Decentralization and local government borrowing in Indonesia

James Alm and Sri Mulyani Indrawati INTRODUCTION For much of its recent history, Indonesia’s constitutional arrangements had established it as a multi-tier unitary state, with provinces as the second tier below the central government and local governments as the third tier. The centralization of authority in Jakarta was justified as a way of maintaining national unity in a nation of over 200 million people, spread across 14 000 islands and two million square kilometers; it was also in part a counter reaction to efforts by a previous colonial power, the Dutch, to assert the importance of federalism as a last effort to control the newly independent Indonesia. In May 1999, however, the government of Indonesia (GOI) started a major program of governmental decentralization with the passage of two laws on various aspects of decentralization, Law No. 22/1999 on Regional Government (UU PD) and Law No. 25/1999 on the Fiscal Balance between the Central Government and the Regions (UU PKPD). The implementation of these laws began in January 2001, and has already begun to transform intergovernmental fiscal relations in Indonesia. One aspect of this decentralization that has been largely unexamined is its potential impact on local government borrowing. If local governments are given more independence in their tax and expenditure decisions, such independence may well extend to their use of borrowing. There is little question that, in principle, local government access to capital markets can provide significant benefits. Local governments can use borrowing to better match current expenditures….