DRAFT: COMMENT WELCOME

IS THERE ANY EXPENDITURE COMPETITION AMONG LOCAL GOVERNMENTS IN EAST JAVA ? AN EMPIRICAL TEST
Rumayya Regional Economic Development Institute (REDI) Economics Faculty of Airlangga University Surabaya, East Java-Indonesia roemayya@yahoo.co.id

April 2006 Prepared for Seminar Akademik Ekonomi 2006 Abstract: In this paper we test whether local governments in East Java influence each others in determining their public spending using maximum likelihood (ML) estimation technique. The result shows that local governments in East Java engage in expenditure competition in the fiscal decentralization era but not in the period beforehand. Estimated elasticity of fiscal reaction function is 0.3, which means 10% increase in neighborhood expenditure percapita will followed by 3 % increase of the local government expenditure percapita. We believe that the media play an important role in enhancing the informational externalities among median voters in each region (especially through Autonomy Award conducted by JPIP). This form of externalities seems strengthening the pattern of yardstick competition among local governments in East Java Keywords: decentralization, local public expenditure, interjurisdiction competition

Corresponding authors alternative e-mail addresses: rumayya@redi.or.id , lizzardiant@yahoo.com

I.

INTRODUCTION

The "Big Bang" Indonesias 2001 decentralization is rapidly moving the country from one of the most centralized systems in the world to one of the most decentralized. The country has embarked on a program of fiscal, administrative, and political decentralization at the same time. Compared to the old system, the structure of local government organization in the new system has changed quite substantially. Provincial governments are not as powerful as before, while local governments (regencies and municipialities) play a more important role in planning and development. All authorities of governments except those reserved for the center and the now 33 provinces are assigned to the more than 400 local governments.

In principle, this new system of fiscal decentralization can improve the provision of public goods in such a way that these become tailored to local preferences and become a local responsibility, due to the government proximity to the local populace and since all local governments have become fully autonomous and responsible for planning, management, financing and delivery for various sectors.

To our perspectives these new setup of local government authoritys raise an interesting theoretical question about fiscal interactions among governments. Fiscal interactions arise when the decisions of one jurisdiction influence the decisions of other neighboring jurisdictions. Theoretically there are three main explanations why governments should be affected by their neighbors when they determine their policy choices (Redoano, 2003). The first one is based on the idea that there exists externalities among jurisdictions and therefore policy choices are not independent. An example of these types of externalities could be the amount of public investments in infrastructures in a jurisdiction (such as roads, airports, rail-

tracks) whose benefits spill over in neighboring jurisdictions, and therefore affect the level of investments in the latter jurisdictions.

Another type of interdependency is based on the idea that citizens can evaluate the performances of their policy makers by comparing the same policy choices taken by the neighboring jurisdictions. This idea of yardstick competition means that politicians are sensitive to their fiscal performance relative to similarly situated jurisdictions, and try not to get too far out of line with policies in those jurisdictions. The result is local authorities mimicking each others behaviour. However, the recent political agency-yardstick competition literature has stressed the role of informational externalities between neighbouring jurisdictions, and predicted tax mimicry at the local level. The actual relevance of the above hypotheses clearly needs to be assessed empirically (Revelli, 2000)

The last type of explanation is based on the tax competition literature: jurisdiction compete with their neighbor in order to attract tax base. The literature on tax competition is now voluminous both in theoretical as well as empirical examination. To mention a few Brueckner and Saavedra (2001) for property tax in Boston on area and Devereux and Redoano (2004) analyzing simultaneous vertical and horizontal competition in excise taxes on cigarettes and gasoline in US states and federal.

In this paper we test whether local governments in East Java influence each others in determining their fiscal choices. Our main goal is to estimate reaction functions for public expenditures using a dataset on regencies (kabupaten) and municipialities (kota) in East Java for the period before (2001) and after (2003) fiscal decentralization. We expect the fiscal interaction among local governments in East Java will only identified in period after fiscal

decentralization, since in the period beforehand the local governments had limited authority to organize and manage their own jurisdiction. Moreover, the local governments at that time are used by the central government to mobilize local resources without allowing them to manage and organize their own resources. However we will not discussed the tax competition since Indonesias fiscal decentralization did not include decentralizing the authorities for regional tax setting.

