The Making of the Big Bang and its Aftermath A Political Economy Perspective (Part 3 of 3)

Bert Hofman and Kai Kaiser World Bank¹

Paper Presented at the Conference: CAN DECENTRALIZATION HELP REBUILD INDONESIA?

A Conference Sponsored by the International Studies Program, Andrew Young School of Policy Studies, Georgia State University

May 1-3 2002

Atlanta, Georgia

3. Issues in the Intergovernmental Fiscal System

Indonesia’s new intergovernmental fiscal system devolves on aggregate enough resources to cover the devolved expenditure responsibilities. But the intergovernmental fiscal system is as of yet far from ideal. The distribution of resources and tasks has caused budgetary problems in some of the regions, especially at the provincial level. The regions’ high dependence on central transfers could undermine local accountability. Inadequate provisions for local taxes risks inappropriate taxation and unhealthy tax exporting. And finally, the system has few means for central government to finance national priorities at the local level.

Law 25 of 1999 meant fundamental reforms of Indonesia’s intergovernmental fiscal relations. The reforms strongly increased the regional government’s share of government resources, moved the transfer system from one dominated by earmarked grants to one largely relying on general grants supplemented by revenue sharing, and—with the reforms introduced by law 34/2000—gave broad taxing authorities to local government.

Before the 2001 decentralization, most resources were transferred from central to regional governments through earmarked grants. The largest of these was the SDO (Subsidi Daerah Autonom or subsidy for autonomous region) grant which covered all civil service salaries and recurrent expenditures for the regions. In addition, INPRES (Instruksi President) grants aimed to finance development spending in the regions. The INPRES grants started as a block grant for development spending in the 1980s, but gradually evolved into an array of specific grants for purposes ranging from re-greening¹⁸

In the new system, central regional transfers remain the dominant means of financing, but the earmarking is gone. The bulk of regional government spending is financed by transfers from the center (see Table 1:DAU Dominates). Well over 90 percent of regional revenues come from the Balancing Fund (dana perimbangan) which includes a general grant (the Dana Alokasi Umum or DAU), shared taxes, natural resource revenues (SDA, sumber daya alam), and a special allocation grant channel (DAK, dana alokasi khusus) Local governments have limited own revenues (PAD, pendapatan asli daerah), which constitutes less than 7 percent of total revenues. Starting 2002, the center is also making additional special autonomy transfer arrangements with two provinces.

Dana Alokasi Umum. The Dana Alokasi Umum (DAU) or general grant is the mainstay of the new intergovernmental fiscal system. The DAU adds up to some 65 percent of regional revenues, and to a little over 70 percent of the Balancing Fund. The DAU is by law a minimum of 25 percent of central government revenues after tax sharing.¹⁹ For 2001 and 2002 this minimum allocation has been maintained by Government and Parliament. However, although the law and the regulations suggest that the 25 percent is the share of actual revenues after revenue sharing, for FY2001 the budgeted amount was disbursed. In all, this cost the region some Rp. 9 Trillion in revenues, or 15 percent of the total DAU for that year.²⁰

Because the “hold harmless” element was interpreted to be a minimum DAU allocation rather than a guaranteed amount, this element took almost 80 percent of the total DAU. In 2002, the minimum DAU was reduced to 50 percent of the total amount, but rather than relating it to past SDO and INPRES, is became a minimum amount per region, plus an amount related to the actual wage bill of 2001. But “hold harmless” obtained a new meaning: Parliament objected against the proposed distribution of the DAU, because the richer regions stood to lose compared to the 2001 distribution.²¹

The formula part of the allocation relies on the notion of expenditure needs and own fiscal capacity. The share in the DAU pool for a region depends on the difference between its fiscal needs and its fiscal capacity. For 2001 there concepts were interpreted different from 2002, in part due to practical reasons, in part due to more analysis done for 2002. In 2001, at the time the formula had to be presented to the Regional Autonomy Advisory Council, the data on shared revenues were not yet available, and it was decided to ignore them. For 2002 they were included, but natural resource revenue shares only for 75 percent. As indicators for expenditure need the formula includes (i) population; (ii) poverty rate; (iii) land area; and(iv) the construction price index as an indicator of “geographical circumstances.” The formula must include these variables, as they arementioned in the elucidation of Law 25/99. In the 2001 formula each of the variables was included with equal weight, whereas in the 2002 formula, population and area both received higher weights than the others.

