What Influences Subnational Competitiveness in a Decentralized Indonesia?

• Author: Amri, Puspa Delima

1. Introduction

   When Indonesia effectively began decentralization in 2001, economic development was among the sectors placed in the hands of the respective subnational (1) governments. Explicitly, this was expected to foster better allocation of resources based on each subnational region's "unique potential and diversity" (Law 22/1999). Implicitly, this meant allowing healthy competition between Indonesia's subnational governments in ways similar to that conceptualized by Tiebout (1956), arguably. Many were hopeful that assigning subnational leaders greater budgetary and policy responsibilities would lead to more effective and innovative programmes, as well as greater public participation (Cheema and Rondinelli 2007). The subsequent introduction of direct elections for governors and district heads in 2005 added further political incentives to boost performance.

   Large and sudden transitions in the governance ecosystem are bound to generate a mixed impact. This is also the case for Indonesia. On the one hand, there have been documented improvements in socioeconomic outcomes and public service delivery (World Bank 2017; Lewis, Nguyen and Hendrawan 2020). Yet, the improvements are rather modest (Lewis 2010) relative to what would be expected under such a large transfer of authority. Experts have also observed moderate progress in accountability (Rumayya et al. 2020)--incumbents are re-elected at very high rates (Lewis, Nguyen and Hendrawan 2020) due, in part and arguably, to their responsiveness to constituents (Skouflas et al. 2014). While there has been more revealed corruption (Valsecchi 2013), more avenues have opened up to report and prosecute corrupt officials, notably through the anti-corruption commission.

   However, decentralization's socio-economic effects have varied dramatically across districts (Sumarto, Vothcnecht and Wijaya 2014; World Bank 2017), including on the quality of local business and investment climates (Patunru, McCulloch and von Luebke 2012), which ultimately affects the long-run economic development of a province or district. Fiscal federalism theories suggest that decentralization can improve a nation's economic development through inter-regional mobility and competition among subnational governments (Tiebout 1956; Pepinsky and Wihardja 2011). While the definition of placebased competitiveness remains "elusive" (Kitson, Martin and Tyler 2004), we think it is nonetheless an important area of study as it reviews the factors that determine whether a region or nation is able to achieve a sustained level of economic growth while providing prosperity and jobs to most of its population over extended periods of time (Porter 1990; Storper 1997). Former European Central Bank President Mario Draghi considers an economy competitive when "institutional and macroeconomic conditions allow productive firms to thrive and in turn, ... these firms support the expansion of employment, investment and trade" (Draghi 2012). (2) With decentralization, Indonesia's subnational governments control important policy levers deemed necessary to attract investment and thus boost competitiveness (Jensen et al. 2012). For example, cities such as Balikpapan and Solo were often ranked as having some of the best business environments due, in part, to a successful streamlining of licensing procedures (Patunru, McCulloch and von Luebke 2012).

   While there have been a few different projects quantifying subnational variations in the business environment (e.g., Indonesian Regional Autonomy Watch (KPPOD) 2007, 2011), quantitative studies that systematically investigate how fiscal decentralization affects these variations are far less common. As such, the primary goal of our paper is to document some of these subnational variations in competitiveness and investigate whether they are correlated to measures of fiscal decentralization. This study also briefly investigates how democratic institutions influence subnational competitiveness, following the prediction that more political competition, greater public participation in the policymaking process and a more active role of society in monitoring local governments arguably promote economic development (Besley, Persson and Sturm 2010). As quantitative measures of democracy do not yet exist for Indonesia's districts, we analyse this question at the provincial level.

   The next section of the paper lays out the context regarding the key elements of Indonesia's decentralization as well as competitiveness trends at the provincial level. The third section reviews the theoretical and empirical literature linking competitiveness to decentralization and competitiveness to democracy. We also present correlations between measures of province-level competitiveness and democracy. Our main econometric analysis is in the fourth section, which discusses the district-level data set, research methodology and findings. A summary and conclusion, as well as policy implications, will be given in the last section.

