OECD Economic Surveys: Indonesia 2024

Chares Dennery
OECD

Real GDP grew by 5.3% in 2022 and 5.0% in 2023, in line with the pre-pandemic average of 5% (Figure 1.1, Panel A). Similar rates of growth are expected for 2024 and 2025 (see below). However, as in many other countries, the level of economic activity has remained below the pre-pandemic trend (Panel B); the gap currently stands at about eight percentage points. Private consumption has been buoyant since 2022, while exports have been boosted by high international demand for commodities. Tourism (5% of GDP and 10% of employment in 2019, before the pandemic) has partly recovered, although tourist arrivals and spending from Asia (both ASEAN and non-ASEAN markets) remain well below pre-pandemic levels. After contracting strongly in 2020, gross fixed capital formation rebounded in 2021 and has remained strong since.

Rising global geopolitical tensions have had contrasting effects on Indonesia. Russia’s war of aggression against Ukraine initially increased the price of energy, food and fertilisers, hitting purchasing power. Meanwhile, surging prices for commodities such as coal, palm oil and metals have improved the terms of trade. And, despite the slowdown in global trade growth (caused, inter alia, by lower global growth and trade tensions, notably between the United States and China), Indonesia has benefited from strong commodity demand. Furthermore, modest trade ties with Europe (accounting for around 11% of exports and 5% of imports) make the country less directly exposed to disruptions in the Red Sea than other Asian economies. Exports surged in 2022 (Figure 1.2, Panel A). Lower international demand and commodity prices, combined with stronger domestic demand, reduced net exports in 2023. Commodities continue to dominate the composition of merchandise exports, but diversification efforts and down-streaming policies (Chapter 2) have led to increased exports in processed metal and motor vehicles in recent years (Figure 1.2, Panel C).

Reflecting the war in Ukraine and the associated increase in global food and energy prices, headline inflation rose from 2.2% in January 2022 to a peak of 6.0% in September 2022. The relative strength of the Rupiah – as well as the presence of administered prices for fuel, electricity, and other commodities – cushioned the effects of the crisis. The government’s decision to cut energy subsidies in September 2022 and partly replace them with cash transfers initially fed into higher headline inflation (for instance, gasoline prices increased by about 30% following the cut in the subsidy). Higher interest rates (see below) and close synergy between the central bank and the government helped tame price increases and headline inflation fell to 2.3% in September 2023. Headline inflation rose to 3% in March 2024, largely due to the effects of El Niño on the rice harvest season, before falling back; in October 2024, it reached 1.7% (Figure 1.3, Panel A). Meanwhile, core inflation has stayed around 2% in recent quarters.

While unemployment has declined to pre-pandemic levels, the labour market has not fully healed from scarring effects. The unemployment rate has fallen from 7.1% in the third quarter of 2020, at the peak of the pandemic, to 4.9% in mid-2024, just below the pre-pandemic range of 5–5.5% (Figure 1.3, Panel C). The labour force participation rate recovered and was the same in 2023 as in 2019 (69.3%, Figure 1.3, Panel D), with an additional 4.8 million workers being employed in mid-2024 (compared to a year earlier). However, the share of formal wage-earners declined between 2019 and 2023 (with an increase in the employment shares of both self-employed and informal workers). The increase in informal work signals a deterioration in labour market conditions and seems very slow to unwind. Labour market reforms carried out in 2020 and 2023, as well as other government initiatives, should eventually improve labour market outcomes and job quality (Chapter 2). Nominal wage growth in the formal sector has picked up (Figure 1.3, Panel B) but real wages have not recovered to pre-pandemic trend levels.

