THE INFLATIONARY IMPACT OF INDIRECT TAXES ON BUDGET DEFICIT IN EGYPT

Prepared by the researcher : Dr. Ahmed Mohamed Adel Abdel Aziz – Economics researcher – Former Member of the advisory office – Of the Minister of Social Solidarity – Egypt

Democratic Arab Center

International Journal of Economic Studies : Twenty Issue – February 2022

A Periodical International Journal published by the “Democratic Arab Center” Germany – Berlin.

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ABSTRACT

Although direct taxes are fairer, indirect taxes are more revenue-generating so Governments of developing countries usually rely on them. This research is concerned with the problem of the inflationary affection of indirect taxes on the public budget deficit in Egypt, during the time period from 2009/2010 to 2019/2020. The reason for choosing this time period is to find out how the political events of this period affected the fiscal policy of Egypt, and the effects of this policy on prices and the public budget deficit. Using the statistical method, the research has found a high ratio of indirect taxes to direct taxes in Egypt, with positive significant correlation between indirect taxes and the consumer price index, positive significant correlation between the consumer price index and the public budget deficit, and a positive significant correlation between indirect taxes and the public budget deficit in Egypt during the study period. Therefore, we can say that indirect taxes increase inflation, and inflation leads to an increase in the public budget deficit, that is, indirect taxes lead to an increase in the public budget deficit, Contrary to the goal of the government. It is one of the public finance puzzles facing decision makers.

1. INTRODUCTION

There is no doubt that inflation and the public budget deficit are among the most serious problems facing the economy of any country. Taxes play a pivotal role in addressing both problems. Taxes, whether direct or indirect, are necessary to bridge the public budget deficit, and direct taxes are theoretically used to reduce aggregate demand and thus reduce inflation.

Governments usually find themselves in trouble when they face a deficit in the public budget and inflation at the same time, because they prefer to use indirect taxes to bridge the deficit of the public budget to increase its proceeds, but this type of taxes leads to cost-push inflation, which increases the general level of prices. This is the focus that the research will deal with, applying to Egypt.

2. STATEMENT OF THE PROBLEM

Taxes are divided into two types: direct taxes DT and indirect taxes IT. Direct Taxes are used as one of fiscal policy tools to counter inflation (usually measured by the consumer price index CPI). On the basis that the increase in direct taxes revenues leads to a reduction in the aggregate demand. In contrast, the indirect taxes have an inflationary effect; it raises the price directly and is paid by the final consumer. In fact, they are part of the price that the consumer pays when purchasing a goods or services. This implies a positive correlation between indirect taxes IT (the independent variable) and CPI (the dependent variable), as expressed by the following equation:

CPI = β₀ + β₁* IT …………. (1)

The role of inflation in increasing the public budget deficit cannot be overlooked. By increasing expenditures due to the increase in the prices of commodities and services requirements that the government needs to perform its traditional functions and it is often forced to decide a cost premium for its employee. In addition, commodity support allocations increase and the cost of public investments increase. Therefore, it can be said that the price index (as an independent variable) has a positive impact on the public budget deficit (as an independent variable). This is expressed by the following equation:

BD = β₀ + β₁* CPI ………….. (2)

Therefore, if the relative weight of indirect taxes is greater than direct taxes, the final effect of the tax policy will be inflationary, which will exacerbate the public budget deficit. Thus, we find that indirect taxes (as an independent variable) have a positive impact on the public budget deficit (as a dependent variable). This is expressed by the following equation:

BD = β₀ + β₁* IT ………….. (3)

3. OBJECTIVE OF THE STUDY

This research aims to answer the basic two questions: first: What is the effect of indirect taxes on inflation? The second: What is the effect of inflation on the public budget deficit? Which means answering a third implicit question, which is, what is the impact of indirect taxes on the public budget deficit?

4. RESEARCH METHODOLOGY AND DATA

The research will depend on official data of indirect taxes, inflation and the public budget deficit in Egypt during the period from 2010 to 2020, and apply the previously mentioned equations with numbers 1, 2, 3 by performing a Pearson correlation test, and then a simple linear regression.

The reason for choosing the time period is to find out how the political events of this period affected the fiscal policy of Egypt, and the effects of this policy on prices and the public budget deficit.

5. DISCUSION AND RESULTS

5.1. DIRECT VS. INDIRECT TAXES IN EGYPT

Most writers define direct taxes as those imposed from the outset on the individual or family intended to bear the burden of these taxes. Indirect taxes are those imposed at another point in the system, and from the outset are intended to allow their burden to be shifted. Therefore, the income, property, and wealth taxes is a direct tax, and the tax on sales, value added taxes, and taxes that are imposed on imports are indirect taxes. (Musgrave & Musgrave, 2017)

Direct taxes are fair and reliable in redistributing income, while indirect taxes are paid by everyone, and lead to an increase in prices due to shifting their burden. (Saez, 2002) Therefor one of the oldest questions in tax theory and practice is the question: what is the right mix of direct and indirect taxes? Choosing between direct and Indirect taxes have contributed to a long, animated political debate and academia, regarding the virtues and disadvantages of these two forms of taxes. (Vulovic, Vasquez, & Liu, 2009)

