The challenge is therefore not simply whether the green transition is desirable, but how it can be financed without undermining debt sustainability, essential public services, or social welfare.

The dilemma takes different forms across countries. Indonesia and South Africa must reduce their dependence on coal while managing risks to government revenue, employment, and energy security (Gomes, 2026; Mustasya, 2026). Nigeria illustrates the political and fiscal difficulty of removing fossil-fuel subsidies: reform can create space for other public spending, but it can also raise transport and living costs (Osho et al., 2026). Bangladesh must divide scarce resources between immediate climate-adaptation needs, such as flood protection and disaster recovery, and longer-term investment in clean energy (Nandi et al., 2025). Meanwhile, countries such as Zambia and Vietnam require substantial financing for renewable generation and electricity infrastructure but remain constrained by limited fiscal space and high borrowing costs.

These examples show that the green transition in EMDEs is not only an environmental challenge. It is also a fiscal balancing act between climate objectives, economic development, debt sustainability, and social welfare.

The Pigouvian rationale

Pollution is a negative externality because firms and consumers do not bear the full social costs of the emissions they produce. Carbon pricing, subsidy reform, environmental regulation, and public investment can help internalize these costs by aligning private incentives more closely with social welfare (Pigou, 1920).

However, policies that improve long-term welfare can still create short-term fiscal and distributional pressures. A coal phase-out may reduce royalties, taxes, and profits from fossil-fuel-related activities. A carbon tax may initially generate public revenue, but that revenue can decline over time as emissions fall. Governments may also need to finance clean infrastructure, support affected workers and regions, and protect vulnerable households from higher energy costs.

The result is a genuine fiscal dilemma. Governments must manage the long-term gains from lower emissions while meeting immediate budget constraints and maintaining public support. This preserves the core logic of the original Pigouvian section without treating carbon taxation as an immediate loss of government revenue.

Multiple dimensions of dilemma

Utilizing a Cons-Pros framework clarifies the exact dilemmas faced by EMDEs. This approach evaluates whether the social benefits of a policy or project justify its economic costs, especially when navigating trade-offs with highly scarce resources. It is widely applicable to critical decision-making areas, including infrastructure investment (Thoft-Christensen, 2012), public health initiatives (Brent, 2014), and urban transportation networks (Mouter et al., 2021). The Cons-Pros of this study is illustrated below

The first strand explains the fiscal dimension of green transition. Cons aspects are quite straightforward, where government face a revenue loss from the fossil fuel (Hansen, 2022), especially where government benefits a huge tax revenue from the fuel excise. High transition spending matters. Shifting from the brown into green economy requires such a huge investment, especially where green technology requires high capital intensity (OECD, 2024). This will be enclosed by the investment loss if the government fails to utilize this high investment (Nawaz & Su, 2026). The riskiness is associated with high uncertainty due to rapid technological disruption, underdeveloped government policies, and steep learning curve of new technology. However, even though we are faced with these issues, benefit aspects reveal the potential such as broader tax base in green economy by shifting the fiscal burden away from brown economy such as fuel excise, into congestion taxes, carbon pricing, and broad-based environmental levies ensures stable revenue to fund climate infrastructure without overburdening working-class taxpayers. This creates stable, long-term public revenue while simultaneously pricing negative externalities. Last but not least, successful implementation of green transition attracts investors, which is translated into job vacancies (Gasparini et al., 2025).

The socioeconomics aspects are explained in the second strand. High transition costs are not limited to direct monetary expenditures but also include the opportunity costs associated with temporary employment losses. Businesses, workers, and infrastructure require time to adjust before the transition can be fully implemented (Emmerling et al., 2025). This further exacerbates the economic impact by causing a sharp increase in energy prices, as consumers and businesses have long relied on fossil fuel subsidies (Belgioioso & Newman, 2025). However, these costs are likely to be offset by improved public health outcomes, as lower pollution levels reduce the incidence of pollution-related illnesses (Li et al., 2023), which also indirectly translated into better human capital quality. In the long term, energy prices are also likely to become more stable and affordable, as renewable energy sources are less exposed to fluctuations in global commodity prices than fossil fuels (Hedley, 2025).

The final strand considers the environmental dimension. Transitioning to a green economy requires the development of new land and infrastructure. At the same time, divestment from the brown economy leaves a permanent environmental “scar” (Baron & Fischer, 2015). For example, quarrying and hydraulic fracturing can cause long-lasting damage to land, regardless of whether governments subsequently transition to a green economy. Nevertheless, this transition also offers significant environmental benefits by enhancing climate resilience and reducing dependence on environmentally harmful resources (UNDP, 2025)

Concluding remarks

All in all, the green transition presents EMDEs with a difficult fiscal balancing act. While the Pigouvian framework justifies government intervention to correct environmental externalities, limited fiscal space, debt constraints, and competing development priorities make implementation challenging. The analysis shows that green transition not only affects fiscal dimension, but rather has socioeconomic and environmental consequences. Successful green transition policies require careful policy design, sound fiscal management, and adequate financing to ensure that long-term sustainability is achieved without compromising economic development and social welfare.

References

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It never mentions AI as a subject of scrutiny, only implying its existence in Articles 10 and 34 of the UU PDP. The articles strictly discuss the procedural response for individuals who object to automated processing of personal data. Uncertainty regarding its definition of crime also increases ambiguity with respect to enforcement mechanisms, amplifying public caution about its potential misuse as an instrument to disarm criticism.

Furthermore, the governance of cybersecurity and AI in Indonesia remains severely underdeveloped. Indonesia’s National Cyber and Encryption Agency (BSSN), which is responsible for cybersecurity, cyber intelligence, and signal intelligence, has only partially met the requirements of “Cybersecurity Good Practice” developed by the International Telecommunication Union’s Guide. The World Bank reports that research funding in Indonesia reached only 0.28% of GDP in 2020, significantly below the global average of 2.46%.

Governance failure in AI and cybersecurity is evident both before and after the establishment of UU PDP. The ‘Bjorka’ data breach case in 2022 showcases the fragilities of cybersecurity governance in Indonesia. The enforcement of UU PDP during the National Data Centre Ransomware Attack in 2024 highlights an urgent problem following its enactment. Issues of human resources allocation in BSSN also persist.

Indonesia’s current government has frequently emphasized the importance of AI to increase productivity. President Prabowo has expressed his view on AI as a crucial instrument for growth, particularly for developing countries. In relation to this commitment, the Ministry of Communication and Digital of Indonesia has stated that it is drafting a national roadmap for AI development.

Although these approaches provide an immediate baseline for AI usage in Indonesia, the government has prevented the result of this evaluation from being made public. This risks undermining the importance of engaging collective inputs on AI development.

The same process happened during the establishment of UU PDP. The Alliance of Independent Journalists (AJI) Indonesia, along with Indonesian Corruption Watch (ICW), has frequently criticized the legislative process undertaken to create UU PDP. The House of Parliament was deemed to have violated the Constitutional Court’s ruling No. 91/2020 by preventing meaningful participation in regulatory changes.

The development of AI Law should be a collective priority. However, by acting as a gatekeeper for the national roadmap and regulatory settings, the Indonesian government risks deteriorating the quality of AI guidelines. A lack of public involvement undermine a sense of collective stake.

The government should not risk repeating past mistakes. UU PDP became evidence of a flawed regulatory framework derived from a flawed mechanism.

It is evident that Indonesia is not lacking in ambition, President Prabowo made that clear. It is, however, lacking an enforcement mechanism. And so far, nothing in the roadmap design signals that necessary change.

Every parent faces a fundamental dilemma: how much protection is too much? Shield a child too little, and they are left vulnerable to a world they are not yet ready for. Shield them too much, and they never develop the resilience needed to stand on their own. This same tension, between nurturing and overprotecting, sits at the heart of one of the oldest and most contested debates in economic policy: should governments intervene to shape which industries survive and grow, or should that outcome be left entirely to market competition?

The infant industry argument posits that newly established industries should be protected and supported by the government until they are ready to “face the world,” much like how a parent nurtures their child. The idea is straightforward. New industries in developing economies may be inherently uncompetitive in the short run, not because they lack potential, but because they have not yet had the time or conditions to grow.

A young child cannot be expected to compete with adults. Similarly, a newly established domestic steel mill cannot immediately compete with a decades-old foreign conglomerate that has already reaped the benefits of accumulated scale and experience. The logical implication is that some degree of temporary government protection - a parent’s sheltering hand - may be warranted during the formative years. What that protection looks like, how long it lasts, and whether it ultimately produces a thriving industry or a permanently dependent one, is precisely what the debate over industrial policy is about.

What is Industrial Policy?

Industrial policy refers to the range of tools that governments use to deliberately shape what an economy produces, rather than leaving industrial outcomes solely to market forces. One definition explains it as “structural policies designed to strengthen the efficiency, scale and international competitiveness of domestic industrial sectors, typically containing an element of national champions, of self-reliance in bringing about growth and development” (Soete, 2007). It is, in essence, a government’s decision to pick, or at least lean toward, certain industries, activities, or sectors deemed strategically important for national development.

This element of favouritism is, at least on its surface, what has made industrial policy such a controversial topic in economics. It appears to challenge the neoliberal belief in the market’s capacity to determine the best outcome, running counter to the open-market, pro-competition orthodoxy long championed by Western economies, encapsulated in the so-called Washington Consensus (Williamson, 2003), which held that trade liberalization, competition, and investment in human capital would drive growth in developing countries.

The data shows that industrial policy is making a comeback. Business subsidies among upper-middle-income countries now average 4.2 percent of GDP, the highest on record, while a review of national development plans across 183 countries found that every single one targets growth in at least one industry (Fernandes & Reed, 2026). Even the United States, long considered the standard-bearer of free-market economics, has pursued industrial policy under both Democratic and Republican administrations in recent years.

One need not believe in industrial policy to recognize that it is, increasingly, the world’s chosen path. The question worth asking is no longer whether governments should intervene - that debate is effectively being settled by practice, not by economists - but whether they will do it well.

Yet appeal is not the same as success. Whether industrial policy fulfills its promise, nurturing an industry into genuine competitiveness, or instead produces the kind of permanent dependency a parent hopes to avoid, depends entirely on how it is designed and withdrawn.

The Well-Nourished Child: When Industrial Policy Works

Lane’s study of South Korea’s Heavy and Chemical Industry (HCI) drive of 1973–1979 offers one of the clearest empirical tests of the infant industry logic available. The policy’s sharp introduction, and its abrupt termination following the 1979 assassination of President Park Chung-hee, allows for an unusually clean before-and-after comparison of targeted industries. The results were substantial: relative to non-targeted manufacturing sectors, targeted heavy-chemical industries expanded output by more than 100%, with labor productivity more than 15% higher (Lane, 2025). The gains did not stop at the targeted firms themselves; industries downstream of HCI intermediates benefited indirectly through input-output linkages, and these benefits persisted even after the policy ended, with some effects taking years to fully materialize.

This is the well-nourished child in its purest form: the state intervened during a formative period, the support eventually ended, and the industry continued to grow under its own strength rather than collapsing without its parent’s hand. The protection was not permanent, and it did not need to be. It had already done its job.

The Spoiled Child: When Industrial Policy Fails

However, for every well-nourished child, there is always a cautionary counterpart. Not every act of protection ends in independence. Sometimes the sheltering hand that was meant to be temporary never lets go. Not because the parent forgot to withdraw it, but because letting go became harder with each year that passed. The industry grows accustomed to the shelter long before anyone notices it has stopped growing at all. This is the other face of industrial policy.

Argentina’s Tierra del Fuego special incentive regime is perhaps the most telling example of this (Fernandes & Reed, 2026). Established in 1972 to develop local manufacturing in a remote southern province through substantial tax and customs benefits, the regime came with an initial sunset clause set to expire 35 years later, in 2007. By then, the targeted industries had still not become internationally competitive. The result was a concentration of low-value assembly activity, particularly in electronics, with no corresponding development of genuine competitiveness. At an annual fiscal cost of roughly US$1.07 billion, the regime paid for the appearance of industrial activity without the substance of it.

Rather than acknowledging this failure and withdrawing support in 2007, political pressures to preserve employment and regional economic stability led to a series of extensions — first to 2021, then most recently to 2038, with some industry-specific extensions running through 2028. What began as a temporary subsidy has become a permanent structure, with an industry that never learned to compete because it was never asked to.

The spoiled child dynamic operates through two compounding mechanisms. The first is a design failure: firms will always optimize for whatever the subsidy actually rewards, not for what the policy was meant to achieve. In Argentina’s case, that meant chasing sales volume instead of building real competitiveness. The second is political capture. Guaranteed support creates its own defenders — workers, firms, and local officials who benefit from its continuation — and they push back the moment a sunset clause threatens to actually take effect. As Anne Krueger (1974) describes in her theory of rent-seeking, government-created privileges like protected market access give firms an incentive to spend resources defending the privilege itself, rather than competing to deserve it.

Parenting Guidelines: Knowing When and How to Let Go

The evidence does not counsel against industrial policy, rather it counsels against industrial policy pursued without discipline. Effective interventions share several common features: tools are matched to a country’s actual capacity rather than its ambitions; support is directed only at activities with genuine knowledge spillovers, not merely large or politically organized industries; and exit is built in from the start, with performance-linked sunset clauses that prevent permanent dependency. And to have an institution with a capacity to successfully execute these policies (Fernandes & Reed, 2026).

Good parents do not refuse to protect their children. That would be neglect. But good parents also do not protect their children from every difficulty forever, that would be the kind of indulgence that produces adults that are unable to function without assistance. The same is true of industrial policy. The goal is not to shelter domestic industries from international competition forever, but to give them the time, the inputs, the knowledge, and the discipline to become competitive on their own terms. When that goal is kept clearly in view, when support is conditional, termination is planned, and institutions are built for accountability, industrial policy earns its place in the development toolkit. When it is forgotten, the child never grows up. And what began as a nursery quietly becomes a life support machine.

