

ministries, in most cases carrying out implementation of centrally laid out plans and

programs. A number of responsibilities have been assigned to local bodies. Key functions

includeeducation,health,waterandsanitation,ruralroads,agricultureextensionandsmall

infrastructuredevelopment. In somecases, localbodiesareallowed todevelop small scale

hydroelectricitygenerationplants.Theassignmentoffunctionsatall levels issymmetric.No

distinction is there between rural or urban local bodies. The assignment to DDC and the

secondtierlocalbodieshasthesamesubjects.

Until2005,severalstudieswerecarriedout to recommendmeasures for thesuccessful

implementation of the fiscal decentralization system in Nepal (LBFC 2000, 2004, 2005;

Shrestha2003;Zimmermann,Horst1996).Thesestudieshavepointedoutseveralproblems

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thatinclude:(i)uncleardivisionoftasksacrosslevelsofgovernmentandbetweentheLB;(ii)

overlappingfunctionsbetweenlocalbodiesandcenteragencies;(iii)contradictioninthelegal

frameworkbetweentheLSGAandthesector laws;(iv)poorrevenueassignment;(v) lackof

clarityonLBrevenuebases,revenuepotentialandrevenuesharingsystembetweenlayersof

government and between LBs; (vi) mismatch between expenditure responsibilities and

revenuepowersandfiscalcapacity;(vii)weakincentiveorstructureforfiscalautonomy(vii)

unclearexpenditureneedsandfinancialimpactofthetransferoftasksdevolvedtoLBs;and

(viii)poormechanismtoenforceaccountability.

ThepoliticalbasisofgovernanceinNepalatthemomentrestsontheInterimConstitutionof

Nepal 2007 which, among other things, incorporates several references to the local

governmentsystem.Theobjectiveoflocalgovernment,asstatedintheInterimConstitution,

is toavail servicesat the local leveland toattaininstitutionaldevelopmentofdemocracy

from the very lowest level. The constitution further stated ,the position of local self

governance related authorities shallbemadebasedondecentralization anddevolutionof

authority inorder topromote theparticipationofpeople to themaximumpossible in the

systemof governanceof the countryby creating suchenvironment as is conducive to the

exerciseofsovereigntybythepeopleevenfromthelocallevel,deliverservicestothepeople

atthelocallevelandhaveinstitutionaldevelopmentofdemocracyevenfromthelocallevel.

Further, the document of ThreeYear Interim Plan (2010/11 2012/13) has specified

decentralizationasamainmeansofenhancinggoodgovernance,aprocessofadministrative,

political,social,andeconomicanddevelopmentworks,andastrategyforpromotingpeoples

participationandpeoplesempowerment.

As pointed by Lama ( 2009), fiscal decentralization also enhances the socioeconomic and

political participation of the people at both central and the community level . It further

promotesdemocraticvalueandpoliticalstabilityatthelocallevelprovidingforumsforsocial

debate issues related to the local development as per people's aspirations and priorities.

WhenLBsareactively involved forgenerating theirown localresourcesand financing their

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own expenditure, they become more accountable to their constituencies for their

developmentthanthecentralgovernment.Incontrasttothis,whenthebulkofthefinancial

ofthelocalresourcescomesfromthecentralgovernment,LBsbecomemoreresponsibleand

accountable to the central government than the local community. Thus there is a direct

linkageamongstfiscaldecentralization,transparencyandlocalaccountability.

Since1995,theVDCshavebeenreceivingannualblockgrantsfromtheGovernment.Theyare

spending theblockgrants to the localeconomic infrastructuresprojectsandother various

services. In fiscal year 2008/09 these grantswere increased to aminimum of 1.5million

rupeesandamaximumof3million rupees.Amajor rationalebehind thegreatly increased

amounts of government and donormoney is going to local government for fostering and

implementinglocaldevelopment.Outoftotalvolumeofgrant,the62%oftheexpenditureof

the capital part went on physical infrastructure projects, including road building (37%),

electrification (12%), drinking water and sanitation (11%), and irrigation and agriculture

(2.5%)and17%oneducation(MLD/UNDP2009).