The governments of developing countries prefer indirect taxes because of the abundance of their revenue and the ease of imposing them, In addition the rich political influence prevent an increase in the tax burden on them. Therefore, the ratio in general of indirect taxes to direct taxes in the developing countries is 50% which equals the double of corresponding ratio in the advanced industrial countries, in which indirect taxes revenues (IT) are usually about 25% of the amount of direct taxes revenues (DT). (Zee & Tanzi, 2001)

Tax revenues in Egypt consist of four sources:  (Financial data, 2021)

• General taxes on income and profits which classified as direct taxes.
• Sales taxes, then value-added tax, from 2016, which classified as indirect taxes.
• Customs taxes, which classified as indirect taxes.
• Other tax revenues, which is difficult to classify; therefore, it will be excluded from the data when analyzing the relationship between direct and indirect taxes in Egypt.

 The following table shows the direct and indirect taxes in Egypt during the study period:

Table (1): Direct and Indirect Taxes in Egypt (2010-2020) (Billion L.E)

Source:  (Financial data, 2021)

Table (1) shows that, the ratio of indirect taxes to direct taxes was very high compared to developed countries, and it also remained above 50%, that meaning it was higher than the average of developing countries as well. This indicates that the tax policy in Egypt during the study period was indifferent to distributive justice.

Using the data of the previous table, we can draw a graph of the evolution of the proportion of indirect taxes to direct taxes in Egypt during the study period as follows.

Figure (1): Indirect to Direct Taxes Ratio in Egypt (2010-2020) %

Figure (1) shows that, the ratio took a general downward trend since the beginning of the study period until 2014, then it took a general upward trend until 2019, and it is noticeable that it decreased in the last year of the study, and despite that, it took a general upward trend during the entire study period.

Politically, the study period is divided into four main terms:

56. Before January 25, 2011: It was represented in only one year and the percentage was 77%. Compared to a previous period, , Al-Isawy’s study shows that the relative weight of indirect taxes in Egypt decreased from 73% in 1975 to 56.4% in 1981, which was the period during President Sadat’s rule after the October victories. Then this percentage tended to rise in the early days of President Mubarak’s rule until it reached about 70% in 1984, then it tended to stabilize between 60% and 65% throughout his reign almost. (Al-Isawy, 2007) Al-Isawy considered that all other taxes are indirect taxes, but in this research, these taxes were excluded because it is not possible to acknowledge with certainty that they are direct or indirect, as we mentioned before.
57. From January 25, 2011 to June 30, 2013: During these years, there was an improvement, as the percentage decreased from 79% to 67%.
58. From June 30, 2013 to June 2014: During this year there was also an improvement, as the percentage decreased to 61%.
59. After June 2014 until June 2020: During these years, a clear deterioration occurred, where the percentage rose to 77% in the first year, and continued to rise until it reached nearly 100% in 2018/2019, then improved and decreased to 85%, but it is still higher than the level it was in previous terms.

From the previous analysis, which is based on official data, it was found that the best term was the third, which amounted to only one year.

5.2. INDIRECT TAXES AND INFLATION IN EGYPT

A government can satisfy its budget deficit either by printing money or by levying taxes. It is known that if the government chooses to depend on indirect taxes, the cost of that is inflation. (Poterba & Rotemberg, 1988) There is researchs stating that direct taxes also have an inflationary effect, but this may be a matter of great disagreement among scholars. (Pitchford & Turnovsky, 1976) But direct taxes are outside the scope of this research. It is agreed that indirect taxes have an inflationary effect. The Egyptian government chose to depend on indirect taxes; the following table shows the inflation and indirect taxes data in Egypt during the study period. Where the price index was calculated by researcher considering the fiscal year 2008/2009 as the base year.

Table (2): Inflation and Indirect Taxes in Egypt (2010-2020)

Source:  (Economic Research, Annual Report, 2021)

For further clarification, we can graphically represent each of the consumer price index (CPI) and indirect taxes in Egypt in the following figure.

Figure (2): CPI and Indirect Taxes in Egypt (2010-2020)

Figure (2) shows that, both the indirect tax revenue and the consumer price index have taken an upward trend, which indicates a strong positive correlation between them.

The relationship between the two variables has been tested considering that indirect taxes are the independent variable and the consumer price index is the dependent variable, using equation No. 1 referred to in the introduction of this research. The results of SPSS application outputs are shown in the Appendix No.1.

From the SPSS results, we find that, there is a strong positive significant correlation between the IT and CPI, with a value of 98.7%. And from the value of adjusted R², we find that the change in indirect taxes as an independent variable explains 97.2% of the change in the consumer price index as a dependent variable. From the value of β₀ and β_1, this relationship can be expressed by the following estimated equation:

CPI = 71.273 + 0.785 IT

This means that if indirect taxes are equal to zero, the CPI will be equal to 71.273, which is the value of the constant item in the equation. This equation also tells us that every one unit change in indirect taxes leads to a less change in the consumer price index, with value of 0.785, which is the marginal slope of this linear equation.

