Decreasing Subsidies Vs. Increasing Taxes

Oil prices have retreated from over $100/barrel at the middle of 2014 to less than $30/barrel at the start of 2016, putting pressure on the government finances of the Gulf Cooperation Council (GCC) countries. Addressing a budget deficit requires either a decrease in expenditure, or an increase in revenues. Accordingly, policymakers examining the issue over the course of the last year have started with decreasing fuel subsidies, and they have drawn up plans for introducing various forms of taxes, most notably value-added tax (VAT).

In fact, such policies were going to be necessary even if oil prices had remained high, due to the rising budgetary pressure resulting from demographic change. For some time, international organizations, such as the International Monetary Fund (IMF), have been advising the GCC countries to reform their subsidy systems and diversify government revenues. The recent policy changes represent an acceleration of fundamental reforms that the respective Ministries of Finance have been planning for some time.

Naturally, the average GCC citizen would prefer to avoid such changes, due to their adverse consequences on a citizen’s purchasing power. However, such desires are no longer tenable, posing an important question: what is preferable between decreasing subsidies and increasing taxes?

The economics profession has a branch called “optimal taxation” which specifically attempts to answer this question. Economists have concluded that–for highly technical reasons–VAT is generally preferable to income taxation, sales taxes, and other alternatives. These intellectual contributions were part of the reason that Sir James Mirlees (UK) and Peter Diamond (USA) won Nobel Prizes in economics, and their theories are used by policymakers the world over when designing tax systems.

In the GCC countries, there is a notable additional consideration that has recently emerged, and that should be taken into account when analyzing optimal taxation: international rankings in indices of economic freedom. In the age of globalization, capitalists regularly search for investment opportunities outside the Western world due to the diminution of the opportunities in advanced economies. However, Western investors suffer from an informational gap about the choices available in non-Western countries, including the GCC, Africa, and South America.

In an attempt to plug this gap, commercial organizations dedicated to the study of non-traditional economies have emerged. They prepare detailed reports on the pros and cons of the countries seeking to attract international capital, presenting recommendations based on substantive analysis, with one of the most prominent examples being Moody’s Investor Services.

Organic competition between such organizations has spawned a niche focusing on “economic freedom.” Following the collapse of the Soviet Union at the end of the twentieth century, policymakers became convinced of the efficacy of economic liberalization. It serves the interests of both domestic and foreign investors, most notably through the protection of property rights, which are considered the cornerstone of a vibrant, modern economy. As an example, the Heritage Foundation in Washington releases an annual ranking of economic freedom as a service to investors, and consequently as a means for encouraging governments to adopt economic liberalization policies.

The GCC countries regularly occupy some of the higher positions in such rankings for a variety of reasons. First, the GCC countries have always philosophically believed in the principle of property rights: their governments have avoided expropriation, even in the period prior to the discovery of oil, which is a distinguishing trait when compared to other emerging economies, including various republics in the Middle East, Africa, and Asia. Such a commitment to private property played an important role in the GCC countries’ ability to evade some of the adverse consequences of the Arab Spring.

Second, the GCC governments structured their budgets on oil revenues by nationalizing their oil companies, allowing them to avoid traditional forms of taxation, and to provide significant subsidies across a variety of basic goods and services. Due to some highly innovative policies, Dubai has managed to achieve the same feat even in the absence of significant oil revenues. As a result, the GCC countries have become attractive destinations for international capital, creating numerous job opportunities for GCC citizens and non-citizens alike.

In light of the fall in oil prices, the GCC countries are likely to struggle to hold on to the top places in the economic freedom rankings, especially if policymakers opt for the imposition of new taxes. Subsidy reform, however, offers a temporary solution. The generous subsidy schemes currently in place play no role in the GCC countries’ elevated rankings. In fact, they damage the GCC countries’ standing, since genuine economic freedom is predicated upon the minimization of government interference in the economy, and subsidies constitute a distortion of market prices. Accordingly, to maintain their reputation for economic freedom, and their high scores in the associated global indices, GCC policymakers should consider reducing subsidies before imposing taxes as they look to tackle their budget deficits, especially in light of the job-creating role of foreign direct investment in the GCC.

Naturally, these are not the only factors to be taken into account; but there are additional reasons for favoring the elimination of subsidies, such as the adverse environmental consequences of subsidizing fuel and energy. Moreover, subsidies have inadvertently transformed from an effective means of providing income-support to low-income households at the time of their conception, to, more recently, a form of regressive taxation, whereby the rich benefit at the expense of the poor! Regardless, GCC societies will surely be dreaming of a day where both taxes and subsidies are deemed unnecessary.

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