TWN Info Service on WTO and Trade Issues (Dec14/02)
9 December 2014
Third World Network  

Palestine losing $306 million a year in fiscal leakage to Israel
Published in SUNS #7931 dated 5 December 2014
 
Geneva, 4 Dec (Kanaga Raja) -- The Occupied Palestinian Territory (OPT) is losing at least $306 million annually in fiscal leakage to Israel resulting from direct and indirect importing from or through the Israeli market and the evasion of customs duties, a new study by the United Nations Conference on Trade and Development (UNCTAD) has said.
 
The study, titled "Palestinian Fiscal Revenue Leakage to Israel under the Paris Protocol on Economic Relations", finds that the estimated costs to the OPT of this annual lost revenue which is not transferred to the Palestinian treasury by Israel is equivalent to 17 per cent of total tax revenue, in addition to 4 per cent in lost GDP and about 10,000 jobs per year.
 
According to UNCTAD, the study is the first analytical attempt to address this topic by using a statistical methodology based on a sequential series of official data from multiple complementary sources, and it also aims to settle the continuing controversy over fiscal leakage estimates.
 
However, the study did not explore the following points: financial leakage from direct taxes imposed by Israel on the income of the Palestinian labour force working in Israel and Israeli settlements; monetary aspects and losses incurred by use of the dominant Israeli currency; tax evasion through undervaluation in declaration of the actual value of imported goods; fiscal losses on flows of services and goods imported by the Palestinian public sector from Israel such as petroleum, electric power and water; and a range of fiscal losses resulting from the lack of sovereignty over natural resources such as land, water and minerals.
 
The study notes that the Protocol on Economic Relations, also known as the Paris Protocol, was signed in 1994 between the Palestine Liberation Organization and the Government of Israel, and it remains the general framework that governs Palestinian trade relations and economic, business and tax policies.
 
The study focused on the Paris Protocol sections dealing with imports, customs and value added tax (VAT) policies, highlighting its main shortcomings.
 
These stem mainly from the fact that the Protocol is outdated and related to a transitional period that was supposed to end in 1999, UNCTAD said.
 
As a result, it no longer addresses the current challenges before the Palestinian economy or its prospects within an independent Palestinian State; neither does it mention the lack of Israeli commitment to the terms of the Protocol, such as the obligation to transfer to the Palestinian National Authority its full financial entitlements to the collection by the Government of Israel of purchase taxes and customs duties on Palestinian imports cleared through Israeli ports of entry.
 
The study's estimate on fiscal leakage resulting from importing from or through the Israeli market, and the ensuing evasion of customs duties is made on the basis of official Palestinian statistics of total imports from Israel, while customs duties evasion is estimated by identifying relevant percentages and indicators from the available data.
 
According to the study, the analysis shows that fiscal leakage from the aforementioned sources exceeded $310 million in 2011, equivalent to 3.6 per cent of total gross domestic product (GDP) and 18 per cent of the tax revenue of the Palestinian National Authority.
 
Around 40 per cent of the fiscal leakage is related to direct and indirect imports from Israel, and the remaining 60 per cent is in the form of evasion of customs duties.
 
Since 1967 Israel has been the biggest channel for Palestinian imports and exports, and the main trading partner of Palestine. Data show that the share of Palestinian trade (total imports and exports) with Israel was between 70-90 per cent of total Palestinian trade between 2007 and 2011.
 
At the same time, the Palestinian trade deficit with Israel increased from $2.3 billion to $3.2 billion, accounting for 75 per cent of the Palestinian trade deficit.
 
The study addressed the negative effects of the Paris Protocol on the fiscal revenues of the Palestinian National Authority, the manner in which the Israeli authorities apply it and the additional constraints unilaterally imposed by Israel.
 
It focused on fiscal leakage from the revenue flows that the Palestinian treasury should be able to collect from indirect taxes imposed on Palestinian imports.
 
According to the study, total indirect taxes amount to over 85 per cent of total tax revenues of the Palestinian National Authority from two main sources: the first is value added tax (VAT) on all goods including those imported from Israel, and the second is the import tax on goods imported from countries other than Israel.
 
The second source is of utmost importance in terms of its contribution to total revenue, amounting to over 40 per cent of total indirect taxes; this figure could rise should imports from Israel be replaced with direct imports from other countries.
 
The study argues that the Palestinian treasury has been deprived of many of its legitimate financial resources under the Protocol and has been suffering repeated suspensions and delays in transferring clearance revenues for political reasons.
 
It noted that various studies have shed light on the negative effects on the Palestinian economy due to the instability, uncertainty and the loss of portions of the fiscal revenues that leak to Israel.
 
Citing previous UNCTAD reports, the study said that the Palestinian National Authority continued its long-term efforts since 2008 to reduce the budget deficit, achieve financial sustainability and reduce dependence on donor aid. These efforts were implemented in an unfavourable environment characterized by declining aid, falling development expenditures and internal political divisions.
 
Despite serious efforts by the Palestinian National Authority, the budget deficit continued, and the overall fiscal situation deteriorated as tax revenues failed to increase sufficiently to catch up with expenditures while donor funding remained below expectations.
 
