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United Arab Emirates: Selected Issues

Author(s):
International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
August 2015
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Strengthening Fiscal Policy and Budget Frameworks in the UAE1

Given the large drop in oil prices, expenditure-containing measures are needed to reduce fiscal vulnerabilities and bring the fiscal stance back to consistency with intergenerational equity. These measures could target energy subsidies and other transfers, capital transfers to Government Related Entities (GREs), and other government expenses. Designing fair, simple, and effective tax systems could also contribute to fiscal consolidation efforts. Strengthening budgeting processes and developing a consolidated forward-looking fiscal framework would help achieve the desirable fiscal policies.

1. This paper proposes ways to ensure long term fiscal sustainability. It provides an overview of government’s revenue and expenditure developments. The paper presents fiscal sustainability analysis that is most relevant to such countries with large hydrocarbon wealth as the UAE. It discusses measures to contain expenditure growth—controlling the public wage bill, reducing subsidies and transfers, and stabilizing other expense in real terms. The paper also proposes options to increase nonhydrocarbon revenue such as broadening corporate income tax with lower rates, introducing a low rate-broad based value added tax, and levying an excise tax on automobiles. It also proposes ways of strengthening budgeting processes in Abu Dhabi to support fiscal policy implementation, and to prepare a consolidated fiscal framework for the UAE as a whole.

A. Revenue and Expenditure Trends

2. Total revenue and expenditure of general government have increased substantially since 2000 in real terms (Figure 1). Driven by increases in the oil price and hydrocarbon production, real total revenue grew by 11 percent on average in 2000-14. Such strong growth in revenue allowed increasing total expenditure substantially, by about 10 percent on average in real terms in the same period. While spending is usually procyclical to oil prices in the UAE, it was countercyclical in the aftermath of the 2008–09 global financial crisis when the authorities were implementing the policy of supporting weakened demand.

Figure 1.Total Revenues, Expenditures, and the Oil Price, 2000-14

(In real AED billions)

Sources: Country authorities; and IMF staff estimates.

3. General government revenue depends strongly on hydrocarbon revenue. Oil and gas revenue amounted to 24 percent of GDP in 2014, up from 18 percent in 2004 (Figure 2).2 In terms of total general government revenue, oil and gas accounted for 65 percent in 2014. Nonhydrocarbon revenue excluding investment income from SWFs increased to about 8 percent of GDP in the last five years from 4-5 percent in 2004-08, mostly from new fees for government-provided services. Investment income from SWF amounted to about 5 percent of GDP in 2014.3

Figure 2.General Government Revenues, 2004-14

(In percent of GDP)

Sources: Country authorities; and IMF staff estimates.

1/ Includes profit transfers from the national oil company to SWF (IMF staff estimates).

2/ IMF staff estimates.

4. Nonhydrocarbon revenue is mainly collected by the federal and Dubai governments.

  • Nonhydrocarbon revenue, excluding investment income, amounts to about 20 percent of total revenue or about 8 percent of GDP. Half of nonhydrocarbon revenue comes from Dubai. The federal government collects most of the remaining nonhydrocarbon revenue (about 3 percent of GDP).
  • The tax structure is as follows: corporate income tax (CIT) of 20 percent levied on foreign banks in Dubai; local municipal property tax of 5 percent of the rental value; a 10 percent local hotel tax on hotel services; the GCC’s common external tariff (a general rate of 5 percent, 50 percent on alcohol, and 100 percent on tobacco4) applied locally; and numerous fees on government services (applied by the federal and Dubai governments).
  • The UAE, as other GCC countries does not collect VAT and excises, while collecting CIT only partially, missing an opportunity to diversify its revenues and strengthen the fiscal position—oil exporters in other regions collect VAT from 1.5 percent of GDP in Algeria to about 8 percent of GDP in Chile and Norway, and about 4 percent of GDP in CIT revenue and 1 percent of GDP in excise taxes (an average for emerging and developing oil exporters) (Figures 35).

Figure 3.VAT Revenue, 2014 (or latest)

(In percent of GDP)

Sources: Country authorities; and IMF staff estimates.

1/ Emerging and developing oil exporters (include Algeria, Botswana, Chile, Colombia, Indonesia, Kazakhstan, Mexico, Mongolia, Nigeria, Peru, Russia, Trinidad and Tobago, Venezuela, and Vietnam).

Figure 4.CIT Revenue, 2014 (or latest)

(In percent of GDP)

Sources: Country authorities; and IMF staff estimates.

1/ Emerging and developing oil exporters (include Algeria, Botswana, Colombia, Indonesia, Kazakhstan, Mongolia, Nigeria, Peru, Russia, Venezuela, and Vietnam).

Figure 5.Excise Revenue, 2014 (or latest)

(In percent of GDP)

Sources: Country authorities; and IMF staff estimates.

1/ Emerging and developing oil exporters (include Chile, Colombia, Indonesia, Kazakhstan, Mexico, Mongolia, Peru, Russia, Trinidad and Tobago, Venezuela, and Vietnam).

