CC BY
150Omar Al-Ubaydli
PhD of Economics, Director of Research and Studies, Bahrain Centre for Strategic, International and Energy Studies (Derasat)
Bldg. 355, Road 96, Block 945, P.O. Box: 39443, Riffa, Kingdom of Bahrain
E-mail: [email protected]
Mariam Albinfalah
Research Intern,
Bahrain Centre for Strategic, International and Energy Studies (Derasat)
Bldg. 355, Road 96, Block 945, P.O. Box: 39443, Riffa, Kingdom of Bahrain
E-mail: [email protected]
Hasan Al-Sayegh
Research Intern,
Bahrain Centre for Strategic, International and Energy Studies (Derasat) Bldg. 355, Road 96, Block 945, P.O. Box: 39443, Riffa, Kingdom of Bahrain
The Evolution of Bahrain's Tax Policy 2009-2024
This paper examines the evolution of Bahrain's tax policy from 2009 to 2024, focusing on the factors driving the shift from a historically low-tax environment to the introduction of value-added tax (VAT) in 2019 and a planned 15% corporation tax on multinational companies starting in 2025. Bahrain's fiscal transformation is contextualized within the broader challenges of declining oil revenues, demographic shifts, and rising security expenditures, which rendered the pre-2009 model of low taxes and high public spending unsustainable. While prior research has explored Bahrain's fiscal policy through economic and socio-political lenses, this paper introduces a novel perspective by analyzing the influence of foreign policy considerations on tax policy decisions. By addressing this gap in the literature, the study not only documents Bahrain's fiscal policy evolution but also provides insights into the rationale for favoring VAT and corporation tax over alternatives such as income and property taxes. The findings contribute to both academic scholarship and policy debates, offering a holistic understanding of Bahrain's fiscal strategy during a critical period of economic restructuring.
Keywords: Bahrain, tax policy, Bahrain economy, Middle East economy, Middle East, world economy, international economic relations.
JEL Classification: F3, H2
For citation: Al-Ubaydli O., Albinfalah M., Al-Sayegh H. The Evolution of Bahrain's Tax Policy 2009-2024. Economy of the Middle East, 2024, vol. 1, no. 2, pp. 5-17. DOI: 10.24412/2949-6470-2024-0070
Аль-Убайдли Омар
PhD, директор по научной работе,
Бахрейнский центр стратегических, международных и энергетических исследований (Дерасат)
Building 355, Road 96, Block 945, P.O. Box: 39443, Riffa, Kingdom of Bahrain E-mail: [email protected]
Альбинфала Мариам
стажер-исследователь,
Бахрейнский центр стратегических, международных и энергетических исследований (Дерасат)
Building 355, Road 96, Block 945, P.O. Box: 39443, Riffa, Kingdom of Bahrain E-mail: [email protected]
Аль-Саег Хасан
стажер-исследователь,
Бахрейнский центр стратегических, международных и энергетических исследований (Дерасат) Building 355, Road 96, Block 945, P.O. Box: 39443, Riffa, Kingdom of Bahrain
Эволюция налоговой политики Бахрейна в 2009-2024 годы
В данной статье рассматривается эволюция налоговой политики Бахрейна с 2009 по 2024 гг., с упором на факторы, обусловившие переход от исторически низких налоговых ставок к введению налога на добавленную стоимость (НДС) в 2019 г. и запланированного 15% корпоративного налога для многонациональных компаний, начиная с 2025 г. Фискальная трансформация Бахрейна контекстуализируется в рамках более широких проблем снижения доходов от нефти, демографических сдвигов и роста расходов на безопасность, что сделало модель низких налогов и высоких государственных расходов до 2009 г. неустойчивой. В то время как предыдущие исследования изучали фискальную политику Бахрейна в экономическом и социально-политическом контексте, в данной статье представлена новая точка зрения, путем анализа влияния внешней политики на решения в области налоговой политики. Устраняя этот пробел в литературе, исследование не только документирует эволюцию фискальной политики Бахрейна, но и дает представление о причинах предпочтения НДС и корпоративного налога по сравнению с альтернативами, такими как подоходный и имущественный налоги. Результаты исследования вносят вклад как в академические исследования, так и в политические дебаты, предлагая целостное понимание фискальной стратегии Бахрейна в критический период экономической реструктуризации.
Ключевые слова: Бахрейн, налоговая политика, экономика Бахрейна, экономика Ближнего Востока, Ближний Восток, мировая экономика, международные экономические отношения.
Для цитирования: Аль-Убайдли О., Альбинфала М., Аль-Сайег Х. Эволюция налоговой политики Бахрейна в 2009-2024 годы // Экономика Ближнего Востока. 2024. Т. 1. № 2. С. 5-17. DOI: 10.24412/2949-6470-2024-0070
Introduction
Bahrain — like several other of the Gulf Cooperation Council (GCC) member states — has historically enjoyed a very low tax environment for its businesses and residents [Naumann, Al-Ubaydli, Abdulla, AlAbassi, 2018]. Levies that people have come to take as granted in other parts of the world, such as income tax, property tax, and corporation tax, have been totally absent in the Kingdom, contributing to its high ranking in international indices of economic freedom [Al-Gasaymeh, 2020].
