Diversification: From Oil to Tax - FDC

Taxation
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Wednesday, February 24, 2016 09:01 AM / FDC

Diversification is used as a technique in risk management, whereby one’s portfolio is made up of a wide range of investments. The reasoning behind this is to minimize risk and reduce sensitivity to market swings. Thus, negative performance by one stock will be neutralized by the positive performance of other stocks.1 This idea of diversification can be applied to areas in macroeconomics ranging from national economic output to government revenue. It simply follows the oldest tip in the book: do not put all your eggs in one basket.


In terms of economic output, the Nigerian economy is already quite diversified. In Q3 2015, the non-oil sector contributed 89.73% of total real GDP while oil contributed only 10.27%. Amongst the top non-oil contributors were: agriculture, trade, and information and communication (Table 1).



On the other hand, government revenue remains largely dependent on oil. This lack of diversification is all the more problematic because of the volatility of the oil sector. Commodities are notorious for their volatility (Chart 1).

This volatility affects prices, production and inventories.2 The weak fundamentals are driven by an elastic demand. Thus, prices are extremely susceptible to changes in demography, climate, exchange rates, growth and policies in major economies.




Currently, an estimated two-thirds of the government’s budgetary revenue is derived from oil. This dependency has been especially catastrophic for the government in the wake of falling oil prices. Oil prices have declined by 69.7% since June 2014 leading to a 32.24% fall in government revenue. In turn, federal allocations to the states have fallen by 48.7% (Chart 2).

 

It goes without saying that this dependency poses a significant budget risk. The 2016 budget released late last year was based on a benchmark price of $38pb and oil prices today hover around $30-35pb. Accordingly, budget revenue is projected to decline by 30% expanding borrowing by another 20%. The outlook for oil prices remains bleak as even the most optimistic forecast of oil prices this year is not close to pre-shock levels (Table 2).



It goes without saying that this dependency poses a significant budget risk. The 2016 budget released late last year was based on a benchmark price of $38pb and oil prices today hover around $30-35pb. Accordingly, budget revenue is projected to decline by 30% expanding borrowing by another 20%. The outlook for oil prices remains bleak as even the most optimistic forecast of oil prices this year is not close to pre-shock levels (Table 2).

 

If dependency continues the result will be the retrenchment of government activities due to shortage of funds, increased deficit and higher debt from borrowing, further currency depreciation, depleted reserves and economic slowdown. We can either permit a continued downward spiral of the economy or make the necessary adjustments. The bottom line is that the diversification of the government’s source of income is no longer an issue of choice. It has become paramount that the Nigerian government diversifies its source of income revenue.



The way out

 

Many advocate the revival of the agricultural sector as the messiah of the present crisis. This will diversify our exports and thus expand the supply source of foreign exchange. But such thinking is rooted in the belief that the shortage in supply of dollars is the reason why we find our economy in the middle of a slowdown.

Rather, the shortfall in forex is only a result of an over-reliance on
one source of foreign exchange revenue. Since agricultural products are commodities, their prices are not exempt from the volatility of the international market. While the development of agriculture will help reduce Nigeria’s food import bill and provide a degree of self-sufficiency, in the end, if that is all that is done, the development and growth of the economy will still be dependent on an exogenous factor: the price of agricultural commodities in the world market.

A more sustainable option would be internal revenue generation through taxes.

Firstly, unlike revenue from oil and other exports, taxes have a very limited vulnerability to external pressure. Secondly, it takes less time, effort and cost to improve tax collection than to implement other long-term development plans such as agricultural reformation, construction of refineries that are expected to contribute to revenue.

 

Problems to tackle

 

Currently, the Nigerian tax system is generating much less than its potential. In 2014, total tax revenue from the Federal Board of Inland Revenue was N4.69trn from N4.78trn in 2013. From this we can calculate that the tax to GDP ratio was 5.9% in 2013 and 4.3% in 2014.7 This is substantially lower than the Sub-Saharan African average of 21% in 2014. This declining trend is not a problem of inappropriate policy but rather one of an inefficient tax collection system.

 

Because the tax officials are not well trained and equipped or well paid and monitored there has been inefficiency and corruption in the past In addition, the wide-spread perception that the government is corrupt and will not efficiently expend the collected revenue for the good of the general public, acts as a deterrent to tax payers.

 

This is further complicated by the unnecessarily onerous process involved in the payment of tax. According to PwC’s report, Paying Taxes 2016, a research that measures the ease of paying tax, Nigeria ranks 181 out of 189 countries.8 Thus, the problem of inefficient mobilization of tax needs to be solved to improve internally generated revenue.

 

At the state level, Lagos offers a valuable lesson. As the nation’s commercial hub, Lagos state has a population of about 21 million, of which at least 20% are in the working class. In 2012, the Lagos

State government generated N219 billion internally, amounting to 55% of the proposed budget for that year.

 

Of this internally generated revenue, 78% stemmed from pay as you earn taxes (income tax). 9The state’s success is due to its rigorous collection of tax at all levels of enterprise- even small scale businesses. This cumulative collection has funded Lagos’ fast development and industrialization.

In conclusion, it is necessary to diversify the government’s revenue base from oil proceeds, to more stable sources like taxes, which are dependent on the national income and can be stimulated by monetary and fiscal policies. Such diversification will reduce the level of exposure to external shocks and boost stability. Where there is economic stability, the country becomes more attractive to foreign investments which are what Nigeria needs in this critical moment to spur economic activity and output. Thus, diversification acts as a springboard for economic growth- the primary concern of every government for its economy.

 

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