A similar study by LBFC (2009a) focused on key infrastructural development activities

foundthatDDCsallocatebudgettovariousdevelopmentactivities.Thesedevelopmentactivities

comprise thesocialsectorand infrastructuraldevelopmentprojects.Theyallocateexpenditure

on health, education, women, children and social welfare programs in social sector. A big

proportionof theexpenditure isoccupiedby infrastructure that liesmainlyondrinkingwater,

irrigation,roadsandbuildingconstruction.Thestudyrevealedthat80%ofDDCsexpenditure is

metbythecentralgrantsinmostoftheDDCs.Similarlythestudydisclosedthattheproportionof

the VDC budget allocated to four activities namely, rural roads, small irrigation, community

drinkingwaterandcommunityandschoolbuildingconstructionsharearound60%to77%ofthe

totalVDCsbudget.Thesepapers illustrate that LBsareplayingaverymuch crucial role in the

affairsoflocalleveleconomicandhumandevelopmentforthecountry.

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TheMinimumConditionsandPerformanceMeasurements(MC/PMs)2system,implemented

by LBFC iswidely appreciated everyone.As highlighted byUNCDF (2010), this system has

helpedLGstoenhanceefficiency,accountabilityandservicedeliverycapacity,andtobetter

honorcitizensrights.Aneffectivefiscaltransfersystemhasbeenestablished.

These literatures clearly indicate that fiscal decentralization has promoted people's

participation,improvedpublicservicedelivery,enhancedpoliticalparticipationatthecommunity

levelandhasprovidedtheforumsforlocaldebateonlocaldevelopmentissuesandpriorities.

CONCEPTUALFRAMEWORKOFFISCALDECENTRALIZATIONANDECONOMICGROWTH

The theory of fiscal decentralization suggests many reasons to expect better public service

delivery at the local level. It tends to improve the efficiency of resource allocationwhich is

relatedwithbothallocativeandproductiveefficiency(Oates1999).

The relationshipbetween fiscaldecentralizationandeconomicgrowthhasbeenanalyzedbya

number of economists during the last three decades. Linking economic growth and fiscal

decentralizationtogetheraccordingtoEllerandBreuss (2004)hasmainlythreereasons: firstly,

growth is seen as an objective of fiscal decentralization and efficiency in the allocation of

resources in the public sector; secondly, it is an explicit intention of governments to adopt

policiesthat leadtoasustained increase inpercapita incomeand,thirdly,percapitagrowth is

2LBFChasbeenimplementingtheminimumconditionsandperformancemeasures(MC/PM)systemforanumberofyearsasanintegralpartoflocalgovernancereform.Underthesystem,theLBs,areannuallyassessedonthebasisofpredefinedcriteriaandprocedures.MCsaresuchindicatorsbywhichtheLBsareassessedtoseewhethertheyobservedthelawswhicharecompulsorytothem.Theyaretheminimumsafeguardsforproperutilizationofpublicresourcesandforidentifyingthebasicabsorptioncapacityfollowedbyfinancialdiscipline.IndicatorsforMCsarestatutoryrequirementsofLBsasprovisionedintheLSGAandassociatedrulesandregulations.Inordertoreceiveanannualunconditionalcapitalgrant,theLBsmusthavemetall indicatorsofMCs. Incase theLBscannot fulfill theminimumconditions, thereshallbereduction incapitalgrantsreceivableby them.PMsaredesigned tocreate incentives forLBs to improve theirperformance.PMsprovidea rangeofscore in different functional areas that help to assess the service delivery capacity and efficiency. LBs annual grantwilldependonthescoresachievedinPMs.Theindicatoroftheperformanceevaluatestheprocedures,resultandqualityofthedifferentworkingareasoftheLBs.

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easier to measure and to interpret than other economic performance indicators. While

theoretical examinations started with the pioneer publications of Tiebout (1956), Musgrave

(1959) and Oates (1972), empirical analysis regarding the role of economic growth on fiscal

decentralizationstartedattheendofthe1970sandestimationsconcerningthedirectimpactof

fiscaldecentralizationoneconomicgrowthhaveonlybeenconductedsincetheendofthe1990s.

