Republic of Armenia: Selected Issues

Although Armenia itself has a population of only about 3 million, an estimated 8 million Armenians live abroad. In this paper, the size and the sources of remittances to Armenia are first discussed. Then, the appropriate definition of remittances and subsequently present estimates of the macroeconomic effects of remittances to Armenia are outlined. Remittances play a significant role in the Armenian economy. They amount to between US$250 million and US$1 billion per year, and constitute from 25 percent to 80 percent of remittance receivers’ incomes.

Abstract

Although Armenia itself has a population of only about 3 million, an estimated 8 million Armenians live abroad. In this paper, the size and the sources of remittances to Armenia are first discussed. Then, the appropriate definition of remittances and subsequently present estimates of the macroeconomic effects of remittances to Armenia are outlined. Remittances play a significant role in the Armenian economy. They amount to between US$250 million and US$1 billion per year, and constitute from 25 percent to 80 percent of remittance receivers’ incomes.

II. Armenia’s Low Tax Revenues: Reasons, Recent Reforms, and Next Steps19

A. Introduction and Summary

28. Tax revenue reforms have been at the center of Armenia’s Fund-supported program as a sufficient domestic revenue base is crucial to finance the government’s expenditure priorities. Armenia’s state budget has for many years benefited from large grants (1.8 percent of GDP on average over 2001–06) and concessional deficit financing (1.9 percent of GDP net). Over 2007–10, grants and net external financing are expected to decline, and to average 0.8 percent and 1.7 percent of GDP, respectively. Grants and concessional financing have created additional expenditure commitments over the next few years, and alternative sources of financing will need to be found for them.

29. Improving revenues gained momentum in 2005, contributing to a sizable rise in the tax-to-GDP ratio. The focus has been on reducing tax policy loopholes that have contributed to evasion and strengthening tax administration. The significant increase in the tax-to-GDP ratio over 2005–06 can be interpreted as a first indication that recent years’ efforts are paying off. The largest increases were achieved in VAT and profits tax, each of which grew by 0.4 percent of GDP during 2005–06.

30. Nevertheless, tax revenues have remained relatively weak. With 14.7 percent of GDP in 2006, the tax-to-GDP ratio is lower than in most other CIS countries. It is also lower than the authorities’ poverty reduction strategy target of 16.2 percent of GDP for 2006 and than the level of 2000.

31. The relatively weak revenue performance is rooted mainly in tax exemptions and tax evasion. The VAT and the profits and income taxes account for the largest shortcomings relative to their potential. The VAT has been undermined by numerous exemptions from taxation at the border, combined with widespread evasion of domestic VAT payment; the profits tax suffers from tax holidays for foreign investors which have contributed to abuse and reporting of tax losses that are difficult to reconcile with strong economic growth; and the income tax is reduced by customary underreporting of wages. Comparing the current revenue from these three taxes with other transition countries and with the potential implied by national accounts data suggests a large additional revenue potential at the current tax rates.

32. Moving forward, tax policy reforms should concentrate on reducing exemptions, while tax administration should focus on tax audits to reduce tax evasion. In tax policy, the priorities are: phasing out most exemptions from VAT payment at the border, not renewing the profits tax exemptions for foreign investors, and bringing large-scale producers in the agricultural sectors and those subject only to presumptive taxes into the regular tax regime. In tax administration, strengthening audits and crosschecks will be essential to reduce the underreporting of VAT and wages and the declaration of tax losses by profitable enterprises, as well as to stem the accumulation of further tax arrears. To focus reforms over the next few years, a comprehensive tax administration modernization program is needed. In the absence of significant improvements in administration, there is the risk that the recent revenue gains could taper off, or that ad hoc measures to raise revenues could gain ground.

B. Reasons for Armenia’s Low Tax Revenue

33. Armenia relies heavily on indirect taxes (VAT, excises, and customs duties) which contributed 9.0 percent of GDP, or 63 percent of total tax revenue in 2005 (Table II.1). Direct taxes, primarily the personal income tax and the profits tax, contribute relatively little revenues; together with the presumptive taxes on a number of economic activities that are particularly prone to evasion (such as restaurants) and the simplified tax for small firms, they amount to 4.2 percent of GDP or 29 percent of total revenue. Wealth taxes (the land and property taxes) are negligible, while other taxes (including stamp duties) contribute 1.2 percent of GDP or 8.3 percent of the total.

Table II.1.

Armenia—Tax Revenue, 2005

article image
Source: Armenian authorities.

