Eritrea Needs New Tax System

Eritrea needs to modernize its tax system and economy

By Teweldeberhan Gebre | Asmara-Online.com

Introduction

Recently, the Government of Eritrea (GoE) has issued Proclamation No. 178/2016 to collect tax from farm income and livestock. The author of this piece contends the title and the provisions of this new proclamation because (1) contrary to the title of Proclamation No. 178/2016 to ‘collect tax from farm income…’ its provisions under Article 4(1 and 2) introduces ‘land lease tax system’, and (2) not only that but also Article 4(1 and 2) of Proclamation No. 178/2016 violates Article 4(1) of the Land Proclamation No. 58/94 -to reform the system of land tenure, which provides Eritrean citizens usufruct rights over lands with no mentions to leasing (click here to see my contention). Whether the GoE should or should not impose ‘usufructuary land lease system’ on the rural households and communities is subject to debate. However, Proclamation No. 178/2016 is in sharp contradiction with the Land Proclamation (No. 58/94). In this regard, citizens are denied their historical and legal usufruct rights over lands.

In the face of contradictory legal provisions such as the above, the GoE is struggling to expand its tax base to the rural communities that are subjected to abject poverty. The rural sector depends on subsistence agriculture which poorly contributes to the overall economy of the country. Hence, any effort to collect tax from this sector cannot improve the public finance position of the government while its impacts on the rural households can be grave.

Instead the GoE should expand its tax base by revitalizing the private sector and diversifying the overall economic structure which is extremely narrow and undiversified. Imposing taxation on the rural households only worsens the already impoverished segment of the population/households and will not improve government revenues whatever the scale of the tax rates are.

In the following few paragraphs I will briefly discuss the key macroeconomic indicators, growth performance against the region, value added share of industries to GDP, public finance, and suggested tax regime to improve public finance.

Macroeconomic Indicators

As in Table 1 below, overall Eritrea’s macroeconomic conditions is poor and disappointing. Real gross domestic product (GDP) growth rate for 2015 is estimated at 0.3% against 1.7% in 2014 indicating poor performance of the economy. Real GDP growth is projected at 2.2% and 3.4% for 2016 and 2017, respectively. The basis for 2016 and 2017 growth projections could be agricultural and the extractive industry. Growth prospects are unimaginable low because the government is not yet genuinely prepared to introduce structural change in the overall economy.

Figure 1: Real GDP growth (percent) against East Africa
and Africa, 2006-2017

During the period from 2006 to 2017, compared to real GDP growth averages of East African countries and Africa at large, Eritrea’s growth performance is the worst except for 2011 and 2012. In other words, Eritrea’s real GDP growth rate remains to be far below the East Africa region and Africa. Clearly, the government of Eritrea (GoE) is not in the business of cooking numbers. I must give the GoE credit for this. Nevertheless, the growth figures for this one-time ‘industrial hub’ country is sincerely disappointing. This situation hurts my soul deeply. A nation failed to learn from its own history of industrialization and entrepreneurship.

About 80% of the Eritrean population depends on subsistence agriculture. Agriculture’ share to GDP in 2009 (most recent available data) was estimated at 14.5% compared to 22.4% and 63% of the industry and service sectors, respectively (see table 2 below). This sort of economic structure is rarely found in the context of least developed countries. Under normal economic transitions, the share of agriculture to GDP and total employment declines while the share of industry and service sectors to GDP and total employment increase. As it appears, Eritrea’s economic structure gives the impression that the country is either in the upper middle or high income category countries. However, the truth is that Eritrea is one of the lower income countries category.

Source: World Development Indicators (World Bank), last updated on 17 November 2016.

Public Finance and Tax revenue

Eritrea’s tax revenue (as a % of GDP) is extremely low as shown in table 3 below. Essentially, Eritrea has no tax income outside the “2% diaspora tax” revenue which drastically declined to less than 10% of GDP after 2012 when countries began to implement the the 2011 unjust UN sanctions and scrutinize the methods used to collect this tax as pointed out by the African Development Bank (2014). Unfortunately, to minimize the impacts of the sanction regime, the GoE could have reacted by introducing concrete measures such as easing businesses to Diaspora Eritreans.

Note: only major items are reported (a); estimates (e) and projections (p) based on AfDB’s calculations.

Source: African Economic Outlook, Eritrea 2014, estimated based on by government authorities available on the web.

The tax revenue as a % of GDP is unpleasantly low forcing the government to impose taxation even on the poorest sectors of the economy. Eritrea’s tax revenue comes principally from the “2% diaspora tax” which is deplorable. In principle, taxing any sector of the economy including agriculture is not a mistake. However, the government should ask itself whether the current tax regime will or will not improve its public finance positions. The combined share of industry and service sectors to GDP is well above 80% for the periods from 2000 to 2009. The service sector’s share to GDP exceeds 60% indicating the sector is the main driver of the economy. In economic sense, the service sector involves the provision of services to businesses and final consumers. Therefore, unlike the agricultural and industry sectors, the service sector produces no physical goods. The service sector, among others, includes trade (wholesale and retail trade), hotels and restaurants, finance, transport and communications, real estates and business, public administration, wholesale and retail trades, domestic services,, automobile repairs, personal services (e.g. computer services, etc.), and other miscellaneous services. In most cases, the financial transactions occur at this level of economic activities.

Undo Existing Tax regimes and Introduce Tax System on bank payments, transfers, financial transactions and withdrawals

Tax revenue is measured as a percent of GDP. Tax revenue of the GoE never exceed 12% of GDP for the last 10 years, from 2006 to 2015. As stated elsewhere above over 80% of GDP comes from the industry and service sectors of which over 60% comes from the service sector. To equitably tax all sectors and citizens the GoE need to reconsider its existing system of taxation. Unfortunately, in business or for that matter in any economic activities there is always unequal play grounds. Instead, the traditional ways of taxation system is randomly applied without considerations to who’s actively participating in the economy and who is facing constraints due to various reasons. The unequal economic participation can be clearly tracked in the financial sectors and the daily financial transactions.

