INDONESIA FOCUS. Achieving Fiscal Sustainability Key To Fostering Higher Economic Growth

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1 Achieving Fiscal Sustainability Key To Fostering Higher Economic Growth Indonesia s fiscal sector has shown remarkable improvement over the past decade or so. In particular, tax revenue grew on average 13.% in the period covering (excluding the global financial crisis year of 29, it grew even higher around 14.4%). Fiscal rule of limiting the deficit of no more than 3 percent of GDP also helped to maintain fiscal prudence and discipline across periods. Reflecting significant and continuous improvements in the fiscal space, the international investment communities have recognized such achievement by granting Indonesia an investment grade ratings by all three major international rating agencies (Fitch, Moody s, and finally Standard & Poor s) as of 217. In fact, in late 217, Fitch upgraded Indonesia s rating to BBB (Stable outlook, up from BBB- previously) and just months after S&P finally gave Indonesia to long-awaited investment grade rating. This puts Indonesia to be on par with the Philippines and Portugal in terms of its investment grade ratings. However, despite the positive tones accompanying the upgrade, most rating agencies do acknowledge that government revenue is still very low across peers of similar ratings as of Indonesia. In this special focus, we dissect a little bit deeper on the revenueexpenditure dynamics on the Indonesian fiscal space. This is an important area as we continue to believe that achieving fiscal sustainability is key to fostering higher and sustainable economic growth of Indonesia. Furthermore, it is by first anchoring a sustainable fiscal posture, only then the Indonesian fiscal policy can desirably adopt counter-cyclical measures to foster higher economic growth in the foreseeable future. Revenue Analysis Fiscal revenue s growth in Indonesia is predominantly driven by tax revenue, of which it was growing relatively robust in years preceding to the commodity down-cycle in the beginning of 212. In particular, Figure 1 shows that growth of tax revenue in the period covering registered an average of 17.5% (excluding 29 global financial crisis year, it grew 2.8%). However, growth of tax revenue declined to an average of just 6.6% in the period of Coincidentally, the pre commodity bust (25-212) tax revenue growth is strongly associated with stellar oil & gas tax revenue (which is classified under the broad category of non-tax revenue). Statistically, the correlation between the tax revenue and the oil & gas-related tax revenue was as positive and as high as.8 in the period of However, it subsequently turned into -.5 correlation in period. In fact using a more sophisticated macro-econometric analytics, we found that rounds of causation suggesting the decline of value-added in the commodity sector has precipitated decline firstly in the manufacturing sector and secondly into the wholesale and consumer sectors. This would imply that as a commodity-dependent economy, the decline in the global commodity prices and hence the commodity-related revenue for Indonesia has a more far reaching impact to the domestic income and automatically affecting the main component of tax revenue, i.e. the corporate and personal income taxes. As such, relying too much on the tax revenue alone would pose significant risk of having more sustainable fiscal revenue going forward. Tax ratio, calculated as the tax revenue divided by the annual nominal GDP, has declined from 12.5% in year 25 to a projected ratio of 1.8% using government and our own estimates. Even as we include a broad measure of tax ratio, of which the nontax revenue of oil & gas is included, broad measure of tax ratio fell from 16.2% in 25 to an estimated 11.7% this year (Figure 2). Perhaps one dominant reason is that given the large informal sector of the Indonesian economy, the tax base of registered taxpayers in Indonesia remains one of the lowest in the world. Additionally, even though tax compliance ratio (calculated as the total number of effective registered taxpayers divided by number of annual tax return) is on the rise (Figure 3), its pace is not fast enough to probably offset the relatively low registered taxpayers in Indonesia, which is related to the relatively subdued annual tax returns filing. All these factors are keenly reflected by the fact that Indonesia has currently one of the lowest tax ratios in the world (Figure 4), just slightly better than China but remains significantly lower than our neighboring countries such as Malaysia and Thailand. In fact, Indonesia s projected tax ratio of 1.8% for 218 is lower than average tax ratio of low income UOB Global Economics & Markets Research 25

