It's time to abolish income tax

By James Castle and Peter Duncan

JAKARTA (JP): Despite attempts at reform over several decades, Indonesia's income tax system continues to be a major disincentive to investment. Abolishing the income tax would be a dramatic and strong move to kick start Indonesia into economic recovery.

Taken at face value, Indonesia's personal and corporate income tax rates of 30 percent are among the most modest in the world. But international accounting firms and foreign investors report that the income tax system's high prepayments, slow refunds, arbitrary denials of deductions and lack of an independent arbitration process make Indonesia one of the most highly taxed business sites in Asia.

Indeed, these sources have gone so far to say that business in Indonesia has been hamstrung throughout the last three decades by an arbitrary, obstructionist income tax bureaucracy. Radical tax reform should, therefore, be an essential component of the political, legal and social reform now being contemplated.

Getting rid of both the corporate and personal income tax would not only produce immense economic benefits by shifting tax modes from production to consumption and removing incentives for false accounting, but it would also send a strong signal that the government is committed to removing one of the most pernicious sources of corruption in the country.

First reactions to such a proposal are likely to be "Great, but impossible! How could the government possibly operate without an income tax?" But in fact, income tax revenues for this fiscal year may amount to no more than 9 percent of the budget after it has been revised to conform with a 15 percent decline in GDP and inflation of 100 percent.

Such projections would result in a budget deficit of Rp 31.9 trillion. This could be covered by privatization revenues -- not an overly unreasonable amount if privatization is vigorously implemented. Indeed, the Thatcher government of the United Kingdom used privatization proceeds to reduce its public sector borrowing.

This budget would include revenues of Rp 12.8 trillion from value-added taxes, Rp 39.5 trillion from luxury taxes and Rp 19.8 trillion in subsidy outlays.

Income tax revenues in the first 1998/1999 budget were projected at 24 percent of internal revenues and 3.6 percent of GDP. They made up 22 percent of internal revenues and 3.3 percent of GDP in the revised budget. Income tax revenues may fall to about 9 percent of internal revenues and 1.2 percent of GDP if the rupiah stabilizes at the 10,000 per U.S. dollar level, if inflation runs about 100 percent, if very little is collected in corporate income tax this year and if personal income tax is much less than last year.

Furthermore, under current roles (if accepted by tax authorities), corporate Indonesia will be entitled to huge loss carryforwards, compromising the potential of income tax revenue for years to come.

Value-added taxes were 106 percent of income tax in the original budget, 109 percent in the revised budget and could be 310 percent in the hypothetical budget we suggest.

So elimination of income tax revenues as estimated for the hypothetical budget would not be an unmanageable option from a budgetary standpoint. Based on the hypothetical budget, an increase of 33 percent in value-added taxes to a rate of 13.3 percent would cover the loss in income tax revenue.

Budgets for subsequent fiscal years would benefit from the supply side effects of increased economic activity, further reform and increased value-added tax and other revenues. Future budgets could also be balanced by additional revenues from privatization.

Abolishing the income tax could also increase spending potential at a time when it is sorely needed, reduce corruption, free up business and personal finances for economic investments and streamline the tax bureaucracy.

It would also require the government to focus on consumer taxes rather than production taxes, thereby providing incentives for production and investment while collecting more taxes from high spenders.

Moderately higher value-added, luxury and excise taxes collected fairly and honestly would be a much more effective form of taxing the rich than an inefficient and corrupt income tax paid by the few who are honest or defenseless. It would also be a pioneering move toward a tax structure that is neutral with respect to the allocation of financial resources.

Other benefits would include the supply side impact of a growing economy on value-added taxes and luxury and excise revenues. It would also contribute to changing Indonesia's reputation as one of the most corrupt countries in the world.

Other benefits include the fact that it would remove the need to use high interest rates to bring money back into the country and the banking system and it could stimulate radical thinking regarding other issues swathed in conventional wisdom.

Perhaps most importantly, though, it would demonstrate that the government recognizes the need that it must help the private sector recover from the protracted crisis.

The table shows key numbers from the original and revised 1998/1999 budgets and from a hypothetical 1998/1999 budget based on an exchange rate of Rp 10,000 to the U.S. dollar, a 15 percent decline in real GDP and inflation of 100 percent. Revenue and spending projections in the hypothetical budget are based on changes to the revised budget.

James Castle is chairman of the Castle Group and Peter Duncan is chief economist of the group.