The Limits of the Oil Rent in Kuwait

In this essay Abdulaziz Al-Mossalem looks at the current state of oil rent in Kuwait.  The IMF has revealed that Kuwait could be headed towards deficit spending by 2017 if things continue along their current path.  Abdulaziz argues that the current relationship between the ruling authority and the people could be prohibitive to the implementation of a tax system.  Only when the ruling authority is seen to be responsible and transparent can such a move be considered.

By Abdulaziz Al-Mossalem, 5th June 2013.

The recent International Monetary Fund consultation by Kuwait revealed that total state expenditure could exhaust all oil revenues by 2017.[1]  The IMF suggested that the state should start to increase its capital expenditure, to cushion the expected deficit spending and even endorsed the introduction of a tax system.  In Kuwait and the rest of the Arab Gulf states there is no income or value added tax; actually the opposite is the case where bonuses from the state are granted to the citizens in addition to the subsidizing of the essential consumer goods.  I will analyse the two recommendations.  I argue that while the increase in capital expenditure is possible but difficult, the introduction of an income tax in the present amounts to no less than the political suicide of the ruling authority.

The Sovereign Wealth Fund

In writing about the “Keynesian accounting equality” i.e. of savings equalling investment, Hazem El-Beblawi argues that the Arab SWFs have not been properly utilizing their savings.  He explains that real investments (as opposed to nominal) are a safer option for these funds to engage in.  He adds that if the funds turn their attention to the less developed countries (LDCs) there will be the opportunity to expand on real investments.[2]  The reason why focusing on the LDCs is needed is because the current nominal investments in the developed countries have a weak inflation hedge, while the LDCs would require real (capital good) investments with a stronger inflation hedge.[3]

Investment vs. Placement

El-Beblawi highlights the distinction between investment (real investment) and placement (nominal investment) for the SWF.  He explains that what has been realized by the Arab SWFs is a focus on placement instead of investment.[4]  With investment, finance is used to add to the capital goods of the economy.  This would result in the holding of the means for increased production in the state.

Placement on the other hand adds to the financial assets of the state, but has nothing to do with increasing the productive capacity of the economy.  An example of placement would be the obtaining of debt instruments by the fund.  The issue here is that the capital goods, because of their productive purpose and tangible nature, are less vulnerable to the fluctuations of the financial market in comparison to the non-tangible financial assets.  El-Beblawi concludes that

Increasing financial assets without corresponding increases in real investment contributed to the emergence of inflation in the late 1970’s and early 1980’s, and eventually the collapse of the financial markets in 2008.

The accounting equality of saving equalling investments, for the Arab SWFs savings, was satisfied primarily by the increase in financial assets in the developed countries and not the capital goods.[5]  Due to this vulnerability to fluctuations in the financial markets, the KIA has had its savings eroded in the past (see figure 1 at end of paper).  The most recent effect was between March and December of 2008 where the KIA reported a loss of more than 30 billion dollars of its total asset worth.[6]

To safeguard against the vulnerability of placement, what the Arab SWF can do is focus on investment in capital goods.  This cannot be significantly accomplished in the developed world as an increase in available real investments would require an increase in the domestic demand structure, which is not captive in the developed world.[7]  The same cannot be said for the developing world where captive markets are more easily identified.  To invest in these developing states, the SWF can utilise the potential for demand to have the savings be paralleled with real investments satisfying the demand.  El-Beblawi however explains that this is easier said than done.  The primary reason being is that the LDCs are “mismanaged, lack skilled labour, and are deficient in infrastructure.”[8]  Yet the current exposure to the fluctuations in the financial markets seems to place much at risk, and so the real investments in the LDCs are perhaps the wiser option.

The KIA – In Need of More Risk Diversity?

