Chpater 3: Boosting Potential Growth New

Luis Breuer, Jaime Guajardo, and Tidiane Kinda
Published Date:
August 2018
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Jongsoon Shin


Indonesia’s economic growth has slowed in the past decade, with contributions from capital and labor falling and that of total factor productivity (TFP) remaining below its peers. Higher growth is needed to address Indonesia’s development needs and reap the benefits of the demographic dividend. To boost growth, the authorities have accelerated infrastructure development and improved the business environment.

Indonesia can achieve stronger inclusive potential growth with structural reforms to infrastructure, regulations, and human capital. Growth remains constrained by a large infrastructure gap, low institutional quality, and inadequate human capital. An illustrative scenario that includes fiscal and structural reforms shows that potential growth could rise to 6.5 percent in the medium term because of permanent supply shifts, about 1 percentage point higher than the baseline scenario. Paired with a clear communication strategy, these structural reforms will help boost confidence in the economy. A large body of literature also highlights the important role of infrastructure investment for growth (Pritchett 2000; Égert, Koźluk, and Sutherland 2009; IMF 2014).

The rest of the chapter is organized as follows: The next two sections discuss growth diagnostics for Indonesia and analyze progress and challenges in infrastructure development. Regulatory reform priorities are then assessed, and the need to build human capital is discussed. A structural reform scenario is developed using the IMF’s Global Integrated Monetary and Fiscal Model (GIMF). The final section concludes that Indonesia can accelerate potential inclusive growth by continuing structural reforms in infrastructure, regulations, and human capital.

Growth Diagnostics

Higher growth is needed to address Indonesia’s development needs and reap the benefits of the demographic dividend. Indonesia’s economic growth has slowed in the past decade, with the contributions from capital and labor falling and that of TFP remaining below its peers (Figures 3.1 and 3.2). Growth has stabilized near 5 percent, and exports and imports have declined relative to GDP. Slower growth has made it more difficult to create quality jobs for the nearly 2 million new labor force entrants each year. Employment varies widely across provinces, and inequality remains somewhat elevated.

Figure 3.1.
Real GDP Growth

(Percent, year over year)

Source: Das 2017.

Figure 3.2.
Contribution to Growth

(Percent, period average)

Sources: Penn World Table; and IMF staff estimates.

To boost growth, the authorities have accelerated infrastructure development and improved the business environment. Public investment in infrastructure has increased with several projects currently under construction. The authorities have also implemented 16 economic policy packages since 2015 to streamline regulations and strengthen productivity. The foreign direct investment (FDI) regime was partially liberalized; barriers to entry have been reduced, including in the sector of logistics and transportation. For example, 100 percent foreign ownership has been allowed for toll road management and cold storage activities, and the setting of the minimum wage has been made clearer. A single submission system, covering the licenses of both the central and 534 regional governments, is being introduced to improve coordination with line ministries and local governments. Reflecting these efforts, the World Bank’s Doing Business ranking for Indonesia improved markedly to the 72nd position in 2018 from the 106th position in 2016.

Previous studies have found that the most binding constraints to growth in Indonesia include infrastructure, regulations, and human capital (ADB 2013; OECD 2016; World Bank 2015). Studies have also found positive effects on growth from reforms to infrastructure, regulations, trade and FDI, labor markets, and education:

  • IMF (2014) finds that the multiplier on output of increasing infrastructure investment by 1 percentage point of GDP ranges between 1 percent and 1.3 percent in the first year, rising gradually to more than 2 percent in 10 years.

  • Barnes (2014) finds that a benchmark reduction in the product market regulation index could increase TFP by about 2 percent of GDP over five years, with larger gains for emerging market economies. For example, a 10 percent reduction in the product market regulation index could lead to gains in TFP of 1.7 percent for the BRICS (Brazil, Russia, India, China, South Africa) and 1.3 percent for Organisation for Economic Co-operation and Development (OECD) countries. Gal and Hijzen (2016) find that product market reforms have positive effects on capital, output, and employment, with their effects increasing over time. After two years, product market reforms raise capital by 4 percent, output by 3 percent, and employment by 1 percent. Bouis, Duval, and Eugster (2016) find that major reductions in entry barriers yield large increases in output and labor productivity over a five-year horizon, and output gains from reforms primarily reflect higher TFP. These effects become statistically significant two to three years after the reform as prices start dropping, and productivity and output increase significantly.