I contend that Pancasila’s principles failed to be fully translated into the operational level, resulting in inconsistent contract enforcement within Indonesian institutional practice. Symptoms of failures in the operationalization of Pancasila are provided with historical evidence, exemplified by a series of instability, power concentration, and corruption, among others.

Historical Context of Pancasila and the Indonesian Government

Pancasila was first introduced at the first session of the Investigating Committee for Preparatory Work for Indonesian Independence. The session emphasized the necessity of a foundational philosophy that encompasses the religious, racial, and cultural diversity of Indonesia (Azis 2025:62). Pancasila was presented by Ir. Soekarno on the 1^st June 1945, and produced an initial consensus for the state philosophy of Indonesia (Azis 2025:64). The result was formalized through the Jakarta Charter on the 22^nd of June 1945, containing the five principles of Pancasila.

The establishment of Pancasila as the state philosophy reflects the compromise undertaken for the sake of national unity. Although formulated on the 22^nd of June, its final form only appeared on the 18^th of August 1945, one day after the proclamation of Indonesian independence. The first principle of Pancasila in the Jakarta Charter was highly contested by religious and ethnic minorities, due to a strong leaning on Islamic religiosity (Azis 2025:65). The first principle was then changed from “Belief in God, with the obligation to carry out Islamic law for its adherents” to “Belief in the one and only God” to ensure religious neutrality within the Indonesian institutional arrangement (Kurniasih & Isma’il 2024:167-168).

Its final form was embedded in the 1945 Constitution of the Republic of Indonesia. The document asserts Pancasila as a source of national guidance and the defining value of the Indonesian nation (Kurniasih and Isma’il 2024:169). Hence, it emerged as the primary reference for determining future formal constraints and shaping informal constraints within Indonesian institutions.

Informal Constraints, Formal Constraints, and the Incomplete Contract Theory

Informal constraint is largely associated with culture, broadly defined as transmitted information via knowledge, values, and other aspects that may influence human behaviour (North 1990:37). Formal constraints include political, legal, and economic rules and contracts and function to lower enforcement costs, supporting informal constraints as possible alternatives to more complex exchanges (North 1990:46-47). Consequently, formal constraints, complementing informal constraints, provide a more stable basic structure of exchange, enabling foreseeable agreement (North 1990:50).

Formal rules do define the structure of rights, but, due to the costliness of measuring the enforcement characteristics of exchange, most contracts are incomplete (North 1990:61). The issues concerning the measurement and enforcement of these rights consist of the structure of property rights, the strength of the legal system, and the development of norms and voluntary arrangements (North 1990:64).

Consequently, cultural norms and informal constraints will contribute more significantly to achieving agreement (North 1990:61). Higher costs of measuring and enforcing rights will force parties to exchange within the boundaries set by informal constraints, or worse, abort the exchange (North 1990:68). Such a limitation highlights the consequences of incomplete contractual arrangements, resulting in uncertainty of exchange when future enforcement of rights and anticipation of events is unsettled.

Due to the impossibility of creating a complete contract, parties will attempt to write an incomplete contract and, as a consequence, make it a subject for continuous revision (Hart 1988:123). Under such conditions, ownership becomes significant because residual rights of control cannot be fully specified or given up (Hart 1988:124). Thus, parties with higher authority over institutional arrangement will have the capacity to interpret and operationalize unresolved aspects of the contract.

Pancasila within the Framework of Incomplete Contract Theory

Pancasila provides normative constraints for social structure, implicating the basic institutional arrangements of Indonesia. The five principles of Pancasila embedded in the Indonesian constitution are effectively a source of formal guidance for legal and political procedures. The incentives are then shaped through legal consequences, displaying Pancasila’s authority in producing formal and informal constraints.

Despite its final form, Pancasila is a subject of incomplete contractual arrangement. The interpretation of Pancasila would become a subject for constant debate throughout Indonesian history. Ir. Soekarno presents Pancasila as a set of uniting principles amid cultural and ideological differences. His regime uses Pancasila as an instrument to unite different factions, openly expressing it as an instrument to unify the nation with other philosophical ideas such as Islam (Lev 1966:125).

Soeharto’s New Order imposed a stricter reinforcement of Pancasila through institutional mechanisms such as the P4 program to anticipate differing interpretations (Ward 2010:30). The post-reform regime, however, abandoned the New Order’s approach to sole interpretation of Pancasila, claiming it as a destabilizing factor that may contribute to political instability and radicalisms within the newly-formed democracy (Ward 2010:37).

Such turbulence showcases the role of Pancasila as a final source of national guidance, while at the same time underlining its difficulty for a consistent operationalization. The differing interpretations of Pancasila display its potential for exploitation. One that reflects an incomplete specification within the institutional framework.

Differing interpretations and reinforcements of Pancasila imply that its authority is also dependent on executive power. Aligned with Hart, such a case suggests the evidence that, within the Incomplete Contract Theory, the government may assert a certain arrangement within the Indonesian institutional landscape. The interpretation is heavily influenced by the perception of national figures, as shown by Soeharto, Soekarno, and post-reform factions with their differing approaches to instrumentalizing Pancasila as a guiding principle.

Such a case is also highlighted by North, arguing that although government could act as a third-party enforcer to uphold contracts, it risks them exerting their interests regardless of their impacts on society (North 1990:59). It then presents a dilemma, for if government should act as the ultimate authority to enforce Pancasila as a contract, misinterpretation regarding its enforcement will not be able to become a subject for contest.

Empirical Evidence of Operationalization Flaw of Pancasila as a Contract

The limitations of Pancasila’s operationalization are illustrated by several empirical cases. Violations of principles, encompassing aspects including religious freedom, human rights violations, democratic backsliding and persistent inequality, are persistent. Illustration of empirical evidence regarding such inconsistencies are illustrated in Table 2.

They illustrate violations of Pancasila’s principles with both the government and civil society as the subjects under scrutiny. Religious tolerance is guaranteed within the framework of Pancasila, but evidence shows it can be undermined within local practices. Religious rights are often sought through prosecution, signalling the government as a source of resolution within the contract. This evidence shows that, despite Pancasila as a source of constraint, norms and cultural aspects within the local context are often more powerful constraints for institutional arrangement.

Evidence of human rights abuses and democratic backsliding signals the benefit of interpretive authority embodied in executive power. The 1965 killings of the communists party members highlight extreme initiative taken by Soeharto’s military regime to undermine contesting political power, namely the communist party (Roosa 2006: 206). Approximately more than 600.000 individuals are killed (Cribb 2002:558). But despite such initiative, Soeharto’s P4 program signals his commitment to uphold Pancasila’s principles, showcasing past structural inconsistencies in defining and defending Pancasila.

Such inconsistencies continue into the era of reformation, showcased by democratic regression through the persistence of elite politics. Following the reform in 1998, the transfer of administrative and fiscal authority to the local government has also created opportunities for political participation. However, a significant barrier remains at the local level. Newly existing regulations gave significant advantages to the elite, through mechanisms that include educational threshold, notation from parties or party coalitions, and campaign costs. All of which undermines the role of the underprivileged in the Indonesian political contest (Buehler 2010: 273-274).

Taken together, this evidence signals that Pancasila’s operational inconsistency is structural, rather than incidental. Hart’s (1988) idea of residual rights of control becomes increasingly relevant because a large part of the interpretive power regarding Pancasila is influenced by the governmental body. Such an arrangement produces interpretive versions of Pancasila that are politically motivated and structurally enabled.

Synthesis: Empirical and Theoretical Misalignment

I argue that failure to achieve a more consistent interpretation of Pancasila’s principles is deeply rooted in its inability to contest more powerful informal constraints in the divergent Indonesian region. Although it had become embedded within the constitution, the Indonesian society is still deeply shaped by informal norms, such as local religious codes, elite networks, and historically entrenched hierarchies that Pancasila’s principles were never specific enough to displace. Pancasila then functions as a source of compromise, rather than an operational guidance, despite presenting itself as a social contractual arrangement.

Despite formalization, informal rules and norms often change incrementally (North 1990:91). This is especially so in a divergent society such as Indonesia. The lag between informal constraints and formal constraints imposed by Pancasila often produce conflicts as many became inconsistent with one another. The formal rules often create a partial equilibrium that undermines the cultural inheritance that shapes informal constraints (North 1990:91). Thus, informal constraints persist as a signal of enduring effectiveness within the local context, due to its ability to solve coordination problems (North 1990:91). The product of such arrangement is often a gradual restructuring of existing constraints, to produce a more stable equilibrium.

Moreover, influences of Pancasila’s principles as formal and informal constraints differ in each region. It can be argued that Indonesian local context possesses a significant degree of path dependence. North (1990:101) contends that differences in relative bargaining power among parties operating under common rules will have a different marginal adjustment, and does not necessarily lead to a convergence.

North illustrates the idea of different marginal adjustment using the case of the implementation of the US Constitution in Latin American countries. Despite having the same formal rules, differences in enforcement mechanism, local norms and behaviours, and subjective models resulted in different structures of incentives and policy consequences leading to a variety of outcomes within local context (North 1990:101). The same logic applies to Pancasila: a uniform framework produced varied institutional outcomes across Indonesian regions because the informal constraints it encountered were never uniform in the first place.

This interpretive gap is then filled by allocation of residual rights of control. Hart (1988:124) argues that when contracts are incomplete, ownership becomes more important because the decision on matters unspecified in the contract rests with one with higher authority. In the Indonesian context, the abstract conceptualization of Pancasila leaves residual interpretive authority unassigned. This authority is captured by whoever has institutional power, as illustrated by differing interpretations and implementations of Pancasila’s principles. Such an arrangement reflects a structural flaw of the contract itself, in the midst of the persistent influence of heterogeneous informal constraints within Indonesian regions.

This gap continues even after the reform. The Constitutional Court (MK) was designed to distribute interpretive authority, but the 2023-2024 controversy over the vice-presidential age limit showcases that even the integrity of such an institution is also a subject for executive influence (Budiono et al. 2024). Thus, residual rights were never fully transferred, and formal constraints can fail without informal backing.

Ultimately, the misalignment between Pancasila’s legitimacy and operational consistency is not incidental or regime-specific. It is structurally embedded in the contract’s incompleteness, sustained by the influence of local constraints and enabled by residual authority in successive holder of institutional powers.

A Complementary Framework: Self-Reinforcing Contracts

Pancasila’s incompleteness as a contract is not a solvable design. Thus, the relevant question is not to eliminate the existence of residual rights of control, as its existence will remain within Pancasila as a form of contract. Rather, it is how to stabilize its enforcement without relying on the government as a primary interpreter.

Institutional change is largely shaped by increasing returns. Drawing from Arthur’s four self-reinforcing mechanisms on how certain technologies stay dominant, he contends that large setup costs, learning effects, coordination effects, and adaptive expectations become the main principles for a sustainable institutional arrangement (North 1990:94-95). Pancasila has benefited from a large setup cost through the process of independence, and has endured different regimes that contributed to continuous learning effects.

However, I contend that Pancasila needs to leverage the dynamics of coordination effects and adaptive expectations. Such an initiative is done by distributing the interpretive authority across civil society, religious institutions, and regional bodies. The government’s role as the primary enforcer of Pancasila would be diminished, and subsequently, increasingly anchored on the coordination needs of Indonesian society.

This does not eliminate the contract incompleteness, but it transforms the residual rights of control into something that can be contested and negotiated. Consequently, the sustainability of Pancasila as a contract will not depend on a singular authoritative body. It will remain within the hands of the Indonesian people.

Conclusion

Pancasila’s persistent operational inconsistency is not incidental, but structurally embedded. It is sustained by heterogeneous informal norms and amplified by the existence of residual rights of interpretive authority within the government body. Yet, the incompleteness of Pancasila is also a cause of its durability. The relevant change is then not to complete the contract, but to distribute the residual rights of control to ensure a more stable equilibrium for Pancasila as a contractual arrangement.

References

Azis MA (2025) ‘BPUPKI dan proses perumusan pancasila sebagai dasar negara’, Maliki Interdisciplinary Journal (MIJ), 3:62-67, http://urj.uin-malang.ac.id/index.php/mij/index

Budiono I, Tanjung AD, and Rahman F (2024), ‘Ambiguity after the constitutional court decision number 90/PUU-XXI/2023 regarding the presidential election’, Jurnal Hukum Prasada, 11(2):111–118, https://doi.org/10.22225/jhp.11.2.2024.111-118.

Buehler M (2010) ‘Decentralisation and local democracy in Indonesia: the marginalisation of the public sphere’, in Aspinall A and Mietzner M (eds) Problems of Democratisation in Indonesia : elections, institutions and society, Institute of Southeast Asian Studies (ISEAS).

Cribb R (2002) ‘Unresolved problems in the Indonesian killings of 1965–1966’, Asian Survey, 42(4):550–563, https://doi.org/10.1525/as.2002.42.4.550.

Freedom House (2025) Freedom in the world: Indonesia, Freedom House Website, accessed 4 Jun 2026.

Hart OD (1988) ‘Incomplete Contracts and the Theory of the Firm’, Economics, & Organization, 4(1):119-139.

Human Rights Watch. (May 5 2012) ‘Indonesia: Rights Record under Scrutiny at UN’, Human Rights Watch, accessed 4 June 2026.

Kurniasih M and Isma’il M (2024) ‘Dari BPUPKI ke Pancasila: refleksi sejarah pembentukan negara dan pendidikan kewarganegaraan di Indonesia’, Jurnal Komunikasi Antar Perguruan Tinggi Agama Islam, 23(2):162–180.

Lev D (1966) The transition to guided democracy: Indonesian politics, 1957-1959. Ithaca : Modern Indonesia Project.

North DC (1990) Institutions, institutional change and economic performance, Cambridge University Press, https://doi.org/10.1017/CBO9780511808678.

