2. Setting the stage for good local employment and skills policies in Indonesia

Looking at Indonesia’s economic development trends over the past years is a prerequisite for understanding employment and skills outcomes across provinces, analysed in Chapters 3 and 4 of this report. Driven by remarkable economic growth, Indonesia is today the largest economy in Southeast Asia by GDP. Despite progress, substantial differences persist across segments of the population and provinces, which require stepping up efforts to boost local economic development across the country in order to create good employment opportunities. The ongoing COVID-19 pandemic crisis poses new and unexpected challenges to Indonesia’s health system and local development opportunities. Some provinces are better prepared than others in facing the pandemic, which risks exacerbating inequalities.

Section 2.1 provides a snapshot of Indonesia and its administrative structure. Section 2.2 presents economic development trends in Indonesia, focusing on economic performance, poverty and inequality. Section 2.3 delves into provincial differences in socio-economic performance across Indonesia. Section 2.4 outlines the main characteristics of decentralisation in Indonesia.

With a population of 270.6 million in 2019 dispersed around more than 17 000 islands, Indonesia is the fourth most populated country and the largest archipelago in the world. Annual population growth has declined since the mid-2000s, but remains above 1% per year. The Indonesian population is projected to reach 305 million in 2035 and 319 million in 2050, according to OECD estimates (OECD, 2019[1]). The island of Java alone gathers 56% of the population, and the island of Sumatra a further 20%. Indonesia continues to urbanise at a steady pace. In 2017, 55% of the population lived in urban areas, up from 45% in 2005. Indonesia has a young population compared to other Southeast Asian economies. The median age of the Indonesian population is 31.1 years, lower than many countries across Southeast Asia (39 in Thailand, 35.6 in Singapore, 31.9 in Viet Nam and 31.1 in Brunei Darussalam).

Indonesia is the largest economy in Southeast Asia, with a GDP of over USD 1.1 trillion (current prices) in 2019, but disparities across provinces are wide. The poverty headcount ratio, defined as the percentage of people living below the international poverty line of USD 1.90 a day, amounted to almost 60% in 1990, while it is today more than ten times lower. However, socio-economic outcomes vary widely across provinces. There are wide disparities across provinces in gross regional domestic product per capita, ranging from more than IDR 230 million (around USD 16 000) in the Special Capital Region of Jakarta to less than IDR 20 million (less than USD 1 500) in East Nusa Tenggara. Regions with higher GDP per capita are more resource-rich, such as East Kalimantan (oil), Papua (copper and gold), Riau and Riau Island (oil, gas and palm oil). On the other hand, provinces with lower GDP per capita tend to be rural and remote islands lacking natural resources, such as Maluku. Previous OECD work shows that disparities in GDP per capita are larger in Indonesia than in other emerging economies, such as Mexico, Brazil, the People’s Republic of China (hereafter “China”) and India. In addition, poverty is substantially more severe in provinces in the East than the rest of the country.

The administrative structure of Indonesia delegates substantial power to local policy makers to foster economic development opportunities. Indonesia consists of 34 provinces, 410 districts (known as regencies) and 98 cities. The population size of provinces ranges from less than 700 000 inhabitants in North Kalimantan to almost 50 million in West Java (see Table 2.1). At the same time, some provinces cover a significantly larger area than others (e.g. 320 000 squared kilometre in Papua, while only 664 in the Special Capital Region of Jakarta). Consequently, population density varies, and it can be as high as 15 000 inhabitants per squared kilometre in the Special Capital Region of Jakarta, while lower than 10 North Kalimantan, Papua and West Papua. Regencies and cities also have different demographic sizes and economic characteristics, with small regencies being home to 6 000 inhabitants, while the population of the largest cities can amount to 4.8 million (Bogor in West Java). Each province, district and city has its own administration, which has the right to establish local regulations. Subnational administrations have wide autonomy except on matters reserved for the central government. Indonesia embarked in a process of decentralised in the early 2000s, which resulted in increased administrative and fiscal power in the hands of local governments.

