DESIGNING INTERGOVERNMENTAL FISCAL TRANSFER

FORMULA AND EXPENDITURE NEEDS ASSESSMENT

OF SELECTED DEVOLVED TASKS

MAIN REPORT

Submitted to

Local Body Fiscal Commission Secretariat/

Decentralization Advisory Support Unit (DASU)

Submitted by

Study Team

May, 2005

Study Team

Mr. Prithivi Raj Ligal Senior Consultant Team Leader

Dr. Devendra P. Shrestha Consultant Member

Mr. Kumar Keshar Bista Consultant Member

Mr. Yadab Chapagain Consultant Member

Mr. Kishor Maharjan Consultant Member

Mr. Dinesh P. Mandal Consultant Member

Ms. Jyoti Sharma Research Associate Member

Ms. Pratiksha Shrestha Research Assistant Member

Ms. Priya Shrestha Computer Assistant Member

KHANCHANPUR

DANDELDHURA

DARCHULA

BAITADI

HUMLA

BAJHANG

BAJURA

KAILALI

DOTI ACHHAM

MUGU

JUMLA KALIKOT

DAILEKH

BARDIA

SURKHET

JAJARKOT

DOLPA

RUKUM

SALLYAN

BANKE

DANG

DEOKHURI

ROLPA

MYAGDI

MUSTANG

BAGLUNG

PYUTHAN GULMI

KAPILVASTU

ARGHAKHANCHI PALPA

RUPANDEHI

P

A

R

B

A

T

KASKI

MANANG

LAMJUNG

NAWALPARASI

TANAHUN SYANGJA

CHITAWAN

GORKHA

DHADING

RASUWA

NUWAKOT

SINDHU

PALCHOK

MAKAWANPUR

PARSA

BARA

R

A

U

T

A

H

A

T

SINDHULI

KABHRE LALITPUR

KATHMANDU

BHAKTAPUR

DOLAHAKA

RAMECHHAP

SARLAHI

M

A

H

O

T

T

A

R

I

D

H

A

N

U

S

H

A

OKHAL

DHUNGA

SOLUKHUMBU

KHOTANG

UDAYAPUR SIRAHA

SAPTARI

BHOJPUR

SANKHUWASABHA

TEPLEJUNG

DHANKUTA

TERHATHUM PANCHTHAR

MORANG SUNSARI

ILAM

JHAPA

Sampled Districts

Nepal

TABLE OF CONTENTS

Content Page No

Acknowledgement i

Acronyms iii-iv

Executive Summary v-xxv

CHAPTER I: INTRODUCTION 1

1.1 Background 1

1.2 Objectives of the Study 2

1.3 Scope of Work 2

1.4 Approach/Methodology of the Study 4

1.4.1 Selection of District/Municipalities/VDCs 5 1.4.2 Survey Instruments 7

1.5 Field Planning, Management and Execution 7

1.6 Field Performance 8

1.7 Data Management and Method of Analysis 8

1.8 Study Limitation 11

1.9 Organization of the Report 12

CHAPTER II: INTERGOVERNMENTAL TRANSFER: THEORY AND PRACTICE 13

2.1 Concept and Economic Rationale 13

2.2 Instruments of Intergovernmental Fiscal Transfer 18

2.3 Criteria for an Effective Transfer System 19

2.4 Components of a Grant System 19

2.5 Types of Grants 22

2.6 Design of Grant Formula for Intergovernmental Fiscal Transfer 23

CHAPTER III: INTERGOVERNMENTAL TRANSFER IN NEPAL: A REVIEW 29

3.1 Background 29

3.2 Intergovernmental Fiscal Transfer 29

3.3 Elements of Transfer System 30

3.4 Conditional and Unconditional Grant Allocation 31

3.4.1 Grants to DDCs 31 3.4.2 Central Guidelines to DDCs on the use of Grant Fund 33 3.4.3 Fiscal Transfers to Municipalities 33 3.4.4 Sources of Finance of Municipalities' Budget 34 3.4.5 Guidelines on the Use of Administrative and Development Grant 34 3.4.6 Guidelines on Additional Development Grant 36 3.4.7 Fiscal Transfer to VDCs 38

3.5 Limitations of the Present System of Fiscal Transfer 38

3.6 Structures and Pattern of Expenditures of Local Bodies 40

3.7 DFDP Minimum Conditions and Performance Measures for Transfer 42

3.8 Perception of Local Bodies on Fiscal Transfer System 43

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CHAPTER IV: DESIGNING INTERGOVERNMENTAL FISCAL TRANSFER 49

4.1 Principles of the Transfer System: 49

4.1.1 Key Characteristics of a Good Transfer System 50 4.1.2 Desired Characteristics of the Formula Based Transfer Design 52

4.2 Funds for Distribution 56

4.2.1 Determination of Distribution Pool 56 4.2.2 Types of Grants 58

4.3 Method of Distributing General-purpose Grant 59

4.3.1 Method of Distribution of Grants to DDCs 59 4.3.2 Method of Distributing General-purpose Grant to Municipalities 66 4.3.3 Method of Distribution of Grants to VDCs 71 4.3.4 Possibility of a formula for Grants from DDC to Municipalities and VDCs 73

4.4 Method of Distributing Specific Purpose Sectoral Grants 74

4.4.1 Clarify the Objective and Identify Grant Pool for each Sectoral Grant 74 4.4.2 Define the Principles of Transfer and Guide for Formula Design 74 4.4.3 Define the Factor to Use 74 4.4.4 Assigning Weight to the Factors Used 75

4.5 Possibility of Introducing Equalization Grant 75

4.6 Concept and Design of Specific Purpose Funds 77

4.6.1 Concept and Practice of Specific Purpose Funds 77 4.6.2 Area of Improvement in the existing Fund Mechanisms in Nepal 77 4.6.3 Design of Specific Purpose Fund for Nepal 78 4.6.4 Administration and Management of Specific-Purpose Fund 78

CHAPTER V: ADMINISTRATION, MANAGEMENT AND INSTITUTIONAL SET UP OF THE FORMULA BASED TRANSFER SYSTEM 79

5.1 Administration and Management 79

5.2 Institutional Set-up 81

CHAPTER VI: EXPENDITURE NEEDS OF DEVOLVED SERVICES 85

6.1 Expenditure Needs Assessment: Measurement Approaches 85

6.2 Framework to Estimate Expenditure Needs 86

6.3 Setting Minimum Standards/Norms for Service Provision 87

6.4 Review of Existing Standards: Health Post 87

6.5 Review of Existing Standards/Norms: Lower Secondary and Secondary Education 90

6.6 Review of Existing Standards/Norms: Rural Infrastructure 91

6.7 Providers’ Perception and Suggestion for Improvement 92

6.8 Expenditure Needs of Selected Devolved Services 94 6.8.1 Expenditure Needs Estimation: Health Post 97

6.8.2 Expenditure Needs Estimation: Lower Secondary and Secondary Education 101 6.8.3 Expenditure Needs Estimation: Rural Infrastructure 105 6.8.4 Expenditure Needs Estimation: District Technical Office (DTO) 109

CHAPTER VII: CONCLUSION AND RECOMMENDATION 113

7.1 Review of Present Grant Distribution System 113

7.2 Unit Cost Estimation of Selected Devolved Services 119

7.3 Action Matrix 122

Bibliography

ANNEXES

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ACKNOWLEDGEMENT The Study Team is highly privileged to have the opportunity to undertake this timely exercise on "Designing Intergovernmental Fiscal Transfer Formula and Expenditure Need Assessment of Selected Devolved Tasks". The Team, therefore, wishes to place on record its sincere gratitude to Local Bodies Fiscal Commission (LBFC) and Decentralization Advisory Support Unit (DASU)/DANIDA for entrusting us this important assignment. We strongly believe that the results and the recommendations made in the study will be very helpful in rationalizing the grant allocation system across Sectors and Local Bodies. The study team wishes to express sincere thanks to Dr. Hikmat Bista, Chief Advisor, DASU/DANIDA for his professional guidance and suggestions. Members of the LBFC Secretariat particularly Mr. Som Lal Subedi, Joint Secretary, Mr. Purosottam Nepal and Mr. Anand R. Dhakal, Under Secretary for their professional inputs and valuable suggestions at various stages of the study. We would also extend our sincere thanks to officials of different Ministries and Departments for having spared their valuable time to interact with the study team members and providing their useful insights in several dimensions of the study. We are indebted to all LDOs including Account Officers, Planning, Monitoring and Administrative Officers and Program Officers of the surveyed districts for their cordiality and hospitality extended to the study team. We are also very much thankful to all of them for providing required information. Chief Executive Officers of all the surveyed Sub-metropolitan/municipalities and the planning, budget and revenue section chiefs deserve appreciation for providing us necessary data/information and also for sharing their experiences and insights. The team is also thankful to the ex-DDC Presidents and ex-mayors and Ex-VDC Chairman of the Districts, Municipalities and VDCs visited who shared their experiences and provided valuable insights. Thanks are also due to all the government line agencies of the districts for sharing their views and concern in finalizing the contents of grant distribution formula and on several aspects of service standards/norms. VDC Secretaries of the surveyed VDCs also deserves special thanks for their cooperation and support. We also extend our sincere thanks to all the participants of the dissemination workshop for their professional inputs and suggestions. The Study Team extends sincere thanks to Mr. Indra Pant of LBFC, Mr. Hari Darshan Sanpkota and Mr. Gajendra Budha of DASU/DANIDA for their excellent support during the field survey. We also express our sincere thanks to all District Technical Officers and HP In charges, MC and SMC office bearers, Head teachers/Teachers of all the surveyed Schools for sparing their valuable time in responding to our questions, participating in the group discussions and contributing towards making the study a success. Finally, Mr. Bandhu Ranjan, Senior Administrative Officer, Mr. Annapurna Sthapit, Accounts Officer and other office bearers of DASU deserves thanks for their all-round support in the study. May, 2005 STUDY TEAM

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Acronyms ADDCN Association of District Development Communities of Nepal AGO Auditor General's Office ASC Agricultural Extension Service Center ASSC Agriculture Services Sub-Center CBO Community Based Organization CBS Central Bureau of Statistics CDO Chief District Officer CFUG Community Forest Users Group CG Central Government CMS Community Managed School COs Community Organizations D (P) HO District (Public) Health Office DADO District Agricultural Development Office DAGs Disadvantaged Groups DANIDA Danish International Development Assistance DASU Decentralization Advisory Support Unit DDA District Development Advisor DDC District Development Committee DDF District Development Fund DEC District Education Committee DEO District Education Office DIMC Decentralization Implementation and Monitoring Committee DIP Decentralization Implementation Plan DIRC District Information and Record Center DMC District Management Committee DoLIDAR Department of Rural and Agricultural Roads DRDD Decentralization and Rural Development Division DTCO District Treasury and Controller's Office DTO District Technical Office DW Drinking Water EC Executive Committee GTZ German Technical Cooperation HLDCC High-Level Decentralization Coordination Committee HMGN His Majesty's Government of Nepal HRD Human Resource Development IEPNA Indigenous/Ethnic Promotion National Academy IGA Income Generating Activities JT Junior Technician JTA Junior Technical Assistant LBFAR Local Bodies Financial Administration Regulation LBFC Local Bodies Fiscal Commission LBs Local Bodies LDF Local Development Fund LDO Local Development Officer LDTA Local Development Training Academy LG Local Governments LGP Local Governance Program LMs Line Ministries LO Livestock Office LSC Livestock Service Center LSGA Local Self Governance Act, 1999 LSSC Live Stock Sub-Service Centre MDF Municipality Development Fund MoLD Ministry of Local Development

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MoES Ministry of Education and Sports MoF Ministry of Finance MoFR Ministry of Forestry MoH Ministry of Health MuAN Municipality Association of Nepal NAVIN National Association of VDCs in Nepal NGO Non-Governmental Organizations NHDR Nepal Human Development Report NPC National Planning Commission O&M Operation and Management PAF Poverty Alleviation Fund PLSS Public Lower Secondary School PMC Project Management Committee PO Program Officer PRSP Poverty Reduction Strategy Paper PSS Public Secondary School PTA Parent Teachers Association SHP Sub-Health Post SHPI&MC Sub-Health Post Implementation and Monitoring Committee SHPMC Sub-Health Post Management Committee SIP School Improvement Plan SMC School Management Committee SNG Sub-National Governments (in Nepal DDCs, VDCs, Municipalities) UC User's Committee UDLE Urban Development through Local Efforts UNDP United Nations Development Fund VDC Village Development Committee VDP Village Development Program VEC Village Education Committee WB World Bank

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EXECUTIVE SUMMARY

E.1 Introduction and Methodology

In Nepal, as a mechanism of intergovernmental fiscal transfer Ministry of Local Development (MOLD) has been providing both conditional and unconditional grants to Local Bodies (LBs). Estimate indicates that the central government transfers still constitute more than three-fourths share of local government expenditure in Nepal. It has often been questioned about the basis of such distribution system. Critics are of the view that distribution system lacks sound basis. To overcome this problem MOLD since FY 2003/04 has introduced formula based grant allocation to District Development Committees. The Interim formula, however, suffered from several limitations: (i) Formula does not fully comply with the norms specified in the LSGA 1999; (ii) Formula treats (1-HDI) as the proxy of financial needs of the districts which is not completely true; (iii) the cost factor has been taken on a proxy basis and is not based on the actual prices of the construction materials at districts; and (iv) undue emphasis of 50 percent weights given to the HDI factor. HMG/N has moved on to the path of decentralized governance system. To reinforce government's commitment toward decentralization HMG/N started devolving some of the basic services (health, education agriculture and livestock extension) to LBs from 2001/02. In the course of devolution, services of higher level such as health post and lower secondary and secondary school have also been gradually devolved. More recently the government has devolved infrastructure sector involving rural roads, small irrigation and small drinking water to DDCs from the current fiscal year 2004/05. Guidelines issued for the services devolved seek direct and indirect participation and involvement of LBs and entrust them with specified responsibilities. The provision of services requires cost. The institutions, which are handed over with the responsibilities must be reasonably compensated for that. From the perspective of both revenues assignment to LBs and intergovernmental transfer system the assessment of the expenditure needs deserves special consideration. In these perspectives, MOLD has realized the need of improving upon the existing system of intergovernmental fiscal transfer through the development of more improved grant distribution formula. The present study further embarks on a systematic assessment of cost implication of devolution process and quantify recurrent and establishment cost of the devolved services viz., health post, lower secondary and secondary education and rural infrastructure service. Such quantification is expected to further strengthen and consolidate the exercise of decentralized governance system in the country through devolution of essential services to LBs. The present study has aimed to address these issues of greater significance to HMG/N. The overall objective of the present study is to develop improved formula for grant distribution to LBs and suggest appropriate modalities for grant equalization. Besides, the present study also aimed at estimating the expenditure needs of selected devolved services viz., lower secondary and secondary education, health post and rural infrastructure covering rural roads, small drinking water and small irrigation. Combination of various study approaches has been adopted for addressing the objectives and the scope of the work of the present study. Major components of the present study are review of documents; consultative meeting; survey of local bodies; interaction meeting with LBs and the district line agencies of the devolved services; providers' survey; and retail outlet survey. DDCs of 18 districts, 15 municipalities and 51 VDCs from the sampled districts were surveyed. In order to make the selection more representatives, the districts were selected based on the ecological and regional considerations. Besides, the districts are also selected based on their performance (strong/weak), resource base and on the consideration of the task devolved to the communities. 15 DP (H) O, 16 DEO and 18 DTO from the surveyed districts were also visited and concerned officials were interviewed. Likewise 14 HP, 14 secondary schools and 5 lower secondary schools were visited and HP in charge, Head Teacher/teachers including SMC members in few

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cases was interacted. Data format, structured questionnaire and in-depth interview checklist were developed. Officials of DDC, municipalities and VDC were interviewed. In order to improve the grant distribution formula various computer simulation exercises were performed and the most appropriate and practical formula has been suggested. Before carrying out the simulation exercise database for districts and municipalities was created with suitable indicators for constructing index. Besides, the perceptions and impression gained in course of interaction with various stakeholders, local key informants were analyzed to redesign the grant allocation formula. Standards/norms for service provision have been reviewed. Based on standards, cost analysis is performed by inputs/activity costing methods. Both recurrent and establishment cost, per service unit e.g.; health post were computed to assess the expenditure needs of such service. E.2 Intergovernmental Transfer: Concepts and Practices

Concept and Economic Rationale for Intergovernmental Transfer In a decentralized system of governance, the need for intergovernmental fiscal transfers arises mainly due to fiscal imbalances between internal revenue and expenditure needs of local bodies. Fiscal imbalances of local bodies occurs because, for macroeconomic and equity considerations, and tax administration efficiency, larger part of revenue authorities are likely to be given to central government. This leaves insufficient resources to the sub-national governments for covering their expenditure needs. Intergovernmental transfers are designed to address the fiscal imbalances. Fiscal imbalances between resources and expenditure needs of local bodies occur in two forms: vertical and horizontal imbalances. Vertical imbalances occur due to inadequacy of the fiscal resources with different levels of government to accomplish the assigned tasks and provide the services to citizens at the specified quality and quantity. Horizontal fiscal imbalance, or difference in the resources among local bodies within the same level, occurs due to various reasons such as differences among local bodies‘ on their resource endowments, fiscal capacity and efforts, and cost of producing services due to differences in physical and infrastructural facilities. It is difficult to eliminate horizontal imbalances. However, attempts should be made to minimize such imbalances; or else there will be difference in the quality of services provided by local bodies across nation. Such a situation is not regarded acceptable because for equity reasons citizens must be provided with a similar set of service of a given quality and quantity across the nation commensurate to their tax contribution. Objectives of intergovernmental transfers

It is observed that there are five key objectives that an intergovernmental transfer system intends to achieve. Two among them are to achieve vertical and horizontal fiscal balance. Besides them an intergovernmental fiscal transfer also aims to compensate the local bodies with funds for their financing for services that also benefit people or area beyond the LB‘s jurisdiction (or to offset the impact of externalities). The fourth objective of intergovernmental fiscal transfer is to avail LBs with resources for their contribution in providing services of national priority (or to finance merit goods). Achieving administrative efficiency is another objective of intergovernmental fiscal transfers. The importance of a good transfer system cannot be overemphasized. System should be designed in such a way that the intended objective would be fulfilled. While the good reasons are important to deepen a decentralized system of governance, the other set of reasoning mostly curtail the pace of the same. Instruments of intergovernmental fiscal transfer

There are different instruments that the central governments could normally use to fill the fiscal gap of local bodies. Empowering local bodies with more fiscal authorities, revenue sharing and

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grants are few such instruments. Revenue assignment is not the focus of the current study. Grants from the central government to the local bodies are essential, because it is observed that despite of well planned revenue assignment and revenue sharing arrangements there still occurs fiscal gap at the local bodies. The present study has focused more on this aspect. Criteria for an effective transfer system

Scholars and practitioners have pointed out that a good intergovernmental transfer programs have certain characteristics in common. Such a system should ensure revenue adequacy to the local government to carry out the assigned the responsibilities. It should be encouraging local tax effort and at the same time through hard budget constraints controls overspending by local bodies. A transfer should be transparent and predictable that enables the local bodies to forecast its own total revenue including the transfers to prepare their budget. The system should also be stable for a reasonable number of years to allow the local bodies to prepare their medium-term plans. Components of a grant system

Design of grant system has to address the following – what is the amount that is to be distributed (vertical balance); what is the purpose of the grant transfer to local bodies; how the grant amount be distributed among local bodies (horizontal distribution); and how is the system being administered, monitored and managed. Size of the grant pool

Determination of the size of the grant pool is essential to ensure vertical balance. There are three common approaches to determining the size of the grant pool. Most countries use one or more of these three methods. These are determination as a share of some central government revenue source, on the basis of cost reimbursement, or on an ad-hoc basis. Under tax sharing system the central government allocates a share of national collections of some tax to the local government sector. What sources are appropriate or what percent of the identified source is to be set aside for local bodies grant pool is crucial. There is no universal rule in regard to both the sources and proportion of funds set aside for local bodies. Cost reimbursement is another approach to determining the size of the revenue pool. The central government defines a service for which it will guarantee to cover the cost incurred by the local government in delivering this service. It is like conditional grant in some regards. Under ad hoc, or discretionary, basis of transfers, the budget for local bodies is allocated each year through parliamentary processes. The ad-hoc approach to determining the size of the distributable pool is the most centralizing approach to designing an intergovernmental transfer system. This is based on negotiations. The disadvantages of this approach are that it is not transparent, is subject to political manipulation, not predictable for local bodies fiscal planning and budgeting. More importantly this approach denies the link between expenditure responsibilities and revenue resources, and discourages local bodies to become self-reliant. On the other hand, the ad hoc approach also has some advantages. From the point of view of the central government, it provides flexibility and space in preparing budget as it does not have to oblige by the predetermined share of local bodies. This is prevailing approach in Nepal. Despite some very apparent flaws, it is widely used, even in some countries that feature decentralization as part of their development plan. The compensatory approach espouses the ex post gap filling. This is less effective to LB autonomy, and high demanding for administrative input in the management of the system. The most decentralizing form of vertical revenue sharing is the shared tax approach. Distribution of the pool of resource among eligible local bodies

Horizontally the transfers might be distributed according to a derivation basis, i.e., local governments may retain a share of what is collected within their boundaries. Alternatively, they may receive grants distributed by formula, by cost reimbursement or according to ad hoc

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methods. Though simple to execute and good in terms of fairness this system is bad in terms of equalization perspective.

A formula based transfer system has at least three advantages over the discretionary system. It is objective that avoids bargaining and increases chances for fair distribution. It also encourages for local tax efforts and imposes hard budget constraints and thus stops over-spending because most formula designs take into account these factors. Formula grants are generally unconditional, which gives locals a maximum of flexibility in deciding on the purpose of expenditures. Further if the grant pool is determined through shared taxes then some degree of certainty in the distribution is also attained which is desired as per principle of transfer.

Types of grants

There are broadly two types of grants: conditional and unconditional. Conditional grants are given in two broad forms. They are matching and non-matching. Again the matching grant is divided into open-ended or closed-ended. Conditional grants are sometimes called specific purpose grants or categorical grants, wherein the central government specifies the purpose for which the recipient local body can use the funds. Conditional grants can be matching or non-matching. In the case of conditional matching grant the central government asks local bodies to match certain portion of the expenses on specific programs as a condition to receive the grant. Open-ended conditional matching grant is a type of grant in which the central government does not impose a limit on the matching funds. Closed ended conditional matching grant is such a grant fund for which the central government puts a maximum ceiling on the cost it will borne to finance a service. For an unconditional grant no restriction is posed on the use of funds. In effect it is a lump sum amount of money provided to the local bodies. In most cases this grant is that it is provided to equalize fiscal capacity of local bodies to ensure that a minimum standard and level of public service is provided to its public. Unconditional grants, for example, are best for promoting autonomy of the local bodies and inter-jurisdictional redistribution, while conditional grants are more efficient in encouraging expenditures on particular types of target services Design of grant formula for intergovernmental fiscal transfer

Bahl suggests that design of a formula based grant system should give serious considerations on the elements of the formula, the data necessary to implement the formula, and the costs associated with administering the grant program. The grant formula has to identify the elements that appropriately reflect the objectives and indicators or proxies for measurement.

Objective of the formula Possible indicators or proxies or elements of the formula

Reflect the expenditure needs and regional cost differences

- Population, i.e., a straight per capita distribution - Indicators of physical factors that may lead to greater costs of service provision, e.g.,

land area, population density, and urbanization. - Measures to reflect the concentration of high cost population in the local government

areas, for example, the percent of families living below the poverty line, the percent of people on pensions, the percent of school aged children, etc.

- Indicators of infrastructure needs, such as miles of paved highways, percent of households with access to adequate water supply, infrastructure needs to support economic development, etc.

Equalize local body income or fiscal capacity

- Level of average income, or the size of the tax base - Amount of money that could be raised if all appropriate tax bases were subjected to

"normal" rates.

Provide incentives to increase revenue

- A measure of tax effort and management performance - Maintenance of a level of revenue mobilization

Reflect a balance between revenue capacity and expenditure needs

- Defined standards of expenditures for desired levels of service - Link minimum expenditure requirements with an assigned tax revenues - Interpolation of historical expenditure figures

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The elements in themselves serve the purpose but they are useful only if related data are available. Therefore selection of elements should be cautiously made and data availability of data must be ensured. Formula grants are administratively demanding to mange the system. A responsible unit to maintain the database and manage the system is considered necessary. To assess efficiency and effectiveness of the system, or identify issues for revisions, grant systems need to be monitored and tracked continuously. Guidelines in designing formula

It is generally accepted among fiscal policy experts that all transfer formulas should consider some general guidelines. These guidelines should be prepared building on the key criteria of adequacy, cost control, encourage local efforts, stability and transparency that apply universally to all transfer mechanisms. A formula based grants system should be:

- General allocation transfers or equalization transfers should be granted as unconditional lump-sum grants for general-purpose financing by LBs

- The transfer mechanism should be, to the extent possible, simple and transparent. - The introduction of a new transfer system should avoid sudden large changes in

funding for local governments. - The formula should support a fair allocation of resources by providing more resources

to districts with greater fiscal needs. - The data source should be respected by all stakeholders, and the factor should be free

from manipulation by local government officials - The factor should reflect the need (demand) for a service (i.e., the number of potential

clients for a government service), and not necessarily the current supply of services - The factor should be statistically sound and regularly updated (for instance, census

data should be used as opposed to variables occasionally produced) - The formula should not rely on the “equality principle”. The system should be rather

equitable (fair) in terms of population or area; efficient to encourage resource allocation in areas where they are needed most; and technically efficient that encourages reasonable size of the local bodies.

Formulas for equalization transfers

Determination of an equalization formula requires assessment of both revenue capacity as well as the expenditure needs of local government since intergovernmental transfer is meant for balancing the revenue and the expenditure needs of a jurisdiction. It is not easy to develop a formula for equalization transfers accounting for the expenditure needs and fiscal capacity. Several approaches to this effect are followed by different countries, thus resulting into several Types of formula suitable to one‘s need and conditions. Type A formula accounts for fiscal needs, fiscal capacity and other transfers, therefore is most equalizing by nature. But data requirement is demanding. Type B formula simply tries to equalize resource by accounting the tax base and tax rate. It is less demanding of data. But it does not account the regional differences of costs. Both of these appear not suitable for Nepal. The approach of Type C formula takes is to calculate the cost of all assigned services and make a transfer accordingly. This approach does not consider the fiscal capacity of local bodies. Type D formula considers equalizing transfers per capita. It is least demanding for data, but also has relatively weak equalization effects. Equal per capita transfer cannot fully equalize but can mitigate regional disparity in fiscal capacity.

Review of the merits and demerits of these formulae suggests that an adapted Type C formula is better option in the present context in Nepal. This is because it requires little data. It ignores the fiscal capacity aspect of the local bodies, but this is not so significant anyway in our present context. Some public policy experts argue that fiscal capacity should not be considered in designing formula since that the local bodies that raise more money have to provide more

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services to its citizens. Therefore they argue that in equalization grant system fiscal capacity aspect becomes redundant to be included in the formula. Measuring fiscal need

Grants are meant to fulfill the fiscal needs of a jurisdiction. Therefore a grant system must adopt systematic approach to measure the fiscal need of a local body. Broadly there are two methods used to determine fiscal needs of sub national governments. The first method estimates the cost for each service. The total fiscal need of a sub national government is the sum of the estimated needs for all these categories. This above method to calculate a local body‘s fiscal needs require substantial information on a variety of different factors that affect the costs of providing public services. Not all countries have this depth of information. Alternative approach is to estimate a local body‘s fiscal need on the basis of certain proxies and weight assigned to them. Most common proxies are population, income level, and area. Other variables that can be considered for this formula include population density, tax effort (revenue/GDP ratio), etc. What to take as proxies is a matter of policy choice, which should be done with extensive consultations with stakeholders, simulations, and judgments. Issues about equalization through formula based transfers

It is very difficult to attain equalization in practice, however it is commonly agreed that equalization should be pursued. Full equalization is almost a wish with a grant formula because there are more than one objectives (equalization of income level, per person revenue, fiscal capacity, expenditure needs) demanding equalization. One may prefer equalization through ad hoc grants since a formula based grant commonly fails to address special needs of a jurisdiction. But due to non-transparency of such a system it has potentials to become a bad public policy choice. Moreover, equalization grants design can have negative impact on tax efforts of local bodies. Furthermore, it is necessary to ensure that equalization principles will be followed by the local bodies as well while allocating resources. In such a case big question arise who will monitor effectiveness of equalization arrangement, how one will monitor and what indicator will one use. E.3 Review of Nepalese Transfer System

Principles of Transfer System: Inter-governmental fiscal transfer system should be able to assure a predictable and steady inflow of resources to local bodies, help to minimize the gap in fiscal capacities among local bodies, pursue rightful policy initiatives and objectives of the center and to contribute towards the enhancement of revenue generation of local bodies. There is uncertainty about the 'divisible pool' of development/capital cost grant to which each level of local body is entitled to participate since it s determined each year based on budget negotiation between the MLD on the one hand and Ministry of Finance/National Planning Commission on the other. The grants provided by the central government to local bodies can broadly be categorized into three types, namely, operating or recurrent grant, program or capital cost grant and conditional grant. Grants other than the operating/recurrent grant are commonly referred to as program or capital cost grant. The amount of development/capital cost grant to individual local bodies is determined by the Ministry of Local Development based on some pre-determined objective criteria in the case of DDCs, on judgmental basis in the case of municipalities and fixed sum without applying any criteria in the case of VDCs. The concept of additional development grant practiced from the current fiscal year is also discriminatory towards the resource rich municipalities since only 10 municipalities considered resource poor and remote enjoy the benefit of such a grant. Equality rather than equity is ensured in the present system of block grant to VDCs. This approach does not take into

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consideration the expenditure needs of VDC lying in different geographical locations, with varying population level and area. Structure and Pattern of Transfer

Transfers from the central governments are the principal source of revenue of all local bodies in Nepal. Of the total resources of local bodies, it is found that Municipalities generate more own source revenue (28.95 percent) than the VDCs (25.92 percent). The ability of DDCs to generate internal revenue is considered the lowest among the local bodies. Transfers to DDC: DDCs receive grant from the central government to meet their administrative expenses. With effect from 2003/04, the DDCs have been given the discretion of budgeting funds required for this purpose out of the recurrent grant provided to them by the center. The inclusion of salary of VDC secretaries as recurrent grant to DDC is not fair on the DDC since they do not have any discretionary authority with regard to the spending of fund set aside for the purpose. Capital grant enables the DDC to execute development activities in the district. The DDCs have the sole discretion to use this grant for the purpose they wish by following the planning and budgeting procedures as set out in the local self-governance law. The capital to DDCs prior to fiscal year 2003/04 was provided as the development grant. In addition to the capital grant, the center is also providing the DDCs with funds to implement: a) rural drinking water and sanitation project, b) local infrastructure and rural road project, c) construction and rehabilitation of large and local level suspension bridges, and d) development programs based on people's participation. With effect from fiscal year 2003/04, DDCs have been given complete authority regarding planning, allocation and selection of the projects from the funds thus provided. The respective share of administrative and general-purpose capital grant and conditional grant in the total grant provided by the center to DDCs is respectively 31.4, 20.8 and 47.8 percent. The recurrent and capital grant has remained more or less at the same level during the two years whereas there is a substantial increase of more than 100 percent in the conditional grant in the year 2003/04 as compared to the year before. The MLD has provided guidelines to DDC which they must follow while spending the grant fund. The grants provided to DDCs include funds to meet recurrent expenditures and capital costs. The Guidelines mainly contain directives to be followed by the DDC in the transfer of funds and allocation of funds. Transfers to Municipalities: Municipalities at present are getting administrative grant and development grant from the center. Administrative grant is provided to enable the municipalities to meet the salary related cost of the staff deputed to them from the center. Only selected municipalities are entitled to receive development grant from the center. According to Local Self-governance Act, municipalities with annual internal revenue below Rupees 10 million are only qualified to receive development grant. The municipal development grants are of three types. Development block grant to the municipalities is given with the discretion to spend the grant fund in the programs/projects of their choice by getting the program and budget approved from the Municipal Council. Conditional development grant are provided to municipalities for fire-fighting, matching fund, rural urban partnership, youth development and construction of land fill sites. The center also provides funds to municipalities in the form of LDF, which the Municipalities can spend on their discretion. In addition to the development grants specified above, the center has also started to provide additional development grant to those municipalities which are not able to provide basic minimum services to the public in an effective manner due to lack of adequate resources, means and capacity. Ten municipalities of the remote areas with low internal resources base are

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selected for the provision of additional development grant of Rs. 5 million each staring with fiscal year 2004/05. An analysis of the fiscal transfers allocation made by the center to municipalities over the past 2 years shows that it constitutes 24.25 percent for administrative purpose including firefighting grant, 57.03 percent by way of unconditional development grant and 18.72 percent as conditional development grant. Fiscal Transfer to VDCs: The center provides Rs. 500,000 per annum with effect from fiscal year 1996/97. The block grant to VDC does not cover the salary and allowance cost of the VDC secretary. Every VDC is permitted to spend an amount not exceeding 25 percent of the grant fund for administrative and human resource development purpose. The amount of grant to VDCs is not determined based on any objective criteria since it is the same for all the VDCs irrespective of their area, population and cost of living or price level. Weaknesses in the Present System of Fiscal Transfer: The development grant to municipalities, block grant to VDCs and capital cost grant to DDCs are allocated out of the divisible pool which is not determined considering the expenditure needs of the local bodies with due consideration to their own source revenue and funds received by them through local development fee/revenue sharing. The application of HDI in allocating grant to DDCs does not take into consideration the population factor. As a result, the grant amount attributable to this criterion tend to favor, on per capita basis, the hill and mountain districts heavily with lower population as compared to the Terai districts which have higher population. Doubts have also been expressed on the results of HDI of certain districts computed through HDI survey compared with the others. Population is considered an important factor, which determines the level of public demand for services from local bodies and therefore their expenditure needs. The weight of 20 percent given to population factor for the distribution of divisible pool is therefore considered insufficient. Unlike the municipalities and VDCs, it is said that the DDC does not have its own territory. In fact the DDC development activities spread across the VDCs and municipalities. Exclusion of urban population in the distribution of capital grant to DDC is therefore considered a weak link in the formula. In the allocation of grant to DDCs and municipalities, there is a tendency of maintaining the overall grant level to the previous year's figure. No adjustments are made on the grants based on national economy and cost of services. Similar is the case of VDC block grant since the same amount of grant is being provided over the past 7 years. The cost factor included as a criterion in the formula for the distribution of capital cost grant to DDC carries a weight of 20 percent share in the divisible pool. The cost factor of districts in the Kathmandu Valley, Terai, hill and mountain districts has not been derived on a scientific basis. It is not based on the collection and analysis of actual cost of materials and labor in these districts. The present provision in which only those municipalities generating own source revenue of less than Rs. 10 million are entitled to get development grant from the center is considered disincentive especially to those municipalities, which are on the verge of attaining the threshold. Similarly, VDCs are all provided block grant at the rate of Rs. 500,000 per annum irrespective of their size, population or remoteness and without having any consideration to the expenditure needs of the VDCs depend which directly depend upon the demand for services and development from the inhabitants. Structure and Pattern of Expenditures of Local Bodies

Proportion of recurrent expenses to total expenses: The DDCs on an average allocate little about 35% of their internal incomes in recurrent expenses. Though there is a wide variation of 30 to 70% in this regard. DDCs with smaller internal revenue tend to spend higher proportion of

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their fund in recurrent purposes. For HMGN grants the proportion of recurrent expense is as high as 80 percent. The Municipalities spend a little less than half of their incomes for recurrent purposes. Compared to the figures of DDCs, there is only a little variation among Municipalities in this aspect. The VDCs spend about one-third of their incomes as recurrent expenses. Looking at the breakdown of the fund into development and recurrent purposes one can easily observe that LBs spend considerable amount of their funds for recurrent purposes. Analysis of the allocation of LBs shows that infrastructure comprises 85% for VDCs, 60% for Municipalities and 62% for DDCs. The Terai DDCs allocate highest proportion in infrastructure. Social sector programs follow the infrastructure, which is dominated by expenses on health and education. Unlike differences among DDCs in geographic regions in the allocation of funds for different sectors, the Municipalities allocation pattern is similar. Similarly the VDCs in various geographic regions in general have a similar pattern of allocating their resources. Special targeted programs are there but are very low; even such programs approved by the council are found to be left as not implemented. Allocations for focused programs (women, DAG, and ethnic groups) comprise only a little – it is around four percent for DDCs and less than one percent for Municipality and VDC.

DFDP Minimum Conditions for Transfer Eligibility and DDC Performance

DFDP has adopted the formula based grant distribution system since the introduction of the formula by MOLD. The DFDP developed a performance measurement framework for DDCs and a scheme to distribute grant based on performance evaluation results. It is intended to draw the lessons from DFDP districts and use the lessons for national level policy reform at a later stage. The feedback on the system relevant to possibility of applying this system for overall grant system is enumerated below. Practice of performance measurement of local bodies is commendable. It is important to impart competitive feeling among local bodies. It also provides incentive to those who do better and helps identify the area of improvements for both rewarded or penalized ones in their operations. The DDCs and stakeholders regard the performance based grant allocation system initiated by DFDP as a good practice. The DDCs found that the indicators identified in the DFDP performance measurement system are practical, and easy to fulfill, and not difficult to dig out information from a DDC. Most of the DDCs consider that such a practice should be followed for allocating all development grants as well. Dhanusha was only DDC that reported that conditions of some of the indicators were difficult to fulfill. It is observed that it is difficult to update DDCs' performance every year following the system and process of DFDP. This system requires heavy input (time and resources) to do it regularly for all the local bodies. Therefore the management requirement of the performance assessment exercise is heavy. For universal application of the system, one may opt to use information that can be updated easily through regular reporting mechanism. Down side of this is that DDC may not differ in performance or the reliability of the data can be questioned. It is found necessary to refine the identified indicators. Rephrasing of the indicators needs to be done to avoid difference of understanding of the meaning. For example existence of pro-poor programs is mentioned in the current measures that need to be further defined as to what include pro-poor programs. Such a system should be applied by all the agencies supporting the DDCs. The experience of the assessors is that since the DDCs had understood that this system is only applied for DFDP grants and they will not loose much even if they failed. Some DDCs expressed that even if DFDP quits other agencies will support them. This attitude prevails simply because it is only DFDP that uses performance measurement data for its grants. The LDTA report suggests that here is a need from, the MLD to make clear that the assessment result will affect all other grants.

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E4. Design of Intergovernmental Fiscal Transfer for Nepal

The present study has taken the learning from a review of the literature about the principles and theory of the intergovernmental fiscal transfer and recommendations and or suggestions made by various previous studies relevant to the design of such a system for Nepal. Besides the study has taken ideas and suggestions from stakeholders (national and international; scholars and practitioners) as basis. Drawing on the experience within the country and abroad, and building on the theoretical underpinning, the system is designed considering the critical factors (both technical and organizational) influencing fiscal transfer in Nepal. Before presenting the system itself the report enumerates the critical factors that have been used as guides to design the system in short.

What the principles say Implications in the formula

Formula should be made with clarity on the objective of the transfer fund

Block grant has two purposes: equalization of resources and meet part of the development needs of the region If more objectives are pursued then it might be better to opt for creating separate funds

It should be transparent and the transfer grant should be predictable and stable

The formula should be simple, easy to understand. The grant pool should be tied up with standards. It should be stable for some time.

Data should be relevant, easily available, and the sources should be credible and acceptable to all

The selection of factors should be cautiously made. As far as possible the formula should use of national data, which is not disputed.

The system should be administratively simple

Do not go for data generated through surveys; preferably use data from regular reports of LBs.

The system should promote decentralization and autonomy of LBs

Increase the proportion of unconditional grants. Review the system and formula should be and ongoing process and done in a participatory manner

Key characteristics of formula based transfer for the case of Nepal include its poverty sensitiveness, and reflecting development needs of a jurisdiction. Furthermore the system should also recognize variation of cost of providing services across LBs. While the system may overlook internal financial revenue in absolute terms, it must reward efforts exerted for mobilizing internal resources. Internal revenue can be ignored because first of all LBs do not have significant tax revenue and whatever they have is result of their commitment for additional services to their tax payers. However, the revenue through shared tax must be considered in the design of equalization system. Determination of distribution pool

The distribution pool is considered scientific and fair if it is based on certain formula. Therefore instead of allocating the amount annually by the parliament it is desirable if some objective basis is defined to determine the size of the distribution pool. International practice is to arrive at the grant pool amount either as a fixed portion of the total national revenue excluding amount of debt service, or a portion of certain tax revenue. Both policy options are feasible and it is a matter of adopting one. The study recommends the first option. Following this option an analysis of the current grant allocation for distribution to local bodies is done. This revealed that about 7.5% of the national revenue is currently set aside, including the local development fee transfers to Municipalities. Because of its characteristics (LB discretion on the tax base and rate) and a need to abolish this fee in near future the study concludes that the local development fee should be treated as grant transfers. Following the notion that in future too the grant size will not decrease, the grant pool should be tied up with the national revenue and the amount should be at least 7.5%. Since introduction of new system will need additional money for distribution as incentive besides the regular funds, and for simplicity it is suggested to make the pool of around 10% of the annual national revenue.

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Types of grants

As discussed earlier the objective of the grant can be conflicting. For example a formula that is inclined to give more grants to poor LBs might disenchant the ones with better internal fiscal effort. Therefore there is a need to establish separate grant-types with different objectives. Against this background it is recommended to divide the grant pool into the following three grant funds in case of the general-purpose grants to be provided to DDC and Municipality.

Grant Fund Size and purpose Characteristics of formula

Unconditional general-purpose grant

Allocate 78% of the grant pool as this grant fund. The fund will be used by LBs fully in their discretion on area of their priority. The intended purpose of the fund is to meet recurrent costs of services generated, and develop additional services to citizens

The formula for distribution will be favor LBs having high poverty, remoteness, and situated in underdeveloped area or region with higher amount of grants.

Unconditional incentive grant

Allocate 20% of the grant pool as this grant. The fund will be used to promote and reward better performance among LBs. The LBs that might have suffered due to not being poor, but have done well, will be compensated with this fund

The formula will favor LBs following good governance practices, putting in high fiscal efforts, and carrying out effective programs in efficient ways

Special purpose (including) administrative grant

Allocate about two percent of the grant pool for this purpose. This is required (as per current practice) to provide administrative grants to local bodies

In the case of grant pool of VDCs creation of separate fund is not advised. This is because such an arrangement would demand huge administrative input. Therefore the pool for distributing grants to VDCs will be one and remain same as it is today. However, the distribution will not remain on an equal basis. Method of distributing block grants

Block grant consists of three major categories of grant – administrative grant, general-purpose grant, and incentive grant. In the long run, the three grant heading will be reduced to two – general purpose grant (which will incorporate the administrative grant) and incentive grant. Since there is little flexibility a local body in Nepal can do about allocation of the administrative grant, it is proposed to calculate it separately. In such a scenario the other two grant categories will be distributed based on formula, and the administrative grant will be distributed as per actual calculation for the interim period. The following sections will describe the formula recommended for distribution of general purpose and incentive grants to DDCs and Municipalities, and block grant to VDCs. Method of distribution of general purpose grants to DDCs

Two aspects are important in developing formula for distributing DDC grants: a) the factors to be included and b) the weight assigned to each of them. For this the study team carried out regression analysis with selection of potential factors. The selection of the factors was done based on the existing formula, suggestions by the stakeholder and the judgment of the study team. The factors used for carrying out a regression analysis are area, population, rural population, population below poverty, 1-HDI, human poverty index, cost factor, infrastructure development index and DDC classification. The present allocation pattern is taken as the dependent variable. The result of the regression analysis showed that most potential factors following different models are presented in the table below.

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Coefficient of Factors R R

2

Area Population

Pop‘n below poverty

Cost factor

District classification index

Infrastructure index

1-HDI

Model 1 0.434 -0.313 0.901 0.879 0.109* - - 0.958 0.918

Model 2 0.409 -0.165 0.809 0.915 - -0.182* - 0.963 0.928

Model 3 0.437 -0.390 0.945 0.938 - - - 0.957 0.915

* The factor was insignificant Simulation observation on the explanatory power and significance of the factors showed that the following factors were found not significant: classification of district; infrastructure index, but its significance was higher than that of district classification; rural population; HDI; and human poverty index. The most significant factors were four; they are cost index, area, population below poverty, and population. These four factors, in Model 3, combined together could predict over 95% of the grant, therefore this is considered most appropriate.

In order to develop the weight of these factors in the formula further analysis of the regression coefficients was done. The coefficients of the factors suggest the following weight that each factor should be given: Area 16%, population 14%, cost factor 35% and population below poverty 35%. For the sake of simplicity the weight is distributed as 15% each to area and population and 35% each for cost factor and population below poverty. Therefore, according to this formula, the general purpose grant that each district is entitled to receive will be calculated as follows:

DDC general purpose grant amount

=

15% of grant amount x a DDC‘s share in area

+

15% of grant amount x a DDC‘s share in population

+

35% of grant amount x a DDC‘s share in cost factor

+

35% of grant amount x a DDC‘s share in Population below poverty

Method of distributing incentive grants to DDCs

The purposes of incentive grants are: a) Encourage better performance by local bodies; b) Compensate some DDCs which, following the formula approach to determining grant amount, may receive an amount less than what they were receiving before; and, c) Use as cushion for phasing out full implementation of formula based distribution of block grant. The total fund to be distributed for incentive grant will be 20% of the total grant allocated for distribution as block grant. This amount is to be distributed on the basis of performance of DDCs measured in terms of their governance, planning and budgeting, operations management, financial management and fiscal discipline, adoption of transparency and accountability practices measured on a 50 points performance measurement scale with in 25 indicators. The weight to each indicator varies from 1 to 4. It is suggested that a cut off score (out of a total score of 50) be determined on the performance measurement scale, and DDCs that score more than the cut off score will be eligible for obtaining the incentive grant. The total amount for incentive grants then will be distributed among the eligible DDCs based on a formula. An equal distribution of such grant equally among the eligible DDCs is considered inequitable and inefficient; therefore the grant amount will be determined proportionate to the performance level. Method of distributing general-purpose grant to Municipalities

As in the case of DDCs the exercise is done to identify the most important factors and their weight for distributing general purpose grant to Municipalities. The potential factors tested for the regression analysis are: population, area, infrastructure development index, and internal revenue. A potential factor, the contribution of Municipal area to the national exchequer, was considered but not included in the analysis because of non-availability of data.

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The study team carried out statistical regression analysis to see the relationship between the current level of grants (total of development and administrative grants) and different combination of factors with a view to develop general-purpose grant to Municipalities in Nepal. Based on different models were identified and the data tested. The result of the different models did not show encouraging result in terms of the explanatory power and significance of these factors. By using the per capita grant as dependent variable and internal revenue per capita, infrastructure index and population as independent factors was then tested. Municipal area as a factor was found not useful. However the exercise resulted into about an explanatory power of 25% (with R-square value 0.248 and adjusted R-square value 0.161) of the model, but none of the variables were statistically significant. The explanatory power of the factors was found a bit higher by converting the figures into natural log, as shown below.

Coefficient of Factors R R2

Population Internal revenue per capita

Infrastructure index

Area

Model 1 -0.617 0.088 -0.167 0.077 0.295 0.183

Model 2 -0.583 0.040 0.151 x 0.292 0.211

Only factor population was significant The table above shows that Model 2, which includes population, infrastructure index and internal revenue per capita, gave more promising results than other models. Though the factors other than population are not statistically significant, this model has about one-third of explanatory power. The coefficients of the factors suggest the following weight that each factor should be given: Population 75%, Infrastructure index 20% and internal revenue 5%. However, the figures as such cannot be taken if the formula should be poverty sensitive. Therefore some adjustment on the basis of "educated estimates" needs to be done on the Weightage of these factors to arrive at a more desirable formula. Along this line the study team recommends to distribute the weight as: 60% to population, 25% to infrastructure index and 15% to internal revenue. Therefore, according to this formula, the general-purpose grant that each district is entitled to receive will be calculated as follows:

Municipal grant amount from general purpose grant fund

=

60% of grant amount x a Municipality's share in Population

+

25% of grant amount x a Municipality's share in infrastructure index

+

15% of grant amount x a Municipality's share in internal revenue

A simulation done according to this formula resulted a correlation figure of some 45% between the current level of grants including development fees and the figures that the simulation exercise gives, which is highest among various simulated models. This means the formula reflects only about 50% of the grants currently being provided to Municipalities. Such a wide variation suggests that Municipality grant would take more efforts to make it formula based. This is because the grants so far had been given on an ad hoc manner on the basis of approach and power and there is no observable pattern or correlation of the grant with any factor. Method of distributing incentive grants to Municipalities

The purposes of incentive grant are same as those in case of DDC. As to the method of distribution alternatives methods can be considered. The incentive grants can be distributed to Municipalities based on a composite performance index as in the case of DDC. Alternatively a simple approach can also be adopted by taking the per capita revenue as measure of revenue effort. Whatever approach is adopted a cut off point will have to be determined on the performance measurement scale, and those municipalities that score more than the cut off point will be eligible for obtaining the incentive grant.

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Issues for implementing the formula based grant system for DDCs and Municipalities

An important management issue is how to implement the formula based distribution system. Comparing the amount allocated today and indicated by the formula, the local bodies will be polarized into ―losers‖ and ―gainers‖. Such is the experience of introducing formula based grants system in other countries as well. There are alternative approaches to deal with this situation: a) arrange additional money to compensate the losers (set aside 2.5% of the amount for this purpose from the proposed 10% of the national revenue, which is spared as the existing requirement is about 7.5%); b) implement the system in phases so that the shock due to change is gradually absorbed; and, c) apply a combination of the ways mentioned in a) and b). If the 10% figure is accepted then there will be some amount to adopt the first option, and it is assumed that the second option will also be adopted. Therefore study team recommends implementing the formula in phases. For this a two to three year incremental plan can be prepared for the formula based distribution to fully take effect. Accordingly, if a two-year plan is chosen, then about 60% of the amount will be adjusted in the first year and the rest in the second year. Another issue is in regard with the capacity of the local bodies. Some DDCs or Municipalities that might have been receiving smaller grant amount because of their limited absorption capacity in the past will suddenly find themselves with a large sum of funds to spend. Their organization structure, system and processes, and number and skills with human resource may not be able to cope with the increased funds. Such a situation demands for central support to increase their capacity. The central agency may require arranging for capacity development fund in this connection. The international experience indicates that several factors cause higher expenditure needs in big cities and jurisdiction headquarters. They include increase in the number of service consumers due to service provided to inhabitants of suburbs and surrounding regions; higher cost of labor and property; higher externalities such as environment protection and transport related to the high population density and concentration of specific problems; and concentration of problems (such as crime, drugs etc.) related to sociological features of large cities. These factors are also valid in Nepali Municipalities and district headquarters as well (rather more so due also to influx of internally displaced people from conflict prone rural areas), however they are not adequately reflected in the grant allocation formula. Method of distribution of grants to VDCs

It is essential that the formula related to grants to VDC should be simpler than DDC and Municipality formula because of huge number of VDCs. The factors that are found to be potential in developing formula for distributing VDC grant were VDC classification, VDC area, and population. The study team carried out a number of scenarios for simulation to arrive at appropriate weight of these factors taking the data of three districts one each in Mountain (Mustang), Hill (Bhaktapur) and Terai (Kanchanpur). Comparative analysis of figures taking equal grant (Model 1); population as sole factor (Model 2); population 85% and area 15% (Model 3); and, population 75%, VDC classification 15% and area 10% (Model 4) was done. Of these models the study team recommends adopting the Model 4 for distributing grants to VDCs. The team observed that because of a significant weight given to the factor Classification, the formula is biased against VDCs classified as A. As a result the VDCs of district headquarters appeared to have suffered from the formula based system, since they are automatically classified as A. There are a few districts whose headquarter is situated in VDCs, therefore instead of completely changing the formula for the sake of few districts, the team suggests to compensate such VDCs with a different mechanism. One option is to incorporate a factor in the formula itself. Method of distributing specific purpose sectoral grants

The study has not focused in detail about method of distributing specific purpose sectoral grants. This is because of unclear expenditure assignments to local bodies, undefined minimum

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service standards on the sectoral service areas, and devolution of limited tasks has taken place only in a few areas. However, the study has outlined the general frame for determining the sectoral grant amount. The following is the recommended framework to determine the specific purpose sectoral grants.

- Clarify on the objective of the grant and identify grant pool for each sectoral grant. This should segregate the grant pool for recurrent and capital purpose and for salary or non-salary purposes.

- Define the principles of transfer and guide for formulae design. Commonly agreed key concepts and principles include poverty focus, result/outcome orientation, not too restrictive of local autonomy, and having reward and punishment elements.

- Identify the factor to use. The factors should represent of the expenditure need and output/resultant situation of the purpose at hand. Data should be available on the chosen factors.

- Assign weight to the factors used. Assignment of the weight to a factor used is crucial. Simulation of various combination and regression analysis will be required to ascertain the appropriate weight to the factors.

In order to ensure ownership of the formula among stakeholders it is recommended that the factors and their respective weight be finalized with intensive exercise (simulation and dialogue with stakeholders) and that this process should continue. Possibility of introducing equalization grant

Assessment of the possibility of introducing equalization grant in the formula for distributing the block grant is one of the points in the scope of the study. Despite serious attempts the study team could not find concrete matters to recommend on this aspect. The reasons are elaborated below. It is a common understanding that a reasonably comparable level of basic public services should be available in all districts (or jurisdictions) within a country. Therefore, in allocating resources, whether by formula or other means, the fiscal needs and capacities of the different local bodies should be taken into account. Certain information should be there in a decentralized system of governance for design of an equalization scheme for implementation. Most important of them are that there should be clear expenditure assignment and defined service standards. Based on these an analysis of the expenditure needs and revenue will give the gap, which is supposed to be fulfilled with equalization grants. Need for design of specific purpose funds for Nepal

Creation of specific-purpose fund is a practice considered good for financing public services. Such funds differ from the general fund with government general reserves, in that here the purpose is specified; against the arrangement that government reserves can be used for any purpose. The specific funds clearly prove commitment and intentions of the government with regard to a specific sector or purpose. The system of special purpose funds is not new in Nepal. These funds operate with a separate management structure. Some other funds are also active but do not have separate management structure. A fund for surcharge on cigarettes is one example of this kind. There are also some funds that have remained as concept and are not active. One of the areas of improvement on a few existing fund mechanisms in Nepal includes that they are not aligned fully in spirit of decentralization in operational terms. The point of contention is that it is not essential to involve the local bodies neither in the decision making process (project identification, selection and prioritization) nor in their implementation (monitoring, supervision, funds flow, evaluation, post implementation operation and management). Being funds established by the state, therefore, they must operate in close coordination with the local bodies

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and the responsibility to attain cooperation should rest on these funds because of two reasons: a) they have to amend on their rules and b) they are the ones who are entering in a local bodies‘ area and not otherwise. Considering the experience of the fund mechanisms the following suggestions can be made as regard to creating specific purpose fund for Nepal.

