Declining Tax Bases

Recorded industrial production by the enterprise sector dropped sharply between 1991 and 1993 (Table 5.6). For the countries where data are available, the fall in real profits was even larger. However, except in Kazakstan, the enterprise tax base includes some or all of the wage bill, in which case changes in industrial production probably provide a better guide to the evolution of the tax base. The fall in industrial production and profits puts downward pressure on real wages and on consumer demand. Unemployment also emerged. Thus, the bases of other taxes—taxes on wages and salaries, and VAT and other indirect taxes—also fell sharply.

Table 5.6.

The Baltics, Russia, and Other Countries of the Former Soviet Union: Change in Tax Bases and Real Revenue, 1991-931¹

(Percentage change, over two years)

Sources: CIS Goskomstat; IMF Economic Reviews; and IMF staff estimates.

¹For countries where revenue has declined, a tax base decline greater than or equal to the fall in real GDP is indicated by an *, while a tax base decline greater than or equal to the fall in real revenue is indicated by a ✓. Only cases where data are available for the same period for tax bases, real revenue, and real GDP are marked.

²1992-93.

Table 5.6.

The Baltics, Russia, and Other Countries of the Former Soviet Union: Change in Tax Bases and Real Revenue, 1991-931¹

(Percentage change, over two years)

	Tax Bases												Real Revenue			Memorandum Item
	Industrial production			Real profits			Real wages			Real retail turnover			Enterprise tax	Taxes on wages and salaries	VAT and other indirect taxes	Real GDP
Armenia	–54			–98			–92			–83			–642	–662	–582	–69
Azerbaijan	–29		✓	…			–492			–79			–14	–34	–152	–33
Belarus	–20	*	✓	–52	*	✓	–22			–38	*	✓	–36	3	–22	–20
Estonia	–68	*	✓	…			–55	*	✓	–56	*	✓	–58	–6	–26	–19
Georgia	–60			…			–80	*		–93	*		–96	–97	–97	–66
Kazakstan	–28	*		–90	*	✓	72			–50	*	✓	–54	–40	–47	–15
Kyrgyz Republic	–44	*	✓	–99	*	✓	–62	*		–67	*	✓	–42	–69	–61	–32
Latvia	–54	*	✓	…			–23			–52	*		–38	–41	–60	–45
Lithuania	–65	*	✓	…			–61	*	✓	–70	*		–60	–61	–73	–48
Moldova	–36	*		…			–522			–66	*	✓	–61	–61	–40	–36
Russia	–31			…			–31			–35			22	–132	–462	–30
Tajikistan	–39		✓	…			…			–81	*	✓	–29	–46	–14	–40
Turkmenistan	–10			–82	*		–29	*		–46	*	✓	9	–62	–34	–12
Ukraine	–16			…			–61	*	✓	–47	*	✓	–30	–27	–5	–29
Uzbekistan	–17			–14			72			–40			30	46	4	–13

Sources: CIS Goskomstat; IMF Economic Reviews; and IMF staff estimates.

¹For countries where revenue has declined, a tax base decline greater than or equal to the fall in real GDP is indicated by an *, while a tax base decline greater than or equal to the fall in real revenue is indicated by a ✓. Only cases where data are available for the same period for tax bases, real revenue, and real GDP are marked.

²1992-93.

View Table

Table 5.6.

The Baltics, Russia, and Other Countries of the Former Soviet Union: Change in Tax Bases and Real Revenue, 1991-931¹

(Percentage change, over two years)

	Tax Bases												Real Revenue			Memorandum Item
	Industrial production			Real profits			Real wages			Real retail turnover			Enterprise tax	Taxes on wages and salaries	VAT and other indirect taxes	Real GDP
Armenia	–54			–98			–92			–83			–642	–662	–582	–69
Azerbaijan	–29		✓	…			–492			–79			–14	–34	–152	–33
Belarus	–20	*	✓	–52	*	✓	–22			–38	*	✓	–36	3	–22	–20
Estonia	–68	*	✓	…			–55	*	✓	–56	*	✓	–58	–6	–26	–19
Georgia	–60			…			–80	*		–93	*		–96	–97	–97	–66
Kazakstan	–28	*		–90	*	✓	72			–50	*	✓	–54	–40	–47	–15
Kyrgyz Republic	–44	*	✓	–99	*	✓	–62	*		–67	*	✓	–42	–69	–61	–32
Latvia	–54	*	✓	…			–23			–52	*		–38	–41	–60	–45
Lithuania	–65	*	✓	…			–61	*	✓	–70	*		–60	–61	–73	–48
Moldova	–36	*		…			–522			–66	*	✓	–61	–61	–40	–36
Russia	–31			…			–31			–35			22	–132	–462	–30
Tajikistan	–39		✓	…			…			–81	*	✓	–29	–46	–14	–40
Turkmenistan	–10			–82	*		–29	*		–46	*	✓	9	–62	–34	–12
Ukraine	–16			…			–61	*	✓	–47	*	✓	–30	–27	–5	–29
Uzbekistan	–17			–14			72			–40			30	46	4	–13