Roosa J (2006) Pretext for mass murder : the September 30th Movement and Suharto’s coup d’état in Indonesia, University of Wisconsin Press.

Ward K (2010) ‘Soeharto’s Javanese Pancasila’, in Aspinall E and Fealy G (eds) Soeharto’s new order and its legacy : essays in honour of Harold Crouch, ANU E Press.

Side-payments are regarded as indispensable for compliance and participation. Yet, its effectiveness is limited by the commitments of donor states (Howes et al. 2026:240). Reliance on side-payments alone will then fail if the distribution of benefits and costs is unequal.

The victim pays principle (VPP) has been among the most effective in incentivizing effective treaties. The North Pacific Fur Seal Treaty and the Montreal Protocol illustrate that the willingness to compensate polluters is not entirely dependent on economic gains but is influenced by other factors, such as health risk and resource conservation (Howes et al. 2026:254).

These cases also show that willingness to provide compensation is attributed to a growing domestic concern, influenced by demographic characteristics and resource availability. The withdrawal of the US from the Paris Agreement also illustrates the fragility of side-payments and VPP to sustain treaty stability (The White House 2017).

Side-payments then risk becoming a short-term political initiative rather than a prolonged commitment. A plastic treaty would face the same landscape, for its durability depends on the support of powerful states.

Furthermore, disagreements over regulatory scope have emerged as a persistent obstacle to reaching consensus. Such divergence is displayed during the Intergovernmental Negotiating Committee (INC) meeting in Busan in 2024. 110 developing countries advocated for the proposal of the “African Group”, while the majority of remaining members were more inclined to support the US proposal (IISD 2024:12). This reflects the differing positions on whether countries should ban harmful chemical products, with opponents voicing concerns over potential impacts on trade limitations and economic inequalities. This disagreement is amplified when Rwanda, on behalf of 85 countries, proclaimed the necessity to include a global requirement to reduce the production of plastic polymers (IISD 2024:4). Rwanda expressed its concerns regarding a “small group of countries” that aim to remove such a requirement (IISD 2024:7).

The heterogeneity of plastic production and consumption patterns deepens the divide for regulatory scope. The African group notes its negligible role in plastic pollution (IISD 2024:7). The Like-Minded group, including the US, China, India, Saudi Arabia and the Russian Federation, were heavily dependent on petro-chemical production. China, the US, Saudi Arabia, and India account for 56% shares of the world’s plastic production (Zero Carbon Analytics 2025). China and Saudi Arabia alone dominate 70% of global subsidies for plastic feedstock (Zero Carbon Analytics 2025). These structural economic differences underline the difficulty of establishing a compromise to support the global plastic pollution treaty.

Lastly, disagreements about treaty designs have also become a source of deadlock. Debates have been centered around the treaty’s mandatory characteristics, on whether measures would meet criteria-based global requirements or be adjusted based on national circumstances (IISD 2024:4). In effect, establishing a design consensus for managing plastic products, reducing plastic waste, and addressing existing plastic pollution remains a structural obstacle that prevents effective agreement (IISD 2024:4-5).

The INC meeting in Busan remains a strong example to illustrate the deadlock. Rwanda, Mexico, and the EU, representing more than 100 countries, firmly advocate for top-down measures for the treaty (IISD 2024:7-8). The Like-Minded group, however, contested against the pursuit of enforceability and posited that such an approach would undermine the inclusivity needed for effective agreements (IISD 2024:8). Both INC-5 in Busan and INC-5.2 in Geneva adjourned without a consensus, with disagreement over scope and treaty design being the primary barriers (Willige 2025).

These obstacles underline that a singular approach is not possible for addressing the global plastic pollution problem. Trade-offs between ambition and participation become necessary to align the divergent interests of treaty members.

Indonesia is well-positioned to bridge these two opposing blocs. Aligned with its foreign policy doctrine, Indonesia operates under the principles of “independent and active”. It underlines the importance of a collective approach to addressing the plastic pollution problem, emphasizing inclusivity (IISD 2024:8).

Indonesia imports 100% of its naphtha, and is also heavily reliant on plastic imports from the Middle East, notably from the United Arab Emirates, Bahrain, Saudi Arabia, and Kuwait. Plastic has not only become an essential resource for its industries, but it also has a significant influence over Indonesian farmers through plastic mulch that helps to prevent water evaporation. The scarcity of plastic will have significant consequences on social and economic development in Indonesia. These import dependencies highlights Indonesia’s incentives to maintain plastic intake for sustaining domestic economic activities.

At the same time, it is heavily affected by marine flows of plastic pollution. Ever since the waste import ban in China in 2018, Indonesia has been experiencing a rising waste intake over the next few years, receiving imported waste from Japan, Australia, and EU nations (Lotulung and Riliananda 2025). The World Bank (2021) estimates that Indonesia produces about 7.8 million tons of plastic each year, with 4.9 million being mismanaged. An estimate of 83% of annual plastic waste leaks into the marine environment, while the rest is disposed in coastal areas. The economic cost of plastic leakage is estimated to be IDR 225 trillion or USD 13.7 billion annually (World Economic Forum 2025).

Consequently, Indonesia is both a major consumer and a victim of global plastic pollution. It sits at the intersection of competing interests: maintaining plastic production and supporting stronger international action for minimizing plastic pollution. Due to this unique position, Indonesia signals both the credibility and incentive to balance these two differing interests.

I argue that Indonesia should advocate for a bottom-up approach to ensure participation of the Like-Minded group, while facilitating the demands of the African group. Immediate norm-setting initiative should be a priority, for it builds momentum for more ambitious plans.

Reflecting the success of the Vienna Convention, a bottom-up approach enables participation to broaden while ambition progresses upwards. The Vienna Convention evolved into the Montreal Protocol, before eventually achieving universal ratification. This illustrates the effectiveness of bottom-up entry if combined with a credible escalation pathway (Multilateral Fund 2025).

Although the bottom-up approach sacrifices further ambition, I believe that it is a necessary trade-off to ensure broader participation. Indonesia must then position itself as a force for this initiative. It is well-positioned to build consensus between two opposing blocs while laying the foundations for stronger initiatives in the long run.

Textbook Reference

Howes S, Agarwal V, and Woolf M (2026) Growth, inequality, and the environment: an introduction, Crawford School of Public Policy, ANU.

These programmes are typically directed towards poor and vulnerable families. For a household confronting rising food prices, an unexpected illness, or a sudden loss of income, that flexibility can mean buying rice, paying for transport, keeping a child in school, covering medicine, meeting rent, or settling an urgent debt.

Indonesia has repeatedly relied on this policy instrument. Bantuan Langsung Tunai (BLT) was introduced in 2005, followed by Bantuan Langsung Sementara Masyarakat (BLSM) in 2013–14. Both programmes were introduced alongside politically difficult fuel-subsidy reforms, helping cushion poorer households from the resulting increase in living costs.

Yet the very flexibility that makes cash transfers appealing also makes them politically contested. When governments hand over cash with few conditions attached, a persistent question follows: what does a cash transfer really buy?

Cash transfers have long carried a moral anxiety. If recipients receive income without working, will they withdraw from the labour market? If they are free to spend the money as they choose, will it disappear into cigarettes, alcohol, or other so-called temptation goods? Beneath these questions lies a broader unease: that welfare may relieve hardship in the short term while quietly weakening self-reliance in the long term.

The empirical record, however, is far less dramatic than the political rhetoric. A growing body of evidence finds little support for the claim that cash transfers systematically reduce labour supply. Reviews of transfer programmes similarly find no average increase in spending on temptation goods. This does not mean that poor households always make perfect choices. Rather, it suggests that poverty is rarely a problem of insufficient discipline. More often, it is a problem of insufficient buffers: too little cash, too little security, and too little room to absorb a shock without falling further behind.

Indonesia provides an especially useful case. In a 2023 study, Ridho Al Izzati, Daniel Suryadarma, and Asep Suryahadi examined the behavioural effects of BLT and BLSM using longitudinal household data with a difference-in-difference design. Their result was straightforward: the transfers did not significantly alter employment, working hours, smoking, arisan participation, risk preferences, or patience.

These findings are reassuring. They weaken the familiar claim that cash transfers erode work ethic or invite irresponsible spending. But they do not show that transfers leave household economic behaviour unchanged. They simply suggest that the most visible forms of behavioural distortion may not be where the important adjustment occurs.

Cash transfers need not change people’s preferences to change the choices available to them. For households with little savings, unstable income, and limited access to formal insurance, even a modest transfer can alter the way a family manages risk. The relevant margin may not be whether a person works less or spends more on temptation goods. It may be whether the household borrows, from whom, and under what terms.

Borrowing is inherently ambiguous. It can be a lifeline: financing food after an income shock, covering medical treatment, keeping a small business operating, or preventing a child from leaving school. But it can also become a liability, creating repayment obligations that outlast the shock that first made the loan necessary.

This is where standard evaluations of cash transfers often remain incomplete. A transfer may substitute for debt by covering an urgent expense that would otherwise require borrowing. Yet it may also facilitate borrowing. A small cash buffer can help a household meet an upfront cost, approach a lender with greater confidence, or pursue an opportunity that previously appeared too risky.

More borrowing, then, is not automatically evidence of policy failure. Nor is less borrowing automatically evidence of success. The more difficult questions are who borrows, from whom, for what purpose, and at what cost.

This was the question I explored in a replication and extension of Al Izzati, Suryadarma, and Suryahadi’s study of Indonesia’s Bantuan Langsung Sementara Masyarakat programme. I extended their analysis to external borrowing: loans obtained from sources other than family and friends.1

The result was counterintuitive. BLSM receipt actually increased the probability that a household attempted to borrow externally by 4.5 percentage points and obtained a loan by 5.0 percentage points. The pattern points less to an approval effect than to an entry effect. BLSM did not appear to make lenders more willing to approve applications; rather, it was associated with more households entering the external credit market in the first place.

The future of cash transfers should not be framed as a choice between blind optimism and moral panic. Unconditional transfers remain valuable when households need immediate relief and flexibility. Conditional transfers, therefore, may be appropriate when governments seek particular investments in education, health, or nutrition. But neither should be assessed only through consumption or labour-market outcomes.

A serious evaluation of social protection should also ask whether households borrow, what kind of credit they use, what that credit costs, and whether it helps them recover from a shock or merely postpones hardship.

Cash transfers may not change who people are. But they can change the financial constraints under which people make decisions. That, too, is a behavioural effect worth taking seriously.

The term “evidence-based policymaking” (EBPM) has acquired a quality that Paul Cairney (2017) describes as “valence”. It is so intuitively appealing that it becomes almost impossible to oppose. Who, after all, would argue for policies made in the absence of evidence? Yet precisely because the term feels altruistic, its implications are rarely examined with care. Once subjected to scrutiny, the concept proves considerably more fragile than it seems.

The analogy most commonly invoked is evidence-based medicine (EBM), a framework built on a relatively stable hierarchy of methodological rigour, with randomised control trials (RCTs) at the apex, followed by systematic reviews, cohort studies, and so on, in which the expectation is that practitioners align their decisions with the best available evidence (Oliver et al., 2014a; 2014b). The logic is coherent within its domain: a controlled clinical setting, a defined intervention, a measurable outcome. Policymaking shares none of these features. There is no agreed hierarchy of evidence, no controlled setting, and no single authoritative decision-maker. What policymaking has, instead, is politics.

Bounded Rationality and the Limits of the Rational Ideal

The theoretical starting point for any serious analysis of EBPM is Herbert Simon’s (1976) concept of bounded rationality. Policymakers operate under conditions of cognitive and informational constraint: time is limited and problems are complex. The amount of potentially relevant evidence far exceeds any individual’s or institution’s capacity to process it. In response, decision-makers rely on heuristics, cognitive shortcuts that simplify judgement. Some of these shortcuts are deliberate and goal-directed: deferring to trusted advisors, privileging familiar information sources, filtering evidence through established institutional frameworks. Others are less conscious, relying on gut instinct and personal bias (Cairney, 2017).

The critical implication of bounded rationality is that evidence never enters a neutral space. It enters a mind that is already engaged in sorting, filtering, and prioritising. As Cairney (2017) notes, most contemporary policy theories treat bounded rationality not as something to fix, but as the fundamental condition of governing. To speak of “evidence-based” policy is, in this view, to describe an ideal type that bears little resemblance to the actual mechanics of decision-making.

Comprehensive rationality, the ideal in which decision-makers survey all available options, weigh all consequences, and select the optimal course of action, has long been treated in the policy literature as a normative benchmark against which real-world behaviour falls short. The EBPM agenda can be read as the latest iteration of this ambition: a renewed effort to bring systematic knowledge to bear on public decisions. What the bounded rationality literature suggests, however, is that this ambition consistently founders not due to a lack of good evidence, but on the structural features of the environments in which policymaking takes place.

What Evidence Must do to Gain Traction

Bounded rationality does not disappear once evidence enters the policy process, it shapes the conditions under which evidence can gain traction at all. Cairney (2017) identifies a set of overlapping strategies that actors must employ to move evidence toward influence. Attention must first be secured. Baumgartner et al. (2018) shows that policy change more often follows shifts in how issues are framed than from the emergence of new evidence, meaning factual claims must be paired with emotional appeals to prompt movement in policymaker attention. Evidence must also be narrativised. Shanahan et al. (2018) demonstrates that simple, morally legible stories that assign clear causes and apportion blame consistently outcompete technically sophisticated arguments in the contest for political salience.

Beyond framing, evidence must contend with the belief structures of dominant coalitions (Weible et al., 2012). And even where framing and coalition alignment are achieved, timing remains a constraint largely independent of the evidence’s quality. Kingdon (1984) argues that policy windows open rarely and close quickly, such that evidence not positioned within the right network at the right moment is likely to be passed over regardless of its quality.

