Reforms to lower structural fiscal deficit

Prior to the 2011 revolution, Egypt was making steady progress in reducing persistent fiscal deficits, thanks to sustained efforts by reformist governments. One of the most enduring legacies of that period is a much-improved tax system, which replaced a bloated and inefficient process with a more streamlined and wider-based structure. Simplified tax procedures and lower rates resulted in steadily growing tax revenue, and these are largely credited with the reduction of the fiscal deficit from 10.4% of GDP in 2002/03 to just 6.8% in 2007/08. The strain placed on the economy by the global economic crisis saw the budget deficit begin to rise slowly in 2008/09 and 2009/10, but it was the political and economic unrest of 2011 that undid the work of the previous decade. The 2011/12 budget deficit exceeded the recent 2002/03 high to reach 10.8%, and by 2012/13 had climbed as high as 13.7%.

The political instability that affected successive administrations exacerbated things. Tax revenue held up reasonably well, rising year-on-year during 2010/11, but non-tax revenue from areas such as tourism fell steeply, even as populist pressures led to a rise in recurrent spending for wages – a significant concern given that an estimated 25% of the labour force works for the government or public sector. Ultimately, the government was compelled by circumstances to maintain an expansionary fiscal policy that it could not afford, and a widening fiscal gap therefore became an inevitability.

Budgetary Reform 

Reducing the structural fiscal deficit is one of the government’s priority economic objectives. In May 2014 an initial budget draft for fiscal year (FY) 2014/15 envisaged a deficit of 12%, or LE288bn ($40.9bn), but as a result of the intervention by the newly elected President Abdel Fattah El Sisi, the Ministry of Finance submitted a revised version of its budget which represented a significant fiscal tightening. Approved by the president in the summer of 2014, the FY2014/15 budget now envisages a deficit of LE240bn ($34.1bn), or 10% of GDP. The reduction of the budget deficit to a percentage of GDP not seen since FY2010/11 has sent a strong signal regarding the government’s economic direction. Speaking in the early weeks of his term, President El Sisi singled out the fiscal deficit as a national concern, stating that the levels of borrowing that it necessitated would not “leave anything good” for future generations.

Since then, the president has made a public show of donating LE500,000 ($71,000) and half his salary to a newly established “Long Live Egypt” fund, an act that was subsequently emulated by senior government members such as the foreign minister, Sameh Shoukri. These very public displays are part of a broader campaign to prepare the public for the difficult reform of a state subsidy system that in recent years has accounted for 20% of government spending. Under the new budget, Egypt has cut spending on energy subsidies – which comprise the bulk of total subsidisation – by almost one-third, so that they account for around 13% of government spending for the year (see analysis). Given the government’s commitment to raising the minimum wage of public sector employees, slashing the costly and inefficient subsidy system represents the most direct route towards achieving a fiscal balance.

Boosting Revenue 

On the other side of the ledger, the government is also making attempts to boost its revenue. While tourism activity has historically been a useful source of revenue, it sank by 33% in the immediate aftermath of the 2011 revolution, according to the Ministry of Tourism, and has remained at a subdued level ever since. After a modest uptick in 2012, it declined by 41% year-on-year in 2013 as visitors shied away from civil unrest. Recovery of tourism revenue is dependent on a prolonged period of political stability, and is unlikely to become apparent until the next fiscal year at the earliest. Thus the government has sought out other areas of potential revenue growth. Receipts from Suez Canal traffic are seen as one such opportunity. Largely unaffected by Egypt’s domestic turbulence, revenues from the Suez Canal have steadily flowed into government coffers, and in 2014 work began on an ambitious plan to increase its capacity. The $4bn project is expected to significantly shorten the time it takes for shipping to pass through the canal. However, despite the government’s undertaking to complete the project in a timely fashion, the revenue boost that is the ultimate goal of the initiative is some years away.

