Tokyo, Japan National Graduate Institute for Policy Studies

THE IMPACT OF GOVERNMENT SPENDING ON REGIONAL ECONOMIC GROWTH IN INDONESIA

A Policy Proposal Paper Submitted in Partial Fulfillment of the Requirements for the Degree of Master of Public Policy

By: Etjih Tasriah (MET06072) Advisor: Professor Reiko Nakamura Transition Economy Program July 2007

Acknowledgement To: Allah SWT, My family, Professor Reiko Nakamura, Professor Hideo Tanaka, The National Graduate Institute for Policy Studies, The International Monetary Fund Regional Office for Asia and the Pacific, Badan Pusat Statistik [BPS-Statistics Indonesia], Friends and colleagues.

Etjih Tasriah (MET06072)

Abstract Over the past decades, several empirical studies using cross-country data have explored the relationship between economic growth and government spending. These findings support either neoclassical or Keynesian theories. However, some country studies on Barros endogenous growth model, such as those by Schalteggler and Torgler for Switzerlands 26 cantons (2004), and Zhang and Zou for Chinas provinces (1997), reveal a negative relationship between growth and the size of government spending. This paper investigates the impact of provincial/district level government spending in Indonesia on regional economic growth between 1983 and 2005. A cross-region growth model is estimated using the Generalized Method of Moment (GMM), with government spending and lagged per capita GDP as endogenous variables, and lag values of explanatory variables as instrument variables. The results confirm the neoclassical view that government spending has a detrimental effect on growth, particularly in the case of unproductive expenditures. Productive spending in the form of public infrastructure outlays has a positive but statistically insignificant impact on growth. Keywords: Government spending, economic growth, endogenous growth model, Keynesian, neoclassical, dynamic panel data regression, GMM.

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Etjih Tasriah (MET06072)

Contents Acknowledgement ...................................................................................................................... i Abstract ......................................................................................................................................ii Contents ................................................................................................................................... iii 1. Introduction ............................................................................................................................ 1 2. Theoretical Framework .......................................................................................................... 2 3. Methodology and Data ........................................................................................................... 3 3.1. Methodology ................................................................................................................... 3 3.2. Data Description ............................................................................................................. 4 4. Results and Findings .............................................................................................................. 6 4.1. Overview of Regional Economy in Indonesia ................................................................ 6 4.2. Empirical Results ............................................................................................................ 7 5. Conclusion, Policy Implications and Recommendations..................................................... 10 6. References ............................................................................................................................ 12 Appendix A: Tables ................................................................................................................. 15 Appendix B: Figures ................................................................................................................ 20

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Etjih Tasriah (MET06072)

The object of government is the welfare of the people. The material progress and prosperity of a nation are desirable chiefly so far as they lead to the moral and material welfare of all good citizens. Theodore Roosevelt

1. Introduction There has been an on-going debate between Keynesian and neoclassical economists regarding the impact of government spending on economic growth. On the one hand, new Keynesians believe that since prices are rigid, fluctuations in any component of spending such as consumption, investment or government expenditure will cause output to fluctuate. Therefore, if government spending increases while holding all other components constant, output will increase (Mankiw, 2007). On the other hand, neoclassical economists believe that steady state growth is driven by exogenous factors, namely labor force growth and technological progress. Therefore, fiscal policy in the form of expansionary spending can only affect the rate of growth during the transition to the steady state (King & Rebelos study as cited in Easterley & Rebelo, 1993). This dichotomy in economic theory has given rise to many empirical studies focusing on the relationship between government spending and economic growth. However, the findings of these studies can be divided into two main categories: those that show a positive relationship, and those that show a negative one. Barro (1990) noted that several cross-country empirical studies differ in their conclusions regarding the relationship between economic growth and government spending1. Moreover, a meta-analysis of 93 published studies and 123 meta-observations by Nijkamp and Poot (2003), aimed at determining the impact of fiscal policy on long-run growth, showed that there is weak evidence supporting the positive impact of conventional fiscal policy on growth. Meanwhile, several country studies using panel data, such as those conducted by Schalteggler and Torgler (2004) for Switzerlands 26 cantons, and Zhang and Zou (1997) for Chinas provinces, revealed a negative relationship between growth and the size of government spending. This study investigates the impact of government spending on regional economic growth in Indonesia. I will try to determine whether additional government spending helps promote economic growth. Using government expenditure data from regional budget statements, this study disaggregates government spending into productive and unproductive spending, in order to determine which of these has a significant impact on growth. Previous studies have used the ratio of government consumption to GDP as a proxy for government spending. In contrast, this study uses the ratio of provincial government expenditure -as expressed in provincial budget statements- to nominal GDP in each respective province.

As cited in Barro (1990), Kormendi & Meguires study (using data from 47 countries in the post-World War II period) found no significant relationship between the average growth rate of real GDP and the share of government consumption spending in GDP. Meanwhile, several studies, such as Grier & Tullock (using 115 countries pooled into cross-section time-series data), Landau (using a cross-section of 104 countries), Barth & Bradley (using data from16 OECD countries in the period of 1971-83), and Barro (using post-World War II data from 98 countries), found a significantly negative relationship.

Etjih Tasriah (MET06072) The next section briefly presents the theoretical literature on government spending and growth. The empirical methodology and data description are contained in section three, in which I explain the model specification based on Barros endogenous growth model (1990), and the method of estimation based on the Generalized Method of Moments proposed by Easterly and Rebelo (1993) and Caselli, Esquivel, and Lefort (1996) for dynamic panel data analysis. Section four describes the estimation results. Section five concludes with policy implications derived from the empirical findings.

