INDONESIA ECONOMIC PROSPECTS IEP Funding Indonesia’s Vision 2045 December 2024 © 2024 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions, and is supported by funding from the Australian Government under the Australia-World Bank Indonesia Partnership (ABIP) program. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent, or the Australian Government. 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Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@ worldbank.org. Photo credits: Front cover and inside chapters: ©Creativa Images/shutterstock.com, ©Mehaniq/ shutterstock.com, and ©Mehaniq/ shutterstock.com Further permission required for reuse. The report was designed and typeset by Arsianti. Indonesia Economic Prospects December 2024 Ta bl e of C o n te n ts Contents Table of Summary Executive LIST OF FIGURES, TABLES, AND BOXES IV PREFACE VI Developments A.1. Recent Economic ABBREVIATIONS VII EXECUTIVE SUMMARY 1 A.2. The Policy I. Economic Update 1 Stance II. Funding Indonesia’s Vision 2045 2 A.3. Outlook and Risks A. ECONOMIC UPDATE 5 1. Recent Economic Developments 5 A.4. Medium- term Growth Simulations 2. The Policy Stance 12 3. The Outlook and Risks 14 4. Medium-term Growth Simulations 15 A.5. Policy Priorities 5. Policy Priorities 17 B.1. Introduction B. FUNDING INDONESIA’S VISION 2045 20 1. Introduction 20 2. Unpacking Indonesia’s tax gap 22 Indonesia’s tax gap B.2. Unpacking 3. The drivers of Indonesia’s tax non-compliance 29 4. Recommendations to increase development financing 35 Indonesia’s tax non- B.3. The drivers of REFERENCES 38 compliance B.4. Recommendations CLICK THE SIDE BUTTONS TO GO TO THE SECTION YOU WISH iii TO READ. Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 LIST OF FIGURES, TABLES, AND BOXES Contents Table of FIGURES Summary Executive Figure A.1: Growth remains resilient in 2024 driven by robust domestic demand 6 Figure A.2: Services remain the main driver of growth whilst manufacturing shows mixed results 6 Figure A.3: Inflation has gradually softened, as pressure from food prices abates 7 Figure A.4: Inflation was broad-based in 2024 although softer than 2023 7 Developments A.1. Recent Economic Figure A.5: Moderating terms of trade dampened exports growth 8 Figure A.6: Goods imports grew at a quicker pace than exports… 8 Figure A.7: …fueled by acceleration in imports of processed intermediate goods 9 Figure A.8: Current account deficit widened to 0.6 percent of GDP year-to-September 9 A.2. The Policy Stance Figure A.9: Healthy portfolio inflows led to a surplus in the financial account 9 Figure A.10: Rupiah performed better than EM peers over the second half of 2024 9 Figure A.11: Favorable global conditions and stable macro conditions have helped reduce currency and 10 investment risks for Rupiah sovereign bonds A.3. Outlook and Risks Figure A.12: Indonesia’s premia on risk of default on sovereign debt has declined and among the lowest 10 compared to other emerging markets Figure A.13: Banks asset quality is healthy, and have enough buffer to withstand adverse shocks 11 A.4. Medium- term Growth Figure A.14: Lending to the private sector continue to grow especially loans for investments 11 Simulations Figure A.15: Fiscal revenues saw marginal growth 12 Figure A.16: While spending rose substantially in almost all areas 12 Figure A.17: Expanding fiscal financing could elevate debt repayments further which estimated to reach its 13 A.5. Policy Priorities peak next year Figure A.18: Though it remains among the lowest compared to peer countries 13 Figure A.19: SRBI maturity peak is in Q4-24 14 B.1. Introduction Figure A.20: A demand stimulus package will boost GDP growth 16 Figure A.21: … but it could be accompanied by high inflationary pressures 16 Figure A.22: Indonesia performance in structural reform areas relative to peers 17 Figure B.1: Fiscal balance, Indonesia 20 Indonesia’s tax gap Figure B.2: Total government debt 20 B.2. Unpacking Figure B.3: Public spending is substantially smaller than countries with the same level of developments 21 Figure B.4: Public revenue relative to peers has been historically low 21 Figure B.5: IDN public capital stock per capita, versus advanced and emerging market (EM) averages (2019, 21 2017 PPP terms) Indonesia’s tax non- Figure B.6: IDN general government investment versus emerging market peers 21 B.3. The drivers of compliance Figure B.7: Both CIT and VAT have been the largest components of tax collections in Indonesia… 22 Figure B.8: …but they remained below what is collected by peer countries… 22 Figure B.9: Decomposing the tax gap into policy and compliance gaps 23 Figure B.10: Tax gap breakdown, VAT and CIT 23 Figure B.11: VAT C-efficiency in Indonesia 24 B.4. Recommendations Figure B.12: C-efficiency and VAT 24 Figure B.13: Statutory VAT rates, Indonesia versus regional and structural peers 24 Figure B.14: VAT policy gap in Indonesia (2016-21) 25 iv Indonesia Economic Prospects December 2024 Figure B.15: Core components of the VAT policy gap (2021) 25 Contents Table of Figure B.16: VAT compliance gap (2016-21) 26 Figure B.17: VAT compliance gap in Indonesia and select middle-income countries 26 Figure B.18: CIT collection efficiency 28 Summary Executive Figure B.19: CIT revenue versus potential 28 Figure B.20: Statutory CIT rates, Indonesia versus regional and structural peers 28 Figure B.21: Tax evasion prevalence, by firm characteristics 30 Figure B.22: Share of firms that find tax rates and administration as moderate or worse obstacles to 30 Developments A.1. Recent business (percent of firms) Economic Figure B.23: Annual audits per million vs log GDP per capita (average from 2018 to 2020) 32 Figure B.24: Financial sector depth and government revenue 33 Figure B.25: Percentage of CIT paid (vs. various indicators of formal finance) 33 A.2. The Policy Figure B.26: Ease of avoiding taxes by use of bank finance 33 Stance Figure B.27: Ease of avoiding taxes by use of electronic payments 33 Figure B.28: Likelihood of taxes being the main reason for competitors to remain informal 33 Figure B.29: Share of informal firms that report registration does not apply to them by city 34 A.3. Outlook and Risks Figure B.30: Firm size distribution in informal sector 34 Figure B.31: Annual sales distribution in informal sector 34 A.4. Medium- TABLES term Growth Simulations Table A.1: Selected Macroeconomic Indicators 18 Table B.1: Human capital index breakdown, Indonesia 22 A.5. Policy Priorities Table B.2: Design of the double list experiment 29 Table B.3: Summary of Recommendations to Raise Tax Revenue 37 B.1. Introduction BOXES Box B.1: High income countries are not immune to compliance challenges 26 Indonesia’s tax gap B.2. Unpacking Box B.2: Georgia and Cambodia’s successes in tax policy and administration reforms 27 Indonesia’s tax non- B.3. The drivers of compliance B.4. Recommendations v Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 Preface Contents Table of Summary Executive The Indonesia Economic Prospects (IEP) is a bi-annual World Bank report that assesses recent macroeconomic developments, the outlook, and risks, as well as specific development challenges for the Indonesian economy. In doing so, the IEP aims to inform the public policy debate and is geared towards a wide audience, including the general public, Developments A.1. Recent Economic the government, the private sector, civil society organizations, and other domestic and international stakeholders. The IEP is a product of the World Bank Jakarta office and receives strategic guidance from an editorial board chaired by Carolyn Turk, Country Director for Indonesia and Timor-Leste. The report is prepared by the Macroeconomics, Trade and Investment (MTI) Global Practice team, under the guidance of Lars Christian Moller (Practice Manager) and Habib A.2. The Policy Rab (Lead Economist). The report is co-led by Wael Mansour (Senior Economist) and Rong Qian (Senior Economist). Stance Deviana Djalil provided administrative support and coordinated the organization of the report launch event. The dissemination was organized by Gb Surya Ningnagara and Maulyati N. Slamet under the guidance of Lestari Boediono Qureshi. The report was designed and typeset by Arsianti. A.3. Outlook and Risks Part A was prepared by Wael Mansour, Dwi Endah Abriningrum, Indira Maulani Hapsari, Mochamad Pasha, Ratih Dwi Rahmadanti and Rully Prassetya. Inputs were provided by Anastasiya Denisova, Shreya Chatterjee, and Abror Tegar Pradana (labor markets), Ou Nie and Neni Lestari (financial sector), and Unnada Chewpreecha (medium-term macro A.4. Medium- modeling). Part A benefitted from the comments of Habib Rab. term Growth Simulations Part B was prepared by Rong Qian and Ray Christopher Gomez, with contributions from Indira Maulani Hapsari. It is based on the “Tax flagship report” (World Bank, forthcoming 2025). Part B benefited from the comments of Habib Rab and Wael Mansour and was peer reviewed by Fernando Blanco (Senior Economist). A.5. Policy Priorities This report is available for download in English and Indonesian via: www.worldbank.org/iep Previous report editions: B.1. Introduction • June 2024: Unleashing Indonesia’s Business Potential • December 2023: Climate Action for Development • June 2023: The Invisible Toll of COVID-19 on Learning To receive the IEP and related publications by email, please contact ddjalil@worldbank.org. For questions and comments, Indonesia’s tax gap please contact wmansour@worldbank.org and rqian@worldbank.org. B.2. Unpacking For information about the World Bank and its activities in Indonesia, please visit: www.worldbank.org/id instagram.com/worldbank Indonesia’s tax non- B.3. The drivers of compliance @BankDunia #IEPBankDunia www.linkedin.com/company/the-world-bank   BankDunia B.4. Recommendations vi Indonesia Economic Prospects December 2024 Abbreviations Contents Table of Summary Executive AFC Asian Financial Crisis LAR Loan at Risk ASEAN Association of Southeast Asian Developments LCR Liquidity Coverage Ratio A.1. Recent Economic Nations LICs Low Income Countries BI Bank Indonesia LMICs Lower-Middle Income Countries BOS Bantuan Operasional Sekolah LPG Liquefied Petroleum Gas BPS Badan Pusat Statistik MOU Memorandum of Understanding CAD Current Account Deficit MSMEs Micro, Small, And Medium A.2. The Policy CAR Capital Adequacy Ratio Enterprises Stance CIT Corporate Income Tax NEER Nominal Effective Exchange Rate CPI Crude Price Index NPL Non-Performing Loan CRM Compliance Risk Management NSFR Net Stable Funding Ratio DEA Data Envelopment Analysis OSS Online Single Submission A.3. Outlook and Risks DGT Directorate General of Taxes PROA Pretax Return on Assets EAP East Asia Pacific ROA Return-on-Assets EM Emerging Markets ROE Return-on-Equity EMCI Emerging Market Currency Index SOEs State-Owned Enterprises A.4. Medium- EU European Union term Growth Simulations SRBI Sekuritas Rupiah Bank Indonesia FDI Foreign Direct Inflow TFP Total Factor Productivity FX Foreign Exchange THL Tax Harmonization Law FSAP Financial Sector Assessment UMICs Upper-Middle Income Countries Program UNESCO United Nations Educational, A.5. Policy FSOL Financial Sector Omnibus Law Priorities Scientific, and Cultural Organization GDP Gross Domestic Product VAT Value-Added Tax GEP Global Economic Prospects VTTL VAT Total Tax Liability GOI Government of Indonesia WBES World Bank Enterprise Survey B.1. Introduction GVCs Global Value Chains WDI World Development Indicators HCI Human Capital Index YOY Year-on-year IEP Indonesia Economic Prospects IMF International Monetary Fund JKP Job Loss Guarantee Program Indonesia’s tax gap B.2. Unpacking Indonesia’s tax non- B.3. The drivers of compliance B.4. Recommendations v ii Executive Summary Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 E xe cut i ve Su m m a r y Contents Table of Summary Executive I. Economic Update Indonesia’s economy remains resilient, buoyed highlight the need for greater revenue mobilization Developments A.1. Recent Economic by strong domestic demand and a recovering to maintain fiscal sustainability and support growth- service sector. GDP has grown at 5 percent during oriented spending. the year, supported by robust private consumption and government spending. The services sector, across Meanwhile, Bank Indonesia (BI) has been the board, continues to be the main driver of growth, incrementally easing its policy stance while A.2. The Policy while manufacturing shows mixed results. Inflation managing currency stability. In September, BI Stance has gradually softened as food and energy prices reduced its policy rate by 25 basis points to 6.0 abated, with headline inflation dropping to 1.5 percent percent, leveraging global monetary easing trends. To in November. This follows a rebound in agricultural mitigate currency pressures, BI continued issuing high- A.3. Outlook production and moderating global oil prices. The yielding monetary instruments, such as the SRBI, which and Risks labor market also demonstrated some resilience, with attracted significant foreign capital. Additionally, BI a reduction in overall unemployment and an increase introduced new macroprudential incentives to promote in labor force participation especially for females. Yet, private credit expansion, including reducing reserve A.4. Medium- a sluggish recovery in real wage and middle-class job requirement ratios for specific sectors. These measures term Growth Simulations creation especially for youth remain a challenge. boosted private sector credit growth, aligning it with BI’s target range of 10-12 percent. The current account deficit widened, driven by moderating terms of trade and cyclical factors The economic outlook remains stable and is subject A.5. Policy Priorities that intensified services and income outflows. to balanced risks. Indonesia’s economy is projected The goods trade surplus narrowed due to declining to grow at an average 5.1 percent over 2024-2027, commodity prices and a relaxation in some import supported by a boost in public consumption and restrictions. Meanwhile, rising travel imports widened investment as the new administration gradually B.1. Introduction the services trade deficit. Despite these developments, implements part of its social assistance and investment global monetary easing and stable macro conditions programs. Inflation is anticipated to stay within BI’s in Indonesia have accelerated capital inflows, bolstered target band but may rise due to robust domestic foreign currency reserves, and relieved pressures on demand and an anticipated VAT rate hike. The Indonesia’s tax gap the Rupiah. Meanwhile, the banking sector prudential current account deficit is projected to widen, with FDI B.2. Unpacking indicators remain sound, but there remains room to remaining a key source of external financing. Fiscal improve financial sector depth. policy is projected to adhere to the fiscal rule, with the budget deficit averaging 2.6 percent of GDP over the After two years of consolidation, the fiscal policy outlook, supported by tax reform. However, elevated stance loosened slightly. The fiscal deficit in 2024 is borrowing costs are also expected to keep interest Indonesia’s tax non- estimated to widen to 2.7 percent of GDP, up from 1.6 payments elevated at around 2.2 percent of GDP. B.3. The drivers of compliance percent in 2023. This shift is attributed to declining The outlook is subject to balanced risks. Downside commodity and taxes revenues combined with rising risks include heightened geopolitical tensions, and a spending on social assistance and infrastructure potential delay of fiscal and structural reform. Upside projects. Despite the widening deficit, the public debt potential includes a stronger-than-anticipated recovery stock dropped slightly to 38.5 percent of GDP, with in major trading partners and favorable swings in key B.4. Recommendations most of the debt denominated in Rupiah, thus reducing commodity prices. exchange rate risks. However, rising debt service costs, estimated to reach 4.9 percent of GDP in 2024, 1 Indonesia Economic Prospects December 2024 Sustained acceleration in economic growth will Indonesia’s long-term growth and job creation are Contents require structural reforms to boost productivity. The closely linked to its progress in competitiveness Table of Indonesian government aims to achieve high-income reforms, which can be categorized into status by 2045 and targets an 8 percent of GDP growth foundational, efficiency, and innovation reforms. by 2028 through a significant stimulus of aggregate Advanced upper-middle-income countries require Summary Executive demand. This strategy involves boosting significantly all three types of reforms to sustain competitiveness. private investment in various sectors, over the 5-years Indonesia has excelled in foundational reforms, mandate, and implementing fiscal stimulus focused on enabling resource shifts to non-agriculture sectors. 