Islamic Republic of Iran: Selected Issues

Abstract

Islamic Republic of Iran: Selected Issues

A Roadmap for Structural Fiscal Reforms in Iran1

  • Iran faces the difficult challenge of reducing its non-oil deficit to support low inflation and to entrench fiscal sustainability, even though spending pressures are mounting, with government debt securitization, translating into higher interest payments, banks’ restructuring leading to potentially large fiscal costs, and supporting the authorities’ growth objective, requiring higher infrastructure investment.

  • Developing a medium-term fiscal framework (MTFF) would provide the authorities with an adequate tool to formulate such a strategy. Within a MTFF, the authorities could establish fiscal rules, tax policies and expenditure policies that would meet all of their fiscal objectives.

A. Iran Faces Spending Pressures

1. Iran has sustained a relatively low overall fiscal deficit in challenging circumstances. Over the past 5 years, the overall fiscal deficit of the central government was kept below 2 percent of GDP despite the drop in oil revenues arising from the impact of the oil embargo and then the decline in world oil prices since-2014. This reflected the government’s policy that aimed to contain the deficit in line with available financing and its longer-term strategy to gradually reduce its dependency on oil revenue. For example, VAT was introduced in 2008, and the rate was gradually increased, to reach 9 percent in 2015/16. In parallel, tax administration was strengthened leading to increasing numbers of registered taxpayers and continued improvements in tax collection. In 2015/16 tax receipts exceeded oil revenues for the first time.

2. Nonetheless, the shock to oil revenues in recent years has exposed a number of underlying vulnerabilities in Iran’s fiscal system:

  • Pro-cyclical fiscal policies: Notwithstanding the improvements made in recent years, the budget continues to rely on oil receipts for about 40 percent of its total revenue. In the wake of the sharp decline in oil receipts and facing limited access to financing, the government cut pro-growth spending to contain the overall level of the deficit. These cuts were pro-cyclical as they occurred when economic growth was already being adversely impacted by the oil revenue shock. The cuts in infrastructure, health and education spending during the period 2012/13–2015/16 were sizeable and amounted to 4 percentage points of GDP. Owing to rigidities in current spending, in large part due to laws superseding the budget (e.g., the law on public wages mandates inflation indexation), investment spending bore the brunt of the cuts. Over the past decade, the execution rate for the investment budget was just 60 percent. The cuts in spending occurred because the budget lacked buffers that it could draw upon to safeguard spending because the Oil Stabilization Fund (OSF), was discontinued in 2011/12.2 As a result when revenue collections fell short of the targets set in the annual budget that is approved by parliament, the Committee of Special Measures determined the allocation and relocation of resources at a strategic level, while the Planning and Budget Organization (PBO) and the Ministry of Finance (Treasury) Allocation Committee then had to bring spending in-line with actual revenue and financing.

  • Weaknesses in spending control and extensive off-budget fiscal activities: In 2015/16, an audit of government arrears revealed a total debt stock of about 42 percent of GDP, against previous estimates of about 17 percent. The additional liabilities reflected unpaid bills of the central government as well as arrears on commitments accumulated outside the central government that were not captured in the fiscal accounts. Estimates suggest that while the central government represents about 17 percent of GDP, the broader public sector represents about 70 percent of GDP (Nasiri and Fatehizadeh, 2011). Noncentral government agencies can commit government funds (e.g., through public guarantees) and shift the cost of these commitments to the central government who then fund these obligations. Moreover, there is no system to record these commitments or monitor arrears as the annual budget and fiscal accounts are prepared on a cash basis. This also dilutes parliamentary oversight of fiscal activity and the budget.

A03ufig1

Impact of Lower Oil Revenue on Spending

(Difference in percentage points of GDP, 2000/01-11/12 and 2012/13-15/16)

Citation: IMF Staff Country Reports 2017, 063; 10.5089/9781475583083.002.A003

Sources: Iran authorities, and IMF staff estimates.
A03ufig2

Outturn vs. Budget

(percent of approved spending)

Citation: IMF Staff Country Reports 2017, 063; 10.5089/9781475583083.002.A003

Sources: Iran authorities; and authors’ estimates.

