CHAPTER II LITERATURE REVIEW

CHAPTER II LITERATURE REVIEW 1.1. Decentralization Theory and Central and Regional Finance 1.1.1. Definition and Concept of Decentralization Before decentralization, during the colonialism the system of government was held by the volksraad. in this institution various policies for the public and local kingdoms in Indonesia are determined by the central government. This centralized Dutch colonial era was intended as a concentration of power by the VOC over Indonesia. Centralization in the old order era was caused by Indonesia being just independent, so there was still little human resource capacity to carry out the life of the state. uneven education has caused management of production land to be held by several people from the center. in addition, centralization was carried out to reduce rebellion in the region due to the extent of Indonesia. Decentralization in Indonesia basically has been implemented since 1974 under Law No.5/1974 under the Soeharto regime but still maintained the control of central government. based on concentration assumptions for the implementation of economic development, the development of Indonesian political stability and development together. but the fact is that inequality of development is uneven, the rights of minority rights are ignored, power is built with patterns of political recruitment, recruitment of office positions based on the closest people (Mara, 2016). After the 1997 economic crises, the central government decreed a new decentralization scheme through Law No.22/1999. The 6

7 new law focuses on the regional government through improving administration and political decentralization particularly at the regency and municipal level, and Law No.25/1999 focuses on fiscal balance between the central government and the regional government. The implementation of this fiscal decentralization began on January 1, 2001. These two laws gave rise to several issues which were then fixed by the government through the passing of Law No. 32/2004 and Law No. 33/2004 about the financial balance of central and local government, and then again by Law No. 23/2014 about regional government. In Law No. 23/2014, decentralization is the delivery of government affairs by the central government to autonomous regions based on the autonomy principles. The principle of autonomy is the basic principle of the implementation of regional government based on regional autonomy. Decentralization is a tool to achieve one of the goals of the state, especially in order to provide better public services and create a more democratic public decision-making process. Decentralization can be realized with the transfer of authority to the lower levels of government for spending, the authority to collect taxes, the formation of the Council elected by the people, the appointment of regional heads elected by the people, and the assistance in the form of transfer from the central government. Decentralization is not easy to define, because it involves diverse forms and dimensions, especially with regard to fiscal, political, administrative, government systems and social and economic development.

8 In general, the benefits and the weakness of fiscal decentralization can be specified as follows: 1 1. The benefits of fiscal decentralization An economic efficiency - the budget for public services could be more easily adapted to local preferences with thelevel of accountability and a high willingness to pay. Opportunities to increase tax revenue from local taxes - the local government can levy taxes based on consumption and assets that cannot be withdrawn by the Central Government. 2. The weakness of fiscal decentralization Low central government control to the macro economy; The difficulty of implementing policies of economic stabilization; The difficulty of implementing policies of econom1c development with equity; A number of costs to local government rather than a benefit. In general, decentralization includes political decentralization; administrative decentralization; fiscal decentralization; and economic or market decentralization. 2 1 Bahl, R. (2008). The Pillars of Fiscal Decentralization. CAF Working Paper. 2 Sidik Machfud.(2002). Format Hubungan Keuangan Pemerintah Pusat dan, Daerah yang Mengacu pada Pencapaian Tujuan Nasional, Seminar Nasional : public sector score card, Jakarta.

9 (see figure 1): Central-regional financial relations arrangements are based on 4 principles (1) Affairs which are the tasks of the central government in the regions in the context of deconcentration are financed from the APBN. (2) Affairs which are the tasks of the regional government itself in the context of decentralization are financed from the APBD. (3) Affairs which are the tasks of the central government or upper level regional government, which are carried out in the framework of assistance tasks, financed by the APBN or provincial APBD. (4) As long as the potential of regional financial resources is insufficient, the government provides a number of contributions. Figure 1 Central-Regional Financial Relations Arrangements Central and regional relations Deconcentra tion Decentraliza tion coadministration APBN APBD government burden Central and Regional Financial Relations PAD (local own revenue) DBH (revenue sharing fund) DAU (general allocation Regional Loans: LN & DN Short & long term Source : Sidik, Machfud. (2002). Format Hubungan Keuangan Pemerintah Pusat dan Daerah yang Mengacu pada Pencapaian Tujuan Nasional, seminar nasional :public sector score card, Jakarta.

