Should Indonesia's mutual funds be taxed?

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.