Economic Research Forum (ERF)

Tax reform for equity and fiscal space in middle-income Arab countries

712
Arab countries have systematically low tax collection rates relative to the size of their economies. What’s more, with rising military expenditures and lower oil prices, the public budgets of the oil-rich states are coming under growing pressure. This column argues that the time is right for region-wide fiscal policy reforms that enact fair and progressive taxation systems.

In a nutshell

Governments in middle-income Arab countries need to improve tax fairness by establishing more equitable, progressive and transparent systems.

Improving tax and customs administration, simplifying coding and regulation, and investing in technology to improve transparency can enhance compliance and increase the potential tax base.

In addition to national tax reforms, a global standard for information exchange is needed to tackle illicit financial flows as well as cross-border tax evasion and tax avoidance.

A fair and progressive taxation system supports the principles of inclusion and equity through collection practices oriented around the ability to pay, and through raising revenues for financing development priorities, including pro-poor initiatives.

Yet Arab countries have systematically low tax collection rates relative to the size of their economies, and little attention is paid to ways of improving taxation systems to raise more revenue. If at all, policy-makers have put all their efforts into raising indirect taxes, such as VAT (value added tax), which by their nature are regressive, placing a higher tax burden on the lower middle class and the poor than on the rich.

The share of taxes in GDP thus varies between 10% and 20% in most Arab middle-income countries (Figure 1A). The exceptions are Morocco and Tunisia, which have undertaken some progressive reforms in income tax recently and where the share is now about 23%.

Indirect taxes, like those on goods and services, constitute the major share of taxes in the tax systems of middle-income Arab countries. Furthermore, this share has increased in some countries over time (Sarangi, 2016; and see Figure 1B). Wealth taxes constitute a negligible share of total tax revenue in most countries in the region. Globally, taxes on property form around 7% of total tax revenue, a much higher share than in Arab countries.

From a political economy perspective, this outcome is not difficult to explain. A prominent feature of ‘rentier states’ is that the bulk of public revenues are generated from external sources such as oil exports. But while this may make sense for resource-rich countries, it does not explain why there is a persistently low tax-to-GDP ratio in resource-poor Arab countries, such as Egypt, Jordan and Syria?

There are two broad explanations. Up until recently, most middle-income Arab countries avoided high taxation to avoid stirring popular demands for fiscal governance reforms, which would necessarily entail higher transparency and voice and accountability.

But such a trade-off is no longer economically feasible, especially as the intra-regional spillovers from the oil-rich countries to the oil-poor ones that may have relieved budget pressure in the past (foreign direct investment, official development assistance, tourism and worker remittances) have significantly contracted since 2011.

Oil-rich countries are coming under fiscal pressure due to rising military expenditures and lower oil prices. Hence it would be fair to say that the time is right for region-wide fiscal policy reforms that enact fair and progressive taxation systems. That is essentially the main message of the most recent report by the United Nations Economic and Social Commission for Western Asia (ESCWA, 2017a).

One of the main arguments in the report to substantiate this claim is the significant potential to improve equity, given that income and wealth taxes constitute a negligible share of total tax in the current system despite evidence of increasing wealth inequality. The policy-relevant question is how to make this happen.

We argue that two key policy shifts are needed to reform current tax systems.

First, make tax systems more fair and progressive – and simplify administrative procedures for better tax compliance

Governments need to consider improving tax fairness by establishing more equitable, progressive and transparent systems that clearly rationalise exemptions. Given growing inequality and the relatively low tax burden on the top income decile and the even lower burden on the richest 1% in some countries, there is clear room for improvement. Experience from other countries shows that this is possible if there is political will.

Even among lower-income countries, direct tax collection could increase from 2% to 4% of GDP. Property tax can be an effective tool to increase revenue and improve equity, but currently, these taxes are low and largely evaded. One of the important benefits of a well-designed property tax or wealth tax would be to dampen rent-seeking and speculative activities, and channel funds to more productive investment.

Poor tax records and complex tax procedures complicate tax compliance and tax fairness analysis. Improving tax and customs administration, simplifying coding and regulation, and investing in technology to improve transparency can enhance compliance and increase the potential tax base.

This would require upfront investment in administrative infrastructure, but over a period, better tax administration would support a broader culture of tax compliance in addition to greater revenues. One way to improve transparency and accountability is the filing of income tax by every citizen, even if not everyone would actually pay tax – an approach that has been encouraged recently in India.

