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«Published in Forum for Development Studies, Vol. 31, No. 1 (July), pp. 89-113 The article analyses factors constraining the capacity of the ...»

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Taxation during state formation.

Lessons from Palestine, 1994-2000∗

Odd-Helge Fjeldstad♣ and Adel al-Zagha♠

Published in Forum for Development Studies, Vol. 31, No. 1 (July), pp. 89-113

The article analyses factors constraining the capacity of the Palestinian National Authority

(PNA) to raise domestic tax revenue during the period 1994-2000. The article shows that

more than any other factor, Israel represented a constraint on the PNA’s tax policies and

revenue collection. Israel collected the bulk of taxes on traded goods on behalf of the PNA, and until 2000 a large share of income tax came from Palestinians working in Israel. By withholding revenue collected on behalf of the PNA, Israel was able to exert substantial financial pressure on the PNA. However, within its restricted room of manoeuvre, the PNA managed to raise significant domestic revenues subject to the constraint of consolidating and maintaining its power. The PNA also used the tax system as a means of enhancing rents from industries and sectors that the leadership believed were important for economic development, and to grant generous tax exemptions to politically important stakeholders.

Keywords: Taxation, tax administration, economic policy, institutions, state formation, foreign aid, Israel, Palestine.

JEL classification: H20, H30, O19, O23, O53

1. Introduction States need money. States under formation need a lot of money. But while the politics of revenue mobilisation is one of the most important policy concerns for any state, we know very little about it during processes of state formation. This is surprising given the fact that tax revenue is central to (i) building state capacity and service delivery; (ii) the shaping of state-society relations; and (iii) the sustainability of aid interventions (Levi, 1988; Steinmo, 1993; Moore, 1998). Furthermore, based on historical evidence from the West, the way a state tackles the issue of domestic revenue mobilisation significantly influences its potential for ∗ This article is the result of the co-operative research programme between Chr. Michelsen Institute, Bergen, and Muwatin, the Palestinian Institute for the Study of Democracy, Ramallah. The programme is financially supported by the Norwegian Agency for Development Cooperation (NORAD) and the Ministry of Foreign Affairs. We would like to thank two anonymous referees for extremely valuable comments and suggestions for improvements of an earlier draft. Points of view and any remaining errors are entirely our responsibility.

♣ Chr. Michelsen Institute, P.O. Box 6033, 5892 Bergen, Norway; e-mail: odd.fjeldstad@cmi.no ♠ Birzeit University, Ramallah, Palestine; e-mail: aalzagha@birzeit.edu 1 economic growth and democratic consolidation (Tilly, 1992). Hence, a key question is: What are the main factorsconstraining a regime’s capacity to raise revenue during state formation?

The Palestinian experiences over the period 1994-2000 provide an opportunity to explore this question. Although the Palestinian National Authority (PNA) operated over only a small part of the territory of the West Bank and Gaza Strip (WBGS), it had a degree of sovereign legitimacy within the Palestinian territories in this period. The PNA set up institutions that were intended gradually to form the core of a future Palestinian state (Hilal and Khan, 2004).

It established state institutions such as ministries and agencies, and a tax system was developed. Based on the institutional literature, we suggest that the PNA faced four main constraints to enhancing domestic revenue. These constraints emanated from: (i) the effectiveness of the tax administration; (ii) the nature and capacity of the political institutions;

(iii) the PNA’s bargaining position vis-à-vis various groups of citizens, including owners of capital; and (iv) the impacts of foreign aid on domestic revenue generation.

The article shows that more than any other factor, Israel represented a constraint on the PNA’s tax policies and revenue collection. Israel collected the bulk of taxes on traded goods on behalf of the PNA, and until 2000 a large share of income taxes came from Palestinians working in Israel. By withholding revenue collected on behalf of the PNA, Israel was able to exert substantial financial pressure on the PNA. However, the article argues, within its restricted room of manoeuvre, the PNA managed to raise significant domestic revenues subject to the constraint of consolidating and maintaining its power. It also used the tax system as a means of enhancing rents from industries and sectors that the leadership believed were important for economic development, and to grant generous tax exemptions to politically important stakeholders such as professionals.

