Republic of Moldova: Selected Issues
Author: International Monetary Fund
Publication Date:
17 Feb 2005
eISBN:
9781451825046
Language:
English
Keywords:
ISCR; CR; enterprise; government; migrant; GDP ratio; unreported profits; CIT rate; enterprise profits; CIT revenue; Income tax systems
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This Selected Issues paper analyzes the macroeconomic impact of workers’ remittances on Moldova. The paper focuses on Moldova’s labor emigration since the late-1990s using survey data designed to shed light on the economic and social consequences of migration. The survey results are broadly consistent both with the findings from balance-of-payments data and with the stylized facts in the labor migration literature. The paper also examines various indicators to assess the appropriateness of the current exchange rate level.

Abstract

This Selected Issues paper analyzes the macroeconomic impact of workers’ remittances on Moldova. The paper focuses on Moldova’s labor emigration since the late-1990s using survey data designed to shed light on the economic and social consequences of migration. The survey results are broadly consistent both with the findings from balance-of-payments data and with the stylized facts in the labor migration literature. The paper also examines various indicators to assess the appropriateness of the current exchange rate level.

VI. Enterprise Profitability, Income Tax Rates, and Income Tax Revenues53

A. Introduction

153. Notwithstanding reductions in corporate income tax (CIT) rates since the late 1990s, nominal revenue collections have been improving. Although CIT rates were cut by 3 percentage points in 2002 and 2003, nominal CIT revenue continued to increase every year, although it remained stable as a share of GDP (Figure 1).54 This could be construed as evidence that more enterprises have been captured into the tax net. Indeed, the government considers the positive performance of nominal CIT revenue as an indication that tax rate cuts motivate enterprises to come out of the underground economy and/or declare more profits.

Figure 1.
Figure 1.

Moldova: Corporate Income Tax Collection

Citation: IMF Staff Country Reports 2005, 054; 10.5089/9781451825046.002.A006

Sources: Ministry of Finance; and Department of Statistics and Sociology.

154. This chapter explores the relation between CIT rates and CIT revenue. To verify whether we can substantiate the claim that lower CIT rates have encouraged enterprises to pay taxes, we assess if tax cuts have had an impact on real—rather than on nominal—collection. We derive collection in real terms both by deflating nominal CIT collection by a price index, and by dividing CIT revenue by enterprises profits. The advantage of using the second indicator is that it gives us an idea of how CIT revenue performed with respect to its base—profits.

155. The chapter is organized as follows. Section B explores the relationship between CIT revenue and enterprise profits in 1998-2003. Section C introduces a model of enterprise profits to analyze conditions we can establish a causal relationship between reductions in CIT rates and tax compliance by enterprises. Section D draws some conclusions.

B. Economic Recovery and Enterprise Profits

156. The recent cuts in CIT rates coincided with a period of economic recovery following the 1998 regional crisis. When we consider CIT revenue in real terms (i.e., deflated by the CPI), it is clear that it started to improve already in 2001, before the 2002 reduction in tax rates (Figure 2). The boost in CIT collections followed the resumption of GDP growth from early 2000. Nevertheless, by 2003 the index of real CIT revenue was still 3 percentage points lower than in 1997 because the enterprise sector had been hit hard by the 1998 crisis and started showing signs of regional recovery only in 2000.

Figure 2.
Figure 2.

Moldova: Corporate Income Tax Rate vs. CIT Collection Indices, 1997-2003

Citation: IMF Staff Country Reports 2005, 054; 10.5089/9781451825046.002.A006

Sources: Ministry of Finance; and DSS.

157. To better capture profits behavior, the analysis is based on financial reports of enterprises, banks, and insurance companies, which include all CIT-paying economic agents.55 These are provided, respectively to the Department of Statistics and Sociology (DSS), the National Bank of Moldova (NBM) and the State Insurance Supervision Agency (SISA). All registered enterprises have to report to the DSS and no enterprise can be registered without the prior knowledge of the DSS; therefore we assume that the number of registered enterprises is equal to the number of existing enterprises. Since the data reported to the DSS are neither transmitted to the State Tax Inspectorate (STI) nor used as a basis for CIT returns, this information has no implication for enterprises’ fiscal liability. Therefore, we can assume that the financial reports reveal the true level of profits of enterprises, and that these revealed profits are not a function of the level of CIT rate. We will refer to the profits reported to the DSS, NBM, and SISA as economic profits—as opposed to fiscal profits reported to the STI.

