Fiscal Decentralization in Indonesia
–
The Challenge of Designing Institutions
By
Claudia Buentjen*
Asian Development Bank
Manila
Abstract
Please send correspondence to Claudia Buentjen, Asian Development Bank, Office of the Director,
Programs Department East, P.O. Box 789, 0980 Manila, Philippines.
Fax: 632-636-2384; e-mail: cbuentjen@adb.org; htpp://www.adb/works/governance
1
IV
List of Abbreviations
Tables and Boxes
1.
International Development Policy Context
1.1.
Rethinking Aid
The case study of institutional changes in the field of fiscal decentralization in Indonesia has to
be seen against the background of an increased interest of the donor community in rethinking
the importance and effectiveness of foreign assistance. There are three major developments
which led to “rethinking aid” (World Bank, 1998).
First, there is a shift in the relevance of aid objectives. Short-term political and strategic
objectives of donors are less important than they were during the times of the cold war. The
objective to promote long-term growth and to achieve poverty reduction is gaining importance.
Second, due to budget problems in donor countries, rising private flows and again, the end of
the cold war, there was a sharp decrease in the provision of donor funds to developing countries
in the 90s. While OECD countries gave about 0.4 % in official development assistance as % of
GNP in 1991, the percentage declined to 0.22 % in 1997.
Third, the Asian crisis has raised awareness that the success of development policies depends
on the policy environment in which development takes place.
The three developments led to increased research and discussions on aid effectiveness. Some
of the major findings and lessons learnt are:

Donor financing with strong conditionality but without strong domestic leadership and
political support has generally failed to produce lasting change. The conclusion of this
finding is that policy-based financing should go only to countries with strong ownership for
domestically initiated reforms. Foreign aid cannot take the lead in promoting reform if there
is little local movement in that direction (World Bank, 1998: 47-59, Sachs: 1994).
 Projects in countries with sound policies and capable institutions have a higher success rate
(86%) than projects in countries with weak institutions and policies (68%) (World Bank,
1997a). The conclusion is that countries with weak institutions and policies will benefit little
from financing. In these countries the focus should be on creating and transmitting
knowledge and capacity. Areas of crucial importance are public expenditure management
and efficient public service delivery.
2

Strengthening domestic institutions and working with stakeholders outside the government
is important to create an effective public sector. Institutions are defined here as sets of rules
governing the actions of individuals and organizations, and the interactions of all relevant
parties and the negotiations among the participants. Specifically, countries need institutions
that strengthen organizations and promote good governance, whether through laws and
regulations or by coordinating the actions of many players (World Bank, 1999/2000: 3). In
broad terms governance is about the institutional environment in which citizens interact
among themselves and with government agencies/officials (ADB, 1995). Key elements of
good governance are accountability, predictability, transparency and participation.
1.2.
Decentralization: Designing institutions for improved service delivery
Related to the discussion of how institutions can best be designed for improved service delivery
decentralization has gained attention in recent years. As the World Bank puts it: “In many cases
innovative approaches to service delivery will involve … decentralization of decision-making”
(World Bank, 1998: 5, 83). While the record of decentralization worldwide is mixed, there is
substantial agreement that well designed and implemented decentralization can yield benefits in
terms of public service performance, political stability, equity and macroeconomic stability
(World Bank, 1999: 107-124).
One desired outcome is improvement in public service performance because decentralization
has the potential to increase the efficiency and responsiveness of government. Locally elected
leaders know their constituents better than authorities at central level and should be in a better
position to provide the public services local residents want and need. Physical proximity makes
it easier for citizens to hold local officials accountable for their performance.
However, there is also a risk related to decentralization programs. When expenditure
responsibilities are decentralized before revenues and there is a hard budget constraint, local
governments will not be able to deliver public services they are supposed to deliver. In contrary
to the opposite case of sequencing which endangers macroeconomic stability (see below) and
which was common in several Latin American countries in the 80s, this case has received much
less attention in the literature on decentralization.
3
A well-designed decentralization program is likely to improve on political stability. When a
country finds itself deeply divided, especially along geographic or ethnic lines, decentralization
provides an institutional mechanism for bringing opposition groups into a formal, rule-bound
bargaining process.
Whether decentralization exacerbates income differences between regions or becomes a
positive force in efforts to alleviate poverty depends on the following factors

The way horizontal equity between regions is addressed by the central government.

The way intraregional equity issues are addressed by regional governments.

