REVENUE POLICY AND ADMINISTRATION IN THE CIS-7: RECENT TRENDS AND FUTURE CHALLENGES

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1 REVENUE POLICY AND ADMINISTRATION IN THE CIS-7: RECENT TRENDS AND FUTURE CHALLENGES Victoria Summers and Katherine Baer, IMF The paper was prepared for the Lucerne Conference of the CIS-7 Initiative, January 20-22, 2003 The usual institutional disclaimer applies

2 The authors, Victoria Summers and Katherine Baer, work in the Fiscal Affairs Department, International Monetary Fund. Mr. Peter Barrand, who until recently was the IMF tax administration advisor in Azerbaijan, contributed to the section on tax administration. 2

3 Introduction During the last 5 to 7 years, most of the CIS-7 countries have undertaken ambitious tax policy reforms with a view to establishing more modern and market-friendly tax systems. They have also, to varying degrees, aimed to reform their tax administrations and increase their effectiveness. This paper provides a brief review of the major trends in tax policy and tax administration in the region. It identifies areas where major progress has been made, and highlights the challenges that remain in order to consolidate the gains made thus far and to continue improvements in both the tax policy framework and tax administration. 1 TAX POLICY REFORM IN THE CIS-7 COUNTRIES, As of the end of 2002, tax policy reform in the CIS-7 countries has advanced further toward the goal of developing a tax system characteristic of a modern, market oriented economy than have the respective tax administrations. This is not surprising, given the quite different nature of the tasks involved in implementing reform in the respective fields legislative change, versus institutional capacity building and this disparity has existed at least since the mid-1990s. 2 Indeed, the tax laws and the policies reflected in the laws of most of the countries are now quite good. This paper examines the nature of the evolution in tax policy that the CIS-7 countries have experienced over approximately the past five years, noting in particular some of the policy areas in which reform was lagging five years ago. It also looks at the revenue and tax rate trends in the countries; and attempts to identify policy areas where significant progress has been made, as well as important remaining problem areas. In much of this discussion, the interface between policy reform and reform of administration will be identified as a locus of these lingering problems. Revenue trends Over the past five years, the majority of countries have achieved slight to moderate increases in tax revenues, expressed as a percentage increase in the tax revenue to GDP ratio (Tables 1 and 2). 3 Uzbekistan had not yet, in 1997, experienced the entire drop in overall revenues typical of the transition countries, although this had begun. 4 In Uzbekistan, overall revenues continued to 1 The paper focuses on domestic tax administration, and does not cover administrative reforms specific to the customs area. 2 See, for example, Tax Reform in the Baltics, Russia, and Other Countries of the Former Soviet Union, Occasional Paper No.182, IMF (Washington DC, 1999). This paper builds on the description and analysis in that paper. 3 For example, Armenia: 5 percent; Georgia: 12.5 percent; Kyrgyz Republic: 27 percent; Tajikistan: 6 percent. 4 Such precipitous declines in government revenues were recorded throughout the transition economies, as economic activity slowed dramatically during the transitions, and as old methods of revenue collection and measurement were no longer applicable. Uzbekistan experienced economic transformation more slowly, and later, than most of the other CIS-7 countries. 3

4 decline over the five year period, ultimately falling by 14 percent during that time. In the case of Moldova, after a dramatic recovery between 1993 and 1997, the overall revenue ratio resumed it s earlier decline. In all of the countries the VAT is by far the most important source of revenue in most cases producing at least one-third of total tax revenues. This has been true over the entire period, despite the problems described below in administering this tax. The individual income tax in most cases has declined in significance, or remained stagnant as a revenue producer. And unsurprisingly, in many cases the importance of customs duties as a revenue source has declined somewhat as trade barriers have been lowered. Table 1. General Government Revenue, / (in percent of GPD) Armenia total revenue 2/ o/w tax revenue Azerbaijan total revenue 2/ o/w tax revenue Georgia total revenue o/w tax revenue Kyrgyz Republic total revenue o/w tax revenue Moldova total revenue o/w tax revenue Tajikistan total revenue o/w tax revenue Uzbekistan total revenue o/w tax revenue Source: IMF data as of 2002 unless otherwise indicated, country authorities 1/ Including grants unless otherwise indicated 2/ Excluding grants 4

5 Table 2. Tax Revenue, (in percent of GDP) Armenia Total tax revenue o/w enterprise profits tax income tax VAT excise taxes customs duties Azerbaijan Total tax revenue o/w enterprise profits tax income tax VAT excise taxes customs duties Georgia Total tax revenue o/w enterprise profits tax income tax VAT excise taxes customs duties Kyrgyz Republic Total tax revenue o/w enterprise profits tax income tax VAT excise taxes customs duties Moldova Total tax revenue o/w enterprise profits tax income tax VAT excise taxes customs duties Tajikistan Total tax revenue o/w enterprise profits tax income tax / 1/ 1/ VAT excise taxes customs duties sales tax (cotton and aluminum) Uzbekistan Total tax revenue o/w enterprise profits tax income tax VAT excise taxes customs duties Source: IMF data as of 2002 unless otherwise indicated; country authorities 1/ Figure for enterprise profits tax includes both EPT and PIT for these years 5

