The bane of Indonesia’s digital policy

How should regulators keep up with the pace of digital innovation? By understanding the nature of digital business and adopting an impact-focused mindset.

The bane of Indonesia’s digital policy Photo: Unsplash

In 2015, internet penetration in Indonesia reached just shy of 40 percent. In 2019, that figure had grown by more than 50 percent. In 2015, there were close to 90 million mobile internet users in Indonesia. In 2019, that figure doubled. In 2016, investment in Indonesia’s internet economy reached just over $1 billion. In 2019, that figure tripled.

At this point, there is no known industry that has grown faster than the digital economy herein. Google-Temasek-Bain’s digital E-Conomy SEA Report (2020) estimated that Indonesia’s internet economy will grow from $44 billion to $124 billion by 2024. That is a threefold increase in five years.

Comparing the growth in the size of the digital or internet economy to their economic contribution is a mathematical juxtaposition. According to McKinsey, Indonesia's digital economy covers various segments of the economy, including commerce, transportation, tourism and financial services, and is expected to support 26 million jobs by 2022. In 2019, the Financial Services Authority survey found a financial inclusion rate of 76.1 percent, up from nearly 50 percent in 2018.

This inclusion of some 40 million unbanked adults was inextricably linked by the role of financial technology (fintech) in facilitating this transition. Overall, the digital economy has increased national economic activity and reduced the gap in digital competitiveness between provinces. As the importance of the digital economy grows, it is important for public policymakers to think about how to appropriately support this sector.

Innovation versus regulation

As the digital industry has grown at an ultra-speed pace, it is natural that legislative development lags behind innovation. Currently, the digital economy sector occupies around 4 percent of Indonesia’s economy and the figure will grow to more than 10 percent by 2024. With many of our economic segments in eastern Indonesia have yet to experience the benefits of digitalization, this pace shows no sign of slowing down. Given such a significant potency of the digital sector in our economic engine, the urgency in setting clear policies to aid this current is clear-cut.

Despite this urgency, policymakers endeavoring to regular the digital sector encountered a significant hurdle: a lack of understanding of how digital business works. As an emerging sector, the speed of innovation and disruption implies that the business model involves so much trial and errors that was beyond the comprehension of outside parties. The way in which revenues are recognized, the way intangibles are being valued, or the expense structure in a digital firm, are among the least understood.

Inevitably, the obscurity of the digital industry poses a challenge in setting policy. For example, consider digital taxation policy. Up until now, our taxation policy has had much reliance on physical presence auditing, which is clearly not the incognito of the digital industry. It is only in 2020, through the issuance of government regulation in lieu of law No 1/2020, which has since been enacted as Law No 2/2020, that the regulation on digital goods taxation has started. While the value-added tax on digital goods has recently been set, the income tax and electronic transaction tax have not yet been legislated. This uncertainty raises concerns among digital players and investors alike aiming to expand or invest in Indonesia.

Ministry of Finance Regulation No 150/2018 (“MOF Reg 150”), which regulates tax holiday incentives, is another example. Reg 150 grants a corporate income tax waiver for years to come for large investments starting from 100 billion ($7.2 million) and for firms operating in any of the 18 “pioneer industries.” Conceivably, this policy aims to incentivize foreign direct investment into Indonesia. In addition to the list of pioneer industries in Ministry of Finance Regulation 35, Reg 150 (which repealed Reg 35) now considers the digital economy, specifically those involved in data hosting, as an addition to the pioneer industries.

However, if one delves deeper, this regulation is derived from Law No 25/2007 on capital Investment. Within this law, “capital investment” must be in the form of capital expenditure in fixed assets. Digital investors, whose investment subject relies less on fixed asset investment, would not be encouraged by this regulation. Although the addition of the digital economy might attract investors to the technology manufacturing sector (egg, data centers), it cannot incentivize investors in the digital sector as it fails to capture the essence of digital business. This is unfortunate, as the digital economy occupies much of the economic pie of Indonesia’s technology sector.

