THE NEW INDONESIAN TAX REFORM INITIATIVES: MEDIATING TWO COMPETING PROPOSALS. Mohamad Ikhsan Ledi Trialdi Syarif Syahrial

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1 THE NEW INDONESIAN TAX REFORM INITIATIVES: MEDIATING TWO COMPETING PROPOSALS Mohamad Ikhsan Ledi Trialdi Syarif Syahrial Jakarta, June 2005

2 TABLE OF CONTENTS 1. INTRODUCTION Background Objectives...! 1.3 Methodology...! 1.4 Proposed Tax Reform Gaps! 1.5 Organization of Study...! 2. REVIEW OF TAX PRINCIPLES AND GOALS Economic Efficiency Equity or Fairness Tax Administration Taxation and Growth ESTIMATION OF TAX POTENTIALS Individual Income Tax in Indonesia: Potential Revenue and Its Distribution Assessing the Potential of Corporate Income Tax Assessing the Potential of Value Added Tax (VAT) GAPS ANALYSIS: PERSONAL AND CORPORATE INCOME TAXES Number of Tax Brackets and Top Marginal Tax Rates Taxable Objects and Gross Income Deduction Tax Administration GAPS ANALYSIS: VALUE-ADDED TAXES Taxation on Services Export VAT on General Mining Goods VAT Rate on Specific Goods SUMMARY OF RECOMMENDATIONS...38 REFERENCES...43

3 1. INTRODUCTION Nowadays, the Indonesian government has faced the real challenge to assure its fiscal sustainability in the near and longer future. The continual decline of revenue from oil and gas can no longer be prevented. At the same time, the government s commitment to gradually lessen the budget reliance on foreign debt also gives rise to the worsening government budget funding. Moreover, those funding problems are complicated by the considerable needs for fund to support, particularly, the ongoing decentralization process as well as the completion of the economic recovery process. By considering the above factors, as a result, efforts should be made particularly to mobilize funding and increase the efficiency of expenditure. At the revenue side, the Indonesian government has no other choice but to effectively mobilize revenue from taxes. Taxes have a great potential to be the main source of government funding. New tax increases can be achieved through improved taxation administration or by expanding the tax basis or by increasing rates. Nonetheless tax implementation up to 2003 shows that there is still the opportunity to increase national revenue without having to increase current rates. There are a number of indicators that illustrate this, including: 1. Tax Ratio in Indonesia is still relatively low compared to other countries. The Indonesia non oil and natural gas tax revenue ratio for 2003 is still as much as 11.9%, far lower than many countries with per capital incomes lower than Indonesia, like India (11.49%), Pakistan (13.76%), Srilanka (19.8%) and other developed countries like Philippines (11%), Thailand (16.5%), Korea (16.07%) and Malaysia (18.5%). 2. The filing ratio, i.e. the ratio between taxpayers that actually pay taxes and registered taxpayers who are unable to afford the three main taxes, individual income tax, commercial income tax and added value tax. For the three types mentioned especially for income tax, the amount of actual taxpayers compared to those registered shows a decrease in the last year. 3. Realization of tax revenue for all types of taxes: income tax and VAT is still below potential. The Administration efficiency ratio (AER) the ratio of actual tax revenue to potential is still quite low. The 1998 IMF 1

4 study show that the AER for individual income tax was the lowest compared to two other types of taxes. This illustrates that not only the amount of taxpayers is low, but also that many taxpayers do not pay the required amount. 4. The elasticity of tax collection for all types of tax is till greater than one, in fact for certain taxes like added value tax, import duty, excise duty and land and construction tax, elasticity is still greater than two. This shows that the in actuality the tax potential is yet to be reached. 5. The distribution of tax revenue is still concentrated on too few tax payers. For example, in 2002, 1% of registered individual tax payers contributed to about 50% of PIT revenues while 2% of registered tax payers contributed to more than 80% of corporate income tax revenues. Those figures revealed a significant potential for tax revenue expansion through tax base expansion rather than an increase in tax rates. The high level of concentration of tax revenue also shows the high level of tax revenue vulnerability. It also calls for a broader tax revenue basis. All five indicators mentioned above illustrate once more that without increasing rates and by increasing the capacity of tax administration and expanding the tax base, tax collection/revenue will increase. The need to reform the tax system in Indonesia is also raised from business competitiveness perspective. With a more integrated world economy, a tax system plays one of the main indicators for investment climate. As a result, tax competition among countries particularly developing countries is intensified in order to attract more investors both domestic and foreign ones to put their portfolio in their countries, Realizing those demands, the Indonesian government through Ditjen Pajak (DJP) has initiated the introduction of a new stipulation proposal for the Indonesian tax reform. At the same time, the government s proposal has been challenged by the KPEN team (i.e., Kadin) that also has proposed its own version proposal. Indeed, both proposals seem to focus on similar efforts to expand the fiscal base and improve the tax administration. However, in implementation, their ideas are somewhat different. Therefore, there need some studies that provide a proper recommendation to fill such gaps along with estimations of tax potentials in those 2

