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.