International Trade and Inequality

Abstract

As Indonesian government is planning to increase production and export of manufacturing products through tax break that improve human capital to escape from the middle-income trap, this thesis aims to investigate the effect of manufacturing export and tax break on manufacturing sectors to income inequality and trade balance. Using IRSAM in 2008 between Indonesia and the Rest of the World, we found that trade overall does not necessarily improve income distribution. This thesis also counters the report by Ministry of National Planning Development that suggest promoting manufacturing sector through tax break. Promoting manufacturing sectors through tax break can only produce positive result both on income distribution and trade balance under extremely restrictive conditions, which are that government has to implement selective financing scheme, and that the manufacturing firms has to translate the received-tax-break by increasing the productivity of unskilled labor only. Under a more-realistic assumption, in which firms respond the tax break policy by adjusting their investment level, we found that tax break on agriculture or food industry, financed by mining sector promotes both equality and efficiency issues at the same time. The use of foreign loan will worsen trade balance, generating inferior results compare to domestic financing, or running constant government budget. Secondly, we also show that improving labor productivity abruptly without targeting will deprive income distribution, as the consumption pattern between skilled and unskilled labor affects the inter-linkages from labor income to household welfare. At the end of this thesis, we provide policy recommendations based on the analysis, which is to target tax break to agriculture sector and food industry and focus on improving productivity of agriculture labor and manual labor of food industry.