Should Indonesia's mutual funds be taxed?

Martin Jenkins, Jakarta

Mutual funds allow the general public easy access to the financial markets. Through these instruments, the man on the street can invest in stocks (in Indonesia's case this means shares in companies listed on the Jakarta Stock Exchange), in government and corporate bonds, as well as money market instruments. And over the past few years, mutual funds have seen stupendous growth, partly due to the industry's current tax break facilities.

But much to the chagrin of the nation's fledgling mutual funds industry, the government has indicated that these tax break facilities will be scrapped by the beginning of 2005. It claims that the tax breaks need to be lifted as wealthy investors are taking advantage of the current law to evade taxes.

It should, however, be realized that the industry's tax breaks only apply to certain types of financial instruments; namely corporate and government bonds. Income from other financial instruments held in mutual funds, such as interest on money market instruments and dividend payments on stocks, are already subject to income tax.

But bonds account for a huge chunk of the funds under management held in Indonesian mutual funds. Indeed, of the Rp 87.32 trillion in funds under management in mutual funds at the end of June 2004, bond mutual funds accounted for some 84.3 percent of the total, or amounting to Rp 73.61 trillion. At the same time, the size of money market funds amounted to only Rp 11.05 trillion, while mixed mutual funds had Rp 1.96 trillion in funds under management and equity mutual funds only a tiny Rp 702 billion.

By lifting the tax breaks, the tax office expects to see a significant increase in tax revenues. Assuming an average bond yield or return of, say, 10 percent (which is actually on the low side), then the total interest income in these bond funds is above Rp 7 trillion per year. If this income were to be taxed at a tax rate of say 20 percent, then the tax department could boost tax revenues by at least another Rp 1.4 trillion per year. Certainly not a small number in any terms.

The tax breaks were given in the first place in a bid to encourage middle-income households to invest in the domestic capital market at a time when the government was issuing vast amounts of government bonds to help finance the state budget deficit. As government bonds offer an attractive yield, and are a proxy to the "risk free" rate of return, they are in strong demand by investors. Only in the unlikely event that the government's finances deteriorate to such an extent that it would have to default on the bonds would investors not get their money back.

But by targeting only one type of financial instrument, investors - mostly the very wealthy -- have naturally reduced their holdings in other asset types -- such as time deposits held in banks which are subject to income taxes -- and switched their funds into mutual funds that invest in government and corporate bonds.

Prima facie, then, it seems that the mutual funds industry has little grounds to complain about the government's plans to scrap the tax breaks. After all, why should the rich be able to earn tax free returns on their investments while the less well off (who may be unaware of the tax benefits of mutual funds) have to pay income tax on their bank deposits? A closer look at the matter, however, suggests that things are not so clear as they first seem.

First of all, some investors are likely to switch their funds from bonds to other types of assets if the government goes ahead and ends the tax breaks. If investors switch into either equity (stocks) or property say, there would be little problem. But if they move their funds into foreign assets or currencies, this could result in significant capital outflows and put further pressure on an already weak rupiah. Besides this, the mutual funds industry, as a whole, will also face tougher times ahead, as the funds under management in mutual funds would probably decline, at least in the near term, given the bond funds' large share of the market.

Besides this, the tax office may not garner as much as it expects by lifting the tax breaks. Fund managers could, for example, follow the lead in some other countries and come up with more innovative products such as zero coupon bonds instead. With zero coupon bonds, for example, investors pay no income tax as they do not receive regular interest payments from the bonds. Instead, the investor will realize a capital gain when the bond matures since the value of the bond will gradually rise throughout the life of the security.

We should also not forget that the promotion of national saving remains a desirable policy objective for the government. The more Indonesia can finance its investments from domestic sources the less dependent it will be on overseas equity and debt capital. Also, mutual funds are a good way to allow Indonesians to save long-term for their retirement. Pensions are often not enough to live on, and additional income will help improve many people's twilight years.

Moreover, returns on mutual funds are far higher than can be obtained by placing funds in bank deposits. Indeed, with interest rates so low now, many Indonesians, although they may not be aware of it, face real negative returns by placing their funds in banks (currently inflation is running at above 7 percent, higher than deposit rates at around 6 to 7 percent). In other words, the bank deposit rates are not high enough to offset the pernicious effects of inflation. You stand to lose money by parking your money in a bank.

Besides this, there is excess liquidity in Indonesia's banking system, as banks have been unable to channel enough fresh loans in the post-crisis period. And this excess liquidity in banks was even blamed for being responsible -- at least in part-- for the rupiah's woes this year, as certain banks apparently speculated on a weaker rupiah by buying U.S. dollars. To help resolve the problem the central bank even had to raise the minimum reserve requirement, thereby absorbing up to Rp 40 trillion of excess bank funds.

Overall then, it seems that the government's plans to remove the tax breaks on bond mutual funds are likely to have many undesirable consequences at the current time. But the tax directorate general's argument that the rich are bucking the system to earn tax-free returns is still valid.

So, why not maintain the tax breaks but limit the amount of funds that a single investor can hold in a bond mutual fund before income taxes start to kick in? Another possibility could even be to delay lifting the tax breaks for say another year until the bond market is more developed and consumers are more aware of the benefits of investing in mutual funds.

The writer is Market Analyst at the Danareksa Research Institute.