This paper assesses the extent to which data unreliability could alter the assessment of the macroeconomic challenges ahead. The contributions of the indirect tax authority (ITA) in remedying the flaws are highlighted, and the architectural agenda is discussed. Fiscal sustainability and the government’s bold initiatives to secure it by restructuring the domestic claims have been assessed and key implementation issues in realizing the government’s plans noted. A survey of selected tax policy issues in Bosnia and Herzegovina is also included in the paper.

Abstract

This paper assesses the extent to which data unreliability could alter the assessment of the macroeconomic challenges ahead. The contributions of the indirect tax authority (ITA) in remedying the flaws are highlighted, and the architectural agenda is discussed. Fiscal sustainability and the government’s bold initiatives to secure it by restructuring the domestic claims have been assessed and key implementation issues in realizing the government’s plans noted. A survey of selected tax policy issues in Bosnia and Herzegovina is also included in the paper.

V. Selected Challenges in Tax Policy1

A. Introduction

1. Tax policy will be critical in supporting medium-term policy objectives. With a premium on maintenance on a strong fiscal stance, continued strong collections—alongside a determined effort to curb expenditure—will be key. In addition, the tax burden is high relative to the capacity of the tax administrations to collect payments, and 40 percent of GDP excluding grants, high relative to GDP. Thus, initiatives to lower the tax burden, consistent with a strong fiscal stance, will support broader reform initiatives.

2. Reforms to indirect and direct taxes, and to customs tariffs are underway which, if successful, will help secure both these goals. But success will require that implementation risks which arise in each case are addressed. This note outlines the objectives for reform in these three sets of taxes and draws attention to implementation risks in each case. In most cases, determination of the appropriate means to address the risks will require technical assistance.

B. Indirect Taxes and the Road to the VAT

3. The authorities have committed to shift from sales tax to the VAT. This reflects their assessment of the administrative and efficiency advantages of the VAT relative to the sales tax. Their decision thus reflects the need to ensure a strong revenue stream. The foundation arrangements for the VAT have been laid with the establishment of the ITA, which unifies the formerly disparate customs administrations and provides for a decision-making framework for policy on indirect taxes, including eventually, VAT (Chapter 3).

4. Key challenges lie immediately ahead for the VAT. As for all VATs, the law will need to be well designed, the reform will need to be well explained to citizens and taxpayers, and administrative arrangements within the tax administration will need to be strong. But in addition, further risks arise in the transition from sales tax raises which are unique in this context—notably concerning revenue allocation and sales tax administrations.

5. In particular, technical issues in implementing the principle of revenue allocation according to final consumption must be resolved. The transfer of revenue collection functions from the Entity tax administrations to the ITA will not occur overnight, but in a sequence. As a first step, all revenue collected by the merged customs administration will accrue to the ITA’s single revenue account once it is established.2 From this account revenue will need to be distributed, and the authorities are currently preparing technical proposals on what type of allocation formula to use for this purpose. One option that is under consideration would use past sales tax revenue collection as a proxy for final consumption as a basis for this formula. However, important details for this formula (e.g., baseline period) and on the allocation mechanism (e.g., frequency of revenue transfers to Entities) need to be determined. The law allows the Governing Board to review the revenue allocation formula every six months until the VAT is introduced. In addition to dealing with this kind of transitional issue, there may be need to establish different formulae for the different taxes.

6. The relationship between the sales tax administrations and the ITA also needs to be resolved in the run up to the VAT. While the framework law on indirect taxation prescribes that revenue from all indirect taxes will eventually (i.e., once the VAT is introduced) be collected by the ITA, the law includes some provisions that leave the administration of certain indirect taxes to the Entities during the transition period. These refer to the sales tax on domestically produced goods and services (including the railroad fee in the RS, and tobacco products on which the sales tax or railroad fee is accounted for during the purchase of tax stamps), excise tax on domestically produced goods (i.e., alcoholic and nonalcoholic beverages, tobacco products, coffee, oil and oil derivatives), and the domestically collected road fees.