A strong economic performance, reduced poverty and inequality, are a pre-requisite for good employment and skills outcomes. Indonesia’s economic performance is remarkable looking at where the country stood in the 1960s: the Indonesian GDP was equivalent to that of many low-income African countries at the time and ranked very low in the Asian context. A gradual process of industrialisation drove Indonesia’s growth and falling oil prices in the 1980s supported economic diversification.

While growth has dramatically reduced poverty and lifted living standards, profound differences exist across provinces and segments of the population. Western provinces typically drive economic activity, also thanks to supporting infrastructure and access to services, while rural and remote regions, predominantly in the east of the country, lag behind. While decentralisation reforms have aimed to improve the effectiveness of service delivery at the local level, they have also made local governments highly reliant on transfers from the central government, and made access to adequate skills in the public service more challenging.

The ongoing COVID-19 pandemic crisis puts substantial pressure on Indonesia’s health system and poses challenges to future economic growth. As of 9 April 2020, all 34 provinces in Indonesia have confirmed COVID-19 cases, with Jakarta recording half of the confirmed cases. Few people are being tested and the availability of Intensive Care Unit (ICU) is poor, with the availability of medical infrastructure varying substantially across provinces. In addition, on 1 April, the government officially revised down its growth forecast from 5.3% to 2.3%. The government has taken measures to support the economy, including increased budget deficit and social assistance measures.

With a GDP of over USD 1.1 trillion (current prices) and a population of 270.6 million in 2019, Indonesia is the largest economy in Southeast Asia and one of the largest emerging economies in the world. The Indonesian economy has been characterised by sustained GDP growth over the last decade, averaging more than 5% almost every year, substantially higher than growth in the OECD and in line with the average across ASEAN countries (see Figure 2.2). The size of the Indonesian economy is even more remarkable considering a larger timeframe. Starting from similar GDP levels as other ASEAN economies as early as in the 1960s, the size of the Indonesian economy today is substantially larger than other ASEAN countries (see Figure 2.3). Supportive macroeconomic policies, greater confidence and strong external demand have benefitted economic activity in recent years. Consumption continues to be an important driver underpinning Indonesia’s growth (OECD, 2018[2]). However, Indonesia runs the risk of remaining stuck in a middle-income trap as, by some estimates, the economy should grow at least 6% per year as a pre-condition for being able to escape the middle-income trap and shift towards higher development levels (Sukmana, 2019[3]). Human capital has been identified as one of five priorities for the government which has set an ambitious target that Indonesia will leave the middle-income trap by 2045. Closing the gap in Global Value Chain (GVC) participation could yield significant productivity and income benefits, speeding up the rate of transfer out of the agricultural sector and informality (OECD, forthcoming[4]).

Indonesia’s achievements in tackling poverty over the last decades have been remarkable. Poverty in Indonesia declined from a peak of 24.2% of people living below the national poverty line in 1999 to 9.2% in 2019. The poverty headcount ratio, defined as the percentage of people living below the international poverty line of USD 1.90 a day, amounted to almost 60% in 1990, while it is today more than ten times lower. A temporary backlash took place as a consequence of the Asian financial crisis in 1997-1998, causing the poverty headcount ratio to increase by almost 6% between 1996 and 1999, and causing almost 18.5% of non-poor urban households to fall into poverty (Dartanto et al., 2017[5]). Poverty has continued to decline in Indonesia over the last decade: the number of people in poverty at USD 1.90 a day has decreased from 50.4 million in 2008 to less than 15 million in 2018. Accordingly, the poverty headcount ratio has decreased from 21.8% in 2008 to 4.6% in 2018 (see Figure 2.4). While efforts to reduce poverty have delivered significant results for the population, about 24.2% of the population, accounting for more than 60 million people, still live on less than the lower middle-income class poverty line, amounting to USD 3.20 per day. This suggests that, although extreme poverty has decreased, further efforts are needed to lift living standards. It should be noted however that poverty measures based on specific monetary values (e.g. USD 1.90 and 3.20 a day) risk not taking into account the effect of inflation.