Established in 1953 with the surplus oil revenue, the KIA’s mission was to have investment returns reduce the state’s dependency on the oil rent.  Today the KIA’s total assets are worth more than 300 billion dollars, and it is considered one of the largest and oldest SWFs in the world.  The KIA contributes a gross fixed investment that is worth 15% of GDP.[9]  Not much is known about the KIAs share of holdings in companies or the geographic location of these holdings.  This, along with other criteria the KIA failed to satisfy, has resulted in the SWF receiving a 6/10 in the Linaburg-Maduell transparency index.  The reason why the KIA has scored so poorly is because of the SWF’s own laws, which prohibit the disclosure of information to the public.[10]

What we can account for, of the KIA’s 300 billion dollars is a fraction of the total asset value in investments.  The KIAs core holdings for example, in Daimler and BP, are worth 6.6 billion in today’s share price.  The holdings in Europe and the US are managed by the Fund for Future Generations (FFG).  It is one of the two funds controlled by the KIA.  The other fund is the general reserve fund (GRF).  What distinguishes the two funds from each other is that the GRF is the state’s repository for oil revenue.  Of that revenue, by law 25% must be allocated to the FFG annually.  While the FFG manages the investments outside the MENA region, the GRF manages those investments within that region.

The current investment strategy was set up when the managing director of the KIA, Bader Al-Saad, was appointed in 2003.  His first order was to hire a consultant group to review the KIA’s investment strategy.  The consultant group suggested several points, one of which was to diversify risk.  As a result the KIA gradually reduced its asset allocation in the equity investment class from over 70% to just over 50%, while increasing the asset allocation in fixed income and alternative asset classes. (See figure 2)  It is unclear how much of the asset classes the KIA is invested in are Shariah compliant.

The only reason this is relevant is because the total assets of Islamic finance worldwide grew from 250 billion dollars in 2005, to 1.8 trillion dollars today.  In 2008 Al-Saad announced through a local newspaper that the KIA would increase its Sharia compliant investments.[11]  However what this increase amounts to is unclear due to the transparency issues; what is known is that the KIA is a shareholder in a couple of Islamic banks in Kuwait – the Kuwait Finance House and Warba.  According to Asim Ali from the Sovereign Wealth Fund Initiative, “the advancement of Islamic finance among SWFs has been anaemic to date.”[12]  While real investments in the developing world are sufficient to create a good inflation hedge, perhaps the careful inclusion of Islamic finance is the next step.  As one writer explains, it is the “only means of ensuring an economic model of regional development […] will be perpetuated, while maintaining the delicate balance between what is economically effective and morally desirable.”[13]

Introduction of an Income Tax – Unlikely

The IMF consultation has endorsed the GCC wide implementation of a VAT and income tax.[14]  While ideally generating revenue from taxes might seem like the obvious answer to resolving the prospects of deficit spending; the problem with this idea, however, is that it does not give consideration to the relationship between the people and the ruling authority in Kuwait.  This relationship can be described as the political acquiescence from the people towards the ruling authority, in exchange for the distribution of the oil rent.  The distribution of the oil rent has been systemized to grant employees in both private and public sectors a bonus income from the state.[15]

In addition the Kuwaiti household is granted subsidized basic foodstuffs, and is expected to pay a symbolic amount in exchange for its water and electricity consumption every year.  In reality, the ministry of water and electricity is not even pursuing the fees.  A conversation I had with an employee at the ministry revealed that the crushing majority of households have failed to pay their water and electricity bills leaving the outstanding amount in bills to be settled at half a billion dollars by the end of 2012.[16]

Distributing the Oil Rent for Acquiescence

It was perhaps with the rise of Sabah Al-Ahmad, the current Emir of Kuwait, that the distribution of the rent took on a more explicit role.  Significant amounts of money began to be distributed across the state following any real increase in political tension.  After gaining the status of Emir in 2006, one of Sabah’s first orders was to grant every citizen 300 KD (just over 1000 usd).  This decision came about following Sabah increasing his own stipend from 28 million USD annually, to 178 million.  He made the decision to distribute the money to off-set the piling up of the opposition’s ranks that were critical of the increase of his own stipend.  This was not the only time Sabah distributed hard cash across the entire state.  With the advent of the Arab spring, Sabah ordered the distribution of more than 3500 USD to every citizen on February 2011.[17]  Recently parliament passed a law relieving all citizens of their debt’s interest rate prior 2008– this relief cost the state 2.6 billion usd.[18]  There are also rumours circulating of yet another 3500 USD to be spread out following the political turmoil in Kuwait.