5. Total expenditure of general government increased because of strong growth in government expenses (Figures 6, 7). Government expenses grew by about 10 percent on average in 2000-14 in real terms. The largest contributors to the growth in government expenses were capital transfers to Abu Dhabi’s government-related entities (GREs)5, other expense that includes security, defense, and administrative spending, and grants to foreign governments. Wages and net acquisition of non-financial assets increased more modestly, by 5 percent and 8 percent, respectively, in 2000-14 on average in real terms. However, wage growth was stronger over the last several years, at 10 percent on average annually, raising the average monthly wage in public administration to the levels compared with the highly profitable financial intermediation and mining sectors (Figure 8). Relative to GDP, total expenditure stabilized at 30 percent over 2011–13, but increased to 32 percent in 2014. UAE’s total expenditure in terms of GDP is lower than in other GCC countries and advanced and emerging oil/commodity exporters on average (Figure 9). There is room, however, in rationalizing expense to bring it to lower levels (e.g. as in Chile and Singapore).

Figure 6.Government Expenditure, FY2000-14

(In real AED billions)

Sources: Country authorities; and IMF staff estimates.

1/ Abu Dhabi loans and equity to GREs.

Figure 7.Government Expenditure, FY2000-14

(Percent of GDP)

Sources: Country authorities; and IMF staff estimates.

1/ Abu Dhabi loans and equity to GREs.

Figure 8.Average Monthly Wages per Employee, 2008

(Thousands of Dirhams)

Source: Country authorities.

Figure 9.Government Expenditure in Commodity Exporters, 2014

(In percent of GDP)

Source: World Economic Outlook (IMF).

1/ Emerging and developing commodity exporters (include Algeria, Botswana, Chile, Colombia, Indonesia, Kazakhstan, Peru, Russia, and Venezuela).

Subsidies

6. Low energy and water prices resulted in large subsidies and elevated consumption of energy products. Sizable subsidies in the UAE, as in other GCC countries, are government’s main way to share wealth, provide social protection, and support industrial sectors. These subsidies are the main reason behind substantial domestic consumption of energy products (Figure 10). On-budget subsidies in the UAE amounted to 2 percent of GDP in 2014 with Abu Dhabi’s water and electricity subsidies accounting for half of it. Total (implicit) energy subsidies were estimated at 5.7 percent in 2011.6

Figure 10.Hydrocarbon Production, Consumption, and Exports, 2000–14

(Millions of barrels per day)

Sources: Country authorities and IMF staff estimates.

7. With lower oil prices and higher tariffs on electricity and water, these subsidies are expected to decline, but will still remain high. While the highest in the region, UAE’s retail fuel prices are lower than international market levels (Table 1).7 This implies that implicit subsidies for petroleum products still exist. Abu Dhabi’s higher water and electricity tariffs since January 2015 and lower oil prices are expected to result in budget savings of 0.5 percent of GDP in 2015. Because of lower oil prices, the UAE will save another 0.4 percent of GDP from lower natural gas implicit subsidies (Table 2). As a result, total (implicit) subsidies are expected to decline to 4.6 percent of GDP in 2015. The size of the subsidies is still high: for example, government spending on health and education was 3 percent of GDP in 2013.

Table 1.Retail Prices of Gasoline and Diesel(June 2015 or latest; in US$ per liter)
GasolineDiesel
Saudi Arabia0.140.06
Qatar0.210.41
Kuwait0.230.37
Algeria0.230.14
Bahrain0.270.27
Oman0.310.38
Iraq0.390.34
Iran0.420.11
UAE0.470.64
United States0.740.76
Sources: Arabian Business, Bloomberg, Datastream, EIA, GlobalPetrolPrices, Ministry of Energy of UAE, Numbeo, and The Peninsula Newspaper.
Sources: Arabian Business, Bloomberg, Datastream, EIA, GlobalPetrolPrices, Ministry of Energy of UAE, Numbeo, and The Peninsula Newspaper.
Table 2.UAE: Pre-tax Subsidies(In percent of GDP
20112015
Petroleum products0.50.2
Electricity1.91.4
Natual gas3.43.0
Total5.74.6
Source: IMF
Source: IMF

8. Water consumption rates and technical losses are high in the UAE, as in other GCC countries (Box 1). Because of water usage’s low tariffs for individuals and industries, implicit natural gas subsidies are high, as natural gas is the main fuel used in producing fresh water in desalination plants. Inefficient agriculture, weak institutional arrangements, and poor management practices result in large water and natural gas subsidies.

B. Fiscal Sustainability Analysis

Fiscal vulnerabilities and intergenerational equity

9. Fiscal consolidation is needed to reduce fiscal vulnerabilities. The fiscal break-even oil price of general government is estimated at $72 per barrel in 2015, an indication of risks associated with permanently low oil prices. Under the authorities’ fiscal consolidation path, the fiscal break-even oil price would fall below the projected oil price levels in 2016 (Figure 11).

Figure 11.Fiscal Break-Even Oil Prices, 2008–20

(U.S dollars per barrel)

Source: IMF staff estimates.

10. Fiscal consolidation would also ensure that fiscal policy is consistent with intergenerational equity. Staff analysis based on the permanent income hypothesis suggests that under conservative baseline assumptions the government does not save its exhaustible oil revenue sufficiently for future generations, but favorable persistent shocks could imply a smaller gap.8 The gap between the projected deficits and the deficits consistent with a constant real per capita annuity is 11 percent of nonhydrocarbon GDP in 2014. With fiscal consolidation assumed by the authorities (the baseline), the gap is projected to almost disappear by 2020. If beyond the forecast period, consolidation continues in the same pace as envisaged for 2020 under the baseline, the fiscal stance would be fully consistent with intergenerational equity by 2022 (Figure 12). Another approach in estimating annuity would yield different results: the constant real annuity rule would imply a negative gap of 9 percent of nonhydrocarbon GDP in 2020. Both types of annuities are used in the literature.9

Figure 12.Fiscal Sustainability Analysis, 2014–20

(Percent of non-hydrocarbon GDP)

Source: IMF staff calculations.