17 priority programs, including several social protection However, the country lags high-performing peers in efficiency reforms. This limits resource reallocation Developments initiatives. The strategy also involves a tax reform to A.1. Recent Economic finance all these fiscal programs while adhering to the to more productive industries and firms. To boost its fiscal rules. The report simulates the impact of this growth potential, Indonesia needs to invest in human strategy on Indonesia’s medium-term growth. Findings capital, social protection, and accelerate domestic suggest that the impact of this demand boost depends revenue mobilization (foundational reforms). Financial A.2. The Policy on accompanying structural reforms. Without reforms, deepening, trade policy reforms, and investment Stance the economy may face steep inflation and other openness, are essential for driving productivity growth macroeconomic imbalances. However, combining (efficiency reforms). Despite significant steps, further demand stimulus with productivity-enhancing reforms efforts are also needed to address bureaucratic could sustain high growth for a longer period and inefficiencies and inconsistent regulation enforcement A.3. Outlook and Risks maintain macroeconomic stability. to attract investment in high-value-added sectors. II. Funding Indonesia’s Vision 2045 A.4. Medium- term Growth Simulations Indonesia needs to significantly increase tax exemptions, and tax breaks significantly narrowed revenues to investment in human and physical the tax base, while widespread tax evasion and weak capital to achieve its high-income status ambitions. enforcement mechanisms undermined compliance. The country’s public capital stock (i.e., assets in A.5. Policy Priorities transport, utilities, and health and education facilities) Weak compliance is a key factor in Indonesia’s low and human capital index (health, nutrition, and tax revenue collection, with tax evasion prevalent education outcomes) lag regional and structural peers, among formal firms. At least a quarter of Indonesian falling far short of advanced economies. Closing these firms engage in some tax evasion, with certain firm B.1. Introduction gaps could enhance productivity growth and support characteristics driving noncompliance. Tax evasion is the sustained 6 percent growth required to reach more widespread among non-exporters, firms which high-income status by 2045. However, the investment report tax administration as a major burden, and firms needed is substantial. A significant portion of this which face strong informal competition. About half of Indonesia’s tax gap must be financed through increased tax revenues, as firms report that it is easy to avoid paying CIT or VAT, B.2. Unpacking a substantial rise in debt would be risky and would while many consider compliance unduly complicated, violate statutory caps on deficit and debt levels. especially among small businesses. These challenges reflect weaknesses in both tax administration and Significant additional revenues can be generated poor incentives for voluntary compliance, driven by by addressing the country’s tax gaps, particularly in complexity and low tax morale. Indonesia’s tax non- VAT and CIT. Indonesia’s 2023 tax ratio of 10.2 percent B.3. The drivers of of GDP is among the lowest compared to regional Indonesia’s tax administration has significant compliance peers, the middle-income average, and other large opportunities to strengthen compliance emerging markets. Cross-country analysis suggests enforcement and improve overall efficiency. By that Indonesia’s tax collection is at least 6 percentage increasing the frequency and effectiveness of audits, points of GDP below that of comparable countries. the system can better identify and address tax evasion. Between 2016 and 2021, Indonesia’s foregone tax Enhancing the enforcement process to efficiently B.4. Recommendations revenues from VAT and CIT averaged 6.3 percent of manage outstanding tax liabilities will further boost GDP. This shortfall resulted from a combination of policy revenue collection. Streamlining taxpayer dispute design and compliance challenges. Special regimes, resolution and addressing regulatory ambiguities 2 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 can help foster trust and transparency. Additionally, Overall, increasing tax revenues will require improving access to timely third-party data presents reforms that widen the tax base, improve tax Contents Table of a valuable pathway for the tax authority to enhance administration, and address structural constraints audit quality and enforcement efforts. to compliance. Reforms to widen the tax base could lower the registration threshold for VAT to align with Summary Executive Developing Indonesia’s financial sector could play a middle-income country norms, which also applies critical role in improving tax compliance by enhancing to the temporary final tax for MSMEs. Meanwhile, a information transparency and encouraging permanent final tax regime could be introduced for formalization. Research shows that countries with MSMEs below the threshold. Special CIT treatments, developed financial markets collect more taxes. Formal such as for construction services, publicly listed Developments A.1. Recent Economic financial systems help track activities, declare assets, firms, and non-standard VAT exemptions, may be and reduce tax evasion. In Indonesia, where the phased out gradually. Tax incentives need to become financial sector is shallow, expanding access to credit more strategic, time-bound, and systematically and financial tools could improve compliance. Firms reviewed. Improving compliance requires better risk A.2. The Policy using formal bank financing for at least 50 percent of management, using high-quality third-party data Stance their needs find it harder to evade VAT or CIT. However, and integrating fragmented government systems. distrust in formal systems discourages businesses from Simplifying and clarifying VAT regulations can reduce using banking transfers, making enforcement harder. disputes and administrative burdens. Lastly, addressing Additionally, financially constrained firms may engage structural constraints involves deepening financial A.3. Outlook and Risks in aggressive tax planning or evasion to manage cash sector depth, which is expected to have the secondary flow, underlining the financial sector’s critical role in effect of facilitating compliance through improved promoting compliance. information and formalization. A.4. Medium- term Growth Simulations A.5. Policy Priorities B.1. Introduction Indonesia’s tax gap B.2. Unpacking Indonesia’s tax non- B.3. The drivers of compliance B.4. Recommendations 3 A. Economic Update Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 A. Economic Update Contents Table of Summary Executive 1. Recent Economic Developments Indonesia’s growth remains resilient buoyed by consumption contributed to a sizeable 55 percent of Developments A.1. Recent Economic strong domestic demand and recovering service growth (Figure A.1). Government consumption also sectors. expanded, contributing 10 percent to overall growth, in line with rising public spending on social assistance Global growth is stabilizing at a low pace, with high programs and election-related expenditures in 2024. risks clouding global conditions. This year, global Meanwhile, investment through downstream activities A.2. The Policy Stance growth has stabilized at 2.6 percent, holding steady in the mining sector, as well as construction activities for the first time in three years despite widening in transport, warehouses, and communication sectors, geopolitical tensions and high interest rates. Supported contributed 27 percent of growth (the same as in 2023). by a resilient US economy, the global economy These positive developments have compensated for A.3. Outlook appears to be in a “soft landing” mode. However, the weak outcome of net exports, which resulted from and Risks global growth remains nearly half a percentage point moderating terms-of-trade and commodity prices (ppt) below its 2010-2019 average pace (World Bank coupled with a rebound in imports. GEP). Many developing economies still face high A.4. Medium- term Growth debt, slow investment growth, and climate-related The services sectors continue to grow while Simulations challenges. The East Asia and Pacific (EAP) region, manufacturing shows mixed results. The services growing at 4.7 percent, continues to outperform the sectors continue to be the main driver of growth. Low rest of the world, supported by a rebound in global value-added services were up by 6.3 percent in 3Q- goods trade, continued recovery in tourism, and 24 (year-over-year, yoy) as the retail & wholesale and A.5. Policy Priorities buoyant domestic demand (World Bank EAP update). hospitality sectors benefitted from robust consumption However, in China, economic activity has moderated (both private and public) (Figure A.2). High value- amid subdued consumer confidence and weakening added services also grew by 6.7 percent (yoy). This B.1. Introduction consumption growth. This adds to the numerous growth is attributed to investment in ICT, real estate, challenges confronting the global economy, including and business services sectors, as well as growth in the tight monetary policies, restrictive financial conditions, financial sector, with banks reporting rising lending geopolitical tensions, and a decline in productivity and profitability. Manufacturing performance was growth, especially among emerging markets (EM). more mixed. Commodity-based manufacturing and Indonesia’s tax gap the construction sector have witnessed robust growth B.2. Unpacking Indonesia’s GDP growth remains resilient, supported linked to downstreaming and the completion of major by strong domestic demand. The economy continued infrastructure and transport projects. Meanwhile, to grow at around 5 percent over the first three quarters tradeable manufacturing growth has moderated, of 2024 (3Q-24). A rapid deceleration in inflation has especially as sectors like textiles have experienced a supported consumer confidence and retail sales, loss in market share and large layoffs. Indonesia’s tax non- B.3. The drivers of which have surpassed pre-pandemic levels. Private compliance B.4. Recommendations 5 Indonesia Economic Prospects December 2024 Figure A.1: Growth remains resilient in 2024 driven by Figure A.2: Services remain the main driver of robust domestic demand growth whilst manufacturing shows mixed results Contents Table of (percentage point contribution to yoy growth) (percentage point contribution to yoy growth) 7 6 Tax-subsidy 6 5.0 5.0 5.0 5 Summary Executive 5 Agriculture 4 4 1.2 1.6 1.1 3 1.4 1.7 High-value add 3 2 1.5 1.3 services 0.8 1.8 1.1 1 2 1.0 Low-value add Developments 0.8 0.5 0.8 services A.1. Recent 0.7 0.3 Economic 0 1 0.6 0.3 0.7 0.6 0.8 0.7 Non-tradable -1 0.8 0.8 0.8 0.7 0.6 manufacturing -2 0.3 0.4 0.5 0 0.0 -0.3 -3 -0.4 Tradable 2018 2019 2020 2021 2022 2023 2024* -1 -0.3 manufacturing -1.4 Commodity-based A.2. The Policy Private consumption Government consumption -2 manufacturing Stance Investment Net exports Statistical discrepancy GDP -3 Total GDP 2018 2019 2020 2021 2022 2023 2024* Source: BPS, World Bank staff calculations. Note: *2024 is for 3 quarters (3Q-24). High-value-add services are ICT, financial & insurance, real estate, business, public admin, defense A.3. Outlook and Risks & social security, education, health, and other services. Low-value-add services are retail & trade, transport & storage, and hospitality. Non-tradable manufacturing are utilities and construction. Tradable manufacturing is manufacturing excl. commodity-based industries. Commodity based manufacturing is mining & quarrying, coal and O&G refinery, rubber products, non-metallic quarrying, and basic metals manufacturing. Despite Rupiah volatility, inflation gradually over across the consumption basket (Figure A.4). From A.4. Medium- term Growth Simulations softened as food and energy prices abated. January to April 2024, on the other hand, prices for 70 percent of the CPI basket rose by up to 4 percent, After accelerating in the first half of 2024, inflation while the remaining items (primarily food, beverages, gradually softened as food and energy prices and tobacco) increased by 4 to 8 percent. Between A.5. Policy Priorities abated. Headline inflation dropped to 1.5 percent in May and July, 60 percent of the basket saw prices rise November (yoy), the lowest since July 2021 (Figure by 0 to 4 percent, while 40 percent rose between 4 to 8 A.3). Such disinflation reflects a rebound in agricultural percent in mostly non-tradeable services. By the latter crop production, notably in grains, horticulture, half of the year, the share of CPI components with B.1. Introduction and rice, following favorable weather conditions. price increases above 4 percent declined to 16 percent, Furthermore, moderating global oil prices, coupled reflecting rapidly moderating food and energy prices with fuel subsidies and government policies to reduce and broad-based disinflation. air transport fares to priority tourist destinations, Indonesia’s tax gap have stabilized overall transport prices. As a result, Currency volatility has had a limited impact on B.2. Unpacking administered inflation eased to 0.8 percent (yoy), its inflation due to imperfect market transmission lowest since August 2021. Meanwhile, core inflation mechanisms. Analysis reveals that the exchange edged up to 2.3 percent, from 1.7 percent earlier rate passthrough to inflation is minimal¹. A 1 percent this year, amid rising prices for services, education, depreciation in nominal effective exchange rate (NEER) and personal care. This also reflects a narrowing gap leads to an instant increase in the CPI by just 0.03 ppt². The effect is depicted across two quarters and then Indonesia’s tax non- between actual and potential economic output. B.3. The drivers of dissipates throughout the year. The finding points to compliance The distribution of price increases across CPI an imperfect market transmission mechanism. These components shows broad-based disinflation, with market distortions could mostly be linked to government narrowing of inflation drivers around non-tradeable price controls and subsidies, especially in the food and services. Throughout 2024, no CPI components energy markets, which constitute the largest share of experienced price hikes exceeding 8 percent, unlike in the CPI basket. This also echoes previous findings on B.4. Recommendations 2022 and 2023 when rising commodity prices spilled delays in passing through price shocks from producers 1 The report uses a Structural Vector Autoregression (SVAR) model to assess the passthrough of nominal effective exchange rate (NEER) to headline inflation (CPI). The model also accounts for domestic demand growth, global oil price and Bank Indonesia’s policy interest rate. Quarterly data is used from Q3:2005 to Q2:2024. 2 Estimates of SVAR with two lags show these variables are statistically significant in causing responses on inflation. In contrast, global oil and NEER shocks are statistically insignificant to lead a response on inflation. 6 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 Figure A.3: Inflation has gradually softened, as pressure Figure A.4: Inflation was broad-based in 2024 from food prices abates although softer than 2023 Contents Table of (percentage point contribution to yoy growth) (Percent share of CPI basket) Non-administered services Administered services 100 8 Summary Executive Non-food Food 80 6 Headline inflation 60 4 Developments 40 A.1. Recent Economic 1.55 20 2 0 0 A.2. The Policy Mar-22 Nov-22 Nov-23 May-22 Mar-23 Nov-24 May-23 Mar-24 May-24 Jan-22 Sep-22 Jan-23 Sep-23 Jan-24 Jul-22 Sep-24 Jul-23 Jul-24 Mar-22 Nov-22 Mar-23 Nov-23 May-22 Nov-24 May-23 Mar-24 May-24 Jan-22 Sep-22 Jan-23 Sep-23 Jan-24 Jul-22 Sep-24 Jul-23 Jul-24 Stance 0-4% >4-8% >8-12% >12-16% Source: BPS, World Bank staff calculations. Source: World Bank staff estimates. Note: the y-axis refers to the share of CPI components whose price A.3. Outlook and Risks increase reached a specific bracket. Brackets are determined by color to consumers (see IEP December 2022). Simulations wage rose by 3.3 percent (yoy) to IDR 3,040,719 whilst also reveal that CPI is mostly sensitive to past inflation the average monthly real wage saw a modest drop, episodes³. More than 85 percent of the CPI change in down 2.6 percent, now standing at IDR 1,393,562. The A.4. Medium- term Growth Simulations the first year after a shock is explained by a change construction and manufacturing sectors have faced in headline inflation a quarter before. This effect the most substantial real wage losses in the past year, moderates afterwards, with demand growth and BI at 9 percent and 4 percent, respectively. policy rate becoming more prominent. Together they A.5. Policy Priorities account for 13 percent of inflation variation. BI policy The Indonesian economy continues to struggle to rate impact on inflation is most likely explained by its generate enough middle-class jobs. As of August effect on inflation expectations. 2023, only 8.4 percent of jobs in the labor market are classified as middle-class jobs, a significant decrease B.1. Introduction While the labor market has shown overall resilience, from 14 percent in 2019, prior to the COVID-19 middle class job creation especially for youth pandemic. Instead, a significant proportion, 39 percent remains a challenge. of jobs, are earning “aspiring middle-class” wages in 2023. This points to overall productivity and job Indonesia’s tax gap Indonesia’s labor market demonstrates resilience, creation concerns, as middle-class jobs are often B.2. Unpacking marked by a reduction in overall unemployment associated with higher productivity and pay. and an increase in labor force participation, though youth employment remains a concern. Supporting those in the aspiring middle-class The unemployment rate dropped from 5.3 percent in category is particularly pertinent given recent job August 2023 to 4.9 percent in August 2024. The labor losses in the textile and manufacturing industries. Indonesia’s tax non- force participation rate increased to 70.6 percent, According to the Ministry of Manpower, job losses B.3. The drivers of compliance driven by a 2 ppt rise in female participation to 56.4 due to employment termination more than doubled percent. Yet, low youth labor force participation (49.6 from 25,114 in 2022 to 64,855 in 2023. The highest percent) and a high youth unemployment rate (17.3 peak was in November 2023, with 12,347 layoffs. percent) highlight the need to focus on job creation Most job losses were concentrated in West and and skill development for this demographic. Central Java and Banten, provinces known for their significant contribution to Indonesia’s manufacturing B.4. Recommendations The growth in real wages has stagnated, particularly base. Historically, the manufacturing sector has been in labor-abundant sectors such as construction particularly susceptible to worker layoffs, potentially and manufacturing. The average monthly nominal due to declining competitiveness⁴. 3 Variance decomposition of the forecast error (Forecast Error Variance Decomposition or FEVD) for each endogenous variable at different time horizons ⁴ In 2018 and 2019, 44 percent and 47 percent of workers reporting employment termination in labor force surveys were in manufacturing. Although this share decreased in 2021 and 2022, it has since returned to 2018 levels. 