Download The Design of Income Tax System Responding To The Middle Class

The Design of Income Tax System Responding To The Middle Class
Growth, and Its Effects on Income Distribution
Anda Nugroho
Researcher, Fiscal Policy Office of Ministry of Finance, Indonesia
Email: [email protected]
Rita Helbra Tenrini
Researcher, Fiscal Policy Office of Ministry of Finance, Indonesia
Email: [email protected]
ABSTRACT
A large portion of the Indonesian population is entering the middle-class as its economy is
growing rapidly. Currently, middle class in Indonesia is the third-largest in the world. There
are about 74 million middle classes in Indonesia, and this number will double by 2020. In the
other hand, economic growth also creates a problem of rising inequality. Inequality in
Indonesia is worsened as the Gini index increasing from 0.308 in 1999 to 0,41 in 2011. Both
conditions, rising middle class and increasing inequalities create a challenge for policy maker
to design optimal personal Income Tax (PIT) system that can capture the tax potential from
middle class growth and at the meantime improving the inequality. In developing countries like
Indonesia the tax system has been aimed at increasing government revenues as for the past 10
years, the personal income tax revenue has increased from 19,5 trillion rupiah in 2002 to 83,3
trillion rupiah in 2012. More than that, the income tax is also supposed to be used as a public
policy instrument to alter after-tax income distribution.
The purpose of this paper is to design a personal income tax system that can capture the increase
in tax potential as the middle class growth and also promote better income distribution in
Indonesia. Using microsimulation and Computable General Equilibrium (CGE) approach, we
quantitatively analyze the way proposed PIT system affect government revenue and alter the
inequality of the income distribution. First, we propose some PIT systems and quantify the way
they affect after tax income by using the micro data. Next, we employ CGE model and execute
the simulation to calculate the effect of proposed PIT systems on the Indonesian economy. We
use Indofiscal (Amir, 2011), a CGE model of the Indonesian economy with a focus on fiscal
policy. The model has capability of evaluating a range of fiscal policy, including personal
income taxes. The result will help the policy makers to design a better income tax system in
responding to the current situation of middle income growth and rising inequality.
Keywords: Middle Class, Personal Income Tax, Inequality
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1.
INTRODUCTION
Tax revenue has an important role for the Indonesian government, since 70% of
government total revenue came from tax. Income tax revenue has the bigest portion of total tax
revenue, therefore the volatility of income tax revenue will also impact the government budget.
Government have to maintain the stability of income tax revenue as it is the main source of
government revenue while using it as a tool for fiscal policy. Income tax consists of three type
of tax: corporate income tax, personal income tax, and other income tax. This research
focussing on the personal income tax policy since it has the largest impact to the income
distribution.
Many research assuming that Indonesia still has a lot of personal income tax potential,
considering more than 250 million populatation all over Indonesia. Furthermore a large portion
of the Indonesian population now is entering the middle-class as its economy is growing
rapidly. Nielsen, a leading media research said that currently, middle class in Indonesia is the
third-largest in the world. There are about 74 million middle classes in Indonesia, and this
number will double by 2020.
The main objective of this study is to analyze to design a personal income tax system that
can capture the increase in tax potential as the middle class growth and also promote better
income distribution in Indonesia. This research would give an input for the indonesian
government in designing proper personal income tax system for the country. The rest of the
paper is organized as follows. Section-2 describes the middle class in Indonesia and it’s tax
potential. The methodology is discussed in section-3. Section-4 describes the result of the
policy simulation.
2.
MIDDLE INCOME CLASS IN INDONESIA AND IT’S TAX POTENTIAL
According to Indonesia Economic Quarterly reports (World Bank, 2011), the concept of
the middle class can be defined in various aspects such as socio-cultural aspect and social
aspect. In the socio-cultural aspect, the middle class generally have a wealthy and prosperous
life in the community. The middle class also have a greater probability than low-income
households to buy home appliances such as TV, refrigerators, motorcycles or car or own a
property like house. Those who in the middle class will be more ability to seek and consume
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higher education, an advanced health care services and recreational. While in the social term,
most economists use income or expenditure pattern to define the middle class.
