The Fiscal Adjustment to the Euro-Med Challenge
Speech by Mr. Dimitris Kourkoulas
The success of the Euro-Mediterranean Partnership is a major challenge for the years to come. In all three pillars of the partnership-political and security, economical and financial, social and cultural- the emphasis is on cooperation between the EU and the Mediterranean countries. Only throuh cooperation will it be possible to achieve the objective of the Barcelona Declaration: an area of shared prosperity.
The Euro- Mediterranean Partnership is much more important than just free-trade. The ambition is to create a deeply integrated Euro- Mediterranean market, with a harmonized regulatory framework and over time a coordinated approach to common societal problems.
Reforms are the name of the Euro- Mediterranean game. The success of the enterprise will be measured by the capacity of Europe and its Med partners to trigger essential reforms and to implement them. Reforms must not be confined to trade or economic matters. Reforms have to go beyond the economic sphere. They have to change attitudes, power structures and the relationship between the state and individuals.
Implementing reforms in civil societies, whatever their nature (companies, associations, municipalities, governments, countries), adapting them to changes in their external environment, is not an easy task. Most societies resent reforms, and their basic impulse is to be conservative. Change is being resisted, as any change means risk, requires adjustment, extra work, and sometimes new power balance.
To adapt its economy and society to the new realities, Lebanon has to continue implementing the necessary reforms. The opportunity offered to Lebanon by the European Union to enter into the necessary reform process in close association with Europe was welcomed and accepted by the political leadership of this country. The alternative would have been either having to undertake the necessary reform without external assistance or becoming increasingly marginalised.
The internal debate in Lebanon about the Association Agreement should therefore be put into the general perspective of the strategic changes that Lebanon and the other countries of the region have to do in any case, with or without the Euro-Med Partnership.
We all agree that fiscal reform is essential for the conclusion of the Association Agreement. But there are other pertinent reasons, some of them urgent, why a fiscal reform is necessary. Before going into the fiscal aspect of the Agreement, I would like to point out some other consequences resulting from the conclusion of this Agreement.
Let me start with the free-trade area:
The question is worth asking in a straightforward manner. If one is not prudent, there is a risk of an adverse effect in cases where tariff dismantling in favor of industrial goods imported from the EU would be too quick or indiscriminate. It is precisely to counter this risk that Association Agreements include a stretching of tariff dismantling over time, exceptions, and safeguard clauses.
However, we should refrain from considering the introduction of free-trade as the sole and essential goal of the Euro-Mediterranean Partnership. Free-trade, in economic terms, is much more of a tool than an objective. Its usefulness is first to constitute a powerful incentive to raise competitive levels in the region’s economies. World experience demonstrates that, without the challenge of competitiveness, economies do not make progress. The second virtue of free-trade is the signal of economic integration to the EU that it gives to private investors, both domestic and foreign.
It is worth recalling here that the EU twins the tariff dismantling process with substantial support to accompanying economic measures: structural adjustment, economic transition measures, training, etc.. The countries concerned are thus not left facing the dry logic of free-trade, but are offered a well balanced package of accompanying measures.
In the end, trade liberalization is closely linked to the process of economic transition.
Despite decades of efforts, regional cooperation in the Mediterranean (outside the EU) has been either non-existent or non-effective. One major obstacle to such cooperation has been political, that is the Arab-Israeli conflict. But there are still main economic obstacles to such cooperation. Trade among Mediterranean countries is insignificant. No more than 6% of total trade of Mediterranean countries is intra-regional trade. That is much less than the intra-regional trade achieved by South-America, North-America, Southeast Asia, South Asia and even the Gulf countries. Neither is there any significant movement of capital among Mediterranean countries. Nor is there any intense intra-Med. movement of people.
The simplest way to push the Mediterranean countries into more cooperation among themselves is to engage them into free trade with Europe to be followed by free trade among themselves.
The rapid conclusion of the Association Agreement, with all Mediterranean countries is the single most important contribution that Europe can offer to make meaningful regional cooperation in the Mediterranean a reality in early next century.
Another factor that has to be taken seriously into account when Lebanon will decide the if and the when of the conclusion of the Euro-Med. Agreement, is about expectations and credibility. Expectations matter a lot in all economies but might have crucial effects on the real economy of this country. If growth and stability are expected, both capital and skills, specially Lebanese capital and skills would continue to come back. In the past few years capital inflows have been very high.
The conclusion of a Euro-Med. Agreement could be perceived as a commitment to a reformist time-table including modernization of the administration and thus increase credibility and attract more investment.
