Since at least the 1970s, the social contract between GCC states and their citizens has been based on a unique system of wealth distribution that provides a wide range of in-kind benefits, including free education and healthcare, energy and food subsidies, and housing support. The most important and unusual benefit of all, however, has been an open-ended guarantee of government employment, particularly for male citizens. This has led to significant overemployment in GCC public sectors, with the majority of nationals holding public rather than private jobs – a situation that is almost unparalleled in the world. The only other country with a comparable welfare system is the small Southeast Asian petro-monarchy of Brunei.

While this arrangement has maintained a broad middle class and kept social peace, it has come at inordinate fiscal cost: In Bahrain, Kuwait, Oman and Saudi Arabia, spending on government salaries and benefits now reaches 50% and more of total government expenditure, which is more than twice the share in advanced non-oil countries. While the share is lower in Qatar and the UAE, their wage bills have also been creeping up quickly.

Public employment guarantees have become fiscally unsustainable in an era of double-digit fiscal deficits. They are also highly economically distortive, as they discourage nationals from becoming active in the private economy, resulting in very low overall labour market participation by citizens. They lead to distorted education and skills acquisition choices and, in many cases, unrealistic expectations regarding work hours and working conditions in the private sector. Especially in the GCC countries with relatively lower oil income per capita relatively less oil-abundant Bahrain, Oman and Saudi Arabia, public employment has also become a highly exclusive and inequitable benefit as not all new job seekers have access to it anymore. Finally, excess employment in public sectors has been bad for administrative efficiency, as de facto job guarantees break incentive systems and make targeted, needs-based recruitment difficult.

It is clear that this system cannot continue – but what can replace it? Simply rescinding job guarantees without compensation is not feasible socially or politically: GCC nationals arguably have a moral and political claim to minimal welfare given the riches of their countries. Wages in the low and mid-skilled segments of the local private sector, moreover, are pulled down by the easy availability of low-cost expatriate labour – another unique feature of GCC labour markets – which makes it difficult for all but the most skilled nationals to compete effectively even if they decide to do so.

GCC economies instead need smart wealth distribution reform, converting spending on surplus public jobs into less distortive, more inclusive and market-conforming welfare mechanisms. The debate on such reforms started across the region after the collapse of oil prices in 2014, and several governments have already experimented with new wealth sharing mechanisms. Some of the debate has been inspired by broader international discussions of a universal basic income (UBI) and other innovative welfare policies, themselves motivated by increasing labour market inequality and threats to traditional employment through automation and artificial intelligence – trends that potentially augment the national employment challenge in the GCC too.

Distributional reforms ideas

There are two basic approaches to distributional reform: unconditional sharing of cash (as through a UBI) or means-tested support payments.

Unconditional cash grants would go to all adult citizens and could serve as a more transparent and inclusive replacement for the wealth sharing implicit in government employment. Such grants should only be available for citizens who do not already hold a government job, thereby incentivizing more entrepreneurial public employees to potentially leave government and try to top up their newly acquired UBI with incomes from private employment or entrepreneurship.

“Golden handshake” policies of early retirement could further help trim the public payroll. New recruitment in government would happen only selectively, leading to significant long-fiscal term savings through gradual, needs-based government downsizing. The leadership would need to give a clear political signal that the government employment guarantee has ended – and stick to this decision. In the short run, complementary financing for a new UBI could be mobilized through energy subsidy reforms, effectively replacing another regressive and distortive, if somewhat smaller, wealth sharing mechanism with a more inclusive one.

The beauty of a well-designed UBI would be that it would provide basic security and a clear and transparent commitment to citizen welfare, while being low enough to incentivize nationals to seek complementary private income to reach the middle class lifestyles they desire. Thanks to a UBI, they could do so even with relatively modest supplementary private income.