3. Iran enters 2017 facing sizeable new spending pressures that will further test the annual budgeting process.

  • Interest payments will rise from less than 1 percent of GDP in 2016/17 to about 3 percent over the medium-term. The main reason is that recognition of the government’s payment arrears has required the authorities to start securitizing this debt with interest-bearing instruments. As the securitization process continues budgeted interest payments will rise.

  • Banks restructuring and recapitalization will put additional pressure on the interest bill and debt burden. With the majority of banks being publicly-owned, these costs will largely fall to the government. At present the magnitude of the fiscal impact is unknown, but cross-country experiences suggest that it could represent a significant share in GDP.

  • Restoring public investment to its pre-sanctions level of about 6 percent of GDP will be necessary to support the authorities’ growth objectives. Higher quality public investment is also required if Iran is to increase its domestic productive capacity and improve its competitiveness. Sadeghi (2017) shows that the growth impact of higher public investment spending is amplified and longer lasting when accompanied by measures to improve the efficiency of public investment management processes in the areas of project selection and implementation.

  • Health and age-related spending is also set to rise. The commitment to move to a universal health care system (Rouhani Care) could cost about 2 percent of GDP, unless accommodated by a reallocation of existing health spending. Similarly, while not immediate, age-related costs (health, pension) could also amount to about 2 percent of GDP annually over the long term.

B. Envisioning a Medium Term Fiscal Framework (MTFF)

4. A MTFF would provide policy makers a comprehensive framework to assess how fiscal policy can balance the need to ensure the sustainable use of oil resources while addressing new spending pressures and supporting the economic recovery. Casting the budget in a MTFF and shifting away from an annual budgeting process would provide the government a more comprehensive tool to assess what the appropriate level of the fiscal deficit is taking into consideration macroeconomic conditions, the level of debt and its sustainability to shocks, and what would be a sustainable use of its oil proceeds. It can inform decisions about the fiscal space available for discretionary fiscal stimulus or in cases where adjustment is needed, the space available for a more gradual adjustment. The framework can also be used to help evaluate the cost, growth and distributional impacts of different policy measures.

5. Table 1 summarizes the medium-term fiscal framework prepared by staff for the 2016 Article IV Consultation. In conducting this analysis of fiscal space we found that Iran has some space to implement a gradual adjustment. This would have the advantage of providing time to implement thorough reforms, which, to be sustainable, will require time to secure broad support and ensure that there is adequate administrative capacity to implement them. In preparing the MTFF, we used the following steps to assess the space and pace of adjustment that would preserve sustainability while balancing the need to support the economic recovery and underpin the credibility of the macroeconomic policy framework:

Table 1.

Medium-Term Fiscal Framework, 2014/15-2021/22

article image
Source: Iran authorities, and IMF staff projections.

Staff estimates of permanent measures to be taken every year.

  • Determining the gap between the level of the fiscal deficit consistent with sustainable use of oil revenues relative to that implied by current policies. The permanent income hypothesis (PIH) determines the level of government expenditure that is consistent with financial income from the wealth generated by oil revenue and existing non-oil revenue. It ensures that the overall level of the fiscal deficit, excluding oil revenues (i.e., non-oil deficit) can be sustained without a sharp increase in debt or cut in spending when oil proceeds are exhausted. The permanent income hypothesis norm for Iran suggests that the sustainable non-oil deficit is 5.6 percent of non-oil GDP (PIH, see IMF, 2012 and 2015). Given the spending pressures outlined above, the non-oil deficit is set to rise from the current level of 11.5 percent of non-oil GDP to almost 20 percent over the medium-term.