I would like to express some views on the main issue of this conference, which is also one of the major issues of the negotiation: Tariffs and tax revenues. Let me first of all stress the fact that both sides of the negotiations, the Lebanese government and the EU are aware of the magnitude of the problem. Indeed, the relative importance of tariffs as a source of revenue is very high in Lebanon for two reasons. First, the imports base is exceptionally large, standing at over 60% of GDP so that a relatively small tariff rate raises significant resources, about 8-9% of GDP. Second, about 55% of imports is from Europe meaning that about 5% of GDP would be lost when tariff rates on European goods are set at zero.
In order to have a realistic picture of the magnitude of the problem we should nevertheless underline two elements:
First, the agreement will only be implemented gradually and is likely to be heavily back-loaded. In addition there are specific provisions for derogation and safeguard measures that could be introduced during the transitional period.
Secondly, for several goods like tobacco, beverage, petroleum products and cars, an excise tax could replace existing tariffs, reducing considerably the lost revenue. Today, all these excise taxes are incorporated in the custom tariffs.
But all this is not sufficient. In an open world economy, countries have an interest in minimizing their dependence on custom duties as a source of government revenue. They are therefore well advised to use this opportunity for introducing modern systems of indirect taxation, ideally a value-added tax, which offers high tax yield, simple administration, fewer possibilities for tax evasion and, last but not least, an accurate method of de-taxing exports and taxing imports. Tax reform is necessary. In fact Lebanon has started reforming its fiscal system since 1995.
The 1995 tariff reform simplified the tariff structure, and reduced the number of rates. A minimum tariff rate, initially at 2 percent andcurrently at 6 percent, is levied on all imports. The 1995 excise reform complemented the tariff reform of the same year, and generated revenue from tobacco and cigarettes, petroleum products, alcoholic beverages, and cement. The reform improved the revenue generating capability of excisable products, despite the fact that the prices to consumers remain far below international levels. It also reinforced their administration by collecting excise duties at the stage of importing and before the release of goods.
Following these reforms, the tax ratio “total duties and taxes as a percent of GDP” has increased from about 6 percent in 1992 to about 13 percent in 1997. Despite this increase, the persistent budget deficits have remained quite high in view of the increasingly heavy debt service which amounted to 15 percent of GDP in 1997. To mobilize additional revenue, the authorities introduced in 1998 a 5 percent service tax on restaurants and hotels, and they proposed but did not implement a 1 percent turnover tax to be paid by all enterprises subject to the business and professionals profits taxes.
The above-mentioned reforms covered virtually all duties and taxes with the exception of having a broad-based tax on the consumption of goods and services. Such a tax, especially when based on the principles of value-added taxation, is becoming an important element of the tax systems of many countries. Currently, 115 countries levy broad-based taxes, but Lebanon remains one of the few countries without a VAT.
The VAT could contribute to the deficit reduction effort and generate needed revenue that cannot be attained through duties on imports.
A VAT will enable Lebanese goods to compete on national, regional, and international markets, and its absence will discriminate against Lebanese goods even on Lebanese markets.
The VAT is not expected to affect adversely the distribution of tax burden. On the contrary, it could improve the fairness of the tax system by taxing services, the bulk of which is received by those in high- income brackets. The exemption of “essential” goods will make those with low and modest income better off.
The problem of small taxpayers can be dealt with more effectively through the exemption threshold. The threshold should be high enough to eliminate the small taxpayers, who, despite their large numbers, contribute a small amount of revenue.
The VAT is certainly the most efficient revenue producer with the least of economic distortions and the lowest cost of administration and compliance.
The revenue effect of introducing a VAT is estimated to be in the range of 5-6 percent of GDP, depending on the rate to be finalized, the size of exemptions to be allowed, and the reductions in the tariff rate to be made.
The price effects of the VAT will be limited to the one-time initial increase in the aggregate price level which is not expected to repeat itself. These price effects could be reduced following reduction of some import tariff rates. This one-time increase in the price level is not expected to lead to further inflation.
To conclude, in my view, Lebanon could introduce a broad-based tax on the consumption of goods and services not only in order to be able to implement its Association Agreement but to control its budget deficit and implement its regional trade obligation like the AFTA.
I remember very well, when my own country joined the EU in 1981, successive Greek governments were spending time and effort asking for derogation in order to delay the introduction of a VAT system. The argument was that the Greek tax administration was not up to the standards and that the Small and Medium Enterprises (SMEs) would have difficulties in managing this new tax.
Finally, when the tax was introduced, thanks to the EU pressure, results were spectacular in terms of reducing tax evasion, in terms of bringing large parts of the black economy into the formal economy, in terms of income revenue from the government and in terms of promoting exports.
It will be a major contribution for the future of this country if thanks to the Association Agreement and technical assistance that the European Union already provides to Lebanon a modern system of indirect taxation was implemented early next century.