Manajemen | Fakultas Ekonomi Universitas Maritim Raja Ali Haji 00074910302012

Bulletin of Indonesian Economic Studies

ISSN: 0007-4918 (Print) 1472-7234 (Online) Journal homepage: http://www.tandfonline.com/loi/cbie20

CHANGE AND CONTINUITY IN INDONESIA'S NEW
FISCAL DECENTRALISATION ARRANGEMENTS
George Fane
To cite this article: George Fane (2003) CHANGE AND CONTINUITY IN INDONESIA'S NEW
FISCAL DECENTRALISATION ARRANGEMENTS, Bulletin of Indonesian Economic Studies, 39:2,
159-176, DOI: 10.1080/00074910302012
To link to this article: http://dx.doi.org/10.1080/00074910302012

Published online: 17 Jun 2010.

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Date: 19 January 2016, At: 20:18

Bulletin of Indonesian Economic Studies, Vol. 39, No. 1, 2003: 159–76

CHANGE AND CONTINUITY IN INDONESIA’S
NEW FISCAL DECENTRALISATION ARRANGEMENTS
George Fane*

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The Australian National University
The changes in grant allocation among regions have been less revolutionary than the
1999 decentralisation legislation envisaged because the resource-rich regions were
able to force the government to modify the proposed fiscal gap formula for allocating general purpose grants so as to put more weight on the status quo. Partly for this
reason, and partly because no major tax was decentralised, there has not been much

increase in autonomy for the regions that have few natural resources. In addition, it
is argued here that the procedures for grant allocation in 2002 created incentives for
regional fragmentation and did not take account of poverty in an appropriate way.

In 1999, President Habibie’s government
introduced two important laws that were
designed to make Indonesia more democratic and to increase the autonomy of
the regions—that is, the provinces and
the local government areas, the latter
comprising both districts (kabupaten) and
municipalities (kota).1 Law 22/1999 on
Regional Governance defined the functions that were to be transferred from the
centre to the regions and set out the
procedures for establishing regional assemblies and for appointing regional
governments.2 In contrast to the substantial decentralisation of responsibility for
regional government spending, there has
been little decentralisation of taxation.
The central government has retained the
responsibility for setting the rates of all
the existing major tax bases, and collecting most of their revenue.3

The limited decentralisation of taxation that has occurred is governed by
Law 34/2000, which somewhat relaxed
the restrictions on regional taxes and
charges that had been imposed by Law
18/1997 to curb nuisance taxes and taxes on regional trade (Silver, Azis and

Schroeder 2001: 358). Law 34/2000 allocated certain existing regional tax
bases to provinces and others to local
governments, but set ceilings on the
maximum rates of these ‘positive list’
taxes. In order to help finance decentralisation, it also authorised all regional
governments to introduce user charges,
and authorised local governments, but
not provinces, to introduce new taxes.
According to Law 34/2000, all new local taxes and local and provincial user
charges must be reviewed by the central government to ensure that they are
efficient and appropriate; for example,
local taxes must not be levied on bases
assigned to provinces or the central government. However, a study by Lewis
(2003c) concludes that out of over a

thousand new taxes and charges that
were proposed or implemented by local governments between April 2000
and June 2002, less than half were in fact
reviewed by the central government.
Because of the much more extensive
decentralisation of expenditure functions than of revenue, the regions’ new
responsibilities have had to be financed

ISSN 0007-4918 print/ISSN 1472-7234 online/03/020159-18

© 2003 Indonesia Project ANU

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160

mainly from two central government
sources: an increase in the share of tax
and natural resource revenues that the
central government returns to the regions in which these revenues originate,

and the introduction of a new type of
grant, the DAU (Dana Alokasi Umum).
This article follows the widespread practice of referring to the DAU as a general
purpose grant, although this is only true
‘at the margin’. The bulk of the DAU is
needed to pay government officials and
to provide services, such as basic education and health, for which regional
governments are responsible. Law
25/1999 on the Fiscal Balance between
the Central and Regional Governments
stipulated that the DAU should be allocated among regions in proportion to
their net fiscal gaps, and Government
Regulation 104/2000 set out a formula
for determining each region’s fiscal gap
in terms of proxies for its fiscal need and
its economic potential.
When Laws 22/1999 and 25/1999,
along with their supporting government
regulations and decrees, came into effect
in January 2001, regional governments

took over responsibility for all government functions except foreign policy,
defence and security, justice, macroeconomic policy, religion, and various
other central government functions such
as national planning, human resource
development, natural resource utilisation, conservation, strategic high technology, state administration and state
economic institutional systems. Since
the functions are not clearly defined,
there is obviously scope for interpreting
them either broadly or narrowly. Nevertheless, there has clearly been a major
transfer of revenue and responsibilities
to the regions, with most of the staff of
the formerly ‘deconcentrated’ agencies
of the central government being transferred to the decentralised agencies of

