POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise APRIL 2010 · Number 9 54078 Agriculture Public Spending and Growth: The Example of Indonesia Enrique Blanco Armas, Camilo Gomez Osorio, and Blanca Moreno-Dodson This note1 analyzes the trends and evolution of public spending in the agriculture sector in Indonesia, as well as its impact on the growth of agriculture during the period 1976­2006. Public spending on agriculture and irrigation had a positive impact on agriculture growth during that period, whereas public spending on fertilizer subsidies had the opposite effect. As Indonesia continues its efforts to revitalize the agriculture sector, public spending should be directed at improving the provision of public services rather than at subsidizing private inputs. Supplying Public Goods Versus Subsidizing pense of the provision of public goods is often negative. Sub- Private Inputs sidizing private inputs may represent only a transfer of re- sources with no impact on the consumption of that input According to the theory of public economics, only the public and, even if the subsidy increases its use, its impact on pro- sector can supply public goods efficiently (and at adequate ductivity is uncertain. amounts) because the market will always under-provide those goods. When supplied in a cost-effective way, public goods The Importance of Public Spending for will generate higher returns than will investments in private Agriculture Growth inputs because they will create positive externalities for the economy as a whole. Because governments have the capacity The purposes of the public sector in agricultural develop- to collect individual contributions to provide public goods, ment--primarily a private sector activity--are to set an en- they can also capture economies of scale, access funding, and abling environment where private sector activities can manage risk better than farmers can manage it. As a result, flourish; to correct instances under which the market fails they are better suited to supply public goods. to allocate resources efficiently; and to minimize the price However, the impact on productivity from subsidizing distortions faced by both farmers and consumers, while pro- private inputs is unclear. Research shows that the record of moting inclusive growth. In practice, those tasks translate governments subsidizing private inputs in the agriculture into interventions along several dimensions: sector is, mixed, at best--although many governments spend · correcting for externalities, which requires making peo- a considerable share of their budgets on such subsidies. The ple pay (or be paid) for the cost and benefits of their productivity impact of subsidizing private inputs at the ex- actions--such as by discouraging the overuse of fertil- 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise izer that leads to pollution, or by rewarding with a 61.5 trillion, an average of 12 percent a year in real terms. patent advances in research and development; This was the result of large budget increases and a big spend- · providing for public goods that are not efficiently and suf- ing boost from decentralization across all sectors, with even ficiently produced by the market--such as by building greater amounts for agriculture. As figure 1 illustrates, the rural roads and irrigation systems, providing extension agriculture share of the budget doubled from 3 percent in services and agriculture marketing, and funding more 2001 to 6 percent by 2008; by that year, it reached 1 percent agriculture research and development; of GDP because of increased spending on agriculture subsi- · addressing information asymmetries and eliminating in- dies. This increase did not result in a corresponding rise in formation gaps so that farmers and consumers can agricultural production, which increased an average of 3 per- make informed decisions on what to produce, with cent between 2001 and 2009. Low agriculture growth com- what level of inputs, and at what price--for example, bined with a constant share of labor force participation in by certifying product input and output quality stan- the sector has led to stagnant per-worker value added. dards and ensuring plant and animal health; and Recent public spending trends in agriculture show that · regulating against monopolistic behavior that reduces so- resources are being directed toward supporting private cial welfare--for example, by having lower outputs sold goods at the expense of providing public goods. In 2009, the at higher prices. government of Indonesia directed 56 percent of agriculture There is renewed interest in improving our understanding resources (Rp 34.4 trillion) toward subsidizing private of the impact of public spending on agricultural growth.2 All goods: fertilizer subsidies accounted for almost half (Rp 18.5 these studies emphasize the concept of opportunity costs of trillion), and the remainder was allocated to seeds, RASKIN,4 subsidies. Although increased use of a particular input may and agriculture credit. As figure 2 shows, by the end of 2009 have a positive effect on production (such as the effect of fer- the allocation for agriculture subsidies was four times its tilizer on rice production), the impact of subsidizing such in- 2001 level, although resources for irrigation have been flat puts is often negative because it is done at the expense of since 2001. The budget of the Ministry of Agriculture has providing public