The crucial point is to remove the perception that the fuel subsidy is an entitlement.

After the Constitutional Court ruling on Aug. 21, we now have a definitive president-elect. The economic challenges facing him and his team are daunting. The 2015 budget prepared by the outgoing President Susilo Bambang Yudhoyono (SBY) government is called '€œbaseline'€ by the outgoing finance minister. That is putting it in a positive light.

The fact is, this budget is no more inspiring than the previous one. And it leaves the next government with a pile of homework. The readily identified issues are subsidies and the need for tax reform. Third is the additional expenditure items mandated by the new law on villages.

No less important, other issues with implications on the budget are: first, the mineral export ban; second, the burgeoning personnel expenditure both at the central and the regional government levels; and third, the rising burden of social welfare expenditure with the enactment of universal health care and employment insurance.

Energy subsidy

Room to maneuver in the 2015 draft budget is very limited without an energy subsidy reduction. The overall fuel subsidy in the draft budget amounts to over Rp 291 trillion (US$25 billion), rising by around Rp 45 trillion from 2014. The subsidized fuel volume in 2015, at 48 million kiloliters (kl), was the original 2014 figure before it was revised down to 46 million kl. The rise of only 2 million kl in volume for 2015, about 4.3 percent, is almost sure to be insufficient unless there is quantitative restriction or a price hike.

Media reports mention that the Joko '€œJokowi'€ Widodo team is pondering a Rp 1,000 to Rp 3,000 average price hike per liter, which would save Rp 48 to Rp 144 trillion. These numbers and statements by Jokowi point to a gradual price hike, which is considered tactical as it minimizes opposition while allowing consumers to adjust to the new price and reduces inflationary spikes.

However, it is not without cost. Raising prices gradually means doing it repeatedly, and opposition will recur when the next adjustment is due. Second, inflationary expectation will remain high for a number of years, pushing up actual inflation. And third, a multiyear price adjustment raises the risk of hoarding as the adjustment period approaches. A once and for all adjustment does away with these shortcomings, but the shock to the system is huge.

Nevertheless, Indonesia has experience with large price hikes, like the one toward the end of 2005, for which the adjustment period barely lasted one quarter. The ideal method is to remove the subsidy completely and float fuel prices according to world oil prices. At present world prices, the necessary upward price adjustments on average are about 50-60 percent for low-octane gasoline and automotive diesel fuel.

Another instrument the government could use is value added tax (10 percent) and vehicle tax (5 percent) on fuel, which could be reduced temporarily, say for public transportation.

The crucial point is to remove the perception that the fuel subsidy is an entitlement. Economizing on fuel usage following a price adjustment would reduce oil imports and help lower the current-account deficit. Oil imports would still remain huge given the number of vehicles already in operation but the rise would become more reasonable and more closely follow the pace of economic growth.

Electricity subsidies contain a lot of room for reduction. State-owned electricity company (PLN) data from 2013 shows that there is over Rp 32 trillion in subsidies for households and commercial entities with 2,000-watt connections. There are also less than 11 thousand firms with 200,000-watt connections enjoying an average Rp 100 million in subsidies per month. This figure is even larger for slightly less than 100 firms with 30-million watt connections, who receive an average of Rp 5.5 billion per month.

Tax reform

In 2014, the tax to gross domestic product (GDP) ratio is estimated at 12.38 percent and projected to fall to 12.32 percent in 2015. A slowing economy and soft commodity prices are the usual suspects to explain why this ratio remains low. Indonesia also has the lowest ratio among Southeast Asian economies, except for the Philippines. Malaysia and Singapore are ahead with tax ratios of 16 percent and 14 percent respectively.

Indeed natural resource extraction and exports have been the mainstay of tax revenue until recently. Another structural issue is the large informal economy that lies outside the regular tax regime. For example, the army of personal drivers and the millions of domestic helpers are not in the tax system. Most cigarette hawkers and food stall vendors are also not paying any tax. For a country with 10 percent value added tax, collection is only a woeful 4.7 percent of GDP.

Tax officials usually blame the rigid civil service procedure for preventing them from firing or replacing suspect, or simply incompetent, personnel. Being part of the Finance Ministry has its downside as well in the form of cumbersome processes to reformulate the tax code and improve the tax office'€™s internal systems. Hence a recent idea was floated to separate the tax office from the ministry.

Although this is the norm in several countries, we need to remember our history; the tax office was a replacement for the taxing power of the sovereign, which is much older than the expenditure management that has evolved into finance ministries. Indonesia inherited its revenue and expenditure functions as a whole from the Dutch system, where the tax office is still within the finance ministry.

