Fiscal Decentralization and Special Local Autonomy: Evidence from an Emerging Market

IBIMA PublishingJournal of Southeast Asian Researchhttp://www.ibimapublishing.com/journals/JSAR/jsar.htmlVol. 2013 (2013), Article ID 554057, 14 pagesDOI: 10.5171/2013.554057

Fiscal Decentralization and Special LocalAutonomy: Evidence from an Emerging Market

Suwandi1 and Ari Warokka2

1Faculty of Economics – Cenderawasih University, Indonesia

2Economic Development Dept., Faculty of Economics – North Sumatera University, Indonesia

Abstract

The quest of searching the endogeny variables of financial decentralization in emerging marketshave become a serious topic due to the increasing wave of decentralized regions in many countries.The paper aimsto examine the effects of fiscal decentralization and specific local autonomy oneconomic growth, employment, poverty, and welfare in the special province Papua (Indonesia). Thestudy exploited the main data of the decentralization fund by using a panel data of eight regenciesand municipals, particularly the regional autonomy fund, direct and indirect governmentexpenditure, and economic growth. The paper used the path analysis to explore the relationships ofthe observed variables. The results revealed that the decentralization fund influenced significantlyon government’s direct expenditure and economic growth. The special local autonomy's fund hasinfluenced considerably on government’s indirect expenditure. Its effect has increased, througheconomic growth as the intermediating variable, meaningfully on employment, poverty, andwelfare. The results are in line with the prior studies, which explore the consequences ofdecentralization and specific autonomy to spur the economic growth in certain regions. It impliesthat the economic development strategies in Indonesia’s less-developed regions should be startedwith a bigger autonomy transfer program to those regions and simultaneously enhanced it byspecial budget allocation to trigger and support the development.

Keywords: Perceived organizational support, organizational commitment, academic expatriate.

Introduction

One of the causes of Indonesia’s economicdevelopment failure is the misleading policy,which has affected the widening disparitiesbetween regions and income groups. Thisunfavorable policy will continually threatenthe development process in Indonesia andcreate a vulnerable situation to the shocksand crises. To manage this problem, theIndonesian government initiated a widerlocal autonomy, which was one of the reformagendas in the post Asia’s financial crisisperiod. This special autonomy program wasimplemented in form of fiscaldecentralization, which allocated an

economic balance between centralgovernment and regional ones. The financialgovernance decentralization in Indonesia,which is legally based on Law No. 33/2004on the balanced fiscal, is intended as theanchor law for the equitable developmentand one of the government’s strategies toreduce the disparities among Indonesianregions.

The more extended regional governance willgive the local government a larger autonomyto conceptualize, build, and implement theirown development planning frameworks tosuit the geographical context. It was intendedto improve development performance at the

Copyright © 2013 Suwandi and Ari Warokka. This is an open access article distributed under the CreativeCommons Attribution License unported 3.0, which permits unrestricted use, distribution, and reproduction inany medium, provided that original work is properly cited. Contact author: Ari Warokka E-mail:[email protected]

Journal of Southeast Asian Research

provinces and regencies' level and can helpto ensure policy design at the central level isrelevant, supports local processes, andpromotes up scaling of good practices (UNDPIndonesia, 2010). This is also consistent withthe Second Fundamental Theorem of WelfareEconomics (Mas-Colell, Whinston & Green,1995) stating that the government canactually choose the desired target ofeconomic equality through transfers,taxation and subsidies, while the rest can beoutsourced economy through marketmechanisms.