  • Dabla-Norris, Ho, and Kyobe (2016) find that trade and FDI liberalization, as well as labor market reforms to remove excessive rigidities, can significantly boost TFP in emerging market economies. Moreover, the short-term costs of these reforms are small, whereas the medium-term benefits are sizable and long-lasting. Coady and Dizioli (2017) find that expanding education would help reduce income inequality, especially in emerging market economies.

Infrastructure Development

The government has prioritized several infrastructure projects. It has selected 247 priority infrastructure projects, with a total cost of US$323 billion (32 percent of GDP), to be implemented in 2015-22 (Coordinating Ministry of Economic Affairs 2017). The plan centers on improving logistics, power generation, water and sanitation, and oil refineries. The authorities have increased infrastructure spending since the fuel subsidy reforms in 2015, which freed some fiscal space, and are seeking to raise infrastructure investment through state-owned enterprises (SOEs) and public-private partnerships (PPPs). The authorities have also improved the institutional and regulatory framework for infrastructure investment, including by streamlining the land acquisition process and making it more flexible, easing the Negative Investment List to attract foreign investment, and improving the framework for PPPs (ADB 2017) (see Chapter 4, “Developing Infrastructure,” for more details).

Notwithstanding these actions, the government relies on SOEs, and investors are concerned about uncertain policy and regulations. Limited fiscal space and low private sector participation have made the government rely on SOEs to jump-start infrastructure investment, which may crowd out private investment and prevent the emergence of a sound, sustainable development framework. Investors appear to be concerned with the lack of transparency in the procurement process, believing that SOEs receive more commercially attractive projects through direct assignments. Investors are also concerned about the uncertain legal and regulatory framework, particularly regarding policy continuity and land acquisition, given the long-term, capital-intensive nature of the projects.

In developing infrastructure, vulnerabilities and risks should be carefully managed to protect macro-financial stability, including by improving the regulatory framework for new financing instruments and institutional investors, pacing infrastructure development in line with available financing and the economy’s absorptive capacity, and sound risk management for SOEs and PPPs (see Chapter 4 for more details).

Regulatory Reforms

In addition to the 16 economic policy packages, the authorities have implemented other reforms to improve the business environment. The FDI regime was partially liberalized, including for logistics, tourism, and agriculture, and the process for setting the minimum wage was made more transparent and predictable. A national single window system to automate export and import permits has been introduced in more than 21 ports. The authorities are also planning to streamline nontariff measures, gradually shifting control from border to post border, and open up to trade through bilateral and regional trade agreements. Compared with the Investment Coordinating Board’s one-stop service that deals with nine types of licenses, the forthcoming single submission system covers about 100 licenses from the central and local governments, thus helping simplify regulations.

Restrictive product market regulations should be reformed to foster competition and productivity growth. The OECD’s Product Market Regulations Index suggests that the biggest gains can be realized by reducing state control, easing trade and FDI regulations, and lowering barriers to business entry, including antitrust exemptions:

  • The dominant role of SOEs needs to be reduced. Even though assets have risen to about 50 percent of GDP and revenue is stable, SOE efficiency declined through 2015 (Figure 3.3). This suggests SOEs have increased their noncommercial activities and are receiving implicit subsidies, including through price controls (for example, on gas, electricity, airfares, and the retail prices of various products) and import and export restrictions. These practices could undermine the financial strength of SOEs, increase fiscal risks from contingent liabilities, and crowd out private investment. SOEs are prevalent in manufacturing, trade and transportation, and financial services (Figure 3.4). SOEs need to be confined to strategic, commercially viable sectors (IMF 2016a) (Figure 3.5). For example, the heavy SOE involvement in network industries such as electricity and railroads needs to be rationalized, which would promote private sector participation and help reduce fixed costs, particularly for smaller firms (Gal and Hijzen 2016). The energy sector, which requires significant investment, merits a review, including on the transmission and distribution of electricity and exploration for hydrocarbons. SOEs should be subject to the competition law and proper bidding procedures, and they should refrain from exercising dominant power. The governance of SOEs also needs to be improved for proper risk management, including through public listing on the Indonesia Stock Exchange, which would enhance public scrutiny and the transparency of financial information (Figure 3.6).