This paper builds on a small but growing empirical literature on strategic interaction between fiscal authorities, initiated by a pioneering study by Case, Rosen and Hines (1993), who estimated an empirical model of strategic interaction in expenditures among state governments in the US. This literature essentially estimates fiscal reaction functions, i.e. parameters which indicate whether any particular fiscal authority will change a tax rate or an expenditure level in response to changes in that variable by other authorities.

If local governments behave strategically toward their voters in order to be reelected, we should especially find positive sloped reaction functions for the expenditures. All these type of interdependencies imply that the reaction functions are positively sloped; but if, instead, they are related to positive fiscal externalities between jurisdictions we should expect a negatively sloped reaction function. The results support the idea that states act interdependently when they take their policy choices. We find evidence that local government engage in yardstick competition in decentralisation period but not in period beforehand.

The remainder of the paper is organized as follows. The next section discusses the empirical specification strategy we used to estimate the fiscal interdependencies in local government spending. Section 3 presents the data and spatial weight matrix, section 4 describes the results

of the estimation on a cross-section of the East Java local governments and section 5 summarizes and concludes.

II.

EMPIRICAL SPECIFICATION

Models of strategic interaction among governments can be classified into two broad types (Brueckner, 2003): the spillover model and the resource flow model. Both model have differently structures but generate a same kind of behavioral relationship, a jurisdictional reaction function, which relate each jurisdiction's fiscal choices to its own characteristics and to the choices of other jurisdictions and can be estimated empirically.

The empirical specification to test the degree of fiscal interdependency in this study follows Redoano (2003) and Brueckner (2003) which can be written in matrix form

zi = Wzi + Xi + i

(1)

Where and are unknown parameters (where latter a vector), i is an error term, and zi is fiscal choices of region i which depend on region i own characterisic which represented by the vectors Xi, and the fiscal choices of is own neigbors represented by Wzi , which is spatial lag of zi. This spatial lag is created by multiplying spatial weight matrix W with zi. These weights indicate the relevance of other jurisdictions in the process of interaction, and the can be viewed as part of jurisdiction is characteristic (detail on spatial weight matrix will be discussed in the next section).

When strategic interaction occurs, the slope parameter of reaction function , which reflects the strengh of interaction among jurisdiction is nonzero. As a result, a proper test for interaction involves a simple signifcance test on the slope coeffcient. If the null hypothesis of a zero reaction-function slope can be rejected, then the evidence points to the existence of strategic interaction among jurisdictions.

From the spatial econometrics perspectives the empirical spesification shown in (1) is known as Spatial Lag Model, where estimation of this model by Ordinary Least Squares (OLS) produces inconsistent estimators due to the presence of a stochastic regressor Wzi , which is always correlated with i , even if the residuals are identically and independently distributed (Anselin, 2000). Hence it is to be estimated by the Maximum Likelihood Method (ML) or the Instrumental Variables Method (IV).

III.

DATA AND SPATIAL WEIGTHS MATRIX

Data set and choice of variabes The dependent variabel in the fiscal reaction function equation (1) is logarithm of per capita public expenditue (PCPE) of East Javas local governments in year 2001 and 2002. This variabel is proxied by dividing realized APBD with total population in each year. As for the explanatory variables, Xi this study uses the variables which are conventionally assumed to affect the determination of public expenditure (Revelli, 2003; Redoano, 2003; Akita and Subkhan, 2004). These variables include socio-economic and demographic characteristics of each jurisdiction:

1. Percapita income (PCI) 2. Total population (POP) 3. Population density (DEN) 4. Percentage of population in poverty (POV) 5. Rate of unemployment (UNE) 6. Percentage of population over 65 (OLD). All variables are in logarithm, following Revelli (2003) and Akita and Subkhan (2004), and available in Jawa Timur dalam Angka and Analisis Indikator Makroekonomi Jawa Timur 2004, published by Central Bureau of Statistics (BPS). Expected sign of percapita income (PCI) is ambiguous; a positive sign is associated with the idea that in higher income jurisdiction there was ability to pay for higher level of public spending. But a negative sign could also equally possible to be argued that low level of income are asssociated with a need to spend more on welfare related spending (Brown and Jackson, 1990).

