Saudi Arabia to use taxes to boost state revenue

Public sector salary cuts and subsidy reductions will play an important part in Saudi Arabia’s effort to close its fiscal gap. However, much attention is also being paid to the other side of the ledger, where a series of tax proposals offer a route to new revenue streams for the government. Historically, taxation has only played a small role in government finances: the IMF estimates that between 2012 and 2014 Saudi Arabia’s tax revenue accounted for only 1.4% of GDP, with most of that coming from levies on trading activity.

This phenomenon is not unique to the Kingdom; within the GCC, the highest tax revenue as a percentage of GDP for the period was claimed by Oman, at just 2.8%. Of the other GCC member states, the UAE posted 2.5%, Qatar 1.7% and Bahrain and Kuwait both recorded tax-to-GDP ratios of less than 1%. However, with growing populations and the possibility of an extended period of low oil prices, this hitherto overlooked area of public finance has come under renewed focus.

Fresh Disposition

One of King Salman bin Abdulaziz Al Saud’s first acts upon his ascension to the throne was the imposition of a 2.5% annual tax on urban land not being developed by its owners – a levy known locally as the “white land tax”. The measure came into effect in June 2016 and is a social initiative as much as a revenue-enhancing one, intended to tackle a chronic housing shortage that the government estimates will require the construction of 1.5m homes through to 2023. In the summer of 2016 the minister of housing announced the imminent publication of detailed implementation regulations, which will likely see the tax rolled out on a phased basis, starting with large plots at first and then expanding to include plots as small as 10,000 sq metres.

The step is a bold one in a tax environment where land owners have traditionally paid no property tax other than a 2.5% zakat (charitable religious tax) on real estate held for speculative purposes. The challenge the government will face in the coming years will be to affect a smooth implementation of the tax. Rolling out the regime in a way that works with the country’s land registration systems, which vary in quality from city to city, will also be difficult.

A so-called “sin tax” on harmful products such as tobacco and sugary drinks is another potential revenue-enhancing proposal open to the government. In 2016 there were calls for price hikes on tobacco products of up to 100% from some locally based campaign groups. More significant from a revenue-generating perspective is the possible introduction of personal income tax for non-residents, an idea that makes an appearance in the National Transformation Programme published in June 2016. The minister of finance, Ibrahim Al Assaf, told media that month that nothing had been approved, and that such a tax was just a proposal.

An Old Approach

In some respects, this represents the return of an old story. Saudi Arabia introduced personal income, capital gains and corporate taxes in the 1950s on both nationals and non-nationals; however, the initiative proved difficult to implement, and within six months of the new tax law’s introduction it was revised to exclude nationals. Then, as the oil boom of the mid1970s fuelled a construction drive in the Kingdom, income taxes on foreigners were suspended in order to make the Saudi market more attractive to an expatriate workforce.

When oil prices declined in the 1980s, an attempt was made to reintroduce an income tax for foreigners. The initiative was met with intense opposition, with some expatriates resorting to strike action – including a number of military contractors whose protests resulted in the grounding of some sections of the Royal Saudi Air Force. Potential opposition, or at the very least a lessening of the Kingdom’s ability to attract foreign labour, remains a challenge to the implementation of a personal income tax on expatriates. The issue is a sensitive one, and was still just a proposal as of the October 2016. However, the potential gains in terms of non-oil revenue for the state that establishing an income tax on the one-third of residents who are non-Saudis may make a potentially difficult implementation process worthwhile.

Regional Move

When it comes to the question of value-added tax (VAT), a topic of discussion for many years in the region, there is more certainty. After much speculation, an agreement signed in February 2016 by GCC ministers has brought some welcome clarity regarding the introduction of VAT to Saudi Arabia. The Kingdom, along with states around the Gulf, will begin to implement VAT from January 2018, and will thereafter have a full year to establish the new tax. The precise timing of the rollout is a matter for each individual country to decide, and the detailed framework, which will reveal exactly which goods and services will be subject to VAT, has yet to be published.

However, while question marks remain regarding some of the finer nuances of the system, there is no doubt that VAT is soon to become a reality for Saudi Arabia’s businesses and consumers. Understandably, the attention of most economic observers has now shifted from questions related to the timing of implementation to the effect that the introduction of VAT will have on the economy.

The proposed rate of 5% is a modest one compared to that being adopted by other emerging markets. For example, in 2016 Egypt is preparing to introduce a VAT system, which, subject to parliamentary approval, is likely to impose a rate of around 10%. The average VAT rate in the advanced economies of Europe, meanwhile, is closer to 20%.

Changes Required

Nonetheless, for Saudi Arabia and the UAE a 5% levy on goods and services represents a significant alteration to a famously low tax environment. In addition to the financial adjustment that will have to be made by the Kingdom’s businesses, a considerable adjustment to processes will also be necessary. Larger firms operating enterprise resource planning (ERP) frameworks will have to revise their systems to enable them to charge and recover VAT, while those without ERP systems will be compelled to implement manual VAT accounting processes. These will include everything from ensuring invoice templates include the relevant fields for VAT accounting, to altering the business structure to avoid unnecessary cash flow or absolute VAT costs arising, particularly on inter-company transactions.

All companies operating in the country will need to revise their terms of business with clients to ensure that VAT becomes a cost to customers rather than to suppliers. For many companies, adjusting to the practicalities of the new framework will be a challenging undertaking. In its recent assessment of the effect of VAT in the GCC, accountancy Deloitte noted that “understanding current readiness to adapt a business to a taxed environment is key, simply as it will identify those areas which will need to be given priority in the undoubtedly hectic build-up to implementation”.

Potential Benefits

While the launch of VAT will undoubtedly present businesses and citizens with financial and bureaucratic costs, the potential gains for the government are considerable. According to the IMF, a VAT system has been implemented in more than 150 countries, where it is the source of around 20% of government revenue.

The low starting rate of VAT in the GCC suits Saudi Arabia well, as the nation has never had a general sales tax, and therefore a higher rate would leave it vulnerable to an inflation spike. The 5% level recently agreed upon was backed by the IMF in August 2015, when the organisation also estimated that even this modest rate would, if implemented, bring in extra revenue worth 1.6% of GDP in Saudi Arabia’s case.

Along with directing a new revenue stream towards the Kingdom’s coffers, the VAT regime offers a number of other potential advantages. For example, as a broad-based tax on consumption, it will be able to secure high and stable revenue, and at the same time greatly reduce opportunities for tax evasion that a simple sales tax is vulnerable to. In addition, a VAT system can be used to boost exports by offering a zero rate on export sales. Lastly, by not taxing business inputs, VAT avoids cascading – by which a commodity is taxed more than once as it progresses from the production phase to final retail – and helps maintain production efficiency by removing the incentive for businesses to vertically integrate in an attempt to avoid paying taxes on inputs to the production process.