Long before the introduction of currency into the economic system people used to exchange one item against another as a form of trade called bartering. In the economic sense, one of the human brainchild in solving the inconvenience of the barter system was the introduction of the financial intermediations. While they play crucial roles the introduction of financial intermediaries in business transactions also creates unfair redistribution of incomes and profits between those involved in the trade transactions. In the real economic sector individuals or households supply raw material, land, labour, and enterprise to manufacturing firms while manufacturers produce finished goods and services for consumers. Whereas in the money flow through the financial intermediaries, firms give remuneration in the form of money to the households sector in the forms of wages and salaries, rent, interest etc. in which case the unfairness takes its roots. In other words, the money flow is the monetary exchange between two sectors while the real flow is the exchange of goods and services between household and firms. In the case of Eritrea, the monetary exchange dominates the real economy (real flow) and continues to erode the value of Nakfa and assets.

Also, Eritrea is facing demand pulled inflation which occurs when there is an increase in aggregate monetary demand due to an increase in aggregate demand and an aggregate supply slow enough to adjust itself with the aggregate demands. Eritrea is in constant demand shocks including earning rising above factor productivity (e.g. recent wages increase and remittances), excess public sector borrowing, etc. under this situation the government should wake up and take appropriate policy measures and get its policies right.

To boost government tax revenue and smoothly implement the financial sector reform, the GoE needs to introduce a tax system on bank payments, transfers, financial transactions, and bank withdrawals. In taxing businesses and firms, under this new system of taxation there are possibilities of double taxation and double non-taxation. However, there are also mechanisms where these occurrences can be minimized and at times can be avoided, particularly, in taxing the economic sectors (agriculture, industry and service sectors) elements of double taxation may occur but can be minimized if bank levies and financial and bank payments taxes are reported by firms in their consolidated annual audited reports. One way to avoid double taxation is remove direct taxation on all businesses, firms, and salaries and wages. Instead, the government can simply impose taxation on bank payments, transfers, financial/business transactions, and withdrawals through the banking system.

In this regard, the author believes under the suggested tax regime tax revenue of the government can be boosted than any time in the past under the existing tax system. The GoE has already introduced check payments including by non-business entities which is a good step in its own right. This step can remarkably facilitate the new way of taxation through the introduction of bank levies, national financial transactions, and bank payments (withdrawal) taxes.

The daily bank payment and transfers turnover could be much higher than the author’s own estimates in table 4 below. The estimated monthly bank payments and transfers below are based on the daily personal observations of the author in late 1990s. Certainly, the size of the economy is changing and much bigger than it was in the 1990s. The government can use different mechanisms to harmonize this new taxation system and avoid fragmentation with the introduction of flat tax rates between 0.1% and 1.0% but should not exceed the 1.0% rate because it may discourages businesses.

As in the table above, the GoE can impose different tax rates at different times given to the Eritrean context. The author suggests a 0.5% flat tax rate on any bank payments, transfers and financial transactions to smooth the implementation of the new taxation system across the board. The amount of tax income increases depending on the size of the economy and economic activities. Certainly, under this tax regime, the government will be better off than with the traditional sources of tax revenue. For example, at an estimated monthly bank payments, transfers, financial transactions and withdrawals of Nkfa 192 billion, by applying a flat tax rate of 0.5%, the monthly tax income is estimated to be around Nkfa 960 million (annually close to Nkfa 11.52 billion). The advantages of imposing tax on financial transactions and payments via the banking sector could be many but the following few advantages can be illustrative:

Increase tax revenue and reduces budget deficit;

Eliminates costs to collect taxes through the tax department and corrupt practices;

It encourages the real sector (agriculture and manufacturing);

Reduces government public borrowing from local banks and makes more money available for private investors;

Reduces tax department human resources needs;

Under this tax system no one can avoid taxation;

How does it work?

Banks play crucial role in collecting the tax revenues. Banks apply the specified flat tax rate into their systems of payments and apply the tax rate by the government into all:

Bank withdrawals (businesses and private bank account holders),

Business to business bank payments,

Consumer to business bank payments,

Bank to bank transfers,

Employers to employees payments via banking,

Salary/wage withdrawals from banks,

Levies on employees’ salaries/wages,

Interest income taxes,

Tax revenue collected by banks from the above payments and transactions must be deposited on a specified government account on daily basis. In the long run, with the automation of the banking sector, payments and financial transactions activities of banks can be automatically tracked by the central bank without involving manual transfers of tax revenue into the said government account.

Conclusions

1. The necessary but not sufficient conditions to practice/introduce taxation on bank payments, transfers, financial transactions and withdrawals are:

Reform and modernize the banking sector;

Discourage cash-payments outside the banking services;

Strongly apply tax avoidance laws;

Encourage private sector investment and smooth market entries for new entrepreneurs;

2. If the government is looking forward to transform the economy it should reconsider its policy on the private sector. Essentially, Eritrea’s private sector is limited to small scale shopping while major economic activities are run by party dominated business entities.

3. If the current situation of anti-privatization policy continues sooner or later Eritrea we will fall into natural resources dependency trap.

4. Eritrea needs to learn from its past industrial history and the Asian Tigers such as Singapore, Taiwan, Honk Kong, Malaysia, and many more Asian countries.

5. Eritrea needs young entrepreneurs and needs to encourage its talented young to establish small, medium and large enterprises before too late.

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