Differences in resource endowments and needs of regions should be balanced to a certain
degree.
Differences in resource capacities may be due to the capacity of local citizens to pay taxes and
charges for public services and the capacity of local governments to derive revenues.
Differences in needs may be due to differences in the level of infrastructure and services
available; population, geographical size, and social conditions, and the costs of providing
services (due to geographical, climatic and other regional conditions).
Decentralization programs also affect macroeconomic stability. Two main impacts can be
isolated. The first is that sub-national governments might act pro-cyclically during business
cycles, thus raising taxes or cutting spending in recessions and cutting taxes and raising
spending during a boom. The second impact is that sub-national governments contribute to
structural fiscal deficits. As Tanzi (1995:17) puts it: “In several cases the local governments
have spent more than they have raised in ordinary revenue, thus, increasing their debt and
occasionally forcing the central government to come to their rescue”. The relevance of the latter
impact depends in particular on the borrowing provisions for sub-national governments.
Macroeconomic stability is also an issue of sequencing decentralization measures. When
revenues are decentralized before expenditure responsibilities, central governments are forced
to maintain spending levels with a smaller resource base, resulting in large central government
deficits.
Although there is insufficient practical literature to guide the transformation of a centralized to a
decentralized system and country-specific solutions have to be developed, there are some
internationally recognized and validated lessons to be learnt.
4
Box 1 gives an overview on some of the main lessons learnt.
Rule #1
Fiscal decentralization should be viewed as a comprehensive system
Rule #2
Finance follows function
Rule #3
There must be a strong central ability to monitor and evaluate decentralization
Rule #4
One intergovernmental system does not fit the urban and the rural sector
simultaneously
Rule #5
Fiscal decentralization requires significant local government taxing powers
Rule #6
Central governments must keep the fiscal decentralization rules that they make
Rule #7
Keep it simple
Rule #8
The design of the intergovernmental transfer system should match the objectives
of the decentralization reform
Rule #9
Fiscal decentralization should consider all three levels of government
Rule #10
Impose a hard budget constraint
Rule #11
Recognize that intergovernmental systems are always in transition and plan for
this.
Rule #12
There must be a champion for fiscal decentralization.
Source:
Bahl (1999)
The World Bank (1999:124) stresses as a major lesson the need to base systems on rules.
Also, the principle of finance follows functions, the necessity of a hard budget constraint at
subnational level and the need for ward-based local politics combined with direct elections for
mayors and governors are mentioned.
The following case study focuses on two aspects.
First, it seeks to document the Indonesian decentralization reform process so far. The
decentralization process is seen against the background of the economic and political transition
following the step down of President Soeharto. The purpose is to assess whether in terms of
due process criteria the decentralization process is likely to generate a successful or
unsuccessful institutional reform. Recommendations are developed on how to improve on the
decentralization process.
5
Second, the case study provides an initial assessment of the legal framework for fiscal
decentralization. In anticipation that the legal system will be reviewed, revised and
strengthened, recommendations for adjustments of the existing legal system are provided.
Identifying what is progressive and sound, and what diverges from international good practices,
should be useful to policy makers wishing to construct an appropriate and robust framework. It
is assessed in how far the proposed changes, which may seem to be appropriate from an
international perspective have a chance to get implemented given the interests and relative
strength of major stakeholders.
2.
The Indonesian Decentralization Reform Process: an Assessment from an
International Perspective
2.1.
The reform context: the multidimensional crisis and subsequent leadership
changes
Among the Asian countries affected by the recent economic crisis, Indonesia has been the most
seriously affected. Overall gross domestic product (GDP) contracted by 13.7 % in 1998, caused
mainly by a massive decline in investment of over 40 %.
The social impact of the crisis has been severe. Recent figures show that poverty increased
from 11% in 1996 to 17 % in 1998 and rose again to 20% in 1999 (SUSENAS).1
Although Java has the greatest number of people in poverty, the outer islands have a greater
percentage of people living below the poverty line (ADB, 2000:4).
The increase in poverty was largely a result of sharp increases in prices and especially the large
increase in food prices. Due to the functioning of the informal social safety net, which is mainly
based on family and kinship, the declines in income of the middle class by far exceeded the
income decreases of the poor.
Box 2 summarized some major social and economic indicators.
The Indonesian poverty line is defined in terms of consumption required to fulfil individuals’ basic food
and non-food needs per month. The food component is defined as the total expenditure required to
provide 2100 calories of energy per day.
1
6
Box 2: Economic and social indicators
Total population 1998 in millions
204.4
Total population on Java 1998 in millions
115.4 (56.4 %)
GDP per capita 1998/99 (dollars, current)
468.3
GDP Growth 1998/99 (in constant prices, %)
-13.7
Consumer Price inflation (annual average)
1997
6.6
1998
58.2
Exchange rate (Rp./$, annual average)
1996
2.364,-
1997
4.667,-
1998
9.849,-
Life expectancy at birth (1994)
Male
62
Female
65
The crisis shook the social and political foundation of the country. There has been a growing
sentiment among people to no longer tolerate corruption, collusion and nepotism. The
perception prevailed that the powerful elite in the center owed their success to an unjust division
of national wealth, corruption, and suppression of local initiative and interest.
Soeharto’s
abdication in favor of his protégé Habibie, brought into play a transition government that was
short on legitimacy. Needing to make their mark as reformers the Habibie government eagerly
initiated an ambitious legal reform program2 in only 512 days of transition.
2
The reform comprises laws such as the Decentralization Laws (Law No. 22 and 25/1999, the Election
Law (Law No. 3/99), the Law on Status and Functions of regional parliaments (Law No. 4/1999), the Law
on Political Parties (Law No. 2/1999), Law on Human Rights (Law No. 39/1999), an Anticorruption Law
(Law No. 31/1999), a Competition Law (Law No. 5/1999) and a new Central Bank Law.
7
The new government, lead by President Wahid Abdurrahman Wahid (Gus Dur) and VicePresident Megawati Sukarnoputri, is the first government, which derives legitimacy from a free
and general election. For a timetable of major political and economic events see box 3.
Box 3: Timetable of major political and economic events
July 1997
Currency crisis hits
21 May 1998
President Soeharto steps down after 32 years of quasi-military
dictatorship, which began on 20 February 1967.
Beginning of Habibie transition government.
November 1998
MPR decision to further decentralization
21 and 23 April 1999
Passage of two new decentralization laws, to be implemented within
2 years
9 and 20 May 1999
Decentralization laws signed by President Habibie
7 June 1999
Elections of the new Parliament (DPR), Result: 33 % PDI, 22 %
Golkar
30 August 1999
Referendum in East Timor. Overwhelming decision of 79 % of the
population voting for separation from Indonesia
20 October 1999
Election of President Wahid
8 November 1999
Mass rally in Aceh demanding a referendum
20 January 2000
IMF letter of intent signed by the Government of Indonesia stating
that the implementing regulations for the decentralization laws are
supposed to be ready by September 2000.
8
2.2.
The Design Process of the Decentralization Laws: Roles and Initiatives of Major
Stakeholders3
Given its large and diverse population and its huge land area, international experience would
suggest Indonesia to be a decentralized country (Alm, Bahl, 1999: 3-4). However, when
Soeharto stepped down Indonesia was highly centralized.
Table 1 gives an overview about the distribution of domestic revenue sources to different levels
of government in the fiscal year 1998/99. It shows a very high degree of centralization in the
distribution of revenues. 91 % of the tax revenues, 100 % of the oil and gas revenues and 89 %
of the non-tax revenues are levied by the central government. All in all 93 % of the total
domestic revenues are levied by the central level of government. The regional governments
depend to a great extent on transfers from the central level. Even after the deduction of
transfers almost 83 % of the domestic revenues belong to the central level.
Table 1:
Distribution of Domestic Revenues to Government Levels in the Fiscal Year
1998/99 (in trillions of Rupiah)
Tax Revenues
Oil and Gas Revenues
Non-tax revenues
Others
Total Domestic
Revenues
Central
Government
Province
(1)
72,93
49,71
26,66
-
(2)
4,47
149,30
6.32
4,57
160,19
6,99
8,68
15,67
13,31
13,25
160,19
Transfers
Distribution of
Domestic revenues
After transfers
3
133,63
1,35
0,5
District,
Total
Subdistrict,
General
Village
Government
(3)
(4)
2,21
79,61
49,71
1,78
29,79
0,58
1,08
(1) n% of (4)
(5)
91.61
100.00
89.49
93.20
83.42
The section draws on an earlier paper by Ferrazzi/Buentjen (2000).
9
Following decades of promises4 of more regional autonomy the Habibie government came
under increased demands5 for

a fairer revenue-sharing of national wealth with regional governments;

more respect from the center for local customs and rights, language, culture and traditional
beliefs;

devolution of functions to the local level;

increased power of the regional parliaments at the expense of the beneficiaries of
Soeharto’s patronage system;

Halting of military and “provocateur” abductions and human right abuses.
Additional pressure came from calls for separatism of selected provinces (see for details of the
nature of the claims: box 4)
4
One should be aware that the Soeharto government constantly postponed a substantive regional
finance reform. Although more than 20 years ago, Law No. 5/74 on Regional Government, the
predecessor of law No. 22/1999 required the revision of Law No. 32/1956 on Fiscal Balance and draft
laws were ready since the late 80s, the political frame conditions caused a complete deadlock.
5
The following list is based on newspaper reviews summarized in GTZ-Support for Decentralization
Measures (1999b).
10
Box 4: Claims for secession in Indonesia
Province
Justification
West Papua (former Irian Jaya)
Human right abuses to which citizens have been
submitted in the past, status as second class citizen
Aceh
Human rights abuses in the past,
Unfair sharing of gas revenues
Riau
Mainly complaints about unfair sharing of oil revenues
East-Kalimantan
Mainly complaints about unfair sharing of natural
resource revenues
Certain districts in Maluku
Segregation of Christian and Muslim communities
Given the lack of legitimate institutions the manner in which concerns were raised was
frequently not a very orderly one. Although there were plenty of demonstrations, sometimes
violent, against the existing political system and the ruling elite down to the village level, precise
concepts of an alternative system were largely missing. Decentralization terminology did not
play a major role until the recent unitarism/federalism debate. This makes it difficult to identify
the major proponents of the decentralization reform.
However it seems that interests groups, in particular the provinces, used the atmosphere of
reform to raise their demands for an improved sharing of national wealth with the regions. These
discussions took place behind the curtain and were not transparent to the general public. There
are some indications for lobbying activities of the Provinces. The first indication is that the
tendency to abolish the provincial autonomy, a movement that has some tradition in Indonesia,
sprang up again during the time of the drafting of the laws. This can be understood as a
countermeasure of the ruling central elite against stronger provincial demands.
11
Also, the November 1998 MPR6 decision, which provided the political mandate for the
administration to reform the decentralization framework, seems to have been influenced by the
provinces. The fact that emphasis was placed on regional autonomy, and on giving the regions
a higher share of national wealth, indicates that provincial governments used the MPR as a
vehicle to exert pressure on the government.
Besides a sense of political commitment and urgency no further political guidance to the
administration was provided in addition to the MPR decision. As Alm/Bahl (1999:6) put it: “The
first step in most successful decentralizations is the development of a general framework within
which the broad goals of the reforms are articulated and agreed upon (…). This step seems to
have been completely skipped in Indonesia”.
Although preparations for a revision of the legal framework for decentralization had been
undertaken for decades and some kind of consensus on how to decentralize the country had
been achieved within the administration, the executive was largely unprepared to draft the laws
under the prevailing time pressure. However, technical donor support provided to the
administration by bilateral donors helped easing the burden on the administration to some
extent.
Two laws were drafted in a few months time and provided to Parliament in February 1999:

Law No. 22/1999 on Regional Government (UU Pemda/Undang-undang Nomor 22 tentang
Pemerintahan Daerah), which replaces Law No. 5/74 on Regional Government and Law No.
5/1979 on Village Administration. The law revises the assignment of functions and redefines
the roles of institutions at all levels of government including the villages.

