Report and Recommendation of the President to the Board of Directors

Transcription

1 Report and Recommendation of the President to the Board of Directors Sri Lanka Project Number: October 2008 Proposed Program Cluster and Loan for Subprogram I Republic of Indonesia: Second Local Government Finance and Governance Reform Program

2 CURRENCY EQUIVALENTS (as of 6 October 2008) Currency Unit rupiah (Rp) Rp1.00 = $ $1.00 = Rp9,590 ABBREVIATIONS ADB Asian Development Bank BAPPENAS Badan Perencanaan Pembangunan Nasional (National Development Planning Agency) BPK Badan Pemeriksa Keuangan (Supreme Audit Authority) BPS Badan Pusat Statistik (Central Bureau of Statistics) CSP country strategy and program DAK Dana Alokasi Khusus (specific allocation fund) DAU Dana Alokasi Umum (general allocation fund) DBH Dana Bagi Hasil (revenue sharing) DPOD Dewan Pertimbangan Otonomi Daerah (Regional Autonomy Advisory Council) DPR Dewan Perwakilan Rakyat (house of representatives) DPRD Dewan Perwakilan Rakyat Daerah (regional house of representatives) DPSP Development Policy Support Program DSF Decentralization Support Facility EA executing agency FMIS financial management information system GDP gross domestic product LGFGR local government finance and governance reform MDG Millennium Development Goal MOF Ministry of Finance MOHA Ministry of Home Affairs MSS minimum service standard MTEF medium-term expenditure framework NAPFD National Action Plan for Fiscal Decentralization PAD Pendapatan Asli Daerah (local own-source revenues) PDAM Perusahaan Daerah Air Minum (state-owned water supply company) PFM public financial management RGPMS regional government performance measurement system RPJM Rencana Pembangunan Jangka Menengah (national medium-term development plan) SCBD Sustainable Capacity Building for Decentralization (project) SIKD Sistem Informasi Keuangan Daerah (regional financial information system) TA technical assistance (i) (ii) NOTES The fiscal year of the Government coincides with the calendar year. In this report, $ refers to US dollars.

3 Vice President C. Lawrence Greenwood, Jr., Operations 2 Director General A. Thapan, Southeast Asia Department (SERD) Director J. Ahmed, Governance, Finance and Trade Division, SERD Team leader Team members T. Niazi, Public Sector Management Specialist, SERD C. Buentjen, Senior Governance and Capacity Development Specialist, SERD E. Ginting, Economist, SERD S. Kawazu, Counsel, Office of the General Counsel

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5 CONTENTS Page LOAN AND PROGRAM SUMMARY i I. THE PROPOSAL 1 II. THE MACROECONOMIC CONTEXT 1 III. THE SECTOR 4 A. Review of the Sector and Performance 4 B. Issues and Opportunities 11 C. Lessons 16 IV. PROPOSED PROGRAM CLUSTER 18 A. Links to LGFGR 1 and Other ADB Assistance 18 B. Outcome and Impact 20 C. Policy Framework and Actions 20 D. Important Features 26 E. Financing Plan 26 F. Implementation Arrangements 27 V. TECHNICAL ASSISTANCE 30 VI. PROGRAM BENEFITS, IMPACT, AND RISKS 31 A. Expected Impact 31 B. Risks and Mitigating Measures 32 VII. ASSURANCES 33 VIII. RECOMMENDATION 33 APPENDIXES 1. Design and Monitoring Framework Development Policy Letter Policy Matrix Development Partners Coordination Matrix Sector Analysis: Decentralization, Service Delivery, Governance Summary Poverty Reduction and Social Strategy List of Ineligible Items Advisory Technical Assistance 74 SUPPLEMENTARY APPENDIXES (available on request) A. Detailed Sector Analysis: Fiscal Decentralization in Indonesia B. Terms of Reference for the Advisory Technical Assistance C. Proposed TA Activities under LGFGR2 Program Cluster

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7 LOAN AND PROGRAM SUMMARY Borrower The Proposal Classification Environment Assessment Program Rationale Republic of Indonesia A program cluster for the Second Local Government Finance and Governance Reform Program (LGFGR 2) and its two subprograms is proposed. It involves (i) a loan of $350 million equivalent for subprogram 1, and (ii) a technical assistance (TA) grant of $1.5 million. Targeting classification: General intervention Sector: Law, economic management, and public policy Subsector: Public finance and expenditure management Themes: Governance, inclusive social development, capacity development Subthemes: Public governance, human development, organizational development Category C Since 1999, the Government of Indonesia has introduced major decentralization reforms that have devolved significant functional responsibilities and funding from the central Government to the regional (provincial, district, and city) governments. The reforms pursued, which in extent and speed have had few precedents elsewhere in the world, have been referred to as the big bang approach to decentralization. After the early frantic years of rapid policy and regulatory design and implementation, a more settled policy and legal framework has gradually emerged. More recent efforts have increasingly gone into fine-tuning the basic policy approaches, adding more depth to the framework of laws (with lower-level regulations and instruments), and addressing the vital issue of strengthening the Government s human and systems capacity. The new policy and legal approaches urgently need to be managed to achieve the improvements that citizens expect, such as better social and physical services, and opportunities to benefit from a much more robust economy. While decentralization has administrative, political, and other dimensions, LGFGR 2 focuses mainly on the fiscal dimension, where implementation is critical and also most challenging. LGFGR 2 will support the Government s ongoing efforts to improve regional autonomy and financing (by strengthening the intergovernmental financing policy framework, regional organizational systems, and regional revenue systems), governance and service delivery (by providing adequate financing and performance measurement), and capacity development (by improving public financial management and human capacity).

8 ii LGFGR 2 will broaden reforms in six target areas: (i) strengthening the management and coordination of fiscal decentralization; (ii) clarifying regional administration to improve services and accountability; (iii) making the release of fiscal transfers and shared revenues more equal, predictable, and transparent; (iv) reducing regional dependency on fiscal transfers by developing more buoyant revenue sources; (v) bolstering the management of regional reserves and debts; and (vi) developing human and systems capacity and strengthening public financial management and accountability. The Asian Development Bank (ADB) supports Indonesia according to the country strategy and program of (i) pro-poor, sustainable economic growth; and (ii) social development. Governance improvements and anticorruption efforts are key themes. Decentralization and local government finance and governance are key issues in this regard, and are among the five key operational areas of engagement: (i) infrastructure, (ii) financial sector deepening, (iii) decentralization, (iv) achievement of Millennium Development Goals (MDGs), and (v) environment and natural resource management. The proposed program cluster will improve decentralization and accelerate MDG achievement by strengthening regional government capacity and contributing to a more transparent, effective, and efficient policy and legal environment for fiscal decentralization, financial management, and service delivery. A joint team from the Government and ADB has been working on the reform program since early Impact and Outcome The proposed LGFGR 2 program cluster will support the Government in its efforts to make regional government spending and service delivery more efficient, effective, and equitable. It will strengthen the organizational capacity of the regional governments and provide a more transparent, effective, and efficient policy and legal environment for fiscal decentralization, financial management, and service delivery. Financing Plan Period and Tranching A loan of $350 million equivalent from the ordinary capital resources of ADB will be provided for subprogram 1 of LGFGR 2 under the London interbank offered rate (LIBOR) based lending facility. The loan will have a term of 15 years, including a grace period of 3 years, an interest rate to be determined according to the LIBOR-based lending facility, a yearly commitment charge of 0.15%, and other terms and conditions set forth in the draft program loan agreement. ADB s Board of Directors has waived the front-end fee of 1.00% for loans approved from 1 July 2007 through 30 June The program cluster period is from January 2006 to December 2011, with a single-tranche loan of $350 million equivalent to be

9 iii disbursed under subprogram 1 in 2008 when the Government shall have met the conditions for effectiveness. Subprogram 2 will be submitted for Board consideration about 36 months after the effectiveness of subprogram 1, subject to the adequate progress of reforms and the Government s readiness to continue with its reform agenda. Counterpart Funds Executing Agency Implementation Arrangements Procurement and Disbursement Program Benefits and Beneficiaries The Government will use the counterpart funds from the loan proceeds to meet program expenditures and the associated costs of local reforms. Directorate General of Fiscal Balance of the Ministry of Finance (MOF) The implementing agencies will be directorates of (i) MOF, (ii) the Ministry of Home Affairs (MOHA), and (iii) the National Development Planning Agency (BAPPENAS). An LGFGR steering committee (with an implementation committee and a secretariat under it) has been formed to coordinate the implementation of the LGFGR program reform actions. The steering committee is chaired by the director general of fiscal balance of MOF and has MOHA and BAPPENAS officials as members. Selected representatives from regional governments will attend meetings of the steering and implementation committees. The steering committee meets at least semi annually to monitor progress and oversee the implementation of the program, and to guide and direct the executing and implementing agencies. The loan of $350 million for LGFGR 2 subprogram 1 will be released in a single tranche when it takes effect. The loan proceeds will finance the full foreign exchange costs (excluding local duties and taxes) of items produced and procured in ADB member countries. Ineligible items and imports financed from other bilateral and multilateral sources will not be covered by the loan. The loan proceeds will be disbursed to the Borrower according to ADB s Simplification of Disbursement Procedures and Related Requirements for Program Loans. Subprogram 1 will provide for retroactive financing for expenditures incurred by the Government 180 days before the loan takes effect. LGFGR 2 will have significant benefits and positive effects on regional service delivery, financing, and capacity development. The key expected benefits are as follows: (i) (ii) Strengthened management and coordination of fiscal decentralization by the central Government, and improved leadership, supervision, and coordination of the capacity development of regional governments. Clearer assignment of expenditures between levels of government and improved criteria for establishing new

10 iv regional governments, leading to more efficient allocation of expenditures and better vertical balance in financing between levels of government. (iii) Improved technical and policy environment for intergovernmental fiscal transfers, revenue sharing, and local own-source revenues, leading to more transparent and equitable outcomes across regions (better horizontal balance), and less dependence on central government transfers. (iv) Strengthened management of regional reserves and debts, contributing to better access to long-term (v) investment financing for infrastructure. Enhanced organizational, systems, and human resource capacity of regional governments, particularly to manage and report finances and to measure performance, thus improving public service delivery and accountability. (vi) Strengthened governance through coordinated performance monitoring and evaluation to improve accountability. Risks and Assumptions While some risks are external and political, the program design and TA will mitigate these and other risks by providing a strong broad-based governance framework with transparency and accountability elements in both the central and regional governments. The potential risks to LGFGR 2 and the underlying assumptions are as follows: (i) (ii) Regional government leadership and capacity. The regional governments might not have the necessary leadership, commitment, and capacity to innovate and learn and to translate financial resource and management systems improvements into better services and reduced poverty. This risk will be mitigated by improvements in (a) bottom-up accountability, with better public financial management and greater transparency in reporting; (b) vertical organizational structures and hierarchical responsibilities; (c) accountability of regional governments to oversight and coordination agencies; (d) accountability through the electoral process; and (e) the regional civil service. Political change. National and regional government elections are due from The new national or regional governments may not endorse the policy framework in the National Action Plan for Fiscal Decentralization (NAPFD) and LGFGR 2. But the political and bureaucratic momentum of reforms has been significant and growing with the rise of reform champions, and is unlikely to be completely reversed by a new administration. Some allowance must, however, be made for new policy approaches at the margins.

11 v (iii) National coordination. Problems in coordination between key national agencies could still delay program implementation despite the improvements made so far. This risk has been mitigated by the emergence of the new Directorate General of Fiscal Balance as the leader in fiscal aspects of decentralization and the longer-term capacity-building efforts of the directorate general and the president s Regional Autonomy Advisory Council (DPOD). Moreover, all key stakeholders will take part in revising the NAPFD in 2009, enhancing national approaches. (iv) Flexibility of regional organizational structures. Organizations and their staff may resist more flexible organizational arrangements and staffing. This resistance is likely to be offset by orderly and socially acceptable rightsizing, combined with growing community support for spending less resources on unproductive administration and more on productive activities. (v) Horizontal equity between regions. Political and other pressures could delay the more equitable distribution of transfers and shared revenues, and benefit relatively better-off, natural resource endowed regions. But equalization has gained important momentum with the removal of the hold harmless provisions of the general equalization grant in 2008, and improved analysis and transparency in intergovernmental financial flows will increase accountability and create a larger constituency in favor of further equalization. Technical Assistance For subprogram 2, the Government has asked ADB for a $1.5 million policy and advisory technical assistance (TA) to be attached to this program. The TA will support the ongoing development of the reform agenda in regional government financing and governance (contained in the NAPFD and the policy matrix for subprogram 2) and its implementation, and provide timely policy advice to the Government as needed. Medium-term support for the reform agenda is expected to come from another TA. The attached TA will center on the Directorate General of Fiscal Balance and will include the following components: (i) extending the NAPFD to , (ii) building a database and financial modeling capacity in the directorate general to support the ongoing review of intergovernmental transfers, (iii) designing and implementing a system of forward estimates for intergovernmental transfers and shared revenues, (iv) developing and disseminating new regulations and guidelines for the specific allocation fund (DAK), (v) developing and implementing a targeted package of incentives and sanctions for selected intergovernmental transfers, (vi) supporting the early stages of devolution of the property tax, and (vii) human and systems capacity building in decentralized locations. About 24

12 vi person-months of international and 80 person-months of national consulting services will be required for the TA. All the consultants will be recruited and hired according to ADB s Guidelines on the Use of Consultants (2007, as amended from time to time). The second TA of $1 million for subprogram 2 policy actions is expected to be processed separately in Subject to more detailed consultations with the Government, the TA will (i) explore further policy options for the future status of DPOD; (ii) study more efficient uses of regional government labor resources by determining the wage bill formula and giving regional governments discretion in the use of general allocation fund; (iii) further support the amendment of sector laws and regulations to make them consistent with the new expenditure assignments and other decentralization laws; (iv) support a creditworthy regional government in planning regional bond issues through training, due diligence studies, and document preparation; (v) pilot-test and roll out the regional government performance measurement system and train regional government staff to use the system; (vi) support the restructuring of regional government budgets through the closure or privatization of low-priority and nonperforming activities and assets, including regional enterprises, and other means; and (vii) inventory the financial management information systems in 171 regional governments and review options for their further expansion.