Prior to the discovery of oil during the 1930s, Bahrain's low taxes were mirrored by low provision of services by the government, which largely restricted itself to public security and external defense [Al-Ubaydli, 2020]. However, following the development of its hydrocarbon resources — and especially in the wake of the 1970s oil price shocks — the Kingdom's government has begun providing a wide range of services typical of modern governments, such as education, health, and infrastructure. It was able to do this without needing to raise taxes by funneling oil revenues to the state and using the income to fund its purchases. During the early years of the 21st century, Bahrain enjoyed budget surpluses and a low level of public debt [Naumann, Al-Ubaydli, Abdulla, AlAbassi, 2018].
In spite of this fiscal discipline, in 2009, the Kingdom of Bahrain realized its first budget deficit of the new millennium due to a variety of factors, including demographic change, declining oil revenues, and increased security expenditure. The continuation of this trend — combined with the collapse of global oil prices during the period 2014-2016 — rendered the previous system of low taxes and high expenditure unsustainable [Al-Ubaydli, 2019a].
While significant amounts of spending were cut, levying taxes constituted a central component of the government's fiscal sustainability strategy. As of 2024, the most salient manifestations are the 2019 imposition of value-added tax (VAT), and the planned (starting in 2025) imposition of a 15% corporation tax on multinational companies operating in the Kingdom. Notably, these two taxes were favored over a wide range of alternatives such as income and property taxes [Al-Ubaydli, 2021].
This paper seeks to answer two questions. First, how did Bahrain's tax policy evolve during the period 2009-2024? Second, what factors account for this evolution? More specifically, why were VAT and corporation tax preferred over the slew of other levies that are commonly seen in other high-income countries? The starting point of 2009 was selected because it was the first year in which a deficit was realized, and because it constituted a turning point in the structure of the Kingdom's fiscal policy.
While Bahrain's fiscal policy has been the subject of significant scholarship, to the best of our knowledge, ours is the first that covers the 15% multinational corporation tax, owing primarily to the recency of the announcement (September 2024). Moreover, our paper is the first to interpret Bahrain's fiscal decisions within the framework of its foreign policy. Previous contributions focus exclusively on economic or domestic socio-political considerations when seeking to understand the Kingdom's preferences regarding taxes.
For example, Waheed [2016] assesses the sustainability of Bahrain's public debt by analyzing the relationship between the budget deficit and the overall level of sovereign debt. Also in the structural domain, Magazzino [2022] demonstrates a disconnect between government revenues and expenditures in Bahrain, drawing attention to the difficulties this poses for fiscal policymakers. El Enbaby and Selim [2018] explain how domestic political economy considerations have contributed to the fiscal challenges that Bahrain's government has faced during the 21st century, while Basheer at al. [2019] analyze the key drivers of fiscal revenues in Bahrain's economy. Saputri and Hamzah [2021] build on these contributions by exploring the impact of Bahrain's fiscal situation on the economy's performance overall. Within this subliterature, Khalil and Pandow [2020] affirm the negative impact of excessive government debt on economic growth in the GCC countries, including Bahrain, while Bansal et al. [2020] and Al-Ubaydli [2019b] analyze the impact of VAT on the economy, contrasting the negative short-term effects with the more positive long-term ones. Al-Tayeb [2024] examines VAT's role in Bahrain's economic diversification. Our paper adds to this literature by analyzing the role of foreign policy considerations in Bahrain's fiscal policy decisions. Beyond addressing this gap in the literature, our paper also contributes to the policy debate regarding Bahrain's fiscal policy by documenting more clearly the choices available to Bahraini policymakers, and by providing a more holistic analysis of the decisions taken than previous papers.
The rest of this paper is organized as follows. Section 1 describes and analyzes the major trends in Bahrain's budget prior to and during the period 2009-2018. Section 2 is a brief primer on the tax instruments available to Bahrain as it considered how to address its fiscal deficit. Section 3 describes and analyzes the main decisions taken.
1. Background: A Brief History of Bahrain's System of Taxation 1.1. Taxation During the 20th Century
Prior to the discovery of oil in the 1930s, Bahrain's arid climate meant that it could only support a small population, limiting the need for a powerful centralized government bureaucracy. The Ottoman Empire did not encompass Bahrain [Anscombe, 2009], while it was classified as a British protectorate following the arrival of the British in the first half of the 19th century [Campbell, 2013. P. 277-279]. Accordingly, Bahrain did not import the European-style state apparatus that emerged during the 1800s. The scope of government services was limited primarily to internal and external defense, and even this latter function was reduced by the regional security hegemony exercised by the British [Al-Ubaydli, 2020]. In 1919, when Bahrain became the first Gulf country to enact formal education with the establishment of the Al-Hidaya Al-Khalifiya School, the project was both conceived of and funded by private philanthropists rather than reflecting the actions of a powerful central bureaucracy [Shirawi, 1987]. Therefore, taxes were almost absent.