7 Indonesia Economic Prospects December 2024 Indonesia’s current account deficit widened as terms last year. Indonesia’s primary income deficit reflects of trade moderated and cyclical factors slightly profit repatriation by foreign companies, especially Contents Table of intensified services and income outflows. those in the commodity sectors. This is typical among resource-rich developing countries. Coupled with a Moderating terms of trade and a relaxation in deteriorating trade balance, these outflows led to a Summary Executive import restrictions reduced the goods trade surplus. widening of the current account deficit (CAD). Year- Declining commodity prices have dampened export to-September data reveals a deficit of 0.6 percent of growth and offset higher demand for Indonesian metals GDP, up from 0.1 percent of GDP over the same period exports, namely iron, steel, and aluminum (Figure A.5). in 2023 (Figure A.8). With the end of the commodity Consequently, goods exports grew at a slower pace boom cycle, the current account balance has returned Developments A.1. Recent Economic than imports, 6.4 percent compared to 8.6 percent to a deficit but remains below pre-pandemic levels respectively (yoy) (Figure A.6). Rising overall investment (averaging 2.5 percent of GDP between 2012-2019). and private sector credit meant that processed intermediate goods drove imports acceleration. This Global monetary easing and stable macro conditions A.2. The Policy follows a partial reversal of import restrictions on a wide in Indonesia have accelerated capital inflows and Stance range of goods, including those used for producing helped lower the cost of financing amid rising clothing, bags, footwear, and electronics⁵ (Figure A.7). external financing needs. Imports of primary intermediates for the food industry also increased modestly, reflecting the government’s Global financial conditions eased over the second A.3. Outlook and Risks measures to stabilize food prices such as expanding half of 2024 amid policy rate cuts in key advanced rice imports quotas and quotas of other select food economies. In the US, declining inflation prompted items. As a result, goods trade surplus narrowed to 1.6 the Federal Reserve to begin its easing cycle with a percent of GDP for the year-to-September, down 0.4 50-basis point (bps) rate cut in September, followed A.4. Medium- term Growth Simulations percentage points from the same period in 2023. by an additional 25-bps reduction in November. Consequently, market expectations of US policy rates Cyclical factors have slightly intensified outflows have shifted, with rates anticipated to drop to 3 percent from services and income accounts. The first factor is by the end of 2026, compared to 4 percent anticipated the Hajj season in June, which saw a 10 percent rise in in June⁶. The European Central Bank and the Bank A.5. Policy Priorities the number of pilgrims compared to 2023. Rising travel of England have also lowered their policy rates since imports widened the services trade deficit, up by 0.1 June. This shift in monetary policy has eased global percent of GDP (year-to-September, yoy). Meanwhile, financial conditions, spurring a return of portfolio flows B.1. Introduction dividend payment and profit repatriation for foreign to emerging markets. Yet, policy rates globally remain investors moderated after June, keeping the income much higher than pre-pandemic years, signaling account deficit almost at par with the same period continued high financing costs. Figure A.5: Moderating terms of trade dampened Figure A.6: Goods imports grew at a quicker pace Indonesia’s tax gap exports growth than exports… B.2. Unpacking (contribution to percent yoy growth) (percent yoy growth (LHS) and US$ billion (RHS)) 20 80 8 10 60 6 0 40 4 Indonesia’s tax non- B.3. The drivers of -10 compliance 20 2 -20 0 0 -30 -20 -2 -40 Price Volume -40 -4 B.4. Recommendations Trade Balance Exports Imports -50 -60 -6 Jan-23 Apr-23 Jan-24 Apr-24 Oct-23 Jul-23 Jul-24 May-22 May-23 May-24 Jan-22 Sep-22 Jan-23 Sep-23 Jan-24 Sep-24 Source: BPS, World Bank staff calculations. 5 Trade Ministry Regulation No. 8/2024 addresses the backlog of about 26,000 containers at Indonesia’s major ports, caused by stricter import regulations introduced previously (Trade Ministry Regulation No. 36/2023). 8 ⁶ Policy rate expectations are derived from the Overnight Index Swap forward curve data, accessed as of June 1 and September 24, 2024. Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 Figure A.7: …fueled by acceleration in imports of Figure A.8: Current account deficit widened to 0.6 processed intermediate goods percent of GDP year-to-September Contents Table of (contribution to percent yoy growth) (percent of annual GDP) 50 Consumer goods Capital goods Primary intermediates Processed intermediates Income Summary 40 Executive 6 Services trade Goods trade 30 Current account balance 4 20 2 Developments A.1. Recent 10 Economic 0 0 -10 -2 A.2. The Policy -20 Stance -4 Mar-22 Nov-22 Mar-23 Nov-23 May-22 May-23 Mar-24 May-24 Jan-22 Sep-22 Jan-23 Sep-23 Jan-24 Jul-22 Jul-23 Jul-24 2018 2019 2020 2021 2022 2023 2024* Source: BPS, World Bank staff calculations. source: BI, World Bank staff calculations. Note: *2024 is for 3 quarters (3Q-24) A.3. Outlook and Risks Global monetary easing and stable macro turned into a surplus of 0.5 percent of GDP (Figure conditions in Indonesia has accelerated capital A.9), driving FX reserves up to a record of USD 151.2 inflows, bolstered foreign currency (FX) reserves, billion in October. This level is adequate and covers 6.6 A.4. Medium- term Growth Simulations and relieved pressures on the Rupiah. Portfolio months of imports. As a result, the Rupiah performed investment recorded net inflows of 0.8 percent of GDP relatively better than its peers. It depreciated by 2.5 by September 2024, compared to net outflows of 0.2 percent year-to-November, less sharply than the 7.0 percent of GDP over the same period in 2023. Foreign percent depreciation of JP Morgan’s Emerging Market direct investment (FDI) also recorded net inflows at 1.4 Currency Index (EMCI) (Figure A.10). A.5. Policy Priorities percent of GDP, up by 0.2 ppt compared to 2023. In contrast, other investments registered a net outflow of Global financial and Indonesia’s stable macro 1.1 percent of GDP as residents have increased financial conditions also combined into a significant drop B.1. Introduction asset purchases abroad⁷. Overall, the financial account in sovereign cost of financing. Spreads between US Figure A.9: Healthy portfolio inflows led to a surplus in Figure A.10: Rupiah performed better than EM peers the financial account over the second half of 2024 (percent of annual GDP) (index, January 2024 = 100) Indonesia’s tax gap B.2. Unpacking 5 Direct Investment 103 Portfolio Investment 4 101 Jan 2024 Appreciation Other Investment =100 3 Financial Account Depreciation 99 Indonesia’s tax non- 2 B.3. The drivers of USD/IDR compliance 97 1 95 0 93 JP Morgan EMCI -1 B.4. Recommendations -2 91 Jan-24 Mar-24 May-24 Jul-24 Sep-24 Nov-24 2018 2019 2020 2021 2022 2023 2024* Source: BI, World Bank staff calculations. Source: BI, JP Morgan, World Bank staff calculations. Note: *2004 is for 3 quarters (3Q-24) 7 These include loan assets, trade credits, currency and deposits abroad. 9 Indonesia Economic Prospects December 2024 Treasury bonds and Indonesia’s USD sovereign bonds Rising external financing needs amid global fell, reflective of declining investment risk (Figure A.11). uncertainty call for structural reforms to further Contents Table of Spreads between Indonesia’s USD sovereign bonds boost FDI, Indonesia’s largest source of external and Rupiah sovereign bonds also narrowed, reflecting financing. A wider CAD and rising public debt declining currency risks (Figure A.12). In parallel, amortization increase external financing needs. They Summary Executive Indonesia’s premia on risk of default on sovereign debt are estimated at 3.3 percent of GDP in 2024, but still has declined and is now among the lowest compared below the pre-pandemic average of 5.3 percent of GDP. to other emerging markets. Capitalizing on global FDI has been a steady source of external financing and monetary easing, fiscal authorities successfully issued has outperformed the more volatile and shorter-term dual-currency global bonds in September, raising EUR nature portfolio investments. Structural reforms to Developments A.1. Recent Economic 1.6 billion and USD 1.8 billion⁸. accelerate FDI inflows become increasingly important, especially amid volatile global financial conditions. Figure A.11: Favorable global conditions and stable Figure A.12: Indonesia’s premia on risk of default on macro conditions have helped reduce currency and sovereign debt has declined and among the lowest A.2. The Policy investment risks for Rupiah sovereign bonds compared to other emerging markets Stance (percent) (percent) IDN 10-Yr IDR IDN 10-Yr USD US 10-Yr Indonesia Brazil China 9 9 8 Philippines Thailand Turkey A.3. Outlook 8 and Risks 7 7 6 6 Currency Risk 5 5 4 A.4. Medium- term Growth 4 Simulations 3 3 Investment Risk 2 2 1 1 0 A.5. Policy 0 Priorities 9/1/2004 12/1/2005 3/1/2007 6/1/2008 9/1/2009 12/1/2010 3/1/2012 6/1/2013 9/1/2014 12/1/2015 3/1/2017 6/1/2018 9/1/2019 12/1/2020 3/1/2022 6/1/2023 9/1/2024 Mar-20 Mar-23 Mar-14 Mar-17 Jun-19 Jun-22 Jun-13 Jun-16 Dec-20 Dec-23 Dec-17 Sep-21 Sep-24 Dec-14 Sep-15 Sep-18 Sep-12 B.1. Introduction Source: Haver Analytics, Bloomberg. Source: Bloomberg. Banking sector prudential indicators are sound but funding ratio (NSFR), designed to gauge bank liquidity there is room to improve financial sector depth. conditions in times of stress, stood at 223 percent and 130 percent, respectively, as of September 2024. Both Bank asset quality is healthy, with banks having are above the 100 percent regulatory minimum. Indonesia’s tax gap B.2. Unpacking sufficient buffers to withstand potential adverse shocks while system-wide funding and market Banking sector profitability remains stable, as liquidity remain adequate. The non-performing loans resilient lending growth rates continue to support (NPL) ratio was low at 2.2 percent as of September the economy. In September, return-on-assets (ROA) (Figure A.13). The capital adequacy ratio (CAR) stood and return-on-equity (ROE) stood at 2.7 percent and at 26.9 percent, well above the regulatory minimum 14.7 percent, respectively, surpassing pre-pandemic Indonesia’s tax non- B.3. The drivers of of 10.5 percent. The level of provisioning was at 192 levels. The banking sector continues to expand lending compliance percent of NPLs in August, providing ample loss- to the private sector. After almost three years of growth, absorption capacity. Notably, the system-wide loan at lending to the private sector continued to expand by risk (LAR) ratio9 continued to trend down to 10.1 percent 10.9 percent in June (yoy). Moreover, the growth of in September, much lower than its levels of over 20 loans used for investment has been outpacing the percent during the pandemic10. Recent bank solvency growth of loans used for consumption and working B.4. Recommendations stress tests suggest that the overall banking sector is capital since March (Figure A.14). This outcome reflects resilient to multiple shocks, although there are tail risks the liquidity and macroprudential incentives used by BI for smaller banks (FSAP 2024). On the liquidity front, to boost the economy. the liquidity coverage ratio (LCR) and the net stable 8 This marks the second issuance of Indonesia’s SDG (Sustainable Development Goals) bonds denominated in Euro since 2021. 9 LAR is a forward-looking indicator of bank asset quality defined as the sum of NPLs, restructured loans, and special mention loans. 10 10 The nine largest banks saw a LAR level exceeding 20 percent between 2021-2022 but all have since seen continued improvement. Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 Nevertheless, the level of private credit is still 2023 Indonesia Enterprise Survey reveals that access to relatively low and reflects structural constraints for finance is considered the biggest obstacle to business Contents Table of financial deepening. Credit to the private sector was by 29 percent of the surveyed firms, particularly small at 31.4 percent of GDP as of the end of 2023. This is one and medium firms (32 and 23 percent, respectively). In of the lowest ratios among peer EAP countries, which particular, the share of micro and small entrepreneurs Summary Executive averaged 124 percent of GDP11. Low levels of private who rely on savings to start or run their business is credit persist against a backdrop of a dominant banking greater among women than men—64 percent vs. 55 sector with strong capital and liquidity positions. This percent, respectively12. Fintech and digital financial follows limited incentives to target the riskier segments services have seen rapid expansion during the of the economy and preferences to focus on stability. COVID-19 pandemic and have the potential to drive Developments A.1. Recent Economic Furthermore, a limited degree of competition in the greater access to finance. banking sector and substantial pricing power by certain market players reduce intermediation efficiency Borrowing costs and domestic funding conditions and increase borrowing costs. Authorities have started remain relatively stable, although funding costs are A.2. The Policy tackling these structural constraints through the elevated relative to peers due to structural factors. Stance implementation of the financial sector omnibus law Corporate bond issuance picked up in 2024. With risks (FSOL), which remains key to tapping further into the largely contained and a resilient economic outlook, sector’s potential. corporate borrowing costs remained stable. The 10- year AA corporate bond yield stood at 8.3 percent as of A.3. Outlook and Risks Access to financial services for underserved October, compared to 9 percent a year earlier. Taking segments, including individuals and small firms, a longer view, the capital market still lacks depth, with has been increasing but has room for further limited secondary trading happening in Indonesia improvement. According to an unpublished 2023 compared to peers. Although the government A.4. Medium- term Growth Simulations National Socioeconomic Survey, 76.3 percent of securities market is relatively well-developed, the Indonesians have an account with a formal financial corporate bond and equity market segments remain institution, while 88.7 percent have used formal shallow, offering limited choices for investors. The financial services. As of June, lending to micro, small, lack of demand from local long-term investors and a and medium enterprises (MSMEs) accounted for 19.6 weak domestic investor base, including relatively small A.5. Policy Priorities percent of all bank lending. This is an increase from the institutional investors, constrains market development lower baseline of 18 percent during the pandemic and and contributes to higher borrowing costs relative to marks an improvement in financial inclusion for the ASEAN and emerging market peers13. B.1. Introduction underserved segments of the economy. However, the Figure A.13: Banks asset quality is healthy, and have Figure A.14: Lending to the private sector continue to enough buffer to withstand adverse shocks grow especially loans for investments (percent) (percent yoy) Indonesia’s tax gap Provision to NPL (RHS) NPL (LHS) 21% Total Loan Working Capital B.2. Unpacking CAR (LHS) Tier-1 Capital (LHS) Investment Consumption 30% 240% 14% 20% 210% 7% Indonesia’s tax non- B.3. The drivers of compliance 10% 180% 0% 0% 150% -7% May-20 May-21 May-22 May-23 May-24 Jan-20 Sep-20 Jan-21 Sep-21 Jan-22 Sep-22 Jan-23 Sep-23 Jan-24 Sep-24 May-20 May-21 May-22 May-23 May-24 Jan-20 Sep-20 Jan-21 Sep-21 Jan-22 Sep-22 Jan-23 Sep-23 Jan-24 Sep-24 B.4. Recommendations Source: The Financial Services Authority (OJK), World Bank Staff calculation. 11 EAP peer countries used for comparison are Malaysia, Philippines, Thailand, and Vietnam (Finstat, 2020-2022). 12 Opening Opportunities: The Economic Cost of Gender Gaps in Entrepreneurship in Indonesia. Washington DC: WBG. 2023. 13 Peer countries with lower cost of borrowing relative to Indonesia, after controlling for other factors, include Malaysia. Thailand, the Philippines, Vietnam, as well as global peers such as Colombia, Hungary, Peru and Mexico. See Buzas et al (2021). 11 Indonesia Economic Prospects December 2024 2. The Policy Stance Contents Table of Falling commodity windfalls and a pick-up in social Spending increased substantially following assistance and capital spending expanded the fiscal policy decisions to boost social assistance and stance and raised debt service. accelerate developments in the new capital city. Summary Executive Total expenditures grew to 11.4 percent of GDP by After two years of consolidation, the fiscal stance October 2024, up by 0.7 ppt from the same period loosened slightly. With marginal growth in revenues in 2023. Multiple policy decisions contributed to this and substantially rising spending, the fiscal deficit increase. First, an 8 percent adjustment of civil servant wages in January 202414 and government transition- Developments markedly widened to a 1.4 percent of GDP by October A.1. Recent Economic 2024 compared to a negligible deficit (0.01 percent of related spending contributed to an increase in GDP) last year. By the end of the year, the Government primary spending by 0.3 percent of GDP (Figure A.16). of Indonesia (GoI) estimates that the deficit will reach Second, accelerated construction in the new capital 2.7 percent of GDP, exceeding the budgeted 2.3 city ahead of the Independence Day celebrations and A.2. The Policy percent, but remaining within the 3 percent fiscal rule. the completion of transport-related projects boosted Stance capital spending by another 0.3 percent of GDP. Third, Tax collections recorded marginal growth while the expansion of social assistance programs, namely natural resource revenues contracted as the effects rice and fertilizer aid, to tackle the food shock. Finally, of high commodity prices abated. Natural resource explicit subsidy spending marginally increased (up 1.5 A.3. Outlook and Risks revenues dropped by 10.9 percent (yoy), a 1.0 ppt percent year-over-year) due to rising fuel and LPG contribution to the overall revenue decline (Figure consumption. A.15). Tax collections grew 0.2 percent (yoy), largely due to smaller company profits, particularly in the oil Fiscal financing needs have risen gradually due to a A.4. Medium- term Growth widening budget deficit and rising capital injections Simulations and gas sector. Remarkably, international trade tax grew by 12.3 percent (yoy), driven by rising customs to SOEs, but financing was mainly available from receipts as imports picked up and by the GoI’s decision domestic market borrowing. In addition to a widening to relax copper export restrictions. Nevertheless, the deficit, capital injections, mainly into SOEs, rose by overall fiscal revenues fell to 10 percent of GDP by around 47 percent (yoy) but remained contained at A.5. Policy Priorities October 2024, down from 10.7 percent in the same 0.3 percent of GDP. Much of the financing has been period in 2023. This represents a lower collection rate sourced from bond issuance, amounting to 1.8 percent of 80.2 percent of the budgeted target, compared to of GDP. The Ministry of Finance also utilized excess B.1. Introduction 90.9 percent in year-to-October 2023. cash from 2023 as a financing source. As a result, net Figure A.15: Fiscal revenues saw marginal growth Figure A.16: While spending rose substantially in (percentage point contribution to yoy revenue growth) almost all areas (percentage point contribution to yoy expenditure Indonesia’s tax gap growth) B.2. Unpacking Grants Primary Expenditure Capital Revenues from public services Interest Payment Subsidy Other non-tax revenues 40 Others Total Expenditure Profits of SOEs 50 Natural Resources Revenues 30 40 Tax Revenues 20 Indonesia’s tax non- Total Revenues B.3. The drivers of 30 compliance 10 20 0 10 -10 0 -20 -10 -30 B.4. Recommendations -20 -40 Oct-19 Oct-20 Oct-21 Oct-22 Oct-23 Oct-24 Oct-19 Oct-20 Oct-21 Oct-22 Oct-23 Oct-24 Source: Ministry of Finance, World Bank staff calculation. “Others” category includes social assistance programs. Source: Ministry of Finance, World Bank staff calculation. 