Economics of Federalism

Federal restructuring of Nepal has emerged as a hot topic in recent political debates and all the political parties, despite their ideological differences, have a consensus that only a federal restructuring can lead to economic transformation of the country. Almost all parties that participated in the Constituent Assembly polls had mentioned in their manifestos that they wanted to implement the federal structure. And after the election, it is clear that the popular mandate is for the federal restructuring of the country.

Now the debate is focusing on the type of the federal structure. In this connection, the question of economic sustainability of the new federal structure of governance is the new challenge to tackle. A consensus is yet to be developed in this regard. For this, it is worth analyzing different models of federal structure of governance in practice in the world and exploring the alterative that best suits Nepal.

The economic dimensions need to be given a serious thought because a federal state cannot achieve development until it is made economically strong and sustainable. Only political and ethnic basis should not be a guiding principle during the federalising process as that will further complicate things leading to disintegration and chaos as is experienced in a number of countries.

Different proposals

If we look at the manifestoes of various political parties, a number of divergent propositions on federalism can be found.

The Nepali Congress and the CPN-UML have proposed autonomous federal states with three structural tiers but they have not mentioned the number of states they want to divide the country into. Both of the parties have stated that the number and size of the federal states would be decided by the Constituent Assembly on the basis of the recommendation of a commission that will be formed for restructuring the state. Only the CPN-Maoist has made a clear proposal that the country would be divided into 11 states and three sub-states and the bases of the division are ethnicity and geographical location. The People’s Front Nepal wants a three-tier federal structure. Similarly, the CPN-ML has proposed seven federal states at the most whereas the National People’s Front is strongly opposed to federalism.

All the major parties (Nepali Congress, CPN –UML and CPN-Maoist) have proposed to have a bicameral legislature at the centre and a unicameral legislature in each of the federal states. Members of the Lower House of the central legislature shall be elected on the basis of population of the given districts while number of representatives in the Upper House shall be equal from each of the federal states.

CPN Maoist has also proposed a three-tier judicial structure: Supreme Courts, High Courts and District Courts followed by civil courts and reconciliation centres. The SC shall be developed as an institution to resolve the serious legal, constitutional and inter-states issues and disputes between the states on sharing and utilisation of national means and resources. The centre shall have control over the security of international border, military management, foreign relations, inter-state trade and commerce, monetary policy and central bank, customs revenue, mega hydro-power projects, railways, airways, national highways and central universities. The state governments shall have the rights on all the remaining issues. Local transportation, local taxation, education, sanitation and utilisation of local resources shall be handled by the local elected bodies, according to CPN Maoist proposal.

However, the proposals of the political parties lack any economic foundation of federalism. The objective of federal models should be to ensure economic transformation and for the upliftment of each and every part of the country, not to increase the burden on the people in the form of various taxes that may be levied by the state and central government.

These economic issues need to be clarified while handing over the terms of reference to the commission to be set up to restructure the country in a federal model.

Economic Significance of Federalism

Federalism entails the division of responsibilities in respect of taxation and public expenditure among the different layers of the government, namely the Centre, the States and the local bodies. Federalism should help the government to realize cost efficiency in providing public services.

There is a wide gap between different regions of Nepal in such important indicators as the number of schools and health facilities, manufacturing establishment, collection of revenue, availability of natural resources (arable land, commercially important forest etc.) which are reflected in income disparities and poverty incidence. In the proposed federal restructuring, there should be a built-in mechanism to reduce these disparities.

Infrastructure development like roads and bridges are confined to Kathmandu Valley and Southern flatland of Terai (Figure 2). The mountainous terrain is cited as the main reason for the slow pace in infrastructure development in hilly regions. Especially, the vast area of west and far-west hilly mountain regions has limited road access.

