Indonesia's fiscal reforms

Indonesia targets fiscal reform

Indonesia's finance ministry recognises an urgent need to raise more tax revenue and achieve its spending targets to support the country's development.
President Susilo Bambang Yudhoyono (AFP)

Indonesia continues to delight its equity and bond investors. The country is achieving healthy economic growth while so many other economies are stagnating, and it is doing so without profligate government spending. But investor-friendly ratios can disguise institutional failings.

President Susilo Bambang Yudhoyono outlined his 2012 budget proposals to parliament on August 16, on the eve of the country’s 66th anniversary. The fiscal deficit is expected to drop to 1.5% of gross domestic product in 2012 from 2.1% of GDP in 2011, maintaining the trend of successive annual falls since 2004.

Wellian Wiranto, HSBC’s Asia economist calls this an “enviable trajectory”. Certainly, in the context of the budget deficits and accumulating debt levels characteristic of several industrialised countries, especially since 2008, it would seem that Indonesia has every reason to be satisfied. The prospect of a further global economic downturn, and the knock-on effects to even Indonesia’s consumption-oriented economy, would suggest that the management of its finances has been prudent and far sighted.

Yet, the assumption is that a declining budget deficit is best for Indonesia. The country is expected to post growth of 6.5% this year, the highest since the Asian financial crisis, but most economists agree that this is too little for a nation that is trying to pull large parts of its population out of poverty. Annual growth rates have been meagre compared with China and India, for instance.

“There is a constant dichotomy between managing a higher deficit in order to promote stronger economic growth and prudence in order to ensure less volatility from contagion to external events,” Bambang Brodjonegoro, head of Indonesia’s ministry of finance fiscal policy office, told FinanceAsia.

That’s fair enough. More contentious is whether that “prudence” is intentional; instead it might be due to fiscal failures rather than success.

International approval for Indonesia, especially by the ratings agencies, has largely been predicated on improving credit metrics and a confidence that institutional inadequacies will be redressed. The ratios look good, but the way they have been achieved is less impressive. On the other hand, the finance ministry is aware of deficiencies and is making efforts to bring about changes.

Take the expenditure side of the equation. Brodjonegoro conceded that as usual, “the deficit will probably be lower by the end of the year because the government will not have met its spending targets”. Poor planning and unrealistic ministerial “wish lists”, together with parliamentary lobbying for special interest projects means that there is a regular “absorption rate shortfall”. So far, only 21% of budgeted capital expenditure has been distributed; in theory, the bulk of it will be spent in the final five months of the year.

And that is unrealistic.

However, from November, all ministries will have to report their bidding processes for projects, which should allow for greater scrutiny at least. And, “in the future, the finance ministry is likely to get its way by imposing a system of rewards and penalties for meeting or failing to achieve spending targets,” said Brodjonegoro.

Failing to spend money allocated to projects is a serious impediment to the country’s development. It means that the projects themselves are either inappropriate or else the system is simply inefficient. After all, as all investors and businessmen are aware, the inadequacy of Indonesia’s physical infrastructure is the main obstacle that the country has to overcome before it can achieve a much higher structural growth rate. “Given the lack of capital spending after the Asian Financial Crisis, its stock of infrastructure has become overburdened,” pointed out HSBC’s Wiranto.

Nevertheless, Wiranto is sanguine. “It is heartening to see that the administration is planning to ramp up development spending sizably in the 2012 budget proposal,” he said. At almost $20 billion, it is more than 19% higher than this year’s allocation, and is expected to go into building 4,000 kilometres of roads, 150 kilometres of rail track and14 new airports, as well as more affordable public housing. In addition, Brodjonegoro is hopeful that the private sector will increase its investment through public-private partnerships, especially in the water and power sectors.

It will be interesting to see the progress achieved this time next year — and, of course, whether the much awaited land acquisition law has been enacted.

Meanwhile, widespread subsidies cause distortions to the economy and, because of their general coverage, are wasteful. They make up 15% of total government spending, which is higher than the sums allocated to infrastructure expenditure. Certainly, subsidies for fuel, food and basic goods for the country’s poor are justified; but, so far, everyone — rich and poor — gets the benefit. The government intends to raise the electricity tariff next year and is discussing lowering the fuel subsidy, except for poor households, but is maintaining food price controls as part of its food security programme.

Tax avoidance and evasion
Yet, the problems the government encounters spending its cash are minor compared to its ability to raise revenue.

Tax receipts make up around 75% of total revenues, but the collection system is rife with avoidance and evasion.

Realisation is always much lower than targeted, said Brodjonegoro, and is only about 12% of GDP. The main factor is a very small tax base.

“Although the country’s workforce is about 119 million, only about 17 million people are registered, and only about one million people in the private sector actually pay tax,” he said.

So much of that labour force is employed by small and medium-sized firms, often informally and usually paid in cash, making it hard to identify prospective taxpayers and evaluate incomes. A proposed national tax census might help, and was flagged by President Yudhoyono in August.

Other proposals by the finance ministry include incentives and tax holidays to “support revenue optimisation”, more effective law enforcement against non-compliance and third-party data utilisation. These policies would also be directed at the customs and excise division, which suffers from similar failings.

But, measures instituted by the finance ministry led by Sri Mulyani Indrawati until May 2010, and by her equally reformist successor have had an effect. In 2007, less than 40% of registered taxpayers met their obligations. In 2008, the number climbed to 52.8%, and in 2009 it improved again to 58.16%.

Indrawati’s successor, Agus Martowardojo, “continues to work for bureaucratic reform, to improve the tax administration and strengthen the customs and excise division”, said Brodjonegoro. The ministry expects tax receipts to rise by 16% in 2012.

There is clearly no sense of complacency. And, as Wiranto put it, “the apparent earnestness with which the government is pursuing higher revenues is driven in part by the realisation that development expenditure needs to be ramped up, particularly for infrastructure”.

But, broadening the tax base is a longer-term goal; stamping out rampant corporate tax evasion, which is often linked to corruption, is a priority.

One of the biggest graft cases in Indonesia’s history unfolded last year with the arrest of Gayus Tambunan, a low-level tax officer found to have $3.3 million stashed in bank accounts.

Tambunan was convicted of bribery in January 2011, and he is expected to stand trial again for taking bribes from corporate taxpayers who allegedly used his services to ease their tax burdens.

Some Indonesian experts estimate that the so-called “tax mafia” steal as much as Rp400 trillion each year.

On the bright side, despite the tax collection problems, Indonesia can rely on access to both domestic and international capital markets to fill in any shortfalls. Brodjonegoro is confident that net issuance of Rp126 trillion will be comfortably achieved this year — and will include a global sukuk — and that Rp134 trillion of net issuance in 2012 is manageable.

Of course, gaining investment grade status will help lower borrowing costs and might mitigate the effects of risk aversion among bond investors should the global economic environment worsen. Brodjonegoro’s “optimistic forecast is that at least one agency will assign Indonesia investment grade status by the end of 2011; more realistically, it will happen next year.” But, attracting international approval for prudence is insufficient. Institutional reform of other revenue sources and implementation of necessary spending plans are essential for the country’s sustainable development. That would indeed be an “enviable trajectory”.

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