Law No. 25 on Fiscal Balance (UU PKPD/Undang-undang Nomor 25 Tahun 1999 tentang
Perimbangan Keuangan antara Pemerintah Pusat dan Daerah), which replaces Law No.
32/1956 on the Fiscal Balance between the central level and the regions. The essence of
the new law is the definition of sources of finance for decentralized, deconcentrated and coadministered functions.
6
The MPR is considered as the highest state institution acting as a channel of political and social
inspirations prevalent in society. It usually meets only once every five years to receive the report of the
President on the implementation of state policies, to elect a new President and Vice-President and to
determine the state policies for the next five years. It consists of 1000 representatives including the 500
12
Box 5: Major changes in administrative and political decentralization stipulated in Law
No. 22/1999

The principle that all functions that are not specifically assigned to central and provincial
level automatically belong to the districts has been introduced. However, the functional
assignment to the central level and the provinces is vague and open to interpretation. Much
depends on implementing regulations.

Regions are to be given more control over their finances, planning process, civil service
organizations and cooperative bodies.

Central ministries are in general no longer allowed to maintain independent deconcentrated
offices in the Provinces or in the rural and urban districts for purposes of executing central level
projects/programs. The deconcentrated offices will be absorbed into regional organizations.

Rural and urban district heads are now fully autonomous and no longer report hierarchically
to provinces. They function solely as the head of the autonomous local government and are
directly and solely responsible to the local parliament.

The regional executive arm is to be more accountable to the regional legislature, particularly
at the district/city level where the regional parliament will elect the head o the district/city and
their deputies with no interference from the center.

A two-year implementation time frame is foreseen in the laws, with subsidiary legal
instruments ready by May 2000 and field implementation realized by May 2001.
The two laws were prepared by different ministries: The Ministry of Finance was responsible for
the preparation of the fiscal decentralization law, while the Ministry of Home Affairs prepared the
draft Law No. 22/1999. The Coordinating Ministry for Development Supervision and
Administrative Reforms had a co-ordinating role in the discussions. Although the assignment of
functions and funding sources and the development of a comprehensive system requires close
co-ordination, only limited interaction between the three relevant ministries occurred. Neither the
line agencies nor the regional governments were involved in a meaningful manner in the
preparation of the laws.
representatives of the Parliament. The other 500 representatives are nominated by the provinces or are
appointed by the President as representatives of various groups in the society (Rohdewohld, 1996:8).
13
Although the regional governments did not play a major role in the drafting process, a draft law
on regional finance accommodated the interests of regional governments. This draft circulated
about six weeks before the draft law was provided to the House of Representatives in February
1999. The original draft law contained rather far-reaching revenue (income tax and natural
resource) sharing arrangements with the regions (GTZ-SfDM, 1999c). However, the draft law
submitted to the House of Representatives did no longer contain any clear provisions to
increase the revenue certainty of the regional governments. The changes were undertaken by
the Ministry of Finance following an IMF intervention. The point was that the far-reaching
revenue sharing was unsustainable in terms of the central budget. Given the additional
demands on the central budget such as the debt service payments on the foreign debt
overhang, the guarantee payments related to the domestic bank crisis and the funding
requirements for the social safety net it was feared that the decentralization program would
endanger macroeconomic stability. The appropriate balance of expenditure and revenue
assignments was not an argument taken into consideration at that time.
The House of Representatives took the decentralization laws very seriously. A special
committee and a smaller formulation team were set up to review the draft law. Officials of the
Ministry of Finance and of the Ministry of Home Affairs were called to several meetings at the
end of March 1999. The most notable change, which followed the discussions of the committee,
concerned the regional finance draft law. Compared to the draft law submitted to the House of
Representative the law passed by parliament contained stipulations defining revenue sharing of
natural resources and the setting of a floor for transfers to the regions, set at 25 % of national
domestic revenues. The members of the House felt they had to respond to persistent demands
of regional governments for a fairer distribution of revenues. The natural resource rich provinces
such as Riau took a leading role in the debates.
There were no public hearings held by the House of Representatives. The press took notice of
the decentralization reform only when the laws were discussed in the House of Representatives.
The assessment of the law’s contents and relevant issues were generally superficial. Law No.
22/1999 was met with a cooler reception than the law on fiscal decentralization. This reception
did overlook the substantial improvements in terms of political decentralization stipulated by
22/1999.
14
A number of prominent NGOs immediately refused the law based on the general objection that
the draft law was not prepared democratically, transparently, and with participation of the public.
Other NGOs more familiar with the subject matter started to disseminate the content of the laws.
Some public figures reminded the government of the need for a wide public discourse (Salim,
1999). This was also the message conveyed informally by various donor agencies.
2.3.
Implementation of the Decentralization Laws
According to Law No. 22/1999 the decentralization laws have to be implemented within two
years upon approval of the laws. The laws themselves only provide a general framework, and
need numerous follow-up regulations to become operational. Upon approval of the laws in early
May, no decision was taken on who should be responsible for which follow-up regulations.
In August 1999 a Presidential Decree (No. 67/1999) was passed giving the Coordinating
Ministry for Development Supervision and Administrative Reforms the overall responsibility for
the coordination of the implementation process. Five working groups were formed under this
umbrella. However, the traditional duplication of efforts of the Ministry of Home Affairs and the
Ministry of Finance has continued.
Between the general elections in June 1999 and the elections of the President in October 1999
a working group discussed the reassignment of functions to the different levels of government
with sectoral departments and started drafting an implementing regulation to Law No. 22/1999.
The preparation of other implementing regulations has been slow due to the fact that the
administration was paralyzed to a considerable degree by the uncertainty regarding the political
priorities of the President to be elected.
The MPR session in October 1999 stated again the commitment to decentralization in general
terms. The MPR acknowledged the needs to address in particular the demands of the provinces
Aceh and Irian Jaya through some kind of special autonomy deal, but could not provide details
on what the offer could look like.
The new government has announced its commitment to decentralization in statements to the
press and to the donor community (Kwik Kwan Gie, 1999: ). Early comments from the President
appear to place emphasis on provincial autonomy. There seems to be a preparedness to loosen
15
the taboo on federalism. The impression occurs that the new President puts emphasis on the
goal of maintaining territorial integrity putting the objective of improved service delivery at the
second place.
In spite of the commitment to decentralization progress in the first months has been slow due. A
reorganization of central level ministries led to overlapping mandates that seem to be designed
to build in inefficiencies. The reorganization was not based on a strategy but is a result of the
need to provide cabinet seats to all the forces that supported Wahid’s election. A new Ministry
for Regional Autonomy was established which has been assigned the coordinating role for the
follow up to the laws 22 and 25. The role is to be handed over from the former Coordinating
Minister for Development Supervision and Administrative Reform (now shrunk to State Ministry
for State Reform7). Presently the Ministry for Regional Autonomy continues the discussions on
the assignment of functions with the line agencies, which had been started by the Ministry for
Development Supervision and Administrative Reform. There is no certainty that the new ministry
will perform this coordinating rule appropriately. Due to overlapping responsibilities with the
Ministry of Home Affairs conflicts between these two ministries are programmed.
In the letter of intent with the IMF signed on 20 January 2000 the government commits itself to
prepare the implementing regulations by September 2000.
2.4.
Recommendations
Defining the general decentralization framework
International experiences suggest that decentralization reforms need to be based on a
comprehensive general framework that spells out the main objectives, the instruments as well
as the sequence and time frame of the measures and the roles of the involved institutions.
The relative importance of goals such as political stability, equity, macroeconomic stability and
efficiency and effectiveness of service delivery has to be defined based on a realistic
assessment of the potential of decentralization reforms and the relative strengths of the main
stakeholders.
16
Against the background of increased separatist claims in a number of provinces there is a
strong political need to address the political stability objective. However, the potential of
decentralization reforms to address separatist tendencies should not be overestimated. It is
unlikely that demands raised by provinces such as Aceh and Irian Jaya, which mainly result
from massive human rights violations in the past, can be accommodated by improved
intergovernmental revenue-sharing arrangements. The designers of the decentralization
program should not be burdened with the need to address a problem that may be better solved
by different instruments.
In contrary, Riau and East Kalimantan’s complaints are based on the perception of unfair
revenue sharing of natural resource revenues. A fiscal decentralization program can in principle
be designed in a way to accommodate these claims. The political pressure for improvements in
this regard is high since in the past the main stakeholders managed to voice their concerns in
an effective manner.
The prime objective of decentralization programs is related to improved service delivery at local
level. Although there is no doubt that improvements in this regard are urgently needed,
demands have been raised in a less organized and outspoken manner than it has been the
case with regard to the equity goal. Institutions to voice demands for better service delivery are
largely missing. In spite of this, the general dissatisfaction with government performance has
been taken the form of demonstrations against corruption, collusion and nepotism and of
attacks against government officials and agencies. However, as a consequence of a lack of
political education and exposure to concepts, the potential of decentralization reforms to solve
these problems has only been recognized by a small number of Indonesians. It can be predicted
that in the medium-term a lack of visible achievement in terms of improved service delivery will
lead to increased political pressure.
The described resistance of the IMF against the first draft of the fiscal decentralization laws
points at the existence of a severe goal conflict between macroeconomic stability on the one
hand and equity and improved service delivery on the other hand. Given the existing mediumterm dependency of the Indonesian budget on foreign funds a decentralization programs can
only be implemented to the extent donors are willing to support the effort. If devolved functions
7
The scope of tasks of the former Ministry for Development Supervision and Administrative Reform has
been reduced to administrative reforms, excluding responsibilities for policy coordination in the field of
17
cannot be matched with financial resources there is a substantial risk of a breakdown of
services at local level as well as of increased inequality amongst regions.
Public discourse
It is crucial for the success of the decentralization reform that an intensive dialogue will be held
in every province on the objectives and path of the reforms. Legislators, bureaucrats and
members of civil society should be involved in a two-way dialogue. Without such a dialogue to
generate enough support to overcome the initial nuisances which cannot be avoided in such a
major public administration reform.
Involving them in the decision-making process on the further legal steps should strengthen the
role of regional governments as major stakeholders. This requires some kind of
institutionalization of regional government’s interest groups at the central level.
Assessing the decentralization laws with regard to the general framework
The new government needs to assess the relevance of the decentralization framework prepared
by the previous government.
It has to be analyzed in how far the existing framework is
appropriate to address the objectives defined in the publicly agreed general framework.
Since Law No. 22 on Regional Government is based on a number of principles that seem to be
in line with principles of the new Wahid government such as democracy, people’s participation
and empowerment, recognizing the potential and diversity of regions. Therefore, it is likely that
an objective assessment will come to the result that the framework can basically be maintained
and minor changes can be incorporated into the implementing regulations which still have to be
drafted. The following chapter analyzes in more detail in how far the Fiscal Balance Law is in
line with what international experience suggests for the design of fiscal decentralization
programs.
3.
An Assessment of the Main Features of the Fiscal Decentralization Law
3.1.
Legal definition of regional government funding sources
regional autonomy.
18
According to the new legal definition of regional government funding sources regional
governments can make use of