  • Lowering trade and FDI restrictions would boost competitiveness and export diversification. Barriers to FDI and trade, particularly nontariff measures, have led to low integration with global value chains and limited competitiveness compared with Asian peers (Das 2017; Chapter 9, “Diversifying Merchandise Exports”) (Figure 3.7). Imports still require overlapping licensing. Indonesian manufacturers, including FDI-affiliated corporations, became less export oriented, in contrast with those in other emerging Asian economies, which increasingly took part in regional production networks (Basri, Rahardja, and Fitrania 2016). Indonesia’s ranking on trading across borders in the World Bank’s 2018 Doing Business report is still low, at 112 out of 190 countries. The priority is to adopt internationally harmonized standards and certification procedures in major sectors (energy, transport, construction, banking, business services). Stronger coordination across ministries would ensure coherent regulation. Free trade agreements could help lower trade and FDI restrictions.

  • Easing administrative burdens and entry barriers would help create businesses and jobs. Existing and new firms still bear a significant burden from licenses and permits required by different ministries and local governments, and from having to undergo their procedures.1

Figure 3.3.
State-Owned Enterprise Assets and Turnover Ratio


Sources: Orbis database; and IMF staff estimates.

1Asset Turnover Ratio = Operating Revenue/Total Assets.

2Estimated using previous year growth for companies for which assets data have not been available.

Figure 3.4.
State-Owned Enterprise Industries


Source: Indonesia, Ministry of State Owned Enterprises.

The overall legal and regulatory framework should also be enhanced.

Figure 3.5.
Framework for Reviewing the Status of Public Enterprises

Source: IMF 2016.

Figure 3.6.
Ownership of State-Owned Enterprises

(Number; as of January 2017)

Source: Indonesia, Ministry of State Owned Enterprises.

Figure 3.7.
Regulations, by Category, 2016

(Number of regulations)

Source: Indonesia, Ministry of National Development Planning.

  • The regulation and policymaking process should be improved by the adoption of a systemic, holistic approach. Laws often lack implementing regulations, or regulations are subject to substantial interpretation and prone to rent-seeking while often conflicting with other regulations. In many cases, implementing regulations are not issued for several years, while the law provides only brief guidelines (Devi and Prayogo 2013). For example, when Construction Services Law No. 2 of 2017 came into effect, implementing regulations were not issued, and it could take up to two years to issue them; meanwhile, the regulations under the old Construction Law are still applicable. Environmental regulations and industrial regulations are often at odds, causing confusion among investors. Therefore, greater ministerial coordination and public consultation are needed to avoid conflicting regulations and policies, particularly between line ministries and local governments (OECD 2012). Regulatory impact assessments should also be strengthened (Intal and Gill 2016) (Table 3.1). A formal, centralized mechanism to simplify and evaluate existing regulations would ensure a holistic approach. The recent presidential decree in 2017 to strengthen the coordination of policies through coordinating ministries is a welcome first step.

  • Local regulations: Local policies and regulations are often inconsistent with national policies (OECD 2016). Since the early 2000s, decentralization without adequate coordination has resulted in a proliferation of local regulations (Figure 3.8).2 Coordination among 405 regional governments has been challenging, with a limited role for the provinces. Therefore, a regional government coordination forum, anchored by a clear national strategy, would help nationwide policy coordination. Adopting merit-based elements linked to the implementation of reform measures and competition factors into fiscal transfers to local governments would enhance accountability and coordination. Continuing efforts are required to synchronize local with central regulations through standardization. Capacity building for local governments is also critical.

TABLE 3.1.Use of Regulatory Management System Instruments
Internal Coordination of Rulemaking ActivityRegulatory Impact AssessmentPublic Consultation Mechanism
Sources: APEC; and NZIER via Economic Research Institute for ASEAN and East Asia.Note: “None” refers to the nonuse of any informal instrument.

Figure 3.8.
Enacted Regulations during 1998-2017

(Number of regulations; as of April 2017)

Source: Indonesia, Ministry of National Development Planning.

