## cr1763

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### Executive summary
- Iran’s correspondent banking relationships (CBRs) were severely damaged by economic sanctions over the past 10 years, disconnecting Iran from the global financial system and disrupting cross-border flows including trade finance and remittances.
- Despite the lifting of international nuclear sanctions on January 16, 2016—“Implementation Day” under the Joint Comprehensive Plan of Action (JCPOA)—Iranian banks face protracted difficulties re-entering the international financial system through correspondent relationships with global banks.
- Progress since Implementation Day includes SWIFT reconnection of the Central Bank of Iran (CBI) and a large number of Iranian banks, and initiation of correspondent relationships by over 200 small and medium-sized international banks.
- Remaining impediments include remaining U.S. sanctions and restrictions, regulatory enforcement risks, deficiencies in Iran’s AML/CFT framework, and lack of transparency of Iranian corporate ownership.

### Sanctions status and legal constraints
- Timeline and scope:
  - First sanctions followed the Iranian revolution in 1979.
  - UN introduced its first sanctions on Iran in 2006.
  - In 2012, the U.S., UN and EU tightened sanctions introducing an oil embargo and banning financial transactions with Iranian banks.
  - JCPOA Adoption Day: October 18, 2015. JCPOA Implementation Day: January 16, 2016.
- Remaining U.S. sanctions and restrictions:
  - U.S. primary sanctions apply to U.S. financial institutions and companies, including their non-U.S. branches (but not their subsidiaries).
  - With very limited exceptions, businesses and individuals related to the U.S. continue to be prohibited generally from dealing with Iran, including with the government.
  - The so-called “U-Turn” transactions remain prohibited; U.S. dollar clearing restrictions have not been lifted.
  - Foreign financial institutions may process U.S. dollar transactions involving Iran only if such transactions do not involve, directly or indirectly, the U.S. financial system or any U.S. person and do not involve any person on the Specially Designated Nationals (SDN) list.
  - Snap-back: Under the JCPOA, there is a period of 10 years during which Iran could be subjected to the reinstatement of sanctions in case of nonperformance of its nuclear-related obligations.
- Blacklists and SDN list:
  - The UN, the EU and the U.S. maintain “black lists” of prohibited individuals and entities under Iran sanctions; not all listed entities were removed on Implementation Day.
  - Secondary sanctions continue to apply to non U.S. persons who knowingly facilitate significant transactions with or provide material or certain other support to individual and entities on the SDN list.

### Measured impact on correspondent banking relationships
- CBR counts and changes:
  - Number of CBRs dropped from 633 in 2006 to around 50 in 2014 (CBI).
  - By end-2016 the number of CBRs rose to 238 (CBI source).
  - Bankers’ Almanac reports 178 CBRs in 11 different currencies (database includes CBRs reported by banks as of December 2016).
  - 13,995 letters of credit (worth $12.8 million) were opened (source report).
- SWIFT and reconnections:
  - SWIFT reconnected the Central Bank of Iran and 15 nonsanctioned Iranian banks in February 2016 (having been disconnected in March 2012).
  - International branches of Iranian banks opened in Europe and were reconnected to TARGET 2.
- Distribution of CBRs (as reported):
  - By country examples: Turkey 33, Switzerland 27, China 26, Germany 20, Italy 19, Russia 17, India 15, Oman 15, Spain 15, UAE 15, Great Britain 12, Korea 9, France 8, Japan 8, Iraq 6, Tajikistan 5, Azerbaijan 4, Belgium 3, Bahrain 2, Sri Lanka 2, Others 8.
  - By currency examples: EUR 125, JPY 21, TRY 17, CNY 14, AED 13, INR 13, CHF 12, RUB 11, OMR 10, GBP 9, KRW 9, USD 7, IQD 2, Others 6.

### Key challenges impeding full reconnection
- Complexity and fragmentation of sanctions:
  - U.S. and EU sanctions are no longer broadly aligned, raising compliance challenges for institutions that must follow both U.S. and EU rules.
  - As of June 2016, thirty-two states (including New York) and Washington D.C have some form of state-level sanctions with measures such as blocking investments of pension funds and government contracts with companies doing business in Iran.
  - Sanctions may be re-imposed (“snap-back”), and some nonnuclear sanctions were broadened in February 2017 to cover new individuals (13) and companies (12) following Iran’s test of ballistic missiles.
  - On December 15, 2016, the Iran Sanctions (10 years) extension Act became law.
- Regulatory enforcement and compliance costs:
  - Global banks face an extremely high compliance burden and have faced large fines for violations of economic sanctions, prompting costly upgrades to compliance measures that have eroded the profitability of CBRs.
- AML/CFT deficiencies and FATF listing:
  - The Financial Action Task Force (FATF) listed Iran on its “black list.”
  - In October 2007 the FATF called on countries to mitigate ML/TF risks from Iran; from February 2008 it called on countries to apply effective countermeasures.
  - In June 2016, following Iran’s commitment to address AML/CFT deficiencies, the FATF decided to keep Iran on the public statement (the “black list”) while calling for a suspension of countermeasures for a period of twelve months.
  - Iran will need to enhance its AML/CFT framework substantially to be removed from the FATF “black” list.
- Transparency and beneficial ownership:
  - Lack of transparency and complex ownership structures of many Iranian corporates make it difficult for foreign banks to identify ultimate beneficial owners.
- Absence of large Tier I correspondent banks:
  - The absence of larger correspondent banks (Tier I) can hamper trade and investment because large-scale operations often require banks with adequate financing capacity.

### Progress to date
- Reconnection and increased activity:
  - 238 small and medium-sized international banks have started correspondent relationships with Iranian banks (CBI report).
  - SWIFT reconnection in February 2016 enabled resumption of cross-border payment transfers related to oil shipments and other foreign trade.
  - Increased opening of accounts, letters of credit, and issuance of payment orders for foreign exchange services and imports.
- Domestic legal and institutional steps:
  - In March 2016, the Parliament adopted a CFT law and made a high-level political commitment to implement an action plan.
  - Authorities requested an IMF assessment of the AML/CFT regime against the FATF standard (assessment scheduled for late 2018).
  - Iran became an observer to the Eurasian AML/CFT group.

### Policy options and recommendations to facilitate reconnection
- Strengthen AML/CFT effectiveness:
  - Bolster the effectiveness of the AML/CFT framework to address FATF-identified deficiencies.
  - Implement measures to increase entity transparency and enable identification of ultimate beneficial owners.
  - Seek removal from the FATF list of high-risk and noncooperative jurisdictions.
- Reduce compliance uncertainty for non-U.S. banks:
  - Clarify and streamline the regulatory environment to lower compliance costs and reduce the perceived enforcement risk for global banks considering CBRs with Iranian banks.
- Targeted domestic reforms:
  - Continue to implement the March 2016 CFT law and follow through on the political commitment and action plan to address AML/CFT deficiencies.
  - Prepare for and cooperate with the IMF AML/CFT assessment to build international confidence.

*Source: IMPEDIMENTS TO CORRESPONDENT BANKING WITH IRAN (February 10, 2017), International Monetary Fund.*

### Box 2. Iran’s Action Plan with the FATF — background and priority actions
- Background and status:
  - In June 2016, Iran made a formal high-level commitment to FATF to implement its action plan to strengthen its AML/CFT framework.
  - FATF decided to keep Iran on the public statement (the “black list”) but called for a suspension of countermeasures for a period of twelve months.
  - Full implementation of the plan will allow Iran to be considered for complete removal from FATF listing; if FATF determines that Iran has not demonstrated sufficient progress, the call for countermeasures will be re-imposed.
  - FATF maintained its call on members to apply enhanced due diligence to business relationships and transactions with natural and legal persons from Iran.
  - Each member country can continue imposing countermeasures based on its own assessment of risks and independently of any call by the FATF.
- Countermeasures and effects on banking relationships:
  - The suspension of the countermeasures eased Iranian banks reconnection to the small and medium size banks.
  - Countermeasures comprise, among others:
    - enhanced due diligence on the quality of respondent institution’s AML/CFT controls;
    - restrictions on opening of correspondent accounts;
    - not allowing Iranian banks to open subsidiaries in foreign jurisdictions.
- Action plan scope, items, and deadlines:
  - The action plan with the FATF includes 10 items with deadlines between May 2017 and January 2018 intended to rectify Iran’s strategic AML/CFT deficiencies.
  - Items relate to criminalization of ML/TF offenses; confiscation and provisional measures; freezing of terrorist financing assets in line with relevant United Nations Security Council Resolutions; ensuring proper AML/CFT requirements for the financial sector; enhancing the role of the financial intelligence unit and reporting of suspicious transactions; ratifying relevant United Nations Conventions (Palermo convention on transnational organized crime, 2000; New York convention for the suppression of the financing of terrorism, 1999); improving international cooperation in regulating alternative remittance systems, wire transfers, and cash couriers.
- Assessment and recommended priorities:
  - Iran’s AML/CFT framework needs further strengthening as a matter of priority.
  - Priority reforms: improving the understanding of ML/TF risks; enhancing the regulatory and supervisory frameworks; bolstering entity transparency.
  - Specific recommended actions:
    - a. Conduct a national risk assessment in line with the FATF standards.
    - b. Build AML/CFT regulation and supervision around a forward-looking risk-based assessment. The CBI should enhance risk-based supervision and impose corrective actions and sanctions when relevant.
    - c. Develop mechanisms to ensure entity transparency. A public registry for beneficial ownership would allow timely access to adequate, accurate, and current information on beneficial ownership of all types of entities in Iran.
      - Example noted: In June 2016, the United Kingdom launched a public register for beneficial ownership information of companies to enhance their transparency.
    - d. Iranian banks should improve compliance, including:
      - investing in AML/CFT internal controls including by upgrading compliance systems and training staff;
      - specializing in low risk business;
      - getting external certification or third part audit of their AML policies and procedures.
      - Correspondent banks can provide technical assistance to clarify their risk tolerance policies to Iranian banks as well as help build their capacities.
- Expected benefits:
  - Continued strengthening of the framework in line with international standards will help mitigate the risks related to ML/TF and underlying offenses (e.g., corruption, tax crimes).

