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Indonesia: Selected Issues

Author(s):
International Monetary Fund. Asia and Pacific Dept
Published Date:
February 2018
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Prioritizing Fiscal Reforms to Enhance Productivity and Equity in Indonesia1

A well-sequenced growth-enhancing fiscal strategy is critical for Indonesia. This paper outlines the priorities of a fiscal strategy, which includes new excise taxes and structural tax reforms to finance infrastructure and well-targeted social programs. These fiscal reforms will enhance productivity and equity and pave the way for future reforms.

A. Introduction to Fiscal Reforms and Sequencing

1. Implementing a growth-enhancing fiscal strategy is critical to promote growth and equity in Indonesia. A Medium-Term Revenue Strategy (MTRS) is necessary to address the low general government revenue (around 12 percent of GDP). The MTRS should increase revenue by at least 3 percent of GDP over the medium term to finance priority expenditure within Indonesia’s fiscal rules. Most of the revenue gains should be generated by tax policy reforms, especially for income and value-added tax (VAT), complemented by improvements to tax administration and introducing excise taxes on vehicles and fuel products. The additional revenue should be used to expand growth and equity enhancing priority expenditure, such as on infrastructure, health, education, and social safety nets, while improving spending efficiency (Jin 2017).

2. As implementing a comprehensive fiscal strategy will take time, near-term policy actions should be taken to arrest the fall in revenue and develop infrastructure. Indonesia’s tax-to-GDP ratio has declined in recent years, therefore the introduction of excises taxes on vehicles and fuel should be frontloaded to raise additional revenue of about 1 percent of GDP. The additional revenue can be used to partly finance the authorities’ infrastructure plan, including the 247 priority projects.

3. A subset of the fiscal strategy could also be prioritized to support inclusive growth. This subset comprises revenue and expenditure measures. On the revenue side, the priorities include removing exemptions in income taxes and VAT, lowering the VAT and corporate income tax (CIT) thresholds, simplifying VAT policy and administration, and enhancing tax administration overall, which could deliver additional revenue of 0.5–1 percent of GDP in the near term. On expenditure, the additional revenue could be used to expand the most effective and targeted social programs to reduce inequality (see Section C below). These reforms would support inclusive growth and pave the way for future reforms.

B. Improving Productivity and the Business Climate Through Tax Reforms

Tax Policy Reforms: Reducing Resource Misallocation to Boost Productivity

4. The April 2017 Fiscal Monitor suggests that resource misallocation induced by distortionary tax treatments is an important source of low productivity (IMF 2017). Such distortionary tax treatments are not uncommon worldwide, including different effective marginal tax rates on capital asset types (machines versus buildings), source of financing (equity versus debt), size of firms (small versus large), and formality of business (former sector versus informal sector):

  • Distortions across capital asset types are due to differences between tax depreciation and economic depreciation, especially in equipment associated with information technology.

  • Distortions across source of financing occur when firms can deduct interest expenses, but not returns to equity, in calculating CIT liability.

  • Distortions across size of firms arise from lower CIT rates for firms below a certain size as measured by the level of profits, turnover, or number of employees.

  • Distortions across business formality are due to higher taxes and social security contributions on formal businesses, while tax administration enforcement is weak on informal businesses.

5. Reducing such distortions through tax reforms could boost potential growth. Although it is difficult to eliminate all distortions, reducing them to the level of the top performing countries in the same income group could deliver substantial benefits. For emerging market economies like Indonesia, such reforms could lead to an increase in real GDP growth of 1.3 percentage points in the long run.

6. Indonesia has several distortionary incentives and exemptions in its tax system. They include not only internationally common practices such as deductibility of interest expenses, but also many Indonesia-specific distortions:

  • CIT exemptions. Although the statutory CIT rate (25 percent) is in line with the OECD average and major emerging market economies, there are several lower-rate CIT regimes: a 1 percent presumptive tax on gross revenue for small and medium enterprises below an annual turnover of IDR 4.8 billion (USD 355,100); a rate reduction of 50 percent for taxable income corresponding to gross turnover up to IDR 4.8 billion of medium-sized enterprises with an annual turnover below IDR 50 billion; and a reduced rate of 20 percent for publicly listed companies.

  • VAT exemptions. Despite a modest VAT statutory rate (10 percent), a long list of exemptions have been granted to final and intermediate goods and services by the VAT law and government regulations: mining (unprocessed products), staple goods (agriculture), tourism (hotels and restaurants), transportation, employment services, banking and insurance, art and entertainment services, education, and medical and social services; capital goods; agricultural, plantation, and forestry products; electricity (excluding that supplied to households with consumption above 6,600 Watts); distributed piped water; cattle, poultry, and seeds, weapons for the army, educational books, ships, trains, aircrafts and their spare parts, and low-cost housing.

