Determinants of Local Government Financial Condition: The Moderating Role of Political Governance

Abstract

The financial condition of local governments has become an important indicator of fiscal sustainability, particularly in decentralized countries where regional governments are expected to provide public services while maintaining sound financial management. This study investigates the effects of economic growth, poverty, local own-source revenue (PAD), and population on the financial condition of provincial governments in Indonesia. It also examines whether political governance, represented by the Indonesian Democracy Index (IDI), influences the relationship between economic conditions and regional financial condition. The study uses balanced panel data from 34 Indonesian provinces during the 2022–2024 period. Local government financial condition is measured using the Financial Condition Index (FCI), which reflects fiscal solvency, financial flexibility, financial independence, and service-level solvency. The proposed relationships are estimated using a fixed-effects panel regression model with cluster-robust standard errors, while interaction terms are incorporated to assess the moderating role of political governance. The results show that poverty significantly weakens local government financial condition, whereas population has a positive and significant effect. Economic growth and PAD, however, do not exhibit a direct influence on financial condition. The findings further reveal that political governance significantly moderates the relationship between economic growth and financial condition, indicating that stronger democratic governance reduces the positive fiscal impact of economic growth. In contrast, political governance does not significantly moderate the relationship between poverty and financial condition. These findings suggest that improving democratic governance alone is not sufficient to strengthen regional financial health. Sustainable fiscal performance also depends on stronger fiscal management, more efficient public spending, and institutional arrangements that enable economic growth to be translated into long-term financial resilience. This study contributes to the literature by demonstrating that political governance serves as a contextual institutional mechanism shaping the fiscal consequences of economic conditions, extending the integration of Fiscal Federalism Theory and Institutional Theory in explaining local government financial condition.