- Amend the rules of existing funds as necessary to increase the scope - Create new funds for rest of other sectors such as agriculture and livestock

development, primary education, health care and so on - Channel government budgetary allocations through these funds - Allow the funds to receive resources from private and other agencies. - Resource can also be raised from sources such as surcharges.

There are alternative ways to choose to administer and manage the fund: through forming separate fund with separate management structure or administration and management of the fund through respective ministries themselves. The purpose of the fund should be made clear as to what is the amount allocated for recurrent and development purposes, and what amount is allocated to meet salary and non-salary expenses. The allocation criteria or allocation formula of the fund should be predetermined to make it more scientific and objective. The formula should be developed based on principles and criteria or relevant factors. E.5 Administration and Management of the Formula Based System

Introduction of formula based grant distribution system demands considerable management inputs on the part of the central agency. Some permanent Unit is considered needed to take the responsibility of managing and administration of formula based grants system. There are regular functions and those that need to be done periodically. The regular functions of the administration and management unit include as an intermediary communication to the stakeholders both upwards and downwards. Another function is to administer the grant mechanism, including planning and phasing the formula based grant implementation scheme; divide the grant pool into various funds; let the stakeholders know; update data, carry out simulations and adjust the grant amount every year. Promotive and regulatory functions of the Unit includes identification of the capacity development needs of local bodies in light of implementing grant system, ensure accountability and oversight of the compliance requirements associated with grants, and monitoring and evaluation of the system. Periodic evaluation of the formula, review and revision responsibility of the formula and the system is another important unction of the Unit. The study has identified a need to strengthen capacity of LBs and central agency as well in order to develop, maintain and use management information that a more scientific formula based grant system would require. For this a possible means would be to create a ―capacity development fund‖ at the central level, which would be used for developing systems at the central and LB levels and for training and capacity enhancement of staff involved in the system. E.6 Expenditure Needs of Selected Devolved Services

According to the latest information available 1273 Primary Schools, 160 Lower Secondary Schools and 67 Secondary Schools have been transferred to School Management Committee (DOE, 2004). Similarly by the end of FY 2060/61, 1156 Sub-health Posts, 11 Health Post and 6 Primary Health Center have been devolved across 25 districts.

Existing national minimum standards set by the government for the provision of services such as health, education are examined. In health the review is limited to Health Post and in education it is confined to Lower Secondary and Secondary Grade.

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Measurement Approaches

Various measurement approaches have been developed for assessing the expenditure needs of government. All the approaches rely on certain norms. Budgetary norms are either based on the cost of inputs, the quantity of outputs or some measure of desired outcomes. Expenditure norms are considered to be very useful in the design of intergovernmental transfers. Likewise, formula based and indicators based norms are common in practice for assessing the expenditure needs. However, both suffer from the problem of choices. Expenditure needs assessment through indicator-based approach requires use of wide varieties of indicators and involves the problems of selection of indicators and weights to be assigned to each of them. Some approaches of expenditure needs assessment relate to national level while others are more appropriate for the sub-national level. At the sub-national level expenditure needs is largely affected by size of population, the presence of population groups requiring special services, maintenance and replacement of infrastructure and congestion of population, among others. An appropriate methodology for assessing the expenditure needs at sub-national level should possess four characteristics: legal, rational, feasible and simple. Three common approaches are widely followed in the estimation of expenditure needs. They are: (i) Conventional Expenditure Approach; (ii) Unit Cost Approach; and (iii) Regression Analysis Approach. Review of international experience clearly shows that there is no single best approach to construct expenditure norms. Framework to Estimate Expenditure Needs

Assessment of expenditure needs, to a larger extent, depends upon the minimum standards set for service delivery. In the present study unit cost approach has been followed to estimate the expenditure needs of selected devolved services. The process involves (i) identification, reviews and update of minimum service standards developed by the government (both technical standards and general guidelines); (ii) quantification of physical inputs on the basis of certain assumptions (iii) costing of all the inputs with required adjustment (iv) obtain the average population to be served; (v) obtain per unit cost of service outlet and cost per population and (vi) obtain the total expenditure needs by multiplying the per capita cost by the total number of service outlets/population. Expenditure Needs of Selected Devolved Services

Attempts have been made to estimate the expenditure needs (costing) of the devolved services. The basis of computation is the standards/norms set by respective Ministries, which specifies the various inputs required. Although standards include several dimensions of service provision, in the computation of costing of the services we have considered those items of the standards which have cost implication. On the basis of the existing standards and the suggestions received from service unit expenditure needs has been computed. The estimation has been made separately for 6 categories of districts as classified by HMG/Nepal. The estimation of expenditure needs involves several assumptions pertaining to various inputs required. Assumptions are specific to each services devolved. The calculation of unit cost is made on a base case scenario. Unit Cost Estimate of Health Post

The estimation shows that each HP in Nepal, require average annual recurrent expenses of Rs 605836, Rs 512882 and 540026 for Mountain, Hill and Terai districts respectively. The unit cost differs across ecological regions. The average unit cost of Rs 552915 per HP estimated in the present study is at a slightly lower side as compared to the estimate of Rs. 661099 made by MTEF study team (NPC, 2004). The average establishment cost of HP is estimated at Rs. 3.34 million in Mountain and Hill and Rs 2.96 million in Terai.

Considering 40000 as the average population served by a HP, the per capita cost of HP turns out to be Rs 13.82. Assuming the daily client caseload of 20 patients, the unit recurrent cost of a typical HP in Nepal works out to be Rs 88.61 per beneficiary.

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Unit Cost Estimates of Lower Secondary and Secondary School

The unit cost estimation in education shows that a typical community LS school in Nepal will require average annual recurrent expenses of Rs. 852353 and establishment cost of Rs 1.99 million. Likewise, a typical Secondary School in Nepal would need average annual recurrent expense of Rs. 1.51 million and establishment cost of Rs 2.59 million. Estimates reveal that Salary component alone constitutes 92 and 94 percent of the total recurrent cost in Lower Secondary and Secondary School respectively. This clearly indicates how much meager amount has been spent to improve the quality of education in the country. Considering the national average of 242 and 225 students per community lower secondary and secondary school the unit recurrent cost works out to be Rs. 3522 and Rs. 6720 per student for lower secondary and secondary respectively. The combined unit cost per student is estimated to be Rs. 5121. The combined unit cost estimate for LS and SS is at the upper side as compared to NPC estimate of Rs 3267 per student. The 20 percent adjustment made in allowance to civil servants as announced by the government could explain the difference in the unit cost between NPC and present study estimate. Unit Cost Estimates of Rural Infrastructure Unit cost estimate of rural roads indicate that in Mountain/Hill Rs. 2.27 million and in Terai Rs.1.20 million is required to construct one km of rural road in the country. The unit cost is almost double for Mountain and Hill probably due to heavy earthwork excavation. In the case of drinking water two types of scheme viz., gravity flow and ground water scheme are considered and the unit cost has also been computed separately. The per capita construction cost is estimated at Rs 790 for ground water scheme and Rs.2654 for gravity flow scheme. Cost of small irrigation has been computed considering the surface irrigation and deep boring... Estimates shown in the summary table indicates that in the case of surface irrigation the unit cost per hectare is Rs.19,800.00 and Rs 40,000.00 in the case of deep boring. Comparisons of the unit cost of rural infrastructure with other estimates are not strictly possible due to differences in the nature of the scheme considered by each estimate. Interestingly our unit cost estimate for drinking water for gravity flow (Rs 2654) type is very close with the NPC estimate of Rs.2365. Like wise in the case of surface irrigation the unit cost estimate of the present study of Rs 19800 is very close with that of the estimate made by Department of Irrigation (Rs. 20000). The average recurrent expenditure required for a typical DTO headed by Senior Divisional Engineer is estimated to be Rs. 2.67 million. It varies from a maximum of Rs 3.26 million in category A district to a minimum of Rs. 2.16 million in F category. The average recurrent expenditure required for DTO headed by Engineer is estimated at Rs. 1.83 million with the maximum of Rs 2.13 million in A category and minimum of Rs. 1.55 million in F category. The average establishment cost of DTO is estimated to be Rs 4.29 million with the maximum of Rs. 4.35 million in A to E category and minimum of Rs 3.98 million for F category districts. Expenditure needs of the devolved services by type of districts have also been shown in the summary Table. It is obvious from the table that the recurrent cost of each devolved services is consistently high in category A and tend to decrease as one move from A to F category. This is attributed to the higher remote/local area allowance in the service units belonging to those districts. Estimation of expenditure needs based on more realistic norms is expected to deliver public services more efficiently and effectively. Minimum service standards set for Health Post are quite comprehensive. However, for lower secondary and secondary school and rural infrastructure the standards are very sketchy. Standards/norms clarifying the details for technical

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and general standards are lacking. This has caused problems in estimating expenditure needs. Clear standards/norms (both technical as well as general), encompassing all the elements is very essential. Government Departments are required to immediately act on this. The standards of physical infrastructure of HP have not been fully met. None of the surveyed HP has facilities as defined in the service standards. Services are offered with scanty facilities. Very few service providers engaged in HP are aware with the service standards set. Service providers should, therefore, be made aware with the standards of the service provision. In many countries population norm is followed for the establishment of service outlets. In Nepal the population size varies significantly across VDCs. From the viewpoint of access and quality service it is desirable to follow population basis. Norms specify that the service outlet should be located centrally among the wards of the VDCs which need to be strictly adhered. MOH has already introduced the package of essential health care services at various levels of service delivery. Service details of each component of essential health care services at HP levels are lacking. In the context of the devolution of services, details of each component should be made operationally clear as far as possible. The FP services of clinical methods such as IUD and Norplant have been made optional depending upon the availability of trained manpower and logistics support. It has been reported that there has been a growing demand for such FP services. In view of this the authority could give a serious thought in introducing this service at the HP level by making provision of trained staffs and required logistic supports. This service provision entails additional resource needs. Essential drug required at HP is listed but not quantified. The quantity of essential drugs supplied to the service units is grossly inadequate. The quantity of drugs or amounts should be increased. Health service providers strongly viewed that the list of essential drugs needs to be periodically updated. It has been observed that the essential drug list lack combination drugs. Supplied drugs are reportedly of low quality and are very much close to expiry date. While supplying drugs these factors should be taken into consideration. Due to central procurement system the service out let has often experienced the shortage of medicine. Medicines supplied are not based on prevalence of disease. MOH should consider giving the authority to HP in charge and the management committee for local procurement. This practice has been introduced where community drug scheme has been introduced. However, some mechanism should be developed so that only the listed drugs with given specification are procured. There is lack of provision of regular replenishment of essential equipments. Equipment such as BP instrument, weighing machine, delivery kit, and diagnostic set are inadequate. The position of ANM has remained unfulfilled in many service outlets. This has been currently hampering the services of safer motherhood in the service centers. MOH‘s policy to provide intensive training of 15 months to MCHW and upgrade their services into ANM is an attempt in right direction as this effort is expected to meet the shortage of ANM in the service outlets. It has been reported that the post of Peon has been eliminated from HP. Viewing the workload and the diverse services HP provides the post of Peon should be retained. Their service is also essential for successfully carrying out the vertical programs as well. It is recommended that the service of peon be locally outsourced. This arrangement is expected to increase the efficiency of services. Wherever the CDS program has been introduced the need of extra manpower should be assessed. The Education Act 2028 and subsequent Education Rule 2059 have set standards/norms for establishing the schools. The standard for physical structure (building) and physical facilities (rooms and furniture) have not been set properly as this is not expressed in quantitative terms. The norm of classroom size of 1 sq meter per student is erroneous. Instead the minimum size of classroom should be specified. Likewise, no norms have been set for science laboratory facilities at Secondary school. The norms make the provision of one teacher for both science and mathematics. Considering the quality of teaching at the secondary school it is better to have a provision of separate teachers for mathematics and science. The number of extra curricular

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activities and their types are not specified. It is suggested that the number and types of extra curricular activities to be organized during the calendar year should be specified. There has been lot of confusion among the school teachers regarding the objective of the government to handover the schools to SMC. The Teachers Unions are not fully supporting the program. The government should issue a white paper highlighting the objectives and other associated aspects of the program. Government should also address the due concerns of the Teachers Union so that school handover process would receive momentum and at the same time would be smooth. Devolution guidelines lack clarity in several aspects of service provisions like recruitment, transfer, promotion etc. Guidelines of schools and health facilities should, therefore, explicitly mention the function as well as the authority and responsibilities of management committees on these aspects. The guideline should also clearly show the vertical and horizontal relationship with other unit and their responsibilities. The Local Service Commission Rule being drafted is expected to clear the doubts. The role of Local Bodies especially VDCs has been bypassed in the process of devolution of schools to SMC. Local Bodies should be involved in the process of devolution and subsequently their functions and responsibilities should be clearly delineated in the management of the school under the SMC. The operational relations between DTO and DDC are not well defined. It is not found uniform across districts. In some districts DTO has been functioning as the technical wing of DDC while in many other districts such a smooth relation is yet to be established. Decision making power and fund flow mechanism in the functioning of DTO also varies across district. In many surveyed DDCs its technical staffs are found placed under DTO. It is recommended that DTO be placed under the organizational umbrella of DDC. More recently, the responsibilities of DTOs have also widened along with the process of devolution of rural infrastructure. In this context the present study recommends to revisit the staffing norms of the DTO so that an appropriate staffing level, including the DDC technical staff, could be determined.

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Summary Table of the Unit Cost of Devolved Services by Category of Districts in Nepal and Comparison with other Estimates Devolved Services District Category Average

unit cost

Catg. A Catg. B Catg. C Catg. D Catg. E Catg. F (in Rs)

A. Health Post – Mountain

Recurrent Cost 714210 672534 538222 498376 605836

Establishment/Capital Cost 3338800 3338800 3338800 3338800 3338800

B. Health Post – Hill

Recurrent Cost 549322 524922 495224 472058 512882

Establishment/Capital Cost 3338800 3338800 3338800 3338800 3338800

C. Health Post – Terai

Recurrent Cost 540026

Establishment/Capital Cost 2964400

D. NPC Recurrent Cost Estimate– Health Post

661099

E. Unit cost of HP/Beneficiary (Patient)

88.61

F. Per capita cost 13.82

F. Community LS School

Recurrent Cost 904554 886263 865158 839125 816613 802402 852353

Establishment/Capital Cost 1901878 1901878 1901878 1901878 1901878 2436435 1990971

G. Commu. Secondary School

Recurrent Cost 1608857 1575013 1535962 1487698 1446043 1418143 1511953

Establishment/Capital Cost 2482098 2482098 2482098 2482098 2482098 3150294 2593464

H. Unit Cost LSS/student 3522

I. Unit Cost SS/student 6720

J. Combined Unit Cost 5121

K. NPC Combined Estimate 3267

L. DTO

Recurrent Cost with SDE 3262781 2921179 2751063 2544171 2354849 2159439 2665580

Recurrent cost with Engineer 2126718 2021532 1901901 1759857 1641912 1550268 1833698

Establishment/Capital Cost 4349900 4349900 4349900 4349900 4349900 3975500 4287500

M. Rural Infrastructure

Rural Roads -- Mountain/Hill -- Terai

2274775 1204551

Rural Drinking Water -- Gravity Flow/per capita -- Ground Water/per capita

2654 790

Small Irrigation -- Surface Irrigation/per ha -- Deep Boring/per ha

19800 40000

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CHAPTER I

INTRODUCTION 1.1 Background

Decentralization has been an important part of governance in Nepal. The Constitution of Nepal 1990 recognized it as the basis of governance. A more systematic process with a legal base was followed since 1999 after the promulgation of Decentralization Act 1999. As decentralization progresses a mismatch between expenditure requirements, revenue collection and fiscal capacity emerges leading to vertical and horizontal fiscal imbalances. To contain these imbalances across the level of government a system of intergovernmental fiscal transfer is adopted. Overtime, such resource transfer from central government to local government units helped contain these imbalances. In Nepal, as a mechanism of intergovernmental fiscal transfer, Ministry of Local Development (MoLD) started providing block grants to Local Bodies (LBs) since 80s. In the absence of any systematic mechanism, distribution of block grants to, until recently, was motivated more by political consideration and access to power. Often times, question was raised about the basis of such distribution system, both at the grass-root level and at the center. Critics are of the view that the distribution system lacks sound basis and the lack of any changes in the amount of distribution compared to earlier years raised the validity of the new allocation system. With a view of initiating a formula based grant distribution system MoLD constituted a Committee to design a formula for distributing block grant to DDC. The Committee recommended an interim formula, which has been adopted by MoLD for distributing grants to District Development Committee (DDC) since FY 2003/04. The weakness of the interim formula for grants distribution to DDCs and the absence of such formula in distributing block grants, both conditional and un-conditional general-purpose grants to all tiers of Local Bodies, MoLD felt it necessary to commission a study on the design of grants distribution formula to the local bodies (all tiers of LBs) by reviewing present grant distribution formula to DDC. Following the budget speech of FY 2001/02, HMG/N started devolving some of the basic services to LBs and Management Committees. Accordingly, the services of agriculture and livestock extension, primary health care services provided through sub-health post, and primary education were devolved from FY 2002/03 on a phase wise manner. Current Tenth Plan has set a target of transferring 8000 community schools during the plan period (NPC, 2002). NPC has also been giving a serious thought on a full-fledged devolution as a pilot in five districts of the country. In the course of devolution, services of higher level such as health post in the case of primary health services and lower secondary and secondary school in case of education have also been gradually devolved. Following the recommendations made in the study on Expenditure Assignment commissioned by LBFC and DASU/DANIDA, more recently HMG/N has devolved infrastructure sector involving rural roads, small irrigation and small drinking water projects to DDCs from the current fiscal year 2004/05. The amount of resources required to render the devolved services of higher level is not fairly known. A study was commissioned jointly by LBFC and DASU/DANIDA to assess the expenditure effectiveness of Local Bodies and estimate the expenditure needs of devolved services (Ligal et.al, 2004). The scope of the study was confined among others to estimate the expenditure needs of community primary schools, sub-health post and agriculture and livestock extension services. Need of estimating the expenditure requirement of higher level services like health post, community lower secondary and secondary schools and rural infrastructure has been urgently felt. Such quantification is expected to further strengthen and consolidate the exercise of decentralized governance in the country through devolution of essential services to LBs.

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In these backgrounds MoLD has realized the need of improving upon the existing system of intergovernmental fiscal transfer through the development of more improved grant distribution formula and also assessing the expenditure requirements of services of higher level (lower secondary and secondary school, health post) including the recently devolved one (rural infrastructure). The present study has aimed to address these issues of greater significance to HMG/N.

1.2 Objectives of the Study

The overall objective of the present study is to develop improved formula for grant distribution to LBs and suggest appropriate modalities for grant equalization. Besides, the present study also aimed at estimating the expenditure needs of selected devolved services viz., lower secondary and secondary education, health post and rural infrastructure covering rural roads, small drinking water and small irrigation. The specific objectives of the study, however, are:

to review existing practice of distributing various types of grants including block grant to LBs;

to suggest improved norms (formula) for the distribution of central grant to DDCs;.

to suggest appropriate methods for allocating central grants to VDCs and Municipalities;

to explore the possibilities of tying up MC and PMs with the grant distribution system to DDCs;

to suggest appropriate norms for intergovernmental fiscal transfer at different levels of LBs;

to explore the possibilities of equalization modalities and suggest the appropriate mechanism of grant equalization and

to assess expenditure needs of LBs and Management Committees to perform the devolved services, namely, rural infrastructure (rural roads, small irrigation and drinking water), health posts and lower and secondary schools;

1.3 Scope of Work

The present study, as specified in the TOR and further elaborated in the inception report of the study, focuses on three research components associated with the intergovernmental transfer and assessment of expenditure needs. The TOR of the study is at Annex I-I.

A. Intergovernmental Fiscal Transfer

The present study examines the existing practice of intergovernmental fiscal transfers in the country. This component of study covers three elements of intergovernmental fiscal transfers.

(i) Improved Formula for Distribution of Grant to DDCs HMG/N is currently adopting an interim grant allocation formula to determine the quantum of annual grant to be distributed to each DDC. This formula is in use since the past few years. The current formula takes into consideration factors like human development index (HDI), population, area and cost factor of the respective districts. The weight given to these factors is 50, 20, 20 and 10 percent respectively. HDI factor used in the interim formula relate to 1996. The validity and appropriateness of the interim grant formula has thus been questioned. The present study is, therefore, required to review the existing practice of grant distribution, identify its limitation and suggest improvements for the fair and equitable distribution of grants to LBs.

(ii) Allocation of Block Grant to Municipalities The sources of funds of Municipalities in Nepal are internal revenue, block and conditional grants provided from the center and contributions received from various donors. The internal revenue includes tax and non-tax sources. After the promulgation of current Local Self-Governance Act, HMG/N abolished the system of Octroi and substituted the same by local development fees levied at the import of goods and materials at custom points. The local

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development fee distributed by the central government is a major source of revenue to Municipalities.

HMG/N has been providing block grant to only those municipalities whose revenue collection from internal sources is below Rs. 1,000,000 per annum. The block grant provided to Municipalities is, however, determined on ad-hoc basis since factors such as population, urban poverty and development requirements are not considered in the determination of block grant. At best, the block grants provided at present reflect the amount of grant allocated in the past. The present study therefore seeks to examine the basis of grant distribution to Municipalities and suggest a more scientific criterion so that a fair and equitable grant distribution to Municipalities could be ensured.

(iii) Develop Formula for Distribution of Grants to VDCs At present, there is lack of a system for allocating grants to VDCs. This is because all the VDCs are provided with equal sum of Rs. 500,000. per annum by way of grant from the central treasury. The present practice is not considered satisfactory since it does not take into consideration factors like area, population, levels of development and cost factor. In the existing arrangement, per capita grant in aid would be higher to VDCs with a lesser population and vice versa. Seen from another perspective, the need of funds to VDC with a larger size would be more as compared with a VDC having smaller size. The level of development also varies among VDCs considering the accessibility to the basic amenities of life. This will largely depend upon the location of the VDC, i.e. whether it is located in a remote or accessible area. This factor will also have an impact on the cost of development. In other words, the more remote a VDC is more will be the need of funds for development due to higher cost of building infrastructures as compared to more accessible areas. This could also be considered as one of the factors to determine the size of central grant. Based on the experience of other countries, there could be several other factors as well, which should be considered in the formulation of bases for the allocation of grant to VDCs. It is in this perspective the present study intends to formulate a formula that would capture all the possible factors with appropriate weights assigned so that each VDCs would receive the central grants based on their needs.

B. Equalization

The capacity of generating revenues from the assigned sources is not uniform even within the same tier of LB. Among the factors, which contributed to this state of affair, includes the size and population of LB and ability to pay taxes resulting from the high or low living condition of the people residing within its territory. In addition, availability of natural resources in general and taxable resources in particular and accessibility to markets also affects the capacity of LBs to generate revenue. The variation in the existence of resource endowment results in to a variation in the revenue potential and thus the capacity of LBs to provide services to its people. This raises a big gap between LBs having resources with revenue potential and those, which do not have these potential. This demands the concept of equalization and the needs to support the resource poor LBs for smoothly carrying out its service delivery function to people. The volume of equalization may be determined primarily by the fiscal capacity of LBs. C. Tying up of minimum conditions and performance measures

UNCDF has introduced the system of minimum conditions (MC) and performance measures (PM) in 20 districts known as DFDP districts. In order to qualify to obtain additional grants from UNCDF under this program DDCs are required to fulfill minimum conditions. Once the MC is fulfilled the amount of additional grant the program district is likely to receive would depend upon the performance of the districts (PM). 39 PM covering seven dimensions have been listed. The present study also requires exploring the possibility of tying up minimum conditions (MCs) and performance measures (PMs) in grant distribution by assessing the status and performance of this system in few surveyed districts where this system has been introduced.

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D. Assessment of Expenditure Needs

Guidelines issued for the services devolved in each sector/sub-sector seek direct and indirect participation and involvement of LBs in the devolution process and entrust them with specified responsibilities. Although the Guidelines has clarified mechanism for the flow of funds from center to the local level, financial commitment of the central government has, however, not been explicitly mentioned therein. The provision of services requires cost. The institutions, which are handed over with the responsibilities must be reasonably compensated for that. These aspects also need to be clarified in the case of infrastructure sector handed over to LBs so that these bodies are not imposed unfunded mandates. In these perspectives, the present study requires to make a systematic assessment of cost implication of devolution process and quantify recurrent and capital needs of the organizations to which the tasks/services have been devolved/handed over. From the perspective of both revenues assignment to LBs and intergovernmental transfer system the assessment of the expenditure needs deserves special consideration. The study, therefore, intends to provide an assessment of the expenditure needs of devolved services of health post, lower secondary and secondary education and rural infrastructure service.

1.4 Approach/Methodology of the Study

The present study is deskwork–cum field-based study. The nature of the study demanded extensive review of documents and use of both secondary and primary data techniques. Combination of various study approaches has been adopted for addressing the objectives and the scope of the work of the present study. The major approaches adopted are:

a) Desk Study

b) Consultative Meeting

c) Survey of Local Bodies

d) Interaction Meeting

e) Providers‘ Survey (Devolved Services)

f) Retail Outlet Survey

g) Custom Checkpoint Visits, and

h) Dissemination Workshop

A. Desk Study

Relevant documents and literatures pertaining to intergovernmental fiscal transfers and equalization modalities were thoroughly reviewed. This approach focused on the detailed review of relevant provisions of Local Self-Governance Act (LSGA), Local Self-Governance Regulation (LSGR), Local Bodies Financial Administration Regulation (LBFAR) and other related regulations in order to document the existing provisions of financial management and allocation of resources. Currently, HMG/N has practiced and distributed resources to LBs under different grants head as conditional, unconditional promotional etc. Various conditions attached with the distribution of conditional grants have been reviewed and their appropriateness has been examined. Existing interim formula of block grant distribution to DDCs have been analyzed from various perspective and major gaps in the formula were identified so as to suggest the improved formula for grant distribution. Minimum national service standards set by the government for devolved services were examined. Various guidelines and operational manuals adopted in the sector devolution were thoroughly reviewed and their correspondence with the service standards was examined. Economic Survey and Red Book of Ministry of Finance and the Annual Auditor Generals‘ Report have been reviewed to examine the trends and patters of government allocation and expenditure in local development including LBs.

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B. Consultation Meeting

Consultative meetings with the key officials from various government institutions were held. They include National Planning Commission (NPC), Ministry of Finance (MoF), Ministry of Local Development (MoLD), Ministry of Education (MoE), LBFC, UNCDF and LB Associations (ADDCN, MuAN and NAVIN). The consultative meetings focused on various dimensions of intergovernmental fiscal transfer including interim grant distribution formula. Government Ministries and other institutions covered in the meetings along with the name of the officials are presented in Annex I-II. C. Survey of Local Bodies

In order to collect both quantitative and qualitative information survey of LBs (DDC, Municipality and VDC) was carried out in sampled districts.

1.4.1 Selection of District/Municipalities/VDCs

In order to gather the perceptions of LBs on the matter of intergovernmental fiscal transfers and devolution of higher level of services including rural infrastructure, discussion and interaction with all tiers of LBs is highly essential. 18 districts including the pre-test district were selected. This constitutes 24 percent of the total districts in the country. In order to make the selection more representatives, the districts were selected based on the ecological and regional considerations. Besides, the districts are also selected based on their performance (strong/weak), resource base and on the consideration of the task devolved to the communities. The districts selected in the earlier studies have also guided district selection. While repetition has been avoided some districts have been purposively selected to match with the DFDP districts. Out of total of 18 districts selected 4 districts matched with the DFDP program districts. All three tiers of LBs of the surveyed districts were surveyed. In the case of VDCs two to three VDCs were surveyed. Selections of VDCs were made in consultation with the DDC officials. Due to security reasons in many districts large numbers of VDC offices have been shifted to district headquarter and temporarily operating in the DDC premises. Our selection of VDC was constrained by this consideration. The selection of districts and their corresponding Municipalities including the selection criterion are presented in Table 1.1. Surveys of Local Bodies covered 18 DDCs; 16 Municipalities and 51 VDCs. Though we intend to cover 3 VDCs from each surveyed districts in few districts only two VDCs were covered. The survey solicited the views of all three tiers LBs on the matter of grant allocation formula and equalization modalities. Major approaches included interaction meeting and in-depth interview. Besides, revenue and expenditure data were gathered from all LBs. In all the districts visited both one to one interview and group interaction meetings were held at the DDC and Municipality office. Account Officers were also interviewed to obtain their views on various aspects of financial management. At the VDC discussion was made with VDC Secretary. In selected districts interaction meetings were also conducted with ex-DDC Chairman and ex-Mayor/Deputy Mayor.

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Table 1.1: District, Municipality Selected and Selection Criterion

Development/ Ecological Region

District Municipality

Custom Point

Selection Criterion

Eastern Terai Hill Mountain

Jhapa Dhankuta Sankhuwasabha

Bhadrapur Dhankuta Khandbari

Biratnagar X X

-Strong performance in program implementation and resource mobilization -Strong performance -Remote district, weak revenue base and performance

Central Terai Hill Mountain

Dhanusha,* Bhaktapur, Nuwakot X

Janakpur Bhaktapur, Bidur X

X X X

Moderate performance High/Moderate resource base

Western Terai Hill Mountain

Rupendehi* Kaski, Gorkha, Mustang

Siddarthanagar & Butwal Pokhara, Prithvi narayan X

Sunauli & Krishnanagar

X

X

Strong performance and sound resource base Strong performance and diversified resource base Moderate performance and weak resource base

Mid-western Terai/Inner Terai Hill Mountain

Banke, Dang, Dailekh Jumla

Nepalgunj, Tribhuvan Nagar Narayan

Jamuniya

Poor performance and weak resource base Poor performance and weak resource base Remote district, weak resource base

Far-Western Terai Hill Mountain:

Kailali* Accham* X

Dhangadhi X X

X

X

Good performance and moderate resource base Poor performance and Weak resource base

Note: * Districts match with the DFDP program districts. 4 DFDP districts out of 20 matches with the districts proposed for the present study.

D. Interaction Meeting

Separate interaction meetings were held with office bearers of district line agencies of selected devolved services. They included District Technical Office (DTO), District Education Office (DEO), District (Public) Health Office (DPHO) and selected district irrigation and road offices. E. Service Providers Interview

The service units (Health Post, Lower Secondary/Secondary School) operating at the VDC level were also interviewed in-depth. Besides, contractors and users committee members were also interviewed to understand their perceptions about the development activities carried out in the districts by LBs. F. Retail Outlet Survey

In order to gather the local price of construction materials and wage rate of different types of labor a retail outlet survey in the selected retail hardware shops in the surveyed districts were

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carried out. It is expected that this survey would help in estimating the relative cost factor of construction materials across the districts. G. Visit of Custom Checkpoint

Custom checkpoints were visited in selected district to gather the cost information of construction materials at custom points. Information was collected to make a fair assessment of the relative cost index of construction materials across districts in the country. H. Dissemination Workshop

Half-day dissemination workshop was organized to share the major findings of the study. Major stakeholders representing NPC, MoLD, MoH, MoES, LBFC, DASU/DANIDA, DOLIDAR, LBs Officials of Lalitpur District and LB Associations participated in the workshop (Refer to Annex I-II for the list of participants). Major issues raised in the workshop included: practicality of present structure of LBs; elements and weights assigned in the grant formula, adequacy of recommended share of grant pool, MC and PF as a tool to allocate incentive grant and provision to appeal by LBs; revenue sharing, model specification problem, unit cost estimation and full scale devolution. Issues raised and suggestions made in the workshop are duly incorporated in the present report, wherever possible.

1.4.2 Survey Instruments

Data format, structured questionnaire and in-depth interview checklist were the major survey instruments used in the present study. Draft instruments were sent to LBFC Secretariat and DASU/DANIDA for their feedback and suggestions. Suggestions were duly incorporated in the final set of questionnaire. The survey instruments were pre-tested in Nuwakot district and necessary modifications in the survey instruments were made. Three sets of structured questionnaire were prepared to administer separately with three tiers of LBs viz, .DDC (Annex I-III), Municipality (Annex I-IV) and VDC (Annex I-V) for final administration. Besides, data format was developed and used to obtain the expenditure and revenue data and sector wise project related information of the completed projects of the LBs. Separate semi-structured questionnaires were developed and administered among line agencies at the district level whose services were devolved. The line agencies included District Education Office (Annex I-VI), District Public Health Office (Annex I-VII) and District Technical Office (Annex I-VIII). The objective was to obtain the first hand information from the concerned officials on service standards and resource requirements to render the standardized services to the people. Two sets of semi-structured questionnaire was also developed and administered among the service unit (HP, Lower Secondary/Secondary School) to understand their views and perceptions on various elements of service provisions (Annex I-IX & I-X). Contractors and Users Committee members were also interviewed to seek their views on the modalities of executing developmental activities of the LBs and cost of construction materials. A brief questionnaire/checklist was developed for this purpose (Annex I-XI).

1.5 Field Planning, Management and Execution

In the present study 18 districts (including Nuwakot) representing different ecological zones of the country were selected. Fieldwork for the present study commenced on December 19, 2004 and ended on January 18, 2005. With a view of providing enough time to complete the information the data sheet was faxed/sent by courier to most District Development Committees (where the facilities were available) in advance. There have been delays in completing the field survey due to frequent bandhs causing restriction in vehicular movements in many places, which unfortunately coincided with our schedule. The field plan thus has to be rescheduled as per the situation. There have been variations in the district proposed in the inception report and district actually covered in the field survey. Few new districts were added; few districts were replaced while few were dropped. However utmost care was taken not to compromise in the representation of sample district

Three teams were formed to manage and execute the entire field activities in a phased manner. Due to time constraint and wider coverage of districts two field supervisors were recruited locally

8

to conduct the survey of LBs in Dailekh and Achham districts. One day training was provided to field supervisors about the objective and scope of the study including the survey instruments and approaches of administering the questionnaire. The core team members imparted the field training. Field training to locally recruited field supervisors was arranged at Nepalgunj. Core team members were involved in providing the training.

1.6 Field Performance

Altogether 18 DDCs, 16 municipalities and 51 VDCs were surveyed. Likewise, three district line agencies of the devolved services (DEO, DPHO and DTO) from each of the surveyed districts were interacted. Altogether, 14 HP were visited and the HP in charge was interviewed. Furthermore, 3 lower secondary and 14 secondary schools were also visited to conduct the in-depth interview with teachers and SMC members. Table 1.2 presents the field performance highlighting the extent of coverage of various research components including their names.

1.7 Data Management and Method of Analysis

Completed questionnaires were manually edited to check consistencies in the recorded answer and missing responses. Data entry format was developed and entered into computer using Microsoft Excel software. Frequencies and cross tabulations are the main output for analysis. Relevant secondary data are analyzed using simple calculations of percentage change and growth rate. Secondary as well as primary data were largely used in constructing index of different nature so as to fit in the grant distribution formula. SPSS software package was used for carrying out correlation and regression analysis. In order to improve the grant distribution formula various computer simulation exercises were performed and the most appropriate and practical formula has been suggested. Before carrying out the simulation exercise huge database for districts and municipalities was created with suitable indicators for constructing index. Besides, the perceptions and impression gained in course of interaction with various stakeholders, local key informants were analyzed to redesign the grant allocation formula. The methodological details about the construction of index and their application in developing the formula for grant allocation to DDC, Municipalities and VDC have been discussed separately in Chapter IV Unit cost approach has been followed to estimate the expenditure needs of devolved services. However, the estimated per unit has been converted into per capita cost estimate following the coverage per unit of such services to the people. Standards/norms for service provision have been reviewed wherever they exist. Attempts are made to develop norms through interaction meeting and consultation with service providers and then quantify the expenditure needs of such services. The details about the methodological aspect of the estimation with itemized cost have been discussed in Chapter VI.

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Table 1.2: Field Performance

District

Local Bodies Service Unit Contractor Users

Committee

DDC Municipality VDC DTO DEO D(P)HO Lower

Secondary School

Secondary School

Health Post

Jhapa

- Bhadrapur - Garamani - Chandragadi

Shri Prithivi Lower Secondary

- Jan Jyoti Gauradaha 2 2

Morang

- Biratnagar - Dinia Namuna - Babiyabirta - Tetariya

-Gayetri Sanskrit

Rani 1 1

Dhankuta

- Dhankuta - Bodhe - Jeetpur

- Jalpadevi Pakhribas 1 1

Sankhuwasabha

- Khadbari - Chechuwa - Mangadewa - Wana

Jambawati Khadbari

Siraha

- Lahan - Gaadha - Taregana Govindapur - Dhodhana

-Pashupati Aadarsh

Lahan 1 1

Dhanusha

- Janakpur - Bharatpur - Badh Chauda - Bindhi

-Shree Tribhuvan Aadarsh

Sinarjoda

Bhaktapur - Bhaktapur

- Nagarkot - Duwakot - Siratar

-Shri Bal Premi

Nagarkot 1 1

Nuwakot -Bidur - Ratomate - Lachyang - Manakamana

- Prithivi

-Mahendra Madhymik

Nuwakot 1 1

Gorkha -Prithivi Narayan

- Chunchet - Physel - Khoplang

-Shree Shakti

1 1

Kaski

- Pokhara - Sarankot - Saimrang - Nirmal Pokhari

Shree Gyanbhumi

Bindhabasini Batulechour 1 1

Mustang

- Jomsom - Chonhup

-Thini -Jharkot

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District

Local Bodies Service Unit Contractor Users

Committee

DDC Municipality VDC DTO DEO D(P)HO Lower

Secondary School

Secondary School

Health Post

Rupendehi - Butwal -Siddharth Nagar

- Dhakdahi - Anandaban

- Shree Ram Naresh Yadav.

- Shree Santi Namuna

- OM Satima

Dhakdhahi 2 2

Dang -Tribhuvan Nagar

- Kavre - Santinagar Namuna - Rampur

Gorakseswar Padmodaya 1 1

Banke

- Nepalgunj - Nanbasta - Khaskarkandho - Piparahwa

Baniyamar Laxmanpur

Jumla - Dillichaur - Chandan Nath - Dhapa

1 1

Dailekh

-Narayan - Rum - Chhundipusakoti - Nepa

Achham

- Chandika - Chalsa - Mangalsen

Kailali - Dhangadi

- Mohanyal - Janakinagar - Lalbhoji

Malakheti 1 1

Note: In Mustang and Bhakatpur district schools could not be covered due to winter vacation in the school. In Nuwakot district pre-test of the survey instruments were carried out. Besides revenue and expenditure data of the LBs were also gathered. Hence it has also been treated as one of the surveyed district. DEO = District Education Office D(P)HO = District (Public) Health Office DTO = District Technical Office

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1.8 Study Limitation

The major limitations of the present study are:

Detail analysis of income and expenditure of local bodies has been constrained by the poor database of local bodies. LBFAR provides a separate sheet for the purpose of account keeping by all local bodies. Income and expenditure account kept by Local Bodies lack classified details in many headings as demanded in the sheet mentioned above. Database prepared is purely for the purpose of account keeping.

Separate index capturing various dimensions of socioeconomic development has been constructed. However, the construction of the index for district and municipalities has been constrained by the lack of adequate data at respective levels. The dimensions covered for the measurement may not be comprehensive enough to capture other important variables as the objective data availability are scanty. In view of this, the index and the weights assigned for each index used in designing the formula may require further refinements as more information becomes readily available.

Studies have documented the importance of infrastructure index. Accordingly index was constructed considering important indicators for which information were available. However, the index was found insignificant and hence did not used in our framework of analysis. As information on other variables capturing infrastructure development are available attempts should be made to establish it's importance.

Present study suggests classifying the pool of resources to be distributed into two categories – general-purpose grant and incentive grant with 80:20 ratios. In the case of former type of grant the amount to be distributed has been obtained by adopting the suggested formula. However, in the case of incentive grant no such exercise has been carried out due to lack of an existing performance system. The present study recommends introducing such practices and suggests inputs to be considered in a performance measure.

In view of the lack of comprehensive data the grant pool recommended in the present report does not include the component of revenue sharing

Review of standards/norms for service provision of devolved services revealed that the present norms in education, is poorly set and not adequately quantified. Absence of quantification posed serious problem while estimating the expenditure needs of such services. However, an attempt has been made to update it with an intensive discussion with the field level service providers and policy makers. While doing the exercise intra-district variations have not been accounted properly. Unit cost estimation should, therefore be considered as indicative.

It should be mentioned here that the estimation of expenditure needs does not capture the resource requirement of LBs for discharging all expenditure assignments. Rather the present exercise is limited to estimating the resource required to render the services of some selected devolved sectors more particularly, the services of health post, lower secondary and secondary education and rural infrastructure.

Field survey was initiated in very difficult circumstances. Series of bandhs and blockade has hampered the field activities resulting to rescheduling of field activities and sample replacement.

Due to Maoist problem access to VDC was severely restricted. Moreover many VDCs Secretaries were stationed at the district headquarter. This situation caused problems in the selection of VDCs. During the field survey inter-district mobility was also severely constrained. In few districts field activities were cut short to avoid unnecessary delays.

In majority of the districts VDC offices were vandalized. In this event important official documents were also destroyed. The field team is, therefore, unable to obtain required information in these VDCs.

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1.9 Organization of the Report

The study report has been organized into seven chapters. Chapter II describes about the concept and practices of intergovernmental transfer. The chapter highlights various types of intergovernmental transfer system and the practices followed in developed and developing countries. Chapter Three reviews the intergovernmental fiscal transfer system adopted in the country. This Chapter also analyses the structure and patterns of expenditure of local bodies in Nepal. This is followed by Chapter Four where design of intergovernmental fiscal transfer for Nepal has been suggested. The highlight of this chapter is the suggested design of a grant distribution formula for DDCs, Municipalities and VDCs. Chapter Five then devotes on the administration and implementation arrangements including plan of action for central agency as well as for LBs. Estimation of expenditure needs of selected devolved services is presented in Chapter Six. Finally, Chapter Seven summarizes the report and suggest measures for the effective management of fiscal transfer system in the country. Annexes are arranged in two ways. Some tables which are directly associated with the design of the grant allocation system are attached in the main body of the report as annex in Main Report volume I, while other tables and supporting information duly referred in the text are arranged separately as Annexure volume II.

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CHAPTER II

INTERGOVERNMENTAL TRANSFER: THEORY AND PRACTICE

2.1 Concept and Economic Rationale

A sound system of intergovernmental fiscal transfers is a pre-condition for strong and stable decentralization process. In a decentralized system of governance, the need for intergovernmental fiscal transfers arises mainly due to fiscal imbalances between own source revenue and expenditure needs of local bodies. Fiscal imbalances of local bodies occurs because, for macroeconomic and equity considerations and tax administration efficiency, larger part of revenue authorities are retained by the central government. This leaves insufficient resources to the sub-national governments for covering their expenditure needs, hence the fiscal imbalance. Such imbalances can be vertical or horizontal in nature - the vertical dimension, concerned with the distribution of revenues between central and local governments and the horizontal dimension, concerned with the allocation of financial resources among the recipient local bodies. A vertical imbalance occurs when the expenditure -responsibilities of sub-national governments do not match with their revenue raising power where as, a horizontal imbalance occurs when own fiscal capacities to carry out the same functions differ across sub-national governments.

The standard economic dimensions of a public finance policy are macroeconomic stability, equity and efficiency (Musgrave and Musgrave, 1984). The efficiency aspect of the economic dimension is, by and large, the fundamental economic rationale for fiscal decentralization.

The economic argument of efficiency stems from the fact that due to closeness to the citizens, local governments are in a position to meet different views and interests of people and allocate resources more efficiently than a central authority. Decisions about public expenditure that are made by a level of government that is closer and more responsive to a local constituency are more likely to reflect people's choices than decisions made by a remote central government. However, efficiency aspect is not the only one in evaluating economic dimension of fiscal decentralization as intergovernmental fiscal design has important implications on macroeconomic stability and equity.

It is often said that decentralization affects macroeconomic stability as, local governments are hardly caring about the implication of wider fiscal deficit and borrowings. However, recent studies on the relationship between fiscal federalism and macroeconomic governance find the other way around - that decentralized fiscal system offers a greater potential for improved macroeconomic governance than centralized fiscal systems. In fact, highly decentralized federal countries, such as Switzerland, Germany, Austria, and USA, have very stable macroeconomic performance and low rates of inflation (Shah, 1997).

Equity aspect of a public finance policy concerns with the redistribution of income to achieve a socially just outcome. In decentralization context, redistribution typically implies a transfer of funds to low-income LBs to ensure compatibility in service delivery in it's jurisdiction. It thus implies, addressing horizontal inequalities. There are two major factors contributing horizontal inequalities: tax bases varying significantly from one LB unit to other and the jurisdictional characteristics affecting the cost of service provision. In addressing horizontal inequalities redistribution policies are designed to provide more resources to poorer LBs through equalization grant.

Intergovernmental transfers serve three basic objectives- one, to address the vertical imbalance – the inadequacy of revenues of sub-national governments to discharge effectively their expenditure liabilities, arising from assignment of functional responsibilities and insufficient own resources among different governmental levels, - two, to alleviate horizontal imbalances, the disparities in the revenue capacity of the local bodies in order that all of them may be in a position to provide basic public services to their citizens at a reasonable level, and three, to off-set inter-jurisdictional cost and benefit spillovers or for merit good reasons. In addition, transfers may also be given to carry out some agency functions for the central government.

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The volume of such transfers cannot be decided in an ad hoc manner but must be anchored to a macro framework defined by parameters of fiscal adjustment in the desired directions along with incentives to induce prudent and efficient fiscal management. It thus, calls for a holistic approach assessing the tasks and function assigned to local bodies, their fiscal capacity and the ability to discharge such functions efficiently. As far as possible, the design of fiscal transfers should be such as can serve the objectives of closing the vertical gap and reducing, if not removing, the horizontal disparities so that LB's can provide basic public services to their people at reasonably comparable levels.

It may be possible to meet the vertical gap by sharing the central revenues on the basis of collection or realization and/or by grants. However, such a system would not help to reduce the horizontal imbalances since correcting horizontal imbalances need to equalize fiscal capacity and tax effort. The skewed distribution of resource endowments and the diversity in the level of socio-economic and infra-structural development limits the feasibility of closing such imbalances. The sharing of revenue on the basis of realization may therefore accentuate horizontal imbalances among LBs. Hence the emphasis has been to base the transfers on the principle of equalization. Vertical vs. horizontal Fiscal Imbalances

Fiscal imbalances between resources and expenditure needs of local bodies occur in two forms: vertical and horizontal imbalances. ―Vertical fiscal imbalance‖ refers to the difference between expenditures and revenues at different levels of LBs, and ―horizontal fiscal imbalance‖ refers to the differences between revenue and expenditure levels within a particular level of Local body. Vertical imbalances arises because the expenditure assignment does not typically match with the tax assignment causing inadequacy of the fiscal resources with different levels of government to accomplish the assigned tasks and provide the services to citizens at the specified quality and quantity. The central government has a comparative advantage in raising revenues where as sub-national governments or LBs are better placed to provide public services efficiently in their jurisdiction. Therefore, assignments according to comparative advantage necessarily result in vertical fiscal imbalance. Moreover, competition in the tax rates and quality of service delivery among LBs lowers revenue and increases the cost per unit as well as the volume of spill over demand of services it delivers accentuating vertical fiscal imbalance. In addition, variations in fiscal management in terms of tax effort and expenditure among different levels of LBs can also contribute to vertical fiscal imbalance. As the local bodies are supposed to deliver tasks committed by the state, it is necessary for the state to make arrangements for the financing of such services, since finance should follow functions. Normally an arrangement to this effect ends up in the form of grants from central government to the local bodies. Horizontal fiscal imbalance refers to the mismatch between revenues and expenditures of governmental units within a level of government. It may arise due to revenue or expenditure differences of LBs as a result of - first, the differences in the fiscal capacity or fiscal effort and secondly, the expenditure differences due to differences in the quantity or quality of public services or differences in the unit cost of services. An important cause of the horizontal imbalances is the skewed distribution of social and physical infrastructure among the LBs. Differences in the level of infrastructure development, resource endowments and also the level of social and human development contributes more towards horizontal imbalances or difference in the resource potential among local bodies within the same level. Thus, horizontal imbalances occur mainly because:

Local governments may differ in their fiscal capacity, that is in their tax base and therefore in their ability to raise a particular level of revenue even with standard rates and administration effort.

Local governments may also differ in their expenditure needs. Even when they may have the same fiscal capacity or ability to raise revenues, they may differ in the costs in providing

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services due to differences in needs arising from different demographic profiles such as, the percentage of school going children or the percentage of people in the retirement age etc., geographical, topographical or the climatic conditions, level of poverty and unemployment etc. The differences of expenditure needs may also arise due to the differences in the costs of such public services.

Some public services have spillover effects on other jurisdictions. Expenditure requirements for such services as the maintenance of inter-state highways, water and air pollution control, higher education, fire control system etc., not only benefits the spending districts or region but also provides benefits to other neighboring districts or regions. The spillover benefits of such services requires central government to share part of the cost of these services, else they may be under funded.

Some local bodies in a state may have extraordinary expenditure needs, because they have high proportions of poor, or like in the current situation in Nepal being an urban center they have to absorb the migrant population from the rural areas, or because they need to maintain national airports or harbors. These reasons escalate the fiscal needs of such local bodies, which should be addressed by central government transfers.

It is difficult to eliminate horizontal imbalances, but needs attempts to minimize it; or else there will be differences in the services provided by local bodies across nation. Such a situation is not regarded acceptable because for equity reasons citizens must be provided with a similar set of service of a given quality and quantity across the nation. From the national point of view, the persistence of large horizontal imbalances are considered improper therefore, needs to be corrected through equalizing transfers from the center or by appropriating resources from rich jurisdiction. Although, this automatically implies the existence of some degree of vertical imbalance, for sustaining the capability to deliver services at a reasonably comparable level, central government needs to compensate to overcome such mismatches of revenue and expenditures at different level of government.

Intergovernmental transfers to correct spillovers It is now well established that when the benefits of public services provided by a local body spillover its jurisdiction, it ignores the benefits accruing to the non-residents while deciding the amount of the service provided. Normally, the LB allocates resources considering the per unit cost of such services to the people living in their jurisdiction by equating the marginal benefits from the public service with the marginal cost of providing it, and as it ignores the part of the benefit accruing to non-residents the result is an inadequate provision of the public service. This results into a poor quality of service delivery. Therefore, spillovers have to be arbitrated through central grants or be compensated by the beneficiary jurisdiction. Reasons for Intergovernmental Transfers

Roy Bahl observes that governments introduce intergovernmental transfers for one of four good reasons, and for a number of not-so-good reasons (Table 2-1). It is commonly observed that the design of an intergovernmental transfer system is a reflection of the objective and reasons that is at the core. Therefore it is strongly stressed that there should be clarity on the objectives for devising a good transfer system.

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Table 2-1: Different Reasons for Intergovernmental Transfers

Good reasons Motive or objective

Vertical balance Fulfill inadequacy of the fiscal resources with different levels of government to accomplish the assigned tasks and provide the services to citizens at the specified quality and quantity.

Horizontal balance and equalization

Minimize difference of in the resources and service they provide among local bodies within the same level

Offset impact of externalities

Compensate the local bodies with funds for their financing for services that also benefit people or area beyond the LB‘s jurisdiction.

Financing merit goods Avail LBs with resources for their contribution in providing services of national priority

Administrative efficiency Harness efficiency gains in revenue collection from certain sources (such as income tax) and distribute the resource to local bodies

Not-so-good reasons

Delay/resist fiscal autonomy to local bodies

Give resource rather than fiscal autonomy and authority to keep the power with central body

Attempt to maintain uniformity among LBs

If majority of resources goes through central grants then it is easier to enforce uniformity

Mechanism to uphold public accountability

Suspicion that LBs will misuse if powers are given to them and that LBs may prove better and challenge the workings of central agency

Use as cushion to offload the budget deficit on LBs

By getting the things going through mechanism of LB grants, public will question the LBs if services are not delivered. At times of resource crunch central body will not be blamed for not providing services

Knowledge of the purpose of the transfer is important to design a good transfer system, since any system is designed to serve the ultimate objective. While the good reasons are important to deepen a decentralized system of governance, the other set of reasoning mostly curtail the pace of the same. The success of decentralization process hinges, by and large, on how the system of fiscal decentralization is designed and implemented. Roy Bahl (1999) suggests the following twelve ―rules‖ for the implementation of a policy of fiscal decentralization: Rule 1: Fiscal decentralization should be viewed as a comprehensive system Rule 2: Finance follows function Rule 3: There must be a strong central ability to monitor and evaluate decentralization Rule 4: One intergovernmental system does not fit the urban and the rural sector Rule 5: Fiscal decentralization requires significant local government taxing powers Rule 6: Central governments must keep the fiscal decentralization rules that they make Rule 7: Keep it simple Rule 8: The design of the intergovernmental transfer system should match the objectives of the

decentralization reform Rule 9: Fiscal decentralization should consider all three levels of government Rule 10: Impose a hard budget constraint Rule 11: Recognize that intergovernmental systems are always in transition and plan for this Rule 12: There must be a champion for fiscal decentralization

As the ultimate objective of the decentralization process is to bring governance closer to the people, and thereby, increasing the efficiency, effectiveness and equity of fiscal policies. The benefits of decentralization can only be materialized if local governments are given a level of discretion

a. in determining local policy priorities, b. collecting local revenue and, c. in selection and implementation of local projects.

