June 2022, No. 100

Trade & Business

New Budget Focuses on Domestic Led Growth

Iran needs to aim at higher economic growth and conjunct sustainable development. The challenge is the how.

Problematic Context

The impact of unilateral sanctions in 2018, COVID-19 in 2020 and significant forex devaluation have adversely affected the economy and sustainable development trends in Iran - over 100,000 deaths due to COVID, strains on the health care system, and increased structural challenges (raised unemployment, reduced labour participation, lowered GDP growth, raised inflation and high wealth inequality). This has significantly worsened conditions for vulnerable populations: with an 85 million population, more than half are now under a relative (composite) poverty threshold², including possibly: circa 12 million unskilled/semi-skilled workers; 2.5 million small holder farmer households in rural areas; 3.5 million female headed households; 8.5 million elderly people; 1.2 million people living with disabilities; etc..

Mohammad Ali Farzin (Ph.D. Development Economics)1

Sanctions have also reduced total non-oil trade. In 2020 it fell to $70 billion; although last year 1400 (March 2021 – March 2022) it had picked up again – by 40% to $101 billion³ – of which: imports $53 billion and exports $49 billion; with China trade taking 20% of all; and total trade with neighbours standing at $52 billion. Quite apparent that trade solutions are being found. The sanctions also limited technology transfer and foreign direct investment – and increased investment uncertainty domestically.

Investment has remained problematic over the last decade; national savings increasingly being invested in non-manufacturing fixed assets with higher capital gains and non-competitive returns (e.g. due to currency devaluation which raises asset prices); rather than in productive value added returns that require more innovation and competition (and proper cost benefit calculations).  Although it is estimated that two thirds of Iranians are owners of some form of assets, wealth inequality remains very high. Added to the wealth shift dynamics, is the liquidity and money supply issue, plus accompanying high money multipliers; overall liquidity now probably at circa 150% of nominal GDP.

Iran has, subsequently, increasingly faced “rent economy” dynamics, jobless growth processes, low productivity and high inflation (i.e. non-inclusive and non-sustainable outcomes normally due to stagflation). Currently, therefore, the recovery of the economy seems K-shaped – benefits going more towards the richer groupings. However, the overall economy seems to be moving towards more appropriate investments: currently, nominal GDP is circa 35,000 Trillion Rials⁴ (hereinafter TR); while between 2019 and 2020 the consumption component of GDP declined by 1% (from 61% to 60% - both Government and private – and despite so much cash and credit injections), the investment component rose by 5% (from 22% to 27%), and mostly coming from construction activity (rather than machinery). The latter well indicating the push towards construction which started after sanctions in 2018. With investment picking, machinery and equipment activity (and trade) will also be rising.

Government Response and Remaining Challenges

The crisis has prompted Government to increase relief measures for vulnerable groups; more cash transfers to households and firms; and social support in national Budget towards health, social protection and employment support increasing significantly. While much effort is focused on cash transfers to the lower income groups, a large part of the state corporate sector (which, de facto, is heavily involved in 70% of the economy, but only with 20% of the employment) has also been provided support. Adjustment measures have also been initiated: reducing reliance on oil/gas revenues; raising taxes; redirecting investments towards productivity improvement and employment generation; and with increasing focus on young population dividend and measures for compensating the ageing trend; etc..

There is now also general agreement that Iran needs to aim at higher economic growth and conjunct sustainable development. The challenge is the how.

Focus on improved manufacturing sector investment to prompt growth and productive jobs has been targeted as the main solution for Iran. The share of broad manufacturing/construction in GDP and employment (circa 35% and 27% respectively) has hardly changed over the last decade, and the decision by Government for selecting the specific driver of construction and infrastructure (especially the capital expenditure on the 1 million housing initiative) will be changing these proportions. Construction is expected to stimulate over 500 lines of manufacturing, work and skills; and to raise factory floor equipment and materials requirements, with own knock-on effects on both capacity use and trade.

