Syrian Arab Republic: Selected Issues

Syria faces two interrelated medium-term challenges posed by the prospective decline in its oil reserves. The recently approved five-year plan (FYP) laid down a comprehensive strategy to address these challenges. Syria’s public finances are headed for challenging times in the coming 10–15 years. Large fiscal deficits have marked the economic history of many developed and developing countries alike during the 1970s and 1980s, with damaging consequences to their economies. Although financial markets can help keep the deficit bias in check, market discipline has proved mostly inadequate.

Abstract

Syria faces two interrelated medium-term challenges posed by the prospective decline in its oil reserves. The recently approved five-year plan (FYP) laid down a comprehensive strategy to address these challenges. Syria’s public finances are headed for challenging times in the coming 10–15 years. Large fiscal deficits have marked the economic history of many developed and developing countries alike during the 1970s and 1980s, with damaging consequences to their economies. Although financial markets can help keep the deficit bias in check, market discipline has proved mostly inadequate.

II. A Reform Agenda for Fiscal Consolidation11

A. Introduction

24. In the years ahead, Syria is expected to face formidable fiscal challenges. With oil production projected to decline in the coming years, fiscal management will be placed under a severe test to find the most effective response. To meet this challenge successfully, fiscal adjustment that began in 2003 must continue steadfastly into the medium term. The recently adopted five-year plan (FYP) (2006–2010) reflects a deep awareness of the challenge ahead and the authorities are determined to find the best policy options to confront it.

25. The purpose of this chapter is to contribute to informing the policy debate about the problem and look at how policy will need to adjust to deal with it. It contains four sections. Following this brief introduction, the next section discusses the size of the fiscal adjustment that would be required over the next ten years and the two preferred measures for achieving it. In turn, each measure is discussed in some detail in Section C, which presents the case for reforming the petroleum price subsidies (PPS), and in Section D, which deals with the design for a broad-based VAT. These measures will need to be supported by a broader reform in complementary fiscal areas, including a tax reform to simplify the tax system and broaden its base; a strengthening of the tax administration in general and for supporting the VAT implementation in particular; an expenditure policy reform to rein in inefficient spending programs so as to create space for more productive expenditure; and, last but not least, an improvement in public financial and expenditure management to provide effective support for the expenditure rationalization.

B. How Much Fiscal Adjustment is Needed and How Should It Be Achieved?

26. Syria is expected to become a net importer of oil by the end of the decade. Domestic oil production, which has fallen by over 20 percent in the last five years to slightly above 20 million tons in 2005, is projected to decline further in the coming years, before flattening out at about 15 million tons per year by the middle of next decade. At the same time, domestic oil consumption has increased steadily by some 40 percent to about 15 million tons in the last five years, and is projected to rise in the coming years to over 20 million tons by the middle of next decade at an average annual rate of about 5½ percent. If these projected trends come to pass, Syria will, by the end of this decade, turn from being a net oil exporter to a net oil importer, and thereafter, its dependence on imported oil is projected to grow increasingly larger.

uA02fig01

Production and Domestic Consumption of Oil

(In millions of tons)

Citation: IMF Staff Country Reports 2006, 295; 10.5089/9781451836301.002.A002

Sources: Syrian authorities; and IMF staff projections.

27. These projected trends will have a significant adverse impact on net oil proceeds to the budget over the medium term. First, as a direct consequence of the projected decline in production, the oil rent to the budget will fall over time, yielding lower return to the government as owner of the dwindling oil reserves. The value of oil production net of production costs and valued at international prices is projected to fall from about 25 percent of GDP in 2006 to less than 12 percent in 2015. Second, and if domestic prices of subsidized petroleum products are kept constant in real terms, the fiscal cost of PPS will level off at about 14½ percent of GDP, assuming no further increases in the relative price of oil and a domestic oil consumption growing in line with the overall growth of the economy. Both trends will result in a drop in net government revenues in excess of 10 percent of GDP, casting a pall over fiscal sustainability in the absence of policy adjustment.

