Local government taxation: An analysis of administrative cost inefficiency

Abstract

Local governments in Indonesia administer taxes inefficiently. The average cost of local tax administration as a percentage of revenue generated is estimated to be over 50%. There is, however, a wide variation in administrative inefficiency across local governments. The estimation of a stochastic cost frontier model suggests that administrative cost inefficiency increases significantly as fiscal transfers from the centre rise; the investigation also demonstrates that local governments with elected executives are no more administratively cost efficient than those with appointed heads. The simple and complex measures of cost inefficiency yield broadly similar results concerning the level and variation of inefficiency across local governments, but can offer significantly different estimates of the relative inefficiency of individual local governments. This poses a dilemma for the central government in monitoring and evaluating local government tax administration performance.

Notes

1 See Undang-Undang 34 Tahun 2000 tentang Perubahan atas Undang-Undang 18 Tahun 1997 tentang Pajak dan Retribusi Daerah [Law 34/2000 concerning the Revision to Law 18/1997 on Regional Taxes and Charges].

2 A caveat is in order with regard to the figure of 6,000 ‘new taxes and charges’. This actually represents the number of new tax and charge by-laws (peraturan daerah, or perda) issued during the period 2000 through mid-2005. Some of these new perda undoubtedly were written in order to change the tariffs and/or bases of existing taxes and charges, as allowed by Law 34/2000. That is, the new perda did not in all cases authorise new tax and charge instruments. As such, the quoted figure might best be thought of as an upper bound on the number of newly established revenue sources.

3 These are the so-called ‘positive list’ taxes, that is, those that are explicitly enumerated in Law 34/2000 as allowable.

4 All data used in this paper are from the Ministry of Finance Regional Financial Information System. The Ministry of Finance has generously provided the author with access to these data.

5 See Lewis (2002) for detailed descriptions of the various kinds of intergovernmental transfers, including allocation methods, and Lewis (2005) for an examination of the impact of transfers on local government spending, own-source revenue generation, and savings.

6 This section of the paper draws heavily on Oosterman (2004).

7 The DiPenda does not set local tax policy; its functions are purely administrative.

8 Deconcentrated offices are divisions of central government departments; that is, they are not part of decentralised regional administrations.

9 The data are available for 224 of the 348 local governments that existed in 2003.

10 By comparison, cost-to-yield estimates from the United States range from less than 1% for most local taxes to around 1.5% for the property tax (Mikesell 1982). The US cost-to-yield ratio is defined as administrative cost divided by revenue net of cost, however. Using this definition to make the figures comparable, the overall cost-to-yield ratio for local governments in Indonesia becomes as high as 110.5%.

11 Any variation in legal authorities and processes across local governments might also, in theory, influence cost-to-yield ratios (independently of changes to efficiency). In Indonesia, however, most local governments operate within the same legal and regulatory environment. The exceptions are those in Aceh and Papua, which have special fiscal arrangements with the central government. These exceptional provisions are concerned mainly with the amount of intergovernmental transfers received from the centre, however, and are not likely to affect directly the cost of local tax administration or the local revenue generated.

12 Note that corruption related to official taxation may influence local government performance of any of the administrative functions—tax coverage, tax liability assessment, tax collection—and the amount of (official) revenue generated. Owing to lack of data, the impact of corruption on administrative performance and revenue generation cannot be incorporated into this analysis.

13 Similarly, there appears to be little variation in levels of major charges across local governments (Barnes et al. 2005). In addition, property tax rates are fixed at uniform levels across districts and municipalities (Lewis 2003a).

14 Finding good measures of local public sector output for use in empirical studies like the present one is a common and particularly vexing problem (Grosskopf and Yaisawarng 1990; Sakata 2004).

15 The use of population also helps control for possible economies of scale in tax administration.

16 Local revenue in kabupaten Badung (Bali), much of which is derived from tax revenue from tourist resorts, comprises 50% of total revenue. If Badung is excluded, local revenue ranges from 1% to 30% of total revenue across local governments. Badung has been dropped from the present analysis, owing to lack of data on other variables. For local governments in the sample, local revenue varies from about 1% to 25% of total revenue.

17 Of the 224 local governments in the sample used in this analysis, 139 (62%) were managed by elected heads in 2003, while 85 (38%) were still governed by appointed heads.

18 The appendix tests the model specification detailed here for a variety of underlying assumptions. The analysis shows that the specification used in the present examination is a reasonable one.

19 Maximum likelihood estimations were performed using LIMDEP econometric software; see Greene (2002) for a detailed explanation of methods. In addition to the truncated normal model employed here, LIMDEP allows for the use of half-normal, gamma and exponential stochastic frontier model specifications. These other models were also tried. Estimation results were very similar under all four models. The conclusions reached here are robust with regard to choice of model.

20 λ and σ are estimated directly via the maximum likelihood procedures. The standard deviations of the two error terms are derived from the estimated values of λ and σ.

21 The insignificance of the urbanisation variable may at least in part be due to its strong collinearity with other variables, especially local revenue and GRDP.

22 Lewis (2002) discusses performance disincentives in the Indonesian transfer system. Starting in 2002, 50% of DAU funds were allocated to cover local civil servant salaries. From 2006, the central government has decided to cover 100% of the local public sector wage bill from the DAU, thus further weakening incentives to rationalise local public sector employment.

23 Other analysts prefer to use an efficiency index (Kumbhaker and Lovell 2000). The efficiency index is the inverse of the ratio shown on the right-hand side of equation 6. It ranges in value from zero to one and indicates the extent to which actual cost approaches the ideal minimum cost.

24 By comparison, in an examination of the costs of providing fire protection services in Japanese local governments, Sakata (2004), using an empirical model similar to the one employed here, found an average inefficiency index of 1.09 and a range of index values from 1.02 to 1.44 (with a standard deviation of 0.07).

25 In the analysis that follows, costs in the cost-to-yield ratio measure of inefficiency have been divided by the Ministry of Finance price index, as was done in the cost frontier model.

26 The general results reached here in respect of agreement rates do not change markedly when different categorisation schemes are used.

Additional information

Notes on contributors

Blane D. Lewis

The author is Senior Adviser for Fiscal Decentralization at the World Bank in Jakarta under financing from the Dutch Trust Fund (TF050378). The views expressed here are those of the author and should not be attributed to the World Bank or the government of the Netherlands. The author would like to thank Indonesia's Ministry of Finance for access to data, Guenther Schultz for useful comments on an earlier draft of the paper, and the editor and two anonymous referees for constructive criticism.