2. Background

   2.1 Indonesia's Fiscal, Administrative and Political Decentralization since 2001

   Indonesia's "big bang" decentralization started with the passing of Law 22/1999 on Regional Governance and Law 25/1999 on Fiscal Balance between Central and Regional Governments. While the former allocates authority, the latter apportions monetary resources from the central to subnational governments. Under these laws, which went into effective implementation in 2001, the tertiary level of government (regencies [kabupaten] and cities [kota], called "districts" henceforth) was at the forefront of regional autonomy. In contrast, provinces as the secondary level of government merely played a coordinative role, and were in charge of interdistrict aspects and tasks that could not be done by the district governments. (3)

   The decentralization laws have been updated twice in 2004 and 2014 (see Table 1). The 2004 update added an element of democratization, whereby subnational leaders became directly elected by the people and must work hand-in-hand with the subnational People's Representative Council (DPRD). Law 32/2004 also enlarged the authority of the provincial government, such as coordinating inter-district service provision (Hutchinson 2017). (4) Subsequently, the 2014 update tried to encourage greater cooperation between the different levels of government (central, provincial and district), and allocated a greater role for the provincial government than before. For example, tasks that can done more efficiently at this level, as well as those that create inter-district externalities, must now be carried out by provinces.

   Although the role of the provincial government is slowly growing, district governments are still largely the main locus of decentralization and have substantially more responsibilities compared to the pre-2001 period (Ostwald, Tajima and Samphantharak 2016), including the power to create (tax) incentives to promote and attract investment (Law 23/2014). As seen in Table 1, investment is one of the obligatory services provided by district governments and an important aspect of that is the creation of one consolidated office that processes all the business licensing and regulations (One Stop Shop programmes). As such, the main focus of our statistical analysis in the fourth section will be conducted at the district level.

   Fifteen years of fiscal data capture the evolution of spending autonomy quite clearly. Indonesia's subnational government expenditure as a share of total public expenditure has risen from 26 per cent in 2001 to 45 per cent in 2016 (Roberts, Sander and Tiwari 2019). This is more or less equivalent to the share in federal countries, even though Indonesia remains a unitary nation. However, most of that spending is financed by generous transfers from the central government (Lewis, Nguyen and Hendrawan 2020), roughly the same situation in about 2008-9 (Pepinsky and Wihardja 2011), implying that extensive fiscal spending autonomy is not matched by the scale of revenue autonomy. On average, revenues raised internally by district governments (pendapatan asli daerah or PAD) make up only 12 per cent of total district revenues in 2016, although this number has increased steadily over time (it was only 6.2 per cent in 2001). (5) The majority of taxes are collected by the centre and redistributed to the provinces and districts based on a specified formula, which, on a per-capita basis, disproportionately benefits low-population districts (Roberts, Sander and Tiwari 2019)--a design primarily driven by redistribution concerns.

   The reluctance to extend more revenue autonomy to district governments may be related to the imprudent public fiscal management of district governments, especially in the earlier period of decentralization (Lewis 2003). (6) Several subnational governments arguably harmed the investment climate by introducing confiscatory taxes and levies that overlapped with existing national regulations (Sumarto, Vothcnecht and Wijaya 2014; Butt and Parsons 2012). A new law was introduced in 2009 to control these counter-productive taxes but its effectiveness remains in question (Sumarto, Vothcnecht and Wijaya 2014). A study by the Indonesian Regional Autonomy Watch (KPPOD) in 2017 found that up to 64 per cent of survey respondents felt that subnational regulations on taxation and levies had "negative economic consequences" (KPPOD 2017). This is because firms must incur extra monetary costs (e.g., additional levies charged to enterprises to secure their business licences, a practice, which, according to national-level regulations, should no longer be allowed) as well as non-monetary costs (e.g., time and effort to comply with the plethora of subnational business regulations, and lack of clarity on how the levies themselves were determined) (KPPOD 2017).

   Likewise, a new regulation called the "Job Creation Law" was issued in 2020, with the stated intention of streamlining...