Innovation activity depends on the allocation between productive
activity and unproductive activity in entrepreneur (Baumol, 1990). This allocation
is determined by what payoff available in society. One of the pay-offs determined by the income after tax
derived from the innovative activity that
received by the entrepreneur. Thus, the lousy
tax policy that creates punitive taxation
will undermine innovative activity (Mitchell, 2018).
Nowadays Indonesian
entrepreneur prefers to invest in another type of investment than invest in
intellectual property. It is because being an investor in for example loan and
stock derived higher after-tax payoff. It resulted from different treatment of withholding tax, because income derived from innovative activity is taxed at a higher rate. Thus,
the marginal tax rate differences create
disincentives for innovation (Aghion et al.,
2016).
Moreover, the provision in tax audit offers unbalance treatment for innovative activity, create higher
uncertainty of audit result for the taxpayer
(Caballé and Panadés, 2005). The reason is
that the high withholding tax tariff will trigger overpayment position at the end of the fiscal year and leads to taxpayer’s restitution that is subject to
tax audit. In contrast, income from stock investment is taxed at a flat and final
rate, there will be no overpayment or audit consequences, and for income from a
loan, investment has loopholes of not
being taxed and audited.
As a result, from 2017 until 2018, there were two issues happened in Indonesia. First,
is the protest from creativity worker over the high rate taxation on royalty
income, they are questioning about the
disincentives for people to innovate. Second, the
fast-growing number of the loan shark investors and the bad-debt that they created, one of the
reason is that the poor regulation on the financial
market outside the banking system. This event even made Indonesia Financial
Service Authority (Otoritas Jasa Keuangan, OJK) to create regulation
specifically to curb loan shark and the effects it created.
The question is why this phenomenon happens? Why Indonesian less
invest in innovative activity? This paper tries
to explain from the perspective of a tax
institution’s role in determining the rule of the game of individual taxpayer
and shaping their innovative behaviour through
the mechanism of tax incentives. This paper argues that strict taxation
on innovation that includes high
withholding tax rate and audit treatment reduces
the level of innovation. This paper excludes the tax treatment on active income since it does not subject to
differential withholding tax.
This paper consists of
several parts. Part 1 deals with the introduction
of the problem and current condition in
Indonesia. Part 2 provides evidence of innovation compare Indonesia’s tax
regime on innovation with ASEAN countries. Part 3 explains about strict
taxation and differential tax rate in Indonesia’s domestic tax regulation. Part
4 explains the theoretical model of
allocation of innovative activity. Part 5 deals with an analytical framework to understand institutional change. Last but
not least, part 6 explains the conclusion and suggestion.
2. Evidence from ASEAN Countries
2.1. Innovation Data
Between ASEAN Countries,
Indonesia is considered left behind from
other countries regarding intellectual
property (“IP”) according to the data from the World
Intellectual Property Organization (WIPO). The data shows that patent
registration in Indonesia in 2016 is 1,154 patents, while Singapore has 6,722,
Thailand has 1,601 and Malaysia 1,963. Indonesia position is only better than
the Philippine and Vietnam which recorded
557 and 633 respectively.
Figure 1 Patent Registration across ASEAN
Source:
Collected from the World Intellectual
Property Organization (http://www.wipo.int/ipstats)2.2. Royalty Income Withholding Tax
The right to derive
income from the asset (Alston and Mueller, 2008) are one factor
that determines the full set of property rights. The payoff from innovation is royalty. Several factors influence the payoff, first is
the royalty rate that determined by the market mechanism and the value of
intellectual property. Second is the withholding tax rate imposed in royalty
income. This paper will focus on the second factor which is the withholding tax
rate.