13 I. THE PROPOSAL 1. I submit for your approval the following report and recommendation on: (i) a proposed program cluster for the Government of Indonesia s Second Local Government Finance and Governance Reform Program (LGFGR 2), and (ii) a proposed loan for subprogram 1 of LGFGR 2. Subprogram 1 was prepared by a joint team from the Government and the Asian Development Bank (ADB). This report also describes proposed technical assistance (TA) for the capacity development of fiscal decentralization agencies. If the Board approves the proposed loan, I, acting under the authority delegated to me by the Board, will approve the TA (para 87). The program design and monitoring framework is in Appendix 1. II. THE MACROECONOMIC CONTEXT 2. Indonesia s economic performance strengthened further in 2007, when economic growth accelerated to a 10-year high of 6.3% despite a slowing global economy. Unlike previously, economic growth appeared to be more employment-friendly: unemployment declined from 10.3% in 2006 to 9.1% in The growth was propelled by a strong pickup in investment due to the progress of reforms and improvement in business perception. High growth was also supported by stronger export performance, attributed to high prices of commodities, particularly coal and palm oil. The government budget deficit at the end of 2007 was 1.3% of gross domestic product (GDP), and the debt-to-gdp ratio, in a continued rapid decline, was around 35%, down from 39% in In 2007, inflation ended at 6.6%, close to the upper end of the Bank Indonesia target. However, since the start of 2008, inflation has been on the rise, reaching 11.85% in August Inflationary pressure has been driven primarily by external factors related to escalating international prices of food and commodities. Until late May 2008, inflation was insulated from surging international prices by the domestic fuel subsidy. The 29% increase in fuel prices announced recently by the Government may exert further inflationary pressure. In response to the rising inflation, Bank Indonesia progressively increased its rate by 150 basis points to 9.50% in October 2008 and has declared its intent to adjust future rates as appropriate to manage inflation expectations. Table 1 presents the key macroeconomic indicators for Indonesia. 4. The rising international fuel prices have generated heavy pressure on the central government budget. Under the current regime of administered pricing, the prices of over two thirds of fuel sold gasoline, transportation diesel, and kerosene have been fixed since As a result, government spending on energy subsidies has grown rapidly and is estimated to have gone up to 4.2% of GDP in 2008, versus the budgeted 1.8%. While the continued escalation in international fuel prices helps the central Government on the revenue side, its overall impact on the budget is negative. Measures have been proposed to cut line-ministry subsidies to electricity and to ration kerosene so that it goes only to the poor. These measures and the fuel price increase are expected to reduce the budget deficit from the budgeted 1.7% of GDP to about 1.3% of GDP. As international oil prices are expected to stay volatile and difficult to predict, the Government is committed to the longer-term goal of pricing energy at market rates to promote efficiency and safeguard its fiscal position. 5. If high commodity prices and the risk of a global economic slowdown persist, the economic outlook will be one of considerable challenge. However, Indonesia is expected to weather the global slowdown reasonably well in the short term with growth slowing slightly to

14 2 6.2% in Going forward in 2009, growth is projected to weaken due to protracted global financial crisis. Increased exchange rate flexibility, adequate reserves, improved export diversity, declining external debt, and the recent preemptive actions taken by the Government should cushion the negative effects of external shocks. Although export growth is projected to slow somewhat in 2008, domestic demand, especially investment, should remain robust realized investment in the first half of 2008 was up by 81%. Consumption could weaken slightly in response to higher inflation, but is expected to remain strong. With continued strong growth, the debt-to-gdp ratio is projected to decline further to 33% by the end of On the downside, without further adjustments in fuel prices, higher international fuel prices will continue to pose significant risk to the central government budget. On the upside, further progress in implementing structural reforms and removing bottlenecks to infrastructure investment would perk up growth. Consistent implementation of fiscal decentralization reforms would also help improve domestic investment. Table 1: Key Macroeconomic Indicators for Indonesia, Year Item a A. Income and Growth 1. GDP per Capita ($, current) 1,050 1,140 1,250 1,570 1,840 2, GDP Growth (%, in constant prices) a. Agriculture b. Industry c. Services B. Saving and Investment (current prices, % of GDP) 1. Gross Domestic Investment Gross National Saving C. Money and Inflation (annual % change) 1. Consumer Price Index Total Liquidity (M2) D. Government Finance (% of GDP) 1. Revenue Expenditure and Onlending Overall Fiscal Surplus (Deficit) E. Balance of Payments 1. Current Account Balance (% of GDP) Merchandise Export ($) (annual % change) 3. Merchandise Import ($) (annual % change) F. External Payments Indicators 1. Gross Official Reserves (in $ billion) (in months of prospective goods and services (7.1) (5.7) (4.3) (4.5) (5.7) (4.5) b imports and government foreign debt payment) 2. External Debt Service (% of exports of goods and services) 3. Total External Debt (% of GDP) G. Memorandum Items 1. GDP (current prices, Rp trillion) 2, , , , , , Exchange Rate (Rp/$, average) 8, , , , , ,265.1 c 3. Population (million) = not available, GDP = gross domestic product. a Estimates. b As of Q c Jan-Mid October Sources: Bank of Indonesia, Central Bureau of Statistics (BPS), and ADB estimates.

15 3 6. The national medium-term development plan (Rencana Pembangunan Jangka Menengah, or RPJM) for is centered on poverty reduction through higher growth with job creation and environmental sustainability, and on activities and investments aimed at achieving the Millennium Development Goals (MDGs). Five priority areas are identified in the plan: (i) job creation and poverty reduction, (ii) macroeconomic stability with fiscal sustainability and financial sector reforms, (iii) accelerated investments and exports with the help of a healthy business climate, (iv) improved access to better-quality education and health services, and (v) infrastructure development with greater participation from the private sector. For these reforms to bear fruit, the Government must increase its development spending to spur economic growth, reduce poverty, and achieve the MDGs more quickly. Recognizing the critical role of regional governments in sustained growth and poverty reduction, the Government, in 2005, launched a comprehensive National Action Plan for Fiscal Decentralization (NAPFD) setting out mediumterm decentralization reforms. 7. ADB s country strategy and program (CSP) for is fully aligned with the RPJM aiming at higher yet sustainable and pro-poor growth and social development for the country, with particular emphasis on good governance and anticorruption measures. There are five core areas of engagement: (i) infrastructure and infrastructure services, (ii) financial sector deepening, (iii) decentralization, (iv) MDG achievement, and (v) environment and natural resource management. The CSP uses innovative approaches including single-tranche cluster program lending. For investment projects, multitranche financing facilities in several sectors provide long-term investment and policy engagement. Supporting TA clusters align the assistance with emerging demands and allow more flexibility. 8. Following on from the first LGFGR program, LGFGR 2 continues to tackle major policy issues in a medium- to longer-term framework to improve the implementation of decentralization policy as envisioned in the RPJM, the NAPFD, and the CSP. It strengthens government institutions that directly support regional development while deepening reforms in fiscal consolidation, good governance, public financial management, and service delivery down to the regional governments. 2 LGFGR 2 also complements the broader policy support from the Development Policy Support Program (DPSP). 3 ADB provides a comprehensive package of support for the Government s overall objectives of poverty reduction and equitable growth. Figure 1 captures the links between the RPJM, the NAPFD, LGFGR 1 and 2, and the CSP. 1 ADB Indonesia: Country Strategy and Program Manila. 2 In this document, regional government encompasses provinces, districts (kabupaten), and cities and municipalities (kota), while local government covers districts (kabupaten) and cities and municipalities (kota). 3 ADB Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the Republic of Indonesia for the Third Development Policy Support Program. Manila (Loan 2394-INO for $200 million).

16 4 Figure 1: Links between the Medium-Term Development Plan, NAPFD, ADB s CSP, and LGFGR Programs 1 and 2 RPJM Priority Areas 1. Job creation and poverty reduction 2. Macroeconomic stability and financial sector reforms 3. Healthy business climate, flexible markets 4. Access to better-quality education, health 5. Infrastructure development via PPP 6. Education and opportunities for the youth 7. Anticorruption and good governance measures LGFGR 1 Core Areas 2. Coordination / Planning 3. Regional administration 4. Intergovernmental fiscal system 5. Planning, budgeting, and PFM 6. FMIS development NAPFD Core Areas 1. Regional administration 2. Regional spending 3. Local revenue administration 4. Local financial management 5. Capacity building LGFGR 2 Core Areas 1. Decentralization framework and program management 2. Regional autonomy and local governance 3. Intergovernmental fiscal system 4. Own-source revenue 5. Regional reserves and debt 6. Capacity development, PFM, and accountability CSP Strategic Areas 1. Improve infrastructure 2. Deepen financial sector 3. Improve decentralization 4. Accelerate MDG achievement 5. Strengthen environment and natural resource management CSP = country strategy and program, FMIS = financial management information system, LGFGR 1 and 2 = Local Government Finance and Governance Reform Programs 1 and 2, MDG = Millennium Development Goal, NAPFD= National Action Plan for Fiscal Decentralization, PFM = public financial management, PPP = public-private partnership, RPJM = Indonesia s medium-term development plan. Note: Items in boldface type show the links between plans and programs. Source: Asian Development Bank. III. THE SECTOR A. Review of the Sector and Performance 9. Sector Review Backed by Significant Diagnostic Study. Apart from the experience gained directly under LGFGR 1 and diagnostic work on fiscal aspects of decentralization during CSP preparation in 2006, the design of LGFGR 2 has benefited from a significant amount of sector diagnostic study done between 2006 and 2008 on the fiscal aspects of decentralization. This work involved: (i) a comprehensive stock taking of fiscal decentralization, undertaken jointly

17 5 by funding agencies and the Government; 4 (ii) a diagnostic review of issues and the preparation of a medium-term work plan for the Decentralization Support Facility (DSF); 5 (iii) an extensive diagnostic review of priority reforms to be considered in designing LGFGR 2 and the project preparatory TA for LGFGR 2; 6 (iv) a public expenditure review with emphasis on the fiscal aspects of decentralization; 7 and (v) various internal government reviews (some supported by ADB TA projects) made to assess progress in implementing LGFGR 1 and the NAPFD. 10. Evolving Administrative and Legal Framework. In the aftermath of the economic and political upheavals of the late 1990s, the Government introduced major decentralization reforms that have devolved significant authority, functional responsibilities, and funding from the central Government to provincial and local governments. The big bang reforms launched in 2001 involved a massive delegation of responsibility for the provision of public services and the reassignment of two thirds of central government civil servants and more than 16,000 service delivery facilities to the regional governments. Regional government expenditures almost doubled, making Indonesia one of the most-decentralized countries in the world, with its regional governments managing more than 40% of total government expenditure. 8 Not surprisingly, the transition to such a radically different system of governance has been far from smooth. Over the last 6 years, there has been continuous reform and fine-tuning. Observers believe that the constant need for change arose because Indonesia did not prepare a white paper setting the overall design and framework for decentralization. 9 Without such a road map, there is a tendency to make it up as we go along, leading to pieces of decentralization strategy that may not fit together. In addition, later policy changes may not be consistent with the overall goals of fiscal decentralization. A case in point is the hold harmless system that was put in place by the house of representatives (Dewan Perwakilan Rakyat, or DPR) to protect regional governments from a reduction in revenues once the new formula-based intergovernmental grants were introduced. The system compromised the equalization effects of the grant and perpetuated perverse wage incentives. Although the fiscal architecture is far from complete, the Government as a matter of policy has turned away from building up the decentralization system and toward fine-tuning the system to improve governance and service delivery. 11. Decentralization reforms in Indonesia formally began in 1999 with the passage of two fundamental laws: (i) a law on local administration (law 22/1999), which spelled out the functional responsibilities and administrative structures of regional governments and defined their autonomy; and (ii) a law on financial balance between the central Government and the regions (law 25/1999), which dealt with revenue sources, including transfers and revenue assignments and other aspects of fiscal relations. Under these laws, decentralization in Indonesia took shape with several distinctive features. As far as organizational structure was concerned, local governments were not hierarchically linked to provincial governments; executive and legislative bodies were elected at each level, leaving the door open for the creation (proliferation) of new regional governments. Regarding expenditure assignments, the central Government reserved for itself a very short list of national responsibilities (international 4 Development Support Facility, Asian Development Bank, US Agency for International Development, and Australian Agency for International Development Stocktaking on Indonesia s Recent Decentralization Reforms. Jakarta. 5 Development Support Facility Focal Area for Fiscal Decentralization, Work Program Jakarta. 6 Martinez, Jorge Indonesia s Fiscal Decentralization: Taking Stock and Future Challenges. Diagnosis for ADB in Preparation of LGFGR II. Manila: ADB. 7 World Bank and Government of Indonesia Indonesia Public Expenditure Review: Spending for Development. Jakarta: World Bank. 8 World Bank Indonesia Public Expenditure Review. Jakarta. 9 Martinez, Jorge, and Roy Bahl Sequencing Fiscal Decentralization. Washington, DC: World Bank/Georgia State University.

