Chapter

Chpater 5: Supporting Inclusive Growth New

Author(s):
Luis Breuer, Jaime Guajardo, and Tidiane Kinda
Published Date:
August 2018
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Author(s)
Hui Jin

Introduction

Fiscal policy is an effective tool for supporting inclusive growth. Although it is difficult to disentangle the impact of fiscal reforms from other factors and to determine causality with certainty, IMF (2015a) suggests that such reforms could lift medium- to long-term growth by ¾ percentage point in advanced economies and even more in developing economies. Fiscal policy promotes growth through macro and structural tax and expenditure policies. At the macro level, it plays an important role in ensuring macroeconomic stability, which is a prerequisite for achieving and maintaining economic growth. At the micro level, through well-designed tax and spending policies, it can boost employment, investment, and productivity.

Indonesia has demonstrated strong fiscal discipline since the early 2000s, anchored by mandatory fiscal rules. Its general government debt was successfully curbed from about 90 percent of GDP in 2000 to less than 30 percent in 2016, driven by strong fiscal discipline and fast economic growth. At the core of Indonesia’s fiscal policy are mandatory fiscal rules that limit the general government deficit to no more than 3 percent of GDP and debt to no more than 60 percent of GDP. Unlike European fiscal rules, there is no escape clause in the 3 percent deficit rule. Although rigid, the rule supports external market funding for Indonesia while its domestic investor base develops, and promotes macro stability, a prerequisite for sustained growth. Importantly, because more than half of government debt is held by nonresidents, fiscal rules play a key role in enhancing international investors’ confidence. A significant body of empirical literature shows that the use of fiscal rules tends to lower the sovereign spread (Feld and others 2017; Iara and Wolff 2010; IMF 2009; Johnson and Kriz 2005). Therefore, Indonesia’s fiscal rule has been and remains an important policy anchor.

However, within the fiscal rule, declining government revenue has constrained priority expenditure. At 14.3 percent of GDP in 2016, Indonesia’s general government revenue is less than 15 percent, a tipping point above which taxation will be able to support state building and the strengthening of the social contract with its citizens (Gaspar, Jaramillo, and Wingender 2016). As it stands, Indonesia does not have enough resources to expand or even maintain its priority expenditures, warranting a medium-term fiscal reform strategy to promote inclusive growth.

After examining Indonesia’s fiscal policy and international experience, a medium-term fiscal strategy is recommended to support inclusive growth in Indonesia. The thrust of the fiscal strategy is to raise revenue by about 5 percent of GDP in the medium term (Chapter 6, Implementing a Medium-Term Revenue Strategy) to finance growth and equity-enhancing expenditure priorities in infrastructure, health, education, and social assistance, with proper sequencing.

The rest of the chapter is organized as follows: the next two sections examine major issues in tax policy and tax administration. Expenditure policy and management are then analyzed, followed by a study of the distributive role of the overall fiscal policy. International experience is discussed, and a policy recommendation for a medium-term fiscal strategy is made, with a medium-term revenue strategy at its core.

Tax Policy: Numerous Exemptions Lead to Revenue Losses and Inefficient Allocation of Resources

Indonesia’s weak government revenue performance indicates shortcomings in tax policy. General government revenue has trailed behind that of its peers, with the gap widening after 2008 (Figure 5.1). Although the sharp decline in oil and gas revenue accounted for the majority of the shortfall, non–oil and gas revenue as a share of GDP remains weak, close to its 2004 level, and has been declining in recent years. These findings suggest that there is much room to improve tax policy.

Figure 5.1.
Revenue Trends

Sources: IMF, World Economic Outlook; Indonesian authorities; World Bank; and IMF staff estimates.

Note: ASEAN = Association of Southeast Asian Nations.

Indonesia’s headline tax rates are largely in line with those of its peers. At 10 percent, the standard value-added tax (VAT) rate is modest and in line with other countries in the region but lower than in major emerging market economies and the Organisation for Economic Co-operation and Development (OECD). The VAT law has authorized the government to increase the VAT rate to up to 15 percent through regulation if needed. The statutory corporate income tax (CIT) rate is 25 percent, in line with the OECD average and with that in major emerging market economies (Figure 5.2). The personal income tax (PIT) schedule, comprising four marginal tax rates (5 percent, 15 percent, 25 percent, 30 percent), is also generally consistent with good practice.