6 In virtually all cases, the authorities are seeking to improve the countries revenue ratios. The level of needed government spending and commitments in the transition countries derived from an earlier era when government services and social supports were relatively generous and sole-source. This level is not commensurate with the current revenue performance. This may be particularly the case in the CIS-7 countries, which by definition have relatively low per capita GDP ratios. 5 Tax rates Considerable evolution has taken place in regard to the setting of tax rates over the past five years, in the individual income tax (PIT) and profits tax (EPT), though not with respect to the VAT. 6 Table 3 shows the trend in income and profits tax rates for the CIS-7 countries over the period This general evolution mirrors that occurring elsewhere in the CIS notably in Russia as well as in the world more broadly. The trend has clearly been to consolidate the number of brackets in the PIT and lower the top marginal rate; and to unify the rate of the EPT. By world standards, income tax rates in the CIS-7 countries are now rather modest, with almost all countries using a top PIT rate of 20 to 25 percent a factor which may serve to explain in part at least the decline or lack of increase in the revenue outturns from this tax and an EPT rate between 20 and 30 percent (with the great majority falling in the lower end of that range). 7 At these levels, it is hard to foresee that additional significant reductions are either feasible from a revenue standpoint, nor, importantly, that they would have a substantial impact, either in the case of the EPT on investment, or on compliance levels generally. 5 This raises a fundamental question, which goes well beyond the scope of this paper, as to just what is the appropriate, or possible, level of taxation. How must the countries balance the need to encourage economic growth and private investment with the need to provide improved infrastructure and the necessary social supports? Must the level of GDP serve to set some fundamental limit on the size of the government sector at least in the medium term? Clearly, all the governments are struggling with these issues, and are attempting to address them on the expenditure side as well as from a revenue perspective. 6 In most cases, the basic VAT rate has remained stable at 20 percent. Azerbaijan lowered its VAT rate to 18 percent, as of January 1, Considerably more variety is found in the zero-bracket level for the PIT. As stated in terms of minimum monthly wages, this level varies from one-half to 25 times the MMW. (Of course, the statutory MMW may also vary somewhat relative to the average monthly income, making this an imperfect comparator.) 6

7 Table 3. Rates of Enterprise Profits Tax and Individual Income Tax, (in percent unless otherwise indicated) / Armenia EPT 12/18/25/30 3/ 20 PIT 12/18/25/30 10//20 PIT threshold 1/ 4 times MW Azerbaijan EPT 25/35/45 4/ 27 8/ PIT 12/15/20/30/40/55 3/ 35 8/ PIT threshold 1/ none 5 times MW Georgia EPT 20/35 4/ 20 PIT 15/17//20 PIT threshold 1/ 6 times MW 0.5 times MW Kyrgyz Republic EPT 10/15/30/45/50 4/ 20 PIT 5/10/15/20/30/40 10//20 PIT threshold 1/ 6.5 times MW Moldova EPT proposed to reduce to 22 PIT 10/20/30/40/50 10/15//25 PIT threshold 1/ 1 times MW 25 times MW proposed to increase to 36 Tajikistan EPT 32/40/55 4/ 30 PIT 10/15/20/25/40 10/15//20 PIT threshold 1/ 0.5 times MW Uzbekistan EPT 31 6/ 24 PIT 40 7/ 13/23/33 3/,5/ PIT threshold 1/ Source: country authorities; published sources 1/ expressed in terms of monthly minimum wage 2/ in some cases, initial rates are for / progressive 4/ by category of activity 5/ 13 percent bracket below 4 MMW 6/ 31 percent rate in effect as of 1/1/2000 7/ 40 was highest bracket as of 1/1/2000 8/ As of 1/1/2001; 35 percent was the highest bracket in the PIT as of that date 7

