Intergovernmental Transfers in Indonesia: The Risk Sharing Effect of Dana Alokasi Umum.

AuthorTakahata, Junichiro
  1. Introduction

    In most countries, decentralized governments make use of intergovernmental transfers. The central government collects taxes, which are then redistributed to local governments through transfers. This system has both merits and demerits. If tax collection were left to local governments, it is quite possible that the tax revenues would be allocated unequally due to bias in the tax base (depending on the region). This could lead to undesirable distortions in the economy. Eliminating this possibility is a considerable merit of the intergovernmental transfers mechanism.

    In general, there are two kinds of intergovernmental transfers: first, a general allocation fund that can be used freely; and second, a special allocation fund that is earmarked to achieve certain development goals. A general allocation fund helps local governments when their own revenue decreases. A system in which local governments receive more transfers when their own revenue falls short serves as insurance to local governments. However, such intergovernmental transfers should not fully cover the uncollected revenue; otherwise local governments will simply lose incentive to collect their own revenue. Setting just the right size of risk coverage is crucial to provide an insurance against functions while maintaining the incentive for generating the local government's own revenue.

    This paper focuses on the function of the Indonesian general allocation fund (Dana Alokasi Umum, or DAU) transferred from the central government to various local government levels. It examines the extent to which DAU adjusts the local government's own revenue fluctuations. The method for allocating government transfers varies from one country to another. Indonesia, however, sets an allocation formula to distribute its government transfers such that the fiscal inequality among local governments in different regions is eliminated.

    The basic formula of DAU's allocation is determined by the fiscal gap of local governments. The fiscal capacities of local governments are calculated by taking the difference between the necessary expenditure for local government operations and a certain percentage of the collected local government's own revenue, PAD (Pendapatan Asli Daerah). If the PAD is not sufficient to cover the local governments' necessary expenditures, DAU is expected to cover the gap to a certain extent. The shortage might not be fully compensated, however, as the allocation formula that determines the amount of DAU paid to all the local governments is predetermined in the national budget, APBN (Anggaran Pendapatan dan Belanja Negara). Therefore, local governments should concurrently employ other measures to make up for the shortfall, such as limiting recurrent expenditures and investments, using buffer savings, and even borrowing additional funds.

    This paper examines the extent to which DAU compensates for PAD shortages. This is analysed from two perspectives. First, we focus on the differences among local governments. Indonesia has thirty-three provinsi (provincial) governments, ninety-three kota (city) governments and 398 kabupaten (regency) governments (as of 2011). Since both kota and kabupaten are on the same local government level, the proportion of DAU allocated differs between provincial governments and city/regency governments. We examine how these differences are reflected in the actual compensation. Second, this study also looks at regional differences. Indonesia is geographically divided into six regions, namely Sumatra, Java, Kalimantan, Sulawesi, Bali-Nusa Tenggara and Maluku-Papua. Given the variation in economic development across these regions, the quantum of DAU compensation in the event of a shortfall in PAD may differ.

    Three key findings emerge from this paper. First, overall, DAU absorbs 83 per cent of PAD shortage for the whole economy--this figure is higher than the value determined by the allocation formula. Second, local regency governments have a higher DAU coverage rate (86 per cent) than city governments (74 per cent) and provincial governments (53 per cent). This order is in sharp contrast to that determined by the allocation formula. Third, while DAU coverage is significant in all the regions, varying between 72 and 92 per cent, the differences among regions are not significant. In other words, the allocation formula is successful in using DAU as an insurance for local governments. When local governments' PAD decreases and they are unable to cover necessary expenses, intergovernmental transfers help fill the void.

    In extant literature on risk-sharing and levelling local government recurrent expenditures, several studies have focused on local allocation tax (LAT) grants and their effect on shortfalls in local government tax revenues. This study employs the framework developed by Okabe (2011) and Ohno and Kobayashi (2019) to examine the smoothing of local government recurrent expenditures. Okabe (2011) uses local government data from Japan between 2003 and 2008 to quantitatively examine how much LAT grants absorb tax revenue fluctuations. The study concludes that 44 per cent of tax reduction is absorbed by the grants. Ohno and Kobayashi (2019) examines the same problem for a longer period, from 1995 to 2014, and finds that LAT grants absorb 56 per cent of tax revenue fluctuation.