  • Law and contract enforcement: Weak enforcement of laws and contracts has hampered business certainty. Indonesia still ranks low in contract enforcement (145th place) in the World Bank’s 2018 Doing Business report.3 Addressing these constraints requires upgrading governance in the legal environment and enhancing the transparency and consistency of the judiciary system. The Supreme Court’s recent decision to recruit 1,500 judges and train them for two years would help mitigate the shortage of judges and foster public trust in the judicial system.

Human Capital

The authorities are trying to improve the performance of the education and labor markets. The government has allocated 20 percent of the annual budget to education and is focusing on improving the efficiency of education spending. Efficiency savings will be channeled into a sovereign wealth fund to finance future education needs. The authorities are also considering labor market reforms to enhance flexibility and align wage growth with productivity growth. Improving education and labor market outcomes would support inclusive growth and job creation.

Further efforts are needed to improve the quality of education and reduce labor market segmentation:

  • Education: Enrollment rates in primary schools vary widely across districts, whereas those in higher education are low, with fewer than one-third of Indonesians completing secondary education. Educational quality is also low, with many graduates not meeting international standards because of unqualified teachers and unaccredited higher education institutions (Figure 3.9). Corporations face persistent skill shortages.

  • Labor market: The transition from employment in agriculture to services has continued, although wage-earning employment has slowed and nonagricultural self-employment has risen. The labor market continues to be segmented, with a large fraction of workers employed on short-term contracts. Informal employment has declined since the early 2000s but remains high (58 percent of total employment) as a result of rigid labor regulations and low on-the-job training. Youth unemployment is also high at about 20 percent, hindered by inadequate education. Female labor force participation has stagnated at about 50 percent, much lower than that of male workers (83 percent).

Figure 3.9.
Government Education Spending and Outcome

Sources: World Bank; and IMF staff estimates.

Note: Latest available data. EMs = emerging markets; OECD = Organisation for Economic Co-operation and Development; PISA = Programme for International Student Assessment; PPP$ = purchasing-power-parity dollars.

The priority is to improve the quality of and access to education.

  • Enhancing the quality of education spending (ADB 2013; OECD 2016; World Bank 2017b): Expenditure on teacher salaries and allowances has risen substantially in recent years. The priority now is to improve the efficiency and quality of spending by strengthening the link between teacher compensation and performance as measured by competency, classroom performance, and professional development. Teachers’ skills should be improved through training and periodic recertification. Monitoring of local government budget spending and schools’ performance should also be improved.

  • Improving access to education: Efficiency savings and additional resources should be directed to ensuring equitable access to quality education, especially in rural areas. A strong role for the central government with regard to resource allocation across regions would help alleviate the imbalance of the distribution of teachers across regions. Opening the education market to foreign investment would help strengthen education quality, particularly in higher education institutions, whereas greater availability of student loans would help increase enrollment in higher education. Early childhood education should also be developed (Jung and Hasan 2014).

  • Tailoring education to labor market needs: Vocational training can be improved by strengthening coordination with employers so that the education process is more closely linked to the needs of corporations, and by including and improving soft skills (computer, language, and thinking skills).

Strengthening active labor market policies and streamlining labor market regulations would support job creation.

  • Active labor market policies, including job placement services and vocational training, would help labor mobility (Allen 2016). Youth employment can be boosted by targeted training in the regions. Female labor force participation can be enhanced by providing affordable childcare and flexible work arrangements, as well as better education opportunities. However, these initiatives should be subject to a cost-benefit test and ex post evaluation given their potential fiscal costs (McKenzie 2017).

  • Easing stringent job protections, such as dismissal procedures and severance payments, while improving vocational training and job placement services, would promote youth employment and reduce the use of short-term contracts. In particular, streamlining administrative procedures, including on mediation by the administration and judicial settlement, would be important, given that administrative procedures are more distortive and disruptive than severance payments (McKenzie 2017). Adopting a more open immigration policy for skilled labor can lower skill mismatches, including in professional services. The minimum wage formula introduced in 2015 should continue to be implemented, which would help foster business certainty.

Structural Reform Scenario

A comprehensive and properly sequenced package of fiscal and structural reforms would be self-reinforcing. Given limited fiscal space, the priority should be on reforming product markets to promote entry and reduce state control, streamlining complex regulations, and fostering financial deepening and inclusion. An increase in revenue from tax reforms would create fiscal space for development spending on infrastructure, education, and health, where policy gaps remain large.

