RESULTADOS ÍNDICE

2.7.1.1. Transfer from the central government

One of the primary goals of fiscal decentralization is to increase self-reliance in local government funding. The local government is forced to be more productive, particularly in collecting income from local resources. Based on that goal, the local original revenue should be the primary funding of local government. Unfortunately, local governments do not often experience improvement in their own resources. Instead, they tend to rely on steady transfers from the central government (Bird and Smart 2001, Brodjonegoro 2001, Widarjono 2006, Brodjonegoro and Ford 2007, Martinez-Vazquez and Searle 2007)

One of the common problems arises regarding the implementation of fiscal decentralization is the fiscal disparities among the local governments; some local governments have strong fiscal capacity to finance their fiscal needs, conversely others still struggle to find the alternative funding resources. Therefore, to address fiscal disparities within regions, the central government provides financial grants, known as intergovernmental transfers. This funding is intended to address fiscal disparities and to force local governments to be more productive so that they can increase their fiscal capacity (Bird & Smart 2001; Brodjonegoro 2001; Martinez- Vazquez & Searle 2007).

Fiscal decentralization is believed to be a way of reducing corruption, since it will strengthen the public control mechanism relating to government. Fisman and Gatti (2002) confirmed the relationship between decentralization and corruption; a high level of decentralization reduced the possibility of corrupt behaviour. In their study, Fisman and Gatti (2002) used the share of central government transfers to measure the degree of decentralization: a government with a

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high proportion of central government transfer in their funding indicates having a low degree of fiscal decentralization. Following the evidence demonstrated by Fisman and Gatti (2002), such a local government has a high possibility of the existence of opportunistic behaviour.

As stated above, the objectives of intergovernmental transfers are to overcome fiscal disparities, both vertical (between the central government and local governments) and horizontal (between local governments) (Martinez-Vazquez and Searle 2007, Bird and Smart 2001, Brodjonegoro and Ford 2007). Transfers from the central government ideally should stimulate the local government to allocate resources to productive sectors and also bring opportunities to increase their local public services and create service improvements (Kuncoro 2009). The local governments also have the opportunity to allocate resources to infrastructure that supports productive activities, thus increasing public welfare. These allocation strategies would bring positive public feedback even if they are associated with a rise in local taxes. In turn, the local governments will be able to increase their local fiscal capacities: to decrease their dependencies on the central government and be able to fund their own fiscal needs.

There are two types of intergovernmental transfers: conditional and unconditional (Brodjonegoro 2001). The conditional transfer is provided by the central government to local government for specific purposes. In this transfer, the central government has determined the use of the funds; the recipient government has no right to allocate the transfer for any other expenditure. With an unconditional transfer, the local government, as the beneficiary, has the authority to use the funds based on their own allocation policies. This transfer is considered a grant allocated to close the gap in fiscal disparities between local governments (Brodjonegoro 2001). It is hopeful that the recipient local government will spend the transfer on areas that stimulate productive activities (Martinez-Vazquez and Searle 2007, Kuncoro 2009, Bird and Smart 2001).

However, some scholars have provided empirical evidence that intergovernmental transfers do not stimulate local governments to increase local revenue. A study by Gemmell et al. (1998) indicated that the central government does not provide a significant impact on increasing revenue. The local government tends to find loopholes for how to retain funds from the central government. This could explain why governments do not perform well: first, they allocate the budget but not to a productive sector; second they attempt to increase the budget expenditure in order to obtain a larger transfer from the central government.

Tsui (2005) examined the impact of intergovernmental transfers on fiscal disparities finding no empirical evidence that such transfers would overcome the gaps in local government fiscal capacities. Instead, he argued that transfers had the opposite effect on fiscal disparities, which

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means that the more intergovernmental transfers received; the more fiscal disparities occurred. In conclusion, he argued that intergovernmental transfers, overall, did not have an impact on fiscal equalization.

Gemmell et al. (1998) provided empirical evidence that an increase in intergovernmental transfers did not impact on local original revenue. Local governments attempted to raise their expenditure in order to obtain a larger amount of transfers, however, this did not positively increase the local original income. There are two possible causes for this: first, the budget expenditure was allocated to unproductive sectors; and second, even though allocated to productive sectors, the spending was ineffective and lead to dissipation.

