Measuring the Effectiveness of Fiscal Policies on Alleviating Poverty Incidence in Indonesia

38 Pages·2009·0.39 MB·English

Measuring the Effectiveness of Fiscal Policies on Alleviating Poverty
Incidence in Indonesia: A CGE-Microsimulation Model Analysis♣♣♣♣

Teguh Dartanto♥♥♥♥,1,2
1PhD Student, Graduate School of International Development, Nagoya University
Furo-cho, Chikusa-ku, Nagoya City, Aichi, Japan, 464-8601
2Researcher, Institute for Economic and Social Research (LPEM FEUI), Department of Economics,
University of Indonesia
[email protected]

Abstract
The fiscal policy, as one of the instruments used by government to intervene in its economy,
can influence the poor through tax, income, and expenditure policies. This research is conducted to
quantitatively measure the effectiveness of the fiscal policies on alleviating poverty incidence in
Indonesia. In contrast to Damuri and Perdana (2003), Oktaviani et al. (2005), and Ikhsan et al. (2005),
this research utilizes Computable General Equilibrium (CGE)-Microsimulation approach (CGE-MS).
The CGE-MS is chosen due to the appropriateness, robustness, and reliability of output (Savard,
2005). The CGE model is built based on the 2003 of Indonesian SAM and the microsimulation utilizes
the 2005 of Susenas Data (National Socio Economic Survey). According to the simulation result, this
research found several results: first, the poverty in Indonesia is sensitive to the increase in foods price.
Second, the progressive transfer financed either by increasing VAT rate or by increasing income tax
rate is not effective to alleviate poverty since the progressive transfer and VAT have an inflationary
effect that worsens the welfare of the poor. Third, the targeted transfer financed either by increasing
corporate income tax rate or by increasing VAT rate of non government services sector is relatively
neutral to the poverty incidence. Fourth, the government expansion on education, health, and
infrastructures financed by increasing income tax rate significantly reduces the poverty incidence in
which the poverty incidence both in rural and urban area decreases roughly 0.75 percent and 0.95
percent respectively.
Keywords: CGE, Microsimulation, Fiscal Policy, Poverty, Poverty Alleviation
JEL Classification: C63, C68, D31, E62, I32, I38

♣ This paper is originally the master thesis which had been submitted to the
Graduate School of Economics, Hitotsubashi University, Japan in partial fulfillment
of the requirement for degree of Master Economics.
♥ Author would like to thank Prof. Motohiro Sato and Prof. Yamasige Shinji for
valuable advices and comments during finishing and defending this master thesis.
Author would also like to thank Mr. Usman (Institute for Economic and Social
Research, University of Indonesia) for statistical assistances and Prof. Shigeru T.
Otsubo (GSID, Nagoya University) for valuable comments.
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I. Introduction
The poverty continues to exist in most of the developing countries although the
government had tried to alleviate it. However, the government should never give up and be
continuously and consistently combating poverty through implementing appropriate macro and
micro policies. The fiscal policy, as one of the macroeconomic policies used by government to
intervene in economy, can influence the poor through tax, income, and expenditure policies.
Tax function is a progressive redistribution tool. Expenditure subsidies also enable public
goods to be consumed at prices below margin. Moreover, the subsidies in basic education and
health sector will be beneficial not only for individual but also to society at large because of
positive externalities The other expenditure such as infrastructures development can promote
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a higher economic growth that can create job opportunities to the poor.
For alleviating poverty, the Government of Indonesia has implemented several
policies including macro and micro policies. In macroeconomic policy - especially in fiscal
policy - there has been some improvement both in quality and quantity compared to previous
years. The Indonesian tax structure has changed significantly, especially after the economic
crisis. The role of indirect taxes, which were previously dominant, has decreased and has
been taken over by the role of direct taxes so the distortion in economy can be minimized. In
the budget allocation, the expenditure on health, education, social safety net, and product
subsidies (fertilizer, fuel, electricity, etc.) are still maintained at a minimum level as same as
the pre-crisis level. However, the huge amount of energy subsidies reduces fiscal space that
means the government has fewer sources to promote economic growth through investment in
infrastructure or human capital (Agustina et al., 2008). Even though the majority of these
subsidies are more often enjoyed by the 40th percentile of the richest income groups than by
poor groups, the government has had difficulties to reduce these subsidies due to political
pressures and social impacts (Dartanto, 2005).
From the success and failure experiences, the question that needs to be asked next is,
“Are revenue and expenditure policies actually effective and efficient in reducing poverty
incidence in Indonesia?” Unfortunately, a comprehensive research, analyzing the impact of
the fiscal policies on poverty alleviation in Indonesia, is relatively limited in both number and
variation of methodology. Previous researches, which are done by Damuri and Perdana
(2003) and Oktaviani et al. (2005) utilizing aggregated stylized RA models for poverty,
neglects that the poverty and inequality by definition are not phenomena that can be reduced
to representative agents, as income distribution is the basis for these indices and ignoring
distribution changes when analyzing policy reforms can lead to biased conclusions (Savard,
2003). Ikhsan, et al. (2005) pioneered applying CGE Microsimulation model for calculating the
impact of fiscal policy on poverty in Indonesia. However, this research still has a weakness in
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the microsimulation methodology. They took into account only the price change that directly
influences the poverty incidence in Indonesia.
Therefore, it is important to conduct a comprehensive research to measure the
effectiveness of fiscal policies on alleviating poverty incidence in Indonesia by utilizing the
most appropriate methodology. The methodology selected should be the one that will be the
most effective to collect and to process the data needed to answer research questions.
Regarding to the above conditions, this research is purposed: first, to quantitatively measure
the impact of tax reforms as well as Value Added Tax, Income Tax, and Tariff, and expenditure
policies such as cash transfer and government expansion on alleviating poverty incidence in
Indonesia; second, to develop an appropriate methodology which links Computable General
Equilibrium (CGE) and Microsimulation (household data). The linking model is chosen due to
the appropriateness, robustness, and reliability of output (Savard, 2005).