The new 1401 Budget, which is more of a “heterodox” structural adjustment type approach for improved revenue performance (raising taxes from a low of 5% to above 15% of GDP), is pushing for capital expenditure support to construction. A target of 1 million houses per annum, possibly costing more than 5,000 TR annually, has been set; and depending on effective implementation, appropriate building methods and finance, will probably generate significant real GDP growth annually. It would start a cycle of manufacturing investment and growth that will have significant further synergies and dynamic multipliers, resulting in employment generation for up to three years – that is, if the 1 million housing approach is sustained for the four years, up to eight years of employment generation may occur (of course, given no adverse exogenous impacts). How sustainable this approach will be remains controversial.

The services and trade sector will also be prompted, especially given the young population, covering hospitality, food and beverages – and as brand and customer centricity are increasingly becoming important here with youngsters. More businesses in the growing start-ups service sector, including innovation hubs and technology based manufacturing and services is indicative – and is part of this ongoing effort by Government. This latter would need further “networking” type dynamics support – if to succeed.

There are many programming challenges, nevertheless, for meeting such domestic objectives. For the construction component, they include: finance, private sector involvement, cheap cost building methods, bank credits, high interest rates, high cost of capital, manufacturing response capacity, partnership possibilities, speculation, distorted asset incentives, rent-seeking, further devaluation, sanctions, and etc. which will all constrain and challenge this driver objective. 

For employment and manufacturing: labour force skills and productivity and innovation remain low⁵; less than 50% of Iran’s workforce has formal (educated and skill) training; labour participation rates, particularly for women, have fallen over the last two to three years; the actual unemployment and underemployment rate is high in both rural and urban areas; a third of the workforce is probably somehow involved in the informal sector (to make ends meet); recovery in employment is below the levels of pre-sanctions and pre-Covid period (according to SCI, employment in mid 2021 was 1.5 million less compared to that of 2019); manufacturing and services need structural change and integration in their value chains (as well as resolution of import dependency issues); a real focus on Micro and SME sector is needed for both higher productivity and employment; compensating social support measures are required to complement the supply sided investment initiative; social support require more in terms of scale and proportion (and smartness) – and hence the recent directive by the Leader for improved social security and support frameworks.

On environment and material footprint issues there will also be adverse outcomes; and the trade-offs are still not clear. With Iran already having a high material footprint of circa 1.2 billion tonnes material usage (and indicating over usage of material resources and intermediates – latter growing at more than 10% annually) the investment push will raise industrial throughput of materials and intermediates to much higher levels. A further problem down the line, once this starts, will be the falling rate of return on investment (which can’t be resolved through forex devaluation again).

Iran has, subsequently, increasingly faced “rent economy” dynamics, jobless growth processes, low productivity and high inflation

New Economic Development Approach

On the development planning and budget allocation side, more focused area-based development approaches (or, as locally termed, spatial planning approaches) will address integrated SME, livelihoods, infrastructure and natural resource development. The Government’s 6^th Development Plan, the Resilient Economy policy and Leap in Production approach have attempted to instill 1) more regional based development approaches, 2) inclusive growth approaches that combine economic growth with employment and social support, 3) construction as driver for prompting manufacturing sector investment and growth and 4) a restructuring of the natural resources architecture (as the recent proposals for new mergers well indicates).

Recent actions undertaken for the 7th Plan and the 1401 (2022) Budget indicate more targeting through geographical (spatial) based measures, micro, small and medium MSME enterprise development and construction projects. The Vice President and Head of Plan and Budget Organization, Dr Mir-Kazemi, at a meeting in November 2021 with the Majlis Industries and Mines Commission, indicated that balanced development should be based on spatial planning and management: as an appropriate approach for both medium term planning and annual budget allocation processes. He indicated focus on geographical areas such as provinces, districts and cities for achieving budgetary objectives; also border areas, which have significant trade opportunities.

Given the prevailing inappropriate development planning and fiscal space context, with significant room for improvement, as well as the need for real belief in sustainable development “smart” programming approaches, the need for effective planning and resource allocation to improve macro indicators, productivity and people's lives is apparent. Despite having spent large amounts on the development of infrastructure, macro-economic indicators in Iran remain below par: partly due to mis-directed allocations and investment; with more than required hardware-oriented capacity has been invested in some sectors with minimal value added generation; previous focus on heavy industry approaches which can’t easily be changed or restructured; and requiring a new development governance perspective.