8 Since Russia adopted its flat 13 percent PIT rate at the beginning of 2001, there has been intense interest among some CIS countries in following suit. None have (as yet) adopted such a radical rate cut, however, largely it appears out of a well-founded fear of the revenue consequences, and the rather greater uncertainty of the potential benefits which such a rate reduction could produce. Evidence on the impact of the consolidation of the Russian PIT rate at 13 percent (from a progressive rate schedule of 12, 20 and 30 percent) is not conclusive. Prior to this change, the effective personal income tax rate is estimated to have been 14 percent. 8 Revenues from the PIT in fact increased over 2001 as a percentage of GDP. However, this effect was even more marked for the other major taxes than the PIT. To the extent that a Laffer curve effect did exist with respect to the PIT, it would more likely be attributable to a reduction in evasion, and resulting increase in the effective tax base, rather than to increased growth as a result of economic stimulus. In fact, the Russian change in the PIT was accompanied by stronger efforts at tax administration and enforcement. To the extent that the effective tax base may have increased, therefore, it is critical to factor this increase in political support for and effectiveness of enforcement into the equation the rate reduction did not occur in isolation. Background of reform All of the CIS-7 countries have enacted a second, fundamental round of tax legislation since their independence was achieved in In some cases, this legislation has taken the form of comprehensive Tax Codes, similar to but generally predating the Russian strategy. While the Russian Ministry of Finance began a very ambitious project of drafting a new Tax Code as early as 1995, thus perhaps setting the stage for similar actions by other CIS countries, ultimately in Russia Part I of the new Code was not adopted until July 1998, coming into effect in Most of the remaining sections on the major tax laws came into effect in the following year, and the profits tax only became effective for The Kyrgz Republic undertook a quite comprehensive reform of its tax laws in 1995, effective in Georgia enacted its new Code effective January 1, Tajikistan adopted a similar model Code though somewhat more detailed, which became effective in quick stages between July 1, 1998, and January 1, Both of these latter sets of laws were good by international standards, laying the foundations for a modern, and fairly simple and straightforward, tax system. These codes were drafted by the authorities in close conjunction with external advice, including from the Fund s legal department. 8 This discussion draws heavily on an paper analyzing the effect of Russian tax reform between 1999 and end-2001, by IMF staff. ( Tax Reform in Russia Since 1999, selected issues paper, February 2002). 9 Kazakhstan was the first of the CIS countries as a whole to adopt a new, modern Tax Code, in In some sense, this Code set the model and the standard for those comprehensive Codes that would follow, in particular Georgia s, and then Tajikistan s, although each of those included additional improvements and refinements. 8

9 In other cases, reform was in stages. For example, in Moldova, a Code was ultimately created, pursuant to a comprehensive plan, but by fundamentally amending all of the major tax laws over a much longer period. 10 In the case of Azerbaijan, similarly, a Code became effective on January 1, 2001, but this Code to a large extent...simply brings together much of the existing legislation. 11. Much of this legislation had itself, however, already been reformed. Armenia utilized the approach of reforming each major law separately, but again ultimately obtained similar comprehensive results. As noted, many of these Codes and laws are quite progressive and comprehensive, including most provisions needed for implementing a modern tax regime for a market economy. For example, in the Moldovan case the new Code included among other points; unified income tax for individuals and legal entities engaged in business, with a unified marginal rate; pooled depreciation with only a few groups of assets, and accelerated rates; loss carryforwards; reorganization and liquidation provisions; provisions for taxation of partnerships and investment funds; VAT on the destination basis with respect to all countries but Russia (prior to July 2001); excises to be levied only at the manufacturers level (or import); increased VAT threshold; loan loss provisions for financial institutions in accordance with the National Bank s loan classification regulations; taxation of capital gains, albeit in effect at half the regular rate. Uzbekistan reformed its laws quite early on, but in a less progressive manner, and with less technical assistance from donors. For example, as of 2001, there were still differences in the rates of excise taxes applied to domestic production and imported goods, and only in that year were most exported excisable goods exempted from tax; expenditures for repayment of investment loans were partially deductible from taxable income; there was no VAT threshold; and VAT applied only to legal entities. Despite this general progress in tax law reform, substantial problems remain, or have recurred, first, through subsequent regression toward distortionary provisions of various sorts, and second, through failure to implement the laws as written. The impairments of the new laws themselves have come in two principle forms a reintroduction of tax incentives and exemptions; and the introduction (or in some cases, retention) of provisions designed to counteract problems that should more properly be corrected through improved administration. For example, a common technique intended to combat VAT fraud through the misstatement of transaction values has been to include minimum price provisions, allowing the authorities to restate transaction prices to reflect market values. In a more extreme and generally earlier form, provisions have required that no transaction price could for VAT purposes be deemed less than the cost of production of the goods in question. (e.g., Armenia, 2000). Such provisions can cause economic distortions in cases between truly 10 The General and the Income Tax sections of the Moldovan Code became effective January 1, 1998; the VAT July 1, 1998; Real Property Tax June 16, 2000; Excises January 1, 2001; Tax Administration provisions July 1, Tax Notes International, October 16, 2000, p

10 unrelated parties, the transaction price should be the market price, by definition, and there are of course frequently reasons why discounts or reduced prices could be used in a market setting. Rather than using price mechanisms, appropriate ways to combat VAT fraud require a well-functioning selective VAT audit system and well-trained auditors. In this case, as in most others, there is simply no substitute for effective administration. As discussed in the other section of this paper, the pressing question is how best to achieve that administration. In other cases, the actual laws have not been changed and remain written in an appropriate manner, but for various reasons distrust of the taxpayers (sometimes correctly so), weakness of the administration, revenue needs they are systematically implemented incorrectly. In many respects, the de jure rules are different from the de facto practices. For example, as discussed at greater length below, an endemic problem in almost all the countries has been the failure to give taxpayer refunds of excess VAT credits as required under the terms of the laws. Specific areas of progress An earlier study 12 identified as of the end of 1997 a few main areas that generally still needed to be changed throughout the CIS countries, for each of the major taxes, as follows: Table 4. Problem Tax Policy Areas as of 1997 Tax Issues needing reform Value-added tax Inappropriate exemptions Shift to destination basis for intra-cis trade Enterprise profits tax Reform of accounting system Removal of holidays and incentives Excise taxes Restriction to appropriate (few) commodities Treat domestic production and imports symmetrically Personal income tax Effective taxation of small business Payroll taxes Excessively high rates (31-45%) Source: IMF Occasional Paper No. 183, Fund staff. Considerable progress has been made in some of these areas. Destination basis for VAT As of July, 2001, Russia adopted the destination basis for CIS trade (except with Belarus) for all commodities other than Russia s two major exports crude oil and natural gas. Prior to this, most of the other CIS countries had partially moved in this direction, in some cases retaining origin based trade only with Russia, in others, maintaining it for all, or all but a few, 12 Ibid, Occasional Paper No