However, since Law 32/2004 on sub-national governance and Law 33/2004 onfiscal decentralization were in force, it hascreated inconclusive effects ofdecentralization. The emerging of sevenadditional provinces, 164 new districts, and34 expanded urban municipals, just givesmore wage costs increased significantly andshifted to local government budgets and leftfew funds for much-needed capital spendingin public facility's development (Eckardt &Shah, 2007). In cross-countries literature,some recent empirical evidence suggests, onthe contrary, a negative effect of fiscaldecentralization on local welfare anddevelopment (Zhang & Zou, 1998; Davoodi &Zou, 1998). Meanwhile, some prior studiesshowthe positive ones, such as the work ofAdi (2005) on the impact of financialdecentralization on economic growth in theJava and Bali’s regencies and municipals thatreveals the said economic authoritydelegation enhances regional economicgrowth. Similarly, the study of Siregar (2009)found that decentralization has significantlyreduced the poverty rate, even though themagnitude of the effect is relatively small. Ithas also reduced the level of inflation andincreased the share of the agricultural andindustrial sectors in the regionaldevelopment that lead to the lower level ofpoverty.

Those debatable results have triggered us totest it in the context of Papua SpecialProvince, the most eastern part of Indonesia,and examine the generalization power of

decentralization theory. The Papua today’soutlook is in paradoxical situation. On theone hand, we can see that Papua has entereda new century marked by the presence ofmodern governmental service, the use ofinformation technology, and the economicactivities. On the other hand, many of theindigenous Papuans still live in traditionalcultures and isolated subsistence. The Papuaprovince has also many universities.However, many Papuans are at the same timeilliterate. The Papua’s abundant resourcesunfortunately cannot support its people tolive economically normal. More than 80% ofPapuan households are still living in thepoverty line, even some of them are inthecategory of absolute poverty (Suebu, 2007).This study chose the Papua province as theresearch object is based on several reasons, i.e., firstly, the disintegration threat as theresult of long territorial-ownership disputebetween Indonesia and Netherland for morethan 18 years (1945-1963) has made thePapua’s economic development is politicallylimited. Secondly, it is the deep-economicinequality between Papua, as one of thebiggest financially contributors to the centralgovernment, and other regions in Indonesia.Thirdly, it is the Papuans’ low human capitalquality, both in terms of social economics andpolitics. And fourthly, it is a quite highly rateof human right violation cases in Papua. Wesummarize these unfavorable conditions asthe decentralization and local autonomy’sproblems on economic growth, employment,poverty reduction, and equitable welfare.

Therefore, this paper is intended to explorethe effect of fiscal decentralization andspecial regional autonomy on economicgrowth, employment, poverty reduction, andequitable welfare in Papua.

Information obtained from this paper willprovide a further understanding and fill theliterature gap in the context of the nexus ofdecentralization and local autonomy in theless-developed provinces and regencies.Furthermore, it will examine the underlyingdimensions of the difference in the regions’conditions and potent that cause the


disparities in the ability of local authorities torun the transferred autonomy. In addition, itis also investigating the Papuangovernment’s self-sufficient competence ingenerating its own financial resources tosupport its economic development programscompared to the central government’sbalanced-fund, which is transferred to theprovincial as well as district governments.The study will complete the missing puzzle ofthe decentralization and special autonomy’seffect on emerging countries.

To present the empirical findings, the paperis organized as follows. The literature reviewand prior studies on fiscal decentralization,special local autonomy, economic growth,employment, poverty reduction andequitable welfare are briefly outlined inSection 2. In this section, the hypotheses'development is also developed. Themethodology and research model isdescribed in Section3, followed by theresearch results and discussion in Section 4.We provide some concluding remarks inSection 5.

Literature Review

The Inter-Related Nexus of FiscalDecentralization and Special RegionalAutonomy

As many developing countries areexperiencing an increasing interest ingovernment design, the main questions focuson whether it is advantageous to givesubnational governments more authority andautonomy in revenue and expendituredecisions or whether it is better to makethose decisions at the central level ofgovernment. Understanding the causes forfiscal decentralization leads to a morecomprehensive understanding of the fiscaldesign of countries.

Many scholars and policy makers havesought to understand the consequences offiscal decentralization. The decentralizedfinancial authority is one of the maincomponents in delegating the national

government’s power to subnational one(Rondinelli, 2001). Many developingcountries used this delegated fiscal policy toavoid the governance’s ineffectiveness andinefficiency, macroeconomic instability, andinequality economic growth (Bahl & Linn,1992).

