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May 2016 Cover Story

Published on: 2016-05-25 13:35:24     2152 times read    0  Comments
The Federal Challenge

--By Sanjeev Sharma

With the promulgation of the new constitution, Nepal has adopted federalism as its administrative system, effectively doing away with its earlier five development regions and 75 districts. The country will be divided into seven states or provinces, the names of which have yet to be determined. As per the constitution, the main structure of Nepal shall be made up of three levels, namely the federation, the state and the local. Contentious political issues regarding the delineation of federal units persist though. Nevertheless, the country which has been under a unitary administrative system for a long period is about to adopt the federal system of governance which is promised to usher in a new dawn for economic development and prosperity. 

The Challenges
Nonetheless, with the opportunities come the challenges. Though many political issues have been resolved with the promulgation of the new constitution, economic issues under the federal system are yet to be finalised. Almost everyone agrees that just forming the federal units cannot bring any significant change in the lives of the people. Rapid economic development, effective policy initiatives and a sound business climate must be the new catchphrases for prosperity. “It requires clear policies backed by strong political will to implement the new system economically,” says Hari Bhakta Sharma, President of Confederation of Nepalese Industries (CNI). 

Taxation
While the Nepali private sector believes that the federal structure can spur the economic development of the country if correctly implemented, it also has some doubts in terms of the appropriate business climate as no clear federal policies regarding the taxation and distribution of revenues and resources among the proposed states have been formulated.   

“Implementation of federalism in our context is a challenge. We need to resolve issues such as taxation and free transport of goods and delivery of services during the implementation phase of the federal structure,” opines Pushapati Murarka, President of the Federation of Nepalese Chambers of Commerce and Industry (FNCCI). Nepali industrialists and businessmen regard taxation as one of the major areas of concern.  Nepal’s tax administration will be decentralised after the implementation of the federal system which is largely centralised at present.  The new constitution has given rights to the central, state and local governments to impose taxes on matters falling within their respective jurisdiction.  Related laws will be formulated according to the constitutional provisions when the process of implementing federalism starts in the near future. 

 “I think the industries and businesses will face various teething problems for a couple of years. The problems are likely to be in the area of taxation,” points out CNI President Sharma, adding, “There are no federal policies formulated for companies or individuals to pay taxes to the state.” Levying various types of taxes on industries and businesses can be an easy solution for the newly formed states to fund their operation. However, the private sector sees the risk of double taxation if the lawmakers do not come up with clear policies. “Introducing a central tax system can ease the problems regarding taxation. The business community needs to be assured that it will not be double taxed,” says Pradeep Kumar Shrestha, Past President of FNCCI. According to him, a central tax structure can be constructed to collect the revenue from the customs points. FNCCI President Murarka suggests applying tax laws under which the central government can undertake the collection of major taxes like customs, VAT, excise duties and income taxes. Meanwhile, Shrestha recommends formulating policies so that state and local governments can collect revenues from vehicles tax, property tax and other local taxes.  

Similarly, the private sector is also asking the lawmakers and the government to avoid ambiguities while formulating tax laws.  “Some of the policies regarding taxation are clear, while others need to be clear in interpretation,” says CNI President Sharma. Business leaders point out the need for clarity in policies as an important factor for creating a good business environment. They demand the same tax rates all across the nation. “Prices of goods, commodities and services may vary if the tax rates are different in different states,” mentions Sharma. While the country adopts the new system, it will be relevant to look into tax practices of other countries as references. Federal tax practices in India can provide lawmakers with examples of how to deal with difficulties in the future. “We can learn particularly from India where the government is planning to introduce Goods and Services Tax (GST) by abolishing the central and states sales taxes,” suggests Murarka, adding, “GST is one of the best tax systems practiced across the world.”  

