Intergovernmental Fiscal Transfers and Local Incentives and Responses: The Case of Indonesia

Abstract Indonesian policymakers are convinced that a number of perverse incentives are embedded in their system of intergovernmental transfers. Officials in countries throughout the developing world have similar views about their own intergovernmental frameworks. In Indonesia, perverse incentives are thought to negatively influence a wide range of local government fiscal behaviours, including as regards own‐source revenues, spending and savings. An empirical analysis of the local government response to transfers, however, offers only mixed support for the existence and strength of the presumed incentives. Overall, the findings in this paper highlight the benefits to central governments of rigorously examining assumed perverse incentives in their intergovernmental frameworks before embarking on attempts to expunge them.