Saragih (2003) argues that regionalautonomy without fiscal decentralization willresult less support to the achievement of thegovernance andpublic services’effectiveness. Therefore, autonomy requiresfinancial decentralization policy. Fiscaldecentralization policy aimed at enablinglocal government budgetary in improvingservice to the community, particularly inachieving minimum service standards (Seda,2004; Mardiasmo & Wihana, 1999). This ismanifested in a policy called a financialbalance between the central government andregions (Mardiasmo, 2004).

There are three missions of giving more localautonomy through fiscal decentralization(Barzelay, 1991), i.e., firstly, to createregional resource management’ efficiencyand effectiveness. Secondly, it is to improvethe quality of public services and welfare.Thirdly, it is to empower local people andgive more places to participate actively in thedevelopment process.

In general, it can be summarized that thefiscal decentralization policy is intended tosolve the problem of lack of income(Buentjen, 1998), to overcome externalitiesand redistribution of national income(Fisher, 1996), as well as stabilize the macroeconomy (Davoodi, 2001). Thus, economicgrowth, employment, poverty reduction, andregional welfare are the main concerns inthis paper to examine the effects of the saidpolicy and autonomy on economicdevelopment. Each component will bediscussed further in the following sections.

Fiscal Decentralization and EconomicGrowth

Theoretically, fiscal decentralization – thedevolution of financial responsibilities and


power from the central government to subnational governments – can enhance ordetract from economic growth. Previousliterature (Panizza, 1999; Triesman, 2006;Martinez-Vazquez & Timofeev, 2009) and thepredicted results in the theoreticalframework reveal the positive sign of the logof GDP per capita exist in countries withhigher levels of income with moredecentralized governance.

However, the existing literatures on thisdecentralization itself are inconclusive. Priorstudies have found a positive relationshipbetween fiscal decentralization and economicgrowth (Oates, 1993; Yilmaz 1999; Iimi,2005), others find evidence of the contrary(Xie, Zou & Davoodi, 1999) while othersestablish no direct relationship (Martinez-Vazquez & McNab, 2005; Thornton, 2007).Such a range of results highlights the lack ofconsensus in the literature on therelationship between financialdecentralization and economic growth.

However, in this study, the authors stand onand develop the positive effects of fiscaldecentralization and special local autonomyon economic growth based on the priorempirical findings, which are similar to oursample data. For example, Oates (1972)argues that economic efficiency can beenhanced across population groups withdifferent preferences and needs throughdecentralization. Preferences for civic goodsand services are likely to vary acrossgeographically differentiated regions. If thisis so, greater utility will result if differentbaskets of public goods and services areprovided to different, homogeneous subregions. Greater efficiency can be achievedthrough the mobility and sorting of thepopulation in decentralized governments(Tiebout, 1956). Prior studies also providesome convinced arguments that regionalgovernments are either more efficient atcollecting information about people's tastesor better able to get local constituents toreveal such information (Tanzi, 2000). Othersupporting authors argue that accountabilityplays a key role since decentralization may

be the best way to create incentives forpoliticians to differentiate adequatelybetween the needs of different groups oftheir citizens and therefore, optimize theprovision of public goods (Sepulveda &Martinez-Vazquez, 2010). Politicians wouldbe willing to modify their objectives to satisfypreferences of their incumbents at a locallevel, since that would help them in re-elections, based on those arguments, our firsthypothesis is:

H1a: Fiscal decentralization affects thePapua Special Province’s economicgrowth

H1b: Special Local Autonomy affectsthe Papua Special Province’s economicgrowth

Fiscal Decentralization, RegionalAutonomy,andEmployment

One of the most important questions relatedto the relationship between fiscaldecentralization and labor market is: Doesfiscal policy create employment? Keynesiansays ‘yes’, fiscal policy can effectively reduceunemployment. In a recession, expansionaryfiscal policy will increase aggregate demand,causing higher output, leading to the creationof more jobs (Pettinger, 2008). Meanwhile,Classical Economics say in contrary. Fiscalpolicy will only create a pseudo employment.It will cause a temporary increase in realoutput as well. In the long run, expansionaryfiscal policy just causes inflation and does notincrease actual gross domestic product(GDP). Classical economists argue that toreduce unemployment it is necessary to usesupply side policies, which increase theflexibility of labour markets (e. g. reducingpower of trades unions).

