Decentralization and Public Expenditure: Does Special Local Autonomy

Affect Regional Economic Growth?

Martapina Anggai
Cenderawasih University, Indonesia

Ari Warokka
State University of Jakarta, Indonesia
Email: ari.warokka@gmail.com

Reference to this paper should be made as follows:

Martapina Anggai and Ari Warokka

Anggai, M. & Warokka, A. (2017). Decentralization and public expenditure: Does special local
autonomy affect regional economic growth? Asian International Journal of Social Sciences,
17(2), 123–138. https://doi.org/10.29139/aijss.20170206

All works licensed under a Creative Commons Attribution-Non Commercial-No Derivatives 4.0 International License.
The Asian International Journal of Social Sciences (AIJSS) allows the author(s) to hold the copyright without restrictions.
The Asian International Journal of Social Sciences (AIJSS) allows the author(s) to retain publishing rights without restrictions.

Abstract: This study examines the relationship between public expenditure within regional

autonomy policy and economic growth in West Papua and Papua provinces. We distinguish two

kinds of expenditure's decentralization – operational and capital – and also private expenditures.

We use an unbalanced panel data over the period of 2007-2010 to investigate those

expenditures, whether they enhance regional economic growth or not. We find that the

government's operating and private expenditures have a positive effect on local economic

growth, but there is no relationship between capital expenditure's decentralization on

economic growth. The findings did not conform to a-priori efficiency expectations, which

suggest needing to reform regional autonomy and fiscal decentralization policy in both

provinces.

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Keywords: economic growth, efficiency, operating and capital expenditures, regional autonomy,

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Introduction

It refers to Law No. 21/2001, which is then revised by the Presidential Decree No.

1/2008, there are local governments labeled special autonomy regions, i.e. Nangroe Aceh

Darussalam, Papua, and West Papua provinces. In this circumstance, they receive a

substantial amount of the fund from central government, including General-Purpose Grant,

Specific Purpose Grant, and tax/non tax sharing revenues. However, unlike other provinces,

the three regions also earn Special Autonomy Fund. Given the large amount of fund and

allocation discretionary, this brought about the need to examine and determine the effect of

budgetary allocations by sector on the regional economy to generate the much-needed

information critical in decision making and prioritizing expenditure.

The impact of public expenditures on economic growth has been the intense research and

heated debate. The existing studies on the linkages between public expenditure and economic

growth showed conflicting results. For instance, according to Ram (1986) and Romer (1989,

1990a, 1990b), there was a significant and positive relationship between public expenditure

and economic growth. In contrast, Landau (1983, 1985), Grier and Tullock (1989), Alexander

(1990), Barro (1990, 1991) found a significant but negative relationship. Kormendi and

Meguire (1985), Levine & Renelt (1992) found the association between public expenditure

and economic growth to be insignificant.

These conflicting findings highlighted the importance of more research to identify the

linkage between the composition of public expenditure and economic growth for developing

countries, including Indonesia. The purpose of this paper is to shed light on the relationship

between the composition of public expenditure and economic growth. As suggested by Bose,

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Haque, and Osborn (2007), to get further insights into the linkages between fiscal policies

and economic growth, we identify the elements of public expenditure.

This paper is closely related to the previous studies, and it contributes to the literature, at

least, in two ways. First, we estimate the regional public expenditure in relation to economic

growth in the case of a special autonomy region which has its own uniqueness. Second, we

combine the local public expenditures and private expenditure approaches. We hope that the

combination of the two approaches can offer wider perspective.

Literature Review

Keynes (1964) advocated for government spending to create jobs and employ capital that

has been unemployed or underutilized when an economy is in a downturn with high

unemployment of labor and capital. Keynes’s theory postulates that government spending is

needed to increase economic output and promote growth.

The explicit intension of public expenditures in relation to economic growth was initiated

by Barro (1990). Previously, the Solow growth model (1956) considered that public expenditure

was only related to the equilibrium factor ratios and it was assumed that public investment

was not related to long run economic growth. The endogenous growth model (Romer, 1990)

argues that the significant relationship between long run economic growth and public

expenditure rests on the inclusion of fiscal policies into the endogenous growth model with

the conclusion that public spending can affect the long run economic growth (Barro and Salai-

Martin, 1992).

Much of the empirical literature on fiscal policy and long-run growth has focused on

taxes rather than public expenditures, and suffers from various methodological weaknesses

(Temple, 1999). In particular, it is now recognized that tests of the growth effect of public

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expenditure decompositions (and other fiscal variables) must accommodate the total government

budget (expenditures, revenues, deficits); a feature missing from much of the earlier literature

(Bleaney, Gemmell, & Kneller, 2001).