II. Theoretical Framework
II.1 Review on the Fiscal Policies
Fiscal policy refers to government attempts to influence the direction of the
economy, in an effort to achieve economic objectives of price stability, full employment,
income distribution, resource allocation, and economic growth, through changes in
government taxation system, or through changes in government spending. The government
spending is classified into three categories as follows: government consumption of goods and
services, government investment such as public infrastructures and research spending, and
government transfers. This spending can be financed by taxes, government borrowing, asset
sales, or seigniorage. How a government chooses to finance its activities can have effects on
the income distribution and on the market efficiency.
II.1.1 Taxes and Pareto Optimality of Taxation
Taxes
A tax is a financial charge imposed on an individual or a legal entity by a state.
Taxation has four main purposes: revenue, redistribution, re-pricing, and representation. As
the revenue, taxes raise money to finance government spending. Tax functioned as
redistribution tools means transferring wealth from the richer group of society to the poor
group. Taxes purposed as re-pricing tools levy to address externalities, for instance: imposing
a tax on tobacco may discourage smoking and imposing a carbon tax may encourage firms to
produce goods and services by utilizing the environment friendly technologies. The
representation means that because the government is the partly performing the act of
imposing taxes, society as a whole decide how the tax system should be organized (Ross,
2004).
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OECD (2004) published the most comprehensive analysis of worldwide tax systems.
It has been covering: capital gains tax, consumption tax, corporate tax, excises, income tax,
inheritance tax, poll tax, property tax, retirement tax, sales tax, tariffs, toll, transfer tax, value
added tax (VAT), wealth tax, and natural resources consumption tax. However, this report
will only describe several taxes that are related to the research topic as well as VAT, Income
Tax, and Tariffs. The VAT, class of an ad valorem tax where the tax base is the value of a
good, service, or property, applies the equivalent of a sales tax to every operation that creates
value added. The standard way to implement a VAT is to say a business owes some
percentage on the price of the product minus all taxes previously paid on the goods. An
income tax is a tax levied on the financial income of persons, corporations, or other legal
entities. The items, subjects being taxed, include personal earnings (wage), capital gains, and
business income. A tariff is a tax imposed on goods when they are moved across a political
boundary which is usually imposed on imported goods and may also be imposed on exported
goods. There are two mainly purposes of imposing tariffs, protection and revenue.
Pareto Optimality of Taxation
Leach (2004) in the book ‘’A course in Public Economics’’ concluded that a system of
taxes causes people to change their behavior. These changes can be separated into income
effects and substitution effects. The income effects occur because the government is taking
away some of their purchasing power, and the substitution effects arise because people try to
limit their exposure to the taxes. It is the later effects that give rise to the deadweight loss of
taxation.
If the government has possibility to levy a lump-sum tax, levying a fixed in amount
no matter what the change in circumstance of the taxed entity, the competitive allocation in the
presence of lump sum taxation is Pareto Optimal. However, it is impossible to impose the
lump sum tax because the society is not homogenous in income and endowment. Suppose
that the government has a positive revenue requirement but can not impose lump-sum taxes,
the government is able to levy a commodity tax where the Pareto Optimal can still be reached.
That is, there is no deadweight loss if the commodity tax rates are equal. Taxes imposed at
the same rate on all commodities are equivalent to a lump-sum tax.
Tax Incidence
Tax incidence is the analysis of the effect of a particular tax on the distribution of
economic welfare. The key concept is that the tax incidence or tax burden does not depend on
where the revenue is collected, but on the price elasticity of demand and price elasticity of
supply. If the elasticity of supply is inelastic and the elasticity of demand is elastic, more of the
tax will be paid by the producer because he can not easily adjust its production and be unable
to pass the tax onto the consumer. If the elasticity of demand is inelastic and the elasticity of
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supply is elastic, more of the tax will be paid by the customer because he demands the same
quantity no matter what the price and the producer is able to pass almost the entire value of
the tax onto the consumer.
II.2 Government Spending
Government collects revenue by levying taxes and tariffs, increasing debt, and
selling assets. The collected revenues are used to finance providing public goods such as
education, health, infrastructure, and government services. It also is used to repay debt and to
finance transfer payments, social security payments, and subsidies. The government has an
important role to stabilize and promote economic growth by implementing an appropriate
policy both in revenue side and in expenditure side.
Conditional cash transfer (CCT) as one of government expenditures is recently
being popular in developing countries due to the effectiveness reducing poverty incidence.
CCT is distributed to persons who satisfy certain criteria, aims either to reduce poverty or to
smooth consumptions of the poor. These criteria may include enrolling children into public
schools, getting regular check-ups at the doctor's office, receiving vaccinations, and providing
emergency assistances for the poor who hit an effect of government policy. Sometimes, the
cash transfer functions as safety nets.
CCT programs are increasingly perceived as an effective tool for poverty alleviation
and have been highly successful in Latin American countries. CCT does not need more costs
than for example energy subsidies that provide greater benefits to the non poor. For instance,
Indonesia spends 5 percent of their gross domestic product (GDP) on energy subsidies, while
Brazil’s Bolsa Familia (Brazil’s CCT), covering the poorest 20 percent of population, costs
about 0.4 percent of their GDP in 2007 (Son, 2008).

