Three Actions for More Equitable School Funding

In many countries, including Nepal, the quality of public education and other government services is linked to the wealth or poverty of a region. To address this inequality in public services, equalization grants are often used. These are funds allocated by the government to ensure all local areas can provide similar levels of services, regardless of their revenue-generating capacity. 

Our research has found that  the equalization grant allocation in Nepal does not align with the true cost of delivering public services, including education, creating an inequitable and uneven playing field across local governments.

Following the transition from a unitary to a federal system, three levels of government were formed in Nepal (federal, provincial, and local) with the principle of self-governance, sharing of power and devolution of authority. 

Accordingly, many public services, including basic and secondary education, were devolved to the 753 local governments in Nepal.

To support local governments in effectively carrying out these responsibilities, four types of grants were made available – fiscal equalization, conditional, special, and matching grants. 

Conditional grants, comprising 41% of the total share, impose specific conditions and constitute a significant portion of local government’s overall financing. Equalization grants, which are discretionary, only make up 17% of the share. 

In addition to these grants, local governments receive a portion of federal and provincial taxes and possess the authority to levy local taxes, which contributes approximately 35% to their total financing. The remaining financing, a small portion, is sourced from matching and special grants.

Equalization grants are intended to balance resources in areas with greater fiscal needs. However, our analysis shows a strong correlation between local government’s ability to generate internal revenue (in the form of tax and non-tax revenues) and the amount of fiscal equalization grants it receives. 

This means that local governments with high internal revenue tend to receive more equalization grants per capita, while those with low revenue aren't adequately compensated.

For example, a rural local government with limited capacity to generate internal revenue typically has higher cost of service delivery per student compared to more urban local governments like Kathmandu. 

These urban local governments benefit from economies of scale, like having less teachers serve a large student population, lowering the per-student cost. Despite this, rural local governments are not compensated with more equalization grants because they generate less internal revenue. This undermines the core purpose of equalization.

A similar correlation is observed with conditional grants, specifically in the education sector. A major share, 89% of the education budget for local governments, is funded through these federal conditional grants. 

Our analysis reveals that equalization grants are highly correlated with the amount of conditional grants received. This results in an un-equalizing effect, as local governments with lower conditional grants—those needing more funds from other sources—end up receiving less equalization grants.

Local governments with high internal revenue tend to receive more equalization grants per capita, while those with low revenue aren't adequately compensated.

When we look closely at how the equalization grant is divided, we see what causes the allocation. The grant is split like this: 30% is given based on population, 5% depends on the performance of the local government, and 65% is based on need. 

Of the need-based portion, 70% (or 45.5% of the total grant) depends on how much was spent in the previous year. Since a big part of local government spending comes from conditional grants (for education, it's about 89% of total education spending), it's clear that these conditional grants directly affect how the equalization grants are given out.

The argument here is that  equalization grants, in their current form, require reforms as they fail the core purpose of equalization. However, a more effective strategy is to avoid examining equalization grants in isolation. 

Instead, a holistic approach that simultaneously integrates the conditional grants, matching grants, and special grants is needed. The deficit in one grant type should be compensated by the another, with the overarching objective of aligning fiscal resources with the specific needs of local governments. The government is aware of the challenges and is working in coordination with development partners to improve the financing.

The following actions are needed to improve the situation:

Revise the grant methodology: The fiscal equalization grant methodology should be revised. The current approach favors historical expenditures over need-based indicators like the Human Development Index, socio-economic disparity, and infrastructure needs. Hence balancing through appropriate weightage is necessary, to ensure the funding aligns with the needs of specific local governments rather than putting higher weightage on the past expenditures.

Simplify Allocation Formula: Alternatively, the allocation formula could be simplified to make it more transparent. The current allocation formula is complex, consisting of interlinked and correlated indicators like human development index and infrastructure cost. However, it places little emphasis on fiscal capacity, which is measured by capacity to generate internal revenue. Further, the limited capacity of the local governments means that these allocation methods are often not well understood.

Simplifying the allocation formula to focus on allocation based on the fiscal capacity per capita, adjusted for the population density to match the cost-of-service delivery will ensure fairer distribution of funds across all local governments by leveling out their disparities in fiscal capacities. This simplification, coupled with performance-based incentives, will make the allocation more understandable for the local governments and motivate them to improve performance for increased rewards.

Integrate local government education financing. A long-term reform strategy should be to integrate local government education financing. The conditional grant, which is a major source of education financing, is currently based on the number of teachers allocated by the federal government to the local government. As the management of teachers devolves to local government, it makes more sense to shift full accountability to them through agreed performance standards. Consequently, the conditional grants can be gradually merged into adjusted equalization grants, with fund allocation based on nationally agreed standards like enrollment rates and student-teacher ratios between federal and local governments. 

This ensures that the fund allocation is aligned with the cost-of-service delivery. Additionally, it will enhance ownership and encourage local governments to invest more discretionary funds in education. 

Though this analysis is primarily focused on education, the re-evaluation of the equalization grant methodology has broader implications across all sectors. This  fair distribution of grants based on needs will establish a level playing field for all local governments, upholding the principle of equity in fiscal federalism.