158. The combined DSS-NBM-SISA databases show that the level of economic profitability of businesses increased dramatically in recent years (Figure 3a). With economic recovery, businesses started to become profitable. For the first time since the early 1990s, in 2002 the volume of profits generated by economic agents was higher that the volume of their losses—i.e., the sector as whole recorded a net income. The volume of net income generated by profit-making economic agents more than doubled between 2001 and 2003. STI data on profits tell essentially the same story as the combined databases used in this chapter—both total profits and the number of CIT returns reporting profits as a share of total returns increased markedly already in 2001, thus contributing to explain the turnaround in real CIT revenue that occurred in that year (Figure 3.b).56

Figure 3a.
Figure 3a.

Economic Profitability of Companies 1/ (I)

Citation: IMF Staff Country Reports 2005, 054; 10.5089/9781451825046.002.A006

Figure 3b.
Figure 3b.

Economic Profitability of Companies (II)

Citation: IMF Staff Country Reports 2005, 054; 10.5089/9781451825046.002.A006

Sources: DSS; National Bank of Moldova (NBM); State Insuarance Supervision Agency (SISA); and State Tax Inspectorate (STI).1/ Note: Only data from 1998 onward are shown because they reflect a new accounting system. As a result, the data reported before 1998 are not comparable.

159. All variables contributing to the volume of profits—the number of registered firms, the percentage of firms reporting profits, and profits per profit-making firm—picked up in 1999 and gathered pace subsequently (Figure 4 and Table 1). Table 1 also suggests that, in recent years, the most important factor driving profits has been the rate of growth of profits per reporting firm, rather than the number of registered firms, or the ratio of the number of profitable firms to the total number of firms.57

Figure 4.
Figure 4.

Moldova: Components of Profits, Nominal GDP, and CIT Revenue Collected by General Government

(Index, 1998=100)

Citation: IMF Staff Country Reports 2005, 054; 10.5089/9781451825046.002.A006

Sources: Ministry of Finance; DSS; NBM; and SISA.
Table 1.

Moldova: Components of Profits, 1998-2003

article image
Sources: Department of Statistics and Sociology, National Bank of Moldova, State Insurance Supervision Agency; and staff calculations

160. Viewed against the background of improved business profitability, CIT collection performance does not appear as strong. To assess how CIT collection performed as the base on which CIT is assessed and paid increased, we computed the Effective Rate of Collection (ERC), which is the ratio between CIT collections and profits declared to the DSS, NBM, and the SISA (Figure 5). Thus computed, the ERC can be also interpreted as an indicator of real collections: the larger its distance from the CIT rate line, the lower the effectiveness of CIT revenue collection. The ERC line shows that the decline in real collections mirrored the decline in CIT rates—i.e., the distance between the CIT rate line and the ERC line remained constant. This means that collection performance (CIT revenue per unit of CIT rate) did not improve as a result of lower CIT rates. Thus, although CIT collections remained stable as a share of GDP, they declined as a share of economic profits. Therefore, it is at best unclear whether CIT rate cuts encouraged reporting of profits.

Figure 5.
Figure 5.

Moldova: Income Tax Rate vs. Effective Rate of Collection

(In percent)

Citation: IMF Staff Country Reports 2005, 054; 10.5089/9781451825046.002.A006

Sources: DSS; Ministry of Finance; NBM; and SISA.1/ Ratio of CIT revenue (general government) divided by profits declared by economic agents.2/ Implicit collections in 2002 (2003) at unchanged rate of 28 (25) percent.3/ Implicit collections at unchanged rate of 28 percent.

161. CIT collections in real terms would have increased with higher profitability of economic agents if CIT rates had not been cut. The two bolded lines jutting out of the ERC line in 2001 show how much CIT revenue would have been collected had CIT rates not been reduced (adjusted ERC lines).58 The almost horizontal path of the adjusted ERC line II shows how much higher CIT revenue per unit of economic profits would have been had rates not been reduced. The distance between the CIT rate line and the Adjusted ERC lines narrows visibly, indicating that collection performance would have increased, essentially as a result of increased profitability, had rates been left at 28 percent.

C. A Model of Business Profits

162. In this section we develop a model of business profits to determine under what conditions lower CIT rates lead to improved compliance and a more-than-proportional increase in declared profits. We start from the basic national accounts identity:

Y = (πR · FR + πN · FN + w · L)59

Equation (1) states that GDP is the sum of business profits (reported and unreported) and labor income. Reported profits can be calculated as GDP minus unreported profits minus labor income:

πR⋅FR=Y−πN⋅FN−w⋅L(2)

Profit tax revenue is defined as the tax rate times reported profits:

T=t⋅πR⋅FR=t⋅(Y−πN⋅FN−w⋅L)(3)

as a share of GDP:

TY=t⋅(1−πN⋅FNY−w⋅LY)(4)

Differentiating (4) we can see how the profit tax/GDP ratio will change in response to changes in other factors:

d(TY)=dt⋅πR⋅FRY−t⋅(dπN⋅FNY+πNY⋅dFN−dY⋅πNFNY2+dw⋅LY+wY⋅dL−dY⋅wLY2)........(5)