Own sources of revenues

Balance fund

Regional loans

Other sources of revenue.
There are two main differences between the old and the new legal definition. The former
transfers by the central level have been replaced by the new concept of a “balance fund” and a
legal basis for regional loans has finally been provided. The changes shall be assessed for each
source of revenue.
3.2.
Own sources of revenue
Under the old law the own sources of revenue consisted of regional taxes and levies, revenues
obtained by regional enterprises and other legal revenues. The legal definition of own sources
of revenue remains basically the same. The only revenue source which has been added, the
revenues resulting from the management of regional wealth, is not very meaningful. The most
important source of regional wealth, the natural resources, is included in the balance fund and
will be discussed later.
Regional taxes and levies, the most important own sources of revenue are further stipulated by
Law No. 18/1997 on Regional Taxes and Regional Levies. Based on Law No. 18/1997 three
taxes are assigned to the provincial level and six taxes are allocated to the district level.
One of the provincial taxes, the Fuel Tax is a shared tax. The revenues are distributed between
the provincial (10 %) and the district level (90 %). Two taxes are assigned completely to the
provinces (Motorized Vehicles Tax, Vehicles Transfer Tax), while the District/city governments
can levy six taxes (Hotel and Restaurant Tax, Entertainment Tax, Advertisement Tax, Street
Lighting Tax, Mineral Tax, Water Usage Tax). In addition the regional governments are allowed
30 kinds of levies. According to the explanations to the Fiscal Balance Law Law No. 18/1997 will
have to be adjusted to make sure that the assignment of funding sources is in line with the
assignment of functions. This means that provincial taxes can be fully or partly assigned to the
district/city level.
The new stipulations on the own sources of revenue of the regional governments do not change
19
the high degree to which regional governments depend on central level transfers. According to
the accountability criterion local decision-makers should be responsive to the preferences of
their constituents. The principle calls for an own-tax base of local governments. Discretion in
local tax policy is necessary and taxes have to be borne by local residents. There must be an
equivalence between the provision of local public goods and the tax borne by local residents.
The tax must be visible to local voters, large enough to impose a noticeable burden, and the
burden must not easily be exported to residents outside the jurisdiction.
Sharing of the income tax and an assignment of property taxes to the local level would have
been good candidates to achieve the accountability criterion in Indonesia. Property taxes are
widely used as local taxes for various reasons:

administration costs can be relatively low compared to other taxes

the tax yield is quite predictable

the tax can be considered as the price of local services such as road and other
infrastructure services and

the tax is relatively immobile.
Tax on wages and salaries would have also been quite appropriate for assignment to the local
level. Due to the information advantages of local administrations, administrative efficiency gains
can be achieved by shifting the responsibility for tax collection to the local level.
The income tax continues to be entirely assigned to the central level. The property taxes have
been integrated into the Balance Fund which will be discussed in the next chapter.
Not utilizing the option of increasing the own sources of revenue of the regional governments is
a severe shortcoming of the new law. However, the argument has to be qualified insofar as the
assignment of functions is entirely unclear and the balance fund contains some revenue
sources, which come close to own sources of revenues.
3.3.
The Balance Fund
20
The components
The balance fund, which as such did not exist before, consists of three components: shared
revenue types of transfers, general grants and specific grants. The shared revenue component
of the balance fund consists of five sources of revenue.

