Jury is still out on VAT's viability in UAE

Revenue growth fuelled by Value Added Tax (VAT) will not come at the cost of the poor. On the contrary, most of the revenue will come from the top two deciles of the economy, said analysts.

A government advisor who has helped draft the VAT model for the UAE, said the tax would double the revenue of the country from customs duties but this hike in the government's income would not hurt ordinary workers. This statement was made in reply to concerns that the introduction of the proposed VAT might adversely affect the poorer groups in the UAE and worsen the distribution of income and expenditure.

Ehtisham Ahmad, an advisor to the UAE Prime Minister's Office (PMO) and author of various papers advocating VAT, told a recent seminar at the Dubai International Financial Centre (DIFC) that the overall distribution would remain unchanged with VAT. Dismissing these fears as "not well founded", he said: "It will have a roughly proportional impact."

Ahmad said the UAE may double its revenue from customs duties and may generate $1.8 billion (Dh6.61bn) annually once VAT is implemented. The Gulf Co-operation Council-wide scheme is scheduled to start in 2012 but this deadline is very tight, he said.

Juma Al Majid, Chairman of Dubai Economic Council, had earlier argued that the UAE economy would not benefit from the VAT scheme. "Such a project needs institutional readniness," he had said.

"Some countries are well advanced, but the deadline looks ambitious, especially as others stopped in 2008, and may not make the 2012 deadline," Ahmad, who has also advised the International Monetary Fund's (IMF) executive director, said.

"The introduction of VAT in the UAE, largely replacing the five per cent customs duty, would not only lead to a more efficient and producer-friendly tax system, it would also generate a more equalising impact in distributional terms," Ahmad said in a paper he co-authored with Prof Giorgio Brosio.

The paper, published by Dubai Economic Council, measured the distributional or welfare impact of the introduction of VAT. The simulation study showed that in general, VAT does not affect the relative positions of households. Consequently, inequality is also not changed.

It showed that the full VAT, without exemptions and introduced in addition to existing customs duties, fees and charges, leads to a marginally higher burden on the poorest deciles than on the rich. But if the VAT replaces customs duties, the impact is reversed and the richest decile pays a higher proportion of the consumption than the poor. This suggests that the proposed introduction of VAT to largely replace customs duties, will improve the overall distribution and equity of the tax system, Ahmad said.

In all cases, most of the absolute VAT collected is due to the consumption of the richest couple of deciles, since they form the strata with the greatest expenditure in an economy, Ahmad said. "Hence, it is quite easy to compensate fully the poorest decile by direct transfers at a fraction of the total collections of VAT."

Currently, tax regimes in the region do not provide revenue buoyancy or a broad based revenue source. Ahmad said the current limited revenue sources were distortive as there were more than 3,000 hidden taxes in the GCC at the moment. "These hidden taxes have negative effects as they add impediments to trade."

With regard to fees and charges, they generally cannot be rebated on exports while adding to the costs of doing business. They also vary by locality, and are not an alternative to general revenues. With regard to customs duties, it has a cascading effect and inefficiencies due to taxation of inputs – the main reason why European states adapted VAT.

VAT, a valuable tool

Value added tax is believed to have existed in France in some form since 1948 but its modern version was introduced in that country in April 1954, with VAT replacing general sales taxes or turnover taxes that had been in existence for a long time.

Before that, Europeans taxed the full value of every transaction without taking into account taxes already paid in the making of the same products in previous transactions. Therefore, the turnover taxes had a cascading characteristic that piled taxes upon taxes. Thus, they distorted the prices of products, and especially, the prices of products that required multiple stages of production.

The VAT, on the other hand, can be measured precisely because it is not a cascading tax. Its impact on final prices is broadly similar to that of a retail tax imposed at the same rate. This turned out to be a very important feature that made VAT a potentially valuable tool to replace the turnover taxes when some European countries became part of a common market.

Shortly after a full-fledged VAT had been introduced in France in 1954, six European countries – France, Germany, Italy, Belgium, the Netherlands and Luxembourg – started the process that would lead to the creation of a European Common Market.

In 1957, the six countries signed the Treaty of Rome, eventually leading to the European Union (EU), which called for the elimination of trade taxes among the member countries as well as for the elimination of measures such as subsidies to exports and import duties. Today, any country joining the EU is required to have a value added tax.

Similarly, the GCC is now on its way to establishing its own common market and a monetary union. These countries have entered into trade agreements with the European Union and with other countries that will cause some fall in the revenue from import duties.

