Debt and Fiscal Sustainability

The word “priority” has a long history. It is said that it came from the word “prior,” which means “fast” in Latin . Then, the word is interpreted as the very first or prioritized.

According to author George McKeown, the word priority came into the English in the 1400s. It was singular. However, starting in the 1900s, people used it in plural: priorities. This is a rather odd logic: if there are multiple “priorities”, then it is no longer clear which one is the most important thing.

Priority is a very important concept in economic policy. It was born as a result of a basic economic problem: scarcity. Humans have unlimited desires, even though we live with limited resources. That\'s why we have to choose. There must be the first, or a priority.

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Priority is important when we talk about government budgets and fiscal sustainability. We know how important fiscal discipline is for maintaining macroeconomic stability and ensuring fiscal sustainability.

However, we are also aware that it is just a tool, not a goal. There is something more important than fiscal discipline: lives and livelihoods. That\'s why, during the pandemic, the theme of fiscal policy around the world is to do whatever it takes. Do whatever it takes to save lives and livelihoods. During the pandemic, even countries that generally adhere to strict fiscal discipline have loosened their policies, such as Singapore, which increased its budget deficit to 13.9 percent of GDP.

The problem is that the government’s revenues are limited. As a result, debt rises.

It is the same with Indonesia. The budget deficit was raised to 6.14 percent. Government spending was also increased to provide economic stimulus. The problem is that the government’s revenues are limited. As a result, debt rises.

What are the risks? What should be done to maintain fiscal sustainability, while at the same keeping us in a position to save lives and livelihoods? How big is our fiscal risk?

Fiscal risk and sustainability

The Macroeconomic Framework and Fiscal Policy Principles Report (KM-PPKF, 2021) of the Finance Ministry shows that all debt indicators increased during the 2015-2020 period compared to the 2010-2015 period. The average debt-to-GDP ratio rose from 24.54 percent to 30.76 percent, the ratio of debt interest payment to government revenue (the interest payment ratio) increased from 8.5 percent to 13.58 percent and the ratio of interest and debt installments to government revenue known as debt service ratio (DSR) increased from 21.54 percent to 36.74 percent.

KOMPAS/PRIYOMBODO

Construction workers finish a concrete pillar on 14 Dec. 2019 at the site of the Light Rail Transit (LRT) Jabodebek project on Jl. H.R. Rasuna Said in South Jakarta. According to the World Bank Quarterly Report, Indonesia’s economic growth is estimated to reach 5 percent in 2019 and 5.1 percent in 2020.

This was caused by a decrease in tax revenue on the one hand and an increase in the spending on the other. In addition, economic growth also declined compared to during 2010-2015 period, partly due to declining commodity and energy prices.

Debt indicators further increased in 2020 as a result of the rise in the budget deficit. The economic contraction resulting from the pandemic resulted in a drop in tax revenue by 16.88 percent. The decline in tax revenue was also caused by weakening commodity and energy prices, as well various tax incentives provided by the government. This explains why the ratio of debt interest payment to government revenue rose sharply from 14 percent in 2019 to 19 percent in 2020. With the projected positive economic growth in 2021, it is expected that that tax revenue will grow again. As of July of this yera, tax revenue had grown 7.6 percent.

In such a situation, will fiscal sustainability be disturbed? Conceptually, the debt-to-GDP ratio will be determined by the primary deficit plus the difference between the growth in debt interest payments and economic growth (interest-growth differential). To put it simply, under certain conditions of primary deficit and debt profiles, if the growth of debt interest that must be paid by the government is smaller than growth of GDP, the debt-to-GDP ratio will fall. International Monetary Fund data shows that Indonesia\'s interest-growth differential during 2009-2017 period was negative 1.2.

This means that debt interest growth is expected to be far larger than economic growth. This explains why the debt-to-GDP ratio increased to 39.39 percent in 2020.

Negative means that the growth of the debt interest is less than economic growth. However, the difference became smaller: minus 0.7 in 2018 and minus 0.2 in 2019. In 2020, the IMF estimated that the interest-growth differential would be positive 2. This means that debt interest growth is expected to be far larger than economic growth. This explains why the debt-to-GDP ratio increased to 39.39 percent in 2020.

A stress test conducted by the IMF this year indeed showed that in the worst case scenario – when economic growth and the rupiah exchange rate against the US dollar decline and interest rates rise – the debt-to-GDP ratio will rise, but it will remain stable at about 48.4 percent of GDP in 2025.

In line with these findings, a stress test conducted by the Asian Development Bank (ADB) showed that under certain conditions such as a growing contingent liability default risk (indirect debt that can be become the burden of the government), a rise in debt servicing, interest rates or inflation or the weakening of the rupiah or economic growth, the growth in the debt-to-GDP ratio can be limited.

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Both the ADB and IMF estimate that our fiscal situation remains sustainable. In accordance with that, debt rating agencies – the institutions most concerned with fiscal sustainability – continue to maintain Indonesia’s credit rating at investment grade.

However, I think we need to be careful. There is a short-term issue that needs a serious attention: the decline in tax revenue. The ratio of debt interest to government revenue and DSR experienced a sharp increase in 2020. This means that, in the short term, fiscal risk will increase.

KOMPAS/PRIYOMBODO

Online motorcycle taxi drivers show customer food orders through an application at Grab Kitchen Tendean, South Jakarta, in late October (29/10/2019). Grab Kitchen is an effort to bring customers closer to their favorite local dishes produced by micro, small and medium enterprises (MSMEs) through online food delivery services. Digital economic growth also helps MSMEs grow and develop.