uA02fig02

Government Oil Revenue Valued at International Prices, Gasoline Taxes, Petroleum Price Subsidies, and Net Government Oil Revenue

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 295; 10.5089/9781451836301.002.A002

Sources: Syrian authorities; and IMF staff projections.1/ Defined as oil production valued at international prices plus taxes on gasoline minus petroleum price subsidies.2/ Net of production costs.
uA02fig03

Medium-Term Fiscal Outlook in the Absence of Adjustment

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 295; 10.5089/9781451836301.002.A002

28. An adjustment in the nonoil budget deficit of some 11 percentage points of GDP is consistent with delivering a stable macroeconomic environment with a prudent debt dynamic in the next decade. A policy that targets an improvement in the nonoil budget balance on average of about 1 percentage point of GDP per year in the next ten years should be pursued. This will yield a strengthening in the nonoil deficit from 13 percent of GDP in 2006 to about 2 percent of GDP by 2015. Consistent with this level of nonoil deficit is an overall budget deficit averaging 2.8 percent of GDP per year, well below the stated objective in the FYP (5 percent of GDP). Such a strategy will contain the rise in public debt to about 40 percent of GDP by 2015, leaving room to accommodate the possibly large cost of bank restructuring and other contingent liabilities (Table 1).

Table 1.

Syrian Arab Republic: Medium-Term Fiscal Outlook, 2005–15 1/

(In percent of GDP)

article image
Sources: Ministry of Finance; and Fund staff estimates and projections.

Assume the VAT is introduced at the rate of 5 percent in 2008, then raised in steps to 15 percent from 2014 on.

Takes into account the impact of the increase in diesel prices on government purchases.

Assumes diesel prices are adjusted in 2007 to close 60 percent of the gap with respect to international prices. The remaining adjustment is spread over the following three years. The remaining implicit subsidy beyond 2010 reflect subsidies on fuel oil.

Assumes that each year 42 percent of gross yield to the government is returned to households.

uA02fig04

Adjustment Scenario: Budget Balance and Public Debt

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 295; 10.5089/9781451836301.002.A002

29. The authorities are strongly encouraged to make the reform of the petroleum price subsidies (PPS) and the introduction of the VAT the main pillars to help bring about the required fiscal adjustment. These measures are highly appropriate for Syria and can provide considerable benefits to the economy beyond the main task of strengthening the budget position. In the fiscal adjustment scenario presented in Table 1, and will be explained in detail in the following two sections, Syria could get through the fall in oil revenue by: (i) gradually adjusting the price of diesel to international levels starting in 2007 and completing it by 2010, and (ii) introducing the VAT at a rate of 5 percent in 2008, increasing it gradually to 15 percent by 2012. The low rate at which the VAT could be brought in initially would facilitate its introduction and encourage greater compliance.

30. That said, it is also important that a broader reform is launched in tandem in supporting fiscal areas. Thus, to complement the introduction of the VAT, a comprehensive tax reform should be undertaken as well to simplify the tax system, starting with a focus on revamping the personal and corporate income taxation, which is overly complex and lacks revenue buoyancy. This effort should be aided with a strengthening of tax administration so as to modernize its operations, develop self assessment, and introduce a large taxpayer unit—all of which should be parts of a restructuring process to help make the tax system easy to comply with. On the expenditure side, policy should be directed toward increasing spending on pro-growth programs in education, health, and infrastructure and curbing transfers to loss making public enterprises and reducing general subsidies. To help plan and carefully monitor these programs, an overall strengthening in the public expenditure management will be required, starting with unifying the recurrent and capital expenditure budgets and improving the budget accounting and reporting systems. While clearly important for the overall fiscal policy management, these topics are not further pursued in this paper. In what follows, we return to discussing the benefits and the design of the two main pillars for reform, starting with the PPS reform.

