Fiscal Decentralization and its effect

1. Session 1 Room 10
Rima Melati Anggraeni, Moh. Khusaini2,
Ferry Prasetyia3
Faculty of Economics and Business,
Universitas Brawijaya 1,2,3
2022 FEB – UB International Conference
October 14th – 15th, 2022
Fiscal Decentralization and
Per Capita Income Convergence
between Regencies/Municipalities in
Java Island

2. INTRODUCTION
2022 FEB – UB International Conference
October 14th – 15th, 2022
Java-Centric Economy & Inequality Portrait in Java
Indonesia's economy
during 2015-2019
was still
concentrated on
Java Island ( Java
contributes >50% to
Indonesia’s GDP)
The growth of provinces in
Java Island always increases
every year and is able to
exceed the national average
per capita GRDP growth
Williamson Index between
regencies/municipalities in Java
↑ Economic Growth, but also ↑
Regional Inequility
The main challenge of development
nowadays is how to reduce
inequality and foster the
convergence of per capita
income
58.47 58.78 59.09 59.38 59.64
42.10 41.90 41.74 41.69 41.39
2015 2016 2017 2018 2019
Contribution to Indonesia’s GDP
Java Island Other Islands
Average per capita GRDP growth (%) amongst
Provinces in Java and Indonesia, 2015-2019

3. INTRODUCTION
2022 FEB – UB International Conference
October 14th – 15th, 2022
Regional inequality
issues have been
increasingly highlighted
since implementation
of fiscal
decentralization in
Indonesia in 2001
Fiscal decentralization can
encourage the acceleration
of convergence (Sugiharti,
2012), allow Governmentto
get betterinformation on
local needs and preference
(Tiebout,1956)
The decentralizationprocess in
Indonesia was implemented
without much preparation
(Brodjonegoro, 2004; Nasution,
2016).
1118.54
1584.52 1454.81 1427.83 1478.07
2015 2016 2017 2018 2019
Development of fiscal balance funds at
regencies/municipalities level in Java,2015-
2019 (billion rupiahs)
510.12
509.08
507.88
507.38
506.90
2015 2016 2017 2018 2019
Average Local Government Own Source Revenue
at Region/Municipalities in Java (billion rupiahs)
9.46
4.58 4.52 4.6 4.54
2015 2016 2017 2018 2019
Average Per Capita Income Growth amongst
Regencies/Municipalities in Java, 2015-2019
Implementation of fiscal decentralization at regencies/municipalities
level in Java has not been optimal
• Most of regencies/municipalities in Java are still dependent with
fiscal balance funds
• The downward trend of Local Government Own Source Revenue and
Per Capita Income Growth

4. LITERATURE REVIEW
Concept of convergence
• Barro & Sala-i-Martin (1992) define convergence as a process of economic growth of countries or regions,
reducing differences or disparities
• There are two types of convergence : γ-convergence and β-convergence
• γ-convergence refers to a reduction in the dispersion of levels of income across economies
• β-convergence occurs when poor economies grow faster than rich ones.
• β-convergence classified into : absolute β-convergence (hypothesis which states that the economic
growth of a region/country is only influenced by the initial per capita income level without other economic
characteristics/factors) and conditional β-convergence (hypothesis which states that the economic
growth of a region/country is not only influenced by initial per capita income but also with other economic
factors, such as investment, labor, fiscal decentralization, etc.)
2022 FEB – UB International Conference
October 14th – 15th, 2022
Neoclassical Economic Theory
• There is a negative relation between initial income levels and growth rates of income of a certain period
• Predicts that there will be a decrease in income inequality (convergence optimism), where the economy
in poor countries/regions grow faster than rich countries/regions because there are decreasing returns
from the capital factor so that poor regions are able to reduce the income gap with richer areas.
Endogenous Growth Theory
• Does not predict convergence.
• Income convergence only occurs when the spillover effect mechanism works from one region to another

5. LITERATURE REVIEW
Fiscal Federalism Theory
- First Generation Theory →There are two opinions that emphasize the allocative advantages of
decentralization :
A. Oates (1993) introduced the use of knowledge in society : with fiscal decentralization, local
governments are more efficient in producing services and providing public goods (allocative
efficiency) so that in the long term it is expected to be able to increase economic growth and
community welfare
B. Tiebout (1956) introduced the dimensions of competition within the government and
competition between regions regarding the allocation of public expenditures where the quality of
public services will be better and enable people to choose various public goods and services
according to their needs and desires.
- Second Generation Theory →focuses on the importance of revenue and expenditure
assignments between levels of government.
Public Expenditure Theory
- Musgrave and Rostow’s Theory of Public Expenditure Growth
- Wagner’s Law of Increasing State Activity
2022 FEB – UB International Conference
October 14th – 15th, 2022

