Fiscal decentralization in Indonesia had been a slow-burning affair since the mid 1970s, with the country being one of the most centralized in the world, until the “Big Bang” of the 1999 reforms, when, in the period of one year, Indonesia became in terms of expenditure shares one of the most decentralized in the world. This paper first reviews the structure and performance of this new system of transfers in Indonesia and then focuses on the unfinished agenda for reform. The discussion concentrates on the DAU, which finances over three-fourths of subnational expenditures. The short story with the development of the equalization grant or DAU in Indonesia is that the Government in 2001 got the fundamental concepts right but got many of the particular details wrong. The performance of the DAU in addition was hindered by several choices made on the implementation of the new system, the most important being an extremely rigid interpretation of the hold harmless provision. The Government has proceeded to reform the DAU for 2002. Although real improvements took place in 2002, some important issues still remain, including how the new system may move away from the suffocating grip of the hold harmless provision. The government faces important challenges but also good opportunities in shaping and increasing the importance of the DAK conditional grant system. With respect to transfers in the form of revenue sharing on a derivation basis, where the central government shares revenues with the subnational governments where the revenues have been collected or derived, this paper recommends that government not develop it further but instead focuses on developing revenue autonomy of subnational governments. To answer how has Indonesia’s new transfer system performed so far this paper addresses more specific issues of: has budget autonomy been preserved, has revenue adequacy for provinces and district/municipalities been maintained, have transfers been stable, has the current system of transfers been reasonable, transparent, and simple, have transfers discouraged subnational tax effort, and have transfers been equalizing?