### Box 1. Authorities’ Financial Sector Reform Plan — key elements
- Improve oversight of the financial sector:
  - Strengthen the capacity of the CBI by revising the banking and central bank laws to clarify and strengthen regulatory and supervisory powers.
- Regulate unlicensed financial institutions:
  - Update laws and regulations, strengthen supervision, and bring unlicensed credit institutions within the regulated financial system.
- Undertake asset quality reviews and bank restructuring:
  - Rank banks using CAMELS; differentiate reserve requirement ratios; prepare restructuring, merger, and resolution frameworks; strengthen private banks’ balance sheets via shareholder capital injections and set target capital adequacy ratios.
- Address nonperforming assets:
  - Create an asset management company; establish a credit bureau and domestic ratings agency; revise laws to allow timely write-offs; oblige banks to form NPL collection committees and provide quarterly reports to the CBI; introduce new provisioning guidelines.
- Strengthen credit market and diversify funding:
  - Use the interbank market and issuance of securities such as certificate of deposits and sukuk; prioritize financing of SMEs and working capital for manufacturing; extend microloans.
- Use open market operations in monetary policy:
  - Establish the bond market; ensure issuance of securities in electronic form; provide incentives to banks to issue sukuk and trade government bonds; engage the CBI in open market operations when the bond market is fully functioning.
- Develop the interbank market:
  - Revise operational guidelines; allow the CBI to receive and place deposits at the market, accept securities as collateral, and use new financial instruments.

### Draft Central Bank and Banking bills — objectives and powers
- Draft Central Bank bill:
  - Aims to modernize the monetary policy framework and puts price stability as the core objective of monetary policy.
  - Incorporates improvements on clarity of objective function, supervisory authority and governance of the CBI.
- Draft Banking and CBI bills:
  - Grant the CBI the power to supervise all deposit-taking institutions.
  - Include financial stability among core objectives; helping economic growth and preservation of the value of foreign currency are secondary to price stability.
  - Oblige the government to repay all the funds it receives from the Central Bank by the end of the same fiscal year.
- Additional elements needed:
  - Restructuring and recapitalization of banks is a priority to sustain financial stability and alleviate liquidity pressures.
  - Define management of financial system liquidity and lender of last resort functions in law; current uncollateralized borrowing from the CBI exposes its balance sheet to credit risk.
  - Increase operational independence for the CBI; decision making bodies should consist of qualified independent experts; better ring fencing of CBI’s resources and a capital buffer are recommended.
- Transition to policy-rate-based funding:
  - The CBI could set a policy rate consistent with its inflation target and start funding healthy banks at its policy rate against collateral.
  - Interim: target an inflation band around the current level of annual inflation (9 percent) and aim for gradual reduction.
  - The new policy rate can be a daily or weekly repo rate; banks would be able to borrow at the policy rate on a collateralized basis.
  - The CBI’s overnight borrowing rate will set the floor of the interest rate corridor and the overdraft rate will set the ceiling rate.
- Fiscal policy support:
  - A prudent fiscal stance, focusing on reducing the non-oil fiscal deficit will help ensure government oil revenue spending does not fuel aggregate demand excessively.
  - The government should stop using the banking system to implement quasi fiscal policies—such as subsidized funding from the CBI to finance government-mandated credit programs.
  - The government should bear the cost of subsidized lending through budget allocations.

### Financial Conditions Index (FCI) for Iran — construction and empirical behavior
- Variables included in the IMF staff FCI for Iran:
  - Money growth, M2 (y/y).
  - Stock market (y/y).
  - Real lending rate for banks set by the CBI (CBI rate of return on facilities weighted by loans and adjusted for inflation; latest annual inflation used for real rate calculation).
  - Real effective exchange rate (REER).
- Weighting and standardization:
  - Variable with highest volatility receives lowest weight; equity market has lowest weight.
  - Liquidity growth has the highest weight, followed by the REER and the real lending rate.
  - Series are standardized by subtracting the FCI’s mean and dividing by its standard deviation.
  - An FCI value above zero implies a tightening and below zero implies a loosening in financial conditions.
  - Quarterly averages of FCI are used as an early indicator of non-oil GDP growth.
- Empirical behavior:
  - Loosening (tightening) in FCI is followed by an increase (decrease) in non-oil activity with one quarter lag.
  - The tightening in the FCI, which started in 2013, has been partially reversed since early 2015.
  - Despite remaining tight, the FCI changed course in 2015 and loosened during the first half of 2016.
  - Increase in liquidity and rise in stock market following the JCPOA contributed to easing in the FCI.
  - The relative easing in the FCI was followed by a rise in non-oil activity starting from the third quarter of 2015.
  - Current level of the FCI suggests financial and monetary conditions remain tight despite some loosening in 2016 and it does not suggest a further increase in the pace of economic activity.

### Long-run determinants of inflation — ARDL results (January 2012 through June 2016)
- Model specification:
  - Autoregressive Distributed Lag (ARDL) (Peseran and Shin, 1997) for January 2012 through June 2016.
  - AP, ER, FAO and IP stand for seasonally adjusted regulated prices, bureau market exchange rate, FAO Food Price Index and Iran’s seasonally adjusted industrial production, respectively. All variables are expressed in logs.
  - ARDL (2,2,0,1) model selected by Schwarz Bayesian criterion.
- Long-run coefficient estimates (Table 1):
  - AP: Coefficient 0.6531; t-Statistic 9.47; Prob. 0.00
  - ER: Coefficient 0.4449; t-Statistic 13.56; Prob. 0.00
  - FAO: Coefficient 0.3383; t-Statistic 3.67; Prob. 0.00
  - IP: Coefficient -0.1039; t-Statistic -2.05; Prob. 0.05
  - Constant: -4.1351; t-Statistic -5.73; Prob. 0.00
- Interpretation:
  - A 1 percent rise in regulated prices increases inflation by 0.65 percent in the long-run.
  - An exchange rate depreciation of 1 percent increases inflation by 0.4 percent.
  - An increase of 1 percent in global food prices would increase inflation by 0.34 percent.
  - An increase of 1 percent in industrial production would reduce inflation by 0.1 percent.
- Policy implications:
  - Prudent macroeconomic policies needed to avoid sizable exchange rate fluctuations and hence inflation.
  - Fiscal and structural reforms are needed to prevent fiscal dominance, improve SOE finances, and reduce need for regulated price increases.
  - Structural reforms and infrastructural improvements to increase productive capacity can help lower inflation in the long-run.

### Fiscal position, MTFF projections, and key fiscal metrics
- Key historical and structural fiscal facts:
  - Over the past 5 years, the overall fiscal deficit of the central government was kept below 2 percent of GDP.
  - VAT introduced in 2008 and increased to reach 9 percent in 2015/16.
  - In 2015/16 tax receipts exceeded oil revenues for the first time.
  - The budget continues to rely on oil receipts for about 40 percent of its total revenue.
  - Cuts in infrastructure, health and education spending during 2012/13–2015/16 amounted to 4 percentage points of GDP.
  - Execution rate for the investment budget over the past decade was just 60 percent.
  - An audit of government arrears in 2015/16 revealed a total debt stock of about 42 percent of GDP, against previous estimates of about 17 percent.
  - The central government represents about 17 percent of GDP; the broader public sector represents about 70 percent of GDP (Nasiri and Fatehizadeh, 2011).
  - Interest payments projected to rise from less than 1 percent of GDP in 2016/17 to about 3 percent over the medium-term.
  - Restoring public investment to its pre-sanctions level of about 6 percent of GDP is identified as necessary to support growth.
  - The commitment to move to a universal health care system (Rouhani Care) could cost about 2 percent of GDP.
  - Age-related costs (health, pension) could amount to about 2 percent of GDP annually over the long term.
- MTFF projections and metrics:
  - Permanent income hypothesis (PIH) norm for Iran suggests the sustainable non-oil deficit is -5.6 percent of non-oil GDP.
  - Non-oil deficit path (percent of non-oil GDP):
    - 2014/15: -11.0
    - 2015/16: -11.5
    - 2016/17: -13.4
    - 2017/18: -14.8
    - 2018/19: -16.2
    - 2019/20: -17.4
    - 2020/21: -18.1
    - 2021/22: -18.8
  - Key contributors (percent of non-oil GDP) — Interest payment:
    - 2014/15: 0.1
    - 2015/16: 0.1
    - 2016/17: 0.9
    - 2017/18: 1.6
    - 2018/19: 1.7
    - 2019/20: 2.1
    - 2020/21: 2.4
    - 2021/22: 2.5
  - Investment spending (including NDFI) (percent of non-oil GDP):
    - 2014/15: 6.1
    - 2015/16: 5.5
    - 2016/17: 5.6
    - 2017/18: 5.7
    - 2018/19: 6.3
    - 2019/20: 6.6
    - 2020/21: 6.7
    - 2021/22: 6.9
  - Staff assessment on non-oil balance to support disinflation and a gradual adjustment (percent of non-oil GDP):
    - 2014/15: -11.0
    - 2015/16: -11.5
    - 2016/17: -13.4
    - 2017/18: -13.4
    - 2018/19: -12.8
    - 2019/20: -12.3
    - 2020/21: -11.5
    - 2021/22: -11.6
- Options to create fiscal space (staff estimates of permanent measures; percent of non-oil GDP):
  - Cumulated impact:
    - 2017/18: 1.5
    - 2018/19: 3.3
    - 2019/20: 5.1
    - 2020/21: 6.6
    - 2021/22: 7.2
  - Tax revenue (annual impacts where provided):
    - 2018/19: -0.2
    - 2019/20: 0.9
    - 2020/21: 0.9
    - 2021/22: 0.9
    - 2022: 0.3 (column entry)
  - Primary current spending:
    - 2018/19: 1.0
    - 2019/20: 0.5
    - 2020/21: 0.4
    - 2021/22: 0.3
    - 2022: 0.1 (column entry)
  - Subsidies reform:
    - 2018/19: 0.7
    - 2019/20: 0.6
    - 2020/21: 0.5
    - 2021/22: 0.4
    - 2022: 0.3 (column entry)
  - Other measures:
    - 2018/19: -0.1
    - 2019/20: -0.1
    - 2020/21: -0.1
    - 2021/22: -0.1
    - 2022: -0.1
- MTFF assessment and policy options:
  - Iran has proven oil and gas resources of 100 years.
  - Iran currently allocates between 2-3 percent of GDP of its annual flow of oil revenues to the NDFI.
  - Overall level of gross debt is just over 40 percent of GDP and financial assets of about 15 percent of GDP.
  - Public debt sustainability analysis shows gross public debt remains low and sustainable under a wide range of shocks if the overall non-oil deficit is kept in the 12 percent of non-oil GDP range over the next 5 years.
  - To bring the non-oil deficit to about 12 percent of GDP, measures of about 7¼ percent of GDP need to be identified over the next five years.
  - Evidence suggests almost half of the country's total tax capacity is untapped.