In recent years, the current account balance has often been negative, largely offset by positive net FDI inflows. The balance of payment surplus increased to USD 6.3 billion in 2023 (0.5% of GDP) (Figure 1.4, Panel A). The current account recorded a small deficit in 2023, after a USD 13.2 billion surplus (1% of GDP) in 2022 (Figure 1.4, Panel B). The lower trade surplus was the result of lower commodity demand and prices, along with the dynamism of domestic demand sustaining imports. The capital and financial account turned positive in 2023, while FDI inflows have remained strong (notably in manufacturing). After considerable outflows in 2022 caused by a lower risk appetite for emerging markets, Indonesia's portfolio investments rebounded in 2023. Reserve assets increased from USD 137 billion at end-2022 to USD 146 billion at end-2023 – on average over 2023, this represented 5.8 months of imports (Panel D). Asset reserves declined to USD 139 billion in May 2024 as the central bank intervened to maintain the stability of the Rupiah but have increased again, to USD 151 billion in October 2024.

Real GDP growth is projected to reach 5.1% in 2024 and 5.2% in 2025. Business and consumer confidence remains strong and private investment is expected to gain momentum. High-frequency spending indicators are generally less optimistic than survey measures. For example, new car and motorbike sales were lower in the first three months of 2024 than in the corresponding months of 2022 and 2023 (Figure 1.5, Panel A). However, expiration of a post-Covid subsidy on some vehicle purchases, along with higher interest rates, likely explains this. Meanwhile, the purchasing-manager index (PMI) for manufacturing and the OECD’s composite leading indicator point to more robust demand (Figure 1.5, Panel B). A resurgence of subsidies in 2024, planned expansion of the free school lunch programme, and investment in the new capital city, Nusantara, will make the fiscal stance more accommodative in 2024 and 2025. However, the deficit is expected to remain within the 3% limit over this period. Along with lower interest rates starting in late 2024, the fiscal stimulus will support domestic demand and output growth in 2024 and 2025. This fiscal position is broadly adequate, given the negative but closing output gap, and moderate core inflation readings.

The labour share has fallen, reflecting the partial adjustment of wages to higher GDP per worker. This is expected to rebalance with real wages increasing more solidly over the projection horizon, while formal employment continues to gradually recover. Together with a more neutral output gap in 2024 and 2025, this will put some positive pressure on core and headline inflation, but annual headline inflation is expected to hover around 2.3% in 2024 and 2025 (Table 1.1). The trade deficit is expected to widen somewhat in 2024 and 2025, due to lower export prices and weak external demand while import growth picks up.

External uncertainties and risks are particularly prominent (Table 1.2). The economy remains reliant on international demand for raw materials and unprocessed commodities, notably from China, despite efforts to diversify markets and products (Chapter 2). Weaker than projected growth in China would hit export revenues and increase the trade deficit. Against this backdrop, fiscal and monetary policy settings should remain prudent.

In response to the COVID-19 pandemic, Bank Indonesia (BI) decreased its main policy rate to a record-low of 3.5% in February 2021, and loosened regulatory requirements for banks. BI also purchased government bonds (SBN) in the primary market (see below). In the immediate aftermath of Russia’s war against Ukraine and the global inflation surge, core inflation readings remained moderate in Indonesia. BI initially refrained from increasing its policy rate, given anchored inflation expectations (Box 1.1) and the continuing need to support the economy. With the surge in domestic inflation, and policy tightening in other countries, BI eventually raised the policy rate from 3.5% to 5.75% between August 2022 and January 2023, turning the real interest rate positive (Figure 1.7, Panel B). The relative strength of the Rupiah in 2022 helped cushion the impact of global energy prices on domestic inflation. The policy rate was further increased in October 2023 and April 2024, then BI initiated a first rate cut in September 2024.

The reserve requirement ratio for conventional banks was reduced from 6% to 3.5% (of total Rupiah deposits) between 2019 and 2020 in response to the pandemic. It has since been raised to 9% in 2022 (Figure 1.7, Panel A) and has remained stable since. For shariah banks (Box 1.1) it now stands at 7.5%. The macroprudential liquidity buffer has remained at 5% of banks’ assets (3.5% for shariah banks) since October 2023, though this ratio is relaxed for loans to priority and green sectors. BI’s countercyclical capital buffers currently remain set at 0%. As such, while high policy rates have helped stabilise the exchange rate and inflation, BI has maintained looser liquidity policies, so as to partly shield domestic credit from external developments.