With the country adopting the federal system, free movement of goods and delivery of services is another area of concern for the Nepali private sector. The globally accepted norms of the open market policy require free flow of goods, delivery of services and labour. However, if an effective tax mechanism is absent in federal Nepal, it is likely to hinder industries and businesses from moving their products and services from one state to another. “Free inter-state movement of goods, services and labour is an important factor,” stresses Murarka. “Creating tariff and non-tariff barriers on the interstate transportation of goods, services, labour and resources will ultimately result in the decline of productivity and worsen the overall business climate.”

Distribution of Resources
Distribution of resources among the states can be another daunting issue for the federal management. The new constitution has envisioned equitable distribution of benefits derived from the use of natural resources (or development) by federal (central), state and local levels. However, the private sector has already cast doubts on such a distribution as clear policies have not been formed and the proposed states are likely to raise their stakes over natural resources located within their territorial boundaries.  Use of a resource like water, for example, can be a possible area of conflict among the federal units. It will be difficult to construct a hydropower or an irrigation project in a scenario when two or more states begin to quarrel on the use of rivers flowing through their territories. Meanwhile, the use of forest resources can be an obstacle in similar situations. 

“Lawmakers need to take precautionary measures when distributing resources. Proportionate distribution of resources can ease the likely tensions among the states,” says FNCCI past president Shrestha. “A river flowing from north to south can generate electricity while irrigation can also provide facilities across many states. A pragmatic approach is required to resolve such disputes.” The business community wants the development of major infrastructures to be handled by the central authorities while also asking the lawmakers and the government to come up with effective policies free of ambiguities. 

Distribution of the federal budget can also become controversial if lack of clarity in the policies persists. National Natural Resources and Fiscal Commission are the constitutional provisions in place, which will make recommendations on the proportionate distribution of resources and the amount of fiscal transfer receivable by state and local levels. “The proposed commission needs to form a guideline in very explicit language understandable to everyone as far as possible,” opines Sharma. He says that such a guideline will ease the doubts of the state and local governments regarding the distribution of money by the central government when such a mechanism is formed. 

Opportunities
Despite being landlocked, Nepal holds immense opportunities and possibilities for investors.  And, the federal system of governance can facilitate the nation with higher economic growth by formulating and implementing proper policies. “Certain states have inherent possibilities in Nepal.  These states can attract significant amounts of investments if the state and local governments show their strong willingness in development initiatives,” mentions CNI President Sharma. Potential exists in the form of conventional sectors such as hydropower, agriculture, tourism and hospitality, forestry and herbal, minerals along with ICT, health and education services being the newer ones. 

However, investors are not lured only by potential and possibilities. They look for a sound economic climate in order to operate businesses in the sectors they desire to invest in. Nepal until now has largely failed to maintain a viable macroeconomic environment to assure investors. As the country is headed towards the federal system, now the time has come for the government and policymakers to demonstrate that the country is safe for investment and industries and businesses can operate without any hindrances. “The major drawback of our country is the lack of infrastructures, be it industrial or administrative,” says FNCCI Past President Shrestha. He suggests strong support from the government in central and state levels to ensure an infrastructure drive in the federal system in order to attract investments. Lack of roads, railways and airports have held back investors as they see difficulties in transportation. Similarly, inadequate power supply has always been a major issue among investors as the country continues to suffer from severe electricity shortage. 

Streamlining FDI policies is also important to lure foreign investors. CNI President Sharma points out two preconditions for the inflow of FDI into the country. “One is the ideal legal protection for investments and another is the competitive local investment environment,” he mentions. He advises an amendment or reformulation of the Foreign Investment Transfer Act for the legal protection of FDIs while going into the federal system. Secondly, he suggests a competitive local investment climate to attract foreign investors. “Foreign investors are also attracted towards such countries where there is a high level of competition between local investors even if the policies are weak,” he opines. 

