Bosnia and Herzegovina: Selected Economic Issues

This Selected Economic Issues paper for Bosnia and Herzegovina reports that output, exports, and incomes have increased and inflation has stabilized. New modern banking laws have been passed in both entities, and the banking sector has been almost completely privatized, with the majority of assets now under foreign ownership. The reforms to the central bank and to the banking system have been aimed to secure stability and to build an efficient financial system.

Abstract

This Selected Economic Issues paper for Bosnia and Herzegovina reports that output, exports, and incomes have increased and inflation has stabilized. New modern banking laws have been passed in both entities, and the banking sector has been almost completely privatized, with the majority of assets now under foreign ownership. The reforms to the central bank and to the banking system have been aimed to secure stability and to build an efficient financial system.

VII. The Value Added Tax1

A. Introduction

1. The task of introducing a value added tax, now scheduled for end-2005, has been unusually challenging. In addition to the change in tax structure and the technical preparations of tax officials and taxpayers, which have exact parallels with VAT reforms elsewhere, this reform in Bosnia and Herzegovina (BiH) has required:

  • abolition of multiple prior sales taxes;

  • arrangements to shift the constitutional competence for indirect taxation from the Entity to State level;

  • a step by step unification of multiple indirect tax and customs administrations;

  • new arrangements for policymaking structures governing indirect taxation; and

  • a new configuration of rules to allocate indirect tax revenue between the different governments.

Many of these steps have been completed. But difficult challenges remain to be resolved before VAT can go into effect.

2. This chapter has four parts. First, it outlines the “starting point”—the sales tax and its administrative structures—from which the VAT initiative began some two years ago. Second, it describes steps already taken to build structures needed for VAT. Third, it outlines the main features of the VAT. And last, it outlines what remains to be done before VAT implementation can proceed.

B. Tax Policy and Administration in 2003

3. Until late 2003, indirect tax policy in BiH was determined and mostly administered at the Entity level. 2 The State was responsible for foreign trade policy and customs policy, including determining external tariffs (Figure 1). The entities and the Brcko District (BD) each had their own “domestic” indirect tax legislation (implying three sales tax, three excise tax laws etc). This domestic legislation was administered by three separate tax administrations, one in each Entity and a further administration in Brcko District. The entities also administered customs taxes and collected these within their own jurisdictions. These arrangements reflected arrangements set out at Dayton.

Figure 1.
Figure 1.

Tax and Customs Policy Determination and Administration in BiH: Before Indirect Tax Reform

(2003 and earlier)

Citation: IMF Staff Country Reports 2005, 198; 10.5089/9781451977783.002.A007

4. The entities did not coordinate sales or excise tax policy or administration. Given the absence of internal borders, this generated significant tax competition, instability in revenue, and a non-harmonized indirect tax structure (Box 1). It also induced significant tax fraud and corruption, notably given absence of cooperation amongst the tax administrations with each other in verifying taxpayer returns, resulting in major revenue losses (Table 1). All these problems compounded those typically associated with all sales taxes (Annex 1).

Table 1.

Estimated Revenue Loss Due To Tax Fraud in BiH

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Indirect Tax Structure in BiH Before the Indirect Tax Reforms

Up to 2003, each entity had its own indirect tax laws. These laws had different structures across entities. The RS law combined the regulation of excises with the sales tax in one law whereas the Federation had a separate law on sales tax and a law for each type of excise. Brcko had a separate law on sales tax and another law on excises.

There were differences across entities in the sales tax. The RS sales tax had a standard rate of 18 percent and a reduced rate of 8 percent with the sales tax on services at 8 percent. The Federation had a standard rate of 20 percent and a reduced rate of 10 percent with the sales tax on services at 10 percent. The sales tax rates in the Brcko District were similar to those in the RS. Exemptions and goods covered under the reduced rate also differed across entities. The tax base, however, included excises and customs in all entities and the District.

There were differences in excises across entities as well. For example, the excise on wine was KM0.20 per litre in the Federation and KM0.25 per litre in the RS; the excise on heating oil was KM0.09 per litre and KM0.30 per litre in the Federation and the RS respectively.

