The Design of Income Tax System Responding to The Middle Class Growth, and Its Effects on Income Distribution

A large portion of the Indonesian population is entering the middle-class as its economy is growing rapidly. Nielsen, a leading media research said that currently, middle class in Indonesia is the third-largest in the world. There are about 74 million middle classes in Indonesia, and this number will double by 2020. In the other hand, economic growth also creates a problem of rising inequality. Inequality in Indonesia is worsened as the Gini index increasing from 0.308 in 1999 to 0,41 in 2011. Both conditions, rising middle class and increasing inequalities create a challenge for policy maker to design optimal Personal Income Tax (PIT) system that can capture the tax potential from middle class growth and at the meantime improving the inequality. In developing countries like Indonesia the tax system has been aimed at increasing government revenues as for the past 10 years, the personal income tax revenue has increased from 19,5 trillion rupiah in 2002 to 83,3 trillion rupiah in 2012. More than that, the income tax is also supposed to be used as a public policy instrument to alter after-tax income distribution. The purpose of this paper is to design a personal income tax system that can capture the increase in tax potential as the middle class growth and also promote better income distribution in Indonesia. Using microsimulaiton and Computable General Equilibrium (CGE) approach, we quantitatively analyze the way proposed PIT system affect government revenue and alter the inequality of the income distribution. First, we propose some PIT systems and quantify the way they affect after tax income by using the micro data. Next, we employ CGE model and execute the simulation to calculate the effect of proposed PIT systems on the Indonesian economy. We use Indofiscal (2011), a CGE model of the Indonesian economy with a focus on fiscal policy. The model has capability of evaluating a range of fiscal policy, including personal income taxes. The research seeks to design a personal income tax system that can capture the increase in tax potential as the middle class growth and also promote better income distribution in Indonesia. The result will help the policy makers to design a better income tax system in responding to the current situation of middle income growth and rising inequality.