Competition of Federal Units- A Higher Ground for Investments
Nepali private sector holds the notion that by creating a competitive environment between the states, it is possible to attract investments. Neighbouring India can be taken as an example where states are heavily competing against each other to attract investments. States such as Gujarat, Bihar, Madhya Pradesh, Haryana, Himanchal Pradesh, Maharashtra and Tamilnadu are currently engaged in announcing competitive lucrative investment schemes. Industrialists stress on the need for policy initiatives to drive the competition in Nepal. With the implementation of the federal system, a one window policy is required to welcome international investors, they say. “The proposed states need to focus on such competition by announcing attractive schemes rather than competing to impose taxes,” says FNCCI President Murarka. “Flexible laws regarding labour and the acquisition of land need to be formulated. This will create a positive business and investment climate in the country.” 

Such competition is also likely to help the low developed states in their development. If underdeveloped federal units are able to introduce policies regarding repatriation of profits and security of investments, industries and businesses are likely to identify those states as their choice of investment destinations. The Indian state of Bihar, for instance, over the past few years has become a hub for investments and development after the Chief Minister Nitish Kumar led government aggressively adopted effective policies. 

Time to Become Responsible
The irresponsible behaviour of politicians and the bureaucracy has held back the economic development of the country for decades. Now the time has come for everyone to demonstrate responsible behaviour to spur speedy economic growth. “The new constitution has empowered Nepalis with lots of constitutional rights. Nevertheless, with the rights come the responsibilities. The proposed states can achieve speedy development and a higher level of economic prosperity by developing responsible citizens,” says CNI President Sharma. 

 

“Businesses will have teething problems in initial years 
of federalism”

 

Hari Bhakta Sharma, President, Confederation of Nepalese Industries (CNI)Hari Bhakta Sharma
President, Confederation of Nepalese Industries (CNI)

What are the expectations of the private sector after the federal system is implemented? What difficulties industries and businesses might face in the process? 
The private sector expects encouragement and the promotion of industries and businesses at the local level after the formation of federal units. We need an ecosystem to drive the economy into the federal model. Since federalism is a totally new system for us and for the government, citizens and the private sector, we need to increase our adaptability and a pragmatic approach is needed to implement it. Otherwise both the government and businesses will have to face tremendous difficulties. At present, we are working in a highly unpredictable industrial and business environment. Now we need to move forward to a more predictable scenario. That predictability can be ensured through rules and regulations and by becoming politically mature.   

I think the industries and businesses will face various teething problems for a couple of years. The problems are likely to be in the area of taxation. There are no federal policies formulated for companies or individuals to pay taxes to the state. For example, the companies may face problems in taxation while paying the salaries of employees across different states. Some of the policies regarding taxation are clear, while others need to be clear in interpretation. Similarly, the industries and businesses may face difficulties while transporting goods and extending services from one state to another. Prices of goods and services may vary due to the difference in rates of local taxes imposed across different states. Similarly, mitigating possible conflicts at the local level regarding the use and distribution of natural resources may also be a huge challenge. 

How is smooth implementation of the federal model possible economically? 
It requires clear policies backed by strong political will to implement the new system economically. The current industrial output of the proposed states is not equal. Each state will try to increase its revenue which would ultimately pressurise the private sector. If we can systematically structure the industrial sector, industries will go to the states where various facilities are announced at the local level. 

Nevertheless, such arrangements have not been made. Clear policies without ambiguities are required. There is a constitutional provision of forming a federal commission. The commission should introduce proper guidelines to avoid ambiguities regarding taxation and other economic policies. 

How can it be achieved?
The question here is on the tasks to be carried out at the central and state levels. The proposed Federal Economic Commission needs to formulate the guideline in very explicit language understandable to everyone as far as possible. Such a guideline will ease the doubts of the state regarding the distribution of money by the central government when such a mechanism is formed. It is important because the main financial aspect of the federal system is that the collection is done at the central government while the distribution is at the state level. A proportionate system needs to be enforced that avoids dispute regarding budget distribution. 