George Fane

regional governments in 2001.4 The deconcentrated agencies that remain are
those responsible for regional implementation of the functions reserved for
the central government (Lewis 2003b: 2).
Apart from strengthening the regions

relative to the centre, the new laws
strengthened local governments relative
to provinces in three ways. First, in place
of the former hierarchical system in
which local governments were responsible to provincial governments, Law
22/1999 made each regional government directly responsible to its legislative assembly, subject to constraints
imposed by the central government.
Provincial governments do, however,
continue to exercise some powers over
local governments, because provincial
governors have a dual role: in addition
to representing their provinces, they also
represent the central government in its
dealings with local governments.
Second, Law 25/1999 transferred most
responsibilities to local rather than provincial governments. Third, Law
25/1999 allocated 90% of the DAU to
local governments and only 10% to the
provinces.
The reason for by-passing the provinces appears to have been that the central government was worried about

secessionist movements: strengthening
the provinces might shore up these
movements, whereas strengthening local governments would weaken them.
The government may have reasoned
that individual local government areas
are too small to be able to secede and
that they would help resist secessionist
pressures if they were the recipients of
substantial transfers from the centre.
The basic argument of this paper is
that the transfer of power from the central government to the regions has so far
been much less revolutionary than
would otherwise have been the case,

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Change and Continuity in Indonesia’s New Fiscal Decentralisation Arrangements

owing to three factors that partially perpetuated the status quo. First, the central government continues to control all
major tax bases and, therefore, the bulk

of the revenues of all regions other than
those that are rich in natural resources.
Since most revenue raising remains centralised, and since ‘he who pays the piper calls the tune’, the extensive transfer
of spending responsibilities to the regions overstates the extent to which decision making has been decentralised.
Second, although responsibility for
most current spending has been transferred to the regions, most development
spending is still under the central government budget. In addition, development spending provides more scope
than routine spending for regions to exercise discretion, since most of the latter
finances officials who cannot be dismissed, together with services, such as
education and health care, that must be
provided at levels set by the centre.
Third, in response to pressure from
regions that would otherwise have had
their grants reduced, the central government assigned a relatively low weight
to the new ‘fiscal gap formula’ for allocating the DAU. Instead, it gave a much
higher weight to past history, in the form
of the wage and salary bills of regional
government officials and the predecentralisation levels of Presidential Instruction (Inpres) grants and grants to
autonomous regions (subsidi daerah
otonom, SDO). These had been the main

general and specific transfers to the
regions before the implementation of
Law 25/1999.5
This paper focuses mainly on the
third factor. It documents the differences between the fiscal gap formula set
out in Law 25/1999 and Regulation
104/2000, and the procedures that have
actually been used for allocating the
DAU among regional governments.

161

REGIONAL GOVERNMENT
REVENUE
The main sources of funds for local and
provincial governments are own-source
income, transfers from the central government of shared tax and natural resource revenues, and general purpose
grants from the central government,
mainly from the DAU. In 2002, the DAU
was supplemented by a Balancing Fund

(referred to by the Ministry of Finance
as ‘Dana Penyeimbang’) that was equivalent to the DAU from the point of view
of regional governments, but treated as
a separate item in the central government’s budget.6 Transfers from the central government’s Specific Purpose
Fund (Dana Alokasi Khusus, DAK)
were of negligible importance in 2001
and 2002. Table 1 shows that in 2002, on
average, local governments generated
just under 5% of their total revenue from
own-tax and non-tax sources, while
transfers from the central government
accounted for the remaining 95%. The
DAU, which was by far the most important source of these transfers, provided
79% of total local government revenue;
the remainder was made up of transfers
from the central government of shared
tax revenue (5%) and shared natural resource revenue (12%).
A comparison of columns 1 and 2 of
table 1 shows that, on a per capita basis,
the unweighted average over all local
government areas of each of the transfers from the central government to local governments is substantially larger
than the corresponding average per capita transfer for Indonesia. The latter is
the weighted average over all local government areas, where each area is
weighted by its population. The fact that
the unweighted averages exceed the
weighted averages demonstrates that
the per capita transfers are negatively
correlated with population: the least

162

George Fane
TABLE 1 Means of Selected Variables, All Local Governments in Indonesia

Unweighted Average for
Average a
Indonesia
(1)

GDP per capita (Rp ‘000)

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Headcount poverty rate (%) b

(2)

Maximum,
Minimum,
Any Local
Any Local
Government Government
(3)
(4)

4,901.2

4,068.3

147,676.8

856.5

24.5

24.4

91.1

1.0

7,028.0
4,853.6
265.4
4,609.6
3,376.5
855.3

144.5
6.4
4.3
0.3
113.1
0.3

Regional per capita own-tax revenue and transfers
received from central government (Rp ’000 per capita)
Transfers from the centre
Shared revenue
Taxes
Natural resources
General purpose grants c
Own-tax and other revenue