10 The implementation of fiscal decentralization will work well if supported by the following factors: - Central government capable of supervision and enforcement; - Strong human resources at the regional government to replace the role of the central government; - Balance and clarity in the distribution of responsibilities and authorities in conducting regional tax and regional levies. Based on Law Number 28 of 2009 concerning Regional Taxes and Regional Levies, regional taxes are divided into two types, namely provincial tax and regency / city tax. Provincial tax consists of motor vehicle tax, motorbike name transfer fee, motor vehicle fuel tax. The district / city tax consists of hotel tax, restaurant tax, entertainment tax, advertisement tax. 1.1.2. Understanding The Concept of intergovernmental transfer funds Intergovernmental transfer funds sourced from The Indonesian National budget (APBN). The Indonesian National budget is the annual financial plan of the Indonesian government approved by the House of Representatives. Intergovernmental transfer funds are revenue allocated to regions to fund the needs of the region for the implementation of decentralization. Intergovernmental transfer funds consist of: (1) Revenue sharing funds; Revenue sharing funds (DBH) are derived from certain revenues of the APBN allocated to producing regions based on certain percentage figures with the

11 aim of reducing the inequality of financial capacity between the central and regional governments. (2) General allocation funds; General allocation funds (DAU) are sourced from APBN revenues allocated for the purpose of equitable inter-regional financial capacity to fund the needs of the region in the context of the implementation of decentralization. By definition, general allocation funds can be interpreted as follows (Sidik, 2002): One of the components of the balancing fund in the APBN, whose allocation is based on the concept of fiscal gap, namely the difference between fiscal needs and fiscal capacity. Instrument to overcome horizontal imbalance, which is allocated with the aim of equal distribution of financial capabilities between regions where its use is determined entirely by the region. Equalization grant, which functions to neutralize financial capacity inequality with the existence of PAD, tax sharing and revenue sharing from the region. The DAU formula should be based on a simple formula, easily understood and calculated by the region if data is available. The calculations made must be logical and meet the rules of the theory and must be consistent for example regions with large fiscal potential but small fiscal needs will get a relatively small DAU allocation. Conversely, regions with small fiscal potential, but large fiscal needs will obtain a relatively large DAU. DAU allocations for regions are

12 calculated using formulas, fiscal gap and basic allocations. fiscal gap is a financial condition of a regional government that is related to its fiscal needs and fiscal capacity. Whereas the basic allocation is the need for regional funds to pay civil servant salaries and infrastructure. In general the basic formulations of DAU in an area are as follows 3 : DAU = AD + CF Where, DAU = General Allocation Fund, AD = Basic Allocation CF = Fiscal Gap = Fiscal Needs - Fiscal Capacity (3) Specific allocation funds. Specific allocation funds (DAK) are sourced from APBN revenues and allocated to a particular region for the purpose of assisting in financing of special activities which constitute the governmental affairs which are under the jurisdiction of the region. Development funded by DAK are directed at various activities that are in the form of public infrastructure provision, including infrastructure in the fields of education, health, agriculture, road, bridges and irrigation as well as procurement of other public infrastructure. Calculation of DAK allocations is based on several criteria : General criteria, based on regional financial capacity 3 Brojonegoro B, Pakpahan A T. (2002), Evaluasi atas Alokasi DAU 2001 dan Permasalahannya; Dana Alokasi Umum, Konsep, Hambatan, dan Prospek di Era Otonomi Daerah, LPEM-UI, Jakarta.

