One should assume that political restructuring under federal structure also intends to decentralise public finances. Since natural endowments, physical conditions and economic opportunities differ significantly across three distinct topographical divisions of the country, this mission is not as easy as advocated.

The politicians are driven by their one-sided desire to establish federal states without public debate on why the existing fiscal system did not work — what are the proposed new political economy of federalism, how are they feasible, and how can they be done?

By now, we are in a position to assess the differences in performances across federations to learn lessons on formulating policies with regard to developmental problems in general and resource generation, management and allocations in particular. Some countries like Switzerland and USA are rich, Argentina and Brazil are poor and Mexico experiences little growth under different federal structures. The task is to find out the behavioural variances making some countries richer and some poorer. This investigation is termed “pathologies of federalism” by economist Barry R Weingast.

The question is how equity can be promoted in a fiscal federal context. In participatory democracy people should be involved in decision-making. If this is not done, a mere political decentralisation would make election a means of socio-political control but not the expression of people’s choice.

In Nepal it will take quite some time to reduce the dependency of local governments for central funding. Data shows that such dependency has weakened the efficiency of the local governments. Since devolution is not separation, the challenge is not to execute internationally articulated “principles” as they are seen, it is the skills among national, state and local governments to manage fundamental policy problems.

The transfer of fiscal resources to sub-national governments requires the reduction in the spending by the central government or an increase in tax resources. In Nepal, ability to pay is eroded. The emerging political environment is not friendly to any increase in tax.

Although the budget of FY 2006/07 aims at increasing budget deficit by 3 per cent by proposing to increase total expenditure incredibly, Nepal’s outstanding debt and absorptive capacity limits this possibility either. For example, the stock of net outstanding external debt in 1996/97 was Rs. 132,086.8 million and it reached to Rs. 219,641.9 million in 2004/05.

The lower rate of growth of revenue as compared to the growth of government expenditure has made fiscal deficit a regular feature of the economy. The fiscal deficit of Rs. 15.83 billion in 2003/04 increased by 14 per cent and escalated to Rs. 18.05 in FY 2004/05 indicating the widening gap between government expenditure and revenue. This shows that the economy has lost its productive capacity to respond to sustained growth. Nepal has always suffered from unequal distribution of limited resources and ineffective economic regulation, which has failed to reduce wealth disparities.

The new hope of the citizens may pose serious policy challenges with the pressures to spend more and tax less contributing to additional deficits in the economy. There is econometric evidence from 32 developing countries that increased local governments’ spending and deficits leads to greater deficits at the national level. In Argentina and Brazil, it was realised that democracy strengthened the federal practices but it weakened macroeconomic performances. Our own experiences during early 1990s also reveal similar story. After reinstating democracy, macroeconomic stability was maintained with 8-9 per cent growth. Unfortunately, this growth was urban-centred. There was inequality between different ecological divisions and income and ethnic groups. The absence of macroeconomic policy to promote equitable distribution of available resources is an example of insensitivity of the policy to address these issues.

Increasing efficiency for higher-quality growth is possible through effective institutions. When institutions fail to address inequalities and distributional conflicts, there is a greater probability of civil unrest under a decentralised governance.

Decentralisation is neither good nor bad, its importance is realised when it is built up under the institution-specific design. As variance in the level of economic performance is noticed under different federal structures, the lesson Nepal should learn is one size does not fit all. Although the fundamentals remain the same, the principles should address the local needs. The dynamics of policy change in the federal systems and variation in reform orientation among the states should be assessed in advance to neutralise the likely challenges of resource constraints that emerge from inter-state competition.

Dr Pyakuryal is professor of Economics, TU