688.4
157.1
28.5
128.6
531.3
22.4

389.7
66.5
18.8
47.7
323.1
18.6

a

The unweighted averages are the arithmetic means of the variables across all local
governments. The average for Indonesia is obtained by taking the weighted average, where
each local government is weighted by its population. The variables are those used by the
Ministry of Finance to calculate DAU and Balancing Fund grants in FY2002.
b

The headcount poverty rate is the percentage of all people in a local government area
living in households whose average expenditure per capita is below the official poverty
line. The source is the National Socio-Economic Survey (Susenas) of the Central Statistical
Agency (BPS).
c

General purpose grants are DAU plus Balancing Fund receipts in 2002.

populous local government areas tend
to receive the largest per capita transfers. This effect is especially marked in
the case of general purpose grants (DAU
and Balancing Fund); the correlation
coefficient, across local government
areas, between population and this variable is –0.5. The corresponding correlation coefficients for shared tax revenue
and shared natural resource revenue are
–0.3 and –0.2 respectively. The correlation coefficient between population and
the sum of these three per capita transfers is –0.4.
The features of the DAU formula that
favour small local government areas will
be described below. The fact that all of
the central government transfers favour

small areas relative to more populous
ones provides an incentive for local government areas to fragment.
THE FISCAL GAP FORMULA
FOR THE DAU
Article 7 of Law 25/1999 specifies that
the total amount of DAU payments
made to regional governments by the
central government must be at least 25%
of the domestic revenue received by the
national budget net of payments to regional governments of shared tax and
natural resource revenues; that 90% of
this amount is to be allocated to local
governments and 10% to provinces; and
that the allocations among local governments and among provinces are to be in

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Change and Continuity in Indonesia’s New Fiscal Decentralisation Arrangements

proportion to the gap between their fiscal need and their economic potential.
Article 17 of Regulation 104/2000 sets
out a formula for calculating fiscal need
and economic potential. Article 17(3)
states that need ‘shall be calculated on
the basis of the multiplication of average expenditure of regions by the total
of indexes of population, territorial area,
building price and relative poverty after being divided by four’. Article 17(4)
states that economic potential ‘shall be
calculated on the basis of the multiplication of average revenue of regions
with the total of indexes of industry,
natural resources and human resources
after being divided by three’.7
The above quotations show that the
fiscal gap formula in article 17 of Regulation 104/2000 was ambiguous. For
example, it did not define relative poverty and the indexes of industry, natural resources and human resources. In
the event, article 17 was interpreted in
different ways in 2001 and in 2002, and
actual allocations from the DAU in both
years were also based on past history
and factors other than those mentioned
in Law 25/1999 and Regulation
104/2000.
Lewis (2001) describes how the DAU
was allocated among local governments
and provinces in 2001. Each local government was given a basic allocation
that was equal to the sum of:
• the annualised8 amount of SDO funding received by the local government
in financial year (FY) 2000, plus 30%
to cover both expected inflation and
the average cost of the transfer from
the central government’s payroll to the
payrolls of the regional governments
of the officials employed by the central government in the regions;9 and
• the annualised amount of Inpres
grants received by the local government in FY2000, plus 10% to cover
expected inflation.

163

The total of the basic allocation,
summed over all local governments,
was Rp 40 trillion. This allocation clearly
involved past history rather than the fiscal gap formula in Regulation 104/2000,
and had the purpose of ensuring that
local governments were financially compensated for the new functions transferred to them. A further amount, equal
to Rp 0.4 trillion in total, was allocated
equally among all local governments.
The fiscal gap formula was used to allocate only Rp 10 billion—just 18.5% of
the Rp 54.5 trillion of DAU payments
made to local governments in 2001—and
this amount was allocated using an
amended version of the formula. The
main amendment was that if the estimated fiscal gap was negative, that is, if
estimated need was less than estimated
economic potential, then the amended
formula amount was set to zero.
Lewis (2001: 329–30) estimates that in
aggregate, and given the increases in
shared tax and natural resource revenues, the DAU allocations to local governments in 2001 were far in excess of
what was needed. According to the estimates in his table 2, a total DAU allocation of Rp 28.7 trillion would have
been sufficient to finance the functions
transferred from the centre, given local
governments’ own revenues and the
greatly increased amounts of shared tax
and natural resource revenues that they
received. This is only 53% of what they
actually received.
Lewis notes that his calculation depends on factors not known with any
certainty, and that, since shared revenues were allocated very unequally
among local governments, what is true
in aggregate was probably not true for
every individual local government. In
particular, the amount of DAU payments allocated to some local governments with few natural resources
was probably not enough to finance

