Examining the effects of fiscal decentralization and income inequality on the economic performance of west Sumatra province, Indonesia

Herianti, Eva; Marundha, Amor Article Examining the effects of fiscal decentralization and income inequality on the economic performance of west Sumatra province, Indonesia Global Business & Finance Review (GBFR) Provided in Cooperation with: People & Global Business Association (P&GBA), Seoul Suggested Citation: Herianti, Eva; Marundha, Amor (2024) : Examining the effects of fiscal decentralization and income inequality on the economic performance of west Sumatra province, Indonesia, Global Business & Finance Review (GBFR), ISSN 2384-1648, People & Global Business Association (P&GBA), Seoul, Vol. 29, Iss. 7, pp. 63-77, https://doi.org/10.17549/gbfr.2024.29.7.63 This Version is available at: https://hdl.handle.net/10419/306028 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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Introduction Income inequality, typically measured using the Gini Ratio, has decreased over the past decade in Indonesia. However, the COVID-19 pandemic has exacerbated the level of income inequality in West Sumatra due to the country's economic downturn resulting in decreased national revenue and regional Received: May. 24, 2024; Revised: Jun. 20, 2024; Accepted: Jul. 21, 2024 † Corresponding author: Eva Herianti E-mail: [email protected] expenditure fell significantly. These disparities, rooted in variations in financial potential and management across regions (F. D. P. Santoso & Mukhlis, 2021). Income inequality can cause social injustice, tension, and increase disparities between groups in society. It can also impact social mobility, social stability, and economic growth in the long term (Bhagaskara, 2023). One of the main factors that determine poverty is income distribution, because poverty is determined by the average per capita expenditure of the population that is below the poverty line, it can be concluded that an increase in income inequality caused by a GLOBAL BUSINESS & FINANCE REVIEW, Volume. 29 Issue. 7 (AUGUST 2024), 63-77 pISSN 1088-6931 / eISSN 2384-1648 Https://doi.org/10.17549/gbfr.2024.29.7.∣63 ⓒ2024 People and Global Business Association GLOBAL BUSINESS & FINANCE REVIEW www.gbfrjournal.org for financial sustainability and people-centered global business1) Examining the Effects of Fiscal Decentralization and Income Inequalit y on the Economic Performance of West Sumatra Province, Indonesia Eva Herianti a† , Amor Marundha b aUniversitas Muhammadiyah Jakarta bUniversitas Bhayangkara Jakarta Raya A B S T R A C T Purpose: The issue of income inequality in various regions of Indonesia is a significant national concern that requires immediate attention. Despite the government's efforts through fiscal decentralization policies, inequality persists. This study decisively explores the impact of fiscal decentralization and regional income inequality on regional financial performance. Design/methodology/approach: The research sample comprises 19 districts/cities in West Sumatra province, with data from 2018 to 2020 sourced from the Ministry of Finance and the Central Statistics Agency of West Sumatra Province. The analytical approach utilized in this study is the SmartPLS ver 3.2 model. Findings: The first research finding indicates that fiscal decentralization has a positive and substantial impact on regional financial performance. A second finding suggests that regional income inequality also positively and significantly affects regional economic performance. Research limitations/implications: These results enrich the perspective of Rostow's stages of economic growth model from a different standpoint. Originality/value: This study contributes to a deeper comprehension of the fields of economics, politics, and social sciences, particularly within the specific context of the province of West Sumatra in Indonesia. Keywords: Fiscal Decentralization, Income Inequality, Rostow Model, West Sumatera Copyright: The Author(s). This is an Open Access journal distributed under the terms of the Creative Commons Attribution ⓒ N on-Commercial License (https://creativecommons.org/licenses/by-nc/4.0/) which permits unrestricted non-commercial use, distribution , and reproduction in any medium, provided the original work is properly cited. GLOBAL BUSINESS & FINANCE REVIEW, Volume. 29 Issue. 7 (AUGUST 2024), 63-77 64 decrease in the level of labor income indirectly attracts population groups that initially have average expenditure above the poverty line to average expenditure below the poverty line (Maskur et al., 2023). Basically, the percentage level of the poor in Indonesia is influenced by income inequality, open unemployment, government spending, or the human development index. Conversely, increasing economic growth requires poverty reduction efforts that depend on the effects of income inequality (Suparman, 2021). Indonesia's economic growth before COVID-19 from 2010 to 2019 tended to decline. In 2020, the COVID-19 pandemic entered Indonesia, causing economic growth to fall even further to -2.07%, indicating that the COVID-19 pandemic has affected Indonesia's economic growth and national development (Widiastuti & Silfiana, 2021). Each of development opportunities can be more evenly utilized across regions, thus impacting the development process in developed areas. This approach will