2. Theoretical Framework Keynesian economics is a theory of total spending in the economy, known as aggregate demand, and its effects on output and inflation. Since government consumption is one part of the famous Keynesian Equation (the others being private consumption, investment, and net export), Keynesians believe that expansionary fiscal policy for example an increase in government spending will lead to an increase in income (Mankiw, 2007). Keynesians argue that market forces alone will not move the economy toward full employment, hence some form of government intervention is needed in order to help the economy attain its full capacity. Therefore, Keynesians are known as advocates for active government involvement in economic activities (Mishkin, 2006). Meanwhile, neoclassical economists hold that government intervention only disrupts the market mechanism, and should therefore be avoided. They believe that market efficiency is attained by optimization choices among economic agents, such as consumers maximizing utility given their budget constraints, and producers maximizing profits subject to their cost of production. From this viewpoint, government spending particularly non-capital spending such as consumption retards growth, because it does not affect the productivity of the private sector. However, capital spending in the form of public investment could have an impact, since it is likely to enhance the productivity of the private sector (Mishkin, 2006). Another basic macroeconomic policy indicator besides government consumption is inflation. According to Fischer (1993), the inflation rate serves as an indicator of the overall ability of the government to manage the economy. All governments aim for low inflation; the macroeconomic situation in any medium or high inflation economy can therefore be expected to change that can lead to uncertainty of the macroeconomic environment. Potential investors which expose to uncertainty about government macroeconomic policy tend to wait before committing themselves whether to invest or not, thus their actions temporarily can reduce the rate of investment. Studies on the impact of inflation on growth have yielded conflicting results. The Mundel-Tobin effect predicts that inflation can have a positive impact on capital accumulation, as a result of a portfolio shift away from money when the rate of return on money falls (Mishkin, 2006). In contrast, various subsequent studies, including Fischer & Modigliani (as cited in Fischer, 1993), have revealed that higher inflation reduces capital accumulation, implying that there is a negative association between the level of income and inflation. New growth theory also predicts an inverse relationship between inflation and growth. From the neoclassical point of view, we know that steady state growth is driven by exogenous factors, namely labor force growth and technological progress. It is said that as the labor force grows, the economy will expand toward its steady state (Jones, 2002).

Etjih Tasriah (MET06072) To sum up, the theory predicts that there is a negative relationship between government spending and growth. The same relationship is predicted for inflation and growth. Conversely, an increase in the labor force leads to economic growth.

3. Methodology and Data 3.1. Methodology This study employed the multiple regression method with panel data, combining annual time-series data during the period of 1983-2005 with cross-section data for 26 provinces. Panel data analysis has several advantages over pure cross-section or time series data that can enrich empirical analysis, as pointed out by Baltagi (as cited in Gujarati, 2003). Some of these advantages are as follows: Panel data estimation can incorporate heterogeneity by allowing individualspecific variables, cross-section units are explicitly related over time. The combination of cross-section and time-series observations gives panel data several desired characteristics, i.e., more informative data, more variability, less collinearity among variables, greater degrees of freedom, and increased efficiency. Panel data represents the dynamics of change better, as it studies repeated crosssection observations. Panel data can better detect and measure effects that are not as easily observed in pure cross-section or time-series data. By making data available for several hundred units (26 provinces over 23 years, or 598 observations), panel data can minimize the bias that might arise if we simply take the aggregate of individuals. As mentioned by Caselli et al. (1996), the typical cross-section model of economic growth is built on a nested equation in this general specification:
ln(Yit ) ln(Yi ,t 1 ) = ln(Yi ,t 1 ) + Wit + i + t + it (1)

where Yit is real per capita GDP in province i at year t, Wit is the set of determinants of economic growth, such as the ratio of government spending, the inflation rate and the share of labor force, i is the provincial-specific effect, t is the time-specific constant, and it is an error term. Interpreting equation 1 depends on the coefficient of lagged GDP. A statistically significant negative coefficient is consistent with the neoclassical growth models prediction of conditional convergence, wherein regions relatively close to their steady growth state tend to have slower growth. In conditional convergence, the variables in Wit and the individual effect i are proxies for the long-run level the regions are converging to. On the other hand, if =0, there is no convergence effect, and the other right-side variables measure differences in the steady-state condition. Equation 1 can be rewritten as: ~ yit = yi ,t 1 + Wit + i + t + it (2)

~ where yit = ln (Yit) and = 1+ is the convergence rate, i.e. the rate in which the economy grows toward its steady state.

Etjih Tasriah (MET06072) From equation 2, it is clear that estimating equation 1 is equivalent to estimating a dynamic equation with a lagged-dependent variable on the right-hand side. A serious difficulty arises when we deal with dynamic equations in a panel data model containing a lagged-dependent variable, such as in equation 2. This problem arises because the laggeddependent variable is correlated with the error term; the resulting correlation creates a largesample bias in the estimate of the coefficient. Moreover, if the other regressors are correlated with the lagged-dependent variable, their coefficients may be seriously biased as well. The application of generalized method of moments (GMM) proposed by Holtz-Eakin, Newey, & Rosen, and Arellano & Bond (as cited by Casselli et al., 1996), can simultaneously address the issues of endogeneous variables and correlated individual effects in a dynamic panel data model. The first step in the procedure of GMM involves first-difference transformation, to eliminate the individual effects, i, and time effects, t; ~ yit = yi ,t 1 + Wit + it (3)

However, this procedure does not correct the endogeneity of variables in Wit, such that the lagged-dependent variable is still correlated with the composed-error term it. To remedy this, Caselli et al. (ibid) suggested using past values of all explanatory variables as instrumental variables. The endogenous growth model proposed by Barro (1990) uses the lagged value of government spending as an instrument variable for government size. Barro argued that government spending is endogenous rather than exogenous, and that government makes decisions concerning its outlays based on past experiences. Although Barro successfully corrected endogeneity by using an instrument variable, he failed to address the individual effects (Caselli et al., ibid). GMM estimators can be used to deal with these two problems, correcting the endogenous explanatory variables as well as eliminating the individual effects. Following the endogenous growth model by Barro, and implementing GMM estimators procedures for the dynamic panel data model, we can write our general function as:
ln_ PCGDPit ln_ PCGDPit 1 = 1 ln_ PCGDPi ,t 1 + 2 RTGS it + 3 LFit + 4 INFit + i + t + it where i is the individual effect, t is the time effect, and it is the error component. This can be rewritten as: ~ ln_ PCGDPit = 1 ln_ PCGDPi ,t 1 + 2 RTGS it + 3 LFit + 4 INFit + i + t + it ~ where 1 = 1+1. Taking the first difference to eliminate individual and time effects, we get: ~ ln_ PCGDPit = 1 ln_ PCGDPi ,t 1 + 2 RTGS it + 3 LFit + 4 INFit + it where i and t denote i-th province and t-th year, respectively. The variables are described in section 3.2.

