“Getting to Denmark" from Indonesia: Starting from State Institutions or Tax Capacity?

Abstract

Introduction/Main Objectives: This paper is aimed at answering the following research questions: Where should Indonesia’s journey toward a prosperous society start from? Should state institutions be improved first to increase the tax collection necessary to finance this journey? Or should the tax capacity be improved first to help improve the institutions? Background Problems: Maintaining good quality state institutions requires fiscal support and, vice versa, maintaining fiscal support through tax revenue requires the existence of good quality state institutions. This paper empirically examines which of these two aspects needs to be improved first to achieve a better society for Indonesians. Novelty: To the best of the author’s knowledge this paper may be the first that tries to empirically explore the causal relationships between the quality of Indonesia’s state institutions and its tax capacity. Research Methods: Answers to the research questions were approached by employing a vector error-correction model of governance indicators and tax revenue data for Indonesia, covering the period from 2002 to 2017. Finding / Results: It has been found that, for Indonesia, the quality of the state institutions and the tax capacity did not have a causal relationship in any direction. Conclusion: Indonesia seems to be caught in a dilemma: On one side, choosing the strategy of improving the quality of the institutions first may not be sustainable because it is unlikely to lead to improvements in the tax capacity, thus the prospects for sustaining good-quality institutions may be uncertain due to the possible lack of fiscal support. On the other hand, improving the tax capacity first does not seem to be a reliable strategy either because it may not result in better quality state institutions, hence revenue mobilization efforts might not be effective due to the incomplete support provided by the poor-quality institutions