Equation (5) can be used to interpret developments over the 1998-2003 period. Figure 1 suggests that profit taxes as percent of GDP remained broadly constant throughout this period of observation:

d⁢(TY)=0(6)

Combining (5) and (6), we obtain:

d⁢t⋅πR⋅FRY=t⋅(d⁢πN⋅FNY+πNY⋅d⁢FN−d⁢Y⋅πN⋅FNY2+d⁢w⋅LY+wY⋅d⁢L−d⁢Y⋅w⁢LY2)(7)

writing dXX=X^, so that

t^⋅πR⋅FRY=(π^N+F^N−Y^)⋅πN⋅FNY+(w^+L^−Y^)⋅w⋅LY(8)

Equation (8) shows that for the tax revenue/GDP ratio to remain constant (d(T/Y)=0, as shown in Figure 1) in the face of a tax rate cut (t^<0), one or two things must have happened:

(a) Total unreported profits grew at a lower rate than nominal GDP (first term on the right-hand side of equation (8)):

π^N+F^N<Y^(9)

and/or:

(b) Overall profitability in the economy, measured in percent of GDP, improved—i.e. nominal GDP growth exceeded the wage bill growth (second term on the right-hand side of equation (8)):

w^+L^<Y^(10)

163. This allows us to consider alternative explanations for the observed behavior of tax revenue in the 1998-2003 period. The revenue/GDP ratio remained constant despite the tax rate cuts either because: (a) overall profitability (as percent of GDP) increased; or, (b) overall profitability did not increase, but tax compliance improved. Case (a) in itself does not rule out improvement in tax compliance, but requires additional analysis to confirm its presence.

164. We use the conceptual framework outlined above to assess these alternative explanations. Table 2 summarizes the salient data for the period 1998-2003, suggesting a better fit for alternative (a): profits as a share of GDP rose from 41.5 to 45.3 percent of GDP during this period. Additional analysis is therefore required to explain the role of unreported profits.

Table 2.

Moldova: Labor and Profit Shares, 1998–2003

article image
Sources: Authorities’ data; and staff estimates.

Total value added excluding profits: includes wage bill plus indirect taxes net of subsidies.

165. To operationalize the conceptual framework for this exercise, we rearrange equation (4) to obtain

Tt⋅Y=1−πN⋅FNY−WY(4⁢b),

where W=w⋅LY

Differentiating (4b), we obtain

d⁢(Tt⋅Y)=−d⁢(πN⋅FNY)−d⁢(WY)(11)

To highlight the behavior of unreported profits (πNFN), we rewrite equation (11) as

d⁢(πN⋅FNY)⁢=−d⁢(WY)−d⁢(Tt⋅Y)(12)

Equation 12 states that the change in unreported profits as a share of GDP is the (negative) sum of two components: the wage share, and tax revenue as a share of GDP divided by the tax rate.

Using data from Table 2, we calculate that

d⁢(WY)=−0.038; d⁢(Tt⋅Y)=0.035; a⁢n⁢d, h⁢e⁢n⁢c⁢e⁢   d⁢(πN⋅FNY)=0.003

166. In other words, unreported profits increased slightly as a share of GDP between 1998 and 2003. To determine the change in unreported profits, we need information on the share of unreported profits in the initial period, which is not available. Table 3 presents the results under alternative assumptions for the initial share of unreported profits.

Table 3.

Moldova: Change in Unreported Profits, 1998–2003

article image
Source: staff calculations.

167. Table 3 suggests that the effectiveness of tax rate cuts in enlarging the tax base—by bringing into the tax net companies that until then had avoided their fiscal obligations—depends critically on the initial share of unreported profits in total profits.60 In 1998–2003, unreported profits may have declined as a share of total profits, particularly if their share was relative large in the initial period. However, it is possible that they may have increased somewhat, if their initial share was already relatively small. For example, if the initial share of unreported profits was one-third, this share would have declined by 2.1 percentage points—from 33.3 percent to 31.2 percent. In contrast, if the initial share was only 5 percent in 1998, the share of unreported profits is estimated to have edged up to 5.2 percent by 2003.61

168. We can use this framework to assess the likely impact of a further cut in the CIT rate to 18 percent in 2005. Table 4 shows the estimates for the needed decline in unreported profits between 2003 and 2005 to (i) keep total profits as percent of GDP constant, and (ii) to keep tax revenue-to-GDP ratio constant. The objective of keeping the tax-to-GDP ratio unchanged becomes particularly challenging if unreported profits are relatively small. For example, with unreported profits of 10 percent of total profits, the number of nonreporting firms would need to be cut in half. If unreported profits account for 5 percent of total profits, they would need to be practically eliminated (brought down to 0.3 percent).

Table 4.

