Shamssedin Hosseini

International economic sanctions and Iran: Are there positive side effects? Part One – Tax Reform

Editor’s Note: Dear IranPolitik readers,

We have returned to bring you new high quality content. Today we will begin a three part mini-series by an economist, Radman Sam, working inside Iran who recently joined the IranPolitik network. We hope you enjoy and look forward to hearing your feedback.

Part Two: Monetary Policy & the Rial

Part Three: Domestic Manufacturing

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By Radman Sam

Introduction

The Islamic Republic of Iran has been under one form of economic sanctions or another since the hostage crisis of 1979, when student supporters of the Ayatollah Ruhollah Khomeini seized the United States embassy in Tehran and took its staff hostage. The hostage crisis and a general downturn in US-Iran relations led to an arms embargo which coincided with an invasion by Ba’athist Iraq under Saddam Hussein, commencing the Iran-Iraq War (1980-1988). The arms embargo against Iran was problematic for the Iranian war effort because the regular Iranian military was up to that point in large part trained and armed by the United States. One consequence of the arms embargo was that Iran was forced to become self-sufficient in the production of a wide range of weapons, laying the foundation for the Islamic Republic’s arms industry which includes a plethora of items including domestically modified or designed light arms, armored personnel carriers, tanks, fighter aircraft, submarines, missiles, and more. The arms embargo also played an important role in shifting resources to actors such as the Islamic Revolutionary Guard Corps (IRGC) and may have had transformational effects beyond the military industries. Could the stringent economic sanctions, which are strangling the Iranian economy today, help create profound changes in the nature of the Iranian economy in the same way the arms embargo helped transform Iran’s military industries and political economy?

Thus far, Western media narratives have rightfully emphasized the negative side effects of sanctions on the Iranian economy. The first has been the precipitous fall in Iran’s income from the export of crude oil. Not only has Iran lost many export markets for its oil because of sanctions, especially since the 01 July 2012 European Union oil embargo which also denies Iran crucial maritime insurance for its oil traffic, but when it can sell oil it has difficulty receiving payment in dollars. Given Iran’s reliance on oil for foreign exchange and the national budget, this will no doubt put the government in a tight fiscal position once its multi-billion dollar reserve of currency is depleted. Beside this basic consequence of sanctions, Iran has also faced a steep decline in the value of its currency and is having trouble importing basic goods, such as medicine and food, both because of the decline in value of its currency and because financial sanctions make it difficult for public and private actors to make and receive payments abroad.

While sanctions promise to make the life of the regime and the lives of ordinary Iranians much more difficult, could they also have some positive side effects? More precisely, by creating a sense of crisis in the modus operandi of the Iranian economy, could sanctions create the impetus for fundamental reforms of the economy which could in the long term benefit both the regime and ordinary Iranians?

This mini-series of articles looks at the ways in which sanctions may be creating the impetus for improved economic governance in Iran. The basic argument is that as sanctions become increasingly comprehensive and multilateral over the long term, the Islamic Republic will be forced to do more with less. The three articles in this mini-series will each focus on one economic area where Iran appears to be seeking to make reforms, and point out possible shortcomings in the regime’s plans. The first article will briefly look at the government’s plans to address a looming fiscal deficit by creating a new revenue stream through the Comprehensive Tax System Plan which seeks to begin collecting taxes more systematically in Iran. The regime may also hope to wean itself off reliance on oil exports through taxation. The second article will briefly look at changes the regime is making to monetary policy the management of the Iranian currency, the rial, particularly through the creation of the Currency Exchange Room. This could have important implications for Iran’s balance of trade and the ability of Iranian producers to compete with foreign goods at home and abroad. Finally, the third article will briefly look at how sanctions may be giving Iranian producers a new lease on life after years out in the wilderness and both boost domestic production and create a new economic constituency for the regime.

Oil addiction: The problematic role of oil in the Iranian economy

The most direct and important effect of the economic sanctions on the Iranian economy has been a decline in crude oil exports and consequently a fall in oil revenues, the main source of Iran’s national budget. According to official reports the average daily oil exports in the months of July and August 2012 were 795,000.5 barrels/day. At the same time last year, this figure was 2,262,000.7 barrels/day, indicating a drop of more than 64.9 percent, or nearly two-thirds. Moreover, the oil export during the first five month of this year were 1,139,00.2 barrels/day, a reduction of 52.2 percent in comparison to the same period last year. These figures confirm that the sale of Iran’s oil has decreased by more than half in recent months.

