Steffen Hertog, London School of Economics
This chapter is part of POMEPS Studies 33: The Politics of Rentier States in the Gulf. Download the full PDF here.
Most oil producers in the Global South have espoused plans to diversify their economies away from hydrocarbons pretty much since the onset of oil production. Yet very few have managed to transcend their hydrocarbons dependence – and those who have done so are mid-level rentiers like Malaysia, with annual resource rents per capita in the hundreds of dollars per year. High-rent countries like the GCC monarchies, Libya, Brunei, or Equatorial-Guinea, where per capita rents amount to many thousands of dollars, all remain deeply dependent on oil income despite decades of diversification plans.
Why is post-oil diversification so difficult? Researchers point to a number of explanations, including economic factors like the Dutch Disease and the negative impact of revenue volatility, as well as political factors like elite-level rent-seeking and the quality of institutions in oil-rich countries. These apply to different degrees in different economies, yet the track record of diversification is generally poor. To help account for this puzzle, this research note will point to an easily overlooked obstacle to economic diversification away from oil: the sheer scale of economic change required to transition away from a high-income oil economy to a post-oil economy.
This memo will spell out what transition to a “post-oil” economy would mean in the case of Saudi Arabia, the MENA region’s most important rentier state. The key finding is that to support a “normal”, non-oil fiscal system and a “normal”, non-oil labor market, the Saudi private sector would need to undergo drastic changes. It would need to grow dramatically if it were to support current levels of state spending through non-oil domestic taxes, all the while dealing with severe contractionary and inflationary effects of taxation. Private employment of Saudis would have to grow by a factor of four or more in order for the kingdom’s labor market to resemble that of non-oil economies. The path to such a non-oil economy is, at best, very long, measured in generations rather than decades.
The Saudi economy’s state dependence
Although the size of the Saudi private sector has grown significantly since the 1970s, the Saudi economy remains highly dependent on state spending, which in turn is largely financed through oil income. Even after the considerable fiscal reforms of 2015-17, recurrent taxes and fees only accounted for slightly more than 10 percent of total state spending in 2017.
The government continues to account for about two-thirds of all employment of Saudi citizens (figure 1), a dramatically higher share than the 10-20 percent in most other countries.
Figure 1: Share of public in total employment of citizens
Salaries constitute close to 50 percent of all Saudi government expenditure, compared to a typical ratio of 20-30 percent around the world. Pay for the minority of Saudis employed in the private sector is lower than in government. Because much of the income of the foreign workers who dominate the private sector is remitted home, household demand in the private economy therefore depends on spending from government employees and thereby is indirectly fed by government.
The kingdom has seen significant economic adjustment measures since 2015, including a brutal corruption crackdown, slashing of government capital expenditure, and delayed or cancelled contractor payments. Most of these have affected economic elites rather than the population at large, however. When fiscal adjustment really hit households in the shape of public sector allowance cuts, the measures were reversed after a couple of months. The recent introduction of VAT and higher energy prices were accompanied by generous compensation measures for Saudi households. Among the major budget items, salary spending has increased the fastest in 2017 and is set to do the same in 2018. Broad-based wealth distribution and sensitivity to the popular mood have continued even under the kingdom’s new, much more ruthless leadership.
The private sector – while treated more harshly – remains as deeply state-dependent as Saudi households, both indirectly through the consumption spending of government employees and directly through contracts and subsidized inputs. The ratio of private sector GDP to state expenditure has remained in a steady state ratio of about 1.2-1.3 since the 1990s, meaning that private economic activity closely tracks state spending. The ratio of government to private consumption in Saudi Arabia is about three times higher than the international average, and much of the private consumption is indirectly state-induced.
The private sector has far to go to create an economy that is driven by self-sustaining private demand, not rent-financed government spending. But how far? One way of answering this question is to estimate what the Saudi private sector would have to look like to sustain a non-rentier system of a similar size to the current rentier economy. We will look at two key aspects of the non-rentier economy: the ability to finance of state operations through domestic taxes rather than external rents and the private sector’s capacity to be the main provider of citizen employment. These two can be understood as minimal criteria for a “post-rentier” economy and reflect economic structures in all of the world’s (non-Communist) non-rentier economies.
States in non-rentier economies are largely financed by domestic taxes, and these taxes are derived from private economy activity. They can be levied on profits, employment or consumption and be borne by owners of capital, workers or consumers. But no matter who takes the hit, the income to pay these taxes needs to be generated in the private economy (unless the state taxes itself). Assuming that the kingdom wants to maintain its current level of state activity, we therefore estimate which level of taxation the Saudi private sector would have to bear to maintain recent levels of state spending.
Saudi state spending reached 926 billion SAR in 2017 and planned spending for 2018 is 978b SAR, while income from recurrent taxes and fees in 2017 amounted to less than 100b SAR. Taxes would have to fill a gap of close to 900 billion SAR (about a third of Saudi GDP) to fully finance state operations planned for 2018. How large would the private sector need to be to be able to bear such a burden? We use OECD taxation levels to provide benchmarks. The average OECD tax/GDP ratio is 34 percent, the lowest being 23 percent (Ireland) and the highest 45 percent (Denmark). The current Saudi tax/GDP ratio is about four percent.
Table 1 shows that the Saudi private sector would have to grow significantly to be able to realistically finance current government expenditure through taxes. Even at Danish taxation levels, the private sector would still need to grow by 29.8 percent to fill the financing gap.
