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Recently, efforts to reform Indonesia’s taxation system have been underway. Several proposals have been made internally in the Government and one of them recommends a shift in the main burden of revenue away from income taxes toward consumption taxes. In this respect, identifying the effects of different tax instruments on economic growth could be important for policy designs. This identification is particularly useful when the Government is considering reforming the existing tax structure in order to minimise the adverse impacts of taxation on economic growth while maintaining the capacity to finance the desired level of provision of public goods and services.

In theory, the mix of direct and indirect taxes may be an important determinant of long-run economic growth. In practice, however, this is not always the case.

One of the ways in which taxes may affect economic growth is that they might reduce the returns to savings, and thus discourage the accumulation of capital. Similarly, since taxes might reduce the reward for work, they could reduce labours’ work efforts and thus depress labour supply. Reductions in the accumulation of capital and labour supply would then result in lower economic output and growth.

Currently, there are two major tax instruments in Indonesia: income tax and value-added tax (VAT). Taxes are also levied on international trade, but their role in supporting government revenue is limited. The first major tax reform in Indonesia was enacted in 1983 against the backdrop of declining government revenue from the oil and gas sector. One of the significant features of the 1983 reform was the introduction of a VAT to replace the old sales tax. Since then, Indonesian tax law has undergone several amendments in 1994, 2000 and 2008.

My paper examines how changes in the tax structure may affect Indonesia’s long-run economic growth, based on the available data. The methodology employed in the paper combines exogenous and endogenous models of growth. Tax instruments were introduced in the model to evaluate how different tax policy reforms may affect economic growth under the assumption of revenue neutrality, where a reduction in one tax instrument is assumed to be followed by an increase in another tax instrument. Data covered the period from 1984 to 2015. Overall, the results show that the mix of income tax and VAT in total government revenue may not be an important determinant of long-run economic growth.

Empirical results from basic regression analysis

My basic regression model, which uses Gross Domestic Product (GDP) as dependent variable and government receipts from income and consumption taxes as independent variables, shows that consumption taxes have significant effects on Indonesia’s long-run economic growth, but that income taxes do not. Based on this basic model, it seems that a tax reform that shifts the burden of revenue toward consumption taxes might have a positive impact on economic growth.

One of the possible explanations for the significant effects of consumption taxes on economic growth, relative to other tax instruments (specifically income taxes), might have to do with the relative neutrality of consumption taxes toward economic agents’ decisions about savings, investment, consumption, production and labour supply. Further, consumption taxes do not affect capital accumulation because they do not interfere with the decision to consume now or later.

The neutrality of consumption taxes may also encourage economic output because consumption taxes do not interfere with decisions about adopting capital-intensive production methods because capital is not the base for consumption taxes. Finally, consumption taxes may encourage economic growth because they do not interfere with labour supply decisions because workers only have to pay taxes when they spend their income on consumption, not on additional hours of work.

Robustness Checks

However, when additional factors, such as trade openness, the financial system, electricity production and inflation are included as control variables, the preliminary findings do not seem to be robust.

When the variable of trade openness is included as a control variable, the mix of income and consumption taxes does not seem to have a statistically significant impact on long-run GDP growth. When the maturity of the financial system is included as a control variable, only consumption taxes show a significant effect on GDP growth. A possible explanation for this phenomenon is that the more mature an economy’s financial system is, the higher the level of consumption in that economy.

A well-developed financial system may ease liquidity constraints facing households, thereby raising the level of consumption through a rapid expansion of credit. In an economy where the financial market is heavily regulated, households may face limits on their ability to borrow due to, for example, low credit limits and high interest rates. This credit constraint may adversely affect the level of households’ consumption. On the other hand, in an economy with liberalisation and deregulation in the financial market, relatively higher credit limits and lower interest rates may ease the borrowing constraints faced by households thus leaving them with more ability to borrow against their future income to finance current consumption and this might lead to higher overall consumption. A higher level of consumption may boost economic growth as well as government revenue from consumption taxes.

When electricity production is added to the regression, both income taxes and consumption taxes do not have a significant impact on economic growth. However, both tax instruments become positive and significant once inflation is included in the regression. The significant effect of income taxes when inflation is added may be explained by possible decreases in the progressivity of Indonesia’s income tax system relative to inflation. In other words, additional tax burdens could arise when income taxes are not frequently adjusted to inflation.

Conclusions

Although theory predicts that the mix of direct and indirect taxes might be an important determinant of long-run economic growth, empirical evidence found that this mix might be unlikely to affect Indonesia’s long-run economic growth.

One of the policy implications from this finding is that rather than focusing on which tax instrument to rely on, policymakers could instead focus their attention to directing the reform toward improving tax administration such as simplifying the tax systems, building trust between taxpayers and tax officials, giving fairer and professional treatment to taxpayers and facilitating compliance.

Another direction for tax reform could be towards improving the equity of the tax system.

 

Further Reading

Iswahyudi, H. (2018). Do Tax Structures Affect Indonesia Economic Growth? Journal of Indonesian Economy and Business, 33(3), 216-242.

 

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