While private sector credit growth has rebounded since the pandemic (Figure 1.8, Panel A) and its level has increased from 26% of GDP in 2002 to 38% in 2022, it remains lower than in neighbouring ASEAN economies (World Bank, 2024[2]). Equity and house prices have increased modestly in nominal terms over the past two years, thus declining in real terms (Panel B); this limits risks of market corrections.

Indonesia’s prudent fiscal policy settings limit debt sustainability risks. After a suspension during the COVID-19 pandemic, the 3% deficit ceiling was reinstated and has been met since 2022 (see below). Sovereign stress risk is low according to the IMF’s Sovereign Risk and Debt Sustainability Framework (IMF, 2023[3]). Sovereign debt spreads with US Treasury bonds remain stable compared with other ASEAN economies (Figure 1.9, Panel A). Foreign holdings of Rupiah-denominated government debt have decreased considerably since the pandemic, in absolute terms and in percentage of the total (Panel B). Since March 2021, BI has replaced foreign investors as the main holder of government debt (see below), and Indonesian banks have also increased their holdings from 4.8% of GDP in 2019 to 6.7% of GDP by end-2023. Likewise, pension funds and insurance companies have increased their holdings as they are required to hold at least 30% of their assets in government securities. Reduced foreign holdings of sovereign debt make Indonesia less vulnerable to rollover risk. However, as BI eventually winds down its holdings and withdraws liquidity, the capacity of the market to absorb additional debt may be tested if foreign investors do not return to act as the marginal buyer on the primary market.

Indonesia’s banks are well-capitalized, with a capital adequacy ratio of 26.0% as of March 2024. Banks have ample liquidity and foreign exchange exposures appear to be limited, with a net open position of 1.6% in November 2023. Real domestic credit growth, which increased rapidly from early 2021, has slowed down since mid-2022. The non-performing loans ratio peaked at 3.4% in mid-2021 and had declined to 2.9% by end-June 2024. The loans-at-risk ratio has fallen from 24.2% in early 2021 to 12.6% in August 2023. The IMF found systemic risk to be modest and stable in early 2023 (IMF, 2023[3]). The IMF’s growth-at-risk analysis also suggests moderate and manageable risks to output growth. The financial sector remains resilient despite ‘high for longer’ interest rates, as suggested by the IMF solvency stress test. IMF analysis suggests that the share of vulnerable firms (whose interest coverage ratio is below 1) could increase from 21% to 28% due to rising interest rates (IMF, 2023[3]) but the risks to banks are manageable as they have increased loan provisions. Loan classification standards were relaxed during the pandemic, and after multiple extensions this credit restructuring policy was rightly terminated in March 2024.

The economy and the financial sector are also exposed to climate risks: the Financial Services Authority (OJK) established a climate risk stress testing programme in 2021 covering 47 financial institutions including banks, insurers, pension funds and securities firms. In March 2024, OJK issued new Climate Risk Management and Scenario Analysis guidelines, which inter alia require all banks to factor in climate risks in their lending decisions from 2026 onwards. Finally, as discussed below, the debt of state-owned enterprises has increased and warrants adequate monitoring.

The monetary policy stance is currently balanced, with high interest rates but ample liquidity. The real rate is above the IMF’s estimate of a 1-2% neutral rate (IMF, 2023[3]). Further reductions in the policy rate should remain prudent and data-dependent. Indonesia has shallow foreign exchange markets, and the use of interventions may be warranted in response to some external shocks, such as shocks triggered by sudden changes in investor risk appetite (Basu et al., 2023[4]). However, BI should remain cautious in using reserves to stabilise the exchange rate and should rely more on other monetary policy tools to attain its statutory goal.

