Saudi Arabia reaps the benefit of establishing VAT

The coronavirus has caused the largest global economic crisis in nearly 100 years, forcing governments to take drastic moves to protect their economies. Saudi Arabia's decision to raise value-added tax (VAT), combined with spending cuts, demonstrates the benefits of the Kingdom's recent steps to restructure its fiscal system.

The Saudi Arabian government’s swift and prudent decision on Monday to triple VAT to 15 percent has left the Kingdom able to rely less on large, painful cuts to public finance spending, and reflects the wider range of fiscal choices at its disposal following the establishment of the tax in January 2018.

The need for belt-tightening is the result of the economic havoc wrought by the coronavirus. Social distancing measures have depressed domestic economic activity, while the temporary suspension of international travel including the Hajj and Umrah pilgrimages has hit the Kingdom’s income from tourism. A historic downturn in oil prices this year has also had an adverse effect, as hydrocarbons represent over 70 percent of Saudi fiscal revenues.

While the Kingdom’s fiscal buffers are generally in good shape – the public debt is less than 30 percent of GDP, and it possesses $500 billion of foreign currency reserves – the government has wisely surmised that stabilizing its finances is critical to creating a positive investment climate. All countries benefit from investment, but the gains are accentuated in Saudi Arabia’s case as the Kingdom is undergoing a deep economic restructuring under the banner of its Vision 2030 reform plan.

Before VAT was introduced, Saudi Arabia was forced to rely almost solely on cuts to public spending in times of economic downturn, as non-oil revenues were small and inflexible. Thus, the government would cut capital spending (mainly infrastructure investment), and would reduce public sector pay, through both salary freezes and decreased hiring.

From a simple balance sheet perspective, the source of a decrease in net spending is largely irrelevant. However, from an economic perspective, there are many important considerations. In particular, fiscal reforms vary in their progressiveness (the extent to which the rich have to pay more than the poor do); their implementation cost; and their impact on long-term economic growth.

Most OECD governments have sophisticated tax systems that are hundreds of years old, affording them a high degree of flexibility when implementing austerity reforms. These governments can adjust income tax, VAT, real estate tax, capital gains tax, and corporation tax with the goal of increasing revenues in a cost-effective manner that protects living standards for the poor and maintains the incentive to invest so that the economy continues to grow.

The desire to develop comparable levels of fiscal maneuverability is what drove Saudi Arabia (and Bahrain and the UAE) to implement VAT during the last two years, consistent with IMF recommendations. VAT has several advantages as a tax instrument: By using exemptions for basic commodities, it can be used progressively; it generates a stable revenue stream; it is relatively cheap to collect; and compared to other taxes, such as capital gains tax, it does not disincentivize investment. That is why it is one of the most popular taxes in the world, spreading rapidly after its creation in the 1920s by German businessperson Wilhelm Von Siemens. In 2019, it generated almost $15 billion of revenues for the Saudi government, equal to just under 2 percent of GDP, a positive start but still lower than the 2017 OECD average of 6.8 percent. And while tripling the rate of VAT will likely provide a significant increase in revenue, the Kingdom still offers the comparative attraction of overall low taxes for its residents, most notably due to the absence of personal income taxes.

Unlike the oil price crash of 2014, the Saudi Arabian government now has the option of increasing VAT to stabilize its finances. This means it can reduce the amount of domestic spending cuts that it would otherwise be forced to implement, as the Kingdom must continue to invest. Moreover, VAT increases are more politically palatable than decreases in wages, a point famously made by British economist John Maynard Keynes in the 1930s. The fact that the Minister of Finance has been communicating these steps to the general public indicates government awareness of how to generate societal buy-in when implementing austerity measures, based on the Kingdom’s own experience and that of many other countries in the wake of the 2008 global financial crisis.

As it happens, public sector salaries were cut in the form of a decreased cost-of-living allowance, but the decrease was significantly smaller than it would have been in the absence of a VAT rise. Moreover, the significant financial and psychological one-off cost of introducing VAT has already been digested by both the government coffers and the general public; introducing a new tax at the same time as tightening belts would have presented a much greater challenge for fiscal authorities, especially when the public are still suffering the trauma of the coronavirus.

It is difficult to make definitive predictions for the next six months, as public health experts are yet to arrive at a consensus on the likely path of the coronavirus, and on attempts to treat it and develop a vaccine. Under these circumstances, the Saudi Arabian government has demonstrated an ability to act quickly and decisively, and to complement its interventions with a sound communication strategy. These measures considerably improve its chances of successfully navigating the crisis. As former US President Theodore Roosevelt once remarked: “In any moment of decision, the best thing you can do is the right thing. The worst thing you can do is nothing.”

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Omar Al-Ubaydli (@omareconomics) is a researcher at Derasat, Bahrain.

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Last Update: Wednesday, 20 May 2020 KSA 09:58 - GMT 06:58
Disclaimer: Views expressed by writers in this section are their own and do not reflect Al Arabiya English's point-of-view.
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