The poverty (POV), unemployment (UNE), and population of old resident (OLD) is expected to have a negative sign since these variables are asssociated with a need to spend more on welfare related spending. While population density (DEN) is expected to have negative sign, since more densely populated and urbanised areas tend to spend more in percapita terms (Revelli, 2003). Total population (POP) is expected to have negative sign due to the economies of population scale (Akita and Subkhan, 2004)

Spatial Weights Matrix The spatial weight matrix is the fundamental tool used to model the spatial interdependence between regions. More precisely, each region is connected to a set of neighboring regions by means of a purely spatial pattern introduced exogenously in this spatial weight matrix W. The

elements of wii on the diagonal are set to zero whereas the elements wij indicate the way the region i is spatially connected to the region j. These elements are non-stochastic, non-negative and finite. In order to normalize the outside influence upon each region, the weight matrix is standardized such that the elements of a row sum up to one.

For the variable zi, this transformation means that the expression Wzi, called the spatial lag variable, is simply the weighted average of the neighboring observations. Various matrices can be considered: a simple binary contiguity matrix, a binary spatial weight matrix with a distancebased critical cut-off, above which spatial interactions are assumed negligible, more sophisticated generalized distance-based spatial weight matrices with or without a critical cutoff. The notion of distance is quite general and different functional form based on distance decay can be used (for example inverse distance, inverse squared distance, negative exponential etc.). The critical cut-off can be the same for all regions or can be defined to be specific to each region leading in the latter case, for example, to k-nearest neighbors weight matrices when the critical cut-off for each region is determined so that each region has the same number of neighbors.

This study use the traditional approach (a general spatial weight matrix) that is based on the geography of the observations, designating regions as 'neighbours' when they are share border of each other (a simple binary contiguity matrix). According to the adjacency criteria, the element of the spatial weight matrix (wij) is one if location i is adjacent to location j, and zero otherwise. For ease of interpretation, the matrix is standardized so that the elements of a row sum to one (row-standardized).

IV.

ESTIMATION RESULT

The estimation results for fiscal reaction function in equation (1) as well as its non spatial version (without spatial lag of dependent variable) are summarized in Table 1. All variables are expressed in logarithm, so that estimated coefficients can be interpreted as elasticities. The result of OLS estimates of non-spatial local governments expenditure equation shows that in period prior to decentralization (2001) the sosio economic and demographic variables have only very small and largely statistically insignificant impacts on spending. The total population is the only variables wich has significant impact in that period, showing the presence of economies of population scale. TABLE 1 TO BE POSITIONED ABOUT HERE

The OLS estimates of non-spatial model shows a better performance in the fiscal decentralization period (2003). The result show strong effects of population, population density, unemployment rate and proportion of old population on percapita spending levels. But the unfortunately the per capita income and the percentage of people in poverty do not appear to have a significant impact on per capita spending.

Turn on the spatial model, the slope parameter of reaction function in equation (1), which reflects the strengh of interaction among jurisdiction is statistically nonzero in period of fiscal decentralization but not in the period beforehand. This shows in Table 1 by the parameter of spatial lag of percapita public expenditure (W_PCPE) which statiscally significant at 99% in 2003, but not significant (even at 90%) the 2001. Estimated elasticity of fiscal reaction function is 0.3, which means 10% increase in neighborhood expenditure percapita will followed by 3 % increase of the local government expenditure percapita. This estimation result provides the

evidence points to the existence of strategic interaction among local governments in East Java in the era of fiscal decentralization. Meanwhile the performance indicators (R2, AIC and SC) in Table 1 shows that non spatial model is performing better for the period prior the decentralization, while the spatial model is more relevant in the period afterwards (lower value of AIC and SC).

The reason why the estimation result of the equation (1) for 2003 outperform the estimation for 2001 may be relies in the fact that the new system of fiscal decentralization can improve the provision of public goods in such a way that these become tailored to local preferences and become a local responsibility due to their proximity to the local populace, since all local governments have become fully autonomous and responsible for planning, management, financing and delivery for various sectors. Furthermore, according to Usui and Alisjahbana (2003), the key objective of decentralization is to move decisions closer to society to make public service distribution more responsible for fulfilling local needs.

In the period prior to fiscal decentralization first-level regional governments and even secondlevel regional governments had limited authority to organize and manage their own regions or districts. In fact, the objective of delegating increased responsibility to the first and second level of regional governments was to implement centralization from the center. Moreover, it was used by the central government to mobilize local resources without allowing local governments to manage and organize their own resources. It seemed that all government levels from provinces to sub-districts acted as agents of the central government.