Contingency. The DAU allocation was supplemented by a “contingency fund” to absorb any mismatches between devolved expenditure responsibilities and revenues. Of a budgeted amount of Rp. 6T. in 2001, some Rp. 3 T was disbursed. The first tranche of Rp. 1.1 T. related to genuine mismatches caused by decentralization. A process of application, review and allocation set out in a Presidential decree was followed for this tranche. The second tranche, however, became necessary because of the centrally mandated salary increase which pushed up the regional wage bill by some 15-30 percent.

Shared revenues. The 2001 decentralization greatly increased the importance of shared revenues. The most important factor was the inclusion of oil and gas revenues and personal income tax in the taxes to be shared. The former were included to accommodate long-standing dissatisfaction of natural resource rich regions which felt that “Jakarta” took their resources, and they did not get anything in return. True or not, with the implementation of Law 25/1999, they now get a significant share of those revenues (see Table 2: Revenue shares). In addition, the personal income tax was included for sharing through Law 17 of 2000.²² For each of these shared taxes, the province gets a minor part, whereas the bulk of revenues goes to the local governments.

The sharing formulae for most of the shared revenues contain an additional element of equalization. For oil and gas, mining, and forestry, the local governments of regions neighboring the producing region receive a share as well. For fisheries, property tax and land transfer tax, a small percentage of the revenues is shared by all local governments in Indonesia. Whereas the underlying motivation may well be one of equalization, with the initiation of a formula-based DAU, these complex sharing mechanisms may well be redundant—whatever a region gets from those shared taxes is counted as own fiscal capacity, and reduces the allocation of the DAU.

Own Revenues. Law 34/2000 greatly expands the scope for local government revenues. The law amended law 18 of 1997, which intended to stop the then-prevailing local government practice of issuing a plethora of local government taxes, many with little revenue potential, and high costs to the taxpayer and the economy. Law 18/1999 therefore restricted regional taxes to a closed list, and made any additional taxes conditional upon approval of the Ministry of Finance.

Law 34 reverses the burden of proof. The law still gives a list of regional taxes, but regional governments can add taxes through regional regulations approved by the regional government council, as long as it abides by the principles mentioned in the law. These principles are sound (Box), but supervising them has turned out to be problematic—not least because the law has tight deadlines for central government to meet if it wants to cancel a local tax. An added complication is the way supervision is structured: Law 22/1999 gives the Minister of Home Affairs the authority to cancel regional regulations, including those on regional taxes. Up until now, the Minister has been hesitant to invoke these powers, not least because regional governments have the right to appeal his decision to the Supreme Court. As a result, there has been little to check regional government’s creativity in taxation, and although the damage still remains limited, 84 out of the more than 1,000 regulations on local taxes have been found to be in conflict with the law. Among them are taxes on the “import” of goats into kabupaten Bogor, and an advertisement tax on Coca-Cola bottles in Lampung province. Meanwhile, the Minister of Home Affairs has as of now formally cancelled only one regional tax.

Do the Regions Get Enough?

A key question for the new intergovernmental fiscal system is whether the regions on aggregate receive enough resources. This question can be considered in three ways: (i) do the regions receive enough resources to cover the expenditures needed for the tasks they are expected to perform? (ii) do the regions receive an amount compatible with what government as a whole can afford? and (iii) do the regions receive enough to cover the spending obligations they inherited from the central government in the course of decentralization.

