Long accustomed to minimal taxes, the most powerful groups in the West Bank – private business, the civil servants' union and the main political party, Fatah – are fighting back, including with threats of labor strikes.
It's unlikely weary donor countries will rush to the rescue. They've cut back aid, paying less than promised in the past two years and triggering a series of financial crises.
The survival of the Palestinian Authority is key to any deal with Israel on setting up a Palestinian state, but donors have become more frugal because of the global financial crisis and paralysis in Mideast diplomacy over the past three years.
Fayyad says the showdown over taxes is as much about the obligations of citizenship as about balancing the books. "This transcends money and finance," Fayyad told The Associated Press.
The tax hike mainly targets the top earners, doubling the maximum rate from 15% to 30%. Business leaders complain that they're being burdened unfairly and are threatening to refuse to pay.
"We'll fight back," said Samir Hleileh, CEO of the $700 million holding company Padico, one of the largest firms in the West Bank. He argued that Fayyad's move will undermine his own policy of encouraging private investment as the main motor of growth in a fragile economy shackled by continued Israeli restrictions on trade and movement.
Fatah, the movement headed by Fayyad's boss, President Mahmoud Abbas, also opposes the tax increase, though Abbas himself has not yet taken a position. A leader of the civil servants' union, dominated by Fatah, argued that the tax hike will lead to higher prices for goods and services and eventually hurt the poor, still a majority of Palestinians, and a small but growing middle class.
"Everyone I know is against it, everyone I know is talking about it," said Omar Matar, a 28-year-old waiter in a Ramallah restaurant whose monthly salary of NIS 3,000 ($793) means that even under the new rules he'll only pay 5% income tax. Matar complained that living expenses are high, services substandard and that he is unable to save for a down payment for a home.
Jamal Muheisen, a senior Fatah official, said Palestinians cannot be expected to carry an additional tax burden as long as they live under Israeli rule, without a state of their own.
"The occupation is the main reason for our crisis. Once we get rid of the occupation, we will have no financial problems. In the meantime, the international community should handle this problem," he said.
Oussama Kanaan, a senior official in the International Monetary Fund, said donors should pay more and on time "so as not to force the Palestinian Authority to take fiscal measures that are too severe, especially given its already solid track record in reforms."
'PA will always be in crisis'
Aid started flowing when the Palestinian Authority was established in 1994, as part of interim Israeli-Palestinian peace deals that envisioned final agreement on the terms of Palestinian statehood by 1999. This and subsequent deadlines were missed as Israelis and Palestinians went through two turbulent decades, including repeated breakdowns in negotiations, two Palestinian uprisings and the violent takeover of Gaza by Fatah's rival, the Islamic militant Hamas.
Western and Arab donors initially hoped to underwrite peace efforts for just a few years but kept paying, in part because of fear that withdrawing funding would escalate the conflict. During the darkest periods, foreign aid was essential to helping the Palestinians survive, including in Gaza, which, though ruled by Hamas, receives almost half of Fayyad's budget in social services and salaries.
Still, donors paid less than promised in 2010 and 2011 for the day-to-day operations of Fayyad's government. Donors prefer to invest directly in development projects, such as roads and sewage treatment plants, and view such running costs – the "pouring money down a hole" version of foreign aid – to be less attractive.
In 2011 alone, donors contributed about 25% less than the nearly $1 billion promised for recurring costs in the $3.7 million budget, said Fayyad. The expected deficit in 2012 is $1.1 billion, and Fayyad said he needs to reduce that by at least $350 million, both by increasing revenues and slashing spending.
Fayyad said he's hit the limit in borrowing from banks and his government already owes the private sector hundreds of millions of dollars for unpaid goods and services.
"We just cannot continue like this," he said. Last year, major cash crises erupted repeatedly, including when Israel temporarily withheld the transfer of taxes and customs it collects on behalf of the Palestinians.
Fayyad has doubled the income tax rate for the wealthiest Palestinians – those who earn more than NIS 200,000 ($53,000) a year – to 30%, while those making more than NIS 150,000 ($40,000) are asked to pay 22.5%. The old tax regime was among the lowest in the region, and the changes don't hurt the poor and the middle class, he argues.
Hleileh, the Padico CEO, said Fayyad's policies are short-sighted and will lead to an economic downturn, after several years of growth, fueled in part by the easing of some Israeli restrictions.
Taking from the rich "means that less investment will be put in the market, less job creation," Hleileh said in an interview in Padico's new glass-fronted office tower, decorated with expressionist-style paintings by artists from Gaza.
"Less job creation means less taxes in two to three years, anyway. It basically means recession," he warned.
He said the tax increase will hurt Padico's 11,000 small shareholders and that a major foreign investor in the company is pulling out, in part over Fayyad's new measures.
Both sides are fighting for public opinion. The business community has taken out newspaper ads against the tax hike, while Fayyad has made his case on Palestinian TV and radio and in brochures distributed with daily newspapers.
Faced with the uproar, Fayyad has agreed to talk with the business leaders who say he should do more to cut spending, trim a bloated bureaucracy and find other ways to raise revenues, such as enforcing the collection of sales tax. Fayyad said he's open to ideas, but only if they don't burden the poor.
He insisted he's still on track for his ambitious goal of weaning his government off foreign aid for operating costs by 2013.
Nasser Abdel Karim, a Palestinian economist, said that under the current Israeli restrictions, the Palestinians will never be able to fund themselves.
"The donors won't abandon the Palestinian Authority ... and will provide money in critical moments. But the Palestinian Authority will always be in crisis," he said.