Figure 5.2.
Statutory Value-Added Tax and Corporate Income Tax Rates

Sources: International Bureau of Fiscal Documentation; KPMG tax profile reports for individual countries; and IMF staff calculations.

Note: BRICS = Brazil, Russia, India, China, South Africa; OECD = Organisation for Economic Co-operation and Development.

However, relatively low tax productivity points to structural issues (Figure 5.3). Indonesia’s C-efficiency ratio is about 0.6, which means the authorities only collect 60 percent of total VAT revenue compared with the benchmark that taxes all consumption at a uniform rate of 10 percent (that is, the current standard VAT rate in Indonesia). In addition, CIT productivity—defined as the ratio between CIT revenue as a percentage of GDP and the top CIT rate—is low. Many factors could explain such low tax productivity, including numerous lower-rate regimes, generous exemptions, and weakness in tax administration.

Figure 5.3.
Productivity of Value-Added Tax and Corporate Income Tax

Indonesia has a myriad of distortionary incentives and exemptions in its main taxes. They include not only internationally common practices such as slow tax depreciation and deductibility of interest expenses (Box 5.1), but also many Indonesia-specific distortions:

  • CIT exemptions: There are numerous lower-rate CIT regimes—a 1 percent presumptive tax on gross revenue for small and medium enterprises with annual turnover of less than Rp 4.8 billion (about US$355,100), a rate reduction of 50 percent for taxable income corresponding to gross turnover up to Rp 4.8 billion for medium-sized enterprises with annual turnover of less than Rp 50 billion, and a reduced rate of 20 percent for publicly listed companies.

  • VAT exemptions: Many VAT exemptions have been granted to both final and intermediate goods and services by the VAT law and government regulation, including for mining (unprocessed products); staple foods (agriculture); tourism (hotel and restaurant), transportation, and employment services; banking and insurance; art and entertainment services; education, medical, and social services; capital goods (machinery, plant, and equipment); agricultural, plantation, and forestry products; electricity (excluding that supplied to households whose consumption exceeds 6,600 watts); distributed piped water; cattle, poultry, and seeds; weapons for the army; educational books; ships, trains, and aircraft and their spare parts; and low-cost housing. Some of the exemptions, for example, for staple foods, are commonly used in other countries to protect the poor, but most other exemptions in Indonesia are not common.

  • VAT threshold: The turnover threshold for mandatory VAT registration is Rp 4.8 billion, the same as the previously mentioned CIT threshold for the 1 percent turnover tax in lieu of the regular CIT. This threshold is very high compared with other countries (Figure 5.4). This VAT threshold covers only 50,000 firms, compared with the more than 400,000 firms previously registered under a much lower threshold of Rp 600 million.

Figure 5.4.
Value-Added Tax Registration Thresholds

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

Note: Figure labels use International Organization for Standardization (ISO) country codes.

Upgrading the Tax System to Boost Productivity

Resource misallocation induced by distortionary tax treatments is an important source of low tax productivity. 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 (formal sector versus informal sector):

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

  • Distortions across sources of financing occur when firms are allowed to deduct interest expenses, but not returns to equity, in calculating corporate income tax (CIT) liability.

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

  • Distortions across formality of business are often driven by higher taxes and social security contributions imposed on formal businesses, while tax enforcement is weak on informal businesses.

Upgrading the tax system will boost long-term productivity. Although it is difficult to eliminate all distortions in practice, reducing them to the level of the top-performing countries in the same income group could deliver substantial benefits. For emerging market economies, such reforms could translate into a higher GDP growth rate of 1.3 percentage points in the long term.

Source: Drawn from the IMF’s April 2017 Fiscal Monitor.

In addition to revenue losses, these incentives and exemptions encourage substantial arbitrage behavior in the Indonesian economy, leading to inefficient resource allocation. For example, the 1 percent presumptive turnover tax for not-so-small firms provides an incentive for firms to stay below the Rp 4.8 billion threshold instead of growing into much larger and more competitive companies. It also disregards the actual profit margins of the firms and may impose a high tax burden on firms experiencing short-term losses. The same VAT threshold and numerous VAT exemptions also lead to breaks in the VAT chain, significantly compromising the VAT’s efficiency and neutrality—the major attractions of VAT. In addition, all these exemptions and thresholds have significantly complicated tax administration, as subsequently discussed.