C. Reforming Petroleum Price Subsidies

31. The fiscal cost of petroleum subsidies has risen sharply since 1999. Prior to 1999, high taxes on gasoline were used to cross subsidize the consumption of other petroleum products, avoiding positive net subsidies. However, the trend increase in international oil prices, since 1999, coupled with the lack of pass-through, eroded the tax on gasoline and increased the cost of subsidies turning net taxes into net subsidies. It is projected that by 2006, net subsidies on petroleum products could swell to 14½ percent of GDP.

uA02fig05

Prices in U.S. Cents Per Liter

Citation: IMF Staff Country Reports 2006, 295; 10.5089/9781451836301.002.A002

Source: Syrian authorities
uA02fig06

Taxes and Subsidies on Petroleum Products

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 295; 10.5089/9781451836301.002.A002

32. In addition to their fiscal costs and large deadweight losses, energy subsidies in Syria are very inequitable. The World Bank estimates that the richest population decile benefits 25 times more than the poorest decile, while the poorest half of the population captures less than 20 percent of total benefits.

uA02fig07

Distribution of of Direct and Indirect Welfare Gains from Petroleum Price Subsidies

Citation: IMF Staff Country Reports 2006, 295; 10.5089/9781451836301.002.A002

Source: Syrian authorities.

33. Thus, the policy commitment to phase out PPS is particularly well judged and timely. In addition to yielding large fiscal savings, this high quality measure will create significant efficiency gains in consumption and production, as price distortion is reduced and eventually eliminated over time, and will address the large inequity in the current policy. Moreover, by slowing the growth of domestic oil consumption, higher prices will dampen net imports of petroleum products which will help contribute to the balance of payments adjustment. Lastly, by protecting spending in critical areas such as education, health, and infrastructure, this policy will contribute to promoting long-term growth.

34. A strategy for reforming PPS involves two interrelated critical choices: (i) the speed at which domestic prices are adjusted towards international levels; and (ii) the amount and distribution of compensation to households to mitigate the impact on their consumption and to make the reform politically feasible. The main trade-offs have to do with: (i) the risk of destabilizing inflation expectations associated with a sharp increase in petroleum prices versus adjustment fatigue from a drawn-out process, and (ii) less fiscal savings versus more political palatability.

35. A proposal currently under consideration by the authorities seems to strike the right balance among the main trade-offs. It calls for:

  • focusing the reform initially on adjusting the price of diesel, as the subsidy on diesel accounts for the bulk of PPS;

  • closing 60 percent of the gap between domestic and international price of diesel upfront and phasing out the remaining adjustment by 2010. The risk of destabilizing inflation expectation appears manageable as most of the increase in the CPI would reflect mainly the increase in the price of diesel itself, and other first round impact on the prices of public transportation—which is government controlled—and the price of agricultural products—a sector quite competitive.

  • in the absence of mechanisms to target the poor, return to all households in the form of a flat per person cash compensation a certain share of the gross fiscal gain from the price adjustment. According to a World Bank study, returning 42 percent of the gross savings would make 50 percent of the population better off.12

Impact on the CPI of Adjusting Diesel Prices

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Source: "Considerations for reforming energy price subsidies in Syria," Draft Policy Note, World Bank, 2006.

Raising prices by 230 percent would close 60 percent of the gap with internatio

Adjusting diesel prices to international levels would imply an increase of 385 percent.

36. Under this proposal, the net gain to the budget is estimated at 4½ percent of GDP per year by 2010 when domestic diesel subsidies are completely withdrawn. Gross budgetary saving is projected at about 6½ percent of GDP, comprising additional gross revenue of 11.3 percent of GDP minus a 4.8 percent of GDP cost of the envisaged cash compensation. However, higher diesel prices will increase government spending on goods and services and on developmental expenditure estimated at 2 percent of GDP per year when the diesel subsidies are fully withdrawn.

uA02fig08

Net Budgetary Impact from Phasing Out PPS

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 295; 10.5089/9781451836301.002.A002

Source: Fund staff projections.

37. The above proposed calibration of the PPS reform is a function of the prevailing international oil prices. In a lower international oil price environment:

  • a more front-loaded adjustment would probably strike a better balance between minimizing the risk of destabilizing inflation expectation and that of adjustment fatigue; and

  • the share of the gross savings that should be returned to households to strike the right balance between maximizing the fiscal savings and enhancing the political feasibility of the reform should be lower, for the reasons explained in Box 1. But in this case, the policy of providing a flat cash compensation per person would be less redistributive, and would make it more pressing to develop appropriate targeting mechanisms.

