Indonesia’s Economy Threatened by Fiscal Sustainability

Indonesia’s Economy Threatened by Fiscal Sustainability
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Despite major domestic and external challenges Indonesia’s economy is expected to grow at around 5 per cent again this year — much like last year — and only slightly below the official estimate of 5.3 per cent. However, it will come in much lower than the 7 per cent the new government had targeted.

Compared to continued downward global growth, including that of China and its Asean neighbours, Indonesia’s stable growth looks quite respectable.

Stable growth is still driven by domestic consumption, even though many indicators remain flat or negative. Net exports contributed negatively to growth in 2016 because of unfavourable external conditions and weak commodity prices. Domestic investment is also weak despite an expansionary monetary policy and 14 economic deregulation packages since September 2015 (See: Ease of Doing Business: Indonesia Leads the World in Reforms).

A lower inflation rate has allowed Indonesia’s central bank to reduce its benchmark interest rate several times, bringing it down 150 basis points. This has led to an actual reduction in interest rates by 60 basis points, but it has failed to boost domestic investment and credit growth among all the uncertainties.

Despite limited fiscal space government spending contributed the most to Indonesia’s economy growing in the first half of 2016, especially in the second quarter.

Fiscal Sustainability Threatens Indonesia’s economy

Indonesia Finance Minister Sri Mulyani Indrawati's forecast of another Rp 210 trillion shortfall in tax revenue saw a more realistic budget
Indonesia Finance Minister Sri Mulyani Indrawati’s forecast of another Rp 210 trillion shortfall in tax revenue saw a more realistic budget Courtesy World Bank

Overall, the biggest issue facing Indonesia’s economy in 2016 was the risk to sustainable fiscal policy. The root cause was the unrealistic tax revenue target set in 2015 to support the priorities of the President and the government in infrastructure, health and other sectors.

Despite the average growth of tax revenues in the last three years being less than 10 per cent and a general slowdown in the economy, the 2015 growth target was set unrealistically at 30 per cent. Realised revenue growth was only 8 per cent. But again in 2016 a 24 per cent target was set, raising the question of fiscal sustainability.

To meet the shortfall in tax revenue, the government would have had to undertake budget cuts to the tune of Rp 200 trillion (about US$15 billion). But the budget cut (of Rp 60 trillion) that was passed in the revised budget fell short of that by around Rp 140 trillion ($11 billion). Instead, an ambitious tax amnesty program was promoted to address the shortfall. These steps did little to address the problem of fiscal sustainability.

In a merciful economic policy-making coup in August, President Joko Widodo brought back the highly respected and experienced finance minister Sri Mulyani Indrawati to re-set fiscal course.

Indonesia Tax Amnesty Programme

Ms Indrawati hit the ground running. She took charge of implementing the ambitious tax amnesty programme, which had faced considerable scepticism and implementation problems. The President undertook a huge and intensive public outreach campaign to the private sector. This included his calling on large corporations himself to seek their participation and commitment. The result has been better than expected in terms of the tax amnesty targets, but less so on the tax reform front.

Indonesia’s tax amnesty programme has done better in terms of assets declared as a percentage of GDP than similar programmes elsewhere — at 35 per cent compared to 32 per cent in India and 8 per cent in Chile. In terms of penalties paid, it clocked up 0.8 per cent of Indonesia GDP, the second highest after India at 0.9 per cent.

But Indonesia has been less successful in widening its tax base and in undertaking comprehensive tax reform programme. The number of tax payers that registered with the tax amnesty programme was 370,000; only 16,000 were new tax payers. Indonesia’s tax-to-GDP ratio has fallen from 11.9 per cent to 10.8 per cent between 2012–2015, compared to its Asean neighbours of 13–17 per cent.

Increased tax scrutiny in the last two years due to ambitious tax revenue targets have hurt both investment and consumption confidence. Yet the President and the finance minister have announced that there are more tax reforms to come, including reducing the corporate tax rate from 25 per cent to 18 per cent.

Tax Revenue Growth Forecast Slashed

Indonesia's central bank has reduced its benchmark interest rate by 150 basis points reducing interest rates by 60 basis points
Indonesia’s central bank has reduced its benchmark interest rate by 150 basis points resulting in a 60 basis points drop in interest rates Courtesy Gunawan Kartapranata

Soon after resuming office, Ms Indrawati forecast another Rp 210 trillion shortfall in tax revenue. A revised budget was passed with more realistic targets to increase Indonesia tax revenue and cut spending by Rp 184 trillion. The revised budget was welcomed as more realistic, although it choked back the government’s contribution to Indonesia’s growth.

Last quarter Indonesia’s economy saw growth fall to 5.02 per cent. Budget plans for 2017 realistically project a 13.5 per cent increase in tax revenues and 9.8 per cent increase in government spending. But fiscal sustainability is still at risk, given that fiscal revenue targets are unlikely to be met with lower growth in 2017 and less than effective reforms on tax collection and on the spending side, especially around fuel and electricity subsidies.

The big issue for Indonesia’s economy in 2017 is how to revive private investment growth, including in infrastructure. The key here is real structural reform.

The 14 economic regulation packages so far fall short on reform even though they focus on reducing the costs of doing business, facilitating trade and investment, and people movement for tourism. What they fail to do is to address the fundamental issues for investors of land clearance, pricing, and clarity on public private partnerships and the investment processes they face. And there is continued ambivalence on protectionism and localisation policies. Dealing with these issues is necessary if Indonesia’s economy is to rise above its 5 per cent trajectory path, or worse, prevent it from drifting further below its potential.


This article was written by Mari Pangestu, a Senior Fellow at the School of International and Public Affairs, Columbia University and was formerly Indonesia’s Minister of Trade and Tourism and the Creative Economy. It first appeared on East Asia Forum under a Creative Commons license and is reproduced here with its permission.

This article is part of an EAF special feature series on 2016 in review and the year ahead.







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