11 other CIS countries. With the Russian shift, the entire CIS (other than Belarus) is now on the destination basis with respect to VAT, for all trade except for trade with Russia in crude oil and natural gas. The key economic distinction between the two methods is that under the destination basis, all firms compete in any given jurisdiction on an even basis, while using the origin basis puts consumers in different jurisdictions on an even basis. Economic theory indicates that the former type of regime results in most circumstances in greater economic efficiency. The debate over this topic in the CIS countries has centered less around the theoretically greater efficiency of the destination basis, however, and rather more around two factors first, the shifts, if any, in net revenues arising on intra-cis trade, from a move from the origin to the destination basis, 13 and second, the perceived administrative difficulties in implementing a credit invoice VAT with zero-rating of exports in a regime without effective border controls. As has been extensively argued elsewhere, 14 the origin basis suffers from some of the same problems requiring some mechanism to accurately value imports. Even more important, the mixed regime that actually prevailed in the CIS countries lent itself at a minimum to inadministrability, and worse, to fraud through round-tripping of goods, and itself could be inefficient. Thus, the move to a nearly universal destination method must be seen as a major step forward for the region. 15 Accounting laws Almost all the CIS-7 countries have made significant progress in reforming their accounting laws, with some including for example Tajikistan (effective January, 2003); Georgia (law passed February 1999); Armenia having officially adopted international accounting standards (IAS) as the basis for their national accounting standards, others having moved some way in this direction including Moldova, which became the first associate member of the International Federation of Accountants; Kyrgyz and others (including Azerbaijan) having made less progress. Interestingly, Uzbekistan, which could be viewed as one of the 13 While theoretically, such a shift would not in the longer run affect international trade, as price levels would adjust or mobile factors of production would move, this result would certainly not hold with respect to changes from the mixed case that existed in the CIS prior to July See, for example, V. Summers and E. Sunley, 1995, An Analysis of Value-Added Taxes in Russia and Other Countries of the Former Soviet Union, Tax Notes International, v. 10, pp Significant problems do remain with respect to the administration of VAT excess credits and refunds, a problem that is linked in large part, though not exclusively, to exports. Nonetheless, these problems appear to exist throughout not only the region of the CIS, but elsewhere in the transition and developing world indeed, to a lesser extent in the industrial countries as well and they are not necessarily, or even often, directly linked to lack of border controls. 11

12 less progressive countries in terms of tax legislation, has adopted national accounting standards that are [C]losely based on IAS compliance with [Uzbek accounting standards] usually results in compliance with IAS. 16 Excise taxes Excise taxes should be restricted to a short list of products that have relatively inelastic demand (e.g., alcohol, tobacco, petroleum products, possibly automobiles). Goods that are unproductive in terms of revenue should be eliminated from excise taxation in order to avoid wasting scarce administrative resources. Such is very frequently the case with so-called luxury goods taxes. Excises should be imposed on the destination basis, in order to tax domestic consumption, and without discrimination between imported and domestically produced goods. Part of the reason for using excise taxes on the aforementioned list of products is to correct for externalities health, environmental and not merely to raise revenue. Excises play both roles, typically though their primary role is generally seen as raising revenue. Several countries have made considerable progress in restricting the coverage of their excise taxes more nearly to the traditional excisable goods petroleum products, alcoholic beverages, and tobacco products though certain luxury items still pervade the excise tax coverage in some cases. Progress has been mixed in attaining symmetric treatment of imported and domestically produced exciseable goods. In a few cases, even where symmetry had been legislated, however, there have been reversals as a result of revenue needs or demands for domestic protection (e.g., in the case of Georgia). VAT thresholds An area not mentioned in Table 4, but nonetheless needing progress five years ago, was the level of VAT registration thresholds across the region. Over the period these have generally increased (Table 5), a most welcome development. There can be no doubt that setting a sufficiently high threshold for registration is of very great practical importance in implementing a VAT successfully. In a number of cases in eastern Europe, Africa, and the CIS Georgia introduction of the tax with an insufficiently high threshold has caused the tax to fail, or nearly to fail. In principle, setting an appropriate threshold involves making a trade-off between revenues and collection costs. While it is possible to construct a theoretical model to assess this trade-off in any given case, as a practical matter advice tends to center upon rules of thumb in particular, to set the threshold based upon the nearly universal statistical regularity that only a very small percentage of firms produce between 80 and 95 percent of all turnover in an economy. This allows almost all of the potential revenue to be captured, with the least possible administrative effort, from the most sophisticated taxpayers. 16 International Accounting Standards Board data, Foreign companies doing business in Uzbekistan must submit accounts that comply with US GAAP. 12