14 The civil servants wage adjustment is the first in five years. Seknas Fitra, February 2024. 12 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 financing more than doubled to 1.7 percent of GDP issuing the SRBI, a high-yielding monetary instrument by October 2024 compared to October 2023. Despite introduced in 2023 (see IEP June 2024). Since January, Contents Table of rising financing needs, the public debt stock decreased SRBI has attracted USD 12.5 billion in foreign capital, to 38.7 percent of GDP, down from 39.2 percent of raising its outstanding value to 4.1 percent of GDP as GDP in 2023. Most of the debt stock is denominated of October. BI managed the scale of SRBI issuances to Summary Executive in Rupiah (72.2 percent of total debt), primarily in counter currency pressures, as demonstrated by the the form of government securities, thereby reducing peak in issuances when the Rupiah hit a multi-year low exchange rate-related risks. in June. With nearly one-third of SRBI held by foreign investors, the instrument has expanded BI’s liabilities Debt service is also rising gradually as financing to non-residents, increasing from 0.7 percent to 1.9 Developments A.1. Recent Economic needs expand. With more than IDR 673 trillion of debt percent of GDP between September 2023 and August amortization due in 2024 (peaking further in 2025) 2024. A quarter of outstanding SRBI, equivalent to 10 (Figure A.17), debt service will reach a notable 4.9 percent of foreign currency reserves, is set to mature in percent of GDP by the end of the year. This situation Q4-2024. This will lead to smaller net issuances unless A.2. The Policy increases pressure on fiscal space and underscores BI opts to increase new issuances (Figure A.19). Stance the need for greater revenue mobilization to maintain fiscal sustainability and support pro-growth spending. BI also announced three new macroprudential Nevertheless, compared to benchmark countries, incentives in October to support private credit Indonesia’s short-term debt maturities have been expansion. First, BI extended the 100 percent loan-to- A.3. Outlook and Risks among the lowest over the past three years (Figure value ratio for mortgages and zero down payment for A.18). car loans until the end of 2025. Second, BI offered zero fees on QR-based payments below IDR 0.5 million for With the focus remaining on currency stability, Bank micro enterprises. Third, BI expanded reductions in the A.4. Medium- term Growth Simulations Indonesia is gradually easing its monetary policy reserve requirement ratio (RRR) to additional sectors, and supplementing this stance with additional including agriculture, manufacturing, wholesale trade, macroprudential incentives to promote private and micro enterprises. With this incentive, banks will credit. now benefit from a lower effective RRR (5-6 percent) compared to the official rate (9 percent). These three A.5. Policy Priorities Bank Indonesia is actively smoothing currency macroprudential measures are expected to further volatility, but challenges remain if global uncertainty boost credit to the private sector, which grew by 10.9 endures. Global monetary easing allowed BI to reduce percent in September, in line with BI’s target range of B.1. Introduction its policy rate by 25 bps to 6.0 percent in September. To 10-12 percent. mitigate currency pressures, the central bank continued Figure A.17: Expanding fiscal financing could elevate Figure A.18: Though it remains among the lowest debt repayments further which estimated to reach its compared to peer countries Indonesia’s tax gap peak next year (debt maturing in 12 months or less, percent of GDP) B.2. Unpacking (debt repayment profile, IDR trillion) 1,000 25 20 800 Indonesia’s tax non- B.3. The drivers of 15 600 compliance 10 400 5 200 0 B.4. Recommendations - 2021 2022 2023 2024F 2025F 2026F 2027F 2028F 2029F 2030F Argentina Brazil China Indonesia External debt repayment Domestic debt repayment Malaysia Mexico Philippines Thailand Source: Ministry of Finance, World Bank staff calculation. Source: Fiscal Space Data, Kose et. al., 2024, World Bank staff Note: Data as of December 2023, F denotes forecasts. calculation. 13 Indonesia Economic Prospects December 2024 Figure A.19: SRBI maturity peak is in Q4-24 Contents Table of (IDR trillion) 200 150 Summary Executive 100 50 Developments A.1. Recent Economic 0 -50 New issuances Maturing SRBI Net issuances -100 A.2. The Policy Nov-24 Nov-23 Aug-24 Mar-24 May-24 Jun-24 Dec-23 Jan-24 Apr-24 Dec-24 Sep-24 Sep-23 Oct-24 Oct-23 Feb-24 Jul-24 Stance Source: BI, CEIC, World Bank staff calculations. Note: Data as of 22 November 2024. A.3. Outlook and Risks 3. The Outlook and Risks The economy is projected to remain resilient with grain production and subsiding commodity prices balanced risks over the outlook. are expected to keep food and administered prices in A.4. Medium- term Growth Simulations check over the outlook period. However, core inflation Indonesia’s economy is projected to remain resilient is expected to pick up following robust domestic over the outlook period. Growth is expected to demand, easing monetary conditions, a 1 ppt VAT hike accelerate slightly to an average of 5.1 percent over (scheduled for January 2025), and the closing of the A.5. Policy Priorities 2024-2027. It will be supported by a boost in public output gap by 2025. This will push overall inflation to consumption and investment as the new administration an average of 2.5 percent over 2025-2027. Inflation gradually implements its social assistance and expectations are also anticipated to remain anchored investment programs, including those in the housing within this range. Pressures linked to food and energy B.1. Introduction and food sectors and the new capital. Private investment price volatility, the two largest components in the CPI is also projected to gain momentum. It will benefit from consumption basket, will be closely monitored. The private sector credit growth due to expected easing authorities remain committed to maintain inflation in in global monetary policy and continued liquidity check by using monetary policy instruments as well as Indonesia’s tax gap incentives from BI. Meanwhile, private consumption is non-market-based measures like subsidies and prices B.2. Unpacking projected to maintain a steady pace, compensating for controls. Targeted social assistance and market-based the lower trade contribution to growth. Exports and policies could be considered alternatively to avoid imports are projected to grow more modestly in 2024- market distortions and reduce fiscal costs. 2027. High base effects, global trade fragmentation, and China’s growth slowdown will hamper export The external position will remain challenging amid Indonesia’s tax non- growth, while resilient domestic demand is expected global uncertainty. The current account deficit is B.3. The drivers of compliance to boost imports. On the supply side, services such as projected to gradually widen to its pre-pandemic transport, warehousing, communication, trade, and levels, reaching 1.6 percent of GDP by 2027, with hospitality will drive growth, benefiting from the pick- moderating commodity prices and terms of trade up in domestic demand. Manufacturing, particularly in hampering exports. FDI will remain the largest source the mining sector, is also expected to boost growth of external financing, with competitiveness reforms, B.4. Recommendations as more investments linked to the downstreaming industrial downstreaming, and the construction of agenda are realized. the new capital expected to attract new projects. Meanwhile, BI’s monetary stance will stay focused Inflation is projected to stay firmly within BI’s target on guarding against high exchange rate volatility band (2.5±1 percent) but is prone to domestic and rapid or excessive capital outflows. Nevertheless, demand pressures. Favorable climate conditions for with inflation firmly anchored and global monetary 14 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 conditions easing, BI’s policy stance could become assistance16. Public investment is also forecast to more accommodating. The pace will be moderated return to its pre-pandemic level average. Gross fiscal Contents Table of and aligned with the normalization of US monetary financing needs are expected to rise after a continuous policy. Foreign currency reserves are projected to decline since the pandemic, averaging 4.8 percent of remain adequate, covering six months of imports. GDP over 2024-2027. Expanding fiscal financing and Summary Executive elevated borrowing costs are also expected to keep The fiscal policy stance will continue to adhere interest payments elevated at around 2.2 percent of to the fiscal rule. The fiscal deficit is projected to GDP or 17.6 percent of total revenues over the medium average 2.6 percent of GDP over 2024-2027 even term. as the government rolls out new priority programs. Developments A.1. Recent Economic Those programs, along with rising interest payments, The outlook is subject to balanced risks. Heightened are projected to push spending to an average of geopolitical tensions might precipitate a steeper decline 15.3 percent of GDP in the medium term (a 0.2 in terms of trade, causing inflation and potentially percent of GDP yearly increase). The additional constricting fiscal space due to lower revenues. The A.2. The Policy spending is assumed to be partially financed by a 1 pace of fiscal and structural reform will significantly Stance ppt increase in the VAT rate as mandated by the 2021 impact FDI inflows, macroeconomic stability, and Tax Harmonization Law as well as strengthened tax growth prospects. On the upside, a stronger-than- administration enforcement measures15. The subsidies anticipated recovery in major trading partners, like bill is anticipated to drop with potential reforms next China or the US, or a swing in key commodity prices, A.3. Outlook and Risks year, shifting support towards more targeted social such as palm oil, nickel, iron ore, or coal, could boost exports, widen fiscal space, and enhance growth. 4. Medium-term Growth Simulations A.4. Medium- term Growth Simulations Sustained acceleration in economic growth will that the total investment growth rate will double in the require structural reforms to boost productivity first five years and will gradually revert to the baseline growth in the second half of the decade. As a result of The new government is committed to achieving this investment push, gross capital formation will be A.5. Policy Priorities Indonesia Vision 2045 of reaching high-income 50 percent higher by 2030 compared to the baseline and has targeted to reach 8 percent GDP growth (55 percent higher by 2035). Those investments are by 2028. To reach 8 percent growth, the authorities expected to be financed primarily by FDI and are are targeting a big boost in aggregate demand over sustained at this level going forward. This scenario also B.1. Introduction the next five years. This strategy includes a major push assumes that the fiscal priority programs will be financed for private sector investment accompanied by fiscal gradually from higher tax receipts, which are projected stimulus. Those private investments are planned in to rise to 16 percent of GDP after 2030. Eighty percent of construction, housing, agrobusiness, natural resources, new government spending is projected to be recurrent Indonesia’s tax gap and manufacturing. A large portion of this investment spending that will benefit households, and twenty B.2. Unpacking is expected to come from FDI. The fiscal stimulus will percent is expected in the form of capital spending. be focused on the GoI’s 17 priority programs, including Government investment will increase to an average of a flagship Nutritious Food Program and other social 2.4 percent of GDP, compared to 1.4 percent in baseline protection programs. To finance those programs and over the decade. The fiscal deficit is assumed to rise to maintain the fiscal deficit rule, the government is also around 2.8 percent of GDP, 0.3 ppt above the baseline, planning to boost tax revenues to 16 percent of GDP but will remain below the 3 percent of GDP fiscal deficit Indonesia’s tax non- B.3. The drivers of by 2030. rule throughout the projection period. This scenario compliance assumes business-as-usual in terms of structural The boost in aggregate demand could have reforms. The second scenario (GovPlanFRTFP) assumes different macroeconomic implications depending that in addition to the demand stimulus package, the on the extent to which it is accompanied by GoI will accelerate structural reforms that will double structural reforms. The report simulates the impact total factor productivity (TFP) growth and significantly B.4. Recommendations of accelerating demand on growth and examines boost returns on capital and labor. Examples of such macroeconomic tradeoffs under two structural reform reforms are discussed in the next section. policy options. The first scenario (GovPlanFR) assumes 15 Estimates show that an improvement of Indonesia’s VAT C-efficiency ratio to a level that is equal to its regional peers and a 1 percentage point VAT rate hike could increase the country’s current revenue collection by up to 32 percent (IEP June 2024). 16 Reuters, November 4, 2024. 15 Indonesia Economic Prospects December 2024 A demand stimulus package could achieve and labor. By creating additional capacity, the economy high growth, but it could also create steep generates more space for demand to catch up, Contents Table of macroeconomic imbalance if not accompanied by minimizing the risks of a boom-bust cycle. Combining productivity enhancing reforms. The GovPlanFR demand-side stimulus with structural reforms aimed scenario could see an acceleration of GDP growth at increasing productivity (Scenario GovPlanFRTFP) Summary Executive to 8 percent (Figure A.20) but the impact might be leads to higher GDP growth (8 percent) for a relatively short-lived as the economy risks overheating. A big longer period compared to demand stimulus alone boost to private and government investment could (GovPlanFR). Critically, it also achieves lower inflation fuel inflationary pressures, which could reach as high (5.6 percent at peak in scenario GovPlanFRTFP). as 9 percent (Figure A.21). Inflation could erode the Developments A.1. Recent Economic purchasing power of households and lower consumer TFP-boosting reforms create room for demand-side demand. It could also reduce export competitiveness measures to stimulate growth without triggering as the real exchange rate appreciates. Furthermore, inflationary pressures as they address supply-side rising investment levels typically lead to higher imports, inefficiencies and enhance the economy’s productive A.2. The Policy a widening current account balance, and pressures on capacity. Reforms that boost Total Factor Productivity Stance foreign currency reserves and the Rupiah. All these help ensure that demand stimulus does not create factors could create a drag on growth and pull the inflationary pressures by increasing the economy’s economy back down to its potential output. These capacity to supply goods and services efficiently. These pressures will also trigger tighter monetary policy to reforms enhance productive capacity, reduce structural A.3. Outlook and Risks manage inflation and reduce exchange rate volatility. bottlenecks, and encourage innovation, enabling the This in turn could hurt credit expansion and domestic supply side to respond effectively to rising demand. investment. By improving labor market efficiency, fostering competition, and supporting investment in technology A.4. Medium- term Growth Simulations A boost to demand accompanied by structural and infrastructure, they lower production costs and reforms could on the other hand fuel sustained mitigate cost-push inflation. As a result, the economy growth within a more stable macro environment. can expand output in response to higher demand This requires policies and structural reforms that boost without significant price increases, maintaining price productivity growth and increase returns on capital stability while supporting growth. A.5. Policy Priorities Figure A.20: A demand stimulus package will boost Figure A.21: … but it could be accompanied by high B.1. Introduction GDP growth inflationary pressures (percent) (percent) GDP Growth Rate (%) Inflation (%) 9 10 Indonesia’s tax gap B.2. Unpacking 8 7 8 6 6 5 4 4 3 Indonesia’s tax non- B.3. The drivers of 2 2 compliance 1 0 0 2024 2029 2034 2024 2029 2034 Baseline GovPlanFR GovPlanFRTFP Baseline GovPlanFR GovPlanFRTFP B.4. Recommendations Source: World Bank Staff Calculations. 