However, several arguments have been madefrom the view point of economic efficiencythat public sector size is likely to increasewith the degree of fiscal decentralization. Afirst argument made by Oates (1985) is thatgreater decentralization may result in theloss of certain economies of scale with the


consequent increase in administration costs.A second argument by Prud'homme (1995) isthat the relative poorer quality of localbureaucrats is likely to weaken publicexpenditure management and result inhigher supply costs of public services. Fromthe viewpoint of political participation,economic historian John Wallis argued thatdecentralization can lead to a larger publicsector because as individuals have morecontrol over public decisions at thesub-national level, they may wish to empower thepublic sector with a wider range of functionsand responsibilities (Prud'homme, 1995). Inthis point of view, civil employment isaffected by the level of governmentdecentralization in a country. Thedecentralized economic development createsdemand for new types of governmentservices, and that these government serviceswill tend to rise at a faster pace.

Another important role for fiscal policy is themitigation of unemployment andstabilization of the economy (Auerbach, Gale,& Harris, 2010). Fiscal policy affects labormarkets both through the design of taxsystems and the structure of social benefits.Two key areas of fiscal policy affectingemployment performance are the design oftax systems and the structure of publicbenefit schemes.Reductions in labor taxescan help stimulate labor demand. A revenue-neutral shift from labor to consumption taxescould boost labor demand. For instance,reductions in employer social securitycontributions financed by higherconsumption taxes (or higher recurrentproperty taxes) can raise labor demand bylowering (non-wage) labor costs.

The appropriately designed fiscal policieswill become increasingly important inpromoting employment and avoiding a shifttoward informality as emerging economiesexpand their social benefit systems.However, a fairly recent study of 10developing countries found thatdecentralization does increase total andsubnational expenditures on publicinfrastructure (Estache & Sinha, 1995). The

major constraint on further expansion ofregional services under decentralizationappears to be a lack of balance between therevenue sources (including transfers)allowed to local governments, and theincreases in service functions assigned tothem (i.e. the creation of new publicemployment).

Since the Indonesia reform 1998, there hasbeen a significant increase in indigenous-population importance in Indonesiansocieties, especially in the eastern part ofIndonesia, which has generated slightlybetter employment conditions and gains inpolitical power for these groups. Suchchanges have yielded favorable effects ontheir standard of living and politicalincorporation. At the same time, however,the said positive effects are not homogenousacross regions and sectors of the economy.While many nativePapuans are able toobtain better jobs (in the private and publicsectors) due to changes in labor marketparticipation, many still suffer chronicunemployment and job turnover; high labormarket segmentation keeps many membersof the indigenous community working ininformal labor markets (Suebu, 2007). Basedon these facts, we hypothesize that:

H2a: Fiscal decentralization througheconomic growth affects employment

H2b: Special local autonomy througheconomic growth affects employment

Fiscal Decentralization, RegionalAutonomyandPovertyReduction

One of the most challenging goals ofdecentralization is poverty reduction. Thework of Von Braun and Grote (2000)concludes that decentralization does indeedserve the poor, although the impact dependson the interaction of political, administrativeand fiscal decentralization systems, and inaddition, the sequencing and pace of thedifferent types of decentralization seem toplay an important role on the final-outcome.Therefore, financial decentralization may


also affect a country’s poverty reductionefforts in a number of ways. It can reducepoverty by improving these well-beingcomponents: private income, basic needs,and security. Similarly, the decentralizationoutcomes can be found in terms of quality ofspecific pro-poor services. For example,Khaleghian (2003) concludes thatdecentralization appears to improve thecoverage of childhood immunization in low-income countries but that the opposite holdsfor middle-income countries. At the sametime, in the latter group, democraticgovernment mitigates the unfavorable effectsof decentralization, and decentralizationreverses the negative effects of ethnictension and ethnos-linguisticfractionalization.

