A picture of Iran's troubled financial situation.
When oil prices fall, as they inevitably will, the Mullah's have big problems. Frankly, even if crude prices don't fall below $20 in the next 3-4 years I still don't know where they will get the money to finance public service jobs for the rapidly oncoming younger generation.
IRAN
Iran’s Precarious Public Finance
By Jahangir Amuzegar
mees.com
In the following article for MEES, Jahangir Amuzegar, a distinguished economist and former member of the IMF Executive Board, reviews Iran’s public finance policies.
The Islamic Republic’s “comprehensive” budget bill for fiscal 1382 (2003/4) finished its long and bumpy road to final passage and went into effect as of 21 March. The approved budget for both the government itself and several hundred state-owned enterprises (SOEs) is, like those of the last 20 years, balanced on paper. But, in actuality, it includes a sizeable deficit to be financed by domestic and foreign borrowings and other unspecified incomes.
Due to a still considerable lack of transparency in the budget document, and the indicative rather than assured nature of projected revenues, the size of the ultimate shortfall is hard to assess. Private budget analysts expect it to be much more than the 1381’s – which was estimated to be three times that of the 1380’s. Regardless of the size of the year-end figure, however, the very existence of a budget gap under current favorable economic circumstances poses a puzzle. For an oil-reliant economy to experience a budget deficit in the midst of a two-year global oil boom and officially claimed thriving domestic economic activity something must be out of kilter. If budget deficits should persist with crude prices having reached their record highs since 1991, and the GDP growth in 1381 is expected to exceed the 6% planned target, when then can Iran achieve a true fiscal balance? A look at salient characteristics of the 1382 budget, and a critical examination of the country’s public finance structure may provide some tentative answers.
A Look at the Past
For more than three quarters of a century since the mid-1920s, Iran has been one of a few developing countries with a regular annual fiscal budget. The four essential processes of preparation, approval, implementation, and audits have been faithfully followed by specific legal entities. Up until 1964, the Finance Ministry was in charge of both budget preparation and its implementation. The Majlis (national assembly) had the task of appropriation and approval. And, an independent Accountancy Court was responsible of post audits. After 1964 the budget preparation was entrusted to the Planning and Budget Organization, and the Ministry of Finance was left with the task of disbursements. The other two procedures remained the same.
Up until the 1979 revolution, the budgetary process followed a vertical chain of executive command, and the Majlis had little discretionary room for maneuvers. By law no Majlis deputy could propose additional expenditure, and the Majlis itself had the power to cut the government’s proposed budget but could not add to it. In a hierarchical power structure, and in the absence of influential pressure groups outside the establishment, what was decided by the executive branch, and approved by the Shah, usually sailed through the Majlis almost intact – despite a lively debate on the floor between the government’s supporters and critics.
The 1964 division of responsibility for budget preparation and implementation, however, had two unintended consequences. First, it caused perpetual friction between the PBO (that usually succumbed to various agencies’ pressure for higher appropriations) and the Ministry of Finance (that was unable to collect optimistically projected revenues). Second, it made perennial budget deficits an inevitable outcome. The one saving grace (ie, a limit on the growth of public debt) was a legal escape clause in the budget document that required the treasury to disburse appropriated expenditures only to the extent of its collected revenues. This clever (albeit cumbersome) pre-auditing check placed a virtually automatic cap on public expenses. For this reason, the ever-present gap between overestimated revenues and under-estimated expenditures resulted in only relatively small government debt. Thus, the IR800bn owed to the banking system by the public sector in 1356 (1977-78) represented largely the state enterprises’ borrowings for their own operations.
Widening Gaps
After the 1979 revolution, budget preparation became vastly more cumbersome, while its fundamental shortcomings were simultaneously multiplied. With the diffusion of power among various political factions, the parochial demands of pressure groups, clerical institutions, and “deprived” regions were added to bureaucratic agencies’ habitual requests for increased budgets. The Majlis’s role in the budgetary process thus became greatly enhanced. More significantly, the national assembly assumed the power to fix prices of public goods and services; prescribe specific volumes of credit to be granted by state banks to the SOEs at subsidized interest rates; and set the official exchange rate of the Iranian currency – the rial. This significant legislative interference with market forces – intended to harness inflation through price controls, low-cost credits, and exchange rate manipulation – placed Iran’s public finance under severe pressures from both sides.
On the expenditure side, the users of funds rose precipitously. To begin with, the constitutionally mandated nationalization of banking, insurance, key industries, foreign trade, and a host of other economic activities increased the government’s size and scope of operation – requiring larger and larger budgets. Concurrently, the confiscation of assets, properties and businesses belonging to private individuals and entities associated with the previous regime, and their transfer to new SOEs or “charitable” foundations (bonyads) made the public sector the dominant force in Iran’s economy. Furthermore, acting as the employer of first resort, the massive army of the unemployed (particularly after the Iran/Iraq ceasefire) was inducted into auxiliary military forces (pasdaran and basij), or absorbed by other state agencies – making the government the country’s largest single employer. Thus, while total population has less than doubled since the revolution, the number of government employees has increased four times. Still further, by prolonging a costly and devastating war with Iraq for eight years, the government increased its postwar financial burdens of reconstruction, veterans’ benefits, and defense replenishments. Finally, to win the rank-and-file’s support and appease the war-weary, socially deprived, and increasingly poorer masses, a costly (and inefficient) system of across-the-board subsidies was put in place. On top of all this, the consolidation of the government’s own accounts with those of the SOEs in a “comprehensive” national budget after 1363 (1984-85) added the ongoing losses of money-losing state enterprises to the annual fiscal hemorrhage.