Tax Administration: Room to Improve Collection Efficiency and Business Climate

The tax administration in Indonesia suffers from low productivity because of both policy shortcomings and administrative weaknesses. The tax administration has allocated a disproportionate number of its staff (more than 50 percent) to enforcing taxpayers’ routine registration and filing obligations, for example, the extensification program that requires all employees to file tax returns. This type of work is not very productive because it is carried out manually and in an untar-geted manner, reflecting weak information systems and, until recently, the absence of risk-based approaches. Similarly, about 80 percent of the tax administration’s audit resources are allocated to examining refund cases that generate only 20 percent of the additional revenue from audit, while only 20 percent of the administration’s audit resources examine the more productive nonrefund cases that generate 80 percent of the additional revenue from audit. This misallocation is due mainly to the legal obligation that requires the tax administration to audit almost all refund claims, regardless of their revenue risk. As a result, the tax administration gives insufficient attention to potentially large amounts of unre-ported taxes by the overwhelming majority of taxpayers who do not claim a refund.

As a result, taxpayer compliance is low, resulting in revenue losses. Only 20 percent of businesses file their employer withholding tax returns on time, and 5 percent make timely payment of their withheld taxes. The overall VAT compliance rate has declined from 53 percent in 2013 to 45 percent in 2015, and the rate of on-time filing of VAT returns has declined from 64 percent in 2014 to 52 percent in 2016. Only about half of individuals who provide professional services file their income tax returns on time, while fewer than one in four professional services corporations meet their filing obligations. Some 2,000 Indonesian individuals own about US$230 billion in assets, and their complex tax affairs provide opportunities for aggressive tax planning. See more detailed discussion on Indonesia’s revenue administration in Chapter 6.

Moreover, cumbersome tax administration procedures in some areas have not been beneficial for the business climate. According to the 2018 World Bank Doing Business report (World Bank 2018), for a typical medium-sized company in Indonesia, the number of tax payments needed per year was reduced from 54 to 43 between 2016 and 2017, but that number is still well above that in peer countries. A medium-sized Indonesian company also needs to spend 18 hours to comply with VAT refunds and waits 47.7 weeks to receive the actual refunds per year, which is longer than in most countries in the region (Figure 5.5). This lengthy wait time is partly driven by the fact that the tax administration has to audit almost every taxpayer who requests a VAT refund, instead of using a modern risk-based approach.

Figure 5.5.
Indonesia’s Tax Performance in Doing Business Report

Source: World Bank 2018.

Note: VAT = value-added tax.

Tax administration weaknesses may also limit the scope for further improvement of Indonesia’s business climate. Indonesia has made significant progress in improving its business climate, with its overall Doing Business ranking upgraded to 72 in 2018 from 106 in 2016 (Table 5.1). This improvement is particularly impressive in the rankings for resolving insolvency (36), enforcing contracts (26), protecting minority investors (26), starting a business (23), and getting electricity (23). However, Indonesia’s rank in paying taxes has barely moved—from 115 to 114—in the past two years. Without significant streamlining of the tax administration, the authorities’ goal of achieving an overall Doing Business ranking of 40 might be challenging.

TABLE 5.1.Indonesia’s Doing Business Ranking
Doing BusinessDoing BusinessDoing BusinessImprovement
2018201720162016-18
Overall Ease of Doing Business Rank729110634
Component Rank
Resolving insolvency38767436
Enforcing contracts14516617126
Protecting minority investors43706926
Starting a business14415116723
Getting electricity38496123
Registering property10611812317
Getting credit55627015
Dealing with construction permits1081161135
Paying taxes1141041151
Trading across borders1121081131
Source: World Bank, Doing Business database.

Expenditure Policy and Management: Expansion Needs and Potential Efficiency Gains

Infrastructure, health, and education are key growth-enhancing expenditure areas for countries such as Indonesia. The IMF (2015a) provides a menu of structural fiscal policy options for promoting medium- to long-term growth: encourage labor supply, enhance investment in physical capital, support human capital development, increase total factor productivity, and promote technological progress. For emerging market economies, the most relevant policies would be to protect and increase the public capital stock, provide more efficient public infrastructure, provide disadvantaged groups with access to education, and expand access to basic health care. In Indonesia, this would mean expanding public expenditure as a percentage of GDP on infrastructure, health, and education, while also improving efficiency in those areas.