Sources: CIS Goskomstat; IMF Economic Reviews; and IMF staff estimates.

¹For countries where revenue has declined, a tax base decline greater than or equal to the fall in real GDP is indicated by an *, while a tax base decline greater than or equal to the fall in real revenue is indicated by a ✓. Only cases where data are available for the same period for tax bases, real revenue, and real GDP are marked.

²1992-93.

The fall in tax bases was in many cases (i.e., for a number of tax categories and countries) larger than the fall in real GDP and the corresponding revenue decline. For example, shrinking tax bases are more than sufficient to explain an overall drop in the revenue-to-GDP ratio in Estonia. To varying and generally lesser degrees, declining tax bases have had a similar impact in other countries. However, the Estonia case also illustrates that there is more going on. For example, while real wages fell by 55 percent, revenue from taxes on wages and salaries dropped by only 6 percent. Clear anomalies (most notably in Uzbekistan, where falling tax bases were accompanied by increasing revenue) also highlight that the decline in traditional tax bases is only part of the overall story. So do the many cases where the fall in revenue cannot be explained by declining tax bases alone. In Estonia, taxes on wages and salaries were relatively buoyant because the tax system was capable of taxing incomes outside the enterprise sector. But this has not proved to be the rule.

The Impact of an Emerging Private Sector

To the extent that profits and wages have fallen faster than output, other incomes must be falling less fast. National accounts data reveal that agricultural incomes have increased as a share of GDP across the region. But there has also been a large and increasing residual, which can be largely attributed to private or informal sector incomes. A significant share of output in most countries of the region has now shifted to the private sector, because new firms have been established or have emerged through privatization, and because an atomistic trade and services sector is developing rapidly. Such firms (and individuals) have not contributed significantly to tax receipts, because of weaknesses in tax policy and tax administration.

One implication of such weaknesses—which are described below—is that the shift in production to the emerging private sector would probably have reduced enterprise tax revenue even if output had not fallen.¹¹ Moreover, to the extent that private firms are not captured in the tax net, both taxes on wages and salaries, and VAT and other indirect taxes, may not be fully collected from them. It is also worth noting that while private sector activity is at least partly reflected in GDP data, to the extent that it is not fully captured, the revenue-to-GDP ratio is in fact overestimated by the currently available data. In other words, the revenue decline may be larger than indicated above.

Changes in Enterprise Taxes

The enterprise tax provides the clearest example of this retrogression. The U.S.S.R. introduced an orthodox profits tax at the beginning of 1991. It had a central rate of 45 percent and a base defined more or less in accordance with industrial country accounting principles.¹² Since then, the base has been changed and the rates have drifted downward.

First, and most notably, almost every country (as already noted, the exception is Kazakstan) has in one way or another reintroduced wages into the tax base. In some cases, this almost doubled the base. Second, and working in the opposite direction, the base has been eroded as exemptions and other tax preferences have proliferated. Third, all countries have cut the basic tax rate and many have returned to a differentiated rate system. In some countries, most notably Russia, this began in 1991 when they started to enter into tax competition with the U.S.S.R. government; in others it came later, to compensate for the expansion of the base. In no country is the basic rate now greater than 35 percent. In some countries (Ukraine, Uzbekistan), it fell to 18 percent in 1993.¹³ Finally, six countries (Armenia, the Kyrgyz Republic, Moldova, Turkmenistan, Ukraine, and Uzbekistan) reintroduced excess profit taxes or asset taxes. These are essentially taxes on capital, justified as proxy dividends paid by the state enterprises to their owner, the government.