Method (i), sometimes labeled the costed minimum standards approach, has practical and theoretical issues. For starters, as was argued previously, Law 22/1999 does not clearly define the functions of the regional governments, as the functions are defined negatively: local government does everything that the center and the provinces does not do. And for the obligatory functions of local government, which are defined in the law, it does not clearly define what part of the function local government performs, not what minimum standards of services should be delivered. Even if these issues could be overcome, the in formation to cost out the functions is lacking at present. Moreover, determining what the functions cost at present may not be very telling for what the functions should cost if efficiently delivered. But apart from all these practical objections, there is a more fundamental objection against this method: unless carefully managed, minimum standards are but a wish list of spending developed independently of what government as a whole can afford.

Method (ii) the affordability approach faces several issues as well. The method requires the Indonesian government to make choices for the nation as a whole as to what it wants to spend its scarce resources on. If the priorities so determined are tasks of regional government, then more resources would need to be devolved—be it through grants, revenue sharing, or devolution of more tax bases to regional governments.²³ Although the method is to be preferred over the costed minimum standard, there are numerous practical impediments, not least the lack of information in the current budget and accounting system which does not allow a link between policy goals and spending.

Central government could devolve more resources if it wanted to do so. Currently, a significant part of its spending is devoted to tasks that could be considered local government tasks. Taking the 2002 budget as a guide, the development budget still contains as much as 10-20 trillion or \[1 percent] of GDP in spending which could be further devolved to the regions, together with a corresponding increase in revenues. Note that implementation of these projects is already largely done at the sub-national level. However, since the financing is done from the central budget, there is no local scrutiny over the spending. On the recurrent budget, the wage bill probably offers further scope for savings, as not all civil servants that ought to have been decentralized actually were. Moreover, the Government has already decided to phase out the fuel subsidies over time, and this will further free up resources that could be made available to the regions. And finally, the government is determined to increase the tax ratio to GDP over time. One quarter of that increase will already be automatically transferred to the regions through the DAU, but more could be made available to the regions.

Whether increased resources should be made available remains to be seen. First, several areas of central government’s own responsibility that have been chronically underfunded, most notably Operations and Maintenance. Second, the central government is aiming for a zero budget deficit by fiscal year 04, and achieving this goal is likely to absorb much of the savings and additional revenues mobilize. And third, local governments may not be ready to absorb additional spending at this time, as they have just almost doubled their levels of spending, and their local planning, budgeting and financial management systems may already be stretched, and accountability at the local level is still weak.

(iii) Do the devolved resources cover the devolved responsibilities? On aggregate, more than enough revenues seem to have been devolved to match the transferred revenue responsibilities. This holds even if we take account of the July 2001 wage increase, and correcting the region’s own development spending for inflation. In total, the regions received “surplus” revenues of some Rp.21 Tr. in 2001, or 1.5 percentage point of GDP (Figure 3.__: More than enough).²⁴

One could, therefore, argue that decentralization “cost” the center this very same amount: if Government could have perfectly targeted the devolved resources, it could have transferred Rp. 21 Trillion less than it actually did. Lewis (2001, p.330) estimates an even higher surplus of Rp.27.5, but this was before the wage increase and the subsequent disbursement of the contingency fund. Lewis also estimates separately the surpluses of the provincial level and the local level. His judgment is that whereas at the provincial level the extra revenues more or less just cover the extra expenditures, local governments received most of the surplus. This findings jives also with the disbursements from the contingency fund, of which a disproportional amount was disbursed to the provinces.

Further evidence for the finding that more than enough resources were transferred can be found in development spending. Budgeted regional development spending made a significant jump in 2001, from an (annualized) Rp. 14 Tr. in FY2000 to a planned Rp. 26 Tr. in FY2001 (Table 3: Consolidated Development Spending).

The regions may have been forced to cut back slightly on these plans after the July wage increase, but there is every reason to believe that development spending in the regions rose significantly. This is good news for government development spending as a whole: because of the increase in regional development spending, the drop of central development spending as a percent of GDP did not lead to a n overall decline: for both 2000 and 2001, this was budgeted to be about 5.1 percent of GDP.

