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Project Name

Domestic Resource Mobilization Program, Subprogram 1

Project Number

56257-001

Country / Economy

• Indonesia

Project Status

Proposed

Project Type / Modality of Assistance

• Loan

Source of Funding / Amount

Loan: Domestic Resource Mobilization Program, Subprogram 1

Source	Amount
Ordinary capital resources	US$ 500.00 million

Sector / Subsector

• Public sector management / Public expenditure and fiscal management

Gender

Effective gender mainstreaming

Description

The proposed program will enhance the government's ability to mobilize sufficient domestic resources to finance planned public expenditures on service delivery and public infrastructure upgrading. Through an integrated approach, the program will support (i) tax administration strengthening, (ii) international tax cooperation and exchange of information enhancement, and (iii) revenue policy improvement. The proposed program is consistent with the Government of Indonesia's National Medium-Term Development Plan (RPJMN), 20202024, which sets out to support inclusive, competitive, and environmentally sustainable growth in the country and prioritizes enhanced domestic resource mobilization (DRM) as a means of financing development.a The proposed program is also aligned with the Asian Development Bank (ADB) country partnership strategy for Indonesia, 20202024, which focuses on (i) improving the well-being of citizens, by strengthening health care, education, and social security; (ii) accelerating economic recovery, by supporting structural economic reforms, including domestic resource mobilization; and (iii) strengthening resilience, including climate change mitigation and adaptation measures, environmental sustainability, and green recovery.b The proposed program contributes to four operational priorities (OPs) of ADB's Strategy 2030: addressing remaining poverty and reducing inequality (OP1), accelerating progress in gender equality (OP2); tackling climate change, building climate and disaster resilience, and enhancing environmental sustainability (OP3); and strengthening governance and institutional capacity (OP6).c Subprogram 1 objectives are aligned with the goals of the Paris Agreement, by building the enabling environment to secure resources for climate change, including through carbon taxes.

Project Rationale and Linkage to Country/Regional Strategy

Background and development

Macroeconomic context. Indonesia's economy has recovered from the impact of the coronavirus disease (COVID-19) pandemic but remains below its full potential. After a contraction of 2.1% in 2020, the economy grew by 3.7% in 2021 and 5.3% in 2022. In 2023, the economy expanded by 5.0%, below the pre-pandemic average annual growth of 5.3% during 20112019, and a 5.0% growth rate is also projected for 2024 and 2025.d The macroeconomic framework remains satisfactory, and central government debt was sustainable at 39.0% of gross domestic product (GDP) in June 2024, below the threshold of 60% of GDP (footnote d). Indonesia's macroeconomic management remains sound, its sovereign credit ratings are stable, and its debt levels are sustainable, providing adequate policy space to mitigate future exogenous shocks.e The government's monetary policy stance remained largely unchanged in 2023, and will continue to target price stability in 2024. The government's fiscal policy remains prudent. The government targeted a budget deficit of 2.9% of GDP in 2023 but achieved a budget deficit of 1.7% by the end of the year. The budget deficit is expected to rise to 2.3% in 2024 as the government aims to stimulate growth.

Government spending plans cannot be realized without enhanced domestic resource mobilization.f To achieve development targets in priority areas, the government needs to scale up infrastructure provision, enhance public services such as health and education, and strengthen social safety nets (footnote a). However, the fiscal space in Indonesia is constrained. Indonesia has established strict legal limits on the fiscal deficit at 3% of GDP and the general government public debt ratio at 60% of GDP. These fiscal rules have contributed to macroeconomic stability and overall creditworthiness, but also resulted in lower levels of public spending than in other emerging and developing economies.g Improved DRM is needed if Indonesia is to fully finance its development priorities while ensuring fiscal sustainability.h Taxation accounted for 80.3% of total government revenue in 2023.i Yet, the government collects around half of its potential tax revenue. Indonesia's tax-to-GDP ratio has been below 15.0% for two decades and has been in steady decline since the 2008 global financial crisis.j Indonesia's tax-to-GDP ratio fell from 13.3% in 2008 to 9.8% in 2019, and the negative impact of the pandemic resulted in a tax-to-GDP ratio of 8.3% in 2020.k By 2023, Indonesia's tax-to-GDP ratio stood at 10.2% of GDP.

