Tax reform could set off virtuous economic circle

David E. Sumual, Jakarta

Amid the barrage of negative news concerning Indonesia's financial markets lately, there has been an encouraging development in that the government finally launched its long- awaited US$1 billion international bond issue last week. This new issuance should effectively boost the supply of foreign exchange and help Indonesia's budget to reach its targeted deficit at 0.8 percent of GDP in 2005.

Yet for the time being, the jitters in the markets remain with investors still concerned over inflationary pressures. Thus, the prospects of higher-than-expected inflation in the near term and the likelihood of further hikes in Bank Indonesia promissory note (SBI) rates seem to outweigh the successful global bonds issue. Also disheartening is the weakening rupiah, which has been, in part, influenced by the United States Federal Reserve's commitment to further hikes in its benchmark rate, the stubbornly high world oil prices and the declining inflows in the country's current account.

Given a lack of fresh domestic leads, the outlook for the rupiah may remain bleak so long as the decline in inflows in the current account surplus cannot be offset by stronger capital inflows. This expectation is also confirmed by the central bank's projection that the country may endure a shortage in foreign exchange of about $600 million in the private sector this year.

Nevertheless, there is actually a development that could mark a turning point in the rupiah's fortunes. It is the government's intention to speed up the submission of the new tax laws to the House of Representatives for deliberation. This could be a potent catalyst to greater optimism on the prospects for the Indonesian economy.

A complicated tax system is one of investors' main concerns in doing business in Indonesia. Many 'loopholes' in the tax regulations make it possible for unscrupulous tax officials and taxpayers to collaborate. Indonesia's tax system also combines the function of tax policy and tax administration under one agency, creating a powerful taxation office.

In other words, the system that now exists effectively makes the Directorate General of Taxation an entity that determines its own receipt targets and policies, meaning less effective administration and independent policies. Other crucial problems, such as the tax collection policy, uncompetitive tax rates and low numbers of individual taxpayers, are some issues that need to be addressed in the proposed tax laws.

Another politically related issue that may draw the public's attention would be the drafting of the bill on a tax amnesty. This could become particularly controversial as managing the whole process of tax reform is far from simple, given the inherently political nature of an such 'big-bang' tax reform programs.

Although the law may finally be endorsed by the House, the legislative process of deliberating upon a comprehensive tax program, especially the tax amnesty law, could be tricky and take longer than expected. As a crucial arena for debating the tax reform issues, the legislature could thus block, or alter significantly, any tax reform proposal.

Moreover, the House is now in recess until May. And given its urgency, the House may first discuss the 2005 budget revision. So, the amended tax laws not even be discussed until the third quarter of this year at the earliest.

Besides widening the tax base in future years, the primary benefit of introducing a tax amnesty actually rests on the belief that billions of dollars that reportedly left the country following the financial crisis in 1997 would be lured back. Of course, not all of the $40 billion to 60 billion in funds that were reportedly transferred abroad during the crisis could be expected to flow back into the country following the policy.

Nobody knows how much exactly would be brought in; and some of the overseas assets may be illiquid. However, if the government's claim that the tax amnesty could rake in at least $6 billion is true, those capital inflows would likely strengthen the rupiah.

It should be noted that $6 billion is not petty cash and it is clearly enough to have some impact on the domestic currency market. The positive impact on the rupiah could even be substantial considering the psychological announcement effect of the passage of a tax amnesty law on the domestic players who have long dollar positions.

Although a bit different in terms of its tax exemption mechanism, the effect of the tax reform on the rupiah could be similar to the effect of the American Jobs Creation Act on the dollar bulls lately.

The law that was signed by Bush in late October 2004 gives tax cuts for foreign subsidiaries of U.S companies in repatriating their profit earned overseas. By awarding those companies a one-year repatriation opportunity with a significant discount in the tax rate, around $135 billion could reportedly be brought back in one year. This expectation along with the Fed's strong signal that it will further hike its benchmark rate may be the reason for both momentum trading and short covering rallies in the dollar recently.

In contrast to a developed country like the U.S however, many things remain to be done in fixing Indonesia's business environment.

Other than tax reform, there are still many laws and regulations that can create uncertainty and a high cost economy, thus hampering the investment-driven economy. If the lawmakers and the government could expedite the bureaucratic process in amending those laws and regulations, there is a good chance that foreign capital would stream in, providing support for the rupiah.

The writer is an Analyst of Danareksa Research Institute. This article is strictly a personal view.