Fiscal disparities in Indonesia in the decentralization era: Does general allocation fund equalize fiscal revenues?

Abstract

AbstractThis study analyses the level and trend of fiscal disparity among Indonesian districts. It also explores the determinants of fiscal disparity using two inequality decomposition methods: decomposition of the Gini coefficient and the coefficient of variation by revenue sources and decomposition of the Theil index by regions. Disparity in shared revenue has been large due to the very uneven spatial distributions of natural resources and tax bases. It is unambiguously an inequality‐increasing fiscal transfer in Indonesia. A general allocation grant has served to equalize fiscal revenue, but overall fiscal disparity is still high. To reduce the disparity, it may be necessary to modify the general allocation formula since it appears to be defective. This study proposes a new allocation formula. Though the reduction in fiscal disparity is not substantial in the short run, the new formula would provide an incentive for resource‐poorer district governments to raise their own source revenue. This could create a virtuous cycle if the additional own source revenue is used for local development, particularly education and infrastructure. Another option to reduce fiscal disparity would be the further expansion of special allocation grant. If the government allocates the special allocation fund effectively across districts in Indonesia, it could make a special allocation grant an inequality‐decreasing fiscal transfer.