Prime Minister Atef Ebeid jokes with Lebanese Prime Minister Rafiq Hariri last month. The new taxes, adopted after Ebeid was asked to curb the deficit, are no laughing matter. By AP Prime Minister Atef Ebeid jokes with Lebanese Prime Minister Rafiq Hariri last month. The new taxes, adopted after Ebeid was asked to curb the deficit, are no laughing matter. By Omar Mohsen “The deficit becomes a snowball. The higher it grows, the more the government has to borrow and then pay off its debts with its interest. The revenue of new taxes may just cover the interest on the deficit which becomes a major item on the state budget. Even if the government does not have new borrowings, the accumulated deficit with its interest becomes a problem in the following year. This is our problem now,” says Al-Ahram’s Magdi Sobhi. By Omar Mohsen “We are facing quick decision-making by government bodies that did not measure the magnitude and the damage it would cause to this industry, which is the largest employer today. We pay 10 percent of the direct taxation of the country and most importantly we have the largest foreign exchange revenue in the country,” says Emeco’s Elhamy El-Zayat.

By Rania Oteify

In what could be the Ebeid governments parting policy decision before the expected resignation of his cabinet this month, a scheme to narrow the growing budget deficit is likely to fall far short of its stated purpose. Instead, new taxes on luxury goods and services have managed to make a large number of people feel rich and poor at the same time. Critics complain that the taxes slapped on goods and services used by just about everybody are poorly timed, ill-conceived, and in some cases, particularly when it comes to car sales, may actually diminish government revenues. In typical form, the government seems to have embraced a short-sighted policy to help abate a crisis, only to watch a new one spring up in its place.

Prime Minister Atef Ebeid may be watching the effects of his cabinets policy unfold in retirement, as President Hosni Mubarak has promised to name a new prime minister once he returns from medical treatment in Germany. The most optimistic estimate suggests the taxes will generate LE 1.5 billion, amounting to a 2 percent drop in a LE 52.3 billion deficit bucket. That may only be enough to pay interest on the governments growing debt on its budget deficit.

Anywhere else in the world, luxury taxes would apply to such items as a bottle of bourbon, a yacht or a diamond ring. Here, the term is being used liberally. Telephone calls, plane tickets and hotel reservations have become badges of a bourgeois lifestyle. While some may find comfort in paying new taxes to help the poor, the vast majority are likely to feel a further pinch on their income, especially with growing concerns about inflation.

Who doesnt have a phone? asks one of the new luxury taxpayers. Or does the government not want us to have them anymore?

The question reveals widespread doubts about the governments judgment. Making commonly used goods and services more expensive may actually stifle growth, the thinking goes. This is a charge the government denies.

Speaking to the financial magazine Al-Ahram El Iktisadi, Minister of Finance Medhat Hassanein reiterated his view that the now-in-effect taxes are the result of extensive government studies to find revenue streams that will not roll over the low-income classes. He compares the allegations that new taxes will cause a slowdown or recession to similar charges when the government added wholesalers and retailers to the sales-tax books in 2001. They are groundless, he said. The sales tax is not the main tax on individuals income. I do not expect these [new taxes] to cause a slowdown because the economic cycle has been going up.

Earlier in May, Hassanein said he expected a gross domestic product (GDP) growth rate of 5 percent in the 2004-05 fiscal year. But analysts believe that figure is too optimistic. Magdi Sobhi, an economic analyst at Al-Ahram Center for Political and Strategic Studies (ACPSS), says the deficit is justified because government spending is necessary to help to revive an economy. It may be a generally acceptable justification. However, in spite of this deficit in the budget, the growth rates have been very low, ranging between 3-3.5 percent. So, the fiscal policy has not realized its goals of pushing the economy [forward], he says, referring to the governments taxing and spending policies.

The new fees are expected to generate somewhere between LE 800 million and LE 1.5 billion, according to press reports. For the fiscal year 2004-05, beginning this month, the deficit is estimated at 7.5 percent of GDP. The new measures were adopted in late May after Prime Minister Atef Ebeids government was asked by the Peoples Assembly and Mubarak to find solutions to curb the growing deficit.

Some of the new duties include: a 3 percent fee on passenger cars with an engine capacity of 1000-1599 cc; 5 percent on cars with a capacity of 1600-1999 cc; 8.5 percent on cars with a capacity of 2000-plus cc; 2 percent on tourist buses; and an LE 50 departure fee and 25 percent tax on all air tickets from Egypt.

Parliament also raised the sales tax on services in hotels, restaurants and tourist transportation companies to 10 percent, up from 5 percent. Other taxes approved include a 9 percent duty on all phone and telegram services, while mobile phone, local and international calls will incur an additional 5 percent sales tax.

