A computable general equilibrium (CGE) model with endogenous labor supply for the study of income taxation in Indonesia

The personal income tax in Indonesia has grown in revenue importance since major changes in 1984 broadened its base and lowered its bracket rates. Currently, the personal income tax and the corporate income tax are the second most important sources of government revenue in Indonesia. This thesis explores how the personal income tax might be used to replace the revenues from a number of alternative taxes including the value-added tax, the oil tax and import duties. Secondly, this thesis explores the welfare consequences of using the personal income tax to redistribute income from rich to poor households in Indonesia. It does this through a number of simulations.; This study develops a Computable General Equilibrium (CGE) model for Indonesia incorporating endogenous labor supply. Workers set consumption levels, saving, and leisure so as they maximize individual utility. The personal income tax, by reducing disposable income and the reward for working, generates a substitution effect opposed to work and an income effect favoring work. The model parameterizes these effects using estimates of the elasticity of substitution between consumption and leisure for Indonesian workers recently made available in the literature (Rochjadi and Leuthold, 1994). The endogeneity of the labor supply makes it possible to study the efficiency effect of alternative tax policies that potentially distort the labor supply decision. This study also extends previous CGE models for Indonesia by incorporating interest dependent household saving, a new specification of household (expanded) income, and an income tax exemption.; Two types of simulations are conducted in the present study: equal-yield tax and income redistribution simulations. Equal-yield tax simulations replace selected taxes with an increase in personal income taxes by assuming a balanced-budget condition. The result of measuring the welfare burden of income taxation using equal-yield simulations demonstrates that replacing import duties with an increase in the personal income tax results in a welfare gain to the society. This result becomes important for Indonesia as the country prepares for eliminating tariff barriers in the beginning of the twenty first century. This study also finds that replacing the VAT entirely by an increase in the personal income tax or replacing personal income tax entirely by an increase in the VAT are not the best policies for improving welfare. The welfare calculation shows that both strategies result in welfare losses if they were applied to Indonesia.; The present study also applies a new approach to measuring the welfare effects of income redistribution plans in Indonesia. Improving the welfare condition of the poor is conducted by increasing the marginal tax rates of the rich and distributing the additional revenues to the poor. If increasing the welfare of the poor by one rupiah costs the rich more than one rupiah, the policy is said to give an extra loss, which is called the Marginal Efficiency Cost of Redistribution (MECR).; The calculation of the marginal efficiency cost of redistribution (MECR) finds a negative MECR for most of the redistribution plans, indicating that improving the welfare conditions of the poor by one rupiah costs the rich less than one rupiah. The finding of a negative MECR points toward the need for further consideration of cash grant plans as policy options for improving income distribution in Indonesia.