### Fiscal risk matrix — selected risks and mitigations
- Oil price shock:
  - Impact: Annual cost of about 2 percent of GDP on average.
  - Mitigation: Assess vulnerability of spending to oil revenue shocks; reduce oil dependency; reinstate fiscal buffers (e.g., through the Oil Stabilization Fund); create spending contingencies in the budget.
- Financial sector vulnerabilities (bank recapitalization/restructuring):
  - Impact: One-off cost, could be high.
  - Mitigation: Assess recapitalization need under stress tests; strengthen supervision; issue government bonds; use NDFI assets; develop resolution mechanisms; maintain buffers.
- Public guarantees, contingent exposures, loans granted by the NDFI:
  - Impact: To be assessed.
  - Mitigation: Quantify implicit guarantees; strengthen oversight; incorporate NDFI operations in budget documents.
- Health and aging-related costs:
  - Impact: Annual cost of 2–4 percent of GDP.
  - Mitigation: Prepare long-term forecasts; assess pension funds; pension reform; identify saving measures.
- Natural disasters and environmental risks:
  - Mitigation: Early warning systems; disaster contingency; improve resilience through public investment.

### Taxation and international taxation policy — major findings and recommendations
- Cross-border activity expected to increase as Iran re-integrates; Iran should modernize its international taxation regime to safeguard its domestic tax base.
- Iran derives a little over one-third of its tax collections from corporate income taxes (CIT).
- Redesigning investment tax incentives:
  - Current practice: exemptions, tax holidays, reduced rates, and enhanced incentives for free trade zones, special economic zones, and less-developed areas; incentives operate through zero-rating taxable income (amended in 2015).
  - Impact: These incentives have eroded Iran’s tax base. In 2015, the CIT-to-GDP ratio in Iran was 2.5 percent.
  - Recommendation: Transition to investment-linked incentives (e.g., accelerated depreciation schemes and investment allowances) for future tax incentives; grandfather existing investments that have qualified under current incentives.
- Preventing base erosion: thin capitalization rules:
  - Design options:
    1. Determine a maximum amount of debt on which deductible interest payments are allowed.
    2. Determine a maximum amount of interest deductible by reference to a ratio (e.g., interest expense to EBITDA).
- Limitation of treaty benefits (LoB) and prevention of treaty shopping:
  - Recommendation: Iran’s new tax treaties should implement specific LoB provisions and consider PPT.
  - Typical persons eligible under LoB provisions listed in source.
- Domestic legal framework: residency, source, and permanent establishment:
  - Residency rules in IDTA unclear; recommendation to move from a citizen- to residence-based tax system and consider a “place of effective management” test.
  - Source rules: law lacks a clear definition of income “derived in Iran”; recommendation to introduce clear source rules aligned with substantive principles.
  - Permanent establishment: Recommendation to include the international concept of “permanent establishment” in domestic legislation and consider a services-PE.
- Withholding taxes (WHT) and cross-border payments:
  - Current practice: Dividends and most interest paid abroad are exempt in Iran; royalty payments and service fees subject to very low effective tax rates because of reduced taxable bases.
  - Given the 25 percent CIT rate in Iran, typical WHT rate of 5 percent effectively allows for 80 percent of these payments to be deducted from the tax base; raising the WHT rate to 15 percent would reduce this deduction to 40 percent.
  - Recommendation: Adopt a unified WHT rate of 15 percent for all kinds of cross-border payments, including dividends.
- Box 3: Selected domestic taxes on cross-border payments (Reduced Tax Base / Effective WHT Rate) (as listed):
  - Dividends — - / 0
  - Interest (intra-group) — 20 / 5
  - Royalty (design of buildings; licensing and other rights; manufacturing and mineral extraction) — 20 / 5
  - Royalty (government contracts) — 30 / 7.5
  - Services (contract-based activities and technical services) — 20 / 5
  - Services (construction incl. infrastructure) — 15 / 3.75
  - Services (exploration, development, and upstream activities hydrocarbon) — 10 / 2.5
  - Services (supply and equipment inclusive price) — 20 / 5
  - Services (transportation) — 18 / 4.5
  - Services (international rail and road) — 15 / 3.75
  - Services (domestic rail, road, water, and air) — 20 / 5
  - Services (education, training, and technical assistance) — 30 / 7.5
  - Services (medical services) — 30 / 7.5
  - Services (other) — 5 / 4.5
- Tax treaty network:
  - Iran has negotiated over 60 DTTs in the last two decades.
  - Current DTT stock: 43 DTTs in force, 9 DTTs concluded but not yet in force, and 8 DTTs under negotiation.
  - Iran has not yet entered into Tax Information Exchange Agreements (TIEAs).
  - Recommendation: Iran can raise domestic WHT rates to the allowable rates in its DTTs.

### Box 4. Re-Allocation of Tax Cost — numeric scenarios
- Setup and assumptions:
  - Foreign investor invests 1,000,000 units in Iran, financed by a loan of 600,000 units taken up in the country of residence.
  - Interest rate is 12 percent.
  - Taxable interest income is 72,000 units.
  - CIT rate in the residence country is 25 percent.
  - DTT allows a maximum WHT rate of 10 percent.
  - Two Iranian WHT rate scenarios on interest payments considered: 3 percent and 10 percent.
- Calculations and numeric results:
  - Common: Taxable interest income: 72,000 units. Foreign CIT (25 percent of 72,000): 18,000 units.
  - If Iranian WHT = 3 percent:
    - Iranian WHT: 2,160 units.
    - Foreign tax credit: 2,160 units.
    - Foreign tax payable (Foreign CIT − Foreign tax credit): 15,840 units.
    - Total Tax Cost (Iranian WHT + Foreign tax payable): 18,000 units.
  - If Iranian WHT = 10 percent:
    - Iranian WHT: 7,200 units.
    - Foreign tax credit: 7,200 units.
    - Foreign tax payable (Foreign CIT − Foreign tax credit): 10,800 units.
    - Total Tax Cost (Iranian WHT + Foreign tax payable): 18,000 units.
- Key finding:
  - Changing the Iranian WHT rate on interest payments from 3 percent to 10 percent re-allocates the tax burden between Iranian withholding tax and foreign corporate income tax payable after credit, but leaves the Total Tax Cost unchanged at 18,000 units.

### Labor market outcomes and policy priorities
- Demographics and labor statistics (2000–2011):
  - Between 2000 and 2011, population grew by "15.8 million people" and employment increased by "3.3 million jobs."
  - Unemployment has hovered around "11 percent" over the past 30 years.
  - Women’s unemployment rates are on average "8 percentage points" higher than men’s.
  - Labor force participation is "40 percent", with female participation of "17 percent".
  - Youth unemployment is "30 percent"; a third of youth are not employed, in education, nor in training.
  - Over a third of the unemployed have been out of work for over a year; around "60 percent" of unemployed women over 25 years old are long-term unemployed.
- Employment structure:
  - Rural: Agriculture constitutes about "50 percent" of employment.
  - Urban: Services represent "60 percent" of employment.
  - Private sector is relatively small and disproportionately composed of self-employment; informal employment has been rising.
- Labor market constraints and indicators:
  - Long-term elasticity of employment to growth is low; evidence points to low total factor productivity (TFP) in the non-oil sector, especially after 2011.
  - Investors’ recovery rate on the dollar is "17.9 cents" (versus "32 cents" in BRICS and "31 cents" in GCC and Algeria).
  - It takes "38 years" to resolve insolvency in Iran (versus "23 years" in BRICS and "25 years" in GCC and Algeria).
- Social protection and unemployment insurance:
  - Eligibility: Available to workers involuntarily unemployed who have contributed to social security for at least "six months".
  - Maximum duration of benefits is "50 months".
  - Allowance is "55 percent" of the insured’s average earnings in the "90 days" before unemployment began plus "10 percent" for each of the first four dependents — minimum benefit equals minimum wage of an unskilled laborer.
  - Current coverage: system provides unemployment benefits to "200,000" unemployed, covering a fraction of the nearly "3 million" unemployed.
- Policy recommendations to bolster private sector employment:
  - Maintain macroeconomic stability.
  - Improve access to finance and insolvency resolution.
  - Reduce inefficient bureaucracy, policy instability, and corruption; liberalize domestic prices and improve transparency and enforcement.
  - Labor market reforms: remove third-party approval requirement for dismissals, reconsider severance pay linked to tenure, and review contract regulations to balance flexibility and security.
  - Skills and activation: involve private sector in curriculum design; organize job fairs; target training to employer-relevant skills.
  - Inclusive policies: improve flexibility of work hours, leave benefits, design fiscal policies minimizing gender biases, and provide family allowances.
- Potential gains from female employment:
  - Estimates cited: bringing female employment rate to male levels could raise GDP by "9 percent" in Japan, "12 percent" in the United Arab Emirates, and "34 percent" in Egypt; under similar assumptions, estimated GDP boost in Iran would be around "40 percent".