16 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 5. Policy Priorities Contents Table of Indonesia’s performance on long-term growth Figure A.22: Indonesia performance in structural and job creation aligns with its progress and gaps reform areas relative to peers in competitiveness reforms. As countries transition (z scores based on multiple competitiveness indices) Summary Executive from low to high income, the relative importance of policy and institutional drivers of competitiveness Macroeconomics evolves. Building on existing literature, competitiveness Basic Governance Structural reform areas reforms can be categorized into three groups: Infrastructure foundational, efficiency, and innovation. Foundational Developments Labor markets A.1. Recent Economic reforms tend to be most critical for Low-Income International trade Countries (LICs) and early-stage Lower-Middle Income Basic human capital Countries (LMICs), while advanced LMICs and early- Business regulations stage Upper-Middle Income Countries (UMICs) benefit Financial sector A.2. The Policy from solid foundations and a stronger emphasis on Competition Stance efficiency reforms. Advanced UMICs require all three— -0.2 0 0.2 0.4 0.6 0.8 foundations, efficiency, and innovation reforms—to sustain competitiveness. Indonesia has performed well Source: World Bank Staff Calculation. Note: Z score (higher score= stronger performance relative to on foundations relative to its peers, enabling resource A.3. Outlook peers; lower score = weaker performance relative to peers). and Risks shifts to non-agriculture sectors. However, it lags high- Dark blue bars indicate reform areas associated with foundational performing peers in implementing efficiency reforms, areas of competitiveness. Light blue bars indicate reform area associated with efficiency drivers. which limits the reallocation of resources to more productive industries and firms, constraining its growth A.4. Medium- term Growth Simulations potential (Figure A.22). productive investments including underserved Despite big advancements, Indonesia has room to segments of the economy (see IEP June 2022 – special pursue critical foundational reforms in the areas focus on financial deepening). Furthermore, trade of human capital, social protection and domestic policy reforms can lead to greater specialization, A.5. Policy Priorities revenue mobilization to boost its growth potential. higher competition, and incentivizes domestic firms Critical foundational reforms for Indonesia include to innovate, thereby improving overall economic the need for investment in human capital and more efficiency. Those reforms include reducing non-tariff B.1. Introduction specifically in education. This include addressing the barriers on goods and services, simplifying customs learning losses from the pandemic, investing in skills, procedures, and improving the logistics ecosystem and investing in education quality to boost education (see IEP December 2022 – special focus trade for outcomes and close the gap with UMIC and HIC growth). Finally, investment openness and business (see IEP June 2023 – special focus education). Other regulatory reforms could incentivize access to higher Indonesia’s tax gap quality inputs, capital, and technology. Indonesia B.2. Unpacking examples of foundational reforms include revenue mobilization reforms to expand Indonesia’s fiscal space has taken important steps to reform its investment in support of funding Vision 2045 (see IEP December climate including the Omnibus Law on Job Creation. 2024 - special focus on tax). This eased restrictions under the Negative Investment List and streamlined business licensing via the OSS Efficiency reforms are important for infusing system. Yet, more can be done to tackle bureaucratic Indonesia’s tax non- B.3. The drivers of skills, knowledge, and technology that help drive inefficiencies and inconsistent regulation enforcement, compliance productivity growth. Among the most important of and address remaining sectoral restrictions, which those efficiency reforms needed in Indonesia is financial hinders investment in high-value added sectors (see deepening and the implementation of the financial IEP June 2024 – special focus on business regulatory sector omnibus law (FSOL). This law not only expands reforms). access to credit but also channels large savings into B.4. Recommendations 17 Indonesia Economic Prospects December 2024 Table A.1: Selected Macroeconomic Indicators Contents Table of 2020 2021 2022 2023 2024 2025 2026 2027 Actual WB projection Real GDP growth and inflation, percent change Real GDP -2.1 3.7 5.3 5.0 5.0 5.1 5.1 5.0 Summary Executive Consumer Price Inflation (average, %) 2.0 1.6 4.1 3.7 2.3 2.4 2.6 2.5 Consumer Price Inflation (end of period, %) 1.7 1.9 5.5 2.7 1.7 2.7 2.5 2.5 Private Consumption -2.7 2.0 5.0 4.9 4.9 5.0 4.9 5.0 Developments Government Consumption 2.1 4.3 -4.5 2.9 5.3 4.2 3.9 5.4 A.1. Recent Economic Gross Fixed Investment -5.0 3.8 3.9 4.4 4.5 5.4 6.3 4.8 Exports -8.4 18.0 16.2 1.3 4.1 3.9 3.4 5.8 Imports -17.6 24.9 15.0 -1.6 2.1 2.9 3.5 4.8 Fiscal accounts, central government, percent of GDP A.2. The Policy Revenues 10.7 11.8 13.5 13.3 12.6 12.5 12.7 12.8 Stance of which Tax Revenue 8.3 9.1 10.4 10.3 10.2 10.4 10.5 10.5 Expenditures 16.8 16.4 15.8 14.9 15.3 15.1 15.3 15.5 Primary Balance -4.1 -2.5 -0.4 0.5 -0.5 -0.2 -0.4 -0.5 A.3. Outlook and Risks Fiscal Balance -6.1 -4.6 -2.4 -1.6 -2.7 -2.5 -2.6 -2.7 Central Government Debt 39.3 40.7 39.5 39.0 39.3 39.6 39.5 39.6 Balance of Payments, percent of GDP unless indicated otherwise Current Account Balance -0.4 0.3 1.0 -0.2 -0.9 -1.4 -1.6 -1.6 A.4. Medium- term Growth Simulations Exports, Goods and Services 16.8 20.8 23.9 21.2 20.9 20.6 20.3 20.4 Imports, Goods and Services 15.1 18.3 20.7 19.2 18.7 18.5 18.5 18.7 Net Foreign Direct Investment 1.3 1.5 1.4 1.1 1.3 1.4 1.5 1.5 Gross Reserves (months of imports of A.5. Policy 10.2 8.0 6.0 6.6 6.9 6.7 6.5 6.2 Priorities goods and services) Memorandum items Nominal GDP (IDR trillion) 15,443 16,977 19,588 20,892 22,501 24,105 25,828 27,708 B.1. Introduction Real GDP Per Capita (IDR thousand) 39,203 40,237 41,952 43,599 45,313 47,138 49,048 51,146 Indonesia’s tax gap B.2. Unpacking Indonesia’s tax non- B.3. The drivers of compliance B.4. Recommendations 18 B. Funding Indonesia’s Vision 2045 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 Contents Table of B. Funding Indonesia’s Vision 2045 Summary Executive Developments A.1. Recent Economic 1. Introduction Indonesia’s strong economic development was After peaking during 2010-2012, when the economy underpinned by the government’s prudent grew by above 6 percent per year, growth averaged 5.1 A.2. The Policy approach to fiscal policy over the past two decades. percent from 2013 to 2019. Though growth moderation Stance Indonesia’s economy grew an average of 5.4 percent is typical in many nations at the lower to upper- per year between 2000 and 2019, while the poverty rate middle-income stage, this slower growth trajectory dropped from 23.4 percent to 9.4 percent based on is insufficient to reach high income status by 2045. the national poverty line. This impressive progress was While fiscal policy played a supportive role, Indonesia’s A.3. Outlook and Risks supported by a well-managed government spending public sector has been small relative to the size of its and borrowing strategy after the Asian Financial Crisis, economy (Figure B.3) and compared to other countries institutionalized by the State Finance Law in 2003. The at similar levels of development. Public spending has law set a fiscal deficit ceiling of 3 percent of GDP and decreased, partly due to declining revenues, falling A.4. Medium- term Growth Simulations a debt ceiling of 60 percent of GDP. These policies from 20 percent of GDP in 2009 to 15 percent by 2019 have translated into moderate fiscal deficits, averaging (Figure B.4), largely driven by reduced non-tax revenue 0.8 percent during 1995-2008, before widening to 1.6 from declining oil and gas exports. To support Vision percent up to 2019 (Figure B.1), and declining public 2045, fiscal space must be expanded to responsibly A.5. Policy Priorities debt (Figure B.2), which dropped from a peak of over finance increased investment and human capital 80 percent during the Asian Financial Crisis (AFC) to enhancements essential for boosting productivity and around 30 percent before the pandemic. accelerating growth. B.1. Introduction Looking forward, the country needs to find new Achieving high-income status by 2045 requires strategies to reinvigorate economic growth as it action to address infrastructure and human capital pursues Vision 2045 of becoming a high-income gaps. Indonesia’s public capital stock17 per capita is country. Growth has moderated in the past decade. low—less than half the emerging market average Indonesia’s tax gap B.2. Unpacking Figure B.1: Fiscal balance, Indonesia Figure B.2: Total government debt (trillion IDR, LHS; percent of GDP, RHS) (percent of GDP) General government revenue Cambodia Indonesia Malaysia General government total expenditure Fiscal Balance (RHS) Philippines Thailand Vietnam 3000 Average Pre 2008 1.5 Average 1.0 Indonesia’s tax non- Average Post 2008 100 B.3. The drivers of 2500 0.5 90 compliance 80 2000 0.0 70 -0.5 60 1500 -1.0 50 40 1000 -1.5 30 -2.0 20 500 B.4. Recommendations -2.5 10 0 0 -3.0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Source: IMF MCM Department, Arslanalp and Tsuda (2014 updated), Source: IMF WEO, Author Calculations. World Bank staff calculations. 17 Refers to accumulated public investments including those in transport, utilities, and health and education facilities. 20 Indonesia Economic Prospects December 2024 Figure B.3: Public spending is substantially smaller than Figure B.4: Public revenue relative to peers has been Contents Table of countries with the same level of developments historically low 0.8 Cambodia Indonesia Malaysia Philippines Primary Gov Expenditure over GDP 0.7 Summary Executive Thailand Average 0.6 East Asia & Pacific Upper middle income Adv Economies 20 0.5 Adv Economies 1995 2019 0.4 (pp) Developments 15 A.1. Recent Emerging LAC Economic 0.3 2019 Emerging LAC 1995 0.2 Emerging East Asia Emerging East Asia 1995 2019 10 0.1 Indonesia 2019 Indonesia 1995 0 A.2. The Policy 5 4 6 8 10 12 Stance 2014 2015 2016 2017 2018 2019 2020 2021 2022 Log of PPP per capita (Units PPP dollars) Source: IMF WEO. Authors calculations. Source: IMF WEO, Author Calculations. and far below advanced economy levels (Figure B.5). below), is the most cautious financing option. A.3. Outlook and Risks Bridging this deficit requires higher spending over the coming years, yet public investment continues to fall Fiscal policy reforms should be complemented short, lagging other emerging economies (Figure B.6). by structural reforms that boost productivity and As regards to human capital development, Indonesia growth, which further enhances fiscal capacity. In A.4. Medium- term Growth Simulations is marginally behind regional and income-level peers addition to reforms that raise revenue and enhance (Table B.1), although gap on education outcomes public spending efficiency, policies that promote is larger. Strategic investments in both physical and productivity are key for long-term economic growth human capital present a transformative opportunity and strong fiscal capacity. Reforms that lower regulatory A.5. Policy for the nation to achieve and sustain the 6 percent barriers for business entry and exit, increase market Priorities annual growth rate needed to reach high-income competition, and foster a supportive environment for status by 2045.18 With statutory limits on deficits and innovation will stimulate productivity and investment debt currently in place, raising tax revenues, particularly growth, ultimately contributing to a higher and broader B.1. Introduction by addressing the country’s large tax gap (see more tax revenue basis. Figure B.5: IDN public capital stock per capita, versus Figure B.6: IDN general government investment advanced and emerging market (EM) averages versus emerging market peers Indonesia’s tax gap B.2. Unpacking (2019, 2017 PPP terms) (2019, percent of GDP) 35,000 31,875 16 30,000 12 25,000 Indonesia’s tax non- B.3. The drivers of 8 20,000 compliance 3.6 15,000 4 10,477 IDR 8,575 trillion 10,000 to close 0 4,254 5,000 Thailand Malaysia Philippines South Africa Turkey Brazil China India Indonesia Hungary Peru Russia Mexico Ecuador Colombia B.4. Recommendations 0 Advanced Emerging Indonesia Source: IMF Investment and Capital Stock Dataset 2021, World Bank staff estimates. 18 Assuming Indonesia’s HCI grows at the past rates until 2045, HCI will reach 0.689, still below high-income countries’ HCI average. 21 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 Table B.1: Human capital index breakdown, Indonesia Indicator Indonesia East Asia & Pacific Upper middle income High income Contents Table of HCI Component 1: Survival Probability of Survival to Age 5 0.98 0.98 0.98 0.99 HCI Component 2: School Summary Executive Expected Years of School 12.4 11.9 11.8 13.2 Harmonized Test Scores 395 432 411 487 HCI Component 3: Health Survival Rate from Age 15-60 0.85 0.86 0.86 0.92 Developments A.1. Recent Economic Fraction of Children Under 5 Not Stunted 0.72 0.76 0.87 0.80 Human Capital Index (HCI) 2020 0.54 0.59 0.56 0.71 Source: World Bank Human Capital Project. A.2. The Policy 2. Unpacking Indonesia’s tax gap Stance 2.1 Indonesia’s tax revenue performance but also reduce the sovereign borrowing costs in international credit markets. Indonesia has significant untapped tax potential, A.3. Outlook and Risks with actual tax collections at least 6 percentage Taxes on Corporate Income Tax (CIT) and Value- points of GDP below what similar countries collect. Added Tax (VAT) have been the main sources of tax This difference is among the largest in a sample of collections and correspond to the largest foregone middle-income countries and is driven by low tax revenues. Due to high labor informality and limited A.4. Medium- term Growth Simulations efficiency—the share of potential tax revenues actually excise taxes, VAT and CIT, these taxes made up 56 collected—which is considerably lower than in many percent of total tax revenues in the 1990s and increased low- to high-income economies. Fully harnessing to 66 percent in 2019.20 Meanwhile, contributions this tax potential could yield substantial revenue from personal income tax declined markedly from 26.6 percent in the 1990s to only 8.1 percent of total A.5. Policy gains. Indonesia has achieved Investment Grade in its Priorities sovereign credit rating.19 Its low tax revenue and the revenues (Figure B.7). Despite relying heavily on VAT underdeveloped financial markets could be a source of and CIT, revenue from these sources is still lower than risk for sovereign credit risk rating. Closing the tax gap that of structural and regional peers (Figure B.8), which B.1. Introduction could not only generate resources for development Figure B.7: Both CIT and VAT have been the largest Figure B.8: …but they remained below what is components of tax collections in Indonesia… collected by peer countries… (percent of total revenue) (percent of GDP) Indonesia’s tax gap B.2. Unpacking 100% Corporate tax on income and capital gains VAT 10% 80% 8% 60% CIT, 36 40% CIT, 31 CIT, 18 6% Indonesia’s tax non- B.3. The drivers of compliance 20% VAT, 35 4% VAT, 30 VAT, 26 0% 2% Indonesia Regional and UMIC structural peers 0% VAT CIT PIT Excises Trade Other IDN (2019) MYS THA (2019) VNM PHL (2019) B.4. Recommendations (2018) (2019) Source: World Bank staff estimates, IMF data. Regional peers include Source: IMF WEO, Author Calculations. Cambodia, Malaysia, Philippines, Thailand, and Vietnam. 19 Buzas et al (2021) found Indonesia to have a higher risk premium on domestic currency bonds compared to peers even after controlling for macroeconomic and financial variables. The combination of higher risk premium and low revenue base results in higher ratio of interest payment as share of revenue. From 2015 to 2022, interest payments averaged 14 percent of government revenue, compared to just 8.5 percent for UMICs and 4 percent for HICs. 20 Property and certain sales taxes are collected by local government, which are not included in this report. 