As a comparison, the
table below shows the difference in
withholding tax rate ASEAN countries. Singapore and Malaysia, the 2 (two) most
innovative countries in ASEAN implement withholding tax rate on royalty 0%,
while Thailand implements 3%. In contrast, Indonesia and Philippine have the highest royalty rate between that country which 15%. A particular case for
Vietnam, which has 10% royalty rates, lower than Indonesia and Philippines, but
the patent registered has lower in number.
 |
| Royalty Tax Across ASEAN (www.taxedu.web.id) |
Source:
PWC Accounting Firm (www.taxsummaries.pwc.com)
Considering the data from
the table above, Singapore, Malaysia, and
Thailand as the most productive countries in ASEAN in term of patent produced
have one thing in common. They have low withholding tax rate on royalty income.
The lower the tariff is, the higher the
payoff received by the innovator.
3. Indonesia’s Strict Taxation: Withholding Tax and Audit Treatment
Since the first modernisation on Indonesia’s income tax
regulation that took place in 1983 (Income Tax Act Number 7 of 1983), there
were four amendments. The first amendment took place in 1991 by the enactment of Income Tax Act Number 7 of 1991.
The Second amendment took place under Income Tax Regulation Number 10 1994. The
Third amendment took place under Income Tax Regulation Number 17 2010. The last Amendment was under Income Tax
Regulation Number 36 of 1994.
In every amendment, each
amendment has a specific aim which the
goal is to inlining tax regulation with
the economic and business condition. For example, the last amendment was to
provide an equal level playing field in
the banking industry. However, regarding
taxation on royalty income, there was no
change of the tax provision ever since the first Income Tax Act enacted.
Under the withholding tax regime, passive income which
consists of Dividend, Interest, and Royalty has a different rate and audit treatment. From entrepreneur perspective,
the differential rate and audit treatment create a condition where one activity is more favourable than the others.
Consider an entrepreneur,
who has IDR 200,000,000 to invest. He has three choices to generate more money.
First is to invest in stock market and receive dividend income, second is to
give a loan to other people and receive
interest income, and third to invest in intellectual property by conducting
research and come out with some innovation, register the IP and received the
royalty income. From the tax perspective, those choices will result in
different outcomes as follows:
Table 2 Differential Tax Treatment
 |
| Indonesian Differential Tax Treatment (www.taxedu.web.id) |
Source:
Author
From the table above, we
can conclude that the royalty income is subject to two different tax treatments
compared to the other passive income. First at the level of the transaction
when the payment received, royalty income is subject to 15% withholding tax rate, resulted
in higher effective tax rate compared to the others. In contrast,
Dividend income only taxed at 10%, and interest income has the opportunity to avoid withholding tax by
structuring the loan contracts.
Second, related to audit
treatment. The audit triggered at the end
of the fiscal year when the taxpayer has
to calculate personal income tax. The withholding tax rate on the royalty
income will trigger tax audit since personal income tax rate layer are lower
than withholding tax, resulted in overpayment position that subjects to tax audit. The uncertainty of the
probability of being audited reduce expected payoff of the taxpayer (Snow and Warren, 2007). While, interest income and dividend income do
create overpayment position. Dividend income is considered low tax risk, since
the application of final and flat tax rate. However, the interest and royalty
income is subject to general taxation at the end of the fiscal
year. Existing regulation state that interest income is exempted from withholding tax if received from the individual
borrower, this explains why more people are becoming loan investor. But, the enforcement in the financial sector is
not strict and too many loopholes that lead to taxpayer rent-seeking behaviour.
4. Theoretical Model: How Tax Affect Innovation
To understand how royalty tax influences innovation activity, we
should examine how interaction between
royalty tax and other investment tax. Using an investment
allocation model used by Blonigen (Blonigen and Piger, 2014), we consider an investor who has two
option of investment.
Assume, investors have a total
amount of capital,
Capital
= K
They have two option;
either to invest in innovation or to invest in other investment. Assume R
represents the amount of capital invested
in innovation,
R
≤ K
The rate of return in
other investment equal to:
r
= r(K - R)
Moreover,
the rate of return in innovation equal to:
r*
= r(R)
With taxes rate as
consideration, the investor will equalize
income after tax. Hence, the amount of R is
determined and depended on (1
- t)r = (1 - t*)r*. t denotes the effective tax rates of other
investment and t*
denotes tax in innovation activity.