goods (such as funding for research on newer increased significantly since 2001, but at a slower pace than varieties or improvements to the irrigation network) that have agriculture subsidies. A more detailed analysis of the Min- a larger positive impact on production. istry of Agriculture budget (conducted for the Agriculture In Indonesia, Fuglie (2004) identifies the drivers of Public Expenditure Review) suggests that more than 40 per- growth in agriculture between the 1960s and 2000. He ar- cent of the ministry's budget is allocated to subsidizing pri- gues that although agricultural productivity in the 1970s and vate inputs in the form of grants to farmers and farmers' 1980s was increasing, this trend has been flat since the early groups. Although this spending may be useful in providing 1990s, with most growth in agriculture being explained by income support to poorer farmers, it is unlikely to lead to increases in production inputs (labor and land). Fuglie also significant increases in agricultural productivity. argues that the reason for the productivity stagnation from the 1990s onward is the low levels of both private and pub- lic investments--in particular, public investments in research Figure 1. Agriculture spending, 2001­09 and development, rural infrastructure, and irrigation (which 40 are necessary complements to private investments in the sector). 35 30 Trends of Agriculture Public Spending in share (%) 25 Indonesia 20 The question that motivated the analysis was whether the 15 volume and composition of public spending are having an 10 impact on growth in the agriculture sector. We first analyze recent trends for public agriculture spending in relation to 5 growth, followed by a time-series quantitative assessment of 0 the impact of public spending on per capita growth in In- 2001 2002 2003 2004 2005 2006 2007 2008 2009 donesia's agriculture sector during the period 1976­2006. year Public spending on agriculture recently has increased in agriculture spending/agriculture GDP agriculture spending/national spending real terms and without a corresponding increase in agricul- agriculture spending/GDP tural production. During the years 2001­09, national spend- ing on agriculture3 increased from Rp 11.0 trillion to Rp Source: World Bank staff calculations. 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Figure 2. Index of agriculture spending, 2001­09 growth and for private inputs (arable land and labor). We then split public spending on agriculture into spending for 5 public goods (development spending for agriculture and ir- index (2001 = 1) 4 rigation) and fertilizer subsidies. The results show that 3 spending on public goods is a positive driver of the growth 2 rate of agriculture GDP per capita, whereas spending on fer- tilizer subsidies appears to have a significant negative effect. 1 The positive effect of public spending on agriculture is as- 0 sociated only with the agriculture and irrigation develop- 2001 2002 2003 2004 2005 2006 2007 2008 2009 ment component. Given the opportunity cost of further year financing subsidies at the expense of other agriculture agriculture (central and subnational) spending and irrigation directly contributing to growth, the irrigation (central and subnational) agriculture subsidies (central) government should consider reallocating spending from fer- tilizer subsidies to public goods (such as agriculture exten- Source: World Bank staff calculations. sion services, research and development, and irrigation) that could lead to faster sector growth.6 Government investment in public goods was largely be- Recommendations hind Indonesia's success in increasing agricultural produc- tivity through the 1970s to the early 1990s. During the years As Indonesia modernizes the agriculture sector and as in- of the Green Revolution, Indonesia invested heavily in its come levels increase, it will be important to allocate re- irrigation network, research and development, extension sources based on a two-pronged strategy that maximizes services, and rural infrastructure; and it subsidized private spending effectiveness, brings higher returns, and leads to agriculture inputs (fertilizer, seeds, and credit). By the early growth for the agriculture sector, while it pays attention to 1990s, the country had achieved high yields across several farmers' welfare and people's access to affordable food. commodities, including rice, cereals, and potatoes (World The government may consider these interventions: Bank 1994). Unfortunately, in the 1990s the upward trend · Reallocate public spending from subsidizing private in productivity flattened. Exacerbated by declining levels of inputs (fertilizer, seeds, and grants to farmers and farm- private and public investment, agricultural productivity ers' groups) to providing agriculture and irrigation growth remains sluggish today. public goods and services. Spending as a share of GDP in agriculture averaged 10 · Put in place a comprehensive monitoring and evalua- percent and 8 percent in the 1970s and 1980s, respectively, tion system that enables the government to assess the compared with 35 percent today. As discussed earlier, we effect of its grants programs. Such a system would be argue that because most of the increased spending in agri- instrumental in improving program design, maximiz- culture is directed at private goods, it has not translated into ing effectiveness in agricultural productivity, and alle- a