Raising revenue without tax hikes

By J. S. Uppal and Sukanto Reksohadrodjo

YOGYAKARTA (JP): Now that the nation has completed the momentous task of democratically electing the national assemblies, the President and vice president, it has to face the stark reality of the massive social and economic problems facing the country. Among several difficult tasks for the new administration, the priority is to raise sufficient government revenue to cover mounting expenditure needed to deal with the nation's problems.

During previous years, with high oil prices and the influx of massive foreign funds, the government could ignore the problem of high fiscal deficits. Now, particularly since the recent economic crisis, when oil prices are not as high as before and foreign capital is not as easily forthcoming, the country faces the grim reality of serious shortfalls in domestic revenue.

Not before long, the nation will have to stand on her own feet rather than depending on uncertain foreign loans. Indonesia's external debt has reached a point where the nation has to sometimes compromise its independence and borrow in order to act on vital issues. Recently, there have been instances where Indonesia had to accept dictates from lending institutions, even when it was clearly not in the national interest. There is a growing feeling among people that too much dependence on foreign aid is robbing Indonesia of its economic independence and has made the country a captive state quite easily manipulated by lending institutions.

Central government revenues are comprised of oil and gas and non-oil and non-gas earnings. Currently (1998-99) 75 percent of total non-oil non-gas revenues come from taxes. The two major taxes are income tax, both individual and corporate, and Value Added Tax, which contribute 34 and 39 percent of tax revenues respectively.

The position of Indonesian tax revenues in comparison with some neighboring Asian countries can be seen from the following table:

Table: Indonesian Tax Revenues Compared with Neighboring Asian Countries

(Percent of GDP)

Indonesia: Total Tax Revenues (12.0), Income Tax (4.8), Value Added Tax (3.2); Malaysia: Total Tax Revenues (20.2), Income Tax (11.5), Value Added Tax (3.1); Philippines: Total Tax Revenues (16.3), Income Tax (9.8), Value Added Tax (3.89); Thailand: Total Tax Revenues (16.9), Income Tax (10.7), Value Added Tax (7.61); S.Korea: Total Tax Revenues (17.10), Income Tax (6.3), Value Added Tax (5.3).

Tax Rates (Initial and Maximum)

Indonesia: Income Tax (10.30), Value Addes Tax (10); Malaysia: Income Tax (5.40), Value Addes Tax (NA); Philippines: Income Tax (10.35), Value Addes Tax (NA); Thailand: Income Tax (5.45), Value Addes Tax (15.00); S.Korea: Income Tax (10.50), Value Addes Tax (10.16);

Note: Calculated from various sources. These figures should be used for illustrative purposes only. Due to differences in tax coverage and periods, these figures are not strictly comparable.

Why does Indonesia lag behind her Asian neighbors in collecting tax revenues (called Tax Effort)? It is not that Indonesian tax rates are so high they would discourage taxpayers and investors. In fact tax rates in Indonesia are in general comparatively lower, as figures in the above table show. It should be noted that these are legal or nominal tax rates. If we take real or effective tax rates (tax actually paid as a percent of taxpayers total income), these figures become much lower.

To cite the case of income tax, while the top tax/nominal tax rate is 30 percent, in real terms, we have estimated that it is not more than 20 percent. It just means that high income earners do not bear the legally mandated burden of taxes.

While statistical, information on the tax burden of different income classes is not available, one could infer that the biggest burden falls on the middle and lower classes, particularly in the case of the VAT.

How do we account for this unfortunate situation? There are two explanations. Firstly, in Indonesia only a small proportion of the population is liable for taxes. It is estimated that between 85 to 90 percent of people in this country do not fall within the income tax net as most of them have incomes below the income tax threshold.

The unfortunate part is that less than 1 million people, or less than one half of one percent of the total population, are even registered for filing tax returns. To make the situation worse, from this small amount of registered taxpayers, only 55 percent even care to file tax returns.