Development constraints. Three interlinked constraints contribute to structurally low DRM levels in Indonesia: (i) weaknesses in domestic tax administration result in low productivity and inadequate taxpayer services; (ii) Eroded tax base from international tax evasion and avoidance, and (iii) policy shortcomings lead to suboptimal revenue performance and an inability to address emerging issues.

Weaknesses in domestic tax administration result in low productivity and inadequate taxpayer services. Although past reforms have enhanced the tax authority's performance in several areas, there remains significant potential to raise organizational efficiency and effectiveness. The revenue authority continues to suffer from an antiquated organizational structure, outdated IT systems, poor taxpayer data, relatively low-skilled and generalist staff, and ill-defined institutional processes, resulting in low productivity.l As a result of deficiencies in tax administration, taxpayer compliance is generally low, which in turn undermines Indonesians' confidence in the fairness of the tax system (footnote h). The revenue administration needs to invest in technology and skills, reform business processes, develop a more service-oriented outlook, and foster a culture of integrity and transparency to improve voluntary compliance. At the same time, improving the quality and reliability of the taxpayer database, enhancing the access of the Directorate General of Taxes to data from third parties, and building capacity to reconcile third-party data to those reported by taxpayers on their tax returns are critical for better risk management and detection of noncompliance.

Eroded tax base from cross-border tax evasion and avoidance. Multinational enterprises and high net worth individuals continue to exploit loopholes in the international tax framework and avoid paying their fair share of tax in Indonesia. Revenue losses to Indonesia from international tax evasion and avoidance are estimated at $3.0 billion annually.m Although Indonesia is already a member of the OECD/Group of Twenty (G20) Inclusive Framework for Base Erosion and Profit Shifting (BEPS), and the Global Forum on Transparency and Exchange of Information for Tax Purposes,n it has yet to fully benefit from international tax cooperation. Indonesia has established a legal and regulatory framework regarding BEPS and Automatic Exchange of Information on bank account information, but there are areas for improvement. Moreover, Indonesia lacks a robust legal and regulatory framework which can address the challenges of the digitalized economy. Indonesia also has limited institutional capacity and technology to implement increasingly complex international tax reforms in a clear and consistent manner, which in turn creates uncertainty for businesses.

Policy shortcomings lead to suboptimal revenue performance and an inability to address emerging issues. Although Indonesia possesses an overarching tax policy framework, many potential revenue sources remain untapped and inherent design weaknesses in the tax system reduce the country's revenue productivity (footnote h). The government primarily collects tax revenues from income taxes (49.1% of total tax receipts in 2023), the value-added tax (VAT) and sales taxes for luxury goods (35.0% in 2023), excises (10.7% in 2023), and taxes on international trade (3.4% in 2023) (footnote i). High thresholds, wasteful exemptions, and uneven treatment between sectors undermine the effectiveness of these taxes. Insufficient environmental and health taxes and an unimplemented tax on carbon emissions further undermine the tax base and inhibit the achievement of broader socioeconomic goals. Indonesia has yet to create a regulatory framework for innovative infrastructure financing modalities, such as land value capture (LVC), that can both increase government revenues and attract private sector contributions.o Rationalizing the tax policy framework especially through base broadening will allow the government to collect more revenues, reduce distortions, improve the equity of taxation, and serve other socioeconomic goals, such as reducing the prevalence of noncommunicable disease.p Adopting a gender perspective to DRM policies is necessary to address implicit gender bias in the tax system and holds significant potential for economic growth and social development in Indonesia (footnote f).