The impact of these reforms on revenue is hard to gauge. The capital taxes and the reinclusion of wages in the profit tax base clearly boosted revenue beyond the yield of a pure profit tax. However, for those countries where the cuts in enterprise tax rates were large (such as Belarus, Kazakstan, Turkmenistan, Ukraine, and Uzbekistan), these caused significant offsetting revenue losses.

From Turnover Tax to VAT and Excises

An important reason for the underperformance of the VAT has been the contraction in consumption. However, there have also been a large number of flaws in VAT design, legislation, and implementation. The choice of rates has been perhaps the single major difficulty. At the outset, it was difficult to estimate revenue-neutral VAT rates, given the many turnover tax rates and the large and staggered impact that price liberalization was having on relative prices. Hence, in 1992, half the countries of the region lost revenue when they introduced the VAT. Despite this loss, a number of countries (Armenia, Azerbaijan, Georgia, Kazakstan, Moldova, and Russia) cut their rates or introduced differentiated rates in 1993, or both, with a resulting adverse effect on VAT revenue. By contrast, Estonia increased its VAT rate, thus ameliorating the revenue decline.¹⁴ In addition, some particular features of the VAT system as adopted hinder timely and effective revenue collection.

(1) Cash basis versus accrual basis. The general rule is to allow taxpayers to use a cash rather than an accrual basis for establishing VAT liability.¹⁵ In general, this procedure delays VAT receipts, since payments are slow. Levying VAT on a cash basis, and allowing manufacturers to claim VAT credits for materials at the time they are used in production, even if they have not paid their suppliers, is particularly costly in revenue terms when there is an accumulation of interenterprise arrears. Since suppliers are not liable until they are paid, VAT credits for materials are being taken or refunded by the government before VAT liability has arisen on purchases of inputs. Moreover, since tax becomes due when arrears are paid, the incentive for enterprises to collect receivables is correspondingly diminished. The practice of allowing VAT credit only when inputs enter into production is also a deterrent to collection because it requires a complex accounting system to monitor the use of inventories.¹⁶

(2) Markup method versus invoice method. The nonmanufacturing sector does not use the usual invoice method to determine VAT liabilities, but rather a markup system whereby VAT is paid not on the actual price but on an estimated fixed markup over cost. Accounting methods for calculating taxable markup (especially the treatment of inventories) are subject to abuse, and their complexity makes audit difficult. There are also adverse consequences when inflation is high (see below).

(3) VAT on international trade. Turnover tax was not levied on imports or exports. Since the introduction of the VAT, trade among members of the Commonwealth of Independent States (CIS)—which consists of all the countries in the region other than the three Baltic states—has been taxed essentially on the origin principle, that is, VAT is collected in the producing country. Initially, trade with other countries was not taxed, but provision was soon made to tax this trade on the destination principle, that is, with imports taxed and exports zero rated.¹⁷ Net importers—from outside the CIS—should have benefited from this provision. However, there are numerous exemptions for imports, and the administration of the destination principle has proved complex. Consequently, trade is taxed haphazardly and yields less VAT revenue than it should.

The introduction of excises has also been disappointing. In contrast to market economies, excises have not been a stable high-yield revenue source. Most notable is the absence of important commodities, such as gasoline for cars, car imports, and some types of alcohol, from the excise base in most countries. Also, tax rates reflect pressure from producer lobbies seeking to keep the prices of excisable goods low. At present, rates on alcohol and cigarettes are about 20 percentage points lower than in countries of the Organization for Economic Cooperation and Development (OECD).

Trade Liberalization

In the former U.S.S.R., revenue from foreign trade mainly came from net export profits.¹⁸ These have either disappeared or diminished sharply with the liberalization of trade.¹⁹ It was envisaged that they would be more than made up for by the introduction of explicit import tariffs and by temporary taxes on windfall gains on exports as the ruble was being depreciated in the move to convertibility. However, though revenue from trade taxes has been growing rapidly, it started from a very low base and generally accounts for less than 5 percent of total revenue. Moreover, its potential is limited by a variety of factors.

First, the Baltics, Russia, and other countries of the former Soviet Union have been reluctant to impose significant tariffs on imports from outside the CIS because they see foreign competition as a central element in domestic demonopolization. Second, most countries do not levy import duties on imports from CIS countries or on personal property imported by CIS citizens. In some cases, these provisions have led to imports being almost fully relieved of duty.²⁰ Third, it has also been necessary to introduce a customs service from scratch and to patrol borders that are many thousands of miles longer than those prior to 1991. Apart from the intrinsic teething problems of a new administration, financial problems have also hindered the introduction of customs. Finally, to the extent that countries were willing to tax trade, they often imposed export taxes rather than import tariffs to maximize the domestic availability of goods.