help reduce economic disparities between regions, address income inequality within economic sectors, tackle low incomes among individuals or groups, combat unemployment, address isolated areas, improve the quality of human resources (HR), and address environmental challenges. These are significant challenges for stakeholders, including local and central governments, the private sector, and the community, who must work together in synergy to find solutions. The evident disparity in per capita income between districts and cities signals unequal development and investment policies or an imbalance that requires equitable distribution of development to ensure more even increases in per capita income. Studies by Damanik et al (2018) and Matondang (2018) found that economic growth and population size can impact income inequality. Policies aimed at fostering economic development have inadvertently worsened regional economic disparities. Various factors contribute to unequal welfare across different regions, as evidenced by the Human Development Index (HDI). The disparities result from regional differences, development issues in West Sumatra, and particularly challenges in the health and infrastructure sectors (Ramadhani & Utomo, 2023). The core feature of regional autonomy is its ability to demonstrate financial potential, decentralization, and effective financial management. The distribution of income and fiscal decentralization significantly impact regional financial performance. Income inequality in developing countries often does not adequately consider its regional dimensions. This is crucial because efforts to reduce income inequality nationally will only succeed in contexts where highly unequal regions coexist with economically relatively equal regions (Savoia, 2020). The expanded authority of regional autonomy allows Regional Governments to independently manage their finances by decentralizing funding to the regions. It is crucial for local governments to transparently and accountably manage these funds to ensure proper allocation and utilization. Fiscal decentralization is vital for enhancing societal welfare by effectively managing regional finances (Rahman & Saputra, 2022). In 2022, the realization of Local Own Source Revenue (PAD) for West Sumatra Province reached 2,848,207,032,876 IDR, marking an increase of 11.6% or approximately 296 billion IDR compared to the previous year. PAD in that year contributed the largest share to regional income, amounting to 46.52%. Local taxes were the largest contributor, comprising 79.86%, followed by Other Legitimate Local Revenues at 16.19%, Income from the Management of Separated Regional Wealth at 3.53%, and Local Levies at 0.42%. The Indonesian government has implemented a performance-based budget system to improve regional financial management's effectiveness, efficiency, transparency, and accountability (Khan, 2024). The research is particularly timely given the high disparity in income distribution between urban and rural areas in West Sumatra, Indonesia, a trend mirrored in other Indonesian cities. This study aims to assess how fiscal decentralization and regional income inequality impact the financial performance of the District Governments of West Sumatra Province. Eva Herianti, Amor Marundha 65 A. Literature Review and Hypothesis Development 1. Rostow's Model of Development Rostow (1960) proposed a development theory outlining a five-stage process for a developing country to achieve developed status. These stages are (1) traditional society, characterized by a limited community structure and low per capita income; (2) the preconditions for take-off, marked by the transition of the middle class towards a more modern society with an advanced economic system; (3) the take-off stage, representing an era of economic development where obstacles to growth give way to forces of progress, leading to a significant increase in investment; (4) the drive to maturity, defined by continuous and regular economic growth utilizing modern technology; and (5) the age of high mass consumption, where the leading sectors of society shift towards durable consumer goods and services. According to this theory, this economic development transition is driven by economic, political, and social orientation changes and shifts in people's attitudes and customs towards economic development. 2. Fiscal Decentralization To implement fiscal decentralization, sources of local government funding are designed more equitably. It reduces political conflict between the central and local governments and provides local government operational funds consisting of local taxes and levies, as well as central and local government balancing funds from the APBN (Sinaga, 2023). This shift in government authority has significant implications for budget administration and fiscal decentralization, particularly regarding the responsibilities of district, city, and provincial government bureaucracies in Indonesia. The sentence Fiscal decentralization is characterized by the autonomy of local governments in managing regional finances, granting them discretion to allocate funds based on regional priorities. Regional autonomy refers to self-governing regions' rights, authority, and obligations to serve local communities in line with statutory regulations. This autonomy is recommended to enhance the efficiency, effectiveness, and accountability of financial management in local government, as highlighted by Hasthoro and Sunardi in 2016 to enhance Indonesia government policy. As local government undertake fiscal decentralization, they are expected to have the independence to finance regional expenditures and pursue development separate from the central government (Iskandar et al., 2021). 