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Tax squeeze

Opaque decision making blights tax policy

by Jeremy Arbid

Lebanon is closer to ratifying a national budget than it has been in recent memory. For the past 12 years, the country has not passed a budget into law. In recent years the roadblock has been, at least publicly, a salary increase for certain public sector workers.

The debate is taking place in a fiscal environment where the money to raise public spending is non-existent, so the revenue needs to be created – through new taxes. To fund the salary increase, some economists and some politicians are arguing for reforming public spending rather than setting new taxes.

Announcing the budget figures at a press conference on the last Thursday of March, Minister of Finance Ali Hassan Khalil provided little by way of details. He laid out spending cuts, and stated that the budget is primarily based on improving tax collection and administration – collecting taxes already on the books, rather than subjecting citizens to new taxes – with the government aiming to address poor collection of revenue from public agencies, including customs. But he did not say what impact these measures would have on public finance.

While there are new taxes in the budget, the minister did not make clear what these were. The government will send an approved budget to Parliament which, it seems, will be tasked with figuring out which taxes to levy – there will almost certainly be new taxes if Parliament ratifies the budget.

Given this debate has been going on since at least 2013, when Najib Mikati was prime minister, there are a few likely candidates for new taxes, including an increase to VAT by a percentage point to 11 percent, a 15 percent tax on capital gains from real estate transactions, an increase of tax on financial institutions’ profits to 17 percent and on interest of deposits to 7 percent.

On taxation, it is difficult to pinpoint with any certainty who has to pay, how much they have to pay, what the expected revenues are, and whether or not there will be an impact on economic growth and gross domestic product (GDP). On the sidelines of the press conference Alain Bifani, the finance ministry’s director general, said the ministry had assessed the budget’s tax measures, but these studies have not been made public. Earlier in March, Executive requested interviews with both Khalil, and Bifani, but did not receive a response. To gain the best available expert assessments of the impacts of proposed taxation under these circumstances, Executive approached economists and stakeholders knowledgeable about various sides of the issue.

The general take

Executive surveyed seven Lebanese economists, including a former minister of finance, individuals from the fields of banking and academia, and one political party (Executive reached out to other political parties to discuss proposed taxation but received no response). This survey resulted in several common themes. First, that public officials have done a very poor job of explaining the new taxes and have not indicated, beyond simple projections, the revenues, social effects or economic impacts of the proposed taxes. Second, that an increase to the Value Added Tax (VAT), one of the proposed measures, could, in the short term, slow economic growth and raise inflation before leveling, and that taxes on the interest of deposits is not a good idea because they could push depositors away from local banks. Third, the economists agree that there is room for a tax increase on corporations, particularly financial institutions, but all pointed out that taxing the profits of last summer’s financial engineering would be a one-time collection noting that a portion of those profits are already committed to government finance. Fourth, those surveyed argue there are alternatives to taxes to finance a salary scale increase, like curtailing wasteful public spending, and concluded that the latest round of street protests in mid-March against a tax hike (plus a carryover effect from 2015’s garbage crisis protests) has probably had some effect toward pushing the government to reform public spending, and may have discouraged imposition of some of the proposed taxes. And lastly, the economists agreed that debate over the salary scale increase, the proposed taxation and the budget approval process were not transparent and discouraged confidence in public financial management.

Impact of tax measures

For real estate, burdening a stagnating sector with new taxes could risk its collapse, argues Raja Makarem, managing director of Ramco, a consultancy catering to the industry, in a contribution to Executive.

For the banking sector, the surveyed economists agreed that there is room for a tax increase on the institutions. “The banks are making profits and could be taxed and incentives for banking in this country is still a lucrative business”, says an economist at the central bank, who did not want to be named, before adding that “You have to estimate [bank profits] in percentages of the return on assets or, better yet, on equity. Is it good or too high? Return on equity in Lebanon for banks is high but not tremendously high when compared to the rest of the world.”

The banks’ position from several years back is that they are penalized because they are the only transparent sector in terms of taxation. The banks are holders of government paper and pay taxes on them, but deduct those taxes from the corporate income tax they pay. What the government is trying to do is prevent the tax deductibility, and the banks are refusing. ((See our 2014 Banking Special Report story: Should our banks pay more?)

