Navigating Uncertainty: Investment Dynamics and Beyond

By Beata Javorcik and Steven Poelhekke

Countries have been increasingly decentralizing and devolving powers to lower levels of government in the hope of improving services delivery. Yet proliferation of governments, particularly in a developing country setting, may create fiscal and policy uncertainty and increase the tax and compliance burden for private businesses, with potentially detrimental effects for investment. This hypothesis is tested in the context of Indonesia, which has increased the number of districts from 284 in 1989 to 511 by 2014. The data show that districts that split received fewer earmarked transfers from the national government, increased the share of own-source revenue and cut back on public investment to pay for the burden of self-administration. Plants operating in the splitting districts responded by reducing investment, and (because demand was not affected) by increasing employment, which is in line with hiring being less costly to reverse than fixed asset purchases. The results also show an increase in the plant-level tax burden and ‘donations’, as well as a persistent decline in the capital-labor ratio. In contrast to private plants, state-owned establishments did not register a drop in investment or an increase in the tax burden.