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Factors to be considered in Designing Intergovernmental Transfers

First and foremost, the design of the transfer system should depend upon the rationale for such a transfer system. The rationale should essentially lay down the objective of a transfer system. Thus, transfers meant for offsetting vertical fiscal imbalances or to ensure horizontal equity or stabilize intergovernmental competition ought to be unconditional. However, the amount of such grants should neither, be considered as a free money that can be used in any way nor, should remain outside the ambit of fiscal rules and regulations. It should at least, not discourage the efforts of LBs to mobilize own source revenue. The Grants given to offset spillovers or those given to ensure minimum outlays on specified Services (merit good reasons) must be purpose specific with matching requirements from the states. While the objectives of intergovernmental transfers are important in designing the system it however, needs to minimize political influence and infuse confidence in the central government or the independent institution who manages the transfer system as a whole. This will require the system to be more objective and formula based. However, the formula-based system should not be a rigid mechanical exercise; it should have sufficient flexibility to take account of changing situations and complexities in intergovernmental fiscal relationships. Intergovernmental transfers can be designed in a variety of ways and the effect of transfers depends on the way they are designed. Although the theoretical rationale helps to identify the objectives of transfers and provides broad guidance on their design, serious considerations have to be made regarding the volume of transfers, components of the distribution formula, flow of funds and method of transfer as well as the management and sustainability of transfer system as a whole. The formula employed may have implications both on equity and incentives and also may have to address various political, historical and economic compulsions. Fiscal decentralization is an on-going process. However, the design of a system of intergovernmental fiscal transfers should focus towards attaining a system that increasingly assures fiscal self-reliance and accountability of local governments over time. At the same time, the system should ensure that at least a reasonable level of resources would continue to flow to the local government even in an unfavorable situation. One way to ensure it is to increase the own revenue sources available to local governments. Secondly, continuing directly funding sectoral projects and programs in each of the local body jurisdiction, as it will not be feasible to discontinue such funds or direct it at once to the respective jurisdiction in terms of block grants- general or specific. It is considered better to rely on a mix of general and specific purpose grants and sectoral transfers, even in the medium to long run. Exclusive reliance on general-purpose grants might give too much discretion to the local government while, heavy reliance on sectoral transfer may result in to a situation where by the local government's existence would be minimized. Hence, a mix between two types of transfers with some degree of control and accountability would be a preferred solution for at least the near to medium term. Universal Principles of Transfer Design

While designing the intergovernmental transfer system it is important to take note of the international practices. The universal principles of transfer design provides a good guidance for designing a system of fiscal transfer that is theoretically sound and hopefully less problems in its implementation. The principles can be elaborated as follows:

a. The system of transfers should provide a source of adequate resources to local governments in

a way that balances national priorities and local autonomy. b. The formula should support a fair allocation of resources by providing more resources to districts

with lower ability to generate resources and greater fiscal needs. c. Transfers should be provided in a predictable manner in a dynamic sense. The formula should be

stable over a period of years to promote revenue predictability and overall budget certainty.

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d. The transfer mechanism should be, to the extent possible, simple and transparent. The formula should also be understandable to all stakeholders, in particular regional officials and legislators, and not be subject to political manipulation or negotiation in any of its aspects.

e. The transfer mechanism should not create negative incentives for revenue mobilization by sub-national governments, neither should the mechanism induce inefficient expenditure choices.

f. General allocation transfers or equalization transfers should be granted as unconditional lump-sum grants for general-purpose financing of sub-national governments, and

g. During the introduction of the new system of intergovernmental transfers, the transfer system should avoid sudden large changes in funding for local governments.

2.2 Instruments of Intergovernmental Fiscal Transfer

There are different instruments that the central governments normally use to fill the fiscal gap of local bodies. They are empowering the local bodies with more fiscal authorities, revenue sharing and grants. Giving Local Bodies with more Tax Authorities

Assignment of revenue authority to local bodies enabling them to raise taxes on their own is in itself a separate dimension of fiscal decentralization. There are theoretical grounds that discuss appropriate sources of revenue that a local body should be bestowed. Different countries have adopted different practices on the same. Revenue assignment is not the focus of the current study, so this aspect will not be deliberated in this exercise. Revenue Sharing

Central government may attempt to fulfill the fiscal gap of local bodies through systems variously described as "tax sharing" or "revenue sharing." In a revenue sharing arrangement the central government shares a portion or all the revenue from a given source with local bodies. Example of revenue sharing in Nepal includes sharing revenues from forest resources, from levy of electricity generation, property registration etc. Another approach in sharing revenue is the sharing of tax base. In this approach, local or central tax are piggy- backed on the normal rates applied on tax base as a surcharge or fee. Local development fee, in Nepal, can be considered as an example of base sharing since local development fee at the rate of 2 % or so is levied on all imports of goods except project goods, raw materials etc., on top of normal import duties. The tax base in this case is the importation of goods. This study will not discuss on the different forms of tax/revenue sharing, policy implication of each of them, and appropriateness of one or another, since it is beyond the scope of this study. However, Nepalese system has incorporated some system of revenue sharing which has significant bearing on the fiscal capacity of the local bodies, particularly that of the DDCs. This study will assess the implication of the currently shared revenues on the fiscal capacity of local bodies, along with an attempt to incorporate the revenue sharing arrangement in the formula based transfer system. Central Government Grants to Local Bodies

Grants from the central government to the local bodies are essential, because it is observed that despite of well planned revenue assignment and revenue sharing arrangements there still occurs fiscal gap at the local bodies. The present study will focus more on this aspect. Most countries have multiple goals for sub national governments, as is often reflected in the variety and structure of transfer programs. General-purpose transfers and special purpose transfers are broad categories of transfers. General-purpose transfers are given to enable the sub-national governments to offset the fiscal disadvantages arising from a lower revenue capacity and a higher unit cost of providing public services. Unconditional grants, for example, are best for promoting autonomy and inter-jurisdictional redistribution, while conditional grants are more efficient in encouraging expenditures on particular types of target services.

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The current study will give more attention on general-purpose transfers (equalizing transfers), since the study focus is on this aspect. Therefore the special purpose transfers or sectoral transfers will be given less attention.

2.3 Criteria for an Effective Transfer System

Transfers should be determined as objectively and openly as possible. Transfers should not be subject to hidden political negotiation. A formula is considered ideal for the purpose. The transfer system is decided in various agencies in different countries: by the central government alone, by an expert body e.g., a grants commission, or by some formal system of central-local committees. In the case of Nepal the LBFC is an autonomous body that makes suggestions which is ultimately subject to the decisions by the central government. Bahl and Linn (1992) and later Shah (1995) have pointed out that the most appropriate form of a transfer depends largely upon its objective. Regardless of the particular design, however, experience demonstrates that good intergovernmental transfer programs have certain characteristics in common: Revenue adequacy: The transfer system should be such that it avails sufficient resources to local bodies to undertake the assigned the responsibilities Local tax effort and expenditure control: An effective transfer system ensures the local bodies put in sufficient efforts to raise local taxes. Similarly the system should ensure that local bodies do not spend more than their resources, in other words the transfer system encourages local bodies to control overspending by local bodies. Transparency and stability: Transfer system should be based on transparent formula that should be made known to the public and the local bodies in advance. This should be such that the local bodies are able to forecast its own total revenue including the transfers to prepare their budget. The system should also be stable for a reasonable number of years to allow the local bodies to prepare their medium-term plans. Grants should be designed such that they fill ex ante gap between sub-national revenues and expenditures. Ex post gap filling could give rise to excessive expenditures at local level, as central government will foot (part of) the bill. One system that appears to achieve the dual objective (stability and flexibility as well for periodic negotiation) is to set the total level of transfers as a fixed proportion of total central revenues, subject to renegotiation periodically (say, every 3-5 years). The formula (or formulae, if there is more than one grant) is transparent, based on credible factors, and as simple as possible. 2.4 Components of a Grant System Every intergovernmental transfer has two dimensions: the first is the vertical dimension, the distribution of revenues between the central and local government. The second is the horizontal dimension, the allocation of transfers among the recipient units. There are three key factors in the design of intergovernmental fiscal transfers: the size of distributable pool, the basis for distributing transfers, and conditionality (Bird, 2000). Design of grant system has to address the following – what is the amount that is to be distributed (vertical balance); what is the purpose of the grant transfer to local bodies; how the grant amount be distributed among local bodies (horizontal distribution); and how is the system being administered, monitored and managed. These form the components of a grant system that are discussed in brief. Size of the Grant Pool

Determination of the size of the grant pool is essential to ensure vertical balance. The size of the grant pool should be fairly independent from macroeconomic conditions, to ensure fairly stable source of money for local bodies. This suggests that it is better to have a broad revenue base that feeds the grant pool compared to single tax based grants.

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There are three common approaches to determining the size of the grant pool. Most countries use one or more of these three methods. These are determination as a share of some central government revenue source, on an ad-hoc basis, or on a basis of cost reimbursement. Tax sharing is widely practiced among developing and transition countries. In this case, the central government allocates a share of national collections of some tax to the local government sector. What sources are appropriate or what percent of the identified source is to be set aside for local bodies grant pool is a matter of policy choice of a country. There is no any established norm or practice as to what is the best tax source to share with local bodies.

There seems to be neither rhyme nor reason to the choices made as to which tax base to share, as is indicated by the following examples:

Russia and China: VAT Colombia: The Tax on Beer India: Excise Duties Indonesia and The Dominican Rep: Property Tax Peru: Sales Tax Nigeria: Natural Resources Taxes Mexico: Payroll Tax Brazil and Colombia: Motor Fuel Taxes

Roy Bahl

Similarly as to what percent of national resource is channeled through local bodies is also different in different countries. The proportion varies from about 5% to as much as 40%. In Nepal the transfers to local bodies in the form of general-purpose grant is found to have been less than 5%.

In Cambodia, the allocation is growing from less than 2% of domestic revenue in fiscal year (FY) 2002 to 5% in FY2006.

The Indian Government shares nearly 35% of its domestic revenues with the state governments, partly under the mandate of a constitutional amendment and partly on the recommendation of a periodic Finance Commission.

Dana Alokasi Umum (DAU) in Indonesia represents at least 25% of the Indonesian Government’s national budget and accounts for nearly 75% of local revenues.

In Pakistan, the pool of resources for the main intergovernmental transfer program to the provinces as determined by a periodic Finance Commission makes up 37.5% of most national revenues, with a few sources sharing 100% on the basis of origin. It accounts for more than 60% of transfers to sub national governments.

The Internal Revenue Allotment (IRA) of the Philippines shares by law 40% of gross national internal revenues (in the third year before the allocation year) and accounts for 94% of all transfers.

Under ad hoc, or discretionary, basis of transfers, the budget for local bodies is allocated each year. The disadvantages of this are that it is not transparent, is subject to political manipulation, not predictable for local bodies fiscal planning and budgeting. More importantly this approach denies the link between expenditure responsibilities and revenue resources, and discourages local bodies to become self-reliant. On the other hand, the ad hoc approach also has some advantages. From the point of view of the central government, it provides flexibility and space in preparing budget, as it does not have to oblige by the predetermined share of local bodies. Cost reimbursement is another approach to determining the size of the revenue pool. The central government defines a service for which it will guarantee to cover the cost incurred by the local government in delivering this service. It is like conditional grant in some regards. Cost reimbursement grants have some significant advantages. First, they can be used to direct investment to high priority national needs or priority. This system also helps to ensure uniformity of standards across the country. The disadvantages of cost reimbursement grants includes that they compromise local choice and can retard true fiscal decentralization. Decentralists almost always argue that central governments do a bid job of setting standards, and in any case, standards should not be uniform because demands for services and local conditions vary across regions within the country. The requirement of uniformity also discourages innovation by local governments, because standards are being set by the central government. Finally, cost reimbursement grants impose an

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administrative cost on the central government, which must monitor the program, and a compliance cost on the local governments who must do significant reporting on their use of funds and their adherence to standards. Cost reimbursement grants are widely used as a method of determining the total flow of funds to sub national governments. It gives the central government control over the amount of funds allocated to the local government sector, and it gives the center some say in how the funds will be spent. It is a centralizing approach to intergovernmental transfers.

Comment

The ad-hoc approach to determining the size of the distributable pool is the most centralizing approach to designing an intergovernmental transfer system. Despite some very apparent flaws, it is widely used, even in some countries that feature decentralization as part of their development plan. The compensatory approach espouses the ex post gap filling. This is less effective to LB autonomy, and high demanding for administrative input in the management of the system. The most decentralizing form of vertical revenue sharing is the shared tax approach. There is no clear policy in Nepal regarding this issue. From the practice one can say that it is based on ad hoc basis, but some historical data are used to determine the pool. Distribution of the Pool of Resource among Eligible Local Bodies

There are numerous issues that require the attention of policy analysts. They include (i) the degree to which grants can be used to promote vertical balance among governments; (ii) use of grants to correct for positive inter-jurisdictional spillovers (categorical or specific grants; matching grants); and, (iii) the need to mitigate the impact on local jurisdictions and their residents of unequal fiscal resources and needs; iv) The design of these transfers is of critical importance for efficiency and equity of local service provision and fiscal health of sub national governments. At the early stages of development, the priority public sector responsibilities are infrastructure development and the provision of basic living necessities, and the protection of economic stability. This dictates fiscal centralization, or more of grants directed for specified sectors or activities. But with economic growth and urbanization, public expenditure needs shift more toward services provided by local governments, e.g., social services, water supply, etc. In the latter case the local bodies need more authority on the allocation of the grants among different sectors or services they provide to their citizens. This calls for developing mechanism that best suits to the development condition of the local bodies. Horizontally the transfers might be distributed according to a derivation basis, i.e., local governments may retain a share of what is collected within their boundaries. Alternatively, they may receive grants distributed by formula, by cost reimbursement or according to ad hoc methods. The derivation approach is practiced widely among developing and transition countries. The system following derivation based distribution, the total grant pool is determined as a share of a national tax, and each local government receives an amount based on collections of that tax within their geographic boundaries. Though simple to execute and good in terms of fairness this system is bad in terms of equalization perspective. A formula based transfer system has at least three advantages over the discretionary system. It is objective that avoids bargaining and increases chances for fair distribution. It also encourages for local tax efforts and imposes hard budget constraints and thus stops over-spending because most formula designs take into account these factors. Formula grants are generally unconditional, which gives locals a maximum of flexibility in deciding on the purpose of expenditures. Further if the grant pool is determined through shared taxes then some degree of certainty in the distribution is also attained which is desired as per principle of transfer.

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2.5 Types of Grants

There are many different forms of intergovernmental transfers, and the right choice for a country depends on the objectives to be achieved. Table 2-2 provides an overview of the generic grants types.

Table 2-2: Generic Grant Types

Conditional grants Matching open ended conditional grant Matching closed-ended conditional grant Non-matching conditional grant

Unconditional General purpose grants

General purpose grants flexible enough to be used as per the local requirements.

Promotional grants Such grants are provided to encourage local government to follow rules and regulations of central as well as local government. Compared to other two types of grants, the volume of promotional grants used to be small and confine only to those local government who strictly follows the set rules and regulations. Such grants may be both conditional and unconditional in nature

Conditional grants are sometimes called specific purpose grants or categorical grants, wherein the central government specifies the purpose for which the recipient local body can use the funds. As the name suggests, such grants are provided to local governments for using funds to address concerns that are highly important to central government, such as, rural infrastructures, education, health, poverty reduction programs or even environmental conservation and pollution control activities etc. Such grants also can be provided for projects and programs with inter-district or regional spillover effects. Specific purpose grants can also take the form of a specialized fund with sole objective of developing and rationalizing sectors/areas for which the fund is established. Examples of such funds are education fund, healthcare fund, drinking water fund or road maintenance fund etc. The distribution of grants of such funds is done in a transparent and objective way through a formula based mechanism, incorporating factors that reflect demand for services they provide. Conditional grants can be matching or non-matching. In the case of conditional matching grant the central government asks local bodies to match certain portion of the expenses on specific programs as a condition to receive the grant. Open-ended conditional matching grant is a type of grant in which the central government does not impose a limit on the matching funds. Closed ended conditional matching grant is such a grant fund for which the central government puts a maximum ceiling on the cost it will borne to finance a service. Matching transfers encourage local bodies to spend their money in a given direction. As a result matching transfers potentially can distort local priorities and be considered inequitable in favor of the richer local bodies as they can raise matching funds more easily. In the case of non-matching grant, the central government avails a fixed sum of money with the requirement that the money is spent on specific public goods. Such public goods are normally of central importance, and the local body is not asked to put in its money for the service. Conditional non-matching transfers are designed to ensure that the local bodies spend on a specified service at least equal to the amount of grant monies. Though, in general, it is found that local bodies will limit their budget to the amount equal to the conditional non-matching transfers, in practice it is likely that that the local bodies spend more in areas such as infrastructure the local bodies may spend an amount exceeding the grants they receive. For an unconditional grant no restriction is posed on the use of funds. In effect it is a lump sum amount of money provided to the local bodies. In most cases such grants are provided to equalize fiscal capacity of local bodies to ensure that a minimum standard and level of public service is provided to its public. Unconditional grants, for example, are best for promoting autonomy of the local bodies and inter-jurisdictional redistribution, while conditional grants are more efficient in encouraging expenditures on particular types of target services

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The broad objectives of central grant to local bodies are to fulfill the fiscal gap, reduce fiscal inequity among jurisdictions, offset the impact of inter-jurisdiction spillovers, and achieve fiscal harmonization. Each of the different grants serves an objective better than others, if the grant system is properly packaged with other factors. For example expenditure harmonization can be accomplished by the use of (non-matching) conditional grants, provided the conditions reflect national efficiency and equity concerns, and where there is a financial penalty associated with failure to comply with any of the conditions. Often central government has more than one objective associated with the grant system, and that each grants type serves some particular objective and not all. To cope with such situation most countries have found it helpful to have separate transfers are targeted at each objective. This will enhance both clarity and effectiveness of transfer. In sum two grant components form a grant package, which can be seen as a formula as below.

Transfer = Special purpose ear-marked (conditional) grants

+ General-purpose equalizing (unconditional) grants

The discussion of the study considers more on the general-purpose equalizing grants.

2.6 Design of Grant Formula for Intergovernmental Fiscal Transfer

Bahl suggests that design of a formula based grant system consists of the considerations. (a) The elements of the formula, (b) the data necessary to implement the formula, and (c) the costs associated with administering the grant program. Elements of the Formula

The grant formula has to identify the elements that appropriately reflect the objectives and indicators or proxies for measurement. Table 2-3 gives a list of possible indicators corresponding to most common objectives. Table 2-3: Objectives of a Grant and Possible Indicators in the Formula

Objective of the formula Possible indicators or proxies or elements of the formula

Reflect the expenditure needs and regional cost differences

- Population, i.e., a straight per capita distribution - Indicators of physical factors that may lead to greater costs of service

provision, e.g., land area, population density, and urbanization. - Measures to reflect the concentration of high cost population in the local

government areas, for example, the percent of families living below the poverty line, the percent of people on pensions, the percent of school aged children, etc.

- Indicators of infrastructure needs, such as miles of paved highways, percent of households with access to adequate water supply, infrastructure needs to support economic development, etc.

Equalize local body income or fiscal capacity

- Level of average income, or the size of the tax base - Amount of money that could be raised if all appropriate tax bases were

subjected to "normal" rates.

Provide incentives to increase revenue

- A measure of tax effort - Maintenance of a level of revenue mobilization

Reflect a balance between revenue capacity and expenditure needs

- Defined standards of expenditures for desired levels of service - Link minimum expenditure requirements with an assigned tax revenues - Interpolation of historical expenditure figures

Finding the Data Required

The elements in themselves serve the purpose if related data are available. The advantages of formula grant systems can be taken away if the data used to allocate the funds are suspect. It is observed that some data are simply not available in disaggregated form as is required (e.g., regional income data, municipal level life expectancy etc). In other cases the data may not be updated as required/expected by the formula (for example census data in Nepal are updated only once in a decade). Without updated data a formula grant system will not be as objective.

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Some data are found for some geographic area and not universally, and often the accuracy of data is questioned. A grant system to be fair and predictable must require credible data, which the designer of the grant system must take into considerations.

Another formula grants issue is that of data difficulty when manipulation is required. For example, the calculation of a tax effort index to use in a formula, or the calculation of an index of poverty to use in a formula is done in some countries. But now the problems in the underlying data recombine with the problems of the method of computing the index. Together with the complexity introduced, these problems can undermine the confidence in the data. Administrative Costs

Formula grants are administratively demanding. There are a number of reasons for this. A unit is necessary for maintaining the database. If indexes are included in the formula and if they need to be annually updated and the final distributions be computed. There is also possibility that interpolation of data is required. Special cases or special situations may have to be dealt separately than the regular formula. When the system is transparent and predictable, then grievances may also arise and disputes (including litigation) need to be handled. Such possibilities demand for a fully responsible and functionally active unit, which means additional costs. Monitoring and evaluation is another administrative cost. Formula grant systems must be monitored on a regular basis. To assess the need for change, grant systems need to be tracked continuously manner so that revisions can be made in reasonable intervals. In this way, a regular system to assess the effectiveness of the grant program is ensured. Guidelines for Designing Formula

Considering equalization grants and sectoral block grants, central governments have many choices on how to structure the equalization formula and even what exact objectives to pursue. However, it is generally accepted among fiscal policy experts that all transfer formulas should consider some common guidelines. They are:

- General allocation transfers or equalization transfers should be granted as unconditional lump-sum grants for general-purpose financing of sub national governments.

- The formula should support a fair allocation of resources by providing more resources to districts with lower ability to generate resources and greater fiscal needs.

- The transfer mechanism should not create negative incentives for revenue mobilization by sub national governments; neither should the mechanism induce inefficient expenditure choices.

- The data source should be respected by all stakeholders, and the factor should be free from manipulation by local government officials (for instance, school enrolment and health care utilization figures can be easily manipulated by local governments; instead the National Statistical Office is seen as an independent source of data by all stakeholders)

- The transfer mechanism should be, to the extent possible, simple and transparent. The formula should also be understandable to all stakeholders, in particular regional officials and legislators, and not be subject to political manipulation or negotiation in any of its aspects.

- During the introduction of the new system of intergovernmental transfers, the transfer system should avoid sudden large changes in funding for local governments.

- The factor should reflect the need (demand) for a service (i.e., the number of potential clients for a government service), not necessarily the current supply. For instance, the use of infrastructure in an allocation formula will likely introduce inequity and inefficiency.

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- The factor should be statistically sound and regularly updated (for instance, census data should be used as opposed to variables occasionally produced)

- The formula should not rely on the ―equality principle‖. The system should be rather equitable (fair) in terms of population or area; efficient to encourage resource allocation in areas where they are needed most; and technically efficient that encourages reasonable size of the local bodies.

Formulas for Equalization Transfers

Determination of an equalization formula requires assessment of both revenue capacity as well as the expenditure needs of local government since intergovernmental transfer is meant for balancing the revenue and the expenditure needs of a jurisdiction. A standard format will require first to define the norms and standard of each expenditure units as well as the fiscal capacity that is the revenue potential at a standard tax effort. The generic formula can be summarized as follows:

Grant = Expenditure Needs of a LB – Fiscal capacity of the LB

Where,

Expenditure Needs = Cost of assigned sectoral services, administrative costs, implementing programs of central government priorities, services committed by local bodies and so on, and Fiscal Capacity = Revenues raised with optimum tax efforts by a local body on the assigned tax base, at a standard tax rates

The formula appears simple but in reality since the determination of expenditure needs and fiscal capacity is complex, therefore several type of formula are developed by countries that suits to their needs and conditions. Juna Ma has classified four types of equalization formula in practice. They are listed below.

1) Formula A: Transfer = Expenditure Needs – Fiscal capacity – Other Transfers This formula considers fiscal needs, fiscal capacity and other transfers, therefore is most equalizing by nature. But data requirement is demanding. Such a system is prevalent in Australia, Germany, Japan, Korea, and the UK. It may not be an appropriate formula type for Nepal due to management difficulties and complexity of data requirement.

In Germany, the interstate equalization formula is calculated as the difference between adjusted taxable capacity and the fiscal need of the state. Expenditure need is defined as

EXP NEED = (sum of TCi/POPi)(PDCi)(POPi) Where, sum of TCi/POPi is used as a proxy of per capita standard expenditure needs and PDCi national

average per capita revenue and POP population of state ‘i’. In the United Kingdom, the general-purpose grant is estimated as a difference between standard

spending assessments minus standard local tax income minus income from non-domestic rates. Standard need assessment measures the locality’s expenditure needs.

2) Formula B: Transfers = Population of a LB x (average national tax base per capita – average

local tax base per capita) x average effective national tax rate This formula only considers the equalization of fiscal capacity. Example of such is found in Canada. Such formula can be administered with even relatively weak database, but it ignores differences of expenditure needs across local bodies, therefore does not do justice to local bodies where expenditure per unit of service is high. This is an over-simplification and may create a new source of regional disparity if the costs of providing public services differ vastly across regions. Therefore this may not be a good approach for Nepal.

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The Canadian equalization program uses a national average standard as the basis for equalization. It calculates the province’s tax capacity based on the national average tax rates to its tax base and compares it with the per capita revenue that could be raised if the province has a standard per capita tax base. A province receives the equalization grants equal to the difference between the province’s tax capacity and the standard tax capacity multiplied by the province’s population.

3) Formula C: Transfers = Expenditure needs for assigned services (sum total of all services

calculated at standard per unit cost of services) Fiscal capacity is not considered in this formula often because such data are difficult to obtain. India, Italy, and Spain use this type of formula. Typical indicators (often used in combination with weights) used to determine regions' fiscal needs include: Per capita income level; Poverty incidence; Unemployment rate; Population density; Area; Infant mortality; Life expectancy; School enrollment rate; Infrastructure (e.g., length of roads and railways); Other indicators of development level (e.g., electricity consumption and number of telephone lines). What indicators should be chosen and how much weight each indicator should be given are highly sensitive questions and need to be answered with careful simulations and consultations with regional authorities.

In India, intergovernmental transfer system consists of three elements namely: (a) General-purpose grants, determined by the Finance commission and updated every five years; (b) Transfers from the central government to the state development plans, determined by the National Planning Commission; and, (c) Local government borrowing authorized by the central government.

While determining the general-purpose grant, the 10th Finance commission of India suggested adoption of a criterion that constitutes:

20 % on the basis of population, 60 % on the basis of distance highest per capita income state, 5 % on the basis of infrastructure, 5 % on the basis of area, 10 % on the basis of tax effort.

District Unconditional Grant formula in Uganda – The factors and weights of the district and the urban grants is:

Administrative Standard Expenditures 50% Population 40% Area 10%

4) Formula D: Transfers = Population of a LB x Per capita transfer allocated for distribution The formula distributes equalization transfers on an equal per capita basis. Such formulas are used in Germany's VAT sharing, Canada's EPF, England's NDR, and in a number of Indonesia's general-purpose grants. It is least demanding for data, but also has relatively weak equalization effects. Equal per capita transfer cannot fully equalize but can mitigate regional disparity in fiscal capacity. Comparative Review of the Types of Formula

Review of the merits and demerits of these formulae suggests that type C formula is better option in the present context in Nepal. This is because it requires little data. It ignores the fiscal capacity aspect of the local bodies, but this is not so significant anyway in our present context. Some public policy experts argue that fiscal capacity should not be considered in designing formula since that the local bodies that raise more money have to provide more services to its citizens. Therefore they argue that in equalization grant system fiscal capacity aspect becomes redundant to be included in the formula. Further the situation in Nepal is such that the local bodies generate only a small amount of resource with their own efforts and the money is mostly spent in maintaining their office operations, and for some petty services that they may wish to fund. Further the fiscal needs of the local bodies are limitless if all the expenditure needs are to be met with central transfers and

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local efforts. In such a situation the central government can at the best develop funding principles for the potential service demands based on certain indicators that can be used as proxy of fiscal needs. Issues about Equalization

It is common that a grant design is regarded well, if it has equalization as an important consideration of the grant formula. Equity is one of the principles that support equalization. However, in practice it is not so easy. Full equalization is almost a wish with a grant formula because there are more than one objectives (equalization of income level, per person revenue, fiscal capacity, expenditure needs) demanding equalization. One may prefer equalization through ad hoc grants since a formula based grant commonly fails to address special needs of a jurisdiction. But due to non-transparency of such a system have potentials to become a bad public policy choice. Moreover, equalization grants design can have negative impact on tax efforts of local bodies. Why should a LB take unpopular decisions if central government is to equalize with additional resource? Furthermore, for example, in case of Nepal even if the central government attempts equalization among DDCs, how can one ensure that the DDCs will behave in the same way and distribute resources to equalize its Ilakas? In such a case big question arise who will monitor effectiveness of equalization arrangement, how one will monitor and what indicator will one use. A formula grant has the potential to be equalizing jurisdictions. Identification of appropriate elements is vital for equalizing otherwise a formula grant can become counter equalizing if it includes factors that benefit richer jurisdictions.

An example is the Philippines where land area, population and "equal amounts" are included in the formula, primarily because this is an understandable and accepted formula. However, research suggests that this is not equalizing.

A formula grant is not likely to correct for externalities because there are not usually conditions placed on the expenditure of the funds. Exceptions may be block grants where a broad range of purposes is designated as an acceptable use of the funds.

A formula grant can include a tax effort provision to stimulate revenue mobilization, but the record of success with this approach is not encouraging. The Korean system is one effort to try to hold tax rates at about their present level: if a city drops below the standard tax rate, there is a built-in penalty in the form of a lower allocation. Other programs are more aggressive and even try to reward higher tax efforts in the allocation. For example, Indian Plan Grants include a measure of tax effort in the formula, as does the Nigerian formula for sharing central revenues with the states. Few countries can follow this practice, however, because the common measure of tax effort is the ratio of taxes to personal income and few countries have adequate measures of local personal income.

Measuring Fiscal Need

Grants are meant to fulfill the fiscal needs of a jurisdiction. Therefore a grant system must adopt systematic approach to measure the fiscal need of a local body. Broadly there are two methods used to determine fiscal needs of sub national governments. The first method estimates the cost for each service. The total fiscal need of a sub national government is the sum of the estimated needs for all these categories. Such method is used by the United Kingdom, Australia, Japan, and Korea. Juna Ma (1997) observes that the equalization transfer formula in most countries takes into account the needs for current expenditures (including maintenance of capital projects) but exclude those for new capital projects. In such cases transfers for new capital projects are decided on an ad hoc basis. This above method to calculate a local body‘s fiscal needs require substantial information on a variety of different factors that affect the costs of providing public services. Not all countries have this depth of information.

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Alternative approach is to estimate a local body‘s fiscal need on the basis of certain proxies and weight assigned to them. Taking population, income level, and area as proxies given below is an example of the formula.

Ni = TE[wP(Pi/P) + wI(IDiPi/DjPj) + wA(Ai/A) ]

Where, Ni is the fiscal need of the ith region; TE is the total expenditure made by regions; P is the total population; Pi is the population in the ith region; wP is the weight assigned to population; IDi is the per capita income distance from the richest region; wI is the weight assigned to income disparity; Ai is the area of ith region; wA is the weight assigned to area; wP + wI + wA = 1 A is total area DjPj is income of richest region

Population is considered to be a good proxy for expenditure needs, since more people means more service needs to produce. The factor area is important to include as it accounts for differences in the cost of providing many public services. Services such as roads, telecommunications, schools, and libraries face higher per capita production costs in sparsely populated regions than those in densely populated regions. The income distance factor in the formula reflects the government's explicit objective to address regional disparity. Other variables that can be considered for this formula include population density, tax effort (revenue/GDP ratio), etc. What to take as proxies is a matter of policy choice, which should be done with extensive consultations with stakeholders, simulations, and judgments. Development of a good and practical transfer formula demands considerable expert judgments. Furthermore, there is a clear trade off between ideal design and simplicity in transfer formula. The practicable approach for a country like Nepal is to have a simple design incorporating the basic objectives of transfers.

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CHAPTER III

INTERGOVERNMENTAL TRANSFER IN NEPAL: A REVIEW

3.1 Background

The Constitution of Nepal 1990 adopted decentralization as the basis of governance in Nepal. The promulgation of Decentralization Act 1999 systematized the process of decentralization. It gave legal base for both administrative and financial decentralization including authorization of planning, budgeting and resource mobilization at different level of local bodies. As decentralization progresses, the skewed distribution of resource endowments, and the diversity of the level of socio-economic and the infra-structural development resulted into a mismatch between expenditure needs, revenue collection and fiscal capacity across the level of local bodies leading to vertical and horizontal fiscal imbalances. To contain these imbalances across the level of government a system of intergovernmental fiscal transfer was adopted. HMG/N is providing different grants, both conditional and general-purpose unconditional grants, to local bodies besides, directly investing huge sum of money annually for socio-economic and infra-structural development at the local level through its district level agencies and offices. The resource transfer from central government to different level of local bodies is thus, expected to contain these imbalances overtime. In addition to block development grant, the center has also been providing conditional specific purpose grants to DDCs and Municipalities. The objective of these grants is to encourage the local bodies to direct their investment towards the development activities in the desired sector/s. The funds provided by the center to undertake drinking water and sanitation projects, local construction and development and agriculture road projects and construction and maintenance of large and local level suspension bridges are the instances of conditional grant provided to DDCs. Additional grant provided to municipalities which are weak in financial resources and the funds provided for rural urban partnership program, youth development, construction and management of land fill sites and matching fund to undertake different programs to the municipalities are in the nature of conditional development grant. The central government should have clear policy vision as regards the sector/s in which it wants local bodies to invest. The amount of funds to be allocated to each local body should be ascertained. Such practice would facilitate translating the vision into actual practice and thereby attaining the goal.

3.2 Intergovernmental Fiscal Transfer

HMG/N transfers annually a significant amount of resources to local level through a variety of programs. Transfers of resources to local level are done both through local bodies, grass root level central government offices, through community organizations and non-governmental organizations. Based on some norms, HMG/N provides both, administrative and development grants annually to DDCs, municipalities and VDCs for taking up different developmental activities and service provision at the local level. Besides, huge sum of money are allocated annually for each districts to carry out district/municipality and VDC level developmental activities and social Upliftment programs through its district level offices and community/non-government organizations. DDCs are not alone in the districts to implement development programs/projects. HMG/N line agencies are also present there to implement specific programs/activities of their respective sectors. The line agencies of agriculture and co-operative, education and sports, forestry and soil conservation, and health sectors are present in all the districts of the country. On the contrary, line agencies of physical planning, irrigation, women and children welfare; water resources and tourism are the sectors whose line agencies serve for more than one district. A review of the average total resources allocated to various line agencies in the districts over a period of 5 years (fiscal year 2000/01 through 2004/05) showed that every district, on an average, were allocated Rs. 260 million per year for the implementation of program/projects of different line agencies. The allocation varied among districts. It ranged between Rs. 50 million

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for Manang district to Rs. 2774 million for Lamjung district. The higher level of allocation to Lamjung district was the result of inclusion of Rs. 2649.5 million budget of Upper Marsyangdi hydro-electricity project as the district level budget allocation. (Refer Annex III-I for detail figures.) Apart from the line agencies, bilateral and multi-lateral agencies as well as national and international non-government organizations are also involved in the implementation of various development programs/activities in the districts. The activities of such agencies and organizations are mostly concentrated in software areas rather than on hardware. The activities of NGOs are usually funded by donor funds. In view of the high number of organizations involved, it is difficult to find out the exact amount of investment made or activities implemented by these organizations in each district.

3.3 Elements of Transfer System

Divisible pool of grants

The development grant to DDCs and municipalities and the block -grant to VDCs in Nepal are allocated out of the divisible pool that is approved by the Parliament on the proposal put forward by the Ministry of Finance. The basis for determining divisible pool is rather arbitrary and often times determined 'a political'. A fixed proportion of national revenue or expenditures are generally used to identify the size of divisible pool. Such international practice has seldom been followed in Nepal. Neither, they are determined considering the expenditure needs of the local bodies with due consideration to their own source revenue and funds received by them through local development fee or revenue sharing. This makes 'divisible pool' of development grant to each level of LBs uncertain and unpredictable. Transfer System to DDCs

HMG/N provides both administrative and development grants to DDC. Administration grants to DDC are determined based on the administrative liability of the central government. The Decentralization Act 1999 and the regulation clearly mention about the types of personnel central government has to depute at the DDC and the types of personnel DDC can recruit locally. All the liabilities of the centrally deputed personnel plus the liability of VDC secretaries plus some administrative expenses are borne by the central government. Development grants to DDCs constitute of both specific purpose conditional grants and the general purpose unconditional grants. The bases for determining such conditional and unconditional grants are, however, until recently, determined on an ad-hoc basis with out assessing the need of the respective DDCs. With a view of initiating a formula based grant distribution system MoLD constituted a Committee to design a formula for distributing block grants to DDCs. The Committee recommended an interim formula, which has been adopted by MoLD for distributing grants to District Development Committee (DDC) since FY 2003/04. The interim formula for determining the size of block grants to DDC constitute of district area, rural population in the district, level of human development and transport cost factor. Following are the weights given to each of these factors in determining the size of the grants to DDC.

50 percent of the fund of the divisible pool allocated on the basis of human development index (HDI) of the district.

20 percent of the fund of the divisible pool allocated on the basis of rural population of the district.

20 percent of the fund of the divisible pool allocated on the basis of cost factor applicable to the district.

10 percent of the fund of the divisible pool allocated on the basis of area of the district.

The objective of applying HDI criteria in the grant allocation formula of DDC is to provide higher level of funds to districts having lower HDI. The formula therefore uses the ratio of (1-HDI) in

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order to ensure this. The district population includes inhabitants of both the rural and urban areas. The formula only takes rural population into consideration while allocating 20 percent fund of the divisible pool on the assumption that the DDC development activities are more concentrated in rural areas rather than in urban areas. Transfer System to Municipalities

The development grant to municipalities and VDCs are provided on ad hoc basis. A cut off amount of internal revenue generation of Rs. 10 million per annum is fixed for municipalities to be eligible for development grant. The concept of additional development grant practiced from the current fiscal year is also discriminatory towards the resource rich municipalities since only 10 municipalities considered resource poor and remote enjoy the benefit of such a grant. Although higher amount of development grant is usually found allocated to resource poor municipalities as compared to municipalities having higher level of own source revenue, it is difficult to get a definite answer as to how the amount of development grant is derived in individual cases. Transfer System to VDCs

Equality rather than equity is ensured in the present system of block grant to VDCs since equal amount of Rs. 500,000 per annum is provided to all. Obviously, this approach does not take into consideration the expenditure needs of VDC lying in different geographical locations, with varying population level and area. On per capita basis, the existing practice tends to favor the VDCs of hill and mountain districts, which are less developed and remote. It is, however, apparent that such a practice is unconsciously done, as there are no objective and transparent criteria on which the grant determining authorities could rely upon.

3.4 Conditional and Unconditional Grant Allocation

Transfers from the central governments are the principal source of revenue of all local bodies in Nepal. Of the total resources of local bodies, it is found that Municipalities generate more own source revenue (28.95 percent) than the VDCs (25.92 percent). The ability of DDCs to generate internal revenue is considered the lowest among the local bodies. The DDCs and Municipalities receive the central transfers directly from the Ministry of Local Development whereas the DDC is given the authority for disbursing grants to the VDCs. The grants provided by the central government to local bodies can broadly be categorized into three types, namely, operating or recurrent grant, program or capital cost grant and conditional grant. Grants other than the operating/recurrent grant are commonly referred to as program or capital cost grant.

3.4.1 Grants to DDCs

Recurrent Grant: DDCs receive grant from the central government to meet their administrative expenses. The purpose of this grant is to enable the DDCs to meet salary cost of staff deputed from the center, staff hired by the DDC, welfare fund contribution of the staff so hired and salary cost of the VDC secretaries. Up to fiscal year 2002/03, the Ministry of Local Development used to specify the amount allocated for each purpose. With effect from 2003/04, DDCs are, however, given the discretion of budgeting funds required for this purpose out of the recurrent grant provided to them by the center. The purpose of including the salary of VDC secretaries as recurrent grant to DDC is not fair upon the DDC since they do not have any discretionary authority with regard to the spending of fund set aside for the purpose. This practice is obviously guided by a consideration of keeping these secretaries under the administrative supervision and control of DDC Secretary who is deputed by the center. In view of this, the picture of fiscal transfer is better reflected if the salary of VDC secretaries is included as part of central grant to VDCs. Capital Grant: This grant is provided to DDC to enable them to execute development activities in the district. The DDCs have the sole discretion to use this grant for the purpose they wish by

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following the planning and budgeting procedures as set out in the local self-governance law. The capital grant to DDCs prior to fiscal year 2003/04 was provided as the development grant. Conditional Grant: In addition to the capital grant, the center is also providing the DDCs with funds to implement: i) rural drinking water and sanitation project, ii) local infrastructure and rural road project, iii) construction and rehabilitation of large and local level suspension bridges, and iv) development programs based on people's participation. The DDCs are given full authority regarding planning, allocation and selection of the projects from the funds thus provided. This was not the case till fiscal year 2003/04. The figures of recurrent grant, capital grant and conditional grant provided by the center to DDCs during the last two fiscal years are provided in a summarized form in Table 3-1. Detail of which is presented in Annex III-II. From the table, it is observed that, for the period under review, the respective share of administrative and general-purpose capital grant and conditional grant in the total grant provided by the center to DDCs is 31.4, 20.8 and 47.8 percent respectively. The table also reveals that the recurrent and capital grant has remained more or less at the same level during the two years whereas there is a substantial increase of more than 100 percent in the conditional grant in the year 2003/04 as compared to the year before. Table 3.1: Grant Allocation to DDC by Type (in ‘million Rs.)

S. No.

Grant Type

Fiscal Year Averag

e Allocati

on of the

Period 2002/04

Average as % of

the Total

2002/03

2003/04

1.

Recurrent Grant 485

486

485.5 31.43

2.

General-purpose Capital grant 319

324

321.5 20.82

3.1

Rural drinking water and sanitation project

116

158

137 8.87

3.2

Local infrastructure and agriculture road project

276

288

282 18.26

3.3

Construction and rehabilitation of large and local level suspension bridges

83 167

125 8.09

3.4

Development programs based on people's participation

10 377 193.5 12.53

3 Total Conditional Grant: (3.1 to 3.4)

485

990 737.5 47.75

Total Grant: (1+2+3) 1,289

1,800 1,544.5 100.00

The specific program/projects implemented by DDCs at present out of the conditional grant provided from the center along with the objectives of each program/project are briefly elaborated in Annex III-III.

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3.4.2 Central Guidelines to DDCs on the use of Grant Fund

The grants provided to DDCs include funds to meet recurrent expenditures and capital costs. The Guidelines issued by the Ministry of Local Development for the use of grant fund provided to DDC strictly prohibits the transfer of funds from capital cost to recurrent expenditure. It further provides that the capital cost portion of the grant should be spent after program budgeting and must not be used on ad hoc basis The Guidelines also contain specific directives to the DDCs which they should follow while allocating funds for the programs. These are:

Uncompleted projects carried forward from the preceding fiscal year should be given priority in the allocation of funds

Investment to be directed towards attaining the objectives, programs and results as set out or preferred in the Tenth Plan, periodic plan/sectoral periodic plan or the DDC itself.

Matching fund may be provided in the projects/programs funded by the donor agencies, INGOs, financial institutions or in public/private partnership and sectoral projects.

Investment may be made after approval of the program in the following cases: - Program related to the capacity enhancement of DDC - Programs involving cross cutting issues - Programs related to minimization of calamity risks and rescue and rehabilitation

Investment may also be made in the programs aimed at fulfilling the minimum conditions specified in the LSGA (participatory planning process and budget formulation, financial management, accounting and auditing, human resources development, establishment of district information center and operation, program evaluation, review and reporting, enhancement internal revenue sources and its mobilization management, settlement of audit irregularities, social audit, grievances hearing, transparency, etc.)

Social mobilization and implementation of targeted group programs may be implemented either independently or in partnership

The Guidelines also discourage the DDC from implementing small village level projects. Instead, it has authorized the DDC to provide grant to VDC or any organization or body within the limit of the approved budget and get such projects implemented as provided in clause 189 (2) of LSGA. The Guidelines also require the DDC to follow the provisions of LSGA and related Regulation to get the accounts of the utilization of grant fund audited internally and externally.

3.4.3 Fiscal Transfers to Municipalities

Types of Grants: At present, municipalities are getting two types of grant from the center: administrative grant and development grant. Administrative grant is provided to enable the municipalities to meet the salary related cost of the staff deputed to them from the center. Eligibility for development grant: Not all the municipalities are entitled to receive development grant from the center. According to Local Self-governance Act, municipalities with annual internal revenue below Rs 10 million are only qualified to receive development grant. The municipal development grants are of three types. The first type may be called development block grant. In this type of grant, the municipalities are given the discretion to spend the grant fund in the programs/projects of their choice by getting the program and budget approved from the Municipal Council. The second type of development grant may be called conditional grant, which the municipalities have to spend on specified purpose/activity. The conditional grants being provided to municipalities at present include grants for fire-fighting, matching fund; Rural Urban Partnership, youth development and construction of land fill sites. This type of grant varies from one year to another depending upon the needs of the municipalities or the requirement of the center to get specific task/s carried out by the municipalities.

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Local Development Fee: The center also provides funds to municipalities in the form of local development fee (LDF). The municipalities are given discretion to use the fee in the manner they wish by following the planning, budgeting and programming procedures as laid down in the local governance law. The LDF is levied by the center at custom point at the rate of 1.5 percent on the value of imports. This fee replaced Octroi, which was being collected by the municipalities previously on the goods and materials, which entered into the municipal territory for consumption. The LDF is not considered as a central grant mainly because it substituted octroi, which was being collected by the municipalities at the local level. It possesses all the features of a block grant. MoLD distributes the LDF based on the revenue figures of municipalities from octroi before it was abolished. In view of the fact that the collection of LDF will have to be discontinued with the country‘s accession to WTO, it is necessary to give some revenue source/s to municipalities hitherto being employed by the center. Alternatively, HMGN has to set aside additional funds from its own revenue sources to finance the expenditure of municipalities.

3.4.4 Sources of Finance of Municipalities' Budget

The sources of finance of municipality budget includes own source revenue, LDF, administrative and development grant received from the center, grant received from DDC and other sources and loan and borrowings. Other sources are miscellaneous income and previous years balance. The sources of finance of municipalities' budget for the period 2000/01 through 2002/03 are provided in detail in Annex III-IV. A summary of the same is presented in Table 3.2. Table 3-2: Sources of Finance of Municipalities during 2000/01 to 2002/03 (in million Rs.)

Source of Finance

Fiscal Year Average for the Period

Average as Percentage of the Total

2000/01 2001/02 2002/03

Internal Revenue 524 698 719 647 28.95

Local Development Fee 987 1,066 989 1,014 45.37

Administrative Grant 43 78 73 65 2.91

Development Grant 116 57 92 88 3.94

Other Grants 194 235 68 166 7.43

Loan and Borrowings 38 9 26 24 1.07

Miscellaneous Income 26 26 37 30 1.34

Previous Balance 234 207 161 201 8.99

Total: 2162 2,376 2165 2,235 100.00

Source: ―Annual Development Program – An Introductory Booklet for Fiscal Year 2003/04 and 2004/05‖, Ministry of Local Development, 2004.

From the table, it is apparent that local development constituting more than 45 percent is the single most important source of finance for municipalities. During the period under review, internal revenue has contributed almost 29 percent of the funding requirement of municipalities. Balance carried forward from previous period and grant from other sources (including those provided by DDC and Town Development Fund) together accounted for more than 16 percent of the total sources of finance for municipalities.

3.4.5 Guidelines on the Use of Administrative and Development Grant

Administrative grant: The municipalities are authorized to use any surplus fund resulting after the payment of salary and allowances of the deputed staff to meet their other administrative expenditure. Block Development grant: The restrictions applicable for the use of development grant are: i) grant should be spent on municipal level programs within the municipality area, and ii) it must not be used for administrative purpose. Matching Fund: There is a policy of MoLD to provide matching fund for programs like rural urban partnership program, youth development program and the projects implemented out of the loan

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provided by the town development fund. There is also a policy of the ministry to provide 60 percent matching fund to finance the cost of human resource development of the municipality provided such a program is implemented by obtaining proposal from the Town Development Training Center or any other recognized institute. Land Fill Site: MoLD has set aside fund for municipalities, which do not have land fill sites of their own. The proceeds of the grant could be used for the purchase of land, land development and management of land fill site. Fund request of municipalities to the Ministry for landfill sites should be supported by financial and technical proposal with an undertaking to bear 30 to 50 percent of the total project cost from own resources. The proposal submission deadline is 15 October of each year. The grant for landfill site is provided if the Ministry upon scrutiny and analysis approves the proposal received. The Guidelines on the use of Administrative and Development Grant include a number of aspects, which the municipalities have to follow/comply while using the development grant. These include procedures for the formulation of plan, plan implementation, supervision and monitoring committee and progress reporting. Other aspects highlighted in the Guidelines are holding of municipal council meeting, settlement of advance and audit irregularities, review and monitoring. The Guidelines require the municipalities to formulate municipal plan by following the procedures and time frame as stipulated in clause 111 of LSGA. The annual plan should be based on and in conformity with the periodic plan of at least 5 year's period as specified in the Act and Regulation. The annual plan should be formulated in such a way that it achieves the indicator specified in the tenth plan. According to the Guidelines, municipalities are required to prepare the implementation plan once the projects are selected. It further requires them to constitute the Project Supervision and Monitoring Committee as provided in Rule 139 (3) of Local Self-governance Regulation, get the supervision and monitoring of the projects undertaken by the committee every month and require the committee to submit reports on a regular basis. The Guidelines requires the Municipality to submit trimester and annual reports on the utilization of grant fund to the Ministry, Municipality Section of the Ministry and District Development Committee. There is a provision in the Guidelines to withhold the grant in case the meeting of municipal council does not pass the budget and program as provided in LSGA. The Guidelines has also stipulated that the municipalities shall be required to settle at least 25 percent and 40 percent respectively of their outstanding advances in order to demand the release of 2nd and 3rd trimester of the grant. The municipalities are also required to make timely response on the information and statement sought on outstanding advances. The Guidelines require the Municipalities to undertake quarterly review of the municipal level projects as provided in LSGA and submit report of the same to the Ministry once every 4 months. The MoLD will undertake monitoring to assess whether the municipalities are following the Guidelines while using the grant provided. In such a monitoring, a detailed assessment of whether the targeted indicators of the tenth plan have been achieved or not will be made. Additional Development Grant: In addition to the development grants specified above, the center has also started to provide additional development grant to municipalities which are not able to provide basic minimum services to the public in an effective manner due to lack of adequate resources, means and capacity. Ten municipalities of the remote areas with low internal resources base are selected for the provision of additional development grant of Rs. 5 million each for fiscal year 2004/05. The objective of this grant is to enable the municipality to provide basic minimum facilities to the inhabitants of the municipality by undertaking more and more activities related to the civil works and development. Selection of Municipalities for Additional Development Grant: In selecting the municipalities for provision of additional development grant, the MoLD has taken into consideration the funds

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provided from the center by way of grant, local development fee and the revenue generated locally by the municipalities during fiscal year 2000/01 through 2002/03. The observance of limit on administrative expenditure by municipalities was also taken as a general guide in the selection of municipalities for additional grant. The municipalities, which are backward from the development perspective and geographical remoteness, were other considerations, which also served as the basis for such selection. Municipal Grants by Type: An analysis of the fiscal transfers allocation made by the center to municipalities over the past four years shows that it constitutes 28.83 percent for administrative purpose including firefighting grant, 56.48 percent by way of unconditional development grant and 14.69 percent as conditional development grant. The annual breakdown of these grants by fiscal year and average for the period is given in Table 3.3. Figures in detail are presented in Annex III-V. Table 3.3: Grant Allocation to Municipalities by Type of Grant (in ‘000 Rs.)

Type of Grant Fiscal Year

Average for the Period

Average as Percentage of

the Total 2001/02 2002/03 2003/04 2004/05

Administrative including fire fighting

36,450 43,650 48,500 48,100 44,175 28.83

Development 95,100 82,350 86,000 84,700 86,538 56.48

Conditional - Development

12,537 9,000 14,460 54,047 22,511 14.69

Total: 144,087 135,000 148,960 186,847 153,224 100.00

Source: ―Annual Development Program – An Introductory Booklet for Fiscal Year 2003/04 and 2004/05‖, Ministry of Local Development, 2004 and Grant allocation statements provided by FCGO.

It is obvious from the table that the percentage of conditional development grant has swelled significantly during fiscal year 2004/05 as compared to the preceding year where it stood only around 9.71 percent of the total grant. This resulted in the average percentage of conditional grant for municipalities reaching 14.69 percent of the total for the period under review.

3.4.6 Guidelines on Additional Development Grant

According to the Guidelines issued by MoLD, the municipalities are required to follow the Local Bodies Financial Administration Regulation while spending the fund. The Guidelines has further clarified that the additional grant would be diverted to weaker municipalities if a municipality fails to use the disbursed funds within 15 April. The Guidelines specifically prohibits the use of the grant for administrative purpose. The Guidelines covers a number of aspects, which the municipalities have to follow while using the additional grant fund. These include selection of projects, their prioritization, implementation, monitoring, progress reporting, final certification of completed work and auditing. The Guidelines require the municipality to make public the figure of budget allocation, expenditure and physical progress of projects selected for funding out of additional development grant. The identification of the projects is to be done by the assembly of the users. Formation of users' committees is mandatory in order to implement the identified projects. The municipality is authorized to accord final approval to the projects thus identified. While prioritizing the identified projects, the municipality is required to follow the basis spelt out in the LSGA and LSGR, guidelines issued by HMG/N from time to time as well as the objectives, policies and targets of the municipality. In addition, the projects which provides direct benefit to women, Dalit, marginalized, indigenous people and the community, tribe or areas which are not integrated in the mainstream of development process are also to be given priority in the selection of projects. As a general rule, the Guidelines has identified following types of projects for funding out of the additional development grants:

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Construction of small culverts (except in highways and feeder roads)

Construction of land fill sites and its management

Construction of shopping complex and market management

Plantation and construction, conservation and management of green park, playing grounds, Children Park, etc.

Construction of drinking water schemes and its distribution

River training, construction of dams and landslide control

Construction of roads, road gravelling and black topping.

Protection of archeological, tourist and natural resources

Construction of community schools and management of physical facilities

Construction and management of public toilets

Construction of mini bus parks

Construction of health post, sub health post and accommodation facility for the attendants of patients

Extension of electricity

Income generating programs which involves the use of local skills and technology or which generate employment.

Implementation of the Project: The Guidelines require municipalities to give priority to users' committee in the implementation of projects funded out of additional development grant. The users committee should be formed through an assembly of beneficiary users of the respective area/s who should be given at least 7 day's notice prior to the convening of the assembly. Users' should be made to contribute in the cost of the project. The Guidelines also require the municipality to get social auditing of the completed projects as provided in the Public Auditing Guidelines. Monitoring: The municipalities are required to get the implemented projects monitored every month by the supervision and monitoring committee as provided in the Rule 139 (3) of Local Self-governance Regulation and to obtain report from the committee. The MoLD will also undertake monitoring to assess whether the additional development grant provided are being used as per the provisions of the Guidelines. Progress Reporting Responsibility: The Guidelines has made the executive officer of the municipality responsible for submission of progress report of the projects implemented out of additional development grant. The progress made in the projects/programs funded out of additional development grant has to be invariably included in the consolidated progress report of the municipality. The requirement of trimester and annual review applicable to other programs/projects of the municipalities shall also apply to the projects/programs implemented out of additional development grant. Final certification of the completed work: On the completion of the project, the municipality is required to finally certify the completed work on the basis of social audit report, technical valuation and related recommendation and hand-over the project to the users' committee. The municipality management section of MoLD should be intimated about the handover upon completion of all these formalities. The users' committee shall be responsible for operating, maintaining and managing the projects completed. Auditing: The same provisions of LSGA and LBFAR regarding the internal auditing and final auditing as is applicable to other programs/projects implemented by the municipality shall also apply to the projects undertaken out of additional development grant.