A second, somewhat less radical approach to distributional reform would be to gradually replace the public sector employment guarantee with more conventional means-tested benefits. One version of these would be a basic income guarantee under which welfare payments are phased out with increasing (private) income. While fiscally less costly, such a system would result in implicit taxation of private incomes, thereby disincentivizing private effort compared to a UBI arrangement.

To reduce this disincentive effect, at least some of the means-tested benefits could be made contingent on private employment, providing wage subsidies that would again be phased out with higher wages – similar to the Earned Income Tax Credit in the US or the Workfare Income Supplement in Singapore. Such wage supplements would encourage citizen labour market participation and improve take-home incomes. At the same time, as some of the subsidies would be indirectly captured by employers due to lower gross wage demands, they would help to narrow the labour cost gap with expatriate workers. This gap is especially large in lower-skilled segments of the labour market [see first graph below]. Again, a combination of transfers and market income could together allow nationals to maintain a middle-class lifestyle.

Any of the above scenarios would be cheaper in the long run than mass public sector employment. The schemes are also less distortive of economic incentives, more conducive to private economic activity, more inclusive, and distributionally progressive compared to the status quo. They are also sensitive to the particular social and economic context in the Gulf, where nationals are exposed to particularly harsh competition from low-wage foreigners, justifying levels of assistance that go somewhat beyond what is offered on advanced labour markets that are less reliant on low-cost migrant workers.

Practical experiences and obstacles

Several countries in the region have gathered initial experiences with innovative distributional reforms. In December 2017, Saudi Arabia introduced a “citizens’ account” system that provides mean-tested cash grants to Saudi households to compensate them for energy subsidy reforms and tax increases. While the means-testing has not been perfect, the program has had a positive distributional effect, primarily aiding poorer households, while under the previous energy subsidy system rich ones tended to benefit disproportionately.

Kuwait has been providing wage subsidies for nationals in the private sector since the early 2000s, which has helped the country reach higher levels of private citizen employment than in Qatar and the UAE. The system’s efficacy has been undermined by repeated increases of public sector wages, however, and it is not means-tested but rather disproportionately benefits Kuwaitis with higher levels of education. There is also evidence of subsidy fraud, highlighting the need for strict monitoring and sanctioning mechanisms in any such system.

Kuwaiti and Saudi technocrats are now discussing UBI and augmented wage subsidy policies internally. While means-tested systems are harder to implement and also are a harder political sell, high-deficit countries like Bahrain, Oman and Saudi Arabia might not have the fiscal luxury anymore to move to a full UBI. For high-rent countries Kuwait, UAE, and Qatar, the UBI option remains feasible and attractive.

In the short- to medium term, the trickiest part of moving to a new distributional system could be the temporary cost of transition. To make public sector downsizing politically acceptable, governments likely have to offer golden handshakes and while UBI or wage subsidies would kick in immediately, the savings from government shrinkage would likely accrue only gradually. In this context, fiscal savings from complementary reforms such as a reduction in energy subsidies could be very helpful: In a recent research paper on distributional reforms in Kuwait, I estimate that the savings from energy subsidy reform alone could finance an ongoing monthly grant of 212 KD per adult ($692) outside of government.

Outlook

The GCC is coming late to the international debate about welfare innovation but is in fact an ideal testing ground for new distributional policies, given that its existing distributional regime is so distortive. Notably, none of the arguments against universal basic income schemes that are routinely made in the Western context apply in the Gulf: different from OECD countries, a UBI in the GCC would necessitate no new taxes and no new net expenditure; it could instead be financed through reforms of existing distributional structures. While a UBI could create work disincentives in OECD labour markets, the incentive distortions of the status quo in the GCC are significantly worse than they would be under a UBI. Finally, the issue of fairness – why should wealthy citizens also receive UBI? – is much less acute in the GCC given that inherited employment and subsidy systems are quite regressive and disproportionately benefit better-off citizens. A move to a UBI would be distributionally progressive.