II.3 Fiscal Policy and Poverty
The fiscal policy either government expenditures or taxation policies will
directly/indirectly influence the poor, despite the fact that the poor is not potentially a taxable
object. The fiscal policies can influence poverty through several ways: first, an increasing
income tax can switch work-leisure preference which can influence households to adjust their
expenditure or life style. The households may cut down charity to the poor, lay off their maid,
and reduce consumptions. It means that the income tax indirectly impoverishes the low
income group. Second, production tax and value added tax (VAT) may result in the adjustment
in labor market and product’s. The producer may charge higher price and cut wage rate
responding to imposing of VAT or production tax. These adjustments directly affect
household’s income/expenditure in which the increase in price reduces purchasing power of
the poor. Third, increasing government revenue resulted from increasing tax revenue may
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increase the government expenditure on subsidies, cash transfer, and infrastructures
development that may be beneficial to the poor. Fourth, lower tariffs will be directly lower price
level. Therefore, it will be increasing the purchasing power of the poor to which they can afford
more goods and services, despite unchanged of income. Moreover, the lower in price level will
also be lower poverty line. Both of those changes may reduce poverty incidence massively.

II.4 General Equilibrium Theory
General Equilibrium Theory follows the Walrasian Tradition/Walras Theory that the
determination of equilibrium prices and quantities is in a system of perfectly competitive
market. The modern concept of General Equilibrium Theory is provided by Kenneth Arrow,
Gerard Debreu, and Lionel W. McKenzie in 1950s. The models describe the allocation of
resources in a market economy as the result of the interaction of supply and demand, leading
to equilibrium prices. The building blocks of these models are equations representing the
behavior of the relevant economic agents - consumers, producers, the government, etc. There
are three mainly component in a simple CGE model: consumers (households), producers
(firm), and markets where interacting among agents result the price equilibrium. Moreover, in
applied CGE, the model includes government and other accounts as well as
saving-investment and rest of world.
Figure 1 Payment Flows in SAM/CGE