5 respective taxes in Indonesia. In principle, regardless of the different proposals for the Indonesian tax reform, the new tax system should be able to meet the main principles and goals of taxation more appropriately. Based on this consideration, accordingly, this study attempts to evaluate the main different ideas from both parties and eventually comes up with some recommendations. This paper is orginzed as followed. Following this introductory section, Section 2 presents a literature review that covers the basic principles and goals of taxation. This principles allow us to evaluate the on going tax reform in Indonesia. Section 3 specifies estimation methods to calculate tax revenue potentials in Indonesia, as well as provides its estimation results. Respectively, tax potentials that are estimated in this study are personal income tax, corporate income tax, and value-added tax (or VAT). In Section 4 and 5, gaps arising from tax reform proposals of Ditjen Pajak and the KPEN team are analyzed and evaluated. The analysis eventually results in some recommendations that are summarized in Section 6. 3

6 2. REVIEW OF TAX PRINCIPLES AND GOALS 1 The main purpose of taxation is to generate sufficient revenue to finance public sector activities. Lack of sufficient revenue often results in large budget deficits. In normal economic condition, deficits generally have undesirable macroeconomic consequences such as crowding out private investment and increasing inflation. Moreover, in many countries, this condition pushes the respective government to raise funds from foreign loans. This is certainly not an effective solution, especially in the long run, because such kind of funds, soon or later, must be returned through government s own source revenue. Despite the fact that tax revenue can be used to anticipate current year (short-run) shortfalls, tax reforms should be undertaken to achieve long-term objectives. Frequent tax changes may increase enforcement and compliance costs as well as efficiency costs. Businesses usually make production and location decisions on the basis of a particular tax structure. Moreover, behaviors of some other taxpayers are also affected by tax changes. They can change their behavior temporarily or even permanently due to tax changes. Apart from the discussion above, tax design in one country must at least satisfy three main criteria, namely economics efficiency, tax equity or fairness, and simple and feasible tax administration. In addition, economic growth objective usually needs to be accompanied by tax design in certain ways. 2.1 Economic Efficiency In economic terms, the amount of taxes themselves is not a cost. Taxes are simply a means of transferring resources from private to public use. Economic costs are incurred only when the amount of resources available for society s use, whether for public or private purposes, is reduced by taxes (Bird, 2003). Both administration and compliance costs are considered economic costs resulted from taxation. The former arises when taxes are collected, 1 Most part of this section is taken from Bird (2003), Tanzi (2001), and Stiglitz (2000) 4

7 while the later is born by taxpayers (or other parties that withhold taxpayers obligation) when they meet their tax obligations. Compliance costs include the time and financial costs of complying with the tax law. In this respect, there can be a tradeoff between administration and compliance costs, particularly in the self-assessment tax system. When taxpayers are required to fill the tax form themselves and provide more information, compliance costs respectively increases, while at the same time, it makes administration cost reduced. In other cases, however, a more sophisticated tax administration may result in the increase of both costs. The other economic costs arise when taxes change economic agents behavior in a certain way. For instance, taxes on wages may reduce incentives to work, and failure to tax capital gains until they are realized encourages the holding of assets (a lock-in-effect). That is why efficiency principle is also named neutrality principle which means that good taxes should be as neutral as possible or able to minimize their impact on changing behavior of economic agents. In economic term, this kind of economic costs is also called deadweight loss or distortion costs. Such costs are real, but they are not directly visible. Since economic inefficiency is incurred with economic costs, good tax policy must attempt to minimize unnecessary economic costs of taxation. Experience suggests three general rules to overcome the problem. First, tax bases should be as broad as possible, and treating all taxable objects as uniformly as possible. 2 Second, tax rates should be set as low as possible and imposed to taxpayers in a single rate on a broad base. Third, careful attention should be given to taxes on production, because, for instance, they affect the location of businesses and change the forms in which business is conducted. Given the general rules of tax efficiency, governments cannot follow them exactly simply because they usually contradict with equity or fairness arguments as explained below. For the sake of equity, usually different tax 2 Commodity taxation is one exception. As observed by Ramsey (1927), uniform commodity taxation is similar with taxes on wages and it gives rise to economic inefficiency, i.e., it discourages works since leisure is untaxed commodity. Therefore, different tax treatment is required for different types of commodity. 5

