Indonesia needs structural and taxation reforms

Indonesian miracle

In many ways, Indonesia is the miracle economy of Southeast Asia. Some twenty years ago, it was mired in economic and political crisis. It was then transformed from dictatorship to democracy, and is now the most democratic country in Southeast Asia. It also achieved two decades of solid economic growth in the 5-6% range, initially by surfing the wave of the commodities boom, driven by China. Although Indonesia is now a net importer of oil, natural resources remain a key driver of the country’s economy, with commodities accounting for 40% of exports.

As a result, extreme poverty (based on a poverty line of $1.90 a day) has been slashed from 47% of the national population in 1996 (before the Asian financial crisis) to 5.7% in 2017 (1). And Indonesia has become a very important country. With 262 million people, it has the world's fourth largest population (after China, India and the US) and the world's largest Muslim population (87% of the population are Muslim). It is the world's third largest democracy after India and the US. And in purchasing power parity terms, today it has the world's seventh largest economy, and could become the world's fourth biggest by the year 2050 (2).

Indonesia is Southeast Asia’s largest economy, and the only one in the region to be a proud member of the G20, an international forum for the world’s leading twenty economies. And Indonesia is strategically located at the cross-straits between the Pacific and Indian Oceans. It is thus the quintessential “Indo-Pacific” country.

In short, there are many good reasons to hope for Indonesia's continued success. Indeed, in a world presently dominated by US/China rivalry, a strong Indonesia would provide more balance in the international system.

Indonesia’s shortcomings

This is why we have reason to be concerned with recent developments and prospects in Indonesia. The country has been underperforming. Today's growth rate of 5% is only half that of China during its high-growth period (1978-2013), and well below India's present rate 7 1/2% (3). Even today when China is suffering a big slow down, it is growing much faster than Indonesia.

While extreme poverty may have fallen, many still live in near-poverty. Almost 60% of the population live on less than $5.50 a day, according to the World Bank. Income inequality, the gap between rich and poor, is very high (4). GDP per capita in PPP terms is only $12,284 compared with China's $16,807, Malaysia’s $29,431, Thailand’s $17,871, and Singapore’s $93,905.

As the IMF has argued, Indonesia is a poor performer when it comes to the world of work. Youth unemployment is high at 15% -- I was told that this official figure probably understates by a long way the real problem of jobs for youth. Some 70% of workers are believed to work in the informal economy, with vulnerability and precarity being the order of the day. And only 55% of women participate in the labour markets. Indeed, Indonesia ranks only 84th out 144 countries in the Global Gender Gap index (5).

And while Indonesia has the pretensions to lead ASEAN (the Association of Southeast Asian Nations), its leadership of this weak organisation is also weak, and Indonesia does not seem to make its presence felt in the G20 grouping.

What's the problem? What has been holding Indonesia back?

Indonesia has always been a notoriously difficult country in which to do business, with bureaucracy and corruption being chronic problems. Under the current President Joko Widido ("Jokowi"), things have improved, but not enough. Indonesia only ranks 72nd by the World Bank out of 190 countries in its 2018 Doing Business survey (5), while Transparency International places it 101 out 180 in its Corruption Perceptions Index (6), and the World Justice Project puts Indonesia at 63rd among its 113 countries in its review of rule of law around the world (7).

These are hardly assessments that would inspire either domestic or international investors. And as the IMF has argued, “Trade barriers and FDI restrictions have contributed to low integration with global value chains compared to ASEAN peers”. The stock of foreign direct investment in Indonesia is only a puny 24% of GDP, compared with 45% in the case of Malaysia, 51% for Thailand and 60% for Vietnam (8).

And according to the OECD, government regulations would be a major factor behind the large informal sector, and informal employment. Easing and improving burdensome government regulations, notably for employment dismissal and minimum wages, would help.

Under previous presidents, an immense infrastructure deficit was allowed to accumulate -- especially in transport, logistics and water treatment -- as they focussed more getting public deficits and debt under control, than investing in the economy (Indonesia’s 2003 Fiscal Law caps the government’s deficit at 3% of GDP and debt at 60% of GDP). Jokowi is making great strides in tackling Indonesia's infrastructure deficit. His government has increased public infrastructure spending by 1 percent of GDP between 2014 and 2017 (9). But seriously tackling the infrastructure deficit will take time and requires financing, while the government is still wasting money on energy subsidies.

And Indonesia also faces a massive human capital challenge. The education system achieves poor results. Around three-quarters of 15 year-olds do not have basic skills in mathematics, and less than one-third have basic reading proficiency. A large part of the problem is teachers, rather than students, as teachers lack competencies, and teacher absenteeism remains a chronic problem. Indonesia needs to invest much more in its education system.

The same could be said for health on which Indonesia spends only 3.4% of its GDP. Healthy life expectancy is only 63 years (10). Stunting is also a major issue affecting some 30% of students, with lasting impacts on cognitive function and school performance. At the same time, the prevalence of non-communicable diseases is rising. Cardiovascular and respiratory diseases, diabetes and related complications caused half of all deaths in 2014.

