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  Basic statistics of Indonesia (2011 unless noted)

  This Survey was prepared in the Economics Department by Annabelle Mourougane and Jens Arnold under the supervision of Peter Jarrett.

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  Executive summary

  Improved macroeconomic and structural policy settings since the Asian crisis have yielded strong and remarkably stable economic growth, as well as a marked reduction in poverty. Further institutional and policy reform would boost productivity growth and help the government reach its objective of becoming one of the 10 largest economies in the world by 2025, while promoting a socially inclusive and green development path.

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  Key policy recommendations

  Achieve the inflation target and, as planned, reduce it over time. This would be achieved by relying on interest rate, liquidity management and macro-prudential measures.

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  Assessment and recommendations

  Indonesia is Asia’s fifth largest economy, the fourth most populous nation in the world and endowed with abundant natural resources (). Thanks to a series of strong policy reforms and improved governance, significant progress has been achieved in social and educational dimensions since the 1997-98 Asian crisis, and the quality of human capital has been markedly enhanced. Strong macroeconomic performance can be attributed to successful policy management and to the substantial reforms undertaken since the Asian crisis that strengthened the macroeconomic framework and liberalised the international trade regime. Considerable investments in network industries have boosted potential output, and further improvements are expected with the gradual implementation of the Master Plan for the Acceleration and Expansion of Indonesia’s Economic Growth. The economy has also been supported by the dynamism of its small firms, which have accounted for most of the job creation and half of the production growth since 2008 (). Gains in total factor productivity have been increasing over time, a pattern that is observed in many other countries in the region (; Park, 2010).

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  Improving the tax system

  Indonesia has come a long way in improving its tax system over the last decade, both in terms of revenues raised and administrative efficiency. Nonetheless, the tax take is still low, given the need for more spending on infrastructure and social protection. With the exception of the natural resources sector, increasing tax revenues would be best achieved through broadening tax bases and improving tax administration, rather than changes in the tax schedule that seems broadly in line with international practice. Possible measures to broaden the tax base include bringing more of the self-employed into the tax system, subjecting employer-provided fringe benefits and allowances to personal income taxation and reducing the exemptions from value-added taxes. Similarly, broad-based investment credits would be a less distortive way to enhance investment incentives than selective tax holidays. Introducing a targeted, simplified tax regime for small and medium-sized enterprises, as currently planned by the government, could foster their integration into the tax system in the longer run, even if its short-run revenue potential is limited. Upgrading tax administration has made substantial progress in Indonesia since 2002, although there is still scope to improve the training of tax officers and the administration’s audit and litigation capacities, while strengthening internal control systems and enhancing the transparency of administrative decisions. The audit system could be further improved by allocating more tax audits on the basis of compliance risks.In the natural resources sector, particularly in mining, there is a case for increasing the government’s share of resource rents through higher tax rates imposed on these rents, as opposed to taxing revenues. This would imply a willingness of the government to bear a larger share of the exploration and development risk than heretofore, which Indonesia, with its improved access to international financial markets and a diversified resource portfolio, is now well placed to do. In the mining sector, a powerful rent tax regime with a large government take would serve the country better than export taxes and ownership restrictions that have been decided recently.

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  Promoting SME development

  Micro, small and medium-sized firms (MSMEs) are a key source of employment and economic growth in Indonesia. They contributed to the country’s economic resilience during the 2008-09 financial crisis. But many suffer from low productivity, curbing their role in boosting living standards. There are several ways to spur MSME productivity growth over the medium term.The first route would be to encourage the formalisation of small firms. Lessening red tape through simplification of the licensing process and lowering tax compliance costs would help. Avoiding excessive rises in the minimum wage in provinces where it is already at a reasonable level would also be important. Looking forward, it would be useful to remove rigidities in the formal labour markets, while moving to some form of unemployment benefit system to insure workers against job-loss risks.The second route would be to boost investment. Clarifying property rights for real estate, and making the information collected by the credit bureau available to all financial institutions would ease access to finance. At the same time, the development of financing alternatives such as venture capital, leasing or micro-finance would enhance credit supply. The poor state of infrastructure, in particular in the transportation and electricity sectors, is also perceived as an important impediment to investment and could be remedied by increasing public infrastructure spending on cost-effective projects.The third route would be to enhance the quality of human resources. The country suffers from a lack of skilled workers, and policies should aim both at increasing the pool of workers and making education and training institutions more responsive to evolving labour-market demand.Indonesia has a long tradition of supporting MSMEs. But responsibilities between the different levels of government and within the central government need to be clarified to minimise overlap and inefficiencies. A rigorous assessment of existing programmes would allow schemes to be consolidated and scarce public funds to be directed to their most cost-effective uses.

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