Spending other people’s money

by Tim Auracher, Budi Sitepu
Some parts of Indonesia share the characteristics of low income countries: village girls in Papua

Some parts of Indonesia share the characteristics of low income countries: village girls in Papua

In radical reforms after 1999, the Indonesian government granted considerable autonomy to sub-national authorities and made substantial funds available to them accordingly. The quality of spending remains poor, however. To make municipal and district governments more accountable to their people, a new reform of tax law is being implemented since 2009. By Tim Auracher and Budi Sitepu

Due to impressive speed and scope, Indonesia’s decentralisation since 1999 is called “the Big Bang”. At the end of the 1990s, Indonesia suffered from the Asian financial crisis and the autocratic regime of President Suharto collapsed. In view of the risk of a disintegrating nation, the government had to react fast and decisively. It opted for an ambitious decentralisation programme, granting broad autonomy to sub-national authorities in 1999. From 2001 on, it introduced a new fiscal transfer system which was mainly based on unconditional grants.

Indonesia has two sub-national levels of government: the provinces (the intermediate level) and the districts and municipalities (the local level). There are currently 33 provinces, 398 districts and 93 municipalities. All are run by elected governments.

The Big Bang worked well, without causing major interruptions of public services or administration. Over two million civil servants, almost two thirds of the central government’s workforce, were transferred to sub-national levels in 2001. The expenditure of sub-national authorities jumped from 17 % of total public spending in 2000 to 30 % in 2001. In 2010, the share was around 40 %.

At the heart of the current fiscal architecture is a general allocation grant (Dana Alokasi Umum, or DAU). These funds are transferred to the sub-national authorities without condition. The DAU is designed to make sure that all sub-national authorities have adequate and similar capacities. By law, at least 26 % of net domestic revenue has to be transferred to sub-national levels through the DAU. The scheme has substantially contributed to closing fiscal gaps in Indonesia’s poorer regions.

Indonesia is marked by great disparities. Some regions resemble middle or even high income countries, while others share the characteristics of low income countries. In Riau and East Kalimantan, two oil and gas producing countries, per capita GDP is almost 20 times higher than in Maluku or East Nusa Tenggara. Poverty rates also vary widely. In some municipalities (for instance, Denpasar in Bali and Bekasi in West Java), fewer than three per cent of the people live below the poverty line; in others (like Manokwari in West Papua or Puncak Jaya in Papua), that ratio is above 50 %.

An accountability issue

The DAU is a huge redistribution machinery. The downside is that it did not lead to appropriate management of funds. The sub-national governments’ share of spending for internal administration has kept growing, reducing the share of spending for public services, and – to judge by international standards – it has become too high. Furthermore, the quality of budget allocation and accounting remains poor. ­According to Indonesia’s Supreme Audit Agency, only three per cent of the sub-national authorities submitted correct annual balance sheets in 2009.

Lack of technical capacities only explains part of the problem. Another crucial factor is that financial dependence on transfers reduces the quality of governance, both in terms of accountability and transparency. This phenomenon is known all over the world. Local authorities that collect their own taxes generally tend to be more accountable than those that are financed by transfers, and that is especially so when transfers are unconditional. The reason is obvious: it is easier to spend someone else’s money than to generate incomes.

In Indonesia, the share of locally generated rev­enue is below 10 % of the total domestic revenue. This figure proves that the tax and revenue system is still heavily centralised. But that is not the only bias. The districts and municipalities are handling a much bigger share of decentralised government functions than the provinces do. The share of national revenue collected by districts and municipalities, however, is below three per cent. The provinces collect around six per cent. The provinces fund roughly half of their expenses through their own revenues. At the local level, that share is only about one tenth.

At first sight, these figures are surprising since Indonesia granted the sub-national administrations considerable freedom to generate their own revenues. Law 34/2000 dealt with local taxes and service charges. It not only defined a certain amount of taxes and charges that could be raised by sub-national governments, but even allowed for the creation of new taxes and charges, provided that such impositions do not contradict higher-level laws and regulations or the public interest. Sub-national authorities were therefore expected to make use of such opportunities and reduce their dependence on the national budget. Indeed, many provinces, districts and municipalities established a wide array of new revenue sources. In the years 2000 to 2005, they passed some 6,000 by-laws on taxes and charges. However, the impact on revenues remained marginal. The rules are so complicated, moreover, that they negatively affect the business climate and cause administration costs that consume more than half of the additional revenue.

The main reason for this failure is that the national policy did not decentralise any substantial sources of revenue. It only left space for nuisance taxes or charges. Taxes on electricity, hotels and restaurants make up 75 % of all district level tax revenues. Charges for health services, building permits and the use of public assets make up two thirds of the charges-­revenue. All other sub-national taxes and charges only generate negligible revenues.

Two important changes

The Indonesian government began to reform this system in 2009. The revision of the law on sub-national taxes and charges brought about two major changes to address the problems:
– The new law (28/2009) defined the taxes and charges that sub-national governments may raise and prohibited the tapping of additional revenue sour­ces. This “closed list” provision is meant to stop the proliferation of nuisance taxes and charges as was witnessed in the past decade.
– The new law, moreover, is devolving the property and property transfer taxes to the district/municipal level. This fits an international pattern: these taxes are decentralised in many countries and generate substantial revenues.

The law was passed in 2009 and became effective in January 2010. Full implementation will take some more time because the local governments have to prepare the legal basis and establish operating procedures. Both changes present serious challenges. The first is likely to overburden the central government because, in spite of the closed list, sub-national authorities are still allowed to introduce new charges. Such measures, however, have to meet rather strict conditions and need the approval of the central government. Accor­dingly, the workload of the central government was increased considerably. It is not easy, moreover, to oversee sub-national authorities’ discontinuation of the taxes and charges that they introduced according to the old law, but are not in line with the new law.

As for the property and property transfer taxes, Indonesia’s districts and municipalities will be in charge of raising these taxes after a transition period by 2014 at the latest. Big municipalities like Jakarta or Surabaya probably have the capacity to handle all relevant issues, but for poor rural districts the challenges are huge. The transition period gives them time to de­velop the capacities needed to administer rather demanding taxes well.

Greater responsibility

So far, property taxes were administered as “shared ­revenues”. The terms mean that the national tax admi­n­istration raised and administered them, but transferred 91 % of the revenue back to where it was generated. The other nine per cent were supposed to cover the admi­nistration costs. Since the bulk of the money always went to the districts and municipalities, one might doubt that this reform will make a big difference. Such doubts would be misled, however. The big difference is that the districts and municipalities are put in charge of setting the rates and assessing property values.

The reform is thus designed to boost the responsibility of the local authorities. The people who pay the respective taxes will know who is in charge and demand to know what is done with their money. Districts and municipalities will thus no longer depend on sums transferred anonymously by a national agency. Instead, they will be accountable to the people whose money they are spending. And if they want to raise rates, they will have to spend wisely.