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164

their new functions and pay the 15%
increase in the wages of government officials that had been decreed by the central government. For this reason, the
central government set up a Contingency Fund from which allocations of
Rp 2.8 trillion were made in 2001 to regional governments that might otherwise not have been able to meet the
salaries of the officials that were transferred to them from the central government’s payroll.
In the case of provinces, 80% of the
DAU payments available in 2001was allocated in proportion to receipts of SDO
and Inpres grants in 2000; the remainder was allocated according to a fiscal
gap formula that was similar to that applied to local governments. However,
the provinces were treated much less
generously than local governments: the
total DAU allocation to them in 2001 was
only Rp 6.1 trillion, whereas their annualised receipts of SDO and Inpres grants
in 2000 had been Rp 7.7 trillion (Lewis
2001: 328–9). Nevertheless, both the resulting revenue shortfall and the cost of
their new functions were slightly more
than offset, on average, by their increased receipts of shared tax and nontax natural resource revenues (Lewis
2001: 330).
DAU ALLOCATIONS IN 2002
This section describes how the Ministry
of Finance (MOF) interpreted the fiscal
gap formula in making DAU allocations
for 2002; how it modified this formula
to produce a less revolutionary outcome,
the ‘original’ formula; and how the government was forced to amend the original formula so as to deviate still less from
the status quo. Because of the complexity of these formulas, it would have been
impossible for local governments to
check their entitlements or find out what
action they would need to take to raise
them. However, it is possible to solve the

George Fane

complex algebra in the official formulas
and calculate the numerical values of the
coefficients on each of the variables in
these formulas. These coefficients, measured in billions of rupiah of DAU
payments per unit of the relevant variable—area, population, natural resource
revenue and so forth—are presented in
table 2 and discussed in the next section.
The detailed algebra of the various formulas is available in the technical appendix to this paper.
A useful minor reform that would
increase the transparency of the decentralisation procedures would be for the
MOF to calculate and announce the corresponding coefficients in future years,
and tell each local government the value, according to the MOF’s database, of
each of the formula variables for that
local government area. Since the formulas are linear, the local government
would be able to add up the contribution of each variable—that is, the level
of the variable multiplied by the relevant
coefficient—and obtain the MOF’s estimate of its DAU entitlement. This reform
would also help to combat the problem
of unreliable data: if the local government felt that the MOF’s data understated the extent of the poverty of its
citizens, for example, it would be able
to protest and produce whatever evidence it could to support its case.
In accordance with Law 25/1999 and
Regulation 104/2000, the MOF defined
the fiscal gap for each local government
in 2002 as the difference between its fiscal need and its economic potential. An
exactly analogous procedure was used
for allocating the 10% of DAU payments
earmarked for provinces. In 2002, economic potential was defined as the sum
of shared tax revenue, 75% of shared
revenue from natural resources, and the
estimated value of own-tax revenue
from a regression of own-tax revenue on
GDP in the services sector. The reason

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Change and Continuity in Indonesia’s New Fiscal Decentralisation Arrangements

for using regression analysis, rather than
the actual value of own-tax resources in
the previous year, was to avoid penalising local governments that had succeeded in collecting relatively high levels of
revenue relative to the potential tax base,
which was regarded as being primarily
GDP in the services sector.10 The actual
amount of own-tax revenue was not
used in calculating general purpose
grants. The weight of 0.75 on revenue
from natural resources is not mentioned
in Regulation 104/2000. It was presumably adopted in the hope of forestalling
protests from regions with abundant
natural resources that their newly acquired shared revenue from these resources was being clawed back by the
DAU formula.
The formula for economic need was
defined as a weighted average of indexes of four variables: population, area,
poverty and prices. Poverty was measured as the ‘expenditure gap of the
poor’, defined as the proportion by
which the average expenditure of poor
people in the local government area was
below the poverty line.11 The price index used was the cost of constructing
government buildings. Regulation 104/
2000 does not define poverty and, in the
present context of determining the grant
for each local government, the expenditure gap is a very unsatisfactory measure of poverty. Two local government
areas, in each of which the average expenditure of those below the poverty
line is 90%, would both have expenditure gaps of 10% and would therefore
receive the same allocations on account
of poverty, even though the numbers of
poor people in each local government
area might be vastly different. An example of the very unsatisfactory way in
which this worked out in practice in
2002 is given in the next section.
The treatment of prices in the formula for need can also be criticised, as

165

Lewis (2001: 332) notes. Rather than including a price index as one term in a
linear equation for need, the appropriate way of allowing for cost differences
among regions is to make each region’s
monetary need directly proportional to
the cost of providing government services.
The MOF initially proposed allocating DAU payments among local governments in 2002 using a formula that put
relatively little weight on the fiscal gap
formula in Regulation 104/2000, and
that set this fiscal gap to zero if it would
otherwise have been negative. The proposal also took account of wage and salary payments to local government
officials in 2001 and included a ‘flat-rate’
amount for every local government, that
is, an amount that was independent of
population, area or any other variable.
This proposal came to be known as the
‘original’ formula because it was subsequently modified in response to intense
political opposition from the resourcerich regions (Hofman, Kadjatmiko and
Kaiser 2002).
Because 11 provinces and 72 local
governments would have received lower DAU payments in 2002 under the
original formula than they had received
in DAU and Contingency Fund payments in 2001, this formula generated
strong political opposition. The government was thus obliged to adjust it to
ensure that every local government received at least as much in 2002, in nominal terms, as it had in 2001. This
adjustment was referred to as the ‘no
harm’ clause. It involved comparing the
amount given by the original formula
with the total amount of DAU and Contingency Fund revenue that each local
government had received in 2001. If the
formula amount was less than the grants
received in 2001, the formula was ignored and the local government received the same nominal amount as it