The Land and Building Tax/Pajak Bumi dan Bangunan (PBB)

The Tax on the Acquisition of Land and Building Rights/Bea Perolehan Hak atas Tanah
dan Bangunan (BPHTB)

Natural resource revenues from forestry, general mining and fishery/Penerimaan negara
dari sumber daya alam sektor kehutanan, sektor pertambangan umum dan sektor
perikanan

Oil revenues/Penerimaan negara dari pertambangan minyak bumi

Gas revenues/Penerimaan Negara dari pertambangan gas alam
The Law on Fiscal Balance states that the components of the balance fund are not supposed to
be isolated from each other, keeping in mind the goal that the components shall be mutually
supplementary. For the purpose of transparency the components should be clearly separated,
although the revenue potential, which is in the amount of the “shared revenue component of the
balance fund” along with other factors, must certainly be taken into account for the calculation of
the general grants.
Property Taxes
There are two property taxes: The Land and Building Tax (PBB) and the Tax on the Acquisition
of Land and Building Rights (BPHTB). Both taxes were considered shared taxes before, but
since the central level redistributes the revenues they were in fact transfers by the central level
of government.
For a comparison of the old and new stipulations on the property taxes see table 2.
Table 2: Changes in the distribution of property tax revenues
21
Revenue
Old
sharing
category
arrangement
Old
New
New
sharing
distribution
distribution
arrangement
mechanism
mechanism
Land and Building
Collection fee:
Collected by
Received
10 % central level
Tax
9% distributed to
central and
directly by the
to be distributed
Category 1:
the levels of
regional
region of
equally to
Urban land
government
governments,
origin. Details
Distrcit/city
Rural land
involved in tax
redistributed
unclear.
90 % regional
Plantations
collection; 10 %
by central
level according to
distributed
level.
existing
equally to the
stipulations.
districts;
16.2 % provinces;
64.8 % districts
Land and Building
Collection fee:
Collected by
Continued
10 % central level
Tax
9% distributed to
central level
to be distributed
Category 2:
the levels of
and
equally to
Forestry sector
government
redistributed
district/city.
Mining sector
involved in tax
to the regional
90 % regional
collection; 10 %
governments
level according to
distributed
existing
equally to the
stipulations.
districts;
16.2 % provinces;
64.8 % districts
Tax on the
20 % central level
Collected
Acquisition of
16 % provinces
central
Land and Building
64 % districts
and
Rights
by
To be directly
level
received by
partly
the regional
redistributed
governments,
to
details
regional
governments
Continued
unclear.
Source: Law No. 25/1999
Five components of the PBB have to be distinguished. The PBB on the mining sector, on the
forestry sector, on the plantations sector, on urban regions and village regions. PBB revenues
are grouped in two categories. Category 1 revenues, consisting of revenues from rural and
22
urban land and plantations and category 2 revenues consisting of revenues from the forestry
and mining sector. In the past the main difference between the categories was the involvement
of the regional governments in the collection of the revenues from plantations, as well as urban
and village regions (category 1 revenues). There was no involvement of regional governments
in the collection of category 2 revenues.
The PBB was intended to be redistributed to the regions based on a common revenue sharing
mechanism for the entire five categories of PBB revenues. A collection fee of 9 % is distributed
to the levels of government involved in the tax administration. In addition 10 % has been
distributed equally to the districts. The provinces were supposed to receive 16.2 % and the
districts 64.8 % of the total PBB revenues. However, the distribution between regional
governments at the same level of government was never clear. This forced the regional
governments to bargain with the Ministry of Finance for their share of the PBB. The revenues
were far below international revenue raising standards.
The BPHTB tax is administered by the central government only. The central level of government
is supposed to receive 20 % of the revenues, while 16 % are allocated to the provincial
governments and the remaining 64 % to the districts. As in the case of the PBB, the distribution
criteria at the provincial and district/city level of government were never clearly stipulated. Since
the BPHTB was introduced only recently there are no studies available yet on the experience
with the collection of the tax.
The changes due to the passage of the Fiscal Balance Law concern the sharing arrangements
of the PBB and the distribution mechanism of PBB category 1 and BPHTB revenues. The
change in the sharing arrangement consists of the abolition of a 9% collection fee previously
assigned to the central level of government.
The changes in the distribution mechanism are not entirely clear. Law No. 22/1999 stipulates
that the revenues of the first PBB category and of the BPHTB are to be directly received by the
regional level. However, Law No. 25/1999 does not provide any clarity on how to change the
existing channelling mechanisms. It is somewhat contradictory that the share of these revenues,
which is supposed to “be directly obtained by the regional governments”, is simultaneously
considered part of the balance fund. The share, which is directly obtained by the regional
governments, should rather be considered a shared tax, a revenue category of “own sources of
revenue” which, as stated previously, is entirely missing.
23
The fact that Law No. 25/1999 does not provide any clarity on the PBB channeling mechanism
and distribution, and does not confirm the stipulations in Law No. 22/1999 points to some
resistance within the Ministry of Finance. This does not come as a surprise since PBB revenues
have been an important source of corruption of Ministry of Finance officials.
If properly implemented, abolishing the need to channel the category 1 PBB and the BPHTB
revenues via the central level will already have a positive effect on the efficiency of tax collection
and thus on the regional revenues. The PBB from the urban and rural property as well as
plantations and estates will become a much more productive revenue source than has been the
case in the past.
The second category of PBB is comparable with other sources of revenue from the mining and
forestry sector. The revenues are considered national wealth. The integration into a balance
fund, therefore, makes sense. According to Law No. 22/1999 the revenues will be distributed
according to equity criteria. The revenues have the potential to be instrumental in achieving the
objective of regional equity.
As far as the revenue sharing between government levels is concerned, it could have been
changed more in favor of the district/city. In many countries throughout the world property taxes
are considered local taxes, without any need of sharing the revenues with higher levels of
government.
Regional governments might also be able to get higher property tax revenues than in the past, if
the requested government regulations stipulate distribution criteria between the entities at the
same level of government in a more transparent manner. This would result from a reduction of
fund leakage.
Revenues from natural resources
24
In the past, oil and gas revenues8 were allocated to the central level of government. In 1998/99
accounted for 18.8 % of total domestic revenues. The revenues are distributed unequally
throughout the country with the Province of Riau producing more than half the country’s oil and
gas output.
Revenues from the forestry and mining sector existed before the passing of the Fiscal Balance
Law. Except for the reforestation fund, which was totally allocated to the central level, they were
shared between levels of government. However, the sharing arrangements were dependent on
the bargaining position of regional governments. Until only recently the majority of the funds
were off-budget, leading to a lack of transparency and efficiency in the use of the funds and
giving reasons for doubt as to whether the funds actually reached the regional governments.
9
Table 3 (column 1 and 2) provides an overview about the old sharing arrangements in the
forestry and mining sector.
Table 3: Changes in the distribution of natural resource revenues
Revenue source
Oil revenues
Gas revenues
Old
sharing
Major
New sharing arrangement
arrangement
change
100 % Center
Assignment of
85 % Center
revenues after
3 % Province of origin
tax deduction
6 % districts/cities of origin
to
6 % other districts/cities in the
100 % Center
regional
governments
Province of origin
Assignment of
70 % Center
share
12 % Province of origin
in
revenues after
6 % districts/cities of origin
tax deduction
6 % other districts/cities in the
to
Province of origin
regional
governments
8
9
Under the production sharing contract system, the government is entitled to 85 % of a
contractor’s gross oil revenue and 70 % of the gross gas revenue, including corporate income tax
and dividend tax payable by contractors to the government. Government after-tax oil revenue is
estimated at 65 % of a contractor’s net revenue.
The introduction of Law No. 20/1997 on non-tax state revenues, which also covers revenues from
natural resources, improved the legal situation substantially, by stipulating that all non-tax
revenues have to be accounted for in the central budget.
25
Reforestation fee
100 % Center
Regional
60 % Center
government
40 % regional governments
component
of origin
integrated into
specific grants