34. Weaknesses in VAT and income taxes explain most of the gap in the tax-to-GDP ratio between Armenia and other transition countries. Figure II.1 shows revenues by tax relative to GDP for 10 CIS and Eastern European countries. Taxes on goods and services (VAT, excises) and taxes on income, profits, and capital gains contribute the main share of revenue in all countries. An analysis of the weaknesses of Armenia’s tax performance will thus have to focus on these two types of taxes that carry most of the potential. Armenia ranks very low among transition economies for both group of taxes: revenues from taxes on goods and services (VAT, excises) rank third from the bottom, about 3 percent of GDP lower than in most other countries; even starker, revenues from taxes on income, profits, and capital gains ranks at the bottom, about 1 percent of GDP lower than in the next-highest group (Azerbaijan, Bulgaria, Romania), and 4–6 percent of GDP lower than in Estonia, Lithuania, Russia, or Ukraine. These gaps are likely to be mostly due to exemptions, loopholes, and weak administration, as Armenia’s tax rates are broadly in line with those in the other countries.20 In sum, comparison with a group of other transition economies suggests an additional tax potential of at least about 3 percent of GDP in VAT and 1 percent of GDP in income taxes.

Figure II.1.
Figure II.1.

Revenue by Tax in Selected Transition Countries, 2005

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A002

Sources: Country authorities; and Fund staff estimates.

35. Total tax revenues in percent of GDP remain below 1999–2001 levels. Figure II.2 shows the composition of tax revenues in Armenia over 1996–2006. VAT revenue has remained highly stable relative to GDP since 1999, although it is partly overstated by the accumulation of VAT refund arrears during this period. Excises have fallen by 0.9 percent of GDP since 2002, due to the appreciation of the dram, as several excises were denominated in US dollars; a change in the denomination to dram and an increase in rates in 2005 should have brought revenue back to its original level in 2006, but growth in excises has remained relatively weak. While the remaining taxes have been stable since 1999 as well, it is the income and profits taxes that have contributed most to the decline in overall tax revenue since then: from 1999 to 2003, they fell by 1.6 percent of GDP, although this is partly explained by one-off effects in 1999. However, in 2005–06, the tax-to-GDP ratio rose by 1.0 percentage points of GDP, excluding a negative one-off effect in excises.

Figure II.2.
Figure II.2.

Revenue by Tax, 1996–2006

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A002

Sources: Armenian authorities; and Fund staff estimates.

36. The VAT falls short of its potential due to the large number of exemptions from VAT payment at the border. While, in principle, these exemptions should shift the first point of collection of VAT inland, in practice it introduces a loophole due to the large number of businesses operating outside the VAT base and the possibility that the importer sells the good for final consumption without charging VAT or underdeclaring the taxable sales value. The fact that most VAT that is not collected at the border is lost is highlighted by the unusually high share of total VAT revenue that is collected at importation: at 69 percent, it was the highest among a sample of transition countries shown in Table II.2;21 also for excises, as well as for total tax revenue, the share of collection at the border is the highest among the transition economies in the sample. Under the extreme assumption that no VAT is currently collected inland on the one-third of imports value that is exempted from taxation at the border, eliminating all exemptions could yield additional revenue of up to 2 percent of GDP, given that VAT revenue collected at the border was 4.2 percent of GDP in 2005.

Table II.2.

Share of Customs Agencies in Revenue, 2004

article image
Sources: Country authorities; and Fund staff estimates.

37. The decline in the profits tax was partly due to the introduction of tax incentives for foreign investors, but mostly due to evasion. In 1998, a tax holiday for foreign investors was introduced and depreciation was accelerated. This tax policy change is widely perceived to explain most of the decline in the GDP ratio. However, there are at least three reasons to believe that most of the loss is explained by evasion and weak administration that have prevented tax revenue from keeping-up with strong buoyant economic growth: first, profit tax revenues collected from companies with foreign participation amounted to only 0.5 percent of GDP in 1999, which suggests that the profit tax-to-GDP ratio could not have declined by more than that as a result of the tax holidays, unless the share of profits of foreign-owned firms in total profits has dramatically increased; second, the ratio of profits tax to GDP has continued to decline several years after the introduction of the tax holidays, as Figure II.3 shows; third, despite strong macroeconomic growth, a large number of the leading companies continues to report losses for tax purposes, not all which can be explained by accelerated depreciation. These three observations suggest that the weak profits tax revenues has been the result of evasion through the shift into foreign investment vehicles set up for tax purposes and underreporting of profits. Both are partly the result of weaknesses in administration, primarily in the area of tax audits. Moreover, the introduction of the simplified tax in 2000 is likely to have created multiple opportunities for tax evasion by smaller taxpayers. In sum, these considerations suggest a large shortfall of profit tax revenues relative to their theoretical potential: based on national accounts data on corporate profits, a 20 percent profits tax should yield about 6 percent of GDP, implying an extra potential of 3 percent of GDP compared to the current total revenue of the profits, presumptive, and simplified taxes.

Figure II.3.

