Egypt economic reformers bet on new sales tax

It has been a difficult three years for Egypt, both politically and economically. The euphoria following the toppling of President Mubarak has given way to violent turmoil and a sharp decline in the country’s traditional economic drivers: exports, FDI and tourism. GDP growth has fallen from 7 per cent in 2009 to just over 1 per cent today and, with unemployment rising to over 13 per cent and a national debt equivalent to 89 per cent of GDP, major economic surgery is required.

In response, Egypt is turning to sales tax as one of the last unreconstructed fiscal pillars, with plans for a draft reform bill this month. Its current 10 per cent general sales tax (GST) regime, introduced in 1991, is antiquated and seen as a major barrier to industrial growth, which leaves the government exposed to unpredictable tax flows and a narrow mix of sources compared with other countries. Egypt’s tax receipts currently total just 14 per cent of GDP compared with 20 per cent in Turkey.

However, perhaps the biggest driver behind the proposed reform is that GST substantially holds back manufacturing and exports. Companies buying, processing and reselling goods throughout the production chain have restricted opportunities to recover the GST they were charged. Compare this with the EU system, which aims to make its VAT completely neutral for corporations by only levying the final consumer, and the problem is clear. The IMF estimates that compounding of GST costs the Egyptian economy up to 0.75 per cent of GDP growth per annum.

Shifting the fiscal burden onto consumers would help fund a more internationally competitive corporate tax rate, something vital to help Egypt attract and retain highly mobile multinationals with their ability to create huge employment and training opportunities. Egypt’s current corporation tax rate is 25 per cent for mid-sized companies upwards, and compares unfavourably with regional challengers such as the 20 per cent implemented by Turkey.

So, what are the proposals?

Ahmed Galal, finance minister, this month suggested the introduction of a standard VAT of between 10 and 12 per cent in January 2015. While, on the face of it, this is not hugely different from the existing GST rate of 10 per cent, under the new proposals, many new services and basic goods would be brought into the regime, substantially increasing revenues. However, with VAT often painted as a regressive tax – penalising the poor who still need to shop – the measures will undoubtedly cause controversy. If the government is sensible it will offset the worst side effects by introducing a reduced rate of around 3 per cent for essentials such as basic foodstuffs, public water and power. Under this framework, the government could potentially raise up to $18.2bn, cutting its current deficit by more than half.

But we have been here before. In 2006, the government drew up plans for a replacement of GST with a modernised VAT regime, only to see the political will for change evaporate in the face of the global financial crisis. The IMF has also been pushing Egyptian consumption tax reform for a number of years, and tried to tie it to last year’s $4.8bn loan offer only to see the country obtain a much softer termed credit line from the Gulf States in December.

This time, however, the economic benefits of an efficient tax regime are much clearer. One only has to look at China to see the boost this can provide to manufacturing exporters. If Egypt is to have any chance of recapturing its 7 per cent growth trajectory, reform is crucial. That said, the events of the last three years have taught us to expect the unexpected and, with social unrest still prevalent, the road back to economic prosperity is one that must be navigated carefully.

See the post on the Financial Times website here.