3. Regional Income Inequality Hakim & Rosini (2022) explained that income inequality refers to the difference in income levels among individuals, specifically between high and low incomes. Furthermore, the inception of the problem of regional disparity indicates differences in welfare levels, so it can be said that rapid growth occurs in some regions while slow growth in others, both of which are caused by the unique characteristics of each region (Asrahmaulyana, 2023). corruption can reduce government spending on education, health, and final consumption, as this leaves fewer resources available for social spending. Thus, it can be concluded that, increased corruption has worsened the position of the poorest. increased corruption will increase income inequality (Sari & Qibthiyyah, 2022). San (1983) identifies three aspects on which regional income inequalities can be based: regional income disparity, urban-rural income disparity, and size distribution of income. Inequality is a major problem of almost every country, especially developing countries. Inequality in distribution can lead to disparities throughout society. Providing equal opportunities to each community to utilize the available social facilities and providing equal opportunities to each community to develop and improve its economy are the main keys in efforts to overcome socioeconomic disparities (Silpia, 2023). GLOBAL BUSINESS & FINANCE REVIEW, Volume. 29 Issue. 7 (AUGUST 2024), 63-77 66 4. Regional Financial Performance All local governments in the cities of Sumatra Island demonstrates a significant level of financial dependency on funds received from the central government, provincial government, and other districts. This high dependency reflects a strong reliance on external assistance to support regional governance and development activities. This is evidenced by the fact that the contribution of transfer income exceeds 50% of the total revenue of each district or city in the region (Abdullah & Mardatillah, 2017). Various factors, including government policies, the economic situation, and regulations governing regional financial management, affect regional financial performance. Improving efficiency, independence, decentralization, effectiveness, and regional dependence can help regional financial performance (Sartika, 2019). Furthermore, By using predetermined financial indicators, regional financial performance can be defined as the level of achievement of regional work results that aim to determine how well and effectively the region manages finances (Saifrizal, 2022). 5. Fiscal Decentralization and Regional Financial Performance In Indonesia, fiscal decentralization plays a crucial role in implementing the principles of regional autonomy aimed at improving community welfare based on local potentials, despite facing various challenges. Initially, fiscal decentralization in Indonesia aimed to promote economic independence at the local level. As a result, regions were granted broad authority in various sectors except for foreign affairs, defense, security, justice, finance, and religion. In the context of regional autonomy, fiscal decentralization is considered a significant second step. The package of State Finance Laws, which includes three state finance regulations, has implemented reforms in national financial policy to support this process (Christia & Ispriyarso, 2019). Fiscal decentralization involves transferring financial responsibilities from the central government to regional or local governments, which is known to impact overall financial performance significantly. This can be observed through the level of autonomy of the central government in handling regional finances and the reduced reliance on the central government. With less dependence on the central government, local administrations can independently manage financial operations, oversee, and exploit financial opportunities, and handle budgeting and allocation. To improve local financial capability, local governments must have the ability to support the financing of government, development, and community activities. In addition, they must encourage the community to participate in regional development and manage local revenue effectively and efficiently (R. T. Santoso et al., 2021). Therefore, building upon existing theory and research, the initial hypothesis presented in this study is: H1: Fiscal Decentralization has a positive effect on regional financial performance. 