How to stimulate Indonesia's economy

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.