C. Steps Taken Towards the VAT

5. From this starting point, steps towards VAT required multiple changes in tax policy and administration.

6. The changes began with the formation of an Indirect Tax Policy Commission in early 2003. With active international community support, the commission was formed with representatives from the entities, the State and the international community. It was tasked to make recommendations to improve tax policy and administration, and three were central:

  • Merge the customs administrations into a single unit,

  • Establish a single administration for all indirect taxation, and

  • Replace the sales tax with a VAT.

These recommendations were aimed at making BiH a “single economic space” and to secure a strong revenue base for government operations.

7. In December 2003, the Indirect Tax System Law was adopted, establishing the Indirect Tax Authority (ITA). Under this law, the ITA alone is charged with implementing indirect tax legislation.3 It’s Board consists of the State and the two Entity Ministers of Finance, and nominated “experts” and the Board is responsible for formulation of indirect tax policy, including making preparations to introduce the VAT.

8. Movement from the devolved to the unified policy determination and administrative structure was planned to occur in stages (Figure 2).

Figure 2.
Figure 2.

Tax and Customs Policy Determination and Administration in BiH: After Indirect Tax Reform

Citation: IMF Staff Country Reports 2005, 198; 10.5089/9781451977783.002.A007

  • In mid-2004, the Entity customs administrations were placed under the effective authority of the newly formed ITA. However, in this context, and for a temporary period, collection of sales tax and excises tax revenues on domestic consumption is still executed at Entity level and under Entity authority, while sales taxes and excises on imports are collected by the ITA directly.

  • Alongside, preparations began to shift the sales and entity tax laws from Entity to the State level. This step would necessitate pooling of the receipts from these taxes into the so-called “single account,” requiring a mechanism to distribute them from the single account to the various governments (Box 2). Agreement on this formula was reached late in 2004 and on December 31, 2004, new State-level sales tax and excise tax laws were passed and implemented on January 1, 2005, and the parallel Entity laws fell into abeyance.

The Single Account

The single account became operational on January 1, 2005. Payments into the account are regulated under the Law on Payment Into the Single Account and Distribution of Revenues. Under this law, all indirect taxes (including import and export duties, excises, taxes chargeable on goods and services including the sales tax on excisables and the road tax) for which the ITA is responsible for must be paid into this account. These revenues started flowing through the Single Account when it became operational. Once VAT goes into effect, all VAT revenues will also be paid into this account.

Pooling indirect tax revenues in the single account required a means of distributing these revenues back to the Entities and the Brcko District. Currently, this is done according to coefficients based on Entity shares in final consumption as revealed in sales tax data. The law envisages that allocation coefficients will be calculated every month with the amounts due to the Entities and the BD to be allocated by multiplying the “relevant amount” in the Single Account by their allocation coefficients. The “relevant amount” is the total amount in the Single Account less the part for the State for financing the institutions of BiH, debt service payments, and the reserve. The allocation coefficient is the result of dividing final consumption for the Entity and BD over twelve months (as revealed by tax return data) by the sum of the final consumption in BiH for the same period. The allocation coefficients in the first part of 2005 for the Federation, Republika Srpska (RS), and the BD are 66.6 percent, 29 percent, and 4.4 percent respectively (Figure 3). However, for practical reasons, the “moving average” feature of the calculation of coefficients has not yet gone into effect, and the coefficients have been fixed for the first part of 2005. Once the ITA Board is satisfied that the practical difficulties in implementing the moving average system have been overcome, it will authorize a shift to the envisaged moving average system.

Indirect tax revenue distribution mechanisms also exist within the Entities. In the Federation, the Single Account revenue is shared between the central government, cantons, and the Road Directorate with the Federation central government receiving 68.5 percent, cantons 23.7 percent, and the Road Directorate 7.8 percent. In the Republika Srpska, the revenue is shared between the central government, the municipalities, and the Road Directorate with each receiving 77.1 percent, 14.3 percent, and 8.6 percent respectively (see Figure 3).