Declining poverty rates do not seem to have translated into decreased inequalities in the country. The Gini Index, measuring inequality in the income distribution, has increased for much of the 2000s, and has continued to rise after 2010, reaching a peak of 0.39 in 2013. It stands to 0.39 in 2018, but the levels are still higher than the beginning of the decade. Structural transformation might be one of the driving factors of rising inequality in Indonesia. The trends of the Gini Index and the share of agriculture to GDP have moved in opposite directions, while the Index and the share of services to GDP move in a similar direction. Inequalities could be rising because capital-intensive and skills-intensive sectors, including finance, telecommunications and other services, employ fewer people, and less educated and unskilled people may not benefit from a rising economy (Dartanto et al., 2017[5]). Inequalities also seem to be more accentuated in Indonesia than in some other ASEAN economies for which data is available. Viet Nam, Thailand and Myanmar all have lower Gini Indices than Indonesia (see Figure 2.5). Consumption data across different segments of the population confirm that substantial inequalities persist in Indonesia. Between 2015 and 2017, the mean consumption of the bottom 40% of the income distribution has increased from USD 2.51 to USD 2.75 per day, as compared to USD 5.68 and 6.24 for the total population. The annualised growth in mean consumption per capita shows a negative shared prosperity premium, with the consumption of the bottom 40% growing less than the mean between 2015 and 2017.

Recent estimates show that the COVID-19 outbreak will heavily affect economic growth worldwide. The pandemic is inflicting high and rising human costs worldwide and severely impacting economic activity. As a result of the pandemic, the global economy is projected to contract sharply by -3% in 2020, much worse than during the 2008–2009 financial crisis (International Monetary Fund, 2020[6]). The Indonesian government’s baseline scenario is for Indonesia’s economic growth to drop to 2.3%, the lowest in 21 years, with a worst-case scenario of an economic contraction of 0.4% (The Jakarta Post, 2020[7]). The International Monetary Fund (IMF) forecasts that GDP growth in Indonesia should drop to 0.5% in 2020.

Millions are likely to fall into poverty, as Indonesia puts in place the necessary protection measures. The government has projected that millions of people will fall into poverty and unemployment as the COVID-19 pandemic batters the Indonesian economy. Under the “bad” scenario, 1.1 million new poor and 2.9 million new unemployed people would be added. The worst-case scenario projected 3.78 million people would fall into poverty and 5.2 million would lose their jobs (The Jakarta Post, 2020[8]).

The Indonesian economy’s growth over the last decades has been remarkable and it has contributed to lifting living standards across regions. Poverty has decreased, and education and labour market outcomes have improved. However, substantial disparities across regions persist in both economic performance and living standards. Differences across provinces in Indonesia emerge when looking at indicators of economic performance as well as living standards. The availability of natural resources is dispersed in Indonesia, contributing to regional disparities (Mokoginta, 2018[9]). The concentration of economic activity has not changed significantly over the last decades, with Java, Bali, Sumatra and Kalimantan experiencing better economic performance than eastern regions (Hill, Resosudarmo and Vidyattama, 2008[10]). The better performing regions in Indonesia are the most connected to the global economy. Jakarta has grown richer than the rest over the last decades, standing out as a special case (ibid.). The regional distribution of growth can be linked to historically poor areas (Hill and Vidyattama, 2016[11]). Western provinces tend to enjoy better living conditions, while more rural and remote provinces, especially in the east of the country, often lag behind in both economic terms and living standards.

As the performance of provinces across Indonesian varies substantially, place-based policies can help each of them make use of their specific strengths to generate economic development. Place-based development policies can provide solutions to help regions utilise their full economic potential (OECD, 2019[12]). Indeed, the Indonesian government has recently taken steps to promote more equitable growth in Indonesia, identifying tourism as a potential driver of growth for regions lagging behind (see Box 2.1). The role of tourism as a driver of growth across provinces in Indonesia is however is facing substantial challenges due to the COVID-19 pandemic as tourism has been one of the most heavily-affected sectors.