Complementarities between reforms should also be exploited. Product market reforms, including relaxing FDI and network industry regulations, can promote private participation in infrastructure. Stronger property rights through regulatory reforms can improve access to credit, while financial inclusion, such as student loans, can expand education opportunities. Financial deepening can help mobilize financing for infrastructure, while infrastructure development can improve access to education in remote areas.

The GIMF is used to estimate the macroeconomic effects of fiscal reforms in Indonesia. The GIMF is a multicountry general equilibrium model that includes a detailed specification of fiscal policy, including different taxes (consumption, labor, corporate) and expenditure items (government consumption, public investment, general and targeted transfers, interest payments) (Kumhof and others 2010).

The main properties of the GIMF calibrated for Indonesia are as follows (Anderson and others 2013; Curristine, Nozaki, and Shin 2016):

  • Tax increases: The multipliers on output in the first year from a 1 percent of GDP permanent rise in revenue due to higher taxes are −0.2 percent for consumption taxes, −0.3 percent for labor taxes, and −0.5 percent for corporate taxes. The negative impact on output from higher consumption taxes declines over time to nearly zero after 10 years, while that from higher labor taxes rises to 0.5 percent in the second year, remaining at that level for the following eight years. The negative impact on output from higher corporate taxes reverses and increases gradually over time to 1.5 percent after 10 years.

  • Infrastructure investment: The multiplier on output from a 1 percent of GDP permanent increase in infrastructure investment is 1 percent in the first year, rising gradually to over 2 percent in 10 years. The rise in the multiplier in the medium term is driven by the increase in private investment, as the higher stock of public capital raises the productivity of private capital.

  • Social transfers: The multipliers on output from a 1 percent of GDP permanent increase in social transfers are modest in the first year, ranging between 0.15 percent for targeted transfers to the poor and 0.05 percent for untargeted general transfers. The medium-term impact is slightly negative as taxes are raised or spending is cut to keep the fiscal deficit unchanged.

  • Other structural reforms: Because the GIMF cannot estimate the impact of other structural reforms directly, they are estimated indirectly through an estimation of the impact of these reforms on TFP based on previous studies (Barnes 2014; Dabla-Norris, Ho, and Kyobe 2016; Bouis, Duval, and Eugster 2016; Gal and Hijzen 2016).

The reform scenario includes higher spending on infrastructure and targeted transfers financed mainly by higher consumption taxes, reduced barriers to trade and FDI, and structural reforms to the product and labor markets (Table 3.2).

TABLE 3.2.Indonesia: Illustrative Effects of Fiscal and Structural Reforms
BaselineReform Scenario
General government revenue14.914.314.
Central government revenues and grants13.112.512.212.412.312.212.312.412.913.413.914.515.2
Of which: tax revenues10.810.49.910.
Oil and gas revenues1.
Non-oil and gas revenues11.911.811.211.411.411.511.611.711.812.513.213.914.5
Tax revenues10.310.
Income tax4.
Nontax revenues1.
Local government revenue net of transfer1.
General government expenditure17.516.816.516.716.616.516.616.717.217.718.218.819.4
Social assistance1.
Other expenditure8.
General government deficit–2.6–2.5–2.5–2.5–2.5–2.5–2.5–2.5–2.5–2.4–2.4–2.3–2.2
General government debt26.828.329.129.630.230.230.430.529.630.130.029.929.7
Real GDP growth4.
Current account deficit/GDP–2–1.8–1.7–1.9–1.8–1.9–2–2–2–2–2.2–2.3–2.3
Sources: Indonesian authorities; World Bank; and IMF staff estimates.Note: The estimated impact of the reforms included in the IMF staff active scenario are based on Currestine, Nozaki, and Shin (2016); Dabla-Norris, Ho, and Kyobe (2015); Bouis, Duval, and Eugster (2016); Gal and Hijzen (2016); and IMF (2016). VAT = value-added tax.
  • Revenue: About 2 percentage points of GDP of the extra revenue from a medium-term revenue strategy would come from consumption taxes such as value-added taxes and excises on fuel, vehicles, and plastic bags, which have low negative multipliers. The other 1 percentage point of GDP would come from taxes with larger negative multipliers.