3.2. Data Description

As previously mentioned, the growth model to measure the impact of government spending uses a combination of cross-section and annual time series data, covering 26 provinces over the period of 23 years (from 1983 to 2005). The variables in the model are as follows:

Etjih Tasriah (MET06072) ln_PCGDPit Natural logarithm of real per capita Gross Domestic Product ln_PCGDPit-1 Initial value of natural logarithm of real per capita GDP RTGS Ratio of Total Government Spending to nominal GDP (percent) LF proportion of labor force to the total population (percent) INF Inflation rate (percent) All the data were derived directly from various statistical publications by Badan Pusat Statistik (Statistics Indonesia, later on BPS), except for the GDP and government spending data, which were recalculated for purposes of data comparability. The original GDP data consisted of three different series based on 1983, 1993, and 2000 constant prices. These were re-estimated using a two-step, backcasting procedure. The first step involved transforming the series into a single base year, by estimating real GDP for the period of 1983-2005 at 2000 constant prices, and using the growth rates of the 1983 and 1993 series. The second step involved estimating the 2000-base GDP deflator, using the growth rates of the 1983 and 1993 deflators. Nominal GDP was calculated by multiplying the 2000base deflator with real GDP at 2000 constant prices. Per capita GDP was obtained by dividing GDP over mid-year population. The April/March fiscal year (FY) was transformed into the calendar year January/December by calculating the average monthly values. This re-estimation was necessary because realized budget spending data for each year is not available. This procedure was done for spending up to 2000, the year in which government changed its definition of the fiscal year to coincide with the calendar year. Below is an illustration of how to transform FY 1982/1983 and FY 1983/84 data into FY 1983 and FY 1984 data. Government spending for the year 1983 is obtained by adding up 25% of the budget for FY 1982/1983 and 75% of the budget for FY 1983/1984.
Fiscal Year 1982/83 FY 1982 FY 1983/84 FY 1983 = FY 1982/83 + FY 1983/84 FY 1984/85 FY 1984 = FY 1983/84 + FY 1984/85 FY 1985

After 2001, the Indonesian government shifted from a centralized to a decentralized system, as a result of a reformation movement aimed at making government more democratic and more close to people. Consequently, new provinces were created as regions were reaggregated. For instance, the Riau Archipelago was created from some parts of Riau, Bangka-Belitung from some parts of South Sumatra, Banten from some parts of West Java, Gorontalo from some parts of North Sulawesi, and North Moluccas from some parts of Moluccas. Today, there are 33 provinces in Indonesia. However, in order to make the panel data consistent, data for the 33 provinces were regrouped into the original 26 provinces. The list of provinces can be found in Table 1, Appendix A. Government spending in this paper refers to provincial budget spending during the specified fiscal year. Indonesias budgetary system adopts a uniform yet fragmented budget system, in which central government expenditures and regional expenditures are planned and executed separately. State budget is planned and executed by central government after approved by national legislature, while local budget is planned and executed by local government after approved by local legislature. Moreover, Law no. 22/1999 on decentralization stipulates that central government has to devote almost 40 percent of state budget for local and provincial government spending. This mechanism is called a fiscal transfer. A uniform budget system means that all government entities must adopt the same budget format; the budget statement consists of two sides, the revenue side and the expenditure side, which must balance. The expenditure side is broken down into routine expenditures and

Etjih Tasriah (MET06072) development expenditures. For purposes of this analysis, routine expenditures were classified as unproductive spending (i.e., wages and salaries, pensions, maintenance fees, etc.), and development expenditures (i.e., public infrastructure outlays) as productive spending. Other explanatory variables included in the estimation are the proportion of the labor force to total population as a proxy for the employment ratio, and the inflation rate as a proxy for price changes. Badan Pusat Statistik (BPS, Statistics Indonesia) defines the labor force as persons 15 years of age or over who are either employed2, or unemployed and actively looking for work. Meanwhile, inflation is defined as a general increase in prices of basic goods and services, or a decline in the currencys purchasing power. The average provincial Consumer Price Index (CPI) was estimated using 45 city CPIs, with 2002 as the base year. The inflation rate was then computed by taking the percentage change in CPI. The list of cities can be seen in Table 2, Appendix A.

4. Results and Findings 4.1. Overview of Regional Economy in Indonesia Indonesia is considered the most diverse country in the world. It consists of more than 17,000 islands; is inhabited by the worlds 4th largest population; and has more than 300 local languages. This diversity is one factor that accounts for differences in economic achievement between regions. Another is natural resource endowments: some regions are blessed with rich natural resources such as oil and natural gas deposits, while others are less so. The government has realized that this condition can create inequality between regions. A centralized development process had been implemented since the countrys independence in 1945 until 2001. Within this period, the central government controlled all natural resources, and distributed income received to finance the equal development of infrastructure throughout the country. The decentralized era started in 2001, with the central government allocating funds based on a regions contribution to revenue generation. Regions rich in natural resources therefore receive a bigger share of revenues from natural resources. This explains the differences in provincial budget revenues, which in turn affect regional spending capacities. Decentralization aims not only to give people more room to develop their capacity and creativity, but also to make them demand better performance from the government. The goal of decentralization is to create local governments that are independent in terms of electing their own officials, promoting their own interest, developing their own institutions, initiating their own policies, managing their own financial resources, and mobilizing support from their own local communities. This emphasis on autonomy at the local government level is devolution of authority. Consequently, there has been a shift in government spending, from a highly centralized system dominated by the central budget, Anggaran Pendapatan dan Belanja Negara (APBN, state budget) to a decentralized system dominated by the local budget, Anggaran Pendapatan dan Belanja Daerah (APBD, local budget)3. Table 3, Appendix A gives a summary of the panel data covering 598 observations (N) from 26 provinces (n) over 23 years (T). The data show that during the period of 1983-2005, the average annual real GDP per capita in Indonesia was Rp. 6,374,394, with deviations from the mean of Rp. 6,862,160 between provinces and of Rp. 1,830,767 within each province.