BI’s purchases of government securities on the primary market between 2020 and 2022 were conducted under a ‘burden-sharing’ agreement with the Ministry of Finance. BI agreed to take on the interest cost of this intervention by pledging to return the yield to the government in full at the bonds’ redemption. Between end-2019 and end-2021, BI holdings of government bonds tripled from IDR 260 trillion to 800 trillion (5% of GDP in 2021), its share of total outstanding securities almost doubling, from 9.5% to 17.1%. The 2023 Financial Sector Omnibus Law (FSOL) states that Government Bonds (SBN) purchases in the primary market are only carried out: 1) during crises, 2) under prudent fiscal policy, and 3) in line with the financial capabilities of the central bank. BI also conducted this operation in a targeted, temporary and transparent manner. BI has appropriately ended its primary market purchases and in particular the burden sharing mechanism (Table 1.3), as recommended in the 2021 Survey (OECD, 2021[5]). The burden-sharing mechanism was appropriate during the pandemic but should only be used against significant economic and financial stress, transparently and with well-defined exit conditions. Other central banks have used monetary financing tools during the pandemic under various institutional arrangements, and FSOL rightly provides safeguards to monetary policy independence.

Bank Indonesia’s sovereign-debt holdings should consequently decline due to redemptions, though they could remain significant due to secondary purchases, in particular as collateral of BI’s new Rupiah securities (SRBI, launched in September 2023). The SRBI is a tradable monetary instrument which uses government securities (SBN) as the underlying asset, instead of the previous non-tradable ones. These securities have proved attractive for foreign investors – who as of June 2024 owned around 26% of them – helping to support the financial account and the foreign exchange reserves. This has also led banks to swap long-term SBN for SRBIs. As a result, BI’s net ownership of SBNs (excluding the SBN held for open market operations) has risen from 16.1% in September 2023 to 21.4% in June 2024, in contrast to its gross ownership which remains unchanged from 24.7% to 24.5%. Gradually reducing these large holdings of government securities could prove warranted.

Under Law No 17 of 2003, the budget deficit must remain below 3% of GDP and the public debt below 60% of GDP. The deficit ceiling was only breached during the pandemic, with a temporary amendment to the law. Following general-government (OECD-defined) deficits of 5.7% of GDP in 2020 and 4.3% in 2021, fiscal consolidation led to a return to normalcy in 2022 with a deficit of 2.2% of GDP. For 2023 a deficit of 2.8% of GDP was budgeted (to support growth and purchasing power amid global uncertainties). However, tax revenues proved 12.6% larger than planned, resulting in a deficit of 1.7% of GDP (Indrawati, Satriawan and Abdurohman, 2024[6]) (Figure 1.10, Panel A). The deficit increases modestly in the 2024 budget to allow for new spending initiatives, but it is expected to remain within the 3% limit over the projection horizon (Table 1.1). Public debt as a share of GDP also increased during the pandemic but has stabilised since (Figure 1.10, Panel B) and is expected to decrease in the future, while local governments carry little debt.

Indonesia’s government expenditures remain low in regional comparison. For instance, as of 2022 spending was 17.4% of GDP, compared with 24.5% in Thailand, 24.7% in Malaysia, 18.7% in Vietnam and 25.9% in the Philippines. This low level of spending reflects the limited development of public provision in key areas, including health, education, social assistance, pensions and infrastructure. Provision can be expected to increase over time reflecting increasing societal demand as Indonesia’s economy develops further. Demand for publicly supported health and pensions is likely to rise further as the population begins to age. Additionally, adaptation to climate change and related natural disasters and decarbonisation will require significant public investments over the next decades (Chapter 4).

Converging from current government spending levels (estimated at 17.4% for 2024) towards a regional average spending ratio of 23% over the next 20 years would represent an increase of 5.6 percentage points. Additional investments in emissions reduction and climate adaptation (Chapter 4) could add another 1.4 percentage points over the next ten years. Taken together, this 7 percentage-point increase of the spending ratio will require a significant increase in tax revenues and ensuring that spending is effectively allocated and spent (see below). The President-elect has proposed to substantially increase the tax-to-GDP ratio by 2029. He also aims to increase the country’s GDP growth rate from 5% to 7%. Yet, if taxation fails to increase in line with increased spending, and if GDP growth does not accelerate, the debt-to-GDP ratio could rise by 6 percentage points by 2045. On the other hand, higher taxation and faster growth would ensure that the debt-to-GDP keeps declining from current levels (Figure 1.11). Furthermore, the current low effective rate of taxation generates a relatively high deficit-to-taxation ratio, which can lead to higher volatility in investors’ appetite for sovereign debt. Hence, the commitment to respect the ceilings for the public debt and fiscal deficit should be renewed and fiscal prudence remains warranted.