From the perspective of fiscal policy, the discovery of oil led to two important developments. The first was the central government acquiring a new income stream that did not rely upon the imposition of traditional taxes. Given that oil income was several orders of magnitude larger than anything previously available to the state, this meant that a significant increase in the scope of government activity was possible without the need to levy taxes [Harrison, 2010].
The second key development was an increase in the importance that external powers such as the UK and US assigned to the region. This led to an increase in their appetite to maintain regional peace, further limiting the need for countries such as Bahrain to levy taxes to fund large armies that would be used to maintain their sovereignty, as occurred in Europe [Fukuyama, 2011]. The US' strength was demonstrated first during the Iraq-Iran War when it intervened to maintain the freedom of navigation of oil supplies in the Arabian Gulf [Navias, Hooton, 1996], and subsequently during the liberation of Kuwait [Perry, 1990].
These developments ensured that Bahrain maintained the virtual absence of taxes, save for customs tax and various other token levies, in addition to the usual suite of fees associated with government services, such as the payments required to register a company or renew a driver's license [Naumann, Al-Ubaydli, Abdulla, AlAbassi, 2018]. The government significantly expanded the scope of its activities to include education, health, infrastructure, and so on, while maintaining its reliance on hydrocarbon income rather than traditional taxes to deliver these services. The state did develop a significant bureaucracy, but this was not associated with the need to collect taxes to fund a war machine, as occurred in continental Europe [Tilly, 2017].
In 1999, the accession to the throne of Hamad bin Isa Al Khalifa created an additional incentive for the maintenance of low taxes. Bahrain had historically been a country characterized by a multidimensional openness (social, political, economic) that was sometimes absent in neighboring countries [Fahy, 2018]. King Hamad wanted to deepen Bahrain's openness in the investment domain, by making the attraction of foreign direct investment (FDI) a central component of the Kingdom's economic strategy. The Economic Development Board was established in 2004 for this express purpose, as FDI was seen as both a source of jobs and as a means for transferring advanced foreign technologies to Bahrain [Al-Khalifa, 2010].
As is evident in the extensive literature on FDI, low taxes are a key factor in attracting foreign capital [Feld, Heckemeyer, 2011]. This motivated Bahrain to maintain its virtual absence of taxes. An indirect incentive took the form of international indices of economic freedom, such as the Heritage Foundation index and the Fraser Institute index. Its low taxes helped the Kingdom maintain a high ranking — sometimes within the top 10 in the world and the highest position in the Gulf region. Moreover, this performance was used as a marketing tool by the investment promotion agency, reinforcing the incentive to keep taxes low [Dkhili, Dhiab, 2018].
Notably, Bahrain's FDI strategy was successful [Al Khalifa, 2010], with large volumes of Emirati, Kuwaiti, and Saudi capital being wooed to the Kingdom, especially in the financial and real estate sectors. Moreover, up to 2008 (see the data below), Bahrain was fiscally healthy, with a thriving economy and plenty of jobs being created for citizens and expatriates alike.
1.2. Rising Fiscal Pressure During the 21st Century
The year 2009 marked an inflexion point in Bahrain's fiscal journey. Figure 1 shows Bahrain's budget balance and its public debt as a percentage of GDP for the period 2008-2018, drawn from the official government accounts. As can be seen, the year 2008 marked the final budget surplus. Moreover, 8 the budget deficit became particularly acute during the period 2015-2017, reaching approximately 15% of GDP.
As a result of the persistent budget deficits, the government was forced to issue debt. In 2008, the public debt was at the highly manageable level of 16% of GDP. However, by 2018, it had reached 95% of GDP. This level — and the overall trajectory of the national debt — were both unsustainable, requiring corrective measures by the government [Naumann, Al-Ubaydli, Abdulla, AlAbassi, 2018].
To better understand the government's response, Figure 2 shows the breakdown of Bahrain's government expenditure into recurring and non-recurring items for the same period. The former includes the critical element that is public sector salaries, while non-recurring expenditure primarily reflects project spending.
2008 2009 2009 2011 2012 2013 2014 2015 2016 2017 2018 ■ Recurring expenditure (% of GDP) □ Non-recurring expenditure (°6 of GDP)
Figure 2: Bahrain's recurring and non-recurring government expenditure as % of GDP, 2008-2018
Source: Bahrain Ministry of Finance and National Economy (2024)
There are two notable observations relating to the expenditure data. The first is that spending was rising steadily throughout the period, with the 2015 figure being over 60% higher than the 2008 figure even controlling for GDP. Second, recurring expenditures constituted the lion's share of government spending throughout the period, and rose in relative importance, too. Accordingly, there was very little opportunity for balancing the budget by cutting spending.
Several factors accounted for this rising spending. The first was demographic evolution: Bahrain's population increased from approximately 1.1 million in 2008 to over 1.5 million in 2018, and while a significant proportion of that increase was migrant workers, it also reflected a high birth rate among nationals [World Bank, 2024]. This larger population required basic government services such as health, education, infrastructure, and so on.
