歩いても歩いても

They say 27 is the age when rockstars often die. We are not rockstars, although life has probably fucked us harder than any drugs imaginable. Most importantly, we aren't died yet. I think we are still blessed in that matter.

Getting older has its bane. These days, I forget easily. There are much to think, but there are less time to commit everything to memory. And in the process I threw away what is essential and kept what is irrelevant instead. Long gone are those times when we stop and ponder and marvel at the banality of our lives. But I am trying.

I know that in the eve of your 27th birthday you wanted to celebrate it in your own way – in solitude, trying to recover some quiet moments. So this time, in your absence, I try to mythologize all the strange roads that we once walked – supplanting the half-remembered nostalgia with an allegory of my own making.

I remember the walk we walked on one night on that alley where we found a kitten, lost and alone in the darkness of the bushes. You told be to throw a cat food that I bring in my pocket. You were worried despite my insistence that it would be fine.

Sometimes I think of us as the kitten. Astray, wailing for its mom. We think it won't survive. But help did come. It survived. The kitten turned out strong despite its apparent helplessness. And so as it survived, we survive.

You survive.

Because you are strong.

Sometimes stubbornly so.

I also remember that time when you once walked for a couple miles, under the scorching sun and the heat waves. Few hours later you were still able to dance it all away, with multitudes of strangers, on the dancefloor in the night market.

I once likened you to the bristlecone pine. A tree that thrives under the cold, harsh gale, yet lives longer than many civilizations. I still think that you are.

A bristlecone pine won't die at 27. 27 is the age when rockstars often die. I think I kinda know why. 27 is the forking path where you can no longer using youthfulness as an excuse. It's a prelude for a full-fledged, well-functioning adulthood. Things are getting more pressing. Societies are more demanding. New expectations are coming. The road that we walk will be harder, perhaps even more punishing. Some people try to resist this, and they crash themselves so hard they destroy themselves in the process.

But I know you are strong, strong enough to walk any road.

That's why I want to walk with you, to watch your figure from behind.

It does not have to be in a faraway land, or places that we dream to walk. I don't care if it's Coburg, or Shimogyo-Ku, or Ubud, or Santorini, or Setiabudi, or Gang Gloria, or Pasar Klewer. I don't care if blisters and cramps come as they may. As long as I walk with you. As long as I walk with you forever. As long as you are happy walking with me.

So, happy 27th birthday, N. May you always be happy on your every journey. I promise I will remember this.

The world gets older, N, and so must we. But if the world gets colder, we must not.

How Much Is the Loss from Tax Avoidance: Revisited

Interesting new paper by Tørsløv, Wier, and Zucman (2018) that came out few days ago intrigued me to revisit the question about missing profits. As you may know, corporation is driven by profits. Taxes cut the profits. So it is economically rational to try to reduce tax. One of the usual modus operandi is to establish subsidiary in low tax jurisdiction and divert the profit to it.

In previous post, I have tried to estimate this loss in macroeconomic setting. Now depending on the condition (whether companies also consider market size or proximity) Indonesia may gain 2% or loss up to 5% of GDP due to tax base spillover. In this post, inspired by an equation mentioned by Tørsløv, et al. I will try to use a much more granular data.

The Setup

Numbers of research concerning profit shifting used commercial database to extract the relevant information from the companies' financial report (mainly from income statement and balance-sheet). These are then entered into some equation. One of the equation mentioned in Tørsløv, et al. is:

where log(πic) denotes natural logarithm of pre-tax profits booked by company i in country c; τp is the tax rate in the parent company; τc is the domestic tax rate; and Firm and Country denote firm- and country-specific fixed effects.

I managed to collect the data for 904 companies for the years of 2012-2017. However, I have to modify the above equation in some ways. First, since I only concern about what happen in Indonesia, I have no use for Country fixed effect. Second, I change the tax differential to include all the subsidiaries in the multinational entities group, instead of the simple parent-subsidiary relationship. The reason is that an Indonesian company (even though it is a subsidiary, for instance) does not necessarily shift the profit to its parent. The profit can be shifted to another subsidiary within its MNE group that is a resident in low tax jurisdiction. The profit can also be "pooled" somewhere and remains unrepatriated to the parent's jurisdiction as in the case of many US companies.

Further, since the logarithmic operation can only be applied to positive numbers, then I must exclude some companies in some years because they booked 0 or loss (negative profit). This makes my panel data unbalanced and the observations are reduced. In the end only 695 companies remain with N = 3,113.