Finally, in net energy-exporting countries—notably Russia and Turkmenistan—it had been expected that the windfall gains from temporary export taxes would provide a cushion for the budget. These potential gains have, however, been undermined. In Russia, pressure for tax relief came not only from the oil industry but also from political tensions between the Moscow government and oil-rich regions that threatened to secede if they were taxed too heavily. In Turkmenistan, the inability of trading partners to pay for their gas imports caused a massive decline in revenue from the gas sector.

Inflation

Besides eroding real tax bases, the failure of most countries to stabilize during 1992-93 left tax systems vulnerable to distortions caused by high inflation. Average inflation in the region exceeded 1,000 percent during 1991-93, though it came down substantially in 1994 (see Section III). The net impact of high inflation on revenues, however, is uncertain.

On the one hand, the absence of proper inflation accounting has led enterprises to book raw materials and inputs at historical costs and some to report abnormally high profits. Similarly, depreciation allowances were not indexed—at least until 1993—and the enterprise tax base expanded on account of decapitalizing taxes on depreciation. Because, in the Soviet system, replenishing the depreciation fund traditionally preempted around 25 percent of total enterprise income, the short-run effect of high inflation could have been to increase enterprise tax receipts by as much as one fourth. A certain amount of bracket creep also occurred, particularly in 1992, although the revenue gain from this was probably minimal.

On the other hand, high inflation depresses revenue in real terms because of collection lags and the markup method of computing VAT liabilities. Despite collection lags that tended to be relatively short by international standards, reflecting the automatic collection of taxes from enterprises through the state banking sector, near hyperinflation in some countries and an inadequate payments system probably led to significant losses in real revenue. A second serious cost to the budget arises from the use of the markup method to compute VAT liabilities. When large price increases occur between the time of purchase and the time of sale, the application of a standard fixed VAT markup on the historic purchase price implies that much value added may go untaxed.

Exemptions

In most countries, revenue has also been eroded by numerous exemptions from all major taxes.²¹ Much new activity benefits from exemptions, and the range of exemptions has increased as governments have tried to earn the support of powerful pressure groups. The main groups lobbying for exemptions are the following.

(1) Sectoral lobbies. The influence of sectoral lobbies is manifest in exemptions and preferences that benefit a whole sector (most notably agriculture), specific subsectors, or individual large enterprises. In Moldova, for example, the agricultural sector—which has the largest representation in Parliament—benefited from exemptions on the enterprise tax that amounted to an estimated 1 percent of GDP in 1993. And in the Kyrgyz Republic, the profitable gold mining sector was exempt from the enterprise tax and VAT until 1994.

(2) Regions. Pressure from regional elites has led to “special rights” being accorded to individual regions by presidential decrees, government resolutions, and parliamentary decisions. This has been a serious problem in Russia, which has experienced a proliferation of free ports and environmentally distressed emergency zones. Territories embracing about a quarter of its area and a third of its productive capacity were functioning under highly concessional special regimes in the middle of 1993. They received, and continue to receive, exemptions from taxes and duties and from the obligatory conversion of hard currency export proceeds, as well as various other fiscal preferences.

(3) Foreign investors. Tax preferences for foreign investors abound, especially for enterprise tax and customs duties. For example, in Azerbaijan, joint ventures with at least 30 percent foreign participation are subject to a reduced profit tax rate of 25 percent; a three-year tax holiday is granted to foreign enterprises commencing activity in the country, which may also be excluded from VAT and customs duties.

Taxpayer Identification

In most countries, there is no system to identify taxpayers by a single taxpayer identification number (TIN). Without such a system, the tax administration has no common identifier that ties together all of a taxpayer’s records. Hence, it is impossible to correlate data with a view to detecting underreporting of income or other forms of evasion. Further, only a few countries have implemented an effective system of taxpayer registration.

Filing and Payment of Taxes

Administrative practices are fraught with duplication and inefficiency. For example, in most countries taxpayers separately submit tax returns to the local tax office and payment orders to the bank. The need to match tax returns and payment orders complicates the task of detecting taxpayers who fail to submit returns and to make timely or full tax payments. This matching process is particularly slow because of the lack of a TIN. In addition, too much of tax officials’ time is devoted to manually checking tax returns, rather than encouraging taxpayer compliance and controlling the collection process.