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3.4.7 Fiscal Transfer to VDCs

Until FY 1995/96, the center used to provide Rs. 300,000 per annum by way of block grant to every VDC. This amount has now been increased to Rs. 500,000 per annum with effect from FY1996/97. The block grant to VDC does not cover the salary and allowance cost of the VDC secretary which is traditionally included as part of the administrative grant of the DDC.

Sources of Funds of VDCs' Budget: These include own source revenue or internal revenue, DDC grant and HMG/N block grant. The summary status of surveyed VDCs1 with regard to internal revenue and grants for the period 2001/02 to 2003/04 is presented in Table 3.4. (Refer Annex III-VI for detailed information of individual VDCs.) Table 3.4: Sources of Finance of 41 VDCs2 during 2001/02 to 2003/04 (in million Rs.)

Source of Finance Fiscal Year Average

for the Period

Average as Percentage of the Total

2001/02 2002/03 2003/04

HMG/N Block Grant 10,487 12,879 18,107 13,824 64.80

Internal Revenue 5,940 5,475 5,175 5,530 25.92

DDC Grant 2,466 1,698 1,774 1,979 9.28

Total: 18,893 20,052 25,056 21,333 100.00 Source: Data Collected during Field Visit, 2004

The table clearly shows that HMG/N block grant is the major source of meeting expenditure needs of the VDCs. Internal revenue is the next contributor with a share of almost 26 percent whereas the DDC grant funded less than 10 percent of the expenditure requirement of the VDCs. Every VDC is permitted to spend an amount not exceeding 25 percent of the grant fund for administrative and human resource development purpose. The amount of grant to VDCs is not determined based on any objective criteria since it is the same for all the VDCs irrespective of their area, population and cost of living or price level. The expenditure need of the VDCs are affected by these factors, which is not recognized by the uniform practice of providing equal amount of block grant to all the VDCs. In view of the decreasing purchasing power of Nepalese currency over the years due to inflation, the value of block grant transfer to VDCs in the fiscal year 2003/04 has in fact decreased substantially in the real term as compared to the grant provided during fiscal year 1996/97.

3.5 Limitations of the Present System of Fiscal Transfer

Uncertainty of the divisible pool: The development grant to DDCs and municipalities and block grant to VDCs are allocated out of the divisible pool, which is approved by the Parliament on the proposal put forward by the Ministry of Finance. The divisible pool is determined neither, by considering the expenditure needs of the local bodies with due consideration to their own source revenue and funds received by them through local development fee/revenue sharing nor, by following international practices of linking it as a proportion of national revenue or expenditures. It is rather determined arbitrarily of course, with political consideration. The volume of divisible pool is determined arbitrarily since increment to make up for inflation is not provided from year to year. The local governance law of Nepal, which guarantees the 'minimum grant' to local bodies without defining what does it actually mean, perpetuates the uncertainty of the divisible pool. Formula of block grant distribution does not fully comply with the norms specified in the LSGA 1999.

1 During the field visit of the study, 51 VDCs in all were covered. The table, however, contatins information regarding

revenue and grant of 42 VDCs only as the remaining VDCs could not provide the required information in full.

2 Out of 42 surveyed VDCs from where the required information were available, Ananandban VDC from Rupandehi

district had internal revenue of Rs. 17,033 thousand during the review period as compared to the total internal revenue of Rs. 16,590 thousand of the remaining 41 VDCs. The figures of this VDC has therefore been excluded from analysis.

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Defects of applying the HDI criteria: HDI, as its components shows, reflects a combination of life expectancy, educational attainment and income and not human poverty, which is more appropriate for reflecting the developmental needs of the people at the grass root level. The grant amount attributable to this criterion tend to favor, on per capita basis, the hill and mountain districts heavily with lower population as compared to the Terai districts which have higher population. Furthermore, doubts have been expressed on the results of HDI of certain districts computed through HDI survey compared with the others. This may have resulted through the inconsistent application of survey instrument, methodology and process by different survey teams visiting the districts for the purpose. In view of these considerations, it is generally argued that the weight of 50 percent given to HDI for the allocation of development grant to DDC is quite on the higher side. Lower weight given to population: Population is considered an important factor, which determines the level of public demand for services from local bodies and therefore their expenditure needs. The weight of 20 percent given to population factor for the distribution of divisible pool of DDC grant for capital expenditure is therefore considered insufficient. Exclusion of urban population: Unlike the municipalities and VDCs, it is said that the DDC does not have its own territory. In fact the DDC development activities spread across the VDCs and municipalities. Some of the municipalities are more equipped with financial resources than the DDCs. This does not however preclude the DDC in implementing programs or projects intended to serve urban population. Exclusion of urban population in the distribution of capital grant to DDC is therefore considered a weak link in the formula. Wrong approach of maintaining previous level of grant: In the allocation of grant to DDCs and municipalities, a tendency to maintain the overall grant level to the previous year's figure is visible. In the case of DDCs, the level of capital/development grant is found increased from what is derived through the interim formula in case the grant amount fell below the previous year's figure. Such adjustments are found made from the surplus fund, which other DDCs are entitled to by the application of the formula. The block grant of VDCs has also remained in the previous year's level since the same amount of grant is being provided over the past 7 years. This is not considered a right approach in view of the fact that the grant in real terms gets reduced due to inflation. The funds provided to DDCs by way of revenue sharing should also be considered a central grant. In recognition of this view point, the Ministry of Local Development has started an innovative exercise under which the development grant of 35 DDCs having revenue sharing source between Rs. 5 million and in excess of Rs. 40 million is reduced for fiscal year 2004/05 by 1 to 7 percent of the amount received through revenue sharing. The surplus resulting through the application of this process was allocated among the remaining 40 DDC to ensure that:

- Each DDC obtains at least Rs. 1.5 million as development grant

- An increment of 5.49 percent in the previous year's development grant figure has been provided to 40 DDCs not having revenue sharing source or with revenue sharing source below Rs. 5 million.

Allocation on cost factor not done on actual cost basis: The cost factor included as a criterion in the formula for the distribution of capital cost grant to DDC carries a weight of 20 percent share in the divisible pool. The cost factor of districts in the Kathmandu Valley, Terai, hill and mountain districts has not been derived on a scientific basis. It is not based on the collection and analysis of actual cost of materials and labor in these districts. The amount allocated to DDCs through this criterion does not therefore reflect the true cost required to build infrastructure or to carry out other programs/activities in the respective districts.

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Disincentive to revenue efforts: The DDCs are permitted to use the capital cost grant in providing matching fund to projects/programs funded by donors or otherwise. Similarly, the municipalities are provided conditional grant, which they can utilize to provide such fund. These practices are not considered conducive to the local bodies to make extra efforts for the generation of additional own source revenue. Defects of cut off amount of internal resource applied to municipalities: At present, municipalities generating own source revenue of less than Rs. 10 million are only entitled to get development grant from the center. This is proving to be a disincentive especially to those municipalities, which are on the verge of attaining the threshold. The fallacy of this threshold is amply reflected in the allocation of Rs. 1 million worth of development grant to Bhadrapur municipality, which had internal revenue of Rs. 9.8 million and none to Damak municipality having internal revenue of Rs. 1.06 million. Lack of formula for the distribution of development grant to municipalities and VDCs: In order to be eligible for development grant from the center, a threshold of Rs. 10 million of internal revenue generation per annum is fixed. The municipalities, which exceed the threshold, are excluded from the purview of such a grant. Even to municipalities having own source revenue less than Rs. 10 million, there are no set criteria for the distribution of development grant. Similarly, VDCs are all provided block grant at the rate of Rs. 500,000 per annum irrespective of their size, population or remoteness. Seen from another perspective, the need of funds to VDC with a larger size would be more as compared with a VDC having smaller size. The level of development also varies among VDCs considering the accessibility to the basic amenities of life. This will largely depend upon the location of the VDC, i.e. whether it is located in a remote or accessible area. This factor will also have an impact on the cost of development. In other words, the more remote a VDC is more will be the need of funds for development due to higher cost of building infrastructures as compared to more accessible areas. This could also be considered as one of the factors to determine the size of central grant. Based on the experience of other countries, there could be several other factors as well, which should be considered in the formulation of bases for the allocation of grant to VDCs. It is in this perspective the present study intends to formulate a formula that would capture all the possible factors with appropriate weights assigned so that each VDC would receive the central grants based on their needs. The expenditure needs of municipalities and VDCs depend directly on the demand for services from the inhabitants and their development needs. In order to ensure predictable and stable source, the transfer system must be objective and transparent. The objectivity and transparency could be ensured only if the distribution is based on some pre-determined formula/criteria.

3.6 Structures and Pattern of Expenditures of Local Bodies

Development of an effective formula of fiscal transfers requires a good understanding about the purpose of the grant. Therefore, knowledge of what the local bodies do with the available resources is all the more important to develop formula for unconditional block grant. The current study did not focus on the use of the funds by local bodies, as this aspect was dealt in detail by an earlier study carried out (Ligal et. al., 2004). The findings and conclusions of this section are largely drawn from the previous study report. The use of funds by local bodies is analyzed focusing on mainly two levels. First, inquiry is to see to what extent the local bodies allocate resource at their disposal for meeting the recurrent expenses and for development purpose. This analysis will thus indicate the portion of the resource that is spent on expanding services. The second level analysis of use of fund will be to see the breakdown of the development expenses by sector. This analysis gives a picture what kind of services the local bodies will focus on if they were given free-hand funds.

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Proportion of recurrent expenses to total expenses

The Expenditure Effectiveness Study has taken the expenses on salary, and office expenses, grants and donations, financial support, prize and membership fee as recurrent expenses. Similarly, capital expenses are regarded as expenses on land and building construction or purchase, and program costs. The capital expenses are also termed as development expenses. With regard to the use of available funds for recurrent and development purposes the following is the findings of the study. The DDCs on an average allocate little about 35% of their internal incomes in recurrent expenses. Though there is a wide variation of 30 to 70% in this regard. DDCs with smaller internal revenue tend to spend higher proportion of their fund in recurrent purposes. For HMGN grants the proportion of recurrent expense is as high as 80 percent. This high proportion of administrative expenses indicates that major proportion of HMGN grant is conditional and for meeting administrative expenses. There is little distinction between HMGN grants and own source revenue made by Municipalities and VDCs as far as allocation of resource is concerned. Therefore the allocation of both the grants and own source revenue is available in aggregate. The Municipalities spend a little less than half of their incomes for recurrent purposes. Compared to the figures of DDCs, there is only a little variation among Municipalities in this aspect. The VDCs spend about one-third of their incomes as recurrent expenses. Looking at the breakdown of the fund into development and recurrent purposes one can easily observe that LBs spend considerable amount of their funds for recurrent purposes. Two explanations are likely for such a pattern of expenditures. One is that the local bodies are not keen to expand services to citizens. Another explanation, which is sympathetic, suggests that it is because of smaller funds they manage the proportion of recurrent funds appears higher. Distribution of capital expenses among different sectoral service areas Another level of inquiry is how development fund is spread among sectoral areas. In sum the allocation pattern of DDC at present appears more driven by traditional concept and skewed towards infrastructure projects. Though such programs do contribute for poverty alleviation and achieve distributional justice but the connection is indirect. Targeted programs of providing direct services to the needy and accelerate poverty reduction still given less priority, and those planned also suffer problems due to programming skills. Many sectors are still untouched by sectoral allocation of many districts. The table below summarizes the expenditure pattern (in percent of development expenses) among sectoral service areas.

Table 3.5: Share of LB's development expenditure (%)

Sectoral areas DDC Municipality VDC

Infrastructure 62 60 85

Social, economic and environment 14 17 1

Focused programs 4 1 0

Institutional development and other 20 22 14

Total 100 100 100

Typical expenditure areas clustered under different headings are as follows:

- Infrastructure: drinking water and sanitation, roads/bridges, electrification, irrigation, soil conservation and river training

- Social, economic and environment: human development, health, education, agriculture and livestock, natural resource management, environment, tourism, cottage industries

- Focused/target group development programs: poverty reduction, women development, Dalits, ethnic groups and DAG, children and child labour, culture and language, sports

- Institutional development: HRD, organization development

Analysis of resource allocation of LBs shows that infrastructure comprises 85% for VDCs, 60% for Municipalities and 62% for DDCs. The Terai DDCs allocate highest proportion in

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infrastructure. Social sector programs follow the infrastructure, which is dominated by expenses on health and education. Unlike differences among DDCs in geographic regions in the allocation of funds for different sectors, the Municipalities allocation pattern is similar. Similarly, the VDCs in various geographic regions in general have a similar pattern of allocating their resources. However, the VDCs in hills appear not spending any fund for social programs. Special targeted programs are there but are very low; even such programs approved by the council are found to be left as not implemented. Allocations for focused programs (women, DAG, and ethnic groups) comprise only a little – it is around four percent for DDCs and less than one percent for Municipality and VDC. It is also observed that a weak program and expenditure for special programs of local bodies suggests that the local bodies in general lack programming skills for the poor and disadvantaged. Over time it is observed that the local bodies‘ plans are getting more balanced and comprehensive these days. It is evident after the formulation of periodic plans by DDCs, and due to presence of interest groups and civil society organizations particularly with Municipality and VDC.

3.7 DFDP Minimum Conditions and Performance Measures for Transfer

DFDP has adopted the formula based grant distribution system since the introduction of the formula by MoLD. Drawing on international experience and own experience of implementing the program, DFDP realized that the provision of grant-fund following a systematic manner alone is not sufficient for DDCs to become transparent, accountable and to provide better services. Therefore, DFDP developed a performance measurement framework for DDCs and a scheme to distribute grant based on performance evaluation results. It is intended to draw the lessons from DFDP districts and use the lessons for national level policy reform at a later stage. This is an innovative initiative and first assessment has taken place in 20 DFDP supported and 4 other non-DFDP districts throughout Nepal. Since the DFDP applied concept to DDC is new and in the process of full implementation, the experience is yet to be consolidated. In the mean time, DFDP is in the process of adjusting the grant amount based on performance assessment. The performance based grant system followed by DFDP evaluates the fulfillment of Minimum Conditions (MCs) and assesses Performance Measures (PMs). The MCs are basic safeguards for the entitlement to use the funds. It is assumed that each DDC must fulfill all the minimum conditions that are bare minimum for a DDC to qualify for access to the grant fund. The PMs are broad based, reflecting mostly statutory requirements, like quality of the annual plan (poverty mapping, level of participation, provision of O/M, fiscal capacity) and more relative that decide the size of the grant and provide incentives to DDCs to improve their performance. The MC and PM indicators are identified from the existing functions, rules and regulations and international experience of good practices3. The MC and PM assessment manual of DFDP asserts that the system can give better impact only if the assessment is done in a highly credible manner. This means the indicators are clearly explained and uniformly understood, the assessors consist of mainly a team of outsiders (with skills in planning, institutional, accounting and program areas) paying visit to individual DDC, who obtain information and review documents in support of a team of insiders. The possibility of getting grant by a DDC depends upon fulfillment of all the MCs. Once a DDC qualifies then the score in PMs will decide the level of grants. If a DDC gets above average scores in PMs, then it will obtain 20% additional grant and if it is below average it will receive 20% less. An average score will fetch an equal grant as the previous year. Feedback on the system

3 MCs include 16 indicators in 5 Areas: 1) planning, 2) financial management, 3) functioning of committees, 4)

Transparency/ communication, and 5) program specific conditions PMs have 39 indicators in 7 areas: 1) planning and program management capacity; 2) Budgeting; 3) Financial

management; 4) Fiscal capacity; 5) Pro-poor expenditure composition; 6) Communication and transparency, and; 7) Monitoring and evaluation

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The feedback on the system has been drawn from the assessment report by LDTA and interactions with four DDCs having DFDP performance measurement experience and other stakeholders at the field and center. Particular feedback relevant to possibility of applying this system for overall grant system is enumerated below. Appreciable aspects of the system:

a. Practice of performance measurement of local bodies is commendable. It is important to impart competitive feeling among local bodies. It also provides incentive to those who do better and helps identify the area of improvements for both rewarded or penalized ones in their operations.

b. The DDCs and stakeholders regard the performance based grant allocation system initiated by DFDP as a good practice. The DDCs consider that such a practice should be followed for allocating all development grants as well. The only comment showing partial appreciation of the system was obtained from Dhanusha DDC, which is understandable, because the district has failed to fulfill the minimum conditions in the assessment recently conducted by LDTA.

c. The DDCs found that the indicators identified in the DFDP performance measurement system are practical, and easy to fulfill, and not difficult to dig out information from a DDC. Again Dhanusha was only DDC that reported that conditions of some of the indicators were difficult to fulfill.

Areas of improvements:

a. It is observed that it is difficult to update DDCs' performance every year following the system and process of DFDP. This system requires heavy input (time and resources) to do it regularly for all the local bodies. Therefore the management requirement of the performance assessment exercise is heavy. For universal application of the system, one may opt to use information that can be updated easily through regular reporting mechanism. Down side of this is that DDC may not differ in performance or the reliability of the data can be questioned.

b. It is found necessary to refine the identified indicators. Rephrasing of the indicators needs to be done to avoid difference of understanding of the meaning. For example existence of pro-poor programs is mentioned in the current measures that need to be further defined as to what include pro-poor programs.

c. It is recommended to apply such a system by all the agencies supporting DDCs. The experience of the assessors is that since the DDCs had understood that this system is only applied for DFDP grants and they will not loose much even if they failed. Some DDCs expressed that even if DFDP quits other agencies will support them. This attitude prevails simply because it is only DFDP that uses performance measurement data for its grants. The LDTA report suggests ―…there is a need from, the MoLD to make clear that the assessment result will affect all other grants. Similar message should also be given by other donor partners that if DDCs do not meet MC and do not perform they would not receive grants from them.‖

d. Make such an assessment a regular process of MoLD. The assessment has both awareness and educating value to the politically elected representatives and DDC administration. Not many districts were prepared for such assessment but they appreciated the process and saw merit in it. This aspect should be kept in perspective while conducting such annual assessment.

e. Provide incentives to do better. Give incentives to those who are performing better and penalize those who are not. Given the increased volume of direct funds for development that the LBs will be receiving, such performance based resource distribution is critical for effective decentralization and to meet the national goal of poverty reduction.

3.8 Perception of Local Bodies on Fiscal Transfer System

Review of DDC block grant formula

The existing block grant distribution formula consists of four factors with half of the weight (or 50%) assigned to poverty measured as distance from an ideal HDI (or 1-HDI). The population

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and cost factor share 20% each and area 10% of the weight. There were both positive and negative comments about the system and many area of improvement in the formula. Positive aspect about the system is that a systematic calculation of the grant amount has begun. This has increased predictability of the system and reduced the possibility of manipulation by anyone. Moreover, the transition period has been smooth since the formula is devised in a way that resulted into almost at the level in which the DDCs were receiving as the grant amount. There are, however, some limitations with regard to the existing formula. They are:

(a) Article 236 of LSGA 1999 has prescribed some norms for the distribution of block grants to LBs. The interim formula of block grant distribution adopted by MOLD does not fully comply with the specified norms.

(b) The interim formula treats human poverty (measured as 1-HDI) of 1996 as the proxy of fiscal needs of the districts. But it does not reflect either of the level of infrastructural development or its requirement. Hence, 1–HDI cannot in its true sense reflect the fiscal need of the district. There are serious doubts raised regarding the greater importance given to the HDI factor without linking it with the population.

(c) The cost factor included in the formula has been taken on a proxy basis and is not based on the actual study of cost factor at the field level. There is a need to adjust the cost factor based on a more rational way.

(d) The development of the formula was not done in a transparent and participatory manner. Despite an existence of formula based distribution the amount that a DDC was receiving was more or less the same due to adeptness in which the formula was prepared and another provision that the amount currently being received will not be reduced. This led to a situation in which the DDCs did not feel any change in the amount after introduction of the formula. Secondly since there was neither a time-bound plan to make the formula fully effective nor effort to make the grant allocations strictly decided by the formula, the difference was not noticed.

Interaction meetings with 18 DDC officials were conducted and suggestion for selecting factors for developing a good block grant formula (Refer to III-VII) was solicited. Only about a third of the LDOs were found to have knowledge about the factors in the existing formula. Many of the suggestions or comments therefore are based on their educated guess and these cannot be taken as suggestions of experienced persons. Table 3-6 gives an indication as what the DDCs suggest.

Major observations, learning and insights The table clearly shows that out of a total of 12 factors enumerated four of them are considered more important than others. They are population of the district, poverty of people, cost factor, and area that collectively score 42 (or 75%) out of a total of 59. Clearly the stakeholders have two objectives of the grants in mind, which can be seen from their selection of the factors. One objective is to support resource poor DDCs with grants and another is to reward those DDCs that have a good intention and possess capacity to do better. This insight leads us to make at least two funds (supportive and promotive) out of the total block grant pool. Table 3-6: Suggested Factors for Block Grant

Suggested factor for Block Grant Formula

Number of DDCs giving the rank to factors Total

Rank 1 Rank 2 Rank 3 Rank 4 Rank 5 Rank 6

Poverty 10 1 11

Population 9 2 11

Cost factor 7 1 1 1 10

Area 1 7 2 10

Internal revenue 2 1 3

Expenditure effectiveness/ absorption capacity 3

HDI 3

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Suggested factor for Block Grant Formula

Number of DDCs giving the rank to factors Total

Rank 1 Rank 2 Rank 3 Rank 4 Rank 5 Rank 6

Infrastructure development need 1 1 2

DDC categorization/ remoteness 2

Conflict 2

Fiscal discipline to reward and punish 1

Existence of foreign aided projects 1

Based on the discussion with the stakeholders and the elements suggested in the above table there are three major areas that can be used to assess the financial situation of DDC. They are:

Key areas Suggested indicators

DDC Capacity Expenditure effectiveness, absorption and use of available funds, revenue potential Expenditure Needs Remoteness, classification of DDC, infrastructure development needs, population,

cost factor, poverty (but not HDI) Fiscal performance Financial discipline (but not audit report), revenue efforts

Stakeholders also cautioned about the possibility of selecting a wrong indicator in the following areas.

It is necessary to use fiscal discipline as an indicator to reward and punish DDCs.

However the audit objections should not be taken as the measure of fiscal discipline. Stakeholders‘ experience is that the audit standards vary from one to another, from one place to another place, and even from one institution to another for the same person. As a result a transaction regarded objectionable by one auditor in one DDC may be treated as acceptable by another auditor in another DDC.

Poverty situation of a district sounds to be a good indicator. But use of HDI as the factor can be misleading. District poverty can be observed in three dimensions, namely economic, social and physical. These should be taken separately, so a gross generalization becomes difficult. For instance, Jhapa (HDI 0.494) is shown poorer than Dhankuta (HDI 0.507) in HDI terms.

It is desirable to equalize the resources of DDCs in order to enable them to meet the expenditure needs for providing services at a certain level. But equalization should not be taken as financial resources in absolute terms (since all DDC do not have similar characteristics). Also that equalization should not encourage a DDC not to put forth more revenue effort (why should I raise internal revenue if I can get the required funds as equalization grant?). Therefore for equalization purposes the source of the fund a DDC collects should be segregated. The royalty and shared revenue incomes obtained by a DDC can be considered for equalization purpose since the DDC has little say in the base or rate and do not have to apply effort). In no situation the internal revenue should be included because of the principle that if a DDC raises more revenue from taxes then it has also more obligations towards citizens.

Various options of equalization could be considered. Allowing more revenue authority and base could be the one option. More autonomy to identify revenue sources and the fixation of rates has high potential. Therefore it is desirable not to go for the option of providing grants to realize the equalization objective.

Opt for conditional grants for specific sectors, or purpose – don‘t mingle these objectives with the general formula developed for block grant distribution. A common formula cannot accommodate all the purposes. This means it is better to create different-purpose funds and develop separate formula.

It is essential to review the formula for distributing grants at least once in five years. There must be two kinds of data sources namely the static and moving. While the static data will not change for about 5 years the moving data needs to be updated every year. Most reasonably indicators related to moving data are better suited for the distribution of incentive grants.

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Suggestions and feedback on municipality block grant distribution system

The Municipalities obtain funds in two forms from the central government. First is the grant, which is provided in three major headings – administrative grant, development grant and specific grants. The special grants provided for fire brigade and sanitation equipments among others bear the characteristics of conditional grant. The development grant is tied up with the internal revenue of Municipality; those having over 10 million do not receive any development grant. Development grant goes in the form of block grants. Administrative grants is given to the Municipalities to cover the salary and allowance of all staff deputed from the center. Another form of grant is from the pool of the development fees, collected through surcharge of 1.5% levied on imports at custom points. The local bodies do not have to put in tax effort; they don‘t have any say on the tax base and rates. The use of the fund is fully at the discretion of respective municipality. Though this transfer is not labeled as grant all of the characteristics of this grant are in the nature of block grant. This fund is distributed based on the revenue of a municipality from Octroi before it was abolished. Since collection of any such surcharge at custom points will have to be stopped with the country‘s accession to WTO, it is necessary to find out some alternative means to finance municipalities‘ expenditure. Most likely scenario is that HMGN has to set aside revenue from its other sources to fund municipalities. In this case, the fund thus distributed is essentially a block grant, albeit done in a different name. There is not any objective basis observed in the distribution of the development grant to municipalities. It is provided by and large following historical figures, and depending upon approach to power. The opinion of the stakeholders on the system of transfer to municipalities in Nepal (Refer to Annex III-VIII) was gathered. The following are the findings:

a. The municipalities tend not to regard the amount that they receive by way of development fee as grant. They claim that it is their right since the mechanism is established to abolish Octroi.

b. There is consensus among most of the stakeholders that the grant distribution to municipalities should also be systematized. Introduction of formula based grant is preferred over the current system in which there is no objective basis of distributing grants.

c. The factors that the municipalities grant distribution formula should use are presented in the Table 3.7. The data is based on the interaction with 16 Municipalities, and other stakeholders.

Table 3.7: Suggested factors for Municipality grant distribution formula

Suggested factor Number of Municipalities assigning ranks to the suggested factors

Rank 1 Rank 2 Rank 3 Rank 4 Rank 5 Total

Poverty 10 1 11

Population 6 3 9

Cost factor 1 6 2 9

Area 2 0 5 2 9

Internal Revenue 2 1 0 3 6

Infrastructure Development Need 3 1 0 0 1 5

Fiscal Discipline 2 1 3

Performance/tax effort 4

d. The table above suggests that poverty, population, cost and area combined together

consist of 38 (or 67%) out of 56 scores. A look into the nature of factors clearly indicates suggestion of two kinds of factors. One kind (such as population, area, cost, poverty and infrastructure development need) suggests including factors that reflect the expenditure needs. Another kind of factors (such as fiscal discipline, performance and tax effort, internal revenue) espouse for inclusion of factors that promote local effort and efficiency.

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This fact suggests us to create two funds – one promotive and another fulfilling the expenditure needs.

VDC Grant Distribution System

Central grant to VDCs is an equal grant amount of Rs 500,000 to each VDC. 25 percent of the total grant is considered as administrative grant and the rest as unconditional grants. Besides the administrative grant each VDC is supported with a VDC Secretary, whose salary is included as DDC administrative grants. Theoretically grant distribution on an equal basis is inequitable and inefficient. It is regarded that there should be some objective basis for the distribution of grant even to VDCs. With this assertion in mind, the study inquired the stakeholders about the suggested grant system and formula. DDC officials, VDC Secretaries NAVIN officials and MLD officials were the stakeholders consulted (Refer to Annex III-IX). The viewpoints expressed in the interactions are summarized below.

i. It is not feasible to design as complex a system for VDCs as is the case with DDC and

Municipalities. This is because of the high number of VDCs.

ii. The system of providing equal grant to VDCs has discouraged or disheartened VDCs that have higher population figures, remote and undeveloped.

iii. The suggested factors that the grant distribution formula for VDCs should use are presented in the Table 3.8. The data is based on the interaction with 33 VDCs, and other stakeholders.

Table 3.8: Suggested Factors for VDC Grants Distribution Formula

VDC suggested factors Number of VDCs assigning ranks to the suggested factors

Rank 1 Rank 2 Rank 3 Rank 4 Rank 5

Rank 6 Total

Poverty 24 5 2 36

Population 4 8 16 7 3 38

Cost factor 2 13 7 8 2 1 33

Area 1 4 8 14 4 1 32

Infrastructure Development Need 7 4 2 1 2 16

Internal Revenue 5 2 5 1 2 15

Fiscal Discipline 2 3 1 1 7

iv. The table above suggests that, in stakeholders‘ opinion, the factors reflecting the need for

expenses should be mainly used as formula. They include poverty, population, infrastructure development need, cost and area. Among the promotive factors fiscal discipline and internal revenue are mentioned.

v. Variation of VDCs on standard indicators is too wide (example there are VDCs with population over 30,000 and under 300). Therefore an allocation of VDC grant purely on indicators will not be

possible. Therefore it is essential to make a basic grant available for operating the VDC as an institution, before the formula system is applied.

However, in case of VDC, it should be noted that the unavailability of information on the level of poverty, infra-structural development and the cost factor limits the application of such factors in the formula to determine the size of the grants. A simple formula with area, population and VDC classification (it can be a proxy for infra-structural development and cost factor combined) is suggested to be used for a VDC level grants formula.

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CHAPTER IV

DESIGNING INTERGOVERNMENTAL FISCAL TRANSFER Drawing upon the experience within the country and abroad, and building on the theoretical underpinning, the system is designed considering the critical factors (both technical and organizational) influencing fiscal transfer in Nepal. The present study has reviewed extensively the literature available on intergovernmental transfer and the country experiences in developing countries of Asia, Africa, Latin America and east European countries besides going through the practices in some of the developed countries. Review of previous studies on the system of intergovernmental transfer in Nepal and India is also carried out extensively. Besides, the study has taken suggestions from stakeholders, both from the field level practitioners and the policy makers at the center. Before presenting the system itself the report enumerates the critical factors that have been used as guidelines to design the system in short that guides to design the system.

4.1 Principles of the Transfer System:

It is believed that the inter-governmental fiscal transfer system should be based on principles that help to attain the following objectives:

Assurance of an unbiased, predictable and steady inflow of resources to local bodies

Minimizing the gap in fiscal capacities among local bodies so that citizens of all the parts of the country receive minimum level of public services

Pursuing rightful policy initiatives and objectives of the center

Contributing towards the enhancement of revenue generation of local bodies

Assurance of predictable and steady inflow of resources

The inter-governmental fiscal transfer should ensure predictable and steady inflow of resources to local bodies so that they can plan and prepare their program and budget in a realistic way. The sources of funds for local bodies include own source revenue, funds received from revenue sharing and the central grant. The local bodies can make a reasonable estimate of the resources that could be generated from internal revenue in the forthcoming fiscal year based on the past trends, revenue base and the efforts that would be likely put by them. The same is the case regarding the funds to be generated from revenue sharing except that the resource is more determined by outside factors rather than on the efforts of local bodies. In Nepal, the budgeting and programming processes of the local bodies are completed well in advance of undertaking such exercises by the central government. In such a situation, the budget and program of local bodies are bound to undergo revision if there is difference in the level of funds previously anticipated and those actually received from the center. In order to assure a predictable level of grant to local bodies, the first requisite is prior estimate or knowledge of the divisible pool to which a particular tier of local body is the participatory or shareholder.

Minimizing the gap in fiscal capacities

The resource base and internal revenue potential of local bodies differ widely due to differing level of 'capacity to pay' resulting from the varying level of development, accessibility and remoteness due to location, cost of development and cost of providing services. The provision of grant to local bodies should be instrumental in reducing such a gap so that the disparities among them could be reduced slowly but steadily. In the long run, this would contribute towards the provision of minimum level of services by local bodies to the citizens irrespective of the location of their residence.

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Pursuing rightful policy initiatives and objectives of the center

In addition to block development grant (or capital grant in the case of DDCs), the center has also been providing conditional block grants to DDCs and Municipalities. The objective of these grants is to encourage the local bodies to direct their investment towards the development activities in the desired sector/s. The funds provided by the center to undertake drinking water and sanitation projects, local construction and development and agriculture road projects and construction and maintenance of large and local level suspension bridges are the instances of conditional grant provided to DDCs. Additional grant provided to municipalities which are weak in financial resources and the funds provided for rural urban partnership program, youth development, construction and management of land fill sites and matching fund to undertake different programs to the municipalities are in the nature of conditional development grant.

The central government should have clear policy vision as regards the sector/s in which it wants

local bodies to invest and determination of the level of funds to each local body should be done

in order to attain the objectives set to translate the vision into actual practice. Contributing towards the enhancement of revenue generation of local bodies

The local bodies in Nepal are heavily dependent upon the grant from the center. Increased revenue generation at the local level should therefore be the long run objective of any inter-governmental fiscal transfer system to reduce this over-dependency and to ensure financial autonomy of the local bodies. The transfer system should therefore not be a disincentive to local bodies generating higher amount of own source revenue. It should rather have an element of reward to motivate them towards putting more revenue effort so that increased revenue generation becomes a distinct possibility. An ideally designed transfer system should have a mix of general purpose and specific purpose transfers. While the objective of general-purpose unconditional transfers is to enable every unit of LBs to provide a given level of public services at a reasonable rate, specific purpose transfers can ensure specified minimum levels of services which have spillovers across states, or which are considered ―merit goods‖. Of course, serious considerations have to be made in determining the volume of transfers, the mix of the two types of transfers, and the extent of equalization. Second, the transfer system should be formula-based rather than discretionary. Third, formula-based transfers should be simple and transparent. Finally, the mechanism for designing and implementing the transfer system should be transparent and objective, refrain from political pressure and flexible enough to adjust to changing economic situations. Usually, the intergovernmental transfer considers only the explicit transfers to LBs, and leave implicit transfers. One should however, remember that the explicit transfers are only a peanut of the actual volume of resources pumped-in in the districts, or the jurisdiction of LBs. In Nepalese case, HMG through its district level offices and community organizations/NGOs as well as directly through the central level offices spent large amount of resources in different social, economic and infrastructural areas in each of the LB's jurisdiction. The program of such expenses is discussed at the LB committees but the amount on such programs is spent directly by the HMG district offices.

4.1.1 Key Characteristics of a Good Transfer System

a) It should have clarity on the objective of the transfer fund. There should be clarity on the objective of the transfer fund. The design of the system largely should be guided by the objective. Possible objectives are to address the vertical fiscal balance, horizontal fiscal balance, and fiscal capacity equalization of local bodies, mitigate the spillover impact of local body services or implementation of nationally important programs some objectives are mutually exclusive to each other. Transfers should, therefore be, adequate to cover both vertical and horizontal imbalances of sub national governments to the extent possible. However, providing funds to equalize financial capacity of weaker local bodies might pose a negative impact on the fiscal efforts of these local bodies. Therefore one must separate funds if more than one objective is set for the transfer. Again, too many funds may also undermine the autonomy of the local bodies; therefore the number of funds should be kept fewer.

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In the case of transfer to local bodies from the central agency in Nepal there is more than one category of transfers. One is categorical (special purpose) conditional grant, for which the transfer system is developing. Grants related to salary of primary education teachers, agriculture and livestock extension services, health posts and administrative grants to the local bodies are of this category. In the case of such grants the basis of arriving at the grant amount is partially historical allocated by the concerned line agencies before devolving such services, and partially on the basis of the service units (e.g., number of agriculture extension centers) or cost elements (e.g., number of teachers positions approved). However the latter approach is yet at the development stage. Another category of grant in general has characteristics of unconditional general-purpose grant. It is not explicitly mentioned about the objective of this grant, and that the expenditure assignment of local bodies is not clear. However, the impression of the stakeholder is that this is for: a) as a state agency cater to the service requirements of citizens in areas where central agencies are not providing services; b) operate as an autonomous entity with some regular functions and services of its own; c) provide services in addition to what central government is providing uniformly across the nation, and; d) take up additional social and infrastructures development activities (roads, drinking water…) in the service area of the concerned LB‘s priority. These objectives are closer to grant intended to meet development needs of the region, with some degree of intentions to reward performance. Point of contention is that these two objectives are by and large contradicting to each other and it is difficult to accommodate both in a formula. The discussion on objective leads us to establishment of at least two general-purpose grant funds – one in which more funds will be provided to more needy and another wherein more funds will be provided to more effective and efficient LBs. The discussions that follow will be centered around the general-purpose grant transfer mechanism and with the twin objectives of meeting fiscal requirements of local bodies and rewarding their better performance. Therefore it may be desirable to introduce unconditional capacity equalization grants, and to reward governments with matching revenue for additional local tax effort, separately from the revenue-sharing formula. b) It should be transparent and the transfer grant should be predictable and stable. A transparent system ensures that it will be accepted and owned by the local bodies. Predictability of the system enables the local bodies to plan their programs in advance with a high degree of confidence. Such a system cannot be one written in stone, so should be flexible enough for review and open to adjustments to the changing circumstances. But it should not be flexible to the extent wherein the local bodies cannot say what will be the transfer in the coming year. A system should be stable for 3-4 years. Different approaches are possible to determine the grant pool and distributing the pool to the local bodies. Generally a formula based grant transfer system is considered appropriate. The formula will be different for different funds depending upon their objectives, and for different sub national local bodies depending upon their expenditure assignments, service standards and norms. The current system of transfer to local bodies is, by and large, ad hoc (Shrestha, 2002). The Ministry of Finance allocates a total budget for MOLD on an annual basis, which includes the grant pool for distribution to DDC, Municipality and VDC. The MOLD is the grant administrator, which then determines the size of the grant to be distributed to respective LBs. The distribution of the grant to VDC is done on the basis of equality, which has attracted criticisms for being inefficient and unjust4. Distribution to Municipalities is done largely on historical basis and on the basis of requirement for specific purposes. Formula based distribution of the grants to DDC is initiated since a couple of years, though the stakeholders have not felt a significant difference of such a system as the grant amount has not changed from the past where it was done on historical basis.

4 Theoretically as well equal grant distribution is considered inequitable, and inefficient in technical and allocation

terms (see Jamie Boex et.al and Jorge Martinez-Vazquez November 2004, Georgia State University, Andrew Young School of Policy Studies on Malawi and Intergovernmental Fiscal Transfers Report, April 2001)

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c) Data should be relevant, easily available, and the sources should be credible and acceptable to all. A scientific system of transfer must base itself on data. The data used for the system should be relevant having close proximity with the objective. If more relevant data is not easily available then closer proxy should be taken. If data is not relevant to reflect the situation well, then the result will be what is seen as the weakness present DDC grant formula. Universally generated and acceptable data having full credibility among the stakeholders is important for a system to function properly. If possible such information should be generated automatically in the system, since gathering data just for transfer purpose might prove an expensive proposition and administratively infeasible option. d) The system should be administratively simple. A simple system that is easy to implement has more chance of being smoothly operational. Broadly the administrative functions comprise annual determination of the grant amount for each LB, monitoring of the flow of grants, gathering the feedback and evaluation of the effectiveness of the system, which require considerable administrative input. The more complex the formula will mean more input need, and the more the number of LBs will imply more efforts. An administratively feasible system is one that has as little computation and adjustments, and demand less effort. The organizational capability of the agency managing the system has to be considered and an appropriate system designed to ensure its effectiveness. For this as far as possible required data should be fed into the system through regular reports and information flow mechanisms. e) Testing and development of the system and factors should be a continuous process. No system is foolproof. Similarly the ground reality keeps on changing over time. The intergovernmental transfer system should capture the more relevant factors as they arise. For this to happen a regular monitoring should be an in-built component of the system and it should be updated through periodic review and improvement. f) The system should promote decentralization and autonomy of LBs. Too much of directions and imposition of conditionality hampers autonomy of LBs. While providing transfers, central government should honor the autonomy of sub national governments in setting their own expenditure priorities. Therefore design of the grant system should be to increase the transfers on unconditional heads, and keep the conditional transfers to bare minimum. Thus, to summarise, a good intergovernmental fiscal transfer system should be designed on the following criterion.

Clear objective of transfer honouring autonomy of sub national government,

Revenue adequacy to meet vertical and horizontal imbalance to the extent possible not discouraging local fiscal effort,

Consideration of equity such that the allocated funds should vary directly with fiscal need and inversely with the taxable capacity of each recipient LBs,

Predictability of fund so that the volume of funds transferred to each LBs should be known in advance,

Simplicity so that the allocation is based on objective factors over which individual units have little control,

Built in incentive for sound fiscal management promoting fiscal effort and control over expenditure and no transfers to finance deficits of sub national governments.

4.1.2 Desired Characteristics of the Formula Based Transfer Design

The present study has considered issues, problems, and possibilities about the design features of formula based grant system that have appeared in the LSGA and Rules, HMGN/MOLD publications (LAFC, 1997; PERC, 1997; High Level Committee for Strengthening Local Bodies, 2004), reports from national and international professionals (Jesper Steffensen, Jamie Boex, Jakob Haugaard, Manoj Shrestha) and from literatures available internationally. Jesper

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Steffensen has listed the qualities of a satisfactory transfer design in greater length5. Based on the synthesis of the suggestions and ideas the key results that a formula based transfer should achieve are listed below. Poverty sensitive: The system should be pro-poor in such a way that poor areas receive higher amount of grant per capita. As poverty is a vague concept appropriate proxy should be taken as the element of the formula. HDI or HPI are considered good proxies, but how the index figures arrive is not so clear to stakeholders resulting into their suspicion as to if this reflects the real poverty situation6. Moreover, the availability of data is a matter of concern since it is not sure that it will be updated regularly. However, in absence of better proxy HDI and HPI may be used as elements for the time being. Two things should be given attention if this is to be used: its weight should not be as high as it is in the current formula, and it should be used factoring in the population figure and not alone7. Addresses development needs of an area. The development levels of Nepalese LBs vary a lot. A formula based transfer should be responsive to the development needs of a LB. Therefore there should be distinction between the grants provided to maintain the existing services and facilities (such as roads, drinking water systems, and agriculture extension centers) from grants that aim to add such services and facilities. These two kinds of grants cannot be decided with same formula. A general-purpose unconditional grant normally is for equalization of service to citizens, therefore the formula should incorporate the needs for additional services. Therefore it can ignore availability of the existing services as factor. Development needs is also a vague term. The coverage of services per area or population can be a good measure for this. If this is to happen a universally applicable formula is needed for which selection of a service or an index of certain services has to be done. Stakeholders across the country tend to agree on using an index comprising of road, electricity, and telephone as a good factor to determine the physical infrastructure needs of an area. Social and economic infrastructure such as availability of banking facility, schools, health facilities and the like can also be included in the index or developed separately depending upon the need. Preparing index is easy said than done as it demands heavy data and administrative input, and since that it is often non-transparent. Therefore caution should be done not to make it difficult. It is often wise to agree with only a few elements in the index rather than aiming for a thorough reflection of the situation at the cost of simplicity and time. The formula suggested by the High-level Commission on Decentralization 2004 appears comprehensive but, as Jakob Haugaard (2004) puts, it comes at the cost of transparency and simplicity. Another simple measure in the case of Nepal is the classification of districts. According to LSGA, the classification of DDC and VDC should be done based on development indicators and financial performance among others; therefore this can be used as a factor of the formula. Recognizes variation of cost of providing services across LBs. Cost of service provision across the country is not uniform. Due to factors such as availability and use of transport facility,

5 Mission Report – Technical Assistance on Fiscal Decentralization and Devolution in Nepal (December 2002). The

satisfying features of a grant system are: 1) keep the objectives clear and transparent and design the system accordingly; 2) contributing to the funding of the vertical fiscal imbalance between assigned tasks and own source revenue; 3) supporting, not undermining, decentralization and local revenue raising; 4) ensure minimum number of different systems of transfers and transfer modalities; 5) transparent, formula and needs based allocation across local governments enhancing horizontal equity (pro-poor); 6) stable, predictable and timely transfers; 7) enabling LB flexibility and initiative within national policy; 8) involving and strengthening the LB structure; 9) upward, downward and horizontal accountability; 10) achieving public participation and transparency; 11) based on the availability of data and kept as simple as possible; and 12) ensure proper incentives to improve on administrative performance and service provision, i.e. rewarding proper initiatives and penalizing inefficiency 6 Interaction with stakeholders revealed two things: they don‘t know how the index is calculated therefore they suspect

the credibility of the data; and they tend to disagree with the relative ranking districts e.g., Dhankuta is shown as poor as Jhapa. 7 Without factoring in population, DFDP experience shows that the per capita allocation of Jajarkot is 5 times higher

than that of Rupandehi (as documented in DFDP reports and note of Jakob Haugaard October 2004)

54

energy sources, and terrain and urbanization the cost is very high in the mountain region compared in Terai and Kathmandu valley. Therefore a formula based system must recognize this difference and take appropriate measures so that LBs in areas with higher costs are compensated properly. Cost factor is included in the current DDC formula, and it is regarded as necessary. The contention by some quarter is in the 20% weight it receives and non-transparency in the method of assigning index of the cost factor to DDCs. As of now the cost index is ―measured in a common sense manner (educated guess)‖ as Jesper Steffensen puts it. Jesper suggestion tends to support ADDCN proposal to develop the cost index using cost figures of a number of key basic LG services/goods such as a basket of construction materials and consumables. The present study estimates cost index at district level using a basket of items consisting of construction materials and service cost of personnel. The information was based on the actual DDC determined prices of these items for construction activities in the district. Financial revenue of a LB can be ignored. A number of people tend to favor the idea that richer LBs with high financial revenue should receive less grants and a corresponding higher amount of grant should be given to LBs with little financial revenue. This argument needs refinement. Financial revenue is a factor of tax base (economy of the jurisdiction, natural endowment, and location such as border area) and tax effort among others. Both of these are equally important to realize a revenue level. Therefore, if such revenue is merely due to rich tax base then the argument could hold some merit. But if a formula is developed in the line as argued then this will negatively impact on the revenue effort of LBs. Furthermore if a LB raises more revenue from citizens then it must also commit for additional services, which means a considerable portion of the revenue has to be allocated for the services committed by the LB. Therefore the LB should not suffer by getting fewer amounts as grant. However if the revenue comes without LB efforts then such amount can be taken as money that the LB receives as equalization grant. The levy that DDCs in Nepal get from electricity generation is such a case. A question arises, how should poor LBs compensated if the richer LBs are not discriminated negatively in transfer design. How can poor LBs get funds so that they can provide minimum level and amount of services to their citizens? The answer to this question is to establish separate equalization fund for poor LBs from where only the eligible poor LBs obtain the transfers. This answer is in line with the notion that different funds needs to be created for different purposes. Performance must be rewarded. A transfer formula must reward the LB for its performance (financial management, planning, fiscal efforts) though more resources. Overwhelming majority of the local bodies expressed that this should be a strong basis of providing grants to them. However, the performance should not be equated with the revenue amount (as discussed in the earlier point) but it is about rewarding for adopting good practices and efforts to keep up them. Similarly DDCs were almost unanimous that financial management should not be equated with audit report or audit objections. They considered it would have been a good measure of financial discipline, but is not practical because there is a wide variation in a report done by different persons in different districts or by the same person over time. As such, measurement of performance is difficult mainly because it encompasses several aspects of management. Attempt to measure DDC in performance benchmark has given encouraging results8. However, the issue of management of the performance evaluation is crucial here. If the administrator agency of grants has to conduct performance measurement surveys every year then it is not considered feasible. Similarly since it is associated with grant money self evaluation by the grantee is also not a practical approach. In such a situation there are two alternatives to choose: a) identify such crucial indicators of performance effectiveness that the information is automatically updated through regular reporting mechanism; and b) carry out performance effectiveness survey periodically (every 3-4 years) and use the static figure for distributing annual grants.

8Supported by Implementation report of Minimum Conditions and Performance Measures of 24 DDCs prepared by

LDTA and submitted to DFDP (2005); and interaction with DFDP and UNCDF officials

55

Captures the quantity and/or nature of beneficiaries of services. This is an important factor particularly for devising formula for distributing targeted grants, such as conditional sectoral grants. It suggests that for calculation of primary education grant for example the number of population of that age group is to be considered. Similarly for agriculture extension grant the number and the size of the farm may be important. Estimation of Cost Index The topographical differences in Nepal make cost of construction activities widely differing from one place to another. The remoteness of most of the hill and mountain district necessitates spending huge amount of money for transporting goods, both construction materials and consumables. This makes construction activities in the hill and mountain district very expensive. Remote district therefore, needs extra spending in carrying out the same task than that in the Terai district, where the accessibility is easier. The present study thus, felt strongly about the need for the estimation of the cost index to be included in the grant pool distribution formula. The interim grant formula used by MoLD for distributing grants to DDC have used transportation cost index as one of the factor determining grants allocation. The index was borrowed from a study on decentralization (Manoj Shrestha). However, the study fails to mention any scientific basis for it, neither it provides the methodology used for estimating such index nor the data base and the sources of such information. It seems, at best, an educational guess. The present study conducted a field survey of 17 districts representing topographical and regional differences and collected data from the DDC/ DTO and also from the retail level survey of construction materials at the district headquarter and the place from where these materials are imported. Later, 5 more district sent the study team the actual DDC used price Table: 4. Selection of Districts for Estimation of Cost Index

Region Mountain Hill Terai Total

Eastern Sankhuwasabha Dhankuta Jhapa Morang Siraha

4

Central Hetauda Bhaktapur Nuwakot

Mahottari Dhanusha

6

Western Mustang Baglung Palpa Gorkha Kaski

Rupandehi 6

Mid-western Jumla Salyan Dang 3

Far-western Baitadi Achham

Kailali 3

Total 3 11 8 22

of different construction materials as well as the wages of different types of skilled and unskilled manpower. Thus all together, the information from 22 districts were collected and used for estimating cost index for construction activities. The cost index was estimated by selecting a basket consisting of different construction materials both, local and imported from other districts, as well as different types of skilled and unskilled manpower. DDC/ DTO used prices of each of these materials and the wage rates of different types of skilled and unskilled manpower was collected. The information was complemented by the retail level survey where ever found necessary. For determining the Weightage of each of these items in the overall construction activities, information of a typical construction activity were collected. Based on the information of the prices of materials and labor, and the Weightage of each of these items in a typical construction activity, cost of construction index was estimated for the selected districts and this was later extrapolated to all the 75 districts. Some minor adjustment was made for districts in remote mountain areas. The information on the prices and the estimation are given in Annex-IV-I.

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Estimation of Cost Index for Selected Districts

Region/District Cost Index

Eastern region Sankhuwasabha Dhankuta Jhapa Morang Siraha

2.5 1.5 1.0 1.0 1.0

Central region Nuwakot Bhaktapur Hetauda Mahottari Dhanusha

1.5 1.5 1.0 1.0 1.0

Western region Mustang Baglung Kaski Gorkha Palpa Rupandehi

2.0 1.5 1.5 1.5 1.5 1.0

Mid-western region Jumla Salyan Dang

3.5 2.0 1.5

Far-western region Baitadi Achham Kailali

2.0 2.5 1.0

4.2 Funds for Distribution

4.2.1 Determination of Distribution Pool

In designing an intergovernmental fiscal transfer system, it is extremely important to resolve the issues regarding the size of the distributive pool and the linkages it should have to make the pool dynamic and not static. The distribution pool is considered scientific and fair if it is based on certain formula. Therefore, instead of allocating the amount annually on an adhoc basis, it is desirable if some objective criteria be defined to determine the size of the distribution pool. International practices in arriving at the grant pool amount are found following either as a fixed portion of the total national revenue (GDP or GNP), total expenditures, total revenue excluding amount of interest payments, interest payments plus pension and gratuity or a portion of certain tax revenue. Both revenue estimates and actual or realized revenue are used for the purpose. In the absence of a strong database and discourse on the revenue from various tax heads it is recommended to adopt a fixed percentage of national revenue estimates minus debt service for determining the size of the distribution for Nepal. What percent of the total national revenue (excluding amount for debt service) is appropriate is another question to be answered. For this, the allocation of the sum of LBs grants to revenue estimates minus debt service of fiscal 2061/62 can be taken as the starting point. Table 4-1 and 4-1.1 gives the picture for FY 2061/629.

9 The amount does not include shared revenue on various headings such as electricity, land registration, forestry and

so on due to unavailability of data. Such data should be used in determining the grant pool.

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Table 4-1: Grants to LBs Compared to National Revenue Estimates, 2061/62

(in Million Rs)

Heads Amount excluding

LDF Amount with

LDF % excluding

LDF % including

LDF

Total revenue excluding debt service 51,890 52,890 100 100

Grants to DDC (Adm+Dev) 810 810 1.56 1.53

Grants to Municipality 182.8 1,182.8 0.35 2.24

Grants to VDC 1,956.5 1,956.5 3.77 3.70

Total grants to LBs 2,949.3 3,949.3 5.68 7.47

Administrative grant to LBs 1,023 1,023 1.97 1.93

Table 4-1.1: Breakdown of Total Grant to LBs

(in Million Rs) Administrative

grant Development

grant Total grants % of Admin

grant % of Dev

grant

Grants to DDC 485.8 324.2 810.0 59.97 40.03

Grants to Municipality 48.1 50.8 98.9 48.61 51.39

Grants to VDC 489.1 1467.4 1956.5 25.00 75.00

Total grants to LBs 1023.0 1842.4 2865.4

Share of HMG grants to LBs (%) 35.70 64.30 100

LBs grants (incl dev fee) as a share of total national revenue (%)

1.93 5.53 7.47

Note:

- The figures are only for central grants to LBs normally transferred for administrative and development purposes, hence do not include sectoral and program related transfers DDC administrative grant includes salary of 3913 VDC Secretaries

- Municipality admin grant includes grant for maintaining fire brigade

- Municipality block grant includes development grant of about 100 million and additional grant to municipality amounting to 50 million

- VDC administrative grant includes 25% of block grant, but excludes salary of VDC Secretary which is included in the DDC administrative grants

It is worth noting that the scenario has been drawn with and without inclusion of Local Development Fees (LDF) that is transferred to Municipalities. The study considers local development fee as part of intergovernmental fiscal transfers because the central government collects the amount and distributes it among municipalities. With the accession in WTO, Nepal has to abolish this fee. Although such a fee will cease to exist, but the Municipalities financing will continue. The government has to find alternative source to compensate the amount from other sources, which most likely will be the regular other tax sources. Therefore we have included this as the grant transfer amount to municipality. Secondly, the figures above do not include amount of grants that are conditional or specifically targeted (such as grants relating to fire brigade, and safety net transfers). But it includes the administrative grants that have been transferred. This is done with a view of the future composition of the grant in question. It is assumed that in the future the administrative transfers will be incorporated in the block grant, whereas the special purpose transfers will be treated separately. The figures show that altogether a closer to 7.5% of total national revenue minus debt service is transferred to local bodies as general-purpose and specific grants (excluding the grants for sectoral services). Therefore, following the notion that in future too it will not decrease, the grant pool may be tied up with the national revenue minus debt service or net revenue for our purpose and the amount should be fixed at least as 7.5% of net revenue estimate in the annual budget.