6. LITERATURE REVIEW
2022 FEB – UB International Conference
October 14th – 15th, 2022
No. Topic Author
1 Determinant of per capita income
convergence
Leonida(2004), Kazakova(2018), Kurniati (2018),
Heriqbaldi(2012),Yeniwati(2014), Amalia et al.(2018)
2 Fiscal decentralization and economic
growth
Akai & Sakata (2002), Martinez & Vazques (2003), Ismail
et al.(2004), Cahyadi (2020)
3 Fiscal decentralization from revenue
side and per capita income convergence
Aritenang (2014), Blöchliger et al. (2016)
Previous Research
This research, will fill the gap in the previous research and contribute to give
comprehensive analysis about fiscal decentralization impact on income per
capita convergence

7. RESEARCH METHODOLODY
Data :
2015-2019 panel data, 113 regencies/municipaties in Java Island (exclude Jakarta)
2022 FEB – UB International Conference
October 14th – 15th, 2022
Variables Code Measurement Reference Source of Data
Dependent
Income per capita
growth
Y ln
𝑦𝑖,𝑡
𝑦𝑖,𝑡−1
Barro and Sala-i Martin
(1992), Khoinurrofik &
Negara (2020), Barkah
(2020)
Central Bureuau of
Statistic
Independent
Initial Income per capita Ln_𝑦𝑡−1 Logaritma natural of Gross Domestic
Regional per capita
Khoinurrofik & Negara
(2020), Barkah (2020)
Central Bureuau of
Statistic
Local Government Own
Source Revenue
LGOR 𝑇𝑜𝑡𝑎𝑙 𝑜𝑓𝐿𝐺𝑂𝑅
𝑇𝑜𝑡𝑎𝑙 𝑜𝑓 𝐿𝑜𝑐𝑎𝑙 𝐺𝑜𝑣 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Blochliger et al. (2016),
Barkah (2020), Saputra
(2013), Aritenang
(2014), Anggraeni
(2017), Khoinurrofik &
Negara (2020),
Directorate General
for Fiscal Balance,
Ministry of Finance
Fiscal Balance Funds BF 𝑇𝑜𝑡𝑎𝑙 𝑜𝑓𝐵𝐹
𝑇𝑜𝑡𝑎𝑙 𝑜𝑓 𝐿𝑜𝑐𝑎𝑙 𝐺𝑜𝑣 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Personnel Expenditure PE 𝑇𝑜𝑡𝑎𝑙 𝑜𝑓𝑃𝐸
𝑇𝑜𝑡𝑎𝑙 𝑜𝑓 𝐿𝑜𝑐𝑎𝑙 𝐺𝑜𝑣 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟
Capital Expenditure CE 𝑇𝑜𝑡𝑎𝑙 𝑜𝑓𝐶𝐸
𝑇𝑜𝑡𝑎𝑙 𝑜𝑓 𝐿𝑜𝑐𝑎𝑙 𝐺𝑜𝑣 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒

8. RESEARCH METHODOLODY
MODEL EQUATION :
 Absolute beta convergence :
𝑌𝑖,𝑡 =∝ +β0 ln 𝑦𝑖,𝑡−1 + 𝜀𝑖,𝑡
 Conditional beta convergence :
𝑌𝑖,𝑡 =∝ +β0 ln 𝑦𝑖,𝑡−1 + 𝛽1𝐿𝐺𝑂𝑅𝑖,𝑡 + 𝛽2𝐵𝐹𝑖,𝑡 + 𝛽3𝑃𝐸𝑖,𝑡 + 𝛽4𝐶𝐸𝑖,𝑡 +𝜀𝑖,𝑡
 Speed of convergence
 Half time converge
2022 FEB – UB International Conference
October 14th – 15th, 2022
𝑣 = −ln (1+ 𝛽0)
𝝁𝒉𝒂𝒍𝒇−𝒍𝒊𝒇𝒆 =
ln 2
𝑣
𝑌𝑖,𝑡 = ln
𝑦𝑖,𝑡
𝑦𝑖,𝑡−1
Model Selection test :
-Chow Test
-Hausman Test
𝑰𝒇 𝜷𝟎 < 0 = Economy tends to converge

