Tax Policy, Growth, and Income Distribution in Indonesia: A Computable General Equilibrium Analysis

This study analyses the impacts of the Indonesian government’s 2008 income tax policy reform on its economy, using the computable general equilibrium (CGE) framework. In 2008, the Indonesian parliament approved the government’s proposal to amend the income tax laws. Essential amendments included adjusting the personal income marginal tax rates and adopting a single corporate income tax rate. These amendments are part of the tax reform and fiscal adjustment program that the government has implemented gradually since the early 2000s, with a value added tax and luxury sales tax reform on the agenda. These policies were initiated to achieve two objectives: to increase tax revenue and to promote sustainable economic growth. Along with economic growth, income equality is an important tax policy objective. Taxes are instruments for the redistribution of income and welfare between different household groups. Normally, a tax system is considered to have a positive effect upon income distribution and welfare if lower-income groups pay less than higher ones, as exemplified in many countries’ progressive income tax policies. A good tax system should be used as a policy instrument not only to protect the low-income households from paying an undue amount of tax but also to reduce the number of households below the poverty line. The relationship between tax policy reforms and the economy is complex; in some cases, large-scale tax reform can impact through inter-industry linkages simultaneously, making it difficult to explain, in theoretical terms, the impacts on the economy. However, identifying the important relationships among these inter-industry relationships may help to measure and evaluate the impacts on the economy. For this study, three policy scenarios were simulated. The first was an adjustment in the personal income tax rate structure; the second was an application of a single rate to the corporate income tax; and the third was a combination of these policies. The simulations were conducted under two different assumptions: with and without a balanced-budget condition. The balanced budget (or budget neutrality) condition is defined as the situation where government spending and revenue move in such a way to maintain a constant budget balance. The non-balanced budget condition is when revenue and spending do not necessarily move in line. The simulations were run under short- and long-run scenarios. The simulation results suggest that under the balanced budget-neutrality condition the income tax policy reform, which comprises the adjustment of the PIT rate structure and the application of a single CIT rate, benefits the overall economy with positive impacts arising. In the long-run, the policies increase aggregate welfare in the economy, indicated by the increase in real GDP and consumption expenditure. The results also show that income taxes tend to have a distortionary effect on the economy. As a result, the tax cut policy brings about increased economic welfare. The policies also cause a production factors to be reorganised. Excess labour, particularly in the government sector, is reallocated to other industries; this reallocation of labour is not only between sectors but also between labour categories-from skilled labour categories (e.g. management/professional and clerical labour) to the more unskilled labour categories (e.g. production and agricultural labour). While the policy simulations only have a small effect on reducing the incidence of poverty, they do increase the level of income inequality. A closer look at the policies’ impacts indicates that the adjustment of the PIT rate structure and the application of a single CIT rate provides more benefits to those in higher income groups, when compared to those with the lowest income. Rather, the impact on the lower income groups arise more from the indirect effects of economic growth. It is noteworthy that the CIT policy is more advantageous compared to the PIT policy in terms of promoting exports, inflation control, and attracting investment. This study improves our understanding of how the Indonesian government’s tax policies affect the country’s economy. Importantly, the study analyses the country’s economic development by examining the taxation policy’s impact not only at a macro-level, such as the impact on economic growth and employment, but also at a micro-level, such as the impacts on poverty and income distribution. The findings of this study provide important lessons to similar developing countries that are reforming their tax systems.