2 3

Defined as those working or temporarily absent from work. Alm, J., Martinez-Vasques, J., & Indrawati, S.M. (eds.). (2004).

Etjih Tasriah (MET06072) The top three richest regions in the country were East Kalimantan, DKI Jakarta, and Riau, with a reported average annual real GDP per capita of Rp. 30.6, Rp. 23.5, and Rp. 16.4 million, respectively. Two of these regions possess rich oil and natural gas reserves (East Kalimantan and Riau), while DKI Jakarta owes its prosperity to being the countrys capital and the center of economic and financial agglomerations. On the other hand, the three poorest regions were East Nusa Tenggara, with an average annual GDP per capita of Rp. 1.76 million, followed by its neighbors, West Nusa Tenggara and Mollucas with approximately the same figure of Rp. 2.3 million annual GDP per capita. East and West Nusa Tenggara are regions with a relative lack of natural resources, and the terrain in these regions hinders productive agriculture. The third poorest region, Mollucas, had been plagued by social tension, which I believe caused a downward economic performance during the late 1990s. Meanwhile, the average provincial government spending was Rp. 563 billion per year (or 3 percent of nominal GDP). Of this amount, Rp. 204 billion (or 1.08 percent of nominal GDP) was allocated to productive spending, as defined in this paper; the rest was allocated to consumption or unproductive spending (civil servants wages and salaries, pensions, etc). As the capital of the country, DKI Jakarta was the biggest spender, with an average provincial budget of Rp. 3.59 trillion annually. Its neighboring regions West and East Java followed, with Rp. 1.67 and Rp. 1.41 trillion, respectively. All of the biggest spenders come from Java island, which is the most populated area in the country and one of the earliest regions to flourish. Additionally, Java had been given special attention in the form of development projects during Suhartos administration, due to its advanced infrastructure endowment and relatively abundant educated labor force. On the opposite end, Bengkulu, South-East Sulawesi, and West Nusa Tenggara are regions with the lowest average annual provincial budget of approximately Rp. 112, Rp. 121, and Rp. 157 billion, respectively. Over the period of 1983-2005, the economy grew at an average rate of 3.6 percent per year, with deviations of 1.5 percent between provinces and of 24.3 percent within each. The employment rate, defined as the ratio of employed individuals to the population, was 43.5 percent on average. The average inflation rate, as measured by the change in the CPI, was 8.28 percent per year. Table 1 reveals substantial variations in the data, such as the standard deviation and min-max values of all variables, not only between provinces, but also within a single province over the same period. Figure 1, Appendix B plots the trend in the ratio of government spending (left-hand axis) against economic growth rates (right-hand axis) over the period. The figure shows that the growth rate of per capita GDP is similar in pattern to government spending. There is a sharp drop in 1998 for both series, due to the economic crisis that hit the economy. This resulted in a negative growth rate of per capita GDP by -16.36 percent, and a reduction in government spending by 52 percent compared with the previous year. Although Figure 1 reveals a slightly positive relationship between government spending and real per capita growth, the extent of this relationship is somewhat vague. From the correlation matrix in Table 4, Appendix A, we know that the level of government spending is positively correlated with per capita income; however this relationship is reversed if we measure government spending as the ratio of budget spending to nominal GDP. Moreover, from the scatter plot in Figure 2, Appendix B, we can see a negative relationship between the log value of per capita GDP and the ratio of government spending. 4.2. Empirical Results Table 5, Appendix A summarizes the empirical results of growth models using three different methods of estimation. Column 2 estimates a growth model using the fixed effect 7

Etjih Tasriah (MET06072) instrument variable method, which treats government spending as an endogenous variable. Column 3 is a first difference transformation of the method used in column 2. First difference transformation is mainly used to eliminate the individual effects, reported in column 2 as the constant. However, this failed to address the issue of correlated individual effects and explanatory variables, as reported by the high value of rho. Finally, column 3 summarizes estimates based on the Arrelano-Bond GMM model, to correct for correlated individual effects and endogenous explanatory variables. Figures 2, 3, and 4, Appendix B show a linear relationship between per capita GDP and its explanatory variables, i.e. a negative association with government spending, a positive relationship with the labor force ratio, and a negative relationship with the inflation rate. The fixed effect regression IV (with RTGS as an endogenous variable and lagged explanatory variables as instruments) model is:
ln_ PCGDPit = 3.78 + 0.722 ln_ PCGDPit 1 0.012 RTGSit + 0.012LFit 0.0018INFit + 0.104 DECt

Based on the theoretical framework, the postulated hypotheses for each individual variable are as follows:
Hypothesis Null Hypothesis Alternative Hypothesis Lag per capita GDP *1 = 0 *1 > 0 Total government spending 2 0 2 < 0 Labor force 3 = 0 3 > 0 Inflation 4 = 0 4 < 0 Decentralization 5 = 0 5 > 0

Note: *1 = 1 + 1 All the coefficients are individually significant, and the explanatory variables jointly explain 76.1 percent of the variation in real per capita GDP. All regions grow toward steady state at a rate of 28 percent (1=.72219421-1), with poor regions growing faster than rich ones, as indicated by negative value of 1 (i.e. convergent coefficient of lag PCGDP). The impact of government spending is negatively related to growth; a one percent increase in the ratio of government spending will decrease GDP per capita growth by 1.2 percent, assuming all other variables constant. This result confirms the neoclassical prediction regarding the impact of fiscal policy on growth. However, the fixed effect estimators failed to address the issues of individual effect and autocorrelation between the error term and explanatory variables; as we can see, column 2 reports a high value of rho (0.549) and a correlation between u_i and Xb (0.7757). In order to correct these two issues, first difference transformation is performed. The results are reported in column 3 of Table 5, which gives us a growth equation in the form of:
ln_ PCGDPit = 0.203 ln_ PCGDPit 1 0.008RTGS it + 0.011LFit 0.0006INFit + 0.049DECt

