Article

With Oil Revenues Declining, Syria Faces a Daunting Fiscal Challenge

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
October 2006
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Syria, which relies on oil revenues for 25 percent of public spending, is running out of crude, raising the specter of unsustainable budget deficits by 2015 if it does not adjust its fiscal policies. Not surprisingly, therefore, the risk of doing too little too late has been at the center of the IMF’s policy dialogue with the Syrian authorities in the past two years. In two background studies for the IMF’s recent assessment of the economy, staff explored fiscal strategies that could help Syria weather the looming challenge.

After peaking at more than 600,000 barrels a day in 1996, oil production has been declining. If not for the increase in international oil prices that began in mid-1999, maintaining financial stability would have been much more challenging. Syria now needs to accelerate structural reforms and fiscal consolidation to generate new sources of growth and income before its oil reserves are exhausted. Without some action, Syria could become locked in a cycle of financial volatility, fiscal deterioration, low growth, and rising unemployment (see chart, top panel).

What can be done? A recent IMF study suggests that Syria adopt a transparent fiscal policy framework that puts the government’s budget constraint in clear perspective over the years to come. The framework should be anchored by a fiscal rule that targets a steady improvement in the non-oil budget balance. To achieve this consolidation, a second study proposes a strategy centered on the phasing out of petroleum price subsidies and the introduction of a value-added tax (VAT).

Putting a straitjacket on the budget

There is an inherent tendency for fiscal policy to generate budget deficits rather than balances. The bias is usually rooted in procyclical fiscal policies that allow discretionary public spending to rise when revenues increase but not fall when revenues decline. To address the problems created by the deficit bias, many countries have adopted forward-looking fiscal policy frameworks designed to contain public spending and promote fiscal discipline. Successful frameworks combine two types of safeguards: transparency, which allows the public to scrutinize policymakers and thus hold them accountable, and fiscal rules, which address specific issues in a country’s fiscal outlook.

Choosing an appropriate fiscal rule boils down to deciding on a medium-term macroeconomic objective for fiscal policy that is always ultimately related to some concept of sustain-ability. It could, for example, be a fiscal stance consistent with the government’s budget constraint as its oil revenues decline. In Syria, as in other oil-producing countries, the oil endowment poses a specific challenge to fiscal sustainability and raises the question of intergenerational equity. With its remaining oil reserves too low to aim for intergenerational equity in the use of the oil wealth, Syria should smooth the adjustment toward a sustainable long-run fiscal position once oil reserves are exhausted.

The IMF study proposes to use the year-on-year change of the non-oil budget balance to approximate the cost of adjustment; this, in turn, is a good proxy for the adjustment’s contractionary impact on the economy in any particular year. On this basis, Syria can minimize the cost of adjustment by aiming for a steady improvement in the non-oil budget balance, and the study proposes this as the fiscal rule that should anchor Syria’s fiscal policy framework. Such an improvement would reduce the risk of painful, abrupt adjustment, which would likely take a toll on much-needed public investment in infrastructure and social areas or require that revenues be raised through highly distor-tionary taxes, given a weak tax administration.

Although the proposed fiscal rule would deliver the same performance as the traditional balanced budget rule if oil revenues were to decline smoothly, it would be superior if oil revenues were to level off before declining. Given the inherent uncertainty about the prospective path of oil revenues, the rule targeting a steady improvement in the non-oil budget balance would be better in all cases. The optimal pace of adjustment of the non-oil budget deficit must be reassessed continuously in light of updated information on the net present discounted value of the oil wealth, and the adjustment each year also has to take into account the economy’s cyclical position.

Game over for oil subsidies; time for a VAT

The second study argues that, for Syria to secure macroeconomic stability and keep its debt at a sustainable level as its oil production declines over the next decade, it must reduce the non-oil budget deficit by some 11 percentage points of GDP, or about 1 percentage point a year, on average. This would bring the non-oil deficit down from the current 13 percent of GDP to 2 percent in 2015 and would contain the rise in public debt to about 40 percent of GDP by 2015, leaving the government room to accommodate possible shocks and other contingent liabilities. To achieve the adjustment, a credible, pro-growth strategy would need to rely principally on phasing out petroleum price subsidies and on introducing a broad-based VAT (see chart, bottom panel).

Most expenditure items are at fairly moderate levels, and some (such as education and health care) are underfunded. For that reason, phasing out subsidies—which, at 14½ percent of GDP, are costly and inequitable—would be a judicious measure. Their elimination would yield large fiscal savings, create significant efficiency gains, and improve equity. Moreover, because higher petroleum prices disproportionately reduce the demand for petroleum products, they generate a greater oil export surplus and contribute to the balance of payments adjustment. By protecting spending on education, health care, and infrastructure, higher petroleum prices also contribute to higher long-term growth.

Cost of inaction versus action

If Syria does not address the impending loss of oil revenues, its public debt could reach unsustainable levels within 10 years.

(percent of GDP both scales)

By taking steps to steadily improve its non-oil budget balance, Syria could weather the looming fiscal challenges.

(percent of GDP, both scales)

Data: National authorities and IMF staff estimates.

Because Syria lacks efficient mechanisms for targeting the poor, providing a flat cash compensation for each person was proposed as a second-best solution. The reform of petroleum price subsidies therefore involves two interrelated, critical choices: the speed of price adjustment and the amount of compensation to offer households. The main trade-offs have to do with the risk of destabilizing inflation expectations if petroleum prices increase sharply versus adjustment fatigue from a drawn-out process, and lower fiscal savings versus greater political palatability.

Given the prevailing international oil prices, the study proposes a calibrated combination of the two choices that would yield a net fiscal saving equivalent to 4½ percent of GDP and make a majority of the population better off. It calls for maximum flexibility in the design of the reform. In particular, lower international prices would call for smaller cash transfers to households because government savings from the price adjustment would be smaller, but the welfare losses to consumers would also be smaller.

Actually, because lower prices will make the country better off once Syria turns into a net oil importer around the year 2010, a smaller cash compensation could achieve the same fiscal savings for the government and, at the same time, entail a smaller net welfare loss for consumers. Mitigating the impact of phasing out subsidies by increasing civil service wages could turn out to be very costly and is not advisable.

To make the case for a VAT, the study argues that Syria’s tax-to-GDP ratio of 10½ percent of GDP in 2005 is low by regional standards and could be increased without unduly burdening the economy or severely distorting people’s incentives to work, save, and invest. The country’s lack of a broad-based tax on consumption is notable and explains the observed low ratio of indirect taxes to total taxes. Some features that would optimize the VAT’s benefits are a single rate (with an option to impose excises on luxury items), broad coverage (with exemptions limited to hard-to-tax sectors such as financial services), and an initially high taxable threshold for cost-effectiveness. Under these design features, a 15 percent VAT rate could yield about 5 percent of GDP.

Jemma Dridi and Patrick Imam

IMF Middle East and Central Asia Department and IMF Institute

This article is based on IMF Country Report No. 06/295, Syrian Arab Republic: Selected Issues. Copies are available for $15.00 each from IMF Publication Services. See page 308 for ordering details. The full text is also available on the IMF’s website (www.imf.org).

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