*Source: Islamic Republic of Iran — IMF country report content (cr1763).*

### References ___________________________________________________________________________ 10

### IMPEDIMENTS TO CORRESPONDENT BANKING WITH IRAN

### Executive summary
- Iran’s correspondent banking relationships (CBRs) were severely damaged by economic sanctions over the past 10 years, disconnecting Iran from the global financial system and disrupting cross-border flows including trade finance and remittances.
- Despite the lifting of international nuclear sanctions on January 16, 2016—“Implementation Day” under the Joint Comprehensive Plan of Action (JCPOA)—Iranian banks face protracted difficulties re-entering the international financial system through correspondent relationships with global banks.
- Progress since Implementation Day includes SWIFT reconnection of the Central Bank of Iran (CBI) and a large number of Iranian banks, and initiation of correspondent relationships by over 200 small and medium-sized international banks. Important challenges remain related to remaining U.S. sanctions, regulatory enforcement risks, deficiencies in Iran’s AML/CFT framework, and lack of transparency of Iranian corporate ownership.

### Sanctions status and legal constraints
- Timeline and scope:
  - First sanctions followed the Iranian revolution in 1979.
  - UN introduced its first sanctions on Iran in 2006.
  - In 2012, the U.S., UN and EU tightened sanctions introducing an oil embargo and banning financial transactions with Iranian banks.
  - JCPOA Adoption Day: October 18, 2015. JCPOA Implementation Day: January 16, 2016.
- Remaining U.S. sanctions and restrictions:
  - U.S. primary sanctions apply to U.S. financial institutions and companies, including their non-U.S. branches (but not their subsidiaries).
  - With very limited exceptions, businesses and individuals related to the U.S. continue to be prohibited generally from dealing with Iran, including with the government.
  - The so-called “U-Turn” transactions remain prohibited; U.S. dollar clearing restrictions have not been lifted.
  - Foreign financial institutions may process U.S. dollar transactions involving Iran only if such transactions do not involve, directly or indirectly, the U.S. financial system or any U.S. person and do not involve any person on the Specially Designated Nationals (SDN) list.
  - Snap-back: Under the JCPOA, there is a period of 10 years during which Iran could be subjected to the reinstatement of sanctions in case of nonperformance of its nuclear-related obligations.
- Blacklists and SDN list:
  - The UN, the EU and the U.S. maintain “black lists” of prohibited individuals and entities under Iran sanctions; not all listed entities were removed on Implementation Day.
  - Secondary sanctions continue to apply to non U.S. persons who knowingly facilitate significant transactions with or provide material or certain other support to individual and entities on the SDN list.

### Measured impact on correspondent banking relationships
- CBR counts and changes:
  - According to the CBI, the number of CBRs dropped from 633 in 2006 to around 50 in 2014.
  - By end-2016 the number of CBRs rose to 238 (CBI source).
  - Bankers’ Almanac has 178 reports of CBRs in 11 different currencies (database includes CBRs reported by banks as of December 2016).
  - 13,995 letters of credit (worth $12.8 million) were opened (source report).
- SWIFT and reconnections:
  - SWIFT reconnected the Central Bank of Iran and 15 nonsanctioned Iranian banks in February 2016 (having been disconnected in March 2012).
  - International branches of Iranian banks opened in Europe and were reconnected to TARGET 2.
- Distribution of CBRs (as reported):
  - By country examples: Turkey 33, Switzerland 27, China 26, Germany 20, Italy 19, Russia 17, India 15, Oman 15, Spain 15, UAE 15, Great Britain 12, Korea 9, France 8, Japan 8, Iraq 6, Tajikistan 5, Azerbaijan 4, Belgium 3, Bahrain 2, Sri Lanka 2, Others 8.
  - By currency examples: EUR 125, JPY 21, TRY 17, CNY 14, AED 13, INR 13, CHF 12, RUB 11, OMR 10, GBP 9, KRW 9, USD 7, IQD 2, Others 6.

### Key challenges impeding full reconnection
- Complexity and fragmentation of sanctions:
  - U.S. and EU sanctions are no longer broadly aligned, raising compliance challenges for institutions that must follow both U.S. and EU rules.
  - As of June 2016, thirty-two states (including New York) and Washington D.C have some form of state-level sanctions with measures such as blocking investments of pension funds and government contracts with companies doing business in Iran.
  - Sanctions may be re-imposed (“snap-back”), and some nonnuclear sanctions were broadened in February 2017 to cover new individuals (13) and companies (12) following Iran’s test of ballistic missiles.
  - On December 15, 2016, the Iran Sanctions (10 years) extension Act became law.
- Regulatory enforcement and compliance costs:
  - Global banks face an extremely high compliance burden and have faced large fines for violations of economic sanctions, prompting costly upgrades to compliance measures that have eroded the profitability of CBRs.
- AML/CFT deficiencies and FATF listing:
  - The Financial Action Task Force (FATF) listed Iran on its “black list.”
  - In October 2007 the FATF called on countries to mitigate ML/TF risks from Iran; from February 2008 it called on countries to apply effective countermeasures.
  - In June 2016, following Iran’s commitment to address AML/CFT deficiencies, the FATF decided to keep Iran on the public statement (the “black list”) while calling for a suspension of countermeasures for a period of twelve months.
  - Iran will need to enhance its AML/CFT framework substantially to be removed from the FATF “black” list.
- Transparency and beneficial ownership:
  - Difficulty of foreign banks in identifying prohibited individuals and entities is compounded by lack of transparency and complex ownership structures of many Iranian corporates, making it difficult to identify ultimate beneficial owners.
- Absence of large Tier I correspondent banks:
  - The absence of larger correspondent banks (Tier I) can hamper trade and investment because large-scale operations often require banks with adequate financing capacity.

### Progress to date
- Reconnection and increased activity:
  - 238 small and medium-sized international banks have started correspondent relationships with Iranian banks (CBI report).
  - SWIFT reconnection in February 2016 enabled resumption of cross-border payment transfers related to oil shipments and other foreign trade.
  - Increased opening of accounts, letters of credit, and issuance of payment orders for foreign exchange services and imports.
- Domestic legal and institutional steps:
  - In March 2016, the Parliament adopted a CFT law and made a high-level political commitment to implement an action plan.
  - Authorities requested an IMF assessment of the AML/CFT regime against the FATF standard (assessment scheduled for late 2018).
  - Iran became an observer to the Eurasian AML/CFT group.

### Policy options and recommendations to facilitate reconnection
- Strengthen AML/CFT effectiveness:
  - Bolster the effectiveness of the AML/CFT framework to address FATF-identified deficiencies.
  - Implement measures to increase entity transparency and enable identification of ultimate beneficial owners.
  - Seek removal from the FATF list of high-risk and noncooperative jurisdictions.
- Reduce compliance uncertainty for non-U.S. banks:
  - Clarify and streamline the regulatory environment to lower compliance costs and reduce the perceived enforcement risk for global banks considering CBRs with Iranian banks.
- Targeted domestic reforms:
  - Continue to implement the March 2016 CFT law and follow through on the political commitment and action plan to address AML/CFT deficiencies.
  - Prepare for and cooperate with the IMF AML/CFT assessment to build international confidence.

*Source: IMPEDIMENTS TO CORRESPONDENT BANKING WITH IRAN (February 10, 2017), International Monetary Fund.*

### Box 2. Iran’s Action Plan with the FATF

### Box 2. Iran’s Action Plan with the FATF

### Background and status
- In June 2016, Iran made a formal high-level commitment to FATF to implement its action plan to strengthen its AML/CFT framework.
- FATF decided to keep Iran on the public statement (the “black list”) but called for a suspension of countermeasures for a period of twelve months.
- Full implementation of the plan will allow Iran to be considered for complete removal from FATF listing; if FATF determines that Iran has not demonstrated sufficient progress, the call for countermeasures will be re-imposed.
- FATF maintained its call on members to apply enhanced due diligence to business relationships and transactions with natural and legal persons from Iran.
- Each member country can continue imposing countermeasures based on its own assessment of risks and independently of any call by the FATF.

### Countermeasures and effects on banking relationships
- The suspension of the countermeasures eased Iranian banks reconnection to the small and medium size banks.
- Countermeasures comprise, among others:
  - enhanced due diligence on the quality of respondent institution’s AML/CFT controls;
  - restrictions on opening of correspondent accounts;
  - not allowing Iranian banks to open subsidiaries in foreign jurisdictions.

### Action plan scope, items, and deadlines
- The action plan with the FATF includes 10 items with deadlines between May 2017 and January 2018 intended to rectify Iran’s strategic AML/CFT deficiencies.
- Items are related to:
  - proper criminalization of the money laundering and terrorist financing offenses;
  - confiscation and provisional measures;
  - freezing of terrorist financing assets in line with relevant United Nations Security Council Resolutions;
  - ensuring proper AML/CFT requirements (preventive measures and customer due diligence) for the financial sector;
  - enhancing the role of the financial intelligence unit and the reporting of suspicious transactions;
  - ratifying relevant United Nations Conventions (Palermo convention on transnational organized crime, 2000; New York convention for the suppression of the financing of terrorism, 1999);
  - improving international cooperation in regulating alternative remittance systems, wire transfers, and cash couriers.

### Assessment: need for further strengthening and implementation challenges
- The Iranian AML/CFT framework needs further strengthening as a matter of priority.
- Iran needs to adopt significant reforms to bring its framework in line with international standards and improve its effectiveness.
- Developing an effective framework to address and mitigate underlying inherent risks will take time and is necessary to allow correspondent banks to improve the risk profile of Iran.

### Priority reforms and policy recommendations
- Reforms should prioritize:
  - improving the understanding of ML/TF risks;
  - enhancing the regulatory and supervisory frameworks;
  - bolstering entity transparency.

- Specific recommended actions:
  - a. Iranian authorities should improve their understanding of ML/TF risks by conducting a national risk assessment in line with the FATF standards.
  - b. AML/CFT regulation and supervision should be built around a forward-looking risk-based assessment. The CBI should enhance the risk-based supervision of banks and impose corrective actions and sanctions when relevant.
  - c. Mechanisms need to be developed to ensure entity transparency. A public registry for beneficial ownership would allow timely access to adequate, accurate, and current information on beneficial ownership of all types of entities in Iran.
    - Example noted in the source: In June 2016, the United Kingdom launched a public register for beneficial ownership information of companies to enhance their transparency.
  - d. Iranian banks should continue improving their compliance to enhance their relationship and bolster trust with correspondent banks. Suggested measures include:
    - investing in AML/CFT internal controls including by upgrading compliance systems and training staff;
    - specializing in low risk business;
    - getting external certification or third part audit of their AML policies and procedures.
    - Correspondent banks can provide technical assistance to clarify their risk tolerance policies to Iranian banks as well as help build their capacities.