Moldova: Change in Unreported Profits Required to Keep Tax/GDP Constant, 2003–05

article image
Source: staff calculations.

D. Conclusions

169. There is much merit in lowering tax rates. High tax rates have been found to impose a deadweight loss on the economy by giving rise to market distortions—particularly if accompanied by various tax exemptions and incentives—and to encourage the development of the informal economy. Hence, in transition economies where market forces are increasingly important in allocating resources, the Fund has advocated that the tax systems be as neutral as possible so as to minimize interference in the allocation process. Ostensibly, the authorities’ strategy to lower tax rates responds to these considerations.

170. However, cutting tax rates is risky in terms of revenue collection, because firms’ response is uncertain ex ante. Will the hitherto nonreporting firms be enticed to join the formal economy? Will the lower tax rates help spur economic activity, leading to higher incomes and higher revenue collection? This chapter has investigated the first question—to what extent lower corporate tax rates have led to better compliance.

171. The main findings are as follows:

  • The recent reductions in CIT rates were set in motion immediately after the onset of a period of economic recovery, characterized by a surge in enterprise registration and profitability.

  • Nominal tax revenue continued to grow, notwithstanding reductions in the CIT rate, although its growth appears less impressive in relative terms—when deflated by the CPI or when measured against enterprise profits.

  • Available data do not allow us to unequivocally conclude that CIT reductions led to improved tax compliance in 1998-2003. Indeed, the set of conditions under which this may have happened is rather restrictive. In particular, the results depend on the initial number of nonreporting enterprises, which is not known.

  • The analysis highlights the revenue risks from future tax rate reductions, particularly if (i) profits remain constant as a share of GDP; and (ii) the relative size of nonreported profits is small.

172. Our analysis indirectly underscores the importance of complementing tax rate reductions with measures to broaden the tax base. That would not only help minimize the risk of revenue losses, but would be desirable on economic efficiency and equity grounds. Refraining from granting new tax incentives and exemptions, and rolling back the existing ones, is an area where the Moldovan authorities should now focus their attention.

53

Prepared by Edgardo Ruggiero and Milan Cuc.

54

Following several cuts starting in 1998, CIT rates were reduced further, to 20 percent in 2004, and to 18 percent in 2005. An additional cut to 15 percent is planned for 2006, as envisaged in the medium-term expenditure framework covering the 2004–06 period.

55

In this chapter the terms economic agents, firms, companies, and businesses are used interchangeably to indicate enterprises, banks, and insurance companies together. As of December 31, 2004, 16 banks and 33 insurance companies operated in Moldova.

56

The STI dataset collects data from CIT returns, not from financial reports of economic entities. Since economic entities often file two CIT returns in the same year to re-assess their CIT liability, the STI dataset does not have readily available figures on the number of firms, which is needed for our analysis.

57

We can break down total profits (Π) into three components, according to the following formula:

Π = Π/FR * FR/F * F

where F is number of firms and the superscript R indicates “reporting profits.” Thus, total profits can be decomposed into profits per reporting firm (Π/FR); reporting firms as a percent of total number of firms (FR/F); and total number of firms (F).

58

The first (second) observation point in the middle ERC line shows how much CIT revenue would have been collected in 2002 (2003), had the CIT rate been left unchanged at 28 percent (25 percent)—i.e., for any given year, the base of the adjustment is the CIT rate in the previous year. The first and the second observation points in the upper line show how much CIT would have been collected in 2002 and 2003, respectively, had the CIT been left unchanged at 28 percent—i.e., for any given year, the base of the adjustment remains the 2001 CIT rate.

59

Y stands for nominal GDP; π for profit per firm; F for number of firms; w for average wage; L for employment; T for profit tax revenue; and t for profit tax rate. Superscripts R, N denote “reported” and “nonreported” profits, and “reporting” and “nonreporting” firms.

60

If we assume that average profits per firm are the same for reporting and nonreporting firms, then the changes in unreported profits relative to total (or reported) profits are due to changes in the relative numbers of reporting and nonreporting firms.

61

If the initial share of unreported profits in total profits was 7.8 percent, it remained unchanged.

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Cover IMF Staff Country Reports
Republic of Moldova: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2005: Issue 054
Publisher:
International Monetary Fund
ISBN:
9781451825046
ISSN:
1934-7685
Pages:
90
DOI:
https://doi.org/10.5089/9781451825046.002

Moldova: Corporate Income Tax Collection

Moldova: Corporate Income Tax Rate vs. CIT Collection Indices, 1997-2003

Economic Profitability of Companies 1/ (I)

Economic Profitability of Companies (II)

Moldova: Components of Profits, Nominal GDP, and CIT Revenue Collected by General Government

(Index, 1998=100)

Moldova: Income Tax Rate vs. Effective Rate of Collection

(In percent)