Organization

In most countries, a single tax officer is usually assigned to handle most administrative functions for a specific group of taxpayers. Consequently, tax officers see the same taxpayers repeatedly and are responsible for several taxes. Regular direct interaction between the same tax officer and taxpayer raises the potential for collusion and consequent tax evasion. Tax officers’ responsibility for a wide range of administrative functions also limits their knowledge in specific technical areas, especially accounting and audit techniques. In particular, they lack the investigative skills to conduct effective audits.

Audit

Audits are often conducted in a perfunctory manner, without any analysis or investigation of enterprises’ business activities. An important reason for this, in addition to the lack of specialized audit skills among tax officers, is the requirement in most countries that all enterprises be audited every one or two years. The development of the private sector is making this impractical and has led tax officers to often take an excessively formalistic approach to auditing taxpayers. Audits frequently amount to no more than determining whether the taxpayer has the correct records with the appropriate signatures and seals. Tax audits are also hindered by the requirement that they cover all taxes in depth. This made sense under central planning, when the major taxes were all tied to a single accounting system, but it now precludes effective audit.

Taxpayer Education

Across the region, taxpayer awareness remains low, and budgets for taxpayer education are almost nonexistent. In many countries, tax returns and other key forms necessary for compliance are not provided to taxpayers. Even when forms are available, there are no instructions on the form or separate document to explain how to complete it.

Customs

Most countries do not have adequate customs controls, either for assessing and imposing tariffs or for applying VAT and excise taxes to imports. To cope with this problem, some countries (such as Lithuania and Moldova) attempt to bypass the customs administration and have their internal revenue service collect domestic indirect taxes on imports. However, both because it is more difficult to follow up on importers once imports have passed across the border and because procedures for information sharing between customs and the internal revenue services are poorly defined, collection has been weak. Furthermore, as already mentioned, the application of the destination principle for VAT on international trade has posed difficulties for customs administration.

Fiscal Federalism

In some countries in the region, uneasy relations between various levels of government appear to have been a significant factor affecting overall revenue performance. In Armenia, Georgia, Moldova, Russia, and Ukraine, collection problems have arisen from disputes over revenue sharing and tax assignment provisions among the central, regional, and local governments. In an ideal situation, fiscal federalism should not influence the revenue position of the general government after consolidation, but several factors have tended to make the overall outcome weaker than expected.

First, legislative confusion and conflicting tax regulations at the central and regional levels in Russia, connected with the struggle of constituent republics for greater economic independence, gave enterprises an opportunity to obey “softer” tax laws or to delay payments without explicitly breaking the law.

Second, revenue underreporting by lower levels of government appears to be widespread and significant across the region. For instance, in 1992-93 commodity-producing, resource-rich regions in Russia—especially those that had been net interregional donors—tended not to transfer revenue to the central budget. While some territories withheld revenue informally, several autonomous republics (Tatarstan, Chechnya, and Bashkortostan) formally declared their unilateral introduction of a “one-channel taxation system.” This meant that all their taxes were to be collected by the regional authorities, and revenue sharing with the central budget was to be negotiated afterward. Under these circumstances, the regional authorities had little incentive to report their revenue collections accurately to the central government.

And third, tax collections at the local level may not be as effective as with a unified tax administration. When Ukraine’s central government tried to transfer revenue responsibilities to local governments in 1994, overall collection dropped. Officials suggested that the local governments were more vulnerable to pressure from enterprises than was the central tax service, particularly when an enterprise was a large local employer and provider of social services. In Belarus, enterprise tax collections were reported to be chaotic in 1992, because local authorities could not handle their revenue collection responsibility; now all collection has been unified under the State Tax Administration.

Policy Environment

The abandonment of the Soviet regime was associated in most countries with political instability, frequent changes of ministers, and ambiguous policy courses. This had several implications for tax collection. First, the lack of a coherent reform strategy was reflected in frequent amendments to tax legislation, with negative repercussions for taxpayer compliance as taxpayers either delayed payments in the hope of a reversal of disadvantageous changes or were simply unfamiliar with new requirements. More generally, the low quality of tax legislation has likely been a contributing factor to the revenue decline. With the exception of the Baltic countries and Russia, tax legislation tends to be badly drafted, is difficult to understand, and contains inconsistent and poorly thought out rules. Second, some governments, in part because of their impermanence and in part because of falling budgetary wages, have had a low degree of legitimacy with their civil service. Such disaffection has contributed to corruption and the misappropriation of revenue. In Azerbaijan in 1993, for instance, “bonus development payments” by foreign oil companies for exploration leases were never received by the budget but were diverted to the State Oil Company (SOCAR). Third, the heavy reliance on sequestration as an instrument of expenditure control has led ministries, local governments, and enterprises to protect themselves against unexpected expenditure cutbacks by withholding revenue from the central authorities.

