Fiscal performance and the debt outlook

Lebanon needs growth oriented policies

There has been quite a lot of concern regarding Lebanon’s recent fiscal performance  and its debt outlook. In its Article IV reviews for Lebanon, the International Monetary Fund has repeatedly alerted officials that the debt burden could derail the government from attaining its economic objectives and could be the prime risk source on financial stability, stressing that a sustained and balanced fiscal adjustment is essential.

The election of a president and the appointment of a new prime minister in 2016 set the stage for a revitalization of Lebanon’s policy making framework. The passage of the 2017 budget, the first in 12 years, indicated a new policy direction and added to the overall confidence and the potential for improved economic performance.

But fiscal performance was strongly affected by the crisis in Syria, which ushered in new challenges. The tax base stalled as economic growth nearly came to a halt, and the revenue share of GDP dropped from 22 percent in 2010 to 20 percent in 2016, further weakened by the removal of the VAT on diesel fuel in 2012.

At the same time, expenditure was burdened by a cost-of-living adjustment in 2012 that raised wages in that year by over 20 percent and maintained them at a higher level of GDP. Wages and salaries of public-sector workers have been rising annually by nearly 8.5 percent on average, a higher rate than that of any other expenditure component, accounting for 33 percent of total spending. Spending on debt servicing, which constitutes another major item of total spending at 32 percent, has been increasing with the rise in gross debt and the increase in interest rates. The recent wage increase will show its full impact in 2018. Subsidies to the public utility, Electricite du Liban (EDL), have benefited in recent years from the decline of oil prices in international markets—with transfers declining by over 50 percent—but remain a serious fiscal burden. Lebanon’s capital spending has been quite low, at less than 5 percent of total spending, and is plagued by slow execution and managerial problems.

The 2017 approved budget adopted a number of tax-raising measures linked to new public spending via the wage increase rather than to an effort to address the fiscal imbalance. The international community has repeatedly warned of the seriousness of the fiscal outcome and the need to place it on a sustainable footing through both raising taxes and trimming spending. The recent move received broad international support.

In spite of the bleak performance and significant spending rigidities—mainly related to salaries and debt service—Lebanon’s fiscal outlook has an optimistic side. A primary surplus (calculated by deducting interest payments from the overall fiscal balance) has been recorded since 2014, aided by the reduced fuel subsidy to EDL and occasional increases in non-recurrent transfers from telecommunications. During the first half of 2017, the primary surplus reached LL2.4 trillion ($1.5 billion). This, however, does not preclude the need for further adjustment, as Lebanon’s public debt burden will continue to rise, adding to existing vulnerabilities and ultimately crowding out essential public investment and social spending.

Fiscal outlook

The recent wage increases, estimated annually at LL1.5 trillion ($1 billion), will further burden the spending bill, but the tax measures, at LL1.7 trillion ($1.13 billion), are estimated to generate enough revenues to exceed the wage-increase expenditure. The most prominent tax increases raise the corporate profit tax rate to 17 percent from 15 percent, raise the tax rate on interest income from deposits and LL treasury bills and bonds to 7 percent from 5 percent, raise VAT to 11 percent from 10 percent, and raise property capital-gains tax and a host of other fees and charges.

These measures were welcomed by the IMF because without them, the fiscal outlook could worsen significantly. Although the corporate tax hike has been criticized by some local businesses, the increase will raise the corporate tax contribution from a low 7.6 percent of total revenues to just 12 percent. Lebanon’s dependence on direct taxation has traditionally been quite limited—the country has relied mostly on indirect taxation, which constitutes less than 4 percent of GDP and only 20 percent of total revenues. Compared to countries with equivalent income levels, Lebanon has a disproportionate dependence on regressive taxes.

The tax rate on earned interest has been effective in generating a higher direct tax rate, as Lebanon does not apply a global income tax and these earnings were largely exempted. VAT taxes, although raised to 11 percent—with extensive exemptions on spending of low income groups—are expected to have less of a regressive impact than has been predicted.

A key potential reform on the spending side would be to trim subsidies, especially to the power sector. This sector receives significant financial subsidies: EDL’s fuel purchases are capped at $25 per barrel of oil, with the treasury covering the excess cost. EDL also sells electricity at the average fixed rate of 75 LL ($0.05) per kilowatt-hour to distributors, while subscribers are charged on average 133 LL ($0.09). This has resulted in a sector that is plagued with shortages and mismanagement. There is an immediate need for reform in the sector, which remains a large drain on the budget and a key bottleneck to improved competitiveness and equity. Other subsidies also constitute an added strain on the budget, mainly subsidies to NGOs providing supposedly social functions and loan interest subsidies in housing and other sectors, which bring total subsidies to over 10 percent of total spending—equivalent to one-third of the total deficit.

These indicators demonstrate that fiscal improvement with a positive impact on the economy could be introduced over a short period of time, and that it’s quite feasible to cut the deficit in half by 2020. With a combination of spending cuts and revenue-raising measures, Lebanon can halt the slippage in fiscal finances and revert into a more solid and sustainable fiscal position. Lebanon has a revenue potential that can reach 25 percent of GDP by 2020 from the current 20 percent. With public investment and social spending remaining steady at 29 percent, this implies a significant cut in the deficit—to 4 percent of GDP.

Furthermore, there has been sustained international concern with the debt dynamics of Lebanon, but these concerns have been overstated. Lebanon’s debt stands at 145 percent of GDP, down from 175 percent in the early 1980s. Certainly, as noted above, a major concerted effort is needed to cut the growth of the debt dynamics. As is well known, the absolute debt, which is estimated to reach the equivalent of $80 billion by 2017, increases annually by the size of the deficit. Lebanon’s debt service is one-third of total spending and 10 percent of GDP. However, the unique quality of Lebanon’s debt is that it’s predominantly due to Lebanese creditors, both local banks, and resident creditors, in Lebanese lira (60 percent) and US dollars (40 percent). This implies that the large debt service is received primarily by Lebanese investors, constituting an internal transfer process, which in turn eases the exposure of the debt to external shocks. The banking sector realizes that preserving the government’s financial stability is crucial for its overall credit rating and profitability.

The most important task before the government is to stabilize the debt-to-GDP ratio and gradually decrease it with growth-oriented policies, as was done during the first decade of the millennium. One main reason for the recent escalation of the debt ratio is due to the subdued growth that was triggered mostly by the Syrian crisis, plus a period of low inflation rates. Debt ratios increase when price deflators are low.

The government has to make fiscal reform its top priority to reduce financial risk in the banking sector, and to ease pressure on the exchange rates.

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