8 treatment and different tax rate are preferable. Therefore, there needs to be a balance between the two tax principles. 2.2 Equity or Fairness There are two traditional approaches have been used to define fairness. The first approach is called ability to pay principle. According to this principle, there are two concepts of equity, namely horizontal and vertical equity. Individuals who are the same in all relevant aspects (i.e., horizontal similarity) are treated the same and pay the same tax, while individuals who have greater ability to pay (i.e, vertical difference) should pay more tax. In the second approach, higher tax is imposed to individuals that receive higher benefit from public services; hence this approach is called benefit approach. In reality, the first approach has been widely accepted. Unfortunately, two concepts in the ability to pay principle may have limited usefulness in tax policy debates. Horizontal equity may lose its relevance because 1) no one, in fact, is identical in all aspects; 2) the concept focuses only on a short time period, and it ignores many benefits that may be received by individuals; and 3) it is difficult to determine which differences are important and why these differences justify different tax treatment. Vertical equity may also in practice be implemented in different ways. Both advocates of flat and progressive tax rates, for example, can fairly justify that their tax design reflect vertical equity. Similarly, the proponents of consumption tax may look their idea better reflect the vertical equity principle than the proponents of income tax. In the end, only through its political institutions can any country really define and implement its view of what is an acceptably fair tax system. Apart from the fairness consideration above, in the perspective of social and economic inequality, the fairness can also be approached from the overall impacts in any tax changes on the distribution of income as well as the overall equity. For instance, in a country like the Russian Federation, indirect taxes such as a VAT and excise taxes may be considered more equitable than income tax. The reason is because untaxed sector in this country is the relatively large shadow economy, and consequently income 6

9 tax is unfairly and largely borne only by government employees and employees of formal market firms. In other case, it is also desirable to exempt certain basic needs items from the broad-based consumption tax simply because it can heavily affect the poor. In addition, economists also consider the economic incidence of taxation in determining the fairness of a tax regime. Individuals who have the liability to pay a particular tax do not necessarily bear the whole burden of tax. In most cases, tax burden is economically shifted to other related parties. For instance, tax imposed on producers is shifted by producers to consumers in the form of price increase, or employees wages are reduced by certain amount due to tax imposed on employers. Determining tax incidence requires a good understanding of how various markets operate in an economy, particularly the ability of different types of taxpayers to shift the cost of the tax to other economic agents. Who actually bears taxes depends on the relative supply and demand elasticity of consumers and suppliers and other factors. The incidence of a corporate income tax, for example, depends on elasticity of supply curve that is affected by such factors as (1) the openness of the overall economy in terms of the inflows and outflows of capital investment; (2) the extent to which capital moves between the corporate and unincorporated sectors; and (3) the relative capital-intensity of corporations. The tax incidence also depends on the corporate elasticity of demand for goods produced by corporations and other businesses. Two other considerations add to the difficulty of trying to determine the tax burden of both individuals and groups of individuals in different income classes. The first factor is the necessity to consider the tax incidence of a group of taxes. Second, a complete analysis of incidence requires consideration of all parts of government activities, i.e., both taxes and benefits from government expenditure programs. For example, a complete analysis of the incidence of a social security tax requires estimates of the incidence of the tax and the retirement benefits provided under the retirement system. 7

10 2.3 Tax Administration Tax policy design must take into account the administrative dimension of taxation. The resources used in administering and complying with taxes are real economic costs, in terms of the ability of the economy to provide goods and services. Good tax policy requires keeping such costs as low as possible while also achieving revenue, growth, and distributional goals as effectively as possible. Three ingredients seem essential to effective tax administration: (1) the political will to administer the tax system effectively, (2) a clear strategy for achieving this goal, and (3) adequate resources for the task. It helps, of course, if the tax system is well designed, appropriate for the country in question, and relatively simple, but even the best designed tax system will not be properly implemented unless these three conditions are fulfilled. The first task of any tax administration is to facilitate compliance. It can be done by completing the followings: (1) finding taxpayers through the registration process that should be as easy as possible; (2) determining tax liabilities through an administrative procedure or by some self-assessment procedure; (3) collecting the taxes due, which is best done through the banking system; and (4) providing adequate taxpayer service in the form of information, pamphlets, forms, advice agencies, payment facilities, telephone and electronic filing, and so on, to make taxpayer compliance with the system as easy as possible. The second important task is to reduce tax evasion. Tax authorities require estimates of the extent and nature of the potential tax base, for example, by estimating what is sometimes called the tax gap. In some countries the major tax problem may be that many taxpayers who are in the system are substantially under-reporting their tax base. Without some knowledge of the unreported base, and its determinants, no administration can properly allocate its resources to improve tax collection and to ensure all parts of society bear their fair share of the tax burden. In addition to exploring the nature of the tax gap and undertaking the often difficult tasks involved in extending the reach of the tax system into the informal economy to the extent feasible, close attention must also be paid to the simple task of ensuring that those who are in the system file 8