7. This approach poses a number of risks to revenue collections. For example, well-trained and qualified staff will likely be attracted to work for the ITA, not least because this organization has a future, eroding the capacity of the Entity sales tax administrations in respect of domestic production. Further, if taxpayers know that the sales tax administration is to close, their incentives to comply with it currently may erode.

8. These risks might be addressed if the sales tax administration for domestically produced goods and services was integrated into the ITA prior to introduction of VAT. The sales tax administration could be progressively incorporated into the ITA during 200405, perhaps first for sales tax on domestically produced excisables and then for the other domestically produced goods and services. This approach would also avoid the simultaneous—and therefore doubly risky—introduction of a new tax administration and a new tax when VAT is introduced.

9. But incorporating sales tax into the ITA carries risks too. It would significantly compound the administrative burden on the ITA which already faces multiple institution-building challenges—including merging two customs systems, both with significant operational weaknesses, and with different pay scales and staffing issues.

10. Alternative solutions should also be explored therefore. One approach could be to provide good sales tax administrators incentives to stay there until the sales tax administration is completely wound down. Such incentives could be in the form of job guarantees in the ITA. And risks of non-compliance by taxpayers ahead of the demise of the sales tax administration could be addressed by publicity indicating that sales tax arrears outstanding after the introduction of the VAT would continue to be enforced by the ITA.

11. Concerning the structure of the VAT, the ITA is required by end-2004 to prepare a draft State level VAT law consistent with European Union standards, to be introduced no later than early 2006. Accordingly, the authorities envisage a modern, broad-based VAT structure. In particular, they are considering two positive rates (standard rate, plus one reduced rate for food and selected other products), few exemptions (e.g., postal, health, and education services; financial services), zero-rating for exports, including customs duties and excises in the tax base, and a sufficiently high annual turnover threshold to exclude small traders. With technical assistance from the EU, a VAT implementation plan will be prepared by end-March 2004.

12. But revenue allocation issues will also need to be carefully weighed in the design of the VAT. For example, while a two-rate system would follow international norms, the administrative burden of having two rather than one rate is magnified in this case because the geographical origin of collections from goods under each rate may need to be tracked precisely in order to allocate the revenue appropriately between the Entities. This would strengthen the case to implement a single rate. Even leaving this aside, the general agreement that VAT proceeds should be distributed on the destination basis requires expression in a formula. The formula could be based on VAT returns or economic indicators (e.g., consumption as determined in the national accounts). But as the national accounts statistics are weak (see Chapter 2), it would appear advisable to apportion VAT revenue, at least at the outset, on the basis of past sales tax revenue collection and later according to VAT collections.

13. Given the advanced state of readiness of the VAT law, progress towards unification of the customs administrations, and the key role of VAT in combating tax evasion, there is a strong case to target implementation of the VAT earlier than January 1 2006. While undue haste carries risks, the attached timeline suggests that, with application, implementation from mid-2005 is feasible (See Table 1).

Table 1.

Establishing the ITA and Introducing VAT—Action Plan

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C. Corporate and Labor Tax Issues

14. Alongside these efforts to strengthen indirect taxation, direct taxes are also under review. Both Entities are preparing reforms to corporate income taxes which could be implemented in 2005. Given that currently three corporate tax structures apply—one in each Entity (with rates of 30 and 10 percent) and another in Brcko District—harmonization will be a key issue. Collections from these taxes are, however, minimal (See Chapter 2).

15. Brcko District has recently implemented a corporate income tax reform. It introduced a new concept called “Allowance for Corporate Equity” (ACE) and the Entities are considering doing likewise. This entails a deduction for the imputed cost of equity that makes the tax system neutral regarding the choice between debt and equity financing. However, this tax is complex, favors capital-intensive enterprises with overvalued assets—a significant risk given the accounting weaknesses—and it could have excessive revenue costs.3 These concerns appear to be decisive against and ACE-based profits tax. Nevertheless, there is a case for the Entities to harmonize their corporate tax structures as differentiation may increasingly give rise to arbitrage through corporate registration in one entity or the other. And duplication (triplilcation) is a further barrier to inward investors for whom more than one corporate tax system is unexpected.