In principle, a rising population should only induce increasing absolute government expenditure, with the spending to GDP ratio being constant as people enter the workforce and expand the economy. However, in Bahrain's case, the 2008 global financial crisis took a heavy toll on Bahrain's economy [Abdelbaki, 2010]. The financial sector accounted for around 20% of GDP, and was a primary source of job creation in the first decade of the new millennium, but this expansion was sustainably checked by the Great Recession. As a partial remedy, the government increased public sector hiring, with the period 2008-2016 witnessing a 25% increase in public sector employment [LMRA, 2024]. Due to their nature, public sector jobs do not increase GDP at the same rate as private sector jobs. This — along with the aforementioned basic services spending — accounts for a large percentage of the rise in recurrent government expenditure. An additional noteworthy contributor was a significant increase in security- 9 related spending, especially following the start of the Arab Spring in 2011 [Yalta, Yalta, 2022].
Turning our attention to the revenue side of the equation, Figure 3 shows the Bahraini government's income from two major sources, oil and gas and taxes and fees, as a percentage of GDP during the period 2008-2018.
35% 30% 25% 20% 15% 10% 5% 0%
Figure 3: Bahrain's government revenues from oil and gas and from taxes and fees as % of GDP, 2008-2018
Source: Bahrain Ministry of Finance and National Economy (2024)
These numbers provide a stark indication of the importance of oil and gas revenues to Bahrain's budget: in 2008, they equaled 23% of GDP, while spending equaled around 21% of GDP. As a corollary, the contribution of revenues from taxes and fees is quite modest, starting out at just under 2% in 2008, and rising to 2.3% in 2018. The dependence of state income on hydrocarbon income persists throughout the entire sample and is also reflected in the sensitivity of gross government revenues to global oil prices. This is why revenues declined sharply following the 20l4 crash in oil prices [Naumann, Al-Ubaydli, Abdulla, AlAbassi, 2018], falling from over 30% of GDP in 2013 when prices were near their peak to just over 15% of GDP in 2016 when prices bottomed out.
Putting all the data together, it becomes clear that the logical focus of the government's efforts at balancing its budget would be increasing non-oil revenues. Increasing oil revenues was technically difficult because Bahrain's oil fields were already mature, and because the outlook for oil prices was highly uncertain [Campbell, 2013. P. 277-279]. Decreasing spending was precarious because of the recurrent nature of most of the spending, and its importance to job creation and national security [AlJazeeri, 2021]. That is not to say that these alternative avenues were ruled out; in fact, the 2018 Fiscal Balance Plan contained several initiatives relating to expenditure reduction [Government of Bahrain, 2018]. However, there was a realization that boosting non-oil revenues needed to be the centerpiece of a sustainable reworking of state finances.
Before exploring how the government went about that task, it is worth briefly noting the importance of balancing budgets in general, and especially in the case of a small open economy such as that of Bahrain. Budget deficits adversely affect investor sentiment among both domestic and foreign capital holders due to the rational expectation of future spending cuts and/or tax increases [Barro, 1989]. This generates a reluctance to invest. Persistent deficits can also generate spiraling debt service costs which crowd out expenditure on the local economy [Lang, Mihalyi, Presbitero, 2023]. Both of these mechanisms are reflected in downgrades to Bahrain's credit rating by global credit rating agencies. For example, Moody's had Bahrain's sovereign debt rated at "A2 stable" in July 2007, meaning that it was well within the "investment grade". However, by August 2018, it had fallen into the non-investment grade, securing a rating of "B2 negative", representing nine notches lower in the 20-level scale [Trading Economics, 2024].
In the specific case of Bahrain, these adverse consequences are amplified for several reasons. First, as mentioned above, attracting foreign direct investment (FDI) is a central plank of the Kingdom's economic strategy, with the government perceiving it to be a source of jobs and technology [Al-Khalifa, 2010; Naumann, Al-Ubaydli, Abdulla, AlAbassi, 2018]. Accordingly, when FDI shrinks due to unstable government finances, a larger proportion of the economy is affected. Moreover, a key point of attraction for foreign investors is Bahrain's longtime adoption of a fixed exchange rate regime vis-a-vis the US dollar. The Kingdom's fiscal challenges precipitated a currency run in 2018, further dampening the confidence of foreign investors [Al-Ubaydli, 2021]. Beyond these issues is the fact that Bahrain is in the midst of an economic transition as it seeks to diversify its income sources [Khayati, Al-Sayegh, 2020; Naumann, Al-Ubaydli, Abdulla, AlAbassi, 2018]. This makes access to capital an even more acute need than under normal circumstances, as prudent, expansive investments are necessary for Bahrain to restructure its economy.
■ Revenues from oil and gas (% of GDP) Revenues from taxes and fees (% of GDP)
2. Available Tax Instruments
To summarize the previous section, from 2009 onward, Bahrain started to face fiscal challenges due to a combination of rising spending requirements and falling oil revenues. Given the adverse effect of sustained budget deficits on investment — and hence on the economy as a whole — the government needed to take corrective action. Given the high level of dependence on unstable oil revenues in the government budget and the political intractability of large cuts in spending, the logical starting point was an exploration of ways of increasing the government's non-oil income, primarily through the levying of taxes. This section is a brief primer on the tax options available to the government at that time.