The government\'s fiscal space is limited. On the other hand, stimulus is needed. How can we balance this? This problem is not unique to Indonesia. A few weeks ago, while teaching on the topic of fiscal policy during the pandemic—in the case of Indonesia—for the Harvard Kennedy School Executive Education Program, several participants, mostly policy makers from various countries, expressed the same concern.

A few steps

The question is: How do developing countries balance the need to finance fiscal deficits to cope with the pandemic without jeopardizing fiscal sustainability? Honestly, there is no single answer to this question. The pandemic has taught us, at least me, to be humble. So many things are unknown and should be studied thoroughly and carefully. More comprehensive and in-depth study is needed. However, there are a number of approaches that could possibly be taken to address the situation.

First, there should be an increase in productivity so that the incremental capital output ratio (ICOR) can be lowered. Indonesia\'s ICOR in 2021 was recorded at 8.16, an increase from 6.8 in 2019, and was far higher than 5.6 in the 2010-2014 period (Verico, 2018). This means that to produce one unit of output in 2021, a larger investment is needed than a few years ago. Why? Maybe, it is caused by low productivity or efficiency. Another possibility is that a lot of the investment is in infrastructure, which can only provide long-term returns so that in the short-term the ICOR will be high.

Whatever the reason, Indonesia must reduce its ICOR by improving efficiency and productivity, such as through a structural reform. Here, the implementation of the Job Creation Law is important. Mitali Das (2018) wrote an interesting article on productivity in Indonesia. He pointed out that improving the quality of human resources, increasing exports and the flow of direct foreign investment will boost Indonesia\'s economic growth to 7 percent.

We need innovation. If economic growth can be increased higher than debt interest growth, the debt-to-GDP ratio will decline.

For this reason, export products must be diversified, both in type and in the country of destination. We need innovation. If economic growth can be increased higher than debt interest growth, the debt-to-GDP ratio will decline.

Second, tax revenue should also be increased. In my article in Kompas (11/8/2021), I wrote about the importance of reforming the tax administration. My study with Mayara Felix, Ben Olken and Rema Hanna (2019) showed the sensitivity of taxable income to changes in tax rates with an elasticity of taxable income (ETI) of 0.59. With an ETI of 0.59, there is room for the government to increase tax revenue through an increase in tariffs. However, it is not without impact.

Our calculations show that for every one rupiah increase in tax revenue, there is an additional burden for the taxpayer (marginal excess burden) of Rp 0.51. This is the dead weight loss or cost that the economy has to bear as a result of such a policy.

Therefore, we proposed reforms in tax administration. For example, by moving the services of business entities from the regular tax office to the medium tax office (KPP Madya), as carried out by the Taxation Directorate General a few months ago. If transferred to KPP Madya, with a larger number of staff, the tax burden will not be borne only by a few large companies, as may be the case in the regular tax office, which has limited resources. As a result, the company can still grow and pay taxes.

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Third, tax expenditure (tax incentives) has been relatively high (1.62 percent of GDP in 2019). The question is whether these tax incentives are effective. Why are so many tax incentives provided if their impact on economic growth is relatively limited? It is now the time for the government to reevaluate the various incentives that have been given to stimulate the economy. Tax incentives should be given more selectively so that they will be more effective.

Another way is to start reducing exemptions in taxes, such as Value Added Tax (VAT). With these measures, tax revenue will increase, perhaps even without the need to increase the tax rate. It is possible because the tax base will be bigger. Another instrument that can be used is exploring the possibility of taxing non-renewable energy, including through carbon taxes, which can be offset by access to carbon credits so that the economic recovery will be ”greener”. Of course, this must be carried out gradually so that the company will be able to make an adjustment. If tax revenue can be increased, the government\'s debt-to-income ratio will decrease.

KOMPAS/TOTOK WIJAYANTO

Workers install external panels at a building site on Sunday (2 Feb. 2020) in Setiabudi, South Jakarta. Bank Indonesia has estimated economic growth of 5.1 percent for 2019.

Fourth, the economy can only recover if the pandemic can be overcome. Before the pandemic can be overcome, a large budget allocation is still needed to provide health, social protection, and support for micro, small and medium enterprises (MSMEs). In the previous article, I proposed an increase in the number of beneficiaries and the value of social assistance, such as direct cash assistance (BLT) and the Family Hope Program. The government’s spending for health should also be increased to meet the additional expenditure for vaccination and other COVID-19 mitigation efforts, such as testing, tracing and treatment.

Fiscal financing

How can we finance this? Make a well-targeted reallocation in the state budget. The focus should be given to health, social protection, such as BLT, PKH, and other social assistance, as well as support for MSMEs. Other sectors can wait. The priority should be clear and be given to the health sector, social protection, MSMEs or other sectors that can bring a large multiplier effect. The quality of spending must be improved. If the budget allocation is well targeted and priority is given to the sectors above, the budget deficit can be maintained. The implication is that the new debts will decrease.

I know it is not an easy choice. There are so many things we have to do while our capacity is limited. That\'s why setting a priority is the key. Economist Thomas Sowell once wrote in a satire, “The first lesson of economics is scarcity, while the first lesson of politics is to disregard it.” I don\'t know how right Sowell was, but it\'s good to remember what Abraham Lincoln wrote, “Discipline is choosing what you want now and what you want most.”

KOMPAS/HERU SRI KUMORO

Muhamad Chatib Basri

Muhamad Chatib Basri, lecturer at the School of Economics and Business, University of Indonesia.

(This article was translated by Hendarsyah Tarmizi).