Because of the exclusion too firms may enter and leave the time series. For example, company A booked profit in 2012, 2013, 2015, and 2017 but had zero/negative profit in 2014 and 2016. Due to the log operation, company A is included in the sample for year 2012, 2013, 2015, and 2017, but it is excluded in 2014 and 2016. As a consequence, I cannot apply firm fixed effect and the model essentially turns into random-effect model. This is also confirmed by the results of Hausman and Lagrange Multiplier tests.

That being said, the model turns into:

where log(πi) denotes natural logarithm of pre-tax profits booked by company i in Indonesia; τavg is the unweighted average tax rate of the MNE group following Johansson et al. (2017); τc is the Indonesian corporate tax rate (25%); the rests are errors.

From a theoretical standpoint, choosing only companies that booked profits still has a benefit. You won't have to pay tax if you suffer loss or you have zero profit, so there is not much use to further avoid tax. Moreover, this allows the model to test whether agency theory is at play here: whether the manager tries to reduce tax without sacrificing much of the shareholder values by having zero profit or even booking loss.

The Result

Difference in tax rate negatively correlated with pre-tax profitability (p-value 0.033). If the tax rate of Indonesia is higher than the average tax rate of the MNE group, the pre-tax profit of Indonesian company belonging to said group becomes lower. For every percentage of tax rate difference, the pre-tax profit of the company drops by 4.37%. This means an Indonesian company whose other MNE group members are located in Singapore (tax rate 17%) and Vietnam (tax rate 20%) will have 18.93% less pre-tax profit than a non-MNE Indonesian company.

Extending the result to include all the companies in the sample, this is how much pre-tax profit is loss on average:

Conclusion

Again, we see evidence of tax avoidance in the samples included in this study. Of course this is not a comprehensive view of tax avoidance behavior. Loss-making companies and those who have zero profit are not covered here, although it is very likely that they engage in tax avoidance behaviors (via transfer pricing or excessive interest expense, for instance).

There are also other, more comprehensive methods to detect profit shifting explored in Tørsløv, Wier, and Zucman (2018). I suggest you read their paper if you want to know about the missing profit of nations. Indonesia, sadly, is not covered there.

References

Johansson, A, Ø. B. Skeie, S. Sorbe, and C. Menon (2017), “Tax Planning by Multinational Firms: Firm-Level Evidence from a Cross-Country Database”, OECD Economics Department working paper 1355.

Tørsløv, T, L. Wier, and G. Zucman (2018), “The Missing Profits of Nations”, NBER Working Paper 24701.

How Much Is the Ｌｏｓｓfrom Tax Avoidance?

This is a short post based on the research by Cobham and Janský (2018) which continues from Crevelli, De Mooij, and Keen (2015).

Here's the context: many countries in the world suffer from loss of tax revenues due to tax avoidance and/or tax evasion. One of the most common methods used by multinational corporations is to set up a subsidiary in the so-called tax havens non-cooperative or low-tax jurisdictions to divert their profits.

Having a subsidiary in non-cooperative/low-tax jurisdictions is not necessarily indicative of tax avoidance. Businesses may have legitimate reason such as access to market, diversification, or centralization of one of their business functions. Nevertheless, the concern of tax revenue loss cannot simply be ignored.

But how much is lost?

The study by Crevelli et al. (2015) tries to estimate how much a country loses their tax revenue from tax avoidance. Cobham and Janský (2018) tests and re-estimates this research. I'd like to try estimating the loss of Indonesia.

The Setup
A company avoid taxes in a country by diverting profit to its subsidiaries in other countries. The tax base of the aforementioned country is thus reduced and "spillover" to other countries.

But how does a company choose the jurisdiction of its subsidiaries?

In a micro-data, such as commercial database (that contains financial reports and jurisdiction of subsidiaries/headquarter), this is much easier and clearer to measure. In fact, many of the measures and monitoring tools for base erosion and profit shifting as outlined in OECD's BEPS Action Plan 11 utilize micro-data from commercial database.

Measuring in a macro (country-level) setting thus requires us to make assumptions. Since a company may create a subsidiary for access to market, we must assume that company does not pick a country purely for its low tax. A company may be hesitant to create a subsidiary in a small or faraway country. Or, given a choice of two countries with similar tax rate, a company will choose the country which is closer or has bigger market than the other one. Thus, we weight the effect of tax rate in every country of the world based on two things: distance and market size (that is represented by GDP).