18 6 relations, defense and security, monetary and fiscal policies, and religious affairs) and decentralized all other public functions, mostly to the local governments (as opposed to the provincial governments; see footnote 1). Local governments deliver public services in most sectors public works, health, education and culture, communication, industry and trade, capital investment, environment, land, cooperatives, and labor. Regional governments have considerable discretion in managing and delivering services. However, because of widespread failure to adapt sectoral laws (on education, public health, etc.) to the new decentralization principles, line ministries and other central government agencies continue to provide services and undertake expenditures in areas that have been decentralized. 12. Law 34/2000 grants taxation and revenue powers to regional governments but gives them little meaningful revenue autonomy. Although regional governments can introduce their own taxes, such taxes have to meet good tax criteria defined in the law. The central Government has kept control of the main taxes, and new taxes introduced by the regional governments tend to be nuisance taxes, distorting domestic trade and economic activity. Under the law, new regional taxes are reviewed by the central Government, which holds ultimate power of revocation. The DPR is considering amending law 34/2000 and including a closed-list approach to regional taxes to rein in nuisance taxes. The main source of financing for regional governments has been transfers, notably from revenue sharing but mostly from the general allocation fund (Dana Alokasi Umum, or DAU), which was conceived fundamentally as an equalization grant. For many years, however, the larger share of this grant has been distributed not according to the equalization formula but rather to finance public sector employees and other objectives. 13. This original framework was reconstructed in 2004, when parliament approved law 32/2004 amending law 22/1999 on regional autonomy, and law 33/2004 amending law 25/1999 on regional fiscal relations. In particular, law 32/2004 reestablished a hierarchical role for the provinces vis-à-vis the districts and cities. Regional planning, budgeting, financial management, and oversight have also undergone significant reforms with the passing of new central finance, treasury, planning, and audit laws in , followed by a raft of new lower-level regulations. 10 The new legal requirements are being gradually introduced in the regions, and modern budgeting and financial management approaches are being put in place in areas such as budget unification, treasury management, medium-term programming and performancebased planning and budgeting, and enhanced monitoring, evaluation, and internal and external audit of performance outcomes. Over time, the LGFGR program cluster and related projects funded by the Government and development partners seek to significantly enhance institutional, systems, and human resource capacity to achieve the desired outcomes from the new approaches to public financial management (PFM) that have been put in place. 14. Figure 2 sets out the basic structure of the regional government system, with 33 provinces, 95 municipalities (kota), 370 districts (kabupaten), and about 73,458 villages (desa and kelurahan). Provinces, districts, and municipalities all have their own elected heads of government (governor, bupati, and mayor, respectively) as well as their own elected representative bodies (Dewan Perwakilan Rakyat Daerah, or DPRD). The subdistricts (kecamatan) are administrative arms of the districts and municipalities, while the villages operate at the community level with elected heads. The main central government coordinating and supervising bodies are: (i) the Ministry of Finance (MOF); (ii) the National Development Planning Agency (Badan Perencanaan Pembangunan Nasional, or BAPPENAS); (iii) the 10 More than 50 new presidential, government, and ministry regulations and decrees relating to fiscal decentralization were passed from 2005 to mid-2008.

19 7 Ministry of Home Affairs (MOHA); (iv) the Supreme Audit Authority (Badan Pemeriksa Keuangan, or BPK); and (v) the president s Regional Autonomy Advisory Council (Dewan Pertimbangan Otonomi Daerah, or DPOD). Established under law 32/2004, the DPOD is chaired by the minister of home affairs and co-chaired by the minister of finance. At the highest level, it contains other ministers and regional government representatives. It has (i) working groups, (ii) technical groups, and (iii) a secretariat. The council advises the president on regional autonomy policy regarding: (i) the establishment, abolition, or merger of regional governments; (ii) the assessment of regional government performance; (iii) the assignment of functions; and (iv) fiscal balance matters, including the DAU and shared-revenue allocations. The longer-term strengthening of the DPOD is an important objective of LGFGR 2. Figure 2: Structure of the Regional Government System in Indonesia Central Government (Pusat) Provinces (Propinsi) (33) Districts (Kabupaten) (370) Municipalities (Kota) (95) Subdistricts (Kecamatan) (635) Subdistricts (Kecamatan) (635) Villages (Desa) (68,593) Villages (Kelurahan) (4,865) Source: Central Bureau of Statistics (BPS), as of the end of Increasingly Decentralized Service Delivery. Regional governments have assumed the key role in the delivery of core services, including education, health, and the development of basic infrastructure such as waterworks and roads. An important issue is the impact of decentralization on the quantity and quality of those services. While decentralization is relatively new, a preliminary assessment at least can be made at this time. The performance of the regional governments can be evaluated from (i) an expenditure perspective (has there been an adequate increase in expenditures allocated to decentralized services, i.e., have funds followed functions?); (ii) an expenditure composition perspective (is there a desirable mix or composition of expenditures?); or (iii) a service delivery perspective (has the quality of services improved?) Unless stated otherwise, fiscal data in this report are drawn from the MOF regional financial information system (SIKD), the Central Bureau of Statistics (BPS), and the Supreme Audit Authority (BPK).

20 8 16. Expenditure Levels. National education expenditures now approach 4% of GDP, up from 2% in With close to 17% of total public expenditures going to education, the country is spending at good standard international levels, adjusted for income per capita. The lion s share of growth in education expenditures has been in the local governments, from negligible levels in 2000 to more than 2% of GDP recently. But central government expenditures have not decreased very significantly (from about 1.3% of GDP in 2000 to 0.9% recently). Much local expenditure is on teacher salaries, with a simple switch in administrative responsibilities from central to local. Total expenditures on public health have increased moderately in recent years but are still less than 2% of GDP, little changed from 2001 and quite low by international standards. Regional government expenditure on public health did increase sharply after 2001 (11.5% of sector expenditures in 2000 and 42.9% in 2006). But this was largely offset by decreases in health expenditures by the central Government (from 64.3% of sector expenditures in 2000 to 41.2% in 2006), while the provincial governments share has declined, from 24.2% in 2000 to 15.8% in Public investment declined from 7% of GDP in 1996 to less than 3% in 2001 and has only recently recovered to pre-crisis levels of about 7% of GDP. In , central government public investment grew from 2.2% of GDP to 2.7% of GDP; local investment over this period grew more rapidly, from 1.3% to 2.8%, while provincial investment grew from 0.3% to 1.0% of GDP. 17. Functional Composition of Expenditures. The current composition of regional expenditures is still less than optimal. While education has become the most important sector in regional budgets, expenditures on public health have not increased significantly. Government administration expenditures are the second most important in regional budgets. Regional governments still spend too little on infrastructure, with central government agencies continuing to control about 50% of infrastructure spending. Low spending on basic infrastructure services has been complicated by two factors. One, regional governments routine expenditures account for 65% of total expenditures and a very high proportion of these go solely to personnel costs. Two, much too little is spent on supplies and equipment. Health clinics, for example, often lack basic medications, clean water, and electricity. 18. Service Delivery. In the little time that has passed since the launching of decentralization reforms in 2001, service delivery performance has been mixed from the limited evidence available, but there are indications that the quality of some services has improved. A recent World Bank survey 12 concluded that decentralized services in education, health, and general administration have improved in quality while police services, which have not been decentralized, have deteriorated. But the survey evidence is merely indicative and has to be confirmed by longer-term trends in objective indicators, which are still being developed. Besides, before 2001, access to many basic services was very low, so any significant improvement will take time to occur. For example, household access to water, sanitation, and electricity is among the lowest in the region, with only 18% of households having access to piped running water and continued slow growth in the number of families with access to safe sanitation (18.2 million families in 2003 and 19.4 million in 2005). Although many state-owned water supply companies (Perusahaan Daerah Air Minum, or PDAMs) have major financial problems, there was a modest increase in PDAM customers of 11.4% from 2001 to The number of households with access to public water taps also grew by 18.2% from 2001 to In education, Indonesia ranks well internationally at the primary level, with net enrollment rates recently (2005) increasing to 95.5%, but is doing less well in junior secondary (65.2%) and 12 World Bank Decentralization, Governance and Public Services in Indonesia. Jakarta: Kaiser, Pattinasarany and Schulze.

21 9 senior secondary school (41.7%). Adult literacy is showing some improvement, from 89.3% in 2001 to 90.9% in 2005, although there are wide regional differences. Trends in the quality of education outcomes still need longer-term assessment. Many health indicators remain poor by international standards: among the countries in the Association of Southeast Asian Nations region Indonesia has the fewest physicians for every 100,000 people. Ratios for nurses and midwives are somewhat better, but again the distribution varies greatly between regions. On the other hand, infant and child mortality rates show good improvement since decentralization. The infant mortality rate fell from 60 per 1,000 live births in 2000 to 28 per 1,000 live births in Life expectancy has also improved, particularly in poorer provinces like Papua, where life expectancy improved from 62.7 years in 1996 to 67.3 years in Social Indicators. More aggregated indicators like poverty trends may show how well decentralized governance has succeeded, even if the latter is only one of many forces that affect poverty trends. According to the Central Bureau of Statistics (Badan Pusat Statistik, or BPS), the poverty headcount ratio has dropped sharply in relative terms since the start of decentralization (from 23.4% in 1999 to 16.6% in 2007). But richer and poorer regional governments have not improved in the same way: poverty in poorer and mainly agricultural regions is still quite high. At the extremes, 4.6% of the population in Jakarta and 40.8% in Papua were considered poor in Trends in Vertical and Horizontal Balance. These trends offer another way of assessing the performance of the decentralization system. As shown in Table 2, total resources available to all regional governments grew strongly from 6.9% of GDP in 2001 (Rp103.4 trillion) to 8.4% of GDP in 2006 (Rp279.0 trillion) and are thought to have grown further since. All forms of revenue have grown sharply in absolute terms. However, in its share of resources the DAU declined somewhat in importance from 2001 to 2006 (but was still 52.2% of total resources in 2006), while resource growth for regional governments has come mainly from the specific allocation fund (Dana Alokasi Khusus, or DAK), at 4.1% of total resources in 2006 (up from 1.1% in 2001), and shared revenues, at 23.3% in 2006 (versus 21.0% in 2001). Most regions arguably have enough resources to make a difference in the lives of their citizens. The challenge now is spending the growing resources effectively. Table 2: Total Resources of Regional Governments (Provinces, Kabupaten, and Kota), (Rp billion and as % of GDP) 2001 Actual 2002 Actual 2003 Actual 2004 Actual 2005 Actual 2006 Actual Item Total Regional Resources DAU (general allocation fund) 60, , , , , ,685.4 DAK (specific allocation fund) 1, , , , , ,569.8 Shared taxes and resources 21, , , , , ,107.0 PAD (local own-source revenues) 15, , , , , ,739.8 Other revenues 4, , , , , ,872.8 Total Regional Resources 103, , , , , ,974.8 As % of gross domestic product % Share of Total Regional Resources DAU (general allocation fund) DAK (specific allocation fund) Shared taxes and resources PAD (local own-source revenues) Other revenues Total Regional Resources Sources: Central Bureau of Statistics (BPS), Supreme Audit Authority (BPK), MOF regional financial information system (SIKD), central government financial report (LKPP).

22 The centerpiece of intergovernmental financing since 2001 has been the unconditional equalization grant, the DAU. Despite political impositions on its implementation (e.g., the hold harmless provision, 13 links to payment of wages and salaries), this system of transfers has reduced fiscal disparities across regional governments. The equalization effects of these transfers could have been much more substantial, however, if the hold harmless provision had been phased out before 2008, and the entire DAU pool had been dedicated strictly to equalization. As shown in Table 3, the total DAU has increased sharply, from Rp60.7 trillion in 2001 to Rp179.8 trillion in 2008, but has remained relatively constant at about 4% of GDP over this period. For all regional governments, the DAU provided 52.2% of total resources in 2006, down from 58.7% in 2001, with the main alternative growth in funding coming from DAK and shared revenues. Data on total per capita resources and per capita expenditures show sizable differences between regions. In 2006 at the extremes Papua province spent about 17 times as much per capita than the lowest-spending province (Jawah Tengah). Expenditure disparities between the highest-spending district (Kabupaten Sarmi in Papua) and the lowest-spending district (Kabupaten Bogor in Jawah Barat) are even wider, at a ratio of 50 to 1 in Table 3: DAU Transfers to Provinces, Districts, and Cities, Item 2001 Actual 2002 Actual 2003 Actual 2004 Actual 2005 Actual 2006 Actual 2007 Actual 2008 Actual (In Rp Billion) Transfers to Provinces 6, , , , , , , ,980.7 Transfers to Districts 54, , , , , , , ,769.3 and Cities Total DAU 60, , , , , , , ,750.0 % Growth (As % of Total GDP) Transfers to Provinces Transfers to Districts and Cities Total DAU DAU = general allocation fund, GDP = gross domestic product. Sources: Central Bureau of Statistics (BPS), Supreme Audit Authority of Indonesia (BPK), MOF regional financial information system (SIKD), central government financial report (LKPP). 23. Despite the low revenue autonomy granted to regional governments, revenue sharing, the DAU, and other transfers have helped close the vertical fiscal gap between the central Government and regional governments, but the horizontal gap has widened since 2001, especially among local governments. Because of recent increases in oil and gas revenues, resource-rich regions and those receiving special autonomy grants, like Aceh, Maluku, and Papua, have seen very rapid growth in shared revenues. As shown in Table 4, central government revenue sharing with all regional governments rose sharply from Rp21.7 billion in 2001 (1.5% of GDP) to Rp65.1 billion in 2006 (2.0% of GDP). Revenue sharing is now almost half of DAU levels and, since much of it is dispersed inequitably (on derivation principles), is a major countervailing force to DAU equalization. 24. The decentralization system is still not doing enough to reduce the horizontal fiscal disparities. The disparities between regions in public services and standards of living are still quite considerable (see para. 22). The Government is therefore emphasizing regional development policies as the most effective way to bring about more geographic balance and to reduce poverty in poorer areas of the country. In a momentous step forward, the Government 13 Under the hold harmless provision, the DAU allocation to a region could not be lower than the previous year s allocation.