In addition, most government expenditures did not match public needs and preferences. The public was assumed to be uneducated and was expected to follow all instructions and

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commands from government officers in order to obtain funds or subsidies. As a result, the local populace kept their distance from officials and considered them as outsiders. Therefore, it was difficult for the local populace and government officials to develop a functional relationship and amicable communications. This lack of local perpectives in local government budgeting explain why the socio-economic and demographic characteristics of jurisdiction fail to statisically explain the variation of per capita regional government public spending in the 2001.

About the nature of possible interactions of regencies and municipalities public expenditures, we expect that their existence is mainly due to a form of yardstick competition, rather than a form of tax competition; since Indonesias fiscal decentralization did not include decentralizing the authorities for regional tax setting. We believe that the media play an important role in enhancing the informational externalities among median voters in each region, especially through Autonomy Award conducted by JPIP (Jawa Post Institute for Pro Autonomy). It seems this form of externalities strengthens the pattern of yardstick competition among local governments in East Java in the period of fiscal decentralizations.

V.

SUMMARY AND CONCLUSION

This paper has estimate the determinants of total expenditures per capita of local governments, and test the existance of fiscal interdependency among regencies and municipalities in period prior to (2001) and after the fiscal decentralization (2003). We perform the empirical test by estimating reaction functions for public expenditures using a dataset on 37 regencies (kabupaten) and municipialities (kota) in East Java for the period before (2001) and after (2003) fiscal decentralization.

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The results of the estimation of the spatial lag model (with spatial interaction in the dependent variable) suggest that the fiscal interaction is an important feature of East Javas local governments expenditure decisions in 2003 (period after fiscal decentralization). We expect that the existence of this fiscal interaction is mainly due to a form of yardstick competition, rather than a form of tax competition; since Indonesias fiscal decentralization did not include decentralizing the authorities for regional tax setting. It seems like informational externalities generates by the media, especially through Autonomy Award conducted by JPIP (Jawa Post Institute for Pro Autonomy) enhances this form of competition.

Eventhough, the fiscal interaction is identified in fiscal decentralization era (2003) there is no empirical evidence that this pattern of interactions exist in the period beforehand (2001). The absence of fiscal interaction pattern in the 2001 was likely arising because at that time the local governments had limited authority to organize and manage their own jurisdiction. Moreover, local governments at that time are used by the central government to mobilize local resources without allowing them to manage and organize their own resources. Eventually, most government expenditures did not match public needs and preferences. This idea strengthened the empirical findings that in period prior to decentralization (2001) most of the sosio-economic and demographic variables have statistically insignificant impacts on the distribution of local public spending.

In contrast for the 2001 period, most of these findings are overturned in 2003. The demographic variables turn out to have a significant statistical impact on spending decisions, probably because the new system of fiscal decentralization has improve the provision of public goods and public service distribution in such a way that these become tailored to local

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preferences and become a local responsibility. Since, the local governments proximity to the local populace makes them more responsible for fulfilling the needs of their populace.

RERERENCES Akita, Takahiro and Subkhan. (2004). The Optimal Size of Local Government and Fiscal Decentralization in Indonesia. Presented at the 6th Indonesian Regional Science Associations International Conference, August 2004, Jogjakarta. Anselin L. (2000). Spatial Econometrics, in B. Baltagi (Ed.), Companion to Econometrics, Basil Blackwell, Oxford. Anselin, L. (2002). Under the Hood. Issues in the Specification and Interpretation of Spatial Regression Models, Agricultural Economics, 27, pp. 247-267. Anselin, L. (2003). Spatial Externalities, Spatial Multipliers and Spatial Econometrics, International Regional Science Review, 26, pp. 153-166. Anselin L. (2003). GeoDa 0.9 Users Guide, Center for Spatially Integrated Social Science. http://www.csiss.org/ Brueckner, Jan K. and Luz A. Saavedra (2001). Do Local Governments Engage in Strategic Property-Tax Competition?. National Tax Journal 54(2), 203-229. Brueckner, Jan K. (2003). Strategic Interaction Among Governments: An Overview of Empirical Studies. International Regional Science Review, 26(2): 175-188. Case, Anne C., Harvey S. Rosen and James R. Hines, Jr. (1993), Budget Spillovers and Fiscal Policy Interdependence, Journal of Public Economics, 52, 285-307. Charlot, Sylvie and Sonia Paty. (2005). The French local tax setting: Do interactions and agglomeration forces matter? CESAER Working Paper 2005/11. Devereux, Michael., B. Lockwood and M. Redoano. (2004). Horizontal And Vertical Indirect Tax Competition: Theory And Some Evidence From The USA. Warwick Economic Research Papers No 704. April 2004 Edmiston, Kelly D. and Geoffrey K. Turnbull. (2003) "Local Government Competition for Economic Development," URAG Working Paper 03-07, Georgia State University, August 2003. Fiva, Jon H. and Jrn Ratts. (2005). Decentralization With Property Taxation To Improve