Consequently, industrial growth is confined mostly to Kathmandu Valley and Terai.  Due to slow development of infrastructure, the pace of industrialisation is much slower in the hills and mountains (Figure 3)

Overall educational achievement in the Hills and Mountains of western and far-western districts is poor—which is demonstrated by fewer numbers of schools and percentage of literate population (Figure 4 and 5).

Thus, so far the developmental endeavours are uneven and clustered to specific geographical regions.

Finding a federal model that will fit well into the socio-economic, geographic, ethnic, linguistic and cultural diversity of Nepal fulfilling the economic needs of the federal state is difficult. Until now, the federal debate has been solely confined to political polemics. And the federal propositions in the manifestoes also indicate a lack of empirical study and research at the political level regarding the transformation process from unitary to the federal sate.

Unitary to Federal Economic Challenges

While going through the budget proposal of 2007-08, it can be noticed that out of total budget of Rs. 168.99 billion, Rs. 99.60 billion was proposed to be borne from current source of revenue (which is only 58% of the total budget) and the balance from foreign assistance and deficit budget. Rs. 98.17 billion has been estimated for recurrent expenditure (58.10% of total budget) and Rs. 55.26 billion for capital expenditure (32.70%) while Rs. 15.56 billion is for repayment of principal of loan (9.20%).

Kathmandu , Birgunj, Bhairahawa, Biratnagar, Jhapa and Nepalgunj are the main revenue collection centres, accounting for more than 80 per cent of the total revenue collection every year. The revenue collected in those centres goes to all the 75 districts of the country. The Far Western and Mid-western regions are able to meet only 18 to 25 per cent of the administrative expenses through the revenue collected in those regions. With such status of revenue collection, these regions need huge external assistance (from other states or countries).

A proper research to identify revenue-expenditure gap at the local level has not yet been conducted in Nepal. However, available data show that the percentage of central grant is much higher than the revenue collected locally through taxes. For example, an unpublished report of High Level Public Expenditure Commission, MOF, 2005 shows that income from local level taxes and duties was US $ 10.7 million but the local level expenses amounted to US $ 50.2 million. The deficit amount of US $ 39.4 million was compensated by the central government.

Such dependency has weakened the efficiency of local governments to spend centrally allocated resources. For example, as the same report shows, out of US $ 37.61 million central grant, the local governments had postponed US $ 14.53 for the next fiscal year because of their poor absorptive capacity. It was found that the local governments have normally spent about 25 percent in administration and 64 percent in the development expenditure from the central grant. 

Also the problem of record keeping about the revenue is poor at the local level. The record on land revenue, for example, is missing in most of the VDCs. There is no information about the targeted amount that the local governments are supposed to collect. This is the reason why the central government faces challenges to balance between the level of revenue generation and investment requirement at the local level.

Several efforts were made in the past to reduce the central, regional, zonal, district, and village level government offices so as to reduce the administrative expenses. Though the number was reduced from 9433 in 1992 to 7826 at the time of the above mentioned report, the reduction of 1607 number of offices could not yield reduction in the overall expenses. The percentage of salary allowances is in increasing trend in the total budgetary expenditure. This indicates the fact that unless the conventional problem of governance is not carefully studied, the exact level of fiscal implications from federal structure is difficult to assess.

Economic aspects need to be taken into account also because they ensure sustainability and independence of the federal provinces. For such sustainability the would-be provinces should have equal share of revenue sources and natural resources. Each state has to be federalized in such a way that it can meet at least 80 per cent of its administrative expenses through its own income. Otherwise, the provinces can’t sustain and their autonomy will be in jeopardy.

The other reality is that the federal system increases the financial burden, and the start-up cost may amount to billions of rupees. The cost of federalism may be passed to the citizens by way of various taxes and levies by the central, state and local government. But the multiplicity of such taxes may push up the prices of the commodities on the one hand and it may adversely affect investment decisions of the entrepreneurs. If we fail to allocate equal sources of income among the federal states, some already backward western regions will continue to remain so even in a federal system.