Evidence Is Inevitably Political

A tempting response to the foregoing analysis is to treat framing, networks, and timing as obstacles to be overcome. Barriers between science and policy that better institutional design might dissolve. This framing, however, misunderstands the nature of policymaking. These factors are core features of any system in which public decisions must be negotiated across the complex landscape of democracy. Even in governments with strong analytical traditions and high state capacity, evidence must compete with other legitimate considerations such as public preferences and coalition constraints. A policymaking process that simply implemented the findings of the best available research would potentially bypass other democratic processes. The goal then, is not to insulate policy from politics, but to ensure that evidence has a genuine and consequential role within the political process. That it survives the filters, rather than being eliminated by them.

Drawing primarily from North (1990) and Hart (1988), Pancasila shapes informal constraints in Indonesia through cultural influence, shared values, and institutional norms. Its existence within the constitution implicates the structure of rights and institutional incentives.

Yet, it displays operational ambiguity. Historically, political actors have attempted to reinterpret and instrumentalize Pancasila, resulting in various interpretations of its principles throughout Indonesian history.

Under Soekarno, it was operationalized as a unifying framework to build compromise among different political factions, while Soeharto’s regime attempted to centralize the interpretation of Pancasila. The Reformasi period created a more open interpretation of Pancasila within a diverse institutional environment. I ask: why has Pancasila produced inconsistent operationalization across different regimes despite being embedded as a normative framework?

Despite being designed to consolidate significant heterogeneity, it imposes formal and informal constraints that fulfill the criteria of a social contract. I contend that it matches the definition of an incomplete contract as defined by Hart (1988), which asserts the impossibility of anticipating all future contractual contingencies.

Within Hart’s framework, I question the concept of government as a subject with higher authority within the contract, thus potentially benefiting from interpretive authority. Furthermore, I further question the conceptualization of government as a third-party enforcer that upholds contracts, while simultaneously being a subject within the contract itself.

The long-run stability of such a framework ultimately depends on alternative enforcement mechanisms. Referencing North (1990), exploration of the concept of self-reinforcing mechanisms and the degree to which they could be implemented for contractual arrangements within the Indonesian context is becoming increasingly timely.

References

North DC (1990) Institutions, Institutional Change and Economic Performance (p. 33). Cambridge: Cambridge University Press.

Hart O (1988) ‘Incomplete Contracts and the Theory of the Firm’, The Journal of Law, Economics, and Organization, 4(1), 119-139.

For more than two decades, Indonesia has operated under what is, in effect, a fiscal constitution: a deficit ceiling of 3% of GDP, codified in Law No. 17/2003. I didn’t live through the 1998 crisis that gave birth to this rule. But the data and institutional memory it left behind make its purpose clear. The Rupiah collapsed, private and state-owned banks failed and were forced into painful consolidation. The 3% rule was not designed as a technical guideline, it was a commitment, a signal to both domestic and global markets that Indonesia would not return to that kind of instability.

Source: Ministry of Finance via Trading Economics

In that sense, it functions less like a constraint and more like a pact. That pact has only been broken twice, in 2020 and 2021, under the extraordinary conditions of the pandemic, when fiscal rules around the world were temporarily suspended to prevent economic collapse. But what we are seeing now is different. The current discussion reflects pressures that appear more structural than cyclical. The government faces a growing set of spending commitments from large-scale social programs to infrastructure ambitions while also dealing with rising energy subsidy burdens driven by the conflict in the Middle East.

Within this context, the 3% ceiling is increasingly seen as a limitation rather than a safeguard. The argument for relaxing it is straightforward, and politically compelling. If additional spending can finance “productive” programs such as human capital development, housing, and institutional expansion, why should a rule drafted more than two decades ago stand in the way? At a glance, the constraint can feel arbitrary, even self-imposed.

But in emerging markets, numbers like this are rarely just numbers. They are reputational anchors. For investors, both domestic and foreign, the 3% threshold has long served as a simple, credible signal of fiscal discipline. It is part of the reason Indonesia has maintained investment-grade status and navigated episodes like the 2008 GFC and the 2013 Taper Tantrum without losing macroeconomic stability. This is where the tension becomes real. On one side, there is the promise of higher growth through expanded state spending. On the other, there is the risk of weakening the very anchor that has underpinned Indonesia’s credibility for over 20 years.

The question is not just whether we can afford to spend more. It is whether we can afford the cost of being perceived as less disciplined. Reading through the current discourse, I was reminded of Aizenman and Hausmann (1994), which offers a useful way to think about this. The key insight is simple but often overlooked: markets do not respond to fiscal changes linearly. A shift from a 3.0% to say, a 3.2% deficit may look trivial in arithmetic terms, just 0.2 percentage points. But in practice, such a move can trigger a disproportionately large reaction in sovereign risk. The reason lies in the convex nature of fiscal costs. As a country moves closer to, or appears to cross, a credibility threshold, the market response can accelerate sharply. What looks like a marginal deviation on paper can, in reality, be interpreted as a regime shift.

The Nonlinearity of Risk.

Fiscal dynamics in emerging markets are not linear. Standard models often assume a smooth relationship between debt and borrowing costs. In practice, that relationship bends. The cost of borrowing, captured by the sovereign risk premium, behaves convexly. As deficits rise toward a perceived threshold, the marginal cost of financing them does not increase gradually. It accelerates. Formally, if we think of borrowing costs as a function of the deficit C(d) then C”(d) > 0. The intuition is straightforward. Markets tolerate fiscal expansion up to a point. Beyond that point, tolerance turns into repricing.

As long as Indonesia stays within the 3% ceiling, it operates on the flat part of this curve. Small changes in the deficit have relatively small effects on borrowing costs. But once that anchor is questioned, even a modest increase can push the country toward the steep part of the curve, where perceptions of sustainability shift quickly. What appears incremental in fiscal terms can become discontinuous in market terms.

Asymmetric Risk and the Possibility of a Sudden Stop

This convexity creates an asymmetric payoff. On the upside, a marginal increase in the deficit may generate a modest boost to growth through the fiscal multiplier. The gains are real, but typically linear and gradual. On the downside, the same increase can be interpreted as a weakening of institutional discipline. If that happens, the adjustment is not gradual. Yields rise, the currency comes under pressure, and capital flows reverse. What follows is not a slowdown, but a repricing. This is the core insight in the Aizenman-Hausmann framework.

Fiscal rules in emerging markets act as hard signals that reduce information asymmetry. They allow investors to distinguish between deliberate policy and fiscal drift. Once that signal is weakened, the distinction becomes blurred. Investors respond defensively, pricing in the risk that discipline is no longer binding. The result can be a precautionary pullback in capital, often described as a sudden stop, where financing conditions tighten enough to offset the original stimulus.

When More Borrowing Reduces Fiscal Space

This dynamic leads to a counterintuitive result. Expanding the deficit does not always expand fiscal space. Abstracting from other complexities, government spending can be written as:

where G is spending, T is revenue (tax, non-tax, etc), and d is fiscal deficit. However, this identity hides an important channel, borrowing is not costless. The interest rate at which the government finances its deficit depends on how markets perceive fiscal risk. To capture this, let the interest rate be a function of the deficit, r(d), and let’s say that B denotes the existing stock debt. The marginal effect of increasing the deficit can therefore be written as:

The first term reflects the direct benefit of additional borrowing. The second term captures the increase in interest payments due to higher perceived risk. When the sensitivity of interest rates to deficits is low, additional borrowing increases fiscal capacity. But once credibility is in question and (dr/dd) rises, the opposite can happen. Each additional unit of debt raises borrowing costs on the existing stock. At that point, new borrowing is no longer financing spending. It is financing higher interest payments. That is the essence of a fiscal trap.

Conclusion: The Constraint That Protects

The temptation to breach the 3% deficit limit is understandable. In a developing economy with real infrastructure gaps and social needs, a rigid fiscal rule can feel outdated, even restrictive. But the cost of relaxing it is not just an additional 0.2% of GDP. It is a shift in how Indonesia is perceived.

Once the 3% cap is treated as a flexible guideline rather than a binding commitment, the signal it provides begins to weaken. And when that signal weakens, markets do not adjust gradually. They reprice risk. Higher yields, currency pressure, and tighter financing conditions can quickly offset any short-term gains from additional spending. What begins as an attempt to expand fiscal space can end up compressing it.

The Alternative: Expanding Capacity Without Expanding Risk

The case for productive spending is valid, but it does not require abandoning the anchor. It requires strengthening what sits behind it. This is something I keep coming back to after 2.5 years of working in fiscal policy, even if it sounds very repetitive. It has been said many times before, but that does not make it any less true. If anything, it reinforces the point: a more credibility-preserving approach is to remain within the existing framework:

1. Revenue Mobilization: Indonesia’s tax-to-GDP ratio remains structurally low. Expanding fiscal capacity through better compliance, administrative reform, and digitalization is slower than borrowing, but it does not carry the same credibility cost.

2. Allocative Efficiency: The binding constraint is not only how much is spent, but how effectively it is deployed. Reallocating broad, untargeted subsidies toward investments with higher multipliers, particularly in human capital and infrastructure, can deliver growth without destabilizing expectations.

Final Word

The 3% rule is not an arbitrary ceiling. It is a commitment that has anchored Indonesia’s fiscal credibility for over two decades. Relaxing it may create room in the short term. But it also changes the terms on which that room is financed. The real challenge is not how to move beyond the constraint, but how to operate more effectively within it.

References
Aizenman, J. and Hausmann, R. (2000) ‘The impact of inflation on budgetary discipline’, Journal of Development Economics, 63(2), pp. 425–449. doi:10.1016/s0304-3878(00)00111-5.

However, a growing body of empirical research has increasingly been challenging the positive linear assumption between poverty alleviation and digital financial inclusion. Several empirical studies have proven that there is a non-linear U-shaped relationship between poverty alleviation or factors that indirectly impact poverty alleviation, and digital financial inclusion initiatives (Lee et al. 2023). Studies also have shown that digital financial inclusion can directly, indirectly, or spatially influence the economic development of a region (Lee et al. 2023).

In Indonesia, numerous studies have explored the link between digital financial inclusion and poverty, although the conclusions are not always consistent. Amaliah et al. (2024) demonstrated that digital access, via ATMs and debit cards, has a notable positive influence on economic growth and poverty reduction. Khoirunurrofik and Fitriatinnisa (2021) identified a non-linear, U-shaped pattern between financial inclusion and poverty/inequality, suggesting that while inclusion initially reduces poverty, there may be negative effects at early stages of adoption due to digital exclusion. As usage increases beyond a certain point, the benefits re-emerge. Ariansyah et al. (2023) observed a reverse U-shaped association between broadband access and income inequality, initial coverage expansion increased inequality up to 60% penetration, then helped reduce it afterward.

These evidence shows that digital financial inclusion has a clear effect on the poverty. However, such non-linearity underscore the conditionality of digital financial inclusion on poverty alleviation. This essay underlines the importance of institutional factors in promoting the effectiveness of digital financial inclusion initiatives on poverty alleviation.

Studies have highlighted the impact of institutional challenges on such non-linear relationship. Ozili (2020) found that fintech providers, prioritizing profitability, often offer services misaligned with poor households’ needs, introducing costly micro-loans with high interest rates that mirror traditional microfinance pitfalls. These issues highlight institutional failures (inadequate regulation and consumer protection), and behavioral factors (low trust and limited literacy) that can worsen poverty if not addressed. Effective digital financial inclusion requires complementary institutional and behavioral interventions to prevent adverse outcomes (Lee et al. 2023).

A growing body of literature argues that institutions determine whether digital financial inclusion translates into meaningful economic gains. Governance quality, regulatory capacity, consumer protection, and educational systems influence how individuals interact with digital financial services. Studies by Aracil et al. (2021), Guo & Zhong (2023), and Chinoda & Kapingura (2024) consistently find that stronger institutions amplify the positive effects of digital financial inclusion, while weaker institutions can undermine or even reverse them.

Other researchers have turned their attention to the role of educational institutions in promoting entrepreneurial skills and financial literacy as tools for poverty reduction. Morgan & Trinh (2019) and Cupák et al. (2021) found that education, particularly at the secondary level, is a key factor in developing financial capabilities. They also highlight the critical mediating function of educational institutions in enhancing the impact of digital financial inclusion on poverty alleviation.

These findings suggest that the success of advancing digital financial inclusion is contingent on institutional factors. Institutions play an important role due to their influence on the acceptability, implementation, and monitoring of digital financial inclusion initiatives.

Within Indonesia, such evidence highlights the importance of strengthening the underlying institutional foundations capable of implementing policy initiatives effectively. Without sufficient institutional support, digital financial inclusion initiatives can backfire, limiting both the accessibility and effective use of digital financial technologies, while potentially increasing existing inequalities.

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Kelikume, I. (2021) ‘Digital financial inclusion, informal economy and poverty reduction in Africa’, Journal of Enterprising Communities: People and Places in the Global Economy, 15(4), pp. 626–640. Available at: https://doi.org/10.1108/JEC-06-2020-0124.

Khoirunurrofik and Fitriatinnisa, D. (2021) ‘Financial inclusion, poverty, inequality: Empirical evidence from provinces in Indonesia’, Economics Development Analysis Journal, 10(2), pp. 159–174.

Lee, C.C., Lou, R. and Wang, F. (2023) ‘Digital financial inclusion and poverty alleviation: Evidence from the sustainable development of China’, Economic Analysis and Policy, 77, pp. 418–434. Available at: https://doi.org/10.1016/j.eap.2022.12.004.

Morgan, P.J. and Trinh, L.Q. (2019) ‘Determinants and impacts of financial literacy in Cambodia and Vietnam’, Journal of Risk and Financial Management, 12(1), p. 19. Available at: https://doi.org/10.3390/jrfm12010019.

Ozili, P.K. (2020) ‘Contesting digital finance for the poor’, MPRA Paper No. 101812. Munich: University Library of Munich.

