59306 January 2011 Note Number 40 Strengthening Fiscal Transfers in Indonesia Using an Output-Based Approach | Peter Ellis, Cledan Mandri-Perrott and Luis Tineo I n 2010 the World Bank approved a US$220 million loan for a Local Government and Decentralization project in Indonesia. e project aims to improve the accountability and reporting of the central government's Speci c Purpose Grants (DAK). Piloted in four infrastruc- ture sub-sectors--irrigation, roads, sanitation, and water-- the project is the World Bank's rst to apply innovative Output-Based Aid (OBA) design principles on a large scale to target improvements in inter-governmental scal transfers. Under the project, the DAK grants will work in a similar way to OBA subsidies, which reimburse service providers for independently veri ed, pre-agreed physical outputs. Up to 81 local governments in ve provinces are Photo by Richard Lord eligible to take part in this project. is note presents an overview of the project objectives and design. (Dana Alokasi Khusus, DAK). DAU are mainly used to fund salaries and other administrative costs. DAK are allocated to finance specific investment expenditures that Since 2001 Indonesia has gone from being one of the are aligned with national priorities and carried out under most centralized countries in the world in administra- the jurisdiction of local governments. In 2010, the DAU tive, fiscal, and political terms to one of the most decen- share of total intergovernmental transfers was 63 percent, tralized. Under this process local governments have as- while the DAK share was around 7 percent. sumed new responsibilities that were previously covered There are currently 14 sectors eligible for DAK by the central government, as well as managing new funds, including four infrastructure sectors--irriga- financial resources that have been transferred from the tion, roads, sanitation, and water supply--which rep- central government or raised within their own localities. resent about 21 percent of the total DAK allocation. Local governments have therefore experienced sub- The amount of the DAK allocation is determined on an stantial increases in financial resources, mostly through annual basis within the national budget. The Ministry increased transfers from the central level for delivery of Finance (MoF) allocates the DAK to each sector and of education, health, and basic infrastructure services. within the sectors local governments have the flexibility Local governments now manage 38 percent of total pub- to determine which activities (sub-projects) they invest lic expenditure and carry out more than half of all public in. The Ministry of Public Works (MPW) provides tech- investment. However, public expenditure reviews show nical guidelines on the implementation, monitoring, and that fiscal decentralization in Indonesia still faces many evaluation of the DAK for each infrastructure sector. The challenges. These include improving and speeding up MPW's technical guidelines clearly specify the outputs spending, and reducing local government dependency on which the DAK grants can be spent, and these are on central government transfers. mostly limited to maintenance, rehabilitation, and the upgrading or improvement of existing infrastructure. Specific Purpose Grants (DAK) Peter Ellis is a Senior Urban Economist in the World Bank's Indonesia Sustainable Development Unit. Cledan Mandri-Perrott is a Senior The bulk of the intergovernmental transfers to local Infrastructure Specialist in the World Bank's Finance, Economics, and governments are the General Purpose Grants (Dana Urban Development Department. Luis Tineo is a Senior Infrastructure Specialist in the Global Partnership on Output-Based Aid. Alokasi Umum, DAU) and the Specific Purpose Grants Supporting the delivery of basic services in developing countries Application of OBA Principles to allocated to the selected local governments, and to re- Improve the Use of DAK Transfers imburse the 10 percent counterpart funding which lo- cal governments are required to provide to participate in the DAK program. The project will be piloted in The aim is to help local governments improve plan- five provinces (Central Kalimantan, East Java, Jambi, ning, budgeting, and investment execution, as well as North Maluku, and West Sulawesi) and all of their 81 monitoring and verification of results. Two options districts. Provinces were selected based on geographic for project design were assessed: (i) a traditional diversity, reporting capacity and performance, and financing of input-based investment subprojects in a success in delivering outputs financed by their DAK. small number of local governments, with disburse- ments tied to individual expenditures or contracts; Institutional Arrangements. The main actors in the and (ii) an output-based approach with disbursements project are the MoF, the MPW, the State Finance and tied to the achievement of pre-agreed outputs within Development Supervisory Board (Badan Pengawasan the scope of the DAK expenditure program. Keuangan dan Pembangunan, BPKP), the World