The Palestinian state-formation process is now at a standstill. Officially, the process started with the signing of the first Oslo Agreement in Washington on 13 September 1993, followed by the famous handshake between the PLO leader Yassar Arafat, the late Israeli Prime Minister Yitzhak Rabin and Foreign Minister Shimon Peres.1 It ended – at least for the 1 The Oslo Agreement was a declaration of principles which laid the foundation for limited, interim Palestinian self-rule in those areas of Palestine occupied by Israel since 1967: the West Bank, including East Jerusalem, and the Gaza Strip (WBGS). This included approximately 20 per cent of the Palestine that the United Nations decided to separate into two states in 1947. Actually, there were two Israeli-Palestinian agreements, referred to as Oslo I (signed in September 1993) and Oslo II (signed in September 1995). See Butenschøn (1998) for an 2 foreseeable future - with Prime Minister Ariel Sharon’s visit to the Temple Mount, which ignited in late September 2000 a popular uprising known as the al-Aqsa intifada in the occupied territories and inside Israel.2 But, although the events since autumn 2000 have put further progress on hold, the experiences over the period 1994-2000 may provide important lessons about the economic, political and institutional constraints that a future Palestinian state will face with respect to revenue mobilisation.





The remaining part of the article is organised as follows: Section 2 briefly describes the macroeconomic policy and the tax system in Palestine over the period 1994-2000. In Section 3 various institutional approaches to analysing the constraints facing a state’s revenue policies are discussed. Section 4 analyses factors constraining the PNAs’ capacity to raise revenue.

Finally, Section 5 concludes.

2. Macroeconomic policy and the tax system in Palestine In the period 1994-2000 the PNA was a self-government that possessed administrative, legislative and political power over only parts of its territory. About a third of the area of the Gaza Strip (GS) and around 60 per cent of the West Bank (WB) were controlled by Israel.

However, the majority of the population of more than 3 million people came under the jurisdiction of the PNA, except those living in East Jerusalem and some villages in the West Bank that were under Israeli security control. With a GDP per capita income of US$ 1387 (in 1998), Palestine fell into the category of middle-income countries (PCBS, 1999).3 The official unemployment rate was 14.1 per cent in 2000 (DSP, 2002). But when workers discouraged from entering or remaining in the labour force are included the unemployment rate is estimated to be almost 40 per cent in the last quarter of 2000.

analysis of the Oslo Agreements placed in the context of Israeli and Palestinian political strategies. Giacaman and Lønning (1998) provide a critical assessment of the Oslo process from various perspectives.

2 The al-Aqsa Mosque, located at the Temple Mount, was built by the Caliph al-Walid (r. 705-715) of the Umayyad dynasty. It is one of the three most revered places of worship for Muslims, and a major religious and educational centre. Moreover, it is a showcase for Islamic architecture and design from Umayyad to Ottoman times.

3 This average excludes East Jerusalem, with a population of more than 210,000 (in 1997). The figure also hides substantial differences between the West Bank and the Gaza Strip. Since the second intifada started in September 2000, living conditions in WBGS have deteriorated dramatically. Real GDP per capita has now reached its lowest level since 1980. By the end of the year 2000, 35 per cent of the population lived below the poverty line, a figure that rose to over 50 per cent by the end of 2001 (see UNSCO, 2001: 29).

3 The PNA implemented and maintained a liberal economic policy regime, emphasising incentives for investments and a stable macroeconomic environment. Following the Oslo Accord between the PLO and Israel, the PNA’s principal challenges were to promote economic development and alleviate poverty. But the PNA faced major constraints in pursuing these objectives: lack of control over borders, limited control over land, water and other natural resources, poor physical infrastructure, weak institutions, limited financial and human capital, and a high degree of political and economic uncertainty. In this setting, the PNA chose an investor-friendly policy with the aim of furthering economic growth. This policy was also encouraged by the international community and foreign donors. In particular, the World Bank and the International Monetary Fund (IMF) were influential in pushing for an export-oriented, private-sector-led market economy (PNA, 1996).