The initiative highlights an ambition for institutional reform of the Indonesian labour market and is coherent within the theoretical frameworks of institutional economics. Coase underlines the implications of higher transaction costs related to information distribution, negotiation processes, contracting, and inspection as major reasons for transaction failure (Coase 1960:15). He argues that eliminating transaction costs is impossible and emphasizes government regulation as a mechanism to reduce transaction costs through its administrative power (Coase 1960:17). Hence, the reform presents itself as an effort to increase market efficiency by reducing regulatory frictions through a government initiative.

The initiative forces an adjustment to the structure of exchange that affects the cost of the transaction. Within a broader institutional framework, it signals the government’s intent to centralize the coordination and production for Indonesian firms. It is theoretically based on the idea about the motivations of firms, the regulatory and business environment, and ability of firms to act as economic agents (North 1990:34). The simplification of the regulatory framework reflects the confidence of the government towards these aspects, and in itself as an institutional body that provides a stable level of contracts for economic exchange.

However, transaction costs are only one of the many significant barriers to formalization. La Porta and Shleifer (2014) underscore several distinct factors that prevent effective formalization. They identify that better access to finance, land, and raw materials is the primary perceived motivation for formalization, compared to better opportunities with formal firms and fewer bribes. They also find that informality is persistent, anchored by the evidence that 91% of formal firms started out as registered (La Porta & Shleifer 2014:117).

Consequently, incentivizing formalization goes beyond simplifying transaction costs. De Mel et al. (2012:18) find that a higher level of formalization strengthens trust in the state, but recognize the importance of incentivizing firms to formalize beyond the simplification of regulatory procedures. They find that most firms in the informal sector are reluctant to formalize without additional incentives in the form of payments, due to concerns about labour taxes and land ownership (De Mel et al. 2012:7). Such evidence underscores the conditional nature of the impact of transaction costs on effective formalization.

For the Indonesian context, barriers to formalization are often more strongly associated with the firm’s side as opposed to regulatory constraints. Rothenberg et al. (2016) underline that tax avoidance and lack of intent to borrow from formal financial sources are the primary reasons for persistent informality amongst firms. Furthermore, they found that an Indonesian policy to reduce registration costs, namely the one-stop shops program, had an insignificant effect on informality rates, highlighting the low impact of regulatory simplification on formalization (Rothenberg et al. 2016:107).

Taken together, these studies show that the success of reducing transaction costs in promoting formalization is highly conditional on firms’ adaptability and motivation. Although regulatory frameworks aimed at simplifying administrative procedures may promote formalization and incentivize entrepreneurial activity, demand-side stimulus for informal firms are necessary to ensure productive outcomes. In the Indonesian context, these demand-side factors appear to be the most significant barriers to formalization.

The 2020 Job Creation Law focuses on providing a simplified regulatory framework for economic exchange to attract investment, create jobs, and stimulate growth. The initiative amends over 75 existing laws operated through several mechanisms, including licensing simplification, investment liberalization, and centralization of regulatory authority (UNCTAD 2020). The law simplifies the process of acquiring a risk standardization certificate, environmental assessment, permits, and licensing for firms. Notably, the government recentralized its authority to direct foreign investment policy for several sectors, including mining, power, forestry, public housing, and healthcare (UNCTAD 2020).

Although the law is in accordance with theoretical frameworks advocating for the minimization of transaction costs to enhance entrepreneurial activities, it becomes an example of misdiagnosis by failing to identify the necessary incentives to promote entrepreneurial activities. Its rushed lawmaking process also undermines the institutional credibility necessary for the enforcement of the newly formed policy.

The regulatory process is marked with flaws that undermine its credibility. The legislative process was unusually quick. The law was officially launched in October 2019 by President Joko Widodo, before being submitted to the parliament in February 2020. It was then passed by the parliament in October 2020. The quick process was formally attributed to minimize the circulation of COVID-19 among legislators, but critics viewed it as an effort to prevent mass labour mobilization against the law (Mahy 2022:61-62). The controversial extends to the enactment process, with the government requiring immediate enactment within three months after the law was passed.

In addition to the procedural imperfections, the law reveals the institutional constraints that limit the effectiveness of transaction cost reduction for productive formalization. Noticeably, the regulatory reform had downgraded key labour provisions from law to government regulation (Mahy 2022:64). Such adjustment significantly extends the power of the government by removing some laws from the oversight of constitutional court. North (1990:59) illustrates this dilemma by underlining the self-interest of the third-party enforcement at the expense of society, undermining the institutional credibility that firms requires to interact with the new economic arrangements.

Figure 1 Trend of business density rate (World Bank 2024)

Empirically, the initiative reveals the gap between the law’s objectives and its outcomes. The registration numbers for firms’ formalization were significantly impacted, displaying a sharp rise in the business density rate from 0.38 to 0.98 (World Bank 2024). At the same time, according to BPS data reported by Kompas, informal employment increased from 74.08 million people (57.27%) in February 2019 to 78.14 million (59.62%) in February 2021, and continues to rise up to 86.58 million (59.40%) by February 2025 (Mediana 2025). This pattern illustrates that reducing transaction costs would not be effective without maintaining institutional credibility and creating incentives for firms to formalize.

Collectively, the 2020 Job Creation Law displays the limitations of understanding transaction costs as the primary constraints towards entrepreneurial activities. While it aligns with institutional economic frameworks that emphazise reducing transaction costs, it fails to address demand-side constraints that incentivize firms to formalize and expand. The phenomenon of persistent informal employment after the regulation was imposed suggests that lowering transaction costs alone is insufficient incentive for formalization, and perhaps risks deprioritizing factors such as access to capital and tax concerns for firms.

The government identified administrative inefficiency and regulatory concerns as barriers to entrepreneurial activities. While correct, it overemphasized the significance of transaction costs while underestimating the importance of alternative incentives. Consequently, many firms remain within the informal sector despite facing lower registration costs.

The rushed legislative process also undermined the institutional credibility necessary to sustain the regulatory framework itself. Although the reform attempted to create more efficient coordination, the procedural faults weakened the trust for government and implicate the stability necessary for the new arrangements. Hence, the initiative became paradoxical: while enacted to reduce transaction costs, it weakened the institutional foundations for effective transaction-cost reduction.

The institutional constraints and demand-side considerations shape a coherent perspective regarding the limitation of transaction costs towards entrepreneurial activity. The regulatory framework in relation to transaction costs should be based on the institutional environment and firms’ regional characteristics. Reducing procedural barriers means little when firms see no advantage in formalizing, and Indonesia shows that in absent of such sensitivity, transaction cost reduction becomes a wasteful exercise with limited effect.

The 2020 Job Creation Law, therefore, shows that transaction costs should be understood as one of many obstacles to growth. Policies should move beyond administrative simplification and incorporate aspects such as institutional trust, productive incentives, access to finance, and long-term demand-side development. Without such consideration, deregulation risks increasing the quantity of formalized firms without substantially improving the quality of economic activity or sustaining a long-run economic transformation.

References

Coase RH (1960) ‘The problem of social cost’, The Journal of Law and Economics, 3:1–44, doi:10.1086/466560.

Mahy P (2022) ‘Indonesia’s omnibus law on job creation: legal hierarchy and responses to judicial review in the labour cluster of amendments’, Asian Journal of Comparative Law, 17(1):51–75, doi:10.1017/asjcl.2022.7.

Mediana C (2025, 4 September) ‘The number of informal workers explodes’, Kompas, accessed 11 May 2026.

De Mel S, McKenzie D and Woodruff C (2012) The demand for, and consequences of, formalization among informal firms in Sri Lanka, Cambridge, MA, doi:10.3386/w18019.

North DC (1990) Institutions, institutional change and economic performance, Cambridge University Press, doi:10.1017/CBO9780511808678.

La Porta R and Shleifer A (2014) ‘Informality and development’, Journal of Economic Perspectives, 28(3):109–126, doi:10.1257/jep.28.3.109.

World Bank (2024, June) ‘Unleashing Indonesia’s business potential’, Indonesia Economic Prospects, accessed 11 May 2026.

UN Trade and Development (2020, 4 November) ‘Omnibus Law’ on job creation has been enacted’, Investment Policy Monitor, accessed 11 May 2026.

John Rawls asserts that every individual possesses an inviolable right anchored in the principles of justice, irrespective of societal welfare (Rawls 1999:3). Using the difference principle, he argues that a society should strive to maximize the position of the least advantaged, provided that equal basic liberties are secured (Rawls 1999:72).

Rawls introduces the difference principle as an egalitarian concept to challenge the principle of efficiency. He argues that an equilibrium could be reached without acknowledging the standpoint of justice. In a society divided into numerous classes, the inability to maximize an individual’s position without lowering others’ reveals the limitation of the principle of efficiency as a standard of justice (Rawls 1999:61-62). According to Rawls, this is insufficient, for justice exists before efficiency (Rawls 1999:69).

Despite allowing for inequality, the difference principle is grounded in mutual benefit for all members of society. Inequality is strictly justified if it improves the position of the least advantaged, as the most fortunate understand that the well-being of every individual depends on social cooperation (Rawls 1999:88). Thus, the difference principle provides a more stable basic structure of society.

Utilitarianism also advocates for reducing inequality, but on a weaker ground. Its strict focus on the greatest average happiness could justify violations of individual rights. Rawls illustrates that a slaveholder might be justified in his actions if he produces a greater overall happiness for society (Rawls 1999:145). Consequently, he concludes that utilitarianism is unfit to provide a stable structure for society compared to Rawlsian principles.

Furthermore, utilitarianism lacks a practical basis to measure individual welfare. Rawls argues that constructing an aggregate measure of utility is unreliable due to the different preferences, characteristics, abilities, and social positions of individuals (Rawls 1999:150). Thus, without an accurate valuation of utility, he maintains that the argument for the average principle of utility itself cannot hold (Rawls 1999:151).

On the opposing side, libertarianism asserts that individual liberty, often illustrated by the protection of property rights, should be prioritized over equality. Libertarianism contends that, provided a just acquisition and transfer of property, people should be entitled to their possession despite unequal outcomes (Howes et al. 2026:133). This idea is known as the “entitlement theory” (Nozick 1974:150).

Nozick provides an example of the former basketball player, Wilt Chamberlain. He argues that if he charges a fee of twenty-five cents a ticket to a million spectators, he is fully entitled to all of his $250,000 earnings (Howes et al. 2026:134). He claims that any idea of redistribution would be viewed as an injustice because the process of property transfer does not violate any principles of justice in acquisition and transfer (Nozick 1974:161). Transferring even some of the income after voluntary participation would suggest forced labour. Hence, any equality-preferring act would strongly be considered a coercive means towards Chamberlain.

Nozick strengthened the logical mechanism of libertarianism by reasserting the Kantian principle that “individuals are ends not means”. Any intervention that results in involuntary participation is not aligned with the principle, thus, an initiative such as redistribution is categorized as illegitimate (Howes et al. 2026:134). Other arguments include the property right to our own bodies. Even though most individuals can survive with one kidney, a kidney transplant demands a mutual agreement (Howes et al. 2026:134). Such a case shows the consistency of libertarianism with the protection of individual liberty within a just institutional mechanism.

By emphasizing the protection of mechanisms regardless of outcomes, libertarianism not only promotes efficiency under fair arrangements but also advocates self-sufficiency. Despite not objecting to unequal consequences, it places an extremely high valuation on individual rights and autonomy.

However, I argue that Rawlsianism triumphs over libertarianism by acknowledging different individual circumstances. Libertarianism overlooks this by relying on the premise that the only necessary intervention to enhance individualism is to ensure a just procedure. The logic of libertarianism reinforces that some are more entitled to liberty than others. For a framework that advocates for individual freedom, the inability to acknowledge differing individual circumstances implies that individual liberty is not universal despite being an absolute goal.

Furthermore, perfectly fair procedural justice is rarely achievable. Rawls illustrates this by giving examples of a criminal trial, arguing that it is impossible to design a legal system that always produces correct results (Rawls 1999:75). Such imperfection challenges the idea that fairness should be understood as compliance with a perfect procedure, asserting that fairness as a whole cannot be separated from the procedural consequences.

Rawls acknowledged that without an effort to preserve equality, distribution of assets is predetermined by natural constraints (Rawls 1999:62). By setting a baseline for individuals within a basic structure that aims to maximize the position of the least advantaged, Rawls has not only identified the inherent self-respect necessary for the basic structure of society, but advocated the infrastructure of individual liberty. Taking Nozick’s analogy on Chamberlain, the difference principle acknowledges that the innate disadvantages of some audience members are beyond their control. A case for equality-preferring intervention, and not particularly as a transfer of cash, thrives as a compensation for such differing positions.

Ultimately, Rawlsianism approaches justice as a process and consequences, while libertarianism relies on the fairness of procedure to define justice as a whole. Separation of fairness in procedure from its consequences allows justice to be partially understood. And a partial definition of justice is a kind of justice partially delivered.

References

Howes S, Agarwal V and Woolf M (2026) Growth, inequality, and the environment: an introduction, Crawford School of Public Policy, ANU.

Nozick R (1974) Anarchy, state, and utopia, Basic Books, New York.

Rawls J (1999) A theory of justice: revised edition, 2nd edn, Belknap Press, Cambridge.

The middle class is the engine of growth. In Indonesia, the middle class contributes to 40% of national consumption, despite comprising less than 20% of the total population (CMCE, 2025). Their stable income levels support long-term investments in human capital, such as education and healthcare, while their spending stimulates private sector growth across diverse industries. A strong middle class is essential for political stability, fiscal strength, and accountable governance (OECD, 2019). Middle-class households not only drive consumption but also contribute to tax revenues, civic engagement, and institutional accountability. They tend to invest more in education and entrepreneurship, while simultaneously demanding better governance and public services.