The Model
We first estimate the φ and λ based on the equation:

, where bit denotes the corporate tax base in country i in time t; τit the domestic tax rate (in this case Indonesia); W-it τit a weighted average of the tax rates in countries other than Indonesia; Xit a vector of controls such as trade openness (import + export divided by GDP), share of agriculture to GDP, and log of GDP per capita in constant 2011 dollar; and μt is time specific effect. I employ LASSO (Least Absolute Shrinkage and Selection Operator) in the estimation to penalize model overfitting, as I don't have much data to begin with.

After we get φ and λ we plug them to equation:

for short term effect (L), and

for long term effect (LL), where Whτ-it denotes the average tax rates of tax haven countries as listed by Gravelle (2013).

The Results
The loss of Indonesia's tax revenue as % of GDP in year 2008-2017 is as follows:

Interestingly, this suggests that if companies actually consider GDP as the main factor to create subsidiary in a country, there is a tax base spillover to Indonesia. Meaning that Indonesia actually gains from tax avoidance.

After I examine the data, it turns out that Indonesia's tax rate is lower than the rest of the world if weighted by GDP. This is understandable as small GDP countries with zero tax rates such as British Virgin Island matters less in this scenario than, for instance, Germany (whose tax rate approximately 30% is higher than Indonesia and whose GDP is much bigger than Indonesia as well.)

On the other hand, if a company seeks to establish a subsidiary in low tax jurisdictions near Indonesia (i.e. assuming it also wants to exploit agglomeration effect or to shorten supply chains), then Indonesia loses tax base approximately 3-5% of GDP.

Translating the above result into Rupiah, this is how much Indonesia loses (gains) the tax revenue:

This is a very crude estimation due to severe data limitation. Maybe I will update this if I have the time to collect more and better data. Maybe.

References:

Crivelli E, De Mooij R, Keen M. 2016. Base erosion, profit shifting and developing countries. FinanzArchiv: Public Finance Analysis 72(3): 268–301. https://doi.org/10.1628/001522116X14646834385460

Cobham A, Janský P. 2018. Global Distribution of Revenue Loss from Corporate Tax Avoidance: Re-estimation and Country Results. Journal of International Development. UNU-WIDER.

Gravelle J G. 2013. Tax havens: international tax avoidance and evasion. Washington, DC. http://fas.org/sgp/crs/misc/R40623.pdf. Accessed 25 June 2018

OECD. 2015. Measuring and Monitoring BEPS, Action 11 - 2015 Final Report. Paris: Organisation for Economic Co-operation and Development.

Data is from World Development Indicator of World Bank; World Economics Outlook and International Finance Statistics of IMF; tax rate data is from KPMG Tax Rate Table, with some additional research for small jurisdictions; Badan Pusat Statistik; and APBN of Indonesia.

Inequality and Tax Evasion in Indonesia

Do rich people evade more taxes, compared to the less wealthy? This pose a problem for some scholars (and government). If the richest understated their income in their tax records – and disproportionately so compared to other taxpayers – the study of inequality which often based on tax records may be inaccurate. Inequality may actually be worse than what appears in Gini ratio.

In answering this question, Annette Alstadsæter, Niels Johannesen, and Gabriel Zucman (2017) conduct a detailed study by using data from Scandinavian countries. Scandinavians are arguably one of the places where the data quality is excellent. They are able to collect data from randomized audit results, provided by Scandinavian tax authorities (because the transparency policy there also grants easier access).

Despite the trove of quality data, they still theorize that audit can potentially fail to capture sophisticated tax evasion scheme done by the rich. So it is still possible that the resulting income in the tax assessment is understated. Thus, they combine the audit data with leaked data from offshore financial institutions (Swiss Leaks and Panama Papers). They also supplement it with information from recent tax amnesties (again, provided by Scandinavian tax authorities).

Based on Swiss Leaks, Panama Papers, and amnesties, Alstadsæter, et al. found that the top 0.01% richest households evade about 25% of the taxes they owe by concealing assets and investment income abroad. Adding the result from the tax evasion detected in random audits, the total evasion in the top 0.01% reaches 25-30%, versus 3% on average in the population.

The State of Inequality in Indonesia
In 2017, Indonesian Statistic Agency (Badan Pusat Statistik/BPS) reported that the Indonesia's Gini index is 39.1.  But you've probably heard/read the Oxfam-INFID paper in 2017. Combining the data from Credit Suisse Global Wealth Databook 2016 and the list of richest people in Forbes, the paper shows shows how the 4 richest Indonesians have more wealth ($25bn) than the combined wealth of 100 million Indonesians in the bottom 40% ($24bn). The same report also suggest that Indonesia is the 6th most unequal countries in the world, after Russia, Denmark, India, United States, and Thailand.