6. Regional Income Inequality and Regional Financial Performance Income inequality measures how income is distributed among people in a specific area or region during a specific time. This trend of increasing income inequality is observed at various levels in Indonesia, including rural, urban, national, and provincial levels. In urban areas, income inequality is more pronounced than in rural areas, which has implications for regional economic performance and public trust in the government. Income inequality is closely linked to poverty, and reducing income distribution inequality or income level gaps will inevitably be a top priority in economic development (Wuladari et al., 2022). Hanum & Muda (2019) The elevated poverty rate in the region is attributed to restricted access to education, wage disparities, and the modest incomes of agricultural workers. By reallocating regional expenditures more effectively, it is possible to promote stronger and more equitable economic growth, thereby addressing the issue of income inequality. Hence, in line with Eva Herianti, Amor Marundha 67 existing theories and previous research, the second hypothesis posited in this study is: H2: Regional income inequality exerts a positive impact on regional financial performance. 7. The Effect of Fiscal Decentralization and Regional Income Inequality on Regional Financial Performance Fiscal decentralization has the potential to enhance efficiency in public and production services. However, the implementation of decentralization varies across different regions, leading to diverse effects due to variations in characteristics and institutions. Fiscal decentralization is crucial in improving regional financial performance and reducing income inequality. According to Galbraith (2012), unequal distribution of development results in income inequality within each region, which, in turn, hinders economic growth and exacerbates income inequality . There exists a correlation between financial performance and regional income inequality. Unequal economic growth contributes to decreased regional income inequality. Regional authorities can proactively and innovatively manage regional finances to foster growth. Efriza (2014) examined income inequality among districts, cities in East Java Province and found that the Williamson index indicates significant income inequality, particularly in Kediri and Surabaya. The Theil Entropy Index also confirms a very high-income inequality in East Java province. Moreover, the inflation rate positively and significantly impacts regional income inequality. Greater local revenue will make a region more independent in financial management (Sarumaha & Annisa, 2023). Therefore, based on existing theory and previous studies, this study proposes the third hypothesis: H3: Fiscal Decentralization and Regional Income Inequality have a positive effect on regional financial performance. II. Methodology This research is a quantitative study that examines and evaluates the effect of fiscal decentralization and regional income inequality on regional financial performance with a conceptual framework as shown in Figure 1. Secondary data from government institutions such as the Central Bureau of Statistics (BPS) of the relevant regions is the source of this research. The required data are Gross Regional Domestic Product (GRDP), APBD, and population. Revenue reports of regional own-source revenues (PAD), central taxes for regions, general allocation H! H2 Fi scal Decentralization Re gi onal Income Inequality Regional Financial Performance Figure 1. Conceptual framework GLOBAL BUSINESS & FINANCE REVIEW, Volume. 29 Issue. 7 (AUGUST 2024), 63-77 68 funds (DAU, and other data relevant to the research used from the APBD besides secondary data also collected through literature research to support this research. This research uses data from 12 districts and 7 cities in West Sumatra. This research uses the smart pls 3.2.2 analysis tool. A. Data Analysis Method Descriptive statistics offer an overview of the data profile within a research sample. In this study, descriptive statistics are employed to provide descriptions of the respondents. These statistics are computed using Microsoft Excel to facilitate the analysis. The study utilizes the SEM technique and employs the SmartPLS 3.2.2 analysis tool to evaluate two models, namely the outer and inner models. 1. The Evaluation of Measurement Model (Outer Model) The outer model is assessed to determine the relationship between the latent construct and its indicators. This model serves to establish the validity and reliability of the research instruments. The validity test encompasses convergent and discriminant validity. In assessing convergent validity, this study employs the loading factor (Solling Hamid & M Anwar, 2019). It stated that a loading factor value > 0.50 is practically significant. Additionally, the cross-loading value for each indicator within a variable differs from the indicator in other variables, with a loading value > 0.5. Furthermore, this study utilizes Cronbach's alpha and composite reliability for reliability testing. The Rule of thumb dictates that the values for Cronbach's alpha and composite reliability must exceed 0.7 for the construct or variable to pass the reliability test (Chua, 2023). 