There are three approaches to defining the middle class based on expenditure or income
households: (i) the absolute approach, (ii) the relative approach, and (iii) a combined approach.
The absolute approach defines the middle class at a certain level of expenditure; those who
have income (or spending) on the specific upper and lower limits considered as middle class.
The relative approach emphasizes the level of household income or expenditure relative to the
others. Numbers of percentile expenditure per capita is often used for the relative approach.
The combined approach is a mix of absolute and relative approaches.
Choice between the absolute approaches, relative and combined depends on the purpose
of the analysis that will be done. For example, in Kharaz and Gertz (2010) says that the absolut
approach is right to be used as the single measure to compare the size of the middle class
between countries. Cannon (1980) concluded that the relative approach would be more
appropriate to assess the "state" or "welfare" of the population, due to the relative hierarchy is
very important for the welfare or status of the middle class. In other words, people consider
themselves as a member of middle class by comparing theirself with others. This study uses
the the absolute approach in order to do an analysis of changes in the number of people in
different income classes. This study using the absolute approach which define middle classes
based on certain spending levels according to the World Bank definition. The middle class are
those with per capita spending between $ 2 to $ 20 per day. This approach is also used by Asian
Development Bank (2010) .
FIGURE-1: Proportion of income class 2007-2010
120
100
80
0.1
0.4
0.3
0.3
51.4
52.1
54.2
54.9
48.5
47.6
45.5
44.8
2007
2008
2009
2010
60
40
20
0
Low
Middle
High
Source : Tenrini and Anda, 2013
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Tenrini and Anda (2013) have calculated tax potential from the rising of middle income
class in Indonesia. They found that more than 50% from all population in Indonesia come from
middle income class. Graph 1 shows the result from that study in. The portion of middle income
class increasing from 51,4 percent in year 2007 to 54,9 percent in 2010, while the portion of
low income class decreasing from 48,5 percent in 2007 to 44,8 percent in 2010. This condition
indicates that there is an increasing tax potential for personal income tax because the rising of
middle income class.
FIGURE-2: Proportion of consumption of each income class 2007-2010
120
100
1.5
4.3
3
4.1
73.2
73.8
74.7
74.6
25.3
21.8
22.3
21.3
2007
2008
2009
2010
80
60
40
20
0
Low
Middle
High
Source : Tenrini and Anda,2013
Figure 2 shows the consumption proportion for each income class for 2007-2010. It is
found that the middle inclome class has is the biggest consumption among others. It is
contribute for more than 70% of total consumption. The portion of the middle class income
consumption increasing from 73,2 percent in 2007 to 74,6 percent in 2010. This condition also
indicates that there is an increasing tax potential for personal income tax because the rising of
middle income class.
Currently, middle class in Indonesia is the third-largest in the world. There are about 74
million middle classes in Indonesia, and this number will double by 2020. In the other hand,
economic growth also creates a problem of rising inequality. Inequality in Indonesia is
worsened as the Gini index increasing from 0.308 in 1999 to 0,41 in 2011. Both conditions,
rising middle class and increasing inequalities create a challenge for policy maker in doing tax
collection. The government should be able to design optimal income tax system that can
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capture the tax potential from middle class growth and at the meantime improving the
inequality.
According to Musgrave and Musgrave (1989), when the goverment doing tax collection,
their also doing their three function, such as; (i) Adressing inefficiencies in a market system,
(ii) Carring out the social equity through income and wealth distribution, and (iii) Creating an
economic stability and overcoming the fluctuations in the economy while ensuring
employment and price stability. Indonesian government using progressive rate Indonesia to
carry out the function of income distribution which is tax rate that increasing if the tax base
getting bigger. (Soemitro. 1990).