International Practices in Federal Countries

In a federal system, defining the political structure and relationship between the central, states and local government is not sufficient. Also the economic relationship among these layers needs to be defined. The international examples show that the modality of sharing of resources among such layers is generally incorporated in the constitution itself.

According to the international examples, customs duty, VAT and other taxes as well as revenue coming from natural resources (such as mining and hydropower) should go to the central government’s coffers. A certain portion of the taxes collected from the natural resources is given to the locality affected by the project that harnesses these resources. The remaining collections made by the centre would then be deposited in the central coffers and that has to be transferred to all the states and local bodies on the basis of their expenditure and programme needs.

In various federal countries, the expenditure responsibility on defence, foreign affairs, international trade, monetary policies, immigration, airlines and railways rest on the central government. Expenditure responsibilities on environment, fiscal policy, natural resources management and utilization, industry and agriculture, police and standards and targeted programmes can be assigned to states and local governments. The ideal division of power is that the centre should keep foreign affairs, security, and monetary policy. Other powers can be devolved to the states. Regions in Brazil have the most extensive power whereas in India the centre is very strong.

Here, we are taking the example of only two countries Switzerland and India for analysing the federal structure. In case of India we find that the revenue collected as Direct Tax (Income tax) goes to central government and the revenue collected as sales tax/VAT (other than inter-state sales tax) goes to state government. But in Switzerland, VAT goes to the central government and income tax is levied by all the cantons. Thus the resources and revenue-sharing modalities are different in different countries.

Switzerland : Lesson for Nepal

Like Nepal, Switzerland is multi-cultural, multilingual, landlocked and small country. In terms of the relative autonomy of its 26 miniature states or cantons, it has one of the most evolved and successful federal system uniting multi-linguistic and multi-cultural provinces with equitable share of resource and authority. The Swiss basic political structure rests on a three-tiered system of government in combination with the principles of subsidiarity and federalism. This political structure along with unique feature of direct democracy (based on consensus rather than opposition and increased participation of people in legislature) has made the Swiss system highly decentralized— facilitating devolution of decision making authority; and ultimately empowering every individual and community.

Switzerland was formed as a federal state in 1848. Before that only the cantons had the undisputed power to impose taxes. After the formation of the federal state in 1848 the cantons had to give away the authorisation for custom duties and all other indirect taxes to the central government. However, the cantons kept the power to levy direct taxes. Consequently, all cantons have their own tax regulations and the taxes levied have varied substantially between the different cantons. After reluctantly releasing a part of their tax authority, cantons tried to compensate their lost source of tax revenue by imposing higher taxes on citizens’ income and property. Thus the direct taxes are the most important source of revenue for all cantons.

The Swiss tax system is shaped by the country’s federal structure. Companies and individuals are taxed at three different levels - federal taxes, cantonal taxes and communal taxes. Based on the tax laws of their canton, the communes also levy direct taxes. However, the Swiss tax rates for companies and individuals are among the lowest anywhere in Europe. Corporate taxes are approximately 16-25%, while individuals are taxed at rates between 5% and 20%. Stable political conditions, a liberal legal framework and the tax competition between cantons and municipalities result in a constant low tax burden.

The Swiss Confederation relies, by and large, on its exclusive right to levy the value-added tax, now set at 7.5%, and various consumption taxes (tobacco, alcohol, mineral oils, duty on heavy vehicles). The cantons enjoy considerable fiscal autonomy and are free to determine the taxation base and tax rates. Generally speaking, most cantonal revenues come from personal and corporate income tax. Most of the cantons also levy taxes on property, gifts and inheritances, property sales, automobiles, games and entertainment and the production of hydroelectric power.

