Adjusting to Decentralization: Investment Dynamics and Beyond

Countries have been increasingly decentralizing and devolving powers to lower levels of government. Yet proliferation of governments, particularly in a developing country setting where administrative capacity is limited, may lead to an increase the tax and compliance burden and deterioration of business climate, with potentially detrimental effects for private investment. This hypothesis is tested in the context of Indonesia, which increased the number of districts from 284 in 1989 to 511 by 2014. The data indicate that plants operating in the splitting districts reduced investment, experienced an increase in the tax burden and boosted ‘donations’. In contrast to private plants, state-owned establishments did not register a drop in investment or an increase in the tax burden, most likely thanks to links to authorities that may have protected them from tax and regulatory uncertainty. Splitting districts also registered a drop in foreign acquisitions and an increase in productivity dispersion among private plants.