ABSTRACT : This study examines how the quality of performance-based budgeting (PBB) shapes the relationship between fiscal decentralization and social welfare in Indonesia. Since the implementation of decentralization in 2001, intergovernmental transfers have expanded by more than 145%. However, improvements in Human Development Index (HDI) remain uneven across regions which suggest that larger fiscal resources do not automatically translate into better social welfare outcomes. Using panel data from 420 districts and municipalities over the period of 2013 – 2022, this research estimates both the direct effects of key fiscal instruments, including General Allocation Grants, Special Allocation Grants, local taxes, local levies, and economic expenditure, and their indirect effects operating through the quality of PBB, proxied by the Welfare State Ratio (WSR). This paper combined fixed-effects panel regression, mediation analysis, and dynamic generalized method of moments (GMM) estimation. The results show that fiscal decentralization has a statistically significant effect on social welfare, but the magnitude and direction depend strongly on the quality of PBB implementation. Economic expenditure appears as the most consistent and effective fiscal tool in supporting welfare outcomes. In contrast, Special Allocation Grants have a negative mediating effect, indicating that conditional transfers may limit institutional flexibility. Regional differences are also evident, with local governments in western Indonesia tend to benefit more from PBB mechanisms than those in eastern regions, in which institutional capacity is restricted. Overall. these findings suggest that the efficiency of fiscal decentralization is determined less by the scale of fiscal resources and more by the institutional capacity to turn fiscal inputs into measurable human development outputs. These findings underscore the need for reforms to more asymmetric transfer systems, combined with targeted capacity-building activities, to ensure equitable and sustainable development throughout Indonesia.

KEYWORDS – Fiscal decentralization; Human Development Index; Indonesia; Performance-based budgeting; Social welfare.