Yet this critical demographic is shrinking. Since 2018, Indonesia’s middle class has contracted in every consecutive year (Figure 1). Over that period, the share of the population classified as middle class has fallen from 22.53% to 17.18% (BPS, 2024), a troubling reversal that has quietly undermined the foundations of Indonesia’s long-term development prospects. Central to this decline is a single, persistent problem: the disappearance of quality middle-class jobs. Jobs with decent pay and proper social security to provide a middle-class living, and thus drive a nation’s consumption (Wihardja & Cunningham, 2021). Without them, economic activity cannot sustain itself. Understanding why these jobs are disappearing requires a look back at what once created them.

Figure 1. Indonesia’s Shrinking Middle Class

Source: Susenas, 2004 - 2024

It Wasn’t Always Like This: The Manufacturing Era

Manufacturing was once the great equalizer of the middle class. It generated middle-skilled jobs, roles that did not necessarily require high levels of formal education, yet paid wages sufficient to sustain a middle-class lifestyle. Families employed in manufacturing could afford their daily needs, save modestly, and participate in larger consumer markets: buying motorcycles, appliances, and perhaps even automobiles. This consumption, in turn, stimulated broader economic activity. The story was visible most clearly in post-World War II America, where rising demand for automobiles and strengthened labor regulations ushered in a generation of factory workers who formed the backbone of the American middle class (Piketty, 2012).

The same dynamic took hold in Indonesia. Manufacturing supported the nation’s middle class throughout the 1980s and 1990s, providing a pathway out of agricultural poverty for millions. But the 1997 Asian Financial Crisis (AFC) changed everything (Wihardja & Cunningham, 2021). Manufacturing never recovered to its pre-AFC levels. Instead, Indonesia turned toward commodities, palm oil, coal, and natural resources, as its primary engine of growth. This pivot offered short-term prosperity but a structural trap in the long run.

The commodity sector, unlike manufacturing, is not labor-intensive. It cannot provide the mass quality employment that factories once did. As Indonesia’s workforce continued to transition away from traditional agriculture, manufacturing jobs were no longer waiting to absorb them. The result was an exodus of workers into the only sector that would take them: low-productivity services.

The Service Trap: Not All Jobs Are Created Equal

Since the manufacturing and commodity sectors could not absorb the full breadth of Indonesia’s growing labor force, the service sector stepped in, but not in the way that policymakers had hoped. The jobs created were concentrated in wholesale and retail trade, accommodation, and food and beverages. As Figure 2 shows, most of these workers are informal: food vendors, street sellers, and ride-hailing drivers. While these jobs provide income, they are low-productivity, low-wage, and largely excluded from formal social security systems. They do not generate the kind of spending power that sustains a middle-class household.

Figure 2. Low-Productivity Services in Indonesia

Source: Wihardja & Cunningham (2021)

The critical insight here is that services are not a homogenous category. They are deeply polarized. At one end of the spectrum are high-skill services such as information technology, finance, law, and professional consulting. These are tradeable services: they can be exported, attract foreign income, and generate significant productivity gains. At the other end are low-skill, demand-constrained services, which can only grow if domestic incomes rise and households spend locally (Nayyar & Davies, 2023). The problem is not that Indonesia has too many service workers, it is that most of them are concentrated in the wrong part of the spectrum.

High-skill services, while lucrative, relatively employ less workers. They require significant educational credentials and technical expertise that much of Indonesia’s labor force does not yet possess. This creates a polarized labor market: a small premium tier of well-paid knowledge workers, and a vast, informal base of low-wage service workers with little prospect for upward mobility. The middle — the stable, modestly skilled manufacturing jobs that once formed the bridge between poverty and middle-class life — has hollowed out.

Technology has compounded this challenge. As manufacturing evolved globally, it became increasingly automated. Manufacturers grew adept at minimizing labor costs through robotics and process optimization, reducing the number of workers needed per unit of output. This means that even if Indonesia were to successfully reindustrialize, the manufacturing sector of today is unlikely to absorb labor at the scale it did in the 1980s. The old playbook is no longer fully available.

Premature Deindustrialization and the Problem with a Service-Led Growth

Indonesia’s experience reflects a broader global phenomenon known as premature deindustrialization, the tendency of developing economies to shift away from manufacturing before they have fully reaped its productivity and employment benefits. Historically, countries industrialized, built a middle class through manufacturing employment, and then gradually transitioned to services as incomes and education levels rose. Indonesia, like many developing nations, appears to have skipped or truncated this middle phase.

As the economy has matured, Indonesia has continued to create more jobs in low-productivity services rather than in the high-productivity sectors that drive wage growth (Wihardja & Cunningham, 2021). This is the service-led growth paradox: the service sector expands, employment statistics improve, yet middle-class formation stagnates because the jobs being created do not pay enough to propel workers into stable, consumption-driven lifestyles.

This is not merely an economic failure, but also a social one. The shrinking middle class weakens institutional accountability, reduces civic participation, and narrows the tax base that funds public services. It is a self-reinforcing cycle: fewer middle-class jobs lead to lower consumption, which suppresses demand for the kinds of services and goods that would otherwise create more middle-class jobs.

Solutions to Creating Middle-class Jobs

Reversing this trajectory requires action on three interlocking fronts (Wihardja & Cunningham, 2021). The first is accelerating productivity growth across the board. Indonesian firms in nearly every sector operate at low productivity levels, and the most effective lever for change is competition-enhancing policy — lowering trade costs, improving the business environment, and attracting foreign direct investment tied to global value chains. Alongside this, small, medium, and household enterprises, which employ the majority of Indonesians, need targeted support to grow their productivity and become better creators of middle-class jobs.

Figure 3. Three Long-Term Strategies to Create Middle Class Jobs

Source: Wihardja & Cunningham (2021)

The second pathway is transitioning workers toward jobs-friendly sectors and firms. Productivity gains alone will not automatically redirect labor toward where middle-class jobs are most likely to emerge. Indonesia needs deliberate investment promotion in modern manufacturing, ICT, health, and export-oriented services, paired with the infrastructure and regulatory environment to make those sectors attractive. Equally critical is closing the information gap: platforms like Karirhub, which consolidate job vacancies and training opportunities, help workers navigate toward better options, but these must be paired with transitional support such as unemployment insurance so that changing jobs is financially viable, not just aspirationally desirable.

The third pathway, and perhaps the most foundational, is building a workforce capable of filling higher-quality jobs. Today, 57 percent of Indonesia’s labor force has a lower-secondary education or less, and the country ranks last among comparable middle-income economies on standardized adult skill assessments (Wihardja & Cunningham, 2021). Preparing the next generation requires an education system with far greater emphasis on cognitive, interpersonal, and digital skills. But the more pressing challenge is the existing adult workforce, which will not return to school. This is where innovations in reskilling matter most: programs like Kartu Prakerja, which funds upskilling through online platforms, point in the right direction, though their scale must expand significantly. These three pathways are not sequential; they must be pursued together, because progress on any one of them depends on advances in the others.

Conclusion: A Coordinated Challenge

Indonesia’s middle-class decline is not the result of a single policy failure, it is the cumulative outcome of structural decisions made over decades: the shift away from manufacturing after the Asian Financial Crisis, the commodity dependence that followed, and the passive absorption of surplus labor into low-productivity services. Reversing it will require an equally structural response.

The three pathways identified are not quick fixes. They are the blueprint of a long-term agenda. What is clear is that the goal cannot simply be to create more jobs. Indonesia already creates millions of jobs each year. The problem is that most of them do not pay enough to sustain a middle-class life. The only path forward is to shift the quality, not just the quantity, of employment. Moving workers up the productivity ladder through deliberate, coordinated policy. Whether Indonesia can do so quickly enough, before its demographic window narrows further, is the defining economic question of the coming decade.

TFP is usually introduced as the residual “A” in the production function: output left unexplained by capital and labor. The conventional story is familiar. TFP rises when countries innovate, educate workers, improve infrastructure, strengthen institutions, and make markets more efficient. Figures 1–3 support this baseline. Figure 1 shows that countries with higher human capital tend to have higher measured TFP. Figure 2 shows a positive association between market efficiency and TFP, suggesting that productivity depends partly on whether resources can move toward better uses. Figure 3 adds the institutional layer: countries with stronger governance quality also tend to record higher TFP. These figures are correlations, not causal proof, but they point to a common idea in the productivity literature: TFP depends not only on what an economy has, but on whether its rules, markets, and institutions allow resources to be used well.

Indonesia’s own TFP path gives this debate a practical urgency. Figure 4 shows that Indonesia’s annual TFP growth has been volatile: large contractions during the Asian Financial Crisis and COVID-19, followed by recoveries, but not a smooth upward trend. In the FRED/Penn World Table series, Indonesia’s TFP index stood at 0.99552 in 2023, still below its 2019 level of 1.00802. This should not be read only as a pessimistic story. It suggests that Indonesia still has room to raise productivity if the right bottlenecks are addressed. The question is where future TFP gains might come from.

The missing link that is often overlooked is within the labor market. In Lagos’ (2006) model of TFP, productivity does not simply fall from the sky as an external technology shock. It emerges from labor-market frictions where jobs are created, destroyed, accepted, and rejected. Each worker-firm match has its own productivity. Some matches are productive enough to survive; others are not. The key mechanism is selection. The economy has a reservation productivity threshold: a cutoff that determines whether a match continues or disappears. If the cutoff is higher, fewer low-productivity matches survive, and average productivity among active jobs rises. If the cutoff is lower, more low-productivity matches remain, and measured TFP can be weaker.

This matters because it turns TFP from a purely technological concept into a labor-market outcome. Productivity depends not only on machines, skills, or infrastructure, but also on which jobs survive, which firms expand, and where workers end up. In this view, the labor market is not just a place where employment is counted. It is a sorting mechanism. It decides whether workers are matched with firms that can use their skills productively, or whether they remain in low-productivity work.

This mechanism is useful for thinking about Indonesia. In a dynamic economy, weak matches should eventually be replaced by better ones: workers leave less productive jobs, productive firms expand, and labor moves toward higher-value activities. But if workers are absorbed into informal, stagnant, or survival-based employment, that selection process may be weaker. The economy may still “employ” people, but not necessarily in jobs that raise average productivity. This is why informality may matter for TFP: not because informal workers are inherently unproductive, but because informality can limit the pathways through which workers move into firms that train, scale, and upgrade them.

Labor absorption therefore becomes central to the productivity debate. To see why, we need to look at Indonesia’s labor-market structure. Figure 5 shows that informality still dominates employment: BPS records informal workers at 59.11 percent of total employment in 2023. Figure 6 shows that this informality is unevenly distributed, especially high in agriculture and rural areas. This matters because informality is not merely a legal category. It often reflects smaller firms, weaker training, lower access to finance, limited worker protection, and fewer pathways into productivity-enhancing jobs. World Bank research similarly finds that informality in Indonesia remains elevated, concentrated in agriculture and low-skilled services, and associated with productivity, education, and wage gaps between formal and informal workers.

This changes the productivity story. Human capital does not automatically become TFP. A worker trained for modern manufacturing or digital services cannot raise productivity if the economy mostly absorbs labor into petty trade, low-productivity services, or survival self-employment. The issue is not simply that Indonesia needs “more skills.” It needs a labor market that converts skills into productive work. Recent World Bank data reinforces this concern: youth labor force participation remains low at 49.6 percent, youth unemployment is high at 17.3 percent, and real wages have stagnated especially in labor-abundant sectors such as construction and manufacturing.

A reasonable counterargument is that this overstates labor markets. Indonesia’s TFP problem may be more about weak innovation, infrastructure gaps, institutional quality, or limited firm capabilities. Better matching cannot substitute for technology adoption or investment. That objection is right, but incomplete. Technology does not diffuse by itself. Infrastructure does not allocate workers by itself. Education does not guarantee productive employment by itself. These inputs must pass through firms and labor markets. If productive firms cannot expand, if informal firms remain too small to train workers, if job information is weak, and if workers cannot move toward better opportunities, then productivity remains trapped.

This is why the policy implication should not be “formalize everything by decree.” The goal is to build pathways from informal and low-productivity work into better matches. That means improving labor-market information, linking vocational training to actual firm demand, helping small firms grow into formal employers, reducing barriers that prevent productive firms from expanding, and designing social protection that supports worker mobility rather than locking people into bad jobs.

Indonesia’s TFP debate already recognizes human capital, market efficiency, institutions, and allocative efficiency. The missing labor-market link is to ask where workers actually go. Productivity is not only created in schools, factories, or infrastructure projects. It is created when workers are matched with firms that can use their skills, train them, and scale their output.

Figures

Amartya Sen provides a framework that attempts to encompass prominent equality-preferring ideas. Sen (1979) advances the definition of equality by inserting capabilities and functioning theory, and argues that neither Utilitarianism nor Rawlsianism have yet sufficiently captured the potential discrimination endured by certain individuals. He attributes the impact of individual circumstances and needs on income distribution, defining its concept as basic capability equality (Sen 1979, p. 217).

Sen illustrates this by providing an example of the potential discrimination endured by disabled individuals. He argues that Utilitarianism and Rawlsianism would put them at a disadvantageous position, stating that they will begin life with a low initial level of total utility (Sen 1979, p. 217). He addresses the importance of a framework to capture “basic capabilities”, highlighting aspects such as the ability to move, nutritional needs, clothing, sheltering, and social participation as a baseline that needs to be acknowledged for every individual (Sen 1979, p. 218).

He views that Rawlsianism’s strict focus on primary goods will limit the understanding of equality by only emphasizing the obtainment of goods, rather than evaluating how these goods will affect the condition of human beings. He states that the concept of basic capability equality would extend the idea of Rawlsianism by shifting the focus from obtaining goods to understanding what these goods will do to the individuals (Sen 1979, p. 219). For Utilitarianism, he argues that such a perspective will only focus on how these goods affect the mental reaction of human beings rather than on individual capabilities. Thus, with Utilitarianism and Rawlsianism, allocating resources to such individuals is baseless due to the lack of a marginal utility argument (expensive), total utility argument (because he is contented), or primary goods deprivation (because he has goods others have) (Sen 1979, p. 218). With basic capabilities, however, the understanding would be more complete due to an agreement on a baseline on individual equality.