11 on time and pay the amounts due. Adequate interest charges must be imposed on late payments to ensure that non-payment of taxes does not become a cheap source of finance. Similarly, an adequate penalty structure is needed. A third major task is keeping the tax administration honest. Even a sound tax structure and sound expenditure policy can be vitiated by a capricious and corrupt tax administration. Tax officials must be adequately compensated, so that they do not need to steal to live. They should be professionally trained, promoted on the basis of merit, and judged by their adherence to the strictest standards of legality and morality. Tax officials should have relatively little direct contact with taxpayers and even less discretion in deciding how to treat them. 2.4 Taxation and Growth There is no instant tax strategy to encourage economic growth. The relationship between taxes and growth is complex. Many countries have sought to improve their economy by introducing a variety of tax incentives for investment, for savings, for exports, for employment, for regional development, and so forth. Often, such incentives are redundant and ineffective, giving up revenue and complicating the fiscal system without achieving their stated objectives. Despite the undesirable facts above, a so-called pro-growth tax system may have several characteristics. First, there would be little or no taxation of profits, to avoid discouraging entrepreneurship and risk-taking. Taxing profits reduces the return from entrepreneurship and risk-taking. Most countries, however, do tax profits, and properly so for example, to prevent people from placing assets in a corporation to avoid personal income taxes and to obtain a share for the host country of profits earned by foreign investors. Nonetheless, high taxes on profits are unlikely to form part of a growth-oriented tax strategy. Instead, at most a reasonably low and stable broad-based profits tax seems called for. A purely growth-oriented tax strategy would also likely tax consumption more than income. The difference between consumption and income is saving, and from a strict growth perspective, more saving is better 9

12 than less. So if domestic savings are essential to financing domestic investment, there is a growth argument for taxing income from savings more lightly. Even in the most growth-oriented tax system, however, taxes should kept be as low as possible on the poorest people simply because they must consume to be productive. Equity (in the sense of not taxing the poor) and growth (in the sense of enhancing the productivity of the labor force) are thus quite compatible objectives. A good VAT in such a system, for example, might exempt certain specific items that constituted a significant fraction of the consumption of poor people. Finally, a growth-oriented tax system in developing countries may seek to increase the cost of operating in the non-monetized traditional sector (through tax or other measures) to encourage movement into the monetary (modern) sector. Imposing higher taxes on traditional agriculture may be difficult politically and administratively, and it may not necessarily be equitable, but it is likely conducive to growth by shifting resources away from the traditional agriculture sector. 10

13 3. ESTIMATION OF TAX POTENTIALS As illustrated in Table 3.1, our best estimation for tax potential revenue expansion for the next 2-3 year would be 2.1 % of GDP where PIT and CIT contributed more than half of that expansion. This estimate is quite conservative despite some tax incentives proposed by the Government by increasing minimum tax allowances and a reduction in corporate income tax rate. Should this current tax reform initiative implemented, tax revenues collective could be further expanded. We expect within the next five year, total non oil central government tax minus property tax which be proposed shifted as local tax would further expanded to 12.2% to GDP compared to 8,6% in Table 3.1 An Assessment of Tax Revenue Expansion (% of GDP) 3.1 Individual Income Tax in Indonesia: Potential Revenue and Its Distribution 3 The administration system of the individual and corporate income tax in Indonesia has great potential as an additional revenue source in the future through the improvement of the design and administration as influenced by economic growth. In 2003 the non oil and gas tax contribution reached 40.4 % for the total central government tax revenue, with approximately two thirds amounting from individual income tax. Income tax also makes up the only developing component of the national taxation system including rapid 3 This section mainly derived from Mark (2003). 11

14 growth and higher average tax rates for families with middle to high incomes compared to families with middle to low income levels. In this discussion, income tax is distinguished from other taxes based on the most general commodities applied in Indonesia like added value tax, excise duty and customs taxes. 4 This assessment focuses on the income potential and the allocation of tax in the individual income tax system in Indonesia. This assessment refers to the calculation of tax payer incomes from tens of thousands of families from the 2002 national economic and social census (Susesnas). The analysis framework developed in this assessment is an initial step carried out though examination of the impact of income from improvements of the administration and design changes to the individual income tax management system. For instance, we can determine the impact of income tax on farmers and the impact of changing the tax free income structure or the growth of taxes. This assessment also provides further information on how the income tax burden is spread across families through income distribution. Findings Table 3.2 shows a number of general characteristics of the tax payer population in Indonesia based on an analysis of the census sample data. A sample of 52.6 million families revealed 63.1 million tax payers. This analysis tends to minimize the total amount of possible tax payers in a family, as income from non-civil servant census data is reported as one unit for a family. It is highly probable that a number of family members in a family have individual non-civil servant incomes, meaning they themselves are tax payers in accordance with tax regulations in Indonesia. In addition, 69% of families have income from farming sources and 36.4% have income from non-farming sources. Approximately 33.7 % of families receive tax free incomes. 4 Luxury goods tax has been supported; however it has not reached the growth levels achieved by income tax in the middle to high level. For example, luxury taxes on items like soft drinks, various types of shoes and electronic goods like mobile telephones have increased. 12

