Tweaking Tax Policies No Silver Bullet to Fund Budget Deficit

Jul 23 , 2022.

The flip side of a government spending plan is financing. Behind the campaign promises, capital expenditures, public sector wage raises, and social welfare programmes is a dilemma.

How can all of this be funded? How should the financing be structured? And what is the consequence of the volume and means of the money raised?

These are partly the questions the recently approved federal budget tries to answer. Total spending this year will be 786.6 billion Br, about 16.6pc higher than last year without adjusting for exchange rate fluctuations. Spending on debt service and defence accounts for over a third of the total. As usual, Prime Minister Abiy Ahmed’s (PhD) administration plans to fund ballooning expenditures through domestic revenues, grants and debt. Considering the prevailing economic reality, political uncertainty and instability in several parts of the country, describing the official mood as over-optimistic is an understatement.

Official grants are usually robust but not lately. It is one of the casualties of deteriorating relationships with development partners in the aftermath of the civil war that broke out in November 2020. Direct budget support has declined substantially. Budget planners at the Finance Ministry knew better; they were reserved about their expectations this year. They expect 42pc less in grants this year than the 2.2 billion dollars development partners had committed last year, covering less than five percent of expenditures.

External debt is the other source of financing. This is part of the budget that counts as a deficit and the money the central bank lends to the federal government. Here too, the Finance Ministry appears to have learned its lessons. Its expectations on the external debt front are restrained. A quarter less than last year’s 1.5 billion dollars is expected, at just over five percent.

Expectations for domestic financing, on the other hand, are on steroids. The federal government wants to cover over a third of its budget selling Treasury Bills (T-bills), 288pc higher than last year. The previous fiscal year’s budget targeted to raise 68.6 billion Br from the T-bill market before it was inflated four-fold. The takers are banks and pension funds, far more reliable funders than development partners or international debt markets.

Budget planners hope - and Parliament agreed - that the lion’s share of the government’s financing can be raised from domestic sources, covering 56pc of spending. They have targeted for non-tax revenues to grow 10pc this year. This is unrealistic. Major earners in this segment are companies like the Ethiopian Airlines, Ethio telecom and the Commercial Bank of Ethiopia (CBE), state enterprises controlling the economy's commanding heights. Tax revenues, at an estimated 400 billion Br, over a third higher than was collected last year, is another matter.

The federal government plans to fund slightly over half of its expenses through taxes. As a percentage of the GDP, revenues from domestic taxes have been on a decline, dropping to six percent. Tax officials rarely met their targets. Last year, the federal government lost 40 billion Br owing to depressed economic activities due to the civil war. Not much has changed on the political or economic front to expect anything to be different.

External debt cannot be a viable alternative, especially in a global environment where interest rates are picking up. Domestic debt is already stretched to the limit. Cephus Research & Analytics estimates that 23 billion Br worth of T-bills will come due every month in the current fiscal year. Yields on government securities are also estimated to rise by about two percentage points, making further borrowing costlier for the federal government. It would not be wise to add to this.

The last resort is what macroeconomic policy pundits describe as broad money growth, printing money by the central bank to lend to the government. It will be a rough ride to contain the dark horses of the economy, worsening inflation and adding to the macroeconomic woes.

The urgency of beefing up tax revenues cannot be overstated. It will save the country much pain.

The challenge is not lost on officials at the Finance Ministry. They are scrambling to string together proposals to mobilise funds in more novel ways. Some recommendations include expanding the value-added (VAT) base and widening excise taxes. The taxman would want to see 145.7 billion Br collected from VAT and 35.2 billion Br from excise tax this year.

Also of note is property taxes. These are a brand new tax category that is relatively common in the rest of the world. But it is unclear whether the law and directives will be completed by this fiscal year to make a difference. If lessons from other countries serve as any guide, a fraction of revenues raised from property taxes go into the federal government coffers.

Such reforms could be designed better. Take property taxes. It is proposed that three-quarters of the revenues be shared with regional states, the balance going to the federal government. This continues to undermine local governments to the advantage of their regional overlords. Property taxes should be the purview of local governments, at most at the district or zonal level, to incentivise competition and strengthen governance.

Even then, the Finance Ministry needs to recognise that revenue mobilisation will not be easily improved. Tweaking laws here and there will not fix what is broken. The real problem lies elsewhere. The economy remains captive to a political development that has gone fundamentally wrong. Loss of productivity across regional states and sectors due to war, conflict, instability and uncertainty led to depressed economic activities.

Enhancing revenue mobilisation could start by improving the business environment. The past two years are not the best measures for judging tax reform efforts, especially in addressing wait times, redundancy and wastage. For instance, quarterly reports show that the Addis Abeba City Administration often surpasses revenue targets. If peace is meaningfully established in other parts of the country, targets could be better achieved.

No less disruptive is an overreliance on corporate, income and import taxes. Alternative sources remain largely untapped. Capital gains tax is a fraction of what it could be due to a lack of a securities exchange, while VAT can be revolutionised by strengthening electronic payments and removing presumptive taxation.

Policymakers should also consider giving breathing space to businesses in at least one crucial front – forex retention. Previous administrations have not focused on private sector-led growth, despite the rhetoric. A low forex retention ratio in a state-directed economic growth model may make sense. The public sector is the appointed driver of growth.

Market-friendly policies require a reorientation. The sectors the government wants to see growing are manufacturing and services, which require constant foreign currency replenishment. Without the resources at the private sector’s disposal, and access to foreign currency, it is unattainable to expect it to contribute to economic development and, subsequently, tax revenues.

A difficult business environment and the absence of coherent implementation strategies are the main obstacles to domestic revenue mobilisation efforts. There should be less tweaking of tax policy and more effort in improving the general business environment.

PUBLISHED ON Jul 23,2022 [ VOL 23 , NO 1160]

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