doing business in indonesia

Doing Business in Indonesia:legal and bureaucratic constraints

Ross H. McLeodIndonesia ProjectAustralian National [email protected]

The Doing Business reports rationale What gets measured, gets done.Low rankings provide clear signal to policymakers of where scope exists for improvement in the business environmentAnd they provide useful ammunition for outsiders pushing for better government performance

The Doing Business reports rationale In principle, this seems a worthwhile exercise, but The methodology is not free from defectsConstructive criticism should lead to more meaningful measurement over timeThis paper contributes to this effort

The Doing Business reports methodology Overall ease of doing business ranking is based on 10 broad topicsEach topic has 3-6 component indicatorsAfter evaluating all countries, each is given a percentile ranking for each component indicatorIts score for a given topic is the simple average of its percentile rankings for each component indicator for that topicIts overall ease of doing business index is the simple average of its 10 topic scores

Topic Component IndicatorsStarting a business Procedures, time, cost and minimum capital to open a new businessDealing with licenses Procedures, time and cost of business inspections and licensing (construction industry)Hiring and firing workers Difficulty of hiring index, rigidity of hours of index, difficulty of firing index, hiring cost and firing costRegistering property Procedures, time and cost to register commercial real estateGetting credit Strength of legal rights index, depth of credit information indexProtecting investors Indices on the extent of disclosure, extent of director liability and ease of shareholder suitsPaying taxes Number of taxes paid, hours per year spent preparing tax returns and total tax payable as share of gross profitTrading across borders Number of documents, number of signatures and time necessary to export and importEnforcing contracts Procedures, time and cost to enforce a debt contractClosing a business Time and cost to close down a business, and recovery rateback

Calculating Doing Business indexback1back2

Sheet1

TopicPercentile rank on componentAverage

123456rank

125144519

255767267

346868235394255

472351741

56380666869

6827956456

751831249

88826625773242

957582246

109928261

Index(converted to a ranking from 1-155)51

Sheet2

Sheet3

Problems with the Doing Business methodology (1)Distinguishing legal/regulatory inputs and business outcomes:Indicators such as the time taken to establish a standardised business are objective measures of red tape (albeit subject to measurement error)Indicators such as the existence or lack of a public credit registry or private credit bureau to assist lending institutions reflect the researchers presumption that such things should exist, in all countriesIndicators such as measures of investor protection reflect the researchers presumption that such protection is necessary, and that the best form for it to take, in all countries, is similar to that in the US

Credit registries and bureausWhy should the public sector be involved at all?Is the private sector likely to put its trust in public credit registries?Is the lack of private sector credit agencies an indication of market failure?Or has the private sector taken the view that such an activity would not be profitable?next

The legal rights indexWhat is the best way of dealing with insolvency?Is Chapter 11 no good?The US rates quite poorly on this measure: only 7 out of 10, and ranking behind 31 other countries, including Bangladesh, Nigeria, Zimbabwe, Kenya, Albaniaback

Problems with the Doing Business methodology (2)Arbitrary relative importance of topics and their componentsEach topic carries equal weightEach component indicator carries equal weight within its topicBut the number of components varies from 3 to 6 per topicSo the weightings of components vary by a factor of 2 (from 1/60 to 1/30), for no obvious reasonScore sheet

Problems with the Doing Business methodology (3)Some components are redundantFor example, if we know the total cost of a licence and the time taken to obtain it, the number of procedures is irrelevant

Sheet1

IndicatorIndonesia

Procedures (number)19

Time (days)224

Cost (% of income per capita)311

Sheet2

Sheet3

Problems with the Doing Business methodology (3)Some components are simply duplicatedIn the Hiring & Firing Workers topic, one component (Rigidity of Employment) is actually an average of three other componentsIn the Protecting Investors topic, one component (Investor Protection Index) is actually an average of all other componentsIn the Getting Credit topic, the Credit Information Index will be zero if public/private credit bureaus do not exist (involving double penalty for countries without these)

Problems with the Doing Business methodology (4)Coverage of data doesnt extend to extra-legal costs (bribes)Overall time taken (e.g.) getting a licence might be greatly reduced with a bribeNeed to focus on actual (typical) times and costs, not those if we play by the rules

Doing business in Indonesia: a closer lookIf we focus more on the things that really matter to business, how does the legal and regulatory environment compare with that in other countries?

