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I haven't researched it, but I assume it just wipes out the negative opionions. Even if you talk your way out the NPCs that caught you will still have a bad opionion of you. Which makes sense as they saw you with their own eyes and don't care what you say.
Though even when I had a few thousand groschen on the indulgence box I was still at 100 in the area...so I don't know if you actually get anything out of paying it.
Yes, cause of reputation taking the hit.
Note how every time you pass one of those checks against a guard, it also notes a loss of reputation in upper right of screen.
In fact, taking your punishment in the pilllory for the lesser things, may hurt your reputation less than talking your way out.