Sen extends his framework by integrating the concept of basic equality into the ends and means of development. He asserts that beyond the metric of growth, the primary objective and means of development should be oriented towards the enhancement of human freedom (Sen 1999, p. 53). He argues that the instrumental roles concerning economic facilities, political freedoms, social opportunities, transparency, and security should be arranged to enhance individual capabilities and promote individual self-sufficiency and autonomy (Sen 1999, p. 53). Consequently, Sen maintains the position that the state should act as a safeguard of such institutional arrangements, and believes that such an equitable structure requires a certain degree of equality between individuals.

Most notably, he identifies poverty as a hindrance towards achieving human freedom. He acknowledges poverty and inequality as a result of conditional variations and states, and that income and capability will also be strongly affected by factors over which a person has limited control over. Sen identifies aspects such as gender, social roles, innate disabilities, geographical factors, and endemic diseases as examples (Sen 1999, p. 88). He highlights that relative income deprivation can create an absolute capability deprivation (Sen 1999, p. 89). Thus, he believes that the paradigm of capability will increase our understanding of the causes of poverty, deprivation, and inequality (Sen 1999, p. 90).

Rather than identifying inequality as a final goal of institutional arrangements, he reframes its existence, along with other metrics such as growth, as a signal to be operationalized for the achievement of an absolute target: the enhancement of human freedom. He posits that economic inequality will inevitably impose a limitation towards it. Accordingly, not only does he provide a robust philosophical baseline that underlines the importance of tackling inequality, but he also accommodates other metrics, such as growth, as a factor of human freedom.

However, Sen himself admits that the capability and functioning theory is not fully defined. Particularly, he did not evaluate the problems regarding distribution and how it relates to capability theory (Robeyns and Byskov 2020). Thus, having to redefine what it means to be equal, the operationalization of his ideas is relatively limited.

Nevertheless, Sen’s idea lays the foundation to rethink of what it means to be equal. His approach not only addresses the limitations of Utilitarianism and Rawlsianism towards conceptualizing equality, but also anticipates the potential discrimination by equality-based approaches, a framework that acknowledges the intrinsic value of individual capabilities despite uneven extrinsic consequences.

Aigner, Greenspon, and Rodrik (2025) provided strong evidence for the case of such unevenness. They highlighted that between 2016 and 2021, the share of total publications in the top 10 economics journals has been dominated by Western countries. The USA accounted for more than half of the total share of publications, while advanced countries, including Western Europe, Canada, Japan, Australia, and New Zealand, cover most of the remainder. Developing countries, including nations in East Asia & Pacific, which have a noticeably larger global GDP share than the USA and those of advanced countries, contributed less than 5% share. This showcases that the global distribution of authorship in economic journals has been severely unequal.

They also found that the inequality is persistent. Since 1990, changes in the share of authorships have been only slight. The USA lost about 20% of its share, but most of the shares were then replaced by contributions from advanced countries. Other regions gained little significance in advancement, despite most of it experiencing significant growth in GDP contribution.

They found that a significant increase in the contribution of developing countries has been mainly attributed to lower-ranked journals. Again, the USA and the advanced countries remain dominant contributors to the top 100 economic journals. Thus, regardless of economic performance, hierarchy seems to persist in the field of economics.

This evidence underlines that some regions have greater influence in shaping the field than others. Representation is not just a matter of inclusion, but about power. If economics is a universal science, then power concentration is a structural problem. And with its universality contested, the question then is: “How universal is economics, and why?”

Maybe, the answer lies, in part, in how knowledge systems reproduce themselves. Hierarchies are often not purely meritocratic, they are also institutional. Prestige itself a byproduct of historical accumulation: trainings, networks, funds, and practices that reinforced visibility. The circumstances are not always intentional.

This matters because economics does not merely describe the world, it shapes it. When those assumptions are generated predominantly by scholars embedded in certain economies, they carry with them a particular reading of what economic problems look like and what solutions are available. The field’s knowledge is not neutral, it is positioned.

None of this is to say that economics has nothing universal to offer. Supply and demand, incentive structures, the logic of comparative advantage, these are not one-sided notions. But there is a difference between universal principles and universal assumptions.

The Aigner, Greenspon, and Rodrik findings should unsettle us not because some economists are wrong, but because an economics that is answerable to only one part of the world will eventually become answerable to no one. The problems of the twenty-first century will not be solved by inherited frameworks alone. They will require economists who carry different problems in their gut, different failures in their memory, different institutions in their baseline assumptions.

So: how universal is economics? In its ambitions, it aspires to be. In its current practice, it is not. The gap between the two is not merely an academic concern. Whose economy we study determines whose economy we understand. And whose economy we understand determines whose economy we build.

As food systems become more industrialized, cheap, calorie-dense, and low-nutrition foods have become widely available (Popkin & Ng, 2022). Processed snacks, sugary drinks, and foods high in fat and sodium are now easier and cheaper to produce than fresh, nutrient-rich alternatives like fruits, vegetables, and high-quality proteins. Calories are abundant. Nutrition isn’t.

This shift comes with serious consequences. Diet-related non-communicable diseases, such as cardiovascular disease, diabetes, and certain cancers, are now among the leading causes of death globally (GNR, 2021). These are not diseases of infection, but of lifestyle, shaped by a combination of behavior, environment, and long-term exposure to poor diets.

For low-income populations, these changes reshape everyday choices. Cheap, highly palatable foods rich in sugar, salt, and fat are now within easy reach. They are not only affordable, but also calorie-dense, which makes them especially attractive for individuals engaged in physically demanding work. When food needs to be both filling and inexpensive, these options become hard to resist.

This creates a difficult trade-off. The poor are no longer only at risk of not getting enough calories, but also of getting the wrong kind of calories. In many places, undernutrition and obesity now coexist within the same communities, even within the same households. This phenomenon is often referred to as the double burden of malnutrition. At one end, food insecurity and nutrient deficiencies remain serious concerns, reflected in persistent rates of stunting and wasting. On the other, rising obesity rates and diet-related diseases are becoming increasingly common among the same populations.

This pattern is not limited to developing countries. In many high-income economies, lower-income individuals are more likely to suffer from obesity and related health conditions than their wealthier counterparts (Salmasi & Celidoni, 2017). The question is why?

One way to understand this is through a simple constraint. When income is limited, people are often forced to choose between foods that are cheap and filling, and foods that are more nutritious but also more expensive (Martin, 2005). In many modern food environments, unhealthy foods tend to provide more calories per unit of cost than healthier options. At the same time, humans are naturally drawn to flavors associated with sugar, fat, and salt (Drewnowski & Specter, 2004). The result is a systematic bias in food choice. When budgets are tight, and preferences align with what is cheap and available, the outcome is not surprising. People consume more calories, but fewer nutrients.

There is also a longer-term dimension to this problem. Investing in healthy food is, in a sense, an investment in future health. But not everyone values the future in the same way. Individuals with higher expected income and more stable prospects have stronger incentives to maintain their health over time. For those facing economic uncertainty, the future may feel more distant or less certain, making immediate needs and gratification more pressing. In economic terms, differences in time preferences across the wealth gradient can shape dietary choices in unfortunate ways.

As Indonesia’s economy continues to grow, it is beginning to face this same dual challenge. Non-communicable diseases are already the leading cause of death in the country (Arifin et al., 2022), and obesity rates are rising across age groups (UNICEF, 2022). At the same time, evidence suggests that an obesogenic food environment, one that encourages excessive calorie consumption, is becoming more widespread.

Given these challenges, policies that focus on “feeding” the population risk missing the problem altogether. Indonesia’s Free Nutritious Meal Program (Makan Bergizi Gratis) offers one example of an intervention with this potential risk. A program that merely redistributes food without addressing the underlying food system risks further reinforcing the trajectory of rising obesity and non-communicable diseases.

The challenge, then, is not simply about feeding the poor, but about understanding the conditions under which they eat. As food becomes cheaper, more accessible, and more engineered for taste, the problem of nutrition becomes less about scarcity and more about incentives. Without addressing this shift, efforts to improve welfare risk solving the wrong problem, and as is often the case, the poorest will be the least equipped to deal with the consequences.

Since the seminal work of Sachs and Warner (1995), a large body of literature has argued that resource abundance often brings not prosperity, but a range of economic and political adversities. Resource-rich countries have been associated with slower growth, weaker competitiveness, lower human development, greater internal conflict, and more pervasive rent-seeking (see, for example, Sachs and Warner 1995; Auty 2001; Rosser 2006).1 What should have been a blessing has, in many cases, appeared closer to a curse.

Over time, these strong arguments have created a deeply pessimistic view towards resource-rich economies. But that pessimism has also sparked the literature to numerous debates. For instance, Brunnschweiler (2008) re-examined the claim and found a positive effect of natural resource abundance on economic growth. Brunnschweiler and Bulte (2009) pushed the debate further by showing that conflict may be a cause of resource dependence, rather than its consequence. James (2015), meanwhile, argued that much of the negativity surrounding the resource curse stems from a misleading tendency to treat resource abundance and resource dependence as if they were the same thing. More recently, Bruckner, Habib, and Lokanc (2023) revisit the debate and find no evidence that natural resource abundance is inherently detrimental to development. On the contrary, they show that natural resources can be associated with higher income, lower poverty, and stronger human development outcomes.

This mixed evidence has kept alive one of the central questions in development economics: are natural resources inherently a blessing, or do their effects depend on how they are governed? Countries such as Norway and Qatar are frequently invoked as examples of resource-rich economies that have managed, in different ways, to convert natural wealth into longer-term national strength. Their experience suggests that the problem may not lie in resources themselves, but in the economic and institutional conditions through which resource wealth is managed.

One of the most influential economic explanations for the resource curse is the Dutch disease.2 During a boom in the natural resource sector, resource-rich economies can experience a loss of competitiveness in other tradable sectors, particularly manufacturing. Rising export revenues place upward pressure on the domestic currency, making other exports less competitive, while labor and capital are drawn toward the booming resource sector. The result is a distorted economic structure and growing imbalance across sectors (Corden and Neary 1982; Reisinezhad 2020).

A related argument in the literature is that the deeper challenge lies less in abundance itself than in the instability that often accompanies it. As Cavalcanti, Mohaddes, and Raissi (2015) suggest, the challenge may stem more from volatility than from resource abundance. Resource revenues are inherently volatile, subject to boom-bust cycles, and are exhaustible. Under such conditions, much of the policy discussion has focused on how states can smooth these shocks, avoid procyclical spending, and preserve wealth over time.

It is in this context that some countries have established sovereign wealth funds (SWFs), or more specifically resource funds, as a response to the volatility of natural resource revenues.3 Financed from natural resource revenues, these funds are typically justified as instruments for stabilization, saving, and investment. Their purpose is to allocate excess resource revenues in ways that protect the economy from the fiscal and macroeconomic pressures associated with volatile commodity income. By reducing the tendency toward procyclical expenditure and helping governments manage windfalls more prudently, resource funds are often seen as one of the most practical institutional responses to the resource curse (Tsalik and Ebel 2003).

A considerable body of work has found that resource funds can generate positive effects, particularly when supported by credible institutions. Existing studies link them to reduced exchange-rate volatility, improved fiscal outcomes, stronger institutional quality, smoother public expenditure, and a greater capacity to dampen the adverse effects of commodity shocks on trade and growth (see, for example, Shabsigh and Ilahi 2007; Bagattini 2011; Tsani 2013; Sugawara 2014; Mohaddes and Raissi 2017; Affuso, Istiak, and Sharland 2022; Alsadiq and Gutiérrez 2023). One notable findings, Bagattini (2011), for example, finds that the mere presence of stabilization funds can improve fiscal outcomes, even where the economic rationale for establishing them appears weak, although their effectiveness depends heavily on institutional quality.

At the same time, resource funds are not without criticism. Their success depends not only on formal design, but on the broader political and institutional setting in which they operate. A fund may exist on paper, but if it is weakly governed, politically exposed, or unsupported by a meaningful revenue base, its capacity to stabilize and save may be far more limited than the optimistic view implies.

In this sense, a broad logic has emerged in the literature. Resource wealth can generate booms, but also volatility, fiscal instability, and competitiveness problems. Resource funds, especially when supported by strong institutions and sound management, are therefore often presented as one way to transform temporary windfalls into more stable and productive forms of wealth, and thereby mitigating the resource curse. Yet one part of the story remains underexplored: ownership.

The more interesting question may lie one step earlier. A resource-based sovereign wealth fund can only manage revenues that the state actually captures. This immediately raises a deeper issue: who owns the resources in the first place?

It is here that ownership becomes analytically central. Luong and Weinthal (2010), for instance, advances an alternative claim: the so-called resource curse is rooted neither in resource wealth nor in resource dependence itself, but in the ownership structure governing natural resources. Khanna (2017) reinforces this point by showing that state ownership and control over resources are associated with stronger growth outcomes than other ownership arrangements, though only where pre-existing institutional quality is sufficiently strong. More recently, Bruckner, Habib, and Lokanc (2023) identify state ownership as an important transmission channel through which natural resource abundance shapes economic development, particularly in countries that combine above-median state ownership with stronger policies and institutions.

At the same time, ownership should not be treated as a simple solution. Greater state control may allow governments to capture a larger share of resource rents, expand fiscal space, and channel those revenues into stabilization, saving, or long-run investment. But the risks are equally clear. Where institutions are weak, stronger state control can also create more room for patronage, political interference, inefficiency, and rent extraction. Private ownership, by contrast, may limit the state’s direct command over rents, but it can also bring capital, technology, and managerial discipline that state-led systems do not always guarantee. The point, then, is not that state ownership is inherently superior to private ownership, but that the developmental significance of ownership is conditional on the institutional environment in which it operates.