Given the overlapping in federal and cantonal finances, there is no fiscal imbalance in Switzerland. What is important from the standpoint of autonomy is the freedom the cantons enjoy to make independent budget choices. This freedom is not entirely the same as regards expenditures and revenues. In terms of expenditures, the cantons are closely tied to federal budget choices. A large part of their revenues come from transfers, which are for the most part tied to the accomplishment of certain responsibilities. However, the Confederation has fairly limited means of controlling the allocation by the cantons of these resources and often confines itself to a political denunciation in the event of overly free implementation. As for revenues, the link is not as strong. The only truly shared tax is direct federal tax, which is levied by the Confederation on income and of which the cantons receive one-third. Roughly one-fifth of federal revenues are derived from this tax, whose legal basis must be renegotiated every four years.

In Switzerland, the relation between the Confederation and Cantons is referred to as executive federalism, which results from the principle of cooperation that characterizes the Swiss federal system (contrary to the principle of separation or competition that prevails in more dual federal systems such as Canada). Executive federalism is the characteristics of the Swiss model in which Confederation is given important decision-making powers, while the cantons are responsible for executing these responsibilities. While growing numbers of responsibilities have been transferred to the federal government in recent decades, especially in such areas as land use planning and development, environmental protection and energy policy, the cantons have maintained considerable power with regard to implementation. This shift has been accompanied by an increase in conditional budget transfers to the cantons. Even fields that are formally fairly centralized, such as transportation policy and social security, are in fact administered by the cantons. Only the public economy (in particular, agriculture) is largely funded by the Confederation despite the formal sharing of jurisdictions by the two levels.

Nepal has much more in common with Switzerland in respect to population, geographical and cultural diversity and a sense of collective identity. Nepal can closely relate to Switzerland and learn lessons and incorporate them in Nepali federal democratic system and make the economy sustainable.

Indian Experience

India has a federal structure with 28 states and seven union territories. India has strong central government with some power given to state as per the constitution of India. Looking at slow progress at some territory, recently India has created new states like Chhattisgarh, Jharkhand and Uttranchal (Uttarakhand) for the upliftment of those territories as per the recommendation of the commission formed for the restructuring of the states. Since India has a federal form of government, it has federal finance system based on the principle that the Centre and the State Governments should be independent of each other by providing the state with sources of raising adequate revenues to discharge the functions entrusted to it.

India has a three-tier federal tax structure (the union government, the state governments and the urban/rural local bodies). The power to levy taxes and duties is distributed between the union government and the state governments in accordance with the provisions of the Indian Constitution. The Constitution points out three lists of legislative fields: 1) the union list (in which the central government has exclusive jurisdiction); 2) the state list (in which the state governments have exclusive jurisdiction); 3)
the concurrent list (in which the union government and the state governments have concurrent jurisdiction, subject to the power of the union government).

Accordingly there are both mandatory and enabling provisions in the Constitution for facilitating a wide-ranging transfer of resources, arranged in a systematic manner, through :

1) Levy of duties by the Centre but collected and retained by the States.

2) Taxes and duties levied and collected by the Centre but assigned in whole to the states

3) Mandatory sharing of the proceeds of income tax

4) Permissible participation in the proceeds of the Union excise duties

5) Statutory grants-in-aid of the revenues of states

6) Grants for any public purpose and

7) Grants of loans for any public purpose

Thus, having provided for a certain division of powers of taxation between the union and the states, the Constitution gives the States a share in the resources available to the Centre.

The natural resources of India have been unevenly distributed among states creating unhealthy relations among the provinces. The basis of division and federal model seems to be inadequate as some Indian states are still fighting with each other from the past fifty years for water. The main reason is their ethnical division. Also the reservation based on the ethnicity has created a lot of problems. It cannot be said that the Indian division of states based on ethnic groups was a good idea. Now some other groups are demanding new states due to lack of adequate development in their region. One example is the Bidharva region of Maharastra. Though Maharastra is recording a very high growth in GDP, farmers in Bidharva region are complaining of being neglected. Some of the other states like Bihar, UP and Orissa are still lagging far behind the average growth rate of the India.