Prior studies reveal there are severalpotential ways in which decentralization mayaffect fundamental needs of the populationthrough the provision of services in areas(Bird & Ebel, 2005; Foster, Fozzard, Naschold& Conway, 2002) such as primary education,basic health and other social services. Thesepublic services affect the quality of life for allpeople, which is an important ingredient forpoverty reduction. Local governments have amore institutionalized linkage withbeneficiary communities, improvedinformation, and the incentive to use thisinformation. Consequently, regionalgovernments are better placed to identify thepoor, to respect native social identities, andto respond more efficiently to localizedvariations in conditions, tastes, standards,affordability, location requirements and soon for services or infrastructure (Galaso &Ravallion, 2005).

Decentralization through delegated fiscalauthority provides a prerequisite conditionof empowerment and security for localregions, thus it creates conduciveenvironment for economic growth andbusiness development. In an indirectmanner, good governance and accountabilityare obvious important precondition forassuring a pro-poor, pro-growth economicenvironment in which government services

are delivered in an efficient and effectivemanner. In addition, fiscal empowerment oflocal governments in a way that bringsgovernment truly closer to the people mayprovide an even more direct benefit to theindigent, by strengthening their voice,representation and basic freedoms. Thus,decentralization can empower the poorthrough the creation of institutions thatpromote greater voice and participation ofthe less-fortunate (Crook, 2003). Based onthose arguments, we hypothesize that:

H3a: Fiscal decentralization &througheconomic growth affects povertyreduction

H3b: Special local autonomy througheconomic growth affects povertyreduction

Fiscal Decentralization, RegionalAutonomyandWelfare

For regional economists, the most importantargument for decentralization is the creationof a higher level of efficiency, so that welfaregains can be achieved. A decentralisedsystem can better respond to the local needsand therefore, reduce over or underconsumption of public goods. Oates’sdecentralization theorem states that unlessresidents across a country are fullyhomogeneous in their preferences and needsof public services – an adjusted decentralisedprovision of public services will be moreefficient than a centralized provision (HongVo, 2009).

Some further argue that fiscaldecentralization will not only mean directwelfare improvements but also indirectlystimulate economic development, revenuemobilization, innovation in public servicedelivery, raise the accountability of electedofficials and increase regional participationin governance (Bahl&Bird, 2008). This is dueto subnational governments’ responsivenessto the demands of local citizens compared tothe central government. The responsivenesswill be stimulated by increased dependence


on own source tax revenues in relation toalternative sources, e. g. intergovernmentaltransfers. The subnational governmentbecomes more attentiveto local financialmovements. This works both ways as citizenswho pay taxes will be more inclined todemand that their local government be moretransparentand accountable for theirdecisions (Mahon 2005). In summary,decentralised government can exploit thesesituations to increase social welfare.

According to Oates (1997), in a world ofperfect information, a benevolent centralplanner could presumably introduce thedifferentiation in local outputs required tomaximize social welfare. The traditionalresponse to this point is to arguethat, inreality, there exist important imperfectionsin information. Morespecifically, individualregional governments are muchcloser to thepeople and geography of their respectivejurisdictions; they possess knowledge oflocalized preferences and cost conditionsthat are hard to come by for a more distantcentral agency. Therefore, by transferringresponsibilities to the local administrator,the national government aims to accomplishone or some of the following priorities:improve economic efficiency, cost efficiency,accountability and increased resourcemobilization (Bird & Vaillancourt 1998).Concentrating on a more economicalperspective, a decentralized system isthought to be in a superior way at mobilizingrevenue and reaching a greater share of thetaxable operations. It is argued that adecentralized tax system and subnationalgovernments, due to their closeness, have thepotential to reach and control better thecollection of taxes in ways that a centralgovernment cannot. The tax base can bebroadened by numerous tax instruments, e.g. operative licenses for firms, bettermentcharges, property taxes, etc. The key is toidentify what kinds of businesses exist within

the community and to understand theirassets and operations.