Ease of Doing Business in Indonesia: Selected Sub-indices and Components

Sheet1

IndicatorRank

(among 155 countries)

Ease of doing business115

Matters relying heavily on the courts

Enforcing contracts145

Time570 days134

Cost (% of debt)127%151

Closing a business116

Time5.5 years133

Cost (% of estate)18%99

Recovery rate (% of amount owed)13%119

Matters involving the bureaucracy

Starting a business144

Time151 days149

Cost (% of income per capita)102%121

Hiring and firing workers120

Difficulty of Hiring Index (0-100)61122

Rigidity of Hours Index (0-100)4063

Difficulty of Firing Index (0-100)70131

Hiring cost (% of salary)10%53

Firing costs (weeks of wages)144.8 weeks150

IndicatorRank


Paying taxes118

Time560 hours119

Registering property107

Time42 days60

Cost (% of property value)11%126

Dealing with licenses107

Time224 days98


Trading across borders49

Time for export25 days62

Time for import30 days64

Sheet2

Sheet3


Sheet1

IndicatorRank





Time570 days134



Time5.5 years133



IndicatorRank





Time151 days149








IndicatorRank


Paying taxes118

Time560 hours119


Time42 days60



Time224 days98





Sheet2

Sheet3

Indonesia looks very poor on the important Doing Business indicators, yet it grew very rapidly for three decades under Soeharto. (These days it is not doing quite so well, although not too badly).

Well come back to this later

The debate on legal heritageThe flavour of the law and finance literatureCommon-law countries give both shareholders and creditors the strongest, and French-civil-law countries the weakest, protection. French civil law countries have both the weakest investor protections and the least developed capital markets, especially as compared to common law countries. The quality of law enforcement is lowest in French-civil-law countries.Taken together, [the empirical] evidence describes a link from the legal system to economic development.

The debate on legal heritageThis literature seems unpersuasiveConsider the relative economic growth performance of five countries representing the main families of legal heritageIn the last three decades of the 20th-century, the US was the standout performerBut France outperformed the UK (slightly)And both outperformed Germany and Sweden (with supposedly better legal systems than France)

The debate on legal heritageBreaking this into two equal sub-periodsThe US was still the standout performerBut France and the UK swapped their positionsAnd both still outperformed Germany and Sweden (which also swapped their positions)

Growth of Real GDP in Major Common Law and Civil Law Economiesback

Some developing country comparisons

Chart1

-35.49

94.49

132.99

216.89

257.7

370.59

524.55

600.85

685.37

E = English Common Law; F = French Civil LawData for Zimbabwe are for 1971-2002.

Figure 10 Real GDP Growth in Select Developing Countries 1971-2003 (%)

Sheet1

197120022003

Congo, Dem Rep (F)-3510061.0964.51

Zimbabwe (E)94100194.49

Nigeria (E)133100210.49232.99

Brazil (F)217100317.5316.89

Algeria (F)258100334.93357.7

India (E)371100433.29470.59

Indonesia (F)525100599.94624.55

Thailand (E)601100655.82700.85

Malaysia (E)685100745.75785.37

Sheet2

Sheet3

Is legal heritage important?Probably notRelative growth performance not clearly related to legal heritageLegal systems tending to converge over time?Developing countries pick and choose from legal and regulatory approaches elsewhereDoing Business findings biased by researchers views as to what is good lawWhat may work well in the US is not necessarily appropriate in countries at earlier stages of development

Is legal heritage important?In Indonesias case, the poor quality of the judiciary/legal system and the bureaucracy is much more a legacy of the Soeharto franchise than of the Dutch colonial system (and French civil law) of six decades ago

Soeharto built up a system that enabled him to exploit the coercive power of government in his own interest for more than three decades

He created and maintained a monopoly on political power, through a franchise system of government

Soehartos franchise systemFull title: multi-branch, multi-level franchiseBranches:Legislature (MPR/DPR/tame parties)Judiciary/legal bureaucracyMilitary/policeBureaucracy (including non-department agencies, esp. Bulog, Bank Indonesia)State-owned enterprises (SOEs)

The franchise analogyImportant characteristics:Contractual relationship between a franchisor and multiple franchiseesFranchisor designs the product and sets the overall operating parametersOther aspects of management delegated to franchisees

The franchise analogyIn this case, the product is the right to undertake private taxationImposed by public sector officials (franchisees)But for their own private benefit

The franchise analogyProduct designThe best tax systems rely on low rates imposed on a large tax baseHigh rates tend to kill off the economic activity being taxed (Laffer curve) and create strong incentive for oppositionSoeharto unusual among corrupt autocrats in understanding and applying this principle

The Soeharto Franchise back3back1back2

Main forms of private taxation(1) Rent generation and harvesting through insider beneficiariesElimination of competition for privileged firms (e.g. legal monopolies)Exploitation of natural resources by privileged firmsNon-arms length transactions between public and private sectorsHarvested rents shared with franchiseesAll these are equivalent to hidden forms of taxation of the general public: income redistribution in favour of the rich