Dependence on petroleum exports and governments’ access to huge incomes from these has historically been linked to a whole host of social, economic, and political problems in majour petroleum producers. This dependence has also been considered to be linked with economic fluctuations and instability in these countries. In Iran on average more than 60 percent of the national budget is financed by oil and oil derivative exports. It is thus perhaps not unfair to connect a certain malaise in the Iranian economy, society, and culture, to the role played by oil wealth in the last century.

In this period constant injections of oil revenue into the economy has caused consumption, saving, and investment behaviour by the government, households and firms to be highly dependent on oil. In other words, the consumption and savings of Iranian households and the investments decisions of firms are influenced by oil revenues. In manufacturing firms, many investment decisions exclude state rents, foreign exchange rates, and banking facilities, all of which are affected by oil revenues. The government has also foregone the use of debt or capital backed financial instruments, preferring to rely on oil revenues. This has in turn meant less variety in the capital markets and led to the persistence of the traditional practice among Iranian households of savings behavior more inclined toward real-estate and gold.

Under these conditions, the rate of return that would be expected of any reasonable investment is replaced by the capital income from the steady increase in the price of real-estate, resulting in inflation in the economy. This situation has resulted in sub-optimal resource allocation in the economy as a whole. This allocative inefficiency has changed the relative prices in the economy in such way that today it is not easy to recognize the real competitive advantages of Iran’s economy.

Tax reform in the Islamic Republic: Creating a majour new revenue stream?

The reliance of budget on oil revenues has also prevented the establishment of an effective tax system, the development of financial markets, and caused inattention to fiscal discipline. Although the reduction of this oil dependence has always been one of the most important slogans of the Islamic Republic and one of the most important elements in formulating annual budgets, in practice due to the low-cost and availability of oil revenues, governments have not been able to ignore Iran’s oil wealth and have never been very intent on reducing this dependence.  However, in the current situation when sanctions have predominantly targeted Iranian oil resources, this trend cannot continue. Relying on these reserves will put the government and the regime at risk for financing the budget. Apparently officials have accepted this, as demonstrated by the increasing frequency with which the discourse of reducing economic dependence on oil revenues has appeared in their speeches.

The government recently took a step beyond mere talk and could be making serious moves in this direction: The Comprehensive Tax System plan. According to this plan, the government is going to replace oil revenues with taxes. Although many in the private sector believe this plan is impossible to implement, the government insists on moving forward with it. In this regard, the minister of economic affairs and finance Shamseddin Hosseini in one of his recent statements announced the implementation of the plan in the coming winter. What is more, the government has specified that the reason for the turbulence in the foreign exchange markets as well as the economic shocks in the housing market after implementation of the sanctions have all been due to the lack of a tax system in these two sectors. It believes that the control of the aforementioned markets is closely bound to the establishment of an effective tax system. According to the authorities, modifications and improvements to the existing tax laws are to be parts of the Comprehensive Tax Plan.

Fatal flaws in the tax plan?

Many of the details of the plan are still unclear, and the government has not been very transparent about how it will be implemented. There are at least two majour obstacles to the idea of tax reform in Iran, both of which are linked to the question of who is to carry this tax burden. Ordinary Iranians and the private sector, crushed under the weight of government corruption and incompetence and foreign sanctions, would likely not be able to carry a significant tax burden. If taxes on foreign exchange and housing market were implemented, it could create some level of social and political instability. The private sector in particular, undermined by competition with state and quasi-state firms which receive billions of dollars in direct and indirect support from the state, seems loathe to pay significantly higher taxes.

Second, can the powerful state and quasi-state actors in the Iranian economy, such as the Khatam al-Anbia Headquarters (a subset of the IRGC), the Bonyad-e Mostazafan (a religious charity which is in fact a large conglomerate), or Iran Khodro (a large auto manufacturer with strong state ties), be forced to pay? The answer is likely a resounding no. Such powerful economic actors with deep political ties are often able to escape painful economic reforms, as state and quasi-state firms did with the recent subsidy plan where they were able to maintain many of their privileges in the form of subsidies on energy (including electricity and a variety of petroleum products). The problem with this in the case of Iran is that such state and quasi-state actors make up the bulk of the Iranian non-oil economy and are likely the most able to pay. But at a time when the regime is in a virtual state of economic war, faces domestic social and political uncertainty, and may soon face external military aggression, it cannot afford to alienate such important domestic players through the imposition of taxes. Thus, the practical result of the Comprehensive Tax System plan could be a tax system which only exists on paper or collects taxes from a small subsection of the economy, generating negligible revenues.

Part two of this mini-series will deal with the Islamic Republic’s plans to improve management of its currency, in part through the Currency Exchange Room.

Radman Sam is an economist in Iran.