Thus, the regions as a whole do not seem strapped for funds. The increase in development spending in the regions also suggests that there is more than sufficient funds to cover the (recurrent cost of) functions transferred. Therefore, the often-heard argument that the regions spend mostly on “bureaucrats” and have too few resources for “services to the people,” therefore seems to be a red herring. In fact, on aggregate, wages make up little over 50 percent of regional spending (Table 4: Summary Regional Expenditures). Moreover, it is a misconception that only development spending can be considered as service delivery: as the civil service numbers in chapter 2 suggest, some 70 percent of the wage bill is paid to teachers and health workers, civil servants that provide direct services to the people.

In conclusion, on aggregate more than sufficient revenues were devolved to cover the additional expenditure responsibilities of the regions. Little can be said about whether this was enough to cover expenditure levels sufficiently large to cover some minimum standard of services in the regions.

How equal is the new intergovernmental fiscal system?

Sufficient resources for the regions on aggregate disguise large variations among the regions in fiscal capacity. Even after redistribution through the DAU, in FY2001 the richest local government had more than fifty times as much revenues per capita as the poorest one (Table A.2). The poorest region has only 20 percent of the per capita revenues as the average. And the variation among the regions as measured by the Gini coefficient for the per capita revenues for the regions is some 0.39.

Some of this variation can be explained by the small size of the units of local government in Indonesia.²⁵

But even if one aggregates revenues at the provincial level, the variation in revenue capacity remains large: the richest province has about ten times as much revenues per capita as the poorest one, and the poorest one has only some 40 percent of the revenue capacity of the average one. For comparison, in the US, the poorest state as about 65 percent of the revenues of the average state, and in Germany, any state falling below 95 percent of average gets subsidized. In Russia, the variation in the \[56] oblasts is more in line with that of Indonesia: the richest of the 89 regions has revenues per capita some 40 times higher than the poorest, which is still considerably less than that among Indonesian local governments, although larger than among the provinces.²⁶ In Brazil, the richest state has 2.3 times the revenues per capita of the poorest state.²⁷ In China, expenditures per capita in the richest province was some 17 times that of the poorest one, but excluding the city provinces of Shanghai, Beijing, and Tianjin, the disparity fell to 5.5 to 1.²⁸

Why are inequalities in fiscal capacity so high among Indonesia’s regions? After all, the Law on Fiscal Balance promises a system that would equalize fiscal capacity among the regions taking into account the regions’ own fiscal capacity and fiscal needs. Two causes of inequality stand out: (i) The large variation in own fiscal capacity among Indonesia’s regions, and (ii) the imperfections in the equalization mechanism of the DAU.

Disparities in own fiscal capacity.

Own fiscal capacity among the regions varies widely. Much of the variation is due to revenues from natural resource sharing. The few regions that do receive substantial amount, but not all. The distribution of the personal income tax share is highly unequal as well, with some regions receiving no revenues at all from this source. Relative to these two sources of revenues, variation in own taxes (PAD) per capita is relatively small.

Equalizing properties of the DAU²⁹

The DAU allocations reduce disparities in fiscal capacity among the regions. Whether it does so by enough is hard to tell, in part because the concept of equalization itself is left vague in the law, the regulations, and even in the political debate surrounding the DAU allocation. Law 25/1999 requires the DAU to be allocated such that it reduces the disparity between expenditure needs and “economic potential.” The allocation is to be done by formula taking objective factors of needs into account and own fiscal capacity. The elucidation of the law mentions explicitly the factors population, area, poverty, and geographical condition—which was later interpreted as cost differences. There are several reasons for this, but the key one was that the allocation of the DAU was restricted by the need to give regions enough finance to pay for the devolved government apparatus, and the resulting “hold harmless” clause was misinterpreted.