23 11 effectively removed the hold harmless clause from the 2008 budget, thus weakening DAU funding for better-off (mainly resource-rich) regional governments to the benefit of regional governments that were less well off and strengthening the equalization aspects of such funding. Table 4: Regional Share of National Tax and Non-tax Revenues (Including Natural Resources), Actual 2002 Actual 2003 Actual 2004 Actual 2005 Actual 2006 Actual Item (In Rp Billion) Shared with Provinces 7, , , , , ,412.2 Shared with Districts and Cities 14, , , , , ,694.8 Total Shared 21, , , , , ,107.0 % Growth (As % of Total GDP) Shared with Provinces Shared with Districts and Cities Total Shared a Excludes transfers from the provinces. Sources: Central Bureau of Statistics (BPS), Supreme Audit Authority of Indonesia (BPK), MOF regional financial information system (SIKD), central government financial report (LKPP). B. Issues and Opportunities 25. The extensive diagnostic work undertaken jointly by ADB and the Government in 2006 and 2007 revealed highly important policy issues, which can be appropriately sequenced for reform during the LGFGR 2 period. The more important of these are set out below and are also addressed in part IV (Proposed Program). Appendix 5 and Supplementary Appendix A provide detailed analyses of fiscal decentralization, service delivery, and governance issues. 26. Proliferation of New Regional Governments. A noticeable feature of Indonesia s decentralization system is the proliferation of regional governments. Six new provinces and more than 100 local governments have been created since 1999, and many more proposals are waiting in the wings. This trend, partly an opportunistic response to fiscal incentives in the system, particularly the sharing of resource revenues, is widely perceived to reduce the overall efficiency of regional governments. Recent policies have slowed down new approvals, and then imposed a moratorium (since lifted) on approvals pending the completion of a revised policy framework. The costs of proliferation are considerable: economies of scale are lost in the delivery of public services, unit costs go up, and the new governments, lacking a sound economic base to raise their own revenues, could end up depending even more on transfers from the center. On the other hand, local residents gain more representation and access to their local representatives, and regional governments are pushed to become more accountable and efficient in their daily operations. Where the new regional governments lie in the balance of efficiency considerations versus enhanced representation and accountability remains an open question pending further study, now under way. 27. Vertical Structure of Subnational Governments. The first decentralization reforms removed hierarchical relationships between the provinces and the districts and cities. But more recent reforms under law 32/2004 have introduced new forms of hierarchical control by the provinces, including the approval of the annual budgets of local governments. These policy changes are motivated by a perceived need to strengthen central oversight and control over the local governments through the provincial authorities, especially the governors. The new setup has benefits, but there are costs as well, including biased actions by intermediate-level

24 12 governments against local governments and the difficulty of finding a true proxy that would pursue the policy objectives of the central Government vis-à-vis the local governments. The pros and cons of reverting to hierarchical relationships between provincial and local governments must therefore be carefully assessed. 28. Expenditure Assignments. Government functions are imprecisely defined. Law 22/1999, taking an all-inclusive approach to the responsibilities of regional governments, simply listed the exclusive functions of the central Government and did not make clear which other functions were obligatory and which were optional for regional governments. Sector laws in decentralized functional areas were never amended to conform to the decentralization laws. Full clarification of the obligatory functions of regional governments was also not made in law 32/2004 but instead was deferred until the issuance of government regulation 38/2007. Over time, line ministries and other central agencies have encroached on expenditure functions that had apparently been assigned to regional governments by using deconcentrated funds. Thus, there is confusion in expenditure assignments of responsibilities and, at times, opposing directions in central government policy objectives. For example, while the central Government has pursued regional equalization through the DAU, the regional distribution of deconcentrated funds has tended to widen the fiscal disparities by generally benefiting regional governments that are better off. Policies, sector laws, and regulations must be better aligned with this new regulation. This work has begun in some pilot ministries. It remains to be seen, however, whether the new government regulation indeed clarifies expenditure assignments, particularly in areas of joint responsibility, and whether it has sufficient legal standing to reverse or nullify laws. 29. Revenue Assignments. Reforms have so far failed to give the regional governments significant tax autonomy. Hence, political accountability among these governments is low, public service delivery less efficient, and fiscal responsibility diminished. In 2006, provincial own-source revenues (Pendapatan Asli Daerah, or PAD) made up 42.5% of provincial revenues while local government PAD represented only 5.9% of total local revenues. These proportions have not changed much since Law 34/2000 allows regional governments to impose their own taxes and charges subject to limited monitoring and control by the central Government. Nuisance taxes have often been the result. Draft revisions in law 34/2000 now pending before the DPR restrict the taxes and charges levied by regional governments to a predetermined (or closed) list. However, two questions remain: whether the closed list of taxes will offer substantial traditional tax bases to the regional governments, and whether the Government will set aside enough resources for monitoring compliance and reducing the nuisance taxes and charges. 30. Any further devolution of taxing powers must recognize the limited administrative capacity and high collection inefficiency of many regional governments. The best candidate for devolution remains the property tax, now administered fully by the central Government, which defines the tax base and sets the rates and then distributes the collected revenues among the regional governments, while retaining 9% of receipts as an administrative fee. 15 The property tax is not used at its full potential the valuation of properties is deficient and the statutory rates are very low (0.1% 0.2%). Collection efficiency is also very low, with less than half of the tax liabilities estimated to be finally collected. One option for devolving the property tax would be to 14 Most regional revenues are raised by provincial governments, especially from motor vehicle registration, title transfer and registration, and interest income. Key revenue sources for local governments are taxes on electricity and on hotels and restaurants, and fees from health clinics, building permits, and public markets. 15 In 2005 property revenue was Rp16 trillion, amply exceeding PAD revenues. However, property taxes on mining (mainly oil and gas) were 75% of revenues, urban areas 20%, and rural areas only 3.4%.

25 13 give the regional governments discretion to set rates between a minimum and a maximum set by the DPR. The administration of the tax could stay centralized at first, although the collection fee of 9% should be reviewed. Over time, it may be possible to further decentralize administration in stages, with better-managed governments taking on more responsibilities earlier than those with less management capacity. In the recent past, opposition to the decentralization of the property tax within the MOF has been interpreted largely as defending turf. Decentralizing the property tax would provide the regional governments with a very visible and considerable source of financing in the future, enhancing accountability and future budget needs. The weighty issue of property tax devolution is now being closely reviewed by the Government and the DPR and in a major breakthrough is now part of the current round of proposed amendments to law 34/2000 that are being addressed by the DPR. 31. Unconditional Equalization Grant (DAU). This continues to be at the center of the decentralization system in Indonesia and represents by far the main form of transfer from the central Government to the regional governments. The subject of constant reform since its introduction in 2001, the DAU has progressively risen to 26% of net central government revenues from 2004, employing the formula of fiscal gap (the difference between expenditure needs and fiscal capacity) plus basic allocation. The present computation of fiscal capacity fully includes all shared revenues, including those from natural resources, in addition to own revenues of regional governments. In computing the index of expenditure needs the Human Development Index is now used instead of the poverty gap indicator of the past, and gross regional domestic product per capita has been added as another factor to the formula. The formula for computing the fiscal gap needs continuous fine-tuning. The estimation of own revenues in the computation of fiscal capacity could be further refined to further reflect disparities in tax bases; however, this refinement may not be immediately feasible, given the lack of data. The method of computing expenditure needs is now based on a weighted index of several indicators. This index is at best an approximation of expenditure needs, since not all drivers of need are included in the computation and those that are do not necessarily capture well what drives needs. A more desirable way to compute expenditure needs would be based on the direct application of minimum service standards (MSS) for service delivery, provided that the regional budgets can accommodate these norms. However, broadly applied MSS are still a long way from being finalized. 32. Until 2008, the actual distribution of DAU transfers was subject to a hold harmless provision, by which no regional government could receive less in transfers than what it received the previous year. This provision effectively worked against the equalizing effects of the DAU, since even regional governments for which the estimate of fiscal capacity exceeded expenditure needs continued to receive transfers. In 2008, in a highly important move the Government effectively eliminated the provision, thus significantly improving horizontal equity between regional governments (although adversely affected regional governments receive limited compensatory funding through other non-dau parts of the budget). 33. The funding of the significant wage bills of all regional governments through the basic allocation of the DAU has also introduced serious perverse incentives to employ more staff despite broad concerns about the excessive administrative costs of regional governments. Staffing efficiency varies widely between regions. In 2006, among the local governments, the extremes were 0.44 staff for every 1,000 people in Kabupaten Serdang Berdagi and for every 1,000 in Kabupaten Halmahera Tengah. The current arrangements create powerful incentives for regional governments to lobby for more staff and send the wrong signal to these regional governments about how to operate in the future. Since any reductions in the wage bill will simply mean a reduction in the level of DAU transfers with a year s lag, regional

26 14 governments are discouraged from streamlining their civil service. There is considerable room for increasing the efficiency of regional governments and reversing the negative message sent by the current arrangements with the basic allocation. A number of reform options are now being closely considered. One option would be to repeal completely the wage bill reforms of Another option would be to fund the wage bill of the regional governments according to a particular formula for structuring relative to size and to allow the governments to use the funds at their own discretion. The regional governments that wanted to streamline their employment rolls could then freely do so without penalty. Other options are being considered with further concrete reform proposed for subprogram Specific Allocation Fund (DAK) and Deconcentration Funds. The policy development of the specific allocation fund (DAK) and the reform of the deconcentrated funds used by central government ministries and other central government agencies for spending programs in the regions are strongly linked. Law 33/2004 provides for the channeling of non-legitimate deconcentration funds to increase the DAK. 16 However, the line ministries typically seek to delay the shift and are shielded in part by the legal ambiguities in the system due to the contradictions between the sectoral laws and the decentralization laws. Government regulation 38/2007, which is intended to clarify expenditure assignments and help the central Government set the ceiling for and screen the budgets of ministries, widens the scope for identifying and reallocating non-legitimate deconcentration funds. Another approach to switching funds to DAK would be to switch deconcentration funds to the DAU and to let those funds be used by the regional governments for functions now administered by line ministries. The approach chosen whether to reinforce the DAK or the DAU will depend on the degree of confidence in the appropriate functioning of a reformed DAK. 35. The DAK has increased in absolute and relative importance, from Rp1.1 trillion in 2001 (0.08% of GDP) to Rp21.2 trillion in 2008 (0.47% of GDP). However, these funds still represent a small share of total regional government revenues (about 5% of total revenues for local governments in 2006 with negligible recent provincial DAK funding). There is scope for restructuring and refocusing the DAK on the basis of clear principles and objectives. The DAK should not be burdened with the objective of equalization if that is effectively provided by the DAU. Ideally a reformed DAK should be defined in the context of the emerging medium-term expenditure framework (MTEF). New arrangements should specify (i) matching requirements for regional governments; (ii) conditions for structuring programs as general block grants versus specific grants; (iii) the form of allocation and distribution of the grants, including formulas and competition through open bidding; and (iv) the role, if any, of provincial authorities in the allocation of resources and the monitoring of results. Careful thought should also be given to ensuring the additionality of DAK transfers, in particular making sure that they do not discourage or crowd out credit operations by regional governments to finance long-term infrastructure needs. 36. Regional Government Borrowing, PDAMs, and Regional Surplus Reserves. The decentralization system in Indonesia is faced with what seems to be a significant paradox. New borrowing by regional governments is negligible at present, while basic infrastructure needs at the local level are huge, as evidenced, for example, by the fact that most public utilities (PDAMs, etc.) for basic services such as water are bankrupt and operate with broken facilities. 16 Legitimate deconcentration covers areas in which the central Government, according to law 32/2004 and government regulation 38/2007, has a legitimate role in providing decentralized service through regional governments (either directly or shared). Illegitimate deconcentration relates to areas of regional activity where the law and government regulations do not allow the central Government to provide services but where the central agencies are still operating.

27 15 On top of that, regional governments are holding on to very large cash reserves amounting to 3% of GDP, although the extent of the reserves varies widely between regions. Each of these issues (lack of borrowing, dysfunctional PDAMs, and very large reserves) could be addressed separately, but considering them together would facilitate effective policy making. With regard to cash reserves beyond loan repayment and infrastructure financing needs, regions rich in natural resources and with large reserves could be encouraged to create trust or inheritance funds so that future generations might also benefit from the exploitation of natural resources in those regions. Putting away part of the funds for future use should also help avoid wasteful overspending in the present. 37. Much of the regulatory attention on borrowing has dwelt on regulating the demand side of local credit markets, including the passing of MOF regulation 147/2006 on the issuance of regional bonds. The regional credit markets have failed to develop in part because of the poor repayment performance of many local governments. The new regulatory framework introduces new rules for onlending, but the processes remain long and restrictive. The unclear assignment of expenditure responsibilities, especially those having to do with obligations for the construction and maintenance of infrastructure, has induced regional governments to wait for funds from the central Government to pay for the needed infrastructure. Direct central government spending in the regions keeps going to functional areas that are the responsibility of regional governments but for which they are less inclined to spend. 38. In addition, public utility regulations stifle the demand for credit. For example, regional governments cannot pledge their revenues or assets except in the case of revenue bonds, and they cannot guarantee PDAM loans. On the other hand, poor maintenance and cost recovery practices have made many PDAMs technically insolvent. Further policy development is needed to encourage PDAMs to function better (raise tariffs to allow cost recovery, lower operation costs, and maintain the capital investment) and for regional governments in general to become more responsible in maintaining infrastructure. Improved capital budgeting and implementation by the regional governments would also help. Much better debt and financial arrangements for the vast majority of PDAMs that are struggling would significantly improve service delivery in the water sector with resulting benefits for community health. The passage of the new MOF decree 120/2008, which provides for more generous debt rescheduling and relief to encourage speedier restructuring, enhances the prospects. 39. Capacity Building for Public Financial Management. As much of the regulatory framework for fiscal decentralization is close to being finalized, attention is now increasingly being directed at ways to raise systems and human capacity. BAPPENAS is taking the lead in trying to improve planning methods and skills at all levels of government and to link plans and policies more closely to budgets in a medium-term framework. Both MOF and MOHA are helping to disseminate the budgeting, reporting, and supervision requirements of the new regulatory regime, particularly in relation to government regulations 58/2005 and 39/2007 and MOHA regulations 13/2006 and 59/2007, which provide the framework for modern and consistent decentralized budget and financial management. In 2007, MOHA conducted specialized PFM courses for about 100 officials of the central Government and 400 from the regional governments. MOF is also training decentralized financial officials nationwide, mainly through the regional universities. In 2007 it conducted training in eight different locations for 1,528 regional officials. A considerable expansion of the scope of training and professional development of regional finance officials is planned under subprogram 2 with significantly higher funding commitments from both MOHA and MOF than in recent times.

