Wrangle over Batam tax

Opposition by local residents and foreign investors to the Indonesian government's decision to impose value added tax (VAT) and luxury sales tax on Batam, Bintan and Karimun islands near Singapore is another example of how bad timing and inadequate planning can undermine a correct policy measure.

Imposing the two taxes on domestic transactions is normal and standard fiscal policy everywhere in the world. The decision to exempt these islands from these two indirect taxes which the rest of the country is subject to was a misguided policy. It is a mistake that has been overlooked since 1978, when the government aggressively promoted Batam as an industrial bonded zone to attract foreign investors.

Establishing Batam, and later the two neighboring islands, as a bonded zone was then and is still the correct strategic policy to woo foreign investment. A bonded zone, like similar facilities in other countries, is an economic concept designed to bolster export competitiveness by allowing export-oriented businesses to bring in capital goods and raw materials without paying import duty, value added tax (VAT) and other indirect levies normally imposed on such transactions.

The concept allows investors to harness location-specific assets that, in the case of Batam and the other two islands, are a strategic location, low-cost labor and good infrastructure, in addition to the fiscal incentives, i.e. tax relief.

The mistake was that Batam, though established as a bonded zone, was from the outset mistakenly treated and promoted as an entirely free trade area. The big difference is that, unlike in a free trade area, all tax and duty exemptions in a bonded zone are effective only for export transactions, not for domestic sales. Companies are entitled to exemptions from import duties as long as their imports are raw materials for export goods, and they are entitled to VAT and luxury sales tax relief as long as their products are exported.

So the government, at the instigation of the International Monetary Fund, rightly decided in 1998 to correct its mistake and put Batam and the other two islands under its trade regime. That means that the tax and duty exemptions are applied only to export and export-related transactions, not to domestic sales.

The problem is the government took the wrong approach in correcting the error. Given that residents and businesses on the islands have taken for granted for more than 20 years the exemptions from the VAT and luxury sales tax, the government should have launched an aggressive campaign since 1998 to precondition the people and businesses on the islands to the new measure.

Bad timing is another factor that stands in the way of the smooth implementation of the new policy. Foreign investors, who are all too familiar with the concept of the bonded zone, would not have been so frustrated as to threaten leaving Batam had the government been more careful in scheduling the implementation of the measure.

Even though the two taxes will not directly affect the companies' competitive edge, as the taxes are applied only to domestic transactions, their imposition beginning in April coincides with the enforcement of the new higher regional minimum wage of Rp 350,000 (US$45) a month and higher electricity rates.

But the scariest part of the new policy seems to be the measure that requires all businesses, whether they are export oriented or not, to pay the VAT and luxury sales tax up front. Even though they are due VAT-payment refunds after exporting their goods, the process of applying for and getting the refund is dreaded by local and foreign businesspeople alike.

Having to routinely deal with the poorly paid, highly venal tax officials to get the VAT reimbursement is exactly the hurdle investors sought to avoid by operating on the three islands in the first place. The obligation to haggle with notorious tax officials would virtually erase all other incentives to operating on the three islands, because this process alone would substantially increase a company's costs.

Businesspeople's complaints about punitively arduous tax procedures are by no means an exaggeration. The government's letter of intent to the IMF stipulates 10 reforms related to the country's tax procedures and refund system that have yet to be implemented.

The government, therefore, would be well advised to phase in the new policy gradually. However, the three islands should eventually be returned to the country's trade regime and not be allowed to remain forever the "Hong Kongs" of Indonesia.

We do not think foreign businesses would leave Batam because of the new tax policy as long as the tax and duty exemptions remained automatic, meaning export-oriented businesses would not have to deal with tax officials to get their refunds. It would be the government's responsibility to set up an effective oversight mechanism to prevent abuse of the system.

If export-oriented businesses enjoying automatic tax and duty exemptions still wanted to leave, it would be better to simply let them go. We do not need investors with those kind of naive double standards.