GCC ripe for subsidy, tax reforms

Governments need to consider alternative revenue streams to maintain fiscal balance

In a pragmatic move aimed at strengthening fiscal position and reducing domestic oil consumption, the UAE government announced the deregulation of transport fuel prices from August 2015.
With GCC economies steadily embracing market-oriented reforms, the surprise move by the UAE has made it the first nation in the GCC to completely abolish fuel subsidies and join the league of other key emerging economies such as India, Indonesia, Mexico and Egypt that have deregulated fuel prices in the recent past.
Oil has been a major contributor to government revenues, accounting for over 80 per cent of total government revenues for most GCC states, while this figure was close to 60 per cent for more diversified economies of Qatar and the UAE.
Given the substantially lower oil prices and record levels of budget spending, the burden of subsidies on state finances is increasingly overbearing for GCC economies.
According to the International Monetary Fund (IMF), pre-tax energy subsidies in the UAE are estimated at $12.6 billion in 2015, almost three per cent of the country's gross domestic product (GDP), while this share was close to 4.5 per cent of GDP for Bahrain and Saudi Arabia. Further, the share of pre-tax energy subsidies to fiscal expenditure was more than 10 per cent for Saudi Arabia and Bahrain while it was close to nine per cent for the UAE.
Fiscal deficit
Clearly, reduction in subsidies is the way forward, especially when most international and regional observers, including the World Bank, IMF and the Organisation of Petroleum Exporting Countries (Opec), expect oil prices to remain below 2014 levels for the next five years.
Moreover, according to the IMF, the fiscal deficit in 2015 resulting from lower oil prices is expected at over 10 per cent of the GDP for Bahrain, Oman and Saudi Arabia while the UAE is expected to post a marginal deficit of three per cent. Qatar and Kuwait are the regional outperformers and will maintain positive fiscal balance despite low oil prices.
Therefore, with year-on-year compounding of fiscal deficits going forward, the pressure to lift subsidies will be significantly higher for some GCC peers, particularly Oman, Bahrain and Saudi Arabia, as compared to the UAE.
Large financial reserves for some GCC states may shield them against oil revenue shortfalls in the near term. However, consistent fiscal deficits for more than a few years may expose these economies to severe fiscal challenges in the mid to long term.
According to the IMF, the financial reserves of Kuwait, the UAE and Qatar can cover fiscal deficit (at current budget) for more than 25 years. However, other GCC economies, including Bahrain, Oman and Saudi Arabia, will struggle in less than five years.
Oil reserves fall
The situation is further accentuated by deteriorating oil reserves for GCC states, particularly Oman and Bahrain. According to the Energy Information Administration, at current production levels, the oil reserves for Bahrain and Oman are expected to be depleted by 2020 and 2030 respectively.
Given the above scenario, the UAE could set a precedent and could possibly prompt other GCC governments to follow suit, especially as the relatively low price of crude oil would make it an opportune time to reform state fuel subsidies without causing a sharp spike in inflation or the cost of living in the near term.
The clearest case for subsidy cuts would be Oman and Bahrain, given their precarious fiscal position and insufficient financial and oil reserves. Kuwait is likely to take a more gradual approach and is considering cutting fuel subsidies step by step starting next fiscal year (April 2016).
Qatar, on the other hand, may not be too inclined for subsidy cuts in the near term considering its strong fiscal and economic position. Saudi Arabia will present an interesting case as the country is already struggling with public discontent over structural problems such as economic inequality and youth unemployment.
Although the country's leading economists (including the governor of Saudi Arabian Monetary Agency) are soliciting for subsidy reforms, Saudi Arabia may pursue spending cuts coupled with partial reduction in subsidies to manage fiscal deficit in the near term.
Public discontent
Over the last year, GCC countries such as Kuwait, Oman and Bahrain undertook several measures to curtail subsidies. While some of them were successful, several encountered considerable public protest.
For instance, Kuwait had to partially reverse the fuel price hike administered early this year while Bahrain has to compensate its citizens (through cash payments) to offset the cut in subsidies. Therefore public discontent will be a prominent factor in deciding the manner and magnitude of subsidy reforms in the GCC.
In addition to subsidy reforms, the regional governments may also explore alternative revenue generating streams such as indirect taxes to partially offset fiscal burden. Recent reports suggest that the UAE along with other GCC countries is preparing a federal tax code, that involves a value added tax (VAT) and corporate tax. The first draft will be completed by third quarter of this year.
While indirect taxation might offer a multitude of benefits from a business and economic point of view, there exist a few issues that GCC nations will have to address first before implementing this law.
Firstly, exposure to indirect taxes will diminish GCC's 'tax-free economy' image among multinationals and the expat community, which will not only result in lower FDI (foreign direct investment) inflows but may also create shortage of skilled professionals. Secondly, the increased tax burden will negatively impact domestic consumption due to heightened inflation and diluted disposable income.
Moreover, a change in tax regime may not sit well with long-term tax exemptions promised to businesses established in free zones and tax-free economic planning strategies that have been developed over many years. Gladly, almost all GCC countries understand the implication of tax regime changes and therefore, are likely to follow a gradual implementation schedule spanning over multiple years.
The writer is the founder and chief executive officer of Al Masah Capital Management Limited. Views expressed by him are his own and do not reflect the newspaper's policies.