15 Table 3.2 Characteristics of Households in Indonesia in the 2003 SUSENAS Total amount of households (million) Amount of tax payers (million) Percentage of households with income from farming Percentage of households with income from non-farming Percentage of households that can submit a claim for reduction Percentage of tax free households (zero income tax) Aggregate Income Potential Table 3.3 shows a number of important aggregate assumptions resulting from the analysis. 5 The total family income calculated reached Rp trillion. 6 These findings should be compared to the official government estimation in the form of GDP, national incomes, and family consumption in 2002 that also displayed the same table. The Susesnas sample clearly reported the amount of family income below the actual amount; however it is not yet known how great the difference is. 7 Perhaps the reason is the principle that families report an amount of income to survey officials that is below the actual amount. Because families also tend to report their income below the actual value to tax officials, this bias is more accurate than the official government calculated tax potential. From the estimated Rp trillion total family incomes, approximately Rp trillion are included in income tax article 21 and 25 and only Rp. 2.1 trillion is included in article 23 (mainly in interest, dividends and royalties). 5 The source of the official introductory hypothesis is in the form of GDP and related findings based on Bank Indonesia, Indonesian Financial Economy, Jakarta, March 2003 Table IX.3. Source of official taxable income received from Ministry of Finance, Financial Statements and APBN 2003 program, Jakarta Appendix 1. 6 This funding is taxable income. Various families that have lost their businesses have negative income for the related year. However tax regulations resolve families in this case and take responsibility for loses to collect business profits in the next five years. If these losses are increased, then the taxable aggregate income findings will decrease to Rp trillion. 7 National income is different from family income in principle because the proportion of national income cannot flow to families. 13

16 The payment of individual income tax of Rp trillion was calculated from a sample under the assumption explained in the last paragraph. From this amount, Rp trillion is covered in income tax article 21 and 25, while Rp. 0.4 trillion is discussed in article 23. The income estimate above can be compared to the income from non oil and gas tax shown in Table 2. Included in the official government data is tax payment article 25 for final individual income tax, and individual income tax for assets in article 23. Total income from individual income tax is Rp trillion, meaning only 43% of the potential income from individual income tax that was estimated from the survey results. If non-oil and gas income from companies is included, the total income reaches 78.7 trillion, or approximately 69% of the potential tax revenue from individual income tax estimated from the survey results data. Table 3.3 Total Estimated Aggregate Results from the 2002 Susesnas Compared to the 2002 Data Publication (Trillion Rupiah) Total household income Household income covered in article 21 and 25 Household income covered in article Comparison of Realization Gross Domestic Product National Income Household consumption Total Individual income tax payments Covered in article 21 and 25 Covered in 23 Comparison compared to Realization Individual income tax covered in article 21 Income tax paid at the end of the year covered in article 25 Individual Organization/corporation Individual income tax from Final Nature Individual income tax covered in article 23 Total individual tax income Total income tax payments

17 A number or portions of income from family business that have been reported in the Susesnas are not doubted to be based on legitimate family businesses. Now, all corporate/business income tax payments originate from medium and large companies, and only a small amount from legitimate small family businesses. This consideration requires more research, but if this is the case then it means that actual income from individual income tax from families is close to the official estimation of individual income tax without adding corporate/business income tax. This issue illustrates that the income data reported in the Susesnas is much smaller than the real figure, and this is a serious factor that must be considered further. On the other hand, the variation of types of incomes reports in the Susenas is in reality very difficult to apply to tax, because there are informal regulations to determine the substance of transactions in the Indonesian economy. This report will discuss this problem later, as an important topic for the analysis of the results of the survey for the future. Finally, we need to record that there is one area where a clear deviation in the estimated potential income based on the survey results occurs, namely in income tax on assets in accordance with article 23. The amount of payments taken from the survey data only amount to Rp. 0.4 trillion, whereas the actual amount of income in 2003 reached Rp trillion. This provides the impression that reported income from assets is smaller than that recorded in the survey results. Alternative Scenario Finally as a simplification from the sensitivity analysis, table 3 compares two alternative scenarios with the following characteristics: Firstly, input from farming enterprise is removed from family income, due to the difficulty of determining tax from this type of income. Secondly, only civil servant income (salary and pension) is included in family income, because this type of income is the easiest to determine. The removal of income from farming reduces the aggregate income estimation by 0.17% to Rp trillion. Considering farming, forestry, 15

18 fishery and animal husbandry contributes 17.5% of the 2003 GDP. Two explanations regarding this issue can be presented. Firstly, that this type of income is reported relatively smaller than the facts in the Susenas sample, in line with the opinion that farming income is difficult to determine as taxable. The other explanation maintains that the production in the farming sector may involve businesses that are much larger than small scale family business. In another case, the removal of income from farming reduces income tax payments by 1.7% to become Rp trillion. A simple explanation, in line with the empirical evidence is that families involved in farming are those families in the middle to low income category. Most of their income is tax free and they tend to be considered low value tax payers. Entering merely the income of civil servants reduces the incomes as much as 35.5% compared to the standard, becoming Rp trillion. However, the revenue potential only reduces by approximately 11.4% to become Rp trillion. Table 3.4 Alternative Scenario for Income Tax Total Households Income Based on all types of income With removal of income from farming Only including civil servant salaries Total Individual Income Tax Payments Based on all types of incomes With removal; of farming income Only including income from civil servants Percentage of tax free Household Income Tax Payments Based on all types of incomes With removal; of farming income Only including income from civil servants Absolute (Trillion Rp) Relative (%) Conclusion Various findings resulting from this assessment include: 1. Total family income calculated reached Rp trillion, where approximately Rp trillion included in income tax article 21 and 25 16

