Foreign direct investment location and tax incentive policy in Indonesia

Abstract

Foreign Direct Investment (FDI) has become a ‘mantra’ for developing countries, as not only is it a source of capital to boost economic development, but an important source of employment and technology. Many developing countries provide incentives to attract foreign investors, such as preferential taxes, but the evidence for these is mixed. Some find they are important, but others that they do not affect FDI location. Indonesia is of interest, since it is a large and rapidly developing Asian economy, which has pursued a policy of ‘openness’ towards FDI. This is supported by a programme of taxes and other incentives, but despite using these measures for more than fifty years their effect is uncertain, and they remain controversial. The purpose of this thesis is to analyse the characteristics of FDI location in Indonesia and to explore the role of tax and other incentives. Overall, the thesis makes three main contributions. First, it provides an up-to-date analysis of FDI location in Indonesia using an original dataset and covering the ‘New Order’ period from the mid-1990s. Second, it undertakes a large-scale questionnaire survey of foreign-owned plants in Indonesia to establish their nature and motive for location. Third, the thesis carries out face-to-face interviews with Indonesian policymakers at a high-level to explore the rationale for inward investment and tax incentive policies. Inward FDI to Indonesia has grown steadily over the last decade, and it is now about US$20 billion per annum. This represents about 2.1% of Indonesian GDP, while comparable domestic investment is about two-thirds smaller, indicating its importance. Making use of realization data provided by the Indonesian Investment Coordinating Board, the thesis shows that the vast majority of FDI in Indonesia is located on Java, the most populous region, and reflects market and labour resource-seeking. Regions outside Java are important more recently and are a target for FDI in mining and agriculture, especially from Europe and America. However, most FDI is from Asia, especially Singapore and Japan. The manufacturing share of FDI has increased over time, although the mean project size is smaller. The thesis finds a sharp division between the Special Areas, in which the incentives are applied intensively, as FDI seeks labour resources and exports, whereas outside these areas it supplies the domestic market. The survey shows that tax incentives are not the main factor for influencing investors’ decisions to locate in Indonesia. Thus, while investors include these incentives in their appraisal, they tend not to be the critical factor for investment in Indonesia. This seems to be well-perceived xvi by policymakers, so that political economy considerations are important for the continuance of these incentives. Other developing countries offer these incentives, so that the expectation of investors and policymakers is that these subsidies will also be available in Indonesia. Further, the tax incentives have largely evaded scrutiny, and the location of FDI has been attributed to other factors. Finally, by being seen to ‘do something’ to attract FDI in a fairly minimal way, the tax incentives are a means by which the government garners political support.