13 Table 5. VAT Threshold Exchange Threshold Threshold Exchange Threshold Threshold Rate (in national (In $) Rate (in national (In $) NC per $ currency) NC per $ currency) A B C=B/A A B C=B/A Armenia ,000,000 3, ,000,000 52,246 Azerbaijan 1/ 3, ,000,000 7,754 4, ,000,000 26,178 Georgia ,000 2, ,000 11,163 Kyrgyz Republic ,000 4, ,000 6,122 Moldova 2/ ,000 9, ,000 7,407 Tajikistan 3/ ,000,000 30,888 2, ,000,000 9,812 Uzbekistan no threshold no threshold Sources: WEO and staff data 1/ In three months, not annual 2/ Planned increase to 200,000 in / Threshold introduced in 1999 Taxation of portfolio income In many of the countries, most or all interest income is now subject to the personal income tax rather than being exempted, as was frequently the case (Armenia; Kyrgyz Republic; Tajikistan; Georgia; Azerbaijan). And in most cases, this income is taxed at a fixed, lower, rate of final withholding. While this might seem at variance with the conventional tax policy wisdom pointing toward a global system of taxation of income on economic efficiency grounds, in fact such a system of final withholding has been proven necessary and most useful in bringing such income into the tax net at all. It is simply not possible, without much more sophisticated tax administration, to rely upon self-assessment by recipients for such taxation; nor is it worthwhile in a system of chronically short administrative resources to attempt to include previously withheld interest income in a global measure of income for each taxpayer, and to credit the withholding. Such a scheme may well work in the case of enterprises, and indeed is frequently used in conjunction with final withholding for individuals. Lingering specific problem areas In other cited areas in Table 4, there has been less progress, and there are additional problems as noted above. Among the most important issues, while some VAT exemptions and tax incentives have indeed been removed, this is by no means universally the case; and, again, in some instances where corrections had been made, they have been reversed. At present, 13

14 exemptions and incentive provisions are still being introduced into law in the various countries. 17 The effective taxation of small businesses and entrepreneurs remains a substantial problem. The treatment of agriculture has for the most part not yet been rationalized. Certain specific regimes for major industries remain in place in a few instances, with the transition problems they raise being somewhat intractable. As noted above, the VAT refund problem is pervasive and critical. While despite their unfortunate tendency to introduce exemptions initially the CIS countries were leaders in having a single rate of VAT (plus the zero-rate), over the past several years in some instances lower, special, rates have also crept into the systems. 18 As noted in Table 4, rates of social contributions were extremely high as of While some progress has been made in reducing these rates, on average they remain quite high, as necessitated by the social support requirements of the societies. The future structure of the social support and pension systems of these countries is a problem which, again, goes beyond the scope of this paper. Suffice it to say that it is an area where there are important and difficult issues that will have to be resolved over a long period of time. Agriculture Special regimes under either or all the income tax, VAT, and land taxes continue to apply to agriculture and farmers in at least 6 of the 7 CIS countries, and indeed in several cases new ones have been introduced relatively recently. 19 These include exemption from VAT of turnover on the sale of agricultural output (Azerbaijan; Armenia; Moldova (reduced rate) Kyrgyz (producers whose primary source of income is own-production of agricultural output exempt)); exemption from or reduction in profits/income taxes on income from agricultural activities (Azerbaijan (individuals, and legal entities, engaged in agriculture, exempt for three years, beginning January 1, 2001); Georgia (entities and individuals exempt from September 20, 2001 through January 1, 2007, if annual production not in excess of 100,000 GEL); Kyrgyz (producers whose primary source of income is own-production of agricultural output exempt); Armenia (income and profits from agricultural production exempt); Moldova (owner-operated farms exempt)). In some cases, farming enterprises or farmers are subject only to the general or a special agricultural land tax, in lieu of the major taxes. In Tajikistan, cotton production remains largely subject to the sales tax. Exactly how, and with what 17 See, e.g., Moldova, where in 2002 alone, the following incentives and exemptions were introduced: tax benefits and exemptions for residents of free enterprise zones; various income tax and VAT exemptions for agricultural cooperatives; VAT exemptions for construction of multi-story apartment blocks, and refrigeration equipment for enterprises; deferral of excise on spirits imported for the fragrance industry; exemption from advance tax for farmers selling dairy products to processors; tax holidays for VAT for manufacture of ethyl spirits. (Tax Notes International, December 30, 2002). 18 Russia was a leader in this, introducing a 10 percent special rate, and the phenomenon spread Azerbaijan, and Uzbekistan had lower rates in addition to their basic rates, as of 1998; since then, Moldova as well has introduced two lower rates of 8 and 5 percent. 19 Comparable information on Uzbekistan was not available. 14