### Expected benefits of reforms
- Continued strengthening of the framework in line with international standards will help mitigate the risks related to ML/TF and underlying offenses (e.g., corruption, tax crimes).

*ISLAMIC REPUBLIC OF IRAN  INTERNATIONAL MONETARY FUND*

### Box 1. Authorities’ Financial Sector Reform Plan

### Box 1. Authorities’ Financial Sector Reform Plan

### Key elements of the comprehensive financial reform plan
- Improve oversight of the financial sector:
  - Strengthen the capacity of the CBI to maintain monetary and financial stability by revising the banking and central bank laws, which would clarify and strengthen regulatory and supervisory powers of the CBI, among others.
- Regulate unlicensed financial institutions:
  - Strengthen and harmonize the regulation and supervision of financial intermediaries by updating laws and regulations, methods of supervision, stricter enforcement of prudential rules and bringing all financial intermediaries, including the unlicensed credit institutions within the regulated financial system.
- Undertake asset quality reviews of banks and develop bank specific restructuring plans:
  - Rank banks using CAMELS rating system, and differentiate reserve requirement ratios based on the ranking of banks.
  - Strengthen supervision of problem banks, prepare regulations and guidelines for restructuring, merger, resolution of banks.
  - Strengthen private banks’ balance sheets through injection of capital by shareholders, set a target capital adequacy ratio for each bank.
- Address nonperforming assets:
  - Reduce nonperforming loans through creating an asset management company.
  - Improve the ability of the banking industry to make more informed credit decisions by establishing a credit bureau and a domestic ratings agency.
  - Revise laws and regulations to allow banks to write-off bad loans in a timely manner, oblige banks to form nonperforming loans (NPL) collection committees and provide quarterly reports to the CBI, and introduce new provisioning guidelines.
- Strengthen credit market:
  - Diversify funding sources of banks through more active use of the interbank market and issuance of securities, such as certificate of deposits and sukuk.
  - Give priority to financing of SMEs and working capital financing of manufacturing companies, and extend microloans to impoverished borrowers.
- Use open market operations in implementing monetary policy:
  - Establish the bond market as the initial step.
  - Ensure issuance of securities in the electronic form, provide incentives to banks to issue sukuk and trade government bonds and other securities.
  - Engage the CBI in open market operations when the bond market is fully functioning.
- Develop the interbank market:
  - Revise and complete operational guidelines for interbank market operations, allow the CBI to receive and place deposits at the market, accept securities as collateral, and use new financial instruments in the interbank market.

### Draft Central Bank and Banking bills — objectives and powers
- The draft Central Bank bill:
  - Aims to modernize the monetary policy framework and puts price stability as the core objective of monetary policy.
  - Incorporates major improvements relative to the current law with regards to the clarity of the objective function, the supervisory authority and governance of the CBI.
- The draft Banking and the CBI bills:
  - Grant the CBI the power to supervise all deposit-taking institutions.
  - Include financial stability among the core objectives of the CBI.
  - State helping with economic growth and preservation of the value of foreign currency are other stated objectives but their undertaking is secondary to price stability objective.
  - Oblige the government to repay all the funds it receives from the Central Bank by the end of the same fiscal year.

### Role of the bond market and recent steps
- The development of the bond market would help the CBI collateralize its funding operations and provide it with the tools to implement open market operations.
- Authorities started issuing government debt instruments and making them marketable as they clear government arrears.
- Amendment to the 2016/17 budget allows for some bond issuance to recapitalize banks.
- As securitization and recapitalization gains pace, the existence of the bond market would help the CBI to collateralize its funding facilities and engage in open market operations.

### Additional elements needed to support transition to market-based monetary policy
- Financial sector reform:
  - Priority should be given to the restructuring and recapitalization of banks to sustain financial stability and alleviate liquidity pressures.
  - Distressed banks are increasingly reliant on CBI funding which makes it difficult for the CBI to control liquidity growth.
  - Distressed banks push deposit interest rates up, damaging the balance sheet of healthier banks and disrupting the monetary transmission mechanism.
- Management of financial system liquidity and lender of last resort functions:
  - Need to be clearly defined in the law.
  - Under the current system, banks can borrow from the CBI without collateral; the CBI meets its lender of last resort function but exposes its balance sheet to significant credit risk.
  - A well-defined regime for emergency liquidity assistance needs to be incorporated in the law.
- Greater operational independence for the CBI:
  - The draft Central Bank bill falls short in ensuring operational and financial independence for the CBI.
  - Decision making bodies in the CBI should consist of qualified independent experts and not contain government representatives.
  - Better ring fencing of CBI’s resources is needed; the CBI needs to hold a capital buffer against variation in its net income that arises from revaluations and against credit losses.
  - Payouts should be avoided from unrealized valuation gains.
  - A capital buffer would create space for the CBI to address valuation fluctuations arising from two-way exchange rate movements.
- Transition to policy-rate-based funding:
  - The CBI could set a policy rate consistent with its inflation target and start funding healthy banks at its policy rate against collateral.
  - In the interim, the CBI can target an inflation band around the current level of annual inflation (9 percent) and aim for a gradual reduction in the following years.
  - The new policy rate can be a daily or weekly repo rate.
  - Banks would be able to borrow at the policy rate on a collateralized basis.
  - The CBI has to manage daily liquidity so that the money market rate, i.e., the interbank rate, does not deviate significantly from the policy rate.
  - The CBI’s overnight borrowing rate will set the floor of the interest rate corridor and the overdraft rate will set the ceiling rate.
- Fiscal policy support:
  - A prudent fiscal stance, focusing on reducing the non-oil fiscal deficit will help ensure the spending of government’s oil revenue does not fuel aggregate demand excessively.
  - The government should stop using the banking system to implement quasi fiscal policies—such as subsidized funding from the CBI to finance government-mandated credit programs, which affects monetary growth.
  - The government should bear the cost of subsidized lending to preferred sectors, such as housing, SMEs, or industry, through allocations in the budget to prevent dilution of the interest rate transmission mechanism.

### Using a Financial Conditions Index (FCI) to assess economic conditions
- Purpose:
  - A well-designed FCI could serve as a guide to the effective stance of policy, after taking into account all the other factors that affect financial variables.
- Challenges for building an FCI for Iran:
  - Lack of timely data reduces the variables that could be included.
  - Absence of a clear policy rate or market rate that is effective in setting loan and deposit rates complicates the task.
  - Absence of data on inflation expectations makes it difficult to determine inflation-adjusted real returns.
  - No liquid government bond market or yield curve; changes in the yield curve or the term spread cannot be used as an indicator.
- Variables included in the IMF staff FCI for Iran:
  - Money growth, M2 (y/y), as a measure of liquidity.
  - Stock market (y/y) as equity prices impact household wealth.
  - Real lending rate for banks set by the CBI:
    - As the CBI does not have a policy rate, the CBI’s rate of return on facilities weighted by the loans allocated to the relevant sectors was used, adjusted for inflation.
    - The latest annual inflation rate was used for calculating the real rate.
  - Real effective exchange rate (REER):
    - Appreciation in the REER represents a tightening in the FCI whereas a depreciation represents a loosening in the index.
- Weighting and standardization:
  - The variable with the highest volatility receives the lowest weight; the equity market has the lowest weight in the FCI.
  - Liquidity growth has the highest weight, followed by the REER and the real lending rate.
  - Series are standardized by subtracting the FCI’s mean and dividing by its standard deviation.
  - An FCI value above zero implies a tightening and below zero implies a loosening in financial conditions.
  - Quarterly averages of FCI are used as an early indicator of non-oil GDP growth.
- Empirical behavior:
  - The model shows that loosening (tightening) in FCI is followed by an increase (decrease) in non-oil activity with one quarter lag.
  - The tightening in the FCI, which started in 2013, has been partially reversed since early 2015.
  - The tightening was broad-based as almost all variables moved in the same direction during that period.
  - Despite remaining tight, the FCI changed course in 2015 and loosened during the first half of 2016.
  - Increase in liquidity, driven by looser fiscal and monetary policies, and the rise in stock market following the JCPOA agreement have contributed to the easing in the FCI.
  - The relative easing in the FCI was followed by a rise in non-oil activity starting from the third quarter of 2015.
  - The current level of the FCI suggests that financial and monetary conditions remain tight despite some loosening in 2016 and it does not suggest a further increase in the pace of economic activity.

### Long-run determinants of inflation — ARDL results (January 2012 through June 2016)
- Model specification:
  - Autoregressive Distributed Lag (ARDL) (Peseran and Shin, 1997) for the period spanning January 2012 through June 2016.
  - AP, ER, FAO and IP stand for the seasonally adjusted regulated prices, bureau market exchange rate, FAO Food Price Index and Iran’s seasonally adjusted industrial production, respectively.
  - All variables are expressed in logs.
- Long-run coefficient estimates (Table 1):
  - AP: Coefficient 0.6531; t-Statistic 9.47; Prob. 0.00
  - ER: Coefficient 0.4449; t-Statistic 13.56; Prob. 0.00
  - FAO: Coefficient 0.3383; t-Statistic 3.67; Prob. 0.00
  - IP: Coefficient -0.1039; t-Statistic -2.05; Prob. 0.05
  - Constant: -4.1351; t-Statistic -5.73; Prob. 0.00
  - Note: ARDL (2,2,0,1) model selected by Schwarz Bayesian criterion. The t-ratios calculated by using the sympthotic standard errors of long-run coefficients.
- Interpretation of results:
  - Regulated prices, the exchange rate and global food prices are important determinants of inflation in the long-run, while inflation is negatively correlated with production.
  - A 1 percent rise in regulated prices increases inflation by 0.65 percent in the long-run.
  - An exchange rate depreciation of 1 percent increases inflation by 0.4 percent.
  - An increase of 1 percent in global food prices would increase inflation by 0.34 percent.
  - An increase of 1 percent in industrial production would reduce inflation by 0.1 percent.
- Policy implications:
  - Importance of setting prudent macroeconomic policies to avoid sizable fluctuations in the exchange rate and hence inflation.
  - Fiscal and structural reforms are needed to prevent fiscal dominance and put state owned enterprise (SOE) finances on a sounder footing and reduce need for regulated price increases.
  - Structural reforms and infrastructural improvements to increase the country’s productive capacity can help lower inflation in the long-run by addressing supply constraints.

