The dynamic relationship between tax revenue and economic growth in Indonesia : an ARDL-ECM and Granger causality approach (1999-2023)

Abstract

This study aims to analyze the tax revenue and economic growth interaction in Indonesia for the period 1999-2023. Indonesia, as a developing country, has to face two challenges: one is to mobilize domestic resources so as to fund development, and the other is to ensure macroeconomic stability. Tax revenue is the main source of government revenue and is important to invest in infrastructure, education, health, and other public goods that provide long-term economic growth. The study examines the impact of tax revenue on economic growth, both in short run and long run, controlling fiscal balance, inflation, household final consumption expenditure, and imports. Data is analyzed using the Autoregressive Distributed Lag-Error Correction Model (ARDL-ECM) which is appropriate for the estimation of dynamic relationships among variables of mixed orders, I(0) and I(1). Moreover, Granger causality test is used to establish the causal direction of the tax revenue and economic growth relationship as well as to correct for the problem of endogeneity which may stem from the possible bidirectional relationship. The empirical results show that the F-statistic value of 46.22 is well above all the critical bound values, indicating the long-run cointegrating relationship among all the variables. The long-run coefficient of tax revenue on GDP growth is positive and statistically significant with a value of 0.7029, suggesting that a 1 percentage point increase in the tax-to-GDP ratio is related to about an additional 0.70 percentage point of economic growth in the long run. Fiscal balance also has a positive impact on growth with the coefficient of 0.8234, while high levels of household final consumption expenditure do not go hand in hand with long-run performance with a coefficient of -0.1870. The error correction term of -1.422 indicates a quick adjustment to the long-run equilibrium. The findings reveal no statistically significant short-run causal relationship between tax revenue and economic growth, both ways, supporting the view that the fiscal transmission mechanism is more related to long-run structural effects. Diagnostic and stability tests reveal the strength and stability of the estimated model. These facts highlight the need for the improvement of tax administration, expansion of the tax base and making public expenditures more effective to maximize the growth effects of taxation. The study adds to the literature on fiscal policy in developing economies and offers evidence-based suggestions on how to encourage sustainable and inclusive economic growth in Indonesia.