Fiscal Priority: Between ‘Must’ and ‘Want’

Thomas Sowell, an economist at Stanford University, may have a sharp tongue. He said, “The first lesson of economics is scarcity: There is never enough of anything to satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics.”

Sowell may be overly cynical, but economic policy is ultimately a matter of choice.

Priority issue is an important theme when discussing Indonesia's fiscal challenges ahead, when so many plans have been made. Sadly, we find that the pandemic has left a deep scar on vulnerable groups. A bright spot is starting to appear: The economy has begun to gradually improve. But it is certainly too early to become complacent. There is a risk of unbalanced economic recovery ahead.

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Data from the Bank Indonesia (BI) Consumer Survey show that the proportion of savings to the total income of the expenditure group earning Rp 5 million (US$350) and below has been declining. On the other hand, savings in the above Rp 5 million expenditure group has been increasing (September 2020-December 2021 period).

Understandably, a large portion of high-end consumption is in secondary or tertiary goods, such as vacations, travel, expensive jewelry, and dining at luxury restaurants. Their savings increased because the mobility restrictions affected their activities. This group also has good digital access, so that were able to continue their activities. On the other hand, the lower middle class has had to survive and their digital access is limited, so their savings was drained.

2022 fiscal capacity

The pandemic may have also caused a decline in the quality of human capital. According to the Asian Development Bank (ADB), about 27 percent of children in some ASEAN countries were unable to follow online schooling because of an inadequate internet infrastructure. The Covid-19 pandemic also came with a message: Health is an investment, not a cost.

The implication is that the fiscal policy must be inclusive. It should focus on providing access to health, education, and protection for the poor and the vulnerable, as well as addressing inequality. All these require funding. Can our fiscal policy do this? To answer this question, a few things needs close ed.

First, I think we need to appreciate the government's performance in managing the state revenues in 2021, which exceeded the target. However, we must also be fair. We have been fortunate because of improvements in the commodity and energy prices. Look at these figures: state revenue grew 21.6 percent in 2021, while non-oil and gas income tax grew 14.73 percent, oil and gas exports grew 60 percent, and non-tax state revenue (BNBP) rose 31.5 percent.

We find that the increase in commodity and energy prices has caused a sharp increase in state revenues. The question is, for how long? Future state revenues cannot rely on good luck. I'm not good enough to answer the question. However, there are several things that could be used as indicators.

Second, Jeffrey Frankel of Harvard Kennedy School (2018) showed that an increase in the United States’ interest rates could result in a decline in energy and commodity prices. The reason is that an increase in the Fed rate can encourage people to shift their investments from spot commodity contracts to financial investments. As a result, demand for energy and commodities decreases. Another implication is the strengthening US dollar exchange rate. As a result, commodity and energy prices – in non-US dollar denominations – become more expensive. Demand for global commodities and energy will decline, and prices will go down.

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Another important factor to consider is China's economic growth. Chinese growth is projected to slow down. All of these factors will ultimately lead to one thing: a decline in commodity and energy prices.

A preliminary quantitative study I conducted with Namira Fitriania of CReco Research showed that an increase in the Fed rate had the potential to lower oil prices in the future. The impact will be seen in 8-9 months. If the Fed starts raising interest rates in the first or second quarter of 2022, there is a possibility that energy prices will start to fall in 2023.

In line with this, the World Bank has projected that coal prices will decline in 2023. If this projection is correct, there is a risk that growth in tax revenues will slow down in 2023. I am aware that it is very difficult to predict energy and commodity prices because there are so many influencing factors. The green economy, for example, could result in a decline in the supply of nonrenewable energy so the price will decline, but not as steeply as expected. Either way, coal prices are unlikely to be as high as they were in 2021.

Third, the law mandates that the state budget deficit must return to below 3 percent of gross domestic product (GDP) by 2023. If revenues decline, spending must be suppressed in order to fulfill this.

Also, the fund allocated for Covid-19 handling was relatively large, while the usable fiscal space was relatively limited.

What is our spending plan? Look at these figures: the debt interest-to-revenue ratio reached 21-22 percent in 2021; education spending accounted for 20 percent of the state budget, regional and village funds disbursements reached almost 30 percent of the state budget. Also, the fund allocated for Covid-19 handling was relatively large, while the usable fiscal space was relatively limited.

This is not to mention the large amount of funding needed for the Nusantara capital city (IKN) relocation project. Relocating the capital city requires a significant amount of funding from the state budget. Why? In the early stages, the government’s financial support is needed to build the new capital city, because it would be difficult to expect the private sector to play a key role as frontline investors if the infrastructure is not available yet. Once the basic infrastructure is in place, the private sector will become interested in developing the new capital city. However, it should be remembered that state budget support is still needed.