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166

had in 2001. This is the sense in which
local governments were unharmed, at
least in nominal terms. Henceforth, the
72 local governments to which the no
harm clause applied are called the ‘no
harm group’, while the remaining 264
are called the ‘formula group’.
The total cost of applying the no harm
clause—that is, the sum of the amounts
by which the DAU transfers to all local
governments in the no harm group under the original formula were below
what they had received in 2001—was
Rp 2,851 billion. This was met partly
from additional central government
transfers, in the form of the Balancing
Fund (Dana Penyeimbang) of Rp 855
billion, and partly by clawing back 22%
of the amount that each local government in the formula group stood to gain
under the original formula.12
THE PROPERTIES OF THE
AMENDED FORMULA
The description in the preceding section
of the amended formula can be summarised and simplified by calculating
the numerical values of the coefficients
on each of the variables included in it.
These coefficients, measured in billions
of rupiah of DAU payments per unit of
the relevant variable, are reported in table 2 for local governments in the formula group, that is, those to which the
formula rather than the no harm clause
applied. For local governments to which
the no harm clause applied, the general
purpose grant was of course exactly
equal in nominal terms to what it had
been in 2001. The last column of table 2
shows the average share of each variable, defined as the sum of its contribution (coefficient x variable) for all local
governments in the formula group as a
percentage of the total DAU and Balancing Fund payments for the formula
group local governments.13 The remainder of this section summarises several

George Fane

important implications that follow immediately from this way of describing
the amended formula.
The Proportion of General Purpose
Grants Allocated Using the Fiscal
Gap Formula
Under the MOF’s original formula for
2002, the share of grants allocated using
the fiscal gap formula itself would have
been 40%; another 10% would have been
allocated as flat-rate payments to each
local government and the remaining
50% would have been allocated in proportion to spending on the wages and
salaries of officials.14 The growing importance of the fiscal gap formula in
grant allocation is shown by the fact that
the corresponding proportion for 2001
was only 20% but will be 60% in 2003.
However, these estimates overstate
the importance of the fiscal gap formula because they ignore the effects of the
no harm clause. In 2002, 22% of general
purpose grants were allocated to local
governments in the no harm group. The
fiscal gap formula was irrelevant to the
size of these grants, which were simply
equal to what each of these local governments had received in 2001. In addition, the importance of the fiscal gap
formula was reduced even for local governments in the formula group, because
the no harm clause was partly financed
by clawing back 22% of the gains of local governments in the formula group.
The data in table 2 can be used to take
account of these problems and derive a
corrected estimate of the importance of
the fiscal gap formula.
The variables in table 2 that are part of
the fiscal gap formula are population,
area, poverty, prices, GDP in services, and
shared tax and natural resource revenues. The sum of the shares of these variables is 35%, which means that 35% of
the general purpose grants received by
local governments in the formula group

Change and Continuity in Indonesia’s New Fiscal Decentralisation Arrangements

167

TABLE 2 Amended Formula for DAU and Balancing Fund Payments
to Local Governments in the Formula Group, 2002 a

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Variable (units in which measured)

1
2
3
4
5
6

Coefficient

Flat rate amount (unity)
Population (thousand)
Area (sq. km.)
Salaries of officials in 2001 (Rp billion)
Expenditure gap of poor (% of poverty line)
Price index of government buildings
(average 1999/2000 = 100)
7 General purpose grant in 2001 (Rp billion)
8 Shared tax revenue in 2001 (Rp billion)
9 GDP in services in 1999 (Rp billion)
10 Shared natural resource revenue (Rp billion)

Average Share (%)

Rp 13.46 billion
Rp 51 million
Rp 1.28 million
60%
Rp 390 million

7
16
4
40
4

Rp 218 million
22%
–44%
–0.4%
–33%

16
19
–2
–2
–1

a

The formula group of local governments is all districts and municipalities to which the no
harm clause does not apply (see text). The average share of each variable is the sum of its
contribution (that is, coefficient x variable) for all local governments in the formula group
as a percentage of the total DAU and Balancing Fund payments for these local governments.