While the economists agreed there was room to tax the banks they also expressed reservation. Banks which hold nearly $49 billion (around a third) of the state’s debt, and are known to be the top buyer of government debt in Lebanon, hold more and more paper and experts worried that if tax is increased then their appetite for holding more paper might decrease. But returns on debt holdings compared to the increase in taxation banks would have to pay makes a very big difference because their stock is huge. And, several economists pointed out, the additional tax they would pay is only on new paper they are going to hold. Georges Corm, a former minister of finance, disagreed that a tax hike on the banks would reduce appetite to buy public debt. Instead, he argues for a different approach, “I would advise the central bank, the ministry of finance and the banking sector to agree to decrease the average interest rate paid by the state on its public debt by around 1 percent on any new issues. Such a decline in the cost of servicing public debt to the state would save the treasury a yearly amount of $700 million in a few years’ time”.

The economists cautioned against raising the tax on the interest of deposits. Talk of a tax increase, says the central bank economist, “is very important when it comes to depositors, non-resident depositors, who have a choice [in where they park their money] and who continuously weigh risks.” Corm said he was not in favor of the tax, but downplayed a negative effective if it were a one-time measure. “Raising this tax from 5 to 7 percent will probably not produce a decline in the amount of deposits in the banking system.”

When it comes to an increase of the Value Added Tax (VAT), the International Monetary Fund (IMF), in its January Article IV consultation report, does not spell out how the tax measure would impact growth, but its analysis shows that imposing taxes initially does negatively impact GDP. Through disposable income (income minus the taxes) an individual will spend, consume, and invest. This will lead to GDP growth through a multiplier effect. With an increase of taxes, what is left to be spent and consumed into the economy is going to decrease. On that point the economists Executive spoke to generally agree with the IMF. “Increasing VAT can penalize consumption and demand. We don’t have a detailed idea of the structure of consumption and what can be affected or penalized by the increase to VAT, but at first inflation could spike and then level out. In the medium and long run it can reduce economic growth, but it is a random hypothesis. I’m not sure because we don’t have data to run a simulation,” says Joseph Gemayel, chair of the economics department at Beirut’s Universite Saint Joseph (USJ).

“Nobody in government or any think tank has recently, at least in the past three to four years, done any tax incidence analysis on any fiscal reform, or at least it’s not public,” Jad Chaaban, a professor of economics at the American University of Beirut, told Executive. When posing the question of what might happen to Lebanon’s economy as a result of the new taxes, a lack of information forces the economists to revert back to basic economic theory. Lebanon’s slow economic growth since 2011 suggests that, “In a typical textbook situation you have to decrease taxes. Unless those taxations and a better fiscal consolidation gives confidence to investors then yes, you might increase taxation and at the same time see confidence increasing that the country is better managed and then see investment increasing. But, this is a big if. If you want to increase taxation and other things remain as they are, business as usual, then definitely it would have a negative effect on economic growth,” says the central bank economist.

Lebanon’s productive sectors are suffering from a slowdown of the nation’s economic activity, argues economist Sami Nader, and the effect of taxes could push companies to the brink of closure. Instead he says, Lebanon should grow its way out of the problem. “At this time, you are expected to do the exact opposite, lower some taxes, make some improvements to the private sector, increase the economic activity in order to increase the revenue,” Nader says. Byblos Bank economist, Nassib Ghobril, cautions that taxes will “definitely affect economic activity on the economy overall. When politicians say these taxes will not affect the poor or the middle class, that’s very misleading. [The tax increases will affect the poor] because inflation will increase.”

The International Institute of Finance as late as February forecasted Lebanon’s economic growth at 3 percent for the year, but the economists say this projection is unlikely. “I don’t see 3 percent growth, even if they do not pass the taxes. The debate alone has poisoned the atmosphere. Now we are three months into the year and you do not feel [that] anything tangible on the ground has changed economically. In my opinion, in addition to addressing the business climate and the competitiveness on the economy, the debate should have been which taxes we should decrease,” says Ghobril. Including the tax measures in the budget, the finance minister is projecting a 2 percent growth of GDP for 2017.

No fiscal policy

If the budget’s tax measures are ratified into law by Parliament, how much revenue will be collected and what will be the effect on the economy? The question has no easy answer.  The entire budget approval process has not been transparent, the figures have not been made available for public scrutiny, the government did not make public the assessments on who would be impacted by the tax measures or what would happen to the economy, and officials would not discuss the matter with Executive.

What’s more, this government and previous ones have not clearly articulated an economic vision or fiscal policy, the  economists surveyed point out. The budget should be the document laying out the objectives of the government for public spending and how it will raise revenue to finance that spending. “Lebanon is entering the 12th year without a budget. It is mind blowing, a country without a budget. Is the objective to boost productivity, contain public debt, boost job creation – what is the objective of the government when it comes to public spending?” asks Jean Tawile, an advisor to political party Kataeb.