What needs to be done to spur a competitive environment between the states?
Certain states have inherent possibilities in Nepal.  These states can attract significant amounts of investments if the local governments show their strong willingness in development initiatives.  States are certainly going to compete with each other in the federal system. However, the nature of the competition, whether it will be positive or negative, is yet to be seen. If the states encourage and promote industries and businesses and adopt policies to attract investments, the competition will positively impact the overall economic development of the country. But if the federal units compete with each other only for the federal budget provided by the central government, the competition will definitely have a negative impact. 

I suggest three policies for healthy competition. Firstly, the states should focus on their core competencies. Secondly, the states should prioritise on innovation, employment generation and infrastructure development to achieve prosperity. There is a huge potential for hydropower, agriculture and herbal products across many states. For example, state number six and seven carry immense potential for agriculture, hydropower, tourism and herbal products. The states also need to establish technical universities to produce a skilled workforce. Similarly, infrastructure support such as roads and electricity supply is also required to lure investors. If the government properly plans such things during the implementation of federalism, the new system will largely benefit the country. 

Thirdly, everyone should act responsibly in order to develop the states. The new constitution has empowered Nepalis with lots of constitutional rights. Nevertheless, with the rights come the responsibilities. Now the time has come for everyone to become responsible. In my opinion, states can achieve speedy development and a higher level of economic prosperity by developing responsible citizens. 

How can the states become investment friendly?
Effective policies and their implementation are the keys to attract investment. Development of areas where infrastructure is lacking is possible only by attracting investment. There are several instances across the world where low developed areas offer lucrative incentives to lure the investors. In India, for example, low developed states offer cash subsidies and tax free benefits to investors. A similar thing can be done by the proposed states in Nepal. They can promote and encourage industries by providing cash incentives, tax free benefits and high quality workforce. 

What FDI policies are needed to attract foreign investors while implementing the federal model?
There are two preconditions for the inflow of FDI into a country. One is the ideal legal protection for investments and another is the competitive local investment environment. For legal protection, Foreign Investment Transfer Act needs to be amended or reformulated while going into the federal system. We need to study references from other countries including our neighbours regarding the process.  In today’s world, investors seek security for their investments, sufficient legal protection, repatriation of capital, and the cost of doing business in a country. 

Similarly, foreign investors are also attracted towards such countries where there is a high level of competition between local investors even if the policies are weak. The central as well as state governments should focus on developing infrastructures such as roads, hydroelectricity and airports. If states aggressively resolve the ongoing energy crisis, and provide quality and cheap electricity, industries and businesses are much more likely to invest.

What policies are needed to facilitate exports in the federal system?
Export in the current context is a global competition. We need to manufacture such products which can be competitive in the international market.  The long term sustenance of industries depends upon the quality and competitiveness of products and the support from the government.  The federal industry policies need to be devised in such a way that every state is able to establish industries according to its inherent potential. This will add value to the local economy. 

What is CNI doing in this regard?
CNI is the first private sector institution with ideas on how the economy should move and how it needs to be defined in the federal system.  We have submitted recommendations to the government and legislature-parliament on the federal economic model. Nevertheless, only a very few of our recommendations were incorporated in the new constitution. CNI will be actively engaging with all stakeholders to resolve the issues that are likely to come in the future. Our interest will be to provide appropriate feedback to the central as well as state governments.

 

“We expect competition among the states when attracting investment”​

 

Pashupati Murarka President, FNCCIPashupati Murarka
President, FNCCI

 

What challenges do you see in the federal system?
There are certain factors which we have to look at. One is the tax system and its structure. The central government should undertake the collection of major taxes like customs, VAT, excise duties and income taxes. These taxes are included in the new constitution under the central government as per our recommendation. After the implementation of federalism, there will be a three-tier administration system, at the central, state and local levels. The role of the new administrations needs be defined properly. Businesses could survive in large countries with bigger states or provinces with a sizeable population even if the tax rates vary. Nevertheless, it will be hard for industries and businesses to survive if the tax rates differ from state to state in a small country like Nepal. The tax system needs to be the same across the country. 