*Source: IMF staff summary of "Box 1. Authorities’ Financial Sector Reform Plan" from the referenced IMF country report content.*

### References

### References

### Literature Cited
- Angelopoulou, E., Balfoussia, H., and Gibson, H, 2013, “Building a Financial Conditions Index for the Euro Area and Selected Euro Area Countries: What Does It Tell Us About the Crisis?” European Central Bank Working Paper No. 154.
- Blotevogel, B. and Liu, Y., 2014, “Monetary Policy and the Inflation-Output Tradeoff in Iran,” IMF Selected Issues.
- Carlos, E, and Domac I., 1998, “The Main Determinants of Inflation in Albania”, World Bank Policy Research Paper No. 1930.
- English, W., Tsatsaronis, K., and Zoli, E., 2005, “Assessing the Predictive Power of Measures of Financial Conditions for Macroeconomic Variables,” BIS Papers No. 22.
- Erdem, M. and Tsatsaronis, K., 2013, “Financial Conditions and Economic Activity: A Statistical Approach,” BIS Quarterly Review March 2013.
- Gauthier, C., Graham, C., and Liu, Y., 2004, “Financial Condition Indexes for Canada,” Bank of Canada Working Paper No.22.
- Hatzius, J., and others, 2010, “Financial Condition Indexes: A Fresh Look after the Financial Crisis,” NBER Working Paper No.16150.
- Pesaran, M.H. and Shin Y., 1997, “An Autoregressive Distributed Lag Modelling Approach to Cointegration Analysis.”
- Pesaran, M.H., Shin, Y. and Smith, R.J., 1996, “Testing for the Existence of a Long Run relationship,” Department of Applied Economic Working Paper No. 9622.

### Key Findings on Iran’s Fiscal Position and Pressures
- Over the past 5 years, the overall fiscal deficit of the central government was kept below 2 percent of GDP.
- VAT introduced in 2008 and increased to reach 9 percent in 2015/16.
- In 2015/16 tax receipts exceeded oil revenues for the first time.
- The budget continues to rely on oil receipts for about 40 percent of its total revenue.
- Cuts in infrastructure, health and education spending during 2012/13–2015/16 amounted to 4 percentage points of GDP.
- Execution rate for the investment budget over the past decade was just 60 percent.
- An audit of government arrears in 2015/16 revealed a total debt stock of about 42 percent of GDP, against previous estimates of about 17 percent.
- The central government represents about 17 percent of GDP; the broader public sector represents about 70 percent of GDP (Nasiri and Fatehizadeh, 2011).
- Interest payments projected to rise from less than 1 percent of GDP in 2016/17 to about 3 percent over the medium-term.
- Restoring public investment to its pre-sanctions level of about 6 percent of GDP is identified as necessary to support growth.
- The commitment to move to a universal health care system (Rouhani Care) could cost about 2 percent of GDP.
- Age-related costs (health, pension) could amount to about 2 percent of GDP annually over the long term.

### Medium-Term Fiscal Framework (MTFF) Projections and Metrics
- Permanent income hypothesis (PIH) norm for Iran suggests the sustainable non-oil deficit is -5.6 percent of non-oil GDP.
- Non-oil deficit path as a result of spending pressures (percent of non-oil GDP):
  - 2014/15: -11.0
  - 2015/16: -11.5
  - 2016/17: -13.4
  - 2017/18: -14.8
  - 2018/19: -16.2
  - 2019/20: -17.4
  - 2020/21: -18.1
  - 2021/22: -18.8
- Key contributors (percent of non-oil GDP):
  - Interest payment:
    - 2014/15: 0.1
    - 2015/16: 0.1
    - 2016/17: 0.9
    - 2017/18: 1.6
    - 2018/19: 1.7
    - 2019/20: 2.1
    - 2020/21: 2.4
    - 2021/22: 2.5
  - Investment spending (including NDFI):
    - 2014/15: 6.1
    - 2015/16: 5.5
    - 2016/17: 5.6
    - 2017/18: 5.7
    - 2018/19: 6.3
    - 2019/20: 6.6
    - 2020/21: 6.7
    - 2021/22: 6.9
- Staff assessment on non-oil balance to support disinflation and a gradual adjustment (percent of non-oil GDP):
  - 2014/15: -11.0
  - 2015/16: -11.5
  - 2016/17: -13.4
  - 2017/18: -13.4
  - 2018/19: -12.8
  - 2019/20: -12.3
  - 2020/21: -11.5
  - 2021/22: -11.6
- Options to create fiscal space (staff estimates of permanent measures to be taken every year; percent of non-oil GDP):
  - Cumulated impact:
    - 2017/18: 1.5
    - 2018/19: 3.3
    - 2019/20: 5.1
    - 2020/21: 6.6
    - 2021/22: 7.2
  - Tax revenue (annual impacts shown where provided):
    - 2018/19: -0.2
    - 2019/20: 0.9
    - 2020/21: 0.9
    - 2021/22: 0.9
    - 2022 (column with 0.3 appears in table)
  - Primary current spending:
    - 2018/19: 1.0
    - 2019/20: 0.5
    - 2020/21: 0.4
    - 2021/22: 0.3
    - 2022 (column with 0.1 appears in table)
  - Subsidies reform:
    - 2018/19: 0.7
    - 2019/20: 0.6
    - 2020/21: 0.5
    - 2021/22: 0.4
    - 2022 (column with 0.3 appears in table)
  - Other measures:
    - 2018/19: -0.1
    - 2019/20: -0.1
    - 2020/21: -0.1
    - 2021/22: -0.1
    - 2022: -0.1

### MTFF Assessment and Policy Options
- Iran has proven oil and gas resources of 100 years.
- Iran currently allocates between 2-3 percent of GDP of its annual flow of oil revenues to the NDFI.
- Overall level of gross debt is just over 40 percent of GDP and financial assets of about 15 percent of GDP.
- Public debt sustainability analysis shows gross public debt remains low and sustainable under a wide range of shocks if the overall non-oil deficit is kept in the 12 percent of non-oil GDP range over the next 5 years.
- To bring the non-oil deficit to about 12 percent of GDP, measures of about 7¼ percent of GDP need to be identified over the next five years.
- Evidence suggests almost half of the country's total tax capacity is untapped (Atashbar (2016), Arabmaza and Zayer (2008)).
- Impact on growth can be minimized by focusing measures on increased tax collections and by funding an increase in public investment to about 6 percent of GDP.

### Fiscal Risk Matrix (Selected Risks and Mitigations)
- Oil price shock:
  - Impact: Annual cost of about 2 percent of GDP on average.
  - Incidence: Continuous.
  - Mitigation: Assess vulnerability of spending to oil revenue shocks; reduce oil dependency; reinstate fiscal buffers (e.g., through the Oil Stabilization Fund); create spending contingencies in the budget.
- Financial sector vulnerabilities (bank recapitalization/restructuring):
  - Impact: One-off cost, could be high, not assessed yet.
  - Incidence: Immediate; Probable.
  - Mitigation: Assess recapitalization need including under stress tests; strengthen banking supervision; issue government bonds; use NDFI financial assets; develop banking resolution mechanism; maintain buffers.
- Public guarantees, contingent exposures, loans granted by the NDFI:
  - Impact: To be assessed.
  - Incidence: Continuous.
  - Mitigation: Quantify implicit guarantees; quantify opportunity cost of NDFI spending vs. budget; strengthen oversight; incorporate NDFI operations in budget documents; maintain central registry of guarantees.
- Health and aging-related costs:
  - Impact: Annual cost of 2–4 percent of GDP.
  - Incidence: Possible.
  - Mitigation: Prepare long-term forecast of fiscal implications; assess pension funds; pension reform; identify saving measures.
- Natural disasters and environmental risks:
  - Impact: To be assessed.
  - Incidence: Possible.
  - Mitigation: Early warning systems; assess impact of climate change; disaster contingency; improve resilience through public investment.

### Implementation Steps and Institutional Reforms for MTFF
- Core MTFF elements proposed:
  - A statement of fiscal policy objectives with the non-oil primary balance as the main fiscal anchor.
  - Projections and targets for medium- and long-term fiscal indicators, including non-oil and overall fiscal deficits, PIH, and public debt levels; expand fiscal accounts coverage to general government.
  - Overall spending envelopes to define binding expenditure ceilings for line ministries and agencies.
  - Closer coordination among Planning and Budget Office, the new Debt Management Office and Treasury; leverage the treasury single account and phased introduction of accrual accounting.
  - A statement of fiscal risk with mitigation measures and disclosure of guarantees and quasi-fiscal operations.
- Greater fiscal transparency and oversight recommended:
  - Consider developing a formal fiscal council, possibly building from the Supreme Audit Court (SAC) and the Parliament Research Center (PRC).
  - A robust communication campaign to build public consensus for fiscal structural reforms.
- Fiscal rule reform:
  - Past rule under the Fifth 5-year National Development Plan allocated oil revenue shares: NIOC 14.5 percent, budget 65.5 percent, NDFI 20 percent increasing by 3 percentage points each year to reach 38 percent.
  - Past rule provided no buffer and was amended in annual budgets for 2015/16–2017/18.
  - Recommended a revised rule that carves out a specific allocation for a stabilization buffer (e.g., reinstate OSF and/or allow use of NDFI financial assets to support budget or bank recapitalization).
  - Consider adding a formal escape clause to the rule in line with best practices.