Fortunately, the GCC’s current wealth distribution regime is so lopsided that smart distributional reform can produce more winners than losers and still produce long-term fiscal savings. While the GCC has come late to industrialization and economic diversification, it has the potential to become a true global leader on welfare reform.

The way forward

In practice, the best policy mix for the GCC is likely to be a combination of different distributional tools, including both conditional and unconditional ones, though probably with a stronger focus on conditional benefits in higher deficit countries. This should not be rushed, however: before settling on a specific package, governments and thought leaders need to increase public awareness about the problems of the status quo and facilitate robust debate about new ideas of welfare reform. Reforming the social contract is a complex undertaking that requires buy-in from a wide range of stakeholders.

Governments willing to consider UBI will want to follow a rigorous approach in the process of designing the policy. This will involve first determining the optimal number of public sector employees under reasonable assumptions of institutional and individual efficiency levels that can be achieved. It will then require the definition of a process by which the surplus will be migrated to a UBI scheme, privileging a gradual process (e.g. non-replacement of employees retiring, or nudging employees towards early retirement) with the right incentives. The most delicate step will be in setting the UBI level, in a way that is sufficient for a modest middle-class lifestyle yet still creates an incentive for private sector employment. This will also have to account for the varying socio-economic contexts of recipients, requiring the development of complementary payments for those that require it.

Most notably, the unusually generous unique social contract that provides for GCC citizens creates cost structures for private producers and disincentives on the private labour market that make conventional industrialisation strategies difficult to implement. There is no clear blueprint or precedent for overcoming these constraints. Diversification will instead require cautious experimentation and a gradual reformulation of the social contract in a way that reduces distortions while maintaining living standards for GCC nationals.

How State Generosity has Increased the Costs of Production

GCC governments have been successful in spreading middle-class wealth fairly broadly among national populations that, by and large, were desperately poor just two generations ago. Yet the spreading of wealth through channels like generous state employment have also created fairly high costs for local producers: Like in other high-income countries, operating businesses in the GCC is not cheap, especially when firms are under pressure to employ nationals whose expectations on wages and working hours are informed by the generous packages available in government.

Different from conventional high-income countries, however, productivity levels in GCC private sectors have not kept pace with the rapid improvement in living standards and wages for citizens. This means that there is a real disconnect between costs of production and efficiency of production. That does not affect the fortunes of the non-tradables sector in the GCC very much, but it impedes the competitiveness of the tradables sector outside of oil and hydrocarbons-related products. A conventional industrialisation path based on relatively low technology levels but cheap labour – which, as Dani Rodrik has shown, has become difficult under the best of circumstances – is not open to the GCC. Even foreign workers, who on average are paid a fraction of citizens in the private sector, are considerably more expensive to employ in the GCC than in their countries of origin.

The relative weakness of national human resources is at the crux of the problem. GCC labour markets continue to be deeply distorted by expansive government employment, which accounts for about 70 percent of all jobs held by GCC citizens. It undermines entrepreneurial incentives, raises wage expectations, and weakens the motivation to acquire skills relevant for the private sector. While this set-up provides middle class lifestyle for a large share of nationals, the resulting labour market structures stymie private-driven diversification.

Different from non-oil economies, citizen wages in GCC economies tend to lie significantly above their marginal product, as evidenced by a striking scatterplot contained in a recent IMF Article IV report on Saudi Arabia (see p. 22). As productivity and practical skills remain relatively weak, the political pressure to provide more state employment in turn remains strong. At the same time, firms tend to focus on the non-tradables sector serving the local market, where they can rely on state-generated demand and can afford to incur higher production costs.

The GCC economies are a victim of their own success: unlike some oil-rich kleptocracies outside of the region, they have shared their riches relatively widely and greatly improved national living standards. As a result, however, production costs and real exchange rates are high, while productivity has been flatlining.