Harvey Rosen (2002) said that progressive rate correspond with vertical equity “it is
widely agreed that tax system should have vertical equity : it should distribute burdens fairly
across people with different abilities to pay”. Furthermore another justification about
progressive tax and income distribution that is income tax should be progressive in that the
higher income groups pay tax proportionately more than the lowest income group as a
percentage of income (Nugraha And Lewis, 2013).
In developing countries like Indonesia the tax system has been aimed an increasing in
government revenues, as for the past 10 years, the personal income tax revenue has increased
from 19,5 trillion rupiah in 2002 to 83,3 trillion rupiah in 2012. More than that, the income tax
is also supposed to be used as a public policy instrument to alter after-tax income distribution.
3.
METHODOLOGY
This study using microsimulation and Computable General Equilibrium (CGE) approach. We
quantitatively analyze the way proposed PIT system affect government revenue and alter the
inequality of the income distribution. First, we propose some PIT systems and quantify the way
they affect after tax income by using the micro data. Next, we employ CGE model and execute
the simulation to calculate the effect of proposed PIT systems on the Indonesian economy. We
use Indofiscal (Amir, 2011), a CGE model of the Indonesian economy with a focus on fiscal
policy. The model has capability of evaluating a range of fiscal policy, including personal
income taxes.
A CGE model is an “economywide” model because it describes the motivations and behavior
of all producers and consumers in an economy and the linkages among them (Burfisher, 2011).
The use of CGE models in the economy has expanded over the last 25 years. It helps us in
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getting a better understanding of the interactions occurs in the economy. Next subsection will
describe the structure of the model and the model database mode clearly.
3.1. Model Description
This study uses Indofiscal (Amir, 2011; Amir et.al, 2013), a CGE model of Indonesia that
equipped with fiscal features. The model is based on ORANI-G (Horridge, 2003) and AGEFIS
(Yusuf et.al, 2008). Using Johansen approach, equations are linearized in percentage changes
instead of levels of variables. This approach characterizes most of Australian CGE models such
as ORANI (Dixon et.al, 1982) and MONASH (Dixon and Rimmer, 2002).
There are four institutions in the model: households, corporations, government, and rest
of the world (ROW). As a source of factors of production, households receive income from the
production activity. It also receives other income from other institution such as governments,
corporations, ROW, and from other households. Taxes are a percentage of household income
based on the marginal income tax rate structure. For the corporations, the revenue earned by
this institution is caming from its ownership of production factors minus corporate income tax,
and transfer from other institutions. While corporate spending goes to payment or transfer to
other institutions.
For the government, revenue can be described as the sum of receipts from various sources
of taxes and other revenue. Government expenditure consists of expenditure on goods and
services for each commodity, and expenditure for the transfer to domestic and foreign parties.
Other expenditures made by the government are in the form of subsidies on commodity goods
and for industries. Last, for the ROW, foreign income is defined as revenue of the it’s
ownership of production factors, payment received from imported commodities and transfer
from other institutions. Foreign expenditure consists of spending for exported commodities,
payment to production factors and transfer to other institutions.
Figure-3 illustrates the nested production structure in the model. Output are produced
through a three-level production structure. At the top nest, the model utilized Leontief function
to combine intermediate inputs, primary factors, and other costs in order to produce
commodities. Using this approach, commodities are produced by fixed proportion of
intermediate demands, primary factors, and other costs.
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FIGURE-3: Structure of production
Source: Adopted from Horridge (2003)
At the lower level of production structure, there are nesting for intermediate input demand
and primary factor demand. Demand for intermediate input are composed of domestic and
imported goods using Constant Elasticity of Substitution (CES) function (Armington, 1969).
By utilizing CES function, the producers choose the composition of their intermediate input
from domestic and imported goods, in which both of them are imperfectly subtitutable. The
demand for primary factors also utilizing CES function to choose the composition of capital
and labor composite. Using the function, the composition of capital and labor are determined
to minimize the production cost. In addition, each production sector is assumed to produce only
a single commodity. It is also assuming constant return to scale and perfect competition in the
market.