Freinkman and Yossifov (1998) found thatfiscal decentralization is positively related tothe share of education spending to theregional education spending, real industrialgrowth and purchasing power of population.They suggest that regions with moredecentralized finances tend to have a lowereconomic decline. Based on those arguments,we hypothesize that:

H4a: Poverty reduction affects socialwelfare

H4b: Employment affects social welfare

H5c: Fiscal decentralization througheconomic growth affects social welfare

H5d: Special local autonomy througheconomic growth affects social welfare

In this study, the researchers propose thatfiscal decentralization and local autonomyhave two types of relationship with povertyreduction, employment, and social welfare, i.e. direct relationship and indirectrelationship through economic growth as themediating variable. Economic growth in thisstudy is expected to improve the magnitudeof the relationship between financialdecentralization and regional autonomy andthe endogenic variables. Baron and Kenny(1986) define the mediating variable as themechanism through which the effect of thedependent variable can be influenced by theindependent variable. The intermediaryvariable can increase the value of theobserved variable. It measures the level offiscal decentralization effect and special localautonomy role onpoverty reduction,employment, and social welfare. Figure 1show the framework of this study.


4

Figure 1: Research Framework on the Relationship Between Fiscal Decentralization, SpecialLocal Autonomy, Economic Growth, Poverty Reduction, Employment, and Social Welfare

Research Methodology

Research Method and Data

This study uses a mixed-method design fordata collection and analysis. A survey wasemployed to collect quantitative data.Meanwhile, the research also employedin-depth interviews to collect un-recorded datain Central Bureau of Statistics and interpretsome of the survey findings. Survey andinterviews are a good combination since asurvey can collect data with breadth andinterviews can collect in-depth, richer data.In this study, the researchers conducted theinterviews after the survey data werecollected and preliminarily analyzed.

This study was conducted at eight regenciesand municipals in Special Province Papua(Indonesia), i. e. Jayapura, Biak Numfor,Nabire, Yapen, Mimika, Merauke, Keeromand Jayawijaya.These regions haveimplemented fiscal decentralization andparticular local autonomy since 2001. Thepooled data used in this study are RegionalOwned-Source of Revenue (PAD), SpecificAllocation Fund (DAK), General AllocationFund (DAU), Tax- and Non Tax-Based onRevenue Sharing Funds, Gross DomesticRegional Product, Employment Index,

Model and Data Analysis

To test the hypotheses, this study used pathanalysis as shown in the following modelequations:

Y1 = Py1x1 X1 + Py1x2 X2 + ε1

Y2 = Py2y1Y1 + ε2

Y3 = Py3y1Y1 + ε2

Y4 = Py4y1 Y1 +Py4Y2 Y2 + Py4y3 Y3 + ε6

Where

X1: Fiscal decentralization

X2: Special Local Autonomy

Y1: Economic growth

Y2: Poverty reduction

Y3: Employment

Y4: Social welfare

To test model fit (Rm2), this study usedgeneralized R2 with equation:R2 model = 1 - (1 - R2 ) (1 - R2 ) (1 - R2 ) (1 -

Poverty Index, Human Development Index,and Special Autonomy Fund.The observationperiod is 2001-2009.

R2 ).1 2 3


R

2

R

R

2 2 2

2

Results

Table 1 shows the results of hypothesis 1, 2,3, and 4.The results exhibit that all

independents variable influence its observedvariable significantly.

Relation Beta t-statistics p-value Coefficient of critical values:Fiscal decentralizationEconomicgrowth

0.239 2.332 0.024 R2 = 60.6%Special local autonomy Economicgrowth

0.341 3.310 0.002 F-statistics = 19.572F-table = 2.553

Economic growth Employment 0.430 3.497 0.001 R2 = 18.5%F-statistics = 12.230F-table = 4.020

Economic growth Poverty reduction -0.353 -2.771 0.008 R2 = 12.5%F-statistics = 7.679F-table = 4.020