Indonesia has room to increase spending and improve efficiency in these key expenditure areas compared with peers. On one hand, constrained by its revenue-mobilization capacity, as discussed above, Indonesia’s spending on infrastructure, health, and education is generally behind that of peers. On the other hand, there are signs of inefficiency in many areas. These are elaborated upon below.

Infrastructure

Indonesia’s infrastructure spending is low compared with that of its peers. Total infrastructure spending was 2.2 percent of GDP in 2016, compared with the emerging market Asia average of 5.1 percent of GDP. Indonesia’s access to infrastructure is particularly low in electricity, road transportation, and health facilities (Figure 5.6).

Figure 5.6.
Infrastructure Investment and Access

Infrastructure development is also highly decentralized and suffers from limited implementation capacity and relatively low efficiency. Of the government’s US$480 billion infrastructure investment plan for 2015-19, only about 30 percent is being executed through the central government. Starting in 2017, 25 percent of central government transfers to regions via the general allocation fund (Dana Alokasi Umum, or DAU) and revenue sharing are earmarked for infrastructure. The non-central-government channels—state-owned enterprises, public-private partnerships, and subnational government (SNG)—seem to involve more risk and entail less capacity to develop, plan, and implement investment projects efficiently. Based on IMF (2015b), an indicator for physical access to infrastructure shows relatively low efficiency in Indonesia’s public investment. The resultant efficiency gap between Indonesia and the most efficient countries with comparable levels of public capital stock per capita is 56 percent, much wider than the average gap for emerging market economies (41 percent), emerging and developing Asia (50 percent), and all countries (41 percent) (Figure 5.7).

Figure 5.7.
Indonesia: Public Investment Efficiency

Sources: Organisation for Economic Co-operation and Development; World Bank; and IMF staff estimates.

Any expansion of infrastructure spending should be accompanied by improved public investment management. The scaling up of public investment often goes hand in hand with a decrease in investment efficiency and an increase in integrity issues. Therefore, better management is required to improve efficiency. For example, the government could consider the following reforms: (1) streamline the annual budget process for public investment; (2) develop a multiyear pipeline of high-quality projects by investing in project development; (3) encourage use of multiyear contracting and carryover, at both the central and local levels of government; (4) improve timeliness and content of information flow to SNGs for special-purpose grants (Dana Alokasi Khusus, or DAK) and line ministry own-investment plans; (5) task the Ministry of Finance and Ministry of Home Affairs with jointly developing a wide-ranging capacity-building plan in the public financial management area for SNGs; and (6) simplify and reduce the reporting burden of SNGs. More important, there are currently five central agencies with some mandate for public investment: the Ministry of Finance, the Ministry of Home Affairs, the National Development Planning Agency (BAPPENAS), the Committee for Accelerated Infrastructure Delivery, and the Evaluation and Monitoring Team for State and Regional Budgets Realization. These central agencies need to coordinate more closely and develop a single-window monitoring system for line ministry and SNG public investments. At a later stage, public-private partnership and state-owned enterprise project monitoring could be integrated with such a system.

Health

Both health insurance coverage and health facilities need to be expanded. Health spending is low in Indonesia compared with peers (Figure 5.8, panel 1). On the demand side of health service, the authorities have made a commitment to expand public health insurance coverage to 100 percent by 2019. At present, more than half of the population is covered, and the bottom one-third of the population (the 92 million poorest individuals) are included through waivers of public health insurance premiums. Essentially, the government is subsidizing the premiums for the poor. Many of the remaining population uncovered by the public health insurance consist of self-employed middle-income individuals, who have reportedly purchased private health insurance. On the supply side, Indonesia also has much room to increase public spending on health infrastructure and open up the health sector to the private sector and foreign investors. Although the central government is legally required to allocate at least 5 percent of its budget expenditure to health, the rule mostly ensures that health spending as a percentage of GDP remains broadly constant without a major expansion. Following Thailand’s experience with implementing universal health coverage, the share of public spending in total health care spending could be expected to rise from 40 percent now to 60 percent over the medium term. If this happens, the ratio of public health spending to GDP would reach 2.1 percent in 2022—0.6 percentage point of GDP above the baseline. Additional expenditure is also needed on the supply side to provide more health infrastructure, doctors, nurses, etc.