By using the similar data from Credit Suisse Global Wealth Databook (year 2017), I found out that the inequality in Indonesia is worse than official Gini index calculated by BPS.

74.8% of Indonesian wealth is owned by the top 10% richest. If we "zoom" it in further, 60% of wealth owned by the top 10% population is owned only by the top 1% richest. In other words, the top 1% richest owned almost half of total Indonesian wealth. 45.4% of total wealth to be precise.

If this distribution is correct, then the Gini ratio should be twice as worse at 83.7, instead of 39.1 as reported by Badan Pusat Statistik.*)

If we were to measure the average wealth of each population decile, the inequality is more pronounced.

The top 10% richest are, on average, 7.31 times more wealthy than the average Indonesian. Meanwhile the top 1% richest are, on average, 44 times more wealthy than average Indonesian. We can go further: top 20% are 287 times richer than the bottom 20%; top 10% and top 1% are 748 and 4,540 times richer than the bottom 10%, respectively. Look at how the average wealth of bottom 10% population did not even show up in the graph above. This is indeed staggering.

I compare the analysis by looking at the distribution of saving accounts in Indonesia. In this regard, saving accounts could be construed as a proxy of wealth (at least, financial wealth), similar to the HSBC data contained in the Swiss leaks used by Alstadsæter, et al. Indonesian Deposit Insurance Agency (Lembaga Penjamin Simpanan/LPS) keeps track of account ownership that are subsequently grouped based on the amount of money in those saving accounts. This is the source of the saving data.

In the LPS data, the state of inequality in Indonesia still looks astoundingly bleak. For instance, in 2017, 98.06% of saving accounts in Indonesia contain less than 100 million Rupiah in amount. But those 98.06% cumulatively only own 14.6% of total deposit in Indonesia.

In contrast, only 0.04% of saving accounts that have more than 5 billion Rupiah in it. But these 0.04% cumulatively own 46.17% of total savings.

To make it easier to imagine: if we scale down Indonesians into 10,000 people, then the richest 4 persons have 3 times more money in their bank accounts than the other 9,800 combined.

I then calculate the average amount in each saving group. Below is the result:

Note how similar this is to the distribution based on Credit Suisse data. The average amount in the lowest group barely show up in the graph at all, despite accounting for 98% of account ownership in Indonesia. The top group (account with > 5 billion Rupiah) on average contains 2,268 times more money than the average Indonesian saving account. This is an obscene picture of inequality.

Tax Evasion

Now we go back to the original question: do rich people evade more taxes? If I had a hand on the data as good as Alstadsæter, et al., combined with a more detailed distribution of wealth in Indonesia, I can get a more precise estimate.

In the case of Indonesian data, however, I face several roadblocks.

First, the distributional data in the World Inequality Database for Indonesia is inadequate. It does not have a detailed distribution for each percentile/decile. That being said, I have to make do with the Credit Suisse data. However, Credit Suisse does not report the range in each decile nor the standard deviations. I have to reconstruct the distribution points based on the assumption that the Indonesian wealth has uniform distribution, so it is efficient to compute its L-statistics to find out the range in each decile.

Second, because of the obvious confidentiality reason, I don't have the full amnesty data, only its statistics. Since the statistics are anonymized and aggregated (meaning I don't know who owns what and how much), I cannot cross them with the names in Swiss Leaks or Panama Papers. Similarly, I also do not have the data from tax audit to cross with the amnesty/leaked data.**)

Despite such limitations, I try my best to follow the method as outlined by Alstadsæter, et al. in their appendix. This is the finding of Alstadsæter, et al. in Scandinavian countries:

Using the available statistics and reconstructed distribution points, this is what I find in Indonesia:

In both cases, we can see that the probability of the rich to use tax amnesty is high, and the richer you are the more likely you use tax amnesty. Nonetheless, in Scandinavia, the probability for 90-95 percentile is quite close to 0%, while the probability for Indonesians in comparable wealth band (91-93 percentile) is twice that number. Admittedly, even the intragroup probability in the 90-100 percentile (top 10% richest) of Indonesia is in stark contrast compared to Scandinavia. You can see that in Indonesia it is skewed exponentially (i.e. increase very quickly) to the very richest compared to the much more steady, linear-like of Scandinavia.

If we consider tax amnesty as a sign of the previously undetected tax-related wrongdoings – be it evading, avoiding, or simply filing the tax return not in correct, complete, and clear manner – then the richest Indonesians disproportionately commit more wrongdoings compared to the general population. The top 1% richest of Indonesia is 16 more likely to use amnesty compared to average Indonesian (and 201 times more likely compared to the bottom 10%). This is after considering the fact that tax amnesty is basically open to all, and that there is no special treatment for the rich.