Structural primary balances

11. Targeting a “structural” primary balance can be a useful complement to the sustainability analysis presented above.10 The structural primary balance is defined as the primary balance excluding the cyclical component of resource revenues. The structural primary balance target could be set to ensure the sustainability of a fiscal policy framework, with the smoothing rule delinking expenditures from volatility in hydrocarbon prices that can result in a pro-cyclical fiscal stance. An important decision to be made is to determine the reference price when computing structural resource revenues. International experience suggests two approaches: the reference oil price could be set by using an automatic formula (the most common approach) or by an independent committee. Both approaches can protect fiscal policy from the pressures of the political cycle.

12. The choice of a price formula will depend on a preference for smoothing expenditures and adjusting to changes in prices. Figure 13 depicts the behavior of structural primary balances under the different price rules in the UAE case (the baseline balances follow the same revenue and expenditure trends as discussed in the intergenerational equity analysis above). Price formulas with a short backward-looking horizon (5,0,0) or with a short backward-looking horizon combined with the current year and a short forward-looking horizon (5,1,3) result in primary balances that better track price changes but which at times may be associated with a more pro-cyclical fiscal policy. Price rules with long backward-looking formulas (10,0,0) imply smoother expenditure paths but may under- or over-shoot revenues if price trends change. The 5,1,3 price rule, applied to the revenue and expenditure paths that bring the fiscal stance to a broad consistency with intergenerational equity by 2020, suggests that the structural primary balances should be 5 percent of GDP in 2020. The 10,0,0 price rule, applied under the same scenario as the 5,1,3 price rule, would indicate the structural primary balances at 8 percent of GDP in 2020.

Figure 13.UAE Baseline and Structural Fiscal Balances, 2001–20

(In percent of GDP)

Source: Country authorities; IMF staff calculations.

1/ A 10-year moving average of hydrocarbon prices (prices of the past 10 years).

2/ A 5-year moving average of hydrocarbon prices (prices of the past five years).

3/ A 9-year moving average of hydrocarbon prices (prices of the past five years and projected prices for the current and the next three years).

C. Sustainable Fiscal Policy Measures

Revenue options

13. A fair, simple, and effective tax system is needed to raise nonhydrocarbon revenues in order to strengthen sustainability and intergenerational equity. Given the UAE’s significant surpluses from hydrocarbon revenues, the main principle for guiding tax policy in the UAE should be low tax rates and very broad bases. Such tax policy generally would limit negative effects on investor and consumer behavior. This principle would also be consistent with the economic diversification strategy. In parallel, tax reform efforts need to focus on strengthening administrative capacity.

14. A corporate income tax (CIT) with broader coverage but lower rates would raise additional revenue and would be seen as more equitable by foreign investors. The tax rate could be lowered to 10 percent from the current 20 percent and the coverage could be broadened by including all companies (foreign, domestic, GCC) except for those located in free economic zones. In addition, a broadened CIT, if applied to unincorporated companies, could provide some progressivity in taxation and would lessen the need to introduce a general income tax on individuals. This measure is estimated to yield 4.1 percent of nonhydrocarbon GDP (Table 3).11

Table 3.Illustrative Menu of Options for Fiscal Adjustment
ExpendituresEstimated gains in 2015–20 1/Comments
IMF staffAuthorities
Total9.013.4
Water and electricity subsidies1.11.1Removal of water and electricity subsidies
Other transfers1.13.1Slowing growth in other transfers
Capital transfers3.55.8Lowering capital transfers to Abu Dhabi GREs
Containing growth in other expense3.33.3Stabilizing other expense in real terms
RevenuesEstimated gains once fully implemented 1/
IMF staff-proposed revenue options
Total7.4
CIT4.1Applying the CIT of 10 percent (to UAE, GCC, and foreign companies)
VAT2.7Introducing a 5 percent VAT
Excise tax0.6Introducing a 15 percent excise tax on automobiles
Source: IMF staff estimates.

In percent of non-hydrocarbon GDP.

Source: IMF staff estimates.

In percent of non-hydrocarbon GDP.

15. The value added tax (VAT) would serve well as a low rate-broad base tax. VAT is generally viewed as the most stable revenue source, which has the least detrimental effects on investments. In such a macro-fiscal environment as in the UAE, a low rate, for example 5 percent, VAT could be considered. A broad-based consumption tax such as VAT would raise revenue proceeds at a low efficiency cost. At the same time, its equity implications would be relatively insignificant in such a macro-fiscal environment as in the UAE, where taxes are minimal and government expenditures are financed by oil revenue. Tax administration would receive a significant and positive boost. The progress in this area depends on how soon VAT frameworks are agreed within the GCC, which are committed to implement a VAT in the medium term.12 The estimated yield from introducing the VAT is 2.7 percent of nonhydrocarbon GDP.13

16. Excises on passenger vehicles could also be considered for raising non-oil revenue. Automobiles impose a number of costs on society. These costs include direct costs such as the cost of maintaining and expanding a network of roads, and indirect costs such as productivity losses due to traffic jams and health costs because of increased pollution. Imposing an excise tax on automobiles would shift costs associated with the usage of automobiles to the owners. Ad valorem tax of 15 percent would yield 0.6 percent of non-hydrocarbon GDP.14 Gains from excises on tobacco and alcohol would be insignificant.