15 timing, to phase out the sales tax and to bring this major industry into the VAT and income tax, has been a source of much debate and advice. As most of the production is exported, the VAT alone, being applied on a destination basis, will not raise sufficient revenue from the sector. There is nothing inherent in the nature of agriculture that means it should be exempt from taxation. However, this is nearly universal, particularly in respect of the VAT, in developing and transition countries. The reasons are generally three-fold: the nature of many farmers as being outside the formal sector; distributional objectives (albeit generally misguided); and political pressures in some places. It is commonly agreed, with respect to the first of these points, that there are collection problems. However, this applies equally to small traders. The appropriate solution to this is to use a sufficiently high VAT threshold, and PIT zero-bracket or threshold income, to exclude most small farmers from the tax net. The distributional argument should clearly apply only to basic foods, not the entire sector; moreover, expenditure policies are generally accepted as being more effective in addressing these issues. In any event, with respect to profits and income taxes, it is quite hard to see why large farming enterprises should be exempt, as opposed to those engaged in commercial production in other industries. And if there is a desire to benefit small farmers themselves, the use of an appropriate PIT threshold will achieve most of the benefit that is possible on the tax side. (Once again, one would have to take the view that farmers were somehow more deserving than other small entrepreneurs, to single them out in this manner.) Small enterprise Similarly, in most countries, special regimes apply to small enterprises. As noted above, progress has been made throughout most of the CIS-7 countries in increasing the turnover thresholds for mandatory VAT registration, thus appropriately moving small and even medium sized businesses out of the tax net. In some instances, quite complex conditions apply to profits/income tax benefits for small businesses (Moldova formula for tax reductions and/or exemptions dependent upon proportion of turnover from ownproduction, increase in number of employees); in others (Azerbaijan, Armenia), a simplified (turnover) tax regime applies to enterprises that have turnover and other income below the VAT threshold; in some cases, such a simplified system is voluntary on the part of the taxpayer (Kyrgyz); in some, the retail sector is subject to a special simplified regime (Armenia). One of the most serious problems, certainly in terms of the equity of the tax system, if not revenue, is the great difficulty in these countries (as elsewhere, including the developed countries) of properly assessing and collecting tax from entrepreneurs and small businesses. In some sense, this is the obverse side of the development of the large taxpayer units discussed in Part II of this paper. It remains a work in progress. Tax incentives holidays One of the most serious problems in the CIS, including the CIS-7 countries, is the widespread use of tax incentives, holidays, and especially special zones, of various sorts, designed to encourage investment, particularly foreign investment. In almost all the countries, there has not only been lack of progress, but actual regression, in getting rid of 15

16 such sectoral or geographic incentives, 20 which may cover profits taxes, VAT, and even income taxation of wages of persons employed in selected sectors or zones. For example, special tax-favored zones currently exist in Armenia, Kyrgyz Republic, and Moldova. Others have geographic benefits designed to benefit rural or poor regions (Azerbaijan). In some countries, tax holidays, generally considered the most damaging and least effective of the possible tax incentives, are still being introduced (Armenia; Moldova). This trend undermines the revenue base severely in many cases, and to uncertain effect in terms of the intended incentive results. These revenue consequences, because of the nature of the exemptions and incentives, are not one-off, or short term problems, but will have ramifications for years into the future. Even if the countries were to immediately stop granting all such benefits in future, unless they were to renege on benefits that have already been granted to investors, the reductions in revenues will span many years. VAT refunds As noted above, one of the most intractable problems in administering the VAT all over the world is the need to grant refunds of excess credits to businesses whose taxable input value exceeds the value of taxable output. The most notable case of this is, of course, exporters, as under the destination system exports are zero-rated. This is perhaps the prime example of a situation exemplifying the tendency discussed earlier, to try to apply legislative solutions to what is fundamentally an administrative problem. Many such remedies have been introduced and proposed, in the CIS-7 as elsewhere: the aforementioned pricing restrictions, designed to avoid the need to evaluate the validity of transactions that ostensibly occurred at certain prices (Russia piloted such provisions, which were then taken up in many of the CIS countries); the exemption from tax of all imports, or all of certain broad categories of imports that could be used as inputs into taxable production, in order to avoid the generation of excess input credits from the payment of tax at the border; the long-running argument illfounded where trade with the non-cis countries was already on the destination basis that CIS trade could not be administered on a destination basis without borders. As noted, there are equally applicable reasons why trade on the origin basis would require measurement of traded values, 21 and the problems of VAT refunds are found equally in countries with weak tax administrations outside the CIS. Part II of the paper discusses the appropriate, albeit difficult, administrative solutions to this problem. 20 Indeed, this was a primary reason for the complete redrafting of the Kazak Tax Code, and the ensuing introduction of a third generation post-fsu tax law there. See also, the excessive creep of incentives in Georgia; and the recent changes in Moldova, cited above. 21 See The Modern VAT; and Summers and Sunley. 16