22 Indonesia Economic Prospects December 2024 also have more diverse tax sources.21 This can be gap suggests that administrative measures such as attributed to the narrow tax base, low compliance, and improvements in audit and enforcement may help to Contents Table of a relatively low effective tax rate. Even after the 2021 recover foregone revenues. Additionally, policies that Tax Harmonization Law (THL), which increased the facilitate compliant behavior among taxpayers (e.g., VAT standard rate to 11 percent and eliminated certain deepening of the financial sector, improvements in tax Summary Executive exemptions, the revenue gap remains sizeable. morale) can further amplify the positive effects of such administrative efforts. We use a simple framework to understand what factors affect tax revenue collection in Indonesia. Figure B.9: Decomposing the tax gap into policy and The first step is to quantify the amount of foregone Developments compliance gaps A.1. Recent Economic revenue (i.e., tax gap) from CIT and VAT (1). This is then 1. Tax gap decomposed by policy design of the tax system (2) and by factors that influence tax compliance. Unpacking tax compliance, we analyze the enforcement effectiveness A.2. The Policy of the tax authority (3), the behavior of taxpayers, 2. Policy 3. Enforcement 5. Structural Stance the prevalence of tax evasion and their potential Framework: by tax authority factors: Rate and Base Financial depth, underlying causes (4). Additionally, (5) structural 4. Tax avoidance/ Informality factors like the development of the financial sector and evasion by taxpayers levels of informality within the economy impact overall A.3. Outlook and Risks compliance rates (Figure B.9). Figure B.10: Tax gap breakdown, VAT and CIT 2.2 Policy and compliance gaps (average 2016-21, percent of GDP) A.4. Medium- term Growth Simulations The tax gap, or foregone revenues, consists of two 8 Compliance Policy components: the policy gap and the compliance gap. The policy gap represents the difference between 6 potential tax revenues and the amount collected by the government based on existing laws and 2.7 A.5. Policy Priorities regulations. These laws and regulations often provide 4 special arrangements and exemptions to certain 0.9 groups. Hence, the policy gap reflects the impact of B.1. Introduction 2 1.7 policies that move the effective tax rate away from the 3.7 2.6 standard rate (e.g., reduced or preferential rates) or 1.1 shrink the tax base (e.g., exemptions, tax breaks). The 0 compliance gap, on the other hand, is the difference between the tax owed to the government and the Source: World Bank staff elaboration. Indonesia’s tax gap Note: Numbers may not add up due to rounding. B.2. Unpacking tax revenue collected. It measures losses from non- compliance, including underreporting, insolvencies, While separate analysis of policy and compliance legal tax optimization, and administrative errors. gaps may be useful, these concepts are closely linked. Revenue improvements from reducing the Around 6.4 percent of GDP in additional VAT and policy gap can only be realized if the compliance gap is CIT revenues can be raised if policy and compliance Indonesia’s tax non- addressed simultaneously. For example, if deductions B.3. The drivers of gaps are closed. Overall, more than half of foregone compliance are removed for certain sectors but taxpayers then revenues from VAT and CIT can be attributed to avoid paying the additional taxes, no additional the compliance gap (Figure B.10). Non-compliance revenues will be gained. Instead, the reduction in is the primary driver of foregone VAT revenue, the policy gap will only turn into a larger compliance while the policy gap accounts for a larger share of gap. However, breaking down foregone revenues foregone CIT revenue. Based on limited international B.4. Recommendations for any given tax type (e.g., VAT or CIT) into policy comparison, Indonesia’s non-compliance levels are and compliance gap components remains useful to high compared to peers and while its policy gaps can determine which measures should be prioritized to be deemed relatively modest. The large compliance maximize collections. 21 High income countries tend to rely more on direct taxation (i.e., CIT and PIT) as VAT tends to be regressive. The VAT payment as share of income can appear regressive in Indonesia when compared to a household’s market income – that is, the income a household receives from labour, capital and private remittances. However, high prevalence of informal sellers who do not collect VAT and that poorer households have higher informal 23 consumption than richer ones, VAT in Indonesia is broadly neutral across the income distribution. Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 2.3 Value-added tax (VAT) gaps Figure B.11: VAT C-efficiency in Indonesia (2016-21) Contents Table of Indonesia’s large VAT gap has been worsening and 64.7% is above some of its regional peers’. This is indicated 61.7% by the VAT system’s declining overall C-efficiency – Summary Executive the ratio of VAT collections to final consumption. 57.9% 58.0% 56.3% This measures of how much VAT revenue is collected 52.8% compared to what would be collected if the standard 51.9% 53.0% VAT rate were applied uniformly across all consumption Developments without exemptions or reduced rates. Indonesia’s VAT A.1. Recent Economic C-efficiency has been on a downtrend trend since 2018 44.5% (averaging 52.8 percent during 2016-2021), reaching a low of 44.5 percent during the pandemic in 2020 (Figure B.11). This low collection efficiency is especially 2013 2015 2017 2019 2021 A.2. The Policy concerning given that Indonesia’s statutory VAT Stance Source: World Bank staff calculation. rate is comparable to that of its peers (Figure B.13). This translates to a widening VAT gap, suggesting that if the government can address the compliance Figure B.12: C-efficiency and VAT revenue-to-GDP and policy gaps, the country could nearly double A.3. Outlook ratios (2019) and Risks its current VAT receipts. Moreover, Indonesia’s VAT C-efficiency is about 17 percentage points lower than C-efficiency (left axis) VAT revenue to GDP (right axis) the average of its regional peers22, collecting nearly one percentage point below the average of its peers 100% 6% A.4. Medium- term Growth Simulations (Figure B.12). Notably, Thailand collects 4.7 percent in 5% 80% VAT (compared to 2.3 percent in Indonesia) despite 4% a substantially lower standard statutory rate and 60% similar scope of exemptions. This indicates significant 3% amounts of forgone revenue due to non-compliance 40% A.5. Policy Priorities 2% in Indonesia. 20% 1% Indonesia had a stable tax system with minimal 0% 0% B.1. Introduction policy changes over the last two decades, resulting IDN PHL THA VNM a stable VAT policy gap. The VAT policy gap remained relatively stable at around 13.5 percent of potential, or Source: World Bank staff estimates. 0.9 percent of GDP, between 2016 and 2021 due to a Figure B.13: Statutory VAT rates, Indonesia versus stable tax rate prior to the THL introduction (Figure Indonesia’s tax gap regional and structural peers B.2. Unpacking B.14). Major sources of foregone revenue due to policy design included the non-taxability of financial 11% 12% and insurance services, private education and health 10% 10% services, and hospitality services (Figure B.15). The non- taxability of mining and quarrying activities contributed 7% to a decline in policy gap. This is because the output Indonesia’s tax non- B.3. The drivers of of this industry is used mostly as intermediate inputs. compliance In cases when the final products and services are still subject to taxation, when the input VAT cannot be deducted, mining and quarrying producers end up overpaying VAT. This results in a decrease in the policy gap. B.4. Recommendations THA VNM KHM IDN PHL Source: World Bank staff estimates. 22 C-efficiency captures the overall efficiency of tax policy design and compliance. 24 Indonesia Economic Prospects December 2024 Figure B.14: VAT policy gap in Indonesia (2016-21) Figure B.15: Core components of the VAT policy gap Contents Table of (2021) Non-taxability of mining and grilling % of potential, LHS % of GDP, RHS Non-taxability of foodstuffs and agricultural Non-taxability of financials 20% 1.1% Non-taxability of health and educaton services (excl. public services) Summary Executive 20% Non-taxability of hospital services Small business 18% 0.9% Policy gap 15% 16% 0.7% Developments 10% A.1. Recent Economic 15.2% 1.4% 14% 0.5% 1.9% 5% 1.7% 1.7% 12% 0.3% 1.4% 0% -3.1% A.2. The Policy 10% 0.1% Stance -5% 2016 2017 2018 2019 2020 2021 VAT policy gap Main components Source: World Bank staff calculation. Source: World Bank staff elaboration. Note: Due to the interdependence between non-deductible VAT and rate applied on intermediate use, components of the VAT policy gap A.3. Outlook and Risks are not cumulative. Compared to peers, Indonesia’s VAT policy gap is B.16). In 2020, compliance gap peaked at 50.7 percent relatively low. This is primarily due to relatively low likely due to the economic impact of the pandemic, A.4. Medium- term Growth expenditure on health, education, and financial services as well as the deferred VAT payments. When the Simulations which typically are not taxed in most VAT systems. For economic situation improved in 2021, the compliance instance, in the EU, where the average policy gap is gap fell to 43.1 percent. Compared to peers, Indonesia’s approximately 46 percent of the potential revenue, compliance gap is high, ranking among the top 25 health, education, and financial services contribute percent in Asia and the Pacific as documented by A.5. Policy Priorities about 21 percentage points to the gap. In contrast, the IMF’s RA-GAP program, which covers data up to these categories accounted for only 7 percentage 2022 (Gupta and Jalles 2022). Moreover, Indonesia’s points in Indonesia. The size of the policy gap is VAT compliance gap surpasses that of the Philippines B.1. Introduction often influenced by the type of relief implemented‒ where the IMF estimated gap was 38 percent in 2015. exemptions without the right to deduct input tax, It is also higher than the compliance gap observed in non-taxability, or flat-rate taxation without the right those other middle-income countries where reliable to deduct input tax. Middle-income countries that rely estimates of the compliance gap are publicly available heavily on reduced rates, such as Turkey (with a VAT (Figure B.17). Indonesia’s tax gap policy gap above 40 percent) and South Africa (with B.2. Unpacking a VAT policy gap of about 30 percent), tend to have Administrative reforms have helped curb higher policy gaps. compliance losses, but more could be done. Tax administration efforts, such as mandatory e-invoicing However, VAT compliance gap is relatively high in introduced in 2016, contributed to the reduction in Indonesia. Between 2016 and 2021, Indonesia’s VAT VAT non-compliance. Similar experiences in high Indonesia’s tax non- B.3. The drivers of compliance gap averaged 43.9 percent of the total income countries indicate that improved access of compliance potential VAT collection, or 2.6 percent of GDP (Figure tax administration to taxpayer information through B.4. Recommendations 25 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 Figure B.16: VAT compliance gap (2016-21) Figure B.17: VAT compliance gap in Indonesia and select middle-income countries Contents Table of (percent of liability) VAT compliance gap (% of the VTTL) 44% 60% VAT compliance gap (% of GDP) 3.5% 38% Summary Executive 31% 50% 3.0% 20% 40% 2.5% 10% Developments A.1. Recent 5% Economic 30% 2.0% 20% Turkey (2014) Bulgaria (2019) Costa Rica (2016) Philippines (2015) Indonesia (2019) Republic of South Africa (2012) 1.5% 10% A.2. The Policy Stance 0% 1.0% 2016 2017 2018 2019 2020 2021 Source: World Bank staff elaboration. Source:World Bank staff calculation based on Canıkalp et al. (2016), IMF (2015), IMF (2018), OECD (2018), and European Commission A.3. Outlook and Risks (2022). Note: Data on compliance gap data is scarce, particularly among regional peers. Data above from various middle-income countries on varying years, sourced from different studies. A.4. Medium- term Growth Simulations digital reporting requirements increases voluntary systems to improve the efficiency and curb corruption compliance and strengthens enforcement measures (Box B.2). The increase in the compliance gap during (Box B.1).23 Among developing countries, Georgia the economic downturn in 2020 highlighted how and Cambodia managed to increase tax revenue strong economic conditions play an important role substantially through a combination of reforms that in bridging tax compliance gaps. Additional efforts to A.5. Policy Priorities include tax code simplifications, human resource and improve tax enforcement and boost tax morale among organizational changes, and leveraging modern IT taxpayers are needed to reduce tax evasion. B.1. Introduction BOX B.1 High income countries are not immune to compliance challenges Indonesia’s tax gap Among OECD countries, VAT compliance gap is non-negligible. The VAT compliance gaps in advanced economies B.2. Unpacking typically range from 2 to 20 percent (Figure B.1.1). This indicates that advanced economies also face taxpayer compliance challenges and complete sealing of the compliance gap is difficult, if not impossible. At the same time, there is broad evidence of success stories, where countries have much lower gaps than other comparators. Overall, more than one-half of the European Union (EU) member states recorded a compliance gap of below 5 percent of the VTTL in 2021. The evolution of the compliance gap in recent years in selected high-income countries also indicates that the Indonesia’s tax non- B.3. The drivers of compliance gaps are actionable. In 2009, the EU-wide compliance gap reached its peak of over 18 percent before compliance reducing to 5.3 percent in 2021 (Figure B.1.2). The increase in taxpayer compliance was accompanied by numerous reforms and efforts of tax administrations. For example, actions such as the introduction of domestic reverse charge, later replaced with the split-payment mechanism, the introduction of e-reporting, and increased penalties for fraud have contributed to a decrease in the VAT compliance gap in Poland from 24 percent in 2015 to under 10 percent in 2021. B.4. Recommendations 23 See European Commission (2022) on the analysis of the impact of digital reporting requirements in the EU, https://op.europa.eu/s/yKu6 26 Indonesia Economic Prospects December 2024 Figure B.1.1: VAT/GST compliance gap in selected Figure B.1.2: Total VAT compliance gap in the EU Contents Table of high-income countries (2021 or most recent available (2000-21) data) (percent of the EU-wide potential revenue) (percent of potential revenue) Summary Executive 17.8% 20% 18% 16% 10.8% 14% 8.0% Developments 7.0% 12% A.1. Recent Economic 4.9% 5.3% 5.4% 10% 2.8% 8% 6% 4% A.2. The Policy 2% Stance 0% 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 A.3. Outlook Sources: European Commission (2023), Canada Revenue Agency Source: Own elaboration based on European Commission (2023). and Risks (2022), Australian Taxation Office. (https://www.ato.gov.au), HM Revenue & Customs (2023). Note: Non-compliance could have increased during pandemic years, leading to elevated tax gap estimates as some countries granted delayed payments options. A.4. Medium- term Growth Simulations BOX B.2 Georgia and Cambodia’s successes in tax policy and administration reforms A.5. Policy Priorities Georgia implemented a comprehensive tax reform focused on tax code simplification and reducing incentives for evasion, leading to a three-fold increase in their tax ratio. During the early 2000s, the government drastically simplified the tax code, consolidating the number of general tax types from 21 to 6, all of which were low, flat, and easier B.1. Introduction to understand. These policy reforms were complemented by innovative tax administration reforms, including compulsory e-filing, IT-based audit risk assessment, and outsourcing tax audits to private firms to encourage tax compliance. Additionally, the introduction of fairer and more transparent dispute resolution mechanisms, as well as targeted measures to ease the administrative burden on small businesses, further improved business-tax authority relations and boosted tax morale. These policy and administration reforms translated to massive increases in tax revenues from 7 percent of GDP Indonesia’s tax gap in 2003 to 24 percent of GDP by 2011.24 B.2. Unpacking Under its Revenue Mobilization Strategy (RMS) 2014–18, Cambodia implemented a series of key tax administration reforms that significantly boosted tax revenue performance to be at par with other emerging markets. Reforms under this strategy included digitalization (e.g., introduction of a centralized taxpayer registration database, full implementation of e-filing and e-payment systems, and strengthened large taxpayer management), HR improvements that expanded the staff to focus on larger taxpayers, and enhanced audit activities which focused on risk-based audits. Indonesia’s tax non- B.3. The drivers of Similar to Georgia, the government also improved dispute resolution mechanisms and prioritized easing administrative compliance burdens of small businesses. As a result, Cambodia’s tax-to-GDP ratio exceeded its targets under the RMS, increasing from 15.2 percent in 2014 to 17.2 percent in 2017, with tax revenue growing significantly faster than the rate of economic growth during the period.25 B.4. Recommendations 24 Source: Gilauri, Nika. Reforming Taxes and Customs. Chapter 5 in Practical Economics, pp. 97–104. 25 Source: Adams, Debra; Jenkins, Charlie; De Mets, Patrick; Wilcox, Stephen. Cambodia: Technical Assistance Report—Tax Administration Modernization Priorities 2019–23. IMF Country Report No. 18/305 27 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 2.4 Corporate Income Tax (CIT) gaps Figure B.18: CIT collection efficiency (2016 to 21) Contents Table of (percent) The government collects less than half of its potential CIT revenues. Between 2016 and 2021, 60% Indonesia’s CIT revenue averaged 42 percent of its Summary Executive potential, despite a statutory CIT rate in-line with 50% regional and structural peers (Figure B.20). This sharply drops in 2020 to 29.3 percent (Figure B.18). Due 40% to the impact of the pandemic on firms’ profits, CIT Developments revenue declined by about 35 percent, widening the A.1. Recent Economic gap between potential and actual collections (Figure 30% B.19). The decline in efficiency is partly due to a six- month postponement of CIT payments and difficulties 20% in accounting for late payments. Nevertheless, despite 2016 2017 2018 2019 2020 2021 A.2. The Policy economic headwinds in 2021, collection efficiency is Stance estimated to have improved only marginally. Source: World Bank staff elaboration. Note: Estimates for 2021 may be subject to larger imprecision due to data unavailability. The policy gap accounts for a larger share of foregone CIT revenues. The CIT policy gap accounted Figure B.19: CIT revenue versus potential (2016 to A.3. Outlook and Risks for about 35.9 percent of its potential, or 1.8 percent 2021) of GDP, between 2016 and 2021. The top three (IDR trillion) sources of foregone CIT revenues are: (i) reduced rates for enterprises with gross turnover below Rp 1000 CIT potential CIT revenue A.4. Medium- term Growth Simulations 4.8 billion; (ii) tax rate discounts for small companies with yearly turnover below Rp 50 billion; and (iii) tax 800 rate reductions for public companies. The long-term decline in the CIT policy gap is primarily due to fewer 600 companies benefiting from preferential regimes over A.5. Policy Priorities 400 the years, driven by inflation and real economic growth for companies with turnover below Rp 50 billion. 