Indonesia still benefits from a demographic dividend, which however is due to end as the productive-age share of the population will decline after 2030, when ageing will eventually offset the fall in fertility. While the current pension system will not bring significant fiscal pressures over the next 20 years, this is partly because the coverage and pension pay-outs are low (see below). In the past, providing for old-age and disability was mostly left to families and communities. Even in the public sector and in state-owned enterprises (SOEs) where coverage is greater, pension provision is often inadequate and has to be complemented by personal savings. But as the population ages, families cannot be expected to address the needs of older and younger dependents. Hence it is important to widen social insurance coverage by enlisting small-and-medium enterprises (SMEs) and self-employed workers and ensure that the level of benefits is adequate (Box 1.3).

Levels of taxation have historically been low in Indonesia, limiting the ability of the government to finance priority initiatives. Echoing government spending (see above), Indonesia’s tax revenues remain among the lowest in the ASEAN context (Figure 1.12, Panel A). Informality and a low degree of tax compliance are key challenges (Hapsari et al., 2023[11]). In comparison with OECD and Asia-Pacific peers, in Indonesia a larger fraction of the budget comes from corporate income taxation (CIT), as well as VAT and other goods and services taxes (GST). However, CIT, VAT and GST receipts are among the lowest as a share of GDP, and other taxes (e.g., personal income, excise and property taxes) are extremely low (OECD, 2023[12]). Volatility in tax receipts is increased by the influence of world commodity prices on extraction royalties and CIT in the commodity sector. Indeed, commodity prices have partly accounted for the decline in the tax revenues-to-GDP ratio before the pandemic and its recovery since 2022 (Figure 1.12, Panel B). The President-elect has set the goal of lifting state revenues from the current 13.5% to 23% of GDP by 2029.

The 2021 Tax Regulation Harmonization Law (HPP Law) remains the most significant tax reform of recent years. This law included provisions to improve tax compliance and increase the tax ratio, alongside pandemic recovery measures. Motor vehicles buyers were prime beneficiaries of these economic recovery measures, with a temporarily reduced Luxury Sales Tax (subject to local-content rules and emission standards). This tax incentive has now been narrowed to electric vehicles. VAT on the purchase of residential property was also partially borne by the government, but after multiple extensions, this exemption has been narrowed (Table 1.4).

As regards long-term tax reform, the 2021 HPP Law introduced a new 35% personal income tax bracket for taxable income exceeding IDR 5 billion (USD 300 000). The Law also increased the corporate income tax rate from 20% to 22%. The VAT rate was increased from 10% to 11% in April 2022; an increase to 12% is scheduled for January 2025. The law also increased excise taxes on cigarettes and e-cigarettes. It also established a carbon tax through a carbon exchange (see Chapter 4); setting a rate of IDR 30 000 (USD 2) per ton for the coal sector in 2022, with expansion to other sectors planned for 2025. The reduced presumptive income tax levied on turnover of young small businesses at a rate of 0.5% (instead of the corporate income tax) has been maintained, while taxes on entertainment activities (bars, restaurants, discotheques) have increased. The HPP Law also streamlined the rules regarding tax withholding for shareholders and in-kind benefits for employees, with a narrower set of tax-exempt benefits.

Raising tax revenues further is essential. As argued in past Surveys (OECD, 2018_[8]; 2021_[3]) and by the IMF (de Mooij, 2018[13]), a medium-term revenue strategy would facilitate an increase in the tax-to-GDP ratio. Further reforms of VAT, excise, income, and property taxation as well as social security need to be key ingredients:

• VAT: Businesses with a turnover below IDR 4.8 billion (USD 300 000) remain exempt from VAT. This threshold is higher than in most OECD countries (OECD, 2022[14]) and much higher than in Thailand and the Philippines, where it is about USD 50 000. Lowering the VAT liability threshold, as well as reducing the number of sectors where VAT is not applied, would increase VAT collections from both newly liable and already-liable ones.