Boththeoreticalandempiricalanalysestendtobeinconclusiveandcomeupwithambiguousand

differingresults.

Woller and Phillips (1998) have analyzed the impact of fiscal decentralization to the LDC

economic growth. According to them, development is widely debated in the development

literature. Accordingly in their study, they have presented an empirical examination of the

relationship between the level of fiscal decentralization and economic growth rates across a

sample of twentythree LDCs from 1974 to 1991. They failed to find any strong relationship

betweenthefiscaldecentralizationandeconomicgrowth.

MartinezVazquezandMcnab(2003)havequestionedtheimpactoffiscaldecentralizationtothe

economic growth and they doubted for being the little research on the causation line from

decentralization to growth, interestingly, there has been extensive empirical analysis of the

reverse question: to what extent is the level of decentralization a function of the level of

economic development? It is well documented that most measures of fiscal decentralization

acrosscountries,suchasshareofexpendituresorrevenuesofsubnationalgovernments inthe

generalgovernmentbudget,arepositivelycorrelatedwith the levelofeconomicdevelopment,

generallymeasuredbypercapitaincome.

UsingdatafromChineseprovinces,ZhangandZou(1998)foundanegativerelationshipbetween

the ratio of provincial government spending to central government spending and provincial

economic growth. That finding contradicts the oftenasserted hypothesis that greater fiscal

decentralization is associatedwithhigher economic growth.However,Akai and Sakata (2002)

foundapositiverelationshipbetweenfiscaldecentralizationwithinUSstatesandstateeconomic

growth.

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The empirical literatures as highlighted indicate that impact of fiscal decentralization on

economic growth and development is widely debated in development literature. The basis

economic argument for fiscal decentralization is that it differentiates the provision of local

outputs according to local tastes and circumstances, thereby increasing the effectiveness and

efficiencyofeconomicdevelopmentplanningandimplementation,particularlythatwhichrelates

toeconomicgrowthanddevelopment.

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MEASUREMENTOFFISCALDECENTRALIZATION

Themeasureof fiscaldecentralization is the subnational shareof totalgovernment spending.

Thehigher isthismeasure,thehigher isthedegreeof fiscaldecentralization (DavoodiandZou

(1998).The right approach to measuring the extent of fiscal decentralization has been long

debatedintheoreticalworksanditissurprisinglydifficulttomeasure.

Thetwostandardmeasuresaretheexpenditureratioandtherevenueratio.(MartinezVazquet

andMcnab(2005)havecalculatedtwomeasuresoffiscaldecentralization:theratiooftotalsub

national government revenues to general government revenues and the ratio of total sub

national governmentexpenditures to generalgovernmentexpenditures. These twomeasures

are the standard measures of fiscal decentralization that have been widely used in various

studiesofdeterminantsandoutcomesoffiscaldecentralization.

Oates (2006) in his recent paper has used the subnational expenditure decentralization (Sub

National Government expenditures as % of General Government expenditures) for the

measurementoffiscaldecentralization.

Onthesetheoreticalbackgrounds,thefiscaldecentralizationindexeshavebeenderivedas:

The ratio of total local bodies' expenditure with comparison to the governmentexpenditure(theindexisusedinmodel1).

Theratiooftotallocalbodies'expenditurewithcomparisontotheGDP(theindexisusedinmodel2).

However,theseindexesarebasedonthefollowingassumptions:

The central government spend 80 % of its budget, unless otherwise mentioned asmandatory

Similarly, the LBs spend 80 % of the block grants ( unconditional capital grant andconditionalrecurrentgrant),

TherevenuesofLBsotherthanthecentralgrantsarenegligible.