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Incentives: Evidence From Local Governments Discrete Choice; Working Paper Series No. 6/2005. Department of Economics and Center of Economic Research, Norwegian University of Science and Technology. Hays, Jude C. and Robert J. Franzese, Jr. (2004).Modeling Spatial Relations in Tax Competition, Prepared for the 100th APSA Annual Meeting & Exhibition Panel 14-11: The Comparative and International Political Economy of Tax Systems. 29 August 2004 Hernandez-Murillo, Ruben (2004), Strategic Interaction in Tax Policies among States,Federal Reserve Bank of St. Louis Review, 85, 47-56. LeSage, James P. (2004). Spatial Econometric of Modeling of Spillovers, Department of Economics, University of Toledo McGarvey, Mary G. and Mary B. Walker.(2004). GMM Estimation of Fiscal Policy Interdependence Across States," URAG Working Paper 04-04, Georgia State University, September 2004. Redoano, Michela. (2003). Fiscal Interactions Among European Countries. Warwick Economic Research Papers No 680. June 2003 Revelli, Federico. (2000) "Spatial Patterns In Public Spending And Taxation: A Test of Horizontal Interaction Among Local Governments". Department of Economics, University of Torino. Revelli, Federico (2003). Reaction or Interaction? Spacial Process Identification MultiTiered Government Structures. Journal of Urban Economics, 53: 29-53. Rumayya, W. Wardaya, and E.A. Landiyanto (2005). Growth in East Java: Convergence or Divergence. Presented at the 7th Indonesian Regional Science Associations International Conference, August 2005, Jakarta. Rumayya, W. Wardaya, and E.A. Landiyanto (2005). Club Convergence & Regional Spillovers in East Java. Presented in Academic Seminars 2005. November 2005. Jakarta. Usui, Norio and Armida Alisjahbana. (2003). Local Development planning and budgeting in decentralized Indonesia: Key issues. A paper for Tokyo symposium, IndonesiaJapanese Joint Study on Indonesias Decentralization World Bank. (2003). Decentralizing Indonesia: A Regional Public Ezpenditure Review Overview Report. Report No. 26191-IND. East Asia Poverty Reduction and Economic Management Unit. June 2003

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Table 1 Local Government Expenditure Equation with Fiscal Reaction Function 2001 non spatial model CONSTANT PCI POP DEN POV UNE OLD W_PCPE R2 AIC SC Obs. 0.527 0.154 11.430 37 OLS 9.410* (5.335) 0.214 (0.940) -0.679*** (0.139) -0.119 (0.220) -0.398 (0.392) -0.157 (0.304) -0.080 (1.921) spatial model ML 7.548 (5.014) 0.430 (0.846) -0.668*** (0.124) -0.159 (0.197) -0.368 (0.350) -0.151 (0.272) 0.025 (1.719) 0.115 (0.168) 0.535 1.702 14.589 37 2003 non spatial model OLS 16.623*** (3.392) -0.183 (0.284) -0.420*** (0.043) 0.187*** (0.187) 0.039 0.088) -1.438** (0.541) -3.764** (1.405) spatial model ML 13.597*** (0.132) -0.026 (0.236) -0.411*** (0.036) 0.188*** (0.418) 0.086 (0.073) -1.418*** (0.448) -3.534*** (1.173) 0.304*** (0.109) 0.918 -88.221 -75.334 37

0.903 -85.167 -73.890 37

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Notes 1) Dependent variabel = PCPE (per capita local government public spending) 2) All variables are in logarithm 3) *** =significant at 99%; ** =significant at 95%; * =significant at 90%

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