According to the study, the Palestinian National Authority's fiscal reform succeeded in narrowing the budget deficit by about 11 per cent between 1999 and 2011 to reach 12.4 per cent of GDP.
 
During the same period, the revenue of the Palestinian National Authority rose from $1.8 billion to $2.2 billion but remained below projections, owing to well-below-potential GDP growth in the West Bank and revenue- neutral GDP growth in Gaza.
 
Total current transfers to the Occupied Palestinian Territory - mostly donor funds - reached $2.4 billion in 2011, 27 per cent less than the previous two years. Budget support stood at $980 million, which was half a billion dollars less than the external budget support needs of the Palestinian National Authority for that year.
 
"This forced the Palestinian National Authority to borrow from local banks and accumulate arrears to private sector contractors and the pension fund. While the arrears grew to $540 million, debt to local banks increased $140 million to reach $1.1 billion - 50 per cent of total revenues - by the end of 2011."
 
In May and November 2011, Israel suspended Palestinian clearance revenues, as it had done in 2002 and 2006, the study noted.
 
"Despite the eventual release of the revenues, this practice undermines the economic and financial stability of the Palestinian National Authority, especially since public expenditure is a key source of economic growth and clearance revenues constitute 70 per cent of total revenue."
 
Another key element of the Palestinian fiscal crisis is the extremely low development expenditure, which was only $215 million (or 3.4 per cent of GDP) in 2008.
 
Expenditures on development expanded slightly in 2011 to reach $368 million, or 4.2 per cent of GDP. The long- term costs of consistently low expenditures on development are high in light of the multiple constraints and weakened Palestinian production base.
 
The taxation system and trade regime enshrined in the Paris Protocol impose losses through the leakage of resources to Israel and lack of sovereignty in collecting taxes and generating accurate taxation data to enhance revenue collection, said UNCTAD.
 
The Palestinian Ministry of National Economy estimates that the economic cost resulting from occupation, in terms of foregone GDP, was as high as $6.9 billion in 2010, or about 82 per cent of GDP. Had it not suffered this loss, the Palestinian National Authority's fiscal situation would have been sound, and abundant resources for development would have been available.
 
UNCTAD cited another study by the World Bank which stressed that re-exporting goods to the Palestinian market had negative effects on the Palestinian treasury and on prices in the Palestinian market.
 
According to World Bank estimates, one third of imports from Israel are "indirect imports" of goods produced in a third country. The fiscal leakage resulting from the trade relation was estimated at $133 million annually, equivalent to about 3.2 per cent of GDP, but this also does not include smuggling.
 
A Bank of Israel report shows that Palestinian indirect imports through the Israeli commercial sector was at least 58 per cent of the total transactions reported as exports to the Palestinian National Authority from Israel in 2008, or 38 per cent if petroleum and energy exports are excluded.
 
The study emphasised that the main cause of fiscal leakage is the nature of the economic relationship resulting from the structure of the Protocol and the clearance system with all its constricting conditions.
 
The principal sources of fiscal leakage are as follows:
 
(1) Fiscal leakage from the VAT collection system within the framework of the customs union. The transfer of VAT revenues to the Palestinian National Authority is conditional on a clearance bill that is recognized as proof of transaction. However, this mechanism has a number of shortcomings, resulting in sustained losses in Palestinian tax revenues.
 
These losses were mainly the result of smuggling and tax evasion, such as:
 
* Non-submission of clearance bills to the Palestinian tax offices. This is motivated by withholding information and tax evasion whereby VAT on invoices from purchases from Israel is paid to the Israeli merchant who in turn pays it to the Israeli treasury, and revenues are not transferred to the Palestinian treasury through clearance. The Ministry of Finance estimates the cost of VAT evasion at around $17 million.
 
However, said the study, the Ministry of Finance estimates are well below those of the IMF, which indicates that the proportion of Palestinian bills not submitted ranges between 30 and 70 per cent.
 
* Forgery and manipulation of clearance bills. As indicated by staff from the Palestinian Ministry of Finance, this includes printing fraudulent clearance bills that are not acknowledged by the Government. These bills are then used between merchants and they cannot be submitted at the clearance sessions.
 
Clearance bills of fake transactions are sold to an Israeli counterpart in return for a percentage that varies between 3 and 7 per cent in order to deduct the value of items listed in the fake transaction bills from the VAT.
 
Therefore, the Israeli merchant who buys the bill benefits because the deduction becomes large, and the merchant benefits by obtaining cash without any actual transaction having taken place.
 
The Palestinian treasury loses part of the VAT because Israel does not pay the tax of those bills to the Palestinian National Authority. The Palestinian National Authority losses are in the range of about $7 million annually from this type of manipulation.
 
* Tax and evasion of customs duties. This entails the movement of goods from the Israeli market and settlements to the Palestinian market without any documentation, which results in purchase tax and VAT losses.
 
Officials and experts from the Ministry of Finance estimate that more than 30 per cent of goods enter the Palestinian market without clearance bills, since the borders between the West Bank and Israel are porous, and trade between the two sides is carried out under the terms of the customs union.
 