Figure 5.8.
Indonesia: Public Spending on Health and Education

Sources: IMF, World Economic Outlook; Indonesian authorities; World Bank; and IMF staff estimates.

Education

Efficiency in education needs to be improved before any expenditure expansion. Although Indonesia’s public education spending is below that of the emerging market Asia average (Figure 5.8, panel 2), the near-term priority should be to improve spending efficiency. Similarly to health, the central government is legally required to allocate at least 20 percent of its budget expenditure to education. However, without strong links to educational outcomes, much of the annual increases are spent on teachers’ compensation, especially through the certification programs. Therefore, the teachers’ compensation system could be reviewed to identify any inefficiency, while the link between compensation and outcomes could be strengthened. Once the inefficiency issue is addressed, public education spending could be further expanded from primary and secondary education to other areas, such as early childhood, vocational, and tertiary education.

Distributive Role of Fiscal Policy: Room to Reduce Inequality

Inequality in Indonesia remains elevated, despite some improvement in recent years (Figure 5.9). According to the World Bank, Indonesia’s income Gini coefficient was 39.5 in 2013, comparable to that of neighboring countries and the BRICS (Brazil, Russia, India, China, South Africa), and inequality has declined modestly in recent years. Mobility across income quintiles appears low (Table 5.2). During 1993-2007, 37 percent of the poorest 20 percent of families remained in the poorest quintile, while 56 percent of the richest 20 percent of families remained in the richest quintile, despite rapid growth (World Bank 2016).

Figure 5.9.
Inequality in Indonesia

TABLE 5.2.Household Income Mobility
2007 Income Quintile
Q1Q2Q3Q4Q5
1993 Income QuintileQ137361962
Q2312819148
Q32327281310
Q41218222621
Q588111856
Source: World Bank 2016.Note: 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.

Much of the inequality is associated with unequal access to social services and infrastructure (Figure 5.10). A significant gap exists in access to pensions; the poorest households have essentially no access to any pension benefits. In health, the situation is better, given that health insurance coverage is similar, about 50 percent, across different income groups, thanks to the government’s effort to subsidize poor households’ health insurance premiums. However, inequality in access to health services across regions is notable—only 28 percent of villages in the poor regions of Maluku and Papua have health centers, compared with the national average of 38 percent. For those villages without a health center, the closest health center is 24 kilometers away, on average, compared with 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 of youngsters from rich households in upper secondary and tertiary education is much higher than of those from poor households (Figure 5.10, panel 3).

Figure 5.10.
Indonesia: Inequality in Access to Social Services and Infrastructure

There is much room for improving the distributive role of Indonesia’s fiscal policy (Figure 5.11, panel 1). The impact of Indonesia’s overall fiscal policy on inequality reduction has been very limited, compared with other emerging market countries, 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. Indonesia also has mandatory spending floors for health and education, as mentioned above, (5 percent and 20 percent of budgetary expenditure, respectively). However, Indonesia still has much room for spending on its most equity-enhancing programs, particularly on conditional cash transfers (Program Keluarga Harapan, or PKH), targeted rice transfers (Beras untuk Rakyat Miskin, or RASKIN), and scholarship programs for poor students (Bantuan Siswa Miskin, or BSM).

Figure 5.11.
Indonesia: Impact of Fiscal Policy on Inequality Reduction

To partly finance the expansion of the most equity-enhancing social assistance programs, other programs could be consolidated to be better targeted and more efficient. In addition to PKH, RASKIN, and BSM, Indonesia has an array of other social assistance programs lacking coverage and adequacy, and a large share of poor and vulnerable households are not receiving all the benefits they are eligible for. An integrated database for social assistance (Pemutakhiran Basis Data Terpadu, or PBDT) has been developed, which covers the bottom 45 percent of the income distribution. This is a good step forward that will enable the authorities to reduce and consolidate various social assistance programs into better-targeted and more efficient programs in the next few years. In the medium term, once administrative capacity has been developed, the authorities could also consider introducing a means-tested guaranteed minimum income program (see Pinxten, Acosta, and Sun 2017 for more details).

Expansion of the most equity-enhancing programs can also be partly financed by the generally equity-neutral tax system in Indonesia. Indonesia’s overall tax system has no apparent impact on equity (Figure 5.11, panel 2). Its VAT is only slightly regressive (VATs in many other emerging market economies are much more regressive; see World Bank 2016) because staple foods are exempt from the VAT in Indonesia to support the poor. Excise taxes are even notably progressive, and so is the personal income tax. Therefore, increasing taxes to finance equity-enhancing expenditure priorities will overall reduce inequality in Indonesia.