Unfortunately, this is the furthest I can do with the data. Given better access, it may be possible to gauge the post-amnesty compliance as outlined by Alstadsæter, et al., or by using macrodata similar to James Alm's study in post-amnesty Colorado. It is also interesting to combine audit data, leaked data, and amnesty data to paint a complete picture of tax evasion and inequality in Indonesia. But, alas.

In the end, it's likely that rich Indonesians have the means and opportunities to concoct tax-evading schemes. And being richer granted even more means and opportunities. "In the little game of tax demagogy," Piketty once wrote, "the weakest seldom come out winners."

Reference:

Alstadsæter, A, N Johannesen and G Zucman (2017), “Tax evasion and inequality”, NBER Working Paper 23772. Appendix available at http://gabriel-zucman.eu/leaks/

Alstadsæter, A, N Johannesen and G Zucman (2018), “Who owns the wealth in tax havens? Macro evidence and implications for global inequality”, Journal of Public Economics, forthcoming.

Piketty, T (2016), "Chronicles: On Our Troubled Times", Penguin

Oxfam - INFID. (2017), "Towards a More Equal Indonesia", Oxfam International

Data:
Lembaga Penjamin Simpanan - Distribusi Simpanan Bank Umum Desember 2017
Badan Pusat Statistik
World Inequality Database, available at WID.world
Direktorat Jenderal Pajak
Credit Suisse (2017) Global Wealth Databook 2017. Credit Suisse Research Institute

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*) Different methodologies could result in different Gini ratios for the same country. For instance, Badan Pusat Statistik use consumption data based on household surveys, while Credit Suisse combined household surveys with SUR and upward-adjustment based on available financial wealth data. Different bracketing could also affect Gini calculation. If you rank the population in decile (1-10) or percentile (1-100) or by 40-40-20 (poorest 40%-middle 40%-richest 20%), the resulting Gini ratios can be very different. If the wealth range in each distribution point is different, Gini can also be different; etc.

**) To my knowledge, Indonesia has yet to implement nationwide randomized audit program. The national audit program for individual taxpayers is focused on prominent people, corporate owners, and entrepreneurs. The good: rich Indonesians are given more scrutiny. The downside: there is not much information regarding the tax compliance of middle-to-low income class. Even if I have the audit data, it may not be representative to infer from these focused audit targets as samples of the general Indonesian population.

36 Years of Inequality or: How I Learn to Stop Worrying and Love the Progressive Income Tax

This post continues from the previous post. In the previous post, I wrote that one of the possible remedies for inequality is progressive taxation. Thomas Piketty advocates an extreme form of progressive income tax, up to 80% tax rate for the ultra-rich.

How could it be justified for Indonesia? Credit Suisse's Global Wealth Report 2017 shows that the top 1% richest Indonesians own 45.4% of national wealth, and top 10% richest own 74.8% of national wealth. If this does not seems obscene to you, take a look at the chart here:

The chart above shows Material Power Index (MPI), one of inequality measure developed by Winters (2013). By measuring the wealth of top 40 richest and divide it by per capita GDP, MPI approximates the relative economic imbalances between the ultra rich and the rest of us.

The MPI chart shows that the Indonesian ultra rich are about 500.000-600.000 times richer than average Indonesian. If we can scale the wealth down, theirs (on average) are worth a unit of apartment. The rest of us are (on average) worth a cup of instant coffee. Not even a cup of Starbucks.

Such obscenity probably warrants a more drastic measure, as what Piketty recommends. Although, income tax rate of 80% for the ultra rich is most likely not feasible politically.

The question, then, is whether a more progressive income tax may lead to a reduction in inequality if any, despite not being as high of a rate as what Piketty recommends.

Given that question, it is interesting to see how Indonesia fares.

On Personal Income Tax and Measurement of Its Progressivity

The first caution to be understood is that Indonesia does not have progressive corporate income tax since 2008. Added to that complication are certain rules such as turnover-based single-rate tax (final income tax according to Government Regulation no. 46 Year 2016) and the 50% discount for corporate taxpayer whose turnover does not exceed 50 billion rupiah (under Article 31E of Income Tax Law).

Secondly, the ultimate beneficiary of corporate profit is not the corporation itself, but the people associated with it: workers, managements, creditors, and shareholders – in the form of bonuses, interests, dividends, and/or capital gains. (Hence the economic double taxation that occurs when we tax dividends.) So, even though corporation could consume parts of its profit to expand, it could not be construed that corporation “enjoys” the profit in the traditional sense.

