Indonesia's fiscal decentralization and its effect on provincial public finances.

Author:Seifert, Jan

    Following the overthrow of President Suharto and with the implementation of reformasi Indonesia engaged in a wide-ranging decentralization move in 1999. In a first analysis of the fiscal implications of the 1999 decentralization laws Alm et al. (2001) suggest that "no nation has ever undertaken economic decentralization on the scale that would result from the laws already in place" (Ibid, 100). However, it should not surprise that Indonesia with its 250 million inhabitants over 3 time zones has decentralized given that "[t]he size of a country [...] seems to be a significant determinant of the degree of expenditure decentralization" (Bahl & Wallace, 2005, p. 92). 15 years forward and with a more consolidated division of powers between the layers of government as well as a series of fiscal data now being available, the discussion over the effects of Indonesia's fiscal decentralization continues. This paper contributes to that debate by analyzing the so far understudied fiscal position of the provinces (provinsi), the middle tier of government between the national and local level (city and district / kota and kabupaten).

    Unlike the stable and healthy fiscal position of the national government, a key feature of provincial budgets is their high variance of a number of fiscal indicators and outcomes despite an otherwise steady economic development of the whole country (see Table 1). This paper aims to explain these outcomes by discussing the structural fiscal policy challenges for Indonesia's provinces. It does not analyze or assess the quality of its spending policies.

    The subsequent analysis and discussion of the specific challenges for provincial governments fill a gap in the literature on Indonesian public finances. Many studies focus either on the central government and Indonesia as a whole or they subsume subnational government under one heading, while de facto discussing the situation at the local level (Blondal, Hawkesworth, & Choi, 2009; Butt & Parsons, 2012; Lewis & Oosterman, 2009; Shah, Qibthiyyah, & Dita, 2012; Venning, 2009; World Bank, 2007). By focusing on the lesser studied provincial governments and by drawing on a new dataset of provincial-level budgets from 2000 to 2012 this paper extends the debate over Indonesia's decentralization and focuses on a level of government that has its own particular challenges, varying from that of local (or the central) governments.

    The paper proceeds as follows. In the next section some background about Indonesia's fiscal decentralization process and the functioning and financing of its provinces is provided. Section three then presents the fiscal challenges of the provinces and these are discussed along five parameters (fiscal health, revenue and expenditure stability, effectiveness in budget management, fiscal independence and fiscal disparity). Subsequently, we discuss more generally the provincial fiscal vulnerability after decentralization. Finally, the fourth section sums up the findings and presents some recommendations for tackling the provinces' fiscal challenges.


    2.1 Historical development and political landscape

    Following the 'Asian financial crisis' and subsequently rigged elect ions in 1998 the long-term President Suharto resigned and a broad transition towards pluralistic democracy came to being commonly referred to as 'Reformasi'. Subsequently, since 1998, Indonesia has developed into a functioning multiparty democracy and engaged in an extensive program of devolution. Bahl and Wallace suggest that "Indonesia's decentralization followed the economic chaos that came with the Asian crisis, and it was a reaction to what was perceived to be overcentralization" (Bahl & Wallace, 2005, p. 85). As part of the process most of Indonesia's decentralized domestic fiscal relations have been codified in laws (no. 22/1999 and 32/2004) and government regulations (no. 25/2000 and 38/2007) since 1999. They stipulate the system of political and fiscal competences of the three main layers of government (central, provincial, local) (3) as well as the funding mechanisms. Although there was a wide consensus for decentralizing the country after Suharto, the country did not strengthen its regions as part of the decentralization push. Instead it delegated powers to local government units (kabupaten/kota, k/k) due to fears of secession (UNDP Indonesia, 2009, p. 5) e.g. about the most eastern (Papua) and western (Aceh) provinces at the time. This led to a situation in which a significant share of funding and political responsibility now rests with the local level (town and district), whereas the role of the provinces is mostly a supportive and intermediary one.