17 Tax policy priorities for the future As the foregoing analysis of tax policy trends in the CIS-7 countries indicates, much progress has in fact been achieved over the past five years, and before. Many of the problems that were inherent in the laws have been resolved, or at least improved upon. And some of the remaining problems relate to the attempt to utilize legislative solutions to solve administrative problems. In some instances, a lack of political will to implement needed policy (and administrative) reforms is also a major factor. Particularly significant remaining tax policy problems in the CIS-7 countries include the following: Tax incentives: special economic zones designed to provide sweeping tax benefits render the revenue base porous, and make administration much more difficult; tax holidays, eliminating income taxation and sometimes VAT for new entrants or investments in certain sectors or locations continue to be granted, rather than being phased out, in some cases; Treatment of agriculture and small business: these areas are problematic throughout the world, not merely in the CIS countries, but are particularly severe in some CIS countries, in the sense that the agriculture in question is commercial in nature and in some instances constitutes a staple of the formal economy; VAT refunds: again, this is an issue that pervades the implementation of VAT throughout the developing world; but has become increasingly acute as sophisticated methods of fraud, particularly in trade, have arisen in the transition countries; Social contributions: rates remain high, but there appears to be little to be done about this at the present time, given the pension commitments of the countries. This is a long term problem that involves expenditure and social policy even more than taxation. 17

18 STATUS OF TAX ADMINISTRATION IN THE CIS-7 COUNTRIES 22 During the second half of the1990s and early 2000s, most of the CIS-7 countries (Armenia, Azerbaijan, Georgia, Moldova, the Kyrgyz Republic, Tajikistan) have aimed to reform tax administration and increase its effectiveness, to varying degrees. 23 The main elements of these reform programs have consisted of: establishing closer links between the tax, customs, and social security administrations with a view to improving compliance control, reorganizing the tax administration along functional lines, consolidating or reducing the number of local tax offices, modernizing core tax administration procedures such as taxpayer registration and returns filing and payment processing, improving the quality of taxpayer services, and increasing the degree of computerization of the tax administration. At the outset of the reform process, most tax administrations in the region lacked a modern organizational structure and were under-resourced. Moreover, several faced the challenge of implementing a new tax code, with tax officials having received relatively little training in the contents of the new code and having a weak understanding of the new code s provisions. During this period, moreover, the number of registered taxpayers continued to increase significantly (Table 6). Table 6. Registered Taxpayers, Total number of registered taxpayers Percent increase (%) Armenia 30, , Azerbaijan 33, , Georgia 23, , Kyrgyz Republic 106, , Moldova 96, , Tajikistan n.a. 980,028 n.a. Source: Tax administration authorities in each country. Against this background, progress has been positive. More recently, there have been encouraging developments in several countries (Azerbaijan, the Kyrgyz Republic, Tajikistan) indicating a willingness among senior government officials to undertake ambitious measures to modernize and increase the effectiveness of tax administration. However, much remains to 22 This section of the paper focuses primarily on issues pertaining to tax administration, and does not address issues specific to customs administration. 23 The tax administration authorities in Uzbekistan have not undertaken major reforms to modernize tax administration in the recent past, and the Fiscal Affairs Department (FAD) of the IMF has not provided technical assistance in tax or customs administration to Uzbekistan since the mid 1990s. FAD sent a questionnaire to the Uzbek authorities to gather background information on tax administration reform for this paper, but the authorities have not yet responded. 18

19 be done. Efforts are required in a number of critical areas both in managing the agreed reform action programs and improving the tax administration s staff capacity to carry out new procedures in order for these reforms to have a visible impact on the tax administration s effectiveness and on taxpayer compliance. The legal framework As discussed in the first part of this paper, all of the CIS-7 countries have introduced new tax laws with a view to modernizing their tax systems and laying the foundation for a more modern and effective tax administration. The inclusion in the tax codes of a special section establishing the legal framework for tax administration represents a major improvement over the previous situation in which the legal provisions pertaining to tax administration were dispersed over a number of separate tax laws, and entire aspects of tax administration were not legislated at all. In the case of Armenia, which adopted a new tax administration law in 2002 (Law on Tax Service), this law is not part of an integrated tax code, but serves the same function. Although the modernization of the tax laws and the incorporation of new tax administration laws into the tax code represent a major step in the direction of improving these countries legal framework for taxation, there are nevertheless a number of challenges that lie ahead in implementing the new legislation. First, there is a need to improve the degree of certainty in the tax law and regulations. In several countries the body of tax law still has a number of gaps. There are still many tax officials, as well as taxpayers, who struggle to understand the concepts behind the laws that have recently been implemented. In several countries (e.g., Azerbaijan), amendments are required to some of the administrative provisions of the tax code to bring them into line with modernized tax administration procedures that are being developed. A number of articles are based on administrative practices that precede tax administration reform programs, including, for example, articles that relate to the processing of tax returns where the administrative procedures to be followed are overly prescriptive and inappropriate for modern return processing systems. Another problem with the application of the new tax administration laws is that there continues to be a practice of referencing administrative provisions in statutes and regulations developed by other government agencies when it would be more appropriate to incorporate these as substantive provisions within the tax code itself. An example of this in Azerbaijan is the referencing of provisions in the general administrative code for the imposition of penalties for late filing of tax returns and late payment of taxes. In almost all countries, the regulatory framework is weak. In most cases, extensive regulations have been developed in accordance with specific directions in the tax code. However, the drafting of these regulations is poor and they often add little to the substantive provisions in the tax code. There are a number of areas where regulations would be useful 19