  • VAT threshold. The threshold of turnover for mandatory VAT registration is IDR 4.8 billion, the same as the CIT threshold for the 1 percent turnover tax in lieu of regular CIT, which is very high compared to other countries (Figure 1). This VAT threshold covers only 50,000 firms, compared to over 400,000 firms previously registered under a much lower threshold of IDR 600 million.

Figure 1.VAT Registration Thresholds

Sources: International Bureau of Fiscal Documentation; and IMF staff estimates.

7. These distortions could encourage arbitrage and lead to inefficient resource allocation. The 1 percent presumptive turnover tax for small and medium firms incentivizes them to stay below the threshold of IDR 4.8 billion, instead of growing into larger and more competitive firms. It also disregards the actual profit margins and may impose high tax burdens on firms experiencing short-term losses. The VAT threshold and numerous exemptions breaks the VAT chain, compromising the VAT’s efficiency and neutrality. In addition, these exemptions and thresholds have made tax administration more complex. The Directorate-General of Taxation (DGT) allocates much of its human resources to deal with these complexities, instead of focusing on more productive areas such as risk-based audits.

8. Tax policy reforms should reduce distortions and improve resource allocation to boost growth. On VAT, reducing the threshold of IDR 4.8 billion (e.g., to the previous threshold of IDR 600 million) would broaden the tax base and raise revenue, without overburdening truly small firms with little capacity to keep proper books and records. Removing unnecessary VAT exemptions on both final and intermediary consumptions would also strengthen the integrity of the VAT chain. On CIT, limiting the application of the 1 percent presumptive tax only to truly small and new firms (e.g., below IDR 600 million) with a phase-out period of a few years for the special treatment would incentivize the establishment of new and innovative firms. Unifying the remaining CIT rates at 25 percent or slightly lower would level the playing field for firms of different sizes and encourage firms to grow.

Tax Administration Reforms: Improving Business Climate to Enhance Growth

9. Indonesia has made significant progress in improving its business climate. According to the 2018 World Bank Doing Business Report (World Bank 2018), Indonesia’s overall ranking has been upgraded to 72 from 106 two year ago, thanks to the 16 economic policy packages adopted by the government since 2015. These packages aim to enhance the business climate by streamlining regulations, cutting bureaucracy, adding one-stop shops, and rationalizing permit and license procedures. Indonesia’s improvement in rankings during 2016–2018 is particularly impressive on resolving insolvency (36), enforcing contracts (26), protecting minority investors (26), starting a business (23), and getting electricity (23) (Table 1).

Table 1.Indonesia’s Doing Business Ranking
Doing BusinessImprovement

2016–2018
201820172016
Overall ease of Doing Business rank729110534
Component rank
Resolving insolvency38757436
Enforcing contracts14515517125
Protecting minority investors43705925
Starting a business14415116723
Getting electricity33495123
Registering property10611812317
Getting credit55527015
Dealing with construction permits1031151135
Paying taxes1141041151
Trading across borders1121031131
Source: World Bank, Doing Business database.
Source: World Bank, Doing Business database.

10. However, Indonesia’s ranking in paying taxes has barely moved, limiting the scope for further improvements of the business climate. The ranking of paying taxes has only improved from the 115th to 114th position in the past two years due to weaknesses on several fronts. For a typical medium-sized company assumed by the World Bank report, the number of tax payments needed per year has been reduced from 54 to 43, but is still above those in peer countries (average 19). Such a firm also needs to spend 18 hours to comply with VAT refunds and wait 47.7 weeks to receive refunds (Figure 2), which is longer than most peers (average 12 hours and 27.9 weeks, respectively). This is partly because Indonesia’s VAT taxpayers must itemize each transaction in their tax returns, in contrast with other countries where only the aggregated amount is needed. Also, the DGT audits almost every taxpayer who requests a VAT refund, instead of using a modern risk-based approach.

Figure 2.Tax Performance in the Doing Business Report

11. Simplifying and strengthening tax administration is needed to address these issues, particularly on VAT. Removing VAT exemptions would significantly simplify VAT administration. Moreover, subjecting VAT refunds to risk-based audits, instead of audits of almost every refund request, would allow the DGT to focus on more productive areas and improve their collection efficiency.

12. In summary, prioritizing the above reforms in tax policy and administration would not only raise revenue but also unlock growth potential. These reforms would contribute to more efficient resource allocation and higher potential growth. Although the revenue potential from these structural tax reforms is modest, estimated at 0.5 percent to 1 percent of GDP in the next couple of years, it could be used to expand the most equity-enhancing priority expenditure discussed below.