Additionally, in the event of liquidation, the excess value of the company will be distributed to those aforementioned people. Whereas, when a person dies, she can bequeath her excess value in the form of inheritance or estate. Both forms of distribution may indeed sustain or even increase inequality, but such effect can only manifest in personal level instead of corporate.

In light of those difficulties, it is more appropriate to measure the progressivity of personal income tax instead. There are several metrics to measure progressivity of an income tax regime. For example, the top statutory tax rate and the rate in each income bracket could be used roughly (at a glance) as indicators of how progressive the income tax is. US, whose top personal income tax rate of 39.6% applies for taxable income of more than $415,000, could be seen as less progressive than Australia, whose top personal income tax rate of 45% applies for taxable income of more than AUD 180,000.

A more refined measure is outlined by, inter alia, Benabou (2002) and Sabirianova Peter, et al. (2010), in which the latter will be used here. Sabirianova Peter, et al. (2010)'s methodology is as follows: first, we obtain per capita GDP of a country in that year. Next, we create a 100-level income distribution, ranging from 4-400% of the aforesaid per capita GDP. This results in 100 different gross income levels. Then, we employ the relevant tax schedule, i.e. apply the standard deduction for single taxpayer and appropriate tax rate. This will result in the tax liability for that particular income level. Finally, we regress the tax liability to the gross income to obtain the regression coefficient. Such coefficient, called ARP (average rate progression) is our progressivity measure of personal income tax.

If the ARP is zero/statistically insignificant, then the personal income tax is neutral. If the ARP positive and statistically significant, that means the personal income tax is progressive. Conversely, negative and statistically significant ARP means the personal income tax is regressive.

Here how the ARP of Indonesia looks like for the years 1981-2016:

The Effect on Inequality

If we graph Gini ratio and our income tax progressivity measure ARP, it would look like the chart below. I plot ARP on secondary axis because the difference in value range (ARP range from 0.01-0.03 while Gini range from 0.3-0.4) makes it visually difficult to see their fluctuations.

We can visually suspect that in the last 36 years (1981-2016) there seems to be a relationship between Gini and progressivity of income tax.

To gauge the effect of progressive personal income tax to inequality, I follow the methodology of Duncan and Sabirianova Peter (2012). I use Instrumental Variable (IV) estimation using ARP as the independent variable and Gini ratio as the dependent variable.

Here ARP is assumed to be endogenous, either due to simultaneity problem (see Slemrod and Bakija 2000) or by the existence of confounding variable. If we use OLS (Ordinary Least Squared), the estimates will be biased. So, I estimate ARP using several IVs, such as inflation, interest rate spread, exchange rate depreciation against USD, population, Freedom House index of civil liberties and political rights, and GDP per capita. Some variables are omitted (such as religion and corruption) because they are either irrelevant in non-cross country comparison or having insufficient data.

Based on the IV estimation of the data from 1981-2016, ARP (progressivity of personal income tax) is negatively correlated with Gini ratio (p-value: 0.013; 95% CI: -2.814528 to -0.33558101). To paraphrase: it is likely that the more progressive personal income tax, the lower income inequality will be. To make it easier to understand the result, I presented it in the graph form below:

Conclusions

We can see that as the value of progressivity get bigger (x-axis), Gini ratio is declining (y-axis), i.e. the more progressive personal income tax is, the lower the Gini ratio is. So, it may be the case that progressive personal income tax can reduce income inequality in Indonesia

How should Indonesian government proceed? I personally think that Indonesian government is somewhat ambivalent in this matter. You want to reduce inequality, which necessitates a transfer of wealth by means of taxation. But on the other hand, you do not want to upset the capital owners; the ones which – as the r > g theory suggests – exacerbate inequality.

80% tax rate for the ultra rich is good, if what Indonesian government aims is drastic reduction in inequality. The second best alternative is to gradually increase tax rate, to make it more progressive, and then hoping that inequality does not creep up faster than our tax reform.

References:

Benabou, Roland. 2002. "Tax and Education Policy in a Heterogeneous Agent Economy: What Levels of Redistribution Maximize Growth and Efficiency?" Econometrica 70, 481–517

Husain, Ishrat and Ishac Diwan [eds]. 1990. Dealing with the Debt Crisis. Washington, DC : The World Bank.