License Fee on Forest
55 % Center
Continued
Enterprises
30 % Provinces
with
15
Forest
Production
Royalty
%
20 % Center
new
sharing
16 % Province
64 % districts/cities
Districts/Cities
arrangement
Of the Royalty on
Continued
Forest Products:
with
30 % Center
sharing
32 % districts/cities of origin
70
arrangement
32 % other districts/cities in
favoring
the Provinces of origin
%
Regional
governments
20 % Center
new
16 % Provinces
districts/cities
in
provinces
of origin.
Mining land rents
65% Center
Continued
19% Provinces
with
16 % District/City
sharing
20 % Center
new
16 % Provinces
64 % districts/cities
arrangement
Mining royalties
30% Center
Continued
56% Provinces
with
14
Districts/Cities
%
20 % Center
new
16 % Provinces
sharing
32 % District/Cities of origin
arrangement
32 % Other District/Cities in
favoring
the province of origin
Kabupaten in
provinces
of
origin.
Fishery Enterprise Fee
Not existent
Newly
20 % Center
introduced
80 % equally distributed to
District/Cities
Fee on Fishery Income
Not existent
Newly
20 % Center
introduced
80 % equally distributed to
District/Cities
Source: Law No. 25/1999,
26
Since it was introduced only recently, one of the revenue sources shall be discussed in more
detail. Through the government regulation 51/1998 on Forest Production Royalty which was
issued in May 1998 the Royalty on Forest Products (IHH) was replaced by a new revenue
source: the Forest Production Royalty (PSDH). The royalty is imposed on every cubic meter of
logs felled from the country’s forests. The rate of the royalty is based on standard prices of logs,
which are determined by the Ministry of Industry and Trade after taking into account prices on
domestic and international markets. The rate of the royalty depends on the type of forest
product and its origin. Compared to the IHH, the rates increased substantially. It can be
expected that the revenues of the Forest Production Royalty will be considerably higher than the
revenues of the IHH.
As far as revenues from natural resources are concerned, the Fiscal Balance Law foresees a
range of changes, which are summarized in table 3, column 3 and 4.
The Fiscal Balance Law assigns 15 % of oil and 30 % of gas revenues (after tax deduction) to
regional levels of government. The sharing arrangement further foresees that the provinces of
origin will get 3 % of oil and 6 % of gas revenues. 12 % of the oil and 6 % of the gas revenues
are provided to the districts/cities of origin. The districts/cities, which do not have any oil and gas
revenues but are located in a province, which explores oil and gas, will also get the same
percentage. The criteria for the distribution of the respective revenues at the same level of
government are to be stipulated by a government regulation.
40 % of the reforestation fee will be integrated into the specific grant component of the balance
fund and will be discussed in the chapter on the balance fund.
In general, the central level gets 20 % of the natural resource revenues of the forestry, mining
and fishery sector. Table 3 shows that there is a general tendency to increase the shares of the
District/city governments in these revenues at the expense of the provincial and central
government. The forest production royalty and the mining royalty are shared between the
provincial governments and the District/City in the provinces in the District/city of origin. It
unclear from the Fiscal Balance Law, whether the revenues assigned to the provincial level will
be distributed to the provinces of origin only or whether they will be shared with other provinces.
Regarding the License Fee on Forest Enterprises and the Mining Royalties the sharing
arrangements improve in favor of the District/city governments. The distribution does not favor
27
regions of origin.
Two new revenue sources will have to be introduced, the Fishery Enterprise Fee and the Fee
on Fishery Income. The legal basis for these new revenue sources currently does only exist in
draft form. The revenues will be shared equally amongst all District/city.
The new Fiscal Balance Law provides oil and gas revenues and fishery revenues to the regions
for the first time and increases the shares of regional governments in other types of natural
resource revenues. This accommodates claims of regional governments, which have been
made for many years.
Not only for political, but also for economic reasons can the assignment of natural resource
revenues to the regions of origin be justified. There is an ongoing discussion in the literature on
fiscal decentralization as to whether natural resources should be considered national or regional
wealth. The question is whether the regions of origin should be compensated for losses in
wealth due to exploitation. However, even if natural resources are considered national wealth
and thus basically allocated to the central level, it is generally accepted that regional
governments are compensated for the use of regional infrastructure needed for the extraction
and transport of the natural resources. Since the District/city in the province where the natural
resource revenues are extracted will also be burdened by the transport of the products,
providing them a share in the revenues can be justified.
Although the exact distribution of functions is not yet clear, revising the existing distribution in
favor of the District/city governments is basically in line with the spirit of Law No. 22/1999.
Law No. 25/1999 improves on the existing situation also insofar as it provides a consistent legal
framework for the revenue sharing from natural resources. The shares of the government levels
are clearly stipulated.
Because of the mobility of the tax base, it makes sense to distribute the revenues from offshore
fishery based on an equal share criterion.
General and specific grants
At present, the central government provides two types of grants: the SDO (subsidi daerah
otonom) and the INPRES (Instruksi Presiden). Together, both types of grants made up 15.8 %
28
of total central government revenues in 1998/99. Indonesia’s local government rely heavily on
grants. Grants were used to finance about half of the provincial revenues and more than 70 %
of the district revenues. Table 6, column 2 provides an overview about the grant system in the
fiscal year 1998/99.
SDO grants represent 55.1 % of the grants transferred to provincial and regional government
budgets by the central level. The funds are intended to support local government’s routine
budgets, particularly personnel expenditures. In the FY 1998/99 8.7 % of total central level
revenues were spent on SDO grants. SDO grants finance more than 60 % of the routine
budgets of the provincial and district governments. As most of the regional government
employees are paid out of the provincial budgets, two thirds of the SDO grants go to the
provincial budget, while the remaining one third goes to the district budgets. 94.9 % of the total
SDO grants are spent to meet the cost of staff. The other 5.1 %, the non-staff element, are used
to finance a share of the costs of a range of decentralized, deconcentrated functions and human
resource development expenditures. The SDO personnel component can be described as a
specific, open grant. SDO are specific because they pay for two types of government
employees and pensions and cannot be used to fund other expenditures. The types of
government employees are: “pegawai daerah otonom” (staff directly employed by the local
government) and “pegawai diperbantukan” (central government staff seconded to local
government, e.g. doctors and primary school teachers). The SDO grant is open, because the
amount spent on SDO grants depends on the staff appointments approved by the central level
combined with the uniform salary level throughout Indonesia. 10
INPRES grants covered about 7 % of total central government spending and are basically to be
used for development purposes.
Different types of INPRES programs can be distinguished.
There are block grants to the provincial and district level, which are administered by the Ministry
of Home Affairs. The grants to the provincial level account for 16.0 % of total INPRES grants,
while the districts get 35.5 %. Block grants are provided to all provinces and districts and are to
be spent on regional development purposes according to regional priorities.
The specific grants are provided to some or all of the regional governments and are supposed
to finance regional activities to achieve national goals. There is an implementation guideline for
29
each of the specific INPRES. The grant composition changes frequently. In addition to the
INPRES grants administered by the Ministry of Home Affairs, there are INPRES grants under
the responsibility of line agencies (like INPRES health, primary schools). The poverty alleviation
programs (P3DT) are carried out under the responsibility of BAPPENAS, the national planning
board. The social safety net projects which account for 25 % of total INPRES grants in the FY
1998/99 are partly administered by line agencies (e.g. manpower, forestry) and partly under the
responsibility of the central planning board BAPPENAS.
Different allocation criteria are used to distribute INPRES grants to the regions. With about 50 %
of all grant allocation depending on it, the population criterion is the most important distribution
criterion. In general, the literature on the Indonesian grant system suggests quite consistently
that a small equalization effect has been achieved.
The following changes of the existing grant system are foreseen in the new Fiscal Balance Law
(1)
Under the new system there will only be general (dana alokasi umum) and specific
