Armed conflict and its aftermath have wide-ranging economic consequences. At the macro-level, armed conflict is associated with lower growth rate, higher inflation, and reduced tax revenues and investment. These can trigger macroeconomic instability. At the local level, conflicts disrupt labour markets and can lead to increased unemployment due to displacement. Conflict can also destroy physical infrastructure and buildings including health institutions and schools.
Apart from the growth, infrastructure and institutional costs, conflict also strains government's fiscal resources. Revenue decreases due to both a decline in the value of the tax base and the reduced capacity and access to collect revenue. This constrained revenue is met by the drastically increased need for spending both during and after the conflict. During conflict, defence spending diverts resources away from social and economic development spending while recovery and reconstruction spending characterises the post-conflict fiscal space. Efficiently using scarce fiscal resources is therefore paramount for ensuring quick economic recovery.
The fiscal impact of the conflict in Ethiopia
In November 2020, armed conflict broke out in the Tigray region of Ethiopia and this has since extended to the neighbouring regions of Afar and Amhara encompassing significant parts of the north and eastern parts of the country. The conflict has resulted in a large death toll as well as extensive social and economic damage. Damage and economic loss estimates made jointly by the government and World Bank reached US$ 28 billion with needs of approximately US$ 19 billion (almost 130% of annual government budget). In November 2022, a peace agreement was signed between the federal government and the Tigray People Liberation Front ushering in a period of humanitarian support, rehabilitation, and recovery. The fiscal implications of this recovery and reconstruction are big.
Figure 1: Tax revenue and fiscal deficit as a percentage of GDP
Notes: Since reaching a peak of 13% in 2015, real tax revenue as a share of GDP has been on a decline, but this decline accelerated even further since the onset of the conflict in 2020. Concurrently, the deficit as a proportion of GDP also experienced a sharp increase mirroring this trend at the start of the conflict. Source: Ministry of Finance
Conflict has had a negative impact on fiscal space in Ethiopia. Although not conclusively established through causal analysis, it is quite likely that tax collection capacity reduced because of the conflict. Real tax revenue and tax revenue as a share of GDP declined partly due to the conflict from a high of 13% in 2015 to 7.2% in 2022. The decrease in revenue occurred in almost all categories of tax revenue implying the broad-based nature of the effect. The conflict resulted in a reduction in the availability of external loans and grants used to finance the deficit, leading to reliance on the issuance of treasury bills and direct advances from the National Bank of Ethiopia. This reliance in turn exerts inflationary pressure on the economy. Limited resources are available for the needed spending on recovery and reconstruction. Given this context, there is an urgent need for innovative revenue mobilisation and the efficient use of limited resources to accelerate recovery and reconstruction.
Figure 2: Deficit financing sources as a percentage of GDP
Notes: External deficit financing sources as a percentage of GDP experienced a sharp decline, which was mirrored by a corresponding increase in domestic debt financing. Source: Ministry of Finance
Post-conflict experience in widening fiscal space
Restoring fiscal resources in other post-conflict contexts has not been straightforward. In most cases, recovery of revenues only comes close to pre-conflict levels. Based on an analysis of tax data for 14 episodes and similar analysis of fiscal data for 12 post-conflict episodes, . in most cases, revenue recovery only reaches levels close to those observed before the conflicts. That recovery, and the so-called peace dividend, is quite idiosyncratic. Given that post-conflict capacity is usually constrained, tax reforms were frequently administrative in nature (for example, customs strengthening Mozambique) rather than major tax overhauls. One of the explanations may be that if the government focuses on immediate higher tax revenues, tensions underlying conflict could be exacerbated.
In general, the best approach to post-conflict taxation policy involves prioritising longer-term strengthening. This entails modernising revenue administration to capitalise on the benefits of digitisation and improving efficiency through effective tax enforcement, thus avoiding the need to increase tax rates or introduce new taxes. However, the impact may not be as immediate as wished. In a post-conflict setting, sustained tax revenue increases from reforms often took ten years as demonstrated in Liberia.