2 26 countries (14.3%) and even lower than average tax ratio of lowmiddle income countries (19.%). Progress has been acknowledged, nevertheless, in terms of diversifying away from relying solely on commodity (notably oil & gas) tax revenue into the non-commodity based tax revenues as depicted by Figure 5. Accordingly, the Indonesian government has also set some main priorities to reform the tax administration/institutions and tax policies in order to increase and accrue the revenue base to achieve a more sustainable fiscal policy. The efforts include beefing up the quality of tax database by utilizing a more reliable and sophisticated information technology system; adapting into a more flexible regulations and business processes; optimizing coordination among key institutions and economic units in the country. The end goals are to achieve higher tax compliance ratio and increase the tax ratio going forward. The increased database from the past tax amnesty program and the upcoming automatic exchange of information platform (likely effective by September 218) are two other notable avenues for increasing the revenue streams. However, we would like to highlight one important issue that warrants focus consideration going forward: falling tax buoyancy in Indonesia. Simply defined, tax buoyancy is a standard measure of how responsive a country s tax revenue is given the changes in the country s GDP. In other words, tax buoyancy measures how responsive tax revenue is as the economy grows. Strong tax buoyancy, measured mathematically by growth rate of tax revenue divided by real GDP growth rate (ΔTR/ΔGDP), would give any government some comfort that if the economy achieves higher GDP growth, then automatically tax revenue will increase to finance its expenditure without resorting to additional concern of relying on external borrowing to finance the budget. Beyond this, it is also a good source of saving during the rainy day as it sets a ground for a consistent expansionary fiscal policy when the real economy is turning slower, i.e. the nature of fiscal counter cyclicality. Tax buoyancy in Indonesia is deemed to be too low. Figure 6 shows that in recent periods (25-217), the highest tax buoyancy that Indonesia has every achieved is only around 1.4 (in 28 and 211), and after the commodity bust, the buoyance is on a steady downhill. In fact, during the global crisis years, the tax buoyancy went into negative territory, which means that tax revenue actually contracted, high base notwithstanding, despite the economy still recording positive growth. This is in contrast with India, for example. In the year prior to the global financial crisis, India s tax buoyancy was as high as 5. and even during the GFC year, whereby India s GDP growth came tumbling down to around 6.% from 9.%, its tax revenue grew much slower at approximately 18.%, which implied a fall in tax ratio to 3.. Even so, such figures are still way higher than Indonesia during normal periods. There are perhaps some noteworthy observations of why tax buoyancy in Indonesia is quite low. Firstly, given the relatively low registered taxpayers and correspondingly low tax compliance ratio, more often than not tax revenue targets were missed. Secondly, as the economy faced the ongoing headwinds from falling commodity prices since 212, the overall buoyancy seemed to have been hit persistently given the nature of commodity dependency of the Indonesian economy. Thirdly, amidst attracting investment to come to the country, various tax incentives and holidays and a one-off tax events such as the sunset policy and the recently concluded tax amnesty would also add pressure for tax revenue target to be met and the question of sustainability is also at stake for future tax UOB Global Economics & Markets Research revenue growth trend. Fourth, the recent slowing of the consumption trend has also affected tax revenue as the economy is less upbeat compared to before. Fifth, low tax compliance ratio over the years is also another important reason explaining the relatively low tax buoyancy in Indonesia. The proposed solutions may not come easy, yet they are much needed to ensure the fiscal sustainability of Indonesia. The government has committed to make the full use of better tax database and to utilize better the higher tax registries came about post tax amnesty exercise in order to increase its tax revenue in the future. Tax reforms on both the administration and broader policies are also believed to bring about improvements in narrowing the gap between actual tax collection and its target. Exploring a broader tax landscape which may now include the digital economy and e-commerce would also be one viable option going forward. There is also some direct but not necessarily painless solutions to achieve higher revenue target, such as increasing the value added tax rate (currently at 1 percent) to 12 percent as recommended by the IMF, lowering the VAT registration threshold, introducing fuel excise tax, removing exemptions to corporate tax and to unify tax rates for corporation, lowering the threshold for top personal income tax rate, increasing the property income tax rates and introducing a recurrent property tax regimes. Expenditure Analysis The pace of fiscal expenditure was faster during the commodity boom years compared to after the bust. Figure 7 shows that in 24-28, fiscal expenditure grew on average 21.5% as compared to periods, whereby the average growth in fiscal expenditure fell to just 8.5%. Secondly, the less-than-full absorption rate in fiscal expenditure has always been a constant feature in the Indonesian fiscal spending (Figure 8). Typically, during the period where revenue is expected to miss its target and the need to comply towards the deficit rule of 3% of GDP, the needed stimulatory fiscal spending is most of the time held hostage. In particular, the spending efficiency towards productive sector is on the decline as shown by the falling share of capital spending to the overall fiscal expenditure. However, we acknowledge significant improvements made in reorienting spending priorities since major energy subsidy cuts in 214. Figures 9 and 1 shows the trend of capital spending and especially infrastructure spending has shown a massive increase versus now a much lower spending on total subsidies. The key focus on fiscal expenditure of Indonesia remains one that requires more sustainable fiscal revenue to finance the longer-term spending such as infrastructure and human capital development. These are the two most important expenditure factors that the government would have to focus in order to attain longer-term fiscal sustainability. They are the factors that may boost GDP growth going forward and in return increase the tax revenue in the foreseeable future. But at this stage, the government has little option but to lift up all the slack in infrastructure spending and other big ticket items as private participation remains relatively muted. Government, however, may consider other alternative financing such as tapping on multilateral financial institutional loans such as those from the World Bank or the Asian Development Bank. Given the budgetary constraint, we foresee the momentum of infrastructure spending may have to be paced with the available financing options and given what we have alluded before in terms of revenue challenges, it seems likely the government would still need to leverage on external financing going forward. This brings us to the next and final discussion point on financing the fiscal gap and risks involved on such option.

