ABSTRACT: This study investigates the mediating role of institutional capacity in the relationship between economic expenditure and social welfare within Indonesia’s fiscal decentralization framework. Using panel data from 420 regencies and cities across Indonesia from 2013 to 2022, this research employs a quantitative approach with Fixed Effects Model analysis and the Sobel test for mediation analysis. Economic expenditure is measured as the percentage of economic spending relative to total regional government expenditure; institutional capacity is assessed through outcome ratios comprising economic growth, poverty reduction, and unemployment reduction performance indicators compared to national targets; while social welfare is proxied by the Human Development Index (HDI).

The findings reveal significant positive effects of economic expenditure on social welfare at the national level (coefficient = 0.061882, p < 0.01), with substantial regional variations ranging from highly responsive regions such as Sumatra (0.089341) to non-significant effects in Papua and Nusa Tenggara-Bali. Economic expenditure also significantly influences institutional capacity (coefficient = 0.531129, p < 0.01), though with lower explanatory power (adjusted R² = 0.351073), indicating that institutional development is influenced by more complex factors beyond fiscal variables.

The mediation analysis confirms that institutional capacity significantly mediates the relationship between economic expenditure and social welfare (t-statistic = 6.13 > 1.97), with regional variations showing effective mediation mechanisms in Sumatra (t = 3.91), Kalimantan (t = 2.19), Java (t = 2.71), and Sulawesi-Maluku (t = 4.76), while Papua and Nusa Tenggara-Bali exhibit non-significant mediation effects.

These findings challenge the linear assumptions in fiscal federalism theory and support the development of a “mediated fiscal federalism” framework, emphasizing that fiscal decentralization effectiveness depends not only on resource allocation but also on institutional mediation mechanisms. The study contributes to the integration of New Public Management principles with Sen’s capability approach, demonstrating that performance-based budgeting effectiveness varies significantly across institutional contexts.

The research provides critical policy implications for reformulating Indonesia’s fiscal policy toward more contextualized and differentiated approaches, redesigning transfer systems based on institutional performance, and strengthening intergovernmental coordination mechanisms for sustainable development.

Keywords: Decentralization, Economic Expenditure, Fiscal Policy, Human Development Index, Outcome Ratio.