When 1950s economics can predict the future: A look at Dubai

December 7, 2009

A little theory should go a long way in providing a “beware” sign for investors and workers who lined up to take part in the UAE’s economic boom in 2007. And one of the surest signs should have been: be cautious of a modern Government without an income tax.Only last year 20 MBA students went with the international experience to Dubai and Abu Dhabi for two weeks in January. During the height of the financial crises, we witnessed the sudden halt and reversal of immigrant labor, erosion of lucrative ex-patriot benefits, and seemingly sudden vulnerability of an economy based on one resource: oil (abu dhabi) and investment (dubai). Lurking in the background of the UAE’s fall was, however, basic errors in property rights, legal structures, and economic planning defined Dubai and Abu Dhabi as iconoclastic “rentier states” which should have served as indicators of what was to come. Christopher Davidson’s recent book Dubai: The Vulnerability of Success, sums up the evolution of the rentier state that was the UAE. The idea is simple: free tax zones and lax restrictions on foreign investment suddenly made patches of otherwise valueless Arabian Desert very expensive. And since only national Emirates could own property, UAE citizens became immensely wealthy overnight by simply leasing the land (for housing, commercial or oil purposes) and obtaining rents. This created a class of wealthy “landlords”, the benefits of which could be largely protected from being distributed to expatriate immigrants. This form of rent-based economy is not unique, and in fact traces back to other oil-rich economies from 1950s Iran to 1990s Gabon and Cameroon, who all faced subsequent economic meltdowns. One would hope that Abu Dhabi and Dubai would have learned from their mistakes. Abu Dhabi, as we saw, attempted to emulate the so-called “Norwegian Model” of government structuring, following Norway’s immense economic boom after discovery of oil in the North Sea. Significantly however, whereas Norway heavily taxes citizens and distributes its rent-generated income in various pension and health-care schemes, the UAE has never taxed its citizens and enforcement of business tax remains voluntary. Yet this seemingly slight (and from a personal viewpoint – very desirable) deviation from the Norwegian model has dire consequences for the region, and the UAE fell into the classic rentier trap. Since the UAE governments did not need the tax revenue from its businesses and citizens, the role of the government changed from being primarily a distributional force to a welfare (allocative) spender. Mentally, as any large welfare program experiences to some degree, this shifts citizens views from being ‘earners’ of money to recipients of money; wealthy by mere fact of their status as citizens. This brings about a mental change away from a desire to produce work and towards reinforcing the status-quo: in this case, property ownership by the elite. In other words, free money creates an incentive to find ways to consume wealth rather than create it. Secondly, wages suffer distortion in a rentier economy, which is already very vulnerable to price disruptions (so-called Dutch disease) since it is dependent on a single source of income. As prosperity increases, labor wages and unwillingness to take local jobs drive an influx of foreign labor, but since rents are narrowly concentrated, the rewards of the labor go mainly to increasing the already-wealthy rent-holders. The same labor, conversely, will subsequently be driven out in a recession as it competes with domestic jobs – as when both the white-collar and working-class ex-patriots found themselves without a job in Dubai almost overnight. While these economic factors play a role in any economy, the singular dependency of the rentier state magnifies their effects immensely. Overall, the greater shock is not so much that Dubai and Abu Dhabi are struggling to recoup foreign investment and the economic loss, but that neither state seemed to take heed of the errors of their foregone cousins.

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Leif Linden