Snowball effect

The budget deficit has indeed grown to an alarming level, admits Sobhi. He harkens back to the day when Egypt took pride in its implementation of the International Monetary Funds (IMF) economic stabilization program in the early 1990s, and the deficit was just 1-1.5 percent of GDP.

It was considered a significant achievement to eliminate the deficit in the state budget. With the governments of Kamal Ganzoury (1996-1999), and then Atef Ebeid, the deficit started growing as these administrations used the fiscal policy as a tool to revive the economy, he says.

Now, the deficit is expected to reach as high as 10 percent of the GDP if the promised 5 percent growth rate is not realized. The government is caught between the growing deficit and low growth rates, he adds. In order to finance part of the deficit, the government has resorted to either inflationary finance, i.e. printing banknotes, or borrowing from the market, he says.

The latter strategy causes two problems. First, it reduces the level of credits available for the private sector because the government is sapping the countrys borrowing capacity. Second, the problem becomes more difficult to address with each passing year.

The deficit becomes a snowball. The higher it grows, the more the government has to borrow and then pay off its debts with its interest. The revenue from new taxes may just cover the interest on the deficit which becomes a major item on the state budget, Sobhi says. Even if the government does not have new borrowings, the accumulated deficit with its interest becomes a problem in the following year. This is our problem now. In short, [the government faces] a growing deficit, a non-aggressive private sector, and a failure from the fiscal policy to attain investments or create higher growth rates.

Sobhi does not pin the blame on the Ministry of Finance alone. Actually, the Ministry of Finance was previously keen on studying any big issue, such as the new tax law, with all concerned parties. The fiscal policy has been designed to fix other ministries faults because they have burdens such as increasing the subsidies (estimated at LE 15.6 billion in the 2004-05 state budget) and other drawbacks of other policies such as the exchange rate, which was not well studied either, he adds.

Sobhi does not deny that any government has the right to raise taxes to cover deficits, but says it must also set clear goals to avoid having a negative impact on the economy.

The fiscal policy is a short-term policy in terms that [the government] increases the deficit in order to revive growth. The monetary policy may decrease interest rates, so in three or four months the economy will respond. Even though it comes in the context of a [policy with long-term implications] the budget is created with goals for one year in mind. If these goals are not realized within a year, there is a problem or failure. In our case, the failure is chronic, he says.

Aftershocks

The Egyptian stock market was the first to measure a reaction to news of the tax hikes. Local indices have shown a decline, particularly in the sectors hit hardest by the new taxes. The Ministry of Foreign Trades official report for May said the telecom and tourism sectors witnessed a significant drop following the news of the taxes.

The decline may be the result of many factors. The most significant of them is the announcement of increasing taxes on mobile phones and the tourism sector, which led investors to expect a decrease in profits in the coming year, reads the report. Additionally, there was a wave of selling after an earlier increase on stock prices. Foreign investors sold stocks in MobiNil and Orascom Telecom; similar fears of future losses were voiced by automotive and tourism operators.

According to some observers, the taxes could have been harsher. The original bill submitted to the Peoples Assembly (PA) included fees on all kinds of vehicles including all passenger cars, buses and trucks, according to Salah El-Hadary, secretary general of the Egyptian Automobile Manufacturers Association (EAMA).

El-Hadary represented EAMA in front of Parliaments budget committee, which responded to EAMAs request to not impose any fees on trucks and pickups to avoid further price hikes for industries that depend on the vehicles to transport commodities, he says. The same was argued for small buses. Any taxes on micro- and mini-buses, El-Hadary says, might increase the transportation fare for limited-income people. They accepted the argument not to impose any fees on buses of up to 26 passengers. After that, for tourist buses there is a 2 percent [duty], he says.

As an alternative to taxes on new cars, El-Hadary says the government ignored EAMAs suggestion to impose a flat fee on renewing car licenses. If the government wanted sure revenues, he says, it should have imposed an LE 50-200 fee depending on the size of the car for renewal.

El-Hadary is skeptical how much the expected revenues from the duties will help alleviate the budget deficit because sales could potentially fall and bring down the states total revenues in the process. When we say the car assembled locally is subject to component customs of 25 percent and a sales tax of 15 percent, we are talking about 40 percent of the price of the car going to the state. If the government adds a 3 percent [duty on top of that] and the car is not sold, then the government is not getting the 40 percent, he says.

Its the same for bigger cars with higher taxes and customs duties, he says. For an imported car of 1600 cc (engine capacity), customs duties are 135 percent and sales tax 30 percent, while sales tax is 45 percent on cars above 2000 cc. So two thirds of the total price of the car is going to the government, he says.

