that they were unable to pay the salaries of local government personnel, despite the fact that funds should have been allocated in the DAU. A number of other problems, such as
Rp 23 billion insolvency in the regency of Timor Tengah Utara in NTT province, Rp 100 billion fiscal deficit in Bangka Belitung province, and Rp 777 billion mismanagement in 13
regencies and municipalities in Southeast Sulawesi province highlights the dire condition of fiscal management in the regions Jaweng 2011a.
Various anecdotal accounts as presented above conclude that decentralization in Indonesia has not delivered on its promise, despite the numerous of praises that it has
received internationally. In an attempt to better understand why decentralization in Indonesia has not resulted in better public services and economic situation for the people,
or at least at the level that is expected, I now turn to theories that explain how and when decentralization may or may not work.
II.2. Market-Preserving Federalism
In order to understand decentralization, one needs to review the literature on inter- government relations, most notably federalism. The first generation theory of fiscal
federalism largely sees the government – be they central or local – as benevolent entities
which purpose are to correct market failures and act as “custodians of the public interest”Oates 2005. Drawing from the classic works regarding public economics in the
1950’s and 1960’s i.e. Kenneth Arrow, Paul Samuelson, Richard Musgrave, the government’s role was understood as to ensure stable macroeconomic condition as well
as distribution of wealth in an equitable manner. These ideas, combined with the notion that local governments have better information of local needs Hayek 1948 and thus
should be encouraged to offer what they see as the most desirable public goods and services for their citizens Tiebout 1956, reflect the main points of First Generation Fiscal
Federalism.
The second generation theory of fiscal federalism supports the arguments of the first generation theory, and extends them further by opening the “black box” of the
government. It draws on the theory of public choice Buchanan and Tullock 1962which argues that public officials, just like private actors, respond to incentives and act to
maximize their utility. The second generation theory also identifies some parallels with the new theory of the firm Williamson 1996 that highlights how managers in a firm
“agents” may not always have interests that are perfectly aligned with those of the shareholders “principals”, especially due to the fact that they often have information
which is not readily available to the shareholders on a day-to-day basis. Therefore the shareholders must spend some resources to monitor the work of the managers. This
thinking runs counter to the earlier notion of the government as benevolent entities. The second generation theory asserts that the government is neither benevolent nor
malevolent, but responds to incentives and must be disciplined in their activities, just like everybody else.
Weingast1995 argues that in order for the economy to thrive, a strong enough government is needed to ensure contracts are enforced and property rights are protected.
However, the government must be disciplined such that it does not trespass the rights of the citizens. A specific type of federalism called “market-preserving federalism” is
proposed as a system that can discipline the government from disrupting the natural functioning of the market for their own private gains Weingast 1995.
In discussing federalism, one should not limit himself to the formal structure of a country, but should look at it more from a practical perspective. Formally de jure, a
country may be a unitary state, but in practice de facto it may be a federal state. Three parameters were presented by Riker 1964to decide whether or not a country is federal.
First is the presence of multi-level government in a particular jurisdiction. This means that in a certain place, a person is subject to the sovereignty of more than one level of
governments. For example, someone who lives in Jatinangor, West Java, is subject to the rules and regulations of three levels of government: the Regency of Sumedang, the
Province of West Java, and the Country of Indonesia. Second is clear delineation of authorities between the different levels of government. This means that there are no
overlapping sovereignty issues that may create confusion or conflict between the levels of government. In the case of Indonesia, it was clear that most issues are within the
domain of local governments, except those that are reserved for the national government i.e., foreign affairs, defense. See above. Third is the presence of institutions that
guarantee each level of government the right to exercise their respective autonomies. For Indonesia, the institutional set-up that forms the legal basis of regional autonomy is the
decentralization law. Using these three parameters as proposed by Riker 1964, Indonesia is using a de facto federal system.
Weingast1995 added three more parameters to determine whether the federalism implemented by a country is a “market-preserving” one, meaning that it
prevents the government from abusing its power andor distorting market incentives at the expense of citizens’ economic rights. The first parameter of market-preserving
federalism is that issues related to the local economy must be within the primary control of sub-national governments. In the case of Indonesia, since the local economy is not
included within the areas of central government responsibility, it formally lies within the jurisdiction of sub-national governments. The second parameter is the presence of a
common market, in the sense that sub-national governments are prevented from erecting barriers that restrict the free movement of goods and services between different regions.
This is where the role of central government is needed to ensure such common market is in place. In Indonesia, Law 332004 prevents sub-national governments from erecting
barriers to mobility of people, goods and services article 7. The third parameter is that sub-
national governments are subject to “hard budget constraint”. This means they do not have access to “easy money”: they cannot print money; they will not be bailed out if
they default; and – to a relative but substantial extent – they have to earn their revenues
by not relying too much on central government transfers. Indonesia does not fulfill this last parameter. As discussed above, almost all 92.6 of sub-national government
revenues in 2003 came from central government transfer. And Law 322004 supports this practice. Although the law does not stipulate the required or desirable proportion of local
revenue sources, it identifies the general purpose grant DAU as mechanism to ensure principles of distribution and justice article 161.
Indonesia goes beyond not implementing a hard budget constraint. The country actually makes a conscious effort to reject this third parameter of market-preserving
federalism. The name of the law that governs fiscal relations Law 332004, even since
its inception in 1999, and consistently re-used in the 2004 revision, is “Law on Fiscal
Balance between Central and Regional Governments” my emphasis. The first principle
of this law is that that fiscal balance is a consequence of division of tasks between central and regional governments article 2. This means that regional governments are entitled
to receive money from the central government for doing their tasks. Thus, for Indonesia, the goal of fiscal decentralization is not primarily to improve efficiency in the delivery of
public goods and services, or to smoothen the functioning of market principles, but to ensure equitable redistribution of fiscal resources among regions.
To conclude this section, we can say that according to Riker 1964 Indonesia is using a de facto federal system, but according to Weingast 1995 the federal system
being used does not work to preserve markets. Why does Indonesia choose this position, and what are its outcomes? The following section will start by analyzing the situation and
structure that led Indonesia to come to this preference, and then continues with modeling the outcomes of such situation and structure.
II.3. A Game Theoretical Exploration of Decentralization in Indonesia
