Page 3 - Working Paper (Fiscal Decentralization and Sub-national Taxes: Specific Case of Indonesia)
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DDTC Working Paper 1015

                   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
                                                                     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
                   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
                   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
                   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
                   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
                   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.
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