Budget deficit, exchange rate fluctuation and high world fuel prices places pressure on budget capacity to stimulate the Indonesian economy. In 2005, the government took a crucial step by reducing only the fuel subsidies expenditure, raising subsidized fuel prices by 29 percent in March and 125 per cent in October, to safeguard the government's budget. In response, the government fuel subsidy fell by 32.76 per cent in 2005 compared to the 2004 budget.
Fuel could be an effect multiplier for the prices of other products. However it was unknown if these price increases would lead to a decline in household incomes and effects on different socioeconomic groups.
The study objective is to analyze the transmission of shock to household income distribution using the case of Indonesia. The fuel subsidies reduction that rose domestic fuel price, tends to increase prices of industrial output that are highly depend on fuel products, especially in the Manufacturing Processing sector, which then experienced a reduction in output. In addition, the increase in consumer prices in this sector would influence producers to reduce production costs. Thus, household income would decline, whereas household welfare would also decrease as they experienced high commodity prices as a result, Formal Non-Fuel and Gas Manufacturing Processing was the hardest-hit sector during the shock, and thus the non-poor urban and non-poor rural households were more susceptible due to their heavy reliance on labour work in that sector. By contrast, the shock from fuel subsidy reduction was also transmitted to rural poor households primarily at risk due to heavy reliance on labour income in the Informal Non-Fuel and Gas Manufacturing Processing sector. However, these sectors also proved to be the dominant and instrumental channel in transmitting the government fuel subsidy reduction to the fall in household income groups, by applying the Structure Path Analysis model. The data used in the model is the Social Accounting Matrix 2005.