Indonesian president-elect, Prabowo Subianto, at the Doha Economic Forum on 15 May 2024.
President-elect Prabowo Subianto has set an ambitious target of achieving 8% economic growth during his first term. This goal is driven by the intention to lift Indonesia out of the middle-income trap and propel it towards high-income status by 2045. This target is outlined in Prabowo’s campaign document and the National Long Term Development Plan (RPJPN) 2025-2045.
Achieving this growth rate will require significantly increased government spending. The intuition is simple: if the current Rp 3,000 trillion government spending can only sustain around 5% growth, then the 8% growth target would need more.
The options
To make room for higher government spending, the president-elect has two options: set an ambitious revenue target, or relax the fiscal rule to allow for a higher deficit and/or debt limit. Here is why pursuing those policy options will prove challenging, and if caution is not exercised, could even jeopardize Indonesia’s long-standing macroeconomic stability.
Prabowo has promised to increase the tax-to-GDP ratio to 16% and the revenue-to-GDP ratio to 23% during his first term. Understandably, this is related to the higher financing needed to support a higher growth trajectory.
This ambition is not new. In 2014, President Joko “Jokowi” Widodo aimed for a 16% tax-to-GDP ratio in order to reach a 7% growth target. In the end, he only achieved an average of a 10% tax ratio and 5% growth during his presidency. The decline in commodity prices, particularly oil and coal, affected revenue generation. As a commodity-dependent nation, Indonesia’s revenue is highly influenced by commodity prices. The commodity boom that benefited former President Susilo Bambang Yudhoyono (SBY) did not continue under Jokowi, affecting revenue generation.
High informality in the labour market, with almost 60% of workers engaged in informal activities, further complicates revenue generation. The next best alternative for raising revenue is through value-added tax (VAT). However, the VAT collection system is currently ineffective, with the share of VAT to GDP being less than 4%, despite an 11% VAT rate. This indicates inefficiencies in the VAT collection system.
There is no easy solution for revenue generation in the short run. In the long run, sustainable generation of revenue will require structural transformation towards a stronger manufacturing sector, which can provide more formal employment opportunities. However, this falls beyond the realm of fiscal policy.
To address the current constraints in revenue generation, Prabowo envisions creating a designated revenue agency called Badan Penerimaan Negara (BPN). The idea is that by separating BPN from the Ministry of Finance (MoF), the revenue generation function can have more autonomy to generate revenue.
However, this could create a risk of a tax shortfall due to potential misalignment between revenue and macro-spending authorities, such as MoF and Bappenas. Indonesia is not known for smooth cross-ministry coordination, and an added layer of bureaucracy could exacerbate this. BPN could set an arbitrarily high revenue target without proper communication with the macro-spending authorities, leading to unrealistic targets and potential cash flow problems, risking Indonesia’s macroeconomic stability.
The fiscal rule
Prabowo has also suggested relaxing Indonesia’s fiscal rule, which currently caps the deficit-to-GDP ratio at 3% and the debt-to-GDP ratio at 60%. He argues that to achieve a high growth trajectory, Indonesia should consider relaxing these seemingly arbitrary caps.
Prabowo is on point regarding the debt-to-GDP ratio. Indonesia’s debt-to-GDP ratio is indeed relatively low compared to other developing economies in the Asian region, indicating some space for more aggressive fiscal policy.
However, relying solely on the debt-to-GDP ratio can be misleading. The ratio of primary balance to GDP (government revenue minus all expenditure excluding interest payments) has been declining and even entering negative territory under Jokowi, averaging -0.5% (excluding 2020 and 2021 due to increasing budgetary need during the Covid-19 crisis) compared to 0.5% under SBY. A positive primary balance allows a country some breathing room to service debt and lower the debt level. A negative primary balance, on the other hand, suggests limited space for generating more debt, as current revenue cannot keep up with regular spending needs, excluding interest payments. The share of government revenue used to pay off debt’s interest (debt service ratio) also increases, from an average of 10% under SBY to more than 14% in Jokowi’s term.
The fiscal rule ensures that Indonesia lives within its means and services its debt well, considering the constraints on revenue generation due to labour market structure and commodity prices. The cautious fiscal approach has contributed to Indonesia’s long-standing macroeconomic stability, preventing a debt-currency crisis spiral like those experienced by Turkey and Argentina.
Abandoning the fiscal rule could undermine market confidence in the Rupiah as the risk of debt failure is rising. This could lead to a loss of value in the Rupiah, rising prices, and economic contraction as Bank Indonesia would be compelled to raise interest rates to tame inflation.
Although this scenario is far from reality in Indonesia, market anxiety was evident when Prabowo floated the idea of increasing the debt level to 50% during his first term. He did this partly to allow a full rollout of his flagship campaign program, namely the free and nutritious meals program. Maintaining fiscal prudence thus means more certainty for investors as it helps control inflation.
Given the current political economy context, macroeconomic stability and fiscal discipline are Indonesia’s last line of defence to protect investors’ trust in the Indonesian economy. This is especially important, since real sector policy would become more uncertain under Prabowo’s big legislative coalition. Without effective opposition, the government can change commercial regulations and laws quite easily anytime it sees fit. Hence, the last hope for maintaining certainty lies in the hands of macroeconomic managers, not politicians.
One proven way to raise more money without damaging stability is by improving the quality of spending. Jokowi successfully reduced inefficient subsidies, freeing up much-needed fiscal space. In 2014, SBY left Jokowi with limited fiscal space, with a quarter of revenue spent on subsidies. By 2023, this share had fallen to less than 10%. However, subsidies are increasing again due to rising commodity prices.
Prabowo’s high political capital presents an opportunity to revisit subsidy spending. Reducing energy subsidies to align with international prices can improve fiscal space, albeit slightly, due to the already low subsidy allocation. Inflation will rise temporarily, but poor households can be compensated with temporary relief programs, as Jokowi has done several times since 2014. This will create larger fiscal space in the medium to long term.
The 8% dream
Importantly, it is not all gloomy. If Prabowo manages to reduce energy subsidies, the primary balance will likely improve, and so will Indonesia’s ability to manage debt more sustainably. This is because the tax and revenue ratio is unlikely to go below what it is now in the short to medium term, as commodity prices will still be staying up in the coming periods.
However, relying only on commodity prices will unlikely help achieve the tax and revenue targets envisioned by the president-elect. Even during the commodity boom period, Indonesia’s tax ratio never touched 16%.
Prabowo can keep his 8% dream alive. After all, it is true that Indonesia needs higher and better-quality growth to absorb new employment and reduce informality. This will definitely shape Indonesia’s fiscal posture for years to come.
But the key here is to maintain prudent fiscal policy and keep the fiscal rule intact, as it remains the proven recipe to provide certainty to investors. Changing it could risk macroeconomic stability, thus pushing Indonesia further away from a higher growth trajectory.
