A unified tax regime may not be best solution for GCC

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

This report is a follow up on the VAT introduction in the UAE. I am not quite sure when this will take place, but a lot of speculation is going on about how this could be agreed upon and then implemented by all member-states of the Gulf Cooperation Council (GCC).

The fact is that it doesn’t have to be done this way. The report will discuss this topic in specific and in comparison with the case of the European Union, which has no unified tax system.

Let me first get one thing clarified. Though the report will be talking about VAT in specific, the argument stands for all taxes regardless of their nature. And before getting into the whole comparison process, one must highlight that a clear distinction needs to be drawn between fiscal and monetary policies to when it comes to any sort of economic union or bloc.

The GCC has a unified policy towards customs as it also negotiates its ‘free trade agreements’ as a single economic bloc. I am not saying here that this is good, neither that it is bad. Now, most of us probably remember the debate that took place when GCC member-states announced that they might adopt a single currency.

With that, there will have to be a single GCC Central Bank that will manage the single currency’s affairs and back it up whenever needed. Well, I do not know how this could have been done with the huge variance between the exchange rates of all GCC member-states even if everything else was agreed on at the time.

Think about the current economic situation of the EU. Two countries: Finland and Sweden. The former adopted the euro when it was first introduced while the latter kept its krona. According to IMF figures, Sweden’s GDP increased by 66 per cent since 1989 while that of Finland increased by 46 per cent.

One of the main challenges facing the EU is the fact that there is a single currency being managed by a European Central Bank (ECB). When the union was formed and additional countries were allowed to join later on, member-states had different economic strengths and weaknesses. Please note here that I am not referring to standards of living, GDP per capita, consumption per capita, and all of these numerous indicators.

What I am referring to is a very basic concept: competitive advantage. Those countries had different sources of income based on what they produced in terms of goods and services and what they exported. So Germany excelled at making and exporting different sorts of products of top quality, while Greece had a more alluring tourism sector.

Other countries were also different in which sectors they excelled in and what products they exported or services they offered. And so when the euro was introduced and adopted, its value — and hence exchange rates — needed to work for everyone in the union, or so the case should have been. I believe it did up to when the financial crisis happened.

What the financial crisis has exposed is not a weakness in the currency but rather a weakness in the economic fundamentals that EU countries had on an individual basis. So instead of diversifying their economies, those who concentrated on a couple of sectors like properties and tourism were the ones who suffered.

And the euro became too expensive to all countries that had much cheaper local currencies before adopting the euro. The scenario is much more complicated than that of course. But the near absence of exporting sectors played a key role in what happened to different EU economies after the crisis, while fiscal mismanagement of various economies did the rest.

Now let’s benchmark the GCC’s case with that of the EU in the monetary aspect of it. Would a single currency seriously work? How would a GCC currency be priced between the very expensive Kuwaiti dinar and the much cheaper Emirati dirham and Saudi Riyal? So that’s that for the monetary part of the GCC discussion. Moving on to the fiscal part of it.

The EU made it clear from the very beginning that member-states get to manage their own fiscal policies. That is, they get to determine their tax rates; manage tax revenues in addition to other revenues; and decide on their own spending — until the country requires a bailout and the IMF steps in.

Generally though, each country does what it deems beneficial to its own economy. So for instance, and VAT being the example here, the lowest rate in France is 2.1 per cent (super reduced rate) and the highest rate being 20 per cent (standard rate). The classification here differs as per the products and services that the VAT targets.

The European Commission lists different VAT rates for different EU member-states. Germany for instance has a “reduced rate” of 7 per cent and a “standard rate” of 19 per cent. In a broad context, a “reduced rate” is the expense we normally incur as tourists.

This enables countries to increase taxes when they need to bridge in a forecasted budget deficit, or decrease it — corporate taxes as an example — for sectors that governments would like to grow by attracting investments into them.

Since corporate rates are also to be introduced, these mustn’t be unified either just like in the EU. To illustrate, corporate tax rate is the lowest in Luxembourg at 4.1 per cent and the highest is the UK’s 23.2 per cent. Lithuania is reported to have 0 per cent corporate taxes, while Germany, which has been doing very well despite fiscal troubles in other EU economies, has the second highest corporate tax in the EU at 22.9 per cent.

So again, why do GCC countries need a single tax system? The EU has done well by not unifying taxes — Euro was the setback. Simply, what might work as a tax or a tax rate for the Netherlands might not work for Finland.

Learning from other people’s experiences, and by not trying to reinvent the wheel, one must assume that a single tax system will not work for the GCC countries. Why? First, GCC economies are of different breakdowns.

Secondly, tourism differs in these countries and VAT can have a different effect in each of those with no individual country having control over its VAT rates. So set the rate too high, and countries with a thriving tourism will suffer.

Set it too low, and the whole purpose of having VAT will seem nothing else than tiresome. The third reason is that these countries generate revenues and spend them differently. And since taxes will be significant sources of revenues for GCC governments, the unification of these rates will mean that any increase to bridge deficits will have to go through a long process of meetings and approvals.

And by the time a change takes place, it would be too little too late.

The counter argument to all of this is that the GCC acts like an economic bloc and negotiates as one to when it comes to trade agreements. Well so does the EU. The EU negotiates trade agreements as one single entity just like the GCC discusses its free trade agreements.

Still, EU member-states have different tax rates for different products and services. Yes, there could be smuggling in the case of varying VATs; but that would be in negligible quantities especially as VATs would probably not differ significantly between GCC member-states. In other words, the trouble of commencing smuggling activities will not be worth the penalties if caught red-handed.

Like pointed out earlier, this is not just about VATs. It is about having the flexibility to introduce and remove all kinds of taxes; the ability to increase and reduce tax rates; and the ability to control a country’s own fiscal policies in ways that work explicitly for that country.

GCC countries need to enjoy that kind of fiscal freedom in order to tailor fiscal policies towards achieving their individual financial and economic goals. Having separate monetary policies worked so far, and having different fiscal policies would work too.

The last thought that I want to leave you with: if GCC import duties need to be raised or reduced with the consent of all, how easy would agreeing on the tax rates be?