The cancellation of the planned increase in the Value Added Tax (VAT) rate from 11 to 12 percent, initially set for 2025, has been welcomed as a relief by the broader public.

The government had previously shown strong enthusiasm for raising the VAT rate as part of its long-term fiscal roadmap. However, amid global economic uncertainty and challenging domestic conditions, growing public pressure led to its cancellation.

With inflation lingering, weakening consumer purchasing power, and small businesses still struggling to recover from the pandemic, the announcement of the cancelled VAT hike on New Year’s Eve brought a glimmer of hope. It is fair to call this a moment of wisdom rather than merely a policy shift.

There is no denying that 2024 was a difficult year. The global economic slowdown impacted Indonesia, particularly the real sector that supports many households. Traditional market traders complained of falling sales, while workers faced mounting expenses despite stagnant wages.

In such a situation, a VAT increase would have dealt another blow. As household consumption remains the primary driver of economic growth, it would certainly have been pressured further. The government’s decision to postpone the VAT hike reflects an empathetic stance.

Tax System and Redistribution

However, the bigger question remains: how far can our tax system address inequality and ensure fairer income distribution? Inequality has become a chronic issue, and more progressive tax reform will be crucial going forward.

Studies show that in developing countries, the redistributive effect of taxation tends to be limited. This is partly due to a heavy reliance on indirect taxes such as VAT.

Indirect taxes are more regressive compared to direct taxes like income tax. VAT, in particular, does not account for differences in income and spending between the rich and the poor. As a result, low-income individuals pay a larger share of their income in taxes relative to their consumption.

Meanwhile, wealthier groups tend to have surplus income that is not spent on consumption, giving them more room to save or invest.

Most developing countries, including Indonesia, rely on indirect taxes because they are seen as more practical. First, a broader tax base makes indirect taxes relatively easier to implement, boosting state revenue.

Second, the efficiency of collecting direct taxes such as income tax is often low. This is further hampered by widespread tax avoidance due to poor compliance and weak tax administration.

Third, the dominance of the informal sector poses another challenge, as income from this sector is difficult to tax directly. The government’s discourse on lowering the final income tax threshold for MSMEs and taxable entrepreneurs from Rp 4.8 billion to Rp 3.6 billion per year seems aimed at expanding the tax base.

As of November 30, 2024, the government’s fiscal report shows that revenue from VAT (and Luxury Goods Sales Tax/PPnBM) stood at Rp 707.76 trillion, or about 41.91 percent of total tax revenue. This heavy reliance on indirect taxes has significant consequences, particularly concerning income distribution.

As previously explained, VAT, as a consumption tax, is applied proportionally to spending, without regard for an individual’s economic capacity.

As a result, low-income groups—who spend most of their earnings on consumption—bear a proportionally heavier tax burden compared to wealthier groups. This regressive effect runs counter to the principles of distributive justice.

In this context, literature such as Bastagli et al. (2015), in the chapter titled “Fiscal Redistribution in Developing Countries,” shows that developing nations generally have limited capacity to use tax systems to reduce inequality.

Personal income tax, for example, often functions primarily as a wage withholding tax (PPh 21).

Beyond that, personal income tax should be designed to effectively tax various forms of capital ownership. In many cases, the wealthy manage to evade their tax obligations through legal loopholes, lack of oversight, or, more troublingly, tax systems that favor them through various incentives.

New Year Optimism

The decision to cancel the VAT hike carries significant implications for preserving the purchasing power of vulnerable communities.

In today’s sluggish economic climate, a more progressive tax reform would be more effective by strengthening fairer direct taxes.

Efforts to expand the reach and effectiveness of personal income tax could have a greater impact on income distribution without placing additional pressure on household consumption.

According to the fiscal report as of November 30, 2024, the realization and contribution of personal income taxes were as follows: personal income tax Rp 13.38 trillion (0.79 percent), final income tax Rp 123.98 trillion (7.34 percent), and employee income tax (PPh 21) Rp 222.13 trillion (13.2 percent).

The contribution of final income tax, some of which is levied on capital owned by the wealthy, remains relatively small. This indicates that the tax system has yet to effectively serve as a tool for redistribution.

Comprehensive political and administrative reform is needed to build a fairer tax system. Progressive taxation targeting the wealthy, elimination of inefficient tax incentives, enhanced oversight against tax avoidance, and expansion of the tax base are urgent steps.

These measures can only be realized if national leaders demonstrate a strong commitment to increasing state revenue with a clear prioritization of equity.

One thing is certain: the cancellation of the VAT hike is a clear victory for the people of Indonesia. It shows that the voices of the public are still heard and taken into account in policymaking, steering policies toward greater public interest.

The highest appreciation should be extended to all those who voiced their objections, as it is through their courage and concern that tax policies are becoming more equitable.

Let us hope that 2025 will not only mark a better start but also serve as a turning point in the ongoing struggle for a tax system that is fairer, more transparent, and focused on public welfare.

The ultimate goal is for taxes to help reduce the inequality that continues to shackle our economy. The author firmly believes that tax reform is key to building a more just and equitable future.

By Ismail Khozen, Lecturer at the Department of Fiscal Administration, Universitas Indonesia

Source: Kompas.id