Similar to the producers that choose input and output levels to maximize their efficiency,
consumers also choose their consumption to maximize their utility; by purchasing the most
satisfying bundle of products given their budgets and the prices of the commodities. Household
demand are for commodity composites are composed using Klein-Rubin utility function
(Horridge, 2003) that differentiate the household demand into two categories: (i) subsistence
demand and (ii) luxury demand.
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The model has several closures, which mainly associated with the simulation timescale.
In the short run, we assume that there is not enough time for the capital stock to adjust so that
there is no new investment. Capital is sector-specific, that is fixed for each industry and cannot
move between sectors. The capital rate of return may adjust to reflect the changes in the demand
of capital. Hence the real wage rate is fixed, while aggregate employment can change to
respond the changes in the labor market. In the long run, capital stock may adjust because there
is quite enough time for the capital stock to adjust, while the capital rate of return is fixed.
Aggregate employment is fixed to reflect full employment assumption in the long run, while
real wage rate may adjust. In addition, there are some variables that are assigned as exogenous
such as technological changes, tax rates, and transfers between institutions.
3.2. Model Database
A CGE model's database describes the circular flow of income and spending in a national
economy within a specific time period. It reports the values of all goods and services that are
produced and also the income generated from production activities. The database are built in
which they are relevant to the research question. Researchers must decide the level of
aggregation or disaggregation of the industries and commodities classification in their
database. For this purpose, we modified the Social Accounting Matrix (SAM) Table used in
the model to analyze the impact of each income tax design.
To dissagregate the SAM table, we use the 2012 Household Survey (SUSENAS) as the
statistical data sources. The 2012 Household Survey, give us valuable information about
household characteristics in term of their income and consumtion pattern. We use the data to
dissaggregate the household data in the model. It s important to capture the impact of each
personal income tax design to each household income group.The SAM table dissaggregation
is a crucial step, since reliable data provide a strong base for reliable policy analysis.
Table 1. Personal Income Tax Formulation
Regulation
Office cost
Non taxable
income
Bracket and 
rate



Year 2009-2012
Act No.36 Tahun 2008
5% from gross income, max IDR 6.000.000
(PMK No.250/PMK.03/2008)
Rp 15.840.000
(Act No.36 Tahun 2008)
until IDR 50 million: 5%
Above IDR 50 million until IDR 250 million: 15%
Above IDR 250 million until IDR 500 million: 25%
Above IDR 500 million: 30%




Year 2013-now
Act No.36 Tahun 2008
5% from gross income, max IDR 6.000.000
(PMK No.250/PMK.03/2008)
Rp 24.300.000
(PMK No.162/PMK.011/2012)
until IDR 50 million: 5%
Above IDR 50 million until IDR 250 million: 15%
Above IDR 250 million until IDR 500 million: 25%
Above IDR 500 million: 30%
Source : Ministry of Finance
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To calculate the effective tax rate on each househod, we apply the actual tax rate on the
Income Tax Act to the household survey data. There has been several changes in Income Tax
Act In Indonesia. Income tax Act first set in the Act No.7 Year 1983, then revised in the Act
No.7 Year 1991, Act No. 10 Year 1994, Act No.17 Year 2000, and Act No. 36 Year 2008.
There has been several adjusted in tax bracket, tax rate and non taxable income. The
comparison between Act no. 17 Year 2000 and Act no.36 Year 2008 in tax formulation can be
seen in the table 1.
4.
SIMULATION AND RESULTS
4.1. Policy Simulation
Ten different scenarios have been prepared to analyze each personal income tax system design.