28 MOF and MOHA, with funding from the LGFGR 1 project loan, are also involved in developing new computerized financial management information system (FMIS) to support planning, budgeting, budget execution, reporting, and auditing in 171 regional governments to begin with, and possibly other regional governments later on. About 9,642 finance and management officials from regional governments will be trained in this major capacity-building project. Moreover, the ADB-funded Sustainable Capacity Building for Decentralization (SCBD) project continues to provide about 40 participating regional governments with general management training and support. Because these two ADB project loans are still disbursing, the Government has decided not to pursue a further project loan under subprogram 1 of LGFGR 2. But the possibility of such a loan under subprogram 2 has not been ruled out, especially if the current project support continues to make good progress. Other development partners with involvement in fiscal decentralization matters are directing most of their efforts at capacity building in one form or another (systems, human resources, etc.) in the regional governments, in some cases (with ADB support) through the leadership of MOF, MOHA, and BPK (see Appendix 4). Improving capacity for decentralized planning, budgeting, and financial management remains a core focus of subprograms 1 and 2 and will require the application of considerable resources from all levels of government and development partners over an extended period of time. Under Indonesia s capacity-building framework, central ministries and agencies must provide leadership and facilitation but the regional governments themselves must take ultimate responsibility for improving their own capacity. There is still scope for development partners to support both centrally led efforts but also increasingly to engage directly with individual regional governments or groups of governments. 41. Development Partner Coordination. Many development partners are actively involved in fiscal aspects of decentralization in Indonesia. Apart from ADB, which plays a lead role in the sector, others actively involved are the following: the World Bank, the Department of International Development (DFID) of the United Kingdom, the German Agency for Technical Cooperation (GTZ), the Australian Agency for International Development, the Canadian International Development Agency, the United States Agency for International Development, the United Nations Development Programme (UNDP), the Japan International Cooperation Agency, the Government of the Netherlands, and the European Commission. ADB is collaborating closely with other development partners in all six core output areas of LGFGR 2, especially those that most heavily involve sector-wide planning and policy formulation. The Decentralization Support Facility (DSF), established in 2005 as a decentralization umbrella organization, strives to harmonize the Government s needs and development partners interventions. The founding members of DSF are ADB, DFID, the Netherlands, UNDP, and the World Bank. DSF is funded mainly by DFID and is managed by the World Bank under a trust fund arrangement. A more formal sector-wide type approach to decentralization support involving all development partners and government stakeholders has been the subject of ongoing discussions, but approaches have not yet been fully harmonized. As the ADB-supported LGFGR moves from program 1 to program 2, many development partners are interested in exploring the possibility of harmonization under the broad heading of the NAPFD and the LGFGR 2 policy matrix. Such an approach is still far from being achieved under subprogram 1 of LGFGR 2, but remains a useful medium-term objective and will be pursued more actively in subprogram 2, including in relation to the proposed revision of the NAPFD to extend the planning framework to C. Lessons 42. Lessons drawn from LGFGR 1 and NAPFD implementation are the most important. In addition, a number of diagnostic assessments and experience gained in implementing ADB s

29 17 SCBD loan were also considered in designing LGFGR 2, as were two recent evaluation studies that looked into decentralization and capacity-building issues in Indonesia. 17 The important lessons learned are: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) Long-term commitment. Indonesia is still in the early phases of very major fiscal decentralization reform. The Government remains very serious about deepening reforms and raising capacity. ADB s medium- to longer-term commitment after LGFGR 1 remains appropriate. Government leadership of the program. A very collaborative and interactive approach to issue analysis and program preparation, driven by the Government, has been taken under LGFGR 2. Intensive, not spasmodic, engagement over time. Intensive longer-term ADB engagement is necessary for the effective formulation and monitoring of the reform agenda. The rushed processing of LGFGR 1 lessened program credibility at the start. ADB must be involved more intensively throughout LGFGR 2. Coordination with government. Decentralization involves complex crosscutting issues with a multitude of stakeholders, requiring close coordination and consensus building among central government agencies and between central the Government and the regional governments. LGFGR 2 addresses the need to improve capacity and coordination among relevant central government agencies and seeks to clarify the roles of various levels of government. Donor coordination. Large, complex strategic issues such as decentralization require active partnering with other development partners. Despite efforts made through DSF and development partners, engagement with development partners in preparing LGFGR 1 was limited. Further serious efforts to develop a single government-led program supported by DSF are warranted over time. Clarity of sector functions. The continuing mismatch between sector policies, laws, and regulations, on the one hand, and the general decentralization framework, on the other, needs to be addressed. LGFGR 2 supports the identification of inconsistencies and is aimed at addressing them in two pilot sectors with follow-ups planned. Horizontal and vertical fiscal decentralization. There must be a better balance between the revenue and expenditure responsibilities of regional governments, and issues of fiscal equalization between richer and poor regions must be addressed. LGFGR 2 is designed to support vertical and horizontal improvements in intergovernmental financing. Capacity building. Decentralization efforts must be complemented with appropriate reforms in organizations and systems, as well as human capacity building, to allow the regions to manage their personnel and finances more efficiently and effectively. LGFGR 2 is aimed at supporting systemic capacity development in budgeting, financial management, service delivery, and human resources improvement. 17 ADB Special Evaluation Study on Capacity Building to Support Decentralization in Indonesia. Manila; and ADB Country Assistance Program Evaluation Indonesia. Manila.

30 18 IV. PROPOSED PROGRAM CLUSTER A. Links to LGFGR 1 and Other ADB Assistance 43. The details and lessons from LGFGR 1 were fully considered in the development of LGFGR 2; 18 the two programs are integrally linked. In LGFGR 1, the desired outcome was increased accountability in the management of regional finances. In LGFGR 2 the outcome has been somewhat broadened to having improved organizational capacities and operating in a more transparent, effective and efficient policy and legal environment for fiscal decentralization, financial management and service delivery. In LGFGR 1, the desired longer-term impact was more effective and efficient delivery of basic public services by regional governments. The longer-term impact sought under LGFGR 2 is broadly similar: improved efficiency, effectiveness and interregional equity of regional government spending. 44. LGFGR 1 had five core output areas, namely: (i) coordination and planning; (ii) regional administration; (iii) intergovernmental finance; (iv) planning, budgeting, and PFM; and (v) FMIS development and project loan planning. LGFGR 2 closely follows these core output areas, although minor reclassification has increased their number to six. Output areas 1 (coordination and planning) and 2 (regional administration) are the same in both programs. But while intergovernmental financing, regional government revenue policy, and debt management were all contained in output area 3 in LGFGR 1, in LGFGR 2 these are now split into areas 3, 4, and 5. And planning, budgeting and financial management, and FMIS development, which were in areas 4 and 5 in LGFGR 1, are all in output area 6 in LGFGR The LGFGR 1 period covered , in a medium-term approach to program development, with further program loans expected to follow the first single-tranche release of $300 million in December The report and recommendation of the President for LGFGR 1 provided for 14 indicative actions that were likely to be pursued in a second phase. These 14 indicative actions are set out in Supplementary Appendix A, Table SAA.1. As the table shows, 13 of the 14 indicative actions have been squarely provided for in the LGFGR 2 policy matrix. The only exclusion relates to the then anticipated development of a regulatory regime for regional government bankruptcies, which was not of sufficiently high priority to the Government to be included in LGFGR 2. With 20 core triggers, the policy actions under LGFGR 2 go deeper than the levels envisaged at the time LGFGR 1 was prepared. 46. The chart in Appendix 5 and Table SAA.2 in Supplementary Appendix A map in a more detailed way the links between actions under LGFGR 1 and LGFGR 2 (subprograms 1 and 2). The mapping indicates that the reform efforts undergo no significant broadening between LGFGR 1 and LGFGR 2 (essentially the same core output groupings are addressed in both) but significantly deepen in LGFGR 2. The most important component that binds the two programs is the Government s NAPFD, which is central to the selection of well-sequenced actions under both programs. While proposed actions under subprograms 1 and 2 of LGFGR 2 heighten the LGFGR 1 reform efforts in several ways, the deepening generally comes from the following: (i) LGFGR 1 finalized higher-level laws and regulations and began work on institutional strengthening and capacity building, particularly with support from the project loan; 18 A fuller treatment of the links between LGFGR 1 and LGFGR 2 appears in Appendix 5 and Supplementary Appendix A.

31 19 (ii) (iii) LGFGR 2 (subprogram 1) is moving much closer to finalizing the regulatory regime while intensifying work on critical policy reforms and on institutional strengthening and capacity building; and LGFGR 2 (subprogram 2) will move to a near-settled regulatory regime with the implementation of identified policy reforms, while further deepening efforts to strengthen institutions and build capacity. 47. In conjunction with the LGFGR 1 program and project loans, ADB since 2003 has provided intensive interaction on decentralization issues through three loans and five TA projects that have supported capacity development, local financing, public financial management, service delivery, performance measurement, and reporting and information systems. 19 ADB has contributed significantly to the achievement of LGFGR 2 subprogram 1 core policy actions through concerted efforts with both the central Government and regional governments. This work has included strong interaction in both the policy and the investment aspects of fiscal decentralization. The SCBD project loan provides ongoing support to 40 regional governments in management capacity building. At the same time, the LGFGR 1 project loan is supporting the implementation of computerized financial management information systems and related financial management capacity building in 171 regional governments. Capacity-building initiatives were designed and the regional government tax law was finalized under TA 4282, the NAPFD was developed and the legal and institutional framework strengthened under TA 4543, and the DPOD received support in institutional strengthening and capacity building under TA At present, a regional government performance measurement system is being designed and implemented under TA 9082, while TA 7010 is supporting medium-term sector planning, NAPFD updating, road map preparation for local revenue enhancement, a study on the devolution of property tax, the drafting of a policy on the proliferation of regional governments, the clarification of expenditure assignments, and the identification of savings from inappropriate deconcentrated expenditures. 48. The LGFGR 2 program cluster has various links with the Poverty Reduction and Millennium Development Goals Acceleration Program, 20 among them, (i) reforms in the system of DAK conditional grants to improve targeting in education and health, and (ii) the development of improved regional government budgeting and more effective service delivery (including the use of MSS) in the education and health sectors. LGFGR 2 is also closely linked with the DPSP targeting broader policy reform in the core areas of (i) macroeconomic stability, (ii) investment climate, (iii) public financial management, and (iv) service delivery. 19 ADB Technical Assistance to the Republic of Indonesia for Local Government Financing Project. Manila (TA 4282-INO for, $0.6 million); ADB Report and Recommendation of the President to the Board of Directors on a Proposed Loan and Technical Assistance Grant to Indonesia for Sustainable Capacity Building for Decentralization Project. Manila (Loan 1964-INO, for $42.2 million); ADB Technical Assistance to Indonesia for Sustaining Decentralization and Local Governance Reforms. Manila (TA 4543-INO, for $0.9 million); ADB Report and Recommendation of the President to the Board of Directors on Proposed Loans and Technical Assistance Grant to Indonesia for Local Government Finance and Governance Reform Sector Development Program. Manila (Loans 2192/2193-INO, for $330 million); ADB Technical Assistance to Indonesia for Supporting an Effective Institutional Framework for Fiscal Decentralization. Manila (TA 4682-INO, for $0.5 million); ADB Grant Assistance to Indonesia for Support for the Local Government Performance Measurement System. Manila (TA 9082-INO, for $0.73 million); and ADB Preparing the Second Local Government Finance and Governance Reform Program. Manila (TA 7010-INO, for $0.7 million). 20 ADB Report and Recommendation of the President to the Board of Directors on a Proposed Program Cluster, Loan, and Technical Assistance Grant to the Republic of Indonesia for the Poverty Reduction and Millennium Development Goals Acceleration Program. Manila (Loan 2361-INO for $400 million and TA 4984-INO).

32 20 B. Outcome and Impact 49. Fiscal decentralization in Indonesia is faced with many issues and challenges, and requires a focused and comprehensive medium- to long-term program response. The LGFGR 2 program has six core output areas, as set out below. The program is expected to improve the organizational capacity of the regional governments and enable them to operate in a more transparent, effective, and efficient policy and legal environment for fiscal decentralization, financial management, and service delivery. Over the longer term, the program is expected to improve the efficiency, effectiveness, and interregional equity of regional government spending. C. Policy Framework and Actions 50. Program Cluster Modality. The program comprises two subprograms structured sequentially as follows: (i) two single-tranche operations (subprogram 1 from January 2006 to December 2008, and subprogram 2 from January 2009 to December 2011) with a well-defined medium-term framework specified at the outset, including reforms to be completed by November 2008 under subprogram 1; and (ii) triggers for subprogram 2, to ensure continuous dialogue with the Government. Subprogram 2 will be further formulated during the LGFGR program review to allow adjustments in the program based on progress made and changes in the external environment. Such formulation does not obligate ADB to additional lending for subprogram 2, which will be subject to Board approval. Specifically, the LGFGR 2 program provides for reform and strengthening in the following six core output areas: (i) Decentralization framework and program management strengthened management and coordination of fiscal decentralization matters; (ii) Regional autonomy and local governance clearer arrangements for regional administration to improve services and accountability; (iii) Intergovernmental fiscal system enhanced equalization, predictability, and transparency in the release of fiscal transfers and shared revenues; (iv) Own-resource revenues more buoyant sources of local revenues to reduce dependency on fiscal transfers; (v) Regional reserves and debts bolstering the management of regional reserves and debts; and (vi) Human and systems capacity development, public financial management and accountability. 1. Decentralization Framework and Program Management 51. Links to LGFGR 1. This output area will ensure a strong legal and management framework for coordinating and implementing LGFGR 2, and the orderly and effective continuation of the decentralization agenda over the medium to long term. In LGFGR, 1 DPOD was newly established under law 32/2004 and related presidential and MOHA regulations. The NAPFD, which was completed in 2005, was the core guide in LGFGR 2 preparation and links LGFGR 1 and LGFGR 2 Subprogram 1 Triggers. There are two triggers: (i) the completion of the updated NAPFD, with options for revisions in policy actions to provide a medium-term framework for fiscal decentralization reform; and (ii) the establishment of the new Directorate General of Fiscal Balance in MOF to lead the development of the fiscal and governance aspects