The postulated hypotheses based on theoretical framework for each individual variable are the same as before, except for lagged per capita GDP, i.e.: Null Hypothesis: 1 = 0 Alternative Hypothesis: 1 < 0 The first difference IV model corrected the individual effect problem by eliminating the constant term 0.However, the correlation between the error term and explanatory variables grew worse while the coefficients of RTGS, Inflation, and Decentralization turned statistically insignificant. I suspect this is happening because the model specification has to employ a system of equations in a dynamic form - not only does it include lagged per capita

Etjih Tasriah (MET06072) GDP in the right hand side of the equation, one or more of the explanatory variables are also endogenous variables (Barro, 1991). To deal with this shortcoming, I follow Fischer in performing a method introduced by Arrelano and Bonds Generalized Methods of Moments (GMM). The regression results for the GMM growth model are reported in column 4 of Table 5:
ln_ PCGDPit = 0.719 ln_ PCGDPit 1 0.016RTGS it + 0.014LFit 0.0018INFit + 0.11DECt

The postulated hypotheses based on the theoretical framework for each individual variable are the same as those for the fixed-effect IV model. All the coefficients are statistically significant at the 1 percent level of significance, except the coefficient of RTGS, which is significant at the 5 percent level. The regions grow toward steady state at a rate of 28 percent annually, and growth in the post-decentralized era is 11.4 percent higher than in the pre-decentralized era. The negative value of the RTGS coefficient confirms the neoclassical view that big government is bad for growth; in this regard, regions with more government spending tend to have lower growth by a difference of 1.6 percent. Neoclassical theory posits that differences in expenditure policy can have important effects in determining the level of output, but are unlikely to have an important effect on the rate of long-run growth. Since steady state growth is driven by exogenous factors i.e., labor force growth and technological progress fiscal policy can only affect the rate of growth during the transition to the steady state (Jones, 2002). Most growth models predict that taxes on investment and income have detrimental effects on growth by reducing the private returns to accumulation. However, which kind of spending results in this effect should be carefully considered. Aschauer and Barro (as cited in Easterly & Rebello, 1993), predict that the effect should be positive for public investment and nil for consumption-type spending. Thus, I disaggregate government spending into two categories: unproductive and productive spending. Unproductive spending consists of consumption-type expenditures, such as wages and salaries, pensions, maintenance fees, etc. Productive spending consists of development expenditures, i.e. public infrastructure spending. The regression results for this model are reported in Table 4, Appendix A, and can be written as:
ln_ PCGDPit = 0.72 ln_ PCGDPit 1 + 0.013RPGS it 0.024RUGS it + 0.013LFit 0.0019INFit + 0.11DEC t

Again, the postulated hypotheses based on theoretical framework for each individual variable are the same as the fixed-effect IV model, except for two items of government spending:
Hypothesis Null Hypothesis Alternative Hypothesis Productive government spending 2 0 2 > 0 Unproductive government spending 3 0 3 < 0

All the coefficients are statistically significant, except for RPGS, which shows a positive but statistically insignificant impact on growth. This is in accordance with the notion that public investment can enhance the productivity of private sectors, although its effect is ambiguous (Barro, 1990). Meanwhile, the negative impact of unproductive government spending can be explained along the lines of classical theory, which states that growth and consumption-type government spending tends to stimulate demand at the cost of inflationary pressures, higher interest rates, and crowding out of private investment. Figure 5, Appendix B gives us a

Etjih Tasriah (MET06072) graphical representation of the negative impact of unproductive government spending on the predicted value of per capita GDP. Meanwhile, in Figure 6, we hardly see any linear relationship between productive government spending and the predicted value of per capita GDP. The scatter plots do not have a positive nor negative slope; therefore the impact of public infrastructure funded by government is inconclusive.

5. Conclusion, Policy Implications and Recommendations The main objective of this paper was to investigate the impact of government spending on growth, using panel data on Indonesias provinces during 1983-2005. Employment and inflation rates along with a dummy variable to capture decentralization were also included in the analysis, to capture other relevant sources of growth. The estimated equations, based on GMM regression, suggest that an increase in government size as measured by the ratio of government spending to GDP has an adverse effect on economic growth. This study managed to answer whether government spending has a positive or negative impact on growth, and to show how productive and unproductive spending affect growth. Neoclassical theory posits that while expansionary fiscal policy may increase aggregate demand, it could also harm growth by creating inflationary pressures, increasing the cost of production, depressing private sector returns, and crowding out private investment. This study confirmed that government spending, measured by the ratio of provincial budget spending to nominal provincial GDP, has a detrimental impact on growth: resulting estimates show than an additional one percent increase in the ratio of government spending will reduce economic growth by 1.6 percent. By disaggregating government spending into productive and unproductive expenditures, this study also revealed that government spending in the form of productive outlays has a positive, although statistically insignificant, impact on growth, while unproductive spending has a negative and statistically significant impact on growth. The economic crisis which occurred in late 1997 to 1998, reinforced by institutional mismanagement and ineffective attempts to stabilize macroeconomic policy4, shows that restoring a normal growth pace in Indonesia requires more than reforming the private sector. In particular, the distortionary effect of government provision through the consumption of goods and services must be reduced. At the same time, the positive effect of public investment on growth should be boosted by giving more allocation to infrastructure development projects which are vital to enhancing the private sectors productivity. Based on the results of this study, I would like to offer some policy recommendations which concern both central and local governments. First of all, local governments should realize that a big government, in terms of a high ratio of government spending to GDP, is bad for growth. However, this does not mean that a local government should cease functioning, as there is a positive impact from productive spending on growth, even though estimation results from this study revealed this impact to be statistically insignificant. Since budget and development priority planning are now the responsibility of local governments under the decentralized system, more funds should be allocated to productive outlays in the form of infrastructure projects, since this kind of spending is likely to enhance private sector

Following the Asian Financial Crisis, the banking system in Indonesia came under severe stress, as many corporate borrowers defaulted on loans, which in turn created a general loss of confidence in the banking system (International Monetary Funds, 2004).