2.1. Criteria for Evaluating Taxes
To understand the pros and cons of each tax, we begin by introducing the key criteria used to evaluate taxes, based on Gruber [2005].
Revenue generation: the extent to which the tax generates revenues for the state — the primary function that a tax serves.
Revenue stability: the extent to which the tax's revenues are stable and predictable, making it easier to plan for.
Progressivity: the extent to which the tax can be levied in a manner where people/businesses with greater means pay a supra-proportionate share than those with lower means, which promotes the social acceptability of the tax.
Political acceptability: the extent to which the imposition of the tax is deemed as legitimate under the existing socio-political configuration from the perspective of the general public. Taxes that administratively fall upon foreigners are especially acceptable from a political perspective.
Ease of implementation: the logistical simplicity of collecting the tax, including the cost of collecting the tax and ensuring compliance.
Non-distortiveness: the extent to which the tax avoids disincentivizing productive economic activity such as hiring and investment.
Resilience to resource flight: the extent to which the tax avoids the problem of the tax base — be it individuals or businesses — leaving the country in the search of a domicile with more favorable tax circumstances.
2.2. The Pros and Cons of Each Tax
In this subsection, we present 10 different tax instruments and describe their generic pros and cons based on the evaluation criteria presented in the previous subsection. The arguments presented are based on Gruber [2005].
Income tax: Income tax consists — evidently — of taxing individuals' labor income. Its key advantages are that it generates large and relatively stable revenues. Moreover, income tax can easily be made progressive. These pros must be weighed against the cons that include significant compliance challenges exacerbated by purposeful evasion; in addition to the disincentive that income taxes create for productive work. Income taxes also exhibit a high degree of political sensitivity, with people expressing a particularly intense dislike of paying income taxes due to the perception that it is a tax on their attempt at earning a living. Beyond this, in countries with large numbers of migrant workers, income taxes also generate a threat of human resource flight, as the migrant workers move to other countries with lower (or zero) income taxes.
Payroll tax: These are similar to income taxes but are administratively imposed upon employers rather than workers, creating a different but equally difficult problem of compliance. Moreover, they are typically flat, which can render them regressive. In general, they disincentivize hiring in a similar manner to income taxes, but they provide stable, robust revenues.
Corporation tax: This class of tax is imposed upon the realized profits of businesses and is usually imposed either progressively or neutrally. In all cases, it can generate significant revenues if the private sector where it is imposed is vibrant and dynamic, and if the government can overcome the considerable compliance challenges. In principle, the tax can incentivize investment if it is imposed upon postinvestment profits; however, it can also disincentivize investment by decreasing a business' appetite to expand its operations. In small open economies, it also creates a risk of capital flight as businesses relocate their branches to neighboring countries with lower levels of corporation tax.
Capital gains tax: These typically take the form of a levy on realized investment profits. Given that such profits tend to be concentrated in the richest echelon, this makes them progressive, but the tax base is also generally adept at evading the tax, creating significant compliance problems that can severely 11 undermine the tax's revenue-generating potential. They can also be distortive by decreasing the incentive
to invest in startups (where the return is usually in the form of a capital gain rather than a dividend), and by decreasing liquidity in financial markets. In small economies, they can also encourage capital flight.
Property tax: This is a tax that is usually related to the value of a property, making it potentially highly regressive due to the overrepresentation of property in the assets of low-income households. On the positive side, it can generate large and stable revenues for governments, but it can undermine the incentive to own property and may induce property flight among rich investors if neighboring countries have lower or absent property taxes. One of its virtues is that it is relatively straightforward to levy because there is already a pre-existing database of land ownership that can be leveraged, though it can be challenging to compose a socially acceptable system for assessing property values, especially if real estate markets are thin.
Sales tax: this straightforward tax which is levied on final goods and services has the benefit of relative simplicity, though there can be difficulty in defining final sales that creating opportunities for evasion. In its basic form, it is regressive because low-income groups spend a greater proportion of their income on consumption than do high-income groups. However, this can be somewhat neutralized by granting exceptions to essential items such as eggs, fuel, meat, and so on. For small businesses, the administrative burden of compliance can be significant. In general, indirect taxes such as sales tax exhibit a relatively high level of political acceptability, due in part to the perception that the tax can be avoided by spending less on certain types of goods and services.
Value-added tax (VAT): this tax can be considered a more sophisticated version of the sales tax whereby each link in the value chain is taxed rather than just the final one. This makes evasion harder and expands the revenue base away from just retail activity to almost all commercial transactions, making it a sound and stable generator of revenue. However, this also renders administering the tax a more complex activity, which can be especially challenging for smaller businesses. When exceptions are deployed, its inherent regressiveness can be neutralized. It is also considered one of the least distortive taxes available to governments and maintains the relatively high levels of political acceptability associated with sales taxes.