As competing on the cost of labour inputs is not feasible, the GCC can only become internationally competitive by leapfrogging into advanced kinds of production. But this is difficult and few economies have managed to do so. Dubai has accomplished some of it through heavy use of skilled foreign manpower in its advanced service sectors, but the model is unlikely to be replicable for GCC countries with larger national populations. The experience of populous commodity-rich countries outside of the region, like the oft-cited Malaysian case, is not particularly relevant. Different from the GCC, Malaysia was not a rich, middle class-based society before industrialisation. Its per capita rents were limited and it could therefore leverage ample cheap labour in the first stages of industrial growth.

That said, GCC economies have assets that other late industrialisers do not: ample capital, high penetration of consumer technology, well-run state-owned enterprises in critical sectors, and a geostrategic position between Europe, Asia and Africa. Some economists see access to relatively cheap foreign labour as a further advantage, but the long-term evidence seems to be that reliance on such labour has pushed GCC economies onto a low productivity path – unlike other industrialisers, where growing supply constraints on national labour pushed firms into investing into skills and technology. GCC economies by and large remain organised around foreign labour – cheap enough to maintain a convenient service economy for citizens but not cheap enough to compete with truly low-cost producers in Asia.

Is There a Solution?

The first conclusion from the above discussion has to be that there is no ready blueprint for GCC diversification: both the assets and the constraints of GCC economies are rather unique. The best that policy-makers can do is to alleviate the constraints in a target fashion while facilitating wide-ranging experimentation with new models of production that might leverage the GCC’s specific assets.

The key binding constraint is low labour productivity. While this can be said about almost every economy struggling to diversify, the factors depressing productivity of national labour in the region are rather specific. They include a labour market that is organised around public sector employment, in which nationals are deterred from seeking private sector jobs through competition with low-cost foreign workers, and in which employers have few incentives to invest in skills or technology given their barely constrained ability to import labour. All these incentives need to change. This could be through gradually converting excess public sector employment into a much less distortionary general cash grant for all citizens, subsidies for national labour in the private market (as already implemented in Kuwait) or migration management that decreases incentives to rely on low-cost workers. We do not know the ideal policy mix, but we know which distortions need tackling, while recognising the political need to maintain a middle-class lifestyle for citizens.

Local experience shows that labour market attitudes can change. In some hotels in Riyadh, Saudis now provide room service – something that was socially unthinkable a decade ago. The willingness to take on private sector work is increasing. This needs to be accompanied by more targeted efforts at upskilling, moving away from the over-production of university graduates in subjects of limited practical relevance. Saudi Arabia’s university enrolment rate of around 70 percent might be the highest in the world, but few programmes prepare graduates for the actual labour market – many of them instead merely serve to postpone unemployment by a few years, while increasing expectations of white-collar employment.

There is time to redefine the social contract in the majority of GCC countries: with the exception of Bahrain and Oman, they retain enough fiscal runway to smooth the transition to a new system. But under current oil prices, this will not be the case much longer, especially in the relatively less wealthy Saudi Arabia. Sticking to the current welfare system for too long increases the risk of a forced adjustment in which the social contract is forcibly dismantled through fiscal and currency crises – not unlike what Egypt experienced in recent years.

Even if the incentive environment is reformed, the GCC’s unique development constraints mean that there is no cookie-cutter recipe for diversification and the international benchmarking that the region’s public policy consultants are so fond of often is of limited relevance. The GCC instead has to find its own path towards leveraging its strengths in digital literacy, heavy industry, infrastructure, geography and consumer tastes. Doing this will require a wide range of experimentation with new forms of production, a process of discovery that can be supported through provision of credit, equity, targeted training and specialised infrastructure. The process should involve private capital and be decentralised. It is less advisable to focus on a few large, state-engineered bets that could go wrong and end up as white elephants.

Until now, none of the GCC governments have really touched the core distributional bargain based on public employment. While there is much investment in new sectors and infrastructures, the policy discussion about sustainability and reform of the GCC social contract remains limited. It is the hardest bit of the economic reform process, but also the one that will pay the strongest long-term dividends.