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Etjih Tasriah (MET06072) productivity. Lastly, the central government can still play an active part, due to the significant role played by fiscal transfers. Central government can regulate fiscal transfers to ensure that an adequate portion is allocated to public infrastructure development. This would allow the positive impact of productive spending to offset the negative impact of unproductive spending. Finally, it should be emphasized that the intention of this study was not to derive a growth model of the Indonesian economy. Rather, it was to investigate the dynamic long-run properties of the main growth determinants, by incorporating recent theories of endogenous growth and focusing on the crucial role played by government intervention. It should also be noted that the empirical results might contain sample selection bias, since I had limited the observation to the period of 1983-2005. Future studies should therefore expand the period of observation to include the preliminary stages of development in the 1960s.

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Etjih Tasriah (MET06072)

6. References Akai, N. & Sakata, M. (2002). Fiscal decentralization contributes to economic growth: Evidence from state-level cross-section data for the US. Journal of Urban Economics, 52, 93-108. Alm, J., Martinez-Vasques, J.,& Indrawati, S.M. (eds.). (2004). Reforming intergovernmental fiscal relations and the rebuilding of Indonesia, the big bang program and its economic consequences. Northampton, Massachusetts: Edward-Elgar Publishing. Aschauer, David A. (2000). Do states optimize? Public capital and economic growth. The Annals of Regional Science, 34: 343-363. Cameron, David R. (1978, December). The expansion of the public economy: A comparative analysis. The American Political Review, vol. 72, no. 4, pp. 1243-1261. Caselli, F., Esquivel, G., & Lefort, F. (1996, September). Reopening the convergence debate: A new look at cross-country growth empirics. Journal of Economic Growth, 1: 363-389. Barro, Robert J. (1989, September). Economic growth in a cross section of countries (Working Paper No. 3120). Cambridge, Massachusetts: National Bureau of Economic Research. Barro, Robert J. (1990, October). Government spending in a simple model of endogenous growth. The Journal of Political Economy, Vol. 98, No. 5, pp. S103-S125. Barro, Robert J. (1997). Determinants of economic growth: A cross-country empirical study. Cambridge, Massachusetts: The MIT Press. Baum, Christopher F. (2006). An introduction to modern econometrics using Stata. Texas: Stata Press Publication, StataCorp LP, College Station. Baumol, W.J., & Blinder, A.S. (2006). Macroeconomics: Principles and policy (10th edition). Mason, Ohio: Thomson South-Western. Badan Pusat Statistik [BPS-Statistics Indonesia]. Gross Regional Domestic Product of Provinces in Indonesia (various issues). Jakarta: BPS. BPS-Statistics Indonesia. Local Government Financial Statistics in Indonesia (various issues). Jakarta: BPS. BPS-Statistics Indonesia. Statistical Yearbook of Indonesia (various issues). Jakarta: BPS. Cheng, B.S. & Lai, T.W. (1997, June). Government expenditure and economic growth in South Korea: A VAR approach. Journal of Economic Development, Vo. 22, No. 1, pp. 11-24. Cullison, William E. (1993, Fall). Public investment and economic growth. Federal Reserve Bank of Richmond, Economic Quarterly, vol. 79/4. Dalamagas, Basil. (2000) Public sector and economic growth: The Greek experience. Journal of Applied Economics, 32, 277-288. Dallerba, S. & LeGallo, J. (2007). Regional convergence and the impact of European structural funds over 1989-1999: A spatial econometric analysis (Discussion Paper). University of Arizona. Dye, Thomas R. (1980, November). Taxing, spending, and economic growth in the American states. The Journal of Politics, vol. 42, no. 4, pp. 1085-1107. Easterly, W. & Rebelo, S. (1993, October) Fiscal policy and economic growth: An empirical investigation (Working Paper No. 4499). National Bureau of Economic Research. Ebel, R.D. & Yilmaz, S. (2002, March). On the measurement and impact of fiscal decentralization (Policy Research Working Paper No. 2809). Economic policy and poverty reduction division, World Bank Institute. Evans, P. & Rauch, J.E. (1999, October). Bureaucracy and growth: A cross-national analysis of the effects of Weberian state structures on economic growth. American Sociological Reviews, vol. 64, no. 5, pp. 748-765.