Customs tax: one of the oldest taxes humans have been deploying is that imposed on goods crossing borders. In the case of countries that are in a customs union, they do not have unilateral control over their customs duties, and so it is not a viable option for increasing revenues. Moreover, for small open economies that are highly dependent on both imports and exports, raising customs duties risks inducing tit-for-tat increases in customs duties by the country's trading partners. Customs taxes are politically highly acceptable because of the perception — correct or otherwise — that foreigners are paying the tax, and that the tax supports local businesses.
Foreign transfer tax: an infrequently applied option is the imposition of a tax on external capital transfers. This is politically highly acceptable because — administratively speaking — the burden falls on foreigners. However, in the world of digital transfers and cryptocurrencies, evading such taxes becomes a straightforward enterprise. Moreover, it is likely to induce human capital flight as the expatriate workers who rely on foreign transfers for their remittances look to work elsewhere. This human capital flight can metamorphose into financial capital flight if investors interpret it as an indicator of the government's willingness to impose capital controls.
Inheritance tax: this tax makes a limited contribution to tax revenues in most countries. In the Islamic world, due to its inconsistency with the straightforward rules regarding the division of estates, it is not a politically viable option, even if it could in principle be an effective tool for redistributing wealth toward low-income groups.
Notably, among the 10 options exposed above, only one was used meaningfully by Bahrain during the 20th century (customs tax), meaning that the government in principle had a wide variety of tax options available to it when it decided to raise revenues.
3. The Chosen Path: Value-Added Tax and Corporation Tax
Section 1 affirmed the need for the Bahraini government to levy taxes as part of its efforts to balance its budget. Section 2 provided an overview of the available options and the pros and cons of each one. This section describes the choices actually made and analyzes the reasons for those decisions in light of the generic pros and cons presented in the preceding section.
3.1. Value-Added Tax 3.1.1. Implementation and Retrospective Impact
12 The Kingdom of Bahrain took the decision to introduce a 5% VAT starting from 01/01/2019 (Article
3 of the VAT law), and this was increased to 10% from the start of 2022 (Law 33 of 2021). The tax had two
notable features. First, a series of exemptions on basic goods and services were granted, such as health, education, and various essential foods. This was done to limit the regressiveness of the tax. The second key feature was that it was implemented under the umbrella of the GCC, in line with the GCC single market established in 2008, which stipulates goods and services being treated homogeneously across all six GCC member states. Saudi Arabia and the UAE had implemented the tax at the start of 2018, with Saudi Arabia raising VAT to 15% in 2020. Given the aforementioned lack of familiarity among Bahrainis regarding taxes [Al-Hadrami, Almoosa, 2019], the government launched a series of workshops to educate the public about how to comply with the tax.
Figure 4 shows Bahrain's government revenues by source as a percentage of GDP for the period 2018-2022.
Figure 4: Bahrain's government revenues from oil and gas and from taxes and fees as % of GDP, 2018-2022 Source: Bahrain Ministry of Finance and National Economy (2024)
The tax generated a perceptible increase in government revenues from non-hydrocarbon sources: in 2018, the last year prior to VAT, revenues from taxes and fees equaled 2.2% of gDp, while in the first three years of VAT — when it was 5% — such revenues rose to around 4.1% of GDP. Moreover, following the doubling of VAT to 10%, state revenues increased again, reaching 6.1% of GDP. As can be seen in the figure, tax revenues are much more stable than those resulting from oil and gas, reflecting a double benefit associated with VAT. To see the impact on the budget overall. Figure 5 shows the budget balance and public debt as a percentage of GDP for the period 2017-2022.
Figure 5: Bahrain's budget balance and public debt both as % of GDP, 2017-2022
Source: Bahrain Ministry of Finance and National Economy (2024)
These figures demonstrate the positive impact that VAT had upon the government's fiscal situation, with the 2017 deficit of 11% of GDP falling to 1.3% by 2022. Similarly, the rate of increase of the public debt declined sharply, with the debt itself decreasing as a percentage of GDP during the period 20202022. This is consistent with Al-Tayeb's [2024] finding that VAT contributed to Bahrain's economic diversification efforts. However, it is important to note the existence of several confounding factors acting in both directions.
On the positive side, oil prices were generally rising through this period, though there was a sharp, COVID-induced dip in 2020. Moreover, Bahrain's government launched a fiscal balancing plan in 2018 which included boosting revenues via VAT, but also included rationalizing expenditure and other cost-cutting measures. On the negative side, the pandemic led to a large rise in government spending due to
exceptional interventions such as COVID-related expenditure, a fiscal stimulus, and so on. Accordingly, one cannot attribute the encouraging changes in Figure 5 solely to VAT.
Bahrain's credit rating showed some signs of improvement following the introduction of VAT, notwithstanding the same confound problem discussed above. Moody's rating rose from "B2 negative" in August 2018 to "B2 stable" in August 2022 [Trading Economics, 2024], while the S&P rating went from "B+ stable" in December 2017 to "B+ positive" in 2022. A corollary benefit of VAT is an improvement in the standard of business accounting in Bahrain's private sector as companies have to demonstrate compliance. This contributes to the Kingdom's efforts at maintaining an attractive commercial environment.