The Indonesian population is concentrated in the islands of Java and Sumatra, which account for more than three quarters of the total population in the country (see Figure 2.6). High concentration of population and economic activity in some islands generates environmental and infrastructure challenges. For example, excessive subterranean water extraction is causing land subsidence and increasing the risk of flooding in Jakarta, while traffic jams and urban air pollution are amongst the worst in the world (OECD, 2019[14]). Concentration can however also permit economies of agglomeration necessary for thriving highly productive services in sectors such as finance and information technology (OECD, forthcoming[4]). The provinces of West Java, East Java and Central Java are the most populous, being home to 18.3%, 15.2% and 13.2% respectively of the total Indonesian population. The Special Capital Region of Jakarta has the highest population density, which can be as high as 15 300 inhabitants per squared kilometre. On the other hand, density levels can be as low as 10 inhabitants per squared kilometre in West Papua, Papua and North Kalimantan.

In addition, it is projected that gap between urban and rural population will exacerbate in Indonesia, as more and more people will move to urban areas (see Figure 2.7). It is expected that the rural population will number barely over 100 million by 2035, whereas the urban population will exceed 200 million, having increased by 71% since 2010 (Jones, 2014[15]). By 2045, 220 million Indonesians will live in urban areas. Urbanisation can boost economic prosperity, by fostering positive agglomeration forces, creating an environment that is conducive to innovation and enhanced productivity. However, not everyone may benefit from the prosperity and liveability generated by urbanisation, as the benefits may fail to spill over to those who remain in the countryside, worsening gaps between urban and rural areas. This requires adequate connectivity both across and within places, to ensure that prosperity does not remain locked up in the cores of the urban areas but is shared more broadly (Roberts, Gil Sander and Tiwari, 2019[16]). Population shifts from rural to urban areas will have profound implications for the labour market, putting pressure on urban areas to get an increasingly larger working age population into jobs (Allen, 2016[17]).

The Special Capital Region of Jakarta is the province with by far the highest gross regional domestic product per capita, amounting to more than IDR 230 million per capita (more than USD 16 000). It is followed by East Kalimantan, North Kalimantan, Riau Islands, Riau, and West Papua. Substantial differences exist between the six top performing provinces in terms of gross regional product per capita and the rest of the country (see Figure 2.8). The remaining 28 provinces have a GDP per capita ranging from IDR 60 to 15 million. While the higher values for the Special Capital Region of Jakarta can be linked to its centrality in the Indonesian economy, regional differences also denote disparities in natural resource endowments. Regions with higher GDP per capita are more resource-rich, such as East Kalimantan (oil), Papua (copper and gold), Riau and Riau Island (oil, gas and palm oil). On the other hand, provinces with lower GDP per capita tend to be rural and remote islands lacking natural resources, such as Maluku (OECD, 2016[18]).

Furthermore, the GDP per capita distribution in Indonesia appears more dispersed than for other emerging market economies, suggesting that Indonesia’s economic development has been characterised by more regional disparities as compared to other emerging economies (see Figure 2.9). Regions lagging behind are characterised by a predominantly agricultural economy. For example, in East Nusa Tenggara employment in agriculture (1.3 million people) is almost four times higher than employment in services (355 000) and six times higher than employment in manufacturing (217 000). In Maluku, agriculture employs almost twice as many people (258 000) as the services sector (143 000) and more than four times more people than manufacturing (59 000). The government’s Fourth National Medium-Term Development Plan (or RPJMN 2020-2025) aims to realise an Indonesia that is self-reliant, advanced, just and prosperous through the acceleration of development on the basis of solid economic structures, supported by high-quality and competitive human resources. As part of the plan, the Indonesian government has designated six regions as “economic corridors” in order to foster investment attraction and develop specific industrial clusters around regional strengths. The corridors include Bali-Nusa Tenggara, Java, Kalimantan, Papua- Maluku Islands, Sulawesi and Sumatra (OECD/ADB, 2015[19]). The corridors aims to generate a more balanced economic base in Indonesia, fostering the potential of provinces other than the Special Capital Region of Jakarta, East and West Java, which today account for nearly half of Indonesia’s GDP. In addition, Indonesia has also been experimenting the use of Special Economic Zones (SEZ) to maximise foreign direct investment (FDI) attraction in different areas of the country (see Box 2.2).