9. DISCUSSION
Estimated Results of absolute β & conditional β convergence, 2015 - 2019
2022 FEB – UB International Conference
October 14th – 15th, 2022
Variable Absolute Convergence Model Conditional Convergence Model
Initial Income per capita (LnPDRB) -0,0560198***
(2,2e-16)
-0,089857***
(2,2e-16)
Local Government Own Source Revenue (LGOR) - 0,372412***
(0,0001151)
Fiscal Balance Funds (BF) - 0.092626 **
(0,0035095)
Personnel Expenditure (PE) - -0.902082 ***
(2,2e-16)
Capital Expenditure (CE) - -0,583796***
(2,2e-16)
R-squared 0,63236 0,84312
Adjusted R-squared 0,54024 0,80205
𝛽0 -0,0560198 -0,809857
Speed of convergence 0,05765 0,08436
Half-life 12,02 years 8,22 years
Time 24,04 years 16,44 years
Signif. codes: 0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1

10. DISCUSSION
By conducting the model selection test from panel data through Chow test and Hausman test, the
most appropriate model for estimate absolute beta convergence and conditional beta convergence is
fixed effect model (FEM).
Absolute beta convergence occurs at 113 regencies/municipalities in Java Island with time to
eliminate all inequalities for 24.04 years, convergence rate at 5.76% per year with half time needed
for region with lowest income per capita to be equal with the region with highest income per capita
approximately 12.02 years.
Conditional beta convergence occurs amongst regencies/municipalities in Java Island with time to
eliminate all inequality over 16,44 years, convergence rate at 8,44% per year with half time needed
for region with lowest income per capita to be equal with the region with highest income per capita
approximately 8.22 years.
Fiscal decentralization indicators that have (-) significant effect to per capita income growth is
personnel expenditure and capital expenditure while Local Government Own Source Revenue
(LGOR) and Fiscal Balance Funds (BF) have (+) significant effect to per capita income growth
2022 FEB – UB International Conference
October 14th – 15th, 2022

11. DISCUSSION
LGOR has positive significant effect on per capita income growth because the high local government
own source revenue also shows the high ability of local governments to finance development activities
in the region>> ↑ Funding Capacity, ↑Economic Activity
Fiscal balance funds has positive significant effect on per capita income growth because fiscal
balance funds can increase the distribution of financial capacity among regions to finance the
needs of regions in the context of implementing decentralization
Personnel Expenditure has negative significant effect on per capita income growth because personnel
expenditures can be categorized as non-productive expenditures that cannot have a direct
influence on increasing economic activity in a regency/municipality
Capital Expenditures has negative significant effect on per capita income growth because in the
early stages of economic development, capital expenditure/infrastructure is still an economic
burden that has not been able to stimulate economic growth
2022 FEB – UB International Conference
October 14th – 15th, 2022

12. CONCLUSION
 Both Absolute Beta Convergence and Conditional beta convergence occurs amongst
113 regencies/municipalities in Java Island during 2015 to 2019 period
 Local Government Own Source Revenue (LGOR) and Fiscal Balance Funds have
positive significant effect to Per Capita Income Growth, while Personnel Expenditure
and Capital Expenditure have negative significant effect to Per Capita Income
Growth.
 All fiscal decentralization indicators such as : Local Government Own Source
Revenue (LGOR) , Fiscal Balance Funds Personnel Expenditure, Capital
Expenditure simultaneously can foster the income per capita convergence
2022 FEB – UB International Conference
October 14th – 15th, 2022

13. CONCLUSION
2022 FEB – UB International Conference
October 14th – 15th, 2022
Some feasible steps that can be taken include:
1. Central government should pay attention to improve regional fiscal capacity,
especially strengthening sources of regional income originating from local taxes
and retribution (increase local taxing power)>> the more fiscal space for the region
for development, the more accelerating the convergence rate of inter-regional economy.
2. Central government should increase the transfer of funds that stimulate local
government to continue , to compete and innovate.
3. Process of accelerating income per capita convergence between regions requires
intervention from the central government, such as : increase the amount of funds
for financing the development of regions that have low fiscal capacity and only
relies on transfer funds.
4. Local Government must improve the quality of spending according to the value
for money principle.

14. Thank you
2022 FEB – UB International Conference
October 14th – 15th, 2022