Change in Ratio of Individual Taxes to GDP, 2000–06

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A002

Sources: Armenian authorities; and Fund staff estimates.Note: The bars show the combined effect of the taxes; for example, in 2005 four taxes together raised the tax/GDP ratio by about 1 percentage point, while three other taxes together reduced it by about 0.5 percentage points.

38. The decline in the income tax is also likely to be mostly due to tax evasion. Revenues have declined by 0.6 percent of GDP since 1999. While the rate schedule was changed in 2001, this has reduced revenues by only 0.14 percent of GDP. Rather, collection efficiency is likely to be the main explanation for the decline, especially through underdeclaration of wages by employers, partly driven by “bracket creep” in the face of strong nominal income growth and in the absence of rate bracket indexation. Based on national accounts data and assuming an informal sector share of 30 percent of GDP, wages should be more than twice as large as currently reported. This suggests an additional revenue potential in the order of 1 percent of GDP from the formal sector alone, without tax policy changes.

39. Shortcomings in tax administration probably account for a large part of the shortfall in revenues relative to potential. Weak tax administration is also likely to account for low revenue buoyancy, that is, the elasticity of revenue growth to the growth of the tax base. Figure II.4 shows the contribution of the growth of the tax base to the observed nominal increase in revenue, with the difference to the actual revenue increase due to tax administration.22 To account for the potential impact of growth in little taxed sectors, the tax base contribution is estimated both by overall nominal GDP growth (the first column for each year in Figure II.4 below) and by separate tax bases for VAT, the profit tax,23 and customs duties (the second column). Tax administration contributed negatively in 2003 and virtually nothing in 2004;24 in both years, the difference between the estimates based on overall GDP and separate tax bases was negligible. However, in 2005–06, the contribution of tax policy and administration became substantially positive. This suggests that the reforms of recent years are beginning to yield results.

Figure II.4.
Figure II.4.

Estimated Contributions to Change in Total Tax Revenue, 2003–06

(In millions of drams)

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A002

Source: Fund staff estimates.Note: For each year, the left bar shows the expected increase in tax revenue according to GDP growth, and the right bar the expected increase according to the growth of the bases of the individual taxes. In both cases, the difference between the expected and the actual increase in tax revenue is due to tax policy and administration.

C. Recent Reforms

40. Improving revenue performance has long been a priority area for structural reforms, but has gained additional momentum in 2005. The fact that many large profitable enterprises pay little taxes has gained increasing attention in the public and political spheres. The introduction of a quarterly publication of the 300 largest taxpayers in the newspapers beginning in April 2005 has contributed to this development. In May 2005, the government approved a 2005–06 action plan for reforms in tax policy and tax and customs administration. The plan’s tax policy reforms focused on broadening the tax base through the reduction of exemptions and loopholes (for example, in the areas of VAT exemptions at the border, profit tax holidays, agriculture, and the simplified and presumptive taxes). Tax and customs administration reforms focus on improving tax compliance (particularly by large enterprises) through audits and reducing the accrual of tax arrears.

41. In the area of tax policy, a number of reforms have been achieved in recent years. Most importantly, in 2006 many exemptions from VAT payment at the border were abolished and the VAT regime was tightened to reduce evasion in the construction sector. Moreover, access to the simplified tax was progressively reduced to return taxpayers to the regular tax regime and a minimum profit tax was introduced to curb the undermining of profit tax collections by evasion schemes. In addition, the profit tax exemption for foreign exchange gains was eliminated, the profit tax loss carry-forward reduced, and the property tax base broadened.

42. Progress in tax administration reform has also picked up. This included the establishment of a dedicated tax arrears collection function, of a large taxpayers unit that also includes the central audit department, and of an internal audit unit, longer time limits for the audit of large enterprises, a code of conduct for tax officials, and moving the VAT refund process and audit selection towards risk-based approaches. Sanctions for providing false documentation to revenue agencies were increased and the audit powers of the State Tax Service (STS) were extended. To better cover the buoyant mining sector, a special large taxpayer unit was set up. Moreover, a 2006–08 IT strategy and an acquisition plan for the STS were finalized, first steps to systematically address impediments to the next generation of tax administration reforms.

43. There has also been some progress in customs administration reforms. The main recent developments were the revision of customs legislation to include valuation principles in conformity with World Trade Organization standards and the installation of the ASYCUDA system in all customs houses. However, custom declarations remain complex and progress in moving to importer self assessment has been slower-than-expected; the implementation of a post clearance verification program has been delayed; and enforcement of a new code of conduct for customs officials is limited.

44. A number of further reforms are envisaged for the remainder of 2006 and early 2007. In tax policy, creation of a unified tax code should improve the consistency of the tax system, and the indexation of the presumptive tax rates should help preserve safeguard against inflation. In tax administration, a unified computer network linking all inspectorates of the STS and an electronic risk-based selection system for VAT cross-checks, audits, and refunds are to be established during 2007. This would be a major step forward for tax administration in Armenia, as many improvements hinge on the removal of IT bottlenecks. In customs administration, an intelligence-based system for risk management is to be established.