Also, there are huge tax arrears to be collected. For income tax alone, Rp 6.236 billion was delinquent in 1997-98, which constitutes 17 percent of the total tax collectible. The rate of tax delinquency has increased in the recent times. This is massive tax evasion indeed, which if not stopped, will make Indonesian income tax ineffective.

Secondly, there is the problem of many tax loopholes used by individuals and corporations to reduce their tax liability. Interestingly, when the existing income tax and VAT were introduced during 1985-86, there were only a few exemptions and deductions. The filing of taxes was made voluntary, assuming honesty on the part of the taxpayer. There was also a stipulation of strict tax law enforcement through intensive audits. It is pertinent to cite the potential effects of proper audits.

In June 1986, an independent task force of auditors consisting largely of returnees from overseas training programs and reporting directly to the Director General of Taxes launched a special audit on two dozen companies reporting zero or negative tax liability. These firms were assessed to owe Rp 87 billion in taxes, fines and penalties. While this audit campaign cost only Rp 250 million, it yielded a direct return of that was 340 times the investment.

Later on, several loopholes were introduced. There were two reasons for this. Firstly the tax department could not cope with the need for intensive audits of large numbers of tax returns found to be in non-compliance with the voluntary tax laws. Rather than strict enforcement of taxes thorough audits, an easy way out was adopted, by introducing a final withholding system of various items of income which of course suited the upper income class taxpayers. If you look at the list of final tax withholdings, some of the items are bizarre: unheard of in countries with reasonable tax systems.

For example if an employee has one job, there is a final withholding of say 15 percent, no matter what his other sources of income -- interest, dividends or rents -- may be. The interesting part is that government pays the tax for government employees. In this way, one can make a fortune with just one job and pay no tax at all.

One can become super rich from other income sources such as interest on deposits, stock dividends, rents and royalties, with tax liability of only 15 percent as the final withholding taxalthough if the total income of this tax payer was put together, he may well be in the 30 percent tax bracket. These are only a few examples of tax abuse.

There are several others showing how these tax loopholes have seriously eroded the Indonesian Tax System and have made a mess of it, as is the case with VAT which has also lost much of its steam from various changes introduced since 1986 to lessen the workload in the tax department and to please vested interests. Indonesian VAT has lost its special feature of being a "Money Machine" as originally stipulated.

Fortunately, however, as a silver lining in the otherwise dark clouds hovering over the Indonesian skies, there exists a big, untapped potential in the tax system. Even with the existing legal tax rates, the government can raise needed tax revenues by following a two-pronged strategy: to make modifications in the tax laws to reduce tax loopholes which have reduced tax revenues and diminished tax equity.

Secondly, the tax administration needs to be strengthened to enforce proper tax compliance. It suffers from a lack of coordination between different agencies, for example between the tax and excise and customs departments. Also the tax department lacks much needed independence to interpret and enforce tax laws without any outside interference.

The legal setup of the American Internal Revenue System would be a good case study to make the Indonesian tax department independent of any politically motivated intervention in enforcing the collection of tax liability, particularly from the politically and economically powerful classes. Consider the independence and power vested in the American tax agency: the Internal Revenue System. There are recent well-known instances where IRS did not even spare the President and Vice President of the United States from accusing them of tax irregularities.

The idea of making tax agencies independent, though common in Western developed countries, is being increasingly adopted in other elsewhere to deal with the serious problem of tax abuse by powerful people. It may also be prudent to invest funds to update computer technology in the tax department to develop an elaborate tax database so that no item of income received by any taxpayer escapes the eyes of the collectors.

Indonesia does not need to increase tax rates. Merely by removing the abuse of tax loopholes and illegal tax evasion practices, the government can collect sufficient tax revenues to decrease the fiscal deficits and to run the nation.

Dr. J. S. Uppal and Dr. Sukanto Reksohadrodjo are professors of economics at the State University of New York at Albany, New York, USA and Gadjah Mada University, Yogyakarta, Indonesia. This article is a part of their continuing research on Tax Reform in Indonesia under the USAID-funded project, Sustainable Indonesian Growth Alliance, based at Gadjah Mada University, Yogyakarta.