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MODEL

BasicModel

ToassessempiricallywhetherandunderwhichconditionsfiscaldecentralizationimprovestheeconomicgrowthofNepal,byfollowingAkaiandSakatta(2002)asimpleOLSmodelhasbeenapplied.ThebasicOLSmodelisasfollows:

0 1 3 (1)t t t ty FiscalDecentralization X = + + + wheretdenotesthetime,XthecontrolvariablesandytheGDPpercapitawhile isanerror term. tFiscalDecentralization represents indicatorsof fiscaldecentralizationatvarious

timeperiods.Theparameters 0 1 3, and arescalars,theerrortermisassumedtobenormallydistributed homoscedastic and independent across observations. Population, inflation andopennesshavebeenusedasthecontrolvariablesforthisstudy.

DATA

The data for GDP per capita, GDP, population and inflation have been taken from IMF datamappers.Theopenness is the sumofexportsand importswhich iscalculated from theWorldBankdatasets.Finally,thedataforthefiscaltransfershavebeentakenfromtheRedBook,theMinistry of Finance. The fiscal transfers' data to the Local bodies has been verified from theMinistry of Local Development sources (Local Bodies Support and Municipal Managementsection).Thetimingforthedataisfor15years(FY1995/962009/10).

Thus,thefinalformulationoftheabovemodelisgivenby

0 1 2 3 4 (2)t t t t t tGDP PerCapita Inflation Pop FD Openness = + + + + + Where,POPandFDrespectivelyspecifythepopulationandfiscaldecentralizationindex.Onthebasisoffiscaldecentralizationindextheequationtwoisfurtherdividedintwoparts(models).ThefiscaldecentralizationindexisderivedwiththecentralgovernmentbudgetinmodeloneandinmodeltwofromtheGDP(tablebelow).

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EmpiricalAnalysis

Theoverallempirical findingsof the resulthavebeen included in table1.The table shows (in

both models) the coefficients of all explanatory variables except the openness are positive.

However, population and openness are statistically significant in both models. The fiscal

decentralization index is only significant in model 2. Finally, it is concluded that fiscal

decentralizationhasasignificantandpositiverole(especiallyinmodel2)inGDPpercapita.

Table1:RegressionResults:DependentvariableGDPPerCapita

Model1 Model2

Variables CoefficientStandarderror tstatistic Variables Coefficient

Standarderror tstatistic

Inflation 2.22 4.47 0.5 Inflation 0.81 3.16 0.26

Pop 53.05* 8.49 6.25 Pop 52.49* 5.94 8.84

FD1 30.17 21.39 1.41 FD2 136.17* 43.75 3.11

Openness 14.95* 3.73 4.01 Openness 12.48* 2.70 4.62

Cons 798.36 155.45 5.14 Cons 745.73 122.66 6.08

2 0.977R = 2 0.967R = 2 0.986R = 2 0.980R = Note:*Indicatesstatisticallysignificanceat5%level.

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CONCLUSIONS

Theimpactoffiscaldecentralizationongrowthismorethananacademicquestion.Whether

fiscaldecentralization affects economic growthhasbecome an importantpolicy issues for

boththedevelopedanddevelopingcountries.

Thepresentfiscaldecentralization inNepalwascarriedoutasperthespiritofLSGA,1999 ,

LSGR2000andLBFAR2007.Inadditiontomanypoliticalandadministrativepowers,theseact

and regulations have provided sufficient financial powers to LBs. However, LBs have not

sufficiently exploited the own source revenues to cover the expanded expenditures. As

pointedby (Devkota2010,LBFC2010andSubedi2010 ),theLBsareheavilydependenton

thecentralgrants.

The literaturesused in thispaper indicate that, fiscaldecentralizationallowsmoreefficient

resourceallocation,politicalandpeople'sparticipationatthelocallevel,betterpublicservice

delivery and performance, effective local planning and implementation. In addition to the

literatures,theempiricalanalysisalsoprovesasignificantpositiverelationshipbetweenfiscal

decentralization andGDP per capita. This paper is the first to observe the affect of fiscal

decentralizationoneconomicgrowthbyusinganempiricalmodelforNepal.Finally,thestudy

clearly reveals that the process of fiscal decentralization is beneficial for the economy of

Nepal.

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