The Single Account consists of accounts at 12 commercial banks where individual revenues are collected. All revenues collected into these account are transferred to the Central Bank on a daily basis. The ITA uses the 12 commercial banks for purposes of refunds, and all payment transactions made are reported to the ITA on a daily basis. The modalities for the distribution of revenues from the Single Account are discussed in the following section.

Figure 3.
Figure 3.

Illustrative Example of the Distribution of Revenues from the Single Account4

Citation: IMF Staff Country Reports 2005, 198; 10.5089/9781451977783.002.A007

9. This last step secured harmonization of all these tax structures and laid the basis for the operation of the single account. Thus, the sales tax has a standard rate of 20 percent and the reduced rate is 10 percent. The tax base includes excises and customs. Excise rates are also now harmonized across the entities.

D. VAT Structure

10. The VAT law was approved in January 2005 and is generally modelled against the EU’s Sixth VAT Directive. This section describes the proposed structure of the VAT.5

11. The VAT will be a single rate consumption tax, in contrast to the current retail sales tax with two rates. The proposed VAT rate will be 17 percent.6 This decision was controversial. The state parliament preferred two rates, following precedents in many other countries, emphasizing that replacing a two-rate retail sales tax with a single rate VAT would adversely affect the poor (Annex 2). But a single rate was eventually chosen in order to minimize administrative complexities that a multiple rate structure would imply, an urgent consideration given the many other administrative challenges in implementing the VAT in Bosnia and Herzegovina’s specific case.

12. The exemptions in the BiH VAT law follow closely the exemptions required in the EU’s Sixth VAT Directive. The VAT law exempts financial and monetary services, activities in the public interest, imports of diplomatic and international organizations, imports into and supply to and within customs-free zones and customs-free warehouses, and international transportation. Fewer goods will be VAT exempt than under the Sales tax.

13. A registration threshold of KM50,000 (US$30,000) will be applied. The threshold aims to balance the administrative and compliance costs against the need for additional revenue. In determining whether a threshold of KM50,000 is met, turnover of companies and other bodies under common direct or indirect control (through possession of shares or in any other way) will be taken into account. The turnover threshold of KM50,000 accounts for about 90 percent of the receipts reported on sales tax returns. It is estimated that about 4000 companies not currently registered for the sales tax will be required to register for the VAT.

14. In line with good practice, the BiH VAT base includes customs duties and excises. The VAT on imports is collected at the time when goods are entered for customs purposes. The VAT base also includes other import charges as well as other public revenues; any indirect costs charged by the supplier to the recipient of goods and services (such as commission, packaging costs, transport and insurance, etc.); and any costs of connection, installation charges, and other amounts charged to the purchaser by the supplier as a condition of supplying goods and services.

15. The VAT law contains clear rules for the place of supply of services that is consistent with international practice. The law specifies that the supply of services will be deemed to have taken place in BiH if the taxpayer has a permanent base in BiH from which services are provided or, in the absence of such a base, has his permanent address or usual place of residence in BiH.

16. Tax returns are required. All taxpayers should submit a VAT tax return for each accounting period by the 10th day of the calendar month following the end of the accounting period and must pay the tax for each accounting period by the deadline for filing the return. VAT refunds will be paid within 60 days of submission of a VAT return. This is in line with best practice. However, given that the administration is new and is expected to be weak initially, dealing with refunds for all tax payers may be difficult.

E. Next Steps

17. Despite progress made, five major challenges still lie ahead before VAT implementation can proceed. These include: various technical preparations, including development of Information Technology (IT); incorporation of excise tax administration into the ITA; a comprehensive reform of arrangements to distribute indirect tax receipts among cantons and municipalities; arrangements to offset the impact of the VAT on the poor; and steps to anticipate uncertainty is collections in the initial period of VAT implementation.

Administrative preparations

18. The following still needs to be completed:

  • Preparation of the information technology systems has been slow. Development of software for VAT returns and payment processing has just started. Computer software testing has not started and should start well in advance of implementation.