On the revenue side, by contrast, the sources of funds shrank considerably. First, with the execution, jailing, or mass exodus of skilled and competent managers and administrators of the old regime, the massively nationalized and confiscated segments of the private economy were entrusted to the “Islamically committed” cadres who lacked business education, managerial experience, and even personal integrity. As a result, not only did individual and corporate income taxes dry up drastically, a growing cluster of money-losing SOEs also had to be kept on various life-support systems through annual budget grants or low-interest loans from the nationalized banking systems. Second, former profitable private enterprises now turned into “charitable” foundations that were immune from government control and exempt from taxes, deprived the treasury of solid sources of revenues. Third, under the pretext of social justice and economic stimulation, some significant chunks of the economy (eg, agriculture, oil, education, sports, and non-oil exports) became legally tax-exempt. Fourth, until March 2002, receipts from crude oil exports were sold to various favored entities below their free market rates at a great loss to the treasury. Finally, in a deliberate attempt to keep import costs down, ad-valorem taxes on foreign purchases were calculated on the basis of an artificial, and highly overvalued, exchange rate which cut short government’s import revenues to between one-fourth and one-half of the actual taxes owed.
The net outcome of multiplying claimants on government resources, and the government’s perennially inadequate revenues, has been a continuous annual budget deficit which in some lean years has exceeded the entire revenue figure. An estimate by a Management and Planning official gives the ratio of the comprehensive annual budget deficit to GDP during the 1991-2001 decade, between 7.4% and 17% – or a yearly average of about 12%. The true magnitude of the total public sector deficit, however, is believed to be much larger than these figures. The officially reported budget gap excludes (a) cash losses of the banking system (bad loans, the Central Bank’s interest-free loans to the government, the imputed cost of subsidized losses by the SOEs); (b) implicit cost of energy and other utilities supplied by the state at less than their market value; and (c) other off-budget transactions involving hidden costs to the government.
Even without these hidden losses, the net outcome of accumulated yearly budget deficits has been a staggering rise in the public sector debt. According to official data published by the Central Bank, the public sector debt to the banking system that stood at about IR800bn in 1977-78 rose to some IR138,500bn by 2001-02, or more than 173 times in nominal terms.
The Current Picture
The Islamic Republic’s public finance is currently plagued with a raft of procedural, disciplinary, and fundamental flaws. Despite substantial improvements made in the last two years under IMF recommendations to bring the budget document in line with the universal GFS model, budget preparation still follows an outmoded system of automatic escalation. Instead of allocating annual budget funds according to an ongoing agency’s previous performance, or a new program’s current objectives, Iran’s budget is largely pre-committed. All expenditures are based on last year’s appropriation plus additional funds to account for expected inflation, or to accommodate new political pressure from influential circles. However, there are never guaranteed corresponding increases on the revenue side. Even while revenues collected in a given category for the year has already fallen short of budget expectations, the figure for the coming year is still automatically increased. In this budget writing method, every expenditure item is thus factual, real, and certain, while almost all revenue items are projected, aspirational and up in the air. Furthermore, each annual budget, after approval by the Majlis still requires more than 20 or so operational bylaws and some 10 or so executive manuals to be further ratified by the Council of Ministers. This process often takes more than the first quarter of the year to be finalized – leaving agency budgets in virtual limbo during that time. Another anomaly in the budget bill is the requirement that part of appropriated funds not be spent during the course of the year – which raises the question as to why such allocations were made to begin with, if performance is to be ignored.
Lax budgeting discipline is the second problem. To begin with, some 64% of the comprehensive budget that belongs to SOEs are routinely passed by the Majlis, and escape its control or supervision, due to these entities’ large number and specialized tasks. Furthermore, cost overruns are frequent and uncensored. Failure to collect projected taxes or other domestic revenue sources carries no administration consequences. And, the Accountancy Court’s report on compliance with the annual budget law is always two to three years late and usually goes unheeded. Still further, although the budget is required to follow the outlines of the ongoing five-year plans, the Majlis often feels free to ignore this legal mandate. For example, the Third Plan (2000-05) law specifies each year’s share of the treasury from the oil export receipts. Any extra foreign exchange received from such exports during oil booms must be deposited in the Special Exchange Reserve Fund to be drawn upon during future oil slumps. Yet, despite an oil boom in the last two years, the Majlis has conveniently amended the Third Plan law twice to increase each annual share by more than $4bn. And finally, since the current budget (eg, salaries, bonuses and supplies) cannot be cut, revenue shortfalls always end up at the expense of development projects. According to official reports, there are currently upward of 9,000 national and 50,000 local unfinished projects around the country – some started 10 or more years ago – because they never received more than 75% of the allotted budget in a given year.