200 B.1. Introduction Compliance challenges in CIT contributed to a third 0 of foregone revenue, at levels that are comparable 2016 2017 2018 2019 2020 2021 to international trends. Between 2016 and 2021, the average CIT compliance gap was about 33 percent of Source: World Bank staff calculation. total CIT potential, equivalent to 1.1 percent of GDP. This Indonesia’s tax gap Figure B.20: Statutory CIT rates, Indonesia versus B.2. Unpacking fluctuated significantly due to misalignments between tax revenue figures and liability estimates, influenced regional and structural peers by audits and tax amnesties in 2016 and 2017, which (percent) caused discrepancies between cash and accrual- based revenue. Despite these issues, the general trend 25% 24% suggests a rising compliance gap. However, these 22% Indonesia’s tax non- B.3. The drivers of levels are comparable to international trends, with 20% 20% 20% compliance Costa Rica at a 60 percent gap in 2015, South Africa between 8 and 12 percent from 2015 to 2017, Poland’s 30 percent gap in 2019 and 2020, and the UK’s 8.7 percent gap in 2017-18. B.4. Recommendations VNM KHM THA IDN MYS PHL Source: PwC tax summaries. 28 Indonesia Economic Prospects December 2024 3. The drivers of Indonesia’s tax non-compliance Contents Table of Tax compliance is a multifaceted issue influenced The prevalence of tax evasion is indirectly estimated by both individual and systemic factors. Non- by comparing the average responses in each group. compliance with tax obligations arises from a variety While this technique, which avoids directly asking a Summary Executive of elements, including taxpayer behavior, government firm whether they avoid taxes, is likely to be a more enforcement effectiveness, and broader structural credible way to interrogate sensitive topics. However, conditions. Taxpayer evasion can stem from attitudes these estimates are still based on self-reported toward taxes (tax morale) and complexities within the information and should be treated as a lower bound Developments tax system, while government actions, such as audits, for the prevalence of tax evasion. A.1. Recent Economic enforcement mechanisms, and dispute resolution processes, play a critical role in ensuring compliance. Certain types of firms are more likely to evade taxes. Tax evasion has been found to be more common 3.1 Behavioral factors that incentivize tax among firms that do not export, face substantial A.2. The Policy evasion26 competition from the informal sector, and believe tax Stance administration is a major obstacle to their business At least a quarter of registered firms admit to not activities (Figure B.21). These findings provide insights paying all the taxes they owe. These are findings on areas where tax administration efforts can facilitate better compliance. For instance, the higher rates of tax A.3. Outlook from a double-list experiment embedded in the 2023 and Risks World Bank Enterprise Survey (WBES). Respondents evasion among non-exporting firms suggest that many were divided randomly into two groups, each receiving firms may perceive that the revenue authority lacks two lists of statements about their firm. Both groups third-party data information about economic activities are given almost identical lists, except the treatment that do not cross international borders. Furthermore, A.4. Medium- term Growth Simulations group contains an extra statement, “This establishment the notably higher rates of tax evasion by firms that does not pay all the taxes it is required to pay.” (Table see tax administration as a major obstacle to their B.2). Firms in each group are then asked to state the business activities provide suggestive evidence that number of statements applicable to their business (i.e., efforts to simplify the tax system may lead to increases in compliance. A.5. Policy Priorities statements which are applicable are not disclosed). Table B.2: Design of the double list experiment B.1. Introduction GROUP A GROUP B List 1 • This establishment had to let go of an • This establishment had to let go of an employee employee over the last year over the last year • This establishment’s last month sales • This establishment’s last month sales increased by increased by 200 percent 200 percent Indonesia’s tax gap • This establishment was temporarily • This establishment was temporarily closed during B.2. Unpacking closed during the COVID-19 pandemic the COVID-19 pandemic • This establishment does not pay all the taxes it is required to pay List 2 • This establishment almost went bankrupt • This establishment almost went bankrupt in the last Indonesia’s tax non- in the last year year B.3. The drivers of compliance • At least one of the employees of this • At least one of the employees of this establishment establishment contracted COVID-19 contracted COVID-19 since the start of pandemic since the start of pandemic • The price of the main product of this establishment • The price of the main product of this changed over the past year establishment changed over the past year B.4. Recommendations • This establishment does not pay all the taxes it is required to pay Source: 2023 WBES, Hoy et al. (2024). 26 This sub-section draws upon the experiment Hoy et al 2024. 29 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 To understand the drivers of non-compliance and informality. Of the 55.6 percent of firms that claim to tax evasion, it can be helpful to take a firm-based have informal or unregistered competitors, about 95 Contents Table of perspective on paying taxes. There are financial percent believe that taxes are the main reason for and time costs associated with complying with tax those competitors not formalizing. obligations, and these may amount to a substantial Summary Executive obstacle to operating a business. Firms will look for About half of firms reported that it is easy to avoid opportunities to minimize these burdens, sometimes paying some of the taxes that they owe. Among even going beyond what is permitted under the tax firms that report being subject to the CIT, about 52 code. In other cases, firms may be non-compliant percent say that it is easy or very easy to avoid paying simply because they have low capacity to understand the full amount of CIT owed. For firms subject to VAT, Developments A.1. Recent Economic their obligations or to carry out the necessary steps. about 44 percent say the same. The link between the Furthermore, firms’ decisions are also shaped by their ease of evasion and the act of evasion may not be underlying attitudes and beliefs about the tax system. straightforward; for instance, many taxpayers may pay Recent data from the 2023 WBES sheds light on all all their taxes irrespective of how easy it is to avoid. A.2. The Policy these factors in the Indonesian context. Nonetheless, at the margin, higher non-compliance Stance should be expected in environments where firms One third of firms say that taxes are an obstacle to believe it is easier to get away with. their operations and an even larger share believe that taxes are discouraging formalization. Firms Firms that perceive tax evasion as easy tend to A.3. Outlook and Risks were asked whether tax rates and tax administration share certain characteristics. Specifically, firms are are a minor, moderate, major, or very severe obstacle more likely to believe it is easy to evade CIT if they: to their business, or not an obstacle at all. On tax rates, (i) have better understanding of their tax obligations, 34.0 percent of firms responded that it was a moderate (ii) find complying is complicated, (iii) finance their A.4. Medium- term Growth Simulations or worse obstacle, while for tax administration, 33.7 working capital entirely through their own funds, and percent of firms said the same. While grievances on the (iv) use external expertise to partially help with their tax system are common findings in enterprise surveys, tax preparation, filing, or payment.27 Interestingly, these results still suggest that the tax system is a using external expertise to fully complete all these tax more widespread pain point for firms than the courts, steps did not affect perceptions of ease of evasion. This A.5. Policy Priorities transport, workforce education, and electricity (Figure possibly indicates a distinction between capable firms B.22). Moreover, these concerns about taxes have seeking specialized help to exploit loopholes versus been becoming more widespread since 2009. Firms’ less capable firms needing full compliance support. B.1. Introduction perception of the tax system may be contributing to Figure B.21: Tax evasion prevalence, by firm Figure B.22: Share of firms that find tax rates and characteristics administration as moderate or worse obstacles to (percent of firms) business (percent of firms) Indonesia’s tax gap B.2. Unpacking 40 35.4 31.6 Estimated tax evasion prevalance (%) 28.2 Tax rate 34.0% 30 26.0 22.4 22.3 19.3 Tax administration 33.7% 20 Indonesia’s tax non- B.3. The drivers of 10 Courts 26.1% compliance 0 Transport 25.4% Full Yes No Yes No Yes No sample Workforce education 24.4% Exporter? Tax admin as a Faces strong B.4. Recommendations major obstacle informal Electricity 22.4% to business? competition? 0.0% 10.0% 20.0% 30.0% 40.0% Source: World Bank staff estimates from 2023 WBES. Source: WBES 2023, World Bank staff estimates. 27 Findings based on logistic regression with size, sector, and location controls. 30 Indonesia Economic Prospects December 2024 Even when firms want to comply, doing so may enforcement and complexity have a negative effect on prove unduly challenging. Almost 70 percent of firms it. The negative effect of tax enforcement on morale Contents Table of say that complying with CIT is complicated, while over may seem puzzling. However, this result likely reflects 40 percent say the same of the VAT. Among those the perception of inspections as an added layer of holding such a view, over two thirds attributed the complexity rather than a supportive measure. While Summary Executive complexity primarily to either conflicting requirements, inspections can foster trust by demonstrating fairness unclear procedures, or low-quality DGT guidance. The and transparency, they may simultaneously reduce burdens of such tax system complexity usually fall morale by increasing administrative burdens and hardest on small, low-capacity firms as evidenced by creating an environment that feels more punitive than a negative correlation between perceived complexity service oriented. This interpretation is reinforced by Developments A.1. Recent Economic and firm size—only 44 percent of firms with 100 or the direct negative effect of tax inspections on morale, more employees felt CIT compliance was complex. contrasted with its indirect positive effect through the Moreover, about 15 percent of firms say that the trust it builds. complexity of CIT compliance has increased over the A.2. The Policy past three years, with most attributing the increase to 3.2 Weakness in the tax enforcement Stance either conflicting requirements or complex tax forms. Tax administration can be broken down into the Promoting favorable beliefs and attitudes core functions of audit, enforcement, and dispute towards tax institutions may improve voluntary resolution. During the audit phase, cases are selected A.3. Outlook and Risks compliance, reducing firms’ inclination to evade either by discretion or through a parametric/risk-based taxes and increasing their willingness to navigate approach, and data and evidence are used to generate tax complexity. Since no tax authority can monitor tax liabilities (i.e., how much the taxpayer should pay every taxpayer or investigate all potential infractions, but has not paid). At the enforcement stage, these A.4. Medium- term Growth Simulations promoting voluntary compliance is essential for tax liabilities are collected using a range of tools, effective revenue collection worldwide. Emerging from warning letters to asset seizures, implemented research highlights the importance of taxpayer sequentially. Lastly, taxpayers have the right to dispute morale and trust for shoring up voluntary compliance. tax liabilities generated in audits. Disputes arising Taxpayer morale refers to the intrinsic motivation or from interpretations of laws and regulations are first A.5. Policy Priorities willingness of firms to comply with tax laws and pay attempted to be resolved through DG Tax’s objection taxes. Taxpayer trust refers to the confidence and belief channels and then elevated via an appeal process to that taxpayers have in the fairness, equity, transparency, the Tax Court,30 if necessary. B.1. Introduction and effectiveness of the tax system and the institutions that administer it. Governments and tax authorities Audits have not been effective at identifying tax likely have a more immediate influence on fostering evasion. Indonesia’s tax authority conducts less audits trust through their policies and behavior, whereas than peers, measured as number of audits per capita. building taxpayer morale may require a longer-term (Figure B.23) Moreover, audit-derived tax liabilities Indonesia’s tax gap effort. B.2. Unpacking for VAT and CIT have been on a consistent decline, suggesting that less tax evasion is being identified. This Taxpayer morale and trust are strongly linked and could in part be driven by the decrease in the number are influenced by factors such as tax enforcement of audit cases, particularly for VAT. This decline may be activity, access to taxpayer services, and tax attributed to the impact of the COVID-19 pandemic, system complexity.28 Interactions with tax authorities, during which the government might have opted for Indonesia’s tax non- B.3. The drivers of especially inspections and use of taxpayer services, less stringent measures to support businesses amid compliance increases taxpayer trust, while tax complexity lowers the economic downturn. In addition, the tax authority it.29 The positive effect of interactions with the tax may be overwhelmed with processing routine refund authority on trust may be related to the favorable view requests, which, by law, must be resolved within 12 that firms have of the DGT—in fact, inspected firms months or the taxpayer has to be compensated, are more likely to state that the DGT is fair, impartial, diverting resources from more revenue-generating B.4. Recommendations and uncorrupted. Second, while trust and taxpayer audits. services positively influence taxpayer morale, both tax 28 Findings based on two-stage structural equation model. 29 Tax enforcement is a measure of how often firms get inspected, whereas tax services reflect the intensity with which firms use taxpayer services and their level of satisfaction with such services. Tax complexity, on the other hand, is based on firms’ understanding of the requirements for compliance with CIT and VAT. 30 This is an independent institution under the Ministry of Finance. However, a recent reform has shifted the administration of this institution from the 31 Ministry of Finance to the Supreme Court. The reorganization will take effect no later than December 31, 2026. Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 Figure B.23: Annual audits per million sharing. Streamlining this data and making it accessible for audits could significantly boost compliance efforts. Contents Table of (average from 2018 to 2020) Lastly, the large volume of disputes highlights the 16,000 necessity for strong regulatory measures that provide 14,000 taxpayers with clear and consistent guidance. Updating Summary Executive 12,000 tax regulations to stay aligned with changing business 10,000 practices and economic conditions can prevent 8,000 misinterpretations that lead to disputes. 6,000 4,000 Developments 3.3 Underdeveloped financial markets A.1. Recent 795 Economic 2,000 0 Cross-country evidence indicates that countries with more developed financial sectors tend to collect more revenues. Indonesia has low levels of both tax A.2. The Policy revenues and financial sector depth, while countries Stance with higher financial system deposits and formal credit Source: World Bank staff estimates, IMF International Survey on to the private sector (as a share of GDP) typically have Revenue Administration. higher tax ratios (Figure B.24). The connection lies in the formal financial system’s role in tracking financial A.3. Outlook and Risks Indonesia’s tax administration has significant activities and supporting the accurate declaration opportunities to enhance the effectiveness of of assets for collateral, which aids tax authorities its enforcement functions in collecting audit- in detecting non-compliance and discouraging tax generated tax liabilities. While warning letters and evasion. Data supports this: businesses with access to A.4. Medium- term Growth Simulations distress warrants are commonly utilized, there is credit lines, savings accounts, and other formal financial potential to explore and streamline the use of more tools typically pay more in corporate income taxes robust enforcement tools, such as account blocking, (Figure B.25) than those without these resources. By arrest, and prevention measures, to improve arrears expanding its financial sector, Indonesia can enhance recovery. Addressing internal procedures that may limit access to finance for businesses to support growth A.5. Policy Priorities their use could unlock these tools’ full potential. The while improving tax compliance through the digital increasing number of taxpayer disputes, particularly trail left by financial transactions. regarding VAT, highlights an opportunity to refine B.1. Introduction regulatory provisions and address ambiguities. This Formal finance is expected to discourage tax trend may also reflect improved taxpayer awareness evasion. WBES results indicate that firms using bank of tax laws, presenting a chance to strengthen audit funds to finance at least 50 percent of their working quality and build greater trust in the system. capital or investments find it more difficult to avoid VAT or corporate income taxes. Similarly, companies using Indonesia’s tax gap Increasing access to information through third- B.2. Unpacking electronic payment systems find tax evasion more party data and strengthening the regulatory challenging than those that do not.31 This suggests frameworks can yield benefits across all three that engaging with formal financial channels creates functions. The fragmented and confidential nature greater obstacles to tax evasion (Figure B.26 and of third-party financial data hampers audit and B.27). Furthermore, a separate World Bank survey of enforcement efforts. Harmonizing bank secrecy, third- Indonesian microenterprises reveals that many avoid Indonesia’s tax non- B.3. The drivers of party data, and tax laws, while upholding privacy banking transfers to evade taxes, driven by concerns compliance protections, can strengthen tax compliance. Currently, that taxes paid through formal systems could be lost. government institutions manage data separately This distrust reflects how a lack of confidence in the under strict confidentiality, limiting the ability to collect system can undermine tax morale and aligns with accurate information on taxpayers’ transactions. DG WBES findings, which highlight tax concerns as a key Tax’s reliance on limited access through MOUs has factor in keeping businesses informal (Figure B.28). B.4. Recommendations proven insufficient for comprehensive and timely data 31 Note that these findings are based on self-reported, survey information. 