grants (dana alokasi khusus).11 There is no longer is mention of SDO grants. The abolition of
SDO means that the routine expenditures of the regional governments, which were used in
particular to pay for the government employees employed directly by the regional level and
central government employees seconded by the central level, have to be paid out of the
regional government budget. This is very much in line with an increased role of the regional
governments in managing their autonomous functions, but requires sufficient revenues at
regional level and certain institutional changes, for instance in terms of more decentralized civil
service systems. If the regional governments will decide on their staffing levels themselves, the
incentive for local governments to demand as much staffing as possible, which was previously
funded automatically by SDO, does no longer exist. A more need and revenue-capacity oriented
staffing at regional level may result from this. The question is whether the regional governments
will be obliged to continue to employ those civil servants, which are currently paid by SDO
grants, even if they want to reduce the staffing level. The regional allocation of SDO grant
allocation depended very much on historical levels of staffing and was very uneven throughout
the country.
10
11
See for a more detained analysis of the non-staff element: Devas (1998), Binder (1998).
In addition there is an emergency fund stipulated in paragraph 16.
30
The SDO allocation to levels of government focused on the provincial level. Since the spirit of
the decentralization laws seems to be to focus on the District/city level, more staff will be
needed at that level of government. A transfer of routine budgets from the provincial to the
District/city level is necessary to accommodate the intention of lawmakers.
(2)
General grants account for at least 25 % of total domestic revenues as reflected in the
central budget. 10 % of the general grants are to be allocated to the provincial budgets, while 90
% will be distributed to the District/city budgets.12
The total amount of grants is supposed to increase considerably. In 1998/99 block grants and
SDO made up 11.3 % of total domestic revenues, while the total grants accounted for 15.8 % of
total domestic revenues. According to UU PKPD the general grants alone are supposed to be
25 % of total government revenues as reflected in APBN. In the FY 1998/99 this would have
meant Rp. 38,7 trillion, almost 1.6 times the amount allocated for grants in that fiscal year.
If grants, which account for at least 25 % of total domestic revenues, are provided each year to
the regional governments, the revenue certainty will greatly increase. In the past, volatility of
funding has made it virtually impossible for local governments to budget for INPRES grants.
The assignment of such a huge amount of grants seems also to be appropriate, given the fact
that the regional governments will most likely have to take on additional functions. There is a
trend to increase the allocation of grants to the District/city level at the expense of the provinces.
This is in line with the general tendency reflected in Law No. 22/1999 to put the emphasis on the
District/city level. However, whether the government regulations on the detailed distribution of
functions between the provinces and the District/city will confirm the focus on District/city level
remains to be seen.
(3)
The allocation of the grants at the same level of government is based on the relative
weight of the region, which depends on needs (based on variables like number of inhabitants,
area, geographic conditions, income) and economic potential (based on revenue potential of the
regions). General grant distribution will be calculated by a newly to be established Fiscal
Balance Secretary, which is meant to be objective. The allocation of the general grant is
supposed to be transparent.
The details of the allocation criteria have still to be stipulated by a government regulation.
However, the criteria mentioned in the Fiscal Balance Law look promising insofar as they will
12
In the case of changes in the relative responsibilities of the provinces/districts/cities the
percentages mentioned above can be changed.
31
focus the grant system more clearly on the equity objective by providing general grants to
regions with relatively higher needs and/or relatively poorer capacities instead of providing them
to all regions. Since the revenue potential of regional governments has to be taken into account
for the calculation of the allocation criteria for the grants, the provinces which are low in natural
resource revenues will benefit indirectly from revenue sharing. It is also noteworthy that in the
future differences in the revenue capacity can be used as a distribution criterion in order to
reward revenue mobilization achievements, i.e. an above average tax effort.
(4)
Specific grants are defined as transfers from the central budget to the regions, which
serve to fund special needs depending on the availability of central budget funds. Special needs
are needs which are not covered by the criteria for the general grants and needs which are a
national commitment or priority. In particular, projects funded by foreign donors and projects,
which cover the basic needs of the populations, are to be channelled via specific grants.
The quantitative relevance of specific grants depends on the government regulation, which has
yet to be prepared. Since the amount of funds which is supposed to be provided to the regional
governments as general grants is already huge, it can be expected that the specific grants will
decrease when compared with the past. This will help to increase the discretion of regional
governments on the use of their funds and thus contribute to a better balanced grant system in
line with a greater role of regional governments in service provision.
The question, which has to be addressed, is which specific INPRES programs can be abolished
and which ones should be retained. Some specific grants like the INPRES primary schools and
the INPRES health are clearly in line with national priorities and have contributed to increases in
the educational and health status of the population. Components of other specific grants, for
example the INPRES agricultural extension service and the maintenance component of the
INPRES school and INPRES health, are to be used for purposes that should, in the long run, be
funded by own revenues of the regional governments.
(5)
40 % of the revenues of the reforestation fund are to be used to finance specific grants
in the regions the funds originate from. The funds are to be provided as matching grants.13
The integration of parts of the reforestation fund into the specific grant component of the
balance fund is a step in the right direction. Since 1980 concessionaires are supposed to pay a
13
Matching grants are distinguished from other financial transfers by the characteristic feature that
the recipient territorial authority has to contribute to the financing of the project subsidized by the
superior level.
32
fee on certain types of wood. The funds raised are to be spent on reforestation in and outside
concession areas and on unproductive land and to finance development of industrial forest
areas. Available information indicates that most of the funds have not been spent for these
purposes. Without any doubt reforestation is a national goal. Since the basic definition of
specific grants is, therefore, fulfilled, the funds can be channeled through the specific grant
mechanism. Together with the on budget accounting, which began already in FY 1998/99 as a
consequence of the passing of Law 20/1997 on Non-tax government revenues, efficiency and
transparency in the use of the funds will increase.14
The specific grants are to be allocated to the regions the reforestation funds originate from.
Against the background of the long history of fund leakage from the reforestation fund this is
justified, since it might increase the incentive of regional governments to monitor the
management of the monies and thus the accountability on the use of the funds. However,
designing the specific grant as a matching grant is not appropriate. To a certain extent it
diminishes the incentive of regional government to make use of the funds.
From a conceptual point of view this is also questionable. Normally matching grants are used for
grants, which are at least to a certain extent subsidized by the central level. As far as the
reforestation fund is concerned, this is not the case, since the fund originates already from
payments of concessionaires located in the respective region. It is also unclear why only 40 %
and not the total amount of reforestation funds has been assigned to the regional governments.
Table 4 gives an overview on the quantitative changes which can be expected based of the
wording of the Fiscal Balance Law.
Table 4: Changes in the grant structure
14
Revenue
FY
1998/99
FY
1998/99
source
Grant revenues
grant
(in billions of
revenues in
rupiah)
%
of
total
FY 1998/99
Change according to
grant
the Fiscal Balance
revenues in
Law
% of total
grant
domestic
revenues
revenues
According to the World Bank (1998b: 44) “the reforestation fund is perhaps the most notorious of
the off-budget funds”. Due to the introduction of Law No. 20/1997, the reforestation fund was
accounted on-budget beginning in the FY 1998/99. The funds are allocated to the Ministry of
Forestry’s budget.
33
SDO
Block
grants,
13,290,200
55.1
8.7
To be abolished
2,022.390
8.4
1.3
To make up at least
of which
25 % of total domestic