2. The Evaluation of Structural Model (Inner Model) In this study, the aim of evaluating the inner model is to scrutinize the research hypothesis. According to Hartono et al (2020), the evaluation of the inner model can be elucidated by the R 2 value for the dependent variable, path coefficient value, or t-value for a significant test between constructs in the inner model. A high R 2 value indicates a strong prediction model for this study. The path coefficient value is explicated by t-statistics and then compared with the t-table value in hypothesis testing. For the one-tailed hypothesis with an alpha of 5%, the t-table value is 1.64 in the case of the mediation effect. The significance test parameter output is derived from the total effect table rather than the path coefficient table. This is because the mediation effect tests the independent variable's direct impact on the dependent variable and examines the indirect relationship between the independent and dependent variables through the mediating variable (indirect effect). The R 2 value is 0.67 (strong) 0.33 (moderate) and 0.19 (weak) testing the path coefficient individually can be used t test or f test from the regression output. The primary objective of this research is to analyze the effects of fiscal decentralization and regional income inequality on the financial performance of the West Sumatra Province. This study seeks to delve into the relationship between these factors and their influence on the economic stability and growth of the region. The research design specifically addresses the research problems, objectives, and hypotheses. Employing a quantitative research approach, the study utilizes panel data measurement, comprising observations across 19 districts/cities in West Sumatra, and incorporates five years of time series data spanning from 2016 to 2020. According to the earlier conceptual variables, identifying research involves two independent variables and one dependent variable, comprising exogenous and endogenous variables. The exogenous variables are categorized as fiscal decentralization and regional income inequality, while the employed endogenous variable is regional financial performance. These research variables are presented in Table 1 below. This study incorporates two independent variables and one dependent variable. The indicators used for Decentralization Fiscal include the Indicator of Regional Expenditure, Regional Income, and Regional Eva Herianti, Amor Marundha 69 Autonomy. Additionally, the study utilizes indicators of Regional Income Inequality, such as the Williamson Index, Theil Entropy Index, and Jamie Bonet Index. Furthermore, the study examines Regional Financial Performance using indicators like Compatibility Ratio, Independency Ratio, Efficiency Ratio, Effectiveness Ratio, Fiscal Effort, and Regional Income Growth Rate. Detailed explanations of the measurement for each research variable can be found in Table 2. III. Results A. The Outer Model Result The researchers performed a measurement assessment (outer model) to evaluate the validity and reliability of the research instrument. Below is a diagram illustrating the path analysis (PLS algorithm Literacy). The loading factor values for the indicators No Variable Name Indicator Code Indicators 1 Fiscal Decentralization (X1) DF 1 DF 2 DF 3 Indicator of Regional Expenditure Indicator of Regional Income Indicator of Regional Autonomy 2 Regional Income Inequality (X2) KPD 1 KPD 2 KPD 3 Williamson Index Theil Entropy Index Jamie Bonet Index 3Regional Financial Performance (Y) KKD 1 KKD 2 KKD 3 KKD 4 KKD 5 KKD 6 Compatibility Ratio Independency Ratio Efficiency Ratio Effectiveness Ratio Fiscal Effort Regional Income Growth Rate Source: Data Processed, 2022 Table 1. Research object based on research variables Variables Types of variables Measurement Variable Measurement Scale Fiscal Decentralization (X1). (Halim, 2001) Independent (X1)      TER = Total Expenditures of Regency TCGE = Total central government expenditures      TDGR = Total District Government Revenue TCGR = Total Central Government Revenue      TODR = Total Original District Revenue TDR = Total District Revenue Ratio Regional Income Inequality (X2) Independent (X2) KPD 1 Williamson Index          where: Yi = GRP Nominal per capita at Province i Y = Average Per Capita Income in West Sumatera Fi = Total Population of District I N = Total Population in West Sumatra Province Ratio Table 2. Operational variables GLOBAL BUSINESS & FINANCE REVIEW, Volume. 29 Issue. 7 (AUGUST 2024), 63-77 70 of each valid and invalid research variable are presented. Any invalid loading factor values will be removed, with a minimum loading factor of 0.50 being the benchmark. Following this, the diagram will be revised and retested multiple times to ensure improvements in the research model. Variables Types of variables Measurement Variable Measurement Scale KPD 2 Theil Entropy Index       ×      I = Theil Entropy Index Yj = GRP Nominal per capita at Province J Y = GRP Nominal per capita at West Sumatera. XJ = Total Population of District j X = Total Population in West Sumatra Province KPD 3 Jamie Bonet Index         Iit = Regional Inequality in I at Year t Yj = GRP Nominal per capita at Province J Y = GRP Nominal per capita at West Sumatera Province Regional Financial Performance (Y) Dependent (Y)      × DECR = District Capital Expenditure Realization DER = District Expenditure Realization      × RODR = Realization of Original District Revenue RRTR = Realization of Regency Transfer Revenue      × DER = District Expenditure Realization DRR = District Revenue Realization      × RROI = Realization of Regional Original Income TROR = Target of Regional Original Revenue      × RROI = Realization of Regional Original Income DGRDP = District Gross Regional Domestic Product KKD 6 Growth rate of Regional Income Growth    – ×  Information: R = Growth Ratio Pn = Total Regional Revenue for Regency, City calculated in the nth year Po = Total Income of West Sumatra Province calculated in the nth year Ratio Source: Data Processed, 2022 Table 2. 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