Indian federal model is much talked about in Nepal due to Nepal’s huge dependency on India and the cultural, religious similarities as well as geographical proximity with India. The Indian experience shows that more important question is about how we can integrate the divided society rather than how we can divide the integrated society further.

Expert Opinion on the Restructuring of Nepal

In the ongoing debate in Nepal for restructuring the Nepali state, the experts have suggested two bases of federal divisions - geographical and ethnic/cultural. The first school of thought advocates for a federal system based on ethnic distribution, which is also the line followed by the Maoists and some Madhesi/Janajati groups. A recently surfacing second school of thought advocates a federal model based on competitive resource allocation. This school of thought views that the federal system based on ethnic distribution has not considered the economic feasibility and that such restructuring is by itself exclusionary as it leaves less space for the Dalits and the other castes. Yet others argue that the problem does not lie in the administrative structure of the state, but more in the system of governance.

Mahendra Lawati represents first school of thought who views that as Nepal is a multicultural society, this societal condition has to be reflected in the state structure and Ethnic Federalism does exactly that. If not, there will be incongruence between the state and society and it could generate conflict. His suggestion is to begin with around 15 regions but this should not be a fixed number - a peaceful mechanism to lower or increase the number should be developed based on the demands expressed by people.

According to Lawati, size is not an issue as many countries smaller in population and territories have federalism: Belgium (10.1 M), Switzerland (7M), Papua New Guinea (4.3M), Holland (15.4M), Austria (8M). He also cites many Indian states that have small population: Sikkim (0.5M), Mizoram (0.7), Arunachal (0.9), Goa (1.2), Nagaland (1.2 M), Manipur (1.8M), Meghalaya (1.8M), Tripura (2.8M). Dividing the country in states does not depend on the economic condition of the country, according to his view. Even poor countries can go federal. For example, India and Papua New Guinea are poor in terms of per capita income. Still both have federal system. On the other hand, Switzerland and some other countries adopted federalism while they were still agricultural societies and not economically well off.

Dr. Surendra Raj Devkota who represent second school of thought has proposed for the four provinces based on competitive resources. His point of view is to divide it by down-top lines in such a way that they have almost equal natural resources. Already existing north south highways will provide accessibility for the people of the four province to contact each other while each province will share borders with southern Indian neighbour (an important factor for a landlocked country), and each province will have ethnic diversity as well. The composition of each of the provinces proposed by Dr Devkota is as below which will be helpful for the overall economic growth of the country representing the ethinic diversity as well (KBC stands for Khas Bahun and Chhetri):

(1) KOSHI (Maithili 35%, KBC 17%, Rai 7%)

(2) GANDAKI (KBC 26%, Bhojpuri 19%, Magar 10%)

(3) KARNALI (KBC 41%, Tharu 15%, Magar 8%)

(4) KTM VALLEY (KBC 36%, Newar 35%, Tamang 9%)

Conclusion

Such a federal structure needs to be in place in which the government is to reach every sector of society and have their voice heard and such resturcturing should lead to economic transformation of each and every regions and community of the country. Similarly, to make central, state and local governments accountable and to maintain financial discipline, certain provisions should be made in the constitution itself such as in Brazil where the constitution limits borrowing and indebtedness for state governments. Any solution we seek must be global, long lasting and shouldn't be just to pacify certain under-represented ethnic group or indigenous cultural group. The federal model should lead economy towards creating the for investor friendly environment, generate the employment opportunities and overall growth of the country.

(Maps are downloded from various websites. The authenticity about the details may be disputed.)

Indian Federalism: Still work-in-progress

India has an area 3.2 million square kilometres populated by over 1,000 million. There are 22 national languages (2000 dialects spoken), dozen of major ethnic/racial and seven religious groups, sixty socio- cultural sub regions and seven natural geographic regions presenting a bewildering diversity.

