Tax and Post-Pandemic Recovery—a Perspective From Arab Countries

Even before the current international developments, many Arab countries faced new challenges, including higher food and energy prices as they emerged from the pandemic. With higher interest rates, many governments’ fiscal situation has tightened, leaving less fiscal space for expansionary policies than during the pandemic.

Restarting Growth

How can governments in the Arab world address this situation and restart vitally needed economic growth?

The key is investment. Because employment can recover only through growth, a proven path is to implement policies that attract investment, both foreign and domestic. Growth-friendly tax policy is an often-overlooked tool to promote investment.

Recently, a World Government Summit forum in Dubai considered how to build a tax system that promotes both growth and fairness. In particular, does moving towards a fairer, more equal global tax system encourage long-term, equitable, inclusive, and sustainable growth?

The impetus behind these reforms is sound. Gaps in tax rules have encouraged profit shifting to low-tax jurisdictions and erosion of domestic tax bases. Thus, the international community has sought to reshape the international tax architecture, culminating in the OECD/G-20 Base Erosion and Profit Shifting project, including its two-pillar framework which proposes a new nexus rule permitting reallocation of taxing right, and a global minimum corporate tax rate of 15% for multinational corporations by 2023, to address the tax challenges of digitalization.

This reform is estimated to raise global tax revenues by around $150 billion per year—much of this in the developing world.

Done well, international tax reform as a package will increase compliance, weaken the shadow economy, and not harm the investment climate. Done poorly, revenues may fall due to removal of all digital services taxes and other relevant similar measures with respect to all companies, leaving governments even more cash-strapped, causing fiscal challenges that may undermine investment efforts.

But how can countries both implement this system and promote the foreign investment that brings jobs and economic growth—particularly countries that rely heavily on corporate tax?

More specifically, how will these tax reforms impact investment flows to the Arab world, as countries seek to attract investors without tax competition as a policy tool?

Arab Countries Building Back Better

Governments in the Arab world need to consider these issues carefully when they are exploring fiscal options for building back better beyond Covid-19. No single response will apply to all countries. At a minimum, however, the recipe for preparedness is clear.

First, balance revenue needs with preserving a strong investment climate. Many governments around the world have already taken bold steps in reforming tax administration, steps that help both government and taxpaying businesses. Adding capacity in tax administration pays off quickly in offering sound and efficient payment of tax in a transparent—ideally, digital—environment.

Arab countries may also consider more recent approaches, such as building tax compliance into taxpayers’ systems, leveraging use of technology, and building a good relationship with taxpayers to enhance tax compliance and improve collection.

Second, consider value-added tax. An important source of revenue in 160 countries, VAT was hit hard in the pandemic as consumption declined precipitously. Tax to GDP ratios have been below the tipping point of 15% in the Arab region even before the pandemic and needed to improve significantly. Addressing VAT may be challenging, but the fiscal situation demands it.

Where appropriate, tackling VAT now may be the best way to increase revenues without unduly hampering recovery, as it is less distorting and hence less likely to discourage investment and growth. Few, if any, governments, can follow the bold step of Saudi Arabia and Bahrain in increasing the VAT rate to 15% and 10% respectively. But for most countries, a well-functioning VAT is an essential component of both their recovery and future prospects.

To make VAT better, fairer, and simpler, focus on the “policy gap” (exemptions) and the “compliance gap” (nonpayment). Many Arab countries can improve compliance to boost revenue through simplifying the VAT system and lowering compliance costs. For small businesses, VAT should be simplified by introducing an appropriate threshold and simplifying registration and filing.

Relatively small and simple policy changes can help taxpayers and governments alike with little, if any, adverse effect on revenue, because often 80% or more of revenue comes from the largest 10% of taxpaying firms.

Raising the VAT rate should not be the only choice for countries with relatively high VAT rates, as a broad-based VAT is more growth friendly. Many countries in the region had tax holidays and used tax free zone measures, which might be more harmful to the VAT base. Consequently, tax expenditures are relatively high, and some of them are not necessary.

To broaden the VAT base, the emphasis should be on rationalizing exemptions in a way that reduces tax expenditures and does not harm investment. Moreover, other complementary measures, including carbon taxation and taxes to improve health outcomes, may also be considered.

Third, take a sectoral approach. In natural resources, reforming the upstream fiscal regime and reducing regulations to promote stability and attract capital is wise. A competitive fiscal regime does not necessarily imply low tax rates but rather a focus on swift payback and recovery of capital spending, probably taxing profits rather than using revenue-based instruments. Arab governments may use this opportunity to consider broader reforms in the sector.

Of course, Arab economies are broader than natural resources. Small and medium-sized enterprises (SMEs) remain the backbone of many economies and the engine to restore growth. Even though they often account for less than 20% of tax revenues, SMEs support the larger economy as both customers and suppliers, fueling economic growth and employment.

As the key to recovery for SMEs is cash flow, this should guide fiscal policy to promote employment. Deferring tax payments, flexible payments, and waiving penalties for the hardest hit sectors may lower short-term revenues but helps to rebuild employment. A “safe exit” from these measures requires a gradual strategy to withdraw them: It is important to determine how these measures will be withdrawn and which sectors will bear the cost of adjustment.

In all of this, it is important to pay attention to the views of taxpayers and foreign investors. They can choose where to place their capital, and with corporate tax being harmonized, other factors drive investment decisions. Responsible foreign investors want to pay legitimate tax—but they also want a system that is transparent, fair, and easy to manage.

Whatever responses they choose, governments should act swiftly to promote recovery and clearly so that taxpayers know what applies to them. Rapid change is both possible and desirable. Consider the United Arab Emirates, which adopted VAT only a few years ago and is now planning to introduce a corporate income tax aligned with the OECD/G-20 reforms. Others can match these efforts.

Even as new subvariants of Covid-19 emerge, clearly the fiscal effects of the pandemic will last longer than the pandemic itself. Getting the balance of policies right will take finesse and a clear understanding of international investment conditions to promote growth as well as a fair and just tax system.

Governments should seize this opportunity and take action now to make a bid for growth, remembering that growth will itself provide the revenue they need to address the Sustainable Development Goals, in partnership with business. Act quickly, therefore, to reset tax systems to aid both economic recovery and increase revenues in the challenging new global tax landscape.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Abdulrahman A. Al-Hamidy is Director General Chairman of the Board of the Arab Monetary Fund.
Daniel A. Witt is President of the International Tax and Investment Center (ITIC).