Thursday, November 22, 2007

Decentralization looks on track but wealth distribution matters

By Martin Manurung and Erny Murniasih, Jakarta
(Jakarta Post, Thursday 22 November 2007)

Seven years on, decentralization faces a critical question: is it going down the right track?

Regional autonomy was part of Indonesian democratic reform, one of the manifestations of the democratization processes which began after the fall of Soeharto. Along with political decentralization, which aims at bringing the government closer to the people, Indonesia also launched economic decentralization to achieve better distribution of income between the central and the local governments. It is also expected that these reforms will enhance the capacity of local governments to provide better services to the people.

Nevertheless, local economic development has been slow. Although the total Gross Domestic Regional Product (GRDP)of the provinces between 2005 and 2006 increased slowly - by about 13 percent -- the GRDP distribution is still concentrated in certain provinces, such as DKI Jakarta. The province with the slowest growth is North Maluku. In addition, the gap between the richest and poorest province tripled over the same time period, demonstrating great inequality among regions.

Another issue is the amount of money that the central government has transferred to the regions. Since 2005, the ratio of the Intergovernmental Fiscal Transfer (IGFR) amount to the total amount of state budgets increased steadily. The figure, in 2005 was 27 percent, increasing to 32 percent in 2006 and 34 percent this year.

The 2007 Government Financial Note argues that more IGFR will result in a higher GDRP, which is the aggregate local income. However, due to problems of inequality and fiscal imbalance, an increase in IGFR does not always mean people are better off at the local level. We must also ask whether the allocated money is effectively spent, on better public services offered locally.

As discussed above, it is the people who should benefit the most from decentralization. Nonetheless, from a budgetary perspective, the majority of local budgets are primarily used to pay the salaries of local government officers. The proportion of the total budget spent on their salaries was 41 percent in 2006 and 43 percent in 2005. Thus, it is an undisputable fact that decentralization program monies are not effectively and efficiently utilized to enhance local economic development.

With this background, several points can be made. First, the government should reconsider the mechanism behind local budgeting. It is true that intervention from the central government is generally undesirable in the local budgeting process. Many believe this would hinder the full implementation of decentralization.

However, as in other countries, it is crucial that local governments are given certain guidelines from the central government, to ensure that budgets are created without delay and that budgetary funds are spent on the delivery of public services.
Recent reports indicate that local governments have "parked" up to 62 trillion rupiah in bank deposits and the central bank certificates (SBI). This is mismanagement of public funds which obviously does not benefit the people.

In view of the mismanagement risk, the central government should not leave local governments on their own, particularly in budgeting matters. This is extremely important because local legislative councils have not been an effective advocate for public needs and public participation in budget preparation is very limited. Therefore, the central government should provide clear and comprehensive guidelines to minimize mismanagement and misinterpretations of regional financial regulations.

Second, the equalization grant needs revision. Currently the amount of this grant is significant. The equalization grant has contributed to overall IGRF to the tune of 60 percent. However, as discussed, the gap between regions is still an unresolved problem. Thus, the government and the parliament must pursue better alternatives to fix the horizontal imbalances.

Third, the complexity of government procurement requirements deserves a thoroughgoing review. Delays in budget implementation is often blamed on these rules. The government must simplify the process without compromising on transparency and the fight against corruption.
Finally, bringing the government closer to the people -- the overall aim -- will remain merely a catchphrase if there is no harmonization between central and local governments. Both sides must work together to resolve the above issues and put aside narrow-mindedness.

Martin Manurung is a senior consultant at Sekurindo Global Consulting and Erni Murniasih is a practitioner in Fiscal Decentralization. Both are 2005 British Chevening Scholars and based in Jakarta.

Monday, November 12, 2007


By Erny Murniasih

In Indonesia, according to Law 33/2004 on Fiscal Balance between central and local government, intergovernmental fiscal transfers are aimed to reduce fiscal gap among tiers of government and between sub-national governments. The so-called ‘Balance Fund’ policy deploys in the form of: Revenue sharing, Specific Purpose Grant (DAK), and General Purpose Grant (DAU).

Revenue Sharing
Revenue sharing is allocated to sub-national governments in order to address the problems of imbalances between central and local governments. As in many countries, some major taxes remain at the central level, i.e. personal income tax, VAT, and property tax. Until recently property tax is still administered at the central level but almost all the money is allocated to local governments through revenue sharing.

The mechanism for revenue sharing derives from taxes and natural resources revenues based on derivation basis from the originating local governments. Revenue sharing from taxes comprises of sharing of revenue from property tax, property tax transfer fee, and PIT.
As for the shared revenue from natural resource, it consists of shared revenues from forestry, mining, fishery, oil, and gas. In addition, the new law on Central and Local Fiscal Balance stipulates additional shared revenue from geo-thermal energy and re-forestation fund. The latter is formed as an earmarked grant for rehabilitating forests in originating local government.

Pressures during the drafting of the new law on Central and Local Fiscal Balance, particularly from rich-natural sources regions, has resulted such changes. The law 33/2004 mandates additional revenue sharing mechanism from geothermal energy and re-forestation. The latter is an earmarked grant specifically for rehabilitating forests in originating regions.
Moreover, the new law also mandates additional percentage on the revenue sharing from oil and gas. According to this, sub-national governments will receive an additional 0.5 percent from oil and gas. Such additional amount is also earmarked for specific provision, that is, for education. Of the 0.5 percent, 0.1 percent goes for provinces, 0.2 percent belongs to originating local governments, and the rest 0.2 percent is divided equally to all local governments in the same province.