Continuing to grant the ruling authority the political acquiescence, without the distribution of the oil rent can perhaps be realized if the ruling authority opted for a more aggressive approach towards the people – which from a constructivist standpoint is unheard of.  In Saudi Arabi for example, no representative body can dare to try and grill the third in line for the kingship.  The history of the ruling families rising to power in the rest of the GCC states witnessed the use of force, creating a stronger divide between the ruling authorities and the people.  In Saudi Arabia’s case, Ibn Saud waged war against five tribal confederacies before declaring himself King in 1932.

In Kuwait, the ruling authority reached its position without the resort to war.  The case can be made that the conflict is limited to within the ruling family (such as Sabah’s struggle with Saad for succession in 2006, and Mubarak’s famous killing of his two brothers in 1899). But the conception of a ruling family armed against the people with the aim of putting them down by force never took shape – a more reconciliatory relationship almost always existed.  This is the reason why the introduction of a tax system would off-set the relatively closer relationship between the people and the ruling authority.  While maintaining stability with the rise of political tension has been responded to with hard cash distributions to alleviate that tension; the thought of imposing an income tax would, by the distribution-stability standards, contribute to the opposition’s ranks.

Members of the Kuwaiti opposition originally wanted to scrap all debt incurred by citizens, but with the opposition’s boycott of the latest elections the current national assembly is perceived by a significant portion of society as the ruling authority’s “yes-men/women.”  This highlights the distinction between the ruling authority and the members of the opposition.  While the former want to utilise the oil rent to keep a stable threshold, the opposition aim to expand the distribution capacity of the state.

Yet not all members of the opposition are resistant to the idea of an income tax.  The socialist opposition for example is in favour of imposing a progressive tax.  That is a tax which increases the higher the individual’s income is.  I recently conducted an interview with Khalid Al-Deyain, who is a member of the socialist opposition in Kuwait.[19]  What Al-Deyain was opposed to was the Value Added Tax (VAT).  He expressed his objection to how the VAT treats the high income earner and the impoverished individual as equals.  The socialist opposition does not have a single member representing them in parliament, and compared to the other candidates be them the tribal service deputies, the liberals or the Islamists; their support base is relatively small.[20]

Would Democratization Help?

Basma Kodmani highlights the need to democratize the wealth funds.  Specifically she talks about the need for a freedom of information law to show where the Arab SWF is making its investments.  More importantly, it would pave the way for public discussion and scrutiny to how the finances are handled.  While many of the Arab states, especially Kuwait, have made progress with regards to freedom of expression and association over the past decade; Kodmani explains how public finance has remained outside the sphere of public scrutiny.[21]  Indeed it was only after the Iraqi invasion of Kuwait, which brought in new faces to the public finance sector after the liberation, that the embezzlement of 1.2 billion usd was discovered.[22]  It must be highlighted this case is what was discovered, what is not discovered will remain as it is so long as investment information is withheld from public oversight.

The embezzlement took place between 1986 and 1992.  A lawsuit was filed against the Kuwait Investment Office’s (London Based KIA office) chairman.  The chairman, Fahad M Al-Sabah who is a member of the ruling family, was accused of setting up various shell companies in cooperation with others based in Spain.  He was accused and found guilty of engaging in fictitious loans and investments.  The new KIO team that was appointed after the liberation of Kuwait took the accused former leader to court – actually several courts. The sheikh who stole the money resided in the Bahamas, KIO was based London and the embezzlement took place in Spain with the stolen funds themselves involved in 19 other states, and so legal action was taken in all these states.  In 2008, 15 years after the embezzlement, the KIO management won the case and was awarded recovery judgment worth 1.1 billion, half of which has been actually recovered so far.