Seen from this angle, not all resource funds are institutionally equivalent. A fund in a country where the state directly controls a large share of extractive rents differs fundamentally from one in a country where the sector is largely privately dominated and public revenues depend mainly on taxation and royalties. The distinction is not merely legal. It shapes the scale, stability, and fiscal significance of the revenues that can ultimately be transferred into the fund. Before asking whether a sovereign wealth fund works, then, we should first ask whether the state has sufficient command over resource rents for the fund to matter in the first place.

If ownership matters for the resource curse, and resource funds matter for how resource-rich countries respond to it, then the interaction between the two may represent one of the most important institutional questions in resource governance. To this end, the nexus between ownership structure and resource funds remains relatively underexplored in the literature.

This broader discussion is also relevant for Indonesia. As a resource-rich country, Indonesia has experienced resource booms in the past, but their long-run management has often been uneven. Although Indonesia now has sovereign wealth vehicles such as INA and Danantara, it still lacks a resource fund specifically designed to stabilize and save commodity revenues. That absence matters. If resource wealth brings not only fiscal opportunity, but also volatility, exchange-rate pressures, and broader macroeconomic risks, then questions of ownership and institutional readiness become difficult to ignore. Should Indonesia consider establishing a resource-based sovereign wealth fund? Would its current ownership structure support meaningful rent capture? And is the country’s institutional quality strong enough for such a fund to work as intended? These are not easy questions, but they are precisely the kinds of questions that deserve more serious attention.

All in all, the resource curse literature has taught us to think carefully about volatility, institutions, and the governance of resource wealth. Sovereign wealth funds have rightly become part of that story. Yet before resource wealth can be stabilized, saved, or invested, it must first be claimed. Ownership, then, is not a peripheral concern. That is why ownership matters. And it is also why the more fundamental question remains: who owns the rents?

Acemoglu et al. (2004) solidified the claim of institutions as a long-term determinant of growth. Operationalizing the European settler’s mortality rates as an institutional proxy, they empirically supported the significant role of inclusive institutions in promoting sustainable economic growth (Acemoglu et al. 2001). They later provided empirical evidence for democracy as a foundation for growth, highlighting that democratization has increased long-run GDP per capita by 20 percentage points (Acemoglu et al. 2019).

Effectively, it showcases an integrated structure between institutions as a vehicle to initiate growth and democracy as its ideological foundation. It manifested in the form of a governance system, backed by theoretical rationale and empirical evidence.

The World Bank (2017) supported this premise. Classifying governance as “rules-based” and “deals-based” bargains, it asserts the importance of inclusivity to ensure prolonged economic development. The “rules-based” system, which emphasized accountability, equitable power distribution, and a less personalized form of governance, is claimed to be a more sustainable political and economic structure. Particularly, it advocates the predictability and adaptability of such a system to ensure effective transition and long-term consensus for the rules of governance.

Other scholars have taken alternative approaches to support the finality of democracy. Sen (2013) argued for the intrinsic value of democracy. He affirmed the role of political, economic, and social freedom as instruments of growth. Aligned with the idea of inclusive institutions and “rules-based bargains”, he stated the importance of transparency and protective security as necessary tools to sustain growth.

However, China, Rwanda, and Singapore raises questions about the generalization of democratic institutions as the sole mechanism for sustainable growth. These countries have distinct historical and sociological characteristics. Rwanda is a former Belgian colony. The colony categorized Hutu and Tutsi into distinct racial and hierarchical identities that resulted in a long-standing resentment between the two factions. The conflict culminated in 1994, when roughly 800,000 Tutsi were massacred by the ruling Hutu, driving most of them into exile in Uganda.

Paul Kagame, a Tutsi, led the Rwandan Patriotic Front (RPF), which ended the genocide during the same year. His military intervention is seen as a successful initiative to bring stability to the region. In 1998, Paul Kagame became the president of the RPF, and then became the national president in 2000. He has ruled since.

His governance is full of contradictions. Although he was successful in stabilizing Rwanda’s political and economic environment, the regime that followed is unambiguously authoritarian. Opposition is often suppressed and political opponents imprisoned. Already ruling for more than 20 years, his last election in 2024 still resulted in him winning 99% of the total votes (Kupemba 2024).

Despite such conditions, Rwanda’s economic performance excelled. From 1994 to 2024, Rwanda’s average GDP per capita growth reached a substantial value of 4.85%. With such an average, Rwanda has not only surpassed the economic performance of its neighbours, but also that of most countries in the world. Referenced from the World Development Indicator, the average GDP per capita growth from 1994 to 2024 has only reached 1.02% in Sub-Saharan Africa, -0.04% in Central Africa, 0.7% in Southern and Eastern Africa, and 1.8% in the world. Furthermore, control of corruption in Rwanda has been one of the best performing, showcasing a value of 0.67 in the World Bank’s Control of Corruption Estimate Index.

Figure 1 World’s GDP per capita growth (1994-2024)
Source: World Development Indicators (n.d.)

Figure 2 Rwanda GDP per Capita Growth (1994-2024)
Source: World Development Indicators (n.d.)

If Rwanda became a significant exception to a democratic form of governance, China and Singapore scaled it by multitudes. Both are considered economic miracles of the 20^th century. They have a centralized approach to political governance and experienced a sustained economic growth at an unprecedented level.

China has existed for millennia. It is one of the largest by region and the most populous in the 21st century. At one point in history, they dominated the global landscape. They had significant transformations over the years, experiencing multiple cultural and political revolutions. From the era of the Han dynasty, to the golden age of the Ming and Qing, to the period of modern communist China, they have endured. Thus, unlike Rwanda, they are a wounded giant attempting to restore its peak (Ho 2014).

Singapore tells a different story. It became independent after separating from Malaysia in 1965. In its entire history, it has been governed by a single party. For much of its time, power is also very much concentrated in the figure of Lee Kuan Yew, the founding father of Singapore and the longest serving prime minister from 1965 to 1990. But in 30 years, the country became one of the higher-performing economies in the world. Then in 2024, it had the 2nd highest per-capita GDP in the world in terms of purchasing power parity.

Their story highlights evidence against the necessity of democratic reforms as a basis for growth. Notably, all three share a common structure. Despite extractive political institutions, their economic institutions are inherently inclusive. Acemoglu & Robinson (2013) categorize this combination as unsustainable, yet, it held.

The limited success of autocratic political institutions does not necessarily disprove effectiveness of democracy: it disproves its generalizability. These cases raise enough evidence to highlight the conditionalities for democracy. That is, the institutional and cultural heterogeneity of countries should be taken into consideration when attempting reform.

Mansfield & Snyder (2005) strengthen this argument by highlighting the importance of sequencing in democratic reforms. Without strong political institutions and the rule of law, political participation and elections can backfire, resulting in unintended consequences. Zakaria (1997) further supported the argument by cautioning against the danger of constitutional liberalism with democracy, arguing that such misinterpretation often leads into ineffective prescriptions for development.

Cultural heterogeneity also becomes a distinct factor that influences this conditionality. Lipset (1959) argues that pre-requisites for democratic governance must first be fulfilled. He highlighted that aspects such as level of education, class structure, and wealth are determinants of whether democratic governance would succeed. Chua (2002) extends his to the Asian context, underscoring that the success of Singapore should also be attributed to the concept of ‘Asian democracy’. Thus, he firmly asserts the role of cultural factors towards forms of governance. While Xu (2011) argued that China, with its “regionally decentralized authoritarian” have been effective in promoting reforms given its unique political system, highlighting its adaptability while detaching itself from the idea of Western democracy.

Altogether, this empirical evidence converges into a single idea: the success of democratic reform itself is conditional. Thus, for the case of Rwanda, China, and Singapore, democratic reform should be viewed as a tool rather than an absolute destination. Evidently, China, Singapore, and Rwanda have simply followed a path shaped by its own constraints.

This iterative process was often ignited during a crisis, such as one shown during the Great Depression. In the worsening condition, policymakers were puzzled to find a reliable metric of its economic impacts. It was during this period that Simon Kuznets, a Russian-American economist and statistician, contributed to the creation and formalization of Gross National Product (GNP). It was defined as the total value of output by a nation’s population, regardless of location. His framework later provided the foundation for Gross Domestic Product (GDP), measured as the sum of consumption, government expenditure, investment, and net exports. Adopted as an international standard for economic performance, it has become the primary lens for economic measurement (Vanham 2021).

Yet, the establishment of GDP as an international metric did not come without challenges. Kuznets himself argued that using GDP as a measure of national welfare will overlook other aspects, including the quality of life, environmental degradation, and income inequality. Therefore, despite providing a foundation for GDP, he expressed a profound disagreement with simplifying the overall definition of economic performance as a measure of productive output (Vanham 2021).

This tension illustrates that a metric could be utilized with numerous interpretations. While GDP provides a consensus, Kuznets showcased that a singular definition of growth should be challenged. More importantly, disagreement regarding definitions should be taken as a corrective process to enhance our understanding of economic progress.

Such a sequence illustrates a recurring pattern that ideas, regardless of how well-formed, are constrained by what they can explain at a particular time. History acts as a record that keeps track of ideas and how they were exposed, revised, and advanced. Thus, with the reach contestation, our understanding of how capital, labour, growth, institutions, and technology will be shaped.

After the Great Depression, the idea that “supply creates its own demand”, known as Say’s Law, was rebutted . The world needed a new intellectual axiom, and at the end of the Great Depression, “The General Theory” by John Maynard Keynes, emerged. It argued that instead of wages, employment is decided by the aggregate demand for goods and services. Rebuking the classical theory, he asserts that government intervention is a necessary tool to help the economy reach full employment.

Building on the Keynesian framework, the Harrod-Domar model was one of the earliest to be introduced. It shows that economic growth is strictly a byproduct of the saving rate and the capital-to-output ratio (Boianovsky 2018). The idea became a landmark for capital fundamentalism, emphasizing capital formation as the main driver of economic growth. The model became enormously influential during the late 1940s to the mid-1950s, being one of the first models of the post-war growth theory.

Criticism emerged shortly after its birth. Comments were made highlighting fundamental problems with the model’s assumptions, defined as the knife-edge instability (Hagemann 2009). Particularly, the model assumes that the warranted rate of growth and the natural rate of growth are exogenously given without mechanisms to align them. This assumption produces an extensive period of rising or falling unemployment. In addition, fixed proportions of labour and capital add to the problem, leaving the model fundamentally unsustainable.

In 1956, the Solow-Swan model became a direct response to the Harrod-Domar model by asserting the roles of technological advancement and the substitutability of labour and capital as factors of production (Hagemann 2009). The model empirically proved the idea in 1957 through the “Solow residual”. It illustrates that a large portion of growth cannot be attributed to capital accumulation or population growth, implying the significance of total factor productivity towards income increase. The discovery effectively iterates the notion that capital accumulation is the determining factor of economic growth.

This sequence is not simply an empirical finding or a theoretical advancement, it was an acknowledgement. From a historical standpoint, it validated the claim that definitions of growth and its measurements are rarely final. More importantly, our understanding of growth will only continuously evolve.

The Solow-Swan began by scrutinizing the instability of its predecessors, only to create room for other sources of evaluation. It validated the limitation of capital as a factor of growth, but left the specification of total factor productivity for interpretation. Thus, theoretical evolutions will be limited by our understanding of current phenomena. Each solution will only expand the question, and not conclude it indefinitely.

After dominating growth theory for decades, the Solow-Swan model was eventually displaced by the Endogenous Growth Theory. The new theory improved upon the model, adding human capital and knowledge spillovers to the construct of total factor productivity (Lucas 1988; Romer 1994). Other perspectives, such as the Adaptive Efficiency Model, argues that growth is a byproduct of institutional adaptation, highlighting the conditionalities imposed by evolving institutions on economic growth (North 1994; Simpson et al. 2025).

Together, they define growth as a byproduct of several endogenous factors. They illustrate the limitations of past models as a predictive tool for growth. They did not replace the Solow-Swan model, but our understanding of growth has changed permanently since they emerged.

These models support the claim that defining growth should come as an evolutionary process. The statement that “the economy grows because of fast capital formation” is deceptive in its simplicity and only partially true. Growth is a phenomenon influenced by many factors, and attributing one factor without the other can only produce an incomplete understanding of its nature.

Acknowledging capital formation as a driver of growth is crucial. However, human capital, knowledge, and institutions determine how capital should be accumulated and will be deployed. The Solow-Swan model confirmed the idea that capital and labour can only explain a fraction of growth, and it has proved the limitation of capital accumulation as its primary explanatory factor.

The consequence of misalignment extends beyond theory. The Harrod-Domar model dominated post-war growth discussion, but its failure in creating a sustainable growth mechanism had severe consequences. It undermined alternative growth factors, and overemphasized its own importance and creates a disproportionate burden on developing countries, implying barriers of equitability (King & Levine 1994).

The same goes for the Solow-Swan. After being the primary reference for understanding growth, it failed specify total factor productivity at the empirical level. Without theoretical improvement, technological advancement could only be understood more broadly, significantly limiting understanding of growth factors, and thus, its policy implications.

The past dynamics of GDP and GNP also display a similar conflict. We agreed that growth is measured as an increase in productive output. But such a definition is not final. There will always be room to incorporate other definitions of growth, allowing alternative measurements to take place, and in effect, other models to emerge.

Therefore, the question of defining and measuring economic growth is not a question of empirical specification, but a clash of consensuses. GDP is a construct of economic growth, but not the entirety of it. The same way that capital formation is proven to be only a factor of growth, and not its whole.

Economic growth is not a problem awaiting a final solution, it is a moving object. The progression from Harrod-Domar to Solow to Endogenous Growth Theory is not a story of convergence but a record of succession, for each exposed the blind spots of its predecessor. Disagreement about definition and measurement is therefore not a weakness but a necessary mechanism by which the discipline advances. The right response to any consensus on growth is not to defend it, but to ask what it cannot see.