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Since introduction of new system will need additional money for distribution as incentive besides the regular funds, and for simplicity it is suggested to make the pool of around 10% of the annual net national revenue estimate10. In this way the size of the pool will vary in line with the national revenue reflecting a much-recommended dynamism in the system. As devolution process gets momentum and is consolidated with devolution of sectoral funds as well the amount has to be gradually increased. Many advantages are seen for tying up, and increasing, the pool size with national revenue. Key of them are:

a) It will take care of local bodies‘ concern that the amount of grants to LB is not periodically reviewed and are unpredictable,

b) It will automatically adjust the inflation (as the rate of inflation has traditionally been less than the increase in the net revenue estimates) and thus will maintain the LB expenditures at least at market price,

c) The increased pool amount can be used for instituting performance incentive grants to LBs for which additional money is required,

d) Spillover effects especially in the case of Municipalities need to be offset by providing additional resources

Of the grant amount thus calculated about 2% will go as administrative grant to meet the minimum administrative costs of the LBs and the rest that is about 8% of net revenue estimate as development and incentive grants. However, in the long run the administrative grant will be transferred as unconditional grant to LBs, so as to give option for the LBs to save budget on administrative expenses and use it for development purposes. The skepticism that the LBs may do the opposite (that is save money from development budget to use for administrative purpose) can be checked by imposing a maximum limit on the administrative expenses. Distribution of the Pool to Vertical Layers of LBs

To ensure predictability of the grant system the grant pool needs to be divided vertically among the local bodies (DDCs, Municipalities and VDCs) in a systematic manner. For this purpose, starting from the current ratio, it is recommended to distribute the pool among the vertical layers of LBs as in Table 4-2. Table 4-2: Vertical Distribution of the Grant Pool

Total revenue excluding debt service Rs 51,890,000,000

Existing Pool

(7.45% of

revenue)

Existing Share of

LBs %

Proposed Pool

(10% of revenue) Proposed Share of

LBs %

Grants to DDC (Adm+Dev) 810,000,000 1.53 1,084,245,000 2.05

Grants to Municipality 182,800,000 2.24 1,556,005,355 3.00

Grants to VDC 1,956,500,000 3.7 2,570,187,416 4.95

Total grants to LBs 2,949,300,000 7.47 5,189,000,000 10.00

It should be noted that the amount of the pool would change with changes in revenue projections or achievements of the central government. However, the ratio will remain constant.

4.2.2 Types of Grants

As discussed earlier the objective of the grant can be conflicting. For example a formula that is inclined to give more grants to poor LBs might disenchant the ones with better internal fiscal effort. Therefore there is a need to establish separate grant-types with different objectives. Again, the number and type of grants should not be too many as to undermine the autonomy of LBs. Against this background it is recommended to divide the grant pool, that is 8% of the national revenue after deducting debt service, into three grant funds (Table 4-3) in case of the general-purpose grants to be provided to DDC and Municipality.

10

It is reported that an earlier LBFC report has recommended making the pool size as 15% of the total budget. Here the report is more concerned with the block grant formula, and not for the total transfer to LBs including sectoral grant transfers. For the block grant purpose the study considers the amount as sufficient. However, with the increased pace of devolution obviously the size will gradually increase.

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Table 4-3: Proposed Division of the Grant Pool for DDC and Municipality

Grant Fund Size and purpose Characteristics of formula

Special purpose administrative grant (20% of the pool)

Allocate about 2 percent of the grant pool for this purpose. This is required (as per current practice) to provide administrative grants to local bodies

Distributed on cost basis

Unconditional general-purpose grant (72% of the pool)

Allocate 7.2% (or 90% of the remaining 8 percent after deducting administrative grant) of the grant pool as this grant fund. The fund will be used by LBs fully in their discretion on area of their priority. The intended purpose of the fund is to meet recurrent costs of services generated, and develop additional services to citizens

The formula for distribution will favor LBs having high poverty, remoteness, and situated in underdeveloped area or region with higher amount of grants.

Unconditional incentive grant (8% of the pool)

Allocate 0.8% (or 10% of the remaining 8 percent after deducting administrative grant) of the grant pool as this grant. The fund will be used to promote and reward better performance among LBs. The LBs that might have suffered due to not being poor, but have done well, will be compensated with this fund

The formula will favor LBs following good governance practices, putting in high fiscal efforts, and carrying out effective programs in efficient ways

In the case of grant pool of VDCs creation of separate fund is not advised. This is because such an arrangement would demand huge administrative input. Therefore the pool for distributing grants to VDCs will be one and remain same as it is today. As discussed earlier, the present system of equal grant system to VDC is neither efficient nor based on the equalization principle let alone reflecting the need of the local people, it is recommended to have an objective and transparent basis incorporated in a formula that broadly reflects the expenditure need of the people and as such, is more efficient.

4.3 Method of Distributing General-purpose Grant

Theoretically, general-purpose grants are given to enable sub-national governments to offset the fiscal imbalances arising due to a low revenue capacity and a higher cost of providing public services. Such imbalances can be minimized by providing unconditional general-purpose transfers to sub-national government in a variety of ways. The standard practice is to provide such grants to their "need revenue" gap. The "need revenue" gap is supposed to measure the difference between what the sub-national government should spend to provide a reasonable level of public services and what it can raise at a standard level of tax effort. However, in the absence of a standard national level data, such gaps are estimated using proxy figures of area, population and its components, poverty and cost factor etc., to arrive at the expenditure needs and own fiscal capacity on the resource side. Block grants to LBs consist of three major categories of grant – Administrative grant, General-purpose grant, and Incentive grant. In the long run, the three grant heading will be reduced to two – general-purpose grant (which will incorporate the administrative grant) and general-purpose incentive grant. Since administrative grant amount is 60% of the block grant amount, and there is little flexibility a DDC can do about allocation of the administrative grant, it is proposed to calculate it separately. In such a scenario the other two grant categories will be distributed based on formula, and the administrative grant will be distributed as per actual calculation for the interim period.

4.3.1 Method of Distribution of Grants to DDCs

The concept of intergovernmental transfer, universal principles in determining such transfers and preferred practices are discussed in the previous chapters of this report. Following are the considerations that are specifically relevant to develop DDC grant formula:

- The administrative and development grants should be merged and a lump sum amount

be given in order to allow DDCs to allocate their budget within approved norms for administrative expenses

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- The formula should be simple and the number of factors included in the formula should be limited to not more than five.

- There should be separate formula for distributing Unconditional general-purpose grant and Incentive-grant

- Incentive grants should use factor(s) that can be updated easily, preferably through regular reporting information

- The data source should be highly credible and the formula should be updated preferably at least, in every three to five years.

- As far as possible the use of factors that demands data processing (such as use of indices) before application should be avoided.

Two aspects are important in developing formula for distributing DDC grants: a) the factors to be included and b) the weight assigned to each of them. These should be identified in connection to developing both general-purpose grant and incentive grant. The factors that were considered potentially useful in developing formula for distributing DDC grant are discussed below. Area: This factor is currently being used. Physical area indicates the extent a DDC has to spread its resources. The more the physical area will mean more spread settlements and need additional resources to serve. More physical area will also mean requirements for more of the physical infrastructures. For general-purpose grant formula area should be directly proportional to the physical area. Population: Population is considered to be a good proxy of demand for services that a local body should produce. Population of the rural area (district population minus population of Municipalities in the district) is a factor used in the current formula. Since population of a DDC is the total population and does not exclude rural areas it is considered wise to use the total population figure in the formula. Therefore this factor is important in order to make an objective grant formula. Rural population: The rural population (total population of the district deducted by population of the municipalities) is a factor used in the current formula. The advocates of this indicator as a factor consider that DDC should focus itself in rural development (however, no documented statement is found to support this notion); therefore it is a pertinent factor. Anyway, this factor is useful to apply in the simulation as an alternative to the total population and adopt if found significant. Population below poverty: Population below poverty is derived as human poverty index multiplied by the population of the district. This factor is considered important in order that the grant formula become pro-poor or poverty sensitive. Nepalese context shows that majority of highly populated districts are relatively rich. If population is used as neutral factor (without considering the poverty), then there is high possibility that the formula might turn out to be poverty insensitive. Use of this factor as well will emphasize poverty issue. 1-HDI: This factor (that is distance of the human development index from an ideal level) is used in the current formula. However, there are doubts raised as to whether it is a good indicator of poverty. In absence of a good proxy this might still be useful. Human poverty index: The human poverty index shows the percent of a district population below poverty. This factor differs from the factor ‗population below poverty‘ described above in that this is not factored by the population of the district. Therefore this index may be separately used in place of population below poverty. Cost Index: Cost index is also used in the current formula. It is recognized fact that districts across Nepal vary in the cost of producing services, mainly that of physical construction programs. It is also observed that a high degree of correlation of the cost index is there with infrastructure index and population below poverty. Therefore the district with high cost index needs to be compensated with general-purpose grant. However, the cost index used in the

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current formula is considered not based on data; it was constructed based on educated judgments. The present study has attempted to update the Cost Index based on concrete database. For this, unit cost of a basket of construction goods in 22 districts, including 17 surveyed districts, is collected (see Annex IV-I). Taking the cost of Rupandehi as the base, the Cost Index is calculated for the 22 districts. The figure is then extrapolated for other districts. Infrastructure index: Development of a jurisdiction is a multi-dimensional process that improves the quality of life for all. This may be reflected in, for example, improvements in the levels of nutrition, morbidity, housing, education, the use of electricity, the availability of water and refuse removal services, and many more. Of them infrastructure is tangible and data is available on these. It is regarded that infrastructure development is highly correlated to cost and poverty, meaning that this may give a good reflection of poverty situation of an area. Since general-purpose grant is likely to be used for physical infrastructure11 this is considered a good indicator of the expenditure needs of a district. Therefore this is a highly potential factor to be included in the DDC general-purpose grant formula. For the current purpose the study has taken seven services to compute the infrastructure index12: road, drinking water, irrigation, bank, cooperatives, health institutions, post office. DDC classification: According to LSGA, HMG can classify DDCs into four categories (A, B, C and D) based on infrastructure availability (road, telephone, electricity, airport) and other factors. Furthermore it is updated every five years. The classification is poverty-sensitive, reflects development need, easily available, and is a practical data for consideration in the general-purpose grant distribution formula. Performance measurement of DDCs: Performance of a DDC in terms of governance, program planning, budgeting, and program management, financial management, and adoption of good governance and transparency measures in the operation is suggested by stakeholders as a factor to be used in the grant formula. An index of performance measurement has been tried by an UN agency13 and tied up the result to the grant amount. It is regarded that if DDCs are expected to perform better than they should be rewarded for their better performance. This is considered a good indicator for use to distribute the general-purpose incentive grants. The section that follows will specifically deal with the method of distributing specific purpose (including administrative) grants, general-purpose grant and incentive grants to DDCs. Distributing Specific Purpose (including administrative) Grants to DDCs Administrative grants to DDCs are traditionally given in several headings. Recently various headings are merged together with a view to let the DDCs exercise their autonomy to distribute the total administrative grant as per their own special situation. However, the grant administrator calculates the specific amount that has been channeled for already committed purposes. These purposes include grants to meet a minimum administrative requirements pertaining the regular HMGN staff deputed to DDC (LDO, PMAO, Accountant), the cost of operating internal audit section, the cost pertaining the staff recruited under the administrative position approved by HMGN but hired locally by DDCs14, and staff welfare fund including others. It is recommended to continue the calculation as such, meaning that there will not be a formula for this, because there is little flexibility that the DDC can exercise on the use of this fund. However, in the long run this grant will also be merged with general-purpose grant along with greater autonomy granted to the DDCs. On that situation one needs to tie-up the administrative grant either as a proportion of the total general-purpose grant, or any other criteria that explains the need more accurately than others.

11

Findings of the Expenditure Effectiveness Study 12

Based on SNV computations 13

DFDP 14

Here cost of staff hired by DDCs from their internal resource is not included, because HMGN do not bear responsibility for such staffs. Therefore, the cost of staff deputed by HMGN and for which positions are approved by HMGN only is taken as cost considerations for administrative transfer.

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b. Method of Distributing General-purpose Grants to DDCs

According to the scheme presented under section 4.2 of this report the amount of the different funds to distribute to DDCs are calculated based on the present allocation pattern. The picture appears to be as presented in Table 4-4. Table 4-4: Amount to be Distributed to DDCs for Different Purposes

Amount as per existing grant pool

Amount as per suggested grant pool

a) Total amount for distribution to DDCs 810,000,000 1,084,245,000

b) Of the total, amount to be distributed as administrative grant

485,779,000 485,779,000

c) Of the total, amount to be distributed as block development grant (a-b)

324,221,000 598,466,000

d) From the total block development grant, amount to be distributed as general-purpose grant (90% of the block grant or ‗c‘)

291,798,900 538,619,400

e) From the total block grant, amount to be distributed as incentive grant (10% of the amount to be distributed as block grant or ‗c‘)

32,422,100 59,846,600

Scenario analysis for different combination of factors was done to develop general-purpose grant to DDCs in Nepal. Table 4-5 gives the matrix of bivariate correlation coefficient of the factors under consideration. Table 4-5: Correlation Coefficients among Possible Factors

Area Population

Rural population

Pop‘n below

poverty 1-HDI

District Classification

Cost factor

Infrastructure index

Human poverty

Area 1 -0.358 -0.324 -0.327 0.437 0.426 -0.419 0.510 0.442

Population 1 0.910 0.921 -0.528 -0.786 0.709 -0.797 -0.462

Rural population 1 0.954 -0.312 -0.733 0.516 -0.808 -0.308

Population below poverty

1 -0.285 -0.687 0.546 -0.776 -0.185

1-HDI 1 0.681 -0.679 0.504 0.837

District Classification

1 -0.730 0.815 0.671

Cost factor 1 -0.616 -0.617

Infrastructure index 1 0.545

Human Poverty 1

All coefficients are statistically significant at 0.01 levels

The one to one correlation of each of the plausible factors determining the demand for services in the districts shows high to moderate correlation. The sign of the correlation were as s expected and the correlation coefficients are highly significant. A linear and in some cases a natural log linear regression equation of the form given below were used to estimate the coefficients of each of the variables and their explanatory power. Computerized SPSS software is used for the estimation. The model: a. Grants_i = a + b1*X1 + b2*X2+ b3 * X3 +…… b. Ln Grants_i = Ln a + b1 * Ln X1 + b2 * Ln X3 +…. A number of estimation using different variables were made and the results were summarized as below. The key factors were used to test different models with a view to test the impact on the grant amount by including different combination and weight to these factors. The result of the different models is shown in Table 4-6. Simulation observations on the explanatory power and significance of the factors Classification of district was not significant

63

Infrastructure index was also not significant, but its significance was higher than that of district classification Rural population as factor is also not so significant HDI is insignificant Human poverty index was insignificant Four factors that were most significant, which combined together could predict over 95% of the grant include: cost index, area, population below poverty, and population Table 4-6: Predictability of Possible Factors used in the Models

Beta Coefficient R R2

Area Population

Pop‘n below poverty

Cost factor

District classification index

Infrastructure index

1-HDI

Model 1 0.434* -0.313* 0.901* 0.879* 0.109 - - 0.958 0.918

Model 2 0.409* -0.165* 0.809* 0.915* - -0.182 - 0.963 0.928

Model 3 0.437* -0.390* 0.945* 0.938* - - - 0.957 0.915

* Coefficients were significant at 0.05 level The modeling showed that Model 3 has high explanatory power and the coefficients are statistically significant. Therefore, the indicators - namely Area, Population, Population below poverty, and Cost factor - are identified as good factors to be included in the formula. The study also tested alternate formula models including internal revenue as a factor for consideration, which did not improve the explanatory power of the formula significantly. So, internal revenue is not included as a factor. Based on these observation and computations the study recommends Model-3 as the appropriate formula for adoption. In order to determine the weight of the factors stepwise regression analysis was carried out. The correlation coefficients of the respective factors are provided in Table 4-7. Table 4-7: Regression Coefficients of the Factors used in the Model

Step Area Cost factor Population below

poverty

Population R R2

1 0.746 0.746 0.557

2 0.499 0.484 0.855 0.731

3 0.438 1.018 0.647 0.946 0.895

4 0.437 0.938 0.945 -0.390 0.957 0.915

The coefficients of the factors suggest the following weight should be given to each factor: Area 16%, Population 14%, Cost factor 35% and Population below poverty 35%. For the sake of simplicity the weight is distributed as 15% each to Area and Population and 35% each for Cost factor and Population below poverty. Thus, according to this formula, the general-purpose grant that each district is entitled to receive will be calculated as follows:

DDC general-

purpose

grant amount =

15% of grant

amount x a

DDC’s share in

area

+

15% of grant

amount x a

DDC’s share in

population

+

35% of grant

amount x a

DDC’s share in

cost factor

+

35% of grant

amount x a

DDC’s share in

Population

below poverty

The study also carried out diagnostic test for multicollinearity among the factors. The result showed that it was evident between the two factors Population and Population below poverty. As the data is a cross sectional and not a time series data, the problem of multicollinearity is relatively less serious. Moreover, it is to be noted that, these two factors are vital in determining the grant formula as it reflects the amount of service DDCs have to provide (population factor) and to make the formula poverty sensitive (Population below poverty). Considering the fact that the two factors are used to determine the weight of the factors, it is noticed that there will not be a big impact on the grants since these two factors combined

64

together will constitute a weight of 50% in the formula, which is internationally acceptable. Based on the recommended formula the general-purpose grant figures each DDC is entitled (See Annex IV-I in the Main Report, Refer to IV-I in ANNEXES for detail) is calculated. The amount in the Annex is calculated for the purpose of comparing the grant amount according to the new formula and the existing formula. Therefore the grant figures are given along with the data on various indicators. A summary of the exercise is presented in Table 4-8. The table shows that there is wide variation in the grant amount among DDCs, which could be attributed to the variations in the area and population of the districts. Therefore, the variation in the grant amount is explained. This demonstrates that the formula adequately considers the equalization objective of the block grant transfer. Table 4-8: Summary of Simulation Analysis for General-purpose Grants to DDCs

Area of

district

Population of

district

Amount as per

suggested formula

Amount as per

existing formula

Amount as per

alternate formula 1

Amount as per

alternate formula 2

Factors and weight

(%)

Pop 15, Area 15;

Pop Below Pov 35,

Cost 35,

Rural Pop 20, 1-

HDI 50; Cost 20;

Area 10

Area 10; Pop 45,

Hum.pov 10, Cost 15,

Int rev 20

Area 10; Pop 50,

Hum.pov 10, Cost 20,

Inverse of int. rev 20

Total (in 000) 147181 23151693 319222 319222 319222 319222

Average (in 000) 1962 308689 4,256 4,256 4256 4256

Maximum (in 000) 7889 1081845 6518 6526 11196 8708

Minimum (in 000) 119 9857 1524 2421 1877 2402

Standard deviation 1147 209988 845 734 1938 1159

Coefficient of

variation (%)

58.46 68.03 19.85 17.25 45.53 27.23

It is to be noted that the present study has taken Rs. 319,222,000 for simulation. This is the amount distributed as block grants last year. The figure is presented merely for comparison purpose, because a different grant pool as suggested in this report will result into a different grant size to DDCs. Salient features of the new formula

- It is poverty sensitive. It takes population below poverty as a factor in account. The existing formula takes only the HDI independent of population size, whereas this takes poverty index in combination with population of a district.

- Population receives 50% weight (15% for total population and 35% for population below poverty

- This is simple as only four factors are taken with easy-to-remember weight – 15% each to two factors and 35% each to other two.

- It also reflects the cost of producing services which varies highly across districts in Nepal

c. Method of Distributing Incentive Grants to DDCs

There are three purposes of incentive grant. a. Encourage better performance by local bodies b. Compensate some DDCs which, following the formula approach to determining grant

amount, may receive an amount less than what they were receiving before. c. Use as cushion for phasing full implementation of formula based distribution of block

grant. The total fund to be distributed for incentive grant will be 10% of the total grant allocated for distribution as block grant. This amount is to be distributed on the basis of performance of DDCs measured in terms of their governance, planning and budgeting, operations management, financial management and fiscal discipline, adoption of transparency and accountability practices measured on a performance measuring scale. A proposed list of indicators and the score for each indicator is given in Table 4-9.

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Table 4-9: Simplified LB performance effectiveness index

SN Criteria Score

1 Governance

1.1 Statutory committees (sectoral, advisory, accounts and audit,

monitoring) formed

All formed = 2; Partially formed =

1; No = 1

1.2 Clear policy and institutional mechanism exists for upliftment of

poor, dalits, ethnic communities and women

Strong = 3; Moderate = 2; To

some extent = 1

1.3 Progress reports prepared and submitted on time Yes = 1; No = 0

1.4 Establishment of internal audit system Yes = 1; No = 0

1.5 Existence of institutional mechanism and evidence that DDC has

worked in cooperation with civil society and private sectors

Strong = 3; Moderate = 2; Weak =

0

2 Planning and budgeting

2.1 Periodic plan prepared Yes = 1; No = 0

2.2 Annual plan and budget synchronized with periodic plan Fully = 2; Partially = 1; No = 0

2.3 Annual council meeting held by the month of Falgun as prescribed in

the law

Yes = 2; No = 0

2.4 Expenditure prioritization done Yes = 1; No = 0

2.5 Allocation on poverty and social upliftment programs made Yes = 1; No = 0

3 Operation and management

3.1 Absorption capacity of available funds (actual expenditure as

proportion to estimate)

≥ 90 = 4; 80-90 =3; 80-70= 2; < 70

= 1

3.2 Internal revenue as percent of total expenditure <20 = 1, 20-30 = 2, 30-40 = 3, >40

= 4

3.3 Feasibility studies/IEEs done before selecting programs/projects (to

be observed in policy statement and collection of study documents)

Yes = 1; No = 0

3.4 MIS in place and regularly updated information from information and

documentation center is available

Fully = 2; Partially = 1; No = 0

3.5 Supervision and monitoring sub-committee meets regularly Yes = 1; No = 0

4 Financial management and fiscal discipline

4.1 Use of manuals and guidelines for accounts keeping Used = 2; Not used = 1

4.2 Statement of financial accounts prepared and submitted for audit in

time (by three months after the end of FY)

Yes = 1; No = 0

4.3 Proportion of irregularities amount (except advance) to total

expenditures (grant and internal revenue)

<10%=3; 10-25% = 2; 25-50% =

1; Above 50% = 0

4.4 Total LB recurrent expenses as proportion of internal revenue >51% = 1; 50-41% = 2; 25-40% =

3; <25 = 4

4.5 Volume of cumulative audit irregularities up to the end of previous

year but one settled during the previous FY

Significant = 4; Moderate = 2; Not

impressive = 0

5 Transparency and accountability

5.1 Necessary responses are timely given on the audit inquiries Yes = 1; No = 0

5.2 Audit report published and notified Yes = 1; No = 0

5.3 Statement of expenditure published or publicly notified Yes = 1; No = 0

5.4 Citizen charter and code of conduct prepared and notified Yes = 1; No = 0

5.5 Mechanisms and procedures to hear and act upon consumers’

complaints with regard to DDC’s services is established

Well established = 3; Initiated = 2;

Not done = 0

Key considerations given on the selection of criteria in performance measurement scale: - Majority of the criteria are updated annually, because the grant is annually distributed

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- Considering the management capacity of the grant administrator, i.e., MOLD, the chosen indicators are such that they can be updated from the regular information channel. No special study will be required for measuring performance of a DDC

- Performance measurement score of this year will influence the grant of next year (not the coming year)

The study proposes that the performance assessment of the DDCs is done by the Unit responsible to administer the grant system. An external assessment is essential for neutrality, credibility and acceptance of the assessment results. It would be difficult to accommodate the idea of letting the concerned DDC themselves to make a self-assessment of their performance, because of the money associated with such an exercise15. Accordingly, an assessment will be done by the responsible unit based on available information, and the finalization of the assessment will be made after allowing the respective DDCs to appeal and reassessment if required. A cut off score of 50 percent that is 25 of a total score of 50 will be determined on the performance measurement scale, and DDCs that score more than the cut off score will be eligible for obtaining the incentive grant. The total amount for incentive grants then will be distributed among the eligible DDCs based on a formula. An equal distribution of such grant equally among the eligible DDCs is considered inequitable and inefficient; therefore the grant amount will be determined proportionate to the performance level. A suggested distribution formula is presented in Table 4-10. Table 4-10: Suggested distribution formula for incentive grants

Score Proportion of Incentives

< 50% 0

50 – 60% 10

60 – 70% 15

70 – 80% 20

80 – 90% 25

> 90% 30

To start with, the eligibility criteria for obtaining the incentive grant to DDC will be:

- DDCs that are eligible to obtain the amount based on performance scale;

- DDCs for which the formula based grant amount comes to be less than what it was receiving before;

- DDCs, who need capacity building support, to use additional money they received from the formula based grant system;

4.3.2 Method of Distributing General-purpose Grant to Municipalities

General-purpose grant to municipalities consists of the three components as in the case of DDCs: Administrative grant, General-purpose grant and Incentive grant. Key considerations in developing formula for distributing grants to municipalities:

- The administrative and development grants should be merged and a lump sum amount be given in order to allow Municipalities to allocate their budget within approved norms for administrative expenses

- The formula should be simple with less number of factors

- Special characteristics such as concentration of population in municipal area should be reflected in the formula

- While the development need is a key factor on one hand therefore it should be there in the formula, to remain under developed should not be attractive on the other hand

15

Experience of experts elsewhere is such that such assessment must be external as no LB would like to give a lower score in the scale to fetch a low grant volume (See Jesper Steffensen and colleagues‘ note on the design of MC and PM for DFDP/UNCDF).

67

- The information should be available from credible source, and should be updated on a regular interval

- There should be separate formula for distributing Unconditional general-purpose grant and incentive-grant

- Incentive grants should use factor(s) that can be updated easily, preferably through regular reporting information

- As far as possible the use of factors that demands data processing (such as use of indices) before application should be avoided

These considerations led the study to identify most likely factors for distributing general-purpose grants to municipalities. The possible factors are briefly described below:

Population: Total number of citizens to whom a municipality provides its services is a strong factor that determines the expenditure needs of the municipality. The more the population the more will be the service requirements and thus expenditure needs. In case of municipalities the number of people as appearing normally in population census is sometimes misleading. Since, being market centre, more people from surrounding areas reside there, which often means that municipalities have to arrange its service for people from other jurisdictions too. However, it is difficult to ascertain such temporary population. Some argue that assigning higher weight to population as the factor is a solution; the logic behind is that higher population would make the jurisdiction more urbanized that attract more people from other jurisdiction. But it is observed that this is not a plausible indicator in the case of Nepal since even a rural jurisdiction is announced as municipality as a political decision. Therefore one needs to find another proxy for arranging additional services for temporary population. Area: As in the case of DDC, area of a jurisdiction is important indicator of expenditure needs of the jurisdiction. Here too more physical coverage would mean higher expenses for providing services. Infrastructure development: Level of urban services that a municipality is managing is an indicator of the level of development the municipality has attained. This indicator gives two ways of looking at the indications as far as the expenditure needs assessment is concerned. One way is to look at the expenditure needs to maintain the level of infrastructure, which is directly proportional to the level of development of the infrastructure. Another way is to look into the gap (that is how backward is a municipality from a desired level) of development, which will indicate the expenditure need to develop those infrastructures. In this way this indicator can be used for distributing general-purpose grant that favors poor jurisdictions, and also for distributing incentive grants that rewards the good performers. For the purpose of developing formula for distributing these grants a composite of urban roads, and coverage of electricity, telephone, and drinking water is taken as elements to measure infrastructure development. The inverse of infrastructure development index is taken as a potential factor for grant allocation. This process is expected to benefit those Municipalities that are poor in infrastructure development. While considering this as a factor the elements of regular operation and maintenance expenditure has not been taken into account. This approach may appear biased against infrastructure-rich Municipalities. It is principally agreed that LBs having better infrastructure have more revenue potential to address the need of operation and maintenance expenditure of infrastructure. Internal revenue: Internal revenue of a municipality reflects many characteristics that have direct bearing on the expenditure needs of the municipality. The key characteristics are an indication of its revenue capacity and potential, and or good performance due to greater tax efforts (thus indicating financial sufficiency or less need for additional financial support). On the other side a higher internal revenue may be linked with a clustering of businesses (from where it has been able to raise more tax) in the municipal area, which means that more people from other jurisdictions inhabit the municipality therefore it requires more money for the development and management of services to citizens. Considering the second argument the internal revenue can be used as a factor for rewarding municipalities that are negatively treated by a pro-poor formula.

68

Performance: Effective performance is a factor that should be taken as an aspect that needs to be rewarded. The usefulness of this indicator is as discussed in case of factors for consideration in case of DDC. In the case of municipalities two alternative approaches are available as to how to measure performance. One is the internal revenue figure, taken as revenue per capita. Another is to compute performance index using different variables such as governance, program management, financial management and fiscal discipline in a scale as in the case of DDCs. Municipal contribution to national exchequer: There is strong belief among a section of stakeholders that distribution of general-purpose grant to municipalities should be proportionate to the amount that the central government raises from the municipal area. The argument is that the revenue raised by central government from a jurisdiction is a strong indicator of the economic activity in the area, population concentration, and thus the burden a municipality bears by providing services to the citizens from other jurisdictions, which is the central government responsibility. Therefore central government would be doing justice to the municipality by compensating with additional grants. Considering the available database however this factor appears difficult to measure. Therefore if this factor is considered to be included in the formula then a suitable proxy is to be identified. For this purpose, the internal revenue itself could be a good proxy in the absence of other better one. The sections that follow will specifically deal with the method of distributing administrative grants, general-purpose grant and incentive grants to municipalities. a. Distributing Specific Purpose (including administrative) Grant to Municipalities

Administrative grants to Municipalities are given to cover the salary and allowances of staff deputed from the center. Further specific purpose grant are given to municipalities for functions of specific nature such as fire-fighting, management of dumping site, preparing town plans and so on. It is recommended to continue the calculation for specific purpose grants including administrative grants as practiced today, meaning that there will not be a formula for this, because there is little flexibility that a Municipality can exercise on the use of this fund. However, in the long run this grant will also be merged with general-purpose grant along with greater autonomy granted to the municipalities. On that situation one needs to tie-up the administrative grant either as a proportion of the total general-purpose grant, or any other criteria that explains the need more accurately than others. b. Method of Distributing General-purpose Grants to Municipalities

According to the scheme presented under section 4.2 of this report the amount of the different funds to distribute to Municipalities are calculated based on the present allocation pattern. The picture appears as follows (Table 4-11). It is to be noted that the funds distributed from the Local Development Fees is also included as central grants to municipalities, because Municipalities neither collect nor have any say on the rates16. Table 4-11: Amount to be Distributed to Municipalities for Different Purposes

Amount

a) Total amount for distributing to Municipalities 98,947,000

b) Of the total, amount to be distributed as administrative grant 48,100,000

c) Of the total, amount to be distributed as block grant (a-b) 50,847,000

d) From the total block grant, amount to be distribute as general-purpose

grant (90% of the block grant or ‘c’) 45,762,300

d) From the total block grant, amount to be distributed as incentive grant

(10% of the amount to be distributed as block grant or ‘c’) 5,084,700

16

During the dissemination workshop the stakeholders suggested to treat LDF as Shared-revenue. The study considers this merely an issue of nomenclature, which is a subject matter of policy decision.

69

The study carried out regression analysis to assess the relationship between the current level of grants (total of development and administrative grants) and different combination of factors with a view to develop general-purpose grant to Municipalities in Nepal (the figures on the grant to Municipalities is presented in Annex IV-II in the Main Report17 along with relevant data). Based on probable factors different models were tested. The result of the different models is shown below:

- Use of total grant (development and administrative) amount as dependent variable did not show any promising result.

- It was difficult to trace any pattern on the municipal grant distribution.

- Use of per capita grant as dependent variable and internal revenue per capita, infrastructure index and population as independent factors was then tested. This resulted into about an explanatory power of 25% (with R-square value 0.248 and adjusted R-square value 0.161) of the model, but none of the variables were statistically significant.

- Municipal area as a factor was found not useful.

Since the data were not encouraging, the data were then converted into natural logs. The results are presented in Table 4-12. Table 4-12: Regression Coefficients of Factors used in the Models

Beta Coefficient R R2

Population Internal revenue per

capita

Infrastructure

index

Area

Model 1 -0.617 0.088 -0.167 0.077 0.295 0.183

Model 2 -0.583 0.040 0.151 x 0.292 0.211

Note: Only Population factor was found significant

Simulation observations on the explanatory power and significance of the factors: - None of the factors were found statistically significant. Model 2, which excludes

municipal area as a factor gave more promising results, with about one-third of explanatory power.

- The existing grants to municipalities tend to be inversely related to population and infrastructures and positively related to internal revenue per capita. Except for the case of infrastructures this relationship is not desired if a formula is to be poverty sensitive.

Model-2 has relatively good explanatory power. Therefore the factors, namely the Internal revenue, Population, and Infrastructure index were identified as factors for consideration in the formula.

The coefficients of the factors suggest the weights to be assigned to each factor as follows: Population 75%, Infrastructure index 20% and Internal revenue 5%. However, the figures as such cannot be taken if the formula should be poverty sensitive. Therefore some adjustment on the basis of "educated estimates" needs to be done on the weights of these factors to arrive at a more desirable formula. Along this line the study recommends to distribute the weight as: 60% to population, 25% to infrastructure index and 15% to internal revenue18. Thus, the general-purpose grant that each district is entitled to receive will be calculated as follows:

Municipal grant

amount from

general-purpose

grant

=

60% of grant

amount x a

Municipality's

share in Pop

+

25% of grant amount x a

Municipality's share in

infrastructure index

+

15% of grant x

Municipality's share

in internal revenue

17

Refer to IV-II ANNEXES for details 18

Municipal area is considered as an important factor to be included in the formula. However the study could not include it as the simulation exercise with Area as factor did not give a convincing result (see table 4-13). Therefore it was dropped.

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A simulation done according to this formula resulted a correlation figure of some 45% between the current level of grants including development fees and the figures that the simulation exercise gives, which is highest among various simulated models. This means the formula reflects only about 50% of the grants currently being provided to Municipalities (Table 4-13). Table 4-13: Summary of Simulation Analysis for General-purpose Grants to Municipalities

Simulations Sim-1 (int rev

10, pop 45,

area 10, infra

20, cost 15)

Sim-2

(int rev 10,

pop 50, infra

25, cost 15)

Sim-3

(int rev 15,

pop 45, infra

25, cost 15)

Sim-4

(int rev 15,

pop 40, infra

25, cost 20)

Sim-5

(int rev 15,

pop 60, cost

25) Average 18573 18573 18573 18573 18573

Maximum 44907 48743 50583 48768 56028

Minimum 8586 9429 9285 9799 6031

Std deviation 9636 10635 11380 10710 13494

Coefficient of variation 52 57 61 58 73

Correlation coefficients 0.4243 0.4474 0.4383 0.4313 0.4515

Such a wide variation suggests that Municipality grant would take more efforts to make it formula based. This is because the grants so far had been given on an ad hoc manner on the basis of approach and power and there is no observable pattern of the grant with any factor. Moreover, there is also noticeable variation in the characteristics (area, population, revenue) of the Municipalities in Nepal. Therefore a certain degree of variation in the grant amount is expected. c. Method of Distributing Incentive Grants to Municipalities

There are three purposes of incentive grant. a) Encourage better performance by local bodies b) Compensate some Municipalities which, following the formula approach to determining grant

amount, may receive an amount less than what they were receiving before. c) Use as cushion for phasing full implementation of formula-based distribution of block grant.

The total fund to be distributed for incentive grant will be 10% of the total grant allocated for distribution as block grant. This amount is to be distributed on the basis of a composite performance measurement index developed for municipalities in line with a similar one developed for DDCs. As an alternative to this simply the per capita revenue as measure of revenue effort can also be used. A cut off point will be determined on the performance measurement scale, and those municipalities that score more than the cutoff point will be eligible for obtaining the incentive grant. The total amount for incentive grants then will be distributed among the eligible Municipalities based on a formula. An equal distribution of such grant equally among the eligible Municipalities is considered inefficient; therefore the grant amount will be determined proportionate to the performance level.

d. Issues in Implementing Formula Based Grant System for DDCs and Municipalities

An important management issue is how to implement the formula based distribution system. Comparing the amount allocated today and indicated by the formula, the local bodies will be polarized into ―losers‖ and ―gainers‖. Such is the experience of introducing formula based grants system in other countries as well. There are alternative approaches to deal with this situation: a) arrange additional money to compensate the losers (set aside 2.5% of the amount for this purpose from the proposed 10% of the national revenue, which is spared as the existing requirement is about 7.5%); b) implement the system in phases so that the shock due to change is gradually absorbed; and, c) apply a combination of the ways mentioned in a) and b). If the 10% figure is accepted then there will be some amount to adopt the first option, and it is assumed that the second option will also be adopted. Therefore it is recommended to implement the formula in phases. For this a two to three year incremental plan can be prepared for the

71

formula based distribution to fully take effect. Accordingly, if a two-year plan is chosen, then about 60% of the amount will be adjusted in the first year and the rest in the second year. Another issue is in regard with the capacity of the local bodies. Some DDCs or Municipalities that might have been receiving smaller grant amount because of their limited absorption capacity in the past will suddenly find themselves with a large sum of funds to spend. Their organization structure, system and processes, and number and skills with human resource may not be able to cope with the increased funds. Such a situation demands for central support to increase their capacity. The central agency may require arranging for capacity development fund in this connection. The international experience indicates that several factors cause higher expenditure needs in big cities and jurisdiction headquarters. They include increase in the number of service consumers due to service provided to inhabitants of suburbs and surrounding regions; higher cost of labor and property; higher externalities such as environment protection and transport related to the high population density and concentration of specific problems; and concentration of problems (such as crime, drugs etc.) related to sociological features of large cities. These factors are also valid in Nepali Municipalities and district headquarters as well (rather more so due also to influx of internally displaced people from conflict prone rural areas), however they are not adequately reflected in the grant allocation formula.

4.3.3 Method of Distribution of Grants to VDCs

Considerations specific to development of VDC grant formula - Should be simpler than DDC and Municipality formula because of huge number of

VDCs. The formula should demand little administrative requirements.

- Use such factors in the formula that do not change frequently. This will mean the formula will be stable for a considerable period of time.

- The data should be available universally across the nation and from highly credible source

Two aspects are important in developing formula for distributing VDC grants: a) the factors to be included and b) the weight assigned to each of them. The factors that are found useful in developing formula for distributing VDC grant are discussed below. Classification of VDCs: According to LSGA, HMG can classify VDCs into four categories (A, B, C and D) based on infrastructure availability (road, telephone, electricity, airport) and location (district headquarters, Kathmandu valley, adjoined with metropolis or sub-metropolis). The classification will be done in recommendation of DDC19 and is for the purpose of providing additional resources to uplift those falling behind others. By definition it is poverty-sensitive, reflects development need, easily available, and is undisputed or accepted by stakeholders. Furthermore it is updated every five years. Therefore this is considered an effective factor to include in the formula for distribution of grants to VDCs. Area: VDCs in Nepal vary a lot in terms of their geographic coverage. Physically wide area of a jurisdiction means spread of population in distant places. When service beneficiaries are spread then it will increase the quantity (such as road, electricity, and land development) of service needs and effort to manage these services. This results in requirement of additional expenses for delivering services. Therefore a VDC that has to provide services in a wide area than other VDCs should be compensated the additional efforts and costs it incurs. This clearly establishes the importance of physical area to be included in the grant formula. Population: The service a VDC provides is to their citizen that is reflected in the population. In public finance terms the number of beneficiaries is a good proxy indicator of demand for

19

DDC normally get approval of categorization through district council, in which VDC Chair and Vice-chair are council members. Such a practice clearly shows that the classification is agreed upon by respective VDCs themselves, thus increasing legitimacy of the classification and ensuring acceptance by all.

72

services that a local body should produce. Therefore this factor is essential in order to make an objective grant formula. Population density: By definition population density is in itself a composite of two factors, population and physical area, that are discussed above. Therefore an attempt is made to use this as factor instead of using population and physical area separately. Assigning appropriate weight to these factors is a judgmental exercise. This is largely done through simulation. The study tried a number of scenarios for simulation to arrive at appropriate weight of these factors. The result of the simulations done for VDCs in three districts, one each from Mountain, hill and Terai, is presented in Table 4-11. Details of grants to each VDC in these districts are presented in Annex IV-III in the Main Report. The comparative result of the simulation carried out for 3 districts in Terai, Hill and Mountain shows the following:

- The factors are credible, acceptable to stakeholders, and the data is easy to obtain. To start a formula based grant system to VDCs inclusion of other factors for which information is to be gathered from the VDC itself is very demanding, therefore may not be possible.

- There is wide difference in the population and area characteristics of the VDCs in a district. Therefore the idea of equal distribution is not justifiable. Furthermore survey of literature also strongly points out the fact that distribution based on equality is inefficient in many ways.

- Among the other three models the fourth model that takes into account the VDC area, population and classification as factors has lower standard deviation and coefficient of variation. Therefore this model appears more promising to be taken as the formula for distributing grants to VDCs.

Table 4-11: Summary of Simulations for VDCs for Different Models

Scenario and weight to factors

Model 1 Equal grant

amount

Model 2 Population

100%

Model 3 Area 15%

Population 85%

Model 4 Area 10%

VDC Classification 15% Population 75%

Kanchanpur

Average grant 500 500 500 500

Maximum grant 500 816 917 860

Minimum grant 500 210 228 269

Standard deviation 0 143.2 159.58 137.35

Coefficient of variation 0 0.29 0.32 0.27

Bhaktapur

Average grant 500 500 500 500

Maximum grant 500 1001 907 819

Minimum grant 500 326 311 333

Standard deviation 0 155.81 131.35 107.28

Coefficient of variation 0 0.31 0.26 0.21

Mustang

Average grant 500 500 500 500

Maximum grant 500 935 805 656

Minimum grant 500 269 231 355

Standard deviation 0 184 141.23 68.33

Coefficient of variation 0 36.8 28.25 13.67

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Recommendation

The study recommends adopting the Model 4 for distributing grants to VDCs. The team observed that because of a significant weight given to the factor Classification, the formula is biased against VDCs classified as A. As a result the VDCs of district headquarters appeared to have suffered from the formula based system, since they are automatically classified as A. There are a few districts whose headquarter is situated in VDCs, therefore instead of completely changing the formula for the sake of few districts, the team suggests to compensate such VDCs with a different mechanism. One option is to incorporate a factor in the formula itself. Another matter to be considered is an issue of how to implement the formula based distribution system. If the formula is applied in the same Rs 500,000 that is currently being distributed equally, then there is likely to be a lot of dissension among stakeholders20. However, since there is no policy announced for additional grant, it is assumed that the formula will be applied for the grant currently being provided. It is recommended to implement the formula in phases. For this a two to three year incremental plan can be prepared for the formula based distribution to fully take effect. Accordingly, if a two-year plan is chosen, then about 60% of the amount will be adjusted in the first year and the rest in the second year. The local bodies in Nepal provide service to all citizens without discriminations against citizens of another LB, even though there are no payments they receive for providing services to citizens of other jurisdiction. In all likelihood, this would mean that a LB that provides a good service could be overrun by citizens of the neighbouring LBs. However, the latter do not contribute to the local revenue in the LG where they receive the service. Likewise, an allocation formula would normally use allocation factors based on the conditions in the single LG assuming that the allocation factors like population etc. would reflect the expenditure need of the LG. But in the case of cross border service delivery this is not the case.

4.3.4 Possibility of a formula for Grants from DDC to Municipalities and VDCs

Exploring the possibility of a formula for distributing grants from DDC to Municipalities and VDCs was one of the areas of this study. Accordingly the study made inquiry with stakeholders in the districts about this aspect. The DDCs expressed that they have not felt the necessity of a formula to distribute grants to Municipalities and VDCs. The Municipalities in general neither expected DDC to provide them grants nor had received some on a regular basis. Similarly the VDCs would expect resources from DDCs but their experience is that such grants come as DDC finance for a project implemented in the VDC area21. The amount of money is administered by the DDC itself. Therefore this aspect appeared not a concern of the LBs. Some of the LB officials tend to misunderstand this concept with the sharing of 35-50% of the revenue from sand, stone and gravel to respective VDCs and Municipalities as the system of distributing the grant. Some DDCs clearly expressed their opinion that they are not legally bound to provide grants to VDCs or Municipalities. A few DDCs were found to have been giving block grants to DDCs and conditional grants to Municipalities, did not see any rationale for developing formula since it is being done by negotiations. They consider that the revenue of a DDC should be solely used for services and functions that a DDC is responsible to its citizens; therefore the DDC itself should be managing their funds. In light of the above the study did not go for developing a formula, as it is not acceptable to the DDCs. It is considered that if a DDC wishes to distribute grants to Municipalities and VDCs, then it can use the formula for providing the central grants as suggested in this report.

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NAVIN clearly showed this concern. NAVIN is in favor of introducing the formula based system on additional amount and retain the equal distribution of Rs 500,000 as it is. They argue that this sum is a minimum for a VDC would require operating as a state entity. 21

An exception to this practice is reported by Morang DDC, where DDC distributes some of its incomes as grants to VDCs on a regular basis.

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4.4 Method of Distributing Specific Purpose Sectoral Grants

The study has not focused in detail about method of distributing specific purpose sectoral grants. This is because of unclear expenditure assignments to local bodies, undefined minimum service standards on the sectoral service areas, and devolution of limited tasks has taken place only in a few areas. However, the study has outlined the general frame for determining the sectoral grant amount. The following section describes the framework in brief.

4.4.1 Clarify the Objective and Identify Grant Pool for each Sectoral Grant

Specific purpose sectoral grants are meant for meeting both the recurrent and capital expenses relating to concerned sector. The cost incurred to regularly maintain the available services (that includes staff costs, recurrent input costs, operation and maintenance costs) and expanding services (creating new institutions e.g., school, health post; new construction and major rehabilitation in case of physical infrastructure; and the like) have different characteristics. The LBs differ greatly in their needs. For example construction of a new road costs high, whereas maintenance of the same may not be as high. The differences should be honored by grant system. Therefore it is suggested to segregate recurrent and capital grants for each sector. Another approach to distributing sectoral grants is to provide a lump sum grant for a sector in question. The assumption behind this approach is to leave room for the local bodies to decide on the proportion of the fund they will use for recurrent expenses and capital investment. Even if this approach is adopted the formula should be such that needy LBs will get at least some amount for capital investments.

4.4.2 Define the Principles of Transfer and Guide for Formula Design

Commonly agreed concepts and principles: - Equity, fairness and increased poverty focus

- Result oriented rather than processes: Focus on ability for LBs to provide service delivery outputs (results) in line with long/medium term plan rather than according to supply and existing commitments (processes)

- Application of rewards and punishments and other additional incentives mechanism based on e.g. assessment, M&E or sector outcome indicators

- Application of 10-20 percent budget autonomy between sector headings

- The demand factor related to the sector service provision or sector objectives should been given priority

- If suitable allocation factors of the sector/area are not available general factors like population and area should be used as proxy

- The formula should be kept simple with as little factors as possible

- The poverty sensitivity factor of the formula should be variable and neutral to other vari-ables

- The allocation formula should be close ended disbursing a predetermined fund pool

4.4.3 Define the Factor to Use

Based on the nature of the sector and performance standards the factors to be used have to be identified. Appropriate factor can be determined based on expenditure assignment, the type of expenses (recurrent or capital) intended to meet, and experience. When the assignment of expenditures and the intended expenses are not clear then the scope of LB‘s responsibility in the sector in question would be unclear, which will make it difficult to judge if a possible factor should be included or not. Below is an indicative list of most commonly used factors in different sectors. Note that since indicators should be developed with specific conditions and purpose of grants, the indicators given below cannot be taken as such.

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Health: - Life expectancy at birth - Maternal and child mortality rates - Population of 0-5 year old - Areas affected by particular diseases - Special health needs of districts

Education: - Population of primary school age children - Population of secondary school age children - Primary school (gross) enrolment - Secondary school (gross) enrolment - Total literacy rate - Female literacy rate

Agriculture/Livestock extension - Number of rural/farming households - Crops acreage - Livestock population - Total area - Population

Roads: - Existing road network assigned to the LB - Terrain specification to road network - Maintenance and rehabilitation cost per km - Road density (length per Km

2 area)

Drinking water - Urban coverage - Rural coverage - Population

Rural energy - Population - Percent of non-conventional energy use - Percent of electricity coverage - Cost factor

Before deciding on the factors to use the availability of data is an issue. Sometimes one may face a situation in which a very good indicator has to be given up because of lack of useful data. The following list could be a good guide to check about the quality of data. The following are the checklists that can be of use while determining the factors to use.

- Availability of data: Is the data available?

- Relevancy of data: Is the data collected and updated timely?

- Credibility of data: Who collects, and how it is collected?

- Desegregation of data: Is the data available for the DDC or district area?

- Predictability of the factor: To what degree the factor correlated with the expenditure needs?

4.4.4 Assigning Weight to the Factors Used

Assignment of the weight to a factor used is crucial. Simulation of various combination and regression analysis will be required to ascertain the appropriate weight to the factors. In order to ensure ownership of the formula among stakeholders it is recommended that the factors and their respective weight be finalized with intensive exercise (simulation and dialogue with stakeholders) and that this process should continue.

4.5 Possibility of Introducing Equalization Grant

It is a common understanding that a reasonably comparable level of basic public services should be available in all districts (or jurisdictions) within a country. The principle behind equalization is to ensure all local governments to provide certain minimum levels of public services to their jurisdiction. Equalization grant therefore, aims at providing extra funds to those local governments whose revenue raising capacities are weak and expenditure needs great, to enable them provide a reasonable level of service within their areas of jurisdictions. Equalization grant thus fosters horizontal equity across same level of local bodies. Therefore, in allocating resources, whether by formula or other means, the fiscal needs and capacities of the different local bodies should be taken into account. This is one of the most important functions of the grant administration. Thus the concept of equalization comes in for. It is a fact that natural endowments, economic activity and population are not evenly spread across the regions. The case is prominent as can be seen from the following facts.

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- With the revenue sharing provision from electricity generation, forestry products, and tourism incomes some DDCs receive huge amount of shared revenue while others do not. The difference is so high that these sources increase the financial strength of a DDC by 40 or 50 million rupees.

- There are examples that some DDCs have been legally forbidden the incomes they would generate. Example is special authorities endowed to KMTNC that precludes the Mustang DDC from getting income from tourism.

- Some DDCs have more revenue potentials from the same tax base. For example Rupandehi and Dhading collect sizeable amount from sand and boulders than other districts and DDCs in Kathmandu valley get from scrap materials.

- There is considerable difference among DDCs in their revenue efforts. Those exerting high efforts have high internal revenue than others.

Therefore the DDCs in Nepal vary in their resources. As a result the ability of a LB to provide services from own revenues and the need for those services vary. The fiscal gap arising thus should be met properly. As discussed earlier, equalization can be judged from both vertical and horizontal perspectives. Vertical equalization is done by adjusting the central grant pool or by reworking on the expenditure assignments. Horizontal equalization is difficult to attain mostly because of the circumstances mentioned above, but this is what is needed. Certain information should be there in a decentralized system of governance for design of an equalization scheme for implementation. Most important of them are:

- Expenditure assignment must be clear. Though expenditure assignment study has taken place the delineation is not yet clear in Nepalese case. Many central government agencies are functioning at the district level and delivering services. In such a situation it is difficult to assess the expenditure need of the jurisdiction. In absence of definite expenditure assignment of the LBs it is difficult to ascertain what expenses a LB must incur.

- Minimum service standards should be defined. Without knowledge of the minimum service standards it is difficult to calculate the expenditure needs. It is must also because equalization can only be considered in light of minimum service standards to be provided.

- Revenue assignment and revenue assessment is another essential factor. Local bodies are supposed to meet their expenses through own source revenue, shared revenue and conditional and unconditional grants. In Nepalese context the revenue assignments are more or less clear and shared revenue figures can also be obtained but a revenue assessment exercise has not taken place.

Having the mentioned information at hand one can calculate the resource gap or surplus of a local body in order to deliver its assigned services. Equalization fund can be then provided more logically to local bodies that fall short of incomes from (own source revenue, shared revenue and conditional and unconditional grants). There are different mechanisms in which equalization of resource is attained in different countries. A common tendency seen in literature on fiscal decentralization suggests that the unconditional block grant is also a form of equalization grant. If this argument is accepted then the formula itself should be devised in such a way that the resource gap of local bodies is filled with the block grants. In the present condition the formula suggested in section 4.3 of this report needs to be revised, which can only be done after having worked out the resource gap of local bodies considering the total expenditure needs and revenues. Since the formula is suggested in view of updating the block grant distribution system considering the changed circumstances, it is not comprehensively prepared (it does not consider the revenue or total expenditure needs). Fraternal scheme of equalization is also practiced elsewhere (Martinez, 2001) in which after working out the resource gap or surplus of all the local bodies the ones having surplus are required to deposit their surplus in the equalization fund to be distribute to the resource short local bodies. A similar concept has been introduced in regard to shared revenue incomes in

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Nepal. While in the past only a DDC having hydro electricity power plant used to get the shared revenue, now with recent change in the regulation the shared revenue amount is distributed proportionately to all DDCs in the watershed area. Another way is equalizing the expenditures in a local body area for services. For this a list of public services can be taken and expenses in each district are calculated taking both the central government and local body expense figures. Then per capita allocation for all government services is worked out for each local body area. Based on this exercise one can equalize per capita sectoral expenses by providing grants to local bodies. This approach is, however, not common. Experts argue that this approach is not aligned with the spirit of decentralization, as it tends not to consider the advantages of decentralized governance system (participation, responsiveness, and accountability) and takes only per capita expenses in a jurisdiction area.