Good infrastructure is an important component of a quality business environment, and can be a facilitator of economic growth. As part of the National Medium-Term Development Plan 2015-2019, the government has highlighted infrastructure development as instrumental in fostering connectivity, accessibility and integration of rural and remote regions. However, the quantity and quality of infrastructure across provinces in Indonesia remains uneven (see Figure 2.10). This reflects the uneven development between Indonesia’s regions and contributing to further exacerbating differences in economic performance. Disparities in road infrastructure remain a significant challenge in Indonesia, with predominantly rural and remote regions, such as Kalimantan, Papua and Maluku, where roads are substantially shorter as a proportion of their land than other regions, such as Sumatra, Java and Sulawesi. The quality of road infrastructure also varies between urban and rural regions, with over 20% of roads classified as damaged in Kalimantan and Maluku, while only 19% of them are considered to be in good quality in Papua (OECD, 2013[24]).

Being an archipelago of more than 17 000 islands, the economic performance of Indonesia depends heavily on the capacity and quality of its port infrastructure. The Quality of Port Infrastructure index developed by the World Economic Forum (WEF) measures business executives’ perception of their country’s port facilities. The index shows that, while the perception of Indonesia’s port infrastructure has been improving, it still lags behind compared to other ASEAN countries such as Singapore, Malaysia and Thailand. The capacity of port infrastructure could be improved in Indonesia. There are more than 100 commercial ports in the country, but most of them only cater to small vessels on domestic routes and lack container facilities. In addition, there are 725 public ports across the country, which appear insufficient to serve the number of islands and the vast area of Indonesia (Leung, 2016[25]). The Tanjung Priok port in Jakarta, Indonesia’s largest port, manages around two thirds of national shipments and traditionally suffers from high dwelling times, hampering the competitiveness of export-oriented industries in the country. The Tanjung Perak port in Surabaya represents the second most important port in the country. Port infrastructure remains underdeveloped in the rest of the country, especially in eastern provinces, with the exception of Makassar, where the Makassar New Port project launched by the government aimed to increase its capacity. The government has recently launched several projects to upgrade the quality of existing port infrastructure in large ports and expand port infrastructure in eastern provinces (see Box 2.3).

Finally, airport infrastructure also plays an important role to foster connectivity across Indonesian provinces. Passenger numbers throughout Indonesian airports have been consistently growing over the last decades and today exceed 120 million on domestic and 21 million on international flights. Jakarta’s Soekarno-Hatta International Airport is the largest airport in the country and one of the busiest in the world, with more than 50 million passengers per year. Other large airports in Indonesia include Surabaya, Bali, Makassar and Medan. Plans to expand and renovate airport infrastructure across Indonesia have taken a prominent role in Indonesia over the last years. Chronic under-capacity of existing airports has been, however, identified by the government as a relevant challenge hampering the potential of air transportation (UK Trade & Investment, 2013[26]). The Masterplan for Acceleration and Expansion of Indonesian Economic Development (MP3EI) 2011-2025 lists 13 airport expansion and refurbishment projects across both western and eastern Indonesia.

The large informal sector contributes to the prevalence of micro-enterprises across regions in Indonesia. However, the density of the SME population is influenced by local factors, including the presence of large employers, natural resource endowments, the size of the informal sector as well as whether the province is mostly rural or urban. Central Java, Bali and East Java have between 21 and 31 industry-based businesses with 1-19 employees per 1 000 people, as compared to 2-3 in West Papua, Papua, North and East Kalimantan and Riau (OECD, 2018[28]).