The hold harmless clause. In the run-up to 2001, the authorities had to solve the intractable issue of matching the new expenditure assignments with the new intergovernmental fiscal system. Expenditures “landed” in those regions where the government apparatus that was to be decentralized was located. To avoid that the bulk of the money, the DAU, would land somewhere else, and thereby risking that civil servants went unpaid and services break down, it was decided that the DAU allocation should hold regions harmless compared to what they received before in SDO and INPRES and what they had to spend extra on the devolved government apparatus. This became known as the “base amount,” equal to 130 percent of SDO and 110 percent of INPRES of (annualized) FY2000 amount. A true hold harmless clause would have ensured that regions would not fall below that amount. Instead, it became a minimum—absorbing some 80 percent of the total DAU.

The DAU allocation for 2001 therefore became strongly correlated with past distribution of grants. This favored the resource rich regions, because the old INPRES system was implicitly compensating these regions for the revenues generated by them. On top of the base amount, each region received an amount based on a formula that included fiscal needs and own fiscal capacity. But because information on revenue sharing was not yet known at the time of formulating the DAU, natural resource revenue shares were not counted as own fiscal capacity.

The “hold harmless” took on a different meaning in 2002. MOF had proposed a more equalizing DAU allocation for 2002—among others by now taking natural resource revenues into account, and the Regional Autonomy Advisory Board had approved the proposal. But the regions that stood to lose lobbied hard with Parliament, and even though according to Law 25/99 Parliament had no formal say in the distribution of the DAU (as opposed to the aggregate amount), it insisted that each region would get at least as much as DAU as in 2001.

The bottom line of all this is that the DAU allocations are less equalizing than one would expect based on the Law. Regression analysis in Hofman, Kajatmiko, Kaiser (partially reproduced in Annex 3) shows that the DAU is positively correlated with own fiscal capacity, and shows a strong relationship with the wage bill. Nevertheless, the DAU still equalizes in the sense that variation in revenue per capita as measured by Gini coefficient or coefficient of variation is reduced by the DAU (Table 5). The reason for this is that regions with high own fiscal capacity do receive less DAU as a proportion of that own fiscal capacity even though in absolute amounts they may receive more that regions with low own fiscal capacity.

Fiscal Dependency

Historically Indonesia has had one of the most centralized tax systems in the world (Ma, Jun 1997). The recent fiscal decentralization actually increased regional fiscal dependence, as measures by the share of own revenues (PAD) in total revenues.International evidence suggests that this high degree of dependence is inversely associated with governance outcomes (de Melo, Luiz and Matias Barenstrein 2001), and fiscal dependence should therefore be a concern for Indonesia.

Law 34/200 on regional taxes should have addressed the issue of fiscal dependency. However, the approach taken in that law led to another set of problems. Law 34/2000 allows for regions to issue their own tax regulations, as long as they abide by certain (sound) principles. This is far more liberal than Law 18/1997 which only allowed a limited number of taxes specified in the law, with high hurdles on additional taxes. At the same time, Law 34/2000 did not devolve a tax most suited for regional governments: the land and real estate tax.³⁰ Arguably the approach of Law 18/1997 may be better, even though it did perhaps not encompass an appropriate tax base for the regions “Nuisance” or “predatory” taxation have received some attention during the first year of decentralization. Many of those taxes are technically illegal, and improved central supervision is clearly one important remedy to this problem,. But a more fundamental solution to the “revenue hunger” of the regions will probably include enhanced local tax bases and marginal levels of revenue discretion. The trouble with this solution is that those taxes that may be most lucrative from a revenue basis, are also be less desirable from an equalization of fiscal capacity perspective (e.g., natural-resources or property/service based taxes which will disproportionately benefit urban areas).³¹

Directions for Reforms

Indonesia’s intergovernmental fiscal system can be much improved. The broad orientation of reforms is to have the relatively rich regions “fend for themselves” with own tax base, shared taxes and commercial borrowing. The poorer regions are to get support through DAU, DAK, and access to well-managed central lending and on-lending facilities to enable them to provide similar quality services at similar local tax rates throughout Indonesia.