17. Fees and charges for government-provided services should not be seen as a substitute for taxes. If fees are lower than the cost of government goods and services (other than public goods and services), raising those fees would be a welcome step. Raising fees for revenue generating purposes could, however, become a complex and inefficient process. A number of relevant shortcomings are as follows: (i) fees distort supply and demand by (for example) encouraging government to keep supplying goods and services it is not efficient at producing; (ii) fees are inequitable and not transparent; (iii) fees are generally more expensive to administer. In addition, the only way to tax private transactions would be to extend fees to private contract – for example, in the form of stamp duties. The alternative to the fee system would be to introduce a single-rate transaction tax on provision of all goods and services, whether by government or private entities (e.g. VAT).

Expenditure measures

18. Containing government expense and prioritizing investment would help buttress fiscal sustainability and achieve intergenerational equity. Policies targeting gradual adjustment in expenses could bring about 8 percent of non-hydrocarbon GDP of savings by 2020 with only mild impact on growth. Such gradual expense controlling measures could save about 15 percent of non-hydrocarbon GDP by 2026, helping to bring the fiscal stance in line with intergenerational equity thresholds (Table 3):

  • Controlling the public wage bill. The authorities need to develop a clear medium-term strategy for the public wage bill to stabilize the size per capita and limit wage increases to correspond to productivity gains This would help keep wages broadly constant as a share of nonhydrocarbon GDP going forward.
  • Continue reducing energy and water subsidies and slowing growth in other transfers, while protecting those in need. Higher electricity and water tariffs in Abu Dhabi (since January 2015) in combination with lower oil prices will result in on-budget savings of 0.5 percent of nonhydrocarbon GDP in 2015. Further gradual increases in electricity and water tariffs could be implemented to bring additional savings of 0.6 percent of nonhydrocarbon GDP by 2020. Containing growth in or reducing other transfers would lead to savings of 1.1 to 3.1 percent of nonhydrocarbon GDP by 2020, depending on the pace of consolidation.
  • Lowering capital transfers to Abu Dhabi GREs is needed to strengthen the Abu Dhabi government finances. In the long term, such capital transfers should be eliminated altogether with the GREs only implementing commercially viable projects. Lowering capital transfers to GREs would bring savings of 3.5 to 5.8 percent of nonhydrocarbon GDP by 2020, depending on the speed of consolidation.
  • Stabilizing other expenses in real terms. Over the last four years, other expenses increased by 7 percent in real terms on average annually. Implementing this measure would provide savings of 3 percent of nonhydrocarbon GDP by 2020.
  • Maintaining government investment at unchanged levels relative to nonhydrocarbon GDP and prioritizing investment projects would also help control spending growth. Capital spending should be based on a careful scrutiny of public investment projects. A resource envelope for all public investment projects needs to be prepared.

19. Reducing energy and water subsidies, explicit and implicit, will not only lead to a lower burden on public finances but will also reduce welfare costs that stem from the distortion of relative prices in the economy:15

  • Subsidies on energy products foster overconsumption and are inefficient in supporting the poor. As mentioned earlier, overconsumption reduces exportable resources and external balances, and therefore limits wealth accumulation leaving fewer resources to future generations. Other negative effects include adverse impacts on congestion, health, the environment, and inefficient specialization of domestic production. Subsidies also crowd out productive spending on human and physical capital.
  • Reducing energy and water subsidies and gradually replacing them with appropriate social safety net instruments, especially cash transfers, would lead to stronger social protection and higher priority expenditure on education and health amid strengthened fiscal positions. Modernizing agriculture, collecting more renewable water, and improving allocation and stemming water losses through better regulation should be implemented in parallel.
  • In the short term, removing energy and water subsidies will have some inflationary impacts and may have negative effects on the competitiveness of industries that use subsidized products as inputs. In the medium term, removing subsidies will eliminate distortions, rationalize energy use, and enhance competitiveness, which are all positive contributors to sustainable economic growth.

20. The UAE has started to embark on energy subsidies’ reforms, as other GCC countries. The recent subsidy reforms in the UAE include raising retail fuel prices in 2010, developing a comprehensive water and electricity consumption strategy in Abu Dhabi, and increasing water and electricity tariffs. The UAE authorities recognize that subsidies encourage over-consumption and are currently studying the effects stemming from the existing energy subsidies—the study will be submitted to the cabinet soon. Other GCC countries have also been raising tariffs for gas, electricity, and water, preparing energy sector strategies, and improving energy efficiency standards and desalination technologies (Table 4).