can be attributed to the fiscal gap formula itself. Since 78% of general purpose
grants were distributed to local governments in the formula group, and since the
formula did not affect the amounts received by those in the no harm group,
this means that 27% of general purpose
grants can be attributed to variables in
the fiscal gap formula in 2002.
The Employment Subsidy
Local governments in the formula group
received an extra Rp 60 million in general purpose grants for every Rp 100 million spent on the wages and salaries of
local government officials in the previous year. If local governments were free
to hire and retrench local government
officials, if they fully understood the
grants formula, and if they expected the
present formula to be maintained, this
would amount to a 60% subsidy on the
employment of local government officials. Of course the ‘ifs’ do not exactly
hold. Nevertheless, if the weight of the

fiscal gap formula, which does not include wages and salaries, were substantially increased, as some MOF officials
have proposed, the implicit subsidy on
employing officials would fall, and the
incentives for local governments not to
make new appointments and to search
for ways of retrenching existing employees would become much greater than
they now are.
The Claw-back of Shared Tax and
Natural Resource Revenues
For local governments in the formula
group, general purpose grants were reduced by 44% of their shared tax revenue. Since the shared revenue from
natural resources receives a weight of
0.75 in the MOF’s measure of economic
potential, its marginal effect on grants
was only three-quarters of this, or –33%.
These coefficients can be read directly
off the amended formula in table 2.
The possibility that the way of allocating general purpose grants would

168

claw back some of the shared natural
resource revenue was noted by McLeod
(2000: 37):

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… the gain to resource rich provinces
and districts/municipalities from
natural resource revenues could be
largely offset if their proportional
entitlements to the general funds
allocation are set at a low level precisely because of their large resource
endowments.

However, McLeod was writing before the no harm clause had been introduced. The effect of this clause is to
prevent the claw-back of shared revenue from applying to local governments
in the no harm group. This means that
the claw-back generally does not apply
to the resource-rich local governments
because the claw-back itself usually
makes the amount they would have received under the original formula less
than the amount they received in 2001.
Strong evidence for this is given by the
fact that the average amount of shared
natural resource revenue per region in
the formula group is Rp 7 billion, whereas the average per region in the no harm
group is Rp 104 billion.
The Bias in Favour of
Fragmentation of Regions
The central government presumably
does not intend to subsidise the fragmentation of regions, but the inclusion
of the flat rate amount in the amended
DAU formula has this effect. A possible
rationale for the flat-rate amount in the
amended DAU formula is that there is a
certain minimum cost of administering
any local government area, and the flatrate amount is intended to cover it. The
flaw in this argument is that it postulates that fragmentation raises administrative costs, but proposes that local
governments should be able to pass all
these costs on to the centre, even though
they have a large say in determining

George Fane

whether or not fragmentation occurs. In
2003, the subsidisation of fragmentation
has been increased by using specific purpose grants from the DAK to allocate
Rp 4 billion to each new district to cover start-up costs.
The amended formula in table 2 allows one to quantify the extent of the
incentive for fragmentation provided by
the amended formula. The local government area in the formula group with the
largest population is the district of
Tangerang (part of Greater Jakarta) with
a population of 2.8 million. This is 76
times the population of the smallest local government area in the formula
group, the district of Malinau in East
Kalimantan with a population of 36,000.
On a per capita basis, the flat-rate
amount in the amended formula, which
is Rp 13.46 billion per local government,
therefore provides Malinau with 76
times as large an allocation per capita
as that provided for Tangerang:
Rp 369,000 per person in Malinau compared with about Rp 5,000 per person
in Tangerang.
The flat-rate amount is not the only
term in the amended formula that provides an incentive for regions to fragment; the way in which the formula
allows for poverty and the price of government buildings has the same effect.
This can be seen by noting that if a local
government area were to split into two
identical halves, each of the new smaller local governments would receive the
same absolute amount as the original
area on account of the flat-rate amount,
poverty and the price of government
buildings, whereas for the other seven
terms in the amended formula—
population, area, salaries of officials,
general purpose grants in the previous
year, shared tax revenue, shared natural resource revenue and GDP in
services—the two new local governments would each receive half of what

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Change and Continuity in Indonesia’s New Fiscal Decentralisation Arrangements

the original local government had received. The estimates reported in the last
column in table 2 imply that 28% of the
general purpose grant of an average local government in the formula group is
attributable to the flat-rate amount, the
expenditure gap of the poor and the
price index of government buildings. It
follows from this that if an average local government area were to split into
two identical halves, the total general
purpose grants of the two new local governments would be 28% more than the
total general purpose grant received by
the original local government.15
The incentives for fragmentation provided by the DAU allocation formulas
are exacerbated by the formulas for the
allocation of shared tax and natural resource revenues. As noted earlier (at the
end of the section on regional government revenue), table 1 demonstrates that
these other formulas also favour small
local government areas over larger ones.
The reasons are essentially the same as
for the DAU: these other formulas also
allocate part of the revenue to be shared
equally among all local government areas, without taking account of their different population sizes.
There are many possible reasons for
the fragmentation that has been occurring among local government areas and
provinces. Some may well be more important than the incentive to fragment
provided by the formulas for allocating
DAU and other shared revenue. But
even if this is true, it would clearly be
sensible for the central government to
stop subsidising fragmentation.
Unequal Treatment of Poverty
in Different Regions
The way in which the formula for general purpose grants treats poverty is
very unsatisfactory. This can be demonstrated by comparing how much particular local governments receive on