Reform areas, ADB's value addition, and sustainability

Government reform agenda. The RPJMN, 20202024, provides the overarching framework for the program (footnote a). It recognizes that Indonesia has limited fiscal space to fund development needs and therefore prioritizes the modernization of revenue administration and the formulation of appropriate revenue policy. The Ministry of Finance's Medium-Term Strategy, 20202024, further details the government's approach to optimizing state revenues and transforming tax administration.q In October 2021, the Parliament passed the Law on the Harmonization of Tax Regulations (HPP), which provides the legislative framework to further enhance Indonesia's tax system. The HPP effectively sets the tax reform agenda for the medium term by outlining a package of measures to broaden the tax base, improve revenue performance, provide more legal certainty, and enhance vertical and horizontal equity. The HPP details the administrative reforms and guiding regulations needed to ensure full implementation of the law over the medium term.r

Reform areas. Informed by the government reform agenda, the proposed program has three mutually reinforcing reform areas:

(i)Reform area 1: Tax administration strengthened. Reforms in the first area will support (a) the digital transformation of tax administration, to enhance organizational efficiency, improve business intelligence, and make paying taxes easier for citizens and businesses; (b) organizational restructuring, streamlining of business processes and procedures, and bolstering of the human resource function to strengthen institutional capacity and productivity, mitigate operational and human capital risks, and create greater career opportunities for female staff; (c) operationalization of risk-based approaches to compliance, to ensure more effective use of organizational resources and improve taxpayer morale; and (d) improvements to taxpayer services and initiatives, including streamlining taxpayer dispute resolution and VAT refund mechanisms to reduce compliance costs for businesses.

(ii)Reform area 2: International tax cooperation and exchange of information enhanced. Under the second reform area policy reforms will include: (a) reducing profit shifting and base erosion via implementation of the BEPS two-pillar solution; (b) improving global tax transparency by transposing the Crypto Asset Reporting Framework (CARF) rules into domestic law and improving the effectiveness of automatic exchange of information, including developing secure and efficient IT systems to handle the exchange of information; (c) formulation and operationalization of new transfer pricing rules; and (d) implementation of a policy framework on the taxation of trusts.

(iii)Reform area 3: Revenue policy improved. Policy reforms in the third area will (a) rationalize existing excise tax regimes (tobacco and alcohol) and broaden the scope of excise taxes to raise additional revenues and to disincentivize socially harmful behaviors; (b) develop methodologies and tools to systematically apply a gender lens to tax policy formulation; (c) operationalize carbon taxes in Indonesia to secure additional revenues to mitigate the impact of climate change; and (d) provide the legal basis for subnational government to implement LVC and mobilize additional resources for public infrastructure projects.

ADB's value addition. ADB has been a key partner for DRM reforms in Indonesia. Under the Asia Pacific Tax Hub, ADB has been providing advisory support and knowledge products on DRM to Indonesia, both bilaterally and at the regional level, in conjunction with other development partners.s ADB has been instrumental in undertaking diagnostic work on barriers to DRM in Indonesia. In 2023, ADB co-led a review of Indonesia's tax administration using the Tax Administration Diagnostic Assessment Tool (TADAT).t ADB has long supported Indonesia to meet internationally agreed standards for tax transparency, counter tax evasion, and tackle base erosion and profit shifting.u Supported by the Domestic Resource Mobilization Trust Fund, ADB is assisting the government to assess the impact of the base erosion and profit shifting two-pillar solution on Indonesia and to formulate appropriate domestic regulations consistent with its international commitments.v ADB is supporting the government to use taxation as a tool to address socially harmful activities and behaviors by providing policy advice to inform Indonesia's carbon tax policy and regulations and to further enhance and expand the country's excise tax regime.w ADB is also supporting Indonesia to explore policy reforms related to gender equality and promoting more gender-responsive tax administration.

Sustainability. The sustainability of reform outcomes will be achieved through the inclusion of the medium-term results framework and ADB's continuous engagement with the government's DRM reforms. ADB will support all three reform areas through policy dialogue, knowledge work, and legal advice.