• Other taxes on goods: Total excise taxation in Indonesia remains low in comparison with other ASEAN economies. Given air pollution externalities and emission reduction goals, there are some opportunities for win-win moves in raising fuel excise taxes and reducing subsidies on fuels, though political sensitiveness has to be overcome. While the Luxury Sales Tax (LST) is borne by affluent households, this tax is complex and induces under-declaration. Taxing car ownership, rather than car purchases, could make the system less prone to under-declarations. Excise taxation on cigarettes should also be further increased, to raise revenues and improve health, as smoking remains a massive health challenge in Indonesia and brings considerable economic losses (WHO, 2020[15]).

• Personal income taxation (PIT): Thresholds remain very high: the basic allowance, at IDR 54mln, is about 65% of GDP per capita and the 25% tax bracket starts at incomes above IDR 250mln (300% of GDP per capita). As a result, the growing middle class is largely shielded from PIT: in 2017, only 10% of the population was actively paying PIT, against an ASEAN average of 15% (IMF, 2024[16]). A reform of the tax treatment of in-kind-benefit will increase the tax base. Nevertheless, there is scope to reduce taxation thresholds. As argued in (OECD, 2021[5]), the first PIT threshold should be frozen, so as to fall in real terms, while the higher thresholds should be lowered in value. Ensuring tax compliance and fighting tax evasion among very high earners could also further raise government revenue.

• Corporate income taxation (CIT): The CIT rate is set at 22% in Indonesia, which is in line with the international average of about 21% (OECD, 2023[17]). Rather than raising the CIT rate, Indonesia has scope to broaden the tax base by reforming and narrowing the small business presumptive tax regime, and by abolishing tax incentives or by making them less generous. Indonesia should also ensure that its tax incentives remain compatible with the Global Minimum Tax agreement.

• Property taxes: Since 2012, the land and building tax has been largely devolved to local governments, in line with international practice. At 0.3% of GDP, property taxation is low in comparison with the ASEAN average. The nominal taxation rate is 0.5% of the appraisal value, but this appraisal value is between 20% (for properties below IDR 1 billion) and 40% (above 1 billion) of the estimated sales value hence the effective rate is between 0.1% and 0.2% of the property’s sales value. Allowing local authorities to increase appraisal values to 100% of the sales value and investing in centralised cadastre and valuation tools, could significantly raise revenues for local governments. Such valuation tools would also allow the gradual rollout of inheritance taxation.

• Social insurance: A rollout of social insurance is underway and provides an opportunity to raise revenue through social contributions, as taxpayers’ willingness to pay can increase in exchange of future new rights for pension and insurance (OECD, 2019[18]). Currently, businesses with 20 or fewer employees are subject to lower employer social contributions, and the informal sector is not covered. The social contribution exemption should be narrowed to those sectors which are most at risk of reverting to informality. Also, small-firm thresholds should be lowered or applied only to unincorporated firms, to reduce the incentives to split businesses in smaller units. By increasing the benefits associated with social contributions and awareness, workers could also have a stronger incentive to request to be declared and covered in full. Full coverage of all workers should remain the long-term objective of social policy.

Further strengthening enforcement is also needed. Tax avoidance remains common among larger firms and high-income individuals (Ibrahim, T and Rusydi, 2021[19]), but improving tax capacity is also necessary if exemption thresholds are lowered for small firms and middle-class individuals (notably on VAT and PIT), as described above. Indonesia has made substantial progress over the past decade in improving tax enforcement, notably for CIT (Basri et al., 2021[20]), and the President-elect has signalled further improvements as a priority. This will notably involve efforts in digitalisation and use of third-party data (Box 1.4). Taken together, these tax reform measures could significantly increase tax revenues (Table 1.5).