Economic growth Social welfare 0.346 2.740 0.008 R2 = 47.6%Employment Social welfare 0.269 2.224 0.029 F-statistics = 15.723Poverty reduction Social welfare -0.380 -3.285 0.002 F-table = 2.783

Each model informs that the overall 2model = 1 – [(1- 0.606) (1 -0.185) (1 – 0.125)regression (all the independent variablescombined in the model) is statistically

(1 – 0.476)]

significant (there is a significant jointrelationship). To test the model fit of fourmodels developed in this study, theresearchers test all combined R2, which is R1

2model

2model

= 1 – [(0.394) (0.815) (0.875) (0.524)]

= 0.852 = 85.2%

= 60.6%, R2 = 18.5%, R3 = 12.5%, and R42 = The R model indicates all variables in the47.6%. Thus, we get: model can explain 85.2% of the causal

relationship tested in the study, and 14.8% isR2 2 2 2model = 1 – [(1- R1 ) (1 -R2 ) (1 - R3 ) (1 –R4 )]

caused by other non-tested variables. Themeasurement model coefficientreveals thatthe proposed model is fit and parsimony.

Journal of Southeast Asian Research 10

Note: * p < 0.01; ** p < 0.05

Figure 2: Path Coefficients and Hypothesis Testing of the Relationship OffiscalDecentralization, Special Local Autonomy, Economic Growth, Poverty Reduction,

Employment, and Social Welfare

Discussions and Implications

The path analysis on the direct effect of fiscaldecentralization on economic growthdemonstrated that it had significantinfluence, which the path coefficient was0.239 with p-value 0.024. It means that thiskind of decentralization directly influencesthe Papua Special Province’s economicgrowth. This finding is in line with the workof Letelier (2005) and Martinez-Vazquez andTimofeev (2009), which find a positiverelation between economic development andfiscal decentralization. It also supports theprior studies of Iimi (2005) and Stansel(2005) that finds financial decentralizationfosters and enhances the economic growth asit influences particularly on the fiscalexpenditure side. However, this result doesnot support the findings of Oates (1972),which find a negative relation betweeneconomic development and fiscaldecentralization and Panizza (1999), whichfinds that the effect differs when outliers areexcluded from theanalysis. In case ofIndonesia, the researchers argue thatdecentralization has a direct impact oneconomic growth when financialdecentralization is focused on publicexpenditure programs. The saiddecentralization, which is measured as

government expenditure, leads to significanteconomic growth in the regions in which thelocal governments have bigger financialauthority to manage and optimize itspotential economic. Fiscal decentralizationalso increases economic efficiency, which isrelated to the dynamics of economic growth.Local administrator has more capabilitiesand advantages to manage the expenditurebudget efficiently in order to satisfy theneeds of regional society. It is because theyknow better their region.

A bigger and significant influence of fiscaldecentralization on social welfare througheconomic growth as the mediating variableindicates that the proposed hypothesis meetsthe study’s expectation (the path coefficientis 0.346 with p-value 0.008). This kindofdecentralization can enhance social welfarethrough the level and quality of economicinfrastructure (roads, ports, and so on).Regional governments are critical toproviding an enabling environment to ensurelocal economic growth, both by providingcapital infrastructure as well as by promotinghuman capital development. In Papua, fiscaldecentralization has created the welfaregains through a decentralized provision of allpublic goods. The same thing happens for theeffect of special local autonomy on social

11 Journal of Southeast Asian Research

welfare through economic growth. Economicgrowth has increased the effect positivelyand significantly. In the pre specificregionalautonomy period, the Papua governmentconcentrated its infrastructure developmentin urban areas; therefore, people who live inrural areas were not able to enjoy the effectof development. This is because, inthe prespecial local autonomy period; the availabledevelopment funds were relatively limitedinfluencing the infrastructure development’spriorities. As the flow of development fundsto Papua fairly large, which is in the form ofspecial autonomy funds, the localgovernment has been able to use this fund tomeet the needs of rural area's people andaccelerate economic growth.

