Tuesday, April 16, 2024
CommentaryRethinking Ethiopia's fiscal pathways: The urgent need for policy reform

Rethinking Ethiopia’s fiscal pathways: The urgent need for policy reform

The fiscal policy stance of national governments is a crucial indicator of how fiscal resources are mobilized and allocated within the economy, reflecting the government’s role in the country’s economic affairs. It also reveals how government finances are managed, with implications for the macroeconomic performance of the national economy and the private sector as a whole.

The fiscal policy framework of countries, where the state controls key sectors of the economy and the market system is underdeveloped, serves as a critical barometer for understanding the government’s role in shaping economic outcomes. By closely examining the details of fiscal resource allocation, we can discern how the public sector establishes its priorities and gain valuable information for the decision-making efforts of economic agents.

A close examination of Ethiopia’s current fiscal system reveals a lack of consistent and effective fiscal framework guiding policies aimed at addressing the country’s pressing economic challenges. Recent fiscal performance in Ethiopia demonstrates a troubling pattern of both inefficient fiscal resource mobilization and poor allocation of these limited resources across economic sectors. These issues have led to fiscal deficits, accumulation of public sector debt, and distorted methods of financing these deficits.

Such recurring features of the fiscal system, combined with fiscal dominance in monetary policy, have resulted in severe and escalating inflationary pressures. Public debt service obligations already account for a significant portion of expenditure, further complicating the inter-temporal characteristics of the fiscal system. Thus, it is imperative to move beyond minor annual adjustments in the budget process and focus on the overall fiscal framework of the government sector, as well as the role it should play in the economic affairs of the system.

The mobilization and spending of fiscal resources are intricately linked to the state and performance of the economy. The prudence and effectiveness of fiscal policy stem from judicious identification of critical economic roles, the design of intervention mechanisms, the mobilization of necessary financial and human resources in the least distorting ways possible, and their effective implementation.

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In this context, it is crucial to address the issue of what economic role the government sector should play, either complementing or supplementing the role of the private sector in the market and exchange mechanisms, within the local economy. In economies where the market and private sectors are in early stages of development, government sector involvement becomes necessary for critical development projects. Private sector-led development should wait until the sector gains momentum and traction, and during the transition process, the public sector needs to play its critical role.

However, achieving a deliberate balance and synchronized transition is what distinguishes an effective economic strategy and policy, especially in the context of emerging and developing countries.

Economic policy, particularly fiscal policy, should be designed based on the state and performance of the economy and be responsive to its priorities. The annual budget declarations serve as a manifestation of the fiscal policy framework and its policy emphasis, linking the current situation to the long-term path of fiscal policy statements.

The Ethiopian economy is currently facing significant challenges, including rampant inflation, severe food insecurity, high levels of poverty (both absolute and relative), elevated unemployment, rapid accumulation of domestic and foreign debt, depletion of the capital stock, deteriorating security environment, and massive displacement of citizens.

These challenges necessitate immediate policy attention and resource allocation. Addressing such deep-rooted economic issues requires a pragmatic approach to fiscal and monetary policy to prevent a full-scale crisis from becoming inevitable. In this context, fiscal policy and budget allocation should reflect the relative priorities of the economy and the population.

However, the recently approved fiscal budget of Ethiopia falls short in fully reflecting these fundamental characteristics, and its prescriptions do not align with the ailing health of the Ethiopian economy. The Ethiopian Parliament approved a budget for the fiscal year 2023/24, with an expenditure package of 801.7 billion birr, approximately 7.1 percent of the estimated GDP.

Out of this package, recurrent expenditure amounts to about 370 billion birr, while capital expenditure is allocated 203 billion birr. Additionally, 214 billion birr is designated as federal fiscal subsidy to the regional states.

When compared to the average fiscal outcomes of the past five years, the budget lacks innovation or reform. It largely repeats the patterns observed in the recent past. The components of recurrent and capital expenditure by the federal government, as well as the federal fiscal subsidies to regional states, largely maintain the status quo. The average allocation pattern remains at around 60 percent for recurrent expenditure and 40 percent for capital expenditure from fiscal years 2017/18 to 2022/23.

While fiscal expenditure has been growing in nominal terms, the erosion in purchasing power due to high inflation suggests that the budget is shrinking in real terms. Additionally, the recent fiscal turnouts reveal that the government is allocating more resources to recurrent expenditure at the expense of capital expenditure, which has adverse consequences for the public investment-driven growth model. This allocation imbalance has resulted in some government offices being unable to pay salaries and civil servants struggling to cope with the increasing cost of living.

On the revenue mobilization side, tax revenue collection in Ethiopia has been declining in recent years, with the current tax revenue expected to be only 3.9 percent of GDP. The decline in the tax revenue-GDP ratio can stem from a significant fall in tax revenue or a relatively rapid increase in GDP. While tax rates have remained unchanged and tax authorities are rigorously enforcing collection, the issue lies in the taxable income base approximated by GDP. Urgent auditing of the GDP figures and conducting an economic census in the country is needed to address this discrepancy.

Ethiopia’s fiscal system exhibits features of an extremely narrow tax base, high concentration of taxation sources, and a prevalence of tax exemptions, limiting the generation of sufficient fiscal resources for public expenditure. Over the past decade, the average tax revenue-GDP ratio has remained around 10 percent, which is low even by developing country standards.

In recent two fiscal years, the tax revenue ratio dropped below four percent of GDP, despite unchanged tax laws and vigorous tax collection efforts. This significant decline in tax revenue suggests a decrease in economic activity and/or the economy’s capacity to generate taxable income, widespread tax evasion, deliberate taxpayer shifts to activities with lower tax obligations, or an inadequate taxation network that fails to reach well-performing segments of the economy, resulting in below fair share contributions to the fiscal pool.

