The European Union Agreement and
Tax Reform in the Middle East
and Mediterranean Region

While there are many fiscal issues which derive from the European-Mediterranean agreements, my focus here will be on the impact of Euro-Med agreements on budget revenues of signatory states or states negotiating to sign, and the necessary policy implications stemming from these agreements.

If direct and indirect effects are taken into account, the losses in tax revenue that are connected with the EU agreement (by the end of the twelve year period as a ratio of GDP) range from 1.5 to 2.0 percent of GDP at the lower end to approximately 4 percent of GDP at the higher end. The most difficult case is Lebanon where the revenue loss is great and the capacity to compensate for it from domestic sources is limited. Revenue losses in Egypt and Morocco are near the lower end, and somewhat higher in Algeria, Jordan and Tunisia. These however are the broad range estimates.

What difference does revenue loss make to these countries? It makes a great deal of difference in a country like Lebanon whose total revenue to GDP is 11 percent and which will lose 4 to 4.5 percent of GDP (according to present estimates), when it eliminates tariffs on European goods. This means that 40 to 45 percent of its revenue is at risk. In an intermediate case, such as Morocco, whose tax effort is about 23 percent, and which will lose about 2.0 percent of GDP, then roughly 10 percent of its total revenues is at risk. In countries which are in between these cases, 10 to 45 percent of revenues could be at risk. If there is no policy response, the revenues derived from the taxation of imports from the EU will continue to decline at the same time as imports from the EU increase as a result of the decrease in imports from third countries.

These estimates are not very firm: They are based on parameters derived from either existing or previous trade figures which are not very useful when projecting twelve years hence; and the dynamic effects are very difficult to estimate. History however is on the side of liberalization. Nearly all countries, with very rare exceptions, benefit when their economies are joined to a larger, richer market. In fact, the poorer the country, the more striking the effect on its rate of growth and its rate of export growth. Exactly what kind of effect there will be on growth and investment, however, is hard to estimate, but evidence suggests that the largest benefits accrue to countries with reasonable macroeconomic stability and flexible domestic markets. And if trade liberalization and closer integration with Europe lead to higher investment and growth in the countries in the region, then the domestic tax bases expand and tax revenues are higher if tax rates are not materially altered. Presumably improvements in tax administration would also take place in the meantime.

However, focusing on immediate fiscal concerns, revenue mobilization is needed to offset this loss of revenue. Two different factors affect the level of revenues;

tax policy change which means moving towards best practices for improvement in the tax system, making it more responsive to growth, and easier to administer; and

tax administration improvements such as institutional capacity-building, which increases the efficiency of collection.

Economic theory and international experience suggest that it is best to move away from international trade taxation whether there is an agreement with Europe or not. In looking at all countries in the world, international trade taxation as a source of revenues declines over time. To compensate for this, improvement must be made in the taxation of domestic consumption, and profits and personal income must be taxed. However, improvement in tax administration improvement requires reorganizing along functional lines, modernizing procedures, computerizing systems, training people, and allowing greater autonomy and better compensation for tax officials.

Where are the MENA countries now relative to the "best practices" in tax reform? A great deal of progress has been achieved: Morocco and Tunisia are the two countries which have been engaged in very well-structured fiscal reforms for several years, followed by Algeria and, to a lesser extent, Egypt and Jordan. It is interesting to note that the Palestinian National Authority, by essentially adopting a modern system of taxation after that of Israel, did very well by instituting the VAT, administering it in a modern manner, and applying other modernized taxes. In fact, their tax performance is quite good. Algeria, Morocco and Tunisia have introduced the VAT; Egypt and Jordan have introduced a generalized sales tax which is similar to the VAT. Although Lebanon, Libya and Syria have not, it is urgent that they begin to consider moving towards some system of taxing domestic consumption. The VATs that have been introduced are not perfect; they have multiple rates, numerous exemptions, difficult administration, but improvements are underway. For example, the International Monetary Fund staff made a preliminary estimate of the efficiency of the VAT in Morocco and Tunisia, and it came to about 65 percent, which is relatively good. Even in Chile, Denmark, Israel and New Zealand — which are among the top performers — there is only about 90 percent efficiency, while most countries in Europe are between 65 and 85 percent.

Therefore, greater efficiency of VAT collection or a 10 percent improvement, translates into 1 percent of GDP. What is more important in tax reform is to widen the base, simplify the rates, and keep them moderate. This is the general direction in which the reforming MENA countries are going.

What will the structure of the tax system look like if these countries complete the reforms in a number of years? Tax reforms require several years and cannot be done overnight, particularly administrative reforms and the building of administrative capacity for the new system. For example, OECD countries derive 0.7 percent of GDP from taxing imports. While the Mediterranean countries derive 5.2 percent of GDP from trade taxes, it is clear that if these countries are to move in the direction of best practices, they will have to liberalize their trade regimes and, thereby, give up some of international trade taxation. The EU agreements do just this. But by how much? The ratio will not drop to the level of the OECD countries — which have developed modern and highly efficient domestic tax systems — but in the direction of 2 to 2.5 percent of GDP, which is a loss of about 3 percent of GDP.

Where would this loss of 3 percent of GDP come from? Domestic consumption in the MENA countries is not in bad shape relative to developing countries, or even to the Middle East as a whole. Because of the introduction of the VAT, these countries generate roughly 6.4 percent from the taxation of domestic consumption, 4.5 percent from VAT, and about 2 percent from excises. Relative to the OECD, which generates 10 percent from domestic consumption taxation, there is room for improvement to 7.5 to 8 percent over the next 10-12 years. Again, there is a gain of 1 to 1.5 percent from the taxation of domestic consumption.

What is left for developing countries to work on is the taxation of profits and incomes? Here they face difficulties because of low personal incomes, low accounting standards of companies and weak administrations. Comparing where they are versus where they need to be, Mediterranean countries generate about 3.7 percent of GDP from the taxation of profits and income whereas OECD countries generate 9 percent. This can be improved to about 5.5 to 5.7 percent of GDP, which is 1.5 percent extra from the taxation of profits and income. It can be done by simplifying corporate and personal income tax, improving administration, establishing large taxpayer units, improving audits, etc. In other words, fiscal reforms must be viewed in the context of macroeconomic adjustment.

Tax reforms have merit on their own as they are essential for fiscal consolidation and macroeconomic stability, regardless of whether you need revenue or not to compensate for trade tax losses. Fiscal reforms (i.e., reforms affecting both revenues and expenditures) are at the center of all adjustment programs. They contribute to improved national savings, the release of resources from the public to the private sector, and an improved environment for investment and growth. Specifically, tax reforms could reduce distortions in the allocation of resources, and thereby improve the environment for investment, while expenditure reforms — which must be part of the package — release revenues to private sector investment and improve the efficiency of government spending.

As these countries make adjustments to meet the globalization challenges, structural reforms are equally if not more important, particularly in the area of restructuring their industries, improving their competitiveness, enhancing the quality and flexibility of their labor markets, and speeding up their integration into the world economy. And while the agreements with the EU clearly carry some risk — loss of revenue, exposure to a more competitive environment, a decline in inefficient industries — they also provide the MENA countries with great opportunities for improved competitiveness, higher investment and growth. The benefits, however, will be realized only to the extent that the countries in the region reform their economies, at the center of which will be the fiscal reforms outlined earlier.

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