169

account of poverty, that is, the amount
received under item 5 in table 2, expressed relative to the number of poor
people in the local government area. The
unsatisfactory treatment of poverty can
be illustrated by comparing the district
of Jember in East Java with the municipality of Denpasar in Bali. These two
local government areas are chosen to
highlight the weaknesses of the amended formula in allowing for poverty.
Poverty in Denpasar is negligible
compared to poverty in Jember: Denpasar has a population of 523,000 of
whom only about 1% are in poverty,
whereas Jember has a population of 2.2
million of whom 46% are in poverty. The
poverty gap measure of poverty tells the
same story: the poverty gap in Jember
is 8.7% whereas that in Denpasar is only
0.23%. However, the amended formula
makes the payment on account of measured poverty directly proportional to
the expenditure gap, which is the
amount by which the average expenditure of poor people is below the poverty line, expressed as a percentage of the
poverty line. The expenditure gap is the
ratio of the poverty gap to the proportion of the population in poverty (see
note 11). In Denpasar the expenditure
gap is therefore 23% of the poverty line,
whereas in Jember it is only 19%. Since
Denpasar and Jember are both in the
formula group, and since the amended
formula allocates Rp 390 million to these
local governments for each percentage
point by which the average incomes of
poor people are below the poverty line
(see table 2), it allocates Rp 9.0 billion to
Denpasar on account of poverty, but
only Rp 7.4 billion to Jember. On a per
poor person basis, this is equivalent to
Rp 1.7 million for each poor person in
Denpasar, but only Rp 8,000 for each
poor person in Jember! Admittedly, the
average expenditure of poor people in
Denpasar is estimated to be 5% less than

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170

in Jember, but this could scarcely justify
allocating over 200 times as much per
poor person to Denpasar as to Jember.
The bizarre implications of the formula documented here result from the fact
that the expenditure gap does not depend on the number of poor people in
an area, but only on the proportion by
which the expenditure of the average poor
person in the area falls short of the poverty line. If two areas have the same
poverty headcount rate, and if the average expenditure of poor people in the
two areas is equal, the DAU formula
would give each of them the same total
amount of money on account of poverty, whatever their total populations. But
if one of the areas contained 10 times as
many people as the other, it should presumably receive 10 times as much as the
other on account of poverty, since it contains 10 times as many poor people, and
since the poor people in both areas are
equally poor on average.
Do Central Government Transfers
Reduce Horizontal Imbalances?
The studies by Lewis (2001) and Hofman, Kadjatmiko and Kaiser (2002) suggest that the DAU reduces horizontal
imbalances. Lewis (2001) took as each
government’s base revenue the fitted
value of own-source per capita revenue
from a regression in which the explanatory variables are per capita GDP and a
dummy for municipal (as opposed to
district) status. He then calculated the
effects on the inequality of per capita
local government revenue in 2001—as
measured by the coefficient of variation,
the standard deviation of the logarithm
and the Gini coefficient—of adding, one
by one, the remaining components of per
capita local government revenue. All
three inequality measures are reduced
when shared tax revenue is added to fitted own-source revenue; all three are
raised very substantially by then add-

George Fane

ing shared natural resource revenue;
and all three are reduced by then adding per capita DAU payments. Table 8
in Hofman, Kadjatmiko and Kaiser
(2002) broadly confirms Lewis’s results
for 2001 and their table 9 shows a similar pattern for 2002.
On the basis of these findings, it seems
likely that the DAU did indeed help to
reduce horizontal fiscal inequalities in
both 2001 and 2002. It would probably
have been a stronger force for equalisation if a weight of unity rather than 0.75
had been put on natural resource revenue in the measure of economic potential, and if the original DAU formula had
not been replaced by the amended formula. The reason is that shared natural
resource revenue increases horizontal
inequalities, and both these amendments to the DAU formula reduce the
extent to which it claws back shared natural resource revenue. However, it does
not follow that these more equalising
policies should have been chosen. The
adoption of a fully equalising DAU formula would have resulted in the sharing of natural resource revenue among
regions in proportion to their fiscal need,
net of their other revenue sources and
without regard to the geographical location of the natural resources. Such a
formula for the DAU would have fully
clawed back natural resource revenue
from the resource-rich regions and thus
made a mockery of the clear intention
in Laws 22 and 25 of 1999 that regions
should receive at least some of the revenue from their natural resources.
SUMMARY
This article distinguishes among three
formulas for allocating general purpose
grants in 2002: the fiscal gap formula
foreshadowed in Law 25/1999 and set
out in Government Regulation 104/
2000; the original formula proposed by
the MOF, which was a weighted aver-