Over the decades ahead, human capital may be Indonesia's biggest challenge. About half of Indonesia’s population is under 30 years of age. The working-age population is now growing by around 2 million annually and is projected to increase over the coming decade. In other words, the country has a large youthful cohort bursting onto the labour market, looking for work. But turning this opportunity into a demographic dividend will require training these workers and having jobs on offer -- and ideally, not any old jobs, but high-quality, high-productivity jobs in the formal sector. In short, Indonesia has a window of opportunity it should not waste, but also a massive challenge.

Financing Indonesia’s development

Financing Indonesia's continued development -- especially infrastructure, education, health and social safety nets -- may represent the greatest challenge it faces. Sure, China has financed some infrastructure projects, as have Japan, the World Bank and the Asian Development Bank.

But Indonesia cannot rely on external financing for all its development. It needs to raises more taxes to finance its economy, and it is here that it has been doing a poor job. Indonesia's total tax revenues represent only 12% of GDP, much lower than countries like Malaysia (15%), the Philippines (17%), Turkey (25%) and Brazil (32%) (11). According to the OECD, “compliance” is the major challenge, meaning that tax-cheating is rife by the nation’s wealthy.

The OECD recommends a substantial strengthening of Indonesia’s tax administration for improving compliance. This means modernising IT systems, hiring and training highly skilled staff, and simplifying tax design. But this is a tall order in a country like Indonesia with a poor education system, and weak IT capacities. Indonesia ranks a lamentable 111th out of 176 on an ICT Development Index (12).

But there is more to it than that, according to the OECD. With some 93% of Indonesian firms operating informally, and 70% of workers employed informally, this means that most citizens escape any responsibility for paying taxes. High-income earners also benefit from tax-free status of fringe benefits, while tax incentives offered to certain investors also erode the tax base. The revenue-raising potential of the value-added tax is undermined by exemptions. And as the OECD argues, Indonesia could uses taxes to tackle health issues like smoking and the environment.

Conclusion

President Jokowi has done a very good job, and is without doubt Indonesia’s best president of the democratic era. He seems “odds on” to be re-elected in 2019’s elections. But he has his work cut out for him to carry out Indonesia’s necessary structural and taxation reforms. Opposition figures are working hard to bring him down, political Islam is on the rise, economic nationalism (meaning protectionism) is always close to the surface, and natural disasters can strike at any moment.

Footnotes

1 World Bank. Poverty & Equity Data Portal.
http://povertydata.worldbank.org/poverty/country/IDN

2 pwc. The World in 2050.
https://www.pwc.com/gx/en/issues/economy/the-world-in-2050.html

3 Asian Development Bank. Asian Development Outlook (ADO) 2018 Update: Maintaining Stability Amid Heightened Uncertainty.
https://www.adb.org/publications/asian-development-outlook-2018-update

4 IMF (2016). Sharing the Growth Dividend: Analysis of Inequality in Asia. Sonali Jain-Chandra, Tidiane Kinda, Kalpana Kochhar, Shi Piao, and Johanna Schauer.
https://www.imf.org/external/pubs/ft/wp/2016/wp1648.pdf

5 World Economic Forum. The Global Gender Gap Report 2017.
http://www3.weforum.org/docs/WEF_GGGR_2017.pdf

5 World Bank. Doing Business 2018 -- reforming to create jobs.
http://www.doingbusiness.org/content/dam/doingBusiness/media/Annual-Reports/English/DB2018-Full-Report.pdf

6 Transparency International. Corruption Perceptions Index 2017.
https://www.transparency.org/news/feature/corruption_perceptions_index_2017?gclid=Cj0KCQjw6rXeBRD3ARIsAD9ni9CUA20_BkPo4maiTY3N4UDt4fGMjjHFEZjk2p6cUKScz_HdnJWTqMUaAuAFEALw_wcB#table

7 World Justice Project. Rule of Law Index 2017-2018.
https://worldjusticeproject.org/sites/default/files/documents/WJP-ROLI-2018-June-Online-Edition_0.pdf

8 UNCTAD. World Investment Report 2018. Country Fact Sheets.
https://unctad.org/en/Pages/DIAE/World%20Investment%20Report/Country-Fact-Sheets.aspx

9 IMF. Indonesia : 2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Indonesia.

https://www.imf.org/en/Publications/CR/Issues/2018/02/06/Indonesia-2017-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-the-45614

10 World Economic Forum. The Global Competitiveness Report 2018.
https://www.weforum.org/reports/the-global-competitveness-report-2018

11 OECD. Economic Survey of Indonesia 2018.
http://www.oecd.org/eco/surveys/economic-survey-indonesia.htm

12 International Telecommunications Union. ICT Development Index 2017.
http://www.itu.int/net4/ITU-D/idi/2017/index.html