Public finance and fiscal policy

Economic Assessment of Indonesia 2008: Improving labour market outcomes


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The following provides a summary of chapter 3 of the Economic Assessment of Indonesia  published on 24 July 2008.




Greater flexibility in employment protection legislation would make for a better use of labour inputs

Better utilisation of labour inputs is another pre requisite for putting growth on a higher, sustainable trajectory. A tightening of labour legislation, especially with enactment of the Manpower Law of 2003, has contributed to poor labour market outcomes. These include high unemployment, persistent informality and a loss of dynamism in labour intensive manufacturing sectors, such as textiles, clothing and footwear, in which Indonesia has a comparative advantage. Indonesia’s labour legislation is rigid in relation to most countries in the OECD area, and particularly in comparison with regional peers. On the basis of the OECD methodology for assessing the stringency of a country’s employment protection legislation (EPL), the Indonesian labour code is particularly restrictive on regular contracts, due essentially to bureaucratic dismissal procedures and costly severance pay requirements. There are also constraints on the use of temporary and fixed term contractual arrangements, because of strict provisions on the duration and number of extensions of such contracts, as well as on the nature of the activities and occupations to which such arrangements apply. Alternative indicators, such as those featured in the World Bank’s Doing Business reports, also underscore the stringency of Indonesia’s EPL in comparison with regional peers and OECD countries. Several options can be considered for making labour legislation more flexible. In particular, consideration could be given to simplifying procedures for dismissals in the case of regular contracts, relaxing restrictions on temporary work and fixed term contracts, and reducing the burden of severance pay and long term compensation on employers.

Employment protection legislation: Cross-country comparisons (1)

Scores (0 6), countries are ranked from lowest to highest overall rigidity


1. Refers to the state of legislation in 2006 for all countries, 2003 for Chile, 2004 for Brazil and 2007 for India, Indonesia and South Africa.
Source: OECD.

Minimum wage legislation should also be reviewed

At about 65% of the median wage of salaried workers, the minimum wage is already relatively high in Indonesia in comparison with OECD countries. It has risen fast, especially after decentralisation in 2001, because the task of setting the value of the minimum wage is now under the local governments’ purview. This increase has had a deleterious impact on labour market performance: increases in the minimum wage that are out of step with productivity gains are likely to displace lower skilled workers. As in the case of EPL stringency, the loss of dynamism in labour intensive sectors can be attributed to a large extent to the rising relative value of the minimum wage. Therefore, further increases in the minimum wage could be capped so as not to exceed labour productivity gains. This, or, if it were possible, a gradual reduction over time would help to alleviate the adverse employment impact of such a high minimum wage (in relation to the median) on low skilled workers and to facilitate formalisation in the labour market.

Ratio of minimum wage to median wage, 2004 (1)


1. For Indonesia, the median wage is calculated for all individuals aged 15-65 working at least 40 hours per week.
Source: Ministry of Manpower, World Bank and OECD.


Enhanced social protection could complement efforts to make the labour code more flexible

Burdensome labour laws, including minimum wage provisions, often penalise vulnerable workers, instead of protecting them. This is because legal provisions are not binding in the informal sector, where income is likely to be lower and job security more precarious. Also, increases in the minimum wage are most harmful to the workers at greatest risk of job losses in the formal sector. Therefore, policy initiatives to build effective social protection while making the labour code more flexible could yield considerable dividends, including in terms of labour market performance. To make tangible progress in this area, several policy options could be considered. For example, unemployment insurance could be introduced in lieu of onerous dismissal/severance compensation entitlements. There are several options for designing an effective unemployment insurance scheme. But, as a general rule, it is important that such schemes be fiscally sound and affordable to workers and employers. At the same time, budget finances permitting, formal social insurance programmes could be developed. To this end, once credibility in the existing social insurance programme (Jamsostek) has been built, participation could be extended to the self employed and employees in smaller enterprises on a voluntary basis, as envisaged by the 2004 Social Security Law (Jamsosnas). Policy action in this area would be welcome to broaden the array of options for saving for retirement and to facilitate access to health care for those workers and their families who are currently uninsured. In any case, it should be acknowledged that the attractiveness of coverage, both by unemployment and social insurance, depends ultimately on the perceived benefits of social protection and the affordability of contributions, which may be a significant constraint for individuals on low incomes.

Social assistance programmes could be improved

 Indonesia already has a number of formal, government financed safety nets. The authorities’ efforts to strengthen these programmes since the 1997-98 financial crisis through community based and targeted income transfers to vulnerable and poor individuals are commendable. These programmes are perceived to be working well, following efforts to improve targeting and governance in the delivery of benefits. Emphasis is now shifting towards enhancing social assistance by equipping vulnerable individuals with the minimum skills needed to pull themselves out of poverty. This change is of course welcome. To build on previous achievements, conditionality could be improved in the main existing income transfer programme (Program Keluarga Harapan) to strengthen the link between social protection and durable improvements in social outcomes. International experience, especially in the Latin America countries that pioneered the design of conditional income transfers, suggests that the most effective eligibility requirements are related to school attendance and participation in preventive health care programmes. Complementary initiatives can also be taken to improve the targeting of overall government social spending. A reduction in outlays on price subsidies for fuels and electricity, which are on balance poorly targeted, as mentioned above, would be a starting point. Budgetary resources could then be diverted to the financing of programmes that do reach the most vulnerable segments of society, improving the overall progressivity of social spending.


How to obtain this publication                                                                                   

The Policy Brief (pdf format) can be downloaded in English. It summarises the OECD assessment. The complete edition of the Economic Assessment of Indonesia 2008 is available from:



Additional information                                                                                                  


For further information please contact the Indonesia Desk at the OECD Economics Department at  The OECD Secretariat's report was prepared by Luiz de Mello and Diego Moccero under the supervision of Peter Jarrett. Research assistance was provided by Anne Legendre.




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