Removal of Exemptions

Exemptions can usually be removed, or at least substantially reduced, immediately. While it may take previously exempt activities some time to adjust to the imposition of taxes, the response being asked of them is no more painful than for other sectors exposed suddenly to price liberalization. Experience in the region since 1991 suggests that little is gained by delaying price shocks.

There are numerous exemptions that should be removed or restricted. As regards enterprise taxes, eliminating pervasive exemptions by source of revenue and type of activity, apart from raising revenue, will create a level playing field for production. State and collective farms, small businesses, manufacturing for export, and enterprises with foreign investment unjustifiably benefit from such exemptions. Given the importance of the emerging private sector, there is an especially strong case for eliminating tax holidays for newly established businesses and replacing them by generous carry-forward of start-up losses, or accelerated depreciation of capital assets, or both.

With regard to taxes on wages and salaries, the definition of taxable income under the personal income tax should be broadened to cover all forms of income, including social security benefits and payments in kind (most notably free housing). Also, tax concessions for families with children and other dependents should be replaced by family allowances paid through the social security system, to lower budgetary costs through improved targeting.

VAT exemptions beyond those justified on social or administrative grounds (education, health, financial services, and so forth) should be eliminated. This would involve extending VAT to most services. In the countries of the CIS, VAT should be applied to all imports from outside the CIS at the same rate as domestic goods. It should also be levied on product prices inclusive of other taxes. Specifically, the VAT base should include any applicable excises. For imports, VAT should be based on their landed value, plus customs tariff and excise duty, converted at the market exchange rate. Zero-rating should be restricted to exports.

Rationalization of Tax Rates

High tax rates are an obvious disincentive to economic revival, while a multiplicity of rates not only results in distortions and inequities but also complicates tax administration and creates opportunities for tax evasion. The immediate harmonization of rates might produce some revenue gains from improvements in efficiency. But, in all likelihood, revenue needs will not permit an immediate reduction in tax rates, which will instead have to be gradually reduced as revenue collections improve.

For multiple-rate enterprise taxes, rates should be consolidated into a single standard rate, which would be aligned with the top personal income tax rate. The rate structure of taxes on wages and salaries should be made less distortionary by raising the threshold and reducing top marginal rates, while increasing the basic rate, which tends to be low by international standards. VAT should also have a single standard rate. Excises should apply at the same rate regardless of origin. In particular, the failure to impose excises on imports discriminates against all domestic production. To the extent possible, the rates of excises and other duties (including import tariffs) should be converted to an ad valorem basis.

Disguised High Tax Rates

Some tax rates in the region are higher than they seem. In countries where wages are included in the enterprise tax base, the effective rate on profits is much higher than the statutory rate. Likewise, depreciation allowances based on historic cost boost the effective tax rate on true profits in countries where inflation is high. For instance, in Ukraine in 1994, the enterprise tax rate was 22 percent; adjusting for the wage component in the base, the effective profit tax was 36 percent. To remove the hidden disincentives, tax bases should be rationalized as quickly as possible. Any such adjustments can be made revenue-neutral by a corresponding adjustment to the tax rate. Most crucially, costs should not be taxed as profits. Also, the taxation of inflationary gains should be eliminated, because it causes the decapitalization of enterprises, thus making them more likely to fail.

Taxing the Emerging Private Sector

It is hoped that a sizable share of the emerging private sector will be taxed as a consequence of eliminating exemptions. Some activities may remain elusive, however, and will have to be taxed by alternative means.