The World Bank Doing Business surveys undertaken in 2010 and 2012, which benchmark 14 Indonesian cities, found substantial differences in the quality of the business environment SMEs and other businesses face across cities in Indonesia (see Figure 2.11). For example, the cost of dealing with construction permits was as high as 132% of the annual per capita income in Makassar (South Sulawesi), compared to only 32% in Jambi, while the cost of opening a new business amounted to 31% of the annual income per capita in Manado (North Sulawesi), compared to 18% in Pontianak (West Kalimantan). The variation in the regulatory environment among cities can be partly attributed to different degree of enforcement of national laws at the local level, suggesting that improvement in the regulatory environment can be attained independently from reforms at the national level. However, the large majority of cities surveyed by the World Bank showed progress between the two surveys, suggesting that there is scope for lagging regions to learn from their Indonesian peers (OECD, 2016[18]). The city of Surabaya has recently stepped up efforts to tackle informality and improve the business environment in the city, making it easier for businesses to register and obtain licences (see Box 2.4).

GDP per capita can fail to measure standards of living, especially for resource-rich provinces. Provinces with high GDP per capita due to the exploitation of natural resources might not fully reap the benefits of it, as part of the income traditionally flows out of the province. For instance, national poverty data shows that the provinces of Papua and West Papua, although having high GDP per capita, have the highest poverty severity across Indonesia. Poverty is mostly a rural and agricultural phenomenon in Indonesia, although not exclusively (OECD, 2015[30]). In remote eastern islands of Indonesia, up to 95% of people in rural communities can be poor. On the other hand, inequalities are higher within urban areas, suggesting that the urbanisation trend that has taken place over the last decades has reduced poverty but accentuated inequalities (OECD, 2016[18]). The city of Makassar, located in the eastern province of South Sulawesi, has recently undertaken several initiatives aiming to tackle poverty and reduce inequalities, getting people into jobs (see Box 2.5).

Health conditions have considerably improved in Indonesia over the past decades. The average life expectancy at birth in Indonesia was over 71 years in 2017 and has steadily increased across the country. Richer provinces however average as many as 10 years of life expectancy more than poorer ones. The Special Region of Yogyakarta has the highest life expectancy in Indonesia, amounting to almost 75 years, while the population of West Sulawesi is expected to live on average less than 65 years.

However, disparities in access to health are wide across Indonesian provinces, and the ongoing COVID-19 pandemic crisis threatens the ability of some provinces to answer adequately. Only 36 in every million people are currently being tested for COVID-19 using the standard polymerase chain reaction (PCR) kits. In comparison, Korea tests 8 996 for every million people, Singapore 6 666, and Malaysia 1 605. The authorities claim that a much larger number of rapid tests are performed, but the figures are disputed and such tests are less reliable. Indicators of access to health show that disparities across provinces are wide (see Figure 2.16). Eastern provinces, which have substantially lower population density levels, are characterised by higher number of health centres per 30 000 people than the rest of the country. However, this does not necessarily reflect the high quality of health services provided. The number of doctors per health centre varies substantially across the country, and the low rate of assisted birth in some province shows that, although hospitals are in place, a health-specialised workforce might be lacking (OECD, 2016[18]). The incidence of diseases such as malaria and tuberculosis also varies across provinces. In 2010, provinces such as Java and Sumatra recorded very low levels of malaria incidence. Meanwhile, incidence amounted to more than 50 cases per 1 000 people in Papua and West Papua. In 2016, most of the provinces had an incidence of malaria of less than one case per 1 000 people, while it remained at 45 cases in Papua. While the incidence of tuberculosis is not correlated with affluence across provinces, success rates vary considerably. In Lampung, more than 95% of cases are treated successfully, while less than 40% are treated in Central Kalimantan.