An alternative to oil revenues

Revenue losses are expected to increase further as countries adapt globalisation and free trade and bilateral agreements. With significant tariff lines reduced to zero by Free Trade Agreements (FTA), Ahmad said potential losses in customs revenues could be as high as 83 per cent in Qatar and 68 per cent in the UAE. The slated loss for Kuwait is 82 per cent, Oman 80 per cent, Bahrain 77 per cent and 76 per cent in Saudi Arabia.

Although the impact is relatively low – considering duties are only less than one per cent of the UAE's gross domestic product (GDP) – the recent financial crisis has made it more apparent that the country and the whole region needs alternatives to oil revenues.

Taxation experts believe that the introduction of VAT with a uniform rate by all the GCC countries would provide them with a flexible instrument that they could use in future. After reaching a peak in July 2008, oil prices fell considerably from close to $150 a barrel to $32 in March 2009, causing a domino effect on major infrastructure projects.

This relative paralysis also happened 10 years ago when GCC countries had run up large fiscal deficits due to a dip in prices. However, the Asian recovery has given oil a boost, and some analysts predict that prices will remain strong this year.

Issue of maintenance

All these instances show that the region, in the absence of fiscal and monetary tools, has very limited choice but to take on a pro-cyclical fiscal policy, which fuels the so-called boom-bust cycle. Because non-oil taxation in the GCC is low, consisting mainly of income tax on foreign corporations (except in Oman, where local corporations are also taxed) government spending tends to be weak when the price of oil is low.

"GCC revenues are highly susceptible to volatile oil prices," Dr Nasser Saidi, Chief Economist, Dubai International Financial Centre Authority, said, pointing out that there is a high correlation between oil prices and exports and government revenues.

He said another fiscal policy issue that will arise is that of maintenance which runs in the range of eight to 10 per cent of the total investment.

"If your investment is $1 trillion, you need to have about $100bn per year for maintenance, [which throws up the question about the kind of] financing that needs to be put in place to ensure sustainability."

Personal income tax may backfire

Personal income tax is "highly unlikely" in the region. Ehtisham Ahmad, Advisor to the UAE Prime Minister's Office, said there are many challenges and problems involved in implementing personal tax income in the "no tax environment" of the GCC.

"Is it feasible to impose income taxes on Emiratis? Will it be on residence or world-wide basis?" he asked, adding that transfers and non-wage incomes are already a significant proportion of the total average income in this region and these incomes are typically not subject to personal income tax.

History shows that any attempt to implement such measures has turned out sour. Saudi Arabia's attempts to impose income tax on foreign workers, for example, have not stuck. "A lot of people will leave," he said.

A mass exodus is something that no GCC country would want to see, especially with expatriates comprising more than 80 per cent of the population. Ahmed said there was no point in taxing maids and drivers and such a move will certainly affect the decisions of expatriates to locate to the UAE or the GCC, where citizenship is not commonly in the offing.

Taxation in the GCC

In the GCC region, non-oil taxation is low, consisting mainly of income tax on foreign corporations — except in Oman, where local corporations are also taxed.

Oman, Qatar, Kuwait and Saudi Arabia have in recent years initiated tax reforms by reducing corporate tax rates. Kuwait has reduced corporate tax from a high of 55 per cent to 15 per cent, Oman from 30 per cent to 12 per cent, Qatar from 35 per cent to 10 per cent and Saudi Arabia from 30 per cent to 20 per cent.

The UAE and Bahrain are largely tax-free jurisdictions. No corporate income tax, capital gains tax or withholding tax rates are imposed by the UAE government (except for taxation of profits of foreign banks), although most of the individual emirates have issued corporate tax decrees, which theoretically apply to all businesses established in the UAE.

Corporate income tax in the UAE

Although there is currently no federal taxation in the UAE, each of the individual emirates (Dubai, Sharjah, Abu Dhabi, Ajman, Umm Al Quwain, Ras Al Khaimah and Fujairah) have issued corporate tax decrees, which theoretically apply to all businesses established in the UAE.

However, in practice, Ernst & Young says these laws have not been applied. It said taxes are currently only imposed on foreign oil and gas-producing companies (oil/hydrocarbon companies with actual production in the UAE) as per specific government concession agreements (which are confidential), and on branches of foreign banks under specific tax decrees or regulations or fixed agreements with the rulers of the emirates in which the branches operate.

"Note that this is merely how the practice has evolved in the UAE," it said. "There is no general exemption in the law. The income tax decrees that have been enacted in each emirate provide for tax to be imposed on the taxable income of all corporate bodies wherever incorporated, and their branches which carry on trade or business, at any time during the taxable year through a permanent establishment."

Corporate bodies are taxed if they carry on trade or business directly in the emirate or indirectly through the agency of another corporate body, it added.

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