How Forward-Looking Are Local Governments? Evidence from Indonesia

Conventional wisdom in the policy community holds that volatile fiscal transfers to local governments will cause volatile local spending, due to policy myopia. I test the degree to which local governments are forward-looking by exploiting unusual variation in intergovernmental grants in Indonesia. A national reform permanently increased the general grant, and the increase was larger for less densely populated districts. Hydrocarbon-rich districts experienced transitory shocks to shared resource revenue. Districts responded to the permanent revenue shock by increasing investment in lumpy public goods. By contrast, districts smoothed their expenditure responses to the transitory revenue shocks, opting not to adjust lumpy public goods. The results suggest that local governments respond to changes in permanent public income over a time horizon of three to five years. I discuss implications for countercyclical fiscal policy and research on taxation and accountability.