Other than these two main changes, the other mechanism on revenue sharing remains the same with the previous scheme in law 25/1999.

General Purpose Grant (Dana Alokasi Umum/DAU)
The DAU intends to address both problems of vertical and horizontal imbalance. Thus it is expected to equalise fiscal capacities across regions to finance public services.
Law 33/2004 sets forth the total amount for DAU allocation as at least 26 percent of net domestic revenues, and starting from 2007 the percentage becomes 26 percent. Previously the magnitude of DAU allocation is 25 percent. The portion for provinces and municipalities/districts is determined by the proportion of responsibilities assigned to each tiers of government (article 29).

In principle, the main content of amendment of DAU in the law 33/2004 concerns the formula for fiscal gap and the basic-amount allocation. The formula for fiscal gap is using the difference of expenditure needs and fiscal capacity. In the law 33/2004, expenditure needs are measured with using proxies of population, surface area, index of cost construction, the inverse of the Human Development Index (HDI) and the inverse of the Gross Regional Domestic Product (GRDP) per capita index.

From the fiscal capacity side, the calculation is based on own-source revenue (OSR) and revenue sharing. OSR is calculated based on the revenue raising capacity (potential revenues) while revenue sharing are shared revenues from tax and natural resources.

Moreover, a major breakthrough of DAU formula in the law 33/2004 is the elimination of hold-harmless provision in the beginning of year 2008. Historically, hold-harmless provision is to maintain all regions should receive DAU in current year at least equal with the amount of DAU received in the previous year. This has been part of the agreement between the Budget Committee in the parliament and the government in the DAU for 2002. The existence of hold-harmless policy in the DAU has certainly disrupted the performance of DAU to improve horizontal fiscal imbalance.

Specific Purpose Grant (DAK)
A conditional or earmarked transfer scheme, DAK, is allocated to specific regions and certain sectoral programs. DAK intends to ‘promote the attainment of minimum standards and compensate for benefit/cost spill-over related to priority capital investment’ (Sidik 2004,p.392). Hence, it is confined mainly to finance physical capital investment and limited-period financing of operational and maintenance needs.

The criteria for DAK are based on the general, special, and technical criteria. The general criteria should consider the financial capacity of the regions, while special criteria emphasise on the characteristic of the regions. Technical criteria are more specific and established by line ministries.

Conditional term attached in DAK lead to the limited scope of sub-national governments’ entitlement, particularly in the usage of funds. Central government gives direction for using DAK for designated sectors. In 2007, the designated sectors which received transfer from DAK comprise of: education, health, infrastructure, fishery, agriculture, local governments’ infrastructure, and environment.


By Erny Murniasih

The previous post has written about the key elements of fiscal decentralisation. One of the elements is intergovernmental fiscal transfers (IGFT). The IGFT has some objectives as follow:

a. To address vertical fiscal imbalances
Historically, the problem of vertical imbalances may always persist, since broad and substantial taxes remain at the central level. Indeed, sub-national governments are often left with low-yielding, unpopular taxes, mainly focused on production rather than wealth and income. This leads to difficulties in tax collection. Thus, intergovernmental transfers are needed to achieve vertical balance.

b. To address horizontal fiscal imbalances
In developing and transition countries, it is not unusual to have large disparities between the richest and the poorest regions. This may happen due to variations in the capacity of sub-national governments to generate own source revenues. Such variation depends on the performance of potential taxes which are derived from the nature of the local economic activities. The disparities will widen because the more urbanised local governments have the greatest taxable capacities. In addition, administrative capacities vary amongst sub-national governments. Hence, this will lead to horizontal imbalances. A system of equalisation grant might be justified to address such problems.

c. To address inter-jurisdictional spill-over effects (or externalities)
There are some public services that have spill-over effects (or externalities) on other jurisdictions. Higher education and pollution control are some examples. A local government may under-spend for these services without paying attention of the substantial public benefits. Therefore, central government should provide incentives or financial resources for local governments to address this particular problem.

There are types of intergovernmental transfer to address the various designated objectives.

a. Conditional transfers
In this scheme, the central government specify the purpose(s) for which the recipient government can use the funds. The types of transfers classified in this group:
(i). Matching open-ended grant, that is, the central government grant depends upon the local governments’ behaviour in spending.
(ii) Matching close-ended grants. This scheme employs a ceiling on the cost borne by central government due to budget constrains in central level.
(iii). Non-matching grants. In this scheme, central government offers fixed sum of money which is directed on a specified public good. Thus, local government does not have to match the contribution of central government.

b. Unconditional transfers
This type on transfers places no restriction of the use of the money. In theory, the scheme consists of revenue sharing arrangements and general purpose grants. The main justification for unconditional grants is that such grants can be used to equalise fiscal capacities of different local governments to ensure the provision of a minimum (or reasonable) level of public services (Ma, 1997). In Indonesia, IGFT (a.k.a in Indonesia “Kebijakan Dana Perimbangan”) consists of Revenue Sharing, General Purpose Grant, and Specific Purpose Grant.

... to be continued