One of the main challenges faced by the region is to tax private business, much of which is concentrated in small-scale activity. Even when new taxpayers have been identified, operational means of taxing them have to be found. For this to be possible in the short term, incorporating some presumptive elements of taxation into existing income taxes needs to be considered, as a way of short-circuiting difficulties in assessing tax liability. For instance, a minimum levy or low flat-rate tax based on presumed turnover of individual proprietorships could be introduced, in combination with a basic license fee.²⁴ A presumptive tax could also be levied in lieu of VAT on small business. The advantage of presumptive taxes is that they broaden the tax base at relatively low administrative cost, encourage taxpayers to move from the informal to the formal sector, and are fairly efficient (because marginal tax rates are zero) and equitable (because they focus on those who would not otherwise pay tax).

Taxing Agriculture

Agriculture is the largest untaxed sector in many countries of the region and has declined less than other sectors because it has benefited significantly from the liberalization of prices of basic foodstuffs. For this reason, it is particularly important that agriculture should be brought into the tax net. The removal of agricultural exemptions from the major taxes is the most desirable way of taxing agriculture. When such an approach is not adequate, consideration should be given to finding alternative means of taxing agriculture, at least in the short run. For instance, payment of a land tax (which already exists in some countries) could be made a secondary proof of ownership or a prerequisite for the right to use land. For the immediate future, the land tax can be seen as a means of bringing farmers into the tax net, and difficulties in land valuation can be dealt with by a certain tolerance for underassessment.²⁵ A land tax can also help reach new small private farmers.

Of particular concern to farmers is an appropriate treatment of losses and carryovers, since their incomes fluctuate from year to year. Hence, if agricultural profits and earnings are to be subject to tax, it may be important—not least for political acceptability—to provide for income averaging (if tax rates are progressive) and loss carryover.²⁶

Taxing Trade

A further likely source of short-term revenue is through enhanced attention to the taxation of trade. Significant revenue can be raised in the CIS countries by applying of a broad-based simple tariff with a standard uniform rate of 10-15 percent on all ex-CIS imports. As some countries have already found, an across-the-board tariff is relatively simple to administer and minimizes distortions. Some countries could improve their revenue yield from trade taxes if imports were valued for tax purposes at a market exchange rate rather than at an official rate. Indeed, the implied loss of revenue is one reason for unifying official and market exchange rates. Export taxation—including implicit taxes imposed through hard currency surrender requirements—should be avoided.

Other Quick-Yield Taxes

Where enterprises prove difficult to tax in the short run, there may be some justification for applying an enterprise property tax of 1-3 percent on all assets of state enterprises other than financial assets and land (net of depreciation). This charge, like an obligatory dividend, is designed to compensate government for its investment, to prepare enterprises for privatization, and, most important, to act as a presumptive tax prior to the introduction of a satisfactory bookkeeping system.²⁷

Petroleum and other energy excises are an important source of revenue in many countries and can be quickly developed. Downstream taxes are particularly low in the Baltic countries, Russia, and other countries of the former Soviet Union. The Russian gasoline excise rate, for example, is 15 1/2 percent compared with tax-inclusive excise rates on gasoline of between 25 percent and 71 percent in major countries of the Organization for Economic Cooperation and Development (OECD). Also, many countries of the region are major producers of petroleum, gas, and minerals but earn little revenue from these sectors compared with international norms. More attention to taxing these products could well generate sizable revenue, as well as encourage energy conservation. In some cases, added revenue can be earned from joint venture arrangements, including up-front payments on the signing of agreements (as in Azerbaijan).

Accounting Practices

Inappropriate accounting practices have already proved to be an obstacle to increasing revenue in some countries. Their reform is a necessary complement to tax reform.

(1) Invoice-method VAT accounting. The replacement of the markup method for calculating VAT liability with the invoice method would ensure that VAT was paid on the full price of goods sold and prevent any erosion of VAT returns on account of inflation.²⁸ A shift to the invoice method would be more feasible if it were accompanied by simplified VAT accounting. In particular, enterprises should be permitted to claim credits in the period they have incurred VAT on their inputs, and not only when these inputs are used in production. Symmetry of treatment for inputs and outputs should be restored for taxpayers using either the cash or accrual basis of accounting for taxes. Specifically, taxpayers who use the cash basis should not take VAT credit for goods or services purchased until they are fully paid for.

(2) Accrual accounting. The use of cash accounting rather than accrual accounting has been costly for the budget. As discussed earlier, if tax falls due at the time payment takes place rather than at the time it accrues, an enterprise’s incentive to liquidate receivables is reduced. A shift to accrual accounting would thus reduce the incentive to incur interenterprise arrears. However, it may lead to greater tax arrears, since cash-strapped enterprises would have to pay accrued VAT on sales to late or nonpaying customers. This is probably an unavoidable consequence of tightening the budget constraint on enterprises. A shift to accrual accounting would also reduce (though not eliminate) incentives for inefficient barter.

