Ethiopia is undergoing a transformative phase in its economic history, marked by the National Bank of Ethiopia’s (NBE) recent announcement of sweeping foreign exchange (FX) reforms. The changes, which liberalize Ethiopia’s tightly controlled currency system, are part of a broader reform program aimed at stabilizing the economy, boosting investment, and promoting private sector growth. These reforms represent a bold step toward modernizing the financial sector and integrating Ethiopia with the global economy. However, the transition comes with challenges, particularly around revenue generation and taxation, which could pose risks if not properly managed.
The most notable shift in the FX reforms is the move to a market-based exchange rate system. Banks are now allowed to buy and sell foreign currencies at rates freely negotiated with clients and among themselves. This change is expected to improve foreign currency availability, encourage foreign investment, and align Ethiopia’s economy with international markets. By removing the previous fixed exchange rate, which had led to a thriving black market, businesses will have better access to foreign currency for imports and operations.
Moreover, the end of surrender requirements—which previously mandated exporters and banks to relinquish portions of their foreign currency earnings to the government—marks another positive step. It allows businesses to retain more of their earnings, providing much-needed liquidity for reinvestment and expansion. Lifting import restrictions on 38 product categories will alleviate the strain on businesses forced to source currency on the black market. The introduction of non-bank FX bureaus and the simplification of foreign currency account rules will also create a more dynamic and inclusive FX market.
However, behind these reforms lies a deeper concern about fiscal sustainability. The Ethiopian government must address how to balance the liberalization of the economy with revenue generation, and this is where taxation becomes a crucial factor.
The Role of Taxation in a Liberalizing Economy
As Ethiopia transitions to a more open and market-based economic model, the government faces the need to diversify its revenue streams. The removal of surrender requirements, for instance, means the government will lose a significant source of foreign currency earnings, previously obtained through mandatory FX surrender quotas. This loss, coupled with the need to maintain public services, repay external debt, and fund social programs, leaves the government searching for new avenues of revenue.
Historically, developing economies like Ethiopia have relied heavily on indirect taxes, such as value-added tax (VAT) and import duties, as well as taxes on essential commodities like fuel, food, and medicines. However, with the backing of international financial institutions like the World Bank and the International Monetary Fund (IMF), Ethiopia is now being encouraged to shift its tax base toward services and non-essential goods.
This approach, from an economic standpoint, is known as a fiscal adjustment mechanism. Essentially, the government broadens its tax net to offset potential short-term losses in revenue due to the liberalization of the exchange rate and the removal of import controls. While this strategy could help Ethiopia maintain its fiscal health, there are inherent risks, especially as the government introduces new taxes or raises existing ones in certain sectors.
Potential Negative Outcomes of Increased Service Taxation
As Ethiopia looks to expand its tax base to cover services and non-essential goods, it risks certain negative economic outcomes, particularly around consumption and investment patterns.
1. Demand Elasticity
From an economic perspective, services tend to have a higher price elasticity of demand compared to essential goods. This means that consumers are more likely to reduce their consumption of services when prices increase, especially if those services are viewed as discretionary. For example, higher taxes on telecommunications services, mobile data, or financial services could lead to reduced demand. As consumers scale back their usage, growth in these sectors may slow down, stunting overall economic development.
For a growing economy like Ethiopia, where access to telecommunications and financial services is still expanding, such a reduction in demand could be particularly harmful. The digital and financial sectors are critical for modernizing Ethiopia’s economy and improving access to markets for small businesses, and higher taxation could slow down these advances.
2. Private Sector Impact
Increased taxation in the services sector could also hinder private sector growth, particularly in industries that are already facing challenges from foreign exchange shortages and increased competition due to liberalization. Ethiopian businesses, especially small and medium enterprises (SMEs), are already navigating new currency risks caused by exchange rate fluctuations. Adding fiscal pressure in the form of higher taxes could reduce profitability, discourage expansion, and lead to a decline in private investment.
SMEs, which often have lower margins and less access to credit, are especially vulnerable. In Ethiopia, these businesses play a crucial role in employment and economic diversification. If service sector taxes further burden SMEs, it could lead to a slowdown in job creation and innovation, undermining the very goals of the reform program.
3. Inflationary Pressures
While essential goods like food and fuel are subsidized, higher taxes on services could contribute to broader inflationary pressures. This is particularly concerning in urban areas where service consumption is higher. As costs increase for services like telecommunications, banking, or transportation, the cost of living for Ethiopian consumers will rise.
This could lead to real wage erosion, where income levels fail to keep pace with rising prices, reducing households’ purchasing power. As disposable income shrinks, consumer spending on non-taxed goods could decline, further stifling demand and economic recovery.
4. Public Backlash
Introducing or raising taxes, especially in sectors like telecommunications or financial services, could lead to public dissatisfaction. Consumers may feel the direct impact of such tax hikes in their daily lives, potentially leading to negative perceptions of the reform process. For the government, managing the public’s response will be crucial to ensuring the political sustainability of these reforms.
The Government’s Dilemma: Growth vs. Revenue
The Ethiopian government faces a classic macroeconomic trade-off: how to foster economic growth while ensuring sufficient revenue to meet its fiscal obligations. On one hand, there is a clear need to attract investment and encourage private sector development by creating a favorable business environment. On the other hand, the government must raise sufficient revenue to fund public services, pay off external debt, and continue its development programs.
Economists refer to this trade-off as a balance between fiscal austerity and growth stimulation. Too much austerity through tax increases can choke off private sector dynamism and consumer demand. Conversely, too little taxation can lead to unsustainable fiscal deficits, forcing the government to borrow excessively, which could further exacerbate inflation and increase debt burdens.
The Need for a Balanced Approach
Ethiopia’s foreign exchange reforms are a bold step toward economic liberalization and modernization. The potential for increased foreign investment, improved foreign currency availability, and enhanced business competitiveness is significant. However, the transition to a more open economy comes with fiscal challenges that need to be carefully managed.
For Ethiopia to achieve its reform objectives, the government must ensure that its taxation policy is equitable and growth-friendly. Rather than relying heavily on indirect taxes on services, the government could explore broadening the tax base in other areas, such as improving tax compliance or reforming property taxes. Additionally, targeted social safety nets for vulnerable populations could help cushion the impact of any inflationary pressures or price increases resulting from higher taxes.
With the backing of international financial institutions and ongoing government efforts to mitigate the immediate impact on the population, Ethiopia has a chance to leverage these reforms for long-term growth. However, the success of this transformative phase will depend on careful monitoring and adaptive policy responses to ensure the benefits of these changes are widely shared.