The lack of accuracy and credibility of the GDP figures raises the possibility that the tax revenue ratio is depressed due to an excessively exaggerated GDP denominator. Economic activity and income generation processes that do not result in taxable income may either be nonexistent, shielded from tax obligations through various layers of exemptions, or attributable to the shadow informal sector of the economy.

Regardless, it is evident that the tax revenue mobilization performance of Ethiopia’s fiscal system is extremely poor, both in comparison to its historical record and to economies at a similar stage of economic development. Although the tax schedule has a nominally progressive rate structure, it fails to make adequate adjustments for inflation, resulting in a relatively meager tax revenue yield. A flat tax rate regime of a modest magnitude could potentially have generated significantly higher revenue with minimum distortion on economic decision-making.

Consequently, the government is forced to rely excessively on non-tax revenue sources to fund its rapidly increasing expenditure. This trend has led to the accumulation of public debt, which will impose a heavier burden on future taxpayers through debt service obligations. Currently, the government plans to allocate about 159 billion birr or 28 percent of its expenditure to service debt, which is eight times more than the budget allocation for the agriculture sector that lacks adequate funding. This fiscal stance, despite the artificially low interest rates on domestic borrowing, indicates serious problems that are being barely managed to prevent a full-blown crisis.

It is this complex nature and inter-temporal aspects of the fiscal system that call for urgent reforms in the government’s fiscal policy framework to address the fundamental structural disequilibrium within the system.

The central problem of the economic policies in Ethiopia is how to break the straightjacket under which the potential economic power of the private sector and a rapidly growing labor force operates and unleash a strategy towards sustainable and inclusive development. The state and performance of the Ethiopian economy are such that the meager resources at its disposal have not been used effectively or efficiently. This reorientation must start with the government’s fiscal resource management.

Widespread misallocation, inefficiency, and increasing corruption across economic activities have hindered the economy’s ability to survive, let alone thrive. The unrealized potentials, lost opportunities, and misallocation of vital resources have trapped the economy in suboptimal performance relative to its potential and global competitors. Ethiopia, with a labor force of approximately 56 million, produces an estimated aggregate output of 11.3 trillion birr, which is extremely poor performance by all measures.

Adding to the challenges, the country is engaged in destructive conflicts that further deplete capital and livelihoods. Military and defense expenditure has far exceeded the economy’s capacity, causing major disruptions. On the civilian side, the economy struggles to absorb the more than two million young people joining the labor force each year. Simple calculations show that the required investment to employ one new worker is approximately one million birr, implying a need for an annual investment of three trillion birr to absorb new entrants. However, recent investment performance indicators reveal that only about 0.7 percent of the requirement is fulfilled.

Addressing these challenges necessitates urgent policy attention.

The severe state of the Ethiopian economy calls for bold and pragmatic economic policy reforms that remove hurdles for productive sectors, improve the business environment for investors, and aim for full employment capacity. Urgent attention is needed to consolidate national economic integration, rationalize the tax regime, facilitate investment in productive sectors, ensure citizen movement and security, address land tenure issues, combat corruption, and implement transparent measures.

Ethiopians deserve the opportunity to earn a decent living through productive activities. It is crucial to train the labor force in areas that align with the economy’s needs, provide access to essential resources like energy, water, and capital for smallholder farmers and rural residents, and build the necessary policy and physical infrastructure for the productive use of economic resources. The current political situation has fragmented the weak national economic space, forcing citizens to operate within their tribal enclaves, undermining the integrated national economic system. This fragmentation must be reversed urgently.

Without rebuilding an integrated national economic space where all citizens and even foreigners are free to conduct business, create value, and generate employment opportunities, the economy will continue to suffer and living standards will deteriorate. Reversing this trend is essential.

There is no other path to address the country’s economic challenges but through the agricultural sector, which still employs nearly 65 percent of the labor force, contributes almost half of the aggregate output, and faces challenges such as land tenure insecurity, implicit taxation, price distortions, lack of capital and investment, and soil fertility depletion. Instead of undergoing structural transformation, the agricultural sector is burdened with an excessive and growing labor force and a depleted capital base, pushing it to the brink of collapse.

In the face of these structural challenges, a new policy framework is required to comprehensively address the economy’s problems. Economic authorities should prioritize the key challenges and allocate resources and policy attention accordingly. Once macroeconomic stability is achieved, gradual liberalization measures can be implemented without adversely affecting the national economy’s performance. While international financial institutions sponsored economic policy reforms often focus on demand management, equal emphasis should be placed on long-term structural and supply side policy targets.

This approach necessitates a well-crafted and credible policy position that establishes a clear framework, trajectory, and achievable parameters for realizing the economic potential of domestic economic agents. The current policy proposals lack credibility and mechanisms for implementation, resulting in one-sided consultations with domestic stakeholders and negotiations with development partners that impose conditionalities misaligned with Ethiopia’s long-term economic interests and priorities.

Therefore, it is the responsibility of Ethiopian authorities to develop a consistent and transparent policy framework and set their priorities in order. Once the economy is stabilized and major gaps in output, inflation, unemployment, inequality, fiscal deficit, exchange rate, and real interest rates are addressed, a comprehensive economic policy roadmap should be established. This roadmap should emphasize private sector-led market principles and be developed in consultation with a broad spectrum of stakeholders to ensure sustainable and inclusive economic development.

Abu Girma Moges (PhD) is a professor of economics at the University of Tsukuba in Japan.

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Video from Enat Bank Youtube Channel.

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