  • Determining the space for a more gradual pace of adjustment to long-germ sustainable levels. Iran has some space to implement a gradual adjustment towards the PIH norm which would help minimize the impact of fiscal adjustment on the non-oil economy when growth remains weak due to the legacy of sanctions and structural bottlenecks. Iran has proven oil and gas resources of 100 years and it currently allocates between 2-3 percent of GDP of its annual flow of oil revenues to the NDFI. Its overall level of gross debt is just over 40 percent of GDP and it has financial assets of about 15 percent of GDP. The public debt sustainability analysis (Appendix II of the Staff Report) shows that gross public debt remains low and sustainable under a wide range of shocks if the overall non-oil deficit is kept in the 12 percent of non-oil GDP range over the next 5 years. This level of deficit would also be compatible with the financing available from the nascent domestic government debt market and would underpin the credibility of the new monetary policy framework.

  • Identifying and evaluating fiscal adjustment measures. To bring the non-oil deficit to the level of about 12 percent of GDP, measures of about 7¼ percent of GDP needed to be identified over the next five years. Staff analysis of the impact of tax and spending measures on growth suggests that measures that focus on increased tax collections, would minimize the adverse impact on growth. Moreover, analysis by Atashbar (2016), and Arabmaza and Zayer (2008), of 20 years of tax collection in Iran, suggests that almost half of the country’s total tax capacity is untapped. In addition, the impact of new fiscal measures on growth could be modified if space is found to fund an increase in public investment spending to about 6 percent of GDP.

  • Finally, the distributional impact of proposed fiscal measures should also be assessed. Iran already has experience in crafting policies to address the distributional aspects of reforms. The fuel subsidy reform implemented in 2010 saw the revenue gains from the increases in fuel prices redistributed to citizens in the form of a universal cash transfer. This helped reduce the Gini coefficient by about 2¾ points. Analysis by Berg, Ostry and Zettlemeyer (2008) suggests distributional improvements of this kind have the potential to boost growth over a period of about 6–7 years. Continuing the subsidy reform, notably by targeting transfers more specifically at the poor could greatly help alleviate the cost of reforms by financing effective social safety nets, and also support the authorities’ growth objective through its redistribution impact.

A03ufig4

Fiscal Deficit Trend to Adjust to the PIH Norm

(Percent of non-oil GDP)

Citation: IMF Staff Country Reports 2017, 063; 10.5089/9781475583083.002.A003

Sources: Iran authorities, and IMF staff projections.
A03ufig5

Non-Oil GDP Growth Implied by Fiscal Measures

(Percent)

Citation: IMF Staff Country Reports 2017, 063; 10.5089/9781475583083.002.A003

Sources: Iran authorities, and IMF staff projections.

C. Implementing a MTFF in Iran

6. Casting the government’s budget in a MTFF and shifting away from an annual budgeting process would require several supporting reforms. A MTFF typically contains a statement of fiscal policy objectives and a set of integrated medium-term macroeconomic and fiscal targets and projections. The approach is “top-down” where the PBO would set the overall fiscal space for government spending. Key elements that should be included in the MTFF are:

  • A statement of fiscal policy objectives and how they are articulated. This step would be essential to formulate a consistent fiscal strategy, by defining long-term objectives (e.g., supporting low and stable inflation, ensuring fiscal sustainability and securitizing arrears), and making the non-oil primary balance the main fiscal anchor. Iran could use its 5-year National Development Plans (NDP) to set the strategic guidance on fiscal objectives. However, NDPs are, at present, weakly linked to the annual budget, as executed budgets depart significantly from approved budgets and the NDP. Creating stronger links between the NDPs and MTFF would also need to be complemented by steps to strengthen the budget preparation, implementation, monitoring and evaluation processes.

  • Projections and targets for medium- and long-term fiscal indicators, including the non-oil and overall fiscal deficits, PIH, and public debt levels. For the MTFF to be a meaningful guide for fiscal policy, it will be necessary to expand the coverage of the fiscal accounts to the general government.

  • Overall spending envelopes. These would be used to define binding expenditure ceilings for line ministries and agencies falling under the MTFF. Over time, depending on administrative capacity and broad political support for the MTF objectives, a more bottom-up approach could be considered within a Medium-Term Expenditure Framework (MTEF).

  • Closer coordination between key players in budget preparation and implementation, namely the Planning and Budget Office, the new Debt Management Office and Treasury. The new treasury single account and phased introduction of accrual accounting will assist the transition to an MTFF.