Table 4.Recent Subsidy Reforms in the GCC
Recent reforms
BahrainIndustrial tariffs for gas in Bahrain were increased by 50 percent on January 1, 2012. Tariffs for electricity and water for non-domestic use were also raised (in October 2013).
KuwaitA study on the impact of a differentiated electricity and water tariff structure has been completed in 2014. Subsidies on diesel have been discontinued.
OmanPlans to double the feedstock gas prices by 2015. An energy sector study is ongoing, with a view to gradually reduce the overall fuel subsidy.
QatarQatar raised the pump prices of gasoline by 25 percent and of diesel by 30 percent in January 2011. Diesel prices were again raised in May 2014, by 50 percent. Efforts are underway to improve desalination technologies and promote public awareness of sustainable use of energy.
Saudi ArabiaSaudi Arabia increased the average price of electricity sold to nonindividual users by 9.6 percent on July 1, 2010. Currently, to curb the rapid growth in energy consumption, the authorities are strengthening building and appliance energy efficiency standards, including in industry. Tighter vehicle emission standards and public transportation networks are planned over the medium-term.
United Arab EmiratesUAE increased gasoline prices in 2010 to the highest level in the GCC. Abu Dhabi is developing a comprehensive electricity and water consumption strategy, which led to an increase in tariffs in January 2015 (by 170 percent for water and 40 percent for electricity). Dubai raised water and electricity tariffs by 15 percent in early 2011.

21. International experience suggests that reforming energy subsidies is challenging, but implementable. An increasing number of countries around the world are reforming or have reformed energy subsidies (e.g. Brazil, Chile, Ghana, Indonesia, Iran, Mauritania, Nigeria, Peru, Philippines).16 The experience from these countries suggests that energy subsidy reforms can fail mainly because of the following: (i) too rapid increases in fuel prices and energy tariffs, (ii) lack of long-term commitment to reform, (iii) the inability to depoliticize pricing policy, (iv) failure to introduce appropriate social safety nets as part of the reform package, and (v) poor communication of the reform objectives and planned mitigating measures to the public. Box 2 presents an interesting experience of Indonesia in reforming energy subsidies.

22. The implementation of subsidy reforms will be successful if the reform package is comprehensive, transparent, gradual, and targeted. The reform package should consist of the following key ingredients:17

  • A comprehensive energy sector reform plan that includes long-term objectives and an assessment of the impact of the reforms.
  • A comprehensive and well-planned communication strategy that will help generate broad public support by informing the public of the cost of subsidies and the benefits of the reform.
  • Appropriately phased and sequenced price increases that will allow households and enterprises to adjust.
  • Improved efficiency of state-owned enterprises that will result in lower producer subsidies and therefore reducing the fiscal burden of the energy sector.
  • Targeted mitigating measures that will alleviate the impact of energy prices’ increases on the poor. Targeted cash transfers are the preferred approach to compensation.
  • Depoliticized price setting that ensures a successful and durable subsidy reform. Adopting an automatic fuel pricing mechanism could be combined with a smoothing feature to avoid domestic fuel price volatility by allowing sharp increases in international prices to be only gradually transmitted to domestic prices. Responsibility for developing and implementing an automatic pricing mechanism can be given to an independent body. In the long term, fuel prices could be fully liberalized.

D. Strengthening Budgeting Approach

23. Progress has also been made in reforming the federal and Dubai budgets, and preparing consolidated fiscal data. The federal government has introduced a three-year budget cycle. Spending ceilings are set top-down and spending is presented on a program basis with associated performance indicators. Dubai has a medium-term fiscal framework setting budget targets through 2017, though targets are not published. The Fiscal Policy Coordination Council, supported by the Ministry of Finance, now prepares consolidated historical fiscal data for the UAE as a whole, an important step towards developing a medium-term fiscal framework.

24. Abu Dhabi produces an unofficial report on the medium-term fiscal outlook and has started work on performance-based budgeting, but achieving greater predictability and credibility of the annual budget is a priority. Strong Public Finance Management systems (PFM) will need to be put in place to keep spending in check (firm expenditure controls, timely and reliable fiscal reporting based on international standards, transparency). In addition, setting a mechanism that would prevent frequent budget amendments during the course of the year would help achieve more credibility in the annual budget process.18

25. Once the annual budget process in Abu Dhabi has been strengthened, the following phases of developing a strong medium-term budgeting approach should be implemented:

  • First phase (near term)x: preparing an official medium-term fiscal strategy document that would serve as the basis for annual budget preparation. This strategy would be based on the top-down resource envelope, which is basically a macroeconomic model estimating revenues, expenditures, nonhydrocarbon balances, and a fiscal anchor (e.g. based on the intergenerational equity and structural primary balance analyses).19 Fiscal risk analysis indicating the sensitivity of fiscal plans to different macroeconomic and hydrocarbon sector assumptions would also be part of this strategy.
  • Second phase (medium term): matching a top-down resource envelope with a bottom-up estimation of the costs of existing policies (or in other words preparing a medium-term budget framework). The Abu Dhabi Department of Finance (DOF) would engage in bottom-up reviews by scrutinizing sector policies aiming at integrating the bottom-up sector programmes with the top-down resource envelope. At the end of this phase, the medium-term budget framework would be fully functioning and integrated in the annual budget process, with the annual budget becoming the first year of the former.
  • Third phase (medium term): gradually turning the medium-term budget framework into a performance-based expenditure framework. The Abu Dhabi DOF has already embarked on developing performance-based budgeting. At this phase, budget funding will be linked to results (shifting the focus from controlling inputs to controlling outcomes and allocating resources according to the results achieved by programs).

26. Strong budgeting frameworks endorsed by the top level decision-makers would result in improved fiscal discipline. These frameworks would help the budget process facilitate countercyclical government spending (with medium-term perspectives built-in). They would also lead to better resource allocation through linking policy, planning, and budgeting, and therefore, more efficient use of public finances. The second and third phases of developing a medium-term budgeting approach as described above are part of the Abu Dhabi Comprehensive Financial Plan (ADCFP) currently under consideration. It is essential that the government approves and operationalizes the ADCFP swiftly.

