Low tax rates will spur tsunami growth in Indonesia

Low tax rates will spur tsunami growth in Indonesia

Gregory Fossedal, Washington D.C.

Susilo Bambang Yudhoyono faced three great challenges upon his
election in 2004. In less than a year since, Susilo has dealt
solidly with two of these -- reducing energy subsidies and
reining in corruption. Along the way he excelled as a crisis
manager in both the tsunami relief and rebuilding effort, and the
recent run on the rupiah.

Now he now faces the most important decision of his
presidency: How to move ahead on tax reform, and the related
question of whether tax relief can be combined with further cuts
in still-large energy subsidies, providing a one-two boost to
incentives and efficiency.

At first glance, and in the eyes of many analysts, Indonesia
isn't in desperate need of a tax rate cut. The country's top rate
of tax on corporate and (more important) personal income are at
30 percent -- a tad lower than such countries as India and the
Philippines, higher than Pakistan (with scheduled cuts),
Singapore, and even developed Norway, Russia, and Hong Kong.

Furthermore, the country has what it thinks is a compliance
problem -- only a small number of Indonesians pay personal taxes,
and the system accordingly generates few revenues compared to
developed countries.

The flip side, of course, is that the system may, like a
discount store still charging a higher price than Wal-Mart, be
discouraging large firms from hiring, or people from starting
small businesses, because of the burden of marginal rates and
paperwork for compliance. The latter is less important in highly
developed legal systems, more important in countries (like
Indonesia) with a history of officials using the tax code as
leverage to extract what might be generously called "bureaucratic
rents."

All of which makes it good news that Susilo's administration
recently put forward a tax reform proposal that would cut rates
for businesses and people by 5 percentage points.

This came in combination with the central bank's spirited
defense of the currency -- at the president's urging -- by
enacting several consecutive interest rate hikes in recent weeks.
At the same time, the administration has begun to muse in public
about further reductions in Indonesia's still-burdensome oil
subsidies.

To complete the economic-growth tsunami they're capable of,
Indonesia's people would benefit from, and might need, an even
sharper tax rate reduction than the 5 percent now on the table.
The administration has emphasized it's open to further
improvement in its initial proposal. There are several reasons to
make the program still more ambitious.

For one thing, in Keynesian terms, Indonesian macroeconomic
policy, and to some extent the burden of events, is relatively
restrictive across the board. Indonesia has now tightened
monetary policy, and tightened spending policy by reducing oil
subsidies. It also faces a meteorological "tightening" in the
vast destruction of physical and human capital after the tsunami.

A tax cut would bring some needed relief to this austere
picture. A bigger tax rate cut, more relief. As well, in
classical or "supply-side" terms, low-wage countries need very-
low tax rates.

Indonesia's greatest resource is a vast pool of talented,
hard-working, but relatively uncredentialed people. To capitalize
on this resource, it needs to reduce what the late Jude Wanniski
used to call the "wedge" between employers and workers. This is
especially important where small business startups are concerned.

In Indonesia as elsewhere, small businesses do a lot of the
hiring and (in effect) self-hiring. Yet they often pay taxes
under the personal code. Tax rates, and the paperwork burden of
complying with one or two codes, are a major factor in their
activity.

Whatever adds to the business-labor wedge lowers the after-tax
reward to workers and raises the cost of providing that
compensation to employers or self-employers. This will tend to
lower the rewards to labor in the formal sector relative to in
the informal or barter sector.

To raise formal employment, low-income countries need an
especially low tax rate and paperwork burden. To compete with
other low-wage economies, they need sharply lower marginal rates,
not rates that are "good enough."

Finally, Indonesia needs to drain the corruption swamp.
Susilo has already cleaned out staff, revised relations with
businesses under the regulatory squeeze, and changed the tone of
the judicial branch. But a very efficient way to further curb the
power of some officials is to reduce the money in their pockets
-- and, especially, to reduce the leverage they have over
taxpayers.

The higher tax rates are, the more leverage officials
throughout the bureaucracy have. The lower they go, the less
daunting the tax stick is.

My own general guideline for policy-makers, all over the world
but especially in emerging markets, is to act decisively, and
make your country something special.

Indonesia, like other developing countries, poses a lot of
risks to investors, from its still-imperfect legal system to the
threat of future tsunamis. It helps to have a strong, simple,
core selling point to attract interest.

In cash flow terms, wouldn't this merely "balance" out, taking
the same amount of money away from consumers and producers as the
ultimate tax cut put back? Yes, in those terms, it would.

But notice the difference in incentives. Energy consumption
would be more costly, and would decline. Investment in energy
conservation would surge. Most important, the rewards for working
would go up, and the cost of hiring or self-hiring, go down.

If that suggestion is too much, Indonesian tax rates on
personal income should at least be brought into line with the
countries of Asia and Eastern Europe that Indonesia needs to
compete with. That means a top rate of, oh, 15 percent: Halving
the current marginal tax burden.

This policy mix would still buy a lot of oil-subsidy relief,
lift employment, curb energy consumption, and reduce bureaucratic
corruption, all in one swoop.

In less than a year, a certain Susilo leadership style has
emerged, one that bodes well for the country not only now but for
years to come. That style includes soft, balanced rhetoric, as
in Susilo's comments on making Indonesia a leader in the moderate
Islamic world; bold, energetic policy steps, and the political
guts to stick with them, from trimming oil subsidies to the
recent central bank tightening; and management competence, as in
his world-class tsunami relief effort.

The president can help Indonesians realize their full
potential by opening the gates to a flood of human initiative --
either with a substantial cut in rates, or, most ambitiously, by
making Indonesia the largest economy in the world to have no
personal income tax at all.

To fight a tsunami of destruction, you need a tsunami of
growth.

The writer is an advisor to international investors on global
markets and political risk, and a senior fellow at the Alexis de
Tocqueville Institution. He is the author of The Democratic
Imperative, a 1989 review of the advance of democracy around the
world.