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Etjih Tasriah (MET06072) Fan, S. & Rao, N. (2003, February). Public spending in developing countries: Trends determination, and impact (Environment and Production Technology Division Discussion Paper no. 9). International Food Policy Research Institute. Fisher, Ronald C. (1997, March/April). The effects of state and local public services on economic development. New England Economic Review. Fischer, Stanley (1993, December). The role of macroeconomic factors in growth (Working Paper No. 4565). National Bureau of Economic Research. Glaeser, E.L. & Shapiro, J. (2001, July). Is there a new urbanism? The growth of US cities in the 1990s (Working Paper No. 8357). National Bureau of Economic Research. Gujarati, Damodar N. (2003). Basic econometrics (4th edition). New York: McGraw-Hill. Helms, L. Jay (1985). The effect of state and local taxes on economic growth: A time seriescross section approach. The Reviews of Economic and Statistics, vol. 67, no. 4 (Nov. 1985), pp. 574-782. Holtz-Eakin, D. & Schwartz, A.E. (1994, August). Infrastructure in a structural model of economic growth (Working Paper No. 4824). National Bureau of Economic Research. International Monetary Fund (2004, July). Indonesia: Selected issues (IMF Country Report No. 04/189). Retrieved July 3, 2007, from http://www.imf.org/external/pubs/ft/scr/2004/cr04189.pdf Jones, Bryan D. (1990). Public policies and economic growth in the American states. The Journal of Politics, vol. 52, no. 1 (Feb. 1990), pp. 219-233. Jones, Charles I. (2002). Introduction to economic growth (2nd edition). New York: W.W. Norton & Company, Inc. Jones, D., Li, C., & Owen, L. (2003, May). Growth and regional inequality in China during the reform era (William Davidson Working Paper No. 561). William Davidson Institute. Kocherlakota, N.R. & Yi, K.M. (1996, February). A simple time series test of endogenous vs. exogenous growth models: an application to the United States. The review of economics and statistics, vol.78, no. 1, pp.126-134. Levitt, S.D. & Snyder, J.M. (1997). The impact of federal spending on house election outcome. The Journal of Political Economy, vol. 105, no. 1 (Feb. 1997), pp. 30-53. Mankiw, N. Gregory. (2007). Macroeconomics (6th edition). New York: Worth Publisher. Martinez-Vazquez, J. & McNab, R.M. (2001, January). Fiscal decentralization and economic growth. JEL classification no. E62, H77. Ministry of Finance. Sistem Informasi Keuangan Daerah [Local Finance Information System].
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Mishkin, Frederic S. (2006). The economics of money, banking, and financial markets (7th edition update). Singapore: Pearson International Edition. Munnell, Alicia H. (Fall 1992). Policy watch: Infrastructure investment and economic growth. Journal of Economic Perspectives, vol. 6, no. 4, pp. 189-198. Nijkamp, P. & Poot, J. (2003, March). Meta-analysis of the impact of fiscal policies on long-run growth (Discussion Paper). Tinbergen Institute. Oughton, C., Landabaso, M., & Morgan, K. (2002). The regional innovation paradox: Innovation policy and industrial policy. Journal of Technology Transfer, 27, 97-110. Plumper, T. & Martin, C.W. (2003). Democracy, government spending, and economic growth: A political-economic explanation of the Barro-effect. Public Choice, no. 117, pp. 27-50, 2003. Rosen, Harvey S. (2005). Public finance (7th edition). McGraw-Hill, New York. Sala-i-Martin, X.X. (1997). I just ran two million regressions. The American Economic Review, Vol. 87, No. 2 (May 1997), pp. 178-183. Schaltegger, C. & Torgler, B. (2004). Growth effects of public expenditure on the state and local level: Evidence from a sample of rich governments (Working Paper No. 2004-16). Center for Research in Economics, Management and Arts Basel: CREMA.

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Etjih Tasriah (MET06072) Wooldridge, Jeffrey M. (2002). Econometric analysis of cross section and panel data. Cambridge, Massachusetts: The MIT Press. Zhang, T. & Zou, H. (1997). Fiscal decentralization, public spending, and economic growth in China. Journal of Public Economics, 67 (1998), pp. 221-240.

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Etjih Tasriah (MET06072)

Appendix A: Tables Table 1 List of Provinces

No Code Province 1 11 Nangroe Aceh Darussalam 2 12 North Sumatra 3 13 West Sumatra 14 Riau 4 5 15 Jambi 6 16 South Sumatra 7 17 Bengkulu 18 Lampung 8 9 31 DKI Jakarta 10 32 West Java 33 Central Java 11 12 34 DI Yogyakarta 13 35 East Java 14 51 Bali 52 West Nusa Tenggara 15 16 53 East Nusa Tenggara 61 West Kalimantan 17 18 62 Central Kalimantan 19 63 South Kalimantan 20 64 East Kalimantan 71 North Sulawesi 21 72 Central Sulawesi 22 23 73 South Sulawesi 24 74 South-East Sulawesi 81 Moluccas 25 26 94 Papua Group of Provinces

Riau & Riau Archipelago South Sumatra & Bangka-Belitung

West Java & Banten

North Sulawesi & Gorontalo

Moluccas & North Moluccas Papua, West Papua, & Central Papua

Source: BPS-Statistics Indonesia

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Etjih Tasriah (MET06072) Table 2 List of Cities in CPI Data

No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 City Lhokseumawe Banda Aceh Padang Sidempuan Sibolga Pematang Siantar Medan Padang Pakanbaru Batam Jambi Palembang Pangkal Pinang Bengkulu Bandar Lampung Jakarta Tasikmalaya Bandung Cirebon Serang/Cilegon Purwokerto Surakarta Semarang Tegal Yogyakarta Jember Kediri Malang Surabaya Denpasar Mataram Kupang Pontianak Sampit Palangkaraya Banjarmasin Balikpapan Samarinda Manado Gorontalo Palu Ujung Pandang/Makasar Kendari Ambon Ternate Jayapura Province Nangroe Aceh Darussalam

North Sumatra West Sumatra Riau Jambi South Sumatra Bengkulu Lampung DKI Jakarta West Java

Central Java DI Yogyakarta East Java Bali West Nusa Tenggara East Nusa Tenggara West Kalimantan Central Kalimantan South Kalimantan East Kalimantan North Sulawesi Central Sulawesi South Sulawesi South-East Sulawesi Moluccas Papua

Source: BPS-Statistics Indonesia

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Etjih Tasriah (MET06072) Table 3 Summary of Indonesias 1983-2005 Panel Data

Variable PCGDP (in Rupiah) overall between within overall between within overall between within overall between within overall between within overall between within overall between within overall between within overall between within overall between within overall between within Mean 6,374,394 Std. Dev. 6,978,944 6,862,160 1,830,767 0.8193227 0.7280524 0.4009521 24.38184 1.453218 24.34009 1,290,000,000 738,000,000 1,070,000,000 2.16403 1.532497 1.555965 883,000,000 505,000,000 731,000,000 1.674504 1.060266 1.311956 448,000,000 237,000,000 382,000,000 0.7764939 0.6093528 0.495293 6.603134 4.356211 5.032306 12.8911 1.619658 12.79272 Min 65,088.26 1,755,289 -3,542,347 11.0835 14.33744 11.98883 -304.1047 0.0448054 -307.3359 21,100,000 112,000,000 -2,800,000,000 0.264458 0.7543601 -3.105294 9,915,646 68,600,000 -1,980,000,000 0.1576798 0.3476617 -2.909754 5,744,983 38,600,000 -821,000,000 0.1011401 0.3228192 -0.3929467 13.1101 37.12753 11.56946 -64.00504 5.901465 -66.14971 Max 34,000,000 30,600,000 16,200,000 17.34216 17.23256 16.57496 215.549 6.855033 212.3178
14,000,000,000 3,590,000,000 11,000,000,000