The study also foundbigger influences fiscaldecentralization on employment if it wasmediated by economic growth. Its effect ispositive and significant. It means that fiscaldecentralization and special local autonomysimultaneously have increased the number ofemployed people in Papua (the pathcoefficient is 0.430 with p-value 0.001). Thesaid variables have created new investments,both in government and private sectors,which does not only trigger demand, but alsoincrease production capacity. An enlargedproduction capacity requires greater otherresources, i. e. human resources, to grow. Ithas created new employment in Papua.Decentralization has also facilitatedeconomic growth through its impact onmacro economic stability (Martinez-Vazquez& McNab, 2005; Agenor, 2004). The saidrecessions decrease the probability of findingnew employment and the level of earningsfor those already employed.Therefore, in thecase of Papua, local governments are criticalto providing an enabling environmentthrough fiscal decentralization and specialregional autonomy to ensure local economicgrowth, both by providing capitalinfrastructure as well as by promotinghuman capital development.

Fiscal decentralization and special regionalautonomy have also played important role toreduce poverty significantly through

economic growth. The negative andsignificant coefficient of the relationshipbetween economic growth and povertyreduction indicates that economic growth isultimately the key to sustainable reduction ofincome poverty at the localized level (thepath coefficient is -0.353 with p-value 0.008).Decentralization and localized autonomyhave given more abilities to regionalgovernance to identifyaccurately the mostproductive infrastructure investments in alocal community. Those variables have alsoprovided extensive local involvement in thepro-poor investment strategy. In the case ofPapua, decentralization has been able topromote the inclusion of poor people in thegrowth process by removing constraints andempowering them to take control of theirown development (through better educationand health) and to take advantage of existingeconomically opportunities as argued in thework of Stern et al. (2005). Decentralizationhas potentially enhanced economicopportunities for the less-fortunate in Papua.

Some important points emerge from thisdiscussion. First, whether decentralizationhas positive effects on social welfare,poverty reduction, and economic growth ornot is a somewhat country- and sector-specific issue. There are surely some types oflocal-impact, low capital-intensive servicesthat are more likely to be efficientlydecentralized. Meanwhile, its variations willbe depended onavailable technologies,institutional structures, and local capacities,which it will influence the desirability ofdecentralization of a specific function in aparticular country. Second, an adequateenabling environment, assignment of anappropriate set of functions to localgovernments, assignment ofa proper set oflocalized own-source revenues to regionalgovernments, the establishment ofasuitableintergovernmental financial transfer system,and the establishment of sufficient access oflocal governments to development capitalare the key elements that should be includedin a good fiscal decentralization program.Third, by considering the current human-resource qualityin Papua, fiscal


decentralization demands a higher level ofadministrative skills from subnationalgovernments, and the right competence isoften a commodity short in supply indeveloping countries, like in Indonesia. Thislow competence at the regional level refers topoliticians, officials and residents (Bahl &Bird, 2008). To solve this problem local fiscaldifferentiation is requiredfor optimization ina multi-level public sector.

Conclusion

This study has successfully answered theresearch objective, which is to examine theeffects of fiscal decentralization and specificlocal autonomy on economic growth,employment, poverty reduction, and socialwelfare in Papua, the most eastern part ofIndonesia. From the path analysis results, itwas found that fiscal decentralization andspecial regional autonomy had a strongindirectly influence through economicgrowth on employment, poverty reductionand social welfare. This finding has provideda clear path to explore more the relationshipbetween these variables, especially in theconflicted areas in otherdevelopingcountries, which is decentralization andspecialized autonomy becomes the option. Itis important to enhance and improvemanagerial and administrative effectivenessof local governance in Papua to reduce thedecentralization funds’ corruption rate.Hence, at the province and district level,there is a need toimprove constantly theexisting human resource’s entrepreneurshipdevelopment. It is particularly in enhancingproper local supervision and supportiveregional people involvement. The resultsfrom the study have also given some inputsto the institutional decision makers indesigning more favorable policies andprocedures that can help improvingdecentralization management in thedeveloping regions.

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Education

Fiscal Decentralization and Special Local Autonomy: Evidence from an Emerging Market