The private sector was dominated by small, family-owned farms and enterprises and peasant agriculture. Many of the larger private firms, including some monopolies, were owned or managed by high-ranking public officials (PLC, 1997; CPRS, 1998). Some of the larger companies were fully or partially owned by the PNA. These included, for instance, the Petroleum Public Commission, the Tobacco Commission, the Radio and Television Commission, and the Palestinian National Company for Economic Development (Nasr, 2004). Private-sector job creation, however, was disappointing despite the growth-oriented policies adopted during the period 1994-2000. As a result the tax base did not expand significantly.

At the same time, the public sector expanded rapidly. Total public expenditures accounted for more than 27 per cent of GDP in 1999, compared to 14.7 per cent when the PNA was established (Fischer et al., 2001: 256). This expansion was mainly due to an almost fourfold increase in public sector employees, including security forces (from 31,140 in 1994 to approximately 110,000 in mid-2000), and an expansion of social services in health and education. This reflects that the PNA used public office holding as a reward for political and personal loyalty, and as a mechanism of incorporation and stabilisation of the regime (Hilal and Khan, 2004). The growth in public sector employment had to slow down by the end of the 1990s, partly because of financial constraints, but also due to increasing criticisms of inefficient, overstaffed government departments. Nevertheless, by end-1999, about 19 per 4 cent of all employed persons in the WBGS were on the PNA’s payroll (including education, health and security forces).4 Fiscal policy and revenue clearance with Israel The ratio of Palestinian fiscal revenue to GDP was estimated at 23.4 per cent in 1999, which compares well with countries at a similar level of development (Fischer et al., 2001: 272).5 Table 1 provides an overview of the composition of fiscal revenue in Palestine during the period 1995-1999. The major tax bases were personal and corporate income taxes (8.2 per cent of total tax revenue in 1999), indirect taxes on domestic goods and services (47.7 per cent) and taxes on international transactions (30.3 per cent). Furthermore, various types of fees and charges were collected. While Value Added Tax (VAT) and other indirect taxes on domestic goods and services still accounted for almost half of the total tax revenue, their share dropped substantially during the late 1990s. In 1995, they accounted for about 66 per cent of total revenue. During the same period, revenue from customs duties and taxes on imported goods increased from about 6 per cent of total revenue in 1995 to approximately 30 per cent in 1999. Income tax revenue remained fairly stable at around 8-9 per cent of total fiscal revenue during the period 1996-99.

TABLE 1 IN ABOUT HERE

4 According to Nasr (2004), the public sector wage bill amounted to more than 12 per cent of GDP in 1999.

5 The figure is, however, higher than the average for Arab countries. In 1995, tax revenue as a percentage of GNP for Egypt was 26.3 per cent, for Yemen 13 per cent, Morocco 23 per cent, Syria 17.8 per cent, Jordan 20.4 per cent, Tunisia 21 per cent, and Lebanon 10.8 per cent. All these countries had lower GDP figures than the PNA due to their dependence on migrant remittances (World Bank, 1997: 258-59).

5 The PNA’s fiscal operations in the period 1994-2000 were to a large extent governed by the principles of the Paris Protocol (PP), signed in 1994. This Protocol of Economic Relations between the Government of the State of Israel and the PLO, Representing the Palestinian People limited the role of the PNA in designing its own fiscal and trade regimes.6 In the area of tax administration, the PP provided a revenue clearance system, according to which Israel collected and transferred to the PNA taxes and customs duties imposed on Palestinian imports from or via Israel, in addition to the income taxes from wages of Palestinians working in Israel.



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