38. Mitigating the impact of phasing out PPS by increasing civil service wages, another option under consideration, would not be advisable for the following reasons. First, the policy eases the impact of the reform on public sector employees only, but does nothing to alleviate the burden on other deserving, if not more deserving, segments of society. Second, because it does not provide compensation to a much wider spectrum of the population, the risks that it will lead to social unrest is much higher. Third, as argued above, the design of the compensation scheme should allow flexibility, such that the level could be adjusted in line with changes in international oil prices. An increase in salary is irreversible and therefore will build a rigidity that might turn out to be very costly. Last but not least, the problem of low wages in the public sector has to be addressed by a well thought out and comprehensive civil service reform where an increase in salary is part of a larger strategy for a better-paid but leaner and more competent administration.

Level of International Oil Prices and Size of the Cash Compensation

The lower the level of international prices, the lower should be the size of the cash compensation to households. This proposition makes sense from the perspective of fiscal sustainability and from the perspective of the welfare loss of consumers:

  • From the perspective of fiscal sustainability, to achieve the same level of net reve2nues from the oil sector to finance the same level of government spending under unchanged tax policy, the level of cash compensation that can be returned to households has to be lower, because the oil rent is lower with lower prices. The simulation shown in the graph to the right shows that to achieve the same net revenues from oil if prices were on average US$20 per barrel less than under the baseline scenario, the cash compensation should be calibrated to equal 21 percent of gross savings only as opposed to 42 percent in the baseline scenario.

  • Lower international prices means that domestic prices would have to be adjusted less than otherwise, which, from the perspective of consumers, means that the loss of consumer surplus would be less. Therefore, a lower cash compensation would be enough to contain the loss of consumer surplus at the same level relative to the baseline. Actually, reflecting the fact that lower prices make the country better off once the country is a net-oil importer, a cash compensation of 21 percent of GDP which achieves the same fiscal objective leads to a smaller welfare loss for consumers than under the baseline scenario (a cumulative loss of 86 percent of 2006 GDP as opposed to 97 percent in the base case).

uA02box01fig01

Phasing Out Petroleum Price Subsidies Under Two International Price Scenarios: Net Budgetary Impact

(Cumulative, in percent of 2006 GDP)

Citation: IMF Staff Country Reports 2006, 295; 10.5089/9781451836301.002.A002

Source:

39. In general, improved targeting will lead to greater net savings for the budget than currently envisaged. The flat cash compensation for every household is a blunt instrument that should not be seen as a viable long-term substitute for a proper mechanism to target the poor. Thus, to promote targeting and ensure that scarce budgetary resources are delivered to those most in need, building up a data base of the working poor and a delivery network of social assistance are important efforts that should be pursued expeditiously.

D. Introducing a Broad-Based VAT

40. In addition to the PPS reform, Syria needs judiciously designed taxes to compensate for declining oil revenue. With a tax-to-GDP ratio equal to 10½ percent of GDP in 2005 and relatively low compared to countries in the region, increasing tax revenue would probably not lead to undue burden on the economy or severely distort incentives for work, savings, and investment. Of course, this would depend on the choice of the tax, including its design and implementation.

Tax revenue in Syria and selected countries in the region

(percent of GDP)

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Sources: IMF staff reports

41. As some taxes, especially ill-designed ones, might be detrimental to growth, it is important for Syria to rely on non-distortionary taxes. Kneller, Bleaney, and Gemmell (1999)13 found that direct taxes such as income and profit taxes, social security taxes, payroll taxes, and property tax tend to reduce growth. At the same time, they also found that non-distortionary taxation such as a broad base consumption tax on goods and services (i.e., a VAT) is neutral for growth. In Syria, relative to direct taxes, the reliance on indirect taxes has been fairly low compared to other countries in the region. Hence, the potential for Syria to raise tax revenue in an efficient way by introducing properly designed and implemented indirect taxes is considerable.