At the end of the 1990s, hand in hand with the democratic transition, Indonesia embarked on a program of decentralisation, revolutionising the previously centralised governance system. The “Big Bang” decentralisation led to a fast transferral of the government apparatus to the regions, corresponding with a hike in the regional share in government spending and the introduction of a new inter-governmental transfer system (Hofman and Kaiser, 2002[32]). Sub-national entities include provinces, regencies and cities, districts and villages (see Table 2.3). They were made responsible for the delivery of public services, with the rationale that increased responsiveness to local needs would allow for better accountability and service delivery. Among these, the state devolved the greatest share of responsibilities to regencies and cities as compared to provinces, which mainly play a supervisory role, represent the government at the regional level, and intervene in matters requiring cross-jurisdictional co-operation (Malley, 2009[33]) (Nasution, 2016[34]). The role of the central government, meanwhile, has been limited to six broad areas, including finance, foreign affairs, defence, security, religion, and state administration and justice (Nasution, 2016[34]).

The size of provinces ranges from 640 000 inhabitants in North Kalimantan to almost 50 million in West Java. The provinces of Aceh, the Special Capital Region of Jakarta, the Special Region of Yogyakarta, Papua and West Papua have special status, enjoying more autonomy. Regencies and cities have different demographic sizes and economic characteristics, with small regencies being home to 6 000 inhabitants, while the population of the largest cities can amount to 4.8 million (Bogor in West Java). Regencies and cities are then divided into more than 7 000 districts that are managed by a civil servant appointed by the regency or city.

Local governments have been granted significant spending autonomy. However, although they can collect minor taxes such as on land and buildings, vehicles, hotels, restaurant, entertainment, base metal and mineral extraction and water, taxing power remains with the central government (Nasution, 2016[34]). The way decentralisation has been implemented in Indonesia has therefore made local governments highly dependent on transfers from the central government, particularly through shared taxes and grants. The entity of transfers varies from one sub-national unit to the other, as some of them do not have substantial own-source revenues. The speed of decentralisation also meant that the required accompanying skills, technical capacities, resources and oversight were sometimes lacking (Vujanovic, 2017[35]). Decentralisation of government functions was not often followed up with equipping subnational governments with the capacity to produce public goods, increase productivity and employment and promote growth in their jurisdiction (Nasution, 2016[34]). Decentralisation can foster competition among regions in the efficient provision of services and attracting businesses, and generate good practice and lessons learnt exchanges among regions (Blöchliger and Kim, 2016[36]), but it can also exacerbate regional disparities. The way decentralisation is implemented has an impact on regional disparities (see Box 2.6). Since decentralisation was launched in Indonesia, the government has made efforts to encourage participatory approaches in community and regional planning and has developed entry points for local communities to get involved (UNDP, 2017[37]). These have been implemented for example through the Musrenbang process, officially started with the adoption of the Law of the National Development Planning System in 2004 (see Box 2.7).

Today, provinces mainly play a co-ordinating and supervisory role, while regencies and cities retain responsibilities in the large majority of policy areas, including health, education, public works, transportation, and many more (see Table 2.4). Regencies and cities therefore play an important role in prioritising local development policies.

Reforms at the beginning of the 2000s provided local governments with increased autonomy, responsibilities, personnel, assets and resources. With a local government law introduced in 2004, Indonesia introduced direct elections for governors, regents and mayors, and expanded their responsibilities. The law delegated most responsibilities to regencies and cities, while it also strengthened the role of provinces as representatives of the central government at the local level and granted them supervisory powers. More recently, a new Local Government Law introduced in 2014 aimed to redefine responsibilities of different levels of governments to make the provision of public services more effective. De facto, it has contributed to transfer some responsibilities back to the central government. The Law outlines exclusive responsibilities for the central government, concurrent and general affairs responsibilities, as well as a list of mandatory and discretionary functions. The law also transferred responsibilities in several areas from regencies and cities to provinces, including in high school education, mining, forestry and coastal management. Despite the efforts, some overlap in responsibilities across levels of government, especially between regencies and cities on one side and provinces on the other, persist. Another 2014 law, the so-called Village Law, has strengthened the authority and resources of villages, recognising them as self-governing bodies.