*Source: Iran authorities, and IMF staff projections.*

### References

### cr1763 - References

### References
- Atashbar, T., 2016, “Analyzing Iran Tax Revenue Potential,” unpublished working paper.
- Berg, A., and J., Ostry, 2008, “Inequality and Unsustainable Growth: Two Sides of the Same Coin?” IMF Staff Discussion Note No. SDN/08/11 (Washington: International Monetary Fund). Available via the Internet: https://www.imf.org/external/pubs/ft/sdn/2011/sdn1108.pdf
- Debrun, X., and T. Kinda, 2014, "Strengthening Post-Crisis Fiscal Credibility–Fiscal Councils on the Rise. A New Dataset," Working Paper 14/58 (Washington: International Monetary Fund).
- IMF, 2012, “Managing Global Growth Risks and Commodity Price Shocks. Vulnerabilities and Policy Challenges for Low-Income Countries” (Washington: International Monetary Fund). Available via the Internet: http://www.imf.org/external/np/pp/eng/2011/092111.pdf
- IMF, 2013, “Jobs and Growth: Analytical and Operational considerations for the Fund” (Washington: International Monetary Fund). Available via the Internet: http://www.imf.org/external/np/pp/eng/2013/031413.pdf
- IMF, 2015, Fiscal Monitor, October (Washington: International Monetary Fund). Available via the Internet: http://www.imf.org/external/pubs/ft/fm/2015/02/pdf/fm1502.pdf
- Mauro, P., 2011. Chipping Away at the Public Debt—Sources of Failure and Keys to Success in Fiscal Adjustment. Hoboken, N.J.: John Wiley and Sons.
- Nasiri, A., and M., Fatehizadeh, 2011, “Does Privatization in Iran Increase the Size of the Private Sector?” Journal of Economic Essays, Vol. 8, 16: pp. 9–48.
- Sadeghi, A., 2017, “How Public Investment Could Help Strengthen Iran Growth Potential: Issues and Options,” Unpublished working paper.

### Major findings and policy recommendations (International Taxation in Iran)
- Cross-border economic activity, including flows of foreign direct investment (FDI), are expected to increase as Iran re-integrates into the global economy; Iran should modernize its international taxation regime to safeguard its domestic tax base.
- Iran derives a little over one-third of its tax collections from corporate income taxes (CIT).
- Iran needs to ready its tax system to deal with cross-border flows and safeguard against the potential erosion of its tax base.
- Replacing open-ended tax incentives with accelerated depreciation allowances; introducing a thin capitalization and a ‘limitation-of-benefits’ provision in its tax treaties would help protect Iran’s tax base.
- Defining income “derived from Iranian sources” and introducing a “permanent establishment” concept in the Direct Tax Act would strengthen Iran’s tax treaties.
- Domestic withholding taxes on cross-border flows are low and could be raised and provision made for a withholding tax on service fee income.

### Redesigning investment tax incentives
- Current practice: under the Iranian Direct Taxes Act (IDTA) Iran has offered exemptions, tax holidays, reduced rates, and enhanced incentives for free trade zones, special economic zones, and less-developed areas; incentives operate through zero-rating taxable income (amended in 2015).
- Impact: These incentives have eroded Iran’s tax base. In 2015, the CIT-to-GDP ratio in Iran was 2.5 percent, two-thirds of the comparator economy average.
- Recommendation:
  - Transition to investment-linked incentives (e.g., accelerated depreciation schemes and investment allowances) for future tax incentives.
  - Grandfather existing investments that have already qualified for current tax incentives.
- Rationale: Investment-linked incentives lower the marginal cost of new investments and are particularly beneficial for less profitable projects; accelerated depreciation can produce lower long-run effective marginal tax rates compared to temporary tax holidays (Box 1 simulation assumptions preserved in source).

### Preventing base erosion: thin capitalization rules
- Concern: Excessive interest deductions by multinational enterprises (MNEs) can erode the tax base. Iran taxes interest deductible from taxable income; investment financed by debt is taxed more lightly than equity.
- Iran derives just over a third of its total tax revenues from CIT.
- Design options for thin capitalization rules:
  1. Determine a maximum amount of debt on which deductible interest payments are allowed.
  2. Determine a maximum amount of interest that may be deducted by reference to a ratio (e.g., interest expense to EBITDA). The latter is increasingly popular and recommended given sectoral heterogeneity.
- Note: Applying uniform ratios across diverse sectors and types of business could be problematic.

### Limitation of treaty benefits (LoB) and prevention of treaty shopping
- Problem: MNEs may use Double Taxation Treaty (DTT) networks to re-route income flows and reduce worldwide tax burden (“treaty shopping”); some countries act as “conduits.”
- Anti-abuse provisions in DTTs:
  - Principal purpose test (PPT): deny DTT benefits when obtaining benefits was one of the principal purposes of the arrangement.
  - Limitation of benefits (LoB): set conditions to be met before an entity is considered a ‘genuine’ resident eligible for treaty benefits.
- Recommendation: Iran’s new tax treaties should implement specific LoB provisions.
- Typical persons eligible under LoB provisions (as listed):
  - An individual;
  - A person engaged in an active conduct of business in the State of residence;
  - A company whose shares are traded on a recognized securities exchange, or wholly owned by such a company;
  - A not-for-profit organization generally exempt from income taxation, provided that more than half of beneficiaries/members are entitled to treaty benefits;
  - A person meeting both: (i) More than 50 percent of the beneficial interest is owned directly or indirectly by persons entitled to treaty benefits; and (ii) Not more than 50 percent of gross income is used to meet liabilities to persons not entitled to treaty benefits.

### Domestic legal framework: residency, source, and permanent establishment
- Residency:
  - Individual residency rule is unclear in the IDTA; relies on physical presence tests (e.g., living in Iran for more than 6 consecutive months in a year, having an occupation in Iran, exceptions for mission/medical treatment).
  - Residency for legal persons linked to registration under the Iranian Commercial Code; could be supplemented by a “place of effective management” test (e.g., location of annual shareholders’ meetings; where records are kept; day-to-day management; board members’ residence).
  - Recommendation: Move from a citizen- to residence-based tax system; broaden tax base to foreign nationals resident in Iran and subject them to the same tax treatment as Iranian residents.
- Income derived in Iran (“Source”):
  - The law lacks a clear definition of income “derived in Iran.” Example: employment income is treated as derived in Iran when the employment contract is concluded with an Iranian employer rather than where employment occurs.
  - Profit derived in Iran is defined by business registration in Iran.
  - Recommendation: Introduce clear source rules aligned with principles:
    - Simple to administer;
    - Based on substantial economic linkage between income and geographical area;
    - Between-country neutrality (source country should not object if rule applied in residence country);
    - Source rule should signal the intention to tax that income source; and
    - Source definition cannot be manipulated by taxpayers; it must be defined by lawmakers.
- Permanent establishment (PE):
  - Non-Iranian persons conducting business in Iran are required to register; IDTA imposes tax liability after registration and contains no threshold for taxing business activities, creating an incentive not to register.
  - Recommendation: Include the recognized international concept of “permanent establishment” in domestic legislation (in line with OECD and UN model conventions); consider a services-PE to capture business service activities and provide an alternative to a withholding tax on services.

### Taxing cross-border payments and withholding taxes (WHT)
- IDTA provides for withholding tax on cross-border payments (Article 107 and the IDTA By-Law).
- Current practice:
  - Dividends and most interest paid abroad are exempt in Iran.
  - Cross-border royalty payments and service fees are subject to very low effective tax rates: applying the 25 percent CIT rate on a reduced tax base (10–40 percent of total annual receipts) effectively mimics WHT of 2.5–7.5 percent.
- Given the 25 percent CIT rate in Iran, the typical WHT rate of 5 percent effectively allows for 80 percent of these payments to be deducted from the tax base; raising the WHT rate to 15 percent would reduce this deduction to 40 percent.
- Observations:
  - Effective WHT rates range from 0 (dividends) to 7.5 percent (certain service payments).
  - Multiple and differentiated WHT rates create administrative burdens and arbitrage opportunities.
  - Unconditional exemption for cross-border dividends increases vulnerability to international tax planning.
- Recommendation: Adopt a unified WHT rate of 15 percent for all kinds of cross-border payments, including dividends, to minimize base erosion risk.
- Box 3: Domestic taxes on cross-border payments — selected entries (Reduced Tax Base / Effective WHT Rate):
  - Dividends — - / 0
  - Interest (intra-group) — 20 / 5
  - Royalty (design of buildings; licensing and other rights; manufacturing and mineral extraction) — 20 / 5
  - Royalty (government contracts) — 30 / 7.5
  - Services (contract-based activities and technical services) — 20 / 5
  - Services (construction incl. infrastructure) — 15 / 3.75
  - Services (exploration, development, and upstream activities hydrocarbon) — 10 / 2.5
  - Services (supply and equipment inclusive price) — 20 / 5
  - Services (transportation) — 18 / 4.5
  - Services (international rail and road) — 15 / 3.75
  - Services (domestic rail, road, water, and air) — 20 / 5
  - Services (education, training, and technical assistance) — 30 / 7.5
  - Services (medical services) — 30 / 7.5
  - Services (other) — 5 / 4.5 (as listed in source)

### Tax treaty network and exploiting DTTs
- Iran has negotiated over 60 DTTs in the last two decades and has DTTs with main trading partners, including the four main countries where its FDI investors reside (China, South Africa, France, and Turkey). Iran is currently negotiating a DTT with the Netherlands.
- Current DTT stock: 43 DTTs in force, 9 DTTs concluded but not yet in force, and 8 DTTs under negotiation.
- Iran has not yet entered into Tax Information Exchange Agreements (TIEAs).
- Allowable WHT rates under most DTTs are generally higher than domestic WHT rates; most DTTs allow WHT rates on dividends, interest, and royalties up to 10 or 15 percent.
- Recommendation: Iran can raise domestic WHT rates to the allowable rates in its DTTs; higher domestic WHTs would be absorbed by treaty partners via foreign tax credits and re-allocate tax revenue between treaty countries without increasing total tax cost of cross-border investment.

