Indonesia’s Economic Growth, Income and Wealth Inequality: Debates and Evidence

1. Introduction

One of the most discussed issue by policymakers in Indonesia is the debate on the “pie” of economic growth: should they focus on enlarging the pie, or focus on evenly dividing the pie? There are continuous suggested pros and cons of both side of the arguments, between choosing to focus on enlarging the pie or to put greater focus on equally dividing the pie. However, such debates could have been wasteful if the country does not have to trade-off between high growth and low inequality. This paper try to unveil the relationship between economic growth and income and wealth inequality in Indonesia, the choice of redistribution policy, possible impact of inequality on the country’s development, possible regional disparities, re-evaluation of the inequality measurement method, and the policy implications occurred.

2. Literature Review

Previous Research on the Empirical Relationship

Most research on the relationship between economic growth and inequality have not been clear yet, due to the complex mechanism in which they interact (Castelló-Climent, 2010, Simangunsong and Kuang-hui, 2018). There arguments for both side of the coins; with the earlier findings being a negative relationship, that higher inequality will reduce growth (Persson and Tabellini, 1994, Deininger and Squire, 1996, Ravallion, 2001). Such relationship is channelled through credit-market imperfections, political economy, socio-political unrest and saving rates (Barro, 2000).  Nevertheless, more recent works have tried to challenge the view by suggesting that economic growth and inequality have positive relationship (Li and Zou, 1998, Forbes, 2000, de Dominicis et al., 2008), implying that government face a trade-off between growth and inequality.

The Role of Redistribution Policy

To explain the sharp contrast of the findings, it will be necessary to analyse the mechanism of the relation – that is through the income redistribution policy. Arestis and Troncoso (2017) emphasized the post-Kaleckian theory that a country can implement either pro-profit or pro-wage income redistribution policy, but the result on economic growth depend on the country’s economic regime; as the increase of wage share will increase consumption, but decrease investment. Hence, total impact on growth is determined by the magnitude of the two contradicting effects. In a small open economy, however, it is most likely that pro-wage redistribution might hurt the economic growth – because increased wage will increase import consumption due to low competitiveness of the local firms, therefore reducing growth (Blecker, 2015). Another explanation proposed is by the trickle-down effect. De Silva and Sumarto (2014) showed that the non-poor actually gain more benefit from the trickle-down effect compared to the poor.

Evidence of Kuznets Curve

Another explanation of the mixed findings might be due to the Kuznets inverted-U curve, that the relationship is positive during early stage of development and became negative as a country become more developed. While this might be true, Azzoni (2001) found evidence of the theory if the analysis of the country is divided into rich and poor regions within the country itself, but not at the national level, implying that the unit of analysis, is not necessarily limited to country level but could be based on regions. Kuznets curve is further criticized that it mainly depend on cross-country analysis (de Dominicis et al., 2008) to justify the theory; but if one is to look at individual country, growth-inequality nexus is more influenced by the country’s conditions and policies rather than complying to a single general rule of thumb, therefore it will be better to avoid aggregate analysis (Delnigner and Squire, 1998).

3. The Case of Indonesia

Choice of Redistribution Policy

Before discussing further on the relationship of growth and inequality in Indonesia, there are some other factors affecting the decision whether Indonesia choose to adopt redistribution policy or not.

Political Environment

Theoretically by the median voter theorem, within a society where the average income is higher than the median income will cause the voting majority to push government toward income redistribution policy (Barro, 2000). Looking through Figure 1, the increase in GDP per capita growth is almost always lower than the national growth, indicating that such population structure is presence in Indonesia.

Figure 2. Indonesia’s GDP growth and Inequality, 2011-2017

Source: Indonesia National Statistics Bureau (BPS)

Coupled with Indonesia’s democracy nature, with The Economist Intelligence Democracy Index of 6.97 in 2016 marked Indonesia as ‘flawed democracy’. Supported by the democratic system and 16 political parties, the median voter theorem might hold. Consequently, as suggested by Persson and Tabellini (1994), society who deem inequality as important tends to tax growth-promoting activities for the purpose of income redistribution. The existences of various income redistribution policy in Indonesia seem to be the result, one of them being the development of ‘Inclusive Economic Growth Index’ by the Ministry of Economic Development and Planning.