International Experience with Fiscal Reform

A basically budget-neutral medium-term fiscal strategy would enhance Indonesia’s growth. International empirical studies find that government expenditure multipliers are notably larger than tax multipliers, although they need to be interpreted with caution (Box 5.2). Therefore, as long as the additional revenue from tax reforms is used for immediate spending, it will likely increase GDP growth rates.

Moreover, preserving and increasing expenditure in key areas is an integral part of a successful reform strategy for resource-revenue-dependent economies. For example, one factor behind Malaysia’s ability to unlock its long-term growth potential as part of its fiscal adjustment in the early 1980s was its maintenance of expenditures on health and education at a steady level of 1.5 percent and 5 percent of GDP, respectively; this expenditure bolstered human capital to support the successful transition to a manufacturing-based economy. These levels are still well above Indonesia’s 2015 spending levels for health and education (1.3 percent and 3.5 percent of GDP, respectively). Similarly, when Chile implemented its massive fiscal consolidation in the late 1970s, it actually increased public spending on primary and secondary education, as well as on primary health care.

Comprehensive tax reforms in large emerging market economies—China (1994) and Mexico (2014)—are also widely considered to have been successful and could serve as an example for Indonesia. Both reforms, through a combination of tax policy and tax administration measures, raised significant revenues in the short and medium term.

China’s 1994 tax reform lifted general government revenue by 5 percent of GDP, which was gradually achieved over the medium term. After a short transition period during 1994–95, total revenue in China gradually increased from 10 percent of GDP to about 15 percent of GDP by 2002 (Ahmad 2011). The reform not only reversed the declining trend of general government revenue since the mid-1980s, but also significantly increased the share of the central government in total revenue from about 20 percent to more than 50 percent (Figure 5.12, panel 1). The reform comprised the following main tax administration and tax policy measures:

Figure 5.12.
Tax Reforms in China and Mexico

Sources: Ahmad 2011; CEIC Data Co. Ltd.; IMF, staff report for Mexico Article IV consultation; and IMF staff estimates.

  • A central-government tax administration (SAT) was created, organizationally separated from existing local-government tax administrations.

  • The VAT was introduced at a rate of 17 percent. It is collected by the SAT, and the revenue is shared between central and local governments based on a formula.

  • Revenue-sharing arrangements between central and local governments for other taxes, such as the corporate income tax and the natural resources tax, were clarified.

Multipliers of Different Fiscal Instruments1

Fiscal multipliers measure the short-term impact of discretionary fiscal policy on output. They are usually defined as the ratio of a change in output to an exogenous change in the fiscal deficit with respect to their baselines. The size of multipliers is determined by various factors such as trade openness, labor market rigidity, size of automatic stabilizers, exchange rate regime, debt level, public expenditure management, revenue administration, state of the business cycle, degree of monetary accommodation to fiscal shocks, and so on.

There is little consensus in the literature on the size of multipliers because estimating them is complicated for several reasons. First, it is difficult to isolate the direct effect of fiscal measures on GDP because of the two-way relationship between these variables. Second, data availability limits the scope for estimating multipliers. For example, econometric and model-based methods (such as structural vector autoregression and dynamic stochastic general equilibrium) have demanding data requirements. Moreover, long quarterly series do not exist, even in many advanced economies, as well as in most emerging market economies and low-income countries.

However, the literature does provide evidence showing that expenditure multipliers tend to be larger than revenue multipliers in advanced economies. Based on a survey of 41 studies of structural vector autoregression and dynamic stochastic general equilibrium models, Mineshima, Poplawski-Ribeiro, and Weber (2014) show that first-year multipliers amount, on average, to 0.75 for government spending and 0.25 for government revenues. Macroeconomic models also imply a clear hierarchy of fiscal instruments (Forni, Monteforte, and Sessa 2009; European Commission 2010; Coenen and others 2012). On the spending side, investment has the highest short-term multiplier, followed by government wages and government purchases, while untargeted transfers to households are associated with the lowest output impact among spending instruments. On the revenue side, the ranking of tax instruments reflects their perceived distortionary effects. Corporate income taxes and personal income taxes have the most negative effects on GDP; consumption taxes do relatively better; and property taxes seem to be the tax instrument with the smallest impact.

