Policy Uncertainties in Indonesia: Trends and Policy Responses

Policy Uncertainties in Indonesia: Trends and Policy Responses Mohamad Ikhsan Advisor to Coordinating Minister for Economic Affairs Republic of Indonesia and Senior Research Associate at the Institute for Economic and Social Research University of Indonesia Presented at Regional Conference on Investment Climate and Competitiveness in East Asia: From Diagnostics to Actions Kuala Lumpur 21-23 November 2005 Organized by Bank Negara Malaysia

Outlines • Overview on the state of Economy since the crisis time • Policy Uncertainty Issues in Indonesia • Macro Uncertainties • Micro Uncertainties • The Impact of Policy Uncertainties on Performances • TFP • Investment • Employment • Major Causes for Uncertainties • Policy Responses

Overviewof State of Economy • Indonesia’s economy has steadily improved since the crisis time. • Per capita income has been backed to pre crisis level since 2004 and growth rate now accelerating to a 6 % p.a • More balance and sustainable sources of growth indicated by picking up on investment and export. • Macroeconomic risks improved significantly indicated by a sharp reduction in public and external debt ratio and short term debt over international reserve

But many (economic) problems remain • Our productivity remains lagging behind pre crisis period or other regional competitors. • Unemployment both open and under employment are still higher than pre crisis. • Poverty trends are moving away of the paths.

Firm and industry level data amplify those fundamental problems

In short, mostly caused by policy uncertainties

From a firm’s perspective, three aspects of government effectiveness are particularly relevant: the capacity of government to manage its resources and provide public services efficiently; the quality of its policies and regulations; and its ability to implement these policies in a credible and consistent manner. In contrast to new order regime, almost all areas Indonesia falls short. Both in term the quality of its policies and regulations—in terms of their complexity, which imposes a heavy administrative burden on firms—and in the extent of policy and regulatory predictability. As shown by a quantitative analysis, Pol Policy Uncertainties, Government Effectiveness, Investment Climate and Firm Performances

Implications of unfavorable investment climate Decline in export ratio Drop in profit Margin

Political transition to democratic regime No clear majority and expected to continue up to the next 10 year Bigbang decentralization. Authority vis a vis responsibility Financial crisis has limited the central government power. Crisis increases government debt services cost and limit the power of central government Most of regions rely on central government transfers. Inducing regional government to take progressive and in many cases unnecessary new tax and retribution. High debt also rises the country’s risks and degree of vulnerability. Debt intolerance in Indonesia is about 35% of GDP. It implies focusing on reducing debt burden still the agenda over 1-2 years ahead. Vulnerability in financial sector have forced the government to take another burden on contingent liability. The crisis also reduced the ability of the state to up grade infrastructures. Government spending on infrastructures reduced to only 3-4 % of GDP compared to 7% during the pre crisis time Sources of Uncertainties

Trend on Policy Uncertainty:Monitoring Results from LPEM-WB Survey • Number of days for setting up a business in Indonesia is about 80 days not 151 days as reported in Doing Business Survey 2006. • But that survey found a huge variation faced the companies when dealing with BKPM.

…but 80 days to start a business is still too long

… new investment law is not enough • to a certain sector, other regulations are required. • Regulatory reforms can be done and needed in both central and local governments

Need to focus on micro sector reforms • Regional Regulations are still problems and sources of policy uncertainties and distortions • Tax administration problems: new draft of tax packages are far from satisfactory and tend to be counterproductive. • Infrastructure: lack of supply and quality • Time to start a business is very long and variance is large. • Small and medium businesses are the losers • Tax refund still takes long time and in practices require “informal payment” to disburse it. • Labor regulations become less flexible make entry and exit cost increased significantly. • No clear vision over the future state owned enterprises • SME Development action plan need to beelaborated further .

… survey results also reveal a lot of effort are needed to improve investment climate in all fronts

Increase competition Raise efficiency Lower risk Greater demand and output Low costs Better risk x return Structural and institutional reforms More investment Lower taxes and cost of capital Macro adjustment Quality of public spending Improving investment climate

Policy Responses: Focusing more on executable actions while handling regulatory issues • Political constraints hinder the ability for GOI to eliminate political uncertainties except for the areas where all parties and/or interest groups relative have common ground. • Improving one areas may open the other Pandora. • Lack of trusts and lack of responsibility • Regional government regulation • Tax Reform initiatives • Central Bank Independence • Some dilemmas: • Need to focus on the process rather than outcomes (but at the cost of relative slow of implementing and results) • High expectation ( partly due to the past memories) also increases the demand for quick outcomes. • Inherent dilemmas: look example in fiscal trilemmas. • PR Problem • “Take it for granted” behavior on the government side. • Intermediary problem • Asymmetric problems of reform: cost of reform always up front while benefit usually appear in the medium term. Benefit per capita in many cases always less than cost per capita.

