A Landmark Shift in How Money Reaches Local Government
Nepal’s transition from a centralised state to a federal republic has long been undermined by a dependency trap of the centre’s own making. The 2015 Constitution promised to bring government to citizens’ doorsteps. A decade on, the federal government’s persistent reluctance to channel adequate financial resources to sub-national levels has left that promise largely on paper.
A recent decision by the Inter-Governmental Fiscal Council (IFC) suggests that the calculation may finally change.
Who Controls the Money
The IFC is Nepal’s primary coordinating body for financial relations, revenue sharing, and grant distribution across all three tiers of government. Chaired by the federal Finance Minister, the IFC’s membership includes Provincial Economic Affairs and Planning Ministers, representatives from local units, and three experts nominated by the federal government. The composition was designed to give sub-national voices a nominal presence in fiscal decision-making.
Four types of grants currently address the fiscal needs of provincial and local governments. Fiscal Equalisation Grants (FEG) are formula-based, unconditional transfers designed to protect local autonomy. Conditional Grants are earmarked for federally mandated sectors, such as education and health. Complementary Grants provide cost-sharing for infrastructure projects, calibrated to local resource capacity. Special Grants provide targeted funding to bridge regional disparities and support marginalised communities.
The problem is structural. In the 2025-26 budget, Conditional Grants account for 58.25 per cent of all sub-national transfers. Fiscal Equalisation Grants, the instrument designed to safeguard local autonomy, make up only 35.48 per cent. The centre’s preference for controllable funding over flexible transfers perpetuates central dominance.
A Decade of Friction
The consequences are measurable. A study on fiscal federalism in Nepal found that in 2024-25, nearly 78 per cent of conditional education grantswere consumed by teacher salaries alone, leaving virtually no room for local infrastructure investment or innovation. Meanwhile, the FEG shrank from 4.9 per cent to 4.7 per cent of the total federal budget. The contraction was exacerbated by unpredictable mid-year cuts that left development projects in Karnali and Sudurpaschim incomplete.
The damage is not confined to balance sheets. Stalled nutrition programmes, under-equipped health posts, and half-built community infrastructure erode public trust in the federal model. The predictability of funding is a form of empowerment, and one that local governments have been systematically denied.
These grievances have found organised expression. The 10th national meeting of the National Association of Rural Municipalities in Nepal (NARMIN), the apex body representing rural municipalities nationwide, issued a 15-point declaration urging the federal government to address FEG cuts and to halt what it characterised as regressive encroachments on constitutionally guaranteed local rights.
The National Assembly’s Special Committee for Strengthening Federalism has reached a similar conclusion: the government must move away from prescribing specific activities and instead set broad sectoral objectives. When a local government is told exactly how many metres of road to pave, its ability to prioritise an urgent local health clinic is lost. The Finance Minister’s proposal at the IFC meeting to channel 50 per cent of equalisation grants through a competitive, performance-based mechanism is an attempt to break this pattern at the structural level.
Rewarding Performance Without Punishing the Poor
The competitive FEG model is underpinned by clear incentives. Municipalities that demonstrate financial discipline, higher internal revenue mobilisation, and transparency in auditing would receive larger grant allocations. The intent is to shift institutional culture away from grant-seeking dependency and towards self-improvement.
The National Natural Resources and Fiscal Commission (NNRFC) currently allocates FEGs using a formula weighted by population, area, and the cost of service delivery. Under this formula, the greatest beneficiaries are remote mountain municipalities with high infrastructure costs and limited revenue bases. Urban centres, expected to achieve relative fiscal self-reliance, receive comparatively less. Introducing performance metrics into this structure would make accountability a financial imperative rather than a governance aspiration.
Performance incentives, however, risk penalising municipalities that simply lack the administrative capacity to compete. A well-resourced urban government cannot be measured against the same criteria as a remote hill municipality with a skeleton staff and no reliable connectivity.