Regarding to the composition of public expenditure, Devarajan, Swaroop, and Zou

(1996) observed economic growth in 140 OECD countries. They show that an increase in the

share of current expenditure has positive and statistically significant growth effects. By contrast,

the relationship between the capital component of public expenditure and per-capita growth is

negative. Thus, seemingly productive expenditures, when used in excess, could become

unproductive.

Colombier (2011) estimates the growth effects of the composition of public expenditure

for the Swiss case. One main finding is that public expenditures on transport infrastructure,

education, and administration foster growth. These results imply that developing-country

governments have been mis-allocating public expenditures in favor of capital expenditures at

the expense of current expenditures.

In the context of developing countries, Sennoga and Matovu (2010) utilize a dynamic

Computable General Equilibrium model to study these interrelationships. Their paper

demonstrates that public spending composition does indeed influence economic growth and

poverty reduction in Uganda. In particular, this study shows that improved public sector

efficiency coupled with re-allocation of public expenditure away from the unproductive

sectors such as public administration and security to the productive sectors, including

agriculture, energy, water, and health leads to higher GDP growth rates and accelerates

poverty reduction.

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 Olabisi and Oloni (2012) explore the relationship between the composition of public

expenditure and economic growth in Nigeria. Government expenditure is expected to be

means of reducing the negative impacts of market failure of the economy. However,

allocations of public expenditure with lack of consideration for the urgent needs of the

country may engender greater distortion in the economy which may be detrimental to growth.

They have analyzed the relationship between public expenditure compositions on economic

growth using the vector auto-regressive models. The finding shows that expenditure on

education has failed to enhance economic growth due to the high rate of rent seeking in the

country as well as the growing rate of unemployment.

Mudagi and Masaviru (2012) investigated the impact of public spending on education,

health, economic affairs, defense, agriculture, transport and communication on economic growth

in Kenya. The findings showed that expenditure on education was a highly significant

determinant of economic growth while expenditure on economic affairs, transport and

communication were also significant albeit weakly. In contrast, expenditure on agriculture

was found to have a significant though a negative impact on economic growth. Outlays on

health and defense were all found to be insignificant determinants of economic growth.

In light of these findings, Barro and Sala-i-Martin (1992) cautioned that government

expenditure may be productive or unproductive. It seems that consumption government

expenditures tend to have a negative impact on economic growth in advanced countries but

have a positive impact in developing countries. Similarly, the productive government

expenditures in developed countries may be productive in developing countries.

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Methodology

Those studies suggest that the root of the problem of the impact of public expenditures on

economic growth is the efficiency of the corresponding expenditures. To test the efficiency of

expenditures, especially local public expenditure, we adopt the conventional Cobb-Douglas

production function and applied at the regency/municipality level in Papua and West Papua

Indonesia.

Based on the literature review in the previous section, the regional income (Y) is assumed

to be dependent on government expenditures (GE) and private expenditures (PE):

Y = f (GE, PE)
The government expenditures can be divided into 2 broad
categories, i.e. capital expenditures
(CE, typically investment expenditures) and operating
expenditures (OE, representing
consumption expenditures):

GE  {CE, OE} (2)

Private expenditure is total expenditure minus total government expenditure:
PE = Y – GE (3)
To avoid perfect co-linearity among variables above, we specified PE in relative term to GE
(PE/GE).

This study has been made on the basis of panel data models to investigate the

contribution of public and private expenditures performance on local economic growth. In order

to overcome this problem, this study uses log linear specification and the model can be written as

follows:

Log Yit = α + β1 Log CEit + β2 Log OEit + β3 (PE/GE)it + eit (4)

Subscripts i denotes regency/municipality, t is time, and e = random disturbance terms.

The neoclassical production theory predicts that an increase in capital expenditure will raise

regional income so we expect β1 is positive. The estimated value of β2 could be positive or

130
negative. When the private expenditure rises, the local income tends to increase. We predict

β3 is positive.

The traditional microeconomic theory proposed that the local government expenditure is

treated similarly to the private expenditure and the local public expenditure is examined

under the assumption that local government faces linear budget constraints to supply public

goods/services. Given that, we can test some restrictions imposed into equation (4):

1 = 2;

i.e. public expenditures have equal impact on economic growth (5)

1 = 2 =1

i.e. public expenditures have an allocative efficiency (6)

[1 = 2] + 3 = 1,

i.e. constant return to scale – Public and private expenditures have equal impact

on economic growth (7)

The test is done using both analysis of variance (F-test) and chi-square (2-test) tests for

each parameter restriction imposed (see for example: Gujarati, 2004).

This study utilizes regencies/municipalities data of Papua and West Papua provinces

throughout a period of 2007 until 2010 with a total of 29 and 11 regencies/municipalities

respectively. Due to the altered number of regions in both provinces during the study period,

the samples utilized in this study are the regions that meet the following criteria: (a) the

availability of Local Budget Realization Report data; (b) regencies/municipalities that already

exist and not experiencing changes (division, unification); and (c) the associated regencies/

municipalities have the complete required data.