    Other studies that have focused on risk-sharing and consumption-smoothing include Asdrubali, Sorensen, and Yosha (1996), Nakakuki and Fujiki (2006), Hepp and von Hagen (2013) and Cont, Porto, and P. Juarros (2017). Most of these studies investigate the local governments' consumption smoothing mechanisms and demonstrate how general allocation funds and other budget components help smooth recurrent expenditures when tax revenues are not sufficient.

    In addition, some studies on dynamic municipal fiscal adjustments (such as Buettner and Wildasin 2006) have championed the use of vector error correction models to examine intertemporal fiscal adjustments. Bessho and Ogawa (2015) examine how local governments responded to budget shocks, and consider how they acted to regain their fiscal balance in the event of major revenue fluctuations in Japan. Using fiscal data from Japanese municipalities from 1977 to 2001, they conclude that about 40 per cent of tax revenue fluctuations was absorbed by LAT grants, which is consistent with the findings of Okabe (2011).

    This paper is structured as follows. The next section explains intergovernmental transfers in Indonesia, with special focus on DAU. The third section provides the theoretical framework to decompose local governments' budget constraints. The subsequent section elaborates on the data used in this study, while the fifth section reports the findings. The final section concludes.

  2. Intergovernmental Transfers in Indonesia: The Case of DAU

    On tracing the history of DAU, it can be seen that that fund has evolved from SDO (Subsidi Daerah Otonom, or subsidy for autonomous region) and INPRES (Instruksi Presiden, or Presidential Instruction)--the two main components of Indonesia's fiscal transfers system prior to 2001 (Silver, Azis, and Schroeder 2001). The basic objective of DAU was to resolve horizontal imbalances. The DAU allocation formula has played a vital role in equalizing the regional fiscal gap to achieve minimum-level service standards, a target that the Indonesian government has defined explicitly (Brodjonegoro and Vazques 2004). However, in practice, DAU also has a role in alleviating vertical imbalances by serving as "[a] balancing factor" or providing "basic allocation" (Lewis 2001).

    Since 2001, both the elements and the construction of the DAU allocation formula have undergone numerous changes. Silver, Azis, and Schroeder (2001) have argued that the reformation of intergovernmental relations between the central and local levels should consider Indonesia's regional variation, particularly in basic sectors such as roads, public health and education. Recently, policymakers in Indonesia have been trying to include incentive mechanisms into their intergovernmental transfers system and looking into the local governments' fiscal behaviour, such as spending and savings activities and the source of their selfsourced revenues (Lewis and Smoke 2017).

    Local governments in Indonesia collect their own taxes as a part of PAD while also receiving intergovernmental transfers in various forms from the central government. DaPer (Dana Perimbangan, or Balancing Fund) is the largest transfer from the central to local governments and DAU is a part of it. Besides DaPer, there exist Dana Insentif Daerah (DID, Regional Incentive Fund), Dana Otonomi Khusus (Special Autonomy Allocation Fund), Dana Keistimewaan Yogyakarta (Yogyakarta Special Allocation Fund), Special Autonomy Fund and Special Status-Quo Fund of DI Yogyakarta.

    This study focuses on DaPer, which mainly contains three categories of transfers: first, DAU, the largest component; second, DBH (Dana Bagi Hasil, or Revenue Sharing), which consists of DBH Pajak (Dana Bagi Hasil Pajak, or Tax Revenue Sharing) and DBH SDA (DBH Sumber Daya Alam, or Natural Resources Revenue Sharing); and third, DAK (Dana Alokasi Khusus, or Special Allocation Fund).

    Indonesia's intergovernmental transfer system did not undergo any major changes since the enactment of the decentralization law UU No.33/2004 (which replaced UU No. 25/1999) and PP (Peraturan Pemerintah, or Government Regulation) No. 55/2005 implemented in 2006. The law sets the total amount of DAU distributed to local governments to at least 26 per cent of PDN (Pendapatan Dalam Negeri) Netto (net domestic revenue). PDN Netto is calculated by subtracting DBH from the national tax revenue. Ten per cent of total DAU is allocated to provincial governments and 90 per cent to regency/city governments. From a macro perspective, this allotment is one of the factors that determine the allocation formula.

    From the micro...

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