16. In addition, the Federation could usefully rationalize the internal allocation of revenue from its corporate income tax. Collections from banks and other financial institutions (e.g., insurance and reinsurance companies), electric power generation, post and telecommunications services, and gambling accrue to the central government. But collections from companies in other sectors are allocated to the Cantons. This issue should be addressed as part of the broader review of revenue assignments within the Federation, as part of strengthening overall fiscal architecture (See Chapter 3).

17. Labor taxes are also high, unharmonized across Entities, and complex. Total labor taxes are 52 percent in the RS and 69 percent in the Federation (both expressed relative to net wages). This compares with an average tax rate for Central and Eastern European Countries in 1997/98 of 75 percent and 45 percent in OECD countries (both according to OECD data). Though not obviously out of line with the transition area, the apparently high rates of unemployment and tax evasion suggest that these rates may be excessive for the Bosnian context (See Chapter 2). Furthermore, in the RS, allowances are subject to taxation, while in the Federation they are not. Were reductions in labor taxation made, this would alleviate pressure for companies from rising wages, improve incentives for more employment, reduce underground economic activity, and reduce overall tax burdens. However, neither Entity was willing to undertake such reforms in the 2004 budgets. This largely reflected pressures from the spending side and implementation complications. The latter arise from the earmarking of particular labor taxes to particular expenditures—so that reductions in a particular labor tax may require offsetting additional transfers from the central budget to the affected fund(s) to replace revenue lost.

D. Taxation of International Trade

18. Tariffs and the associated collections have been lowered in recent years, putting pressure to strengthen direct and indirect tax receipts. The nominal effective composite import tariff is some 10 percent (Table 2). The composite consists of ad valorem customs duties, an import verification fee and specific surcharges on mostly agricultural goods:

Table 2.

Bosnia and Herzegovina: Customs Revenues and Implied Import Tariffs by Entity, 2000-03.

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Sources: Customs administrations of the Federation and the RS.
  • Customs duties are low with a maximum of 15 percent and an unweighted average of 6.4 percent. This is in line with European countries and below the world average of 13 percent.

  • A one percent import verification fee is levied on all imports.

  • Surcharges, none of which are ad valorem, are levied on about 850 mostly agricultural items. Revenue from the surcharges is equal to about 30 percent of revenue from “normal” customs duties on all 11,000 items in the tariff schedule. This suggests that the effective composite tariff rate on goods for which surcharges are levied is very high.4

19. The effective rate has been lowered to about 8 percent due to the phasing in of free trade agreements (FTAs) with neighboring countries. Free trade agreements are now effective with all of the former Yugoslav republics as well as with Albania, Bulgaria, Moldova, Romania, and Turkey. All these agreements, except those with Albania and Moldova are asymmetric in the sense that they provide for immediate duty free access of most of BiH’s exports to those countries (and a phasing out of duties on a select list of goods over a three-year period) while tariffs on all imports into BiH from these countries are phased out over periods of three to five year.

20. Under the FTAs, customs duties on goods imported into BiH are to be reduced to the following percentage of the normal tariff schedule:

Table 3.

Percentage of Standard Tariff Rates to be Applied to Imports from FTA Partner Countries

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21. Surcharges aside, the tariff regime has broadly desirable characteristics, but the agenda ahead could usefully reflect several concerns.

  • First, further reductions in trade protection will support broader efforts to restructure domestic output. In this context, effective January 1, 2004 imports from Croatia and Serbia and Montenegro were supposed to have obtained duty free access to Bosnia and Herzegovina (see schedule above). However, in response to producers’ concerns the authorities unilaterally postponed full implementation of the relevant FTAs for three months. This decision could complicate other trade negotiations and aspirations to secure accession to the WTO in 2004.5

  • Second, revenue losses from trade liberalization impact most severely on the Federation central government, which relies heavily on those receipts, than on the RS central government which has a broader revenue base (See Chapter 3). Given the broader benefits of further trade liberalization, there may be need to adjust the internal revenue allocation systems within the Federation so as to better accommodate this.