In assessing these options, the project drew impor- Bank, and the participating local governments. tant lessons from two core principles that have been ap- Figure 1 summarizes the flow of funds and account- plied in the design of output-based aid (OBA) projects ability in the project. funded by the Global Partnership on Output-Based Aid (GPOBA): change in the financing paradigm (from in- Eligible Outputs. Eligible outputs are single sub-projects puts to outputs); and transfer of operational and invest- (Paket Pekerjaan) financed by DAK grants and may ment risk (from the funding entity to the entities best include: positioned to deliver the desired outputs). On this basis, the following advantages of an output-based approach · Road sub-sector: Periodic maintenance, improve- were considered to achieve the project's objective: ment, and rehabilitation of provincial, district or city roads and bridges. · Increasing transparency by tying the reimburse- · Irrigation sub-sector: Improvement, rehabilita- ment of DAK grants to defined outputs estimated tion, and development of irrigation networks, according to agreed reference unit costs. including swamp reclamation networks and village · Increasing accountability by shifting performance irrigation networks. risk to local governments and structuring financial · Water sub-sector: Development of water intake incentives, in addition to the DAK allocation, to from surface water, water intake from wells, small reward timely and compliant performance in the water treatment plants, water pipe networks, delivery of agreed outputs. household connections, and public water hydrants. · Increasing sustainability of public funding by · Sanitation sub-sector: Development of communi- linking payment of incentives to local governments ty sanitation facilities, community waste drainage to the delivery of sustainable services. facilities, solid waste facilities, public toilets, and · Enhancing monitoring of results since project funds small wastewater treatment plants for households. are disbursed against independently verified outputs. · Building capacity within Indonesia to scale up Establishment of Unit Costs. Project funds will be the approach beyond the World Bank project, disbursed using reference unit costs (RUC) for each thereby aligning with the Bank's programmatic of the eligible outputs. The RUC are established by the engagement strategy in Indonesia. MPW prior to the start of the DAK cycle at the begin- ning of the year. They are calculations of provincial Project Characteristics aggregates based on actual competitively procured contracts. They also reflect regional variations and Scope of Financing. The project is a specific invest- take into account the construction cost index and ment loan of US$220 million to be implemented other differences across provinces. over four years using an output-based approach. The project will reimburse a slice of the existing DAK for Risk Transfer and Pre-financing of Outputs. infrastructure based on delivery of independently Generally, in OBA projects, the service provider takes verified physical outputs by selected local govern- on the risk of pre-financing the outputs and the OBA ments. Project funds will be used to reimburse the funds reimburse the service provider for the costs central government for infrastructure expenditures incurred on the basis of pre-defined unit costs. The January 2011 Note Number 40 Figure 1. Flow of Funds and Accountability Reimbursement & incentives (8) World Bank Reimbursement application (7) MoF/MPW BPKP reports to MoF and DAK Province / recommends allocation district reports reimbursement and to MoF/MPW MoF technical on output (6) consolidates assistance delivery (3) districts' funds (1) reports(4) BPKP Districts Specific sector Independent outputs (2) Loan proceeds verification of physical outputs Irrigation GoI output delivery chain and compliance (5) Roads BPKP activities Water & DAK reports sanitation Reimbursement application entitlement nature of the DAK grants restricts the transfers to local governments, however, and this extent to which operational and investment risks can can incentivize the local governments to perform be fully transferred from the MoF to the local govern- both by delivering outputs on time and by comply- ments. Local governments' capacity to pre-finance the ing with financial and technical reporting. delivery of outputs, a determining incentive for the · Successful delivery of outputs will result in a success of any output-based approach, is also limited, reward consisting of a portion of the Bank reim- as is the concept of "contracting out" or "delegation" bursement to be transferred from the MoF to local of service provision to local governments within the governments, representing the required 10 percent DAK framework. Under this project, the central gov- counterpart funding of the DAK allocation. This ernment's budget expenditures allocated for the DAK 10 percent counterpart funding will be reimbursed grants will play the pre-financing role. Local govern- to the local governments