The pros and cons before UAE gets into VAT mode

This article appeared originally in Gulf News: link to original article

The UAE’s Ministry of Finance announced recently that value-added taxes (VAT) are going to be introduced. For quite a long time, this topic has been of much speculation and debate.

Should taxes be introduced in the UAE? And, if they were, what kind of taxes should be introduced and at what percentages? Before getting into a more detailed discussion of a UAE’s tax system, it should be highlighted here that the UAE’s economy is consumption-driven. The explanation of the relation of this to taxes follows.

Taxes are perceived to produce what economists refer to as a ‘deadweight loss’ (DWL). I am yet to come across a person or a book that would explain this in ways that could be quantified and illustrated in precise numbers. Anyway, conventional wisdom here states that the DWL is typically referred to as the drop in economic activity as a result of introducing a new tax or increasing an existing one.

Another matter of debate is on who bears the cost of the tax which relates, more or less, to the price elasticity of the product or the service being taxed and market demand for it. So for instance, when consumers — i.e., the public — are indifferent to price hikes, they will be willing to pay the additional amount and will be those who the DWL will affect in a greater manner.

And yet, demand will be affected negatively even if the effect is a small one. On the contrary — and if demand for a specific product or service is relatively lower or consumers are very price sensitive — producers, i.e., providers of goods and services, will have to incur the cost of paying the tax even if only partially.

Therefore, DWL will fall into their domain reflected by a reduction in sales. The Laffer curve explains how, beyond a certain tax rate, taxes wouldn’t collect enough revenues because of the drop in sales that would occur when that tax keeps on increasing.

The case for taxes in the UAE is solid for mainly two reasons. The first being that the country is diversifying away from its previously main source of revenues — oil. While diversifying and at the same time providing citizens and residents of the country with different public services, revenue sources need to be increased and diversified from traditional ones.

A very obvious source of revenue for a more sustainable financial model for the UAE, in the long run, is in the introduction and maintenance of taxes. But for this to work, a taxation law need to be drafted and its policy introduced and explained. The latter two will need to include all existing taxes and all taxes that are to be introduced at a later stage.

As of the time of writing this report, existing taxes in the UAE cover: alcohol by a percentage said to be around 131 per cent; hotel taxes; and the inevitability of a tax on tobacco of 100 per cent. There are also the typical taxes that are associated with airline tickets.

Since there aren’t many right now; the introduction of additional taxes would necessitate the establishment of an entity within the Ministry of Finance or an independent federal entity to regulate tax imposing and revenues collection across all seven emirates. Guidelines will then need to be issued on what taxes are in the UAE and how revenues and others need to be reported and how the taxes can be paid.

In addition to that, there will also be the need to establish a mechanism to refund wrongly reported and paid taxes. The guidelines and mechanism set in place when a tax policy is drafted and communicated should keep future errors minimal.

The second reason for why taxes should be introduced in the UAE would be to discourage unwanted consumption and encourage private savings. Unwanted consumption is what has stirred the argument to imposing a tobacco tax in the GCC as an effort to make cigarettes unaffordable for teenagers.

The stated policy did in fact work in France, but with a price of a pack of high-end brand cigarettes being €7 (Dh28.71) — more than double the current prices in the UAE.

Additional unwanted consumption has to do with all foods’ substances that are direct and indirect causes of non-communicable diseases (NCDs). The World Health Organisation estimated deaths from NCDs in the UAE to be 65 per cent out of 9,700 deaths. We could all argue about what substances in food cause what kind of NCDs, or whether or not cholesterol in eggs is considered good or bad cholesterol.

We could agree though, for instance, that sugar intake accompanied with disruption in insulin secretion by the pancreas could lead to future diabetes, especially if family history supports it. We could also agree on the dangers of saturated fats in causing blockage of arteries etc. So, does the consumption of these qualify as unwanted?

When the Ministry of Finance announced that VAT will be introduced in the UAE, I could not help not think of how relatively easier it would have been to at first tax foods or substances of foods so that people could adjust to the new concept of basically taxing consumption.

Since such taxes are imposed for the primary purpose of achieving better health outcomes for the entire population, the introduction of VATs will be smoother and understandable. Then, the proceeds of the food-related taxes could be used to fund or subsidise health programmes and health insurances which would make perfect sense to the public and would diversify government’s health spending away from government’s direct payout.

In the Philippines, a tax on tobacco was used to fund insurance programmes. The nature of food-related taxes is VAT anyway and would pave the way to expanding the list of products and services that VAT will cover. This would not only curb unwanted consumption, but will also induce future savings for the economy and the government in terms of higher productivity and less health-related costs.

Now since it’s going to be the VAT, we know from shopping abroad and standing in queues to get tax refunds … not in all countries though.

What would be a reasonable rate to introduce? One must consider the ever increasing number of tourists visiting the country and how VAT, if high enough, could eliminate any advantage that the UAE had in the lower prices that its products and services enjoyed when benchmarked with countries with VAT worldwide.

Therefore, it would be reasonable to start with a 3 per cent VAT after which the effect would be measured before deciding to raise it further — by a research team based in the tax regulatory entity. By doing so, it would be feasible to reach an optimal tax rate, referred to as T* in the Laffer curve, and is the point at which maximum tax collection is made possible.

Beyond that point, or a very high VAT, would dampen tourists’ spending and lead to a decline in domestic spending which will be associated with a drop in tax revenues and inflation moving into a negative territory (Japan’s consumption tax is a good example). In the UAE’s case, I trust here that a reasonable VAT and the reduction of fuel subsidy would balance things out when it comes to inflation.

The next question to be debated when introducing VAT (other than on food) is whether or not the tax amounts should be refunded back to tourists. If VAT was 3 per cent for instance, the refunding tax would not generate the anticipated revenues from it.

The logic here is straightforward. With a great share of the population choosing to repatriate income back to their home countries, $29 billion (Dh108.52 billion) in 2014, and no repatriation tax or exchange houses’ fees being in place, VAT will discourage their domestic spending further. And so if tax was refunded to tourists, the income to be realised will shrink to levels that might make the whole introduction of VAT not worth the trouble.

The most pressing matter here would be introducing VAT in a way that would balance an increase in revenues while managing to attract a steady flow of tourists. DWL here would be partly through lower sales and partly in spending, domestically and by tourists, depending on demand and price elasticity and how high VAT is.

The last thought I want to leave you with is: would gasoline be ever taxed?

(Note: the US is a major producer of oil and has a federal gasoline tax of 18.4 cents per gallon).