The new approach (as, for example, in the 1401 Budget) seems to be responding to this and is restructuring allocations and fiscal space: an economic growth focus along with social support concern;  directed to create jobs;  targeting proportions of economic growth for agriculture, industry, construction, services, transportation and other sectors; and seemingly trying to remove obstacles and raise competitive opportunities. Increasing investment in agriculture and rural infrastructure, more social sector push, improved access issues in health, education and protection, more cash transfers, more public works schemes in rural areas, more guaranteed procurement schemes for the poor and micro enterprises, etc. – are on the programme. The total Government Budget is set at circa 15,000 TR (of which 13,000 TR is core and requiring revenue targeting). The two Clauses that directly support households, firms, employment and growth (from both the demand side and supply side), that is Clause 14 and 18 of the Budget, account for circa half of this total amount. All these together may create the demand necessary for the economy to grow through the supply sided construction drive.

The previous 1400 (March 2021 – March 2022) Budget performance results are also out and indicate revenue performance that only met 79% of target, of which: the tax (and tariffs) revenue result was more than expected (at 114% performance; more likely due to the VAT component, which automatically rises during inflation); while physical and financial asset sales (oil, gas, property, bonds, shares etc.) revenue was below 50% of target, indicating possible unwillingness to sell physical property, lower oil/gas sales than expected and weak capital markets. The new 1401 (March 2022 – March 2023) Budget recently ratified by Majlis has a total revenue and expenditure target of 13,070 TR, of which: current revenue is set at 6,600 TR (tax component at 5,000 TR) and current expenditure 9,600 TR. This latter is a significant current deficit, if expenditure targets are to be met. The physical and financial based revenues are set at 7,000 TR and expenditure at 4,000 TR (with a surplus - to be used to pay off the current deficit). The Ministry budgets have increased circa 50% on average – to about 3,500 TR. The Clause 14 component – that is, subsidies paid from energy based revenues – are up significantly to 6,000 TR (from 3,700 TR last year!).

Certainly, large scale; at about 40% of current GDP; nominally an expansionary budget, and probably inflationary; while social expenditure support is circa 50% of budget. Given the composite and complicated nature of such a fiscal adjustment instrument, it is difficult to specify exactly the nature and outcome. However, the below may be indicative:

• The President is targeting 8% real GDP growth; with over 2,500 TR direct capital investments foreseen in the Budget (doubled from last year; and mostly construction related). Given high multipliers, this component will be quite expansionary.

• An overall 9.5% rise in the nominal Budget, while inflation is now 45%; along with a clause disallowing borrowing from Central Bank; along with large scale bond sales foreseen. This aspect is possibly relatively pro inflation reduction.

• On the money side: the dollar rate seemingly set at 230,000 Rials/$ (remains unclear for this writer); dollar sales of oil revenue to Central Bank set at 230,000 Rial rate; a near 1,400 TR offtake from National Development Fund. If undertaken inappropriately, could all be inflationary.

• Fiscal gap: circa total 3,000 TR (i.e. a deficit of circa 9% of GDP). Possibly inflationary, if not dealt with through the surplus revenue transfers.

• Distribution: significant tax rise at over 60%; on wealth significant (especially on capital gains, valuable houses / automobiles, etc); income taxation rate has been reduced.  Nevertheless, relatively contractionary (but depending on other effects) as realisation issues and affects on capital gains in stag-flationary contexts.

• Socio-economic support more targeted: will raise bottom 70% income earners cash transfer amounts (and possibly by removing top 30%); increase total Clause 14 to 6,000 TR and its cash transfers to circa over 3,500 TR; Ministries budgets up 50%. Prompts demand, possibly relatively inflationary (depending on multiplier dynamics).

• Oil dependency still there: over 2,000 TR set aside for oil exports.

• Removal of preferential forex provision for strategic food imports. Possibly inflationary, if not compensated appropriately.