The Down Side of Inequality

There are various debates on the negative effect of high inequality. In Indonesia, inequality reduce the ability of economic growth to reduce poverty, making poverty alleviation programmes and policies less effective that what it could have been with less inequality (De Silva and Sumarto, 2014, Miranti et al., 2014). Furthermore, Simangunsong and Kuang-hui (2018) emphasized that even though higher inequality may increase economic growth, the issue of social justice will arise along with other conflicts.

Empirical Relationship in Indonesia

Among the limited number of studies analysing growth and inequality in Indonesia, the majority seemed to find positive relationship (Forbes, 2000, Zulfan Tadjoeddin, 2013, De Silva and Sumarto, 2014, Simangunsong and Kuang-hui, 2018). Although their findings vary on the significance of the relationship, this suggests that government face trade-off between high growth or low inequality. Deininger and Squire (1996), in contrast, found the association to be negative by using cross-country analysis. The differences in those research are mainly due to the method and data used. Nevertheless, more evidence of positive relationship was during the 1997 crisis where Indonesia’s growth hit its lowest, inequality is reduced as the rich received greater wealth reduction  through hyperinflated prices of agricultural products that emit benefit for rural areas.

To test the majority of findings, we roughly map out the relationship between Gini ratio and GDP per capita growth in 2016. The result hints that the nexus is positive.

Figure 1. GDP per capita growth and inequality across provinces in Indonesia, 2016

Source: Indonesia National Statistics Bureau (BPS)

Another attempt at explaining the relationship is by calculating correlation between growth and inequality at the province level for the recent years of 2011-2017. From Table 1 (see Appendix), it can be seen that there exists regional disparities of the nexus. At the national level, the correlation is positive 0.56. On the other hand, the correlation at the provincial level differs largely from -0.86 in Jawa Barat (West Java) to 0.87 in Bali. If the same redistribution policy is implemented in both region, the effect could be the inverse of the other; implying that government has to be extra cautious on determining redistribution policy for specific areas and not to draw false conclusions. In this case, our correlation method might be incorrect or the indicator used is not sufficient. Since previous research using different methods yield different results, it is necessary to use a robust method (Forbes, 2000)

Measuring Inequality

The officially used method for measuring national inequality in Indonesia is by Gini coefficient. However, the method of aggregation used in a very dispersed country with 16.056 islands such as Indonesia have been continuously questioned (De Silva and Sumarto, 2014, Miranti et al., 2014, Nugraha and Lewis, 2013, Zulfan Tadjoeddin, 2013). It should also be considered that most research on inequality in Indonesia use the Socioeconomic National Survey (SUSENAS), with the majority of survey respondents being the lower and middle income households and difficult to reach the rich (Miranti et al., 2014). Therefore, the index calculated is likely to be undervalue.

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Failures of using Gini ratio to represent actual inequality could be analysed to few decades ago. Indonesia’s pro-poor growth in the 70-90s had been appraised as the Asia’s economic miracle (Thorbecke, 1991, Prawiro, 1998) with remarkable economic growth, low inequality and low poverty. This was later challenged by (Zulfan Tadjoeddin, 2013) through alternative method of inequality measurement, finding that inequality during those period is actually higher than reported. He encouraged the use of disaggregated level of analysis to find evidences that are not presence at aggregate level. Similarly, Zulfan Tadjoeddin (2013) found evidences of Kuznets curve at the across-district level, which could not be found by analysing Gini ratio at the national level. Another example is shown by Nugraha and Lewis (2013) that the use of non-market income will yield lower level of inequality calculation.

Conclusion and Policy Implication

Given the democracy nature of Indonesia’s political system and the vast majority of people below the average income and the negative effect of inequality, redistribution policy could not be avoided. Therefore, government shall focus on creating redistribution-oriented taxation system that will not hinder economic growth. In order to do so, such policy has to be designed suitable based on the existing condition in Indonesia regarding the growth-inequality nexus. However, the relationship is not conclusive, with growing debates and mixed results. The very few research on Indonesia’s case, under the constraint of data and measurement limitation, mostly saw the relationship to be positive – with no strong evidence yet of Kuznets curve. For future policy design, it will be beneficial for the government to develop another robust method for measuring inequality apart from Gini coefficient.

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Appendix.

Table 1. Correlation of GDP per capita growth and Inequality across provinces in Indonesia, 2011 – 2017

Source: Indonesia National Statistics Bureau (BPS), calculated

Figure 3. GDP growth and Inequality across provinces in Indonesia, 2016

Source: Indonesia National Statistics Bureau (BPS)