Fiscal reforms to help Saudi Arabia achieve budget surplus

With Vision 2030 and the National Transformation Programme (NTP) already in place, Saudi citizens, businesses and economic observers are keen to see how the government will adjust its expenditure and revenue streams to meet its newly established goals under the Fiscal Balance Programme (FBP) announced in early 2017. The FBP outlines the ways in which the government intends to achieve a fiscal surplus. The plan originally targeted a surplus by 2020; however, this was revised to 2023 in an update to the FBP in early 2018, in order to mitigate downward pressure on GDP growth.

Under the 2018 budget, the deficit is now projected to reach 7.3% of GDP, down from 8.9% in 2017 and 12.8% in 2016, suggesting the strategy has been successful so far. The FBP is one of the most comprehensive fiscal documents to be produced by the authorities, containing roadmaps and schedules covering spending rationalisation, energy price reform and non-oil revenue generation.

Cutting Costs

The FBP sets the ambitious target of SR209bn ($55.7bn) in savings, the bulk of which is to be derived from the wholesale reform of energy and utility prices. By focusing on the costly subsidy system, the government is engaging in a regional trend that has seen authorities from Cairo to Muscat announce reductions in support for essentials like electricity, fuel, water and food. In many cases, the process is a politically sensitive one, although in Saudi Arabia most concern relates to the effect reductions will have on economic growth.

The government’s current proposals, defined by the FBP, build on the electricity and fuel price increases that took effect in the first half of 2016. This first phase of reform represented only a marginal correction, and did not include the price of water – the government wishing to wait until new billing and metering infrastructure was in place before making any adjustments to that utility.

The second phase of subsidy reform will see a more sustained and steady approach, featuring gradual price increases through to 2020. Domestic prices will be linked as a percentage to the export price of each respective product, and will fluctuate according to movements in international markets. This linkage will be gradually phased in by a schedule that varies by product: household electricity prices will be the first to reach 100% of the reference export price, with the other utility prices scheduled to reach 100% by 2020.

Depending on the fluctuations in global markets, the new framework may result in significantly more expensive inputs for business, as well as weightier bills for residents. To mitigate the effect of the changes, therefore, the government intends to provide targeted support for industries to ensure they can remain globally cost-competitive; however, the details have yet to be revealed.

A more extensive mitigation effort is planned for private citizens. The FBP includes the establishment of a Household Allowance Programme to assist vulnerable, low- and middle-income households to meet the extra energy and water costs. Under the terms of the programme, eligible households will receive an allowance determined by the size of the family, the impact of the price changes and the effects of other reforms, such as the introduction of the value-added tax in 2018. The programme will also encourage more sustainable consumption levels by basing entitlements on “sensible” usage, defined as 398 litres of petrol per month for families with two cars, and 2594 KWh of electricity consumption per month for each household.

Boosting Efficiency

Beyond subsidy reform, the government has other ideas with regard to cutting costs. By establishing a new Bureau of Capital and Operational Spending Rationalisation Unit, it hopes to end an era of looser spending discipline which has seen an average budget overrun of 22.2% each year between 1999 and 2016. The new body will be seeking efficiencies in government contracting, leveraging economies of scale for procurement and optimising the consumption of utilities, looking at current and capital spending. The latter will be under particularly close scrutiny over the coming period. According to the FBP, the total outstanding cost of public capital projects – which stood at SR1.4trn ($373.2bn) as of 2016, of which SR220bn ($58.7bn), belonging to five ministries – was under review.

A 2017 research paper by Riyadh-based Jadwa Investment shows that the government was able to reduce this cost by roughly SR100bn ($26.7bn) as a result of applying global best practices, and points out that if it is able to achieve a similar level of optimisation for the remaining of projects, “it would mean a significant preservation of fiscal buffers, and would allow for a significant increase in growth-enhancing capital spending”.

Increasing Revenue

The government is also intent on strengthening its revenue streams, an effort which is centred on the non-oil component of income. Taxes and fees accounted for approximately 46% of non-oil revenue in 2016, and this is the area of the balance sheet where the government intends to make its revenue-enhancing changes. The introduction of excise duties in 2017 was expected to add SR12bn ($3.2bn) in extra revenue, while estimates for the new VAT system run to around SR15bn ($4bn), making it the single biggest driver of revenue growth (see overview). These initiatives have been broadly accepted by stakeholders as being a necessary part of a modern taxation framework.

More challenging for some, however, is the introduction of a new expat levy, which, according to Al Rajhi Capital, a major local investment firm, is expected to account for 45-50% of incremental non-oil revenue in 2020. The implementation of the levy has been a low-cost enterprise for the government, as it has been able to make use of the existing visa infrastructure to apply it. The schedule for the levy applies a variable rate for foreign residents, which depends on the number of dependants, starting at SR100 ($27) per dependent per month in 2017 and increasing to SR400 ($107) per month in 2020. Companies are expected to pay similar rates per foreigner employed, with a slightly higher levy on those that hire more expatriates than nationals.

Extra Costs

The changes, while remunerative for the government and useful from a domestic employment perspective, represent a significant additional cost to expats and companies operating on low margins. Some sectors have been more adversely affected than others: construction, real estate and the hotel industry, for example, employ large numbers of foreign workers, and are being compelled to find efficiencies elsewhere to maintain profitability. Just how sizeable the impact will be on aggregate corporate revenue remains to be seen.

Al Rajhi Capital, using the General Authority for Statistics’ survey for 2015 as its reference, estimates that the impact on the broader economy will be 1% to 2% of aggregate business revenue by 2020, when the levy reaches its peak. For companies in sectors that are more vulnerable to the levy, this rises to 2.5-4%. The most obvious risk of this scenario is that Saudi businesses will pass on the extra costs to end users, which would likely result in a slowdown in consumer spending. However, the clarity of the government’s plans with regard to the expat levy, as well as the clearly defined programme of changes to other input costs, affords companies with sufficient time to adjust to the new operating environment.

Potential Gains

The government is following a challenging timeline of cost savings and revenue targets, but the potential gains from its efforts are substantial. Jadwa Investment expects the initiatives undertaken in 2017 alone to result in SR100bn ($26.7bn) worth of public savings, and that by 2020 the government, through the FBP, will have saved approximately SR363bn ($96.8bn), leading to a fiscal surplus of SR162bn ($43.2bn). Estimates initially predicted the reform measures of the FBP would see a budget surplus by 2019; however, following the annual meeting with the IMF in October 2017, Mohammed Al Jadaan, minister of finance, told local media that the government was open to adjusting how aggressively it pursued its fiscal reforms, and the target date was subsequently revised to 2023.

Conservative estimates, which assume delays in the implementation of energy and water price reform, and a stubbornly low oil price, still see a budget surplus by that date, with only the most conservative predictions forecasting the continuation of a deficit. Should the Kingdom balance its books as expected, it will have completed one of the most important phases of fiscal reform in decades, and taken a key step towards meeting the long-term objectives that were established in Vision 2030.