Zakaria Mackary, senior manager for marketing and sales at Mercedes-Benz passenger cars division, agrees that a drop in sales for the rest of the year is likely. When you increase prices, demand goes down, he says. Oddly enough, the logic of supply and demand did not hold true last year, when rising prices did not lower demand. The variable last year does not exist this year it was [a result of the] heavy devaluation of the Egyptian pound that made people transfer their savings in Egyptian pounds to assets such as cars, apartments, appliances, says Mackary.

Unlike 2003, this year has witnessed a stabilization of exchange rates, so demand started to fall even prior to the new taxes, says Mackary. Therefore, there will be an automatic decrease in car sales, especially for those categories that are higher in price and worse affected by the measures, he says.

A decrease in sales would surely drive down the governments total revenue from cars. El-Hadary calculates that if sales drop 5-8 percent especially for cars over 2000 cc government revenues will fall despite the new taxes. He warns that there may be some misleading signals in the meantime. In the week between parliamentary discussions and the approval of the taxes, the market witnessed a spike in demand that was similar to the 2003 phenomenon.

We should not judge the impact of the new law on the market by the sales statistics of May, simply because people rushed to buy cars just like they did at the time of the pound devaluation. Actually the impact of these measures may not show for a month or two, he says.

It will also show in a gradual increase of car prices since some wholesalers, according to El-Hadary, bought cars based on the old prices. They will be selling them in the coming month or so, taking part of the duties on themselves. The prices will go up gradually, he adds.

Luckily, the decision came as the exchange rate has stabilized and there has been a significant decrease in activity on the black market, says El-Hadary. The stability allows automotive manufacturing companies to absorb part of the duties and prevent a huge drop in sales, he says.

We already have a problem in using the production capacity for car factories in Egypt. The percentage is not more than 30 percent. They cannot afford a decrease, which will result in damages to the labor and subordinate industries. The coming period, I believe, will just witness a partial increase in prices, he adds.

Mackary agrees that car manufacturers and dealers who have no choice except to comply with the law will try to be as efficient as possible in pricing their cars. But we expect people to look for smaller, more economic cars. The total sales of the year according to the current variables will go down unless something happens before the end of the year, he says.

Thats not the only challenge facing the car industry, says Mackary. The swift passage of the new policy has left many in the industry scrambling to address ambiguities in implementation.

It was a quick decision lacking an implementation mechanism which created chaos, especially in the second and third phases of the sales tax. According to the decision, the development fee will be added to the invoice of the producer. What is the case when the producer sells to the wholesalers and the wholesalers sell to the retailer? We are trying to clarify these points in order to comply with the law, he says.

El-Hadary stresses that the car industry supports efforts to reduce the budget deficit and increase the states revenues. But the government has to find alternatives that do not damage national industries or harm limited-income people, he says.

When it comes to cars, El-Hadary rejects the argument that the new duties will not hurt the average buyer. The Peoples Assembly exempted only cars less than 1000 cc (of engine capacity) considering they are limited-income peoples cars. There is a conflict here with the market statistics, he says. Cars below 1000 cc represented a meager 2 percent of sales, or 1500 cars out of 52,000 cars sold, according to last years figures so, its plausible that the government was not interested in the smaller class of cars. There is greater demand for family cars, which range from 1000-1600 cc and represented 86 percent of sales in 2003, says El-Hadary, meaning the vast majority of car buyers are affected by the new duties. Still, buyers of high-end vehicles will be paying a disproportionate share of the new fees.

Additionally, El-Hadary worries that the taxes do nothing to promote the local industry compared to imports. All cars up to 1000 cc are imported as a result of customs tariffs. It is cheaper to import the whole car than to import all the components because customs duties on small cars are 40 percent compared to the 25 percent duties a manufacturer must pay for components, which does not allow local producers to be competitive in the class of smaller cars. Cars above 1300 cc face higher customs duties, which is why they are produced locally. So, the new duties affect local producers as much as, if not more than, importers, El-Hadary says.

While the government seems to have its own idea of limited- and unlimited-income classes, Sobhi believes the new measures contradict the governments philosophy of not touching limited-income classes.

I do not view that cars of 1000 cc engine are for higher classes, he says. These are small cars and the decision will touch the middle- or low-category of the middle class. Therefore, the government did not offer the clear differentiation between the more and less capable classes to pay extra taxes, he says. I would understand if they want to impose such fees they can impose it at 10 percent or more for 2000-plus cc. It is known that these cars are already very expensive and it will not affect the decision of the buyer as much as when it comes to a car of 1000 cc, he adds.

Tourism drag

In Sobhis opinion, the tourism industry has been put in an even tougher spot by the taxes than the auto industry.

The automotive sector is relatively different [from tourism] as the tax will be added to those who can afford buying a new car. On the other side, it is mainly an assembling industry. The value added in it is very low, he says, meaning there are fewer advantages to manufacturing in Egypt. Whoever wants to work should adapt to these circumstances. It may be justified just to keep the fittest. But in the tourism sector there is no such consideration, and imposing new taxes is a real concern.