Main forms of private taxation(2) Extortion of outsider firms and individualsBureaucratic extortionJudicial corruption (auction of favorable decisions)Military/police extortion by threat of violence or bogus chargesIllegally generated income often greatly exceeds formal remunerationAll this is equivalent to semi-hidden forms of taxation of the general publicbut can be blamed on individual shortcomings, rather than an inherent feature of the system of government

Bureaucratic extortion (private taxation)Bribes to obtain licenses to do businessBribes for the provision of services when there is already an entitlement to themIllegal levies on trucks and buses

back

Soeharto as franchise ownerElection system rigged so that he could not lose: the essential political monopolyPotential troublemakers in the army bought off with senior positions in bureaucracy, judiciary, SOEs, and by grant of privileged access to natural resources, especially timberHarsh action against actual troublemakersJail, violence, banishment to backwaters

Incentives for franchiseesOpportunities to become very wealthy if they served the interests of the franchise wellIncluding opportunities to engage in nepotismRight to support from (protection by) the franchiseThreat of exclusion, or worse, if they failed to do so, or worked against the franchiseIn short: strong sticks and carrots to work as part of a huge, mutually supporting group

Roles of the branchesEach branch of the franchise was nominally intended to serve the interests of the general public, and did so to some extentBut the interests of the franchise came first in cases where there was conflictThe main branch roles of relevance to the Doing Business reports involve the bureaucracy and judiciary:

Roles of the branchesJudiciary/legal bureaucracyDeflect legal challenges to the regime and the actions of franchiseesImpose legal sanctions on opponents of the regimeProtect the interests of privileged firms and individuals in the private sector

Roles of the branchesBureaucracyImplementation of economic policies conducive to rapid growthImplementation of policies to generate rents for privileged companies and individualsImplementation of policies intended to generate mass support for the regimee.g. Subsidy schemes for farmers, small businesse.g. Increasing access to education and health for the poor

Returning to the ConundrumIndonesia ranks very poorly according to the recent Doing Business reportsAnd it probably would have ranked just as poorly during the Soeharto eraYet during that era it maintained sustained high growth for decadesHow to reconcile poor legal and regulatory environment with excellent growth performance?

Returning to the ConundrumThe Doing Business reports overlook the important distinction between insider and outsider firms, which still exists (albeit less clearly)The low ranking of Indonesia on most indicators is relevant to outsider firmsBut insider firms escape extortion by the bureaucracy/judiciary/military/police, and benefit from dealings with SOEsAnd much of the economic action is with the insiders, which lead growth and structural transformation

In Indonesia, at least, legal heritage is of little importance relative to the Soeharto legacyIn any case, the legal heritage aspect has disappeared from Doing Business reports beyond the first one (in 2004)It is no longer even possible to download data on the classification of countries by their legal heritage

Doing Business in Indonesia:legal and bureaucratic constraints

Ross H. McLeodIndonesia Project, [email protected]

End productback

RecommendationsDrop two of the sub-indices altogether: Protecting Investors and Getting CreditAvoid double counting through inclusion of redundant measuresThink more carefully about the weights given to each component indicatorFocus on reality rather than what the rules say, including measures of public sector extortion of business


Sheet1

IndicatorRank





Time570 days134



Time5.5 years133



IndicatorRank





Time151 days149








IndicatorRank




Paying taxes118

Time560 hours119


Time42 days60



Time224 days98





Sheet2

Sheet3

Obligations of franchiseesPayment (in cash or kind) to join, and for continuing membershipRecruitment of lower-level franchiseesPromotion of high-performersTermination of poor performersDealing with threats to the franchise

The regime provided effective governmentThe system provided strong incentives to franchisees to ensure the success of the franchiseThe franchise prospered by lightly taxing a large, rapidly growing tax baseRapid economic growth was essential to ongoing success (cf. Nigeria, Zimbabwe)Close correspondence between interests of the franchise and interests of the publicGrowth is good!

Ross H. McLeod, Government-business relations in Soehartos Indonesia, in Peter Drysdale (ed.), Reform and recovery in East Asia: the role of the state and economic enterprise, Routledge, London and New York, 2000.

Ross H. McLeod, Government-business relations in Soehartos Indonesia, in Peter Drysdale (ed.), Reform and recovery in East Asia: the role of the state and economic enterprise, Routledge, London and New York, 2000.

Mechanisms for rent sharing:Free shares in the business;Cash payments;Donations to foundations;Payment of bills for transport, education, accommodation, etcMechanisms for rent sharing:Free shares in the business;Cash payments;Donations to foundations;Payment of bills for transport, education, accommodation, etcNon-government parties forced to merge; their leaders co-optedArmy and Golkar controlled elections down to village level

Case of the Bupati in Bantul (1996)Sacking of Billy JoedonoKilling of the journalist who exposed the Bupati

doing business in indonesia

Documents

business time

business procedures

business methodology

business ranking

business outcomes

business environmentand

standardised business

cost of business inspections