In Brief
Nepal’s transition to decentralised governance has placed more responsibility in the hands of provincial and local governments. But fair fiscal management has proved difficult. Structural flaws in funding allocation mechanisms have led to a misallocation of resources and an underspending of local government budgets. Yet increasing reliance on conditional grants relative to fiscal equalisation grants could undermine local government autonomy, presenting issues for the effectiveness of decentralised government.
Nepal’s transition from a unitary to a federal system of governance, characterised by decentralised decision-making and local autonomy, has presented teething problems. The mechanism for allocating funds to local governments has created resource misallocations, with the overuse of ‘conditional grants’ posing a risk to the effectiveness of the federal system.
The Constitution of Nepal provides for four types of grants: fiscal equalisation grants, conditional grants and special and matching grants to fund provincial and local government development. While local governments’ share of fiscal transfers is increasing, large portions of these funds are sourced from conditional grants, undermining local governments’ fiscal autonomy.
The effectiveness of conditional grants in driving local development remains questionable. A study of four federal ministries’ planning and budgeting systems found that conditional grants are predominantly diverted towards recurrent costs, leaving critical investments underfunded. In FY 2024–25, 78.21 per cent of conditional grants for the education sector were used to cover teacher salaries, while funding for infrastructure, digital learning and training programs was limited.
This misalignment stems from deeper structural flaws, including weak local institutions, technical gaps and poor data-driven planning. These flaws collectively undermine the transformative potential of decentralised governance. Without reforms to unlock flexible spending and strengthen fiscal capacity, conditional grants will continue to fall short of delivering equitable development.
The budget share of fiscal equalisation grants is declining. Fiscal equalisation grants that accounted for 4.9 per cent of the 2023–24 fiscal year’s federal budget, slipped to 4.7 per cent in the 2024–25 financial year. The 2024 decision of the Financial Comptroller General Office (FCGO) to reduce fiscal equalisation grants will continue this trend.
Fiscal equalisation grants are provided to provincial and local governments based on their respective expenditure needs and resource capacities. They have a significant role in funding sub-national governments. This decision goes against the recommendation of the Federalism Special Committee of the National Assembly and the National Natural Resources and Fiscal Commission to gradually increase fiscal equalisation grants. The proposed way to achieve this is by decreasing conditional grants.
The FCGO slashed the third quarter instalment of fiscal equalisation grants for the 2024–25 financial year to 13.24 per cent from 25 per cent. Local governments will now receive only Rs 3 billion (US$35.4 million) as a third instalment amount instead of Rs 22 billion (US$259.6 million) due to the cuts. The National Association of Rural Municipalities in Nepal and the Municipal Association of Nepal have publicly condemned this decision.
Experts have described these decisions as reflecting a lack of urgency and commitment from the federal government towards institutionalising and promoting fiscal decentralisation.
Policy circles agree the government should gradually decrease the earmarked conditional grant and increase the fiscal equalisation grant. The National Assembly’s Federal Implementation and Monitoring Special Committee for Strengthening Federalism proposes restructuring conditional grants for provinces and local governments. Tying allocations to sectoral objectives and measurable outcomes rather than predefined activities will enhance fiscal efficiency and governance.
The committee advocates for performance-based incentives, suggesting that 50 per cent of fiscal equalisation grants should be allocated competitively to encourage accountability and spur healthy competition among local governments.
In the absence of transparent and timely fiscal transfer, vertical and horizontal fiscal imbalances are both increasingly pertinent issues. The disparity between the revenue-sharing capacities and expenditure responsibilities of sub-national governments is widening. Local governments operating in provinces like Karnali and Sudurpaschim face persistent horizontal fiscal imbalances and funding cuts. They receive disproportionately lower fiscal transfers compared with more advantaged regions such as Bagmati, which benefits from stronger political influence and advanced infrastructure.
This inequitable distribution of government funding has exacerbated regional disparities, leaving marginalised provinces struggling to meet basic developmental needs. Cuts in federal funding in Karnali have led to decline in the quality of nutrition programs, posing severe consequences for poorer Nepalese families and children, including malnutrition and stunting.
Expenditure capacities of sub-national governments are a further limiting factor. The World Bank’s Nepal Fiscal Federalism Update 2024 states that provincial governments underspent 34 per cent of their budget. The underspending rate of local governments stood at 24.4 per cent.
In a bid to address growing fiscal imbalances, the National Planning Commission of Nepal has prepared an action plan to implement capacity-based fiscal federalism standards, aimed at allocating more complementary grants to resource-poor municipalities.
The plan categorises local levels into groups ‘A’ through ‘G’ based on resources, assets and capacity. The updated grant modality aims to allocate up to 80 per cent of the grant to local levels in category ‘A’ with weak revenue sources. Municipalities with strong revenue and infrastructure development will fall under category ‘G’ and receive only 20 per cent of the grant. Despite this, the overall ability of the commission’s grants to fix larger resource misallocation problems remains limited.
It will be necessary to revise the existing grant mechanism based on a transparent and consultative process to increase the predictability of financial resources. Incorporating mechanisms to increase the flexibility of sub-national governments in the programming and use of these grants will be key in institutionalising a decentralised governance system.
Strategic fiscal reforms must prioritise equitable resource allocation and local governance capacity. Transitioning from restrictive conditional grants to performance-based fiscal transfers, implementing needs-based equalisation mechanisms and strengthening revenue-sharing systems are critical. These measures, coupled with transparent monitoring and the strengthening of local institutions, would enhance fiscal autonomy and cater to specific local-level needs.
Kushal Pokharel is an independent researcher and columnist based in Nepal with expertise on federalism, local democracy. He is also a Research Fellow at the Southasia Institute of Advanced Studies (SIAS) in Nepal.
This blog article was first published at East Asia Forum (EAF) May 30, 2025.
“Views expressed here are personal and not associated with any affiliated organisations”
