Journal Article

How Can Fiscal Policy Untap Lebanon’s Manufacturing Potential?

| Mar. 14, 2023

While Lebanon's economic crisis has rapidly worsened since 2019, untapped opportunities for exploiting existing productive capacity and enhancing local manufacturing remain. The cost of labor has decreased as poverty rates have increased and as the Lebanese pound’s (LBP) value has deteriorated. These developments have prompted Lebanese entrepreneurs to launch business initiatives focused on manufacturing sophisticated products, such as electric bicycles and lithium batteries. Such decisions suggest – or signal that the business community is confident – that there are enough unemployed individuals with relevant skills to meet labor demand in these sectors. These initiatives could entice qualified youth to forego emigration, create high-quality private sector jobs, produce additional sophisticated products, increase economic output, reduce demand for public sector jobs, and efficiently utilize savings in the absence of a functioning banking sector. While the state is not currently incentivizing such initiatives, their numbers and size could grow using fiscal policy tools, namely, tax incentives. Such measures would not only aid entrepreneurs and firms but also contribute to diversifying Lebanese manufacturing. 

As a starting point, it is necessary to identify and assess firms’ and manufacturers’ incentives for branching into a new market. A clear idea about how firms decide to enter markets would inform policy makers and firms about market exploration mechanisms, whether market failures exist, and what incentives may work. Additionally, identifying which firms and products survive longer and grow faster could better inform state policies aimed at incentivizing economic development and growth. As documented by Amsden (1992)Kehoe and Ruhl (2013), and Lucas (1993), new products and economic growth are correlated within the industrialization processes of countries. Haidar (2022) showed that firms which optimize entry decisions and internalize informational externalities survive longer and grow faster. The study complemented recent research on the determinants of product diversification and success, as well as the design of diversification policies.

Lebanon’s manufacturing sector has been lagging for over one decade, far pre-dating the outset of the economic, financial, and monetary crises. The overvalued exchange rate and relatively high labor costs contributed to reducing the competitiveness of locally manufactured products in foreign and local markets before 2020. Compounding this, the monopolized market structure lowered entry incentives in key manufacturing sectors. As a result, from 2011 to 2019, value added in manufacturing dropped by 25% to $3.1 billion, and by another 27% from 2019 to 2021. 

Lebanon's economy has become less complex over the last 10 years, worsening four positions to 47th on the 2020 Economic Complexity Index (ECI) ranking. Lebanon's diminishing complexity was driven in large part by a lack of export diversification. The largest share of Lebanon's exports are stone and agriculture, which are classified as moderate and low complexity products. While Lebanon has diversified into a sufficient number of new products, the contribution of these products to substantial income growth remains small. Specifically, Lebanon has added 17 new products since 2005, which contributed $8 in income per capita in 2020. 

Growth can be driven by a process of diversifying know-how to produce a broader and increasingly more complex set of goods and services. Lebanon is more complex than expected for its income level, but that is not enough. Countries in which products are more complex than expected for their income level grow faster. Moving forward, Lebanon can take advantage of many opportunities to diversify its local production of goods using its existing knowhow

However, Lebanon has yet to initiate the process of structural transformation, a key source of economic growth, which refocuses economic activity from low- to high-productivity sectors. It broadly moves production activities out of agriculture into textiles, followed by electronics and/or machinery manufacturing. Lebanon’s global market share in textile exports stagnated over the previous decade while electronics and machinery have yet to take off. Lebanon's production dynamic over the past five years has been driven by services. Worryingly, exports in services have fallen, and as a result, economic growth in Lebanon has been hindered by concentrating on a declining sector of global exports.

Countries tend to diversify by moving into nearby and related products or into those that require similar knowhow to build on existing capabilities. For example, countries that produce textiles are highly likely to be able to produce other textiles, but share few links to the knowhow required to produce machinery. Recent publications outlined paths to diversify Lebanon's economy based on the connectedness of its knowhow. They promoted the need for (a) government incentives for entrepreneurs to focus on developing highly sophisticated products,  (b) complex exports through upgrading productive knowledge, and (c) capitalizing on Lebanon’s comparative advantage. Lebanon has comparative advantage in the production of agri-food, machinery and electrical equipment, chemicals, and paper and wood. Thus, Lebanon is able to diversify its products further by developing these sectors, among others. 

By understanding Lebanon's productive capacities, policymakers can use incentives to create jobs in sectors in which Lebanon has a comparative advantage. For instance, targeted and well-designed tax incentives – such as exempting imported intermediate products or capital goods from selected tariffs, as well as exempting existing and new companies in specific sectors from taxes – can encourage the manufacturing of new products that Lebanon is able to produce. Targeted corporate tax incentives can also encourage quality vocational training and support innovation. Moreover, such a move can help diversify Lebanon's manufacturing base without focusing on or favoring a few large and influential firms. 

Recent evidence shows that tax incentives work. Consider that the value of Lebanon’s car imports increased by 78% from 2021 to 2022, to $1.87 billion, the highest level of car imports in terms of value since at least 2013 (the earliest available data). Moreover, the value of Lebanon’s machinery and electrical equipment imports increased by 108% over the same period, to $2.45 billion. As the Lebanese anticipated higher customs duties at the end of 2022, they rushed to buy cars and machines in higher quantities before the Ministry of Finance increased the customs dollar rate from LBP 1,500 to LBP 15,000.1 This evidence suggests that fiscal authorities can incentivize further imports of machines to enlarge Lebanon’s production base, using tax and tariff incentives.

Taxing employers discourages them from hiring and exploring new product markets, particularly during the current crisis. Taxing employees’ wages lowers their take-home pay and discourages productivity. Making across-the-board reductions to these tax burdens would be difficult for fiscal authorities in Lebanon, as the government is already battling to reduce fiscal deficits. Thus, such targeted tax incentives could generate employment gains as well as enhance and diversify the manufacturing sector at an efficient cost. Such tax incentives are costless for the government in the short term and can raise public revenue expectations in the medium and long terms. Without such tax incentives, firms may not be willing to enter markets or expand investments. But, with such tax incentives, firms may be willing to do so in the short term and the government can raise taxes from them in the medium and long term.

Tax incentives in specific manufacturing sectors are a low-hanging fruit for economic policy makers in Lebanon. There is an urgent need to create jobs for the skilled labor force in the country, especially as Lebanon has existing comparative advantage and productive capabilities in relevant sectors. Developing these manufacturing sectors requires a small push in the form of incentivizing producers and entrepreneurs to go in this direction. Such a push does not need foreign funding, infrastructure investment, or specialized education reform. The required human capital exists in Lebanon. Tax incentives can make a breakthrough assuming there is political will and commitment at the highest level, especially as the market players will not go in this direction without incentives. 

Recent research shows that once a firm is incentivized to enter a market by tax policies or other measures, it will most likely be followed by another firm to the same market if it succeeds. First-movers generate information that can be used by late-movers to a market. This information is typically concerned with market supply and demand. Firms can learn from each other about product demand, consumer preferences, quality standards, regulations, and distribution networks. However, a lack of government action reduces incentives to enter a new product market, even by more productive exporters. The large probability of market coordination failure necessitates government action – i.e. tax incentives – to move the manufacturing sector to a more preferred equilibrium in Lebanon.

  – Via The Policy Initiative.

For more information on this publication: Belfer Communications Office
For Academic Citation: Haidar, Jamal. How Can Fiscal Policy Untap Lebanon’s Manufacturing Potential?.” , (March 14, 2023) .

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