Last summer, Egypt’s long-planned expansion of its value-added tax seemed like a good idea.
The government needed revenue to plug a severe budget deficit, which in the year to end of last June was running at 11.5 per cent of GDP, and it had been losing credibility for its reluctance to take measures to get its finances under control.
Egypt has pledged to implement the new tax in exchange for unlocking finance from the World Bank.
But in the past year the economy, especially the private sector, has not performed nearly as well as hoped, and now there is a danger that the VAT could do more damage than good.
The concept of a VAT has been floating around Egypt for years.
Unlike a sales tax, which only taxes the final transaction, a VAT extracts a share along every step of the production process. A factory, for example, can subtract the value of components it has had to buy to build its product, then pay the government only for the value it has added.
The advantage to the government is that a VAT encourages businesses to report on one another, making it harder for them to avoid paying taxes.
The government promised to implement a VAT under an IMF accord it signed in 1991, and indeed in that year it took the first step by introducing a simple sales tax. It promised to expand this into a fully fledged VAT within four years, but never quite got around to doing so.
It did, however, gradually convert the sales tax into something resembling a VAT in manufacturing, but not in services, where a simple 10 per cent sales tax borne by the end consumer is still in effect.
In 2008, the government tried twice to expand the VAT to services, but delayed it the first time because of a spike in international commodity prices, and the second time later in the year because of the global economic crisis.
The most recent proposal to expand the VAT has been floating around for about two years. In addition to expanding it to services, the finance ministry planned to set a new rate of 14 per cent, instead of the current sales tax of 10 per cent.
This, it was projected, would earn the government an additional 30 billion Egyptian pounds (Dh12.4bn), which at the time was equivalent to about 1.3 per cent of GDP, says Ashraf Al Arabi, a former head of the tax authority and now an appointed member of parliament serving on the economic committee.
A year ago, when the government announced this year’s budget, it said it would rely on the VAT to bring the deficit down to 9 per cent of GDP. But with only a couple weeks left in the 2015-16 fiscal, the VAT has yet to be implemented.
The government last year had already backed down on a number of other measures to boost revenue or reduce spending, placing its finances in ever increasing peril. It froze the implementation of a new capital gains tax for two years, it cancelled a planned increase in electricity prices for small customers and it reduced the income tax to a unified 22.5 per cent from the previous 25 per cent for individuals and 30 per cent for corporations.
Now, in the coming few weeks, the government is finally due to send the new draft law to parliament for discussion and approval.
The draft exempts banking, insurance, medical services, education and public transport from the VAT. It also leaves the size of the percentage that will be charged for parliament to decide, rather than specifying 14 per cent as before.
In retrospect, the delay to the VAT is probably a good thing. The economy’s performance has been disappointingly bad over the past two years, making it a particularly bad time to impose a major tax on business.
According to one of the most widely watched measures, the Purchasing Managers Index (PMI), business activity has contracted in all but three months since the end of 2014. The PMI is calculated from a monthly survey of several hundred private sector firms in Egypt.
One possible outcome of a VAT is that companies will pass the extra cost on to consumers who, lacking money, will buy fewer goods and services. If the fall in consumption is big enough, the tax authority could conceivably end up collecting even less revenue than before the VAT was expanded. Either that, or businesses and consumers will come up with innovative new ways to do business under the table.
Before pushing through the VAT expansion, the finance ministry should conduct a careful review of its effect on prices and its ultimate benefit to the treasury. Inflation shot up to 12.3 per cent in May from an already painful 10.3 per cent in April.
The finance ministry might also allocate resources to boost its woefully inadequate ability to enforce collection of taxes already on the books.
There is also the political cost. Does the government want to aggravate the business community for what in the end may turn out to be a pittance in new revenue?
A more sensible approach might simply be to expand the VAT mechanism to services but to leave the rate as it is at 10 per cent.
Egypt has promised to implement the VAT as part of a package of reforms in return for World Bank financing. But it is Egypt that drew up the package and not the World Bank. Perhaps it is time to return to the negotiating table and offer a far more crucial reform instead: a major devaluation of the currency.
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