Exploring transformative opportunities in post-conflict resource mobilisation
Nonetheless, considering the importance of domestic resource mobilisation to a successful recovery effort, it is important to explore ‘windows of opportunity’ for more transformative impact. Examples of using the post-conflict setting as ‘windows of opportunity’ include Nepal and Peru which focused on modernising administration and reaped unprecedented revenue gains. Given the temporary nature of some reconstruction expenditures, efforts can be made to match these with temporary increases in fiscal resources. One approach is implementing temporary taxes with clearly defined expiration dates. For example, Solomon Islands introduced a targeted amnesty, relieving taxpayers who voluntarily disclosed underreporting from penalties, and placed a greater focus on arrears collection (1% of GDP).
Another example of a revenue-generating measure with short-term impact is the acceleration of planned programmes of asset divestiture. One major asset class relates to natural resource extraction. However, caution must be exercised as the sub-regional location of resources has the potential to exacerbate conflict. An example where rules governing the sharing of natural resource rents contributed to peace is in the Aceh region of Indonesia. Local authorities were given 70% of hydrocarbon deposits revenue as part of the peace agreement.
Some experiences show that implementing steep tax increases particularly in productive sectors like agriculture (or agricultural exports), can hinder the recovery of these sectors. Alternatively, other options include increasing tax rates on taxes with a high point of concentration such as imports or large taxpayers. This could yield quick returns depending on the threshold effects of tax increases. Additionally, another option is to introduce additional levies on natural resources, banking, and telecommunication services.
Strategies for Ethiopia's economic recovery
Ethiopia can learn from such experiences and use this opportunity to undertake tax reforms that are easier and more manageable to implement. The government has been actively introducing various tax reform measures through a three-year reform programme. Revisions in excise tax, VAT, and most recently property taxes are notable examples. Furthermore, the government has overhauled and revamped the tax expenditure administration to tighten and target incentives. Prompt implementation of these reforms is, hence, essential to increase domestic resource mobilisation to match the desired pace of recovery and reconstruction.
Another relevant option is the sale of assets as the government has already embarked on reforming state-owned enterprises – the recent announcement in the telecommunications sector is an apt illustration of this. Ethiopia has already established Ethiopia Investment Holdings (EIH) as the basis for a Public Wealth Fund. Resource mobilisation does not have to be limited to divestiture of SOEs but can also encompass dividends or the sale of unexploited assets within commercially managed SOEs. Ethiopia also has considerable scope for selling rights to resource extraction (more promising compared with exporting the commodity or taxing profits of firms with auctions usually being the best method). However, in the early post-conflict years, it might be advisable to not sell rights for a long-term horizon. This is because the discounts associated with post-conflict uncertainty can result in bids of only a small fraction of their eventual worth.
Another potential source of revenue can be mobilising resources from the diaspora, building on the strong support the diaspora provided during the war. Identifying ways to restore aid flows in alignment with recovery priorities as this will play an important role in resource mobilisation. Resorting to inflationary financing by borrowing from the National Bank of Ethiopia should be considered a last resort as it can simultaneously diminish the real value of resources mobilised.
Just as the demands of a post-conflict setting call for renewed focus on revenue mobilisation, they likewise present an opportunity to consolidate other expenditures that may have become lower priorities. Public expenditure needs to be leveraged to yield maximum value that accelerates recovery and restores productive capacities. This requires careful budget design and reallocation of resources to more impactful projects. The increased emphasis that the Home-Grown Economic Reform Programme placed on a greater role for the private sector is equally relevant in designing a recovery and reconstruction package. For example, expanding the role for private sector employment can be an effective way to reduce the strain on livelihoods from those affected by the conflict. While Ethiopia faces significant challenges in fiscal resources, the options highlighted by other post-conflict experiences hopefully provide some guidance.