(2) Leakage from indirect imports. Indirect imports result in the entry of products of non-Israeli origin to the Palestinian market as if they were produced in Israel, or Israeli goods that do not meet the rules of origin to qualify as Israeli exports. Indirect imports are goods imported by an Israeli shipper. Customs duties on them are paid to the Israeli treasury, and they are re-exported to the Palestinian market.
 
According to the Paris Protocol, since such goods are perceived to be made in Israel, they enter the Occupied Palestinian Territory duty-free. Since trade taxes constitute a significant part of Palestinian revenues, this results in the loss of access to legitimate fiscal resources by the Palestinian National Authority, but with a number of other serious adverse effects on the Palestinian economy.
 
The UNCTAD study underlined that regardless of the manner in which it takes place, indirect imports cause fiscal leakage and much wider economic losses. Depriving the Palestinian National Authority of revenues due to it from this type of importing increases its financial difficulties and limits the scope of fiscal and trade policies at the disposal of decision-makers.
 
According to the study, fiscal leakage resulting from importing from the Israeli market (this does not include smuggling) reached an annual average of $115 million in 2010 and 2011, including the foregone VAT, customs duties and purchase tax.
 
Average leakage from indirect imports is valued at about $46 million; leakage as a result of the Palestinian National Authority not receiving all its dues from collected purchase taxes and VAT was about $70 million.
 
The average annual fiscal leakage resulting from smuggling in 2010 and 2011 (goods smuggled from the Israeli market regardless of its origin) can be estimated at around $190 million.
 
One third of this fiscal leakage is due to loss of revenues from import taxes, and the other two thirds are the result of losing revenues of the VAT that could have been collected from these goods.
 
The total annual average fiscal leakage resulting from customs duties evasion and direct and indirect importing for the years 2010-2011 is estimated to be around $306 million. This represents around 3.6 per cent of GDP and more than 17 per cent of the tax revenues collected by the Palestinian National Authority in one year.
 
To evaluate the costs of the fiscal leakage, the study said the macro-econometric model developed by UNCTAD of the Palestinian economy was simulated to assess economic performance under alternative scenarios that assume that the leakage did not occur and the leaked resources were instead available to the Palestinian National Authority to finance, for example, either transfer payments to the poorest or an export promotion programme.
 
Three alternative scenarios were simulated:
 
* The baseline scenario reflects economic performance under the present conditions using actual historical data, including fiscal leakage;
 
* The transfer payment scenario also uses historical data, but assumes no fiscal leakage and hence an increase in tax revenue (17 per cent) equivalent to the estimated leakage, which is used to increase expenditure on transfer payments;
 
* The export promotion scenario is similar to the second scenario, but assumes that the increase in revenue is allocated to promote Palestinian exports.
 
According to the study, results show that capturing the leaked revenue would expand the fiscal policy space available to Palestinian policymakers and facilitate fiscal stimulus.
 
While the transfer scenario would increase real GDP in 2004 dollars by about $205 million (3 per cent) above the baseline in 2012, the export promotion scenario would increase GDP by $280 million (4 per cent).
 
As for the impact on employment, the transfer and export promotion scenarios would increase employment over the baseline scenario by 3,300 and 9,200 jobs respectively.
 
The estimated costs to the Occupied Palestinian Territory of the $306 million leaked annually to Israel is equivalent to 17 per cent of total tax revenue, in addition to 4 per cent in lost GDP and about 10,000 jobs per year. The analysis also shows that these costs are compounded over time as the economy grows.
 
UNCTAD however cautioned that the estimated fiscal leakage in this study is modest and conservative, given that the research did not take into account total accumulating economic losses resulting from many other channels of fiscal leakage that are not covered by this study.
 
Second, said the study, it would be necessary to carry out additional studies covering all sources of Palestinian fiscal leakage.
 
Third, the economic cost of the estimated fiscal leakage in this study is modest, considering the structural deformity of the Palestinian economy and its limited capacity to create highly productive job opportunities because of restrictive policies under prolonged occupation and the forced erosion of the Palestinian productive base.
 
"As a result, the economy is forced to increase imports when new fiscal and/or economic resources are available."
 
The study said that there is an urgent need to make fundamental changes in the structure of the Palestinian trade system under the Paris Protocol.
 
"This system, which has endured for two decades, has not allowed the Palestinian economy to achieve tangible or sustainable development; it has actually prevented such development. This is mainly due to Israel's lack of commitment in applying the terms of the Protocol, as well as the shortcomings of some provisions relating to trade, taxation and monetary policies."
 
The study suggests a number of recommendations pointing to the pressing need to change the modus operandi of the Palestinian import regime to ensure Palestinian rights in all economic, trade, financial and taxation areas.
 
This will require new trade arrangements that cover borders, customs and a tax collection mechanism to prevent fiscal leakage to Israel.
 
With regard to indirect imports, information should be exchanged regularly between the Palestinian and Israeli authorities, customs and monitoring systems should be developed and the Government of Israel should acknowledge Palestinian financial entitlements to purchase taxes on goods made in Israel and sold on the Palestinian market and to the customs duties and purchase tax revenue collected on products indirectly imported through Israel, said the study. +