Sabirianova Peter, Klara, Steve Buttrick, and Denvil Duncan. 2010. “Global Reform of Personal Income Taxation, 1981-2005: Evidence from 189 Countries.” National Tax Journal, 63(3): 447–478.

Duncan, Denvil and Klara Sabirianova Peter. 2012. Unequal Inequalities: Do Progressive Taxes Reduce Income Inequality? IZA Discussion Papers, No. 6910

Sargan, J. D. 1958. The Estimation of Economic Relationships Using Instrumental Variables. Econometrica 26: 393-415.

Solt, Frederick. 2016. “The Standardized World Income Inequality Database.” Social Science Quarterly 97(5):1267-1281.

Slemrod, Joel B. and Jon Bakija. 2000. Does Growing Inequality Reduce Tax Progressivity? Should it? NBER Working Paper No. w7576. Available at SSRN: https://ssrn.com/abstract=220033

Winters, Jeffrey A. 2013. Oligarchy and Democracy in Indonesia. Indonesia (96), 11-33. doi:10.5728/indonesia.96.0099

Wooldridge, Jeffrey M. 1995. “Score Diagnostics for Linear Models Estimated by Two Stage Least Squares”, in Advances in Econometrics and Quantitative Economics: Essays in Honor of Professor C. R. Rao, ed. G. S. Maddala, P. C. B. Phillips, and T. N. Srinivasan, 66-87. Oxford: Blackwell.

Data Source:
MPI: author's calculation based on Winters (2013)
Gini ratio: Solt (2016), Badan Pusat Statistik
Progressivity (ARP): author's calculation based on Sabirianova Peter, et al. (2010)
Civil liberties and political rights: Freedom House
Interest rate spread (interest on loans minus interest on deposits): Husain and Diwan (1990), World Development Indicator
Inflation (end of period): IMF World Economic Outlook
Per capita GDP (t-1, logged): IMF World Economic Outlook
Population (total, logged): IMF World Economic Outlook
Exchange Rate (Currency annual depreciation rate with respect to USD, end of period): IMF International Finance Statistics

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Appendix

ARP is correctly identified as endogenous using Woolridge (1995) robust regression-based test (p = 0.0040). However there may be misspecification in the equation, based on the result of Sargan (1958) test of overidentifying restriction (p = 0.0224).

Further, I wish to re-calculate the confidence intervals assuming weak instrumental variable. The results, using conditional likelihood ratio (CLR), Anderson-Rubin, Wald, and Lagrange’s K and J tests, are as follow:

r > g and Inequality in Indonesia

In his controversial book, “Capital in the Twenty-First Century”, Thomas Piketty outlines the apparent cause of inequality in the world. He espouses the notion of “r > g”, i.e. as long as the rate of return from capital (r) is bigger than the GDP growth (g), most of economic growth is accumulated by capital owners. This, Piketty says, worsens the inequality.

Even though Piketty vehemently denies that he is a Marxist, the concept of capital accumulation is indeed best elaborated by Karl Marx. In Marxist lens, it could be argued that “r > g” would naturally follow as long as capital owners appropriate surplus value and further accumulate wealth by valorisation of fictitious capitals. (Whether this condition can be dismantled by introducing wealth tax/extreme progressive taxation for the rich or by seizing the means of production, is where Piketty and Marx depart from each other.)

I'm not gonna explore further about Piketty vis-à-vis Marx. I am more interested in knowing whether Piketty’s “r > g” actually hold, especially in Indonesian context.

In a 2017 paper titled “The Rate of Return on Everything, 1870-2015”, Òscar Jordà and co. provided interesting tool to empirically probe this theory. In this short blog post, I try to apply their method with some modification. I modify some of Jordà, et al. specifications due to the unavailability of the data here in Indonesia. However, I would try to be as faithful as possible to their methodology.

Variable Construction

Jordà, et al. define r as the weighted average real returns (inflation-adjusted) of risky investments (housing and equities) and safe investments (government bonds and bills). The general equation is r = r_housing x w_housing + r_equities x w_equities + r_bonds x w_bonds. This method has its limits, however. Income from dividends, interests from private debts, or alienation of immovable property cannot be captured here.

For the rate of return on housing, Jordà, et al. uses price-to-rent ratio. I use Residential Properties Price Index (RPPI) instead. RPPI a composite index of housing price from 16 cities in Indonesia. As a caveat, RPPI also cannot capture rent income as other source of returns for house owners, as well as depreciation and maintenance costs that may reduce the returns of housing investment.

