How to stimulate Indonesia's economy

David E. Sumual, Jakarta

President Megawati Soekarnoputri fulfilled the yearly ritual of the address to the nation last week, unveiling the government's draft 2005 budget. Staying with a similar budget policy that it has had over the last five years, the government continues to rely on orthodox fiscal consolidation methods, calling for further reductions in the deficit from 1.2 percent of gross domestic product (GDP) in 2004 to a more contractionary budgeted deficit of 0.8 percent in 2005.

Five consecutive years of uninterrupted fiscal consolidation show that the government is not comfortable to consider Keynesian (economic model) options to revive the economy. Seemingly based on the rational expectations argument, the government argues that fiscal policy is not so effective in boosting the economy.

Although the credit risk has fallen gradually since 1998 (as seen by upgrades in sovereign credit ratings from triple C to B in 2004), the government also seems to continuously focus on monetizing its debt, in which total debt to GDP ratio has actually fallen from 98 percent in 2000 to 60.1 percent in 2004.

The government has set in its 2005 state budget payment for domestic debt interest at Rp 38.8 trillion and external debt interest at Rp 25.1 trillion. As such, like the previous budgets in the past five years, the spending plan is likely to have a contractionary affect on the economy, as a significant portion of the government's expenditures will be going toward payments and foreign debt.

Actually, the government may come up with the more "lean against the wind policies" to shore up the current easing monetary environment. Without explicit policies to increase demand, the current slow growth will remain, undermining for long-term sustainable growth. However, boosting government spending is not the only option.

Unlike developed countries like the U.S. or Japan, boosting Indonesia's economy through government spending would be ineffective due to the higher probability of leakages. As most of Indonesia's institutional arrangements are still susceptible to corruption, a tax stimulus would be a preferable choice.

Other than boosting government spending, the government could instead give a tax stimulus to break the vicious circle of low investment spending. Cash in the hands of consumers or entrepreneurs would be expected to stimulate the economy. However, such a tax stimulus should be defined with a specific target. And what the country needs are actually targeted fiscal incentives to boost the current dilapidated investment spending nationally.

For instance, the government could give a broad, two-year temporary investment tax exemption that pays 10 percent of company capital spending for equipment and machinery. It would, of course, substantially raise the business spending by making such an expenditure 10 percent cheaper today than it would be after 2006.

Another similar tax incentive for companies in the form of a decrease in excise duty for the importation of machinery could also have a major affect on the country's investment spending. If these steps succeed in preventing a deep decline in investment activity, the result could be only a small increase in the size of the budget deficit, or even a small decrease due to higher output expected.

To the extent that is necessary to offset a revenue loss, this would ideally be done by a well-calculated reduction in oil subsidies, which may explode in the months to come due to higher oil prices. This kind of tax stimulus has proven to be effective, as evidenced by the revival of the electronics industry last year. The economic effect has multiplied more than the Rp 6 trillion tax stimulus given by the government in the form of reducing and canceling several luxury goods taxes (PPnBM) in 2003. Analysis by the DRI economic team suggests that the above targeted tax proposal that focused on companies' capital spending would be equal to the stimulus of roughly 2 percent of a Bank Indonesia easing of interest rates.

Obviously, monetary policy is now the sole focus of Indonesia's attempts to breathe life into the economy. The short- term benchmark interest rate has been driven down to 7.3 percent, but the room for continued easing might be limited. There are also fears that the global economy may not be as robust as hoped this year as the current oil shock may rein in global economic expansion.

Domestically, Indonesia also continues to experience slow growth. The country's second quarter GDP growth was disappointing, and in sharp contrast to the strong economic revivals being witnessed in the economies of neighbors such as Malaysia and Thailand. The economy continues to run on the single engine of private consumption, and even that engine of growth as seen by the latest data is starting to slow down.

The Central Statistics Agency (BPS) announced that the growth in the second quarter of this year was only 4.32 percent year on year, down from 4.80 percent in the same period last year. More worryingly, private investment growth was only 5.26 percent year on year in the second quarter, down from 5.65 percent growth in the first quarter of 2004. The same story occurred in foreign investment approvals that reached only 3.3 billion dollars for the January-July period this year, falling 33.6 percent from 4.97 billion dollars in investments pledged in the same period last year.

Given the possibility of slowing global growth and the investment that continues to remain at sub-optimal levels, the economy needs a larger fiscal stimulus than the already proposed budget. To cope with this current development and to meet the assumption of 5.4 percent economic growth, the government needs whatever economic tools it has at its disposal to revive the economy. One of the tools should be the tax stimulus that is specified for boosting the investment climate in Indonesia.

The writer is an analyst at Danareksa Research Institute. This article is a personal view.