  • Third, given the general weakness of corporate governance—which essentially mean that many companies do not seek profits and therefore do not react appropriately to price signals—the gains to further trade reform are being attenuated by corporate weaknesses. This strengthens the case to accelerate the corporate reforms.

  • A trade agreement with the EU provides some assurance that effective protection will not rise. This arises because BiH has duty free access to the EU on condition that it does not increase trade tariffs on goods imported from the EU. This arrangement is secured at least until 2005 and its scope will widen effective May 1, 2004 with the inclusion of the 10 EU accession countries.6 It leaves scope, however, for accelerated reductions in tariffs on imported inputs to increase effective protection and for some trade diversion if tariffs are not applied uniformly. The authorities could consider adding commitments that, FTA’s aside, the tariff regime would be uniform and that tariffs across the board will be lowered together.7

  • Last, though EU accession is not yet imminent, duties on imports from the EU will be zero at the point of accession and it would be advisable to anticipate that in advance to allow appropriate adjustment of the economy ahead of full implementation. This could warrant adoption of a multi-year phased reduction in rates, following the example of other EU accessants.

E. Conclusion

22. Reductions in tariffs have led recent initiatives to lower the overall tax burden, but a more integrated approach seems warranted in future. In indirect taxes, initiatives are focused on strengthening administration and laying the groundwork for the VAT. These are welcome, but critical implementation risks—notably on revenue allocation and transitional arrangements for sales tax collections which have no direct parallel in other VATs—need to be addressed. And the revenue allocation processes also call for a simple VAT structure, preferably a single rate. A strong VAT, alongside determined expenditure reform will facilitate reductions in the overall tax burden. The latter appears best achieved through further tariff reductions and reductions in the burden of labor taxation. The former requires a reconfiguration of the internal revenue allocation system in the Federation. And both tariff and labor tax cuts will only realize their full potential in the context of profound reform of corporate structures through privatization and so on. In that context, corporate taxes should move towards simplification, harmonization, and a low rate, so as to encourage enterprise reform while also ensuring that as profitability strengthens, collections strengthen alongside.

1

Contributed by Gunther Taube and Geert Almekinders.

2

The indirect tax framework law requires the adoption of regulations on the allocation of indirect tax revenue, methods of payment into the single account, and customs policy, within six months from entry into force of the framework law (i.e., by end-June 2004). The ITA Director has to submit to the Governing Board a customs reorganization plan within 90 days after the framework law becomes effective (i.e., by end-March 2004); the plan shall be approved by the GB within 30 days following its submission.

3

An ACE-based corporate profit tax was also introduced in Croatia in 1994, but abandoned in 2000 and replaced with a more orthodox corporate profit tax.

4

Effective January 1, 2003, the specific surcharges were formally merged with the ad valorem customs duties to create a composite tariff schedule. However, in the data reporting the two components are still reported separately.

5

BiH applied for WTO accession in May 1999 and a memorandum on the foreign trade regime was reviewed by the working party on BiH accession in November 2003. The next meeting of the working party could take place in the spring of 2004, following submission of BiH’s comprehensive legislative action plan.

6

Slovenia’s entry into the EU causes its exports to Bosnia and Herzegovina to be taxed again at 100 percent of the import tariff schedule effective May 1, 2004.

7

Regrettably, certification and phyto-sanitary regulations for meat and animal products fall short of EU requirements, impeding full utilization by producers of the beneficial access to EU markets. Approval of national phyto-sanitary legislation, which is part of the conditionality of the EU’s macro-financial assistance facility, should help bring the quality of plants and seeds produced in Bosnia and Herzegovina up to international standards.