Each scenario is designed with specific assumptions so that we can compare all of the results
of the personal income tax system design more comprehensively
Table 2. Simulation Design
Simulation
SIM1
SIM2
SIM3
SIM4
SIM5
SIM6
SIM7
SIM8
SIM9
SIM10
brackets
more
less
bracket start from
lower
higher
rate
lower
higher
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
In the SIM1 and SIM2, we re-design the income tax bracket, so we create more brackets SIM1
and less bracket in SIM2. From the simulation result in the SIM1 and SIM2 we can analyze the
impact of bracket design to tax revenue and the income distribution of the midle class. Next in
the SIM3 to SIM6, we compliment the personal income tax design in the SIM1 and SIM2 with
the lowest bracket shift. In SIM3 and SIM4 we shift down the lowest bracket, while in SIM 5
and SIM6 we shift up the lowest bracket. In SIM7 to SIM10 we compliment the personal
income tax design in the SIM1 and SIM2 with the change in the tax rate.
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4.2. Impact on Income Ditribution Macroeconomy
The impact of the personal income tax system design on the income distribution arereported in
table 4. In the reponse of personal income tax system design on the SIM1 to SIM10, the income
distribution are change for each household income group. HH1 represent the lowest household
income group, while HH10 represent the higest household income group.
Table 3. Impact on the Income Distribution
HH by Income deciles
SIM1
SIM2
SIM3
SIM4
SIM5
SIM6
SIM7
SIM8
SIM9
SIM10
HH1
-0.002
0.062
0.123
1.247
-0.056
-0.07
-0.059
0.005
0.731
0.802
HH2
0
0.039
0.099
0.961
-0.038
-0.05
-0.028
0.011
0.556
0.595
HH3
0.002
0.017
0.075
-0.181
-0.021
-0.031
0
0.015
-0.109
-0.098
HH4
0.004
0.002
0.058
-2.041
-0.01
-0.017
0.02
0.018
-1.18
-1.189
HH5
0.005
-0.007
0.047
-3.562
-0.002
-0.009
0.032
0.02
-2.054
-2.075
HH6
0.005
-0.017
0.034
-4.949
0.005
0
0.044
0.022
-2.851
-2.885
HH7
0.006
-0.025
-0.325
-6.477
0.012
0.008
0.053
0.022
-3.727
-3.771
HH8
0.007
-0.111
-1.432
-7.965
0.123
0.121
0.115
-0.003
-4.588
-4.721
HH9
-0.014
-1.244
-1.67
-8.204
1.212
1.631
0.848
-0.381
-4.854
-6.098
HH10
0.291
-1.968
-0.821
-5.659
1.335
1.37
3.152
0.893
-4.642
-7.578
0.12
-1
-0.736
-5.438
0.733
0.805
1.438
0.319
-3.719
-5.123
Total HH Income
Source: Simulation results
In SIM1 more tax bracket create only little effect on income distrbution, while in the SIM2,
less tax bracket create income redistribution from the upper class to the lower class. In SIM3
and SIM4 the shift down in the lowest bracket create income redistribution from the upper class
to the lower class, while in the SIM5 and SIM6 the shift up in the lowest bracket create income
redistribution from the lower class to the upper class. In SIM7 and SIM8, lower tax rate result
increase in the income in almost all income group, while in in SIM9 and SIM10. Higher tax
rate result increase in the income of lower level, and decrease in the income of the middle and
upper level.