Taxation

In the shorter term taxation represents the most promising route to boosting revenues and reducing the fiscal deficit, despite having some negative effects on growth. As with subsidies, tax reform is a politically sensitive issue, but the government has nonetheless demonstrated a willingness to tackle it. In 2014, for example, the Cabinet approved a 5% income tax hike on individual taxpayers earning more than LE1m ($142,000) per year, to be implemented for a three-year period as a special measure to combat the nation’s deteriorating economic position. Such measures are not unusual and are similar to capital levies raised elsewhere, although their efficiency is uncertain. The government has also introduced a capital gains tax, which is expected to come into effect on January 1, 2015. The 10% tax will be levied on net capital gains made from the stock market, calculated at the end of the year, and in its current form excludes Treasury bills from its scope.

VAT in Focus

The new taxes are the first steps of what will be a longer process of taxation reform. While the income tax system is an obvious starting point for this process, other areas of taxation offer the government the prospect of increased revenue. The replacement of the current sales tax with a value-added tax (VAT) has long been a subject of debate in Egypt. The economic turbulence wrought by the 2011 revolution restarted this debate, in large part due to a potential offer of financing from the IMF, which according to press reports suggested changes to the tax system, including a transition to a VAT mechanism on sales and purchases.

Debate

In late 2013 the Egyptian Centre for Economic Studies (ECES) organised a symposium to look at the question of introducing a VAT as a means of bolstering revenues in the country. The event marked the most recent turn in a long-running debate on the question of VAT that emerged in the wake of Egypt’s major tax reforms of 2005 and 2006 – changes which together added around a million extra taxpayers to the tax base.

The suggested VAT mechanism would replace a sales tax introduced in Egypt in 1991. The current tax applies to all non-exempt domestic goods and goods imported for commercial purposes, and is levied at a standard rate of 10% with a maximum tax rate of 25% on some luxury goods and a reduced tax rate of 5% on essential goods. As of 2013 VAT had been implemented in over 150 countries, according to the IMF, and in those countries it accounted for around 20% of all tax revenue.

VAT offers advantages over the general sales tax mechanisms: as a broad-based tax on consumption it can secure high and stable revenue and reduce the opportunities for tax evasion; a VAT system could be used to boost exports by offering a zero-rate on export sales; and, by not taxing business inputs, VAT also avoids cascading (by which a good is taxed more than once as it progresses from production to final retail) helping to 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.

Moreover, the potential benefits in terms of revenue that might stem from VAT are significant. According to figures from the ECES, implementing a VAT in Egypt (assuming a modest VAT rate of 10%) could potentially generate around LE113.8bn ($16.2bn) per year in additional revenue.

Still, the question of feasibility remains. The depreciation of the Egyptian pound, which has fallen from its usual range of around 5.50-6 to the dollar to 7.12 to the dollar as of late October 2014 – also poses a challenge, in that introducing VAT when imported goods are becoming more expensive runs the risk of having it blamed for higher prices and thus attracting public opprobrium. Also, with such a sizeable informal sector the taxation of consumption in Egypt is particularly complicated.

Many Benefits 

However, the goal of establishing a VAT system in Egypt appears to be an attainable one, and one that could bring with it significant benefits. Other countries have faced similar challenges and overcome them successfully – the ECES offers the example of Indonesia, which in 1984 displayed many commonalities with the Egyptian economy of today, such as a large informal sector (accounting for around 35% of economic activity compared to Egypt’s 40%) and similar tax revenue (16% of GDP compared to 14%). Indonesia introduced its VAT mechanism in 1985, and by FY2012/13 it had emerged as a key source of revenue, accounting for around 38% of the total tax take.

While the challenges facing the implementation of VAT in Egypt are considerable, the rewards of a more efficient and broad-based tax system – and stronger and more sustainable revenues – could well make it worthwhile. In October 2014 the IMF resumed talks with the Egyptian government on the introduction of VAT, according to a statement made by Christine Lagarde, the fund’s managing director.