Inter-governmental transfers represent the core of local governments’ budgets in Indonesia, as their capacity to raise taxes is limited. A challenge linked to inter-governmental fiscal systems is whether they create the right incentives for local governments to act in a responsible, productive and accountable manner, as transfers may not generate improved quantity, mix, quality and impact of local government spending and might distort expenditure behaviour (Lewis and Smoke, 2017[41]). In 2016, transfers from the central government amounted to 82.7% of local governments’ budget, while tax revenues accounted for only 15.7% of their total revenues, and non-tax revenues for the remaining portion (see Figure 2.17). The high reliance of local governments on inter-governmental transfers emerges even more clearly when comparing Indonesia to the OECD average, where transfers from the central government amount to 37.2% of local governments’ budget and revenues to 44.6%. Regencies, cities and villages account for more than 70% of all revenues at the sub-national level. While regencies, cities and villages are highly reliant on transfers from the central government, provinces’ budget mainly derives from taxes (41% of provinces’ revenue). Provinces collect 73% of all sub-national tax revenue, but overall tax revenue of local governments is limited, as the central government retains the power to collect major taxes and prohibits local governments from collecting other taxes than those set in national regulations. Provinces are mainly responsible for collecting motor vehicle taxes (an annual tax on the value as well as a tax levied when the motor vehicle is sold), as well as fuel, surface water and other taxes (OECD/UCLG, 2019[40]).

Several types of grants exist as part of the inter-governmental transfer system in Indonesia. The main grants include the General Allocation Fund (Dana Alokasi Umum, DAU), the Special Allocation Fund (Dana Alokasi Khusus, DAK), and the Revenue-Sharing Fund (Dana Bagi Hasil, DBH). The former accounts for around half of all central government transfers and, despite being a general purpose block grant, half of it is devoted to wages and salaries, while there are no restrictions for the remaining portion. On the other hand, the DAK is a special purpose grant, aiming to financing responsibilities considered as national priorities, including both capital expenditures and additional financing for the cost of service delivery. DBH aims to redistribute revenues from taxes as well as natural resources. About 20% of the DBH on the personal income tax is redistributed to provinces (40%) and regencies/cities (60%). In addition, other grants exist, aiming to support villages’ financing (the Village Fund) as well as autonomy funds with the special regions of Aceh, Papua and West Papua, a special fund for Yogyakarta, regional incentive grants and so-called “de-concentration funds”, granted from line ministries to local governments for specific projects (OECD/UCLG, 2019[40]).

Expenditure of local governments in Indonesia accounted for 8.1% of GDP and 47.7% of public expenditure in 2016, compared to the OECD averages of 16.2% and 40.4% respectively. This suggests that while expenditure is rather low as a percentage of GDP, it is quite high as a share of total public expenditure. Expenditure in public staff amounts to 53.4% of general government expenditure, compared to 43% for OECD unitary countries. Staff expenditure represents 40% of total expenditure for regencies and cities, compared to 18% for provinces. Regency and city governments and villages make up roughly two thirds of total expenditure of sub-national governments, and account for 6% of GDP and 35.2% of total public expenditure respectively, as compared to provinces, whose expenditure amounts to only 2.1% of GDP and 12.6% of total public expenditure (OECD/UCLG, 2019[40]).

The large majority of sub-national government spending in Indonesia pertains to general public services, education and housing and community amenities, amounting to 34.1%, 26.1% and 15.5% of sub-national government expenditure respectively (see Figure 2.18). General public services, including housing and community amenities, economic affairs and transport and health, represented more than 60% of provinces’ expenditure in 2016. On the other hand, the largest spending items for regencies and cities are education (34% of their expenditure), general public services (24%), housing and community amenities (16%) and health (12%) (OECD/UCLG, 2019[40]).

The analysis of the economic development context in Indonesia is a pre-requisite to understand employment and skills outcomes at the local level. Economic growth has gone hand in hand with poverty reduction in Indonesia over the past decades, but disparities among provinces are wide. While the delegation of responsibilities to lower levels of government can make the delivery of public services closer to the needs of the local communities, a coherent governance system will be instrumental to achieve effective local development strategies. Building on the overview provided by this chapter, Chapters 3 and 4 delve into differences in employment and skills outcomes across provinces in Indonesia and policies and programmes being implemented at the local level to foster job opportunities.


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