From the previous analysis, we find that the statistical results support the hypothesis of a positive and significant effect, as indirect taxes lead to a rise in the consumer price index.

In comparison with previous periods, Al-Isawy’s study showed that the inflation rate ranged on average around 10% from 1975 to 1981, while it rose to revolve around an average of 15% during the period from 1982 to 1996, and then took a downward trend after that, which was only interrupted by the rise that occurred in 2004 Following the floatation of the Egyptian pound in 2003. (Al-Isawy, 2007)

5.3. INFLATION AND BUDGET DEFICIT IN EGYPT

The deterioration of the purchasing power of money pushes public spending to increase, as the cost of purchasing goods and services that the government needs to perform its traditional functions increases. Also, with the intensification of inflationary pressures, the government is often forced to decide a cost-of-living allowance in the salaries of government employees. In addition, commodity support allocations increase, and the cost of public investments increases. Therefore, inflation is one of the causes of the public budget deficit. Although inflation may lead to an increase in incomes, sales, profits and interests, who may lead to an increase in, tax revenues, but if we calculate the real value of those, tax revenues, we will find that it decreased. (Tanzi, 1978) We must not forget the problem of fiscal lag, as there is an interval between the increase in prices and the increase in incomes, and the increase in tax revenues. (Olivera, 1979) Therefore, inflation will lead to an increase in the public budget deficit. The following table shows the budget deficit and inflation data represented by the consumer price index during the study period.

Table (4): CPI and Budget Deficit in Egypt (2010-2020)

Source:  (Economic Research, Annual Report, 2021)

For further clarification, we can represent the data of the previous table in the following figure.

Figure (3): CPI and Budget Deficit in Egypt (2010-2020)

Figure (3) shows that, both the consumer price index and the general budget deficit took an upward trend. This indicates a strong positive correlation between them.

The relationship between the two variables has been tested considering that CPI is the independent variable and budget deficit BD is the dependent variable, using equation No. 2 of this research. The results of SPSS application outputs are shown in the Appendix No.2. From the SPSS results, we find that there is a strong positive significant correlation between the CPI and BD, with a value of 95.7%. And from the value of adjusted R², we find that the change in CPI as an independent variable explains 90.6% of the change in the budget deficit BD as a dependent variable. From the value of β₀ and β_1, this relationship can be expressed by the following estimated equation:

BD = -1.240 + 1.421 CPI

This means that if CPI is equal to zero, the BD will be equal to -1.240; this means that there is a surplus in the public budget, which is the value of the constant item in the equation β₀. This equation also tells us that every one unit change in CPI leads to a higher change in the BD, with value of 1.421, which is the marginal slope of this linear equation β₁.

From the all previous analysis, we can say that the statistical results support the existence of a positive and significant effect, as indirect taxes lead to a rise in the consumer price index, which lead to a rise in budget deficit. Thus, we can deduce that, indirect taxes lead to a public budget deficit indirectly. The following figure clearly shows this.

Figure (4): IT and BD in Egypt (2010-2020)

The previous figure shows that both variables took a general upward trend during the study period. By conducting the statistical tests as shown in Appendix No. 3, it becomes clear to us that there is a positive significant correlation between them with a value of 91.7%, and the value of the R² shows that the change in indirect taxes as an independent variable explains 82.3% of the change in the public budget deficit as a dependent variable. Also from the value of β₀ and β_1, this relationship can be expressed by the following estimated equation:

BD = 105.802 + 1.083 IT

This means that if IT is equal to zero, the BD will be equal to 105.802, which is the value of the constant item in the equation β₀. This equation also tells us that every one unit change in IT leads to a higher change in the BD, with value of 1.083, which is the marginal slope of this linear equation β₁.

CONCLUSION

Results:  This research has found a high ratio of indirect taxes to direct taxes in Egypt during the period from the fiscal year 2009/2010 to the fiscal year 2019/2020, which leads to an increase in burdens on the middle and poor classes. It also concluded that there is a positive and significant correlation between indirect taxes and the consumer price index in Egypt, and a positive and significant correlation between the price index and the public budget deficit during the study period, and therefore there is a significant positive correlation between indirect taxes and the public budget deficit in Egypt during the study period.

Recommendations

The research basically recommends reducing indirect taxes, and relying more on direct taxes, by following a fair tax policy. This will lead to relative stability in prices and a reduction in inflation rates, and consequently a decrease in the public budget deficit and an improvement in the lives of Egyptians.

APPENDIX

(1): SPSS Outputs for CPI & IT (IDTX) Model

(2): SPSS Outputs for CPI & BD Model

(3): SPSS Outputs for IT (IDTX) & BD Model

(3): SPSS Outputs for CPI & IT (IDTX) Model

BIBLIOGRAPHY

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