Page 3 - Working Paper (Fiscal Decentralization and Sub-national Taxes: Specific Case of Indonesia)

DDTC Working Paper 1015
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1. Introduction Table 1 - Tax Assignment in Different Government
Level: the Standard Approach
Theory of public finance sTaTes District/
ThaT each policy ThaT will be Revenues Central Provincial City
Taken should consider efficiency Personal income taxes Yes Possible No
(allocaTion), equiTy (disTribuTion), Piggyback
and sTabilizaTion goals. Payroll taxes Yes Possible No
Piggyback
Enterprise profit taxes Yes No No
This paper mostly conducts literature review Natural resource taxes Yes Limited No
on sub-national taxes in developing countries
Value-Added taxes Yes No No
with specific case of Indonesia. Similar to many
Retail sales taxes Yes Yes No
developing countries that experience process
Customs duties Yes No No
of fiscal decentralization, central government in
Indonesia devolves mostly expenditure task to Possible
Excise taxes Yes No
sub-national governments after 2001. During the Piggyback
decentralization era, the capacity of sub-national Property taxes No No Yes
governments to raise own-source revenues is Source: Bird, R,”Subnational Taxation in Developing Countries: A Review of the
Literature”, PREM, the World Bank, Oct 2010
way below their capacity to finance expenditure
assignments, due that reason they rely heavily
on intergovernmental fiscal transfers, such as
Figure 1 - Laffer Curve
from general block grant (Dana Alokasi Umum),
specific allocation grant (Dana Alokasi Khusus), and
revenue-sharing grant (Dana Bagi Hasil).

Further, a good sub-national tax system is
critical to an effective and sustainable system of
intergovernmental fiscal relations – a need that
has become increasingly important around the
world as more and more public services are being Government Revenue
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delivered through sub-national governments . In
many developing countries, for example, given the
restrictions on residential property taxes and the
unreliability of central transfers, business taxes
have sometimes provided almost the only way
in which sub-national governments have been 0 t* 100
Tax Rate (percent)
able to expand revenues in response to perceived
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local needs . According to Table 1, district or city
mainly imposes property tax in addition to user is little PIT (personal income tax) base on which
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charges. In other countries, regional or provincial to impose surcharge . Arthur Laffer, moreover,
governments may be permitted to impose retail provides an analysis of the relationship between
sales taxes and a few excises as well as to piggy- optimal tax revenue and tax rate. The main idea
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back . behind this model, as appear on Figure 1 above,
is policy makers at both central and sub-national
There are several reasons where most of heavily level should set and determine tax rate at which
collected taxes are still managed by the central it will create an optimal revenue collection. Move
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government. First, Musgrave mentioned the need further from t* (or tax rate at potential level),
to achieve redistributive equity within countries government revenue will fall leading to economic
as a whole. Second, most central government distortion. In most of economic literature, experts
in developing countries seldom secures much use the Laffer curve as one possible presentation
revenue from the personal income tax so there of the relationship between rates of taxation and
the hypothetical resulting levels of government
1. Bird, R and Roy Bahl,”Subnational Taxes in Developing Countries: revenue. In essence, there are two effects of
The Way Forward”, Institute for International Business, IIB Paper No. changing tax rates on revenues: the arithmetic and
16, August 2008.
2. Ibid. economic effects. The arithmetic effect tells that if
3. Piggy-back tax is an additional surcharge to centrally-imposed personal tax rates are increased, tax revenue will increase as
income or payroll taxes.
4. Musgrave, R.A. (1983) “Who Should Tax, Where and What?” in C. 5. Bird, R.M. and E. Zolt (2005) “The Limited Role of the Personal
McLure, ed., Tax Assignment in Federal Countries (Canberra: Centre for Income Tax in Developing Countries,” Journal of Asian Economics 16:
Research on Federal Financial Relations, Australian National University). 928-46.