  • Expenditure: This extra revenue would be used to increase spending on infrastructure (1.3 percentage points of GDP) and targeted transfers to education, health, and social programs (1.5 percentage points of GDP), which have larger multipliers.

  • Other structural reforms would center on reducing restrictions to trade and FDI and streamlining product and labor market regulations to promote entry, rationalize the role of SOEs, and foster employment. The reform scenario assumes a 10 percent reduction in the OECD’s product market regulations over five years, to a level comparable to the average of the BRICS economies. This includes rationalizing the role of SOEs by enhancing their governance and reducing price controls, removing FDI and trade restrictions, and easing entry barriers and administrative burdens on businesses. These measures would be accompanied by reforms to the legal and regulatory framework. The effects of reforms on education and the labor market would take longer to realize, but would be conducive to inclusive growth.

Potential real GDP growth would increase gradually to 6.5 percent by 2022, 0.9 percentage point higher than the baseline scenario (Figure 3.10). Most of the gains in potential growth in the initial years would come from public and private investment resulting from fiscal reforms and improved efficiency, while gains in TFP from other structural reforms would play a bigger role in the outer years. Higher infrastructure investment and lower trade and FDI regulations, which would also catalyze private investment and employment, would be the main growth drivers in the first two years, raising potential growth by 0.2–0.3 percentage point. Implementing the medium-term revenue strategy would help contain the fiscal deficit and government debt, while allowing greater social and infrastructure spending. While infrastructure spending would stabilize in the medium term, higher private investment, partly attributable to improved efficiency, and employment growth would play an increasing role over time, raising potential growth by an additional 0.5 and 0.2 percentage point, respectively, by 2022 relative to the baseline. Gains in TFP from regulatory reforms, including to product market regulations, would raise potential growth by 0.1 percentage point in 2020–21 and 0.2 percentage point in 2022. Gains in TFP would become larger in the long term, benefiting from enhanced competition, improved labor skills, and greater integration with global value chains.

Figure 3.10.
Growth under Reform Scenario


Sources: Penn World Table; and IMF staff estimates.

The reform scenario also assumes continued macroeconomic stability:

  • Inflation would rise to about 4 percent (year over year) in the initial years because of the demand stimulus and higher consumption taxes, but it would moderate afterward as a result of a tighter monetary stance, stronger domestic competition, and expanded production capacity.

  • The current account deficit would widen to about 2.3 percent of GDP because of higher public and private investment–related imports (or a lower saving-investment gap in the private sector), which would be partly offset by higher exports attributable to enhanced competitiveness.

  • With a medium-term revenue strategy in place, the fiscal deficit would be contained at about 2.2 percent and government debt below 30 percent of GDP in the medium term.


Growth in Indonesia remains constrained by a large infrastructure gap, low institutional quality, and inadequate human capital. Indonesia can achieve stronger inclusive potential growth with structural reforms to infrastructure, regulations, and human capital:

  • Infrastructure: Priority should be given to financing infrastructure development with revenue from a medium-term revenue strategy. Infrastructure development should be paced in line with available financing and the economy’s absorptive capacity.

  • Regulations: The dominant role of SOEs needs to be reduced. Lowering trade and FDI restrictions would boost competitiveness and export diversification.

  • Human capital: The authorities should enhance the quality of education spending while improving access to education. Active labor market policies, including job placement services and vocational training, would help labor mobility.

An illustrative scenario that includes fiscal and structural reforms shows that potential growth could rise to 6.5 percent in the medium term as a result of permanent supply shifts, about 1 percentage point higher than the baseline scenario. Paired with a clear communication strategy, these structural reforms would help boost confidence in the economy. Investing in infrastructure, including digital infrastructure, and human capital while streamlining regulations and FDI restrictions would also help the country capitalize on the digital economy and facilitate the development of competitive sectors, which could, in turn, help absorb the large and growing young labor force.


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In 2006, the government launched the “one door services” in every province to help with administrative processes associated with licenses and permits.

The government has recently started to align national and regional policies. Since 2016, 3,143 regional regulations have been discontinued.

It takes 498 days to enforce contracts in Indonesia, with sizable costs during the process. Weak property rights are also reflected in low rankings for starting a business (144th place) and registering property (106th place).

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