13 Specific criteria, formulated based on legislation governing the implementation of special autonomy, and regional characteristics Technical criteria, prepared based on specific activity indicators that will be funded from DAK. Arrangements regarding technical criteria are prepared by the relevant technical minister for example the education sector was formulated by the education minister or health sector was formulated by minister of health. 1.2. Economic Growth and Income Disparity Among Regions 1.2.1. Economic Growth Economic growth is defined as the expansion of the capacity to produce goods and services of an economy or the expansion of the possibility of producing of an economy. The success of regional economic growth, in order to improve the welfare of the population, can be assessed by the growth rate of gross domestic product (GDP). The GDP is the output generated from inputs that are calculated in prices in a base year or also known as the GDP at constant prices. The term growth can be interpreted differently by one person to another, one area with another, one country with another country. It is important for us to be able to have the same definition in terms of growth. Traditionally growth has been a continuous increase in the gross domestic product or a country's gross domestic product. For regions, traditional growth meanings are focused on increasing gross domestic product of a province, district or city.

14 The definition of economic growth according to several prominent economists are as follows: (1) According to the views of the classical economists (Adam Smith, David Ricardo, Thomas Robert Malthus and John Stuart Mill), as well as the neoclassical economists (Robert Solow and Trevor Swan), there are basically four factors affecting economic growth: (1) total population, (2) total stock of capital goods, (3) land area and natural wealth, and (4) level of technology used. An economy is said to experience growth if the level of economic activity is higher than what was achieved in the past. 4 (2) According to Kuznets, economic growth is the increase in long-term capacity of the countries concerned to provide various items to the citizen. The increase in capacity itself is determined or made possible by advances in technology or adjustments, institutional and ideologically, against various claims. 5 (3) M. P. Todaro (2000) defines economic growth as a steady process whereby the production capacity of an economy increases over time to generate an even greater level of national income. The increase in capacity itself is determined by technological, institutional and ideological advances in the various demands of the situation 6 4 Mudrajad, Kuncoro. (2004). Otonomi dan Pembangunan Daerah: Reformasi, Perencanaan, Strategi, dan Peluang, Penerbit Erlangga, Jakarta. 5 Jhingan, M. L. (2000). Ekonomi Pembangunan dan Perencanaan, edisi 3, Rajawali Press, Jakarta 6 Todaro, M.P. (2000). Pembangunan Ekonomi di Dunia ke Tiga, edisi 4, Penerbit Erlangga, Jakarta

15 (4) According to Budiono (1999), economic growth is a process of long-term per capita output growth that occurs when there is a tendency (per capita output to rise) that comes from the internal process of the economy (the forces within the economy itself), not from outside. Or in other words, selfgenerating, which means that the growth process itself produces a force or momentum for the continuation of that growth in subsequent periods. 7 (5) Sadono Sukirno (2005) argues that economic growth is a change in the level of economic activity prevailing from year to year. So to estimate it units of measurement must be held constant for comparison of national income from year to year, known as the rate of economic growth. 8 Furthermore, Todaro (2000) stated there are three components in the definition of economic growth, namely: (1) The increase in output on an ongoing basis is a manifestation or embodiment of what is known as economic growth, while the ability to provide different types of goods is itself a sign of economic maturity in a country. (2) The development of technology is the basis or a precondition for the continuity of sustainable economic growth. This is a condition that is necessary, but is not sufficient, so in addition to the development or advancement of technology, other factors are needed. (3) In order to realize the growth potential inherent in the new technology, we need to hold a series of institutional adjustments, attitudes and ideologies. 7 Budiono, (1999). Teori Pertumbuhan Ekonomi, seri sinopsi,edisi 1, bpfe, Jogjakarta, 8 Sukirno, S. (2005). Makroekonomi teori pengantar. Jakarta: PT Raja Grafindo Persada.

16 Technological innovation without social innovation means the potential is there, but without the complementary input then it cannot produce any results. 1.2.2. Income disparity among regions Aspects of "fairness and equity" can be reviewed on the basis of interpersonal relationships, but can also be reviewed by region. Interpersonally, it indicates whether income among individuals or groups of community members is fair and equitable. Meanwhile, inter-regional interpersonally, it shows equity that occurs between regions, both between provinces and between districts/cities. (1) Distribution of income between income class (size distribution of income) or relative income inequality. (2) Revenue sharing between urban and rural areas (urban-rural income disparities). (3) Regional income sharing (regional income disparities). Thus, in principle, the distribution of national income reflects the uneven and uneven distribution of a country's development outcomes among its inhabitants. There are various criteria or benchmarks to assess the level of distribution is as follows (1) The Lorenz Curve The Lorenz Curve illustrates the cumulative distribution of national income among the layers of the population and is cumulative as well. This curve lies within a square that symbolizes the establishment of the cumulative

