Incentives in Balancing Funds

To put it together, the net effect of balancing funds in general is reductive to fiscal disparity among local governments, as shown by CV analysis. From the equality viewpoint, this means that balancing funds as a system equalizes local governments’ fiscal capacity. Since fiscal capacity is associated with local governments’ potential to generate revenue in order to provide standardized public services (Martinez-Vazquez and Boex 1997), more equal fiscal capacity will also equalize local governments’ potential to provide public services. The outcome of this condition is more comparable public services that can be accessed by citizens anywhere across the country.

Based on the CV results, some points to note in how balancing funds work as a system are (1) DAU and DBH work in opposite directions in reducing inequality, (2) salary expenditure reduce the equalizing effect of DAU, and (3) DAK shifts from specific to equalization grants.

The last point signifies that intergovernmental grants have lost the functions of specific grants which provide funding for capital investment to the majority of subnational governments.

from property taxes. The allocation formula provides 3.5% of revenue from property taxes to be distributed to local governments whose contribution realization for property taxes exceeded the budgeted amount. Although the collection of such taxes is administered by central governments, local governments assist the process by providing accurate data and encouraging local citizens to comply with property tax obligation. However, since the property taxes and land rent have become local taxes, the incentives issue is no longer relevant in the context of intergovernmental grants, as the revenues will be parts of own-source revenues (OSR).

In DAU allocation formula, for example, official salary is accounted as a variable in determining DAU allocation. This can stimulate subnational governments to employ more people. Therefore, an incentive for efficiency is embedded in DAU formula to discourage ambitious recruitment of new employees and/or launching more generous fringe benefit plans.

As basic allocation in the DAU formula only covers a part of salary expenditure (in 2011, 83.1% of salary expenditure in provinces and 68.56% in cities/regencies, according to Ministry of Finance (2011)), the part that is not covered by DAU must be provided from other sources, thus adding a financial burden to subnational budgets. This can be an incentive for subnational governments to stop employing more people. This incentive, however, is not always effective.

For subnational governments who perceive hiring people as an alternative to providing employment, partially covered salary expenditure may still be seen as an incentive to recruit.¹³

Some incentives feature can be observed in the DAK allocation formula. Examples from drinking water and sanitation service will be used for illustration.

a. DAK for drinking water

The allocation of DAK for drinking water is formula-based. One of the components in the allocation formula is the drinking water technical index. The higher the index, the higher DAK allocation a subnational government will receive. How the index is calculated

13To control the growth of subnational government officials, the recruiting and dismissing of subnational government officials are regulated by the central government.

is determined by the Ministry of Public Works, and the index figures may change every year. In 2012, the technical index (TI) for drinking water is determined as follows (Ministry of Public Works 2011):

Where:

Water scarcity index (WS)

= Number of villages with water scarcity in a city/regency Number of villages with water scarcity in Indonesia Low-income

population index (LP) = Number of low-income population in a city/regency Number of low-income population in Indonesia Water coverage index

(WC) = % population without access to piped water in a city/regency

% population without access to piped water in Indonesia Idle capacity index

(IC) = Idle capacity of water in a city/region Idle capacity of water in Indonesia Awareness index

(AW) = % budget allocated for water sector, not including DAK, by a city/regency

% budget allocated for water sector, not including DAK, by all local govts Reporting index (RP) = Score of DAK for drinking water implementation in the previous year

Total national score of DAK for drinking water implementation in the previous year

It can be observed from the formula that the allocation of DAK for drinking water favors subnational governments who allocate more budget for drinking water, as shown by the awareness index (AW). This is a positive incentive to encourage subnational governments to increase spending in drinking water sector, as this can improve accountability of subnational governments in providing water service through providing additional resources.

The incentive is particularly important in the presence of the fungibility effect. It’s been a concern in previous research and literature that conditional grants, like DAK, are prone to fungibility (Slack 2007), a situation where grants recipients shift their funding to unassisted sector, as a result of receiving grants. This is contrary to the spirit of allocating conditional grants; the intention of providing the grants is to support recipients’ financial condition so thatmorefunds are allocated to the targeted sector. In other words, conditional

TI = 5% WS + 40% LP + 5% WC + 40% IC + 5% AW + 5% RP

grants are supposed to complement, rather than to substitute, the recipient’s own financial resources. Responding to this, the allocation formula of DAK for drinking water includes the awareness index. The index accounts for the allocation of the subnational budget for drinking wateroutsideDAK.

An incentive for performance that can also be observed in the formula is the reporting index. The Ministry of Public Works gives a score to the result of DAK implementation. The higher the score, the more favorable the reporting index becomes, which will lead to higher DAK allocation. This can encourage subnational governments’

compliance to reporting requirements.

b. Sanitation

Another example is sanitation sector. Technical index (TI) for sanitation sector in 2012 is determined as follows:

Where :

Low-income population

index (LP) = Number of low-income population in a city/regency Number of low-income population in Indonesia Sanitation coverage

index (SC) = % population with access to sanitation in a city/region

% population with access to sanitation in Indonesia

Awareness index (AW) = % budget allocated for water sector, not including DAK, by a city/regency

% budget allocated for water sector, not including DAK, by all local govts Reporting index (RP) = Score of DAK for drinking water implementation in the previous year

Total national score of DAK for drinking water implementation in the previous year

Regional Sanitation

Strategy Index (RS) = % subnational government’s ownership of regional sanitation strategy documents

For the sanitation sector, the same incentives case as the drinking water sector applies to the reporting index and awareness index. Another incentive that can be observed in the sanitation formula is in the sanitation coverage index. The sanitation coverage index favors the percentage of population with access, implying that the more people to get

TI = 25% LP + 30% SC + 15% AW + 15% RP + 15% RS

access to sanitation, the higher the allocation of DAK for sanitation. This appears like a contradictive concept, but in this case performance is incentivized. Reward is given to improved performance. Subnational governments, where large parts of the population have access to sanitation, are appreciated for making efforts to improve sanitation condition. The technical index for sanitation gives 30% weight for the sanitation coverage index, the highest of other variables in the formula.

All in all, it can be said that incentive features, albeit implicitly, have been incorporated in the DAU and DAK allocation formulas. The incentives, however, do not clearly link to improved performance and accountability. The subnational governments’ awareness of the incentives feature is not yet empirically measured, but since the information on formulas are publicly available, the correlation between incentives (e.g. higher DAK allocation) and performance (e.g. higher sanitation coverage, higher counterpart funding allocation from subnational budgets) should have been observed.