3 Financing The Gap: The Way Forward Given the shortfall of revenue and recognizing the need for a more persistent efficient and productive spending, Indonesia would still need to resort to external financing to plug the budget deficit. However, more often than not, the rigid rule (despite set to ensure fiscal prudence and discipline as we have alluded before) remains one key constraint especially given the persistently low tax buoyancy. Even though it seemed that fiscal attempted to support the economy during bad time, the extent of it to adequately lift the growth momentum is somewhat sub-optimal, which again is related somewhat to the fiscal rule that unfortunately came at a cost of slowing the momentum of productive spending (Figure 11). Indonesia s budget deficit financing carries the risks of heavy reliance on external borrowing that cannot be belittled, notably amidst monetary policy normalization across the globe and in particular the US Federal Reserve. The total outstanding Indonesian government securities has grown 18.4% in 217, reaching a total outstanding of IDR2,99tn as of end December 217 (Figure 12). Out of that total figure, non-resident currently holds 38.7% of the total outstanding Indonesian rupiah denominated government bonds (Figure 13). We have seen in episodes before during which emerging market securities, including government bonds, were suffering the brunt of capital reversal during externally driven global events such as 212 s Fed s Taper Tantrum, Brexit, and the US Presidential Election results. Figure 14 shows the 1-Year Indonesian benchmark government bond yield has recently moved higher year-to-date in 218, after reaching a record low of 6.12% in January, and currently traded at 6.82% (as of 12 March 218). Non-resident has sold IDR48.4tn (USD3.5bn) to-date this year from its peak level recorded in January on the back of external factors such as the possibility that US Fed may hike its Fed Funds rate more aggressively. Consequently, the US Treasury yield traced higher approaching the psychologically sensitive level of 3.% that has somewhat sparked some sell-off in emerging market bonds, including from Indonesia. This highlighted the peril of over-reliance on external financing for Indonesia, especially given a relatively high level of foreign ownership. Thus, a more sustainable source of revenue as well as attracting a more sticky foreign direct investment (FDI) is called for to ensure the sustainability of the Indonesian fiscal sector going forward. Conclusion In conclusion, we have taken a closer look at the revenueexpenditure dynamics of the Indonesian fiscal sector. We found that reforms would be needed to ensure higher tax compliance and tax buoyancy in Indonesia. The shift in focus from fiscal expenditure into more infrastructure and social-development is duly acknowledged and applauded. However, given risks of relying on external financing, the institutional reforms or some drastic measures to increase tax revenue remain key to not only ensuring fiscal sustainability, but also to foster higher GDP growth momentum and unleash further Indonesia's economic potential. Figure 1. Tax Revenue Growth Bottomed Out in 216 Source: MOF, UOB Global Economics & Markets Research Figure 2. Tax Ratios Improving Recently, but Remains at Low Levels 1,8 1,6 1,4 1,2 1, % 35% 3% 25% 2% 1% 5% % -5% 19% 17% 13% 11% 9% -1% F Tax Revenue (IDRtn) Tax Revenue Growth (%) 7% F Tax Ratio (Narrow Criteria) Tax Ratio (Broad Criteria) Figure 3. Tax Compliance Ratio Figure 4. Indonesia's Tax Ratio is One of The Lowest in the World Source: IMF, UOB Global Economics & Markets Research 8.% 7.% 6.% 5.% 4.% 3.% 2.% 1.%.% UK France Australia Thailand Malaysia Canada Germany USA Avg tax ratio: ID (218 Projection) China Avg tax ratio: high income countries Avg tax ratio: middle-high income countries Avg tax ratio: low-middle income countries Avg tax ratio: low income countries UOB Global Economics & Markets Research 27

4 Figure 5. Share of Non-Oil Gas Revenue is On the Rise Source: MOF, UOB Global Economics & Markets Research Figure 6. Tax Buoyancy is Turning Up but Still Way Too Low (%) Oil and Gas Non-Oil and Gas VAT Property Taxes International Taxes F Figure 7. Expenditure Growth Reaccelerated Consistently For Past 3 Years 2,5 4% Figure 's Absorption Rate Above Recent Average 11 2, 1,5 3% 2% 98 1, 1% 95 5 % F Government Expenditure Growth -1% Figure 9. Subsidies Spending Has Been Falling Figure 1. Productive Spending are On The Rise 3% 25% 2% % % % Capital Subsidies Interest Payment Education Infrastructure Health Energy Subidies 28 UOB Global Economics & Markets Research

5 Figure 11. Budget Deficit And GDP Growth 7. Figure 12. Foreign Holdings Rose In Tandem With Increase In Outstanding Government Bonds 2, F Budget Defisit (%) Real GDP Growth (%) 2,15 2,5 1,95 1,85 1,75 1,65 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Total Outstanding Government Bonds of Indonesia Foreign Holding of Outstanding Indonesian Government Bonds Figure 13. But Foreign Holdings As Share Of Total Outstanding Has Recently Declined 42.% 41.5% 41.% 4.5% 4.% 39.5% 39.% 38.5% 38.% 37.5% 37.% Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Non-Resident Share of Indonesia Outstanding Government Bonds Figure 14. 1Y Indonesian Government Securities Yield Is On Gradual Rise 11 1 % Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 1Y US Treasury 1 Y Indonesia Government Bonds (IDR) 1 Y INDON (USD) 3% UST Level 7% Indonesia Government Bond Yield UOB Global Economics & Markets Research 29