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Change and Continuity in Indonesia’s New Fiscal Decentralisation Arrangements

age of the fiscal gap formula, a flat-rate
amount for every local government area
(regardless of size) and the wage and
salary bill of officials in the previous
year; and the amended formula that the
government was obliged to adopt in the
face of intense lobbying from the resource-rich provinces, whose natural
resource revenue would have been partially clawed back by both the other formulas. The analysis of these formulas
showed that there is a common thread
linking the various changes that were
made to the fiscal gap formula in order
to arrive at the amended formula actually used to allocate general purpose
grants: all these changes helped to preserve the historical pattern of grant allocation.
It was also argued that each of these
formulas contains defects that were unnecessary in the sense that they were not
forced on the government by political
pressure. They allow for differences in
costs among local government areas in
an additive way, whereas such differences should be allowed for in a multiplicative way: if prices in one area are
double those in another, the former area
needs twice the revenue of the latter,
everything else being equal. The same
criticism applies to the way in which the
formulas allow for population differences: other things being equal, an area that
contains twice as many people as another should receive twice as large a grant.
Instead, all three formulas make grants
a linear function of several variables, of
which population is only one. In the case
of poverty, the failure to take proper account of population size means that in
some cases areas containing hundreds
of thousands of poor people receive less
than areas containing only a few thousand poor people. Denpasar, where only
about 5,000 people are below the poverty line, received a slightly larger share
of the DAU on account of poverty than

171

Jember, where almost a million people
were below the poverty line!
More important than the relatively
minor defects of the various formulas is
that the decentralisation of decision
making has been greatly limited by the
central government’s retention of control over all the major tax bases. This effect has been reinforced by the fact that
those expenditures that have been decentralised are mainly routine expenditures over which regional governments
have little discretion.
In any fairly stable system for allocating central government grants to regional governments, the amounts received
annually by each individual regional
government will be closely related to
what was received in the previous year.
The shares of each region in the total
may alter to reflect inflation, growth and
special factors, but are unlikely to alter
greatly between one year and the next.
In apparent contradiction of this rule,
Indonesia’s adoption of a new grants
formula in 2001 and 2002 had the potential to disrupt the old system. Substantial changes were desired, but the
changes that would have resulted from
applying the fiscal gap formula in Regulation 104/2000—which inevitably
used imperfect proxies of need and potential—would have made it impossible
for some regions to provide basic services or to go on paying their employees. It
was therefore impracticable to distribute all grants according to any simple
formula and to ignore completely the
historical pattern of grants among regions that had resulted from political
competition for grants over many years.
The fiscal gap formula had to be modified to increase the influence of the status quo in the pattern of grant allocation.
This greatly assisted the resource-rich
regions, whose new shared revenues
would otherwise have been clawed back
by the reductions in their general pur-

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172

pose grants that would have resulted
from allocating all grants according to a
fiscal gap formula that fully included
natural resource revenue in economic
potential.
It would be an exaggeration of the
extent to which the status quo has been
preserved to say that the 1999 decentralisation laws have not greatly changed
the numbers of officials employed in
the regions, or what they do, but have
merely resulted in the officials who used
to be employed by the central government’s deconcentrated agencies now
receiving their salaries from regional
governments, which in turn receive increased grants from the centre. The most
important change to the status quo that
this too cynical view of decentralisation
omits is the increased autonomy that
resource-rich regions have acquired as
a result of having much of their natural
resource revenue returned to them by
the central government.
However, the exaggeration contains
an important element of truth: as long
as the resource-poor regional governments are dependent on grants from the
central government for almost 80% of
their funding, they will not be genuinely autonomous. To realise the potential
for decentralisation to make governments more cost-efficient and more sensitive to local aspirations, regional
governments need genuine autonomy.
The resource-poor regions will only
achieve this if the central government
reduces their dependence on grants by
allowing them to set the rates of one or
more major tax bases, administer the
collection of the revenue, and then retain all the revenue collected. The main
candidate for decentralisation is the
property tax (Lewis 2003a). Ryder
(2003) argues strongly that it would be
feasible and desirable to partially decentralise the income tax by allowing
each regional government to add its

George Fane

chosen percentage rate, applicable only
to the incomes of its own residents, to
the income tax rates set by the central
government.
NOTES
*

1

2

3

4

I am grateful for helpful comments from
two referees, many ANU colleagues and,
especially, Blane Lewis. All remaining
errors are mine.
Decentralisation policies during the New
Order period are described in Qureshi
(1997) and Silver, Azis and Schroeder
(2001). Paauw (1955) describes the limited but nevertheless significant extent of
self-finance by local governments in West
Java and Central Sumatra during the
Sukarno period.
All the laws and government regulations
mentioned in the present article can be
found at http://www.gtzsfdm.or.id.
The property tax is officially classified as
a central government tax, not a local government one. Its rate is set centrally but
its administration is shared between the
central government and each local government (Lewis 2003a). For every Rp 100
of gross revenue from the property tax,
the central government retains Rp 10 to
cover administration costs and returns
the rest to regional governments. However, the source local government itself
receives only Rp 64.8, with the remaining Rp 25.2 going to provinces