20 but have not yet been prepared. For example, in several countries (Azerbaijan, the Kyrgyz Republic, Tajikistan), the legal requirements of the tax code need to be supplemented with detailed guidelines on the use of VAT invoices. Strengthening the regulatory framework for tax administration should be a priority for the tax authorities in the next few years. Capacity and management The weak capacity of tax department staff, the lack of effective management, and the existence of corrupt practices continue to be major obstacles to improved tax administration effectiveness throughout the region. Although several countries (Armenia, Azerbaijan, Georgia, Moldova ) have made efforts to train tax department staff in different areas (e.g., technical skills related to returns processing, audit, enforcement), training is still insufficient, the staff s general technical capacity is weak, and there is a lack of professionalism. Salaries continue to be low by local and international standards. In most of the countries, the tax administration has a relatively small headquarters staff, and because of this there is considerable pressure on a relatively few skilled people to carry out work that is required. Although most tax administrations have undertaken a range of training courses for their staff in different aspects of tax administration (the new tax laws, procedures, etc.), staff, and in particular managers, have received little or no training focused exclusively on management issues. Efforts to improve skills in a range of areas are needed for the future: Management skills International accounting skills and knowledge Functional skills covering both operational procedures and auditing Supporting functions such as financial management, human resource management and training Project management Partly as a result of these factors, and partly because of the absence of effective management and internal audit functions, the incidence of corruption among tax administration staff is still a problem in the tax administrations throughout the region. In Georgia, the government tried to address these problems through a program aimed at improving the levels of professionalism and the salaries of the tax department s staff. The program was based on a series of tests and aimed to reduce the number of non-qualified tax department staff. However, this effort was not supported by key senior officials and has not had the intended results. Corrupt practices among tax officials of the CIS-7 countries undermine the operations of the tax administration and discourage taxpayers from complying with the tax laws. However, in order to deal effectively with corruption, there must, at the outset, be a commitment from the government to address the problem. This goes beyond mere statements that corruption will 20

21 not be tolerated. Positive actions by ministers and other high ranking government officials are much more effective. This commitment must be supported by a comprehensive strategy to put a range of measures in place and to ensure that they operate effectively over time. The elements of a strategy to promote greater integrity in the administration of the tax and customs systems include: a clearly defined and well understood policy framework; simple, transparent procedures; a professional administration; performance standards; a code of conduct; effective internal audit; and administrative autonomy balanced by an appropriate level of scrutiny. If taxpayers and members of the trade community are encouraged to come forward to discuss issues with the administration, if an independent, honest judicial system is functioning well, and if the press is willing and able to raise issues of corruption, the task of addressing corruption problems in tax and customs administrations on a sustained basis will be that much easier. Another factor affecting the tax administration s staff capacity has been an inappropriate allocation of resources to implement the planned reforms in tax administration. Based on data reported by tax administration authorities in some of the CIS-7 countries (Table 7), the costs of tax administration in these countries do not appear to differ significantly from international norms for developing and transition countries, in terms of the percentage of tax collection devoted to administration. 24 This may be misleading, though, as most of these administrations lack the necessary resources to carry out the full range of tax administration functions and to finance the reforms that need to be undertaken to modernize tax administration. It is not clear whether this is because there are insufficient resources to finance the needed reforms, or whether resources are not being allocated to the core tax administration activities that require improvements. This has put constraints on the quality and scope of the implementation effort. In Azerbaijan, for example, there is limited funding for improving taxpayer services, including the publication of taxpayer information material, and for the development of training material. The government s salary structures limit the tax administration s ability to recruit and retain skilled staff in both tax administration tasks and in support areas such as information technology. The standard of basic office equipment needs to be improved. 24 Administrative costs are the direct costs incurred by government in operating the tax system, including the costs of its modification. Typically, these costs include salaries (and associated employee costs), accommodation, equipment, telephone, stationery and the costs of all other goods and services consumed by the revenue collection authority. The ratio is computed by comparing costs of administration incurred by the revenue authority with the revenue collected over the course of a financial/ tax year. The cost of administration ratio typically ranges from approximately 0.5 to approximately 1.5 in the most advanced tax administrations, and up to 2.5 or 3.0 in the case of the developing and transition economies. There are many factors that can influence the ratio which are not related to changes in efficiency and effectiveness, such as changes in tax rates, macroeconomic changes, and unusual expenditures of the tax authority. For this reason this ratio should be interpreted with caution. 21