17 percentage of national income, while the flat side represents the cumulative percentage of the population. The Lorenz Curve shows the quantitative relationship between the percentage of receipts (incomes of the population) and the percentage of total revenue actually earned over a certain period. The farther the Lorenz Curve diverges from the straight diagonal line (perfect evenness), the more unequal income distribution. The Lorenz Curve is shown in the graph below. Figure 2 The Lorenz Curve Yi, Income (%) Pi, Population (%) Source : A practical example of a Lorenz curve by Mohammad Zulfan Tadjoeddin (2003) The Lorenz Curve is represented by the OBA line. The income distribution is said to be uniform if the curve of the Lorenz is a diagonal line of OA, where 40% of income is received by 40% of the population, and 60% of income is received by 60% of the population. So the further the Lorenz Curve is from the

18 diagonal line, the more uneven the distribution of income. This leads to the Gini Index number ranging between zero and one. 9 (2) Gini Index The Gini Index is a coefficient that ranges from zero to one, explaining the level of inequality of the distribution of national income. The smaller (the closer to zero) the coefficient, the better or more even the distribution. On the other hand, an increasingly large coefficient (approaching one) implies an increasingly unbalanced distribution. Gini Index figures can be assessed visually directly from the Lorenz Curve, the more curved the Lorenz Curve, the larger the divided area, the greater the Gini Index, implying an increasingly uneven income distribution. Some economists argue that the Gini Index is considered to have weaknesses because it is less sensitive to changes in the low income group. Regardless of this, the Gini Index that uses expenditure data as a proxy for income data is considered to be still better than many ways of calculating existing income distributions. 9 Tadjoeddin, Mohammad Zulfan (2003). Aspiration to Inequality : Regional Disparity and Centre-Regional Conflicts in Indonesia,Paper disampaikan pada UNU/WIDER Project Conference on Spatial Inequality in Asia, United Nations University Centre, Tokyo.

19 Table 1 Gini Index In West Java Province from 2011 to 2016 Gini Ratio In West Java Province City/Regency 2011 2012 2013 2014 2015 2016 Bogor 0.41 0.42 0.38 0.39 0.42 0.4 Sukabumi 0.3 0.35 0.3 0.32 0.36 0.33 Cianjur 0.29 0.33 0.29 0.28 0.28 0.36 Bandung 0.36 0.36 0.34 0.37 0.4 0.4 Garut 0.3 0.34 0.31 0.33 0.31 0.35 Tasikmalaya 0.37 0.33 0.32 0.29 0.3 0.3 Ciamis 0.31 0.31 0.33 0.31 0.33 0.33 Kuningan 0.33 0.36 0.33 0.37 0.34 0.33 Cirebon 0.27 0.36 0.32 0.28 0.33 0.36 Majalengka 0.31 0.39 0.32 0.34 0.35 0.36 Sumedang 0.33 0.37 0.34 0.33 0.35 0.37 Indramayu 0.28 0.29 0.28 0.28 0.29 0.26 Subang 0.28 0.33 0.33 0.31 0.33 0.35 Purwakarta 0.34 0.39 0.39 0.37 0.35 0.36 Karawang 0.33 0.34 0.32 0.3 0.34 0.34 Bekasi 0.33 0.36 0.33 0.33 0.35 0.31 Bandung Barat 0.29 0.37 0.31 0.33 0.34 0.36 Kota Bogor 0.39 0.45 0.41 0.36 0.47 0.43 Kota Sukabumi 0.34 0.4 0.34 0.36 0.43 0.42 Kota Bandung 0.41 0.42 0.42 0.48 0.44 0.44 Kota Cirebon 0.38 0.41 0.38 0.4 0.41 0.4 Kota Bekasi 0.37 0.37 0.35 0.33 0.41 0.39 Kota Depok 0.36 0.4 0.39 0.37 0.4 0.4 Kota Cimahi 0.34 0.37 0.4 0.39 0.4 0.42 Kota Tasikmalaya 0.37 0.4 0.39 0.37 0.49 0.42 Kota Banjar 0.37 0.39 0.34 0.32 0.42 0.37 Source : BPS West Java Province 2011-2016 From the data above in Table 1 income inequality in West Java is retailively high, especially in urban areas. This might be because in Bandung city and Bogor city is a big city and this local government has not been able to overcome the problem of income inequality so that income has not been perfectly distributed. (3) Williamson Index The existence of differences in natural resources between regions also causes changes in distribution between regions. The index commonly used in