Source: Lofgren, Harris, and Robilliard, 2002

II.5 CGE-Microsimulation Approach
In recent years, a number of papers have presented different approaches using
CGE models to analyze poverty and income distribution. Savard (2003) have classified
previous works in to three main categories and proposed one category. Therefore, the CGE
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model widely used to analyze poverty can be classified into four categories as follow:
1. CGE Model with Representative Household (CGE-RH), this approach is the traditional
method which has been widely applied in addressing an impact of policy on income
distribution. Poverty analysis is performed by using the variation of income of the RH
generated by CGE model with household survey data to perform ex ante poverty
comparison. Although, this approach is easier to use because it does not require specific
modeling effort, but it can not capture intra-group income distribution change.
2. Integrated Multi-Households CGE Analysis (CGE-IMH), this approach consists of
multiplying the number of representative household compared to the CGE-RH approach.
Since computing efficiency, it is quite simple to add as many households in CGE model
and it also easily to solve the large model. The main advantages of this approach,
compared to previous approach, are that they allow for intra-group income distributional
change as well as leaving the modeler free from pre-selecting housing grouping or
aggregation. The main disadvantages of this approach are the limit it imposes in terms of
microeconomic household behavior. As a matter of fact, the size of model can quickly
become a constraint, and data reconciliation can be relatively difficult.
3. CGE-Microsimulation Approach (CGE-MS), this approach uses a CGE model to generate
prices that links in to a micro-econometric household micro-simulation model. The main
advantage of this approach is that it provides richness in household behavior, while
remaining extremely flexible in term of specific behaviors which can be modeled. The
main drawbacks to the approach are the coherence between the macro and micro
models, which is not always guaranteed, and the fact that the feedback effects of
household behavior are not taken into account in the CGE/Macro model.
4. CGE-Household Microsimulation (CGE-HHS), this approach, pioneered by Savard (2003),
attempts to use the advantages of CGE-IMG and CGE-MS method. He proposed to
examine coherence between the household model and the CGE model, introducing a
bi-directional link and, therefore, obtaining a converging solution between the two models.
The basic idea of the approach is to use the CGE model to generate a price vector
(including wage rates) and a household micro-simulation (HHMS) model, to calculate the
household behaviors (consumption and labor supply). The value added of this approach
comes from the fact that feedback effects, provided by the household model, which are
back in the CGE to insure coherence between the two models. The CGE-HHS approach
provides richer information than the standard CGE-RH approach, more flexibility (larger
number of households and use of more flexible functional forms) than the CGE-IMH
approach, and more global coherence than the unidirectional CGE-MS approach.

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II.6 Microsimulation
Chen and Ravallion (2003) proposed the monetary value of the welfare impact of price
and wage changes. They take the predicted price and wage impacts from the CGE model as
given for the analysis of household-level welfare impacts. The money metric of the change in
utility (welfare change):
g ≡ dui =∑m psqs dpisj − pd(qd +z )dpidj +∑n w Ls dwk 
i vπi j=1 ij ij pisj ij ij ij pidj  k=1 k ik wk 
where
v
πi = the marginal utility of income for household i
psqs
ij ij = the revenue (selling value) from household production activities in
sector j
dps
ij = the change of supply price
ps
ij
( )
− pd qd +z
ij ij ij =the (negative) weight for demand price changes
w Ls
k ik = the weight for changes in the wage rate for activity k.
( )
psqs − pd qd + z
They refer to the term ij ij ij ij ij as “net revenue” which (to a first-order
approximation) gives the welfare impact of an equi-proportionate increase in the price of
commodity j.

II.7 Definition of Poverty and Poverty Line
Researchers in poverty field employ a wide definition of poverty. Basically, definitions
can fit into one of the following categories (Hagenaars and De Vos, 1988): (1) poverty is
having less than objectively defined, absolute minimum, (2) poverty is having less than others
in society, (3) poverty is feeling you do not have enough to get along.
The common starting point of many poverty calculations is a food intake requirement
of 2,100 calories per person per day (Ravallion, 1994). A food poverty line (FL) is the
expenditures necessary to achieve this caloric intake. Calories are just a proxy for an overall
nutritional adequacy, which requires protein and micronutrients as well as calories. While the
total amount of calories in food poverty basket is fixed ‘’absolutely’’, the basket and quality of
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those foods used to reach that level is ultimately a social convention (Pradhan et al., 2000).
BPS (The Central Statistic Bureau of Indonesia) used 2,100 calories/capita/day
resulted from 52 commodities for calculating food poverty line (FPL)1. The food poverty line
will be heterogeneous among region due to the different of foods price among region. To get
the poverty line, it must be added with non food expenditures such as health, education,
transportation, etc. However, choosing the allowance made for the non food expenditures is
ever more difficult because there is no equivalent of nutritional standard to provide even a
weak anchor to the amount. The monetary value of the food poverty line (FPL) and poverty
line (PL) in Indonesia are showed in Table 1.
Table 1 show that the poverty line changes responding to the change in economic
conditions and policies. When economic crisis hit, the poverty line in 1999 jumped more than
double compared to the line in 1996. The same pattern also happened in 2002 and 2006. In
this period, the government cut fuel subsidies in order to maintain budget sustainability.
Table 1 Poverty Line in Indonesia (IDR/capita/month)
Region 1996 1999 2002 2004 2005 2006
FPL PL FPL PL FPL PL FPL PL FPL PL FPL PL
Rural 23,844 31,366 59,822 74,272 73,030 96,512 * 108,725 84,014 117,259 103,180 131,256
Urban 30,454 42,032 70,959 92,409 93,351 130,499 * 143,455 103,992 150,799 126,527 175,324
Source: BPS Publication, *not available