as a block grant and will ments will use the DAK allocation to contract out the be not earmarked for future infrastructure sector output delivery work to private contractors, following expenditures. It will thus act in a similar way to an Indonesia's procurement law. The central government, OBA subsidy, providing a new kind of incentive to which has pre-financed the outputs, will be ultimately local governments. accountable to the World Bank for successful output · An additional incentive, which makes local gov- delivery. ernment participation in the program attractive and mitigates performance risks, is the technical Performance Incentives. The project builds a series assistance that the central government will provide of incentives for the MoF and local governments to to local governments during the project. deliver outputs: Output Verification. The verification of outputs will · The risk of non-performance is borne by the be conducted by the BPKP, which will compile a list of central government, as Bank funds will not be completed outputs as reported by the local governments disbursed to the central government if a local gov- and submit it to the MoF by the end of the first quarter ernment is found to be non-compliant. The central of each year. The BPKP will then randomly sample 20 government has the power to retain future fiscal percent of reported outputs in each province and verify Table 1. Method for Assessing Reimbursement Amounts Calculation Definition STEP 1: Calculate for each local government: Value of Potential Reimbursement (VPR) Sum of the outputs reported by the local governments multiplied by their reference unit costs. Qualifying Percentage (QP) Number of outputs in the sample that meet the eligibility criteria, expressed as a share of sampled outputs. Value of Qualifying Reimbursement (VQR) QP multiplied by VPR. STEP 2: Calculate the total for all local governments: Value of Total Reimbursement (VTR) Sum of VQR across all local governments. STEP 3: Determine World Bank reimbursement: Advance Payment (AP) Sum of the central government's first DAK payments to each local government. Value of Final Reimbursement (VFR) VTR ­ AP Local Government Reimbursement 10 percent of DAK counterpart funding the timeliness and accuracy of the financial and techni- Conclusions cal reports submitted by participating local governments to the MoF and the MPW. The BPKP will work closely The project, which became effective in January 2011, with the MPW in verifying the outputs to ensure that the presents a shift away from financing individual outputs for the specific allocation have been physically investment sub-projects in a small number of local achieved and are in compliance with agreed procedures governments. It focuses instead on improving the and policies on procurement, financial management, and government framework within which DAK-funded social and environmental safeguards. investments take place. This places the emphasis on achieving results by delivering independently verified Disbursement Modalities and Conditions. The project outputs in compliance with the government's fiduciary will disburse funds using two modalities: (i) advance and safeguards laws and regulations. Over time, the payment (AP) and (ii) value of final reimbursement project will be expanded through follow-on operations (VFR). The project will reimburse both the AP and the to strengthen downward accountability from local VFR values, plus the 10 percent counterpart funding to governments to communities, while also improving the infrastructure sector in that year. The World Bank re- the efficiency and effectiveness of local government imbursements will be made based on BPKP's report and expenditures. Additional design features of OBA, such recommendation. Table 1 provides a summary of steps as targeting the poor, or continued transferring of risk for the assessment of the reimbursement amounts that down to the local governments and on to the service may be claimed by the central government once BPKP providers and contractors, will be explored as part has issued the output verification report. of the World Bank's programmatic engagement with Indonesia on results-based approaches. About OBApproaches OBApproaches is a forum for discussing and disseminating The case studies have been chosen and presented by the au- recent experiences and innovations in supporting the delivery thors in agreement with the GPOBA management team and are of basic services to the poor. The series focuses on the provi- not to be attributed to GPOBA's donors, the World Bank, or any sion of water, energy, telecommunications, transport, health, other affiliated organizations. Nor do any of the conclusions rep- and education in developing countries, in particular through resent official policy of GPOBA, the World Bank, or the countries output- or performance-based approaches. they represent. To find out more, visit www.gpoba.org e Global Partnership on Output-Based Aid e Global Partnership on Output-Based Aid Supporting the delivery of basic services in developing countries