33 21 of decentralization. 21 MOF is preparing a longer-term strategy document (the draft grand strategy for fiscal decentralization) to guide medium-term actions under NAPFD and successive LGFGR programs. In the broader coordination of all aspects of decentralization, the DPOD, as the advisory body to the president, has an important role. In subprogram 1, the DPOD initiatives include a capacity development report and a draft 2-year training plan for the secretariat staff covering administrative, management, and policy coordination training. 53. LGFGR 2 Subprogram 2 Triggers and Milestones. Two triggers are proposed for subprogram 2: first, the grand strategy document will be finalized and will guide the setting of long-term directions for fiscal decentralization; and second, the leadership role of the Directorate General of Fiscal Balance will be heightened through regular consultations with all stakeholders, enhanced flows of fiscal decentralization information, and annual progress reporting. An updated version of NAPFD (up to ) will be prepared, policy options for strengthening DPOD will be further reviewed, and the DPOD secretariat staff will undergo capacity development and training. The DPOD board, technical team, and working groups will meet regularly. 2. Regional Autonomy and Local Governance 54. Links to LGFGR 1. Reforms and strengthening in administrative areas of regional autonomy will be undertaken in this output area to improve service delivery and accountability. During the LGFGR 1 period, law 32/2004 on regional administration and government regulation 65/2005 on MSS were passed, providing the broad framework for regional autonomy and local governance. 55. LGFGR 2 Subprogram 1 Triggers. The subprogram supports the Government s efforts to improve the policy and legal framework, in answer to the problem of proliferating regional governments. The improvements will be achieved through a new government regulation (78/2007) that addresses the establishment, breakup, and merger of regional governments. The trigger is passing of government regulation 6/2008, which covers the evaluation of regional government performance, in relation to the establishment and merger of governments and other matters. Preparations for a draft grand strategy paper on territorial subdivision have begun in the DPR, and are likely to lead to further policy and regulatory reform to better manage the establishment, breakup, and merger of regional governments. 56. Subprogram 1 also supports efforts to clarify the intermediate role of provinces and their governors through a government regulation in this area as part of a broader review of law 32/2004 on regional administration. The reform of decentralized civil service arrangements has another trigger: a new government regulation (41/2007) providing principles and guidelines on regional organizational structures and facilitating the reform of decentralized civil service arrangements. MOF has reviewed the possibility of delinking the basic/staffing allocation from the DAU to support more flexible regional organizational and staffing arrangements. Subprogram 1 further supports reforms to clarify expenditure assignments across levels of government, with two triggers: (i) the passage of a very detailed government regulation (38/2007) on the assignment of expenditures to different levels of government; and (ii) the start of practical work to identify inconsistencies between the new regulation and sector policies and laws, including a detailed review of inconsistencies in the ministries of environment, and 21 The Directorate General of Fiscal Balance is responsible for all policy and administrative aspects of financial arrangements between the central Government and regional governments broadly covering the following: (i) fiscal balance including transfers and revenue sharing, (ii) regional taxes and levies, (iii) loans and grants and regional capacity building, and (iv) consolidation of financial information and evaluation of financial performance.

34 22 communications and information. Draft legal amendments and policy statements are being prepared to rectify the inconsistencies. 57. LGFGR 2 Subprogram 2 Triggers and Milestones. There are two triggers: (i) the processing of applications for the establishment of new regions according to the methodology specified in the new policy and legal framework, with less emphasis on purely political considerations; and (ii) the finalization of the framework for addressing inconsistencies in laws, and the start of implementation. DPR commission members will be trained in the new legal framework. The legal and regulatory clarifications on the intermediate role of provinces and governors will also be finalized. Furthermore, the basic (staffing) allocation will be delinked from the DAU and incentives linked to transfers will be pilot-tested, to stimulate the switching of regional expenditures from administrative staffing to higher-priority outlays. Finally, the work on removing inconsistencies between sector and decentralization laws will intensify and at least 85% of the ministries will review and prepare draft amendments to sector policies, laws, and regulations that are consistent with government regulation 38/ Intergovernmental Fiscal System 58. Links to LGFGR 1. This output area supports the Government s reforms to enhance equalization, predictability, and transparency in the release of fiscal transfers and shared revenues. During the LGFGR 1 period, law 33/2004 on fiscal balance and the related government regulation 55/2005 were passed, providing the framework for fiscal transfers and shared revenues. Government regulation 56/2005, providing guidelines on regional financial management information systems, was also passed. 59. LGFGR 2 Subprogram 1. Under this subprogram, the DAU continues as the principal form of central funds transfers and is based on the gap between fiscal capacities and fiscal needs. The first of the four triggers is the review of options for possible delinking of the basic (staffing) allocation from the DAU to support more flexible regional staffing and organizational arrangements and to significantly enhance the equalization effects of the DAU. The second trigger is the removal in 2008 of the hold harmless clause, which favored better-off regions, significantly enhancing the equalization effects of the DAU. The Directorate General of Fiscal Balance in MOF has regularly reviewed the DAU formula including the following aspects: (i) disparities in tax bases, (ii) the continued inclusion of all revenue sources, and (iii) the need to improve indicators of expenditure needs. The latest formulas and weights used in computing fiscal capacities and needs are now being published as part of budget documents. 60. Over time, provisions will be made for the preparation of forward estimates of major transfers as part of a broader move by the central Government to an MTEF planning and budgeting system. MOF is preparing a preliminary design approach for such estimates. Under subprogram 1, the Government has sought to reduce central government expenditures on activities that have been legally assigned to the regional governments to make room for higher priorities. Government regulation 7/2008, which provides guidelines for managing the legitimate deconcentration expenditures of the central Government, has been passed. This, along with the new government regulation 38/2007, provides a basis for identifying and gradually removing non-legitimate central government expenditures. This forms the third trigger by which nonlegitimate central expenditures for the health, education, and infrastructure ministries have been reduced by about Rp4.2 trillion, with DAK increasing by 24% in the 2008 budget. The fourth trigger is a detailed data analysis by BAPPENAS, MOF, and MOHA in two pilot ministries (education and environment) to identify further non-legitimate expenditures for removal in the 2010 budget. Furthermore, the Government will increase funding and improve the design of

35 23 DAK to enhance the impact of these expenditures. A joint ministerial letter (MOF, MOHA, BAPPENAS) providing for strengthened DAK monitoring and evaluation arrangements has been prepared. Work has also started on a new MOF regulation or an update of MOF guidelines on the DAK. 61. Work under subprogram 1 to test performance- and sanction-based elements of central transfers has begun. A policy paper is being prepared by MOF on the possibility of increasing the use of incentives and sanctions to stimulate better results in areas such as the timely preparation of budgets and financial and performance reports, and the reduction of administrative outlays. Finally, regional governments have taken a keen interest in ensuring that releases of shared revenues are smooth and predictable. MOF has made the release system more efficient; smoother flows of funds releases are now based on government regulations 142/2006 (natural resource revenues) and 217/2007 (oil revenues in Aceh province). 62. LGFGR 2 Subprogram 2 Triggers and Milestones. The first of the three triggers will be the formulation of a legal basis for delinking wage payments from the DAU to allow flexible management of regional staffing levels without limiting access to the DAU, thus significantly improving the equalization effects. The DAU formula will be further refined. The Directorate General of Fiscal Balance in MOF will regularly review and refine the formula (see para. 59). The latest formulas and weights used in computing fiscal capacities and needs will be published in annual budget documents. The preparation and publication of forward estimates for all major transfers and shared revenues will be the second trigger. The final trigger will be the identification and realization of significant further savings of up to 50% in non-legitimate central ministry expenditures in two pilot ministries. The implementation of the new DAK guidelines will considerably improve the targeting and impact of DAK expenditures. Finally, the new packages of incentives and sanctions for central transfers will be pilot-tested. Full implementation of all these intergovernmental financing reforms during subprogram 2 will be highly significant achievements. 4. Own-Source Revenues 63. Links to LGFGR 1. The activities in this output area will be aimed at reducing dependency on fiscal transfers by developing more buoyant sources of local revenues. In LGFGR 1, draft amendments to law 34/2000 (regional tax law) were prepared. Inconsistent regional government tax laws were also revoked by the central Government. 64. LGFGR 2 Subprogram 1 Triggers. The subprogram has two triggers. The first trigger, in support of the Government s efforts to amend law 34/2000 on regional taxes and levies, will involve a shift to a closed-list approach to regional taxes, to reduce the number of nuisance taxes and at the same time provide more autonomy to the regions in imposing taxes according to the closed list. In a breakthrough move, the DPR is considering devolving further taxing powers, including the property tax and stamp duty type taxes on the sale of land and property. The DPR is expected to pass the amendments to law 34/2000 in Moreover, MOF is designing and implementing a computerized system for the submission and processing of regional tax laws that will markedly reduce processing time and enable the Government to weed out inappropriate and illegal regional taxes. MOF is also preparing a road map for tax policy reform, which will become part of the draft grand strategy for fiscal decentralization. The second trigger is the preparatory work to develop options for gradually devolving the property tax to the regions, with a study being undertaken to develop proposals and draft legal amendments to provide for the gradual decentralization of the property tax.

36 LGFGR 2 Subprogram 2 Triggers and Milestones. The amendments to law 34/2000 will be disseminated and the tax regime will be further reviewed. The automated system for vetting regional taxes will be fully implemented in MOF. The decentralized tax reform road map will be closely aligned with the medium-term NAPFD and the longer-term grand strategy, and will be complemented by an annual report from the Regional Revenue Directorate of MOF, charting progress in the implementation of the road map. The single and very critical trigger under subprogram 2 will be the implementation of an agreed approach to devolving the property tax, including the review of valued assessments. 5. Regional Reserves and Debts 66. Links to LGFGR 1. This output area is aimed at strengthening the management of regional reserves and debts. In LGFGR 1, the legal framework for debt management was significantly enhanced, with the passage of government regulation 54/2005 on regional government borrowing, government regulation 14/2004 on the workout of regional government debts, and MOF decree 129/2005 on the workout of regional government debts. Debt and arrears workouts were also initiated in seven PDAMs. 67. LGFGR 2 Subprogram 1. Under this subprogram, the emergence of significant financial reserves in a large number of regional governments has become an important fiscal policy issue, and MOF has developed systems for monitoring cash holdings in the banking system in response. MOF is also developing concepts for longer-term trust fund arrangements, especially in wealthier regions. MOF decree 45/2006, which sets out guidelines for the submission and publication of regional government debt data for better management of regional debt, has been passed. The director general of treasury of MOF has also implemented a computerized debt management and financial accounting system (DMFAS). 68. The difficult financial circumstances of many PDAMs have severely hampered their ability to provide adequate water and sanitation infrastructure. Treasury regulation 53/2006 set out guidelines for rescheduling PDAM debts. Under subprogram 1, significant progress has been made to restructure nonperforming PDAM debts with the passage of a new MOF decree 120/2008, which further streamlines application procedures with more generous debt rescheduling and relief arrangements to speed up debt restructuring. The three triggers in this component are: (i) MOF s entry into discussions and dissemination with all 175 regional governments and PDAMs with arrears, to facilitate the participation of the PDAMs in the new restructuring scheme; (ii) the preparation of a draft MOF decree on technical approaches to use part of the revenue-sharing transfers (Dana Bagi Hasil, or DBH) and DAU transfers to the regional governments to meet outstanding debt service payments to the central Government; and (iii) ongoing support for the development of a regional bond market in creditworthy governments in selected pilot locations. MOF has issued a decree (147/2006) specifying the authorities and guidelines for issuing regional government bonds; with dissemination of guidelines and training of concerned officials. 69. LGFGR 2 Subprogram 2 Triggers and Milestones. The three triggers will be: (i) the full operationalization of DMFAS and the improvement of information flows, which will help strengthen debt management and policy and thus reduce the arrears that curb regional investment borrowing; (ii) the restructuring of at least 85% of nonperforming PDAM debts and their prompt payment; and (iii) central government support for the development of regional bond issues in at least five creditworthy regional governments (including training, due-diligence studies, document preparation, private credit ratings, and a strengthened regulatory regime for dealing with defaults and bankruptcies). Other actions include the pilot implementation of a trust

37 25 fund mechanism in at least two provinces and four local governments, and the implementation of the new intercept arrangements for fund transfers. 6. Capacity Development, Public Financial Management, and Accountability 70. Links to LGFGR 1. This component is aimed at developing human and systems capacity and strengthening public financial management and accountability. During the LGFGR 1 period, an extensive higher-level legal framework was put in place to underpin reforms in PFM and accountability. Important laws and regulations passed included the following: (i) laws on development planning (25/2004) and on the state treasury (1/2004); (ii) government regulations on work plans (20/2004), on budgeting (21/2004), on government accounting standards (24/2005), and on regional financial management (58/2005); and (iii) a presidential decree on government accounting standards (2/2005). An action plan for the implementation of the new legal framework was prepared. Action plans were also drawn up for (i) the computerization of data transmission for the regional financial information system (Sistem Informasi Keuangan Daerah, or SIKD), and (ii) the development of financial management information systems (FMIS) for the regional governments. The Government also selected and reached agreement with 171 provinces and districts for their participation in SIKD and FMIS development. 71. LGFGR 2 Subprogram 1. The Government recognizes that developing capacity in the regional governments is perhaps the most important issue to be addressed under LGFGR 2 and that success will involve considerable resources and effort. As the new legal and regulatory regime has come more fully into place under subprogram 1, the central Government has redoubled its efforts to provide improved funding and coordination, and development partners have intensified the development and rollout of resources in support of human and systems capacity building in the regions. Improved coordination in capacity building is being addressed in part through MOHA with the preparation of a proposed presidential regulation on capacity building, which was drafted under subprogram 1. Elevating capacity building to the presidential level makes it more likely that capacity building will be better coordinated and backed with adequate resources. 72. Subprogram 1 has five triggers for this component: (i) MOHA regulations 13/2006 and 59/2007, and related Bappenas and MOF regulations issued which guide systems and approaches to PFM in the regional governments; (ii) MOHA trained 100 central government and 400 regional government officials, while MOF trained 1,528 regional government officials in PFM; (iii) MOF designed a certification system for new functional positions in government finance, including those based in the regions (such as the regional treasury offices throughout the country), in the form of a detailed draft regulation to be submitted to the Civil Service Commission (MENPAN); (iv) design and development of computerized FMIS to support implementation of new SIKD information collection and transmission system in 171 locations for improving financial reporting to the central Government; and (v) government regulation 6/2008 has been passed to provide a comprehensive approach to evaluating the performance of regional governments. The new computer-based FMIS and SIKD being rolled out in 2008 and 2009 will be used to train about 9,642 key users of the new systems and middle and upper-level managers. 73. In subprogram 1, the need to improve coordination in collecting and analyzing regional financial data to reduce bureaucratic overlaps is recognized. Improved coordination (especially between MOF, MOHA, and BPS) is achieved through more effective reporting and improved higher-level monitoring of reported outcomes. Computerized software is being designed to provide and transmit SIKD data to MOF and MOHA in formats that are consistent with

