The announcement of the planned introduction of a federal value-added tax (VAT) and a corporate tax in the UAE has stimulated a lot of discussion on what this means for the country and its residents.
I have a slightly different view to the current mainstream opinions, and would like to share it.
The overall premise of the conventional wisdom is that the federal government of the UAE is introducing new taxes to offset a decline in oil revenue due to lower oil prices. The problem is that the federal government does not generate its revenue from oil sales, as it does not own or sell oil. The majority of oil is to be found in the emirate of Abu Dhabi, and oil price changes would affect the emirate’s revenue, not that of the federal government.
What this means is that the tax receipts generated would not be to replace revenue lost to oil price declines, but would instead be additional revenue available to the federal government to spend and invest in the country. That means an expansionary budget at the federal level, a good thing.
At the same time, a consolidated approach to the country’s economy at the federal level is an extremely positive sign for the economy. Increasing the economic integration of the economies of the seven emirates can only yield dividends, as the sum will be greater than the parts.
In terms of the demand-side effects of the VAT – how it might affect consumer spending, in other words – I disagree with the idea that this will necessarily cause a significant decline in spending and I believe it will, in all probability, not have a negative impact on the economy.
Standard economic theory says that if consumer spending drops, then producers will make less money and therefore have less to spend, leading to a vicious downwards spiral. This standard model is based on three assumptions that do not appear in the current context of the UAE.
First, the standard theory assumes that consumers reduce spending, as they have reduced means to do so. For instance, they are laid off or have lost a lot of money in a stock market crash. That is not true in the case of the UAE. If the VAT increases prices of luxury goods, then who says that the wealthy will not have the means to continue spending?
This brings us to the second unfounded assumption, and that is that the introduction of VAT will increase the prices of goods and services. The idea here is that sellers will pass on the cost of the VAT to buyers. This is not necessarily true. In the lexicon of economists, the price elasticity of supply might be high, in other words sellers might be making such big margins that they absorb most if not all of the cost of the taxes to maintain their competitiveness.
The third assumption in the standard economic model that is not fully present in the UAE is that the preponderance of production is based onshore. In the UAE, much of the production economy is imported. If in Germany demand for luxury cars drops drastically, factories in that country will go out of business. In the UAE, only a handful of agents will feel any economic impact.
In the final analysis, taxes do not take money out of the economy, they just transfer funds from the private sector to the public sector. If these funds are squandered on bloating the government, then taxes are bad. If, on the other hand, these funds are invested for continued growth in areas such as infrastructure and social services, then taxes are good.
Given the ongoing successful management of the various governments of their investment in the economy, I am entirely optimistic that the tax-based funds transferred from the private sector to the public sector will continue to create an environment that allows for long-term sustainable growth that is competitive with global benchmarks.
At a time when global economies are already taxing at high rates to bail out economies in trouble, the UAE’s strategy to introduce a small tax on an unburdened economy should lead to a continued improvement of the UAE’s global competitiveness.
This article was originally published in The National.