Why? The new capital city is not merely a long-term project. It also crosses the government’s fiscal periods. Even though the IKN Law has been passed, there are still political risks. Investors will only be willing to invest with a guarantee that the IKN project will continue. At the very least, investors will ask the government to return their investments if the project is canceled.

This government guarantee will be a burden on the state budget. It becomes implicit debt (contingent liabilities). Public-private partnership (PPPs) also need state budget support because they may require a viability gap fund or a project development fund so the project will be commercially feasible.

What will happen if the investors are state-owned enterprises (SOEs)? SOEs also need state capital injection. In addition, the risks from SOE investments can also be a contingent liability on the government. In the end, it again burdens the state budget. That is why the role of the state budget in IKN financing, both explicitly and implicitly, will be relatively large. In fact, the state budget priorities need to focus on reducing poverty, protecting vulnerable groups, overcoming the risk of income inequality, providing access to education, and investing in health.

We know that the main goal of development is the welfare of the people. Not only that, there will be political risks if inclusive development or inequality issues are ignored, including for the next government. So far, the inclusive development strategy, although not yet perfect, has been able to minimize the impacts of the pandemic. In the future, it must be a top priority, especially during the post-pandemic era.

At the same time, we are also committed to the green economy. Transitioning to a green economy will take time and also needs support from the state budget, which will not be small during the initial stage. In fact, we know that there is a large gap between the budgetary requirements for a green economy and the available funds in the state budget.

Tax reform

Fourth, what can be done? Tax revenues must be increased and a spending priorities must be made t the same time. How?

The implementation of the new Tax Law is expected to increase state revenues. However, that's not enough. Another alternative is to increase the tax rate. However, this will impose a burden on the economy. An article I cowrote with Mayara Felix, Rema Hanna, and Benjamin A. Olken that was published in the American Economic Review (2021) showed that for every rupiah increase in tax revenue, there was an additional burden of Rp 0.51 for taxpayers (marginal excess burden).

This is the deadweight loss that the economy has to bear as a result of this policy. That is why we proposed tax administration reform rather than increasing the tax rate, for example by moving corporate tax services from the Pratama Tax Office to the Madya Tax Office, as the Directorate General of Taxes has carried out since 2021. Our study showed that due to limited resources, the Pratama Tax Office tended to focus on taxpayers with high income potential.

If corporate tax services are transferred to the Madya Tax Office, which has a larger number of staff, the treatment of business entities will be more uniform.

As a result, large corporations were the main targets. There is a possibility that they will try to avoid paying taxes as their businesses grow. If corporate tax services are transferred to the Madya Tax Office, which has a larger number of staff, the treatment of business entities will be more uniform.

The tax burden will not be "borne" by only a handful of large companies. As a result, they can still grow and pay taxes.

In addition, we need to review the government’s existing tax incentives. The tax-to-GDP ratio (tax incentives) was relatively large (1.52 percent of GDP) in 2020. Why have so many tax incentives been given, but their impact on economic growth has been relatively limited? Stop ineffective incentives. Another alternative is to reduce tax exemptions, such as for value added tax (VAT).

The government's move to expand tax coverage to sugary drinks is right. With such a measure, the tax revenue will increase, perhaps even without the need to increase the rate, as the tax base will expand.

Other instruments that need to be explored are taxing nonrenewable energy and increasing carbon taxes, offset by developing carbon markets, so the economic recovery can be greener. Of course, this must be done gradually so that the private sector will be able to make adjustments. If tax revenues can be increased, the fiscal space will expand.

Review priorities

On the expenditure side, priorities and quality of spending must be reviewed again. The state budget allocation should be focused on inclusive, green development. Other sectors can wait, and be given their allocations in stages once the fiscal space becomes available. We need to distinguish between "must-haves" and "nice-to-haves".

The Law on Central-Regional Fiscal Relations can also be used to ensure that spending in the regions is truly effective and efficient. The efforts to improve the quality of spending must be accompanied by structural reform to increase productivity. I once wrote in this daily (Kompas, 2/9/2021), that the incremental capital output ratio (ICOR) was relatively high at 8.16 in 2021. This is much higher than 5.6 in the 2010-2014 period (Verico, 2018).

It means that in 2021, the investment needed to produce one unit of output was larger than it was a few years ago due to low productivity or efficiency. Indonesia must increase productivity. The trick is structural reform.

The fiscal challenges ahead will not be easy. The government must carry out fiscal consolidation when the expenditure burden increases. This is why focus and priorities are important. I recall what Steve Jobs once said: “People think focus means saying yes to the thing you've got to focus on. But that's not what it means at all. It means saying no to the hundred other good ideas that there are. You have to pick carefully.”

KOMPAS/HERU SRI KUMORO

Muhammad Chatib Basri

Muhammad Chatib Basriis a lecturer at the University of Indonesia School of Economics and Business.

(This article was translated by Hendarsyah Tarmizi)