Free inter-state movement of goods, services and labour is another important factor. Creating tariff and non-tariff barriers on the transportation of goods, services, labour and resources will ultimately result in the decline of productivity and worsen the overall business climate. 

 Similarly, the distribution of national resources is another concern. The natural resources of all states should be kept under the control of the central government. The new constitution has stated that ‘major’ resources such as rivers will be kept under the central government. However, since the quantum has not been specified, disputes among the states are likely to arise regarding the distribution of such resources. The government needs to form mechanisms to identify, develop and collect revenues from such resources while also leveling the disputes that may come up in the future. 

What are your recommendations on the federal tax system? 
We have succeeded in convincing the lawmakers to exclude the dual tax system while the new constitution was being written. Earlier, the right to collect excise duty and income tax had been given to both central and state governments in the draft of the constitution. Our keen interest is to avoid hindrances in operating businesses and industries at any place. It will be easy to work if uniformity is maintained across all states. Varying rules and regulations in different states would increase the cost for industries and businesses. 

What can we learn from the federal tax practices of other countries, particularly India?
We are focusing on the tax system. We have brought tax specialists from Germany and conducted interactions with the policymakers and government officials at different levels and places. We can learn particularly from India regarding the tax system practices. India is planning to introduce Goods and Services Tax (GST) by abolishing the central and states sales tax. GST is the best tax system which is being practiced across many countries of the world. 

How challenging is it economically to implement federalism in Nepal?
Our country is a small and we have limited resources. Administrative costs will increase in the federal system. It is economically challenging because we have to go through more than four states to bring goods from east to west which will increase various associated costs and create hindrances.

How can we create an investment friendly environment?
We expect competition among the states when attracting investment. The proposed states need to focus on such competition by announcing attractive schemes rather than competing to impose taxes. Indian states including Gujrat, Maharashtra, Haryana and Bihar are success stories. Such activities will help in the rapid development of the states. However, if there are hindrances for the private sector, the development of the states will be affected negatively.

How can Nepal increase FDI in the federal system?
FDI is very important for the development of an underdeveloped country like ours. Lawmakers and the government must change how they look at FDI. The mentality that foreign companies come here and take away the profit should change. 

What facilities can be given to the investors by the state governments?
 Flexible laws regarding labour and the acquisition of land need to be formulated. This will create a positive business and investment climate in the country. Moreover, state governments should have a business-friendly approach in formulating environmental laws. Investors will get attracted to states with a pragmatic and business-friendly approach.

How is FNCCI planning to move ahead in the federal system?
FNCCI will play a coordinating role to avert the possible problems in the federal system. We will move forward amending the FNCCI’s constitution according to the federal structure of the country. Moreover, we will play a positive role in such a way that the government can also benefit and entrepreneurs will also get a sound business environment

 

“Implementation of federalism in our context is a challenge”​

 

Pradeep Kumar Shrestha, Past President, FNCCIPradeep Kumar Shrestha
Past President, FNCCI

 

We are about to enter the federal system. What are the expectations of the private sector?
We expect investment and business friendly approach from the central government as well as the governments in the states. The country will economically leap forward if effective policies are formulated and implemented. 

When the nation got the new constitution, the private sector welcomed it. We have been continuously stressing on the need for proper economic development without which the country cannot be stable, despite the change in the current political scenario. 

How challenging is it economically to implement federalism?
Implementation of federalism in our context is a challenge. Issues such as taxation and unobstructed transport of goods and delivery services will directly impact investments. Similarly, the distribution of resources among the states is also likely to become contentious. 

Clear and effective policies regarding investment, taxation and inter-state transportation of goods and services need to be formulated beforehand. Free transport of goods and services should be put into effect. Similarly, introducing a central tax system can ease the problems regarding taxation. The business community needs to be assured that it will not be double taxed. Central duty structure can be formulated to collect the revenue from the customs points. The government then can distribute the money to the states. This will also ease the dispute among the states regarding the distribution of government revenue. Meanwhile, the states can be given authority to collect local taxes. 