D. Next Steps

45. Moving forward, tax policy reforms should focus on limiting loopholes in the tax system to reduce evasion and make the system more equitable. Priority steps include reducing exemptions from VAT payment at importation; further narrowing the access to the simplified tax; and bringing large-scale operations from the presumptive to the normal tax regime. It will also be important that the exemptions for foreign investors indeed lapse in 2008 as envisaged at their inception, and the agricultural sector is brought into the tax system by 2009, in line with Armenia’s WTO agreement.

46. Reducing exemptions from VAT payment at the border is crucial. The reason for their introduction was to provide cash-flow relief to importers of intermediate and capital goods in the face of shortcomings in the VAT refund system. The 2005 introduction of the capital deferral system solves this problem by deferring taxation but recording the goods for VAT purposes. Any capital goods that remain tax exempt should be moved to the capital deferral system. Moreover, the VAT refund system, whose deficiencies previously were also a reason for VAT exemptions, has been significantly improved in recent years, as documented by stabilization of the stock of VAT refund arrears in 2005.

47. To raise profits tax revenue, the tax holiday for foreign investors should be abolished, access to the simplified tax should be narrowed, and tax audits should be improved. The standard profits tax is favorable for investors: its rate of 20 percent is comparatively low by international standards, and the depreciation schedule and the provision on loss carry-forward are generous. In this context, the additional positive growth impact of the tax holiday is likely to be limited, while it has implied a significant revenue loss which has been exacerbated by tax evasion schemes. To reduce evasion, not least through the declaration of losses for tax purposes by profitable companies, tax audits should be improved by the introduction of full-fledged risk-based selection criteria and better training for auditors.

48. Activities that are not particularly difficult to tax, as well as large-scale businesses should be moved from the presumptive to the regular VAT and profits tax regime. This concerns in particular imported petrol and diesel fuel and natural gas, given the relative ease in valuation and seemingly limited risk of smuggling. Currently, any profits tax beyond the presumptive tax liability is lost for businesses in these areas. To stem the danger of revenue loss, the minimum of the normal profits tax and the respective presumptive tax could apply. In the medium term, most (if not all) remaining activities should be moved from the presumptive to the regular tax regime.

49. The construction sector, which is particularly prone to evasion, should be taxed more, and large-scale agriculture should be brought into the regular VAT and profit tax regime. The contribution of the fast-growing construction sector should be increased, possibly through the introduction of a presumptive tax. Moreover, it is important to bring large-scale agriculture into the tax system by 2009. Most small farmers are below the income tax and VAT thresholds and will thus remain unaffected.

50. These steps would not only raise revenues, but also make the tax system more equitable. Currently, the overwhelming share of taxes on goods and services adds a regressive element to the tax system, as lower income groups consume a larger part of their income. Moreover, the property and land taxes could introduce more progression into the tax system if true market values were applied to calculate their base.

51. In tax administration, the focus should be on tax audits and tax arrears collection. Specifically, the move towards risk-based selection mechanisms and crosschecking based on modern information systems will be central to the next step in upgrading tax administration. In addition, the audit powers of the tax agency and the capacity of the large taxpayers unit will need to be strengthened further, as well as the enforcement powers of the tax agency in tax arrears collection. Upgrading the IT capacity, for example, by establishing a network linking headquarters and the branches, is crucial for improving audits and crosschecks.

19

Prepared by David Hauner (FAD).

20

Armenia and most of the other transition economies in the sample have a standard VAT rate of 20 percent (and some have a lower rate), but Armenia’s VAT productivity (that is [VAT revenue/consumption] / rate) is lower than in most peer countries. However, Armenia’s income and profit tax rates are relatively low.

21

Some of these differences may be due to the various national institutional arrangements.

22

The expected nominal increase in revenues is the growth rate of the tax base times revenue in the preceding period. If, such as in 2003, the actual increase in revenues is smaller than this expected increase, the elasticity of revenues to base is below unity, and the ratio of revenues to tax base falls. In the absence of changes in tax policy, such a shortfall is due to tax administration not keeping up with the tax base growth.

23

Excluding agriculture and construction.

24

There was no reduction to revenues from tax policy during this period, so all the residual is accounted for by tax administration. A negative contribution implies that revenue should have grown faster than it actually did.

Republic of Armenia: Selected Issues
Author: International Monetary Fund
  • View in gallery

    Revenue by Tax in Selected Transition Countries, 2005

    (In percent of GDP)

  • View in gallery

    Revenue by Tax, 1996–2006

    (In percent of GDP)

  • View in gallery

    Change in Ratio of Individual Taxes to GDP, 2000–06

  • View in gallery

    Estimated Contributions to Change in Total Tax Revenue, 2003–06

    (In millions of drams)