Protecting the State from Fiscal Failure

Indonesia may face fiscal failure in 2016 if fundamental improvements are not immediately made to the draft revision of the 2016 State Budget (RAPBN-P), which is currently being deliberated by the government and the House of Representatives.

Fiscal failure is a situation in which state revenues, spending and financing do not adhere to the discipline and economic propriety outlined in law. Fiscal failure cannot be underestimated in the context of the latest state politics. The Obama administration experienced it in 2013 as a result of failure to comply with the maximum limit of the debt ratio to gross domestic product (GDP), which led to fiscal shutdown in the US. In Brazil, fiscal failure had more extreme consequences, namely impeachment of President Dilma Rousseff, who was considered to have violated constitutional provisions regarding fiscal financing mechanisms.

In this case, generally speaking, there are no changes in the rough posture of the 2016 RAPBN-P proposed by the government. The total budget dropped from Rp 1.82 quadrillion in the 2016 APBN to Rp 1.73 quadrillion in the 2016 RAPBN-P as a result of a RP 88 trillion fall in state revenues. The fall in revenues was compensated by cutting spending by Rp 48 trillion and an additional Rp 40 trillion in debt financing. The reduction in expenditure, which was not equal to the fall in state revenues, led to the increase in the budget deficit plan in 2016, from Rp 273 trillion or 2.15 percent of GDP to Rp 313 trillion or 2.46 percent of GDP.

The calculation of the budget deficit plan is conservative as the deficit realization as of May in the current fiscal year reached Rp 198.2 trillion, or 69.3 percent of the full-year target of Rp 273 trillion. The figure has risen almost threefold from the realization of deficit in the corresponding period last year, amounting to Rp 71.2 trillion or 32 percent of the target.

Weaknesses of tax amnesty

From a simulation we carried out, the realization of deficit will be close to Rp 500 trillion by the end of 2016. Or, in a ratio of about 4.1 percent to the estimation of the GDP, which means crossing the maximum limit of 3 percent as mandated by Law No. 17/2003 on state finance. This means that Indonesia is in danger of experiencing fiscal failure.

The government is anticipating this possibility by preparing a tax amnesty in the 2016 RAPBN-P, targeting additional revenues of Rp 165 trillion to prevent the ballooning deficit. However, the policy has several weaknesses. First, the assumption of additional revenues of Rp 165 trillion is too optimistic. Several institutions, including Bank Indonesia, estimate that revenues from a tax amnesty would reach Rp 60 trillion at the maximum. In other words, there will be a risk of a state revenue shortage of about Rp 100 trillion, enough to bring about fiscal failure, since the deficit ratio to GDP reaches 3.6 percent.

Second, the tax amnesty policy also has the potential to cause liquidity mismatch between state revenue and expenditure. The increase in the revenue plan from the compensation tariffs of the tax amnesty, which are expected to take place by the end of the year, means the drying up of liquidity in the preceding months. Therefore, there will certainly be several delays in payments of expenditure or additional working capital debts to cover the state reserves.

Third, the policy will clash with several other laws, including the Law on Taxation and Law on Banking. At this point, a legal breakthrough is needed because the government and the House do not have enough time to revise clauses in the other laws, which contradict the Amnesty Law. In term of fairness, there is a sense that social justice is being torn apart when tax evaders can avoid administrative and criminal sanctions simply by paying compensation tariffs of 1 to 6 percent.

Fourth, the tax amnesty damages the structure of state revenues, representing an unsustainably substantial rise in tax revenues. The tax amnesty policy merely delays the budget deficit from the 2016 fiscal year to following years. If this is applied, state revenues will necessarily decrease in the future. Meanwhile, state expenditure will tend to remain the same or rise slightly. As a result, the deficit figure will again explode.