The digital firm

Consider Amazon as a case study. Amazon, as we know, is a highly profitable company. Looking through its history, it took eight years for Amazon to record a positive net income, and another decade to record any meaningful profits. Before then, it decided to go public even before it was profitable. More so, in early years, almost all investors’ money went into operational expenditure. From a traditional investor perspective, these moves merit no consideration. But why are Amazon’s investors so confident of its prospect from early on?

The underlying logic of digital business rests in its desire to introduce something entirely different to the market. The nature of the digital product is then sidestepped by the business’ absolute commitment to conquer the market through network effect: without a massive number of users actively using the product at any given point of time, the business would not make economic sense. Thus, it is an absolute must to normalize, incentivize or situate the alien product in such a way that it is accepted by the general market. This is why network effect becomes integral, more so than research and development or fixed asset investment, in the initial stage of the business. And such is done through spending to establish the network.

Thus, spending to improve scalability can be thought of as an investment to acquire intangible assets known as the “digital ecosystem.” This business logic is analogous to when the first telephone was unveiled to the world. Before any further product enhancement is made, one must first and foremost ensure that the market accepts the product, for the economic logic of any further investment must bow down to the certainty of a priori establishment of such a network. Indeed, scale activation is the key to sustainability for a business to reach profitability, which will be followed by capital commitment later on. This model is more sophisticated than the simple critique of “valuation gaming” in the tech industry that many finance professionals would suggest. Ecosystem-building is essentially the core model of a disruptive innovation in the digital industry.

The primacy of incentivizing user acquisition and utmost effort in maintaining their activation stood in contrast to other traditional businesses. Traditional business usually requires a large investment up front for factory set-ups, land acquisition, or setting up manufacturing capability before operating. After that, only a relative hindsight of capital commitment, a so-called “maintenance capital expenditures,” is needed to sustain the operation.

In the digital business, this process is reversed: the intensive fixed asset commitment and R&D aspects of digital technology will come naturally as the scale progresses. Without the scale, capital expenditure will not make cogent economic sense. Due to the necessity in building the ecosystem, the investment horizon in this industry is relatively longer than other industries.

Digital economy and public policy

Even the most skilled legislators are no prophets. One cannot possibly anticipate such a bullish overflow of capital or an entirely different business model to appear in such a short period of time. However, keeping up with this trend is a challenge that policymakers must address. Policy design in the digital sector must not be bound by traditional business logic.

Policy design in the digital sector must not be bound by traditional business logic.

Rather, policy design should always be impact-centric. It must be geared towards enabling digital transformation for the benefit of the greater good. With this alternative logic, the spending of digital firms should not be met with raised eyebrows. It is a capital inflow akin to wealth distribution from investors to small and medium enterprises.

This impact-focused mindset can be implemented along with the spirit of economic recovery from the Covid-19 pandemic. The Indonesian government has repeatedly perpetuated the importance of technology in assisting small and medium enterprises, especially in the face of the pandemic. In this regard, the digital economy plays an important role in facilitating recoveries. As digital firms allow the integration of various segments of the population into its network, it directly opens up new employment opportunities and enhances the productivity of SMEs by keeping the economy running and restoring aggregate demand. As just more than 16 percent of SMEs in Indonesia have access to the digital world, digital transformation is key to boost their resilience going forward. This can be achieved through a supportive regulation that recognizes the impact of digitalization on SMEs. Concurrently, with a thriving ecosystem, digital innovation can assist the government in accelerating SMEs recoveries at the time of pandemic.

Although our market potential is huge, our digital competitiveness is still lacking. With digital innovation constantly spiraling disruptively, regulators must adopt the agile mindset akin to that of the pace of the innovation itself. Ultimately, regulators must encourage investment and healthy competition among digital firms to reap maximum consumer surplus. As Indonesia’s digital market is now the largest in Southeast Asia and one of the largest in the world, we must not only become the market test subject, but also the force that transposes the zeitgeist of innovation.

Gilbert Sanjaya is a country strategic project manager at Grab Indonesia.

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