With a widening state deficit, it is time for the Kingdom’s fiscal system to mature.

Nearly two decades after the departure of the United Nations’ mission to usher in Cambodia’s democratic system after years of upheaval, the country still receives around half its revenues from foreign sources.

One source is foreign development assistance and another is foreign loans and grants – mainly from China – and there’s little indication this situation will end any time soon: government revenues in the first nine months of 2011 rose to 4,474.81 billion riel ($1.18 billion), a 6.7% increase on the same period last year, but the amount falls well short of the 5,919.97 billion riel ($1.47 billion) of spending to September.

With a 2012 budget allocating $2.75 billion in spending, the coming year is also likely to result in a wide deficit. To fill this shortfall, the new budget gives the government the option of drawing on $1.1 billion in concessional loans, but an increase in domestic revenues remains key to weaning the country off foreign sources of income and insulating it against external economic shocks. In a report released last February, the International Monetary Fund (IMF) argued that current revenue levels will continue to “limit the scope to fully address development priority needs”. “Potential setbacks in efforts to strengthen the business environment and enhance public sector revenues and service delivery constitute major downside risks to growth,” it stated in the report.

How to achieve this remains the million-dollar question. The lion’s share of local revenue – more than four-fifths projected for 2011 – is made up of taxes. Revenues from tax are on the up in Cambodia: in the first nine months of 2011, tax receipts increased by around 10% on the same period last year, from 3,462.35 billion riel ($865m) to 3,823.17 billion riel ($955m). But the system operates well below its potential: the IMF report noted that while the country’s tax revenue to GDP ratio has doubled since the mid-1990s to 12 percent, it remains the second-lowest among low income countries in Asia (average 17%).

The system is also hamstrung by bureaucracy and corruption. For instance, the introduction of a new property tax – set to come into force at the end of 2011 – has been rocky, with property owners complaining of a lack of public information and the payment of a rash of informal ‘fees’ to tax officials. Local media have reported that property owners were being asked to value their own properties, and that few have received information from the authorities about the new tax.

Like much of the financial system, Cambodia’s tax system remains in its infancy. The current banking and finance system is barely two decades old, erected following the 1975-79 rule of the Khmer Rouge, which abolished money and ushered in a Stone Age barter economy. Despite great strides since the early 1990s, when the country exchanged its old system of state socialism for a modern market-based economy, the country faces massive challenges in habituating the concept of taxation, creating mechanisms to levy and collect it and ensuring the transparency of public finances.

“Cambodia is an evolving society,” said Mukul Asher, a finance professor at the National University of Singapore’s Lee Kuan Yew School of Public Policy. “It’s not easy to have human capital development [and] institutional development come to almost halt for a generation or more and then come out and create a modern state that quickly.”

Cambodia currently derives the majority of its tax revenue from taxes on goods and services, while income and capital gains taxes – difficult to engineer in an overwhelmingly rural, cash-based economy – remain low. Professor Asher earmarked property tax and taxes on natural resource extraction as two key areas in which Cambodia has the potential to boost revenues – especially if recent oil discoveries in the Gulf of Thailand translate into a significant revenue stream.

With support from international institutions, the Cambodian government has plans in place to boost tax revenues, but critics say the key will be what the Kingdom does to tackle the country’s endemic levels of corruption. In its most recent Corruption Perceptions Index, released last month, global graft watchdog Transparency International ranked Cambodia equal 164th out of 182 countries for public sector corruption. One of the first issues tackled this year by the country’s new Anti-corruption Unit was the collection of road ‘taxes’ by traffic police.

Opposition leader Sam Rainsy said the country’s relative dearth of tax revenues could be put down to one thing – misappropriation of funds by ruling elites. “Cambodia’s main problem is the lack of rule of law allowing corruption and irresponsibility to thrive,” said Rainsy, who served as finance minister during the 1990s. “There is no political will to reform and modernise the tax system because any effective reform would undermine the interests of the ruling elite.”

Asher said the possible influx of potential oil revenues would be a litmus test for the tax system. “Whether they have the capacity to suddenly utilise large amounts of revenue in a productive way, or whether it will be frittered away – that is a very big public financial management challenge,” he said.

Rainsy was critical of the general lack of financial transparency in the country – even to elected members of the political opposition. For instance, he argued, it is impossible to determine the extent of Cambodia’s foreign debt since government officials spout varied and contradictory figures. Rainsy and his self-named Sam Rainsy Party, also claims the $1.1 billion in concessional loans included in the 2012 budget have been subject to little parliamentary oversight.

Meanwhile, the dependence on foreign loans – not to mention development assistance – is useful for government patronage, allowing “continuous fiscal and monetary irresponsibility by the government, rampant government corruption and an undemocratic patronage system unable to effectively move the country out of poverty”, Rainsy said.

Ultimately, Professor Asher said the reform of the country’s public finances and the establishment of a modern tax system was part of a wider systemic challenge, which would need to be underpinned by political will. In addition to tackling corrupt activity in and of itself, the country will also need to set long-term goals. “Some part of this is also going to be building of social capital, having some sort of a vision for the country, and elites and others that are committed to the vision in substance and not just in terms of political slogans,” Asher said.

Whether that is the case in Cambodia remains to be seen, but Asher said that there was room to be cautiously optimistic about the country’s financial future. With assistance from international financial institutions such as the Asian Development Bank and the International Monetary Fund, it can certainly turn things around. “That will make Cambodia a much more valuable partner for the other countries, while improving the future of its citizens.” ϒ