32 Indonesia Economic Prospects December 2024 Figure B.24: Financial sector depth and government Figure B.25: Percentage of CIT paid (vs. various Contents Table of revenue indicators of formal finance) 20 18 17.02* Have a line of credit or loan 16 Summary Executive Tax revenue (% of GDP) 14 0.32 12 Have an overdraft facility 10 8 12.93** KHM CHN IDN Have a saving account Developments 6 A.1. Recent Economic 4 LAO MYS MMR Purchased machinery, vehicles, 7.67 2 PHL THA VN equipment, land, or buildings 0 0 50 100 150 -20 -10 0 10 20 30 40 Credit to Private Sector (% of GDP) A.2. The Policy Source: World Bank staff calculation. Source: World Bank staff estimates. Stance Figure B.26: Ease of avoiding taxes by use of bank Figure B.27: Ease of avoiding taxes by use of finance electronic payments A.3. Outlook (percent that find it easy to avoid taxes) (percent that find it easy or very easy to avoid) and Risks >=50% working capital financed by bank >25% of payments electronic 0% working capital financed by bank 0% of total payments electronic 52% 48% A.4. Medium- term Growth Simulations 40% 36% 37% 38% 32% 28% A.5. Policy Priorities VAT CIT VAT CIT B.1. Introduction Source: WBES, World Bank staff calculation. Source: World Bank staff estimates. Firms facing financial constraints are more likely to Figure B.28: Likelihood of taxes being the main engage in tax planning to ease cash flow problems. reason for competitors to remain informal Indonesia’s tax gap (percent of respondents) B.2. Unpacking The underlying intuition is that firms under financial pressure have a stronger incentive to engage in tax Very likely Likely Unlikely Not likely at all planning32, which, if done aggressively, can border 80% on tax evasion, to maintain necessary liquidity levels. Econometric analysis provides some evidence that 60% financially constrained firms are more likely to engage Indonesia’s tax non- B.3. The drivers of in tax planning. These findings are robust even after 40% compliance controlling for various firm-specific factors, such as changes in pretax return on assets (PROA), sales, book- 20% to-market ratio (BM), and leverage, which ensures that the observed effects are not driven by other variables. 0% Small Medium Large B.4. Recommendations 32 Examples of tax planning: (i) Taxpayers can reduce their taxable income by taking advantage of deductions e.g., deducting expenses related to operations, such as salaries, rent, and equipment costs; (ii) Tax credits directly reduce the amount of tax owed e.g., a company might receive a tax credit for investing in renewable energy or research and development; (iii) Companies can apply deferrals, which delays the recognition of income or accelerating the recognition of expenses to push tax liabilities to future periods e.g., a business might postpone invoicing until the next tax year to defer income; (iv) Through income shifting companies can move income or expenses between different entities or tax jurisdictions to take advantage of lower tax rates e.g., a company might shift profits to a subsidiary in a country with a lower tax rate. 33 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 3.4 High prevalence of informality Figure B.29: Share of informal firms that report Contents Table of registration does not apply to them by city A significant portion of Indonesia’s firms operates informally, particularly among micro-enterprises. 0.9 A 2023 World Bank Informal Sector Enterprise Survey 0.8 Summary Executive conducted across six Indonesian cities highlights the 0.7 prevalence of informality. On average, around two- 0.6 0.5 thirds of firms are informal, with notable variations 0.4 across cities: 67 percent of firms in Makassar operate 0.3 informally, while this figure rises to 78 percent in Developments A.1. Recent Economic 0.2 Jakarta (Figure B.29). Interestingly, over 70 percent 0.1 of informal firms recognize the importance of paying 0 taxes, indicating a general awareness of tax obligations. However, this agreement tends to be lower in cities with A.2. The Policy higher levels of informality. Additionally, 60 percent Stance of informal firms believe that business registration does not apply to them, revealing a widespread Figure B.30: Firm size distribution in informal sector misconception. This misunderstanding is especially pronounced in Surabaya (81 percent) and Denpasar A.3. Outlook and Risks 1 (75 percent). These findings suggest that targeted tax education and awareness campaigns could play Small (5−19) a critical role in addressing misconceptions about tax .8 Medium (20−99) registration and encouraging formalization. Large (100+) A.4. Medium- term Growth Simulations .6 Given the characteristics of informal firms and the high threshold for standard tax rates, the foregone .4 revenue from the informal sector is likely to be small. First, the distribution of firms in the informal A.5. Policy Priorities .2 sector is heavily skewed toward very small enterprises (Figure B.30). These firms typically lack the capacity to comply with standard tax regimes, as evidenced 0 B.1. Introduction by the fact that only 14 percent of firms prepare a profit and loss statement at least once a year. Second, the annual sales of informal firms (Figure B.31) are Figure B.31: Annual sales distribution in informal notably low and fall significantly below the current tax sector threshold of IDR 4.8 billion for standard VAT and CIT. Indonesia’s tax gap While formalizing these micro firms may not generate B.2. Unpacking .8 substantial tax revenue in the short term, it holds the potential to broaden the tax base in the long run. Formalized firms could benefit from opportunities to .6 do business with other formal enterprises, gain access Density to credit at lower interest rates, and take advantage Indonesia’s tax non- B.3. The drivers of .4 of government programs that incentivize investment compliance and innovation. These benefits not only support the growth of individual firms but also contribute to overall .2 economic development. 0 0 5 10 15 B.4. Recommendations Annual sales (billion LCU) 34 Indonesia Economic Prospects December 2024 4. Recommendations to increase development financing Contents Table of 4.1 Updating tax policies to widen the tax The VAT tax base can be expanded substantially base by reducing the registration threshold and exemptions. Reducing the VAT registration threshold Summary Executive To simplify CIT and boost revenue, Indonesia can from IDR 4.8 billion to IDR 0.5 billion would help to consider withdrawing special treatments and capture more businesses in the tax net, fostering concessional schemes. Removing special treatments formal business interactions between small and large for the construction services sector, publicly listed firms.34 Additionally, removing exemptions for various Developments firms, and MSMEs can help close the CIT policy gap sectors, such as the extractive industry, imports of A.1. Recent Economic and potentially generate considerable revenue. machinery, basic food, and private healthcare, can help Construction services, which have been under a final align Indonesia’s VAT system with international best tax regime, need to be reintegrated into the standard practices. Simplifying the VAT system in this manner CIT system to align tax collections with the sector’s would broaden the tax base and help with compliance. A.2. The Policy GDP growth. Similarly, the ongoing tax preferences for Stance publicly listed firms can be abolished, as the Indonesia Tax rates hikes will lead to higher revenue when Stock Exchange has become a mature market that no compliance challenges are addressed at the same longer requires tax incentives to attract listings. The time. Indonesia’s VAT rate, even with the scheduled concessional CIT scheme for MSMEs, which is overly increase to 12 percent, will still lag peer countries. There A.3. Outlook and Risks complex and creates horizontal inequities,33 could also is room for further increases in the VAT rate to align with be replaced with a simpler, more permanent regime. the average rates of other lower-middle and upper- middle-income countries. To ensure that revenue Tax holidays could be made more strategic gains from these rate increases are not undermined A.4. Medium- term Growth Simulations and systematically evaluated to achieve better by poor compliance, tax administration needs to be outcomes. While tax holidays are commonly used by strengthened, incorporating more third-party data countries to attract foreign direct investment (FDI), to enforce compliance. Additionally, zero-rating for promote innovation, and support key sectors or non-exports and the final VAT regime for hard-to-tax sectors could be eliminated, as they complicate the A.5. Policy regions, international evidence suggests they are often Priorities inefficient. They tend to benefit already-profitable system and create opportunities for tax evasion. projects rather than encouraging new investments. Additionally, tax incentives are not a major factor in 4.2 Enhancing tax administration to B.1. Introduction attracting foreign investors and can lead to substantial increase compliance revenue losses. A more effective approach would be to replace tax holidays with horizontal policies that Enhance compliance risk management (CRM) could reduce the overall cost of doing business. This includes improve detection and deterrence of tax evasion. lowering regulatory barriers, improving access to Indonesia’s tax gap The Indonesian tax authority can strengthen its CRM B.2. Unpacking finance, supporting labor mobility and reskilling, and process by gaining access to high-quality third-party investing in infrastructure to reduce logistics costs. data, such as financial and transactional records, to In the short term, conducting a comprehensive better identify and manage taxpayer compliance risks. assessment of the costs and benefits of existing tax Increased accuracy in detecting tax evasion will lead to incentives would help identify any redundancies. Best more accurate tax assessments from audits and more practices for granting tax incentives involve using cost- successful enforcement. Achieving this will require Indonesia’s tax non- B.3. The drivers of based incentives, ensuring that all tax incentives are aligning bank secrecy laws with tax regulations to compliance time-bound and performance-based. ensure that relevant financial data can be shared without compromising privacy rights. Additionally, integrating B.4. Recommendations 33 Firms and sectors with higher profit margins receive larger benefits. 34 With an exceptionally high threshold, most small firms are exempt, which may discourage large firms’ purchases from these small businesses (as large firms are not allowed to claim VAT credits on their inputs bought from exempt small businesses). 35 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 fragmented data across various government agencies will reduce information asymmetries and provide the and making it easily accessible to the DGT will improve tax authority with better data, ultimately leading to Contents Table of audit accuracy and help reduce tax evasion. increased revenue collection. Clarify and strengthen VAT regulations to help Enhance third-party data sharing from the financial Summary Executive reduce tax disputes. The government can simplify and sector with the tax authority to enhance accuracy of clarify VAT regulations to minimize disputes between CRM. The government can prioritize improving third- taxpayers and tax authorities. Clearer guidelines and party data availability, particularly from the financial more consistent application of VAT rules will help sector, to enhance tax compliance. This can be achieved prevent misunderstandings, improve compliance, and by aligning regulations to encourage data sharing, Developments A.1. Recent Economic reduce the administrative burden on both taxpayers establishing clear memorandums of understanding and the tax authority. Strengthening VAT regulations with financial institutions, and investing in IT systems is essential to providing taxpayers with confidence for automated data reporting. These steps will allow and reducing litigation, ultimately improving audit tax authorities to verify income declarations more A.2. The Policy outcomes and closing the tax compliance gap. effectively, reducing the tax gap and promoting fair Stance taxation across the economy. 4.3 Addressing structural constraints to further facilitate compliance Formalizing micro firms could support firms’ growth and raise revenue in the long term. To raise A.3. Outlook and Risks Continue strengthening the financial sector to tax awareness and promote formalization among further improve financial inclusion and economic micro firms, governments can simplify tax systems, growth while also facilitating tax compliance. offer education and outreach programs, and highlight The government has made significant strides in the tangible benefits of formalization, such as access A.4. Medium- term Growth Simulations addressing the challenges in Indonesia’s financial to credit, government programs, and new market sector, most notably through the adoption of the opportunities. Reduced registration costs and phased Financial Sector Omnibus Law (2023). These efforts tax obligations can further encourage compliance. align with the World Bank’s framework for financial Providing support services, leveraging technology for sector development, which emphasizes expanding the easy registration and filing, and partnering with local A.5. Policy Priorities funding base, increasing access to finance, improving organizations can make the transition more accessible. resource allocation efficiency, and maintaining financial Building trust through transparent use of tax revenues stability. By maintaining a strong commitment to these and showcasing the impact of taxes on community B.1. Introduction priorities, the government can further strengthen the development is crucial for long-term success. sector. A more efficient financial sector, with better credit information systems and formalized savings, Indonesia’s tax gap B.2. Unpacking Indonesia’s tax non- B.3. The drivers of compliance B.4. Recommendations 36 Indonesia Economic Prospects December 2024 Table B.3: Summary of Recommendations to Raise Tax Revenue Contents Table of Objective Recommendation Additional Information Broaden the tax Reduce the registration threshold Ideally to IDR 500 million which is more aligned with base for VAT, which also applies to the international averages for middle income countries. For temporary final tax regime for firms below the threshold, institute a permanent final tax Summary Executive MSMEs. regime for MSMEs. Remove special treatments and Remove special treatments for construction services, concessional schemes publicly listed firms for CIT, and remove non common VAT exemptions. Developments A.1. Recent Economic Rationalize tax incentives Make tax incentives more strategic, time bound, and systematically evaluated. Increase Enhance compliance risk Strengthen CRM by accessing high-quality third-party compliance management data and integrating fragmented data across government agencies. A.2. The Policy Clarify and strengthen VAT Simplify VAT regulations to reduce disputes and reduce Stance regulations administrative burden Address structural Expand the reach, depth, and Expand the funding base through digital access and the constraints efficiency of the financial sector growth of institutional investors. A.3. Outlook to facilitate and Risks compliance Increase access to finance to individuals and SMEs. Improve efficiency of financial resource allocation with digital finance, increasing competition, and enhancing A.4. Medium- term Growth Simulations financial infrastructure (better credit information systems, collateral registries, insolvency framework, and consumer protection laws). Strengthen supervision of financial conglomerates, legal A.5. Policy Priorities protections for regulatory staff, and crisis management coordination. B.1. Introduction Indonesia’s tax gap B.2. Unpacking Indonesia’s tax non- B.3. The drivers of compliance B.4. Recommendations 37 Indonesia Economic Prospects Funding Vision2024 December Indonesia’s 2045 Re ference s Contents Table of Summary Executive PART A Developments A.1. Recent Economic Alibhai, Aly Salman et al. 2024. Can Public Credit Schemes Improve Access to Finance for Small Businesses? Evidence from Indonesia. Policy Research Working Paper no. WPS 10894, Washington, DC: World Bank Group. Buzas, Laszlo et al. 2021. Analyzing the Determinants of EMDE Local-Currency Sovereign Yields : A Simple Comparative Approach. Washington, DC: World Bank Group. http://documents.worldbank.org/curated/en/133441620285208043/ A.2. The Policy Analyzing-the-Determinants-of-EMDE-Local-Currency-Sovereign-Yields-A-Simple-Comparative-Approach Stance Kose, M. 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Available at: https:// Developments databank.worldbank.org/source/world-development-indicators. A.1. Recent Economic A.2. The Policy Stance A.3. Outlook and Risks A.4. Medium- term Growth Simulations A.5. Policy Priorities B.1. Introduction Indonesia’s tax gap B.2. Unpacking Indonesia’s tax non- B.3. The drivers of compliance B.4. Recommendations 40 Supported by funding from the Australian Government through the Australia-World Bank Indonesia Partnership (ABIP)