38 26 government regulations 56/2005 (regional financial reporting), and 13/2006 and 59/2007 (regional financial management). The closely related need for better coordinated approaches to the collection and analysis of (nonfinancial) performance information by various agencies, including directorates general and directorates of MOHA, MOF, BAPPENAS, BPS, and line ministries, is also recognized. Arrangements for improved coordination are being developed through MOHA. Continued efforts are under way under subprogram 1 to compare and publish benchmarked performance information between regions. A MOHA decree is also being prepared to provide more detailed technical guidelines, including standard performance indicators for service delivery monitoring. Work is under way to prepare a regional government performance measurement system (RGPMS). 74. LGFGR 2 Subprogram 2 Triggers and Milestones. There will be three triggers for subprogram 2. First, the implementation of the presidential regulation on capacity building will begin, while implementation of other capacity development efforts including the following, will intensify: (i) significant additional government funding for PFM training and capacity building through MOHA and MOF (at least 25% growth yearly over the 2008 level); (ii) full implementation of the regional training plan for subprogram 2; (iii) implementation of computerized FMIS and SIKD data transmission systems, along with training and support, and their full operationalization in 171 regional governments with free software that will significantly reduce the time needed to prepare central consolidated regional government financial information (from 3 years to 1 year); and (iv) finalization of regulations and certification of new functional positions for key finance officials. Second, the improved coordination developed under subprogram 1 will be implemented under subprogram 2 with enhanced use of electronic transmission and improved access to more timely information on regional budget and financial performance, including Web-based information. Finally, the RGPMS will be functioning in at least 40 pilot locations in subprogram 2, with a central database allowing for transparent comparisons across regional governments. D. Important Features 75. LGFGR 2 has several distinctive features. First, it helps strengthen ADB s partnership with the Government. By basing financial assistance on completed actions derived from the Government s own reform program, LGFGR 2 strengthens government ownership of reform strategies, with support from development partners operating in a coordinated manner. Second, the inclusion of policy triggers and milestones for subprogram 2 facilitates broad-based dialogue on the Government s fiscal decentralization agenda in the medium term, with reforms flowing sequentially from LGFGR 1 to the two subprograms of LGFGR 2. Third, the LGFGR program helps to establish an institutional mechanism for achieving better interagency coordination and implementation of reforms across the central Government and regional governments. Finally, the program cluster approach helps to lay out a comprehensive set of complex reforms in a well-sequenced fashion. The flexibility provided by single-tranche program cluster funding allows adjustments to be made to suit changing circumstances within the longer-term cluster concept, without losing focus on achievable outcomes up front, including high-impact outcomes to be completed before each Board consideration of financing. E. Financing Plan 76. The Government has requested a loan of $350 million equivalent from ADB s ordinary capital resources to support policy action under subprogram 1, as outlined in the development policy letter and the policy matrix. The loan will have a term of 15 years, including a grace period of 3 years, an interest rate determined according to ADB s London interbank offered rate

39 27 (LIBOR) based lending facility, and a commitment charge of 0.15% yearly. 22 The decision to borrow under this lending facility was made independently by the Government, which has given an undertaking that the choice was not based on advice from ADB. The Government also envisages the need for a loan of $350 million to finance subprogram 2; the loan amount will be confirmed at the time of loan processing in The reform agenda for subprogram 2 will be refined to reflect progress and evolving circumstances. The loan for subprogram 1 will be released in one tranche after meeting the conditions of the policy matrix. 77. The program loan reflects the Government s development financing needs in 2008 (Table 5). According to the latest budget update of the Government, the gross financing (external and domestic) requirement for 2008 is expected to lower than budgeted at Rp125.4 trillion, reflecting a lower deficit of about 1.3% of GDP. In line with the Government s debt management strategy of diversifying its liability portfolio by increasing longer-term rupiah and dollar bonds and maximizing overseas concessional development assistance financing, gross external borrowing is projected at Rp47.1 trillion. With the decline in borrowing requirements, the country s debt-to-gdp ratio is projected to decline further in The assessment of debt sustainability by ADB staff indicates that the Government s debt stock and strategy are sustainable over the medium term. The proposed subprogram loan amount of $350 million equivalent will help to close the financing gap for Table 5: Projected Financing Requirements of the Government of Indonesia for 2008 ($ million) Financing Mix Proposed Amount Gross Financing Requirements 13, Less Amortization 6, Net Financing Requirement 6, Programmed Gross External Borrowings 5, of which: ADB s proposed loan pipeline Development Policy Support Program Infrastructure Reform Support Development Program Local Government Financing and Governance Reform 2 (Subprogram 1) Other donor and commercial borrowings 4, ADB = Asian Development Bank. Note: Exchange rate: $1 = Rp9,276. Sources: Ministry of Finance and ADB estimates. F. Implementation Arrangements 1. Program Management 78. The MOF Directorate General of Fiscal Balance will be the Executing Agency (EA) and will be responsible for the overall implementation of subprograms 1 and 2 of LGFGR 2 including compliance with all policy actions, program administration, disbursements, and maintenance of all program records. MOF has established a steering committee chaired by the MOF director general of fiscal balance with the following as members: the MOF directors general for treasury, budget, and debt management; the MOHA directors general for regional financial management, regional autonomy, and government affairs; and the BAPPENAS deputies for regional development and local autonomy and for development funding. Selected representatives from the provincial and local governments will be invited to participate in meetings of the steering 22 ADB s Board of Directors has discounted the commitment charge to 0.15%, and waived the front-end fee of 1.00% for loans approved from 1 July 2007 through 30 June 2009.

40 28 committee, which will coordinate the implementation of LGFGR 2 policy actions with relevant agencies supporting the program. The committee meets at least semi annually to monitor the progress and oversee the implementation of the program. ADB may be invited to participate in the meetings as an observer. Below the steering committee is an implementation committee chaired by the secretary of the Directorate General of Fiscal Balance and comprising about 30 senior members from the program implementing agencies, including all the relevant implementing directorates of MOF, MOHA, and BAPPENAS. Selected representatives from the provincial and local governments will be invited to participate in meetings of the implementation committee. 2. Implementation Period 79. The subprogram 1 implementation period is from January 2006 to December All actions included in the policy matrix under subprogram 1 have been implemented. By June 2009, the Government and ADB will have prepared a subprogram 1 program completion report, which, subject to the approval of subprogram 2, will be used as part of the overall program completion report. 3. Procurement and Disbursement Arrangements 80. The subprogram 1 loan of $350 million will be released in a single tranche when it takes effect (i.e., all actions in boldface type in the subprogram 1 policy matrix in Appendix 3 must have been satisfactorily complied with before the release of the tranche). The loan proceeds will be used to finance the full foreign exchange cost (excluding local duties and taxes) of items produced in and procured from ADB member countries, excluding ineligible items and imports financed from other bilateral and multilateral sources. As provided in ADB s simplified disbursement procedures and requirements for program loans, 23 the proceeds of the program loan will be disbursed to the Republic of Indonesia as the Borrower. Under this program the Government will certify that the value of total imports minus (i) imports from nonmember countries, (ii) ineligible imports, and (iii) disbursements made under other official development assistance, is greater than the amount expected to be disbursed during the year. ADB reserves the right to audit the use of the loan proceeds and to verify the accuracy of the Government s certification. Disbursements will be made according to the simplified procedures for program loans. As provided in ADB s simplified disbursement procedures and related requirements for program loans, all goods and services procured must be produced in ADB member countries and originate in such countries, with due consideration to economy and efficiency, in accordance with the Government s standard public procedures and normal private sector commercial practices acceptable to ADB. Goods commonly traded on the international commodity market will be procured according to procedures appropriate to the trade and acceptable to ADB. Subprogram 1 will provide for retroactive financing for expenditures incurred by the Government 180 days before the loan takes effect. The Borrower has been informed that the approval in principle of the retroactive financing does not commit ADB to finance this program. 4. Anticorruption and Fiduciary Issues 81. ADB s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the Government. Consistent with its commitment to good governance, accountability, and transparency, ADB reserves the right to investigate, directly or through its agents, any alleged 23 ADB Simplification of Disbursement Procedures and Related Requirements for Program Loans. Manila.

41 29 corrupt, fraudulent, collusive, or coercive practices relating to the Program. To support these efforts, relevant provisions of ADB s Anticorruption Policy are included in the loan regulations and the bidding documents for the Program. In particular, all contracts financed by ADB in connection with the Program shall include provisions specifying the right of ADB to audit and examine the records and accounts of the EA and all contractors, suppliers, consultants, and other service providers as they relate to the Program. 82. For the purpose of this program, an assessment of Indonesia s financial management systems has been carried out to determine appropriate fiduciary arrangements. The diagnostic assessments were based on the World Bank s Indonesia Public Expenditure Review Discussions with the Government during the formulation of subprogram 1 have taken into consideration the ongoing reforms identified in these diagnostic studies. The assessment indicates that the fiduciary arrangements for the program are satisfactory. 83. Indonesia has a strong record of aggregate fiscal discipline, as reflected in low budget deficits and a relative low level of public debt. The country has made progress in reforming its public finances and a sound regulatory framework for financial management is now in place. The passage of the State Finance Law, the Treasury Law, the Audit Law, and the National Development Planning Law were significant steps that brought Indonesia closer to conformity with international practice. The laws are now being implemented, most notably to make the national budget compatible with the international standard government financial statistics classification, establish a single treasury account to strengthen cash management, and unify the previously separate recurrent and development budgets. Indonesia has a well-defined budget process with both the executive and the legislative branches adhering to defined schedules, and high transparency of the budget. But more attention needs to be paid to improving the strategic allocation of resources through performance-based budgeting. Weaknesses also remain in various dimensions of budget execution including financial reporting and internal controls on budget execution by spending agencies. Public investment budgets are disbursed slowly and a disproportionately large share of funds is spent near the end of the fiscal year. 84. The legal and regulatory framework for public procurement has improved and the Government Procurement Policy Office under the president is preparing standard procurement procedures for the country, including standardized bidding documents. However, the capacity to implement procurement has not kept pace. Pilot e-procurement initiatives and the introduction of training and certification of procurement practitioners are thus important undertakings. ADB is also providing a TA to support e-procurement. The State Audit Law has strengthened the role of BPK, which now has sole charge of the external audit of all government organizations, while the State Development Audit Agency (Badan Pengawasan Keuangan dan Pembangunan, or BPKP), together with the inspector general of each ministry, coordinates the internal audit and special investigations of the central Government, and the Regional Monitoring Board (Badan Pengawasan Daerah, or BAWASDA) offices manage the internal audits in the regional governments. 5. Accounting, Auditing, and Reporting 85. ADB retains the right to audit the use of the loan proceeds and to verify the accuracy of the Government s certification of withdrawal applications. Before withdrawal, the Government 24 World Bank Indonesia Public Expenditure Review: Spending for Development. Making the Most of Indonesia s New Opportunities. Jakarta.

42 30 will open a deposit account with Bank Indonesia, the central bank, to receive the loan proceeds. The account will be managed, operated, and liquidated according to terms satisfactory to ADB. 6. Performance Monitoring, Evaluation, and Program Review 86. In coordination with the committee, ADB will periodically review the progress of implementation and assess the impact of subprogram 1. The Government will keep ADB informed of the outcome of policy discussions with other multilateral and bilateral agencies that have implications for LGFGR 2 implementation, and will provide ADB with the opportunity to comment on any resulting policy proposals. ADB, in collaboration with the committee, will review the performance of the program 12 months after the loan takes effect to review the outcome of subprogram 1 and prepare for subprogram 2. V. TECHNICAL ASSISTANCE 87. In connection with subprogram 2, the Government has asked ADB for a $1.5 million policy and advisory TA to be attached to this program. The assistance will support the ongoing development of the reform agenda in regional government financing and governance (as contained in the NAPFD and the policy matrix for subprogram 2) and its implementation, and provide the Government with timely policy advice as needed. It is expected that, in the medium term, another TA amounting to $1 million will be needed to support the reform agenda (see para. 88). The attached TA will focus on the Directorate General of Fiscal Balance of MOF and, subject to further discussions, will have the following components: (i) revision of the NAPFD to cover the period up to , (ii) assistance in building a database and financial modeling capacity in the directorate general to support the ongoing review of intergovernmental financing systems, (iii) design and implementation of a system of forward estimates for intergovernmental transfers and shared revenues, (iv) development and dissemination of new DAK regulations and guidelines, (v) development and implementation of a targeted package of incentives and sanctions for selected intergovernmental transfers, (vi) support in implementing the early stages of devolution of the property tax, and (vii) human and systems capacity building in decentralized locations. All components and cost estimates are described in Appendix The second TA of $1 million intended to achieve subprogram 2 policy actions is expected to be processed separately in Subject to more detailed consultations with the Government, the TA is likely to deal with (i) further policy options regarding the future status of DPOD; (ii) more efficient use of regional government labor resources with the help of a wage bill formula and regional government discretion in the use of the funds; (iii) amendment of sector laws and regulations to make them consistent with the new expenditure assignments and other decentralization laws; (iv) support for a creditworthy regional government in developing regional bond issues, including training, due-diligence studies, and document preparation; (v) pilot-testing and rollout of the regional government performance measurement system, and training in its use; (vi) restructuring of regional government budgets and the closure or privatization of low-priority and nonperforming activities or assets, including regional enterprises; and (vii) inventory of FMISs in 171 regional governments to review options for further expansion. Supplementary Appendix C describes all the proposed TA activities to support LGFGR 2.

