Local Taxation Authorities Under Regional Autonomy

Parliament passed amendments to Law No. 18/1997 on local taxation on December 7. The amended version was signed on December 20 as Law No. 34/2000 and it came into effect along with regional autonomy legislation on January 1, 2001. The law gives local governments broader authority to levy taxes and fees than they previously enjoyed. Local officials now have access to new sources of revenue that will help them balance their budgets and reduce the need for the central government to bail out under funded regions. On the other hand, many local governments are using their new authority to issue a wide array of questionable taxes and levies that could have a negative impact on investment and economic growth. While the amended law contains language prohibiting taxes that are economically unsound, it is not clear whether the Ministry of Finance has the political will or the capacity to enforce the law.

The government enacted Law No. 18 in 1997 in response to a spurt of uncontrolled local taxation that threatened to stifle internal commerce and price Indonesian exports out of the market. With the passage of Law No. 25/1999 on fiscal decentralization, the government announced that it would amend Law No. 18/1997 to bring it in line with the spirit of regional autonomy. The original law limited provincial governments to three kinds taxes (motor vehicles, change of title on motor vehicles, and motor vehicle fuel) and sub-provincial (district and city) governments to six kinds of taxes (hotels, restaurants, entertainment, advertisement, street lighting, mining of non-strategic minerals, and surface and ground water usage). Jakarta established maximum rates for each kind of tax, and limited the total number of fees and levies to 30 for any single government.

The amended law transfers the local government tax on surface and groundwater to the provincial level and expands the definition of motor vehicles to include motorized water transport. Local governments acquire a new tax on parking services. More importantly, the law allows sub-provincial governments to create new taxes and levies on top of those specified under the law, subject to central government approval. Jakarta still controls provincial tax rates, but district and city-level governments are free to set rates within broad limits.

Potential benefits: The new provisions will give local governments the flexibility to tailor their taxes to fit their regions’ particular circumstances. Prior to January 1, many regions were unable to draw tax revenue from their most dynamic sectors (handicrafts, agriculture). If it is implemented carefully, the law will help provinces develop good fiscal practices, which is a major goal of decentralization. The government’s fiscal decentralization allocation formula does not link transferred revenues explicitly to new functions. It is therefore likely to leave some regions with large surpluses and leave others with insufficient funding to fulfill their new responsibilities under regional autonomy. Since Jakarta would likely have to make up the shortfall by drawing from the central budget, it is in the government’s interest to expand local taxation authority.

Possible pitfalls: This new taxation authority is highly susceptible to abuse by overzealous local officials. They could stage a repeat of the mid-1990s taxing spree that led to the enactment of Law 18 in the first place. In anticipation of this, the government announced early this year that it would prohibit any laws that did not conform to "good tax" criteria. The criteria as defined in the law are somewhat vague. New taxes can not duplicate those imposed by other levels of government, and local governments can impose them only on entities or activities located within district boundaries. Tax objects must be of relatively low mobility. The tax must generate sufficient revenue to justify collection, and it must not cause harm to the environment or impose an unfair burden on local residents. Finally, the law contains the catch-all provision that new taxes and fees must not run counter to the "public interest." Local governments have fifteen days to submit any new tax proposals to the Ministry of Finance (MOF) for review. The MOF in turn has thirty days to strike down any they deem to be dubious.

With some 367 local governments and 30 provinces, many questionable taxes will probably make it through the sieve. In addition, the MOF is under pressure not to appear to stifle regional aspirations, so it will have to pick its battles. Finally, the more taxes the MOF strikes down, the more likely the government will have to shoulder the budgetary burden for devolved responsibilities. Two new implementing regulations slated for release at the end of April may clarify the distinction between acceptable and unacceptable tax laws.

There is already anecdotal evidence that local governments are creating nuisance taxes and levies that are detrimental to internal commerce and investment. Some of these taxes are intended to plug anticipated local budget gaps, while others will help to fund large new projects like bridges, ports, mosques, and industrial parks. Many also target not only foreign investors but also businesses and merchants from other parts of Indonesia. Others, like levies on trucks, docking privileges, and veterinary services, are merely impediments to local commerce. In a series of conferences sponsored in part by USAID and the Ministry of Industry and Trade, technical experts and academics are been emphasizing to local officials the dangers of excessive local taxation. In meetings with embassy visitors, some local officials have shown an awareness of the chilling effect increased taxation can have on foreign and domestic investment.

Over time, as regions start to compete for investment, the more onerous taxes may begin to disappear. However, smaller levies such as road transit fees, which are mainly a nuisance to small producers and traders, may continue to proliferate. This will have a sclerotic effect on inter-regional trade. The net effect will likely be a rise in the number of taxes throughout the archipelago, and taxation as a proportion of GDP may rise.

Like local borrowing, natural resource revenue, and civil servant transfers, local taxation is one of the potential problem areas of fiscal decentralization. If done right, it can serve as a half-way house for local governments on the road to fiscal self-reliance (under Law 25/1999 on fiscal decentralization, Jakarta still collects and re-allocates the bulk of revenues that will fund regional governments' activities). Government slowness in completing the amendment has allowed nuisance taxes to proliferate, however, and Jakarta faces an uphill battle in undoing what has been done so far. The big question is whether the government can muster the political will to rein in local governments. If it does, it may have to endure accusations of bureaucratic despotism. But the consequences of not acting will be more painful in the long run.