*Prepared by Aqib Aslam, Geerten Michielse, and Christopher J. Heady.*

### Box 4. Re-Allocation of Tax Cost

### Box 4. Re-Allocation of Tax Cost

### Setup and assumptions
- A foreign investor invests 1,000,000 units in Iran, financed by a loan of 600,000 units taken up in the country of residence.
- The interest rate is 12 percent.
- Taxable interest income is 72,000 units.
- The CIT rate in the residence country is 25 percent.
- The DTT allows a maximum WHT rate of 10 percent.
- Two Iranian WHT rate scenarios on interest payments are considered: 3 percent and 10 percent.

### Calculations and numeric results (by WHT scenario)
- Common calculation:
  - Taxable interest income: 72,000 units.
  - Foreign CIT (25 percent of 72,000): 18,000 units.

- If Iranian WHT rate on interest payments = 3 percent:
  - Iranian WHT: 2,160 units.
  - Foreign CIT: 18,000 units.
  - Foreign tax credit: 2,160 units.
  - Foreign tax payable (Foreign CIT − Foreign tax credit): 15,840 units.
  - Total Tax Cost (Iranian WHT + Foreign tax payable): 18,000 units.

- If Iranian WHT rate on interest payments = 10 percent:
  - Iranian WHT: 7,200 units.
  - Foreign CIT: 18,000 units.
  - Foreign tax credit: 7,200 units.
  - Foreign tax payable (Foreign CIT − Foreign tax credit): 10,800 units.
  - Total Tax Cost (Iranian WHT + Foreign tax payable): 18,000 units.

### Key finding
- Changing the Iranian WHT rate on interest payments from 3 percent to 10 percent re-allocates the tax burden between Iranian withholding tax and foreign corporate income tax payable after credit, but leaves the Total Tax Cost unchanged at 18,000 units.

*International Monetary Fund*

### 15.8 million people between 2000 and 2011, employment increased by 3.3 million jobs. Previous

### cr1763 - 15.8 million people between 2000 and 2011, employment increased by 3.3 million jobs. Previous

### Labor market outcomes and structural context
- Between 2000 and 2011, population grew by "15.8 million people" and employment increased by "3.3 million jobs."
- Long-term elasticity of employment to growth (even using non-oil growth) is low by international standards; evidence points to low total factor productivity (TFP) in the non-oil sector, especially after 2011.
- Unemployment has hovered around "11 percent" over the past 30 years.
- Women’s unemployment rates are on average "8 percentage points" higher than men’s.
- Labor force participation is "40 percent", driven by very low female participation of "17 percent".
- Youth unemployment is "30 percent"; a third of youth are not employed, in education, nor in training.
- Over a third of the unemployed have been out of work for over a year; around "60 percent" of unemployed women over 25 years old are long-term unemployed.
- Rural-urban employment structure:
  - Agriculture constitutes about "50 percent" of employment in rural areas.
  - Services represent "60 percent" of employment in urban areas.
  - Under-employment rates are higher in rural areas; unemployment rates are higher in urban areas.
- Private sector employment characteristics:
  - Private sector is relatively small and disproportionately composed of self-employment, especially own-account workers.
  - Informal employment has been rising; women are more likely to work in the informal sector.
- Education and human capital:
  - Iran scores better than other MENA countries in international tests for mathematics and science but is below other middle income countries such as Russia.
  - Graduates have high expectations and are not fully prepared for private sector employment; some manual-work jobs experience labor shortages.

### Key findings on drivers of non-oil growth and employment elasticities
- Growth decomposition (2000-2011) attributes per capita non-oil growth to:
  - Growth linked to output per worker
  - Growth linked to changes in employment rate
  - Growth linked to changes in the share of population of working age
- Employment elasticities with respect to non-oil GDP show low responsiveness, with sectoral variation (construction, mining, communication, utility, financial services, transport, public services, industry, retail, agriculture, non-oil total) and weaker elasticities in the 2000-2011 period relative to longer horizons.

### Key elements of a strategy to foster private sector employment (summary)
- A comprehensive strategy requires coordination across:
  - Macroeconomic policies that provide stability.
  - Transparent and adequate regulations.
  - Supply-side policies to empower the workforce.
  - Worker protection and policies to facilitate job-to-job transitions.
- Implementation requires coordination among ministries and consultations with unions, employer representatives, and Civil Society Organizations (CSOs).
- The sixth National Development Plan (NDP) lays principles for fostering job creation and should lead to such a strategy.

### Priority reform areas to bolster labor demand (business leader views and indicators)
- Maintaining macroeconomic stability: inflation was in double digits until recently; the exchange rate was volatile; sanctions created uncertainty discouraging investment.
- Improving access to finance: three of the four de-jure regulation indicators furthest from best performance relate to the financial sector—getting credit, protecting minority investors, resolving insolvency.
  - Investors’ recovery rate on the dollar is "17.9 cents" (versus "32 cents" in BRICS and "31 cents" in Gulf Cooperation Countries (GCC) and Algeria).
  - It takes "38 years" to resolve insolvency in Iran (versus "23 years" in BRICS and "25 years" in GCC and Algeria).
- Inefficient government bureaucracy, policy instability, and corruption are major constraints; agenda includes reducing government direct activity, improving role as facilitator, infrastructure provision, removing excessive government-imposed constraints (e.g., red tape, liberalizing domestic prices), improving transparency and enforcement, and commercial orientation of state-owned and quasi-state firms.
- The sixth NDP includes measures to make it easier for the public sector to do business with the private sector.

### Designing regulations to accompany job creation
- Labor market efficiency is weaker than in comparator countries; scope to better nurture and attract talent domestically and internationally.
- Most Iranian labor market de jure regulations are within international averages, but dismissals are relatively difficult:
  - Employers must obtain approval by a third-party to dismiss any worker—practice found in only "20 percent" of countries.
  - Severance pay is about twice the world’s average for workers with "10-year" tenure.
  - Severance pay linked to tenure can be regressive; only a fraction of workers are covered.
- Recommendations on dismissal and severance:
  - Remove third-party approval requirement for dismissals, especially small-scale dismissals, and ensure transparent dismissal processes to encourage labor reallocation.
  - Weaken the link between severance pay and tenure (for example, by imposing a maximum amount a worker can obtain).
  - Consider reducing generosity of severance payments to align more with international experience and rely more on unemployment benefits as efficient insurance.
- Flexible contracts:
  - Temporary contracts are allowed and can increase flexibility, but relying solely on temporary contracts amid stringent permanent-contract regulations risks increasing precarious employment.
  - The ongoing review of regulations on all contract types is crucial.

### Empowering the labor force with adequate skills and technology adoption
- NDP initiatives:
  - Allow more exchanges between public and private education sectors.
  - Plans to equip school graduates with relevant skills, including entrepreneurship skills.
- Practical measures to increase employability:
  - Organize job market fairs.
  - Involve private sector professionals in curriculum design and teaching.
- Boosting TFP in the non-oil sector through innovation and technology adoption:
  - Iran has relatively weak technological readiness, including ICT use and technology adoption.
  - NDP aims to foster research and technological development.

### Protecting workers and facilitating matching
- Social protection and unemployment insurance:
  - Iran has a mix of passive and active policies covering old age, sickness, unemployment, and means-tested social assistance.
  - The unemployment insurance program eligibility and allowances are broadly in line with best practices:
    - Available to workers involuntarily unemployed who have contributed to social security for at least "six months".
    - Maximum duration of benefits is "50 months".
    - Allowance is "55 percent" of the insured’s average earnings in the "90 days" before unemployment began plus "10 percent" for each of the first four dependents — the minimum benefit equals the minimum wage of an unskilled laborer.
  - Current coverage: the system provides unemployment benefits to "200,000" unemployed, covering a fraction of the nearly "3 million" unemployed.
  - Labor market reforms that improve mobility will increase demand on the unemployment benefit system.
- Training and activation programs:
  - Training schemes have been central to activation strategy; effectiveness varies.
  - Well-targeted programs that provide employer-relevant skills, including soft skills, can improve job prospects.
  - Authorities are increasing private sector involvement in design and provision of training, with government ensuring quality of providers.
- Job intermediation services:
  - Can improve matching by disseminating information and leveraging information technology.
  - Recommendation: better leverage provincial public employment services centers, bring employers into the process (candidate screening, vacancy management) to improve information on vacancies.
- Employment subsidies and social security exemptions:
  - Government initially pays social security contribution for new hires in small firms if they add to total employment.
  - Employer contributions are "23 percent", slightly above the middle-income country average of "20 percent".
  - NDP provides a two-year exemption of the employer's share and unemployment insurance for employers who recruit young university graduates with at least BA/BS degree for internship programs.
  - Such subsidies should be temporary and carefully targeted to minimize deadweight and substitution effects; authorities could investigate net impacts and consider international evidence on success criteria.

### Creating opportunities for all and inclusive policy design
- Gender and participation gains:
  - Estimates cited: bringing female employment rate to male levels could raise GDP by "9 percent" in Japan, "12 percent" in the United Arab Emirates, and "34 percent" in Egypt.
  - Under similar assumptions, estimated GDP boost in Iran would be around "40 percent".
- Regulatory and policy barriers affecting vulnerable groups:
  - Evidence of gender discrimination in hiring and unequal remuneration for work of equal value (as in about "60 percent" of countries).
  - Women do not get full wages while on maternity leave (while they do in "68 percent" of countries).
  - Other hurdles: lack of five days of sick leave per year (about "70 percent" of countries provide these days); night and overtime work allowed but associated wage premium is high.
- Policy recommendations to improve inclusiveness:
  - Improve flexibility of work hours and provide leave benefits to enhance female labor force participation and work-life balance.
  - Design fiscal policies to minimize gender biases (for example, individual income taxation, tax credits, benefits for low-wage earners).
  - Provide social assistance policies (family allowances) to help reconcile work and family care.
  - Address retirement age gaps between men and women via pension reforms to incentivize female participation and improve old-age income.

*Source: Islamic Republic of Iran — IMF country report text provided in the content unit.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr1763.pdf_