19 and Rp. 2.1 trillion included in income tax article 23 (mainly interest, dividends, and royalties) 2. From the total income above, tax revenue should reach of Rp trillion, while in reality only Rp trillion was obtained. This means that only 43% of the total estimated tax collection was achieved. 3. If non oil and gas income tax from business is included, the total income reached 78.7 trillion, or about 69% of the potential tax revenue from individual income tax estimated from the results of the survey. 4. Differences in estimation occurs in the estimated potential income based on the survey results, namely on income tax on assets in accordance with article 23. The amount of payments taken from the survey data only reached Rp. 0.4 trillion whereas the actual amount of income in 2003 reached Rp trillion. This gives the impression that reported income from assets is smaller than that amount in the survey results. 5. By establishing a scenario, namely the removal of income from farming, this is estimated to reduce the aggregate income by 0.17% to Rp trillion. And reduce tax payments by 1.7% to Rp trillion. A simple explanation, in line with empirical evidence shows that families involved in farming are middle to low income earners. 6. The second scenario is a calculation only including the income of civil servants. This scenario reduced revenue by 35.5% of the standard, to Rp trillion. However, the income potential only reduces by 11.4% to Rp trillion. 3.2 Assessing the Potential of Corporate Income Tax In assessing the corporate income tax we have utilized data from the Social Accounting Matrices (SAM) in 2000 and the corporate tax based GDP estimation published by the Center Bureau of Statistic (BPS) in Some steps to asses the potential of corporate income tax are: 1. To estimate the company s profit share of GDP. Based on SAM s data either before the crisis or from 2000, the profit share is relatively stable at about % of GDP. This profit share is presumed constant and produces the company s total profit of Rp trillion in

20 2. The amount of corporate income tax depends on profit distribution. In estimating such profit sharing we utilized the results of the BPS survey which is grouped by the company s scale. 3. From the amount of percentage of GDP share grouped by company scale, the produced company profit is based on the their scale group (See Table.1). This profit then is multiplied by the current tax rate and produces the amount of tax that should be paid by the company. 4. The average CIT potential per each company is then multiplied by the number of companies and results in a total CIT potential of about Rp trillion or 6.24% of GDP. Table 3.5 Estimating Corporate Income Tax Revenue Potential, Corporate Share in VA i Total Number Profit/ CIT Size GDP Profit Company Company Potential (percent) (Rp Tr) (Rp Tr) (million) (Rp mill) (Rp Tr) (1) (2) (3) (4) (5) (6) (7) 2000 Small Medium , Large , Total 1, , In percentage to GDP Small Medium , Large , Total 2, , In percentage to GDP 6.24 Memo items Profit Ratio to GDP Assessing the Potential of Value Added Tax (VAT) Value Added Tax (VAT) in Indonesia is in accordance with the general international regulations implement in various countries, including: 1. VAT on the expenditure of capital goods postponed on tax obligations. Meaning that VAT is essentially a consumption tax. 18

21 Investment expenditure tax slows the growth of the economy and development. 2. Export tax is zero, while imports attract compulsory tax; this is based on the destination principle from VAT regulations. This approach is consistent with the implementation in other countries. 3. To simplify and clarify administration, a VAT level system is implemented. This factor is to avoid mistakes in the classification of goods and services. 4. Retail transition is also subject to VAT. However, while other countries exempt various goods and services, Indonesia exempts more goods and major services. In estimation the VAT potential revenues, we follow Mark (2005). As in other countries, the Indonesian VAT system, export tax is exempted, but imports are taxable. Certainly various imported products are taxexempt, and others are utilized as input products for companies where these products are exempt from tax. There are types of goods and services within the economy. For goods to-i, the condition of a balanced market is: (1) Qi + M i = aijq n j= 1 j + C i + X i If the company produces goods i that are subject VAT, then this is calculated: (2) Ti = ti pi ( Qi X i ) δ i t n j= 1 j With imports the VAT revenue is increased with import tax: n (3) TM = t i= 1 i p M i i p j a ji Q i Total VAT revenue is the amount between the equation (2) and (3), which can be written as: n (4) T = t p ( Q X ) δ i i i i i j j ji i i= 1 j= 1 i= 1 n t p a Q + n t p M i i i 19

