Taxes to rise despite record oil revenues

Taxes are set to rise in the Gulf. News that the UAE has asked the IMF for technical help in developing a VAT system made front-page news in the Emirates recently. This development should not come as too much of a surprise. While we don't expect an imminent implementation of new taxes in the Gulf, we have long argued that the introduction of a Gulf wide VAT was likely over the next couple of years. This may strike many observers as strange given that the region is on track for record oil revenues in 2005, but it reflects a growing maturity of fiscal policy and is evidence that policymakers are increasingly looking beyond the current oil boom.

Record revenues but taxes to rise

We estimate that the six nation members of the Gulf Co-operation Council* (GCC) will raise over USD 220bn in oil revenues in 2005, an increase of 25% over 2004 and a record high. Given the central importance of oil revenues to government budgets, they typically accounts for 90% of revenues, we estimate that the combined budget surplus of the GCC is likely to breach the USD 60bn or 15% of GDP recorded in 2004.

There are broadly two reasons why the Gulf's governments are looking to raise additional non-oil revenues. First to reduce the impact if oil revenues fall over the medium term. Oil prices are notoriously volatile. While the market is now focusing on the likelihood of ever increasing oil prices, it is important to remember that only seven years ago prices dipped below USD 10 per barrel. The region's budgets reported a consolidated deficit of USD 18bn in 1998. Moreover some states, in particular Oman and Dubai, are already seeing oil production begin to contract and therefore need to seek additional sources of funding. Second demographics; The GCC population is growing at 3.5% per annum, leading to increasing demand for government services and raising the cost of subsidies. During the last oil boom in the early 1980s, per capita oil revenues were twice as high as current levels in real terms.

VAT - an efficient tax

As a tax method, the choice of VAT makes sense. VAT is an efficient form of taxation with a good history both internationally and regionally. VAT is levied in over 120 countries, including all OECD countries, and raises about a quarter of the world's tax revenue.

It also has a remarkable track record in the Middle East. Jordan, Egypt and the French speaking North Africa all levy a sales tax or VAT, with the tax accounting for 22% of their total revenues. Lebanon most recently introduced the tax in 2002 at the rate of 10%. Despite concerns about administrative and public confusion, it was rolled out relatively smoothly and has now become a key source of government revenues. Its introduction did not prevent an economic recovery from gathering pace and while inflation rose slightly, it remained below 2% throughout 2003.

So how much would it raise? That would depend on the tax rate. Lebanon's VAT rate of 10% raises the equivalent of 5% of GDP. Overall the region's average 15% rate raises just under 8% of GDP. This is slightly better than the world average. World Bank studies suggest that for every additional increase of 1% in the tax rate an additional 0.4% of GDP is raised in revenues. The better ratio in the Middle East may reflect a higher propensity to consume imports. Assuming that this experience was replicated in the Gulf, a 5% sales tax, for example, would probably yield around USD 8bn, or 2.5% of non-oil GDP.

Positive for fiscal reform

While this is not a huge amount it would be significant, and a step in the right direction. Introducing a tax could also have fringe benefits. It would make government revenues more predictable, dampening the volatility associated with oil prices, and therefore facilitate medium term budgeting. This would be a good in itself. Several international studies have concluded that erratic government spending can reduce the quality and efficiency of public spending. Levying taxes on the non-oil economy could also act as an automatic stabiliser, with the total tax take rising when the economy is growing and therefore acting as a break to demand and vice versa.

The impact on competitiveness is likely to be small. A low VAT rate is unlikely to reduce the GCC's position as a low tax destination. In the UAE, for example, there is currently no personal taxation and only international banks and gas companies pay any tax on their profits. Dubai also levies a 10% fee on hotel bills.

Economically, imposing VAT may make sense but, politically it will present challenges. Tax is certainly a sensitive subject in the GCC. However, the obstacles can be overstated. A sales tax is unlikely to attract as much opposition as an income tax. More importantly, by acting now the GCC will be in a better position to deal with long term wealth issues, which could raise greater political difficulties in the future. Moreover, by dealing with it now, the Gulf will be able to do so from a position of strength - a position last enjoyed twenty years ago.

*The Gulf Co-operation Council (GCC) includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, UAE