27. It is important that the medium-term budgeting is fully integrated in the annual budget process. In practice, achieving such integration is challenging and a budgeting framework may remain a stand-alone document. For this framework to be successfully integrated in the annual budget process, top-down resource envelopes will need to be credible, while close coordination among the macro-fiscal unit, the budget department, and other relevant departments would be essential. A medium-term budgeting framework that is not endorsed by top policy decision makers—the Executive Council of Abu Dhabi—and/or prepared without the cooperation of the budget department is unlikely to maintain credible spending ceilings and, as a result, might not influence the annual budget process.

28. Box 3 presents Korea’s experience in introducing medium-term budgeting. As in the UAE, there were no imminent serious fiscal issues in Korea. Rather, there was widespread perception in the country of the need of budget reforms. Korea successfully introduced the budgeting framework in 2004 to incorporate longer term perspectives, including increasing social welfare spending, into the regular budget process. The Korean case highlights the importance of (i) having strong support for a medium-term budgeting framework from top policy decision makers; (ii) finding ways of integrating a medium-term budgeting framework into the budget process; and (iii) building capacity of relevant stakeholders.

29. Efforts in strengthening intergovernmental fiscal coordination should continue. In parallel to the strengthening of the Abu Dhabi budgeting process, the authorities should develop a consolidated forward-looking medium-term fiscal framework to set clearly the direction for fiscal policy for the UAE as a whole.

E. Conclusions

30. Expenditure-containing measures and revenue-raising options need to be considered to reduce fiscal vulnerabilities and ensure intergenerational equity. Driven by increases in the oil price and hydrocarbon production, total revenue and expenditure of general government have increased substantially since 2000. Sizable government expenses present risks for fiscal sustainability in the medium to long term, especially in the context of low oil prices. Measures aimed at containing government expenses would help reduce fiscal vulnerabilities and bring the fiscal position back to consistency with intergenerational equity. Raising nonhydrocarbon revenues should also be considered to diversify revenues and contribute to fiscal consolidation efforts. The proposed revenue options include a corporate income tax with broader coverage and lower rates, a low rate-broad based consumption tax such as VAT, and excises on passenger vehicles. On the expenditure side, the proposed measures include controlling the public wage bill, reducing subsidies and capital and other transfers, and stabilizing other expense in real terms.

31. The paper proposes strengthening a budgeting approach and fiscal frameworks in the UAE. Priority should be given to achieving greater predictability and credibility of the Abu Dhabi annual budget by strengthening its PFM systems. The next step would be developing official medium-term budgeting in Abu Dhabi and preparing a medium-term fiscal strategy document that would serve as the basis for annual budget preparation. The medium-term budget framework would be integrated in the annual budget process, helping improve fiscal discipline. Over the medium term, the authorities would gradually turn the budget framework into a performance-based expenditure framework, with budget funding linked to results. In parallel to the Abu Dhabi budget reform process, the authorities need to develop a consolidated forward-looking medium-term fiscal framework to set clearly the direction for fiscal policy for the UAE as a whole.

Box 1.Water Consumption in the GCC1

On a per capita per annum (pcpa) basis, GCC countries consume about 65 percent more water than the world average—816 cubic meters (m3) pcpa, versus 500 (m3) pcpa. Renewable resources, notably from rainfall and groundwater are in short supply, and these countries depend on desalinating seawater, which is energy intensive, imposing a cost on the economy and the environment. For example, Saudi Arabia and the United Arab Emirates (UAE) consume between 10 and 39 times the amount of renewable water available to them, depleting their aquifers at much faster rates than they can be replenished by rainfall. Only Oman comes close to having enough water from renewable sources to meet its domestic demand. Reflecting the average population growth of about 3 percent and a sizable influx of expatriates since 1970, per capita freshwater availability dropped substantially, from 680 cubic meters in1970 to 180 cubic meters in 2000.

To satisfy the growing demand, the GCC has been building and operating costly desalination plants. Desalination provides two-thirds or more of the potable water used in most of the GCC, but it carries enormous economic and environmental costs. Despite a considerable improvement in efficiency in the last decades, the cost to desalinate seawater is still a relatively expensive way of producing potable water. Moreover, seawater desalination is an energy-intensive process, accounting for 10–25 percent of energy consumption in the GCC on average (about 50 percent in Qatar). The desalination process has increased the temperature and salinity of the Gulf, with the latter estimated to have risen by around 2 percent over the last 20 years, with a negative impact on marine life and ecosystems.

Inefficient agriculture, weak institutional arrangements, and poor management practices present a significant drain on water resources. Demand from the agriculture sector in the GCC constitutes up to 80 percent of total water demand (the sector enjoys quite a few privileges such as the absence of agricultural water tariffs and various incentive programs that result in excessive cultivation of water-intensive crops). At the same time, agriculture contributes only a few percentage points of GDP to the GCC’s economies. There are also enormous irrigation losses, up to 40 percent. Some of the GCC countries are now trying to limit water overconsumption in agriculture (e.g. by encouraging local farmers to grow crops that need less water and phasing out projects to export wheat). Weak institutional arrangements and poor management practices are contributing to wastefulness of water resources. On average, about 20 percent of domestic water is either lost to leakage or is not metered.