4.6 Concept and Design of Specific Purpose Funds

4.6.1 Concept of Practice of Specific Purpose Funds

Creation of specific-purpose fund is a practice considered good for financing public services. Such funds differ from the general fund with government general reserves, in that here the purpose is specified; against the arrangement that government reserves can be used for any purpose. The specific funds clearly prove commitment and intentions of the government with regard to a specific sector or purpose. Another important feature of specific purpose fund is that because of its adaptability than in the case of general reserve funds, it can mobilize other stakeholders‘ resources as well. Such resources may come from private sector, aid agencies and others. For internal resources a separate mechanism for resource can also be instituted for meeting the funding requirement of the sector. Surcharge on petroleum products for roads maintenance practiced in Nepal is an example of such an arrangement. Specific purpose funds are established by international agencies as well. UN capital development fund (UNCDF), global fund against HIV/AIDS, tuberculosis and malaria (GFATM), global environmental facilities (GEF) are some examples of such funds. These funds provide resources to recipients upon fulfillment of their requirements and eligibility criteria. The system of special purpose funds is not new in Nepal. Quite a few such funds have been created and they are functioning even today. Notable of them are Tourism Board, Poverty Alleviation Fund, Road Maintenance Fund, Rural Drinking Water and Sanitation Fund Board. These funds operate with a separate management structure. Some other funds are also active but do not have separate management structure. A fund for surcharge on cigarettes is one example of this kind. There are also some funds that have remained as concept and are not active. Education fund raising money from private schools to fund activities to improve quality of government school education is of this kind.

4.6.2 Area of Improvement on a Few Existing Fund Mechanisms in Nepal

The existing funds operating through separate management structure, especially the Poverty Alleviation Fund and Rural Drinking Water and Sanitation Fund Board are highly appreciated by all for their noble purpose. These funds finance programs and projects to community groups based on the demand. In this way the planning process is highly participatory, and follow bottom up decision-making mechanisms. However, in operational terms local bodies and some experts consider their approaches not aligned fully in spirit of decentralization. The point of contention is that it is not essential to involve the local bodies neither in the decision making process (project identification, selection and prioritization) nor in their implementation (monitoring, supervision, funds flow, evaluation, post implementation operation and management). As a result often the local bodies feel themselves being bypassed by these agencies. By passing of local bodies is raised as an issue not for political reasons but because it has negative implication on the planning and decisions of local bodies. Moreover, since the responsibility of providing services to local inhabitants is that of local bodies, they should know

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who is doing what in their area. Only with a full knowledge of the activity of all other actors in an area that the local bodies can best allocate their budget, select and prioritize projects and programs. Being funds established by the state, therefore, they must operate in close coordination with the local bodies and the responsibility to attain cooperation should rest on these funds because of two reasons: a) they have to amend on their rules and b) they are the ones who are entering in a local bodies‘ area and not otherwise.

4.6.3 Design of Specific Purpose Fund for Nepal

It is necessary to design specific purpose funds against the background of the experience obtained so far. The main learning in this regard includes:

- The purpose should be clear. Funding criteria are guided by the purpose.

- Allocation of fund to different LBs should be done based on a formula that best reflect the need for such fund

- Operational mechanism should be clearly aligned with decentralization processes. They must involve the local bodies at least in planning and implementation processes. The involvement is not required in decision-making authority, but the funds flow can easily be done through DDF (district development fund), and supervision and monitoring authority can be given to local bodies.

- Mobilization of resources from private sectors and aid agencies should be encouraged to augment the fund size.

- Such a ―fund mechanism‖ can be established even at district level. District agriculture development fund is an example.

- Creation of separate structure is not mandatory. What matters most is the operational flexibility and efficiency. A fund can also be managed or administered though administrative units of HMGN ministries.

Considering the experience of the fund mechanisms the following suggestions can be made as regard to creating specific purpose fund for Nepal.

- Amend the rules of existing funds as necessary to increase the scope, particularly providing due role for LBs

- Create new funds for rest of other sectors such as agriculture and livestock development, primary education, health care and so on

- design allocation formula identifying relevant factors, eg. literacy rate, % of school going children and dropout rates etc., for allocating education fund in the district etc.

- Channelize government budgetary allocations through these funds

- Allow the funds to receive resources from private and other donor agencies.

- Resource can also be raised from sources such as surcharges, specific development fee etc.

4.6.4 Administration and Management of Specific-Purpose Fund

There are alternative ways to choose to administer and manage the fund: through forming separate fund with separate management structure or administration and management of the fund through respective ministries themselves. The purpose of the fund should be made clear as to what is the amount allocated for recurrent and development purposes, and what amount is allocated to meet salary and non-salary expenses. The allocation criteria or allocation formula of the fund should be predetermined to make it more scientific and objective. The formula should be developed based on principles and criteria or factors mentioned in section 4.4 of this report.

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CHAPTER V

ADMINISTRATION, MANAGEMENT AND INSTITUTIONAL SET UP OF THE FORMULA BASED TRANSFER SYSTEM

5.1 Administration and Management

As noted earlier, an important pre-condition for a successful intergovernmental transfer system is that, it should be simple, objective, transparent and flexible to cope with the changing socio-economic situation. Besides, it should also be equitable and incentive compatible. A proper institutional mechanism, therefore, is an important prerequisite for an effective transfer system. The mechanism should not only help in designing and implementing the transfer system in accordance with policy objectives, but also should foster mutual trust and confidence between the central government and the local bodies. Roy Bahl views fiscal decentralization and as such, the design and implementation of intergovernmental transfer as crucial for the overall process of decentralization itself in a country. As such, the institution mandated to look after the system and management of intergovernmental resource transfer should not only be efficient in discharging the assigned function but also be credible to the stakeholder.

System that exist

At present there are four central level agencies that determines, allocate, disburse and administer intergovernmental transfer in Nepal. Based on the macro-economy and the resource projection, National Planning Commission determines the size of the budget, both recurrent and capital or regular and development expenditures for the fiscal year. This also includes size of the fund to be distributed to LBs and sectoral ministries. There is however, no sound basis, except the tradition and to some extent the political pressure, in determining the size of the fund to LBs. Consultation with the finance ministry about the volume of resources and the ministry of local development responsible for local bodies are done before finalizing the distribution fund. Ministry of finance, as a coordinator of budget and foreign aid, tries to ensure releasing the allocated amount to LBs on a quarterly basis through district level Financial Comptroller office. The office also demands statement of expenditures from LBs for releases of new tranche. Financial comptroller general's office also help in carrying out internal audit of all expenses of DDC. Final audit, however, is done by the auditor General's office in the case of DDC. Ministry of Local Development (MLD), as a line ministry for LBs, disburse the allocated LB fund to DDC, Municipalities and VDCs. It provides both administrative and development grants to each of the LBs subject to some criteria as listed in the LB Financial regulation. Since last year, it is now providing both conditional and unconditional grants to LBs. MLD is also responsible for deputing personnel in the LB along with its human resource development. A separate wing within the ministry looks after the need of DDC/VDC and municipality. The fourth institution in the line to look after LBs is the Local Body Finance Commission (LBFC). This is a separate institution within the central government with mandate to provide independent views on LB financial requirements, local level resource mobilization and budget. It is relatively a new institution but within a short span has been able to prove its existence through a variety of reports on expenditure assignment, expenditure effectiveness of LBs, along with interim formula for intergovernmental transfer of resources etc. However, to build up the confidence among the stakeholder, the institution needs to be made independent and equipped with required manpower. A major chunk of resources in the annual budget are allocated to be disbursed in the district through district level central government agencies and offices. This ranges from resources meant for infrastructure development such as, inter and intra- district road construction and maintenance, construction and maintenance of a variety of irrigation schemes, drinking water

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projects to social sector programs such as health and education, population management, nature conservation, energy programs and awareness and poverty related income generating and skill training programs etc. DDCs have to approve these programs but they hardly have a say in the prioritisation, allocation of resources, and implementation of these programs in the district. With devolution of some district level tasks, some changes have been noticed in recent years, in the implementation modality of such tasks at the district level. However, these changes are occurring at a highly slow pace and as such are hardly been felt by respective agencies. The Institutional Mechanism for Intergovernmental Transfers

Introduction of formula based grant distribution system demands considerable management inputs on the part of the central agency. This demands a separate empowered unit at the center, a commission or an institution. The unit should be politically unbiased and autonomous in its function. The unit will carry out the regular functions as well as those that need to be done periodically. The following are the specific functions that such a responsible Unit needs to undertake as regular functions.

Communication to stakeholders

- Communicate stakeholders about the formula and the funds. The stakeholders to be communicated include the central government (communication upward) and the recipients of the grants (communication downward). Communication upwards will focus on giving feedback on the system obtained and providing with justification for determining the grant pool. Communication downwards would include transparency about the formula itself and informing about the size of the grant pool and grant amount to the local bodies.

Management of the grant scheme and implementation support mechanisms

- Phasing of formula based grant implementation plan. As discussed earlier the formula based system can better be successfully implemented in phases. The Unit would have key role to play in this regard. The unit has to administer the formula by adopting the suggested adjustment modality in the first two years. For this, firstly it has to collect information and compute the transfer amount that the LBs are entitled as administrative, block and incentive grants and inform the LBs by the end of Kartik of a given fiscal year. The information should contain the facts and figures used for the district, and the elements and their respective weights assigned. The Unit has also to make a 35-days provision for appeal if the LBs are not satisfied with their share of the grants, especially incentive grants. Having acted upon the appeal, as applied, a final decision on the grant should be made by the middle of Poush and release final grants figure by end of Poush so that the DDCs would be able to make an informed discussion during their annual Council Meeting, which normally should take place in the month of Falgun as per LSGA.

- Update data, carry out simulations, and adjust the amount that each LB is entitled to obtain in a year. Some data are to be updated annually, others periodically. The Unit should be vigilant enough to update the relevant data, as they are available. Development of the information system and its management is part of the process. Use of indices in formula involves processing of primary information and computing. Especially in case of performance indicators a data obtained might be challenged by recipient local bodies, which need to be timely resolved.

- Divide the pool into various funds. Based on regular updates of the data and the divisible grant pool the unit needs to divide the pool into various funds as recommended. The fund should then be divided among eligible local bodies based on the formula. The Unit should then clearly ascertain the total amount of grant a local body is entitled, with breakdown of the fund by each category of fund.

- Identify capacity development needs. The Unit is supposed to identify capacity development needs of local bodies. The Unit is effective if it can facilitate local bodies to identify their capacity needs particularly on the critical aspects that the LB, such as,

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revenue collection, better planning and management, management information system and monitoring of projects / programs as well as accounting and auditing etc. Similarly the Unit should be able to furnish with critical information in relation to capacity building needs of LBs to enabling agencies.

- Accountability and oversight of provisions. Grants have varying types of accountability provisions, which should be overviewed by a responsible Unit.

- Monitor and evaluate effectiveness and impact of the grant formula. No formula is static or foolproof. New circumstances may emerge that influence the nature of expenditure needs. The parameters of the formula need periodic review to enable new circumstances to be taken into account. The changes should be objectively justifiable. For this one must monitor the effectiveness and impact of the formula and its factors. The responsible Unit should carry out such evaluations. Besides, institutional arrangements should also be made for a periodic evaluation of the effectiveness of expenditures and the quality and standard of services provided by respective LBs receiving grants based on the formula. This will help feed back the adequacy of the fund received by LBs for service provision and utilization of such funds.

- Identify issues for deliberations and carry out studies. Occasional studies are required to see the relevance of the transfer system. For this a responsible Unit must identify issues, prepare a plan of actions, carry out studies and incorporate the information in a meaningful way.

- Review the formula at least at an interval of every 3-4 years. For this an in-depth study is likely. The Unit should be responsible to review and if necessary revise the formula.

Coordinating donor and national funding of resources

Besides national resources, a significant amount of resources are being funneled in a variety of programs directly through the multilateral and bi-lateral international donors and NGOs and INGOs, with or without the knowledge of LBs. It is extremely important to coordinate and streamline these resources for the betterment of the respective jurisdiction of LBs. Such programs can have both positive and negative effects. Often times, a number of donor funds similar programs in the jurisdiction without the knowledge of each other with the result that the same community or sometimes the person get involved in many similar programs at a time. Such duplication of programs and inefficient utilization of funds needs to be minimized. The list is not exhaustive but an indicative of the extent of functions such a Unit should be regularly doing. Currently the MLD has at least two Units for this purpose. Local Governance Support Division looks into the functions related to DDCs and VDCs and the Municipality Support Division is providing its support to Municipalities. It is recommended to review the organizational and human resource capacity (in terms of system and human resource number and skills) and assess if these Units need to be reorganized or can do the necessary tasks and functions with the current structure, and organizational processes and human resources. Local Body Fiscal Commission LBFC), as noted earlier, is another institution with in the government, which is supposed to provide independent views on LB particularly in the implementation of fiscal decentralization. It can be one strong candidate institution to take up the job provided, it be made fully independent and equipped with the necessary manpower and budget.

5.2 Institutional Set-up

The effectiveness of an intergovernmental transfer largely depends upon a sound institutional set-up. The institutional set-up congenial to an effective intergovernmental transfer corresponds to a set-up that espouses decentralized governance in general. Several studies and reports have consistently mentioned measures to make the process of decentralization and decentralized service delivery effective (LAFC, 2000; Ligal et.al, 2004). Some of the most relevant and crucial factors are pointed here that facilitate the formula based grant system.

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Restructuring of local bodies

The size and number of local bodies are decided on an ad hoc basis. Experts have pointed out that the number of DDCs and VDCs can be reduced. The criteria for formation of Municipalities can also be reviewed. The transformation of VDCs into Municipalities is believed to have been based on criteria that are often loosely followed. As such there are huge differences among Municipalities on characteristics such as population, area, physical infrastructure development and so on. The existing system of providing an equal amount of grant to VDCs gives incentive to make smaller units which needs to be corrected. The local bodies at present appear more as administrative units of the central government than an autonomous Local Body in true sense with its own socio-economic-administrative standing. In such a situation it is difficult to design a scientific formula for transfer of resources. Issues have been raised if the electoral process of the local body Board is appropriate. It is noted that the some Board members – particularly the Vice-Chairperson, Vice-Mayor and Vice-President – do not find enough role for them to play. The same person in local bodies has to play the role of legislature and executive, so the mechanism of upholding accountability along with authority and responsibility is affected. If there is no clearly defined role of the Local Body officials, and appropriate system of check and balance of authority and responsibility, then it is not sure that the citizens get the benefit of decentralized governance. Define expenditure assignments and revenue assignments for local bodies

At present it is not clear what are the services that local bodies are expected to provide exclusively since there is great overlap of responsibilities across the level of governments. As a result it is difficult to assess what is the minimum expenditure need of the local bodies. When the expenditure needs is unclear then it is difficult to design an appropriate transfer formula. It is therefore essential to delineate specific functions that LBs must undertake in each sectoral area. Define program planning and financial management practice

As noted by an earlier study the normal reports and documents of LBs do not categorically show the allocations and expenditure of local bodies for specific purposes such as salary or non-salary; recurrent or capital; and on sectoral areas such as agriculture, education, health, roads. Often such information is difficult to gather because financial information is documented mostly for accounting purpose. The funds-flow mechanism of the devolved services are getting clear, but there are still some areas of confusion (e.g., Why is DDC involved to release the fund for Primary Teachers‘ salary if the school is not handed over to LBs? Why should District Education Office manage Primary teacher‘s payroll if the service is considered to have been devolved? How one can say that the agriculture and livestock extension services are devolved if the expenditure authority lies with the Secretary of Ministry?). According to the existing practice, the salary of VDC secretaries is considered as administrative grant to DDCs, which is not justifiable. Some central agencies, such as the Poverty Alleviation Fund, channel their budget completely by-passing the local bodies, while others such as the Road Board channel through local bodies. Stakeholders have also suggested that it is useful to prepare guidelines for the use of conditional grants, and norms for the use of unconditional grants. These issues need to be addressed to make the financial management practices more effective. The fund-flow mechanism of the proposed Sectoral Funds has to be worked out in line with the spirit of fiscal decentralization. It is recommended that the modalities of its operation of such a fund should be clearly spelt out.

Define functional linkages between local bodies and line agencies

It is difficult to assess the expenditure needs of the local bodies in sectoral areas unless their functional relationships with the line agencies are delineated and areas of LBs sole

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responsibilities are sorted out. When the expenditure needs is not ascertained then it is of little use to devise an intergovernmental transfer system. In this context, it is essential to review the linkages envisaged by LSGA and other documents and harmonize the relationships if there are areas of improvement. In case of sectoral areas where the linkages and relationships are adequately defined the implementation aspect has to be made effective. Strengthen the capacity of LBFC

The organizational capacity of LBFC is crucial to make the fiscal decentralization process more effective. This agency is to work independently drawing on lessons from theoretical underpinnings and practices all over the world. LBFC is not supposed to act as an agency that merely appreciates the decisions of the government but as one that is not driven by the existing policy or administrative direction. For this LBFC should be made truly independent institution and its image projected as an independent institution among stakeholders (as against presently where most stakeholders view it as an unit within the MoLD). Two aspects are important to make LBFC independent institution. One of them is appropriate number and level of professionals, and another is continuous sharpening of skills and exposure to the professionals at LBFC. The study observes that there is a need to make special arrangement for strengthening capacity of LBFC and local bodies to make the grant system operationally effective. Therefore, the team has stressed the need to continuously monitor and implement capacity enhancement programs for LBs. One possible mechanism would be the establishment of "Capacity Development Fund". Such a grant fund can be used, among others, for strengthening the Information and Documentation Center of LBs, strengthening MIS at center, and enhancing skills of personnel at LBs and LBFC.

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CHAPTER VI

EXPENDITURE NEEDS OF DEVOLVED SERVICES Following the budget speech of FY 2001/02, HMG/N started devolving some of the basic services to LBs and local level Management Committees. Accordingly, primary health care services provided through sub-health post, primary education and agriculture and livestock extension services were devolved from FY 2002/03 on a phase wise manner. In the course of devolution, services of higher level such as health post in the case of primary health services and lower secondary and secondary school in case of education have also been devolved in few districts. More recently HMG/N has devolved infrastructure sector involving rural roads, small irrigation and small drinking water projects to DDCs. According to the latest information available, HMG/N has transferred 1273 primary schools, 160 Lower Secondary Schools and 67 Secondary Schools to local level School Management Committee (SMC) (DOE, 2004). Similarly, in health up to the end of FY 2060/61, 1156 Sub-health Posts, 11 HP and 6 PHC have been devolved across 25 districts. In the present chapter measurement approach of expenditure needs are reviewed. Existing national minimum standards set by the government for the provision of services such as health, education are examined. In health, the review is limited to Health Post and in education it is confined to Lower Secondary and Secondary Grade. Based on the review of measurement approaches, the framework for the estimation of expenditure need has been discussed and expenditure needs of the selected devolved services are quantified. It should be mentioned here that the estimation of expenditure needs does not capture the resource requirement of LBs for discharging all expenditure assignments. Rather the present exercise is limited to estimating the resource required to render the services of some selected devolved sectors more particularly, the services of health post, lower secondary and secondary education and rural infrastructure.

6.1 Expenditure Needs Assessment: Measurement Approaches

Various measurement approaches have been developed for assessing the expenditure needs of government.22 All the approaches rely on certain norms. Budgetary norms and expenditure norms are widely followed while assessing expenditure needs. Budgetary norms are either based on the cost of inputs, the quantity of outputs or some measure of desired outcomes. Expenditure norms are considered to be very useful in the design of intergovernmental transfers. Likewise, formula based and indicators based norms are common in practice for assessing the expenditure needs. However, both suffer from the problem of choices. In developing grant formula there is a problem of choice whether to include capital or current expenditure or both in the formula. Expenditure needs assessment through indicator-based approach requires use of wide varieties of indicators and involves the problems of selection of indicators and weights to be assigned to each of them. Some approaches of expenditure needs assessment relate to national level while others are more appropriate for the sub-national level. At the sub-national level expenditure needs are largely affected by size of population, the presence of population groups requiring special services, maintenance and replacement of infrastructure and congestion of population, among others. According to Moore and Rhodes (1981), an appropriate methodology for assessing the expenditure needs at sub-national level should possess four characteristics: legal, rational, feasible and simple. Three common approaches are widely followed in the estimation of expenditure needs.

22

For the extensive discussion on various approaches of expenditure needs practiced internationally refer to James Alm and Jorge Martinez – Vazquez 's: On the Use of Budgetary Norms as a Tool for Fiscal Management, George State University, Andrew Young School of Policy Studies Working Paper 02-15, May 2002

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A. Conventional Expenditure Approach

This approach is based on actual experience of the governments relating to actual government expenditure in various service categories. The process involves: first, minimum required expenditure in different service categories is determined on a per resident basis. It is based on the assumption that actual expenditures reflect the appropriate standard. Service categories include areas such as education, health care, social services, transportation etc. Second, these per capita amounts are adjusted upward or downward on the basis of specific population, geographic, or infrastructure characteristic that are thought to affect the cost and/or the quality of service provision. Lastly, the estimated per resident expenditure norm in each category is multiplied by the size of the population of the given area and then totaled across all expenditure categories. This gives the total expenditure needs for the sub-national government. This is a supply side approach. However, the demand for such services may vary. Even the spillover demand from adjacent district/VDC Ilakas has to be adjusted. The existing actual per unit expenditure plus some adjustment for quality improvement can provide estimates for a minimum expenditure required. B. Unit Cost Approach

Unit cost approach tries to estimate the cost of providing a defined standard of services in a respective jurisdiction. This approach assumes service delivered to a defined number of people residing in a specified geographical area. The problems associated with unit cost approach are: first, the approach is unable to capture the differences in "need" among local governments. Secondly the applicability of unit cost approach depends upon how adequately the standards of services are defined. C. Regression Analysis Approach

This approach is considered as the most sophisticated approach to the estimation of expenditure needs. This statistical tool uses actual expenditure data to impute explicit weights for need based on demographics and other characteristics of the local bodies. This method allows us to take into account differences in prices, differences in level of efficiency in provision of services and in differences in government regulations. However, the method provides only a relative measure of need in the group of local government included in the regression. The relevance of this approach to developing countries is very limited due to the fact that in these countries central government imposes expenditure norms and LBs lack budgetary autonomy at the sub-national level. Besides, there is a lack of adequate statistical information in the application of the technique (Vazquez, 1999: Website: The Assignment of Expenditure Responsibilities: Web). Review of international experience clearly shows that there is no single best approach to construct expenditure norms (Alm and Martinez, 2002). Perhaps the most basic issue in the assessment of expenditure needs is the actual construction of the norms. It has been argued that in measuring local expenditure needs and providing resources to local governments physical norms should not be used in the budget allocation process. Instead local government grants should be allocated using financial norms that consider number of potential customers and other measures of variations of cost and local needs.

6.2 Framework to Estimate Expenditure Needs

Assessment of expenditure needs, to a larger extent, depends upon the minimum standards set for service delivery. We have relied more on rules based or technical standards (For the types of minimum standards please refer to the following discussion). In the present chapter unit cost approach has been followed to estimate the expenditure needs of selected devolved services. The process involves (i) identification, reviews and update of minimum service standards developed by the government (both technical standards and general guidelines); (ii) quantification of physical inputs on the basis of certain assumptions (iii) costing of all the inputs with required adjustment (iv) obtain the average population to be served; (v) obtain per unit cost

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of service outlet and cost per population and (vi) obtain the total expenditure needs by multiplying the per capita cost by the total number of service outlets/population.

6.3 Setting Minimum Standards/Norms for Service Provision

In the provision of services to the public, countries set their own minimum standards with a view of ensuring quality services to the people. Minimum standards are a set of goals for service delivery with the purpose of ensuring a measure of equalization in functional service delivery by different levels of government across geographic jurisdiction. Standard and norms ranges from very detailed technical standards to general guidelines. Standards also define the inputs in terms of human resource, infrastructure, instruments, equipments and logistics needed for delivering the defined services. Minimum standards are of basically two types: Rules Based Standards and Performance Standards.

A. Rules Based Standards: This type of standards is often set through legislation. Their measurement occurs technically through detailed specification of the way in which the service is provided or financially as inputs and outputs. Standards set are ‗Technical‘, ‗Input‘, or ‗Output‘. Technical specifications of standards detail every aspect of service delivery and are legally binding. They are used for quality control or for public safety reasons.

B. Performance Standards: This type of standard sets goals on the results of service delivery. They are often measured as outcomes. Therefore, they are known as ‗Outcome Standards‘.

The choice of one or the other is dependent on the constitutional and political system. However, in the case of national priority areas such as education and health, technical standards are more common in practice. The legal and constitutional autonomy of the local government determines the extent to which central government can set minimum standards for local level compliance. Standards tend to have immediate budgetary implications on the part of central government. In the context of devolution of services to local government, the standards will serve as the basis for determining the amount of grant to be provided by the center to the local bodies. Grant and fiscal transfer system affects the ability of central government to enforce minimum service standards. Review of documents has revealed that only in the case of Health Post standards/norms are set and quantified. In education the standards/norms are poorly set and not adequately quantified. The existing standards/norms have been widely discussed with the service provider at health posts and schoolteachers as well as with other stakeholders. Existing standards/norms were thus reviewed and required improvements have been suggested.

6.4 Review of Existing Standards: Health Post

In order to ensure that basic quality health services are available to the common people through service outlets, HIMDD under DHS has set standards/guidelines for various levels of health care institutions. Separate standards/guidelines for HP have been set. The standards set are in respect to human resources, physical infrastructure, equipment and medical consumables. These standards formed the basis for establishment, staffing and provision of health care equipment and drugs in HP (MoH, 1995). HP is the second tier in the hierarchy from below of the health service delivery institutions in Nepal. It is responsible for providing health services in an integrated way through preventive, promotive and curative service and treatment of minor ailments. HP provides basic primary health care in the respective catchments area either directly or through referral. It conducts outreach clinic for 4-5 days in a month at selected catchments areas. Purpose of outreach clinic is to increase accessibility to health services to a maximum number of people possible through mobilization of village leaders, social workers, mothers group and grass root level health workers as well as community health volunteers such as FCHV, TBA. Standards include provision of HP in each Ilaka. The area of service coverage of HP ranges from 5-15 VDCs depending upon the coverage of the Ilaka and the terrain of a particular district. Rationale for establishing HP in each Ilaka is to make health services accessible more easily to

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the people. Standards are also set for the types of health services to be provided, location of service outlet to be established, service hour, provision of manpower including their tasks, types of essential drugs and quantity of drugs to be procured and stored and list of items to be carried in out-reach clinic. Standards are also set for other medical consumables. Minimum service standards of HP set by Ministry of Health and suggestions for improvement in the existing standard has been presented in Table6.1. Table 6.1: Summary of Service Standards/Guidelines of Health Post

S. No

Service Elements Existing Standards/Norms Remarks Recommended standards/Norms

1. Service coverage One HP in each Ilaka covering 5-15 VDC

Ilaka has been set as the norm for the establishment of HP. VDCs covered by each Ilaka varies widely between 5 to 15 VDCs. Accordingly the size of population to be served also differs significantly.

Estimated HP population ratio is 33200. But, many HPs are serving population of more than 50,000. The population paramedic‘s ratio of such HP is much higher than the national average. Such HP should receive separate treatment resource allocation and facilities.

2. Location of HP To be located centrally so that it is easily accessible to all people from the surrounding area. Availability of water supply and location of other health institutions in the vicinity also to be considered.

Norms not strictly followed. Existing norm is okay.

3 Service Hour Defined (10AM to 4 PM) 10-2 PM outdoor services After 2 PM Emergency services and other administrative and record keeping task

Defined service hours are not strictly followed.

Regular M&S required so that service center would strictly adhere to service hours.

4 Type of Health services to be provided

(i) Provide essential health care services. *It includes: Control of communicable disease, Safe Motherhood, Reproductive Health, Child Health, Nutrition, Diarrhea, ARI and Health information and Communication (ii) Conduct sterilization camp as per schedule provided by DHO. (iii) Management of epidemic and natural calamities (iv) Introduce community drug scheme (v) To run static and out-reach clinic (vi) Provide Curative Services - care and treatment of minor ailment like cuts and injuries, fever, diarrhea, dysentery, worm infestation and skin infections (vii) Normal delivery in emergency cases (viii) Emergency services and referral

Health services to be offered by HP are quite diversified. Services of environmental health and sanitation and school health program are mere listing of services and they are less functional. Service details of each program activities are lacking. In many districts Community Drug Scheme has not been introduced yet. For further details of the services offered under each type refer to MOH (1995)

Basic pathological service of routine stool, urine, and blood could be made optional.

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S. No

Service Elements Existing Standards/Norms Remarks Recommended standards/Norms

5. Provision of Health Personnel to be stationed

Manpower provisioned for HP varies by ecological regions of the country which are as follows: Terai

HA/SAHW –1 ANM* - 1 AHW – 2 VHW/MCHW** - Adm. Assistant - 1 Peon - 2 For Hill only one AHW has

been provisioned while in Mountain one additional

peon is provisioned.

Minimum qualifications of each manned staffs are specified

*Existing manpower provision is adequate provided all are posted as provisioned; *It has been reported that the post of Peon has been scraped from HP. Viewing the workload and the diversified services HP provides the post of Peon is required. *Outsourcing has been suggested as better option for hiring the services of peon; *Wherever CDS has been introduced extra manpower is required for account keeping;

6. Task of each stationed health personnel

Clearly defined See Staffs Job Description 2054,

Job description require some change to incorporate the new provisions

7. Physical Facilities (Land and Building).

5 Ropanis/10 Katthas of land is required for the construction of HP building and staff quarters. Building with rooms Examination room - 1 Treatment room -1 Adm/Regd. Room – 1 FP/MCH Room – 1 Room for Vaccination 1 Dispensary - 1 Patient waiting space -1 Store room - 1 Male/Female Toilets Staff Quarters: Depending upon the need staff quarter to accommodate 3 to 4 staffs.

Responsibility of land & building assigned to VDCs. Although staff quarters are provisioned in the standards not all HP has this facility Refer Annex Volume VI–I Architectural designs of HP building and dimensions of room prepared by HIMDD

Three additional rooms: separate administration room, delivery room and drug store room have been recommended; The norms of the provision of staff quarters should be fulfilled. This will increase in the effective use of services by retaining the staffs in the service outlet and also emergency services could also be provided

8 Waste Disposal Construct waste pit at a safe distance from HP & community. Select the site for construction of pit in such a way that ground or surface water will not come into contact with the deposit

None of the surveyed HP has waste pit constructed as designed in the service standards. Refer Annex Volume VI–II for design of a standard waste pit

Provision of budget should be made if such norm is to be adhered.

9 Type of Drugs & their Quantity

39 drugs listed as EDs. ED to be supplied and stored at HP is identified. (Refer Annex Vol VI--III for list of ED).

ED for HP is listed but not quantified. Supplied to Mountain Hill and Terai arbitrarily

ED List requires updating with few inclusions as well as exclusion. See Annex VII-IV-IV for additional drugs to be included in the ED List

10 Furniture & Other Supplies

Sizes and number required specified

Refer Annex Volume VI–III for list of furniture and their numbers

No changes required in the existing norm

11 Rubber Goods, Glasses and other Supplies

Type and quantity specified Refer Annex Volume VI–III

12. Equipments for Clinical Use

Type and quantity specified Refer Annex Volume VI– IV

13. List of items to be carried in Out-reach Clinic

Clearly defined and quantified

Refer Annex Volume VI–V For items to carry in the outreach clinic

No changes required in the existing norm

14. Health Service Management

Different aspects of health service management clearly stated and provisioned.

For details of the health service management please refer to DOHS 1995

No changes required

15 Community Participation in the Management of Health Services

Role of community in the management defined. 8 members HPMC provisioned in the devolution guidelines

See Devolution Guidelines for details of community participation

A clear guideline explicitly mentioning the function as well as the authority and responsibilities of management community should be given. Such guidelines should also

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S. No

Service Elements Existing Standards/Norms Remarks Recommended standards/Norms

clearly show the vertical and horizontal relationship with other unit and their responsibilities.

6.5 Review of Existing Standards/Norms: Lower Secondary and Secondary Education

MoES, under Education Act 2028 and Education Rules 2059 has set the standards/norms for service provision of schools. Standards are set separately for community primary, lower secondary and secondary schools. The standards are defined in terms of classroom size, layout of the classroom including height of the classroom, number of students per classroom, minimum number of teachers, furniture, play ground, compound wall and school hour. The norms are also prescribed for education materials, textbook, instructional manual and library facilities. Standards have also made provision of lavatory facilities, drinking water and first-aid facility. The standard for physical structure (building.) and physical facilities (rooms and furniture) have not been set properly as this is not expressed in quantitative terms. The standard also requires community schools to have compound wall and play ground without specifying the minimum areas for the same. Recently, MoES has issued guidelines for the distribution of grants to schools (MoES, 2061). The guidelines have specified various norms for the sake of classifying the school into three broad categories: Basic Level, Level One and Level Two. Those standards/norms include: building, classrooms, furniture, trained teachers, license holder teacher, female teachers, provision of playground, safe drinking water, and separate toilets for boys and girls, provision of demonstration board, preparation of education calendar, extracurricular activities, time table and its strict adherence etc. In this section we have reviewed the standards set for community lower secondary and secondary schools. The minimum standards set in the Education Act Amendment 2056 along with recommended norms have been summarized in Table 6.2 While costing the community LS and SS the guidelines issued by MoES for the distribution of grants to community schools have been duly incorporated wherever appropriate. Table 6.2: National Minimum Standard Set for Community Lower Secondary and Secondary School

SN

Service Elements

Existing Standards/Norms

Remarks Recommended Standards

1. . Classroom size and height

1.00 sq. Meter/student; Height 9 feet

Classroom size is inadequate

12‘*20‘ sized classroom would be better

2. 3 Layout of the Classroom

Clearly ventilated with adequate light

Norm is good Norms should be adhered

3. 4 Student Classroom Size

Defined Maximum of 50 in KV &Terai; 45 in Hill; 40 in Mountain

Student classroom ratio in Terai and Hill has been considered to be very high while in Mountain it is low

Ratio should be reduced to 25 to 30 students per class.

4. 5 Minimum Number of Teachers Required

For LS (Grade 1-8) Minimum of 7 teachers (English 1, Science/Math 1,Nepali 1, Social studies 1 and 3 other general subjects For SS (Grade 1-10) As provisioned for LS above plus minimum 3 teachers of Primary Level

Minimum qualification with required training of subject wise teacher specified

Subject wise teachers have been felt very essential. In Math and science subjects separate teachers are required. Hence the existing provision of teachers considered to be inadequate

5. 6 Selection of Head Teacher

Selection criterion set Selection criterion should be strictly followed while recruiting Head Teacher

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SN

Service Elements

Existing Standards/Norms

Remarks Recommended Standards

6. 8 Physical Facilities (Building &Rooms)

Standard not set properly Not quantified; For recommended norm see Assumption

Minimum of 10 and 12 rooms building required for LS and SS respectively. School should have sufficient space for playground as well.

7. . Furniture No standard set Refer Annex Volume VI–VI for recommended norms

3 students per bench, Bench should be 4 ft length, desk & bench should not be attached; should have drawer in each desk

8. 1 Educational Materials

Should have blackboard, chalk, duster, maps, globe, and math sets

Practice of quantifying per student is good.

A minimum threshold amount, however, should be specified.

9. Textbook Instructional Materials/Library

Should have textbook, instructional materials & library facilities

Not adequately defined and itemized

Sports and others materials should be quantified.

10. Science Lab. No standards set (Refer Annex Volume VI-VII for lists of equipments)

Standards should be set

Science labs with minimum equipments have been recommended.

11. 1 Lavatory Facilities Have separate toilets for boys and girls

Not in practice in all the schools.

This norm is required to be strictly adhered.

12. Compound Should have compound Minimum area of compound not defined

It is better to define the minimum area required for a compound.

13. Playground Should have playground & sports materials

Undefined minimum playground area

Should have adequate playground.

14. 1 Drinking Water Should have provision of drinking water

Access to safe drinking water is not satisfactory

Ensure that the drinking water is clean and safe. Periodic checks is required to ensure the cleanliness

15. First-Aid Facility Should have First – Aid Kit Box

Practice not strictly followed in view of the lack of fund

Budgetary provision should be made and list of essential medicine should be defined.

16. Teachers Training and Licensing

Teachers should be trained and license holder

MOE has already introduced the teacher licensing system.

Difficult to follow the norm immediately, Should be gradually followed specifying the deadline

17. Extracurricular Activities

Should organize extracurricular activities

Number and type not specified

Better to specify the number and type

18. 7 Community Participation in the Management of School

Role of community in the management defined. 7 members SMC provisioned and the basis of formation defined

See Devolution Guidelines for details of community participation

SMC and PTA should be made more active.

6.6 Review of Existing Standards/Norms: Rural Infrastructure

HMG/N has been providing technical supports to all the DDC by establishing a District Technical Office (DTO) at district headquarters. DTO extends its technical support to DDCs in the construction of rural/agricultural roads, small irrigation, small drinking water and other construction works commissioned in the districts. The office works under the administration of DoLIDAR. It has set standards for the construction and maintenance of rural roads by class and type of rural roads. The standards are more in the form of design standards that is presented below in Table 6.3. Such details of design standards for rural drinking water and small irrigation are lacking.

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6.7 Providers’ Perception and Suggestion for Improvement

In the present study we have assessed the level of knowledge of service providers on service standards set by the Departments of the respective Ministries. We have also solicited their views on various aspects of service standards like physical facilities (building, rooms, and furniture), drugs, equipments and medical consumables etc. Separate checklist/semi structured questionnaires were prepared for District offices of the devolved services (D (P) HO, DEO) and Service Providers at the VDC. Service providers included, Health Post, Community Lower Secondary and Secondary Schools. District offices as well as service outlet stationed at the village were visited. Officials and station in-charge and Head Master including member of SMC (in selected cases) were interviewed in-depth. Table 6.3: Design Standards of Rural Roads

S. No

Design Parameters

Class 'A' District Road

Class 'B' Village Road

Hill Terrain Hill Terrain

1. Design capacity-in both directions (Vehicle per day/T.U. per day)

200 (400)

400 (800)

100 (100)

200 (400)

2. Design speed (km per hour) 20 40 15 30

3. Right of way, either side from the road center (m) 10 10 7.5 7.5

4. Formation width (m) –includes 0.6 m drainage & 0.4m parapet which will be kept wherever needed.

5.0 6.0 4.0 4.5

5. Carriageway width (m) 3.0 3.0 3.0 3.0

6. Shoulder width, either side (m) 1.0 1.5 0.5 0.75

7. Paving the earthen surface by Broken stones or Gravel

Gravelling or Brick Soling

None None

8. Minimum radius in horizontal curve (m) 10 20 10 20

9. Maximum average gradient (%) 8 5 8 5

10. Maximum gradient (%) 12 7 12 7

11. Easing of gradient for every 500m increment in altitude (rate of easing)

0.50 - 0.50 -

12. Minimum gradient on hill roads (for better drainage) (%)

l - l -

13. Free Board from HFL (m) 0.5 0.5 0.5 0.5

14. Minimum stopping sight distance (m) 20 40 15 30

15. Cross slope in carriageway camber (%) 4 4 5 5

16. Cross slope in shoulder camber (%) 5 5 5 5

17. Carriageway width at culvert/bridge* (m) 3.0 3.0 3.0 3.0

18. Dimensions (width x length) of Lay-bye/passing zones (m x m)

3.0 x 20 3.0 x 20 3.0 x 20 3.0 x 20

19. Lay-byes/passing zone strips at interval of (m) 300 500 300 500

Adapted from DOLIDAR's Approach Manual, 1999.

Stakeholders were interviewed to assess their level of knowledge about service standards/norms and solicit their perceptions on different elements of service standards. Service Providers‘ perceptions gathered through various methods are narrated below. a) Areas to be served

The norm of one HP per Ilaka of the district has been set. That is why HPs in the country are known as Ilaka Health Post. Though in many countries population norm is followed, in Nepal this norm has not been strictly adopted. HP population ratio is not uniform across the country. This ratio tends to depend upon the VDCs covered by each Ilaka. In the 16 surveyed districts the catchment area of some HP varies from the minimum of one VDC in Kaski and Sankhusabha to a maximum of 12 VDCs in Dhanusha district. The population health facility ratio in some HP is much higher while in others the ratio is much lower than the national average of 33200. Some HPs in Gorkha district serve to a minimum of 10000 populations while in Dhanusha some HPs serve to a maximum of 50,000 populations. For such HP the existing norm of Ilaka is less practical. Service providers argued that VDCs having more than 30,000 populations should receive the facilities equal to Ilaka level service unit.

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b) Knowledge about the Service Standards

Very few service providers are familiar with the service standards set by their Departments. HP In-charges are only aware of the types of health services offered from their service outlet. Knowledge about other elements of service standards is found to be very limited. c) Drugs/Equipments

Most of DPHO In-charge and few HP in-charge strongly viewed that the list of essential drugs needs to be updated. The list is quite old. The updating suggested in the ED list is presented separately.

ED required at HP is listed but not quantified. The quantity of drugs to be supplied to Mountain, Hill and Terai district is arbitrarily fixed.

The quantity of essential drugs supplied is grossly inadequate in all the service units. Each HP receives drugs worth of 50,000 annually. Service provider in HP observed that with the existing supply of drugs it could be managed only for 4 to 6 months. They further observed that drugs like antibiotics, iron folic, Asthalin, Albendazole, dextrose injection, disposable syringe, gloves, absorbent cotton and bandage are very much in short supply while others like Dentak, Clove Oil and Xylocaine are supplied more than required. Yet others are less useful like Tincture Benzoin.

It has been observed that ED list lacks combination drugs. The list should include such drugs as well.

Supplied drugs are of low quality and are very much close to expiry date.

Service Providers observed that some of the equipments supplied are non-functional and there is no provision of regular replenishment. They further stressed that equipment such as BP instrument; weighing machine, delivery kit, and diagnostic set are inadequate. They demanded to increase their numbers. They also viewed that dental kit and intravenous stand be provided. One small weighing machine is required for growth monitoring.

Drugs supplied from the DPHO correspond with the disease pattern of the catchments area while the drugs supplied from KFW do not correspond with the disease pattern.

d) Support Staffs

Recently, MOH has removed the provision of peon from the HP and the existing posts of peon are being adjusted elsewhere within MoH. Service providers observed that the provision of peon should be retained, as their service is very essential both for regular activities and for vertical programs as well. It has been suggested that outsourcing would be a better option for recruiting the support staff like peon.

e) Services Offered

Health services to be offered by HP are quite diversified. Services of environmental health and sanitation and school health program are mere listing of services and they are less functional. Service details of each program activities are lacking. In many districts Community Drug Scheme has not been introduced.

While fulfilling the sanctioned post service providers having the training of IUD and Norplant be placed so that these services would be provided by the HP

Basic laboratory test facility is another service the providers are seeking. However, this service is not included in the norm/standards. Norms could make this service as optional.

One of the services offered in HP is the facility of community drug scheme. In the surveyed districts CDS in various form have been introduced. In those districts where CDS has been introduced all the service providers demanded one extra manpower as CDS requires many activities from billing, dispensing of prescribed medicine, updating inventory record and introducing ‗first expiry first out‘ (FEFO) system.

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f) Physical Infrastructure

The standards of physical infrastructure in all the devolved services have not been met. Services are offered with scanty facilities. Though the standards for HP specify 8 rooms building with separate staff quarters none of the surveyed HP has adequate facilities. Some providers go beyond suggesting 10 room building that should include one additional room for emergency treatment, separate room for administration and one separate room for drug store. Lavatory facilities in the surveyed HP were not satisfactory leave alone male and female separate toilets as recommended in the norms. None of the surveyed HP has waste pit constructed as per suggested norms.

In primary schools rooms are inadequate buildings are in dilapidated state. Toilet service is inadequate and not properly maintained. There are no separate toilets for girls and boys. In many community schools visited bench and desk are inadequate and students are cramped in one bench.

g) Restructuring of Community Schools

Student school ratio in the country is quite diverse. In many community primary schools in High Mountain have very low student enrolment resulting to very low student teacher ratio. From the efficiency point of view it is advised to restructure the community primary schools for the fair distribution of schools based on the actual need of the VDCs. In such districts general schooling may not be very applicable rather some model of alternative schooling could be thought out. Re-mapping of schools has been suggested.

h) Educational Materials

Many schools surveyed demanded overhead projector and microscope. They argue that provision of such facilities would help to increase the quality of teaching in LS and SS.

i) Office Operating Expenses

The minimum operating expenses has not been fixed. The new directives of school grant distribution 2061(MoES, 2061), however, specifies the norm for stationary provision for community schools. According to the new arrangement each community LS and SS will receive annually Rs 500 per teacher for miscellaneous expenses. This amount is reportedly inadequate for one full year. Each community LS and SS will also receive annually Rs. 13,000 and 21000 respectively toward administrative expenses. But major share of the amount goes in the salary of the peon.

HP receives goods in kind which amount to about 3000 to 4000 per annum. Service provider stated that they require about Rs. 10,000 to 12,000 annually as operating expenses.

j) Human Resource Development

It has been widely viewed that health personnel require refresher training to update their knowledge and skill on regular basis. They also demanded the training of clinical methods of family planning like IUD and Norplant. Likewise the teachers of LS and SS schools observed the need of refresher training on teaching learning methods. Teachers also observed that the radio-training program has not been very effective due to inappropriate timing of the airing of the program.

6.8 Expenditure Needs of Selected Devolved Services

Attempts have been made to estimate the expenditure needs (costing) of the devolved services. The basis of computation is the standards/norms set by respective Ministries (as discussed above), which specifies the various inputs required. Although standards include several dimensions of service provision in the computation of costing of the services we have considered those items of the standards, which have cost implication. In order to have a more realistic estimate of costing we have interacted with many stakeholders to understand their views on the service provision and the associated cost for providing those services. On the basis of the existing standards and the suggestions received from service unit on standards as

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well as our own observation expenditure needs has been computed. The estimation has been made separately for 6 categories of districts as classified by HMG/Nepal (Refer Annex Volume VI-VIII). It should be mentioned here that HMG has classified 75 districts in 6 broad categories on the basis of geographic remoteness. This has been done for the more scientific provisioning of the remote and local allowances for the civil servants. The estimation of expenditure needs involves several assumptions pertaining to various inputs required. Assumptions are specific to each services devolved. Table 6.4 presents the assumptions made relating to specific components for each service devolved.

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Assumptions Table 6.4: Assumptions associated with expenditure needs estimation of each devolved services

Community School

Assumptions Health Post Lower Secondary Secondary School District Technical

Office

A. Salary Includes basic salary only

Includes basic salary only; Class II & III prevail

Includes basic salary only; Class II & III prevail

Includes basic salary only

B. Providend Fund Base case scenario, no grade included

Base case scenario, no grade included

Base case scenario, no grade included

Base case scenario, no grade included

C. Local allowance 90% employees are eligible

25% employees are eligible.

25% employees eligible.

90% of the employees are eligible

D. Building Space

(Floor Area)

3200 sq ft of area as per standard

Floor area of 3868 sq. ft. is assumed to be required following the norm of 1 sq. mt per student with the average student norm of 45 per class.

Floor area of 3868 sq. ft. is assumed to be required following the norm of 1 sq. mt. per student with the average student norm of 45 per class.

3200 sq ft of area

E. Building Construction Cost

Unit cost of Rs. 1009/sq.ft–M/H & 892 for Terai

Unit cost is Rs 444/sq.ft-M/H Rs. 582- Terai

Unit cost is Rs 444/sq.ft-M/H Rs. 582- Terai

Unit cost of Rs. 1009/sq.ft–M/H & 892 for Terai

F. Cost of Land Community's responsibility hence not included -

Community's responsibility hence not included

Community's responsibility hence not included -

DDC would provide –hence not included

G. Field Allowance/ TA/DA

Calculated as Rs. 43200 (Refer to Table 6.4 -6.6)

No field allowance/TA DA is required

No field allowance/TA DA is required

5% of recurrent cost

H. Drugs Each HP receives Rs. 50,000 worth of drugs which is adequate for 6 months

I. Rent & Office Maintenance

1% of Establishments cost

0.5% of establishment cost for office maintenance

0.5% of establishment cost for office maintenance

Rs 15000 to 20000 per month

J. Student school ratio

360 students /school ratio for computing Estb. Cost and national average of 242 of public schools for education and sports materials.

450 students/school for computing Estb. Cost and national average of 225 of public schools for education and sports materials

K. Edu. & Sports Materials (Recur)

Rs 100/student Rs 100/student

L. Type of School Public School Public School

M. SHP Coverage 5 SHP

N. Program Cost Cost of vertical program not included

Program cost like free textbook & scholarship not included

Program cost like free textbook & scholarship not included

O. Outsourcing options

Outsourcing of peon

Outsourcing of administrative staff and peon

Outsourcing of administrative staff and peon

Estimations of salary component are made on the basis of existing as well as recommended norms. The calculation of unit cost is made on a base case scenario and therefore does not include the grades. Actual total resource required by a service unit should include the grades that its employees are entitled. The cost of physical facilities, mainly building, tends to vary across the geographical region of the country. In order to estimate the building cost of schools the norms prescribed in BPEP-II

97

Master Plan has been followed, which pertains to building with CGI roofing sheet. Accordingly, the cost per square feet of floor area for schools is arrived at Rs. 444 in Mountain and Hills, and Rs. 582 in Terai. The itemized detail of cost of a building is presented in Annex Volume VI-IX. In case of Health Posts RCC roof building is assumed and the unit cost is estimated at Rs. 892 in Terai and Rs. 1009 in Mountain and Hills.

6.8.1 Expenditure Needs Estimation: Health Post

Manpower provision for the health post varies by ecological regions in the standards formulated by Ministry of Health for HP. The cost estimation for HP has therefore been made separately for each of the ecological region. While doing so district category belonging to ecological regions were considered. Costing exercise is based on the existing standards as well as the suggestions received from various stakeholders on several components of service standards. Altogether 14 districts D (P) HO officials and 14 HP officials were interviewed to solicit their views on different aspects of service standards. Their suggestions have been incorporated while doing the cost analysis of HP. It may be mentioned here that in Dailekh and Accham districts no service units were covered. Table 6.5 to 6.7 presents the costing of HP of Mountain, Hill and Terai respectively based on the existing standards/norms. The estimation shows that each HP in Nepal, depending upon the category of district it falls, will require average annual recurrent expenses of Rs 605836, Rs 512882 and 540026 for Mountain, Hill and Terai districts respectively. The average unit cost works out to be Rs 552915 per HP. It should be noted here that salary alone constitutes 70 percent of the total recurrent cost. The unit recurrent cost of the present study is at a slightly lower side as compared to the estimate of Rs. 661099 made by MTEF (NPC, 2004). Comparison of the two estimates has been constrained due to lack of itemized details in the estimation of unit cost. The present estimate is based on the assumption of base case scenario i.e. non-inclusion of grades of the staffs. The difference in the unit cost could, therefore, be attributed to the grade component of salary items, which has not been included in the present estimates. The establishment cost alone is estimated to be Rs. 3.34 million, 3.34 million and 2.96 million for health post belonging to Mountain Hill and Terai region respectively. One Health Post in the country is estimated to serve population of 40000 on an average (10 VDC x 4000 population). Average of 10 VDCs have been worked out on the basis of the set norm of HP's coverage of minimum of 5 and maximum of 15 VDCs. Considering this as the average population served by HP the per capita cost of HP turns out to be Rs 13.82. This per capita cost does not include the cost of vertical programs. Looking into the client caseload of the surveyed HP average caseload is about 20 cases per day. Assuming this as the daily client caseload of a typical HP in Nepal the unit recurrent cost of HP per beneficiary/patient works out to be Rs 88.61. A study conducted (VaRG, 1995) in 1995 estimated the unit recurrent cost at Rs 36.41. If one adjusts the yearly increment and periodic revision of the salary the estimates comes close with the present estimates.

98

Table 6.5: HEALTH POST – ANNUAL UNIT COST ESTIMATION: BASE CASE – MOUNTAIN

Cost Component No. as per

norm

Rate per month for

13 months

Local allowance according to groups of districts as categorized by MOF

Allowance (20% of basic

pay)

Clothing allowance

(for districts in A & B)

Total

Average

A B D E A B D E

RECURRENT EXPENSES

A1 Salary

A1.1 HA/Sr. AHW 1 7820 5847 4679 2000 914 1564 500 193458.5 178481 130279 117148 154842

A1.2 ANM 1 4320 3230 2585 1105 505 864 500 107096 98822 71970 64716 85651

A1.3 AHW 2 4320 3230 2585 1105 505 864 500 214192 197644 143940 129432 171302

A1.4 Mukhiya 1 3480 2835 2270 1000 450 696 500 88886 82010 59442 52824 70790.5

A1.5 Peon 3 3160 2365 1890 895 370 632 350 235044 216792 160752 142032 188655

Sub Total Annual Salary 538122 496446 364134 324288 430748

A2. TA/DA 43200 43200 43200 43200 43200

A3. Drugs 80000 80000 80000 80000 80000

A4. Office operation and service cost

A4.1. Rent and Maintenance 33388 33388 33388 33388 33388

A4.2. Office Stationary and Consumables

3000 3000 3000 3000 3000

A4.3. Water and electricity 6000 6000 6000 6000 6000

A4.4. Fuel (Kerosene) 8000 8000 6000 6000 7000

A4.5. Miscellaneous 2500 2500 2500 2500 2500

Sub Total: Office operation and services

714210 672534 538222 498376 605836

A5. HRD (Refresher Training)

Total of Annual Recurrent Expenses

714210 672534 538222 498376 605836

ESTABLISHMENT COSTS

E1. Building, space 3228800 3228800 3228800 3228800 3228800

E3. Equipments 30000 30000 30000 30000 30000

E4. Furniture 80000 80000 80000 80000 80000

Total Establishment costs 3338800 3338800 3338800 3338800 3338800

99

Table 6.6: HEALTH POST – ANNUAL UNIT COST ESTIMATION: BASE CASE – HILL

Cost Component No. as per norm

Rate per month for 13 months

Local allowance according to groups of districts as categorized by MOF

Allowance (20% of basic pay)

Total

Average

C D E F C D E F

RECURRENT EXPENSES

A1. Salary

A1.1. HA/Sr. AHW 1 7820 3331 2000 914 0 1564 165784 151414.8 139684.8 129812 147065

A1.2 ANM 1 4320 1840 1105 505 0 864 91584 83646 77166 71712 81243

A1.1. AHW 1 4320 1840 1105 505 0 864 91584 83646 77166 71712 81243

A1. 2.VHW 1 3830 1700 1000 450 0 766 81938 74378 68438 63578 72274.5

A1.3. Mukhiya 1 3480 1700 1000 450 0 696 76128 68568 62628 57768 66447

A1.4. Peon 2 3160 1420 895 370 0 632 135584 124244 112904 104912 119569

Sub Total Annual Salary 385234 350836 321136 297970 338794

A2. TA/DA 43200 43200 43200 43200 43200

A3. Drugs 80000 80000 80000 80000 80000

A4. Office operation and service cost

A4.1. Rent & Maintenance 33388 33388 33388 33388 33388

A4.2. Office Stationary and Consumables

3000 3000 3000 3000 3000

A4.3. Water and electricity 6000 6000 6000 6000 6000

A4.4. Fuel (Kerosene) 6000 6000 6000 6000 6000

A4.5.Miscellaneous 2500 2500 2500 2500 2500

Sub Total: Office operation and services

559322 524924 495224 472058 512882

A5. HRD (Refresher Training)

Total of Annual Recurrent Expenses

559322 524924 495224 472058 512882

ESTABLISHMENT COSTS

E1. Building, space 3228800 3228800 3228800 3228800 3228800

E3. Equipments 30000 30000 30000 30000 30000

E4. Furniture 80000 80000 80000 80000 80000

Total Establishment costs 3338800 3338800 3338800 3338800 3338800

100

Table 6.7: HEALTH POST – ANNUAL UNIT COST ESTIMATION: BASE CASE - Terai

Cost Component Number as per norm

Rate per month for 13 months

Allowance (20% of basic pay)

Total

RECURRENT EXPENSES

A1. Salary

A1.1. HA/Sr. AHW 1 7820 1564 129812

A1.2 ANM 1 4320 864 71712

A1.1. AHW 2 4320 864 143424

A1. 2. VHW 1 3830 766 63578

A1.3. Mukhiya 1 3480 696 57768

A1.4. Peon 2 3160 632 104912

Sub Total Annual Salary 369682

A2. TA/DA 43200

A3. Drugs 80000

A4. Office operation & service cost

A4.1. Rent and Maintenance 29644

A4.2. Office Stationary and Consumables

3000

A4.3. Water and electricity 6000

A4.4. Fuel (Kerosene) 6000

A4.5. Miscellaneous 2500

Sub Total: Office operation and services

540026

A5. HRD (Refresher Training)

Total of Annual Recurrent Expenses 540026

ESTABLISHMENT COSTS

E1. Building, space 2854400

E3. Equipments 30000

E4. Furniture 80000

Total Establishment costs 2964400

Assumptions (applicable for all three eco-regions): Grade: HMGN employees receive annual increment in their salary as grade, to a maximum

of 15 to 20 grades at the rate of Rs 80 to 120 depending upon their position. The calculation of unit cost is made on a base case scenario and therefore does not include the grades. Actual total resource required by a service unit should include the grades that its employees are entitled.