Apart from these two peripheral handicaps, by far the most vexing aspect of the Islamic Republic’s current public finance relates to its fundamentally flawed structure. First the country lacks an adequate and reliable tax base. Leaving aside the underground economy (trade smuggling, counterfeit and pirated foreign products, petty trades, moonlighting, and illicit activities) which may account for as much as 20% of true GDP and escape taxation, the rest of the economy is also tax deficient. According to a recent Finance Ministry estimate, as much as 50-60% of Iran’s formal economy is presently tax free. The taxed segment is subject to levies on income, wealth, and consumption. There are non-tax earnings from sale of public goods and services, and privatization of SOEs. Upward of 50 different fees and charges are also collected by various public agencies for their specified activities. The totality of all these regular and nuisance taxes is still pretty small. The ratio of taxes to GDP is about 6%. The percentage of all non-oil receipts in GDP is about 9% – both among the lowest in the world.
Second, the treasury is perilously dependent on receipts from volatile oil and gas exports – which are not really revenues but sales of exhaustible national assets. Annual oil incomes, per se, normally constitute less than 50% of the government budget. But a good part of other sources of public receipts (eg, taxes on imports, excise taxes on domestically consumed fuel products, and others) is also oil-export dependent – raising the energy’s total share of the budget close to 65%. Figures for the entire post-1979 period show that budget deficits are not only invariably caused by reduced oil revenues, but also mainly offset, or largely made-up, by the sale of petrodollars in the open market at the free market exchange rate. More disturbing still, new annual public investment projects that are expected to replace depleted oil reserves as fresh sources of income in the future always trail behind annual oil receipts by as much as one third.
Third, the inflexible and highly inelastic character of specific excise taxes on consumption and production – which are based on volume of sales rather than value of goods sold – perennially fall behind rising inflation, and deprives the treasury of its due shares. Pressed by the IMF in recent years to come up with a modern value-added tax system, the government’s earnest efforts have so far been resisted by various vested interests, and hampered by the potential difficulty of implementation under Iran’s poor bookkeeping system.
Fourth, despite a number of different methods followed by the treasury to collect due taxes, evasion has been the rule rather than the exception. According to a recent report, the treasury is owed some IR20,000bn in taxes involving cases dating back eight years. Part of the problem, apart from endemic and institutionalized corruption, lies in the highly cumbersome collection procedures. Some 50% of private corporations and professional businesses reportedly always disagree with the treasury’s assessments. These complaints go through a maze of review committees, with 35% of protesters coming out as winners with reduced taxes. The other 15% are referred to arbitration commissions that take years to come up with a final decision. And even if the treasury wins the case, accumulated annual inflation make the final payment worth very little.
Fifth, there is much waste in the annual budget. For example, there are more than a dozen educational and research centers doing duplicate work on “Islamic propagation,” each receiving separate and specific allocation of their own. A number of purely private but influential entities (eg, Islamic Free University, Iran’s Chamber of Commerce and Industry) get a share of the budget. Some independent and profitable agencies (eg, Iran’s official Radio and TV network that have huge advertising income) still get a budget allocation. And despite repeated injunctions by the leadership against starting new projects in the same field while others remain unfinished due to lack of funds, the practice continues.
The Fault Lines
Thanks to the Islamic injunction against reba (payment of fixed interest), the virtual absence of money markets, and the state-controlled financial rates of return, budget deficits in Iran are less disruptive and more manageable than they are in the developed countries. The bulk of Iran’s public sector debt consists of interest-free loans owed to the Central Bank, or low-interest-bearing obligations to the nationalized banks. They therefore involve no corresponding interest expenses in the current or future annual budgets, and little financial burdens on “future generations.” From a monetary point of view, too, they will never have to be repaid since they are already monetized. And, even if they were ever to be repaid, it would be mostly an accounting transaction since they are debts of the government to itself as both the Central Bank and nearly all commercial banks and insurance companies belong to the state.
From a socio-economic view point, however, the colossal debt still involve heavy costs in terms of crowding out the private sector; increasing domestic liquidity and fueling inflation; and pushing more people below absolute and relative poverty lines. More significantly still, unless serious steps are taken to reduce the treasury’s unhealthy dependence on volatile and uncertain oil and gas receipts, Iran’s public finance – and with it the entire Iranian economy – may face unexpected shocks sooner or later. With predictions of the oil price decline after Iraq’s resumption of oil export, Iran’s public finance may encounter unpleasant surprises. In the absence of compensating foreign investment inflows in both the energy and industry sectors, economic chaos can scarcely be avoided. Should oil prices fall below $20/B, budget deficits would exceed tolerable ratios to GDP, and the government would have to go deeper and deeper into foreign debt to finance needed imports. Due to Iran’s relatively small foreign debt, the immediate shortfalls can be managed for a while. However, at prices below $15/B – and no compensatory foreign financing – the economy is likely to face a full-blown recession. At $10/B or less, the country would be courting financial disaster. The time to accelerate fiscal reforms and reduce dependence on oil is thus already past due. |
