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Policy reversals erode Indonesia's economic stability

While the government's decision to backtrack on the planned VAT rate hike offers short-term relief, it also erodes public trust and investor confidence amid a shrinking middle class, which points to a need for comprehensive reforms that include labor formalization, downstreaming expansion, human capital development and supply chain integration.

Rania Teguh (The Jakarta Post)
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Canberra
Fri, January 3, 2025

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Policy reversals erode Indonesia's economic stability Timepieces by luxury watchmaker Rolex are displayed in this stock image. (Shutterstock)

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resident Prabowo Subianto’s decision to scale back the plan to increase the value-added tax (VAT) rate highlights policy inconsistency. The hike from 11 percent to 12 percent, initially set across the board, will now apply only to luxury goods and services.

Businesses, having prepared for months, now face operational disruptions and compliance issues. This reversal unsettles investors and undermines Indonesia’s image as a stable business destination.

The VAT hike aimed to increase state revenue, improve the tax-to-gross domestic product ratio (currently 10.5 percent) and fund infrastructure and education. Limiting it to luxury goods reduces fiscal impact. Protecting low-income households is essential, but this approach fails to address structural inequities or fiscal gaps.

Indonesia’s shrinking middle class, now 17 percent of the population compared to 23 percent in 2018, faces mounting pressures. Layoffs in labor-intensive industries like textiles and chemicals further strain this group. Essential goods remain unaffordable for many, with wages stagnant and living costs rising. Policy inconsistencies exacerbate these challenges.

The labor force, dominated by workers with elementary or junior high school education, is well suited to labor-intensive industries like footwear and apparel. These sectors are relatively crisis-proof and export-oriented, and benefit from stable demand.

Indonesia’s underdeveloped industrial ecosystem and volatile trade policies hinder growth. For example, raw materials for textile products are heavily sourced from Vietnam due to local supply constraints.

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The government’s focus on downstreaming – processing raw materials domestically – while capital-intensive, generates fewer jobs. Labor-intensive industries, crucial for middle class stability, need stronger support. Coherent industrial strategies aligned with fiscal policies could mitigate economic risks.

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