proportional increase in growth. viating poverty in rural areas. Results of the Empirical Analysis Notes In trying to learn whether the volume and composition of 1. This Economic Premise is based on the results of the In- spending have an impact on growth in the agriculture sector, donesia Agriculture Public Expenditure Review, World we look at the relationship between agriculture public Bank, 2009­10. spending and the growth rate of agriculture GDP per capita, 2. Evidence provided by a U.N. Food and Agriculture Or- using time-series data with both ordinary least squares and ganization research project conducted in 20 countries in general method of moments econometric techniques. The Latin America shows that public spending in rural areas has model chosen for this analysis introduces specific character- a positive impact on agriculture growth (Allcott, Lederman, istics and innovations to fit the Indonesian context as well and López 2006). The study also shows that both the vol- as the broader analysis objectives of the Public Expenditure ume and the composition of spending matter. Assuming a Review.5 fixed amount of spending in the agriculture sector, a large The overall results of the empirical analysis show that share of spending on subsidies to private inputs has a neg- spending on agriculture has a statistically significant positive ative impact on agriculture growth, given the corresponding effect on the agriculture GDP per capita growth rate, after lower spending on the provision of public goods. López and controlling for the effects of nonagriculture GDP per capita Galinato (2007) find similar results, and they argue that the 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise positive effect of public spending on rural incomes is pri- About the Authors marily dependent on the composition of spending. They es- timate that a 10 percent reallocation from subsidizing Enrique Blanco Armas is a senior economist and Camilo Gomez private goods to providing public goods can increase per Osorio is an economist of the Poverty Reduction and Economic capita income from agriculture by 5 percent. In a related Management (PREM) Network, East Asia; and Blanca Moreno- piece of work, Santos and Ortega (2006) show how the Dodson is a senior economist of PREM, World Bank, Washing- share of the budget allocated to subsidizing private inputs ton, DC. To learn more about PREM, please visit http://www. has a negative and significant impact on the efficiency of worldbank.org/prem. public spending. References 3. National spending on agriculture includes central gov- ernment spending on irrigation by the Ministry of Public Allcott, Hunt, Daniel Lederman, and Ramón López. 2006. "Political Insti- Works and on agriculture by the Ministry of Agriculture. tutions, Inequality, and Agricultural Growth: The Public Expenditure Subnational government spending on agriculture and irriga- Connection." Policy Research Working Paper 3902, World Bank, Wash- tion is done by district and provincial governments and agri- ington, DC. Bayraktar, Nihal, and Blanca Moreno-Dodson. Forthcoming. "How Public culture subsidies. Spending Can Help You Grow. An Empirical Analysis for Developing 4. RASKIN (Beras Miskin) is not a subsidy to agricultural Countries." World Bank, Washington, DC. inputs, but primarily a program to provide subsidized rice Blanco Armas, Enrique, Blanca Moreno-Dodson, and Camilo Gomez Oso- for the poor. To the extent that it increases domestic demand rio. Forthcoming. "Agriculture Public Spending and Growth: The Ex- for rice and is partly used to stabilize prices and therefore ample of Indonesia." PREM Note 149. provide an incentive for increased rice production, it will Fuglie, Keith O. 2004. "Productivity Growth in Indonesian Agriculture, 1961­2000." Bulletin of Indonesian Economic Studies 40 (2): 209­25. also have an impact on rice production. In any case, we in- López, Ramón, and Gregmar I. Galinato. 2007. "Should Governments Stop clude it as an agriculture subsidy because the Ministry of Fi- Subsidies to Private Goods? Evidence from Rural Latin America." Jour- nance includes it; note, however, that it is not entirely a nal of Public Economics 91 (5­6): 1071­94. subsidy to agricultural production. Moreno-Dodson, Blanca. 2008. "Assessing the Impact of Public Spending 5. Different function specifications were considered, tak- on Growth. An Empirical Analysis for Seven Fast Growing Countries." Policy Research Working Paper 4663, World Bank, Washington, DC. ing into account previous analyses of the impact of public Santos Rocha, Józimo, and Jorge Ortega. 2006. "Crecimiento, inversión pri- spending in the agriculture sector. See, for example, López vada y eficiencia del gasto público en las áreas rurales de América Latina and Galinato (2007); Moreno-Dodson (2008); and Bayrak- y el Caribe." In Políticas Públicas y Desarrollo Rural en América Latina y tar and Moreno-Dodson (forthcoming). el Caribe ­ El papel del gasto público, ed. Fernando Soto Baquero, Józimo 6. For econometrics details, see Blanco Armas, Moreno- Santos Rocha, and Jorge Ortega, 127­63. Santiago de Chile: Food and Dodson, and Gomez Osorio (forthcoming). Agriculture Organization of the United Nations. World Bank. 1994. "Indonesia, Stability, Growth and Equity in Repelita IV." Washington, DC. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. It is produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at www.worldbank.org/economicpremise.