Implementing Paris III: what it takes

As part of Paris III, the Lebanese government has promisedto embark on a number of fiscal reforms addressing primarilythe revenue side “in view of the relatively limited scopefor further cuts in public spending.”

The objective of these reforms is set in paragraph 92 of theParis III reform agenda. It aims at minimizing distortionsand enhancing equity and fairness in the distribution of thetax system.

Can these reforms achieve their objective?

Lebanon’s revenue structure relies heavily on indirecttaxes. Taxes on income and profits constitute only 14.5% oftotal revenues and 3.3% of GDP; while indirect taxes (mostlyVAT and customs) contribute 46% of the total. In spite ofexemptions, indirect taxes are, as generally recognized,regressive.

To recall, the most important tax measure taken recently wasthe introduction of a one rate and one stage value added tax(VAT) in 2002 that resembles more a sales tax. This isregressive tax in spite of exempting basic items andservices. It was a step forward to shore up revenue anddiversify its base. Its impact was visible and raised taxrevenue to a record 15% of GDP. However, it magnified equitydistortions as it was not accompanied by other tax reformsto enhance equity. Customs top rate, for instance, remainsat 90%, and customs provide 25% of tax revenue.

Making adjustments

Will the proposed new measures, as part of Paris III,impact significantly on revenues and its structure? The taxadjustments include VAT increase to 12% in 2008 and to 15%in 2010, and the tax on interest income to 7% in 2008.

These two adjustments, assuming a neutral effect oncapital and on the consumption pattern, could raise taxrevenue by 1.5%, accruing mostly from VAT. Raising taxrevenue to GDP to the desired objective of 18% by 2011 hasto be generated by administrative measures. These include:activating the large tax payer’s office (LTO), fullystaffing the Tax Roll department – a data base department,expanding the withheld tax registration, and adopting a TaxProcedure Code. A Global Income Tax without rate change isplanned for 2008. These measures are expected to raiserevenue by another 1.5% of GDP.

Direct tax collection on income (enterprise and wagetaxes) will, after all, remain very low at 4% of GDP by 2011compared to an unweighted average statutory rate of 10%.This implies the presence of either extensive tax evasionand/ or ineffectiveness in collection. An endemic problem inLebanon, which is not being addressed genuinely by any ofthe proposed measures except in the enhancement of coverageby tax withholding.

The revenue structure will continue to remain nearlystagnant, and to rely heavily on indirect taxes (50% oftotal revenue) and non-tax revenue (32%); without enhancingequity. A comparison of before and after tax income (basedon the family income distribution study CDS, 1998) showedthe ineffectiveness of the pre-1999 structure (a moreprogressive tax) on equity enhancement. The after tax incomeshare of the tranche with the lowest income (6%) increasedto 1.12% compared to 1.09 % of the total before taxes. Forthe tranche with the largest income (3.1%), the after taxincome share dropped only to 15% from a 15.9% share beforetaxes.

These indicators point out to the need to further strengthenincome tax share to enhance equity; especially in the caseof Lebanon, where income distribution is highly skewed. TheOECD countries, for instance, have moved in their recent taxpolicy reform towards reducing marginal income tax rates andplacing more reliance on VAT and other indirect taxes.However, income taxes remained the largest portion of totaltax revenue in these countries (25%, compared to 3.3% inLebanon). Their reforms set priority on fairness andsimplicity, and were based on public support reflected inthe platform of political parties.

New measures needed

In Lebanon, a more effective collection of income tax evenat the current rate structure (five marginal rates) couldraise revenue by another 6% of GDP, thus closing most of thefiscal gap needed to reduce debt accumulation. Income is thelargest tax base that needs to be fully tapped. Currently,civil servants and wage earners are the most compliant. Somereforms are inevitable, however, such as treating financialand on-financial enterprises equally by raising the rate onthe former to 21% and applying this one rate on both.

The direction of reforms in Lebanon needs to be based onpublic choice rather on a centralized decision induced onlyby the objective of raising revenue. An open public debate(or even a referendum) on tax choices could guide thegovernment and garner support for its decision.

Dr. Mounir Rached is a senior IMF economist and a founding member of the Lebanese EconomicAssociation. The views in this article don’t represent those of the IMF. Dr. Ghassan Deeba is Associate Professor at the LAU.