A reform agenda • Macro reform: • Fiscal Policy trilemma • Stabilization policy • Micro Reform: • Financial Sector • Trade Liberalization • Tax Reform including regional tax • Reform in business regulation • Combating corruption

Fiscal policy trilema Reduce public debt/GDP Increase public investment Lower taxes

Fiscal reform • Reduce public debt / GDP ratio: • Sustain a high primary surplus • Lower the cost of debt • Restructure public spending to accommodate rise in public sector investment • Reduce tax burden • Develop a medium-term fiscal framework that lowers political risk. • Gradually reduce contingent liability • Abolish the financial sector blanket system while introducing new deposit insurance companies • State Owned Companies Restructuring including initiating new law on Regional State Owned Companies • Diversifying financial sector and including giving more access to SMEs • Most of them have been achieved and further reforms are underway.

Action Program Solving regional regulation problems • Central government exercises the power to abolish contra productive local government regulation: • From 2001-Oct 05 : 469 Perdas have been cancelled and about 170 of them abolished between Okt 04-05 • Amendment Law No.34/2000: • Changing the concept from open list to closed list • Exercise General Allocation Fund as tool to impose discipline to regional government if : • They do not report new Perda to Central Government • Still exercise a Perda that has been cancelled by central government. • Implement a perda without central government approval. • Improving Perda Monitoring System by Ministry of Finance and Ministry of Home Affair • This can be done because we have some fiscal space.

Progress on Anti Corruption Effort • Two indicators of corruption dropped sharply. • Bribes to government officials as share of production costs fell from 10.8% in 2001 to just 1.8% in the current survey (3.4% in the 2003 ICA). • At the same time, percent of senior management time spent dealing with government officials dropped from 12.8% in the 2001 survey to just 4.9%. • Two possible explainations : • Improvement in anti-corruption efforts including establishing new and powerful anti corruption agency • A more competitive environment among regions to provide a better environment and efficient in public sector

Launching a new packages of investment law and regulation • Investment Law Objectives: • Increasing the quality and number of Investment • Reducing cost of doing business in Indonesia. Several Highlights of the Investment Law Draft: • Equal treatment for Domestic and Foreign Investors. • Simplifying Procedure for Registration & Licensing • Repositioning the role of Investment Board (BKPM) as an investment promotion and facilitation agency. • Clear and Transparent Negative List. • Target of 30 days for setting up business in Indonesia can be achieved through other improvement in government regulation. • As part investment packages, GOI also will prepare a serial package of deregulation. • We try to use all opportunities to lunch new package of deregulation • The 1st October 2005 packet was initiated along with domestic fuel price adjustments.

Fiscal Incentives: Tax and Custom • Tax Reduction: • Company tax rate reduction from 30% to 28% in 2007. Beyond 2007 there would be a reduction of 1 % annually to achieve the new tax rate of 25% in 2010. • Individual tax rate reduction from the maximum of 35% to 33 % in 2007 and achieved a new maximum tax rate of 30% in 2010. • Simplifying Procedures of Tax & Custom, and also Tax refund • Equal Treatment for tax payer and officer • Government will discuss further improvements on tax law draft with the parliament to meet business sector demand

Non-Fiscal Incentives • Improving Coordination Mechanism for Export and Investment by empowering National Committee on Export Promotion and Investment (PEPI) • President SBY will chair PEPI. • Empowering Domestic Industries and SMEs. • Action plan for SMEs Development is on the final stages

Improving Communication • President try to use a more inclusive approach. • But it may cost the delay of reform. • Use the good and bad guy tactics when launching unpopular policies. • This is also used to test the water.

Conclusion • Surveys shows some improvements in policy uncertainties during the SBY-JK administration. • But there are gaps between political will (for improvement in investment gap) and implementation. • Need “hands in” policy to improve investment climate in both central government and local government.

Policy Uncertainties in Indonesia: Trends and Policy Responses