The move to separate the tax department from the ministry may be explained by the post-Soeharto momentum when we splintered central government units into many agencies, along with devolving power to the regions. The record of these new bodies is mixed at best, while costs have ballooned. Therefore, before we consider spinning off the tax office from the ministry, we must undertake an overhaul of government structure. After that, only if it can be shown that further reform is needed, should we consider separation.

New mandated expenditure

The cost to fulfill all of Jokowi'€™s campaign promises, and implement village assistance, all in the first year will be staggering. About Rp 348 trillion alone will be needed to give 28 million poor families assistance of up to Rp1 million per month. Next is the bandied amount of Rp1.4 billion per village per annum, which totals about Rp 111 trillion. And we have not yet counted free health and education, farmland purchase assistance, etc.

For sure, the village assistance will be implemented in stages. An official from the Home Ministry recently stated that only Rp 400 million in new funds would be made available per village in 2015. In addition, another Rp 100 million will be reallocated from another part of the budget.

In 2014, Indonesia initiated a form of social insurance encompassing health coverage and insurance against unemployment and work-related injuries. In addition to contributing members, the coverage includes poor families, thus making it universal, at least in principle. In 2014, almost half of the population had been registered. The cost amounts to Rp 26 trillion, which includes coverage for government employees and members of the armed forces. It should be noted that after 2030, as the population ages, the dependency ratio (dependents, including the retired, to the working population) will rise. Hence the severe budget strain experienced by many developed nations will visit us.

The new government is also expected to spend on massive infrastructure projects to alleviate the severe supply shortfall. Jammed roads and insufficient electricity have curtailed investments, affecting economic growth. The effects are also cascading by raising the amount of investment needed to produce an additional unit of output of jobs.

This will need massive funding, as well as the will to push through regulation to simplify and enforce land acquisition. The well-understood problem of the banks'€™ reluctance to provide long-term financing remains the main issue. Opening up opportunities for private participation by providing guarantees and tax incentives may be necessary for commercially viable projects, while the government will have to focus its limited resources on non-commercially viable projects.

General government reform

We come now to the crux of government reform. There are two dimensions. First is realignment between organization and objectives. Over time, bureaucracies have grown and many have outgrown their original intentions. Hence a revisit is necessary and, where required, pruning maybe needed. The aim is to have the most efficient organization to deliver what it is designed to do.

Second is to connect the government budget programs with their intended outcome. The common practice has been to claim success when the output is regulation. The intended outcome is seldom entered into the equation. Those days should end soon. At the extreme, funding should be continued only for those programs that have measurable intended outcomes.

Human resources are another problem for the government. For the long term, training and education should be provided. But for the short term, the government should open up high-level positions to those outside government service. Raising government pay to private sector level is neither affordable nor necessary. Those with the calling might want to spend a few years in public service. This will increase competition for key positions, which is always a good idea.

Mineral export ban

A poorly designed policy with good intentions usually has a negative outcome. The mineral export ban is one such example. Problems immediately appeared after its implementation. First was the drop in mineral exports. Second was the lack of smelter investment realization, mainly due to the lack of electricity. But there are also other issues: surplus global smelting capacity and the heightened risk over long-term investment regulatory certainty. Global supply demand and Indonesian reserves also vary from mineral to mineral types.

In addition, Indonesia has been brought to international arbitration by Newmont over its West Nusa Tenggara mine concession.

Hence a reconsideration of the export ban appears to be in order. More generally, we need to formulate a mineral mining, processing and export regulatory framework. First, we need to be clear what we want to, and what we can, achieve, realistically. Second, the regulatory framework must take into account differing circumstances by mineral type. Third is to provide the necessary infrastructure, especially electricity. And fourth is to somehow reclaim the credibility that is now under question.

Bottom line

There is high expectation that the next government can deliver on a long list of demands from the public. For the government budget and associated regulations, we have identified key issues including subsidies, tax reform and newly mandated expenditure. These new expenditure items can become a strain on the budget over the long term.

With such a long list of essential improvements, we must conclude that a massive government overhaul is needed. Firstly to realign the organizational structure with what the government is tasked to do. This may end up as an exercise in clearing dead wood.

Next is to tie the outcome to budgetary expenditure. And lastly, to improve the human resources situation by providing training, education and opening up key positions for candidates from outside the government.

It is a tall order. But it is imperative.

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