Limited fiscal space accentuates the need to arbitrate between spending priorities. Additional spending should only be funded via tax increases; hence the sequencing of new spending will need to be carefully designed, with an emphasis on education and health (see Chapter 2) as well as infrastructure. This sequencing of spending must be underpinned by sound cost-benefit analysis, and strict monitoring of costs.

The current cyclicality of the fiscal position also requires attention. As the amount of interest payment and subsidies depends on global financial conditions and commodity prices, the high share of variable expenses makes funding for other items of the budget more volatile, notably investments in infrastructures and human capital. As such, a reordering of the government’s spending priorities would not only free up some of the current fiscal space, but it would also make investments more stable, avoiding the risks associated to stop-and-go cycles. Eventually, it would also free space for more countercyclical fiscal policies.

Around the world, spending reviews have become an increasingly common tool of budget governance (OECD, 2021[25]). Conducting them regularly has been identified by the OECD as a key feature of quality budget institutions (OECD, 2022[26]), along with clear objectives, sound economic assumptions, multi-year expenditure baselines, top-down expenditure ceilings, informed spending decisions (for example, green or gender budgeting) and budget transparency. Consolidating all forms of expenses is also important, including loans or implicit subsidies, whose cost should be estimated, accounted, and/or funded upfront. Alongside external spending reviews, Indonesia would benefit from carrying its own regular spending reviews, possibly as part of the regular five-year middle term development plans, or more frequently.

The World Bank’s exhaustive Public Expenditure Review of Indonesia (2020[27]) highlighted the inconsistencies between the definitions of programmes, over time and between the planning and budget frameworks. These inconsistencies make it hard to properly assess public spending performance. Better coordination between the planning and finance ministries is also warranted. Some progress has been made in monitoring and reporting spending data, but scope remains to improve data systems further and enhance the quality and accountability of government spending. The Review also sheds light on inefficiencies in fiscal transfers to subnational government. The General Allocation Grant (DAU) is based on districts’ wage bills and the gap between fiscal needs and fiscal capacity. This provides an incentive to overspend on personnel, rather than earmark funds for investments. Districts would be more incentivised to fully use their taxation capacities if the fiscal gap was based on potential rather than actual revenues. The Review also suggested to experiment with performance-based intergovernmental transfers, though this would require strong implementation and governance capacity at the local level.

Coordination between the different levels of government is especially important for health and education services, where local governments are in the frontline. By law, 20% of the budget is earmarked for education, but performance gaps remain significant (see Chapter 2). Districts account for the bulk of education spending but differ in their capacity to manage education performance. Improving their fiscal and administrative capacity, and the coordination with the central government, would allow them to better deliver quality education. Public health expenditure is low in regional comparison; equipment, training and drugs availability are often insufficient, especially in remote areas. Addressing the financial and institutional fragmentation of the health system and introducing a better design of service delivery is also essential. Introducing more performance-based financing for health and education will help in making spending more efficient, but it will require good data and administrative capacity from local governments. For social assistance programmes, coordination with subnational governments and agencies should aim at increasing supply-side provision (along subsidising demand), notably in remote areas (World Bank, 2020[27]). Digitalisation offers opportunities in this regard (Chapter 3).

A strengthening and enlargement of the free school lunch programme has been announced, where nutritious food is served in schools or can be taken home. This programme is commendable but subject to implementation difficulties, in terms of logistics and funding. Milk production is notably insufficient for instance (FAO, 2023[28]), and delivering food across the archipelago will prove challenging. The programme will be implemented in phases and its cost is estimated at USD 4.3 billion in the 2025 budget, possibly increasing to up to USD 30 billion, or 14% of the government’s budget. Hence a flexible and targeted approach will prove essential to ensure the programme’s effectiveness and fiscal sustainability, as in other countries such as India, which in 2021 provided free lunches to 118 million students enrolled in 1.12 million schools. According to assessments, India has proved successful at keeping costs under control. A decentralised approach – the programme being conducted by state governments with help and subsidies from the central government – has helped to ensure flexibility and limit the exposure of the central government (Bakri, 2024[29]).

