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. 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