22 With the definition provided in the equation (1) then the equation (4) changes to become: n (5) T = ti pici + ti pi i= 1 i= 1 j= 1 n h ( 1 δ ) a Q j ij Equation (5) shows that if there are goods that are tax free (ti=di=0), then the VAT revenue is from tax paid on the purchasing input. While if the goods mentioned are taxable, then the VAT revenue can be calculated from household consumption tax for the goods mentioned. j 2) Calculation Scenarios When calculating the potential VAT revenue in 2002 we use six scenarios: Scenario 1. Tax stipulation is in accordance with regulations implemented where the sectors are, like sectors with codes 01, 03, 24, 25, 26, 29, 51, 54, 55, 56, 57, 61, 63, and 64 are not subject to VAT. Scenario 2. If scenario 1 is altered to establish VAT on electricity, gas and drinking water sectors (code 51). Scenario 3. If scenario 1 is changed to establish VAT on coal and metal mining (code 24), along with Mining and other excavations. Scenario 4. Consolidation of scenario 2 and 3. Scenario 5. Scenario 4 with the addition of the imposition of VAT on oil, gas and geothermal (code 25). Scenario 6. If all sectors are subject to VAT 3) Simulation Results Table 3.6 and 3.7 below show explicitly that the potential tax revenue for 2003 increased as much as 3.6% of the GDP compared to the potential in With the actual tax revenue the same in both years mentioned, this illustrates the decrease of efficiency of tax collection in Table 3.6 Difference in Actual and Potential VAT Revenue, 2000 (percentage of GDP) 20

23 Scenario Actual Potential Ratio (1) (2) (1)/(2) Table 3.7 Difference in Actual and Potential VAT Revenue, 2003 (percentage of GDP) Scenario Actual Potential Ratio (1) (2) (1)/(2) Both tables show clearly the government stipulation of VAT laws that exist at the present. VAT revenue can still be raised by 46.95% and 52.13% of the actual VAT revenue in 2000 and 2003 (Scenario 1). In order to increase the revenue gained from VAT we can still endeavor to make tax collection more effective, without having to increase VAT tariffs and impose more taxable objects. If the government decides to impose VAT in the electricity, gas, and drinking water sector (scenario 2) the potential for the government to obtain a rise in tax revenues is greater than if VAT imposed on oil, gas, and geothermal sector. While if VAT is imposed on the coal and mineral mining sector, along with other mining and excavation sectors (scenario 3), the revenue potential for VAT will decrease as much as 3% from the normal potential. If all sectors attract VAT, the increase of tax revenue is estimated (Scenario 6) at about 67.07% and 73.47% of the actual VAT revenue from 2000 and 21

24 2003. In other words if all sectors attract VAT this will increase the potential revenue by 13.6% in 2000 and 14.03% in 2003 from the normal revenue potential. Although a significant increase, it will probably bring about pros and cons in general society. 4. REVIEW ON TWO COMPETING TAX PROPOSALS ON INCOME TAX BILL. In this section we will review those two competing proposals from the GOI and the Indonesian Business Communities (hereafter KPEN). We analyze those proposal according to the subject of interest. We begin our analysis on the discussion over rates and followed by the discussion on tax objects. 4.1 Number of Tax Brackets and Top Marginal Tax Rates Decisions regarding number of tax brackets, particularly in personal income tax, aim at enhancing tax equity as well as raising more revenue. It is expected that more tax brackets may result in more progressivity, and accordingly more equity. In so doing, such number of tax brackets should be administratively feasible, competitive (compared with other countries), and more likely to broaden the tax bases. Moreover, careful attention should also be paid to the choice and the level of tax deduction or exemption items that probably undercuts the progressivity and more benefits high income people. In Indonesia, tax deduction or exemption items are very limited, since social security system in Indonesia is not yet well developed. There are only common personal and dependence allowance, complemented with an optional zakat deduction for Moslem citizens. As a result, in deciding number of tax brackets, more concern should be devoted on such factors as tax progressivity and tax competitiveness, tax administration, and number of tax bases. Table 4.1 Proposed Changes of Non Taxable Income (Rupiah) Present Proposed Changes Individual Tax Payer 2,880,000 12,000,000 Married Tax Payer 1,440,000 1,200,000 For Wife with Combined Income 2,880,000 12,000,000 22

25 For Dependents 1,440,000 1,200,000 Maximum Dependents (per family) 3 people 2 people Maximum 8,640,000 15,600,000 The first proposal gap between Ditjen Pajak and the KPEN team is concerning the change in number of personal income tax brackets. Ditjen Pajak proposed the idea of reducing tax brackets from five to four tax brackets that eliminates the lowest 5 percent bracket. In addition, as revealed in Table 4.1 above, Ditjen Pajak also proposed changes of non taxable income (PTKP). The prior maximum PTKP is 8.6 million rupiahs, while the proposed maximum PTKP is double to more than 15 million rupiahs. On the other hand, the KPEN team insisted to have five brackets with the underlying rationale that the poor will be heavily affected by the higher 10 percent tariff. In order to evaluate both progressivity and competitiveness of current tax system, there needs the calculation of effective rates of personal income tax. As calculated by Ikhsan et.al. (2004), effective personal income tax rates in Indonesia as well as their comparisons with some other countries are depicted in Figure 4.1 below. Figure 4.1 Comparisons of the Effective Personal Income Tax Rates to Levels of Income in Various Countries 23