To address this, the National Planning Commission (NPC) has prepared an action plan centred on a capacity-based model. Local governments are categorised into seven groups, from ‘A’ to ‘G’, based on resources, existing assets, and administrative capacity. Of Nepal’s 753 local governments, 162 drawn from Karnali, Sudurpaschim, Koshi, and Gandaki provinces fall into the most vulnerable categories. Under the revised modality, these governments would receive up to 80 per cent of specific grants. Resource-rich municipalities at the other end of the scale would receive as little as 20 per cent. The intention is that any increase in the FEG does not merely reward already-wealthy urban centres but functions as a genuine equaliser for structurally disadvantaged communities.
Four Reforms That Could Rewrite the Rules
The IFC meeting, chaired by Finance Minister Dr Swarnim Wagle, formalised four structural reforms, collectively representing the most significant rebalancing of Nepal’s intergovernmental fiscal architecture since the constitution came into force.
The first addresses budget fragmentation. The IFC has set a minimum cost threshold for federal projects, preventing the federal budget from being diluted by politically motivated micro-projects: pocket-sized drains and boundary walls funded for electoral optics rather than for developmental impact. The centre will now be compelled to focus on strategic national infrastructure, such as highways and transmission lines, leaving genuinely local works to the governments best placed to manage them.
The second concerns the National Project Bank. The National Project Bank (NPB) is a digital repository managed by the NPC that requires all three tiers of government to route projects through a unified platform, which screens for technical and economic feasibility before any funds are committed. The NPB is designed to eliminate sick projects, those half-conceived schemes that have long consumed budget allocations without producing outcomes and have undermined Nepal’s development credibility.
The third is a royalty reform with real teeth. To correct vertical imbalances that have long deprived resource-hosting communities of fair returns, the IFC has significantly revised royalty-sharing arrangements. The local government share of royalties from hydropower and mountaineering has risen from 10 per cent to 25 per cent. The share from mining, minerals, and forest resources has doubled from 10 per cent to 20 per cent. Communities that have historically borne the environmental and social costs of resource extraction will now retain a significantly larger share of the wealth generated within their boundaries.
The fourth concerns fiscal discipline. The agreement to settle long-standing intergovernmental arrears and to adopt austerity measures reflects a maturing conception of federalism, one that is no longer solely about transfers flowing from the centre, but also about local governments being accountable to the taxpaying public. These decisions are expected to be reflected in the upcoming federal budget and associated financial instruments.
What Successful Federations Have Learnt
Nepal’s struggle is not without precedent. Australia’s Commonwealth Grants Commission uses horizontal fiscal equalisation to ensure that every state can deliver comparable public services, regardless of its revenue base. South Africa’s constitutionally protected Equitable Share formula was explicitly designed to correct historical regional inequalities. The common thread in successful federal systems is a shift away from discretionary, politically mediated transfers towards transparent, formula-driven mechanisms that sub-national governments can plan around with confidence.
Nepal is attempting a version of this shift. Whether it succeeds will depend not on the elegance of the IFC’s resolutions but on the integrity of their implementation.
An Inflection Point
The IFC’s resolutions reframe the relationship between Nepal’s federal centre and its sub-national governments. By committing to increase the FEG, reduce over-reliance on restrictive conditional grants, and embed performance and equity considerations within the transfer architecture, the federal government is, for the first time in a decade, demonstrating structural trust in local institutions.
The road ahead, however, demands more than capital. The performance-based FEG model must be accompanied by genuine capacity-building investments for the most vulnerable municipalities, so that the equity gap is narrowed through support rather than merely acknowledged through classification. Royalty reforms must be matched by transparent local reporting. And the federal government’s commitment to rule-based, predictable transfers must withstand the political pressures that have historically reversed such commitments.
Specifically, the A-to-G categorisation of local governments must remain insulated from political interference. The competitive FEG allocations must be governed by publicly disclosed, independently verifiable criteria. And royalty reform revenues must reach communities in real fiscal time rather than accumulating as another set of unrealised constitutional entitlements.
Nepal’s federal experiment is at an inflection point. The IFC has provided the framework. The test now is whether institutions at all three tiers of government can deliver on it.