USJ’s Gemayel says that the lack of transparency diminishes the government’s ability to articulate such a fiscal policy, and points out that flexibility in public spending is nevertheless restricted. “There is no clear vision, whether toward expansive or restrictive fiscal policy. We know that monetary policy is restricted because of the pegging to the USD, and fiscal policy is constrained by public debt and the deficit. There is a need for structural reform, but Lebanon is not able to articulate that reform. The financial needs of the public sector are growing, but the function of the public sector in the economy is too little, in terms of GDP. So it is a paradox.”

Other economists agreed with the notion that the government has not publicly articulated its fiscal priorities, and said that a lack of transparency over the draft budget has confused the process. “Nobody knew what the exact taxes included in the budget were, and that’s because the ministry of finance did not release a draft of the budget, which is not a good sign. The draft budget should be moderately accessible; I don’t understand why they did not make it available to the public. That’s a lack of transparency in my opinion,” Ghobril told Executive.

A better way

The IMF, drawing on consultations with the government plus government data to reach its conclusions, says in its latest Article IV paper that Lebanon should increase some taxes irrespective of the salary scale because of the weight of the country’s public debt, nearly $80 billion at the end of 2016 or 144 percent of gross domestic product (GDP). The IMF’s Article IV paper argues that the public debt is unsustainable so fiscal measures must be adjusted in order to put the debt on a sustainable path regardless of new spending, like the proposed salary scale. The report also “urged passage of a budget” because it is a critical priority, and “stressed the immediate need for reform in the electricity sector, which remains a large drain on the budget and a key bottleneck to improved competitiveness and equity.”

Projections of the increase in salary spending has ranged from $2.1 billion down to $1.1 billion, according to a 2014 report by Al Akhbar English that did not note if those were annual figures or projections for the first year of implementation alone. By removing retroactive pay this government cut $400 million from its salary scale estimate. The government has framed the tax measures this way: It said it would need $800 million in spending on the salary scale, so it would collect $800 million in revenue.

The government does not acknowledge, economists pointed out, that moving forward the salary mass would increase exponentially even without new hiring, and that revenue mass would increase very gradually or even remain unchanged when measured as a percentage of GDP. The “public sector salary increase is not $800 million, nobody knows how much the exact cost of it will be,” says Ghobril.

Assessments by the ministry of finance were not made public, and government officials with knowledge of the matter did not respond to questions seeking clarification. It seems the government believes the salary scale and taxes would be budget neutral. The economists say in general that imposing taxes would negatively impact GDP, at least in the near term, and thereby any generated revenue from a tax increase could decline in the medium to long term.

Economists interviewed agree there are other ways to pay for the salary increase. “The tax approach of the government for the budget is to finance the public sector salary increase. The argument is that there are sources of financing other than taxes,” says Ghobril. The Kataeb party opposed the new taxation to finance a public sector wage increase, according to Tawile. Instead Kataeb has argued that a reduction of government inefficiencies, as Tawile politely put it, must be the source of financing for the wage increase.

To Nader, the government, “officially recognized that there is corruption to the point that they nominated a minister and called it the state ministry for combatting corruption. They recognize they are corrupt, and now want the citizens to finance the corruption?” Saad Hariri, Lebanon’s prime minister, in addressing the March 19 protest against a tax hike, made a big promise to the crowd as they pelted him with water bottles: he and president Michel Aoun would stamp out corruption, inshallah. Hariri, in forming his cabinet in late December, created a ministerial portfolio that would target corruption – but it is unclear what its objectives are or what, if anything, has been accomplished so far (Executive had asked for an interview with the Minister of State for Combating Corruption in January but the request went unanswered).

The government has announced a plan to reform spending in the electricity sector. The ministry of energy was set to lay out the details after Executive went to print, so it is not exactly clear how much money might be saved, but Finance Minister Khalil, in announcing the budget figures, said allocations to cover Electricite du Liban (EDL) deficits would be capped at nearly $1.4 billion. In general, the plan calls for a reduction of the subsidy to EDL and an increase of rates. For EDL the price per barrel at which it will pay for oil – with help from the treasury – to generate electricity will rise from $25 to $60. For customers the plan calls for a tariff increase on electricity bills that is said to be around 40 percent but the details are not yet clear.

At a minimum, the economists say, emphasis on capturing revenue instead of more taxes and reforming electricity spending is probably a reaction to the street protests, political pressure, and acknowledgment of the fiscal advice that the IMF and World Bank, among others, have long advocated. All of it is an embarrassingly loud testimony to Lebanon’s lack of fiscal policy, with neither clear-cut priorities nor a strategic vision guiding how the government manages taxing and spending.

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Jeremy Arbid

Jeremy is Executive's former economics and policy editor.

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