A study of fiscal decentralization in Indonesia conducted by Hirawan (2006) sought to investigate the effectiveness of the central government transfer on stimulating local governments to increase their local revenue. Hirawan (2006) confirmed that during the first five years of decentralization, there was no significant improvement in the local original revenue contributions. The transfer from the central government tended to increase from year to year and still dominated the government budget, where its contribution reached 74.5% of the total local revenue. The indication was that local governments did not significantly increase their local original revenues, as this would have reduced funding from the central government.

Nanga (2005) attempted to investigate the behaviour of local governments in using the grant transfer from central government in local finance. Based on the investigation, local governments tended to increase their spending expenditure, however the local governments did not increase the revenue from local resources. The transfers failed to encourage local governments to be more productive. Nanga (2005) argued that a transfer from central government tends to de-motivate the regional government in terms of self-sufficiency, because the large amount of funding brings the opportunity to spend more, however it was not supported by effort to increase their local tax.

The above studies seem to investigate the impact of transfers using only an input-output

approach, but they do not focus on the possible ineffective allocation or dissipation in the budget, which could cause poor local government performance. Local governments have the opportunity to utilize the transfers for their own interests, both political and individual. This may occur because they have the budget authority, but limited resources to satisfy their constituents' expectations. As a result, the transfers may dissipate since they are allocated to projects or infrastructure that provides more lucrative opportunities for budget actors to seek rent (Mauro and Driscoll 1997, Mauro 1998, Tanzi and Davoodi 2006).

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Related to the ineffectiveness of transfers from central government to improve local self- reliance, Brodjonegoro and Ford (2007) stated that fiscal equalization policies very often only play an important role in overcoming financial problems on the expense side, not on the revenue side. It is very difficult to achieve the objective of decentralization to increase local self-reliance when the nature of the intergovernmental transfer does not stimulate the local government to become more independent. Further examination is required to determine whether the expenditure funded from the transfer promotes better performance in local government, or conversely, stimulates more waste that is harmful to performance. The study of the impact of intergovernmental transfer ideally should relate to rent-seeking behaviour, because with the large amount received, it may trigger the budget actors to abuse their power in allocating revenue for specific interests (Mauro 2004).

In the studies of the effect intergovernmental transfers, local original revenue and natural resources show how these funding resources play a significant role in the existence of rent- seeking behaviour in local governments (Abdullah and Asmara 2007, Gylfason 2001, Leite and Weidmann 2002, Larson 2002). The budget actors who engage in rent-seeking seem to attempt to benefit themselves with resources that are received in a large amount. Local governments seemingly do make an effort to sustain their resources. This phenomenon indicates the possibility of different patterns of rent-seeking behaviour based on the revenue side. It is very important to distinguish between local governments that really depend on transfers from the central government and local governments that rely on their original revenue resources.

This related to the ineffectiveness of revenue resources in improving local performance study reflected the possibility of the existence of negative behaviour in the agency relationship, as stated by Jensen and Meckling (1976), that since the agent may have more information than the principal does, the agent may not deliver the information sufficiently for decision making. The local government, as the agent, tends to propose larger amounts of transfers by increasing their expenditure budget. The central government, as it has less information about the needs and the capacity of the local government, will hardly reject the budget proposal if they do not have supported rational reasons (Brodjonegoro and Ford 2007, Mahi and Brodjonegoro 2003, Tommasi and Weinschelbaum 2007).

2.7.1.2. Local original revenue and natural resources revenue

One of the objectives of fiscal decentralization is that local government can optimize the funding using local original resources. In the long-term, hopefully they will have the revenue

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as the main resources to fund local expenditure. Transfers from central government will ideally decline in line with the greater ability of local government to collect their original revenue.

Regarding the horizontal fiscal disparities, it is common for a local government with substantial local resources, such as local taxes and natural resource income, to have lower fund transfers from the central government than other local governments with inadequate local resources (Martinez-Vazquez and Searle 2007, Bird and Smart 2001). Logically, changes in revenue will have an impact on budget expenditure. The interesting issue arises as to whether the government has a similar pattern of spending from any resources, both the revenue received from the central government and collected from original resources. The difference in the spending pattern is known as the flypaper effect4 _{(Hines and Thaler 1995, Widarjono 2006,}

Kuncoro 2007, Kang and Setyawan 2012, Mukhtaruddin et al. 2013). The information obtained from such studies is how the budget sector dominantly impacts on the decision of local spending.