  • Staffing and recruitment for the new VAT administration has lagged and progress is needed urgently. A number of recruitment-unfriendly rules in labour legislation, the inadequate quality of applicants, and a non-transparent recruitment process have hindered progress.

  • Taxpayer education has started but should be much strengthened.

  • The preparation of Regional Tax Centres is lagging and need to be ready in time for VAT introduction.

  • Implementing regulations remain to be defined, including guidelines on taxpayer registration, and guidelines on enforcement procedures.

Incorporation of excise administrations into the ITA

19. For purposes of administrative efficiency, excise administration will be incorporated into the ITA. This will ensure that indirect taxes with closely related tax bases (i.e., customs duties, excises, and the VAT) are collected and controlled by the same administrative entity at the State level, as foreseen by the ITS law and the nationwide excise tax law that was adopted at end-2004. It will further help in preventing tax induced distortions of production and trade, and will reduce companies’ compliance costs. The integration has already taken place as far as excises on imported goods are concerned, while the deadline for the integration into the ITA of the administration of domestic excisables is July 1 this year. The deadline is expected to be met, in part because very few companies are involved, and the precondition is that no further excise taxes will be introduced.

Revenue Allocation for Cantons and Municipalities

20. Intra-Entity distribution of indirect tax revenues will have to change. Under the sales tax, collections were administered by the central government in the Federation and allocated to the Cantons and Municipalities. In the RS, collections were administered by the central government and shared between the central government and the municipalities. Even in the current “intermediate” stage—where the sales tax on excisables is pooled in the single account—this allocation rule remains viable (and in place) because the sales tax data are still collected and provide a basis to distribute those funds from the single account within each Entity on that basis. But this key will not be available once the VAT is introduced because tax origin will not be recorded under the VAT at the sub-entity level.

21. The authorities are receiving TA in this area.7 Among the ideas being considered for replacing origin based sales taxes are the introduction of a uniform minimum municipal share of the new personal income tax (which is expected to replace the wage and citizen taxes by January 1, 2006), possibly combined with general equalizing revenue grants from the entity central governments directly to the municipalities, calculated as fixed amounts per capita. For the Cantons, different models involving general revenue grants are being analyzed. This work will need to be completed swiftly given the deadlines for the VAT.

Impact of VAT on the poor

22. The authorities hope to address the impact of the VAT on the poor. A FAD TA mission in March 2005 assessed this impact, finding as follows:

  • The average increase in the tax burden is estimated at KM 300 (2.4 percent of consumption spending) per annum per household.

  • The absolute increase in the tax burden falls disproportionately on richer households. Households in the upper income deciles would pick up about 16 percent of the increase in the total burden, while those in the lower deciles only about 4 percent.

  • But as a proportion of household consumption, however, the additional tax burden (compared with the sales tax) is regressively distributed. It amounts to 2.6 and 1.9 percent of consumption spending for the lowest deciles and highest deciles, respectively.

  • There are also important inter- and intra-entity differences in the distribution of the additional tax burden. Households in the Federation will bear a higher burden than those in the RS. Also, urban households will be more adversely affected than households in rural municipalities.

23. The FAD mission advised that an Entity-level social welfare program is the most appropriate instrument to compensate households which will be adversely affected by the VAT. But establishing such a suitable mechanism will be challenging because the existing programs are poorly targeted and their separate policy formulation, financing, and implementation has resulted in wide variation of service provision across cantons and municipalities.8 The mission favoured centralization of these social programs at Entity level and laws to this effect are being drafted with assistance from the World Bank.

Collection uncertainty immediately following implementation

24. Even if all administrative preparations proceed smoothly, the revenue yield from VAT is uncertain. The estimates of the “revenue neutral” rate (of 16 percent) are based on BiH macroeconomic data, which are less than completely reliable.9 Errors in the estimate could go both ways.

25. Preparations for the 2006 budgets will need to anticipate this uncertainty in order to ensure continued control over the consolidated fiscal balance.