Improving the intergovernmental fiscal system in this direction requires, among others:

• Moving to a more equalizing DAU by phasing out the transitional elements in the allocation.
• Restricting local taxes to a closed list over which the regions have tax rate autonomy—possibly within centrally set limits.
• This list of taxes should include the property taxes, and could include a local surcharge in the personal income tax and payroll taxes and selective business taxes. Expanding motor vehicle use or fuel taxation is a further option.
• Deciding on a transparent and consistent treatment of natural resource revenues in revenue sharing and in the equalization formula.
• Introducing a selective system of specific grants—combined with an (on) lending window—to promote the financing of national priorities at local level. A larger DAK could be financed from a gradual reduction in the center’s own development spending on regional functions.

References

¹ The findings, interpretations and conclusions expressed in this paper are entirely those of the authors. They do not represent the views of the World Bank, its Executive Directors, or the countries they represent. This paper draws on the forthcoming World Bank Regional Public Expenditure Review for Indonesia, and on Hofman, Kaiser and Kajatmiko (2001). The authors wish to express thanks to Jorge Martinez, Roy Bahl, Richard Bird, Roy Kelly, Dana Weist, Blane Lewis, Bernd May, and Machfud Sidik for the many helpful discussions on the topic of the paper. We thank Fitria Fitriani for excellent research assistance.

¹⁸ See Annex Table XXX for detail, and Silver, Christopher, Iwan J. Azis, and Larry Schroeder. 2001. Intergovernmental Transfers and Decentralization in Indonesia. Bulletin for Indonesian Economic Studies 37 (3):345-62

¹⁹ Law 25 is not specific on whether the 25 percent is before or after revenue sharing. PP104 has taken this interpretation, which has apparently been accepted by Parliament and the regions.

²⁰ Revenues in the approved budget for 2001 were Rp.263T and revenue sharing Rp. 20 T, which yields a DAU of Rp. 60T. Actual revenues as per preliminary outcome data suggests revenues of Rp. 299T. Assuming the same amount of revenue sharing, this would result in a DAU of Rp. 69T

²¹ This Parliamentary involvement in the distribution seems against Law 25/1999 which specifies that the Regional Autonomy Advisory Council proposes the distribution of the DAU to the President, who approves it by Presidential decree.

²² The sharing of the personal income tax on a derivation basis was decided at the last moment, and inspired by a conversation the Minister ff Finance had on a trip to disseminate the decentralization laws. Art .31C of Law 17/2000 describes the sharing. However, the article is unclear whether the sharing of the personal income tax is based on the residence principle or the place of work.

²³ South Africa is operating such a system. The constitution prescribes functions for the provinces and municipalities, and orders the government to give each level of government its “equitable share” of the national revenues. The equitable share is determined in the context of budget preparation, which in the case of South Africa is ased on a medium term expenditure framework. If, say, more priority is put on health case, the equitable share of the province—which is responsible for it, will; get a larger share.

²⁴ One caveat here is the assumption that all development projects implemented by the Kanvils and Kandeps continue to be financed from the central budget. This seems to have been the case but the center is now trying to find ways do devolve this financing responsibility.

²⁵ This point was made by Richard Bird in a comment at the Bali conference on Decentralization in East Asia, January 10-11 2002.

²⁶ Martinez-Vazquaesz, Jorge and Jameson Boex (1998): Fiscal Decentralization in the Russian Federation: Main Trends and Issues. Report prepared for the World Bank/EDI, December.

²⁷ Issues in Brazilian Federalism, Draft World Bank Report, May 8, 2001

²⁸ World Bank, 2001 China: Provincial Expenditures Review, Report No. 22591-CHA), November, Washington DC.

²⁹ For more detail on this issue see Lewis (2001) and Hofman, Kajatmiko, and Kaiser (2002)

³⁰ The thinking in the ministry of Finance on this has already shifted in the direction of devolvingthis tax.

³¹ Zhuravskaya (2000) argues that the intergovernmental fiscal system prevailing in the Russian federation in the ninetees provided no incentives to increase the local tax base or provide public goods. Shared revenue allocations effectively penalized regions that raised their own revenues. When regions effectively have no opportunity to increase local revenues, they will also have little incentives to increase the local tax base and will over-regulate local business.