Sizable subsidies finance the inefficient structure that results in high water consumption rates and presents fiscal risks in the long term. Qatar, Saudi Arabia, and the United Arab Emirates consume almost twice as much as the global average for water consumption, while other GCC countries are also above the global average. While data on water subsidies in the GCC are generally not available, they may reach up to a few percentage points of regional GDP. Rationalizing the water usage and reducing waste could reduce consumption substantially (e.g. up to 40 percent in Qatar).

1 See Achieving a Sustainable Water Sector in the GCC: Managing Supply and Demand, Building Institutions; PWC, 2014; Water Resources in the GCC Countries: An Overview; Water Resources Management 14: 59–75, 2000.

Box 2.Energy Subsidy Reform in Indonesia1

Reforming energy subsidies in Indonesia has been challenging. The fiscal costs of energy subsidies were high at about 3 percent of GDP in 2008. The Indonesian authorities have implemented several measures since 1997 to reduce subsidies and strengthen the fiscal position as well as improve energy efficiency and protect the environment.

The reform has been implemented with mixed success since 1997:

  • In the aftermath of the 1997 Asian financial crisis, the government attempted to cut energy subsidies by increasing the prices of diesel and gasoline by 60 percent and 71 percent, respectively. The attempt was not successful as the announced increases in fuel prices were too large (instead of being gradually phased-in).
  • In 2000–01, fuel prices were raised for households and industries and in 2003, the government attempted to introduce an automatic pricing mechanism. As these reforms were poorly communicated, and some of the announced compensation programs did not materialize, the government was forced to roll back some of the price increases and discontinue the implementation of the automatic pricing mechanism.
  • In 2008, with international fuel prices at their peak, domestic fuel prices were successfully raised (by 29 percent on average) and subsidies to larger industrial electricity consumers were discontinued.
  • In 2010, the government announced plans for removing fuel subsidies in the period ahead, but at the end of the year, budget allocations for subsidized fuel consumption were raised.
  • In 2013, the government raised fuel prices, by 44 percent for gasoline and 22 percent for diesel. Electricity tariffs were increased for almost all types of customers—the increase in tariffs was levied every three months up to total capped increase of 15 percent year-on-year.In December 2014, the government announced the removal of gasoline subsidies. Because of lower international oil prices, gasoline and diesel prices were actually reduced in January 2015. A new pricing mechanism was introduced: (i) gasoline to be sold at market prices, but the distribution costs to continue to be subsidized and (ii) price changes to be announced every two to four weeks. The government has started raising electricity tariffs on a monthly basis while publishing monthly electricity tariff announcements since May 2014.

Programs to protect the poor were introduced to accompany the energy subsidy reforms. The government increased spending on health, education, and social welfare. The programs also included other compensating measures such as unconditional cash transfer payments targeted at poor households, the health insurance for the poor, school operational assistance programs, and expanded rural infrastructure support projects. The more recent programs include the Poor Student Education Support program, the Hopeful Family Program conditional cash transfer, and the Productive Family Program, which cover education, financial assistance, and healthcare support implemented with card technologies.

The Indonesian experience presents interesting lessons. First, a too rapid reduction of subsidies can generate opposition to reform. Second, durable and successful reform requires long-term commitment to it. Third, ad hoc price adjustments and the inability to depoliticize pricing policy will inevitably lead to the reemergence of subsidies. Fourth, targeted cash transfers can reduce opposition to subsidy reform and assist the poor. And finally, effectively communicating the reform objectives and planned mitigating measures to the public can help promote the acceptance of reforms.

1 Based on Case Studies on Energy Subsidy Reform: Lessons and Implications, IMF, 2013; Indonesia Energy Subsidy Review, GSI/IISD, 2014; Indonesia Energy Subsidy Briefing, GSI/IISD, 2015.

Box 3.Korea’s Experience in Introducing Medium Term Budgeting1

The Korean case is interesting because there were no urgent serious fiscal issues to commence the reforms. The medium-term expenditure reform (MTEF) was initiated because of a strong demand for budget reform agenda from a new administration and widespread perception in civil society organizations and public officials of the need for PFM reform. The MTEF was introduced to incorporate longer term perspectives such as increasing government debt, aging population, and increasing social welfare spending, into annual budget process.

The MTEF or “National Fiscal Management Plan” (NFMP) was introduced in Korea in 2004 and has been successfully implemented since then.2 The reform package consisted of MTEF, top-down budgeting, performance-oriented budgeting, and an integrated financial management information system. The Ministry of Strategy and Finance (MSF) prepares macroeconomic projections for the next four years; line ministries provide cost estimates of their programs and submit their own medium-term fiscal plans. Based on these, the MSF develops the first draft of the NFMP that covers major policy directions, the fiscal aggregates, and tentative ceilings for line ministries. The Fiscal Strategy Cabinet Meeting is then held to finalize the spending ceilings for line ministries. Subsequently, guidelines to budget preparation are issued to line ministries, which develop budget requests for submission to the MSF. Following negotiation between line ministries and the MSF, the NFMP and budget draft are finalized. Each NFMP covers five years: the current year, the budget year, and three following years. The NFMP is a rolling document, which is revised every year.

The Korean case provides three main policy implications for MTEF reform.