  • A statement of fiscal risk. Fiscal risk should be assessed and mitigating measures disclosed, notably guarantees and quasi-fiscal operations. This would strengthen the credibility of fiscal policy, enhance its resilience and help to build a consensus on the measures needed. Currently, fiscal risks are not assessed in the annual budget process. Table 2 provides an overview of the potential fiscal risks facing Iran, which if they materialize, can increase spending pressures further. The most probable and sizeable risk is the prospective restructuring and recapitalization of the banking sector discussed above, where at present only a small budgetary allocation has been made (See Staff report).

Table 2.

Fiscal Risks

article image
Source: IMF staff.

Continuous = regular events that cause outturns to differ from forecasts; Probable = likely to materialize in the near term; Possible = likely to occur, but unlikely in the near-term; Remote = potentially significant but difficult to predict over a given timeframe.

7. Greater fiscal transparency and oversight will also be critical to support the MTFF and fiscal consolidation.

  • Fiscal consolidations, especially those requiring fiscal structural reforms (e.g., tax reforms, strengthening the budget process), require strong consensus and support from all economic agents (Mauro, 2011). A new MTFF accompanied by a robust communication campaign could educate the public about the scale of fiscal challenges and explain tradeoffs involved in selecting measures.

  • Strengthening budget oversight would also help the authorities implement their fiscal strategy. In this perspective Iran could consider developing a formal fiscal council, possibly building from the existing institutions, i.e. the Supreme Audit Court (SAC) and the Parliament Research Center (PRC). In line with best practices (IMF, 2013, and Debrun and Kinda, 2014) a formal independent monitoring of a government’s fiscal policies, plans, and performance could help improve the budget process, in particular by fostering a formal public debate where the authorities would need to discuss reasons/options to address vulnerabilities identified by the watchdogs. There is suggestive evidence that, all else being equal, fiscal councils contribute to fiscal discipline (IMF, 2013).

8. Finally, the MTFF could be accompanied by a revised fiscal rule to guide the allocation of oil revenues. The Fifth 5-year National Development Plan had introduced a fiscal rule on the repartition of oil revenue between the National Iranian oil company (NIOC), 14.5 percent, the budget (65.5 percent), and the National Development Fund of Iran (NDFI, 20 percent increasing by 3 percentage points each year to reach a share of 38 percent). However, this rule did not provide the budget a buffer to address shocks, and, as a result, the rule was amended in each of the past three budgets. The annual budget laws for 2015/16–2017/18 approved an ad-hoc adjustment of the NDFI share to increase the share of the oil revenue allocated to the budget. A revised rule that carves out a specific allocation for a stabilization buffer could protect budgeted spending against oil or other revenue shocks. This could be done, for example, by reinstating the OSF and/or allowing the use of NDFI financial assets to support the budget or bank recapitalization needs. Determining the share that would be allocated to the OSF would require an analysis of the level of buffers needed to address typical shocks. Since the past experience of Iran’s fiscal rule has been mixed, the authorities could consider adding to the rule a formal escape clause, in line with best practices.

References

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  • Debrun, X., and T. Kinda, 2014,”Strengthening Post-Crisis Fiscal Credibility–Fiscal Councils on the Rise. A New Dataset,Working Paper 14/58 (Washington: International Monetary Fund).

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  • IMF, 2015, Fiscal Monitor, October (Washington: International Monetary Fund). Available via the Internet: http://www.imf.org/external/pubs/ft/fm/2015/02/pdf/fm1502.pdf

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  • Mauro, P. 2011. Chipping Away at the Public Debt—Sources of Failure and Keys to Success in Fiscal Adjustment Hoboken, N.J.: John Wiley and Sons.

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1

By Olivier Basdevant (IMF) and Tohid Atashbar (Iran Parliament Research Center).

2

The OSF was replaced by the National Development Fund of Iran (NDFI), which on-lends oil proceeds to the private sector for investment and it is legally prohibited from financing the budget.

Islamic Republic of Iran: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.