C. Enhancing the Distributive Role of Fiscal Policy

13. Inequality in Indonesia remains elevated, despite some improvement in recent years (Figure 3). According to the World Bank, Indonesia’s income Gini coefficient was 39.5 in 2013, comparable to neighboring countries and the BRICS, and inequality has declined modestly in recent years. Mobility across income quintiles appears low (Table 2). During 1993–2007, 37 percent of the poorest 20 percent families remained in the poorest quintile, while 56 percent of the richest 20 percent families remained in the richest quintile, despite rapid growth (World Bank 2016).

Figure 3.Inequality in Indonesia

Table 2.Indonesia: Household Income Mobility 1/
2007 Income Quintile
Q1Q2Q3Q4Q5
1993 Income QuintileQ137%36%19%6%2%
Q231%28%19%14%8%
Q323%27%28%13%10%
Q412%18%22%26%21%
Q58%8%11%18%56%
Source: World Bank.

Q1 is the poorest, and Q5 is the richest. Percentage in each cell represents the proportion of the income quintile in 1993 that moved to the income quintile in 2007.

Source: World Bank.

Q1 is the poorest, and Q5 is the richest. Percentage in each cell represents the proportion of the income quintile in 1993 that moved to the income quintile in 2007.

14. Much of the inequality is associated with unequal access to social services and infrastructure (Figure 4). There is a significant gap in access to pension benefits, with the poorest households having no access. Access to health is better, as health insurance coverage is similar across income groups at around 50 percent, thanks to the government’s effort to subsidize poor households’ health insurance. However, inequality in access to health services across regions is notable, with only 28 percent of the villages in the poor regions of Maluku and Papua having health centers, compared to the national average of 38 percent. For the villages without health centers, the closest health center is 24 kilometers away, compared to the national average of 6 kilometers (World Bank 2016). In education, enrollment in free primary and lower secondary education is close to universal across all income groups, but enrollment from rich households in upper secondary and tertiary education is much higher than those from poor households.

Figure 4.Inequality in Access to Social Services and Infrastructure

15. There is much room to improve the distributive role of the fiscal policy (Figure 5). The impact of Indonesia’s fiscal policy on inequality has been limited compared to other emerging market economies, particularly those in Latin America. Latin American countries spent much of their windfall revenue from the commodity boom in the 2000s on equity-enhancing areas, such as social assistance, health, education, and infrastructure. In Indonesia, there are also mandatory spending floors for health and education, which are 5 percent and 20 percent of budgetary expenditure, respectively. However, Indonesia still has much room to spend more on its most equity-enhancing programs, particularly on conditional cash transfers (PKH), targeted rice transfers (RASKIN), and scholarship programs for poor students (BSM).

Figure 5.Impact of Fiscal Policy on Inequality Reduction 1/

1/ On the right chart, the effectiveness index (left scale) of inequality reducing measures the cost-effectiveness of each tax or expenditure item. A larger bar means that the Gini was reduced by more for the given percent of GDP collected or spent than the item with a lower bar.

16. Equity-enhancing expenditure can be financed by the generally equity-neutral tax system. Indonesia’s overall tax system has a limited impact on equity (Figure 5). Its VAT is only slightly regressive, because staple foods are exempt to support the poor. Excise taxes are notably progressive, and so is personal income tax. Therefore, increasing taxes to finance equity-enhancing priority expenditure would reduce inequality in Indonesia. Given the small size of the most equity-enhancing programs (0.3 percent of GDP spent on PKH, RASKIN and BSM), expanding them with the additional revenue of 0.5–1 percent of GDP from the above structural tax reforms would provide a strong boost to equity in Indonesia.

D. Paving the Way for Future Fiscal Reforms

17. The above priority fiscal reforms will help lay a solid foundation for implementing the growth-enhancing fiscal strategy. Lowering the VAT threshold and removing distortionary VAT exemptions is a prerequisite for raising the VAT rate from 10 percent to a higher rate (e.g., 12 percent). Without these reforms, increases in the VAT statutory rate would amplify existing distortions. In addition, these fiscal reforms could help set the stage and gradually build public support for further reforms as infrastructure is developed and inequality reduced. Once consensus is reached, the remaining part of the growth-enhancing fiscal strategy (Jin 2017) could be rolled out, such as raising the VAT rate to finance health, education, and further infrastructure development. With a full implementation of the fiscal strategy, Indonesia will gain much-needed resources for moving beyond its middle-income status.

References

Prepared by Hui Jin.

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