Tax Administration

An unmeasurable but significant reason for the revenue decline has been the diminishing effectiveness of planned economy tax collection methods as the transition has progressed. Existing tax administration systems and procedures need to be overhauled and many new ones introduced if the tax administration is to handle a larger and more diverse taxpaying population. These reforms need to begin immediately, or to be accelerated where they have already started, in tandem with the policy changes described above.

(1) Registration. For emerging sectors to be captured, new taxpayers will have to be identified and registered. Local tax offices, with assistance and supervision from the central tax administration, should devote considerable resources to ensuring complete registration of all firms and individuals covered by the tax law. Moreover, upon registration, taxpayers should be given a unique TIN. The adoption of a nationwide TIN will vastly facilitate the cross-checking of information regarding taxpayer compliance (e.g., income reported by third parties, such as government institutions against income reported by taxpayers).

(2) Returns (and other documents). More generally, moving away from a tax system based on central planning accounting techniques will require the overhaul of return forms and other tax documents so that they reflect newly appropriate accounting procedures, can be used by more diverse types of taxpayers, are easy for the taxpayer to understand, and are quick to process. Shortcomings in the design of documentation are considered to have been particularly damaging to the productivity of the VAT. A single standard document should be adopted for the supplier and purchaser to record a sale and its associated VAT liability.

(3) Taxpayer education. In a system with rising numbers of taxpayers, there are likely to be important gains to revenue collection if taxpayers can pay their liabilities without involving tax administrators. In the first instance, taxpayers should be given clear and concise information describing what is taxable, when taxes apply, how to calculate their tax liabilities, and exactly what they are required to do to pay their taxes. In the long run, the goal will be for tax collection to be based largely on self assessment.

(4) Organization. The tax administrations of the Baltic countries, Russia, and other countries of the former Soviet Union should organize their operations according to basic functions—registration, taxpayer information, returns processing, collection enforcement, and audit. Assigning specific taxpayers to tax officers is no longer appropriate and creates undesirable opportunities for evasion and corruption. Greater specialization and expertise among tax officials should be achieved by assigning staff to defined and limited functions.

A large-taxpayers unit should be created.²⁹ It would monitor collection of taxes from important taxpayers who, although not numerous, account for the major part of tax revenue.³⁰ In energy-exporting economies, a few large taxpayers can account for 90 percent of total revenue. In some countries, large taxpayers engaged in cash cropping and processing account for a substantial part of revenues. A large-taxpayers unit properly focuses initial efforts of tax administration reform on the adoption of more efficient procedures for the more important taxpayers, rather than on the increasing number of small taxpayers whose revenue contribution is not substantial.

(5) Audit. Taxpayers must believe that if they fail to comply with the tax law they will be caught and penalized. They also need to be assured that their competitors are paying the same taxes. Hence, an effective audit program is an integral part of tax collection and requires the setting up of an audit unit. To enhance compliance, the tax administration should not make its audit strategy public, nor should it disclose the number of taxpayers to be audited during a given period. Instead, it should promote the view that a variety of factors may lead to an audit and the belief that the probability of an audit is higher than it really is.

(6) Penalties. Adequate but not excessive penalties must be imposed, not only for tax evasion but also for failure to file returns, issue and maintain appropriate tax documents, and pay full tax on time. Interest provisions for late tax payment should compensate the government for the time that the taxpayer has use of the government’s revenue. To ensure that penalties remain realistic under conditions of high inflation, they should to be periodically revised.

(7) Arrears. A specific strategy for collecting outstanding tax arrears is needed. Each local tax office should carry out an analysis of its arrears, identifying them by debtor, size, time outstanding, and type of tax. This will allow administrators to set priorities for pursuing the largest and most recent debts and to eliminate those that are considered uncollectible or insignificant.

(8) Customs. For trade to be taxed effectively, countries need to strengthen their customs administration and should allocate realistic budgetary funds to do so. Besides valuing and taxing imports, customs administrations should develop and implement reliable procedures for validating exports of goods for zero-rating under the VAT, and should install safeguards against the reimporting or “round-tripping” of goods to and from the region. Eventually, to minimize leakage of revenue, customs administrations will have to assume responsibility for collecting VAT and excise taxes on imports.