42. The absence of a broad-based tax on consumption in Syria is notable, which explains the observed low indirect tax to total tax ratio. The existing consumption tax introduced in late 2004 applies only to a positive list of goods and services (imported or locally produced). This narrow tax has a dozen rates, together with a credit mechanism, and a refund system for exporters (only).14 It suffers from several weaknesses, including tax cascading, which distorts business activity, a narrow base, which limits its revenue potential, and a high burden on tax administration and high compliance costs on taxpayers due to its complicated rate structure and the absence of a registration threshold. Because small businesses—which have limited capacity to maintain proper accounting records—are not excluded from this tax, the difficulty of administrating the tax is increased considerably, without necessarily having an appreciable impact on revenue (small businesses as a rule do not pay much taxes).

43. The government decision to replace the present consumption tax with a VAT to support fiscal consolidation is apt. A properly designed VAT will not impose a burden on investment and exports—on which long-term growth depends—while offering the possibility of high revenue collection if the base is broad. In addition, a VAT could play a catalytic role in nurturing a taxpaying culture, as taxpayers will have an incentive to file returns to comply with the tax if they wish to recover their VAT refunds. Furthermore, if well-designed, a VAT will have relatively little impact on the poor, who would likely not make the bulk of their purchases from traders who would have to collect the VAT.15

44. To optimize its benefits, a VAT would need to be properly designed. The VAT should be levied on the destination principle. Both domestically produced goods and imports should be taxed. Through the input tax credit mechanism, exports will be zero-rated. VAT credit should be provided for all inputs, including capital goods.16 Thus, investment (for which full credit will be provided) will not be subject to the VAT. The scope of the tax should be broad—bringing into the tax net virtually all goods and services. Exemptions should be severely limited, preferably to hard-to-tax sectors such as financial services (and those excluded via the threshold, of which, more below). Modern VAT like the one introduced in New Zealand has a relatively high revenue productivity precisely because its base is extremely wide.

VAT revenue productivity in selected countries (2003)

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Sources: IMF

45. The VAT should preferably have one single rate. This will greatly reduce compliance cost to taxpayers and the burden on tax administration. More than 40 percent of the countries that have adopted a VAT have chosen a single rate, such as Lebanon, which has a single rate of 10 percent. The reason often advanced for favoring more than one rate is that differential rates can help achieve greater social equity. This argument is weak, even specious, largely based on a misunderstanding of what a VAT is best designed to do, namely to raise revenue in an efficient manner. If the objective is to tax the consumption of certain luxury goods at higher rates, this can be better achieved through the use of selective excises. Similarly, if the goal is redistributive (for example, to help the poor by providing a special VAT treatment to food), it is best that such concerns be taken care of through well targeted spending programs.

46. The taxable threshold should be set at a high level in order to keep out small businesses. To help tax administration cope with the new tax, it is advisable that the VAT threshold be chosen so that the number of enterprises registered for the VAT is between 4,000-6,000 taxpayers for the first 2–3 years of its implementation. Coverage could be expended later as administrative capability is built-up. Setting an appropriate threshold will require a good data base on the distribution of businesses by turnover, a task which should be given a high priority in the VAT preparation.

47. Preliminary estimates are that each point of the VAT could yield about 0.35 percent of GDP in revenue on a gross basis in the initial years. How much revenue a VAT might raise depends of course on its design features. As argued earlier, a case can be made for starting the VAT at a low rate of 5 percent (which is much lower than the standard rates adopted by most countries) and, when needed to compensate for the decline in oil revenue, the rate can be raised. On the assumption of a comprehensive VAT base (but with adjustment for base reduction due to small businesses in agriculture and the trading sector that are below the taxable threshold and for some leakages due to evasion), a standard rate of 5 percent will yield about 1.8 percent of GDP in revenue.17 However, on a net basis, since the VAT will be replacing the present consumption tax (about 1.2 percent of GDP), its initial yield is projected at 0.6 percent of GDP in 2008 (see Table 1). Over time, as the rate is increased, eventually reaching 15 percent, and as the number of VAT taxpayers rises, it is foreseeable that the VAT could easily raise 5 percent of GDP or more (a productivity yield that is about on par with the single rate Lebanese VAT).