20 distribution between these regions is the Williamson Index. The formula used in the Williamson Index is as follows: W ( ) 2 Yi Y * fi / N = Y * Where: W = Williamson Index Y i = GRDP / Capita in the city / district i Y * = fi = West GRDP Java / Province Capita city / district population i N = population in West Java Province The Williamson index obtained is located between 0 (zero) to 1 (one). If the Williamson index approaches 0 then the inequality of income distribution between regencies / cities in West Java Province is low or economic growth between regions is evenly distributed. If the Williamson index approaches 1, the inequality of income distribution between regencies / cities in West Java Province is high or economic growth between regions is uneven.

21 1.3. Empirical Review of Research on Fiscal Decentralization 1.3.1. Research on Fiscal Decentralization in Other Countries Fiscal Decentralization Contributes to Economic Growth: Evidenc efrom State- Level Cross-Section Data for The United States as conducted by Nobuo akai and Masayo Sakata, 2002. This study shows new evidence that fiscal decentralization effects economic growth. It used a cross-sectional method with 50 observations, taking the average 1992 to 1994 for time series and 50 states in the United States. The empirical models used to look at economic growth are : GSP α + α Decentrali + Χ β + ε i = 0 1 zation i i i, i=1,..., 50...(2.1) Where i is the state, ΔGSP I gross state production from 1992 to 1996, decentralizations show the average annual growth of the fiscal decentralization indicator in state i, and Xi is the control variable. Empirical research above shows that based on existing data, fiscal decentralization has contributed to economic growth. The paper finds that fiscal decentralization plays a key role in economic growth in the US. As expected, the results also indicate that there are others affecting economic growth. 1.3.2. Research on Fiscal Decentralization In Indonesia 1) "Fiscal Decentralization: It s Impact on Cities Growth" as conducted by B. Raksaka Mahi, 2001 This study used a simultaneous econometric model two stage least square (TSLS) and regional econometric macros for; (1) Evaluating intergovernmental transfers and their impact on municipal government revenues and (2) Elaborating

22 on the implications of the transfer from government to city growth and disparity between regions in Indonesia. The variable fiscal decentralization is measured by Revenue sharing fund, sharing funds, DAU, and DAK. The study concluded that: (a) The policy of fiscal decentralization in Indonesia is very important for policy making in the regions, almost all standard instruments for fiscal decentralization are used by the government. (b) DBHSDA policies not only have the potential to reduce growth rates, but also increase disparities between regions. (c) DBHPPh will reduce growth. (d) DAU is more promising for growth than others, although the DAU policy does not support equity among regions. and (e) The combination of existing policies in Indonesia promises growth, but still cannot reduce the occurrence of disparities between regions. 2) Dampak Desentralisasi Fiskal di Indonesia Terhadap Pertumbuhan Ekonomi dan Disparitas Antar Daerah : Analisa Model Makro Ekonometrik Simultan " as conducted by Teguh Dartanto, 2002. This study used a simultaneous macroeconometric regional model with two stage least square (TSLS). The Simultaneous Macro Econometric Model is made for analyzing the fiscal decentralization impact to economic growth and region disparity. The policy simulation in this model used transfer fund from central government such as Tax Revenue Sharing, Natural Resource Revenue Sharing and General Allocation Fund. The simulation is carried out to see the optimality of various possible existing policies. The optimality is measured by evaluating the high rate of economic growth and low disparity.