Second, take steps to control tax evasion, tax avoidance and illicit financial flows

In 2014 and 2015, illicit outflows from the Arab region outstripped the combined inflows of foreign direct investment and official development assistance (ESCWA, 2017b; IMF, 2016).

Trade mis-invoicing constituted a significant leakage, amounting to about 68% of cumulative illicit flows between 2011 and 2015. In addition to national tax reforms, a global standard for information exchange needs to be adopted to tackle illicit financial flows as well as cross-border tax evasion and tax avoidance.

Further reading

ESCWA (2017a) ‘Rethinking Fiscal Policy for the Arab Region’.

ESCWA (2017b) ‘The Arab Financing for Development Scorecard: Overall Results’.

IMF (2016) World Revenue Longitudinal Data.

Sarangi, Niranjan (2017) ‘Domestic Public Resources in the Arab Region: Where Do We Stand?’, ESCWA Working Paper.

Figure 1:

 

Most read

Egypt’s care economy needs to address deteriorating working conditions

A robust and high-quality care economy is critical for supporting women’s employment – as both an employer of women and a mechanism for redistributing unpaid care work to the market. Yet in Egypt, despite national goals of expanding care services, employment in the sector has been shrinking, while becoming increasingly privatised. As this column reports, care jobs have also experienced worsening conditions of work, including reduced formality and the emergence of a pay penalty for care workers.

Unemployment among young women in GCC countries

The average rate of unemployment among young women in the high-income countries of the Gulf Cooperation Council (GCC) is far higher than the equivalent for young men. This column reports new evidence on the extent to which flexible labour markets, in the context of a generous social contract, can reduce female youth unemployment rates in the region.

Boosting trade through flexible rules of origin in preferential agreements

Rules of origin are critical components of preferential trade agreements designed to stop products coming in under insufficient transformation or through the partner that applies the lowest tariff. But in practice, these rules are often needlessly complex, undoing the benefits of market access associated with trade agreements. This column reports research showing that the adoption of more flexible product-specific rules of origin within preferential agreements would give a significant boost to global trade.

Challenges of GCC investment in the energy transition

The countries of the Gulf Cooperation Council (GCC) have identified the energy transition as a crucial area of growth and are investing heavily in a diverse array of projects. However, as this column explains, the region faces a number of challenges in making a success of these investments, most notably its current dependence on fossil fuels, a lack of infrastructure and technical expertise, the high upfront costs, and geopolitical tensions.

The decline of social insurance in Egypt: directions for reform

The longstanding challenge for the Egyptian economy of providing its workers with decent, formal, socially insured jobs has become even more difficult. As this column explains, informality has been rising rather than falling, with a substantial reduction in social insurance coverage for the employed since the late 1990s. Reforms are needed to reverse this decline.

Social insurance in Egypt: between costly formality and legal informality

The rates of participation of Egyptian workers in contributory social insurance has continued to decline, even during times when the country has had positive annual growth rates. This column discusses key institutional elements in the design of the current social insurance scheme that have contributed to the growing gap in coverage, particularly the scheme’s cost and eligibility requirements.

Making trade agreements more environmentally friendly in the MENA region

Trade policy can play a significant role in efforts to decarbonise the global economy. But as this column explains, there need to be more environmental provisions in trade agreements in which developing countries participate – and stronger legal enforcement of those provisions at the international level. The MENA region would benefit substantially from such changes.

Jordan: navigating through multiple crises

Jordan’s real GDP per capita is today no higher than it was 40 years ago. While external factors have undoubtedly had an adverse effect on the country’s economic outcomes, weak macroeconomic management and low public spending on investment and the social sectors have also played a substantial role. This column explores what can be done to reduce high public debt, accelerate private sector development and enhance social outcomes.

Egypt and Iraq: amenities, environmental quality and taste for revolution

The Middle East and North Africa is a region marked by significant political turbulence. This column explores a novel dimension of these upheavals: the relationship between people’s satisfaction with, on one hand, the amenities to which they have access and the environmental quality they experience, and, on the other hand, their inclination towards revolutionary actions. The data come from the World Value Survey collected in 2018 in Egypt and Iraq.

Iran’s globalisation and Saudi Arabia’s defence budget

How might Saudi Arabia react to Iran's renewed participation in global trade and investment? This column explores whether the expanding economic globalisation of Iran, following the lifting of nuclear sanctions, could yield a peace dividend for Saudi Arabia, consequently dampening the Middle East arms competition. These issues have attracted increased attention in recent times, notably after a pivotal agreement between the two countries in March 2023, marking the resumption of their political ties after a seven-year conflict.