26 Source: Ikhsan et.al.(2004) From the figure above, we can observe the slope of each effective tariff line. Effective tariff line of Indonesia is relatively steeper than that of Malaysia, Cambodia, and, to some extent, Philippines. It indicates that Indonesian personal tax is relatively more progressive than those respective countries. On the other hand, the figure also shows that Indonesian personal tax is more competitive than most countries in the figure, except for Malaysia and Cambodia. The removal of the lowest bracket (5 percent bracket) slightly reduce both tax progressivity and tax competitiveness of income level in the new lowest bracket (10 percent bracket), since the maximum PTKP is now also double. Nevertheless, overall tax progressivity, indeed, is improved without changing efficiency or competitiveness too much. Instead now, the tax administration is more simplified and thus most likely to increase more tax bases as well as tax revenue. Moreover, the fear of the KPEN team that the poor is heavily affected by the tariff increase will not materialize. The tariff increase is sufficiently compensated with the higher maximum PTKP for the poor. Therefore, this policy needs support to be implemented in Indonesian tax system. Table 4.2 Number of Tax Brackets and Top Marginal Tax Rates for both Personal and Corporate Taxpayers 24

27 Source: LPEM UI and various sources, mainly from the Tax Authority website of those respective countries 25

28 Apart from the discussions regarding tax brackets, Table 4.2 also shows top marginal tax rates of both personal and corporate income taxes in various selected countries. The proposals of Ditjen Pajak and the KPEN team regarding these rates are slightly different (i.e., the second and the third proposal gaps). Ditjen Pajak proposed the maximum rate of 30 percent for personal income tax, and the maximum 5 percent increase depending on local governments decisions. Corporate tax rate was proposed to be a single flat rate of 28 percent that will gradually decline to 25 percent within three years. 8 On the other hand, the KPEN team suggested the maximum rate of 30 percent for personal income tax and the single rate of 25 percent for corporate income tax. Decisions regarding top marginal tax rates in both kinds of taxes should be made mainly on the basis of raising revenue, tax competitiveness and tax harmonization concerns. Tax competitiveness is required in any country especially to attract foreign investment and to avoid tax revenue flight. As a consequence, the maximum tariff, either in multiple rates or single rate system, should be set as comparable as in other countries, i.e., not too high and not too low. Moreover, the maximum tariff in both kinds of income taxes should also be harmonized. In practice, too big gap between the two top rates may provide a strong incentive for some taxpayers to shift their tax burden to one tax that has a lower tax rate. Therefore, in support to this analysis, again we need to know effective rates of both top marginal tariffs in personal and corporate income taxes that complement the information provided in Table 4.2. From Table 4.2, we can roughly observe that the gaps between top marginal tax rates in personal and corporate income tax vary among countries. Five countries, namely the U.K., South Korea, Thailand, Cambodia, and China, have relatively big gaps, while the other countries have either no gap or narrow gaps. Furthermore, top official rates of both personal and corporate income taxes are relatively competitive. Indonesian official rate of personal income tax in the highest bracket is 35 percent, which is higher than that in Malaysia, Philippines, Singapore, and 8 Except for SMEs, corporate tax tariff is set 10 percent, and the KPEN team already agreed with this proposal 26

29 Cambodia. On the other hand, for corporate income tax, Indonesian official rate is only higher than that in Singapore and South Korea. Figure 4.2 Comparison of Effective Corporate Income Tax Rates in Indonesia and in Several Neighboring Countries Source: Directorate General of Tax, Academic Assessment Report, 2003 Nevertheless, the above information may not show a true picture. Different tax exemptions, tax deductions, and tax credits can diminish the effective tax rate in each country, while compliance costs (either legal or illegal through bribery activities) that may arise can boost up the effective tax rate. Based on the simulation of effective income tax tariff calculations, Indonesia is still relatively more competitive than Vietnam, China, Thailand, and all selected developed countries for all levels of profit (see Figure 4.2 and 4.3). However, for levels of profit above $25,000, the most competitive is Cambodia. Indonesia is still also more competitive when compared to the effective tariff levels in Malaysia for levels of profit up to $115,000. Figure 4.2 Comparison of Effective Corporation Tax Rate, FY

30 Source: the Ministry of Finance, Japan From Figures 4.1 and 4.2, effective personal income tax rate in the top bracket is approaching 30 percent, while in corporate income tax, the maximum rate is approaching 28 percent. This is indeed relatively ideal composition, both in competitiveness and harmonization point of view. However, as argued by the KPEN team, effective corporate tax rate could even be higher with so many illegal official activities such as bribery that should be borne by companies. This kind of problem is rarely found in personal income tax compliance. Even though this condition should be accommodated by the Indonesian government, indeed, corporate tax rate cannot be set too low. First, in the competitiveness point of view, it is clear that such problem is not only faced by Indonesian firms, but also firms in our neighboring countries that have similar administrative problem. Perhaps hence, 28