A long period of instability in Nepal is characterised by the breakdown in legitimate power of the state, creating chaos and anarchy. People suspect that the country might soon be categorised as a ‘failed state’ in the event of another postponement of CA polls.

Since people’s war has had a negative impact on local economic growth, livelihood and service delivery, rising inequality has now become a big issue. Unemployed working class population has increased in the period between two censuses. The 15-59 age-group population has increased from around 9.6 million in 1991 to 12.3 million with an average annual growth rate of around 2.5 per cent. The Gini Coefficient increased from 34.2% in 1996/97 to 41.4% in 2003/04. Although about 6% of total expenditure goes for paying principal amount, which constitutes 8.5% of the government revenue, aid in Nepal has failed to address wider inequality in income and mass poverty.

The foreign exchange reserve currently stands at Rs 62. 41 billion, which is 1.6% less than last year’s growth of 23.3%. One of the reasons for the reduction is currency appreciation. There has been 13.3% appreciation of NC vis-à-vis US dollar this year. This has eroded the value of exports and remittance earnings. Huge trade deficits with India has made it necessary for the government to purchase INRs 57,360 million this year as compared to INRs 39, 270 million last year.

Nepal’s current inflation (mid-June 2007) is suppressed and remains at 4.5% compared to 9.1% in corresponding period of previous year, the rise in price of POL products in March 2006 being the main cause. As soon as the price went up, inflation was bound to accelerate. During the first 11 months of 2006-07, total expenditure rose by 21% compared to an increase of 19.3% in the corresponding period last year. The growth in recurrent expenditure was 15.4% as against 10.6% the previous year. The capital rise in expenditure was 51.4% as compared to 38.2% last year.

The contribution of corporate tax, customs and excise in the import of high-tax yielding vehicles and spare parts was responsible for increasing revenue by 20.8% as against 0.5% last year. Against this backdrop and continuing conflict situation, the issues of fiscal implications under federal structure are worth considering.

Policy dialogue in economic federalism requires proper understanding of the working of federalism in diverse settings. In Nepal’s case, the knowledge of the working of central vs local units is crucial to find out the extent of dependency and the erosion in the capability of local units and in deciding on the right size of physical structure and scale of economy.

As natural endowments, climate and physical conditions differ significantly across the regions, there are different economic opportunities. Regions and countries differ in various factors like per capita income, level of unemployment, physical quality of life, human development and property prices. This is the reason that under the federal structure, the US and Switzerland are rich, while Argentina and Brazil are poor; and China grows much faster than Mexico. Even in the same country the difference is stark. The eastern costal region of China is highly prosperousbut the western hinterland of China is poor.

Country-wise, the case of India and Canada is noteworthy in terms of per capita income. For example, the ratio of the lowest to the highest provincial per capita incomes in 2002 is only 1.88 in Canada compared to 4.5 in India. As regards the present system in Nepal, let us consider some facts. There is a big revenue-expenditure gap at the local level. The percentage of central grant is much higher than revenue collected locally. The report of the Auditor General reveals that 3-year (1999/00-2001/02) grant at the local level stood at $175.2 million; internal revenue contributed a meagre $13.7 million. The Public Expenditure Commission Study, 2004 also shows that when the income from local tax and duties was merely $10.7 million, the expenses amounted to $ 50.2 million; the deficit of $ 39.4 million was compensated by the central government. Within the five-year period, the grant amounted to $296.7 million. Since dependency is increasing, local governments are getting less and less capable.

The next question is how equity can be promoted in a fiscal federal context. There is a need to study the centre-state relationship and formulation of clearly defined authority. In Brazil and Argentina, state deficits and federal transfers were out of control. Federal practices were found to have strengthened, but macroeconomic performance weakened. This is contrary to what happened in Nepal during liberalisation. There was macroeconomic stability but the governance was dysfunctional. Such uniqueness necessitates special policy design while restructuring Nepali economy. To conclude, economic restructuring should not be the victim of exclusion.

Pyakuryal is Economics professor, TU