48. The VAT could be supplemented by a small number of excises on few commodities. A few excises are presently in place. Some of these (particularly, excises on alcoholic and tobacco products) should remain as they can help address negative externalities. Excises could also be levied on petroleum products, cars, and telecommunication—which can provide a good tax handle given their broad bases and fairly limited distribution points. Higher excises could be levied on certain goods such as luxury cars. However, for ease of administration, products such as leather products, cosmetics, jewelry, watches, and the likes should not be excised as they are likely to be produced and/or distributed at numerous locations, spread over many regions, making enforcement and collection costly for the tax administration.

49. Work for the preparation for the VAT has started, albeit at a measured pace. A mid-level project team has been set-up to prepare for VAT implementation in 2008, and the general policy direction seems to be to implement the VAT within an integrated, function-based tax administration, which is appropriate. But, even if several key policy design issues are yet to be taken, a careful planning for the VAT implementation will need to be carried out as soon as possible. Attention needs to be given to the design of a VAT refund system, for which little has been done so far. This will require clear provisions in the law (for example, ensuring prompt refund of excess VAT credits to exporters), simple forms and procedures, and include a risk-based system to focus resources on audit of refund claims with high risk. Lastly, it is critical that the VAT law is adopted at least six months ahead of the effective date of implementation.

11

Prepared by Dale Chua and Rakia Moalla-Fetini.

12

The existing coupon system to provide subsidies for sugar and rice to the entire population could be piggy backed on to implement this scheme.

13

Kneller, R, M F. Bleaney, and N Gemmell, 1999, “Fiscal Policy and Growth: Evidence from OECD countries”, Journal of Public Economics, Vol. 74, p171–190.

14

The large number of rates is a vestige of past reform. When the consumption tax was introduced, quite a few excisable commodities were transferred to become taxable under the new consumption tax bearing different rates. Correspondingly, excises today are levied on only four products.

15

Under a well-designed VAT, only those businesses that have a relatively high turnover will have to collect the VAT on their sales. The poor are not very likely to shop from such outlets but, rather, would buy from small traders in street corners and so forth. The latter would be excluded from the VAT because of their low turnover threshold.

16

To limit the revenue impact of VAT refunds for capital goods, some countries mandate that excess VAT credits be carried over to subsequent filing periods rather than be refunded immediately.

17

The estimate, calculated using 2002 data, is based on the following assumptions: (a) 50 percent of sales of the agricultural sector (which presents virtually all unprocessed food sold to consumers) and 75 percent of trade margins of wholesalers and retailers are exempt from the tax; and (b) a leakage of 10 percent due to evasion.

Syrian Arab Republic: Selected Issues
Author: International Monetary Fund
  • View in gallery

    Production and Domestic Consumption of Oil

    (In millions of tons)

  • View in gallery

    Government Oil Revenue Valued at International Prices, Gasoline Taxes, Petroleum Price Subsidies, and Net Government Oil Revenue

    (In percent of GDP)

  • View in gallery

    Medium-Term Fiscal Outlook in the Absence of Adjustment

    (in percent of GDP)

  • View in gallery

    Adjustment Scenario: Budget Balance and Public Debt

    (in percent of GDP)

  • View in gallery

    Prices in U.S. Cents Per Liter

  • View in gallery

    Taxes and Subsidies on Petroleum Products

    (In percent of GDP)

  • View in gallery

    Distribution of of Direct and Indirect Welfare Gains from Petroleum Price Subsidies

  • View in gallery

    Net Budgetary Impact from Phasing Out PPS

    (In percent of GDP)

  • View in gallery

    Phasing Out Petroleum Price Subsidies Under Two International Price Scenarios: Net Budgetary Impact

    (Cumulative, in percent of 2006 GDP)