23 The results of the study indicate that revenue sharing funds from natural resources (DBHSDA), land and building tax (PBB), tax on Acquisition of land and building (DBPHTB) and income tax (PPH) generate negative economic growth rates. General allocation funds (DAU) as an inter-regional fiscal spattering factor a the most dominant factor in encouraging regional economic growth and have a very big role in encouraging regional economic growth as well as being an economic growth regulator among regions. These conditions indicate a very large dependence on the central government. However, when combined with the revenue-sharing policy and general allocation funds, they will result in positive (although relatively small) growth and can reduce disparities between regions. The combination also significantly affects investment growth but does not significantly affect the growth of consumption in the region. The impact of fiscal decentralization policy is more pronounced in the Eastern Region of Indonesia (KTI) than in the Western Region of Indonesia (KBI). The simulation results also indicate the dependence of local governments on transfer funds from the central government. Therefore, local governments are also expected to actively seek nondistortive sources of income. 3) Dampak Transfer Pemerintah Pusat Terhadap Penurunan Ketimpangan Pendapatan Di Indonesia as conducted by Adhitya Wardhana., Bambang Juanda., Hermanto Siregar dan Kodrat Wibowo, Sosiohumaniora, Volume 15 no. 2 Juli 2013: 111 118 The method used in this study uses data panel regression with the period 2001-2010. For regional characteristics, it is made as a dummy of rich regions

24 equal to one. The Harmless hold variable in the study was made as a dummy variable which before 2009 was given a value of one. The data used is data from 32 provinces in Indonesia. Determination of income inequality equation can be seen as follows: IW = f (dau, regional characteristics, dau area rich, dak road infrastructure, rules Harmless hold, road infrastructure, total population ) The model used is: iw = γ0 + γ1 Lndauit + γ2 D rich t + γ3 D rich * Lndau t + γ4 Lndakjln t + γ5 LnDhhit + γ6 Lnjlnit + γ7 Lnpopit + et Remarks: iw: Inequality (Index Williamson); dau: General Allocation Fund (million); daujln: Special Allocation Fund road infrastructure; pop: population; Dkaya: Rich area = 1, jln: infrastructure Street; Dhh: Harmless hold rule before2009 = 1; i: province to i, t: year t This study looked determined factors inequality in Indonesian 2001-2010. After the rule hold harmless has eliminated 2008 showed estimation from general purpose grant (DAU), special purpose grant (DAK) significantly affected the decreasing inequality of income. This research will look at the development of the provinces income inequality by using Williamson index. The result of inequality on the poor region more prevalent than the rich region. The determination of the rich and poor region of using the median of GDP per capita.

25 1.4. Theoretical Framework Figure 3 Theoretical framework Regional Autonomy Fiscal Decentralization UU No. 32 / 2004 UU No. 33 / 2004 Intergovermental Transfer Funds DBH (Tax revenue sharing) DAK (Spesific allocation funds) DAU (General allocation funds) Economic Growth Region Income Disparity Kuznet Theory Todaro Theory Wiliamson Index Realization The balance between the authority of the central government and local government is realized through the policy of regional autonomy and fiscal decentralization. The policy of regional autonomy and fiscal decentralization has been running since 2001. In the era of regional autonomy, each local government manages their finances to increase regional economic

26 activity. Each region will increase their GRDP. The increase in GRDP must come from regional revenues such as PAD and intergovernmental transfer funds The central government issued intergovernmental transfer funds (DAU, DAK and DBH) to make a major contribution to regional expenditure. According to Brodjonegoro (2001), the central government provides transfer funds to the regions for financial equality between regions through DAU and DAK. The central government provides these funds so that local governments are more responsive to improve their development through regional spending.. The central government through fiscal policy will provide intergovernmental transfer funds that are expected to increase economic growth and affect income inequality between regions. In reducing inequality, various alternative fiscal policies are implemented which can equalize regional finances accompanied by meeting minimum service standards. 1.5. Hypothesis In this study the hypothesis that will be tested is: 1) Decentralization indicators, namely Intergovernmenral transfer (revenue sharing fund (DBH), general allocation fund (DAU) and specific allocation fund (DAK)) significantly influence regional economic growth. 2) Intergovernmental transfer funds derived from revenue sharing fund (DBH) increase disparity between regions. 3) The general allocation fund (DAU) is effective to reduce disparities between regions.