  • First, strong support from top decision makers is crucial for MTEF to cover the entire government. In the Korean case, the support of top decision makers sustained the medium-term budgeting reform until the institutionalization of MTEF in the National Assembly was achieved.
  • Second, a MTEF must be integrated into the budget process. In the Korean case, the link between the MTEF and annual budgeting was top-down budgeting. This implies that the MSF had an important task of preparing credible spending ceilings with the active involvement of the central budget office, which is responsible for annual budgets. As Korean reformers realized, a MTEF developed without the cooperation of the budget office is unlikely to maintain credible spending ceilings. As a result, a MTEF may not be integrated into annual budgeting in practice.
  • Third, enhancing the capacity of line ministries was essential to fully realizing the benefits of a MTEF. With the reform, line ministries’ budget divisions required the capacity to develop ministerial budget drafts, aligned with government-wide priorities. To strengthen the ministerial budget divisions, the MSF upgraded the teams’ status and added personnel. Successful medium-term budgeting reforms usually require plans for building the capacity of stakeholders.
1 Based on Achieving Medium-Term Expenditure Framework Reform, a Case Study of Korea, The World Bank Policy Research Working Paper, 2013.2 An earlier attempt at a MTEF took place in Korea in 2001 focusing on integrating the existing medium-term plan into a regular budget process and aligning resources with the policy directions of the government. This attempt failed mostly because of lack of support from top policy makers.
References

    Achieving Medium-term Expenditure Framework ReformA Case Study of Korea Policy Research Working PaperWorld BankJanuary2013

    Achieving a Sustainable Water Sector in the GCC: Managing Supply and DemandBuilding Institutions; PWC2014.

    Case Studies on Energy Subsidy Reform: Lessons and Implications;IMF2013

    Energy Subsidy Reform: Lessons and ImplicationsIMF2013

    Indonesia Energy Subsidy Briefing GSI/IISD2015

    Indonesia Energy Subsidy Review GSI/IISD2014

    Macroeconomic Policy Frameworks for Resource-Rich Developing Countries IMF2012

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1Prepared by Bahrom Shukurov under the guidance of Zeine Zeidane and with assistance from Juan Carlos Flores.
2Hydrocarbon revenue as presented here and in Figure 2 includes profit transfers from the national oil company to the sovereign wealth fund (SWF). These profit transfers are not reflected in the official budget statistics and are estimated by IMF staff.
3Investment income flows from SWF’ investment activities abroad are estimated by IMF staff and are not reflected in the official budget statistics.
4There are no explicit forms of excise taxation in the UAE.
5These capital transfers have started since 2008 with the Abu Dhabi government supporting the economy through GRE spending on development projects.
6The 5.7 percent of GDP in energy subsidies is estimated by the IMF for 2011. The 2014 IMF paper uses the international fuel price as the benchmark price to estimate the cost of subsidies (the country would generally incur an opportunity cost if it simply sold the fuel at the domestic production cost).
7UAE’s retail fuel prices were close to international market levels in Q4 2014 – Q1 2015.
8Long-term sustainability assumes intergenerational equity by calculating a constant real per capita government spending path (and related nonhydrocarbon deficit) that delivers a constant real per capita annuity to finance government spending after hydrocarbon revenues are exhausted. Projections until 2020 are based on staff’s macroframework, including the WEO assumptions about the oil price. After 2020, the baseline scenario assumes flat hydrocarbon production and annual oil price growth of 2 percent, inflation of 2 percent, population growth of 1.5 percent, and real return on assets of 4 percent. Alternative scenarios assume (i) lower population growth by 0.5 percentage point, (ii) lower real return on assets by 1 percentage point, (iii) lower oil price by $10 in 2015–20 and to remain constant thereafter, and (iv) higher oil price by $10 in 2015–20 and to increase by 2 percent per annum in nominal terms thereafter.
9See Bems, R., and I. de Carvalho Filho, 2009, “Exchange Rate Assessments: Methodologies for Oil Exporting Countries,” IMF Working Paper 09/
11The following methodology was used to estimate the yield from CIT: (i) calculating profits of nonhydrocarbon and nonfree zone corporations by subtracting compensation of employees, profits of hydrocarbon companies (assumed at 90 percent of hydrocarbon exports), and profits of free zone companies (assumed at 20 percent of free zone exports) from gross domestic product (all based on the 2013 data); (ii) applying the 10 percent CIT to the profits of nonhydrocarbon and nonfree zone corporations; (iii) applying the tax effort ratio of 58 percent that is observed in nonoil countries of the MENA region (IMF, 2013); and (iv) subtracting the existing corporate income tax revenue that is collected from foreign banks in Dubai from the CIT revenue calculated as per above.
12The UAE authorities have indicated their preference to proceed with a VAT reform jointly with the GCC.
13The following methodology was used to estimate the yield from VAT: (i) applying the 5 percent VAT to the 2013 final consumption amount; and (ii) applying the tax effort ratio of 58 percent that is observed in nonoil countries of the MENA region (IMF, 2013).
14The following methodology was used to estimate the yield from the excise tax on automobiles: applying the 15 percent excise tax on the 2013 value of net imports of automobiles (imports minus re-exports).
18Revenue and spending overruns have been a usual practice in Abu Dhabi. The initial budgets have traditionally been amended over the course of the year leading to substantial gaps between outturns and initial budgets.
19The Abu Dhabi Department of Finance already prepares a medium-term framework, but on an informal basis (it is not officially approved by the Abu Dhabi government).

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