 The implementation of a federal structure in a country like Nepal comes with lots of challenges. We do not have proper mechanisms to resolve the possible disputes between the federal units regarding the distribution of resources. All these factors will have either a positive or negative impact on the country’s economy. 

How can the federal tax system be streamlined?
The central government should announce clear tax policies before implementing the federal system with the states adopting it accordingly. A consensus on tax collection, revenue generation and distribution of resources is also needed. 

FNCCI has recommended various suggestions to the government and lawmakers on these issues. We have mentioned that the FDI policies should be governed by the central government.  Similarly, we have made various suggestions on revenue generation and distribution of taxes in state and central levels. We have demanded clarity on issues such as the roles of the central and state tax administrations and distribution of rights. For example customs and excise duties, VAT and institutional income taxes should be kept under the central tax administration. Similarly, state authorities can levy taxes regarding the use of vehicles, properties and other local taxes. Likewise, business tax can be under the state administrations.  Dual taxation needs to be avoided while formulating tax policies. The lawmakers should focus on avoiding ambiguities.  

How can the proposed states competitively attract investment?
It is important for healthy competition between the states. In my opinion, there should be competition among the proposed states in facilitating and supporting the private sector rather than taxing and becoming extractive. States can largely benefit from the support they provide to the industries and businesses. 

It is possible to attract investment in the proposed states with fewer resources through effective strategies. For instance, states with little natural resources can prosper by attracting investment in sectors such as agriculture and tourism along with infrastructure development. We can take the Indian state of Bihar as an example. Similarly, the US state of Nevada, which in fact is a vast desert area, has prospered through the gambling and gaming industry. Likewise, we can take inspiration from the competitive initiatives of Indian states in terms of attracting investment. 

 Politicising everything in every sector has been the main problem in our country. This malpractice needs to be stopped. It is challenging to make the states sustainable. Nevertheless, identifying core competitive areas and implementing effective economic plans can help the states to become self-sufficient. 

How can we resolve the disputes that are likely to arise in the federal system regarding the distribution of resources? 
Lawmakers need to take precautionary measures when distributing resources. Proportionate distribution of resources can ease the likely tensions among the states. A river flowing from north to south can generate electricity while irrigation can also provide facilities across many states. A pragmatic approach is required to resolve such disputes. 

Political parties also have a greater role in leveling disputes in case they arise. Leaders should leave aside their egos and come out with a sensible civic insight to mitigate altercations. Broad magnanimity is required among the communities and political parties to avoid conflicts. We have to study references from other countries regarding the dispute among federal units and their resolutions. We can also develop think tanks at central and state levels to advise the governments with pragmatic solutions. Similarly, the involvement of the private sector in policy making is also necessary to avoid such shortcomings while the country adopts the federal system. 

What are your suggestions regarding the FDI policy?
The major drawback of our country is the lack of infrastructures, be it industrial or administrative. We have to demonstrate open magnanimity to the foreign investors. Hydropower sector, for instance, carries a huge potential in terms of attracting FDI. Nevertheless, we have just been able to produce 700-750 MW over the last century. Now the time has come to streamline policies and ease various bureaucratic hurdles to welcome foreign investors. The proposed states need to adopt a one window policy and provide more facilities to international investors to attract FDI across various sectors. If a state can be a perfect model for foreign investors, others too will follow suit. There will be a competition among the federal units to attract foreign investments which will ultimately benefit the whole nation. 

How is FNCCI adopting the federal system?
Currently, we are actively involved in the amendment of the FNCCI constitution to make it, and ourselves, compatible with the new constitution of the country. Our organisation will have representatives from the seven states from the earlier 14 administrative zones. The new FNCCI constitution will be announced after a few months. 

Our new constitution will incorporate the idea that the scope and market of business should cover the whole nation. We are also thinking of electing additional three or four nationwide representatives with the seven from the states. This will spur a connection of businessmen across the nation. Our thrust will be to involve all proposed states in the economic development of the country leaving 
none in isolation. 


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