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Reinvigorating Indonesia’s fiscal policy

by November 8, 2016 General

As the room for and the impact of monetary policy have become limited, we are now more in need of fiscal support. Unfortunately, our fiscal balance sheet is rather constrained.

The liability side of our fiscal balance sheet, which lists down all spending, continuously ratchets up. Over 30 years, spending ranged between 15 to 18 percent of gross domestic product (GDP).

Relative to its liability counterpart, the growth in assets has not been as buoyant. The claim on tax, which is the single most important and enviable asset class, accounted for only 10 to 12 percent of GDP.

Add to it another revenue source, fiscal revenue only made up around 12 to 15 percent of GDP. As a result, the deficit had always varied between 2 to 5 percent of GDP.

This not only imposes strict limits on our fiscal maneuverability, but also creates pressure on the rupiah, has exposed us to global currency fluctuations — Indonesia had to borrow externally to plug the deficit — and ultimately places our bonds under the high-yield category (a euphemism for junk bonds), hence raising the cost of servicing public debt.

The claim on tax is not a deep magic pocket to get cash, for two reasons: One, people don’t like to pay tax. Two, people are less tax compliant because the government, especially in developing countries, has often failed to spend taxpayers’ money wisely to the benefit of all its citizens.

Low tax ratio

Indonesia started its development drive around 1967 to 1970, just like Malaysia, Singapore, Philippines, South Korea, China and India. In the mid-1980s, when fundamental reforms started to be implemented, our tax ratio was around 9 percent of GDP. Other countries reached around 9 to 10 percent of GDP.

Despite the fundamental changes over three decades to date: in fiscal governance, revenue/spending administration, policy framework and even in the shape and content of its balance sheet, our tax ratio only edged a bit to 11 to 12 percent of GDP.

In contrast, our peers have tasted a 15 to 19 percent ratio. They have passed the psychological threshold of 14 percent to be called “cash flow-safe” budgets.

There are four culprits behind such records.

First, the sizeable amount of economic activities never brought into the tax net — sometimes dubbed “the underground economy”.

Second, limited administrative capacity to tax has led to suboptimal tax collection and tax evasion. Third, limited “wealth-conversion effects” of fiscal spending. Four, the narrow tax base.

Can tax amnesty deal with these four issues? Some believe it can. But I don’t. Amnesty can deal with the first two, but not all four, and with varying degree of success. The rest must be tackled with using a mix of strategies.

Tax amnesty vs underground activities

That we have a massive underground economic activities operating outside the tax net is hardly news.

Everyone talks about it, but no one knows how big it is. Tax amnesty has commonly been employed to permanently reduce certain activities occurring in the underground economy.

Our tax amnesty program, halfway into the implementation, looks like a big success on this objective.

The amount of money being declared and repatriated, at Rp 3,500 trillion, was 28 percent of Indonesia’s estimated nominal 2016 GDP.

That is the size of underground economic activities being brought into the tax net.

The tax amnesty has helped a bit with short-term revenue. At Rp 98 trillion, the fiscal receipt from amnesty contributed: 0.75 percent of the revised 2016 budget; 2.7 percent of the 2016 GDP; 30 to 31 percent of the 2016 fiscal deficit.

Using such metrics, in comparison with other countries in the past 50 years, Indonesia may claim its achievement.

However, against its own target, this was only 58 percent of the government own target. The jury will still be out until March 2017.

Amnesty not been effective in recovering capital flight

The current repatriated sum represented just 10 percent of the target. Why so low? If international experience is of any lesson, amnesty alone cannot recover capital flight.

The government must address the causes of capital flight before this objective can be achieved. France is a good case.

A French experiment in 1986 specifically designed its amnesty to attract capital flight. But its success — judged by the 400 percent increase in non-bank private transfers into France — was largely not as a result of the amnesty, but by the simultaneous introduction of several structural measures including tax rate reductions, abolition of wealth tax, a ruling to allow anonymous holdings of gold, and a few other changes. We can learn from them.

Can tax amnesty lead to a sustained increase in tax ratio?

Ample research shows no evidence that tax amnesty is panacea to a low tax ratio.

Evidence suggests, though, that a high tax ratio is linked with three factors: First, stronger enforcement mechanisms — and we can learn this from Ireland.

A stronger tax administration always leads to an increase in taxpayers’ subsequent reported income. Second, good spending policies-vis-à-vis lower tax rates — and these are the two factors explaining tax-evasion behavior the most.

A good spending policy that can ensure fiscal liabilities can be converted into revenue-generating assets can in turn provide revenue for subsequent spending.

This is what I referred to as “the wealth-conversion effects” of fiscal spending. Third, a universal participation in public financing. It is the latter that brings me to my final comment.

On the asset side, we have 250-plus million people, of which 186 million own an identity card (KTP). Of that figure 27 million own a tax identification number (NPWP) and perhaps only 10-plus million pay income tax.

I wonder why we don’t give one NPWP to every one KTP? On the liability side, there are 86-plus million people with access to some form of social security. That number is rising.

Since asset growth is less buoyant than liability, and to create a link between asset and liability, I wonder why we don’t give everyone an NPWP in exchange of his/her social security number?

Further, by linking the KTP with the NPWP we can also link them to financial services and any efforts to strengthen tax enforcement.

Our tax administration can also learn from the logic of price discrimination. Tax evasion can be reduced if the government resorts to permanent programs for encouraging tax disclosures.

The main idea is to consolidate taxpayers’ expectations about the government’s commitment to fight evasion. Such a measure can complement others.

When a good mixture of strategies and programs is carefully devised, we can expect higher tax ratios (and a stronger fiscal engine) going forward.

The author is PT Bank CIMB Niaga chief economist. The views expressed are his own and do not necessarily reflect those of CIMB Niaga.