3.1.2. Selection Causes
As was evident in section 2.2, once it took the decision that it needed to increase its tax revenues, it had a broad range of options before it; what made it settle in favor of VAT? Several factors contributed to this, and arguably the most important was Bahrain's commitment to the economic harmonization systems of the GCC. Due to its status as the smallest economy in the bloc, and due to its reliance on foreign direct investment, international trade, and international rule of law, the Kingdom of Bahrain is perennially looking to strengthen systems of international cooperation, with leadership by example being the main means. This accounts for its enthusiastic adherence to the GCC customs union and single market when other countries in the bloc have demonstrated lower levels of commitment. Accordingly, when a tax option gained traction at the regional level [Harrison, 2010], Bahrain's enrollment was almost assured. This also partially accounts for Bahrain's refusal to consider a unilateral increase in customs tax, though its economic idiosyncrasies also played a role (see below).
A further detail in this motivation was Bahrain's receipt of financial aid from three GCC member states (Kuwait, Saudi Arabia, the UAE) — including the two that had already adopted VAT — in 2018. The currency run that Bahrain experienced in the middle of 2018 forced it to take rapid action to correct its fiscal path, resulting in the launch of the fiscal balance plan in collaboration with the Kingdom's partners in the GCC. Given that Saudi Arabia and the UAE had already convinced themselves of the virtues of VAT, they logically would have preferred that Bahrain use the same tax instrument as them as part of its fiscal balancing efforts, and as donor countries, their opinion carries additional weight.
Beyond this international-relations-grounded reason are a series of factors that are specific to the fiscal domain, much of which were behind the GCC's initial decision to encourage the adoption of the tax. These include the tax's sound revenue-generating potential, especially in light of the global experience with VAT when compared to alternatives such as sales tax. This — along with the stability of the income it creates — can be seen clearly in the data shown above (Figure 4). Moreover, in the specific case of Bahrain, the political acceptability of VAT was considerably higher than that of alternatives such as income tax.
Bahrain's status as a small open economy also contributed to the preference for VAT. The centrality of FDI to the Kingdom's economic strategy renders corporation taxes, capital gains taxes, and property taxes highly precarious, as all are expected to induce capital flight. This fear is reinforced by the presence of several highly attractive destinations for capital within the region, such as Qatar, Saudi Arabia, and the UAE. Similarly, a foreign transfer tax is also considered a threat to Bahrain's hard-earned reputation as a country that imposes no restrictions on the movement of capital [Al-Ubaydli, 2019a]. Bahrain's dependence on imports and exports also accentuated its aversion to customs tax beyond the role that its membership in a customs union played. Payroll taxes were avoided because Bahrain's government prioritizes job creation for its citizens, and such taxes may act as a disincentive to hiring.
3.2. Corporation Tax 3.2.1. Implementation and Expected Impact
In September 2024, Bahrain announced its intention to implement a new tax on multinational corporations operating in the Kingdom starting from 01.01.2025. The levy will apply to companies that generate annual revenues of at least $830 million globally during at least two of the last four fiscal years. It will take the form of a 15% tax on profits earned in Bahrain [Nagraj, 2024]. When announcing the tax, the government did not indicate the expected level of revenue generation and given the lack of publicly available data on the local profitability of large businesses, it is impossible for researchers to develop reliable forecasts.
The most important feature of the tax is fully aligned with the global taxation guidelines of the Organisation for Economic Co-operation and Development (OECD). The OECD's program represents a concerted attempt by over 140 countries globally to limit tax evasion by multinational corporations, which have been exploiting the ability to shift assets and commercial registrations between tax domiciles to avoid paying taxes. The guidelines stipulate a minimum of 15%, which is what Bahrain has chosen
to adhere to. Notably, while Bahrain is not the first country in the GCC to impose corporation taxes (Saudi Arabia and the UAE already have them in some form), it is the first to explicitly join the OECD's framework. This is to be contrasted with VAT, where Bahrain was the third GCC country to join in.
3.2.2. Selection Causes
In section 3.2.1, we argued that VAT was chosen over corporation tax for reasons that include the fear that the latter would induce capital flight, possibly to neighboring economies. Why did Bahrain decide to start levying corporation tax six years after it rejected the tax in favor of VAT? As in the case of VAT, considerations relating to international relations played a central role in the decision [Al-Ubaydli, 2024].
The context is particularly important. VAT is a tax that has been used by various countries for decades, without being associated with any global movement. At the GCC level, the initiative was driven by technical considerations relating to revenue generation, while maintaining the sound functioning of the GCC single market.
In contrast, the OECD's global corporation tax is borne out of a broader social movement to limit inequality and to create more just and sustainable societies. Books like Piketty's [2014] Capital in the 21st Century and activities such as the "Occupy Wall Street" protests have had a profound impact on the societal discourse regarding the difference between rich and poor. Multinational corporations have been identified as an important cause of rising inequality through their tax evasion strategies. Accordingly, unlike imposing VAT, efforts at taxing multinational corporations represent much more than an effort to boost government coffers; they constitute a contribution to an international effort at tackling politically unsustainable and ethically unacceptable increases in global inequality.