For emerging market economies and low-income countries, various research seems to suggest a similar pattern. In general, little is known about the size of fiscal multipliers in emerging markets and low-income countries, and it is not clear whether multipliers should be expected to be higher or lower than in advanced economies from a theoretical point of view. However, some model-based estimates suggest that expenditure multipliers are generally larger than revenue multipliers in these economies (Table 5.2.1).

TABLE 5.2.1.Model-Based Estimates of Short-Term Multipliers in Emerging Market Economies and Low-Income Countries
OECD 2009GIMF2009–2013Ducanes and others 2006
Expenditure
CountryExpenditureRevenueExpenditureRevenueIncreaseDecreaseRevenue
Bangladesh0.40.80.1
Bulgaria0.60.4
China0.31.60.4
Hungary0.50.1
Indonesia0.20.80.2
Mexico0.70.2
Philippines0.30.70.0
Poland0.60.2
Russia0.80.3
Turkey0.70.20.90.3
Emerging Asia1.00.5
Note: GIMF = Global Integrated Monetary and Fiscal Model; OECD = Organisation for Economic Co-operation and Development.
1Drawn from Batini and others (2014).

Mexico’s 2013 tax reform, together with gradual fuel price liberalization and improvements in revenue administration, have increased non-oil tax revenue by more than 2 percent of GDP since 2013. The reform has to a large extent offset the sharp decline in Mexico’s oil revenue (Figure 5.12, panel 2). It comprised the following elements:

  • For the income tax, deductions and exemptions were limited; new tax brackets and new taxes on certain dividends and gains were implemented; the fiscal consolidation regime was eliminated; and the IDE (tax on cash deposits) and the IETU (flat business tax) were eliminated.

  • Reduced VAT rates for US border states and the Baja Peninsula were suppressed.

  • A new excise tax was imposed on sugary beverages and high-calorie foods, pesticides, and carbon-producing products.

Rough estimates suggest that the reform increased revenues by 1.5 percent of GDP. In addition, the decline in fuel prices in recent years and the fuel price liberalization process that began in 2016 permitted the removal of fuel subsidies and together yielded additional fuel excise revenue of about 0.8 percent of GDP.

Policy Recommendation: Medium-Term Fiscal Strategy to Support Inclusive Growth

From the macro-fiscal perspective, Indonesia’s medium-term fiscal strategy could aim to establish a small countercyclical buffer within its fiscal rule in the medium term. Indonesia’s low debt and deficit levels, small gross financing needs, and other macro indicators suggest the availability of some fiscal space. Moreover, the authorities have carefully managed the deficit to be about 2½ percent of GDP in recent years. However, in the medium term, aiming for a deficit target of 2¼ percent of GDP would provide a countercyclical buffer of ¾ percent of GDP under the fiscal rule, to help fend off potential internal and external shocks.

At the core of the medium-term fiscal strategy is a medium-term revenue strategy (MTRS), which is critical to finance priority spending (Chapter 6). The MTRS should aim to raise revenue by about 5 percent of GDP in the medium term, which would allow the government to expand spending on infrastructure, education, health, and social assistance and would support critical structural reforms (Table 5.3). At the same time, efficiency of expenditure should be enhanced, such as by improving public investment management, strengthening the link between teachers’ compensation and their educational outcomes, and consolidating social assistance programs, as discussed above. The overall medium-term fiscal strategy will likely increase Indonesia’s GDP growth rate to 6.5 percent by 2022, based on simulation results from the Global Integrated Monetary and Fiscal Model (Curristine, Nozaki, and Shin 2016; Anderson and others 2013).