The weeks that followed the tax hikes witnessed ongoing discussions between the tourist chambers and the government in attempt to alleviate the damage of the new taxes on their businesses. Elhamy El-Zayat, head of the Egyptian Federation for Tourist Chambers, says tourist operators are not against new taxes, but timing was poor.

It is very normal for developing countries to have a sales tax, or a value-added tax, of around 10 percent while countries like France, the UK or other European destinations add up to 17 percent taxes on services because people there have higher incomes. We are trying to attract tourists, so a 10 percent tax is not a major issue per se, he says.

However, increasing taxes without prior notice has caused a problem for everyone in the sector. We need time to inform our end customer or client that he will be charged an additional tax. Implementation cannot happen overnight. If I am a customer who comes to Egypt, I may [only carry a certain] amount of money. If I am stopped at a hotel and asked to pay this sales tax, I would say no. The people came without knowing that such conditions apply. It is really detrimental to our image, he says.

Other issues include contracts between Egyptian tour operators and their overseas counterparts, who were also shocked by the new taxes. Overseas tour operators need advance notice of between 21-120 days according to their countries regulations, says El-Zayat, who also heads Emeco Travel. But if the tour operator takes a 5 percent or even 3 percent hit it means a tremendous loss for them which means that he may stop sales instead of selling at a loss, he says.

Because the operating profit of any tour operator in the world is anywhere between 3-4 percent. Even if he will weigh the advantages and disadvantages, he has printed a brochure and his name is in the market, he may accept to work and say, I will lose for the next two months, but I will never program Egypt again. This is a very serious concern.

ACPSS Sobhi worries that neighboring countries suffering from a slowdown due to unrest in the region, such as Jordan, have reduced their duties on tourism as Egypt is slapping on new ones. We may be facing very fierce competition in case these duties have been actually reduced in other countries. Besides, the other fees such as departure fees and the rising ticket prices will all add to the tourists costs. We are facing a problem here, especially due to the fact that the government does not have clear goals with such decisions, he says.

Tourism operators are bound to lose not only now but later as well, says El-Zayat. Many argue that operators in Egypt will have to absorb the price hikes. But while they may be able to absorb it for some time, thereby cutting their profits, there are other challenges to tackle.

First, assuming tour operators and hotels absorb the tax instead of transferring it to their customers, hotels owned by the public sector or by joint ventures between the public and private sector may run into problems. The Central Auditing Authority will come later to the company that owns shares in it and ask them who told you to give a present to a client? (in the form of costs that were absorbed by the company). Because the law is very clear and they may be imprisoned, he adds. So, government employees eager to avoid any accusations of corruption will be inclined to pass these taxes onto the tourist.

Private-sector hotel companies do not face the same constraints. But when it comes to the corporate tax, the tax officials are not likely to care if the company has passed on the costs or absorbed them. They are unlikely to remove the additional 5 percent sales tax paid by the hotel from the taxable profits of the company, says El-Zayat.

We must find a solution. We will carry this on to the Peoples Assembly and various committees because we do not want to be liable for another tax later on [for taxes] we already paidIt is absolutely ridiculous, he says. We are caught in the middle between the client and the government. That is why we are strongly opposed to immediate implementation of the law, but we have to comply with it.

Sobhi believes the government action amounts to a direct cut out of these companies profits. With the 5 percent tax accounting for as much as 90 percent of hotel profits, some see the tax as a serious assault on the profitability of the tourism industry. They also fear the taxes may reduce the flow of tourist to Egypt in the coming years, which reached record levels last year.

The khawaga complex

The Ministry of Tourism appears to be giving international tour operators some time to adjust to the new taxes. An announcement by the ministry says the local private sector must bear the tax increases now, while the tax on international tour operators, including international hotel chains, will not apply until Nov. 1.

El-Zayat considers the move an act of discrimination. I am strongly objecting this discrimination between one who has blue eyes and another who has black eyes, he says. While the damage is the same to operators and hotels, hotels take the biggest chunk of tourist dollars about $80 of every $100 the tourist spends in Egypt. (Discrimination aside, the grace period also means the government has decided to forgo revenue from the industrys biggest money-makes.)

The tourist chambers cannot save face in front of foreign customers forever, says El-Zayat. We do not face international problems, fundamentalism or wars. We are facing quick decision-making by government bodies that did not measure the magnitude and the damage this decision causes to tourism which is the largest employer today, he says, employing 1.2 million Egyptians and another 2.6 million in indirect employment. We pay 10 percent of the direct taxation of the country, and most importantly, we have the largest foreign exchange revenue in the country.

But until the government gets a handle on the concept of long-term planning, the deficit will continue to spiral beyond control. bt