Observation N = 598 n = 26 T = 23 N n T N n T N n T N n T N n T N n T N n T N n T N n T N n T = = = = = = = = = = = = = = = = = = = = = = = = = = = = = = 598 26 23 572 26 22 598 26 23 598 26 23 598 26 23 598 26 23 598 26 23 598 26 23 598 26 23 572 26 22

ln_PCGDP

15.29948

GROWTH (%)

3.623796

G
(thousand Rp)

563,000,000

RTGS (%)

3.007161

14.37796 7.323268 11.33348 9,980,000,000 2,460,000,000 7,880,000,000 11.70056 5.436428 8.763698 4,480,000,000 1,120,000,000 3,560,000,000 4.852862 2.374682 4.185952 100.039 53.18007 93.527 77.07818 10.55439 75.36808

GU
(thousand Rp)

359,000,000

RUGS (%)

1.92375

GP
(thousand Rp)

204,000,000

RPGS (%)

1.083411

LF (%)

43.49572

INFLATION (%)

8.278672

Source: BPS-Statistics Indonesia and authors calculation Note: N = total observations, n = number of provinces, T = number of years

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Etjih Tasriah (MET06072) Table 4 Correlation Matrix

Variable PCGDP ln_PCGDP G RTGS GU RUGS GP RPGS LF INFLATION PCGDP 1 0.8612 0.4303 -0.3035 0.4063 -0.2717 0.4424 -0.2567 -0.1392 0.0148 ln_PCGDP 1 0.3834 -0.3641 0.3527 -0.3341 0.4127 -0.2912 -0.0491 0.0451 G RTGS GU RUGS GP RPGS LF

1 -0.0525 0.9862 -0.0306 0.9452 -0.0785 -0.063 0.016

1 -0.0398 0.9463 -0.0733 0.7395 -0.0053 -0.1411

1 -0.0008 0.8782 -0.1062 -0.0547 0.0072

1 -0.0869 0.4822 -0.012 -0.1484

1 -0.0175 -0.0743 0.0323

1 0.0106 -0.0735

1 0.1617

Source: BPS-Statistics Indonesia and authors calculation

Table 5 Three Growth Regression Models Comparison of Results

Variable 1 lagln_PCGDP RTGS LF INFLATION DEC D.lagln_PCGDP D.RTGS D.LF D.INFLATION D.DEC _cons rho corr(u_i, Xb) R-sq 3.7766633*** (0.35364197) 0.54905944 0.7757 0.7611 Fixed effect IV regression 2 0.72219421*** (0.0237826) -0.01215285** (0.0056684) 0.0122682*** (0.00176142) -0.00178989*** (0.0006379) 0.10366171*** (0.02109972) 1st differenced IV regression 3 Arrelano-Bond GMM 4 0.71944184*** (0.02985475)

-0.20291313*** (0.03710594) -0.00769831 (0.0119684) 0.01095666*** (0.0015064) -0.00062452 (0.00041908) 0.04939265 (0.03635352)

-0.0158955** (0.0069843) 0.0141549*** (0.00217907) -0.00184459** (0.00079562) 0.1136498*** (0.02607708)

0.9570228 -0.8782 0.7696

Note: standard error of coefficients in parenthesis. *, **, and *** are significant at 10, 5, and 1 percent levels.

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Etjih Tasriah (MET06072) Table 6 Regression Results for Two Components of Government Spending
Variable LD.ln_PCGDP D.RPGS D.RUGS D.LF D.INFLATION D.DEC Coefficients 0.71967773*** (0.02986396) 0.01278054 (0.0214131) -0.02418146*** (0.00882648) 0.01336715*** (0.00215318) -0.00186436** (0.00079455) 0.1148784*** (0.02615648)

Note: standard error of coefficients in parenthesis. *, **, and *** are significant at 10, 5, and 1 percent levels.

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Etjih Tasriah (MET06072)

Appendix B: Figures Figure 1

Government spending and growth of per capita GDP (%)
2.5 Ratio of government spending to GDP 10.0 5.0 0.0 1.5 -5.0 1.0 -10.0 0.5 -15.0 -20.0

0.0

Source: BPS-Statistics Indonesia and authors calculation

10

12

ln_PCGDP 14

16

18

19 8 19 3 8 19 4 85 19 8 19 6 8 19 7 8 19 8 8 19 9 9 19 0 9 19 1 9 19 2 9 19 3 94 19 9 19 5 9 19 6 9 19 7 9 19 8 9 20 9 0 20 0 01 20 0 20 2 0 20 3 0 20 4 05

Unproductive GS

Productive GS

Growth per capita GDP

Figure 2 Scatter plot between the Ratio of Total Government Spending and log Per Capita GDP

5 RTGS

10

15

20

Growth of per capita GDP

2.0

Etjih Tasriah (MET06072)

Figure 3 Scatter plot between the Labor Force Ratio and log Per Capita GDP
18 10 12 ln_PCGDP 14 16

20

40 LF

60

80

100

Figure 4 Scatter plot between the Inflation Rate and log Per Capita GDP
18 10 -100 12 ln_PCGDP 14 16

-50

0 INFLATION

50

100

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Etjih Tasriah (MET06072)

Figure 5 Scatter plot between Predicted per Capita GDP and The Ratio of Unproductive Government Spending
18 8 0 10 ypredict 12 14 16

5 RUGS

10

15

Figure 6 Scatter plot between Predicted per Capita GDP and The Ratio of Productive Government Spending
18 8 0 10 ypredict 12 14 16

2 RPGS

22