III. Research Methodology
This research will apply the CGE-Micro Simulation Approach (CGE-MS). The general
idea of the CGE-MS approach is that a CGE model feeds market and factor price changes
into a microsimulation household model. The CGE-MS model of this research basically follows
the idea proposed by Ravallion and Chen (2003) in which its model is adjusted to be
compatible to the Indonesian data. The main advantage of this approach is that it provides
richness in household behavior, while remaining extremely flexible in term of specific
behaviors which can be modeled. However, the main drawback of this approach is that the
micro-feedback effects are not necessarily taken into account. The CGE-MS approach, the
income and expenditure of household do not need to be balanced (Boccafunso and Savard,
2006).
There are five steps in calculating the impact of fiscal policies on poverty alleviation:
First, calculate the initial condition of poverty utilizing the 2005 Susenas data (National Socio
Economic Survey). This data was published by the Central Statistic Bureau of Indonesia
(BPS). Second, using the CGE model, simulate the impact of fiscal policies change, for

1 Pradan et al.(2000) shows the list of commodities in their Appendix.
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example: increasing/reducing tax rate, increasing direct transfer, and cutting subsidies, on the
change of price (including factors income).
Third, data on increases in prices (including factors income) obtained from the CGE
model is entered into the Susenas data set to calculate the impact of fiscal policy on
household’s welfare. This step is known as the microsimulation procedure. Fourth, adjust the
poverty line using the price changes obtained from CGE in which the poverty line becomes
endogenous. The increasing commodity price will increase the money metric of obtaining
2,100 calories, hence the poverty line will change following a variation in relative prices
(Decaluwe, Savard, and Thorbecke, 2005). Fifth, recalculate the poverty incidence using the
data obtained from the step three and four and then comparing with the initial poverty
incidence. If the simulated poverty incidence is lower than the initial poverty, the fiscal policy is
effective to alleviate poverty.

III.1 A Standard Computable General Equilibrium Model (CGE Model)
Computable General Equilibrium (CGE) models are a class of economic model that
uses actual economic data to estimate how an economy might react to changes in policy,
technology or other external factors. According to Hoseo, Gasawa, and Hashimoto (2004) and
also Hosoe (2004), the CGE analyses usually take the four following steps: first, construction
of data base; second, model estimation (calibration) by utilizing information from SAM
database; third, solving the model for the reference run; fourth, solving the model with counter
factual scenarios to identify changes from the base run and comparing these two equilibriums
to know the policy impact quantitatively as well as qualitatively.
Basically, A Standard CGE Model requires data set and set of simultaneous equation.
The data set is used to define model parameter values in a manner that assures that the base
solution to the model exactly reproduces the value in SAM. The model is ‘’calibrated’’ to the
SAM. One of the merits of the CGE models is that necessary data for model estimation are
input-output/social accounting matrix tables for only a single year. The other data used in the
CGE model are elasticities data including household expenditure elasticity, trade/Armington
elasticity, elasticity substitution between factor production, and elasticity between intermediate
input and factor production. The elasticity data used in this CGE refers to the elasticity in
Wayang Model, CGE model for Indonesia.
The CGE model is built based on the 2003 of Indonesian SAM following the
standard of IFRI CGE model which has been developed by Lofgren, Harris, and Robinson
(2001) 2,3,4. This CGE model is adjusted to be compatible with Indonesian data and be useful

2 This file is the core model file for the IFPRI/TMD Standard CGE Model, documented in: Lofgren, Hans,
Rebecca Lee Harris, and Sherman Robinson, with the assistance of Moataz El-Said and Marcelle Thomas.
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