Strengthening fiscal transfers in Indonesia using an output-based approach

59306 January 2011 Note Number 40 Strengthening Fiscal Transfers in Indonesia Using an Output-Based Approach | Peter Ellis, Cledan Mandri-Perrott and Luis Tineo I n 2010 the World Bank approved a US$220 million loan for a Local Government and Decentralization project in Indonesia. e project aims to improve the accountability and reporting of the central government's Speci c Purpose Grants (DAK). Piloted in four infrastruc- ture sub-sectors--irrigation, roads, sanitation, and water-- the project is the World Bank's rst to apply innovative Output-Based Aid (OBA) design principles on a large scale to target improvements in inter-governmental scal transfers. Under the project, the DAK grants will work in a similar way to OBA subsidies, which reimburse service providers for independently veri ed, pre-agreed physical outputs. Up to 81 local governments in ve provinces are Photo by Richard Lord eligible to take part in this project. is note presents an overview of the project objectives and design. (Dana Alokasi Khusus, DAK). DAU are mainly used to fund salaries and other administrative costs. DAK are allocated to finance specific investment expenditures that Since 2001 Indonesia has gone from being one of the are aligned with national priorities and carried out under most centralized countries in the world in administra- the jurisdiction of local governments. In 2010, the DAU tive, fiscal, and political terms to one of the most decen- share of total intergovernmental transfers was 63 percent, tralized. Under this process local governments have as- while the DAK share was around 7 percent. sumed new responsibilities that were previously covered There are currently 14 sectors eligible for DAK by the central government, as well as managing new funds, including four infrastructure sectors--irriga- financial resources that have been transferred from the tion, roads, sanitation, and water supply--which rep- central government or raised within their own localities. resent about 21 percent of the total DAK allocation. Local governments have therefore experienced sub- The amount of the DAK allocation is determined on an stantial increases in financial resources, mostly through annual basis within the national budget. The Ministry increased transfers from the central level for delivery of Finance (MoF) allocates the DAK to each sector and of education, health, and basic infrastructure services. within the sectors local governments have the flexibility Local governments now manage 38 percent of total pub- to determine which activities (sub-projects) they invest lic expenditure and carry out more than half of all public in. The Ministry of Public Works (MPW) provides tech- investment. However, public expenditure reviews show nical guidelines on the implementation, monitoring, and that fiscal decentralization in Indonesia still faces many evaluation of the DAK for each infrastructure sector. The challenges. These include improving and speeding up MPW's technical guidelines clearly specify the outputs spending, and reducing local government dependency on which the DAK grants can be spent, and these are on central government transfers. mostly limited to maintenance, rehabilitation, and the upgrading or improvement of existing infrastructure. Specific Purpose Grants (DAK) Peter Ellis is a Senior Urban Economist in the World Bank's Indonesia Sustainable Development Unit. Cledan Mandri-Perrott is a Senior The bulk of the intergovernmental transfers to local Infrastructure Specialist in the World Bank's Finance, Economics, and governments are the General Purpose Grants (Dana Urban Development Department. Luis Tineo is a Senior Infrastructure Specialist in the Global Partnership on Output-Based Aid. Alokasi Umum, DAU) and the Specific Purpose Grants Supporting the delivery of basic services in developing countries Application of OBA Principles to allocated to the selected local governments, and to re- Improve the Use of DAK Transfers imburse the 10 percent counterpart funding which lo- cal governments are required to provide to participate in the DAK program. The project will be piloted in The aim is to help local governments improve plan- five provinces (Central Kalimantan, East Java, Jambi, ning, budgeting, and investment execution, as well as North Maluku, and West Sulawesi) and all of their 81 monitoring and verification of results. Two options districts. Provinces were selected based on geographic for project design were assessed: (i) a traditional diversity, reporting capacity and performance, and financing of input-based investment subprojects in a success in delivering outputs financed by their DAK. small number of local governments, with disburse- ments tied to individual expenditures or contracts; Institutional Arrangements. The main actors in the and (ii) an output-based approach with disbursements project are the MoF, the MPW, the State Finance and tied to the achievement of pre-agreed outputs within Development Supervisory Board (Badan Pengawasan the scope of the DAK expenditure program. Keuangan dan Pembangunan, BPKP), the World In assessing these options, the project drew impor- Bank, and the participating local governments. tant lessons from two core principles that have been ap- Figure 1 summarizes the flow of funds and account- plied in the design of output-based aid (OBA) projects ability in the project. funded by the Global Partnership on Output-Based Aid (GPOBA): change in the financing paradigm (from in- Eligible Outputs. Eligible outputs are single sub-projects puts to outputs); and transfer of operational and invest- (Paket Pekerjaan) financed by DAK grants and may ment risk (from the funding entity to the entities best include: positioned to deliver the desired outputs). On this basis, the following advantages of an output-based approach