Wrangle over Batam tax

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.