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 Referring to those above criteria, there were only 87 sample-points

regencies/municipalities exerted as a sample in this study. All the data are taken from Local

Budget Realization Report data published by General Directorate of Fiscal Balance, Ministry of

Treasury website (http://www.djpk.depkeu.go.id/). Other data come from Central Board of

Statistics (http://www.bps.go.id). This study employs regression analysis, i.e. multiple regression

analysis and applied for unbalanced panel data by assuming all requirements in regression

analysis are satisfied.

The variables used here are specified as follows. The regional income is the summation

of final products measured in 2000 constant prices (million Rupiah). The capital expenditure

follows the sectoral/functional budgetary realizations. The operating expenditures cover

realizations of wage/salary, goods/services purchases, maintenance, etc. (in million Rupiahs).

Those expenditures are then converted into a real term by dividing by GDP deflator (2000 =

1).

Results and discussion

Table 1 delivers the descriptive statistics of all variables under study covering mean,

extreme, standard deviation, and also kurtosis values covering all regions. Statistically, a variable

is said to be volatile if its CV (coefficient of variation, the ratio of standard deviation to mean)

is more than 50 percent. Based on the empirical rule, the regional income is the most volatile

indicated by the highest CV (312.15 percent) which more than 54 trillion contributed by

Mimika regency.

The variability of capital expenditure is also relatively high closes to 46 percent. The total

public expenditure is the least diverse revealed by the lowest CV (36.25 percent). This raises

preliminary hypothesis that capital expenditures and private expenditures support to regional

132
economic growth. We will check it more deeply later using econometric tools.

All of variables of interest are asymmetrically distributed (bell-shaped) indicated by the high

value of skewness, especially Y. Intuitively, the null hypotheses state that the series data is

normally distributed can be rejected The Jarque-Bera test supports to the asymmetric

distribution. The upper tail of the distribution is thicker than the lower tail (indicated by the

positive values of skewness), and the tails of the distribution are thicker than the normal

(indicated by the kurtosis coefficient is greater than 3).

Table 1
Descriptive Statistics
CE TE Y
Mean 206269.98 529998.56 2647428.61
Median 202406.65 540975.73 708169.73
Maximum 547009.17 1207114.12 54840480.61
Minimum 43119.77 161236.20 140707.55
Std. Dev. 94777.05 192148.65 8264070.60
Skewness 0.7413 0.5266 5.1829
Kurtosis 3.8205 4.4275 29.4212
CV (%) 45.95 36.25 312.15
Jarque-Bera 10.4080 11.4078 2920.0373
Probability 0.0055 0.0033 0.0000

Table 2 reports the estimation results of log linear model based on the fixed effect model

as specified in equation (4) for West Papua, Papua, and both provinces respectively. The sign of

public expenditures coefficients are contradict both across expenditure and province. The

coefficient of capital expenditure is negative (in Papua and total provinces) and as expected

before is positive (in West Papua). The sign of operating expenditures coefficients are

positive for all three regions.

The statistical evaluation on the corresponding coefficient unfortunately is statistically

insignificant. Given that, we infer that public capital expenditure failed to support regional

133
economic growth suggesting the capital expenditure is unproductive. This finding is in line

with recent studies in developing countries, especially for Africa (Olabisi & Oloni, 2012;

Mudaki & Masaviru, 2012).

With regard to the operating expenditure, the magnitude of the corresponding coefficients

is higher compared to the capital expenditure, especially in Papua province. Consequently,

overall, the public expenditures remain contributing marginally to economic growth. Given

that, we can say that the division/construction of new localities in the spirit of regional

autonomy followed by increasing operating expenditures support to economic growth.

The private expenditure significantly contributes to the local income growth. The increase 1

percent in private expenditure overall tends to raise local income for about 0.1 percent on the

average. Looking at the coefficient of private expenditure, the magnitude is lower than that of

the operating expenditure for all three cases. When we replaced it with its lag to

accommodate persistent private investment, the result does not change. In such a case, we

conclude that private sector is weak enough to play an important role to the economy.

Probably, it could explain why Papua and West Papua provinces are relatively less developed

than other provinces in Indonesia.