Local allowance Assumed that only 75% of the employees from outside of the districts are eligible for local allowance

TADA Average 5 SHP per HP x 4 visits/year; 2 days per visit x 3 staff + 20 days for visit to HQ @Rs 240/day

Drugs At present each HP receives drugs worth Rs 50,000 per year on an average, which reportedly meets the demand only for about 6 months. So the amount is adjusted to provide drugs adequate for the whole year with assumption that Community Drugs Scheme will be introduced in all HPs

Rent and Maintenance: 1% of establishment cost is considered for rent and office maintenance

Miscellaneous Includes communication expenses

Water and electricity @Rs 500/month; includes minimum cost for staff quarter as well

Fuel 12 to 15 liters of kerosene per month

HRD Assumed 3-5 days long refresher training to be organized at the district for which about Rs 15,000 needs to be allocated to each DPHO

Building space Floor area of 3200 sq ft is taken as per the standard of MoH; and construction cost of Rs 892 per sq ft for Terai and Rs 1009 per sq ft for Hills and Mountain. The unit cost does not include contingencies, government tax and contractors profit

Furniture Includes furniture for staff quarter. List of furniture and cost attached in Annex Volume—III

101

6.8.2 Expenditure Needs Estimation: Lower Secondary and Secondary Education

In estimating the cost of lower secondary and secondary school we have considered the school/level as the unit of estimation not the grade these two types of school represent. To make it more clear cost has been calculated for lower secondary (1 to 8 grades) and secondary school (1 to 10 grades). The estimation of expenditure needs of public lower secondary and secondary school involve several assumptions. The assumptions involved in the computation are already presented above under the title ―assumptions‖. While computing the cost the guidelines recently issued by MoES for the distribution of grants to community schools have been duly incorporated wherever appropriate. In order to make the estimation more realistic an interaction with the stakeholders (teachers, head teachers, SMC members) were made. Altogether 12 community LS and SS were visited in the 16 sampled districts. Teachers and head teachers including SMC members were interviewed in depth to seek their views on the different aspects of minimum service standards and resource requirement for the smooth functioning of the community schools. The interactions have been very fruitful in redesigning the minimum standards. Their views and suggestions have been adopted. It should be mentioned here that in the present study cost of land has not been included in the estimation as it is considered to be the responsibility of the community to provide the land for the construction of the schools. The costing of the community LS and SS has been presented in Table 6.8 and 6.9 respectively. Estimates presented in the Table show that a typical community LS school in Nepal, will require average annual recurrent expenses of Rs. 852353. Assuming the national average students of 242 per community LS school the per capita recurrent cost of student works out to be Rs 3522 The annual recurrent expense varies from a maximum of Rs 904554 in A and a minimum of Rs. 802402 for schools belonging to F category district. The average establishment cost of LS school is estimated at Rs.1.99 million with a minimum of Rs 1.90 million in Category A districts and a maximum of Rs. 2.44 million in F category. A typical community secondary school in Nepal would need average annual recurrent expense of Rs. 1.51 million. Assuming the national average students of 225 per public secondary school the per capita recurrent cost of student works out to be Rs 6720.00. The annual recurrent expense varies from a maximum of Rs 1.61 million in category A to a minimum of Rs. 1.42 million for schools belonging to F category district. The average establishment cost of SS is estimated at Rs. 2.59 million with a maximum of Rs 3.15 million in F category and a minimum of Rs. 2.48 million in rest of the categories of districts. NPC has also estimated Rs. 3267 per student as the combined unit cost of LS and SS. The estimates however, lack itemized details of the cost. Further, the unit cost for lower secondary and secondary school has not been separately computed. This has made the comparison of the unit cost with the present study difficult. Considering the national average of 242 and 225 students per community lower secondary and secondary school the unit recurrent cost works out to be Rs. 3522 and Rs. 6720 for lower secondary and secondary respectively. The combined unit cost per student is estimated to be Rs. 5121. Our combined unit cost estimate for LS and SS is at the upper side as compared to NPC estimate. In our computation we have incorporated the 20 percent allowance to civil servants as announced by the government. This adjustment could explain the difference in the unit cost between our and NPC estimate. It should be mentioned here that salary component alone constitutes 92 and 94 percent of the total recurrent cost in Lower Secondary and Secondary School respectively. This clearly indicates how much meager amount has been spent to improve the quality of education in the country.

102

Table 6.8: Lower Secondary School Unit (GRADE 1-8) - Cost Calculation

Cost Component No. as

per norm

Rate per

mth for 13

mths

Local allowance according to groups of districts as categorized

by MOF

DA 20% of

pay Total Average

A B C D E A B C D E F

RECURRENT EXPENSES

A1. Salary

A1.1. HT 1 7800 5625 4650 3525 2100 900 1500 129135 126210 122835 118560 114960 112260 120660

A1.2.1 LS Teachers Class II 1 7500 5625 4650 3525 2100 900 1500 124875 121950 118575 114300 110700 108000 116400

A1.2.2 LS Teachers Class III 2 4900 3675 3038 2303 1372 588 980 163170 159348 154938 149352 144648 141120 152096

A1.2.3 PL Teachers Class II 2 4900 3675 3038 2303 1372 588 980 163170 159348 154938 149352 144648 141120 152096

A1.2.4 PL Teachers Class III 3 4100 3075 2542 1927 1148 492 820 204795 199998 194463 187452 181548 177120 190896

A1.3 Administrative staff 1 4000 800 52800 52800 52800 52800 52800 52800 52800

Sub Total Annual Salary 837945 819654 798549 771816 749304 732420 784948

A2. TA/DA

A3. Office operation and service cost

A3.1 Education materials 24200 24200 24200 24200 24200 24200 24200

A3.2 Extra curricular activities 12100 12100 12100 12100 12100 12100 12100

A3.3 Maintenance 9509 9509 9509 9509 9509 12182 9955

A3.4 Stationary and administrative costs 13000 13000 13000 13000 13000 13000 13000

A3.5 Water and electricity 1800 1800 1800 2500 2500 2500 2150

A3.6 Miscellaneous 6000 6000 6000 6000 6000 6000 6000

Sub Total Office operation and services

66609 66609 66609 67309 67309 69982 67405

A4. HRD (Refresher Training)

Total of Annual Recurrent Expenses 904554 886263 865158 839125 816613 802402 852353

ESTABLISHMENT COSTS

E1. Building, space 1719878 1719878 1719878 1719878 1719878 2254435 1808971

E2. Furniture 162000 162000 162000 162000 162000 162000 162000

E3. Education & sports materials (durable)

20000 20000 20000 20000 20000 20000 20000

Total Establishment costs 1901878 1901878 1901878 1901878 1901878 2436435 1990971

103

Table 6.9: SECONDARY SCHOOL UNIT (GRADE 1-10) - COST CALCULATION

Cost Component No. as per

norm

Rate per

mth for

13 mths

Local allowance according to groups of

districts as categorized by MOF

DA 20%

of pay Total Average

A B C D E A B C D E F

RECURRENT EXPENSES

A1. Salary

A1.1. HT 1 9540 6930 5729 4343 2587 1109 1848 158106 154502 150344 145078 140642 137316 147665

A1.2.1 SL Teachers Class II 2 7820 5865 4848 3675 2190 938 1564 260406 254306 247268 238354 230846 225216 242733

A1.2.2 SL Teachers Class III 2 7500 5625 4650 3525 2100 900 1500 249750 243900 237150 228600 221400 216000 232800

A1.2.3 LL Teachers Class II 2 7500 5625 4650 3525 2100 900 1500 249750 243900 237150 228600 221400 216000 232800

A1.2.4 LL Teachers Class III 2 4900 3675 3038 2303 1372 588 980 163170 159348 154938 149352 144648 141120 152096

A1.2.3 PL Teachers Class II 2 4900 3675 3038 2303 1372 588 980 163170 159348 154938 149352 144648 141120 152096

A1.2.4 PL Teachers Class III 3 4100 3075 2542 1927 1148 492 820 204795 199998 194463 187452 181548 177120 190896

A1.3 Administrative staff 1 6000 1200 78000 78000 78000 78000 78000 78000 78000

Sub Total Annual Salary 1527147 1493303 1454252 1404787 1363133 1331892 1429086

A2. TA/DA

A3. Office operation and service cost

A3.1 Education and sports materials (non-

durable)

22500 22500 22500 22500 22500 22500 22500

A3.2. School maintenance 12410 12410 12410 12410 12410 15751 12967

A5.2. Stationary and administrative costs 21000 21000 21000 21000 21000 21000 21000

A5.3. Water and electricity 1800 1800 1800 3000 3000 3000 2400

A3.2 Science laboratory 3750 3750 3750 3750 3750 3750 3750

A5.4. Extracurricular activities 11250 11250 11250 11250 11250 11250 11250

A5.5. Miscellaneous 9000 9000 9000 9000 9000 9000 9000

Sub Total Office operation and services 81710 81710 81710 82910 82910 86251 82867

A6. HRD (Refresher Training)

Total of Annual Recurrent Expenses 1608857 1575013 1535962 1487698 1446043 1418143 1511953

ESTABLISHMENT COSTS

E1. Building, space 2149848 2149848 2149848 2149848 2149848 2818044 2261214

E2. Furniture 277250 277250 277250 277250 277250 277250 277250

E3. Education & sports materials (durable) 30000 30000 30000 30000 30000 30000 30000

E4. Laboratory establishment 25000 25000 25000 25000 25000 25000 25000

Total Establishment costs 2482098 2482098 2482098 2482098 2482098 3150294 2593464

104

Assumptions:

Teachers Salary: Currently teachers in Public Schools are of three Types (class I, II and III).

However, for the calculation of salary Class II and III teachers are included based on the survey of selected schools. For primary level teacher‘s minimum salary of Rs 4100 is considered. Salary includes basic salary, 10% Providend fund, and HT allowance of Rs 300 and Rs 500 for PLSS and PSS respectively.

Grade: Teachers receive annual increment in their salary as grade, to a maximum of 15 to 20 grades. The calculation of unit cost is made on a base case and therefore does not include the grades.

Allowance Calculation is made based on district types with following rates: A - 75% of salary; B - 62%; C - 47%; D - 28 and E - 12% of the basic salary. Assumed that 25% of teachers are eligible to obtain local allowance.

Administrative staff A lump sum amount is provided assuming that the services will be locally outsourced

TADA Assumed that teachers do not receive TADA

Education and sports materials (non-durable)

Includes cost of chalk, duster, and consumable sports items. Calculated as Rs 100 per student. Student size is taken from the national average of 242 students per PLSS unit and 225 per PSS unit (DoE, 2003).

Maintenance: Assumed to be 0.5% of the establishment costs

Administrative costs Amount provisioned as per the guidelines of DoE for grant allocation

Laboratory expenses Calculated as 15% of the establishment cost of laboratory, which is applicable for only PSS

Extracurricular activities At least 4 extra-curricular activities per year per level are assumed. Rs 50 per student is assumed to cover the expenses

HRD: Assumed 3 to 5 days long refresher training to be organized at the district (or resource centre level) for which budget is reflected in DEO/RC budget. Therefore the cost is not included.

Building space and construction cost

Building space is calculated at 1 sq meter per student as per norm. For calculation of building space student classroom ratio of 45 is assumed resulting to total floor area of 450 sq m (or 4842 sq ft) for PSS and 360 sq m (or 3873 sq ft) for PLSS. Building construction cost for Hills and Terai is estimated at Rs 444 and 582 per square feet respectively (description attached). For the sake of calculation the rate for Terai is used for districts in F category and that for Hills is used for all other districts. The unit cost does not include contingencies, government tax and contractors profit.

Furniture As per the list of items and estimated cost attached. Includes furniture for science laboratory for PSS. The total cost of furniture for LSS is proportionately reduced from the cost of secondary school.

Education and sports materials (durable)

The cost includes development of playground and durable items such as poles and net

Medium Term Expenditure Framework III under the aegis of National Planning Commission (NPC) estimated the unit cost of lower secondary and secondary school. The estimated unit cost is Rs. 3267 per student. The estimates however, lack itemized details of the cost. Further, the unit cost for lower secondary and secondary school has not been separately computed. This has made the comparison of the unit cost with the present study difficult. The unit recurrent cost of lower secondary school is estimated to be Rs. 3125. Likewise for secondary school it is Rs 7392. The unit cost per student of Lower Secondary and Secondary School, taken together, stands at Rs. 4852. This estimate is based on the assumption of the total enrolment of 135 students in LS and 90 students in secondary school. Our unit cost estimate for LS is very close with that of the estimates of NPC for LS. However, in the case of Secondary school our estimate is quite high. The average figure of Rs 4852 per student works out to be much closer than secondary school estimate alone.

105

6.8.3 Estimation of Expenditure Needs: Rural Infrastructure

In the process of devolving basic services to LBs HMG/N has devolved infrastructure sector involving rural roads, small irrigation and small drinking water projects to DDCs from the FY 2004/05. In this section attempt has been made to estimate the unit costs of rural roads, small drinking water and small irrigation. The study also solicited views from the Engineers working at the district office of different services including DTO on various aspects of design standards and associated cost in the construction of services. Our estimates are thus based on the design standards set by respective Ministries and their Departments and the interaction we had with the stakeholders at the surveyed districts. Obviously the estimates involve several assumptions including technical specifications, which are discussed below.

A. Rural Roads

According to approach manual of DoLIDAR, rural roads have been defined as the road, which connects one or more VDC centers or growth centers (market, tourism center, industry, etc) or several VDCs with the headquarters of the same/neighboring district directly or through the National Strategic Road Network. Rural roads are basically fair weather, labor based, local resource oriented, environment friendly techniques and in accordance with the HMG/N decentralized, participatory approach. Rural roads are classified into five broad categories and the unit cost is expected to vary by type of roads. For the details of the categorization of rural roads please refer to DoLIDAR Approach Manual 1999. The cost of rural roads is greatly affected by (i) topographical and geological conditions; (ii) labor rate and (iii) cost of construction materials. In the cost analysis these factors have been considered. Since the cost of constructing rural roads tend to depend upon topographical and geological condition in the present study unit cost of rural roads has, therefore, been estimated for Mountain/Hill and Terai separately. Table 6.10 presents the results of the unit cost analysis of rural roads in the country. Results presented in the table indicate that in Mountain/Hill Rs. 2.27 million and in Terai Rs.1.20 million is required to construct one km of rural road in the country. The unit cost is almost double for Mountain and Hill probably due to heavy earthwork excavation. Rural roads involve routine/periodic maintenance and rehabilitation. According to National Plan for Rural Road Maintenance (NPRRM), published by DoLIDAR, maintenance cost for rural roads are:

(a) Routine maintenance = Rs. 14,000/km (every year) (b) Periodic maintenance =Rs.100,000/km (once in two years) (c) Rehabilitation =Rs. 300,000/km (whenever required)

106

Table 6.10: Per Kilometer Rate Analysis of Rural Road in Nepal by Ecological Region

Mountain/Hill Terai

S.No Activities Unit Quantity Rate Amount Quantity Rate Amount

1 E/W excavation

a) Ordinary Soil Cu.m. 1000 75 75000 2150 50 107500

b) Hard Soil Cu.m. 750 90 67500 1065 60 63900

Sub Total 1 171400

c) Medium Rock Cu.m. 450 600 270000

d) Hard Rock Cu.m. 125 2550 318750

Sub-Total (1) 731250

2 Retaining Wall

a) Dry Wall Cu.m. 900 515 463500 425 1100 467500

b) Gabion Wall Cu.m. 325 1710 555750 180 1950 351000

Sub-Total (2) 1019250 Sub Total 2 818500

Total (1+2) 1750500 Total (1+2) 989900

3 Drainage structure

25% of Actual

262575 247475

Total (1+2+3) 2013075 Total

(1+2+3)

1065975

4 Other cost 13% of

Total**

261700 138576

Grand Total

(1+2+3+4) 2274775 Grand Total

(1+2+3+4)

1204551

** Other cost includes Tools, equipment, Local Supervision, Bio-engineering, Store, Stationary, miscellaneous expenses

B. Small Drinking Water

According to DoWSS, small drinking water scheme is defined as the scheme that covers drinking water facilities to not more than 1000 population. In this scheme user contributions must be 15-30% of the total estimated cost. The scheme is community based and participatory in nature. The cost of drinking water is greatly affected by technical and other general standards/norms set for small drinking water and small irrigation which is presented below :

Standard/Norms Small irrigation Schemes Small drinking water Schemes

Width Bed 20-30 cm 30-45 cm

Depth 30-45 cm Not more than 90 cm

Demand per day - 45 liter /per capita / day

Gradient 0.5-1% Not less than 0.5%

Public participation 15-30% 15-30%

Implementation Modality Users Committee Users Committee

Based on the above standards/norms per capita construction cost of small drinking water schemes has been estimated. In the case of drinking water two types of scheme viz., gravity flow and ground water scheme are considered and the unit cost has also been computed separately. Technical as well as other general specifications associated with each scheme are presented in the following table below. S.No Specifications Gravity Flow

Scheme Ground Water

Scheme

1 Population/Household to be benefited 714/145 1031/146

2 Transmission Line 3400m

3 Distribution Line 2860m

4 No of Tap Stand 23

5 Capacity of Reservoir Tank 10m3

6 No of Shallow Tube well 16

107

B1. Small Drinking Water: Ground Water Scheme

The itemized cost break down of ground water scheme with the specifications mentioned above is presented in Table 6.11.

Table 6.11: Cost Analysis of Small Drinking Water: Ground Water Scheme

S.N. Particulars Cost (Rs.)

1 Cement* 25770

2 PVC & Accessories* 63152

3 GI pipe* 5440

4 Tools* 36822

5 Construction material* 100116

6 Transportation* 380

7 Skilled labour* 172150

8 Unskilled labour* 100894

9 Staffing* 141700

10 Activities* 109200

11 Overhead* 58422

Total 814046

Per capita construction cost 790

Per capita maintenance cost* 100

*Based on RWSSFDC standards

B2. Small Drinking Water: Gravity Flow Scheme

The itemized cost break down of gravity flow scheme with the specifications mentioned above is presented in Table 6.12.

Table 6.12: Cost Analysis of Small Drinking Water: Gravity Flow Scheme

S.N. Items Quantity Units Cost (Rs)

1 Polythene pipe 5913 m 311895

2 GI pipe 347 m 100589

3 No. of Intake 1 59000

4 No. of Reservoir tank 1 84725

5 No. of BPT 11 171350

6 No. of Valve box 2 16937

7 No. of Tap stand 23 212215

8 No. of Suspended crossing (20m span)

3 41038

9 No. of Distribution Chamber 2 74754

10 Fittings* 72778

11 Cement* 146220

12 Skilled labour* 16880

13 Unskilled labour* 163445

14 Tools* 59000

15 Staffing* 203750

16 Activities* 43312

17 Overhead* 116910

Total 1894798

Per capita construction cost 2654

Per capita maintenance cost 200

C. Small Irrigation

Department of Irrigation has defined small irrigation scheme as the one that covers not more than100 hectares of command area. Unit cost of this type of scheme should not exceed Rs. 20000 per hectare. The definition further specifies that users should contribute 15 to 30 percent of the total construction cost. It is a community-based scheme having wider community participation at different stages of the work. The cost is greatly affected by technical and other general standards/norms set for small irrigation scheme has been presented above.

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Based on the above standards/norms per hectare construction cost of small irrigation schemes has been estimated. Cost has been computed considering the surface irrigation and deep boring. Technical as well as other general specifications associated with these two types of irrigation scheme are presented in the following table below.

S.No Specifications Surface Irrigation Deep Boring

1 Length of canal/kulo 2km 500m (without structure)

2 Bed width of canal/kulo 30cm 30cm (unlined)

3 Top width of canal/kulo 45cm 45cm(unlined

4 Command area 15ha

The itemized cost break down of small irrigation with the specifications mentioned above is presented in Table 6.13. Results presented in the table indicate that in the case of surface irrigation the unit cost per hectare is estimated at Rs.19,800.00 and Rs 40,000.00 in the case of deep boring. Table 6.13: Cost Analysis of Small Irrigation by Types

S.No Activities Quantity Unit Rate Cost (Rs.)

1 Earthwork in excavation in ordinary soil 1593 m3

2 Earthwork in excavation in medium rock 92 m3

3 P.C.C. work (1:2:4) 8 m3

4 Stone masonry 21 m3

5 Gabion work 69 m3

Cost Items

A Skilled labour (person days)* 49 200 9800

B Unskilled labour (person days)* 1591 150 238650

C Cement* 49 bags 500 24500

D GI Wire* 345 kg 55 18975

E Transportation* LS 5000

Total 296925

Per hectare construction cost – surface irrigation 19800

Per hectare maintenance cost** 500

Per hectare construction cost – deep boring 40000

Per hectare maintenance cost** 2500 Note: *All the quantity required is based on the interaction with DTO of surveyed districts

*Based on Department of Irrigation Norms

Comparisons of the unit cost of rural infrastructure with other estimates are presented in Table 6.14. Results are not strictly comparable due to differences in the nature of the scheme considered by each estimate. The details of the schemes are also lacking. This makes the comparison little difficult. The DoR's per km unit cost of rural road of Rs 7.5 million in Hill and 3.2 million in Terai per km is quite high as compared to the estimate of present study. The difference could be partly attributed to the width of road. The present considered 3.5m as standard norm while DoR considered 6m and 5m for Terai and Hill region respectively. Secondly, the DoR's technical standards are at a higher side causing higher cost. Yet it is difficult to account for such a high unit cost. In the present study we have adopted DoLIDAR's norm, which is much at a lower side. NPC unit cost estimate for small irrigation scheme is at a very higher side. The scheme considered seems to be is based on project level cost. Interestingly our unit cost estimate for drinking water for gravity flow type is very close with the NPC estimate. Likewise in the case of surface irrigation the unit cost estimate of the present study is very close with that of the estimate made by Department of Irrigation (Refer Table 6.14)

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Table 6.14: Unit Cost Comparison across Sources

Particulars MTEF (1)

DOI (2)

DOWSS (3)

DOR Present Study

Rural Road - Hill/Mountain/km. - Terrain km.

7,500,000* 3,200,000*

2,275,000 1,205,000

Small Drinking Water - Gravity flow scheme/ per capita - Ground water scheme/ per capita

2365 1150

5000 1500

2654 790

Small Irrigation Scheme - Surface Irrigation/Ha. - Deep boring/Ha.

3,37,000 75,000

20,000

19,800 40,000

Sources: 1.NPC, 2004. Third Medium Term Expenditure Framework (FY 2004/05-2006/07)- Main Volume, 2. DoI, Implementation guidelines of irrigation project (Nepali) 2054/055; Annual Report Part-1, 3. As reported by district engineers of the district water supply & sanitation, divisional office in selected

surveyed districts. * Earthen road, width 5m (Hill) and 6m (Terai) structures excluding bridge

6.8.4 Expenditure Needs Estimation of District Technical Office (DTO)

HMG/N has been providing technical supports to all the DDC through establishing a District Technical Office (DTO). This office extends its technical support to the construction of rural/ agricultural roads, small irrigation, rural drinking water and other construction works of the districts. The office works under the administration of DoLIDAR. There are two categories of offices provisioning two different types of manpower to be stationed in the offices. 26 districts have the provision of Senior Divisional Engineer (SDE) to head the office, while Engineer heads rest 49 district offices. DTOs are active in rendering services like survey, engineering design, cost estimation, construction and supervision of all infrastructure work within the district. Itemized costing of DTO has been made for DTO with SDE. The standards/norms of the DTO have not been properly listed and quantified. The study covered 18 DTO offices of the surveyed districts. The office in charge including other technical staffs was interacted about various technical norms set by various Ministries and cost of construction of various rural infrastructure services. On the basis of the interaction, norms/standards have been developed for DTO building, equipments, and furniture. The costing made in the present study is based on the recommended norms. The estimation of expenditure need of DTO headed by SDE has been presented in Table 6.15. The computation of the estimation assumes certain assumptions pertaining to inputs required which are separately indicated in Annex Volume VI--X. The average recurrent cost is estimated at Rs.2.66 million with the maximum of Rs 3.26 million in category A to the minimum of Rs. 2.16 million in category F district. The average recurrent expenditure required for DTO headed by Engineer is estimated at Rs. 1.83 million with the maximum of Rs 2.12 million in 'A' category and minimum of Rs. 1.55 million in F category. The average establishment cost of DTO is estimated to be Rs 4.29 million with the maximum of Rs. 4.35 million in A to E category and minimum of Rs 3.97 million for F category of districts. Expenditure needs of the devolved services by type of districts have been summarized in Table 6.16. It is obvious from the table that both the recurrent and establishment cost is high in category A and tend to decrease as one move from A to F category. This is attributed to the higher remote/local area allowance in the service units belonging to those districts.

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Table 6.15: District Technical Office with Senior Divisional Engineer – Unit Cost Estimation Cost Component No. as

per norm

Rate per

month for 13

months

Local allowance according to groups of

districts as categorized by MOF

Allowance (20% of

basic pay)

Total Average

A B C D E A B C D E F

RECURRENT EXPENSES

A1. Salary*

A1.1. S DE 1 8650 6488 5363 4066 2422 1038 1670 212935 200790 186777 169028 154080 142870 177747

A1.2 Engineer 2 7500 5625 4650 3525 2100 900 1500 370500 349440 325140 294360 268440 249000 309480

A1.3 Overseer 7 4900 3675 3038 2303 1372 588 980 847210 799053 743487 673103 613833 569380 707678

A1.4 Sub-overseer 5 4100 4100 3230 2585 1840 1105 820 561700 514720 479890 439660 399970 340300 456040

Technician 2 4100 4100 2835 2270 1700 1000 820 224680 197356 185152 172840 157720 136120 178978

Accountant 1 4900 4900 3675 3038 2303 1372 980 134260 121030 114150 106212 96158 81340 108858

Administrative 1 4100 4100 3230 2585 1840 1105 820 112340 102944 95978 87932 79994 68060 91208

Peon 3 3160 2370 1959 1485 885 379 632 234156 220846 205488 186036 169654 157368 195591

Sub Total Annual Salary 2697781 2506179 2336063 2129171 1939849 1744438 2225580

A2. Field Allowance and TA/DA 150000 150000 150000 150000 150000 150000 150000

A3. Operation and service cost

A3.1. Maintenance and rent 200000 200000 200000 200000 200000 200000 200000

A3.2. Stationary and consumables 100000 100000 100000 100000 100000 100000 100000

A3.3. Water and electricity 30000 30000 30000 30000 30000 30000 30000

A3.4 Fuel 25000 25000 25000 25000 25000 25000 25000

A3.5 Contingencies 10000 10000 10000 10000 10000 10000 10000

Sub Total Office operation and

services

515000 365000 365000 365000 365000 365000 390000

A4. HRD (Refresher Training) 50000 50000 50000 50000 50000 50001 50000

Total of Annual Recurrent

Expenses

3262781 2921179 2751063 2544171 2354849 2159439 2665580

Recurrent cost of DTO headed by

Engineer

2126718 2021532 1901901 1759857 1641912 1550268 1833698

ESTABLISHMENT COSTS

E1. Building, space 3228800 3228800 3228800 3228800 3228800 2854400 3166400

E2. Furniture 210500 210500 210500 210500 210500 210500 210500

E3. Machinery and equipments 910600 910600 910600 910600 910600 910600 910600

Total Establishment costs 4349900 4349900 4349900 4349900 4349900 3975500 4287500

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Assumptions Staff DTOs are of two types – one headed by SDE and others by Engineer. The former type is

confined only in 26 districts. The number of other technical staffs also varies by category (Dolidar 2056). In DTOs headed by SDE there are provisions for 2 Engineers, 7 Overseers and 5 Sub-overseers. DTOs headed by Engineer have provisions for 1 Engineer, 5 Overseers, and 3 Sub-overseers only. Technicians, accountants and peons are same for both types. For the sake of calculation of staff the type headed by SDE is considered. The recurrent cost should be correspondingly adjusted.

Salary Includes 20% of basic salary as special allowance for 12 months as recently announced by HMGN

Allowance Calculation is based on district types with following rates: A - 75%; B - 62%; C - 47%; D - 28 and E - 12% of the basic salary. Assumed that 90% of staffs are eligible to obtain local allowance.

TA/DA A lump sum amount of Rs 150000 per year

Rent A lump sum amount Rs 200000 per year

HRD: Training on Autocad, GIS, required; Assumed about 2 persons trained every year from a DTO and a few staff participate in experience sharing workshop

Furniture As per list and price attached

Machinery & equipments

As per list and price attached

Building space Building construction cost for Hills and Terai is estimated at Rs 1009 and 892 per square feet respectively (description attached). 8 rooms with floor area of 3200 sq ft will be required for building construction. The cost of land not included in the estimates.

* The staffing level of DTO is taken from the norms as defined by DoLIDAR. In many surveyed DDCs its technical staffs are found placed under DTO. In the process of assessing the possibility of adjusting the DDC Technical staff under the defined norms no common views were found among DDCs. More recently the responsibilities of DTOs seem to have widened along with the process of devolution of rural infrastructure. In this context the staffing norms of the DTO needs to be revisited and an appropriate staffing level, including the DDC technical staff, should be determined.

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Table 6.16: Summary Table of the Unit Cost of Devolved Services according to Category of Districts in Nepal and Comparison with other Estimates

Devolved Services District Category Average

unit cost

Catg. A Catg. B Catg. C Catg. D Catg. E Catg. F (in Rs)

A. Health Post – Mountain

Recurrent Cost 714210 672534 538222 498376 605836

Establishment/Capital Cost 3338800 3338800 3338800 3338800 3338800

B. Health Post – Hill

Recurrent Cost 549322 524922 495224 472058 512882

Establishment/Capital Cost 3338800 3338800 3338800 3338800 3338800

C. Health Post – Terai

Recurrent Cost 540026

Establishment/Capital Cost 2964400

D. NPC Estimate– Health Post 661099

E. Unit cost of HP/Beneficiary(Patient)

88.61

F. Per capita cost* 13.82

G. Community LS School

Recurrent Cost 904554 886263 865158 839125 816613 802402 852353

Establishment/Capital Cost 1901878 1901878 1901878 1901878 1901878 2436435 1990971

H. Commu. Secondary School

Recurrent Cost 1608857 1575013 1535962 1487698 1446043 1418143 1511953

Establishment/Capital Cost 2482098 2482098 2482098 2482098 2482098 3150294 2593464

I. Unit Cost LSS/student 3522

J. Unit Cost SS/student 6720

K. Combined Unit Cost 5121

L. NPC Combined Estimate 3267

M. DTO

Recurrent Cost with SDE 3262781 2921179 2751063 2544171 2354849 2159439 2665580

Recurrent cost with Engineer 2126718 2021532 1901901 1759857 1641912 1550268 1833698

Establishment/Capital Cost 4349900 4349900 4349900 4349900 4349900 3975500 4287500

N. Rural Infrastructure

Rural Roads -- Mountain/Hill -- Terai

2274775 1204551

Rural Drinking Water -- Gravity Flow/per capita -- Ground Water/per capita

2654 790

Small Irrigation -- Surface Irrigation/per ha -- Deep Boring/per ha

19800 40000

* The per capita cost is calculated on the basis of minimum recurrent expenditures, which does not include various program costs incurred in providing essential health care services at the HP level.

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CHAPTER VII

CONCLUSION AND RECOMMENDATION The present study has two main research themes. One is to review the existing grant distribution system and formula to the local bodies in Nepal and recommend suitable approach and system for distribution of all central grants to the local bodies. Another is to estimate the unit cost of selected devolved services. This chapter focuses on the key findings and recommendations associated with these themes.

7.1 Review of Present Grant Distribution System

The study reviewed the principles and practices of intergovernmental transfer, the existing grant system and formula, and carried out consultation with stakeholders at the district and central level. The observations and comments on various issues are presented in the concerning places throughout the report. Most of the recommendations are also presented in the specific sections. In this section the key conclusions of the study and the specific recommendation are presented. a. Overall Transfer System The intergovernmental transfer system in Nepal is not scientific. It is mostly adhoc in nature. The purpose of the transfer, amount to be transferred, and the basis of transfers are neither based on a sound system nor transparent to the recipients. Systematic determination of the divisible pool for block grant transfers is one of the characteristics of a sound system. The divisible pool of resource in Nepal is annually approved by the parliament and is determined on the basis of negotiations or at best, on the tradition. Undefined size of the divisible pool has problems in terms of predictability of the transfer amount and thus to prepare annual and medium term plans by the local bodies. The analysis of the grants to local bodies as against national economy reveals that the grant amount (including the development fee to Municipalities collected from custom points) comes about 7.5% of national internal revenue less debt servicing cost. This calculation takes into account two things that might attract explanations. One is that debt-servicing cost is deducted from the total revenue. This is done with an assumption that this amount is at the disposal of the state to allocate for services to citizens. Secondly, it includes the development fee, which Municipalities receive. This is because the nature of development fee fits with a block grant transfer in all respects. Sectoral grants transfers to local bodies are very limited. With devolution of services in an increasing trend DDCs receive some sectoral grants, which is based on historical amount that respective line agencies used to spend. The expenditure assignment of the local bodies is under constant review, which makes it difficult to assess the expenditure needs of the local bodies, and therefore to define the purpose of the block grant. However, it is commonly understood that the block grant is for:

catering, as a state agency, to the service requirements of citizens in areas where central agencies are not providing services;

operating as an autonomous entity with some regular functions and services of its own;

providing services in addition to what central government is providing uniformly across the nation, and

taking up additional social and infrastructures development activities in the service area of the concerned LB‘s priority.

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Recommendations As discussed above, inter-governmental transfer consists of three fundamental things, namely choice of divisible pool, formula based distribution system and monitoring and accountability of the transferred resources. All these have to be done in a transparent and unbiased manner. As such, first, it is recommended to make the divisible pool systematic and tied up with the national revenue. The study recommends determining the size of the divisible pool to be 10% of the national internal revenue after deducting the amount for debt servicing. This is recommended considering the current level of resource transfer to local bodies, and in view of a need to have additional funds during the transition period, as well as the international practices. It is to be noted that the amount does not include the volume of resources HMG agencies and offices spend directly for different developmental activities, awareness programs and service delivery etc., in the district. This percentage share may increase over time, as government devolve more and more function/ task to local bodies. The study suggests to treat the distribution of development fees to Municipalities as a kind of grant (or, shared revenue base) and to use the same formula for block grants for distribution of this grant as well. It is also recommended that a specific purpose fund be created for sectoral expenditures and to institute a system of distribution of these funds to local bodies. b. DDC Block Grant System HMGN has been providing block grants to DDCs. The block grants package has primarily three components: administrative, conditional and unconditional grants. From the recent past the MoLD has initiated the practice of lumping of several conditional grants into the unconditional grant heading. It is noticed that MoLD treats the salary and perks of VDC secretaries as central administrative grants to DDCs. This arrangement will underscore the grants to VDCs and inflate that of DDCs. Since last two years, an interim formula has been developed and practiced for distribution of block grants to DDCs. The formula consists of four factors, namely HDI distance (1-HDI) with 50% weight, population and cost factors each carrying 20% weight and area carrying 10% weight. Consultation with stakeholders on the formula and factors reveals that it should be improved. The key reasons are HDI is an impact level indicator therefore it does not reflect the needs for services. Further HDI distance in the formula is not used in combination with the population of a district; therefore it treats two districts with similar HDI equally even if one has many times more population than other. Moreover, the cost factor is largely an educated estimation with no sound basis. The grant system to DDCs does not take into account of the performance or good practices by DDCs. The grant system is neutral to all district – fully complying rules and regulations or not and also performing or not. This shows the system supporting non-performing and less transparent DDCs at the cost of others. What this approach misses is that such a bias can also be a disincentive to do better and mobilize more resources. In this sense the current system is considered biased against good performance and development. The study carried out regression analysis of the pattern of the existing grant for its explanation with use of different factors. The factors that were identified based on suggestions of the stakeholders, literature survey and observation are: DDC classification, HDI, human poverty index, infrastructure index, cost factor, and population below poverty. The regression analysis showed four factors (population, population below poverty, cost factor and area) together explaining over 95% of the amount of grant. Therefore they were considered as appropriate factors to be included in the formula. The selection of factors in the formula is based on national level survey data and as such has minimum chances of biasness.

Recommendations The study recommends creating three grants funds: administrative, general-purpose, and incentive grants. While the administrative grant is conditional, other two are unconditional block

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grants. The administrative grant be distributed on the basis of the actual costs of current level of staff supported, salary and office expenses. The study recommends dividing the block grant into two: The general-purpose grant consisting of 80% of the block grant amount and incentive grant with 20% of the block grant amount. The general-purpose grant is recommended to be distributed based on formula with following factors and weight. Grant to a DDC = 15% for Area + 15% for Population + 35% for Population below poverty + 35%

for Cost factor

While the general-purpose grant is biased for poor DDCs, incentive grant is formulated for rewarding good performance and better results. For distribution of the incentive grant it is recommended to develop a simple 50-point performance measurement index (PMI) consisting of 25 indicators in 5 key performance areas, namely governance, planning and budgeting, operations management, financial management and fiscal discipline, and adoption of transparency and accountability practices. Incentive grant should be disbursed on the basis of a formula that measures the performance score of each district in the previous year. DDCs should be given the right to appeal if they are not satisfied with the assessment. This grant should be distributed only among the eligible or performing DDCs with say a score of 50 in the PMI and more. ( A suggested allocation formula is given in the chapter above) The study recommends implementing the formula based grant transfer system in phases. Since there may be considerable amount of changes in the amount of grant a DDC will receive according to the prescribed formula, full application of the same in the first year itself can create tensions and adjustment problems to DDCs, particularly to those that are receiving more grants than the recommended formula suggests. Therefore, it is recommended that the implementation be phased in two years before the formula based system becomes fully effective: Say 60% of the grant amount adjusted in the first year and 100 % in the second year. The Grants allocation formula should not be taken as a rigid formula. Rather, as the survey data is updated and new information are available the Weightage should be updated. Looking at the nature of the factors used and the periodicity of new data, it is recommended that the formula be updated only in every 3 to 5 years. This will provide predictability on the grant system and accordingly, DDCs may feel comfortable in resource projection for annual planning and budgeting. c. Municipality Grant System HMGN has been providing block grants to Municipalities. The block grants package has primarily three components: administrative, conditional and unconditional grants. The administrative grant consists of the salary and perks of the centrally deployed staffs. Municipal unconditional grant at present does not include the fund that HMGN transfers from the development fees levied on the imports of goods at the custom points. There are guidelines for distributing these grants (provisions such as no development grant to Municipalities that collecting above 10 million as internal revenue, and that the development fee is distributed proportionately on the revenue on Octroi before it was abolished). However, regression analysis of different factors on the present level of grants to municipalities shows no any discernable pattern. The basis of distributing grants to Municipalities is ad hoc. This means, municipalities obtain the funds based on their capacity to mobilize their access and power. It is noticed that though the mechanism of collecting development fees has replaced the Octroi, not all the revenues from development fee collected in a year is distributed. Similarly the ratio of distribution has also been felt as distorted and needs improvements.

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Municipalities in Nepal are strongly in favor of formula based grant system. However, there is a range of suggestions by stakeholders with regard to the factors and their Weightage to be included in the formula. Broadly two types of factors are suggested. One type suggests making the formula pro-poor (development needs, backwardness, population, area) and another type suggest making it more performance based. Both of these concerns cannot be accommodated in the same formula therefore two separate funds can be considered. The study carried out regression analysis of the pattern of the existing grant for its explanation with use of different factors. The factors that were identified are: area, population, internal revenue, infrastructure index, and cost factor. None of the factors were good at explaining the grant. This suggests highly ad hoc grant distribution practice. About one-third of the explanation was provided by population, internal revenue per capita and infrastructural index.

Recommendations The study recommends including the amount distributed as grant from the development fees as block grant. The fund is collected by the central government and distributed to Municipalities, the latter do not have a say on the rate and base, and they do not have to put effort for this. These facts qualify the grant to be taken as block grant. The study recommends creating three grant funds: administrative, general-purpose, and incentive grants. While the administrative grant is conditional, other two are unconditional block grants. The administrative grant will be distributed as what is currently being done. That is based on calculation of the actual costs based on current level of staff etc. It is recommended to divide the block grant into two: The general-purpose grant consisting of 80% of the block grant amount and incentive grant with 20% of the block grant amount. The general-purpose grant should be distributed based on formula with following factors and weight. Grant to a Municipality = 60% for Population + 25% for infrastructure index + 15% for per capita

revenue

While the general-purpose grant is biased for weak Municipalities, incentive grant is formulated for rewarding good performance and better results. For distribution of the incentive grant it is recommended to follow PMI prepared for DDCs. This grant should be distributed among eligible municipalities proportionately to their scores in the PMI. The study recommends implementing the formula based grant transfer system in phases. Since there may be considerable changes in the amount of grant a Municipality will receive according to the prescribed formula, full application of the same in the first year itself can create tensions and adjustment problems to Municipalities, particularly those that were receiving more grants than the recommended formula suggests. Therefore, it is recommended that the implementation be phased in two years before the formula based system becomes fully effective: 60% of the grant amount adjusted in the first year and 100 % adjusted in the second year.

d. VDC Grant System

The VDCs receive grant from central government in two forms. One is the lump sum grant of Rs

500,000 per VDC, distributed on an equal basis. The lump sum grant has primarily two

components: administrative and unconditional block grant. Another is the salary and perks of the

VDC Secretary. Unjustifiably, this is shown as DDC administrative grant. Equality basis of block grant transfer is considered not efficient and equitable. It is inequitable because it is not doing justice to VDCs who have high population concentration and wide area to serve. It is not efficient in allocation terms because resource would not be going to where it is needed most and technically also it is not efficient because such a system gives undue incentive to create smaller jurisdictions.

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VDCs in Nepal favor formula based grant system. However, there is range of suggestions by stakeholders with regard to the factors and their weight to be included in the formula. Some even cannot think of making formula based system for VDCs because of the sheer number of VDCs. Everybody agrees that formula for VDCs should be very simple using factor for which data are available at the national levels. The study carried out scenario analysis of the grants for VDCs in three districts (one each in Mountain, Hill and Terai) using area, population and VDC classification as possible factors. The result was satisfactory.

Recommendations It is recommended to adopt a formula based distribution system to VDC as well. The grant fund be divided into two main headings: administrative, and block grant. The salary and perks of VDC Secretary should be reflected in the VDC administrative grant and not in the DDC grant. The calculation of the VDC Secretary administrative cost etc., is recommended to be continued as present. Distribution of block grant is done on a formula with the following factors and weight. Grant to a VDC = 85% for population + 15% for VDC classification + 10% for area Formula for providing grants to VDCs was noticed unfavorable for VDCs that are also DDC headquarters. In such a case, special provision should be made to top-up the resources to such VDCs for carrying out the extra load of work as being the district head quarter. The study recommends implementing the formula based grant transfer system in two steps before the system fully effective. As a first step, adjustment of some 60% of the grant amount is recommended in first year and the rest adjusted in the second year. The VDCs assert that they need at least a minimum sum of amount to operate as a state institution. Therefore, it is logical to define a thresh hold limit of say, Rs 300,000 as the minimum amount a VDC will be receiving. If based on the formula, a VDC allocation turns out to be less than the thresh hold amount, it will receive Rs. 300,000. e. Suitability of Introducing Performance Based Grant System to Local Bodies Performance based grant provision is a new practice in Nepal. Only since last year, Decentralized Financing and Development Program (DFDP) have developed a performance based grant scheme. This initiative has taken a new step to introduce performance based grant system in Nepal. The concept and system of performance based grant distribution to DDCs is appreciated by most stakeholders and recipient DDCs. In fact, the stakeholders, including the DDC have strongly opined that the grant system of HMGN should reward better performance and punish worse. However, with regard to the adoption of the same system for all grants, the stakeholders have pointed out a need for further refinements. The existing system adopted by DFDP is considered demanding in terms of management efforts, time, and resource needs. According to this system, an external team of experts is required to visit each LB annually and carry out joint assessment with a team designated by the LBs. This is a considerable job even to carry out the assessment of 75 DDCs and 58 Municipalities, not to mention about 4000 VDCs.

Recommendations

The study recommends creating an incentive grant fund and rewarding the LBs for their better performance. The incentive grant system should use an adapted performance measurement tool, as recommended in the text, to make it more manageable to use in the general grant distribution system. f. Resource Equalization of DDC It is agreed by all that resource equalization of DDCs should be aimed to achieve. This aspect has become all the more prominent when it is observed that DDCs across Nepal are receiving a disproportionate amount of funds through shared resource provisions, especially after the

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revenue-sharing from hydroelectricity power started. It is also observed that DDCs differ in revenue raising potentials because of differences in resource endowments. A segment of stakeholders maintain that equalization of resources should rather ignore the resource differences due to local tax efforts. They argue that if a DDC raises more revenue through local tax efforts then it is because of additional services the DDC has committed to citizens. So such amount cannot be included in the figures used for equalization scheme. However, revenues for which DDCs do not need local tax efforts e.g., shared revenue through royalty should be taken into account. Analysis of equalization needs requires information about expenditure assignments and revenue assignments. Then calculation of expenditure gap followed by revenues will give the resource gap (surplus or deficit) of local bodies. The gap is what is required to be met by equalization grants. As obvious, this can be done only after investigating the resource potential of DDCs along with its expenditure needs.

Recommendation

Since the present study does not investigate the resource potential of the LBs, it will be premature to assess the resource gap and suggest the amount of resources required as equalization grant. It is therefore, recommended that a thorough study be carried out investigating all the potential of revenue sources of LBs and estimates the resource gap. g. Possibility of Grant Formula from DDC to VDC and Municipalities The study also inquired the possibility to develop formula for distributing grants to VDCs and Municipalities from DDCs. The field observation and interaction suggested that DDCs normally do not distribute grants to Municipalities and VDCs on a regular basis, nor they are mandated to do so. Most of the DDC funds going to VDCs or Municipalities were found to finance DDC projects in those jurisdictions. A few DDCs were found to have been giving block grants to VDCs and conditional grants to Municipalities. Such grants, if any, are found to be determined on the basis of negotiation rather than through any other systematic means. Therefore, there is no rationale for developing a grant formula for the purpose.

Recommendation

Since, DDC grant to municipalities and VDCs are not a regular feature, design of a grant formula is not required for the purpose. Let DDC provide resources based on the task devolved or the development activities it wants to carry out in the respective LBs jurisdiction. However, care should be taken that the resources thus transferred for the purpose should fully cover the cost. It is noticed that in some cases DDC share the cost of the task carried out by municipality outside its jurisdiction, say for running fire fighting equipments outside municipality area, on the basis of negotiation between them. This should be continued. Any spillover benefit reaped by neighboring jurisdiction should fully be compensated to sustain the quality of services. Therefore, either the neighboring LB or DDC should compensate the cost of such services. h. Creating Funds at the Central Level It is opined that special purpose funds have potentials to become effective in a decentralized system. Quite a number of funds (example: Poverty Alleviation Fund, Road Board, Tourism Development Board) are presently operating in Nepal. The objective of such funds should not be competing but should be complementing. The activities of such specifically tasked fund should not be duplicative rather, it should, in a responsible manner, gradually take over field level such activities from other agencies saving resources of central government for other important activities not carried out by the fund.

It is also observed that the operating mechanisms of these funds are not properly linked to the

local bodies, rather in some cases; it marginalized the role of LBs. In a decentralized context, it is

important that the LBs be given its due role.

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Recommendation

The study recommends creating different Funds for financing sectoral services. These funds should operate involving local bodies in the decision making, field operations and monitoring and evaluation. The study therefore, recommends to review the functioning of different Funds, including its act and regulations to align their operations with that of local bodies. A formula based transfer system can also be established in case of such funds.

i. Management and administration of the grant system Management and administration of the formula based grant system is a demanding task. To undertake the identified responsibilities, a responsible Unit at the central level is considered necessary. In the current system, two units within the MoLD, the Local Governance Support Division and Municipal Administration Division, are handling the system. The LBFC is acting as the advisory body in broad policy matters. The existing level of capacity of LBFC and the local bodies is considered weak. Hence a need of strengthening the management capacity of the institutions is strongly felt.

Recommendation The study recommends creating a responsible autonomous unit at the center to carry out the administrative and management function of the grant system. As noted earlier, such system should be unbiased and politically not intervening. Local Body Fiscal Commission, if adequately empowered and staffed can work as the central unit managing and administering the grant system. It is recommended that a Capacity Development Fund at the central level be created, and such fund should be exclusively used for strengthening organization and management capacity of LBFC and local bodies. In short, while designing the intergovernmental transfer formula it should be noted that

A. Besides being equitable , the formula must be simple, transparent, and predictable,

B. It should discourage fiscal laxity and provide hard budget ceiling to the recipient local body for realistic planning,

C. It should devoid of political pressure and should be seen to be objective , progressive and flexible enough to accommodate changing socio-economic situation,

D. It should use national level data and update formula periodically, and

E. The management of the formula should preferably be entrusted to an independent body with government commitment to ensure release of fund allocated.

To conclude, ―Even when the transfer system is formula based, it may not subserve the objectives if, the design of transfers creates perverse incentives. Thus, if the transfers are designed to perform ―fiscal dentistry‖, they can only induce larger budgetary cavities; designing transfers to fill the budgetary gaps of the states can only encourage fiscal mismanagement. Avoiding perverse incentives in designing transfers and imparting objectivity and flexibility to the transfer systems are as important as targeting the transfers to fulfill the economic objectives in the design of transfer systems.‖

7.2 Unit Cost Estimation of Selected Devolved Services

The unit cost estimation shows that each HP in Nepal, require average annual recurrent expenses of Rs 605836, Rs 512882 and 540026 for Mountain, Hill and Terai districts respectively. The average establishment cost of HP is estimated at Rs. 3.34 million in Mountain and Hill and Rs 2.96 million in Terai. The unit cost estimation in education shows that a community LS school in Nepal will require average annual recurrent expenses of Rs. 852353 and establishment cost of Rs. 1.99 million. Likewise, a typical Secondary School in Nepal would need average annual recurrent expense of Rs. 1.52 million and establishment cost of Rs 2.59 million. Unit cost estimate of rural roads indicate that in Mountain/Hill Rs. 2.27 million and in Terai Rs.1.20 million is required to construct one km of rural road in the country. In the case of

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drinking water the per capita construction cost is estimated at Rs. 790 for ground water scheme and Rs. 2654 for gravity flow scheme. In the case of surface irrigation the unit cost per hectare is Rs.19,800 and Rs 40,000 in the case of deep boring. The average recurrent expenditure required for a typical DTO headed by Senior Divisional Engineer and Engineer is estimated to be Rs. 2.67 million and Rs. 1.84 million respectively. The average establishment cost of DTO is estimated to be Rs 4.29 million.

Service Standards/Norms Estimation of expenditure needs based on more realistic norms is expected to deliver public services more efficiently and effectively. Minimum service standards set for Health Post are quite comprehensive. However, for lower secondary and secondary school and rural infrastructure the standards are very sketchy. Standards/norms clarifying the details for technical and general standards are lacking. This has caused problems in estimating expenditure needs. Clear standards/norms (both technical as well as general), encompassing all the elements is very essential. Government Departments are required to immediately act on this. Very few service providers engaged in HP are aware with the service standards set by Department of Health Services. HPs in charges are aware of the types of health services offered from their service outlet. However, knowledge about other elements of service standards is found to be very limited. Service providers should, therefore, be made aware with the standards of the service provision. For the establishment of service outlet administrative unit has been considered as the norm not the population size. In many countries population norm is followed for the establishment of service outlets. In Nepal the population size varies significantly across VDCs. Some of the VDCs in the country have the population size of more than 30000. Such VDCs should receive additional facilities. From the viewpoint of access and quality service it is desirable to follow population basis. Norms specify that the service outlet should be located centrally among the wards of the VDCs so that it is easily accessible to all people residing in the VDCs. In practice this norms is not followed widely. In order to increase the access to services the norm set should be strictly adhered. Health services to be offered by HP are quite diversified. HoH has already introduced the package of essential health care services at various levels of service delivery. The FP services of clinical methods such as IUD and Norplant have been made optional depending upon the availability of trained manpower and logistics support. It has been reported that there has been a growing demand for such FP services. In view of this the authority could give a serious thought in introducing this service at the HP level by making provision of trained staffs and required logistic supports. Service details of every component of essential health care services at HP levels are lacking. In the context of the devolution of services details of each component should be made operationally clear as far as possible. Services of environmental health and sanitation and school health program are mere listing of services. Efforts should be made to make the service more operational. Essential drug required at HP is listed but not quantified. Essential Drug List requires periodic updating. Most of DPHO in charge and few HP in charge strongly viewed that the list of essential drugs needs to be updated. They observed that the ED list lack combination drugs. The list should include such drugs as well. Supplied drugs are reportedly of low quality and are very much close to expiry date. While supplying drugs these factors should be taken into consideration. Due to central procurement system the service out let has often experienced the shortage of medicine. Medicines supplied are not based on prevalence of disease. MOH should consider giving the authority to HP in charge and the management committee for local procurement. However, some mechanism should be developed so that only quality medicine is procured.