(1
- t)r = (1 - t*)r
Hence, the optimal
allocation of innovation, R, depends on the differential
tax rates imposed on the types of investment.
t
= t(K - R; x) and t* = t(R)
Hence the allocation of
innovative activity will be:
5. Analytical Framework
5.1. How Tax Regulation affects Innovation
Institution
is the rule of the game that devised by human
to shapes human interaction (North, 1994). Institution will create incentives in the form
of political, social and economic incentives. The significant role of institution for the society is to lower the
uncertainty and establish stability in human interaction, although the stability that institution does not
necessarily mean efficiency. Nevertheless, together with other factors
such as stock of knowledge and demographic, institution determine the economic
growth of the nations.
The critical role that institution takes place is
through the enactment of laws, regulations,
conventions, norms, contracts, and so forth.
Those instruments are continuously altering the choice available in the society
(Greif, 2006). By providing
incentives and constraints in the choices available, the society behaviour
will react to incentives and avoid disincentives. Through organization, an economic agent in society interacts with set or rules enacted by
the institution to respond to the
incentives, and in the long run, will
result in institutional change. One of regulation that shapes the incentives is
tax regulation which set the rule of the payoff of innovative activity.
In Indonesia, when
innovator invents or innovates something, they should register the
IP to Directorate General of Intellectual Property Rights (DGIP)
of Indonesia. After that, it depends on the inventor whether they want to
exploit it themselves commercially, or to
license it to other party and generate royalty income. Royalty income is
subject to tax are under Indonesia’s income taxation regulation. The taxation
treatment to royalty income is the determining
factor for taxpayer’s incentives to innovate. Since tax also reduce the profit,
as consequences for alterations from informal to formal form of property rights
(Alston and Mueller, 2008).
Figure 2 Institutional Framework
 |
| Institutional Framework (www.taxedu.web.id) |
Source:
Author
From the picture above,
the tax institution mainly focuses on two
aspects. First is the determination of
the withholding tax rate, second is about the tax audit consequences. Those two
instruments determine the incentives scheme in Indonesia’s tax environment.
On the
other
hand, a collective agent that consists of taxpayers establishes organization to
react to those set of rules and interact with those rules in the market. In the
long run, the tax rules determine the direction of institutional changes. This institutional change depends on the taxation act (high-level
regulation) and on how the taxpayer responds to the incentives of the rules (Kingston and Caballero, 2009). The willingness and capacity to conduct innovative activities
although the indeterminate forthcoming is mostly reliant on the setting that created
by the institutional framework (North, 1992). Therefore, Government through
public policy has a vital role in providing certainties and predictability by
establishing formal rules (for example tax rule) to enable the learning development
and to encourage creative capacity of the entrepreneur (Song and Simpson, 2018).
Mitchel observed that one
percentage point increase in individual tax, decrease the likelihood of
innovation (patenting) by 0.63 percentage point in the next three years (Mitchell, 2018). He also argues that one percentage point increase in
tax leads to a decrease in patent
registration by 1.1% and decrease the number
of citation (research paper) by 1.4%-1.7%. He also points out that tax should
be as low as possible to nurture innovation.
Clemens also finds that the amount of taxes will influence
the quality and the location of innovation (Clemens, 2008). He finds out that tax has intensive and extensive decision to influence the mobility of
inventor and their decision on location.
Given
the existing tax rules in Indonesia creating an unfavourable environment for
innovation, as a result, reducing incentives to innovate and influence taxpayer
to choose another kind of investment than intellectual property, affecting
long-term growth since incentives to acquire innovation (essential factor for
economic growth) was distorted by monetary rewards of tax system (North, 1994). Hence, the high tax rate hurts innovative output,
while tax decreases have a positive impact on innovation (Atanassov and Liu, 2014). Furthermore, taxes have
significant adverse effects on
the quantity and quality of innovation (Akcigit et al.,
2018).