    In 2011 around 64% of expenditure is incurred at the central government, 27% at the k/k and 9% at the provincial level (Shah et al., 2012). In the 2014 budget the share of central government expenditure has gone up to 67.8% (4) Whereas the central government is responsible for common nation-wide concerns like defense, religion, trade and some welfare regimes, the local level is responsible for the local infrastructure and the delivery of most public services like health care and education. This leaves little distinct responsibility for provincial governments. It mostly holds a supportive or coordinating role including the following:

    "(1) deconcentrated functions of the national government, (2) providing assistance to certain national government affairs, (3) providing services that are provincial in scale or concern, (4) coordinating inter-regencies/cities and cross border or regional affairs, (5) taking care of functions that certain local governments are not able to perform, and (6) facilitating local governments to carry out their affairs" (UNDP Indonesia, 2009, p. 8).

    The decentralization laws also stipulate eleven mandatory provincial competences. However most of these overlap in big parts with those of the local level (e.g. environment, health, education) (Ibid). It is therefore ill-defined what the concrete function of the provincial level actually is. That ambiguity is also reflected in its political role and functioning. The evolving decentralization process has also seen the number of provinces grow from initially 26 in 1999 to 34 in 2012, mostly due to the carving out of resource-rich parts of existing provinces. On top of that and partly because of secessionist movements the two Papua provinces and Aceh have a high degree of autonomy (including special financial autonomy support from the central government).

    Institutionally each province is governed by a (directly-elected) governor who is elected for 5 year-terms. The legislative side is made up of a regional chamber (Dewan Perwakilan Rakyat Daerah Provinsi, DPR-D) which is elected every five years in parallel to the national parliament. Executive responsibility lies with the governor but provincial budgets need to be adopted by the DPR-D which also performs oversight functions. On the budget management side, however, the situation is complex. Provincial budgets are passed by the provincial parliament but require approval from the national Ministry of Finance (MoF) before execution. This usually takes some time with implementing orders and final budget figures not coming through until some months into the budget year (Blondal et al., 2009). At the same time the governors act as the representatives of the national government. Their delegated task is to check and confirm the legality of local government budgets--which in turn delays project and service implementation at the lower levels of government.

    Provincial and local governments are in great parts financed through transfers from the central government although there are also big differences in their relevance for the two decentralized government layers. In 2004 figures (World Bank, 2007, p. 120) the General Allocation Grant (DAU) is by far the biggest source of local government income, representing 62% of total revenues, while own-source revenues (PAD) only account for 8%. MoF figures for the provinces show that DAU accounts for only 15% of provincial revenues and own-source revenues for 47%. Table 2 shows the relevance of the different revenue sources for the provincial aggregate. As discussed further below they may vary quite substantially across provinces but it is also clear that the revenue structure of the provinces is significantly different from that of the local (k/k) governments due to the different formula for DAU, lower levels of expenses and more advanced ability for provinces to cover these with own-source revenues.

    The own-source revenue (PAD) is collected directly at the provincial level in the form of taxes and fees. It is relatively diverse with the biggest source coming from vehicle taxes that are exclusively charged at the provincial level. Transfers (DBH) include primarily shared taxes (income, property, change of ownership) as well as the General Allocation Grant (DAU) and Special Allocation Grant (DAK) to lower tiers of government. The remaining intergovernmental transfers are the autonomy funds for Aceh and Papua and some other adjustments. Central government transfers make up a sizeable share of provincial income although, compared to the local level, provinces have a relatively high degree of self-funding from their own resources. For the shared taxes (DBH) there is a formula stipulating the division between central government and provincial/local (see Table 3 below). The DAK is relatively insignificant as a share of total revenues, but it is a fund with relatively high extractive interest for policymakers due to its opacity (Seknas FITRA, 2012, p. 14). Priorities for DAK projects are primarily defined at the parliament in Jakarta. The DAU is a formula-driven mechanism including two components: the basic allocation and the fiscal gap. The basic allocation makes up almost half of the DAU and...

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