Provinces

809,353
3.4
0.5
Districts
1,213,037
5.0
0.8
Block grants +
15,312,590
63.5
11.3
3,558,039
14.8
2.3
revenues
25.0
SDO
Specific
grants,
of
which

Provinces

Districts
INPRES Desa
Other
grants
Depending
on
availability of APBN
927,749
3.8
2,630,290
11.0
funds
(at least 40 % of
reforestation funds)
476,982
1.9
0.3
Unclear
4,773,000
19.8
3.1
To be integrated into
(Social Safety
specific grants or to
Net,
be abolished
Primary
schools,
health,)
Total grants
Total domestic
24,120,534
152,909,500
100.0
15.8
100.0
revenues
3.4.
Regional loans
Due to the limited sources of own revenues, spending and borrowing by regional governments
has not played a major role. There were no clear provisions for regional borrowing, but
borrowing has mainly been channeled through RDA, the Regional Development Account, which
was created as a facility to finance infrastructure investments carried out by regional
governments and enterprises. In addition, the RDI, the Investment Funds account, serves to onlend funds borrowed abroad from official sources to state enterprises through Subsidiary Loan
34
Agreements. Only very limited RDI have been provided to regional governments. There are a
number of deficiencies related to both funds.
Under the new decentralization laws regional governments can borrow from domestic sources
as well as from foreign sources through the national government. Foreign loans have to be
approved by the central level. There are provisions for transparency and accountability with
regard to regional loans. Limits for the total amount of loans will have to be stipulated by a
government regulation. The central level will be able to use general grants for debt repayment, if
the regional government defaults on their debt towards the central level.
4.
Impact of the New Fiscal Balance Law on Major Decentralization Objectives
4.1.
Revenue adequacy (Finance follows function)
The statements contained in the Law on Regional Government concerning the devolution of
expenditure functions to the central and provincial level are very unclear. Given the vagueness
of the expenditure assignment it is highly questionable that funding sources have already been
assigned. The content of the government regulation on the assignment of functions to the
provinces which is currently being drafted is crucial, because it has, in a residual manner, an
impact on the assignment of functions to the district/cities as well. If the assignment of funding
sources is kept in mind in the preparation of the government regulation on the assignment of
functions there is still a chance of achieving the objective of revenue adequacy. However, this
approach reverses the ideal way of going about decentralization, which is to determine
expenditure responsibilities first.
For the time being, due to the unclear assignment of functions it is impossible to assess
precisely whether the new decentralization laws will achieve the objective of revenue adequacy.
Only with the completion of follow-up regulations will this be known.
As previously described, there is a tendency to transfer additional responsibilities to the
Kabupaten/Kota levels of government.
Whether the regional governments will get additional funding sources depends on the relative
loss in SDO and INPRES grants compared to the additional assignment of own sources of
35
revenues and balance fund transfers. Ideally the average regional government entity should be
able to fund its functions using own sources of revenues.
As previously described the legal definition of own sources of revenue remains basically the
same. Since the option to introduce shared taxes as a source of own revenues has clearly been
passed over, the new stipulations on the own sources of revenue of the regional governments
do not change the high degree to which regional governments depend on central level transfers.
It cannot be expected that this means of assigning revenues will be sufficient to fund the newly
assigned functions of the average regional government. It must be stressed here that not
utilizing the option of increasing the own sources of revenue of the regional governments is a
severe shortcoming of the Fiscal Balance Law. Also it has to be criticized that the property taxes
are not considered own sources of revenues but included in the balance fund and that the
channeling mechanisms for PBB category 1 and BPHTB tax revenues are not transparent.
What can be said here is that there is a danger that the regional governments will not be able to
fund their newly assigned functions and that the new law serves to shift expenditure
responsibilities to the regional governments in order to free funds at central level. The general
tendency to increase the shares of the Kabupaten/Kota governments in natural resource
revenues at the expense of the provincial and central government can be considered as the
most positive aspect of the law in terms of approaching the objective of revenue adequacy.
However, the fact that the revenues have to be channeled via the balance fund poses some
risks in terms of fund leakage.
As previously stated the total amount of grants is supposed to increase considerably. According
to the Fiscal Balance Law the general grants alone are supposed to be 25 % of total
government revenues as reflected in the central budget. If grants, which account for at least 25
% of total domestic revenues, are provided each year to the regional governments, this will
certainly have a very positive impact on the achievement of the revenue adequacy goal.
However, regarding the implementation of this particular element of the law, there are reasons
for doubts, whether the wording of the law will be taken literally.
Against the background of the huge structural problems at central level (reform of the banking
sector and international debt problems) it is unlikely that the general grants will be provided in
the coming years. Although in contrary with the spirit of the law, this would legally this is
possible. Based on the wording of the Fiscal Balance Law there is no room for interpretation as
far as the definition of “total domestic revenues reflected in the APBN” is concerned. However,
36
the details of the balance fund still have to be stipulated by government regulation and the
grants have to be confirmed each year by the budget law. It remains to be seen whether GOI
will manage to continue the spirit of the law while preparing the government regulations.
4.2.
Equity
Changes in the assignment of revenues, in particular of own sources of revenues and grants by
the central level have an interregional equity impact.
Most of the natural resource revenue sharing mechanism as well as the sharing mechanisms for
property taxes favor the regions of origin. Those provinces, which are rich in natural resources
and Districts/Cities located in such provinces, will primarily benefit from the introduction the Law
on Fiscal Balance. It can be expected that the distribution of regional own sources of revenues
plus natural resources will become much more uneven between government entities at the
same level. The horizontal imbalance will have to be compensated for by the balance fund.
Since no negative grants are foreseen, more funds will have to be provided for equalization
purposes than it has been the case in the past. Thus, the achievement of the 25 % target is not
only crucial for the objective of revenue adequacy, but also for the equity objective. The total
equity effect of the balance fund depends on the government regulation, which has to be drafted
yet. However, if the government regulation is going to follow the criteria mentioned already in
the explanations of Fiscal Balance Law it is likely that an equity effect will be achieved.
4.3
Macroeconomic stability
The objective of macroeconomic stability has never clearly been operationalized in Indonesia. In
fact, the risk of macroeconomic stability being diminished by regional government’s policies has
been minimal, in particular, because due to the limited sources of own revenues, spending and
borrowing by regional governments has not played a major role.
Due to the huge structural fiscal deficits and the additional funding assigned to the regional
governments (particularly the floor on transfers to general allocation fund of 25 % of domestic
revenues) there is a risk that the macroeconomic stability objective will not be met. Through
37
increased decentralization, the opportunities for regional governments to have an impact on
macroeconomic stability will certainly increase.
Because of the structural budget deficit at central level there is a high risk that the Fiscal
Balance Law will not be implemented as foreseen in the Law. If functions are assigned to the
regional governments which are not accompanied by sufficient funding a negative impact on the
effectiveness of service delivery can be expected.
The Fiscal Balance Law fulfills the basic requirements for limiting local borrowing in order to
avoid a situation where the central level has to repay regional loans. For instance, the most
important prerequisite, which is to make the regional governments accountable for their regional
borrowing to their regional constituencies, is fulfilled. Regional governments have to publish
each loan taken on and have to account for the loan itself and the expenses, which will be
funded out of the loan in the regional budget APBD. Limits for regional borrowing will have to be
defined by a government regulation and the central government controls regional loans by
approving them and by not taking them over in case of default. The revision of RDA and RDI is
very much needed in order to adjust them to the requirements stipulated in Fiscal Balance Law.
38
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