Analyzing and forecasting the Gulf Cooperation Council's geopolitical environment

Commercial and Financial Risks of the Value Added Tax

By Grant Huxham and Emmaline Ivy Johnson
July 7, 2016

In an effort to mitigate budgetary shortfalls due to plummeting oil prices, members of the Gulf Cooperation Council (GCC) plan to implement the new Value Added Tax (VAT) on January 1, 2018 (and to finalize all tax revenue systems and procedures by early 2019). UAE officials claim that VAT will generate USD 3 billion in national revenue during the first year. With health, education and over one hundred food items exempt, they also maintain that this new tax will have minimal impact on consumers.

VAT is a consumption tax by which the government collects revenue on sales and then refunds the tax difference to the seller. This differs from a sales tax, which requires a business to determine the buyer’s intent. If the buyer intends to purchase merchandise, add value, and then resell it, the seller does not need to impose any tax. On the other hand, if the buyer’s intent is to consume the goods in their current state, the opposite is true. This system incentivizes both merchants and consumers to claim that their goods will not be consumed in their current state. VAT is an alternative to sales tax, whereby a tax is charged every time goods are bought and sold. VAT is a temporary payment to the state based on the purchase price that is subsequently refunded after value has been added. This arrangement removes any incentive to inaccurately report consumption because the seller invariably receives a refund. Consumers with no possible refund have no reason to inaccurately report their intended use. In the end, only the consumer is taxed, as is the case with a sales tax.

Direct taxes, like income taxes, necessitate a great amount of institutional framework and preparation. In the UAE, as in other GCC countries, it will likely take years (if not decades) to fully develop and implement VAT. At a rate of 5 percent, VAT slowly introduces the idea of taxation to a region that is accustomed to subsidies and government handouts. In February 2016, Christine Lagarde, Managing Director of the IMF, declared, “It is time people are made to understand that public services need to be priced. Either a viable pricing mechanism needs be implemented to fund public services or governments can resort to big borrowings, which is not sustainable in the long term.” The UAE is expected to generate revenue from VAT in the sum of 1 to 2 percent of its gross domestic product.

The effect of VAT on UAE consumers will depend on income and spending habits. With essential food items, education, and healthcare exempt, low-income families are unlikely to see a significant difference. As is the case with most economic policies, the middle class will be, over time, affected the most. Consumers in the habit of frequently upgrading their appliances, electronics and automobiles will certainly feel the greatest burden. For them, VAT is unlikely to discourage spending, however, since a tax of USD 50 on a purchase of USD 1,000, while noticeable, is still small. Those in the higher income brackets should not be affected at all.

How will VAT impact the UAE’s tourism sector? Dubai is attractive to high-end travelers for its tax-free shopping. Karen Patel, marketing manager of 2GIS Middle East, argues that because tax-free shopping will no longer exist, we may see a decline in tourist spending. Tourists to the UAE will be charged a 5 percent VAT and then be taxed again when they reach home. Other analysts consider it unlikely that the 5 percent VAT, which is low by international standards, will cause wealthy tourists to rethink purchases. It is also probable that consumption related to tourism may turn out to be ‘zero-rated’ or ‘exempt’ from VAT. GCC officials may decide that VAT will be levied at a ‘zero-rate’ on hotel accommodations, high-end purchases at the duty-free counter and some forms of public transport.

In order to stay afloat economically, the UAE and its fellow GCC members must diversify their sources of revenue. But they must tread carefully. Because their populations are not accustomed to taxation, which is as much a cultural phenomenon as it is an economic one, the 5 percent VAT will allow the UAE to diversify without pushing the mostly expatriate middle class to other markets. Moreover, the absence of an income tax (and exemptions for education and health care) will still allow the UAE to boast tax-free income as an enticement to foreign workers.

Ultimately, the introduction of the VAT is a soothing mechanism, designed to ease taxation upon UAE residents. As oil prices remain low, the GCC will have to continue to diversify and broaden its sources of revenue. The IMF reports that single-digit indirect taxation in the form of VAT is the most viable option for Gulf Arab states in the first stage of taxation, as implementation of direct taxes requires a fairly well developed institutional framework. VAT is by no means the final step, rather just the beginning of inevitable taxation in the UAE and other GCC nations.

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Grant Huxham is an advisor at Gulf State Analytics and the Chief Financial Officer at Health Safety Emirates. Emmaline Ivy Johnson is a contributor to Gulf State Analytics.