Indonesia's Fiscal-Capacity Evolution and Policy Reforms: Crisis-Driven Governance and Its Implications for Foreign Investment

Indonesia's fiscal policy reforms since the pandemic have been shaped by a dual imperative: stabilizing a fragile economy amid global uncertainties and recalibrating governance structures to address long-standing inefficiencies. The country's conservative fiscal approach-marked by deficit reduction, centralization of capital spending, and structural tax reforms-has yielded mixed outcomes for foreign investment. While these measures aim to strengthen fiscal sustainability, their implications for long-term capital flows and economic growth in an emerging market context remain complex and contested.

Crisis-Driven Fiscal Prudence and Centralization

Post-pandemic, Indonesia adopted a fiscally conservative stance to mitigate inflationary pressures and borrowing costs. By 2023, the government achieved a primary budget surplus of 0.4% of GDP-the first since 2012-while narrowing the overall deficit to ease financing pressures according to a 2024 journal article. That article also documents Bank Indonesia's contractionary monetary policy, including higher policy rates and reserve requirements. However, the trade-off for fiscal discipline has been slower growth, with GDP expansion falling from 5.3% in 2022 to 5.0% in 2023, partly due to weaker global demand and limited policy support, as noted in the same analysis.

A critical feature of Indonesia's fiscal strategy has been the centralization of capital expenditures. Local governments, once key drivers of infrastructure development, now face declining allocations for Special Purpose Transfers (Dana Alokasi Khusus Fisik), projected to drop from 2.9% of the national budget in 2015 to 1.1% in 2025, a trend documented in the 2024 analysis. Meanwhile, the central government has prioritized Nationally Strategic Projects, which, while potentially boosting long-term productivity, risk creating bottlenecks due to bureaucratic inertia and limited local capacity. This centralization reflects a broader retreat from fiscal decentralization, a policy once championed to empower regional governance but now criticized for fostering inefficiencies and inequality, as discussed in an East Asia Forum article an East Asia Forum article.

Fiscal Decentralization's Mixed Legacy and FDI Dynamics

The impact of fiscal decentralization on foreign investment has been paradoxical. A 2025 study found that decentralization had a negative effect on economic growth (as measured by GRDP) between 2015–2019, potentially deterring foreign investors. Yet, a provincial and sectoral analysis noted that FDI remains a critical growth driver, particularly in manufacturing, mining, and services, where capital accumulation and technology transfer enhance productivity. Conversely, that provincial and sectoral analysis shows FDI in agriculture has exhibited negative returns, underscoring sector-specific risks.

The 2022 fiscal decentralization law (Law 1/2022) aims to address these challenges by enhancing local fiscal responsibility through performance incentives and revenue earmarking. However, critics argue that the law's design-focused on central control mechanisms-may exacerbate corruption and clientelism rather than mitigate them, as outlined in a critical assessment. Additionally, fiscal decentralization has been linked to rising income inequality, as measured by the Gini ratio, a point made in the 2025 study cited earlier. For foreign investors, this creates a fragmented landscape where some regions offer improved infrastructure and governance, while others struggle with fiscal distress and underdeveloped institutions, a pattern documented in a SAGE article.

Structural Reforms and the Path to High-Income Status

To achieve its 2045 aspiration of becoming a high-income country, Indonesia must address structural bottlenecks in tax administration, public spending efficiency, and energy subsidies, as highlighted in the 2024 journal article. The current tax ratio remains low, constraining fiscal space for growth-oriented investments. A 2025 OECD report emphasizes the need for comprehensive tax reforms, including the rationalization of incentives and exemptions, to broaden the revenue base, an argument consistent with the earlier analysis. Similarly, improving access to innovative financing mechanisms-such as municipal bonds for local governments-could unlock private capital for infrastructure projects, a solution discussed in the 2024 study.

For foreign investors, these reforms present both opportunities and risks. On one hand, a more efficient tax system and targeted social spending could create a more stable investment climate. On the other, the centralization of fiscal authority may limit local governments' ability to respond to regional needs, potentially deterring sector-specific investments in agriculture or small-scale manufacturing, as suggested by the SAGE study.

Conclusion: Balancing Prudence and Innovation

Indonesia's fiscal evolution post-crisis highlights the tension between short-term stability and long-term growth. While fiscal conservatism has helped stabilize public finances, the centralization of capital spending and the mixed legacy of decentralization complicate its appeal to foreign investors. Success will depend on the government's ability to balance structural reforms-such as tax modernization and local fiscal empowerment-with policies that address inequality and regional disparities. For emerging market investors, Indonesia's trajectory offers a cautionary tale: crisis-driven governance can yield fiscal discipline, but sustainable growth requires innovation, inclusivity, and a nuanced understanding of regional dynamics.