  • To address risk of lower than expected revenues, a spending reserve—a so-called “delayed spending list”—should be established in the 2005 budgets, with the spending in the reserve only authorized during 2006 in light of actual collections. This spending reserve should be created at the State level, and at the Entity central Government level. Arrangements for revenue allocation from the Single Account will need to be set up so as to implement this approach. Given that interpretation of collections—whatever they are––following VAT introduction cannot be confirmed swiftly, the reserves should be created to be in place for at least six months, to allow appropriate analysis of the collections data in the early months of 2006.

  • In the event that revenue exceeds expectations—and this trend is confirmed after an appropriate period to ensure that this is not “noise” in the early months— consideration will have to be given to the appropriate use of the “permanent windfall” receipts. Given considerable inefficiencies in government spending, proposals to apply the windfall to additional programs should be resisted. Instead, a better option would be to apply the “permanent windfall” to reductions in labor taxes. These are currently heavy—52 percent of the net wage (including benefits) in the RS and 69 percent of the net wage (excluding benefits) in the Federation. At these levels, this taxation discourages tax compliance and job creation. Use of a permanent VAT windfall to lower the burden of labor taxation would secure an appropriate shift from direct to indirect taxation in the tax system, and prevent further expansions in the size of government which application of any permanent VAT windfall to spending would imply.

Annex 1. Advantages of a VAT Compared With a Sales Tax

The main features of the VAT widely accepted as constituting best practice in consumption tax design include production efficiency and absence of cascading.10

As a tax on consumption, VAT meets the production efficiency criterion. Since VAT does not fall on intermediate production, any VAT paid by a supplier or in intermediate production is refunded. As a result, it does not distort the production process.

The VAT does not cascade. Cascading occurs when a tax is levied on both inputs and outputs of the same production process. The higher the number of production stages, the higher the tax burden would be if a tax is not levied on final consumption. Cascading results in a much higher tax burden than would otherwise be the case if the tax were only levied on final consumption. Though the VAT is levied in all stages of production, refunds on inputs ensure that the VAT ultimately is only levied on final consumption.

The retail sales tax that the VAT will replace in BiH is also a production efficient tax but involves cascading. Since the retail sales tax charged on inputs is not refunded it generally results in a much higher tax burden than would otherwise be the case. Cascading of the sales tax in BiH is, however, limited as it is primarily collected at the retail stage (except for excisables that are taxed at the import and manufacturing stages). Also, the raw materials and semi-finished goods used in the production of excisable products are exempt.

Annex 2. VAT Rates Applied in the European Commission Member States

(as of September 1, 2004)

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Source: European Commission.
1

Prepared by Nombulelo Wandwasi.

2

The Entities are the Republika Srpska and the Federation.

3

Interpretations of the relationship between the ITA Board and the State Parliament vary, a key “fiscal architectural” issue. See Chapters 8 and 10.

4

This illustration is based on payment from the Single Account in the first quarter of 2005.

5

The BiH authorities received extensive technical assistance (TA) from the IMFs’ Fiscal Affairs Department (FAD) and from the European Union-Customs and Fiscal Assistance Office (EU-CAFAO) in the design of and preparatory work for the VAT.

6

An FAD TA mission in June 2004 estimated that the revenue neutral rate is 16 percent.

7

TA is being provided by the the Governance Accountability Project (GAP), financed jointly by USAID and the Swedish International Development Cooperation Agency (SIDA) and supported by the international community.

8

See Staff Report, Text Box 4.

9

See Chapter 5.

10

For a detailed discussion, see L. Ebrill, M. Keen J. Bodin, and V. Summers, The Modern VAT, (Washington: International Monetary Fund, 2001).

Bosnia and Herzegovina: Selected Economic Issues
Author: International Monetary Fund
  • View in gallery

    Tax and Customs Policy Determination and Administration in BiH: Before Indirect Tax Reform

    (2003 and earlier)

  • View in gallery

    Tax and Customs Policy Determination and Administration in BiH: After Indirect Tax Reform

  • View in gallery

    Illustrative Example of the Distribution of Revenues from the Single Account4