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The quantity of essential drugs supplied is grossly inadequate in all the service units. Service provider in HP observed that with the existing supply of drugs worth of average Rs 50,000 annually services could be managed only for 6 months. The quantity of drugs or amounts should be increased so that service could be made more effective. It has also been reported that some of the equipments supplied are non-functional and there is no provision of regular replenishment. Equipment such as BP instrument, weighing machine, delivery kit, and diagnostic set are inadequate. The number of such equipment/instruments is expected to increase the quality of service. The minimum operating expenses has not been fixed. The amounts Service Centers are receiving are grossly inadequate and should be enhanced. It has also been complained that sometimes Department tend to supply less useful equipments. In view of the lack of proper training on the application of such equipments they remain ideal. It is therefore desirable that HP technical staffs should be provided training on the use of such equipments. The position of ANM has remained unfulfilled in many service outlets. This has been currently hampering the services of safer motherhood in the service centers. MoH‘s policy to provide intensive training of 15 months to MoHW and upgrade their services into ANM is an attempt in right direction as this effort is expected to meet the shortage of ANM in the service outlets. In this regard minimum qualification to be eligible to obtain the training should be specified considering the minimum qualification of ANM. It has been reported that the post of Peon has been eliminated from HP. Viewing the workload and the diverse services HP provides the post of Peon should be retained. Their service is also essential for successfully carrying out the vertical programs as well. It is recommended that the service of peon be locally outsourced. This arrangement is expected to increase the efficiency of services. HPs are demanding extra manpower for the smooth functioning of the program. Examining patient, writing prescription, providing medicine and maintaining the inventory of medicine as per CDS requirements by one single person is really burdensome. Wherever the CDS program has been introduced the need of extra manpower should be assessed Job description for each staff stationed in the service outlet must be clearly mentioned. The standards of physical infrastructure have not been met. Though the standards for HP specify 8 rooms building and separate staff quarters none of the surveyed HP has adequate facilities. Services are offered with scanty facilities. Some providers go beyond suggesting 10 rooms building that should include one separate room for administration and another for conducting deliveries. There are no separate toilets for male and female as recommended in the norms. None of the surveyed HP has waste pit constructed as per defined norms. The situation is not different for other service units. In lower secondary and secondary schools rooms are inadequate; buildings are in dilapidated state, and classroom furniture is inadequate. Adequate budgetary provision should be made to meet the minimum required facilities. The Education Act 2028 and subsequent Education Rule 2059 have set standards/norms for establishing the schools. The standard for physical structure (building) and physical facilities (rooms and furniture) have not been set properly as this is not expressed in quantitative terms. The norm of 1 sq meter per student of classroom size has been felt inadequate. Instead the minimum size of classroom should also be specified. Likewise, no norms have been set for science laboratory facilities at Secondary school. The norms make the provision of one teacher for both science and mathematics. Considering the quality of teaching at the secondary school it is better to have a provision of separate teachers for mathematics and science. The need of extracurricular activities has been pointed out. However, the number of extracurricular activities and their types are not specified. It is suggested that the number and types of extracurricular activities to be organized during the calendar year should be specified. There has been lot of misunderstanding among the school teachers regarding the objective of the government to handover the schools to SMC. In order to avoid such confusion the government should issue a white paper highlighting the objectives and other associated aspects of the program. The Teachers Unions are not fully supporting the program. Government should

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address their concerns so that school handover process would receive momentum and at the same time would be smooth. Devolution guidelines of schools and health facilities should explicitly mention the function as well as the authority and responsibilities of management committees. The guideline should also clearly show the vertical and horizontal relationship with other unit and their responsibilities. The Local Service Commission Rule being drafted is expected to clear the doubts in the service provisions. The role of Local Bodies has been bypassed in the process of devolution of schools to SMC. Local Bodies should be involved in the process of devolution and subsequently their functions and responsibilities should be clearly delineated in the management of the school under the SMC. The operational relations between DTO and DDC are not well defined. It is not found uniform across districts. In some districts DTO has been functioning as the technical wing of DDC while in many other districts such a smooth relation is yet to be established. Decision making power and fund flow mechanism in the functioning of DTO also varies across district. In the present context of the devolution of rural infrastructure to DDCs it is recommended that DTO be placed under the organizational umbrella of DDC. In many surveyed DDCs its technical staffs are found placed under DTO. More recently the responsibilities of DTOs have also widened along with the process of devolution of rural infrastructure. In this context the present study recommends to revisit the staffing norms of the DTO so that an appropriate staffing level, including the DDC technical staff, could be determined.

7.3 Action Matrix

Action areas Suggested activities Responsible

agencies

1. Inter-governmental Fiscal Transfer

1.1 Link the annual grant pool for Local Bodies with net national revenue estimate to ensure progressivity and predictability of grants

1.2 Define annual grant pool for DDC 1.3 Define annual grant pool for Municipality 1.4 Define annual grant pool for VDC

NPC/ MoF/ MoLD/LBFC

1.5 Divide the annual grant pool of DDC and Municipality into three components (administrative, block and incentive) and inform respective local bodies

1.6 Review and finalize the suggested grant formula with factors and their respective weights for DDC, Municipality and VDC

1.7 Review and finalize the suggested measures for distributing incentive grants to DDC and Municipality

1.8 Introduce MTEF in LBs and provide grants in a 3-year framework 1.9 Ensure to release committed allocations to LBs for predictability

of resource and planning by LBs

MoLD/LBFC NPC/MoLD/MoF MoF/MoLD

1.10 Prepare MIS and update database for use in the grant formula 1.11 Communicate all local bodies about the design of the transfer

system (administrative, block and incentive grants) and quantification of the amounts receivable under each type of grant

1.12 Administer the formula by adopting the suggested adjustment modality in the first two years

- Compute grant amount the LBs are entitled as administrative, block and incentive and inform the LBs by the end of Kartik,

- Make a 35-days provision for appeal if not satisfied, especially for incentive grants

- Make final decisions and release final grants figure by Poush 1.13 Designate institution for administering transfer system

MoLD/LBFC LB Associations LBFC or Central Administering unit HMG/MoLD

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Action areas Suggested activities Responsible

agencies

2. Monitoring and reviewing the transfer system

2.1 Monitor the use of conditional and unconditional grants by LBs 2.2 Review the modality and effectiveness of present Sector Fund

concept such as PAF, RWSSFB, Road Maintenance Fund and assess the feasibility of these existing funds to accommodate the need of LBs

2.3 Assess the effectiveness of the transfer system once in every 3 to 4 years through various approaches (e.g., stakeholders' feedback; expert review)

2.4 Create new Funds for Rural Energy Development, Education,

Primary Health Care, and Agriculture/Livestock Extension by streamlining similar activities of different agencies and ensure to respond all LBs‘ sectoral needs through these independently managed fund

2.4 Reformulate the transfer system, if needed

LBFC / LB Associations NPC/respective fund/line ministry Grant administering unit NPC/line ministry Grant administering unit

3. Expenditure needs of selected devolved tasks

3.1 Specify the type of services to be rendered 3.2 Define/redefine the minimum service standards/norms of services

(Health Post; Lower Secondary and Secondary School; Rural Infrastructure) in the identified areas

Respective Departments/Ministry

3.3 Review and finalize the estimated unit cost of Service Units 3.4 Administer the estimated Unit Costs 3.5 Bring out action plan on devolution to minimize ad-hocism

Respective Dept /Ministry/NPC

4. Reviewing the Unit Costs

4.1 Assess the soundness of the adopted Unit Cost once in 2 to 3 years through various approaches (e.g., stakeholders' feedback; expert review)

4.2 Recalculate the Unit Cost to accommodate periodic changes in the cost elements

Respective Departments / LBFC/ LB Association

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109. Zimmermann, Horst (1996): ―Local Government Finance in Nepal - Option for Reform”, A Study for the Decentralization Coordination Committee and Decentralization Working Committee, Nepal and GTZ Project ‗Urban Development through Local Efforts‘, Kathmandu.

128

ANNEXURE

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Terms of Reference for Undertaking Studies to

Assess Expenditure Needs of some Devolved Services, Formulate Fiscal Transfer Modalities from the Center to Local Bodies,

and Explore the Possibility of Introducing Equalization Concept in Nepal

1. Background:

The Directive Principle of the Constitution of Nepal 1990 has recognized decentralization as a fundamental component of democratic governance. The promulgation of Local Self-Governance Act (LSGA) was the direct result of the realization made to the effect that the legislation applicable to local bodies did not provide enough powers, responsibilities and resources to the local bodies. As provided under Article 237 of LSGA, Local Authorities Fiscal Commission (LAFC) was constituted in 2000. The LAFC was mandated to conduct study and research on tax source s to be assigned to local bodies and allocation of revenue between the center and local bodies; and render policy recommendations for timely restructuring of the system of tax and accounting applicable to local bodies.

The LAFC conducted studies in 2000 and recommended a number of measures for effective fiscal decentralization including assignment of responsibilities and revenue assignment to the local bodies. Realizing the need and importance of such a commission, HMG/N constituted permanent Local Bodies Fiscal Commission (LBFC) under the convenership of Vice Chairman of National Planning Commission as recommended by the first fiscal commission. The objectives of LBFC include coordinating the implementation of the LAFC recommendations, clarifying the expenditure responsibilities of different levels of governments and revenue assignments of local bodies, development of systems of intergovernmental fiscal transfers and bringing about reforms in the accounting and revenue systems of local bodies. The Secretariat of LBFC was established in July 2003 with a full time working member secretary.

A detailed Road Map (RM) for the LBFC was elaborated and adopted in February 2003. The implementation of the activities included in the RM is expected to provide necessary groundwork to carry out fiscal decentralization in a more coordinated and consistent manner. The RM contains description of 11 major activities to be implemented by the Commission within a period of first 18 months. Out of these activities, 6 are selected for implementation during fiscal year 2003/04. The selected major activities are further elaborated into 19 assignments/studies.

One of the activities of the RM includes carrying out a study to assess expenditure needs of the local bodies. With effect from fiscal year 2004/05, His Majesty's Government of Nepal (HMG/N) has taken a policy decision to devolve infrastructure sector involving rural roads, small irrigation and small drinking water sub-projects to local bodies (LBs). This policy decision is not, however, preceded by proper assessment of expenditure needs of LBs to perform these types of additional tasks. Similarly, HMG/N has also devolved certain services presently being performed by the central government to management committees. These include devolution of primary schools (PSs) to school management committees (SMCs) and sub-health posts (SHPs) to sub-health post implementation and management committees (SHPIMC). At the time of handover of PSs, some lower secondary and secondary schools have also been handed over to SMCs. Similarly, HMG/N has also a plan to handover one health post in each district to such committees.

xxxiv

The LBFC work plan has also highlighted undertaking studies to undertake studies to formulate Fiscal Transfer Modalities from the Center to Local bodies (LBs) and Exploring the Possibility of Introducing Equalization Concept in the context of Fiscal Decentralization in order to achieve the long-term reform agenda on fiscal decentralization.

The present study shall therefore include following components:

Assessment of expenditure needs of LBs and management committees to perform the specific tasks/services (lower secondary and secondary schools, health posts and infrastructure related activities) devolved to them

Formulate Fiscal Transfer Modalities from the Center to Local Bodies and Explore the Possibility of Introducing Equalization Concept in Nepal

2. Statement of the Problem:

2.1 Assessment of Expenditure Needs:

Guidelines issued for the services devolved in each sector/sub-sector seek direct and indirect participation and involvement of LBs in the devolution process and entrust them with specified responsibilities. Although the Guidelines has clarified mechanism for the flow of funds from center to the local level, financial commitment of the central government has, however, not been explicitly mentioned therein. The provision of services requires cost. The institutions, which are handed over with the responsibilities must be reasonably compensated for that. These aspects also need to be clarified in the case of infrastructure sector handed over to LBs so that these bodies are not imposed unfunded mandates.

In these perspectives, the present study shall make a systematic assessment of cost implication of devolution process and quantify recurrent and capital needs of the organizations to which the tasks/services have been devolved/handed over.

2.2 Fiscal Transfer Modalities from the Center to Local Bodies including the Possibility of Introduction of Equalization Concept:

Formulation of Interim Formula for distribution of grants to VDCs: At present, there is lack of a system for allocating grants to VDCs numbering 3,912 spread over the 75 districts of Nepal. This is because all the VDCs are provided with equal sum of Rs. 500,000.00 per annum by way of grant from the central treasury. The present practice is not considered satisfactory since it does not take into consideration factors like area, population, level of development and cost factor. In the present allocation system, per capita grant in aid would be higher to VDCs with a lesser population and vice versa.

Seen from another angle, the need of funds to VDC with a larger size would be more as compared with a VDC having smaller size. The level of development also varies among VDCs considering the accessibility to the basic amenities of life. This will largely depend upon the location of the VDC, i.e. whether it is located in a remote or accessible area. This factor will also have an impact on the cost of development. In other words, the more remote area a VDC is situated in more will be the need of funds for development due to higher cost of building infrastructures as compared to more accessible areas. This could also be considered as one of the factors to determine the size of central grant. Based on the experience of other countries, there could be several other factors as well, which should be considered in the formulation of bases for the allocation of grant to VDCs.

Bases for the allocation of Block Grant to Municipalities: The sources of funds of Municipalities in Nepal are internal revenue, block and conditional grants provided from the center and contributions received from various donors. The internal revenue

xxxv

includes tax and non-tax sources. After the promulgation of current Local Self-Governance Act, HMG/N abolished the system of octroi being collected by Municipalities and substituted the same by local development fees levied in the import of goods and materials at custom points. The local development fee distributed by the central government is a major source of revenue of Municipalities.

HMG/N has been providing block grant to only those municipalities whose revenue collection from internal sources is below Rs. 1,000,000 per annum. The block grant provided to Municipalities is, however, determined on adhoc basis since no bases such as population, urban poverty and development requirements are considered in the determination of block grant. At best, the block grants provided at present reflect the amount of grant allocated in the past.

Improved Formula for Distribution of Grant to DDCs: HMG/N is currently employing an interim grant allocation formula to determine the quantum of annual grant to be disbursed to each DDC. The current formula takes into consideration factors like human development index (HDI), population, and area and cost factor of the respective districts. The weight given in the formula to different factors is not equal. Weight of 50, 20, 20 and 10 percent is given respectively to HDI, area, cost and population factor in this formula. At present, the cost factor included in the formula has been taken on a proxy basis and is not based on the actual study of cost factor at the field level.

Doubts are being raised regarding the greater importance given to the HDI factor without linking it with the population. Per capita allocation of grant to DDCs with higher population came to be very low as compared to the DDCs with lower population. As a result, there was substantial reduction on the amount of grant for DDCs with higher level of population and HDI. Therefore, the present interim formula of grant allocation as well as the weight given in the formula to different factors has to be reviewed carefully and reformulated based on the information at the field level. Moreover, there is enough ground to develop the cost index applicable to different districts based on the proper investigation of actual situation existing in the field.

The present formula for disbursement of block grant to DDCs is in use since the past few years and this formula was used as an interim arrangement only. It is therefore imperative to evaluate the same as regards its validity and appropriateness. Such an evaluation should be based upon the results of the study carried out regarding its impact on disbursement of grant to DDCs.

Possibility of Introduction of Equalization Concept: The capacity of generating revenues from the assigned sources is not uniform even within the same tier of LB. Among the factors, which contributed to this state of affair, includes the size and population of LB and ability to pay taxes resulting from the high or low living condition of the people residing within its territory. In addition, availability of natural resources in general and taxable resources in particular and accessibility to markets also impacts upon the capacity level of LBs to generate revenue.

The ability to pay also determines the extent to which the LB can impose tax within the limit permitted by the legislation. In the case of LBs (within the same tier) generating varying level of income from internal sources, the current level of performance should be judged in terms of lack of capacity, unwillingness on the part of LB to levy taxes and charges or due to the lower endowment level. The performance regarding the utilization of assigned sources and amount raised from local source should therefore be judged and evaluated from these perspectives and not in the absolute terms. Accordingly, initiatives should be taken to build the capacity of LBs to raise potential revenue from the existing sources. A mechanism for the substitution of short revenue of LBs with low endowment must be thought about if this proposition is not feasible.

xxxvi

From the equity point of view, it is reasonable to make the LBs with higher endowment and therefore having greater share of internal revenue to compensate LBs with lower endowment. The mechanism for such an adjustment could be through correction in the grant allocation system or through a system of pooling of resources from LBs with higher endowment for allocation of additional funds to the LBs with lower endowment.

It is in these perspectives that the LBFC intends to carry out study for the development of interim formula for the distribution of grant to VDCs, bases for the distribution of block grant to municipalities and improved formula for disbursement of grant to DDCs in future. Furthermore, it also intends to explore the possibility of introducing equalization concept into practice in the overall context of fiscal decentralization. The study is also expected to suggest the appropriate bases for allocation or adjustment of grants under this system.

3. Objective:

The overall objective of the proposed study is to assist and facilitate LBFC:

i. to make an assessment of expenditure needs, both capital and recurrent, of LBs and management committees to perform the devolved tasks/services, namely, local infrastructure (rural roads, small irrigation and drinking water), health posts and lower and secondary schools.

ii. to review present modality of grants disbursement to LBs and suggest options and methods for allocating central grant to VDCs and Municipalities as well as suggesting an improved formula for the distribution of central grant to DDCs.

4. Expected Outputs:

i. Expenditure needs in carrying out devolved tasks (rural roads, small drinking water and small irrigation as well as health posts and lower and secondary schools) of institutions to which responsibilities for providing services are devolved assessed.

The assessment should be in terms of funds requirement under different expense categories and assumptions made to derive the expenditure needs.

ii. Objective parameters, which should be considered for the allocation of block grant to VDCs, Municipalities and DDCs identified.

iii. Specific objectives of each type of central grant identified.

iv. Necessity of equalization fund in the context of current availability of different financial resources for LBs examined.

v. Measures for effective implementation of Minimum Conditions (MCs) and Performance Measures (PMs) suggested and possibility for their tie up with the grant system explored.

vi. Alternative bases/formulas to allocate central grant to VDCs, Municipalities and DDCs developed.

vii. Approaches for the creation and management of equalization fund examined.

viii. Inter-governmental fiscal transfer modalities of grants for all sectors and for all LBs recommended.

5. Methodology/Process:

The tasks as outlined in the Scope of Work will be carried out in 3 phases by following the process/methodology described below: 5.1 Inception Phase:

This phase of study is expected to require 0.50 month. A detailed questionnaire/check list/data sheet shall be designed to collect information on the

xxxvii

existing practices and cost structure to assess the expenditure needs after devolution and to ascertain the viewpoints of stakeholders on the possible methods for inter-governmental fiscal transfer and equalization.

The study team will also be required to prepare a detailed work plan and methodology of the study indicating the sample districts selected for field visit to hold interaction meetings with the line agencies and service units.

5.2 Field Work:

The fieldwork phase will be completed within a period of 3 weeks. This phase will be required to collect data, information and responses/feedback from the field to undertake tasks (iii) to (v) included under sub-point (a) and tasks (iii) to (vi) included under sub-point (b) indicated under point 6 "Scope of Work". The tasks thus accomplished shall then form baseline information for subsequent tasks (vi) to (viii) to be performed under sub-point (a) and (vii) to (x) to be undertaken under sub-point (b).

5.3 Desk Work:

The deskwork phase of the study is expected to require 2.75 months. This phase of work shall consist of two stages, the first prior to the field visit and the second after the completion of field missions. The first stage comprising 0.50 month shall be utilized by the consultants to review the existing service standards applicable to devolved tasks and review the existing conditional and unconditional grants provided from the center to LBs The pre-test of questionnaire/ checklists and data sheet shall also be carried out within the time allotted for this stage of the work.

In the second stage of the deskwork, the consultants the consultants shall analyze information collected in order to undertake tasks (vi) to (viii) included under sub-point (a) and tasks (vii) to (x) included under sub-point (b) indicated under point 6 "Scope of Work".

Of the total time period estimated for this phase of work, two week's period is assigned for the finalization of the report after receiving feedback from LBFC, other key stakeholders and experts.

In addition to the methodologies specified above, the team of experts shall hold discussions, interactions and seminars with the stakeholders and experts of the related field at different stages of the performance of their work depending upon the need of the situation.

6. Scope of Work:

The study should specifically include the following tasks in respect of each component of the Study Work:

(a) Assessment of Expenditure Needs:

i. Design a comprehensive questionnaire/check list to collect information on existing practices including norms and standards prescribed, if any, and cost structure with a view to assess expenditure needs of the organization after devolution/hand-over.

ii. Carry out field missions to line agencies and service units at sample districts, which were previously providing these services.

iii. Make an in-depth review of service standards, if any, which are applicable for lower secondary and secondary schools and health posts, devolved to management committees and the existing standard norms for the execution of infrastructure sub-projects/schemes.

xxxviii

iv. Assess the adequacy or otherwise of the existing service standards, if any, prescribed. In case there are no such standards, explore the possibility of introducing such standards.

v. Examine the existing service standards in terms of acceptable level of service provision to the local people/community.

vi. Undertake an assessment of per unit cost to perform different types of activities included in the devolved services based on the analysis of past data and information.

vii. Based on the examination done and assessment made under (v) and (vi), make a fair assessment of expenditure needs of devolved services/tasks.

viii. Design minimum norms and standard of such services, wherever practical, to provide acceptable level of quality service and estimate cost per service unit by topographical zone.

(b) Formulation of Fiscal Transfer Modalities including Possibility of Introducing Equalization Concept:

i. Design a comprehensive questionnaire/check list to collect information and feedback from LBs of selected districts.

ii. Carry out field missions at LBs of selected districts.

iii. Review and analyze the existing conditional and unconditional grants provided from the center to different tiers of LBs

A specific analysis of cost factors in the case of existing DDC grant distribution formula should also be undertaken.

iv. Identify areas/factors that need to be corrected/addressed in the existing DDC grant distribution formula.

v. Identify the specific objectives of each type of central grant including sectoral and conditional grants with special emphasis on devolved tasks and indicative objectives in the case of prospective sectors for devolution.

vi. Review MCs and PMs and suggest measures for their effective implementation and explore the possibility for their tie up with the overall grant allocation system.

vii. Design appropriate allocation criteria and formula to distribute block and conditional grant from the center to LBs and from DDCs to Municipalities and VDCs.

viii. Explore the possibility of introducing vertical and horizontal equalization concept in the context of fiscal decentralization.

ix. Design fiscal transfer modalities for grants of all the sectors.

x. Identify institutional issues and management modalities for the proposed grant systems.

7. Input and Team Composition:

7.1 The Team:

LBFC is seeking the services of a core team of experts for a period of 4.50 months. The team shall comprise experts of the following field:

Decentralization Expert

Economist

Local Governance/Institutional Expert

Financial Analyst

Each of the experts should have a strong background in the respective areas of their expertise. The experts shall be expected to demonstrate specific familiarity with

xxxix

Nepal's decentralization policy and other reforms and policy initiatives. They shall also be specially required to show their acquaintance with the studies carried out by the previous Local Bodies Finance Commission and various recommendations made by such studies.

7.2 Requirement for Each Expert:

The Decentralization Expert/Economist should have a strong background and knowledge in local governance in general and functioning of the local bodies in particular. He should also possess in-depth knowledge of the legal and regulatory framework (LSGA and other regulations) applicable in Nepal in the field of local governance. In addition, the expert/economist should also possess in-depth knowledge of the devolution process and guidelines issued in different sectors to administer devolution and special knowledge in the system of revenue sharing and inter-governmental transfer system currently being applied in Nepal.

The Local Governance/Institutional Expert should have a strong background in local governance and institutional set up and functioning of local bodies and possess in-depth knowledge of legal and regulatory framework related to local governance, which are applicable in Nepal. The expert should also possess special knowledge of devolution process and guidelines issued in different sectors to administer devolution and the system of revenue sharing and allocation of grant to LBs applicable in Nepal at present.

Financial Analyst should have a strong background in local government finance and should be thoroughly conversant in the legal and regulatory framework of Nepal applicable to local bodies. The expert should also possess in-depth knowledge in the field of financial management of LBs including accounting, flow of funds and financial reporting applicable to tasks devolved to DDCs and management committees. He should also have a special knowledge in the system of revenue sharing and inter-governmental transfer system applicable in Nepal at present.

7.3 Input:

The estimated input of the experts will be as indicated below: Decentralization Expert/Economist: 4.00 months (on full time basis)

Economist: 4.00 months (on full time basis)

Local Governance/Institutional Expert: 4.00 months (on 6 hours a day basis)

Financial Analyst: 4.00 months (on full time basis)

A sub-committee formed to facilitate the work of the study with representations from LBFC, MLD, Associations of LBs and other stakeholders will supervise and monitor the performance of the team on a periodic basis. In addition, the required number of surveyor/enumerators will assist the study team to collect information/data from the field sites.

8. Timing and Implementation Schedule:

The study will be conducted during November 2004 – March 2005. The schedule of implementation of the proposed study shall be as indicated below:

Activity Month 1 Month 2 Month 3 Month 4 A. Inception Report B. Deskwork (I Stage) C. Field Work: 1. Carry out field missions to LBs, line agencies

and service units.

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D. Deskwork (II Stage) 1. Make an in-depth review of service

standards, if any, which are applicable for tasks handed over or services devolved.

2. Assess adequacy or otherwise of the existing service standards, if any, prescribed.

3. Examine the existing service standards in terms of acceptable level of service provision to the local people/ community.

4. Review and analyze the existing conditional and unconditional grants provided to different tiers of LBs.

A specific analysis of cost factors in the case of existing DDC grant distribution formula shall also be undertaken.

5. Identify areas/factors that need to be corrected/addressed in the existing DDC grant distribution formula.

6. Identify the specific objectives of each type of central grant including sectoral and conditional grants with special emphasis on devolved tasks and indicative objectives in the case of prospective sectors for devolution.

7. Review MCs and PMs and suggest measures for their effective implementation and explore the possibility for their tie up with the overall grant allocation system.

8. Undertake an assessment of per unit cost to perform different types of activities included in the devolved services.

9. Make a fair assessment of expenditure needs of devolved services/tasks.

10. Design appropriate allocation criteria and formula to distribute block and conditional grant from the center to LBs and from DDCs to Municipalities and VDCs.

11. Explore the possibility of introducing vertical and horizontal equalization concept in the context of fiscal decentralization.

12. Design fiscal transfer modalities for grants of all the sectors.

13. Design minimum norms and standard of such services to provide acceptable level of quality service and estimate cost per service unit by topographical zone.

14. Identify institutional issues and management modalities for the proposed grant systems.

E. Draft Report

F. Comments and Feedback: 15. Organize a Workshop to present the main

findings and recommendations of the study team and finalize the report taking into consideration the feedback received.

G. Final Report

9. Reporting Requirements:

The Study Team shall be required to provide following outputs:

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a) 3 copies of Inception Report, which will include a detailed interpretation of the ToR and the study work, a description of the methodology, which will be followed and a work-plan for the study. This report shall also include recommendation for the fieldwork and selection of sample LBs.

The Study Team will submit this report within 0.50 month from the date of commencement of the study work.

b) 3 copies of draft report within 4.00 month from the date of commencement of the study work by the Study Team.

c) 3 Copies of the final report comprising all outputs included under point 4 within 4.50

months from the date of commencement of the study. LBFC Secretariat shall provide written comments on the Draft Report within 2 weeks from the date of submission of such report. In addition, written comments from experts of the related field shall be sought through LBFC. The Study Team shall finalize its Draft Report duly addressing issues raised and suggestions provided during workshop/seminar and written comments provided by LBFC and the experts.

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Annex IV-I

Key Characteristics of DDC and Amount of General-Purpose Grant According to the Existing

and New (Recommended) formula

S.N District Area

(Sq km)

Pop Hum. pov

index 2001

Pop below

poverty

Rural pop

HDI 2001

1-hdi 2001

Infrastructure index

Classification

New cost scale

Amount (in 000) as

new formula

(Model 3)

Amount (in 000) as of existing

formula

1 Achham 1680 231285 59.2 136921 231285 0.350 0.650 8.950 4 2.5 4635 4637

2 Arghakhanchi 1193 208391 40.5 84398 208391 0.471 0.529 14.507 3 1.5 2813 3589

3 Baglung 1784 268937 35.7 96011 248085 0.492 0.508 15.456 3 1.5 4261 4393

4 Baitadi 1519 234418 48.7 114162 216073 0.391 0.609 14.357 4 2 4319 4487

5 Bajhang 3422 167026 59.9 100049 167026 0.331 0.669 13.066 4 2 4631 4915

6 Bajura 2188 108781 56.4 61352 108781 0.310 0.690 10.737 4 2.5 4644 5116

7 Banke 2337 385840 34.4 132729 328305 0.479 0.521 20.911 1 1 3132 3723

8 Bara 1190 559135 45.5 254406 526875 0.465 0.535 27.051 1 1 4560 4109

9 Bardia 2025 382649 43.2 165304 336638 0.429 0.571 28.416 2 1 3410 3697

10 Bhaktapur 119 225461 29.9 67413 105167 0.595 0.405 50.801 1 1.5 1801 2548

11 Bhojpur 1507 203018 43.6 88516 203018 0.472 0.528 10.387 3 2 3946 4145

12 Chitwan 2218 472048 31.9 150583 344934 0.518 0.482 28.681 1 1 3483 3559

13 Dad'dhura 1538 126162 46.2 58287 107772 0.434 0.566 12.863 3 1.5 3439 4116

14 Dailekh 1502 225201 52.5 118231 205755 0.381 0.619 8.539 3 2 4343 4482

15 Dang 2955 462380 41.4 191425 385378 0.409 0.591 17.224 2 1.5 4187 4071

16 Darchula 2322 121996 45.4 55386 121996 0.424 0.576 13.204 3 2.5 4644 4834

17 Dhading 1926 338658 47.7 161540 338658 0.410 0.590 15.893 3 1.5 4235 4394

18 Dhankuta 891 166479 34.4 57269 145811 0.507 0.493 18.279 2 1.5 2306 3104

19 Dhanusha 1180 671364 41.4 277945 597172 0.449 0.551 27.504 1 1 5068 4269

20 Dolakha 2191 204229 44.0 89861 182313 0.450 0.550 16.710 2 2 5180 4829

21 Dolpa 7889 29545 61.9 18288 29545 0.371 0.629 9.210 4 3.5 6817 6526

22 Doti 2025 207066 53.4 110573 185005 0.402 0.598 10.196 4 2 4384 4519

23 Gorakha 3610 288134 41.7 120152 262351 0.454 0.546 12.559 3 1.5 5181 4926

24 Gulmi 1149 296654 39.4 116882 296654 0.467 0.533 15.863 3 1.5 4359 4445

25 Humla 5655 40595 63.8 25900 40595 0.367 0.633 10.540 4 3.5 6203 5995

26 Illam 1703 282806 33.7 95306 266569 0.521 0.479 18.299 2 1.5 3262 3733

27 Jajarkot 2230 134868 57.2 77144 134868 0.343 0.657 8.557 4 2.5 3905 4526

28 Jhapa 1606 688109 29.2 200928 585895 0.494 0.506 25.160 1 1 4328 4037

29 Jumla 2531 89427 56.8 50795 89427 0.348 0.652 12.667 4 3.5 5583 5555

30 Kavre 1396 385672 33.5 129200 332766 0.543 0.457 20.596 1 1.5 3777 3878

31 Kailali 3235 616697 39.5 243595 510528 0.442 0.558 20.850 1 1 5216 4532

32 Kalikot 1741 105580 58.9 62187 105580 0.322 0.678 7.543 4 3.5 5495 5564

33 Kanch'pur 1610 377899 35.2 133020 297060 0.463 0.537 25.710 2 1 2883 3393

34 Kaski 2017 380527 24.9 94751 182846 0.593 0.407 21.146 1 1.5 3560 3313

35 Kathmandu 395 1081845 25.8 279116 369164 0.652 0.348 53.389 1 1.5 6172 2795

36 Khotang 1591 231385 42.8 99033 231385 0.442 0.558 11.504 3 2.5 4157 4357

37 Kapilvastu 1738 481976 48.5 233758 454806 0.437 0.563 20.323 2 1 4334 4070

38 Lalitpur 385 337785 25.0 84446 174794 0.588 0.412 37.487 1 1.5 2322 2421

39 Lamjung 1692 177149 37.5 66431 177149 0.492 0.508 18.446 3 1.5 2698 3460

40 Mahottari 1002 553481 50.6 280061 531435 0.407 0.593 21.819 1 1 4791 4042

41 Makawan'r 2426 392604 35.3 138589 324122 0.479 0.521 16.663 2 1.2 4238 4296

42 Manang 2246 9857 37.9 3736 9587 0.502 0.498 18.240 4 2.5 4768 4962

43 Morang 1855 843220 34.4 290068 676546 0.531 0.469 36.353 1 1 5787 4382

44 Mugu 3535 43937 61.1 26846 43937 0.304 0.696 9.021 4 3.5 5532 5850

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S.N District Area (Sq km)

Pop Hum. pov

index 2001

Pop below

poverty

Rural pop

HDI 2001

1-hdi 2001

Infrastructure index

Classification

New cost scale

Amount (in 000) as

new formula

(Model 3)

Amount (in 000) as of existing

formula

45 Mustang 3573 14981 41.5 6217 41981 0.482 0.518 24.696 4 2.5 5240 5323

46 Myagdi 2297 114447 40.3 46122 114447 0.498 0.502 15.044 4 2 3517 4165

47 Na'parasi 2162 562870 40.2 226274 540240 0.482 0.518 23.009 2 1 4550 4391

48 Nuwakot 1121 288478 43.8 126353 267285 0.463 0.537 19.437 2 2 4446 4389

49 Ok'dhunga 1074 156702 46.0 72083 156702 0.481 0.519 12.734 3 2.5 3514 3937

50 Palpa 1373 268558 33.0 88624 248127 0.486 0.514 18.241 2 1.5 3046 3737

51 Panchthar 1241 202056 42.1 85066 202056 0.484 0.516 14.571 3 2 3817 4156

52 Parsa 1353 497219 44.4 220765 384735 0.448 0.552 32.646 1 1 4086 3546

53 Parbat 494 157826 35.5 56028 157826 0.504 0.496 18.109 2 1.5 2145 3194

54 Pyuthan 1309 212484 47.9 101780 212484 0.416 0.584 13.309 3 2 4058 4220

55 Ramechap 1546 212408 53.4 113426 212408 0.434 0.566 14.067 3 2 4273 4296

56 Rasuwa 1544 44731 54.5 24378 44731 0.394 0.606 16.756 4 2 3863 4543

57 Rautahat 1126 545132 51.0 278017 519749 0.409 0.591 23.659 2 1 4790 4076

58 Rolpa 1879 210004 53.1 111512 210004 0.384 0.616 11.346 4 2.5 4354 4521

59 Rukum 2877 188438 53.7 101191 188438 0.386 0.614 11.769 4 2.5 4512 4649

60 Rupandehi 1360 708419 29.2 206858 580466 0.546 0.454 29.521 1 1 4360 4155

61 Salyan 1462 213500 48.2 102907 213500 0.399 0.601 15.366 4 2.5 4124 4485

62 S'sabha 3480 159203 43.5 69253 137414 0.481 0.519 11.494 3 2.5 5262 4887

63 Saptari 1363 570282 40.2 229253 539929 0.453 0.547 32.674 1 1 4341 3985

64 Sarlahi 1259 635701 49.8 316579 617217 0.408 0.592 29.530 1 1 5478 4357

65 Sindhuli 2491 279821 48.3 135154 246983 0.469 0.531 13.751 3 1.5 3985 4107

66 S'palchauk 2542 305857 51.1 156293 305857 0.414 0.586 17.249 3 2 6292 5498

67 Siraha 1188 572399 47.1 269600 520757 0.427 0.573 24.069 1 1 4767 3961

68 Solu 3312 107686 45.8 49320 107686 0.479 0.521 12.643 3 2.5 4864 4790

69 Sunsari 1257 625633 32.2 201454 465891 0.500 0.500 27.650 1 1 4091 3700

70 Surkhet 2451 288527 44.6 128683 257146 0.486 0.514 16.780 2 1.5 3913 3937

71 Syangja 1164 317320 35.3 112014 267239 0.535 0.465 17.581 2 1.5 3356 3624

72 Tanahu 1546 315237 42.0 132400 286992 0.524 0.476 15.214 1 1.5 3718 3751

73 Taplejung 3646 134698 38.4 51724 134698 0.467 0.533 15.850 3 2 5057 4920

74 Tehrathum 679 113111 40.9 46262 113111 0.523 0.477 15.084 3 2 2990 3546

75 Udaypur 2063 287689 40.0 115076 232398 0.488 0.512 13.690 3 1.2 3624 3780

TOTAL 319222 319222

Average 1962 308689 4,256 4,256

Maximum 7889 1081845 6518 6526

Minimum 119 9857 1524 2421

Standard deviation 1147 209988 845 734

Coefficient of variation (%) 58.45 68.03 19.85 17.25

xlv

Annex IV-1.1

Comparative data of alternate formula incorporating internal revenue as one of the factors

Total amount for distribution taken as actual of HMG development grant on FY 03/04 319222 Formula Factors and Weight

Suggested formula (SF) Area 15%, Population 15%, Poppulation below poverty 35%, Cost 35%

Alternate Formula 1 (F1) Area 10%, Population 45%, Cost 15%, Human Poverty 10%, Inverse of Internal revenue 20%

Alternate Formula 2 (F2) Area 10%, Population 50%, Cost 20, Human Poverty 10%, Internal revenue index 10%

GP SF Grants per capita as per suggested formula

GP F1 Grants per capita as per alternate formula 1

GP F2 Grants per capita as per alternate formula 2

Districts Area (Sq km)

Population

HMG Dev Grant 03/04

Int rev 02/03

Inverse of Int Rev Index

SF F 1 F 2 GP SF GP F1

GP F2

Achham 1680 231285 4950 646 1080 4750 3338 4887 21 14 21

A‘Khacnhi 1193 208391 4984 5546 126 3081 2995 2946 15 14 14

Baglung 1784 268937 6107 6102 114 3536 3503 3432 13 13 13

Baitadi 1519 234418 5801 1915 364 4014 3156 3770 17 13 16

Bajhang 3422 167026 4929 261 2673 4326 3108 6284 26 19 38

Bajura 2188 108781 4849 317 2201 3766 2630 5318 35 24 49

Banke 2337 385840 3324 12722 55 3973 4761 4042 10 12 10

Bara 1190 559135 4112 25515 27 5401 6867 5067 10 12 9

Bardia 2025 382649 4499 2933 238 4251 3864 4233 11 10 11

Bhaktapur 119 225461 2982 18917 37 2565 3988 2632 11 18 12

Bhojpur 1507 203018 4159 3335 209 3641 3038 3336 18 15 16

Chitwan 2218 472048 3560 13146 53 4324 5285 4584 9 11 10

Dadeldhura 1538 126162 4530 2408 290 2713 2329 2684 22 18 21

Dailekh 1502 225201 4495 285 2448 4038 2983 5957 18 13 26

Dang 2955 462380 4072 4102 170 5448 4830 5135 12 10 11

Darchula 2322 121996 4566 1119 624 3766 2707 3653 31 22 30

Dhading 1926 338658 3689 48347 14 4503 7949 3955 13 23 12

Dhankuta 891 166479 4498 3641 192 2574 2436 2602 15 15 16

Dhanusha 1180 671364 4272 8465 82 5909 5961 5857 9 9 9

Dolakha 2191 204229 4562 10408 67 3882 3845 3345 19 19 16

Dolpa 7889 29545 5978 1739 401 5787 3919 4628 196 133 157

Doti 2025 207066 4533 2159 323 4079 3164 3693 20 15 18

Gorakha 3610 288134 5240 2502 279 4456 3748 4194 15 13 15

Gulmi 1149 296654 5659 1308 533 3634 3135 3967 12 11 13

Humla 5655 40595 5447 951 734 5173 3450 4592 127 85 113

Illam 1703 282806 4327 6117 114 3530 3554 3490 12 13 12

Jajarkot 2230 134868 4539 205 3404 4021 2799 6794 30 21 50

Jhapa 1606 688109 4040 17912 39 5169 6902 5899 8 10 9

Jumla 2531 89427 5007 1593 438 4553 3066 3868 51 34 43

Kavre 1396 385672 4773 7407 94 4045 4241 4110 10 11 11

Kailali 3235 616697 4534 14434 48 6057 6595 5871 10 11 10

Kalikot 1741 105580 5216 886 788 4465 2950 4200 42 28 40

Kanchanpur 1610 377899 2794 18532 38 3723 5094 3819 10 13 10

Kaski 2017 380527 3608 8756 80 3828 4383 4110 10 12 11

kathmandu 395 1081845 3230 29952 23 6936 10331 8542 6 10 8

Khotang 1591 231385 4571 3001 233 4272 3374 3807 18 15 16

Kapilvastu 1738 481976 4072 12618 55 5175 5356 4713 11 11 10

Lalitpur 385 337785 2856 22728 31 3086 5044 3410 9 15 10

Lamjung 1692 177149 5454 2790 250 2966 2628 2941 17 15 17

xlvi

Districts Area (Sq km)

Population

HMG Dev Grant 03/04

Int rev 02/03

Inverse of Int Rev Index

SF F 1 F 2 GP SF GP F1

GP F2

Mahottari 1002 553481 4045 5745 121 5632 5032 5137 10 9 9

Makawanpur 2426 392604 2791 55155 13 4253 8786 4168 11 22 11

Manang 2246 9857 3114 626 1115 2897 1877 3312 294 190 336

Morang 1855 843220 3684 36514 19 6627 9672 7052 8 11 8

Mugu 3535 43937 5302 448 1558 4502 2938 5005 102 67 114

Mustang 3573 14981 3488 2592 269 3369 2411 2771 225 161 185

Myagdi 2297 114447 4378 3150 222 3212 2611 2877 28 23 25

Nawalparsi 2162 562870 4393 13309 52 5391 5932 5278 10 11 9

Nuwakot 1121 288478 4403 38886 18 4141 6740 3640 14 23 13

Okhaldunga 1074 156702 3951 3902 179 3630 2912 3154 23 19 20

Palpa 1373 268558 4031 2870 243 3314 3090 3451 12 12 13

Panchthar 1241 202056 4670 7449 94 3512 3336 3134 17 17 16

Parsa 1353 497219 3547 27918 25 4927 6727 4662 10 14 9

Parbat 494 157826 3488 6266 111 2412 2547 2381 15 16 15

Pyuthan 1309 212484 4234 3999 174 3753 3157 3363 18 15 16

Ramechhap 1546 212408 4310 5493 127 3969 3398 3417 19 16 16

Rasuwa 1544 44731 4275 1037 673 2565 1960 2852 57 44 64

Rautahat 1126 545132 4078 5019 139 5631 4944 5129 10 9 9

Rolpa 1879 210004 4534 2715 257 4470 3379 3849 21 16 18

Rukum 2877 188438 4663 1550 450 4627 3360 4128 25 18 22

Rupandehi 1360 708419 1457 64043 11 5201 11196 5956 7 16 8

Salyan 1462 213500 4499 2151 324 4239 3210 3806 20 15 18

S‘Sabha 3480 159203 4619 834 837 4384 3145 4368 28 20 27

Saptari 1363 570282 3987 5506 127 5182 5091 5235 9 9 9

Sarlahi 1259 635701 4360 5675 123 6319 5584 5753 10 9 9

Sindhuli 2491 279821 4402 5556 126 4253 3797 3796 15 14 14

S‘Palchauk 2542 305857 4632 2261 309 4994 3876 4448 16 13 15

Siraha 1188 572399 3963 11409 61 5608 5674 5210 10 10 9

Solu 3312 107686 3422 928 752 3987 2820 3909 37 26 36

Sunsari 1257 625633 3702 19230 36 4932 6589 5419 8 11 9

Surkhet 2451 288527 4331 1541 453 4181 3439 4159 14 12 14

Syangja 1164 317320 2519 1420 491 3624 3237 4028 11 10 13

Tanahu 1546 315237 4646 17473 40 3986 4841 3682 13 15 12

Taplejung 3646 134698 4853 1118 624 3759 2825 3719 28 21 28

Tehrathum 679 113111 3559 908 768 2685 2052 3105 24 18 27

Udaypur 2063 287689 4074 7360 95 3639 3729 3499 13 13 12

Average 1962 308689 4256 9304 400 4256 4256 4256 23 21 27

Maximum 7889 1081845 6107 64043 3404 6936 11196 8708 190 172 324

Minimum 119 9857 1457 205 11 2412 1877 2402 9 9 8

Std Devi 1147 209988 810 12901 630 993 1938 1159

Coeff Var% 58.45 68.03 19.04 138.67 157.41 23.33 45.53 27.23 45.53 0.00 27.23

Maxi-Min ratio 2.88 5.97 3.63 21.68 18.64 40.27

xlvii

Annex IV-II

Simulation Models for Selected Municipalities

Municipality Adm+ dev

Adm+ dev+ Int rev Pop Area Infrastr Cost Sim 1 Sim 2 Sim 3 Sim 4 Sim 5

grts devfee index factor

Bhadrapur 4051 9355 3582 18.15 10.56 356.05 1 10465 11554 11565 11961 10376

Bhaktapur 1047 22407 87007 72.54 6.86 455.72 1.5 36817 39299 46079 45869 46709

Bhimeswor 3266 5666 644 21.20 57.84 243.67 2 12670 11964 11648 12708 8468

Biratnagar 2059 73123 30435 166.67 58.48 305.51 1 40059 42106 41971 39731 48689

Birendranagar 4953 41685 2601 31.38 36.00 281.33 1 12278 12564 12248 12409 11764

Butwal 933 14073 27535 75.38 69.28 436.25 1 26907 27396 28611 27992 30470

Dhangadi 3333 7173 4926 67.45 103.73 150.68 1 19001 17370 16630 16151 18066

Dhankuta 3766 17806 1589 20.67 48.21 316.12 1.5 12276 12091 11872 12582 9741

Dhulikhel 1521 3921 656 11.52 12.08 329.73 1 8586 9429 9285 9799 7744

Guleria 1177 3577 2545 46.01 91.19 192.13 1 15251 13767 13187 13088 13482

Inarwa 1680 21120 3453 23.20 22.36 252.72 1 10342 10827 10735 11041 9816

Janakpur 4621 7021 5873 74.19 24.61 420.39 1 21084 22921 22149 21551 23944

Kamalamai 3821 6221 611 32.84 205.12 140.79 1.2 16202 10706 10180 10459 9343

Khadbari 6353 14225 925 21.79 124.02 209.22 2.5 15569 12665 12364 13772 8138

Lahan 4900 57328 3415 27.65 20.23 310.58 1 11696 12507 12333 12560 11650

Lalitpur 560 52988 51039 162.99 15.15 459.90 1.5 44907 48743 50583 48768 56028

Lekhnath 770 12698 2898 41.37 77.45 254.97 1.5 15995 15060 14594 14937 13565

Madhyapur Thimi 801 7755 5580 47.75 11.11 319.37 1.5 16203 17687 17357 17587 16668

Mahendranagar 4586 30890 10362 80.84 171.24 434.48 1 27809 25151 24678 23961 26827

Mechinagar 1526 3886 6179 49.06 55.72 242.42 1 15909 15761 15464 15311 15921

Narayan 2600 24632 384 19.45 67.01 115.12 2 11040 9614 9304 10395 6031

Nepalgunj 4015 43963 6261 57.54 12.51 359.23 1 17353 19090 18650 18347 19558

Pokhara 3914 6314 17646 156.31 55.22 389.28 1.5 38045 40271 39133 37437 44223

Prithwinarayan 3100 5512 1497 25.78 39.59 228.64 1.5 11718 11626 11308 11927 9449

Putali Bazar 3427 30199 873 29.67 64.51 341.40 1.5 14411 13947 13501 14052 11849

Siddharthanagar 3600 6000 12853 52.57 36.03 466.72 1 19862 21097 21356 21141 22000

Tansen 4000 6400 2826 20.43 21.72 349.02 1.5 12034 12788 12688 13402 10544

Tikapur 3600 6000 1291 38.72 67.11 204.88 1.2 13679 12869 12302 12477 11778

Tribhuvannagar 3093 7545 2196 43.13 74.45 125.17 1.2 13795 12584 12022 12119 11733

Tulsipur 4000 7720 2791 33.88 95.00 299.18 1.2 15238 13749 13407 13667 12625

Total 91072 557202 300472 1570 1754 8991 39 557202 557202 557202 557202 557202

Simulations Weights Assigned in the

Simulation Summary of Simulation Results

Average Max Min Standard Deviation

Coeffi. of variance

Coeffi of correlation

Int Rev Pop Area Infra Ind Cost

Simulation 1 0.1 0.45 0.1 0.2 0.15 18573 44907 8586 9636 52 0.42

Simulation 2 0.1 0.5 0 0.25 0.15 18573 48743 9429 10635 57 0.44

Simulation 3 0.15 0.45 0 0.25 0.15 18573 50583 9285 11380 61 0.43

Simulation 4 0.15 0.4 0 0.25 0.2 18573 48768 9799 10710 58 0.43

Simulation 5 0.15 0.6 0 0.25 0 18573 56028 6031 13494 73 0.45

xlviii

Annex IV-III

Simulation of Grants to VDC in Selected Districts

a. Mustang district

SN Village Development Committee

Area Population Classification Rs.5 lakhs Equal

distribution

Pop=100 %

Area/Pop Area/Pop/clsf

0.1

0.25 0.5

0.75 0.4

1 Charang 325 661 3 500 364 455 464

2 Chhonhup 99 1070 3 500 589 498 526

3 Chhoser 347 783 3 500 431 518 502

4 Chhusang 489 668 3 500 368 550 502

5 Dhami 221 850 3 500 468 475 492

6 Jhong 51 489 3 500 269 231 355

7 Jomsom 185 1698 1 500 935 805 579

8 Kagbeni 284 994 3 500 547 570 546

9 Kowang 80 786 3 500 433 370 443

10 Kunjo 75 725 3 500 399 341 425

11 Lete 50 1142 3 500 629 500 534

12 Lomanthan 284 848 3 500 467 510 506

13 Marpha 93 1550 3 500 854 692 656

14 Muktinath 60 990 3 500 545 442 495

15 Surkhang 800 515 3 500 284 662 530

16 Tukuche 122 756 3 500 416 381 444

Total 3565 14525 46 8000 8000 8000 8000

Average 223 908 3 500 500 500 500

Maximum 800.44 1698 3 500 935.22 805.35 656.43

Minimum 49.833 489 1 500 269.33 230.57 354.79

Standard Deviation 201.65 334.07 0.50 0.00 184.00 141.23 68.33

Coeff of variation % 90.50 36.80 17.39 0.00 36.80 28.25 13.67

xlix

Annex IV-III

b.Bhaktapur District

SN Village Development Committee

Area Population Classification

Rs.5 lakhs Equal distr

Pop=100 %

Area/Pop Area/Pop/clsf

0.1

0.15 0.75

0.85 0.15

1 Duwakot 6.3 6290 2 500 483 481 470

2 Jhaukhel 5.42 6678 3 500 513 496 517

3 Chhaling 8.24 7674 3 500 589 592 595

4 Changunarayan 6.1 5858 3 500 450 450 475

5 Bageshwori 6 5013 3 500 385 394 425

6 Nagarkot 13 4247 3 500 326 422 433

7 Sudal 10 7053 3 500 541 571 573

8 Tathali 8 5652 2 500 434 458 446

9 Chittapol 8.44 5497 3 500 422 453 471

10 Nakhel 5 5213 2 500 400 396 399

11 Sipadol 8 7004 2 500 538 546 524

12 katunje 5 13043 1 500 1001 907 819

13 Gundu 6 5757 3 500 442 442 468

14 Dadhikot 7 7244 2 500 556 551 531

15 Sirutar 1.4 4532 2 500 348 311 333

16 balkot 4 7454 2 500 572 531 520

Total 107.9 104209 39 8000 8000 8000 8000

Average 7 6513 2 500 500 500 500

Maximum 13 13043 3 500 1001.30 906.71 818.81

Minimum 1.4 4247 1 500 326.04 311.30 332.86

Standard Deviation 2.63 2029.64 0.63 0.00 155.81 131.35 107.28

Coeff of variation 0.38 0.31 0.25 0.00 0.31 0.26 0.21

l

Annex IV-III

c.Kanchanpur District

SN Village Development Committee

Area Population Classification

Rs.5 lakhs Equal dist

Pop=100 %

Area/Pop Area/Pop/clsf

0.1

0.15 0.75

0.85 0.15

1 Shreepur 57.62 18618 1 500 597 586 520

2 Dodhara 25.57 18556 2 500 595 541 509

3 Suda 58.02 18061 2 500 580 571 527

4 Tribhuvanbasti 25.3 12507b 2 500 401 375 363

5 Laxmipur 28.35 11767 3 500 378 359 368

6 Kalika 31.45 13002 3 500 417 397 401

7 Shankarpur 36.41 6538 4 500 210 228 269

8 Jhalari 103.7 15926 4 500 511 574 556

9 Rampur 40.31 15484 4 500 497 477 488

10 Raikwarbishawa 80.84 14564 4 500 467 506 502

11 Chandani 31.8 16847 4 500 541 502 513

12 Baishebichwa 62.64 11490 4 500 369 398 412

13 Beldadi 23.3 14815 5 500 475 436 477

14 Rautelibichuwa 13.51 9956 5 500 319 290 351

15 Krishanpur 165.2 25442 5 500 816 917 860

16 Dekhatbhuli 90.11 16521 5 500 530 572 578

17 Pipladi 42.94 19734 5 500 633 596 613

18 Parasan 37.9 13523 5 500 434 420 459

19 Daijee 100 22681 5 500 728 754 735

Total 1054.97 296032 72 9500 9500 9500 9500

Average 56 15581 4 500 500 500 500

Maximum 165.2 25442 5 500 816 917 860

Minimum 13.51 6538 1 500 210 228 269

Standard Deviation 37.85 4462.14 1.27 0.00 143.20 159.58 137.35

Coeff of variation 0.68 0.28 0.33 0.00 0.29 0.32 0.27