Table 4. Impact on the Income Distribution
HH by Income deciles
SIM1
SIM2
SIM3
SIM4
SIM5
SIM6
SIM7
SIM8
SIM9
SIM10
HH1
lower
lower
lower
lower
lower
lower
lower
lower
lower
lower
HH2
middle
middle
middle
middle
middle
middle
middle
middle
middle
middle
HH3
middle
middle
middle
middle
middle
middle
middle
middle
middle
middle
HH4
middle
middle
middle
middle
middle
middle
middle
middle
middle
middle
HH5
middle
middle
middle
middle
middle
middle
middle
middle
middle
middle
HH6
middle
middle
middle
middle
middle
middle
middle
middle
middle
middle
HH7
middle
middle
middle
middle
middle
middle
middle
middle
middle
middle
HH8
middle
middle
middle
middle
middle
middle
middle
middle
middle
middle
HH9
middle
middle
middle
middle
middle
middle
middle
middle
middle
middle
HH10
middle
middle
middle
middle
middle
middle
middle
middle
middle
middle
Total HH
upper
upper
upper
middle
upper
upper
upper
middle
middle
middle
10
4.3. Impact on The Macroeconomy
Table 5. Impact on the Macroeconomy
Macro Variable
SIM1
SIM2
SIM3
SIM4
SIM5
SIM6
Real PDB
0.008
-0.068
-0.044
-0.309
0.049
0.12
-1
-0.736
-5.438
0.733
Real export
-0.201
1.69
1.255
9.333
Real import
0.067
-0.565
-0.426
Consumer price index
0.098
-0.842
Aggregate employment
0.019
-0.142
Real consumption
SIM7
SIM8
SIM9
SIM10
0.053
0.1
0.023
-0.219
-0.316
0.805
1.438
0.319
-3.719
-5.123
-1.241
-1.364
-2.426
-0.535
6.365
8.736
-3.163
0.416
0.458
0.807
0.176
-2.15
-2.94
-0.664
-5.065
0.624
0.69
1.194
0.254
-3.398
-4.572
-0.081
-0.528
0.101
0.108
0.214
0.053
-0.395
-0.6
Source: Simulation results
Table 6. Impact on the Government Revenue
Govt Revenue
SIM1
SIM2
SIM3
SIM4
SIM5
SIM6
SIM7
SIM8
SIM9
SIM10
Indirect Tax
0.1%
-0.9%
-0.7%
-5.2%
0.6%
0.7%
1.2%
0.3%
-3.5%
-4.7%
Import Tariff
0.1%
-0.5%
-0.4%
-3.4%
0.4%
0.4%
0.8%
0.2%
-2.3%
-3.0%
Personal Income Tax
-3.9%
35.6%
30.5%
234.7%
-26.8%
-30.0%
-49.2%
-9.7%
154.6%
203.6%
Corporate Income Tax
0.1%
-0.8%
-0.6%
-4.5%
0.6%
0.6%
1.1%
0.2%
-3.0%
-4.1%
-0.2%
2.1%
1.8%
14.1%
-1.6%
-1.8%
-2.8%
-0.5%
9.3%
12.1%
Total Revenue
Source: Simulation results
Table 7. Impact on the Sectoral Performance
Sector
SIM1
SIM2
SIM3
SIM4
SIM5
SIM6
SIM7
SIM8
SIM9
SIM10
Agriculture
0.008
-0.072
-0.065
-0.505
0.054
0.061
0.098
0.018
-0.329
-0.426
Mining
-0.008
0.071
0.056
0.423
-0.053
-0.058
-0.101
-0.022
0.285
0.384
Manufact
-0.018
0.148
0.111
0.831
-0.109
-0.12
-0.212
-0.047
0.565
0.772
Utilities
0.012
-0.105
-0.084
-0.621
0.078
0.087
0.148
0.031
-0.417
-0.563
Construction
0.001
-0.012
-0.008
-0.059
0.009
0.009
0.017
0.004
-0.041
-0.058
TradeHtlRest
-0.005
0.063
0.083
0.682
-0.052
-0.062
-0.073
-0.006
0.417
0.496
TransCom
0.009
-0.076
-0.054
-0.358
0.056
0.061
0.109
0.024
-0.251
-0.357
FinReal
0.015
-0.106
-0.048
-0.302
0.073
0.076
0.165
0.045
-0.246
-0.401
Service
0.095
Source: Simulation results
-0.78
-0.55
-3.976
0.569
0.622
1.13
0.256
-2.754
-3.854
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