Table 1: How large would private sector GDP have to be to support current government spending under different tax/GDP ratios?
* assuming the GDP share of the private economy in KSA reaches the OECD average of 78%
At current levels of private sector activity, Saudi government expenditure levels simply cannot be tax-financed – especially if we consider that for reasons of political feasibility and competitiveness an Ireland-level tax ratio is much more realistic than a Danish one.
In practice, given weak private demand generation and strong dependence on government stimulus, increasing taxes would lead to significant contraction of the Saudi private sector. There is an acute trade-off between raising non-oil revenue and private sector growth. Conservatively assuming a fiscal multiplier of 0.5 (based on IMF estimates), raising taxes by 900b SAR would shave 450 SAR off GDP – more than a third of the size of the current private economy, while creating significant inflation. This makes the growth assumptions needed for the above taxation scenarios even more implausible. Total factor productivity and labor productivity would have to increase dramatically to allow such private growth. They have, however, been stagnant since the 1970s.
Most employment in non-oil economies is created in the private sector. How many jobs would the Saudi private sector have to provide to make local labor market structures converge on those of non-oil countries? We again use the OECD as benchmark. Figure 2 below shows the share of public in total employment in the OECD. The average of 20 percent is drastically lower than the Saudi share of about 65 percent.
Figure 2: Public sector employment as a percentage of total employment across the OECD (2009 and 2013)
In estimating how many private jobs would be needed for the kingdom to converge on OECD levels, we first build a scenario in which total employment levels for Saudis stay constant. In this case, 2.27 million jobs would need to move from the public to the private sector – a growth of 120 percent on the private side (see table 2). At a compound annual growth rate of five percent for private Saudi jobs, this would take 16 years; at a three percent growth rate, 27 years. In principle, shrinkage of state employment would allow lowering of state expenditure and thereby reduce the fiscal burden on the private sector estimated in the previous section. Less expenditure would also reduce government-induced private demand, however, in turn making it harder to create private growth and jobs. There are millions of low-cost foreign workers in the Saudi private sector that could in principle be replaced by Saudis. Attempt to induce such substitution in the past have, however, created considerable costs for business and a shrinkage in aggregate employment. (See Leber in this collection).
Table 2: Current and hypothetical OECD-like distribution of jobs in Saudi Arabia
In practice, the Saudi workforce continues to grow at about two percent per year, so job creation would have to be considerably faster to avoid quickly rising unemployment or continued reliance on government jobs.
The above scenario assumed a constant Saudi workforce. What if Saudi Arabia aspired to OECD-type employment ratios? The current share of Saudis in working age who hold jobs is 35.4 percent, a uniquely low number in global comparison. The OECD average is 67.8 percent. To reach an OECD-level public/private job ratio and participation rate, private sector jobs for Saudis would need to grow by 321 percent to almost eight million (table 3). At a five percent CAGR of private Saudi jobs, this would take 30 years; at three percent growth, 49 years.
Table 3: Current and hypothetical OECD-like distribution of jobs in Saudi Arabia assuming an OECD-level employment ratio
This estimate again abstracts from future growth of the Saudi working age population, which is likely to expand by about five million within the next 20 years. Accommodating this new generation at the average OECD employment ratio would require the creation of about 3.65 million more jobs, of which 2.88 million would need to come from the private sector. This could only be borne by a substantially larger private sector. At current (low) Saudi private pay levels, just the salaries of 7.96 million Saudis in the private sector would gobble up more than 60 percent of private sector GDP, compared to the current ratio of 17 percent.
In sum, even at private employment growth rates that have never been achieved among mid- to high-income countries, Saudi Arabia would need decades to reshape its labor market to reach the OECD benchmark of high employment and (relatively) low state dependency. The above scenarios are purely illustrative and should not necessarily be a target for policy-makers. They do, however, give an idea of how far the kingdom is from a “normal” economy based on private production and employment, and how heavily state-dependent the labor market is.
The point of this note is not prediction or prescriptive scenario-building; it is creating a theoretical benchmark to assess how far Saudi Arabia is from a post-oil economy. Moving beyond hydrocarbons dependence is a valid ambition, but the depth of the structural change needed is often underestimated. Even under ideal conditions, it will be impossible to become “post-rentier” by 2030 and hard to imagine even by 2050. The maths are quite similar for other high-rent countries, including those of the GCC.
The note has assumed that Saudi Arabia will remain a high-income country. There is in fact a quicker way to become post-rentier: through pauperization due to falling and eventually vanishing resource rents. The fiscal constraints created by lower oil rents would sooner or later lead to lower government spending, which will in turn also shrink the private sector – but quite likely at a proportionally lower rate, as happened during the austere 1980s and 1990s. Relatively speaking, the economy will be less oil dependent, but also poorer. Given the current oil price environment and the kingdom’s fiscal and overseas reserves, this is not an immediate prospect. Yet it might well happen before the structural conditions for a prosperous post-rentier age are in place.
 See the MoF’s 2018 budget statement, which contains an overview if 2017 spending and expenditure categories: https://www.mof.gov.sa/en/financialreport/budget2018/Pages/default.aspx
 For 2018 and 2018 Saudi budget data and details on social transfers see https://www.mof.gov.sa/en/financialreport/budget2018/Pages/default.aspx and https://www.mof.gov.sa/en/financialreport/budget2019/Pages/default.aspx
 See the official budget statement from December 2017: https://www.mof.gov.sa/en/financialreport/budget2018/Pages/default.aspx