For the housing weight, the paper uses stock of housing wealth scaled to GDP. The absence of such data in Indonesia compels me to use real estate contributions towards GDP in lieu of housing stocks. This choice is actually problematic as it severely discounted weight because big portions of Indonesian housing wealth aren’t captured, although inequality in housing (or generally, land) is evident here. For instance, Indonesian land Gini coefficient shows increasing trend as shown by graph below. (A land Gini of 0 means everyone have the same amount of land; a Gini of 1 means every land in Indonesian is owned by 1 person).

As an important note, the paper by Jordà finds that housing comprises significant portion of investments in many countries.

For the rate of return on equities, I use the growth of IHSG (Jakarta Composite Index) as it is representative of stock market returns. The limit for this, of course is in its inability to capture private/unlisted stock values. Similar to Jordà, et al., I use market capitalization scaled to GDP as weighting.

For the rate of return on safe investments, I use the 10-Year Indonesian government bond yield. Again, following Jordà, et al., I use public debt to GDP ratio as weighting.

There are still other types of financial instruments that should actually be included for any discussion about inequality. For instance, a report by OJK (Financial Service Authority) in Q2 2017 shows that 48 conglomeration group own 66.96% of total financial assets in the financial service system (SJK). Further, according to the report by LPS (Deposit Guarantee Body) on October 2017, 56.87% of total deposit in banks are owned by only 0.11% of bank account. 98.07% of bank accounts own just 14.03% total deposits.

Regardless of the limitation, I shall proceed with Jordà's paper. All the above-mentioned variables are entered into the general equation specified before, resulting in the variable r. For g, I use real GDP growth. The inequality measure I use is Gini ratio. If r - g is positive, i.e. r > g, we would observe an increase in Gini ratio and hence an increase in inequalities. In other words, we want to know if changes in Gini ratio trail the value of the excess of r over g.

Results and Discussions

Unlike Jordà and co. which manage to collect data spanning hundreds of years, I only have 10 data points for Indonesia. There is not much degree of freedom here, so it may not be appropriate to use inferential statistics. (It would lead to bias). Nevertheless, by visual inspection it seems that whenever r minus g is positive, change in Gini ratio is also positive. In other words, when r > g, Gini ratio for that year is also increasing from the previous year. And vice versa.

I further add a trendline of those two variables (r minus g and changes in Gini ratio) and find out that they show similar trends. Thus, Piketty’s theory of r > g as the cause of economic inequality may be true here in Indonesia.
 
For additional comparison, here is how the net worth growth of 40 richest Indonesian (based on Forbes), compared with growth of per capita GDP of Indonesian people.

If we calculate r-g based on the difference between growth in 40 richest Indonesians' net worth and GDP growth, then compare it to changes in Gini, it would look like this:

So, what could be done in the light of such fact? The ultimate solution is like what Marx said: if means of production or the capitals are owned by all, then the returns from those capitals are appropriated by all. However, in a nation still haunted by the invoked spectre of the dead PKI party, proletariat revolution is politically hard to implement. It may as well be impossible.

A practical application of such non-capitalistic underlying principle actually exists: a co-operative. To be quite simplistic, there are no shareholders to appropriate the surplus value in a co-operative. Co-operative thus poses no agency problem. It also reduces the incentive to take aggressive/speculative profit-taking behaviors. So basically, if you manage to scale up this type of economy into the size of a nation, r will pretty much the same with g. (Some Marxists will see co-operative as insufficiently revolutionary, though. But still.)

What are the other options? Generally, as long as r < g, society would be getting more equal. So, financial crisis and war could theoretically be the great leveler. But we all do not want that. Thus, reducing the excess of r over g via super-progressive income tax combined with wealth tax, is one of the option to lessen the inequality. But this one is also politically hard to implement – in Indonesia or anywhere else.

References

Durand, Cédric. 2017. Fictitious Capital: How Finance Is Appropriating Our Future. Verso Book

Jordà, Òscar, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2017. “The Rate of Return on Everything, 1870–2015” Federal Reserve Bank of San Francisco Working Paper 2017-25. https://doi.org/10.24148/wp2017-25.

Piketty, Thomas. 2014. Capital in the Twenty-First Century. Harvard University Press

Scheidel, Walter. 2017. The Great Leveler: Violence and the History of Inequality from the Stone Age to the Twenty-First Century. Princeton University Press

The data for RPPI is from Global Property Guide. IHSG and market cap data are from IDX. Indonesian government 10-Y bond yield is from Bank of Indonesia. Debt-to-GDP and real GDP growth data are from IMF. Real estate as portion to GDP, inflation, land Gini ratio, and GDP current price data are from BPS. I also use the reports from LPS and OJK.