Energy subsidies (electricity, fuel and liquefied petroleum gas – LPG) account for a significant share of the government’s budget. While they were cut in the mid-2010s (see Chapter 4), they were increased in 2018 to stabilise end-user fuel prices, and in 2021 the subsidy-related government budget reached IDR 243 trillion (USD 16 billion). There has been some welcome refocussing of support to low-income consumers in 2022, yet the subsidies reached IDR 211 trillion (USD 14 billion) in 2023 for fuel, LPG and electricity, while direct cash assistance towards low-income households were not renewed. Currently, only the electricity subsidy policy for low-income households is well targeted; subsidised 3kg LPG cylinders are supposed to benefit poorer households, but many other individuals also receive them. However, the government has announced in early 2024 that these will eventually be restricted to the poorest households, through customer preregistration. Efforts should be made to ensure that this policy remains targeted. Eventually, the authorities need to move back to automatic formulas for fuel and electricity prices that allow global energy prices to pass through to retail prices and imply lower subsidies, to make the central budget less linked on commodity prices, and as a first step towards phasing out untargeted subsidies. Targeted cash assistance remains more cost-effective and redistributive than subsidies, but the priority should also be in helping poorer households in their transition towards cleaner technologies (see Chapter 4).

Indonesia’s large SOE sector (see Chapter 2) also exposes the government to fiscal risks. SOE losses have no immediate fiscal implications if they can borrow without being accounted for in the government’s unconsolidated balance sheet. However, their rising debt stock can force periodic recapitalisation by the government, and the frontier between bailouts and government equity injection can be hard to draw (IMF, 2024[16]). Some of Indonesia’s SOEs have been hit hard by the COVID-19 pandemic and its aftermath. For instance, in mid-2023, the government recapitalised some SOEs in the construction sector, to the tune of USD 2 billion. In 2020, the electricity company PLN was also recapitalised by USD 2.4 billion. Such amounts, while modest as a fraction of GDP, account for a significant share of the government’s budget. Given the limited ability of the government to increase tax receipts and the cost of raising additional debt, such contingent expenses can crowd out priority spending initiatives. A systematic consolidation of the debt and losses of all non-financial SOEs should be considered. This could increase transparency and reduce scope for government to make excessive use of SOEs to conduct off-balance investments and subsidies.

Financial management of SOEs needs to improve. As a general rule, subsidies for goods and services should be reduced to reflect true prices. When SOEs carry public interest activities (such as providing subsidised goods or services), the associated costs should be transparently and regularly passed on to the government, rather than absorbed as losses (warranting future recapitalisation) or indirectly subsidised. Such indirect subsidies have, at times, included favourable financing terms from state-owned banks, competition or regulatory leniency on other unrelated business activities, or subsidised inputs provided by other SOEs. When SOEs have explicit or implicit government guarantees, great scrutiny should be applied to ensure that they do not expand outside their core business. Finally, while the central government is not directly exposed to provincially- and municipally- owned enterprises, the same degree of scrutiny should be applied to limit the exposure of local government.

Risks to government finances from Public-Private-Partnerships (PPPs) need to be contained, notably in infrastructure projects. Operational risks require a fine ex ante assessment, to ensure that the risk-sharing mechanism between the government and the private partner remains appropriate and sound. Finally, the cost of some flagship infrastructure projects should be closely monitored, to ensure that government spending does not unduly favour parts of the country through off-balance PPP or SOE investments, at the expense of less developed regions, and other spending priorities.

[29] Bakri, M. (2024), Prabowo bites off more than he can chew with free lunch promise, East Asia Forum, https://doi.org/10.59425/eabc.1713391200.

[20] Basri, M. et al. (2021), “Tax Administration versus Tax Rates: Evidence from Corporate Taxation in Indonesia”, American Economic Review, Vol. 111/12, pp. 3827-3871, https://doi.org/10.1257/aer.20201237.

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