Another case which was discovered, were the procedural abuses made by Ali Al-Khalifa al Sabah, the Finance minister during the Iraqi invasion.  The abuses were pointed out by the minister of oil in a report in 2001 (ten years after the liberation of Kuwait).[23]  The report revealed that the Kuwait Oil Tanker Company was suspected to have embezzled, through false transactions, 200 million usd.  The former minister was not found guilty of embezzlement however due to the lack of evidence – yet this ruling was publicly received with significant criticism.  The reason being is that Ali Al-Khalifa was perceived to have had a humble financial background prior to the concerned transactions, but appeared to have gained significant wealth after the liberation of Kuwait.[24]

In both cases the abuses were only pointed out after a new management team took over the office.  The public could have remained ignorant of these abuses if the new management decided remain silent.  For this reason, the democratization of public finance, in this case the improvement of the KIA ranking on the Linaburg-Maduell transparency index, would certainly add an extra reason for the person in charge to abide by the procedural process.  In this regard, when I asked Al-Deyain why more democracy is needed in Kuwait he said “it would help force the sheikh in charge to separate his proud status as sheikh from the duty assigned to him.  As sheikh he is surrounded by yes-men, and if he is left without public scrutiny, he will merge his complacent environment with whatever public office he holds – this results in procedural abuses.”[25]

What about the Tax System?

Giacomo Luciani explains that whenever the state needs to tax its citizenry, the issue of democratization comes up.[26]  If a tax is imposed there would be less political acquiescence and a greater demand for holding public figures accountable.  This is captured in the slogan “there is no taxation without representation.”  If the state does decide to introduce a tax system, the income it accrues from the people will be coupled with the expectation of more public involvement in governance.  This would not be limited to the financial sphere but the overall political environment.

Today the Kuwaiti opposition are already explicitly calling for having a PM from the people, which by law is sanctioned.  It just so happens that the custom in the state had every PM be perceived as the second or third in line for the emirship, hence all were part of the ruling family.  The imposition of a tax would certainly boost the demand for a PM from the people, or perhaps even go further and aim to limit the powers of the Emir himself.[27]

In this regard the perception of the ruling authority by the people plays an important role.  The citizen will ask himself “who is handling the expenses? And can I trust him?”  The former Prime Minister Nasser Al-Mohammed was grilled for his multi-billion dollar spending on trinkets; a leaked document from the State Audit Bureau revealed that Al-Mohammed spent, for example, around a million usd on carpets, cufflinks and watches as gifts to visiting delegations. (See figure 4)[28]

Today the members of the ruling authority are granted a separate income in addition to the distribution of the oil rent the rest of the citizens get.[29]  This financial divide between the people and the ruling authority would not be received well by the tax payer; quite simply the tax payer would perceive the sheikh in charge as someone who would mismanage the state’s tax income because of the lack in transparency, and further solidify the income inequality between the ruling authority and the people.  This would make the imposition of a tax one of the last things the ruling authority would want.  Essentially they would be in a position to choose between being held more accountable in return for the tax paid, or maintaining the status quo which is to have the political acquiescence in return for the wealth distribution.

One way to reconcile the likely resentment the people would feel towards the ruling authority if the tax is imposed is by dropping the added benefits ruling family members enjoy.  These families are not limited in number in the European sense, and do form a significant portion of society.  Having them start off on a level playing field, equal in all aspects to the rest of society, would certainly make the rest of society more open to the option of an income tax being imposed.

Conclusion

The IMF consultation revealed that Kuwait might be headed towards deficit spending in 2017.  I look at the two endorsements the IMF made, which are the increasing of capital investments through the state’s SWF and the possibility of implementing a tax system.  I explain that it is difficult to fully assess the investment approach of the KIA due to transparency issues; however I point out the likely possibility that the KIA was impacted by the fluctuations in the financial markets due to its nominal as opposed to financial investments.

As for the implementing of a tax system I explain how the current relationship between the ruling authority and the people might be resistant to such a move.  I conclude with highlighting the importance of the ruling authority portraying itself as a responsible and transparent manager of the wealth.  It is practically only after such a perception of the ruling authority is made true that the possibility of a tax system being imposed would not lead to public resentment towards the government.