Indonesia Reforms its Tax Structure

If all goes well, at the first of 2009 Indonesia will engineer a radical redesign of its tax structure, instituting election-year tax sweeteners, slashing income taxes and eliminating the country’s hated Rp1 million (US$108.71) departure tax for local residents and registered foreign workers.

The changes, finalized recently by Indonesia’s House of Representatives, are extremely important to the business community, particularly the foreign one. A September, 2007 study by the International Finance Corporation, a World Bank unit, found that despite the fact that Indonesia is reforming its government structures faster than any other Asian country except China, its performance still ranks below every country in the region except the Philippines.

The tax changes are thus an integral part of the country’s continuing reforms, which began in 2002 and picked up steam with President Susilo Bambang Yudhoyono’s campaign to improve the business and investment climate. The changes are scheduled to be voted on when the legislature reopens. They follow a steadily increasing number of simplifications in the tax structure over the last year.

The projected reforms would give tax breaks to companies that list at least 40 percent of their shares on the market and seek to increase revenues by improved tax collection to offset the tax breaks. Overall tax revenues as a percentage of gross domestic product amount to only 11.4 percent. By contrast, the figure for the world’s top 10 countries, led by Sweden, Denmark and Belgium, is more than 40 percent.

Under the legislation, which is expected to pass the House of Representatives in the new session, Indonesia would fine unregistered taxpayers 20 percent of their total taxes if they fail to register by the end of this year. With 225 million residents, the country has only 4-6 million registered taxpayers and only about a third of them actually pay. Darmin Nasution, the director general of taxation, said he expects registered taxpayers to rise to 10 million by the end of 2008.

The barrier to increased tax collections is widespread corruption. According to the Business Anti-Corruption Portal, an anti-corruption website based in Copenhagen, while foreign investment is on the rise, investors still point at corruption, red tape and an uncertain legal environment as the main challenges when conducting business in the country. Companies report that they pay bribes amounting to nearly 40 percent of their taxes despite the campaign vow by Yudhoyono to eliminate backhanders.

Although the tax cuts could cost government coffers as much as Rp40 trillion (US$4.35 billion) in potential tax revenue, Darmin Nasution told the House of Representatives in May that the government projects that tax revenue would increase by 21 percent because of the improving economic picture, healthy exports and increases in tax collections. The 2008 state budget projects tax revenue at Rp580.20 trillion, climbing to Rp702.04 trillion in 2009.

First-half tax revenues were Rp265.18 trillion, a 50.78 percent increase year-on-year, driven by Indonesia’s 5.5 percent GDP growth and heady increases in revenues from energy and mining exports.

Indonesia’s exit tax (or fiscal as it is called locally) was kicked up by 150 percent at the height at the Asian financial crisis of 1997-1998 in an effort to discourage residents from moving their money overseas, particularly to convenient banks in Singapore. In an effort to increase registrations, initially only those who have registered as taxpayers and their families will be exempted from the tax. By 2011, the tax-free policy is to be extended to all citizens. Tourists pay Rp100,000 in departure tax.

Along with other changes in the tax code, the top corporate rate is to be dropped to 28 percent in 2009 to 25 percent in 2010. Companies going public will have their income tax cut by 5 percent to 23 percent in 2009, then to 20 percent in 2010. Companies that earn less than Rp50 billion a year will have taxes cut in half to 14 percent in 2009 and 12.5 percent in 2010. Maximum dividend taxes will drop 10 percent, down from 20 percent.

In an effort to ease the collection process, the government is opening tax offices in malls throughout the country, supplementing post offices or regional state-owned banks as payment outlets.

Reforms have moved forward steadily, according to an International Monetary Fund study of developments from 2001 to 2007 by economists John Brondolo, Carlos Silvani, Eric Le Borgne, and Frank Bosch, because of strong political support from the ministry of finance and other senior officials, the appointment of capable staff to oversee the reforms, setting achievable targets to protect the tax regime from being overwhelmed by the reforms and linking the reforms to the country’s fiscal adjustment program.