This goes some way to explaining Bahrain's eagerness to adopt this tax, in spite of the aforementioned fears regarding capital flight. While exploiting legal loopholes to evade taxes is not a literal violation of international law, it does contradict the spirit of international law. This helps us understand why Bahrain — as a small country in an unstable region — is keen to contribute to efforts at eradicating this phenomenon.
This mindset is reflected in numerous other pro-social (in the global sense) Bahraini initiatives. In 2019, Bahrain was a founding member of the International Maritime Security Construct, a naval alliance seeking to counter piracy in the Straits of Hormuz [Mosly, 2023], as well as joining Operation Prosperity Guardian in 2023 as part of its contribution to maintaining freedom of navigation in the Red Sea [Salt, 2024]. The Kingdom of Bahrain also joined the Global Coalition Against Daesh in 2014 [Almutawa, 2018], as well as the Islamic Military Counter Terrorism Coalition in 2015 [Bahrain Ministry of Foreign Affairs, 2024]. All these contributions were preceded by Bahrain joining the Counter-piracy Combined Maritime Forces in 2009 in response to rising piracy in the Arabian Sea [Guilfoyle, 2013].
Bahrain has been active in non-military domains, too. Its 2020 entry into the Abraham Accords — leading to the naturalization of its relationship with Israel — was motivated by several reasons, with one of them being the desire to use diplomatic means to further regional peace [Singer, 2021]. In 2022, Bahrain hosted a visit by Pope Francis and several other global religious leaders as part of its commitment to religious tolerance and coexistence [Monier, 2024].
In this regard, Bahrain's decision to adopt corporation tax should be interpreted as a contribution to its efforts at cultivating a reputation as a constructive member of the international community, and at setting a positive example for other countries [Fahy, 2018]. Bahrain always wants to be seen as a supporter of global cooperation that seeks to create a more just and stable world order.
Beyond these considerations, the OECD coordination played a direct role, too. The 140+ members, including all GCC and OECD states, helped assuage capital flight fears that the Bahraini government has regarding the imposition of a corporation tax. However, it is important to note the limited scope of this tax, as it only applies to multinational corporations that exceed a certain size. Accordingly, its net impact on government revenues might be limited. In future — under the OECD umbrella or otherwise — we might see the scope or level of the tax expanding, as occurred during the first few years of VAT.
Conclusion
In the first few years of the new millennium, Bahrain was on a sustainable fiscal path, with small budget surpluses and a low public debt. This allowed it to maintain the low tax environment that it historically operated, funded by hydrocarbon income. However, around 2009, a combination of factors, including demographic change, the global financial crisis, and the need for increasing security spending, led to an unfavorable change in Bahrain's fiscal situation. These adverse developments were exacerbated by the 2014-2016 collapse in global oil prices, which severely affected the revenue side of the government's ledger. While a wide range of reforms were needed to regain fiscal sustainability, a central component was the imposition of new taxes.
In light of its historically low taxes, Bahrain had close to a blank slate when it came to selecting from the menu of available taxes. It ultimately settled on the introduction of VAT in 2019, and a corporation tax on multinational companies in 2025. Technical considerations relating to the efficacy of these taxes were an important factor in explaining these decisions. In particular, the demonstrated effectiveness of VAT in Europe and elsewhere made it an attractive option, as did the ability to use exemptions to avoid the tax becoming regressive. VAT has contributed to a significant improvement in Bahrain's fiscal situation, both in terms of reducing the absolute value of the budget deficit and in decreasing its oil-price-induced volatility.
However, to fully understand these decisions, it is important to appreciate the role that Bahrain's foreign policy plays. In the case of VAT, Bahrain's affinity for the tax was enhanced by the fact that the GCC studied and planned its adoption centrally, in line with the best practices associated with common markets. As a primary beneficiary of international systems of cooperation such as the GCC single market, Bahrain was keen to demonstrate its willingness to contribute to economic integration projects, and to set a positive example for others. These motivations were further reinforced by the fact that the two other VAT adopters — Saudi Arabia and the UAE — coincidentally became sources of financial aid when Bahrain's fiscal challenges grew in 2018. It was logical for them to push for Bahrain to adopt the tax that had served them well fiscally, too.
In the case of the tax on multinational corporations, the context was international cooperation seeking to combat what is perceived to be unjust tax evasion by commercial behemoths. Bahrain played the role of early mover in a coalition of over 140 countries, spearheaded by the OECD, and underwritten by a global social movement calling for lower inequality. This economic initiative mimics Bahrain's contribution to global alliances operating in other fields, such as countering terrorism and piracy.
The common thread in all of these efforts is a foreign policy centered on promoting international cooperation and upholding international rule of law across all domains, both by being a direct contributor and by setting an example for others to follow. This approach is also consistent with Bahrain cultivating a national identity that emphasizes tolerance and peaceful coexistence.
In the short term, the result has been a successful stabilization of Bahrain's public finances. However, in the long run, further fiscal reforms will be necessary for the Kingdom to reduce its public debt to levels that would return its credit rating to investment grade. The extent to which future taxes fall under the umbrella of international cooperation remains to be seen.
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