Kang and Setyawan (2012) examined the flypaper effect in local government budgeting in Indonesia. The background of the study is the phenomenon of the high dependency of the local government on transfers from central government. Kang and Setyawan (2012) use both cross-section and time-series data analysis, covering 188 local governments from 2006 to 2008) for a cross section analysis, and 484 local governments from 2001 to 2008 for a cross- sectional analysis. The study provided empirical evidence that both transfers from central government and local original revenue had a positive impact on local government spending. However, the other finding showed that there was no evidence that central government transfers had a more powerful influence than local original revenue in budget expenditure. There was no evidence of flypaper effect on local budgeting in Indonesia.

Another study conducted by Abdullah and Asmara (2007) intended to investigate the effect of local own revenue on the opportunistic behaviour of the legislature in local budgeting. The researchers used the total change of budget on the education sector, health sector and

4 _{Flypaper effect is a phenomenon of local government to utilize the intergovernmental transfer more on local} spending rather than using local original revenue Kang, Y. & Setyawan, D. 2012. 'Intergovernmental Transfer And The Flypaper Effect–Evidence From Municipalities/Regencies In Indonesia.' KDI School of Pub Policy & Management Paper:12-06, Kuncoro, H. 2007. 'Fenomena Flypaper Effect pada kinerja keuangan pemerintah daerah kota dan Kabupaten di Indonesia (Flypaper Effect Phenomenon on Local Government Financial Performance in Indonesia).' Simposium Nasional Akuntansi X, 1-29, Mukhtaruddin, M., Anastasia, P. & Hasni, Y. 2013. 'Regional Revenue And Infrastructure Expenditure: Is There A Flypaper Practices?' Paper presented at Proceedings of Asian Pacific Conference on International Accounting Issues, Widarjono, A. 2006. 'Does Intergovernmental Transfers Cause Flypaper effect on Local Spending?' Economic Journal of Emerging Markets, 11:2.

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infrastructure as the indicator of opportunistic behaviour in which the education and health were measured negatively while the infrastructure was a positive change. This measurement relied on the prior studies that indicated the intention of shifting the proportion of the budget from education and health sectors to other sectors that provided more opportunity for rent- seeking. The results of the study confirmed that local original revenue had a significant influence on opportunistic behaviour.

The higher magnitude of local original revenue in budget spending provides another insight to the budget authorities’ preference in opportunistic behaviour in local government. One of the reasons for the evidence is that there is a possibility of a reduction in transfers from central government with the better capability of local government in collecting revenue from own resources. The other possibility of the higher significance of local original revenue is the superior power of the legislature in spreading the budget from the resources.

Some local governments (in Indonesia) are rich with natural resources, hence there is a similar possibility of rent-seeking because of these resources. The availability of large income from natural resources has become the primary financing source to promote economic growth, however it also related to slow economic growth. Gylfason (2001) presents a number of reasons why the natural resources become counterproductive to growth, including: first, the availability of the resources is susceptible to rent-seeking motives for example giving certain privileges to investors (in order to obtain bribe) and also altering the allocations to certain sectors; second is the government may be over confident with its richness, tending to abandon improvements to human development, such as providing good-quality education and health services.

Kolstad and Søreide (2009) asserted that one of the main causes of bad economic performance of resource-rich countries is a high level of corruption. A list of countries with their gross of domestic product (GDP) relied on natural resources demonstrated a low level of corruption control, such as Algeria, Gabon, Yamen, Kazakhstan, Azerbaijan etc. Similar to Gylfason (2001), Kolstad and Søreide (2009) contended the modus of corruption in such rich countries as being rent-seeking and patronage. Natural resources become an effective resource, both for politicians and government officers, to increase their prosperity or to manage the sustainability of their authority. One of the examples is using the public-fund more on sector(s) that offer social-benefit, rather than on ones that support economic performance. The consequence is a higher possibility of inefficient allocation which in turn can harm economic growth.

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