5.2. Game Theoretical Framework in Analyzing Taxpayer Response
This paper develops a simple
theoretical framework to determine the direction
of institutional change in entrepreneur innovation as a response to strict taxation
on innovation. In addition to that, the framework is useful to explain the
loan-shark phenomenon and lower innovation in Indonesia.
Consider the game of
innovation and taxation. The game consists
of player 1 (individual entrepreneur taxpayer) and player 2 (tax institution as
government representative). The strategy of player 1 is either to invest in
innovation or not to invest in innovation (invest in other types of investment,
for example, loan). The strategy of
player 2 is to impose strict taxation (high tax rate and audit) on innovation
or to impose loose taxation (low tax rate and no audit) to boost innovation.
The payoff of player 2 is tax revenues as a result from player 1 action. The
payoff function is modified from Payoff
Matrix of Corruption-Investment Game (Dartanto, 2010) described in the
table below:
Table 3 Game Theoretical Framework
 |
| Game Theory for Innovation (www.taxedu.web.id) |
Source:
Author
From the taxpayer
perspective, Let R is royalty income, A
denotes audit risk resulted from overpayment. I is the income from other investment other than innovation. X denotes the incentives of not being
audited and taxed at a lower level, r denotes rent-seeking activity to exploit loopholes in financial and tax regulation,
where k denotes knowledge from
innovation. From the tax institution perspective, PIT denotes tax revenue from personal income tax rate, where WHT denotes tax revenue from withholding
tax rate. TA denotes tax revenues
from the audit process, IP denotes Intellectual property
resulted from innovative activity.
Assume that R = I, r < k, and IP > (TA +
PIT + WHT). The ideal condition is that when government impose loose
taxation in innovation and receive payoff on PIT + IP, and taxpayer receive full R and incentive X and
knowledge k. However, what happens now is that strict taxation in
innovation resulted in not invest in innovation in Nash equilibrium. Government
payoff is only personal income tax PIT,
and taxpayer payoff is income from other investment than innovation I (interest) and incentives of not being
audited X, and r rent-seeking of loan-shark
from exploiting loopholes in tax and financial regulation. This equilibrium
explained the phenomenon on what happened
in Indonesia right now.
Indeed strict taxation derives maximum payoff for tax revenue.
However, the government mistake is solely too much focus on tax revenue rather
than accumulation in intellectual property.
6. Conclusion and Suggestion
If the institution
rewards innovative activities, then
taxpayer engage more in innovation (North, 1994). However, tax
institution in Indonesia does not provide enough incentives for innovation.
Thus the set of rules that influence critical changes in the economy through the allocation of entrepreneurial resources (Baumol, 1990). In Indonesia,
the symptoms are apparent, lower
innovation, and high rent seeking through financial market become the direction
of institutional change.
Indonesia’s Tax
institution should change by providing balanced incentives to kick-start the
innovation. Since nowadays, the capacity and willingness to conduct innovation are
hampered by the institutional framework (North, 1992), primarily tax institution.
Economic growth should be
the focus rather than tax revenues, Indonesia should avoid an environment where designed by a destructive
ruler which objective is only to maximise
tax revenue, rather than economic growth (North, 1981). Since innovation
has a significant role as an engine of economic growth (Acemoglu, 2015), the environment
should encourage creative activity and
innovation in any field to direct economic
growth. Since the speed of economic growth depends on the speed of learning, however the direction
of the growth depends on the expected payoffs in acquiring different kinds of
knowledge (North, 1994). That is why incentives structures need to be modified.
Maybe some people say
that the tax regulation does not have to adjust to the economic change, but the
trigger of changes should come from the need of the society. Thus, considering
what happens in Indonesia now, it is crucial that tax regulation should change.
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