Governance and Administrative Units

• Three tier of Government - Union, States and Local Government Units
• 28 states
• 5 Union Territories
• 2 Union Territories having their own legislative assembly.
• 604 Districts
• 240 thousand rural government and 4100 urban government
• 600 thousands Villages

Rationale for Indian Federal Systems

• Provide political and social space for diverse minorities
• Devolution of power up to the grass root level
• Interdependence with autonomy
• Preserve distinct cultural identities
• Help to fight emerging challenges
• Ensure development and security to the people
• Means of self ruled and shared ruled
• Unity in diversity - Learning from each other

Structure and Features of Indian Federalism

• Parliamentary Federalism
• Supremacy of the constitution
• Distribution of power
• Three tiers of Government- Union, State and Local Government Units
• Independent Judiciary
• Legislative power and responsibilities divided as Union list 97 subjects, state list 66 subjects and concurrent list 47 subjects.
• Federal structure with unitary features (Quasi-federalism or cooperative federalism)
• Federalism in India is still work-in-progress.

Conflict Management in Indian Federal Structure

• There is an Inter-State Council chaired by the Prime Minister
• Heavily engaged on policy matters and to preserve the common interest of the states.

Decentralization and Fiscal Transfer in Indian Federalism

• Local government units as the lowest tier of the government were recognized by the Constitution in early 90s.
• 29 and 18 activities devolved for rural and urban government respectively.
• Roles and responsibilities with legislative power are clearly defined by the Constitution between union, state and local government
• The devolution of power from the state to their local government units
• Local government units are comparatively weak and they collect very minimum resource, i.e. 5 percent of their expenditure.
• Finance commission and planning commission transfer the resources from centre to state for establishment and development expenses respectively.
• Transfer of resources from finance commission is based on certain parameters
• Each state has its own finance commission to deal with the financial matters between state and local government units.

Administrative system under Indian Federal Structure

• Three types of Civil Service cadre - All India Service (AIS) cadre, Union cadre and State cadre
• All India Service is a unique feature of Indian Federation consisting of three different services - Indian Administrative Services, Indian Police Service and Indian Forest Service.
• AIS cadres are selected by Union Public Service Commission, appointed by the president and posted in the states.
• AIS are considered as the means of national unification.
• Every state has its own civil service cadre, very few of them can be promoted to the AIS.
• Union and State Parliaments have their own separate cadres.
• For assistant level in the administrative service, there are ministerial cadres along with separate hiring committee.

Judiciary

• Unified system of Judiciary with the Supreme Court at its apex and the High Courts below it.
• 23 Appeal Courts
• District courts in each district

Issues and challenges of the Indian Federal Structure

• Very strong media
• Strong Civil Society
• Emerging NGOs and community based organizations
• Emerging regional parties and assurance of social inclusion
• Currently a coalition government which is more inclusive but it is felt to be slow in decision process
• Big population
• Variance in capacity of States
• Weak local governments
• Growing urbanization
• Positive discrimination – felt to be a necessity though it has also fomented dissatisfaction
• Decentralized frame with centralized culture
• Changing life style and growing middle class
• Fast economic growth but it is still unable to reach the poor and grass root level.

Lessons learnt

• No single definition of Federalism and one federal system cannot be compared with another
• Context is significant
• In Indian Federalism, the power devolved from the top
• Independent Judiciary as a safeguard of the federalism.
• Strong bureaucracy as means of unification
• Role delineation between the levels of government must be addressed in the constitution
• Training required in all levels of government.
• Socio-economic and cultural conditions of the country should be considered while federating the country.
• Reservation/ Inclusive governance
• Right to information
• Two-way relationship (Local-State-Centre)
• Inclusiveness has to be achieved without killing the national interest
• Targeted programmes from the centre to the grass root.

(Excerpted and edited from a report presented at an interaction held at Kathmandu after a group of senior government officials of Nepal returned home from a two-week visit to India studying Indian federalism)

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