43 31 VI. PROGRAM BENEFITS, IMPACT, AND RISKS A. Expected Impact 89. Over the medium term, LGFGR 2 provides for policy, administrative, and legal changes and capacity-building initiatives. The expected impact is more transparent, efficient, equitable, and effective management and use of public resources for regional development. The institutional, financial, economic, and social benefits taken together should improve service delivery, boost growth and employment, and reduce poverty in the regions. The most important expected benefits are as follows. 90. Institutional Benefits. The medium-term NAPFD will continue to be the framework for reform. LGFGR 2 will provide increasing technical support to the new Directorate General of Fiscal Balance in MOF as the lead national agency for fiscal decentralization. Longer-term capacity-building support for the president s decentralization adviser, DPOD, will help improve the coordination of broader aspects of decentralization. Increased flexibility in the setting of organizational structures and staffing in the regional governments will facilitate restructuring away from high administrative expenditures. Ongoing long-term capacity building (of institutions, systems, human resources) in the regional governments will also be significantly supported, particularly in planning, budgeting, financial management and reporting, and internal and external audit. 91. Financial and Economic Benefits. Most benefits will come from improved financial and economic management at all government levels. The benefits will be as follows: (i) (ii) (iii) (iv) (v) (vi) (vii) clearer assignment of expenditures between levels of government, and thus more efficient allocation of expenditures and better vertical balance in financing between levels of government; improved criteria for establishing new regional governments, leading to greater efficiency through more appropriately established and sized regional governments; improved technical and policy environment for intergovernmental fiscal transfers and revenue sharing, leading to more transparent and equitable outcomes across regions (better horizontal balance); improved policies conducive to the development of more buoyant own-source revenues for regional governments, including a medium-term road map for tax reform and detailed options for decentralizing property taxes; strengthened management of regional reserves with the help of improved information sources and policies; enhanced policies and approaches (including restructuring and intercepting DAU payments) for dealing with the long-standing debt arrears of regional governments and many of their utility companies; and strengthened governance through coordinated performance monitoring and evaluation to improve accountability. 92. Social Benefits. While most of the benefits will be financial and economic, many important longer-term benefits sought are social in nature, particularly the improved delivery of the many important public services that are now decentralized (including education, health, and physical infrastructure). The benefits will take the form of (i) better defined service delivery needs and performance in key sectors, and (ii) systems for performance evaluation monitoring

44 32 and benchmarking of regional government outcomes especially for meeting the needs of the poor. Appendix 6 discusses the poverty reduction impact of the program in greater detail. B. Risks and Mitigating Measures 93. While some risks are external and political, the program design and TA will mitigate these and other risks by providing a strong broad-based governance framework, with transparency and accountability elements in both the central and regional governments. The potential risks to LGFGR 2 and the corresponding mitigating measures are as follows: (i) (ii) (iii) (iv) (v) (vi) Regional government leadership and capacity. The regional governments may not have the necessary leadership, commitment, and capacity to innovate and learn and to translate financial resource and management systems improvements into better services and reduced poverty. This risk will be mitigated by improvements in (a) bottom-up accountability with better PFM and greater transparency in reporting, (b) vertical organizational structures and hierarchical responsibilities, (c) accountability of regional governments to oversight and coordination agencies, (d) accountability through the electoral process, and (e) the regional civil service. Political change. National and regional government elections are due from The new national or regional governments may not endorse the policy framework in the NAPFD and LGFGR 2. But the political and bureaucratic momentum of reforms has been significant and growing with the rise of reform champions, and is unlikely to be completely reversed by a new administration. Some allowance must, however, be made for new policy approaches at the margins. National coordination. Problems in coordination between key national agencies could still delay program implementation despite the improvements made so far. This risk has been mitigated by the emergence of the new Directorate General of Fiscal Balance as the leader in fiscal aspects of decentralization and the longerterm capacity-building efforts of the directorate general and DPOD. Moreover, all key stakeholders will take part in revising the NAPFD in 2009, enhancing national approaches. Adequate representation of regional governments in coordination bodies will ensure strong ownership. Flexibility of regional organizational structures. Organizations and their staff may resist more flexible organizational arrangements and staffing. This resistance is likely to be offset by orderly and socially acceptable rightsizing, combined with growing community support for spending less resources on unproductive administration and more on productive activities. Horizontal equity between regions. Political and other pressures could delay the more equitable distribution of transfers and shared revenues, and benefit of relatively better-off natural resource endowed regions. But equalization has gained important momentum with the removal of the hold harmless provisions of the DAU in 2008, and improved analysis and transparency in intergovernmental financial flows will increase accountability and create a larger constituency in favor of further equalization. Revenue collection in the regions. Political and bureaucratic opposition in the central Government could stall the further devolution of taxing powers. In a breakthrough move, the DPR is considering devolving property tax in a proposed amendment to the tax law. In addition, a gradual medium-term approach to

45 33 (vii) revenue reforms, based on a medium-term plan and well-researched and argued cases, is being taken and will be supported by LGFGR 2 and other programs. Fuel prices and resource constraints. Any increase in fuel subsidies may require the reallocation of resources from administrative expenditure, including reform programs, and leave the Government with insufficient resources for capacity development. The Government has therefore indicated that it will reduce the fuel subsidy over the medium term. In addition, LGFGR 2 provides significant TA resources to support capacity building over the medium term through Support from other development partners will also be used. 94. Conditions for Loan Effectiveness. The loan will take effect after all the tranche conditions specified in the policy matrix (Appendix 3) are met. VII. ASSURANCES 95. In addition to the standard assurances, the Government has given the following assurances, which are incorporated in the legal documents: (i) (ii) Counterpart funds will be used to finance the structural adjustment costs and local currency costs relating to the implementation of the Program and other activities consistent with the objectives of the Program, as more fully described in the development policy letter (Appendix 2). The policies and actions taken prior to the date of the subprogram 1 loan agreement, as described in the development policy letter (including the policy matrix), will continue to be in effect for the duration of the subprogram 1 and subsequently. VIII. RECOMMENDATION 96. I am satisfied that the proposed program cluster and loan would comply with the Articles of Agreement of the Asian Development Bank and recommend that the Board approve: (i) (ii) the program cluster to the Republic of Indonesia for the Second Local Government Finance and Governance Reform Program; and the loan of $350,000,000 equivalent to the Republic of Indonesia for subprogram 1 of the Second Local Government Finance and Governance Reform Program, from ADB s ordinary capital resources, with interest to be determined in accordance with ADB s London interbank offered rate (LIBOR) based lending facility; a term of 15 years, including a grace period of 3 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Program Loan Agreement presented to the Board. Haruhiko Kuroda President 24 October 2008

46 34 Appendix 1 DESIGN AND MONITORING FRAMEWORK Design Summary Impact More efficient, effective, and equitable regional government spending Performance Targets/ Indicators Over 60% citizen satisfaction with health and education services by 2011 (versus 58.1% satisfaction rating for health and 50.3% for education in 2007) Data Sources/Reporting Mechanisms GDS Assumptions and Risks Risk Insufficient leadership and ownership in regional governments to translate institutional capacity improvements into better services and reduced poverty Outcome Improved organizational capacity of regional governments, which operate in a more transparent, effective, and efficient policy and legal environment for fiscal decentralization, financial management, and service delivery Less than 15% poor in the total population by 2011 (from 16.6% in 2007) 1 million more households gain access to piped water connection yearly, from a baseline of 9,449,505 in 2005 Increase in total DAK to 0.8% of GDP by 2011 from a baseline of 0.46% in 2008, at the expense of incorrect deconcentrated funds Decrease in regional government reserves in local bank accounts to 2.5% of GDP or less by December 2010 from a baseline of 3.1% in November 2006 BPS BPS BPS, SIKD, MOF MOF/BI monitoring system Assumptions Stronger bottom-up accountability with improved PFM and reporting transparency Stronger vertical organization structures and hierarchical responsibilities Stronger accountability of regional governments to oversight and coordination agencies Increased accountability through the electoral process Regional civil service reforms initiated under the program Risk Diminished support for reforms from new governments Assumption Growing political and bureaucratic momentum of reforms with emergence of reform champions; polices are therefore not expected to be completely reversed, but flexibility for changes must be maintained at the margins Gradual increase in shares of regional government sector spending for health (7% of total regional budget in 2004), agriculture (4%), infrastructure (17%), and environment and special planning (1%), at the expense of government administration spending (32%) SIKD, MOF

47 Appendix 1 35 Design Summary Outputs 1. Improved management and coordination of fiscal decentralization by central Government 2. Better defined functional and organizational arrangements for regional governments Performance Targets/ Indicators Issuance of NAPFD in 2009 Regular meetings of DPOD board and technical team (at least three times a year in 2008 and four times a year from 2009 onward) Approval of applications for new regions according to criteria set in grand strategy for all applications processed from January 2010 onward More flexible arrangements for regional government staffing and organizational structures Data Sources/Reporting Mechanisms Copy of NAPFD Minutes of meeting and NAPFD implementation report MOHA reporting/ independent process review Independent review of regulations and regional operating practices Assumptions and Risks Risk Persistent problems of coordination between key national agencies despite improvements, delaying program implementation Assumptions Leadership provided by new DG Fiscal Balance in MOF Additional capacity-building support for DPOD NAPFD revision with participation of all key stakeholders Risk Organized staff resistance to more flexible staffing and organizational arrangements Assumption Orderly and socially acceptable approaches to rightsizing 3. Greater equity, predictability, and transparency in the release of fiscal transfers and shared revenues 4. Improved access of regional governments to own-source revenues Review of basic allocation and links to regional wages conducted by 2009 Latest formulas and weights used in determining fiscal capacity and needs published in budget documents from 2009 onward Forward estimates prepared for all major transfers and shared revenues from 2010 onward 50% reduction in inappropriate deconcentration expenditure in 2 pilot ministries by 2011 Devolution of property tax and 2% yearly increase in collections from 2010 onward Review report Budget documents provided by MOF MOF MOF or sector ministry data MOF data Risk More equitable distribution of transfers and shared revenues delayed by political and other pressures, to the benefit of better-off regions Assumption Important equalization momentum from removal of hold harmless provision of DAU; likely to continue as analysis and transparency improves Risk Further devolution of taxing powers stalled by political and bureaucratic opposition in central Government Assumption Devolution of property tax in an amendment to law being considered by DPR Gradual medium-term approach to devolution approved and implemented 5. Strengthened management of regional reserves 85% of PDAM debts restructured and paid on time in relation to newly MOF data

48 36 Appendix 1 Design Summary and debts Performance Targets/ Indicators agreed arrangements by 2011 Data Sources/Reporting Mechanisms Assumptions and Risks 6. Improved capacity development, public financial management, and accountability RGPMS performance data generated in 40 pilot districts by % yearly growth in allocations in MOF and MOHA annual budget for human resources and systems development in regional governments from 2010 onward MOHA data MOF, MOHA and central government budget data Full implementation of regional government PFM capacity-building plan for LGFGR subprogram 2 by 2011 MOHA monitoring and evaluation data Reduction in number of regional government financial reports required by central government agencies MOF data Activities with Milestones 1.1 Ensure continued implementation of medium- and long-term decentralization agenda. 1.2 Streamline and strengthen coordination functions of relevant central government agencies. 2.1 Improve policy and legal framework to rationalize number of regional governments. 2.2 Clarify the intermediate roles of provinces and governors. 2.3 Reform decentralized civil service arrangements to enhance flexibility. 2.4 Clarify expenditure assignments and service responsibilities across levels of government. 3.1 Improve equalization and transparency of DAU. 3.2 Make provision for forward estimates of major transfers. 3.3 Gradually reduce levels of central government funding in relation to activities that are legally regional government responsibilities. 3.4 Improve design and management of DAK funding. 3.5 Test performance- and sanction-based elements for transfers. 3.6 Ensure smooth cash releases of shared revenue transfers. Inputs ADB $350 million equivalent for subprogram 1 $1.5 million attached to the program to support implementation of reform measures in subprogram 2 $1 million expected to be provided to support medium-term implementation of the reform measures in subprogram 2 ADB $350 million equivalent for subprogram Amend law 34/2000 on regional taxes and charges. 4.2 Implement computerized system in MOF for receiving and processing regional tax laws. 4.3 Develop a medium-term road map for decentralized tax reform. 4.4 Gradually devolve the property tax to the regions. 5.1 Improve monitoring and analysis of reserves accumulation in all locations and develop policy responses. 5.2 Develop improved data systems for monitoring subnational debts. 5.3 Pursue effective restructuring of PDAM debts.

49 Appendix 1 37 Activities with Milestones 5.4 Finalize and implement MOF decree providing for use of DBH/DAU intercept mechanisms to repay debts. 5.5 Support development of subnational bond market in selected pilot locations. 6.1 Continue efforts to compare and publish benchmarked performance in service delivery (and other areas) between regions. 6.2 Improve funding and coordination of central and donor efforts to develop and roll out resources to support human and systems capacity building in the regions. 6.3 Develop a plan to support implementation of the newly reformed PFM regulatory regime. 6.4 Improve coordination in collection and analysis of regional financial data. 6.5 Develop coordinated approach to performance monitoring and evaluation. APBD = state budget, BPS = Central Bureau of Statistics, DAK = special allocation fund, DAU = general allocation fund, DBH = revenue sharing, DG = directorate general, DMFAS = debt management and financial accounting system, DP = development partner, DPOD = Regional Autonomy Advisory Council, GDP = gross domestic product, GDS 3 = Third Governance and Decentralization Survey, LGFGR 2 = Second Local Government Finance and Governance Reform Program, MOF = Ministry of Finance, MOHA = Ministry of Home Affairs, NAPFD = National Action Plan for Fiscal Decentralization, PDAM = local water supply utility, PFM = public financial management, RGPMS = regional government performance measurement system, SIKD = regional financial information system.

50 38 Appendix 2

51 Appendix 2 39

52 40 Appendix 2