ADB's past engagement and lessons. ADB's engagement in DRM reforms in Indonesia underlines the need for a tailored approach that not only reflects the country context, but also takes account of institutional capacity constraints, ensures full government buy-in of the reforms, and respects broader government priorities, including the need to promote investments and job creation, reduce inequality, and tackle climate change (footnote r). These needs can be best supported over the medium term through a programmatic approach, with sufficient TA to design and implement complex reforms. DRM reforms also necessitate development partner coordination, and ADB has worked closely with the International Monetary Fund (IMF), the Organisation for Economic Co-operation and Development, the World Bank, and others to ensure complementarities in reform support.

Development coordination. The IMF actively engages with the government on fiscal policy through its Article IV dialogue and provides targeted assistance on tax policy and administration. Recent World Bank lending programs have focused on fiscal reform, including revenue policy, and on enhancing subnational government finance. The World Bank also administers a multidonor trust fund that supports revenue policy and administration. The Government of Australia, through the Australia Indonesia Partnership for Economic Development (PROSPERA), supports the Government of Indonesia to improve its public finances and enhance government revenue performance. The Organisation for Economic Co-operation and Development advises the government on international tax matters. German and French development cooperation agenciesthrough KfW and Agence Fran

aise de D

veloppement, respectivelyhave ongoing TA programs on tax policy and administration. ADB coordinates with other agencies through regular dialogue and has partnered with these agencies to provide coordinated support to the government on DRM matters.

Expected outcome of the reform

The proposed program is aligned with the overarching objective of Indonesia's RPJMN, 20202024 (footnote a). The expected outcome of the proposed program is sufficient domestic revenues raised to maintain sustainable, resilient, and inclusive development and improve the lives of citizens. Improved DRM is expected to contribute to a more sustainable fiscal position, supporting macroeconomic stability, and will provide fiscal space to fund essential public goods and services and to upgrade public infrastructure. Policy reforms will be consistent with the fundamentals of a good tax system, including neutrality, efficiency, certainty and simplicity, effectiveness and fairness, and flexibility, to build taxpayer morale and encourage voluntary tax compliance.x At the same time, reforms will also build institutional capacity to be more selective in enforcement activities, tackling noncompliance in a more targeted manner, and reducing the administrative costs for compliant taxpayers. Reforms will also aim to promote gender mainstreaming through tax policy and administration. The choice of reform areas builds on the existing institutional arrangements within the government, with the aim of reinforcing collaboration and cooperation between the tax policy function and tax administration.

Development financing needs and budget support

The programmatic approach is estimated at $1.5 billion and will comprise policy-based loans for three subprograms, with indicative loan sizes of $500 million for each subprogram. The loan sizes are based on Indonesia's financing needs over 20252029. The fiscal deficit is estimated to be 2.6% of GDP in 2025 and below 3.0% of GDP in the subsequent 45 years in line with the legislative threshold.

Implementation arrangements

The Fiscal Policy Agency (BKF) of the Ministry of Finance will be the executing agency. The BKF, the Directorate General of Taxes, and the Coordinating Ministry for Economic Affairs will be the implementing agencies. A steering group, cochaired by the BKF and ADB, will coordinate program reforms. The program implementation period will be from December 2021 to November 2028. Subprogram 1 will be implemented from December 2021 to November 2024, subprogram 2 from December 2024 to November 2026, and subprogram 3 from December 2026 to November 2028.

Impact

Outcome

Outputs

Geographical Location

Nation-wide

Safeguard Categories

Environment

C

Involuntary Resettlement

C

Indigenous Peoples

C

Summary of Environmental and Social Aspects

Environmental Aspects

Involuntary Resettlement

Indigenous Peoples

Stakeholder Communication, Participation, and Consultation

During Project Design

During Project Implementation

Contact

Responsible ADB Officer

Morton, Sion L.

Responsible ADB Department

Sectors Department 3

Responsible ADB Division

Public Sector Management and Governance Sector Office?(SD3-PSMG)

Executing Agencies

Ministry of Finance Directorate General of Budget Financing and Risk Management

Timetable

Concept Clearance

02 Feb 2024

Fact Finding

03 Feb 2025 to 14 Feb 2025

MRM

17 Apr 2025

Approval

-

Last Review Mission

-

Last PDS Update

30 Oct 2024

Funding