Table 2
Regression Results
Dep. Var: Log (Y) West Papua Papua Total
Coeff. t-stat Coeff. t-stat Coeff. t-stat
Constant 1.520003 0.77857 -2.323454 -0.72032 2.686592 1.12620
Log (CE) 0.213823 1.51770 -0.136237 -0.57788 -0.249710 -1.61253
Log (OE) 0.726996 4.91650 1.371784 6.00736 1.082461 6.15540
(PE/GE) 0.300831 9.78143 0.093181 12.92708 0.094119 12.08317
R-sq 0.83449 0.81947 0.69558
F 58.82415 66.57738 63.21556
SEE 0.32998 0.53291 0.58631
N 39 48 87

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 So far, we have talked about the determinants of local economic growth. In the next

section, we will answer the main question, whether both the public and private expenditures have

been already optimal. In absolute term, the expenditures' elasticity as presented in Table 2 in

some cases is less than unity. It seems that the increase in regional income is slower than that

in both public and private expenditures implying inefficiency in the corresponding

expenditures.

Table 3 presents the result of statistical tests based on some restrictions imposed into the

regression equation. By imposing coefficient of both public expenditures are assumed to be

equal (β1 = β2), the result shows that we can reject it in all provinces. The coefficient of

capital expenditure statistically does not equal to the operating expenditure implying that the

local government internally faces allocative inefficiency problems.

Table 3
Test of Restrictions
Restrictions West Papua Papua Total
F ; 2 Stat Prob. F ; 2 Stat Prob. F ; 2 Stat Prob.
β1 = β2 4.69106 0.0372 16.26817 0.0002 25.82817 0.0000
4.69106 0.0303 16.26817 0.0001 25.82817 0.0000
β1 = β2 = 1 3.40868 0.0733 2.65080 0.1106 0.21988 0.6404
3.40868 0.0649 2.65080 0.1035 0.21988 0.6391
[(β1=β2) + β3] = 1 16.13373 0.0000 11.81258 0.0001 33.09966 0.0000
32.26746 0.0000 23.62516 0.0000 66.19931 0.0000

Furthermore, imposing coefficient of operating expenditure equals to unity (β1 = β2 = 1),

the result shows that we can accept it in all provinces. The corresponding coefficient statistically

does not equal to unity implying that the operating expenditure is elastic with respect to

regional income. This result is consistent with the analysis above that only the operating

expenditures support to regional economic growth.

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 The third restriction is an assumption of the existence of constant return to scale ([β1=β2]

+ β3 = 1), i.e. the sum of magnitude coefficients of public and private expenditures are imposed

equals to unity. The regional output is said to enjoy a constant return to scale when the

increase in both public and private expenditures induce proportionally the regional output

increase. In such a case, the regional income is then said to be efficient.

The statistical tests show that we reject the restriction for both provinces. To accept the

null hypothesis that the private and public expenditures induce proportionally the local output,

we need almost 0 percent confidence level. It means that regency/municipality in West Papua

and Papua provinces do not experience constant return to scale. This is in line with the result

of the second restriction that proves statistically that β1 = 0 and β2 = 1.

To sum up, all regency/municipality in both provinces has not enjoyed a constant return

to scale yet or even experienced increasing return to scale. Consequently, the expenditure is not

optimal yet and potential to be prioritized further. This conclusion is consistent with the fact

that the human development indices in most regency/municipality in Papua and West Papua

provinces are the lowest compared to the other provinces in Indonesia (BPS, 2011). The

human development index is determined mainly by regional income, health and education

expenditures. The two latest variables are also decentralized to local government. It implies

that the private and public expenditures have some technical inefficient problems in the

provinces.

Conclusion

This paper analyzed the local income growth in relation to public expenditure's

optimization in the special autonomy region, i.e. Papua and West Papua provinces. The study

136
employed secondary data published by formal institutions focusing on the unbalanced panel data

at the regency/municipality level. The motivation of this paper is triggered by the fact that local

governments in Indonesia have been decentralized to manage their own revenues and outlays.

This brought about the need to examine the efficiency of sectoral budgetary allocations to

provide the critical information in decision making and prioritizing their expenditures.

This paper adopts input-output elasticity method to evaluate the present public and private

expenditure optimization at the regency/municipality level in the period of 2007-2010. The

elasticity of capital expenditure with respect to regional income is insignificant indicating that

the economic growth is not responsive to the capital expenditure. Regarding the operating

expenditure, we found unitary elastic indicating that it supports to regional economic growth.

Combining to the private expenditure, the regency/municipality in both provinces has

increased return to scale implying that the local economy is suboptimal and potential to be

accelerated further.

Based on those findings, we suggest that local governments need to improve

discretionary public expenditures at the local level, such as prioritize their expenditures and

sharpen them – into soft and hard infrastructures - so they create complement to the private

expenditures.

They also should improve the budget composition as well as enforce the expenditures'

efficiency. Furthermore, the study leads to the recommendation to improve local business

environment, such as streamlining local regulations and reducing harmful local taxes and user

charges to attract more investors. Finally, it needs to reform regional autonomy and fiscal

decentralization policies in both provinces.

137
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