Egypt faces a taxing challenge amid its inaction on cutting fiscal deficit

To tackle a projected budget shortfall of 8.9% of GDP, Cairo says it will introduce a value-added levy. But its implementation is another matter, writes Patrick Werr.

The Egyptian government hopes that a value-added tax would encourage companies operating in the informal sector to join the formal economy. Dana Smillie for The National

Egypt’s government in the coming months faces one of its biggest economic challenges since it came to power a year ago: the implementation of the long-planned value-added tax (VAT).

The VAT promises to be hugely unpopular among businesses, which are already suffering from five years of economic stagnation. But the tax is crucial for raising funds and shows that Egypt is committed to long-term reform.

The government says it is relying on the VAT to keep its budget deficit under 9 per cent of GDP in the 2015-16 financial year that began on July 1.

However, over the past few months the government backtracked on a series of other deficit-lowering measures.

It froze a proposed capital gains tax for two years, it cancelled an increase in electricity prices for small consumers, and it delayed an increase in the price of subsidised fuel that had been expected to be put in place last month. Further tightening its revenue streams, it reduced the income tax to a unified 22.5 per cent from the previous 25 per cent for individuals, and 30 per cent for corporations.

Abdel Moneim Matar, the head of the tax authority, said this week that the government would proceed with instituting the VAT, but he did not say when.

On Tuesday, the news site Masr Al Ekhbaria cited him as saying that the timing was political and not the responsibility of the tax authority itself. The new VAT law, he said, was on the desk of the finance minister, Hany Kadry Dimian, waiting to be sent to the cabinet for approval.

Mr Matar said he expected the VAT would bring in an extra 30 billion Egyptian pounds (Dh14.03bn) for the 2015-16 fiscal year.

This is by far the government’s biggest revenue-raising measure. The finance ministry projects spending 865bn pounds in the 2015-16 financial year and getting revenue of 622bn pounds. This would leave a deficit of 243bn pounds, or 8.9 per cent of GDP, down from 10.8 per cent in 2014-15 and 12.8 per cent in 2013-14. This means that the VAT would account for nearly 5 per cent of revenue this year.

The government has repeatedly baulked at introducing a VAT for fear of incurring public wrath.

In 1991, Egypt introduced a 10 per cent sales tax as part of an IMF agreement signed that year. The agreement was part of a grand deal in which Arabian Gulf and Paris Club debtors cancelled US$25bn of its foreign debt. Egypt promised to turn the sales tax into a fully-fledged VAT within four years, but the deadline slipped by with no action.

In 1996, Egypt again promised to introduce VAT within a year as part of a second IMF agreement, and once again the deadline slipped by without action.

Under a VAT, producers and retailers must pay a percentage of the price to the government of any goods or services they sell. But when calculating the tax, they in turn are able to subtract the price of any goods or services they previously bought to make or obtain their products. Thus only the part added at each step of the way is taxed.

Under the current sales tax, which the VAT would replace, only the final product bought by the end consumer is taxed.

One major benefit to the government is that by giving an incentive to the producer to declare previous purchases, it forces the producers they bought their goods from to also declare their sales.

This double reporting system has the effect of encouraging companies operating in the informal economy to join the formal economy, which is good for the government but not particularly pleasing to those small businesses that have long avoided the government’s tax demands.

If the VAT is not introduced within the next two or three months, it will throw off the government’s ability to meet its revenue target this financial year, which is already a month and a half gone.

If the government postpones introducing the VAT altogether, not only will it raise concerns about its ability to adopt long-term and sustainable reforms, but it will also send it scrambling to find new financing to plug the immediate budget gap.

Local banks long ago reached the limit of what they could lend the government through the purchase of treasury bills and bonds, with some two-thirds of all their lending now going to the state. This has crowded out private sector companies, which have been starved of financing for new investments.

The government could attract funds to its money markets from abroad, but this would require lowering the value of the pound, which the government has long resisted doing. Foreign investors do not want to buy Egyptian treasury bills and bonds if they fear a devaluation or that they will face delays in getting their funds back into dollars once they sell.

The government could also turn to Arabian Gulf countries for finance. But over the past year that pipeline has tightened, perhaps as Arabian Gulf countries, facing their own financial problems after the collapse of oil prices, grow weary of the prospect of endless Egyptian deficits.

Patrick Werr has worked as a financial writer in Egypt for 25 years