TABLE 5.3.Indonesia: An Illustrative Medium-Term Fiscal Strategy to Support Inclusive Growth
Reform OptionsEstimated Fiscal Impact by 2022 (percent of GDP)Details of the Reform
Medium-Term Revenue Strategy1+5.0
Tax Policy+3.5
Value-added tax+1.2Remove exemptions, lower value-added tax registration threshold, and increase rate from 10 percent to 12 percent.
Excise taxes+1.1Introduce fuel excise tax and convert the current luxury goods sales tax on vehicles to a vehicle excise tax.
Income taxes+0.9Remove corporate income tax exemptions and unify corporate income tax rates, impose alternative minimum tax to fight profit shifting, lower threshold for top personal income tax rate.
Property tax+0.3Increase rate and gradually replace transaction tax with recurrent property tax.
Revenue Administration+1.5Improve taxpayer compliance, institutional reform, legal reform.
Additional Expenditure Needs2+4.7
Infrastructure+3.0Increase investment expenditure to above 5 percent of GDP while improving efficiency.
Education+0.8Increase education expenditure toward emerging market average (4.8 percent of GDP) while improving efficiency.
Health+0.9Implement universal health coverage, increase medical service supply, while improving efficiency.
Social assistance+0.1Expand the most equity-enhancing programs while consolidating poorly targeted programs.
Other expenditure−0.1Cut nonpriority expenditure.
Additional Countercyclical Buffer+0.3Reduce deficit from about 2½ percent of GDP in recent years to 2¼ percent of GDP in the medium term.
Source: IMF staff estimates.

The MTRS should center on front-loaded tax policy reforms and gradual benefits from tax administration reform. It should remove most incentives and exemptions in the VAT, CIT, and PIT; introduce excise taxes on vehicles and fuel; and raise the VAT rate to 12 percent from 10 percent. It should also improve compliance and streamline tax administration. These reforms should be carefully designed and communicated (Chapter 6).

However, because implementing the MTRS will take time, some near-term policy actions could be front-loaded to arrest the revenue fall and finance infrastructure development. Indonesia’s tax-to-GDP ratio has continuously declined in recent years, so excise taxes on vehicles and fuel could be introduced as short-term actions to raise additional revenue of about 1 percent of GDP to reverse the trend. Meanwhile, these revenue gains could be used to partly finance the authorities’ ambitious infrastructure plan, including the 247 national strategic projects.

At the same time, a structural subset of the MTRS could also be prioritized to support inclusive growth. This subset comprises the removal of exemptions from income taxes and the VAT, lowering the VAT and CIT thresholds, simplifying VAT policy and administration, and enhancing tax administration, which may deliver another revenue gain of 0.5–1.0 percent of GDP in the near term. Such reforms may help further increase long-term growth by 1.3 percentage points (Box 5.1). The additional revenue from the structural tax reform could finance expansion of social assistance programs to reduce inequality. Given the current small size of expenditure in the most equity-enhancing programs (0.3 percent of GDP spent on PKH, RASKIN, and BSM), expanding these targeted programs, financed by the additional revenue of 0.5–1.0 percent of GDP from the structural tax reform, would provide a strong boost to equity in Indonesia, while other less efficient social assistance programs are consolidated and more accurately targeted.

These structural fiscal reforms will also lay a solid foundation for full implementation of the medium-term fiscal strategy in the future. Lowering the VAT threshold and removing distortionary VAT exemptions is a prerequisite for raising the VAT rate from 10 percent to a higher rate (for example, 12 percent). Without these reforms, increases in the VAT statutory rate would amplify existing distortions. In addition, these fiscal reforms could gradually build public support for further reforms as infrastructure is developed and inequality reduced. Once consensus is reached, the remaining part of the fiscal strategy could be rolled out, such as raising the VAT rate to finance health, education, and additional infrastructure development. With full implementation of the fiscal strategy, Indonesia will gain much-needed resources for moving beyond its middle-income status.

Conclusion

This chapter recommends a medium-term fiscal strategy to enhance growth and equity in Indonesia. Although the country’s fiscal rules have been and should continue to be an important policy anchor, declining government revenue in recent years has constrained priority expenditure. Numerous exemptions have compromised tax policy, and there is much room to improve collection efficiency and the business climate through tax administration reform. The overall fiscal policy can also play a much larger distributive role in Indonesia. Based on the analysis of Indonesia’s fiscal policy and international experience, this chapter recommends a medium-term fiscal strategy, with a medium-term revenue strategy at its core.

The thrust of the fiscal strategy is to raise revenue by about 5 percent of GDP in the medium term to finance growth and equity-enhancing expenditure priorities in infrastructure, health, education, and social assistance. With regard to sequencing, tax policy reforms, including the introduction of new excise taxes and removing exemptions, should be front-loaded in the near term to arrest the decline in revenue and support inclusive growth, which will also be complemented by tax administration reform. This prioritized subset of the fiscal strategy would also lay the foundation for implementation of the remaining part in the future.

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