Partners on a Climb : Financial Sector Development and Tax Collections in Indonesia

Shallow financial markets may act as an important structural constraint on a country’s ability to mobilize tax revenues. This paper explores this hypothesis in the context of Indonesia, a middle-income country with persistently low tax collections and low financial sector depth. At the macro level, relating cross-country financial development to new estimates of tax gaps, it finds that a 1 percent increase in private credit as a share of GDP could reduce the tax gap by approximately 0.2 percent. At the micro level, analysis of publicly listed Indonesian companies suggests that a one-decile increase in financial constraints is associated with a 0.18 percentage point drop in cash effective tax rates, indicating that financially constrained firms may be using tax planning as a liquidity tool. The results suggest that tax collections are positively associated with financial sector deepening.