Political will erodes for GCC tax plan

10 January 2013

The Arab uprisings and economic crisis sap urgency for introducing value-added tax in the GCC

If the headlines in 2008-10 were to have been believed, the GCC should have introduced value-added tax (VAT) by now. Instead, the plan is gathering dust, along with the GCC’s other long list of initiatives that inch forward at glacial pace. It is a victim both of governments’ wariness of imposing new revenue-raising measures on populations in the wake of the Arab uprisings, and the lack of urgent need for such revenues in the context of sustained high oil export earnings.

This lack of urgency is evident. Presenting the state budget on 2 January, Oman’s Financial Affairs Minister Darwish bin Islamail al-Balushi acknowledged that introducing VAT in “current conditions” was simply not feasible.

All this marks a sharp contrast with five years ago. Back then, GCC leaders appeared eager to bring in new forms of taxation, which were unlikely to impinge much on the public’s rising disposable incomes. In a report to the UAE’s federal authorities in January 2008, Dubai Customs had looked forward to rolling out VAT across the country as early as 2009, with a user-friendly 3 per cent cap. Geopolitical events and the global economic crisis are blamed at least in part for the UAE’s failure to implement the plan.

Compelling reasons

VAT is now seen as an idea whose time has not yet come. But advocates contend that it remains highly relevant, even if the ardour for implementation has clearly seeped from GCC policymakers compared with previous years.

Fresh attention on the subject came in late November 2012, when a global report co-authored by the Washington-based World Bank, International Finance Corporation and consultants PWC, said the GCC was targeting to introduce VAT within two to four years.

“I don’t sense any appetite among governments for moving ahead with [VAT] at the moment”

Simon Williams, HSBC

That may be wishful thinking, but there are nonetheless compelling reasons for Gulf leaders to give deeper consideration to bringing in a GCC-wide VAT system. Prime among these is the fact that the region is facing a potentially serious loss of customs duty revenues as a result of the signing of free trading agreements (FTAs) with key trade partners. It was this, rather than the need to broaden the tax base, that played a large role in originally motiving the GCC states to consider VAT.

Bilateral agreements such as the Bahrain-US FTA and regional variants, such as the GCC-Singapore FTA, threaten to remove a large slice of revenues from state budgets, as the foundation of the FTAs is the elimination of trade restricting measures such as external tariffs.

According to Ehtisham Ahmad, a former adviser to the Saudi finance minister and a senior fellow of the London School of Economics’ Asia Research Centre, VAT was intended to replace the GCC’s common external tariff, which will be lost with the upcoming trade agreements with the EU and other trading partners. “It was meant as a more efficient replacement of the customs duties. The idea was that if you replaced customs duties with VAT of a similar magnitude, that would also minimise the inflationary impact,” he says.

Despite the pressing need, the GCC is unlikely to move quickly on VAT. Politically, taxation remains a controversial issue in the Gulf. Low taxes have long been one of the region’s chief attractions. Local companies are exempt from tax and the average total tax rate for the region, at 14.6 per cent, is more than 30 percentage points below the world average of 44.7 per cent, according to a recent survey from the World Bank. The UAE and Bahrain have no corporate taxation and no GCC state levies personal income tax on its citizens.

Regional plan

GCC policymakers have no desire to introduce new forms of taxation. VAT, however, may be one area where governments could relatively painlessly introduce a viable form of taxation that could also help meet longer-term economic challenges. In this effort, they will have the strong support of the IMF, which back in 2001 warned that the GCC states could no longer rely on oil sales, recommending that they implement VAT along with income tax, corporate tax and consumption tax.

Although none of the six GCC member states seems ready to take the plunge and make the first move, countries are at various stages of advancement. Saudi Arabia is said to be most prepared of all of the GCC states in administrative terms. In Kuwait, the Finance Ministry is studying the preparation of the provisions of a VAT law. It has also established an independent VAT Division in order to be fully prepared for future implementation plans.

However, the focus of preparations for VAT is at the pan-regional, rather than individual state level. Without cross-border coordination, VAT would be a non-starter in the GCC, since smuggling would be the inevitable corollary if one of the six states were to be left out of the process. None will seek to implement VAT in isolation.

All the GCC states have announced intentions to harmonise VAT laws, with the original deadline set for 2015. In June 2012, the GCC made the first tentative steps to formalise the process with the estalishment of a Customs Union Authority, mandated to devise a formula for dividing customs revenues between the governments. This would be a precursor to replacing the intra-GCC customs duty regime if and when VAT implementation gets under way.

The consensus is that any VAT rate in the GCC will initially be levied at 5 per cent, mirroring the 5 per cent GCC customs duty. This low level - compared with the EU average standard rate of 21 per cent - would ensure a painless introduction. Although a 5 per cent VAT rate would not have a big impact on individuals’ spending power, analysts believe it is still a big ask in the current climate.

“In principle, the arguments for implementing VAT are strong,” says Simon Williams, chief economist for the Gulf at the UK’s HSBC. “However, in practice, given the strength of oil revenues and public finances, and the general anxieties over restarting inflation, I don’t sense there’s any appetite among governments for moving ahead with this at the moment.”

It is not just the short-term pain that is putting governments off pushing for VAT. “The inflation hit would be one-off, but broader concerns about the impact on lower and middle-income families would be to the fore,” says James Reeve, deputy chief economist at Saudi Arabia’s Samba Financial Group.

Despite compelling reasons to introduce VAT, the likely adverse political consequences may stymie progress.

“It is important to develop non-oil revenues in order to reduce vulnerability to oil price movements,” says Reeve. “However, I don’t expect any move on VAT in the foreseeable future. It is a regressive tax and would hit low and middle-income earners the hardest, and would not be attempted given the fragile regional political environment.”

There does not appear to be any real appetite for inflation, even if it is only in the short-term. “The argument in favour of broadening the tax base is strong in order to reduce the reliance on oil revenues and to extend the period for which regional governments can continue to offer a powerful fiscal stimulus to economic growth,” says Williams. “But, while in principle the arguments in favour are strong, in practice, with oil prices where they are and state budgets as comfortable as they currently are, it’s not being approached with any real urgency.”

Other analysts point out that the much-feared inflationary impact of VAT may be exaggerated. Its implementation may instead yield a one-shot adjustment in relative prices, rather than triggering inflation. “What you get with VAT introduction is a change in relative prices, which is desirable,” says Ahmad.

Introducing VAT will clearly prove problematic, but if the inflationary impact is contained, GCC authorities would be able to use a more efficient tax instrument that could also be used to expand trade. It could also help meet the most pressing policy requirement of boosting employment levels of nationals.

Long-term development

“People think it’s a new shock horror tax, so let’s not do it, but if it has been properly explained they will realise it is a more efficient thing to do,” says Ahmad. “You have import duties that you cannot rebate and add to the cost of doing business. If you want more efficient instruments that don’t affect trade, it makes sense to replace customs duties with an equivalent VAT.”

In the long-term, VAT may serve a deeper purpose in helping to lay the basis for a more formalised tax system in the region. This would support the long-term development agenda and lay the foundations for more efficient trade and investment regimes across the GCC. China, which first introduced VAT in 1994, may serve as a useful example in this regard. It suffered no ill consequences from bringing in VAT and has been able to sustain impressive economic growth.

VAT remains firmly on the agenda in the GCC. The original 2015 timetable for implementation may be a challenge, but the bloc cannot put off the inevitable, particularly when there are other beneficial spin-offs. “VAT is not just a revenue raising measure, but it also provides information on transactions,” says Ahmad. “The information effect is particularly important if you are trying to document your economy more effectively.”

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