Bahrain needs to scale back subsidies to cope with rising pressure on state finances - but in a tense political climate it will have to offer its people jobs and better services in return.
The Gulf island kingdom is the smallest oil producer in the region and the first country to grapple head-on with these reforms, but others are watching closely since they will eventually have to make similar changes as they diversify away from oil, analysts say.
The government plans to significantly increase spending on housing, health and education over the next two years after a recent security crackdown renewed complaints by the Shi'ite majority population that it is neglected by the Sunni-led government.
But Bahrain will not be able to sustain higher expenditures for long and needs to cut subsidies, create a tax-base for higher government revenues and diversify the economy to create jobs for its growing population.
"They take a year to produce [the oil that] Saudi produces in ten days so you can see the writing on the wall," said John Sfakianakis, chief economist at Banque Saudi Fransi.
"If they remove the subsidies, certainly that would create discontent, but if they don't the fiscal situation over the next five years will not be sustainable," he said.
Bahrain posted a budget deficit of about 10 percent of GDP last year for the first time since at least 2005 as oil prices remained below its estimated budget break-even price of about $80 per barrel, the highest in the region.
Its debt to GDP ratio has risen from 8.5 percent in 2008 to 27.3 percent at the end of the second quarter, according to central bank data.
This will further rise as the government plans to boost government spending by 26 percent in its budget draft for 2011 and 2012 compared to what it spent in 2009 combined with what it pencilled in as expenditures for this year.
The government plans to reduce its annual subsidy bill of about BD500m ($1.33bn), or 25 percent of its total expenditures.
Alanoud Al Sharekh, a Bahrain-based analyst at the International Institute for Strategic Studies (IISS), said citizens in the Gulf still pledged allegiance to rulers in return for cheap goods and services, a deeply entrenched arrangement.
"Subsidies still form a very important part of the balance in our GCC psyche," she said.
She said this would only change if the government improved healthcare in return and if programmes that offer vocational training to Bahrainis to qualify them for the private sector prove successful.
The government has said it will try to reduce its subsidy bill by arguing it wants to target only the needy parts of the population - whereas everyone benefits from blanket gasoline subsidies - but any such hint in the past has led to street protests and an outcry from the opposition.
The Economic Development Board that sets Bahrain's economic policies is likely to have proposals ready in its drawers, but it is difficult to predict when it will see the right political moment to try and push through a reduction in subsidies.
"They have no choice but to rethink how they make allocations over the next few years; the question is when are they going to move," said Sfakianakis.
In the meantime, the government is likely to quietly increase fees and penalties. In 2008, it introduced a monthly fee on visas for foreign workers, which officials privately say they considered to be the country's first company tax.
Bahrain is seen as the Gulf's policy laboratory as its weaker economic position has forced it to be the first to tackle reforms its larger neighbours like top oil exporter Saudi Arabia also need to undertake.
This includes reforming regional labour markets that are heavily distorted by cheap Asian labourers and diversifying economies away from oil industries.
Bahrain's king introduced a new constitution and parliamentary elections in the early 2000s to quell the Shi'ite unrest Bahrain saw during the 1990s.
Tensions have risen again in recent years and peaked in August when the government launched a broad security crackdown against some Shi'ite groups and also curtailed media freedoms.
This will limit the government's ability to tackle fiscal reforms, analysts said.
"It's not too likely the [opposition] MPs will see progress on many of their political issues...so I think for one thing MPs will be very much against any reduction in subsidies that would affect their constituents," said Jane Kinninmont, analyst at the Economist Intelligence Unit.
She said that if Bahrain wanted to introduce taxes the government would have to significantly improve transparency on how it would spend funds.
"I just find it hard to see the royal family and the government being willing to go down that route," she said.
Taxing foreigners, who make up about half of Bahrain's population of just over one million, and foreign companies would be less politically charged but would hurt Bahrain's competitiveness vis-a-vis other business hubs like Dubai.
"Probably you will not see any company taxes in the near term because of all the PR they used to attract companies here, it is based on the fact that it is a zero tax location," said Jarmo Kotilaine, chief economist at NCB Capital.
Moody's downgraded Bahrain's government debt ratings by one notch to A3 in August, partly because it viewed the government's ability to broaden its revenue base as limited.
GCC agreements limit the ability of its members states to introduce value-added taxes unilaterally.For all the latest business news from the UAE and Gulf countries, follow us on Twitter and Linkedin, like us on Facebook and subscribe to our YouTube page, which is updated daily.
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