The tax amnesty policy is also just a temporary remedy of the APBN deficit problem, which is already critical. The root of the problem is the unrealistic assumption of state revenues, starting in 2015. At that time, the government raised the revenue plan from the tax sector by nearly Rp 350 trillion, a 26 percent of the realization of revenues in the previous year. Even then, the realization of revenues in 2015 of Rp 1.24 quadrillion was lower than the 2014 target of Rp 1.25 quadrillion.

The other source of problems is the macro assumption set by the government. As is seen in the 2015 APBN-P, in which the government insisted on a growth assumption of 5.7 percent, which later fell short by nearly 1 percent as growth was recorded at only 4.8 percent. In the 2016 RAPBN-P, the government also insisted on setting a growth assumption of 5.3 percent by the end of the year. This figure is also predicted to miss, because it is not in accordance with the latest condition where many institutions predict maximum growth of no more than 5.1 percent.

The difference between the growth rate assumption and the real growth has an implication on tax revenues, the largest component of state revenues. Slowdown in economic growth leads to the weakening of state revenues because taxes depend heavily on the income of the community and its future expectations. Furthermore, the use of GDP growth figures for the assumption of macro APBN is less relevant to measure the potential of revenues. The government should have used per capita income figures, which more realistically portrays purchasing power and potential tax payments.

Fiscal adjustment

In addition to the revenue side, the 2016 RAPBN is also at risk on its expenditure side. Cutting state expenditure by Rp 48 trillion is a major task, both at the central and regional levels. Many questions will appear about the priorities of the budget and the means of reducing spending. On the financing side, the 2016 RAPBN will absorb more public funds due to rises in government debt. This directly reduces the amount of available liquidity for the private sector. Additional financing through debt will cause a kind of crowding-out effect and lead to more pressure on investment and consumption in the private sector. In reality, the additional debts are intended to cover current spending, which would have less of an impact on growth figures.

Of course the government argues that the state debt position is still in a safe category, with the ratio of debt to GDP in the first quarter of 2016 amounting to 36.5 percent. This ratio is still below the maximum provision of 60 percent as set out in the State Finance Law.

However, this argument is only partially valid. Because, at this time, aside from the finance minister, who, according to the law, should be the sole controller of state debt, the state enterprises minister can also de facto borrow from abroad by mortgaging the assets of state enterprises under her control. This additional state enterprise debt is not included in the calculation of the state debts so that the quantity of the existing ratio tends to be on the downward bias. This action itself disregards the fiscal discipline outlined in the State Finance Law.

Moreover, the ratio of debt to GDP is not the only measure of financing security, especially for open economies like Indonesia, whose foreign exchange revenues are very volatile. As occurred in the crises of 1998 and 2008, the escalation of foreign exchange availability could happen very rapidly and cause a domestic liquidity crisis. From this description, it can be concluded that the potential of fiscal failure is very real. The position of the RAPBN-P 2016 is very not realistic and far from being prudent.

Therefore, fiscal adjustment measures outside the widening of the deficit figures have to be taken. This adjustment can be implemented through two steps: spending cuts and fiscal switching. Spending cuts would involve further reduction of functional spending of the ministries/institutions in which productivity is low. The room for adjustment on this type of expenditure is still wide open since there is an increase of nearly Rp 60 trillion in the 2016 APBN compared with the realization in 2015.

The second step, conducting fiscal switching or reallocation of budgets from expenditure with low stimulus power to expenditure with high stimulus power. In this context, two budget posts should get priority. First, strengthening the capital expenditure budget in the2016 RAPBN-P. Second, the procurement or strengthening of state budget for direct transfer to the community to maintain people's consumption at a time when their purchasing power is weakening.

At the same time, the government and the House of Representatives need to re-enforce their commitment to state fiscal discipline by reinforcing compliance with the provisions of the limit of the maximum fiscal ratio outlined by the law and cover the space for the authorization of financing beyond the control of the finance minister. With such measures, economic reliance will strengthen so that the country is protected from the possibility of fiscal failure and concomitant political complications.

by M. Ikhsan Modjo

source Kompas, Friday, June 17, 2016