Kyrgyz Republic
Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.
Publication Date:
25 Jun 2013
eISBN:
9781484322796
Language:
English
Keywords:
ISCR; CR; Kyrgyzstan; Kyrgyz government; SDB law; business environment; rate; Kyrgyz authorities; tax regime; tax procedure; refund mechanism; tax authority; VAT exemptions; VAT productivity
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The government of the Kyrgyz Republic is determined to consolidate its finances over the coming years. This note describes the main elements of the tax regime in the Kyrgyz Republic, looks into tax incentives, and provides some reform options to raise revenues. The second note is on monetary policy in the Kyrgyz Republic, which faces challenges with respect to formulation and efficacy given the low monetization, the shallow financial system, high dollarization, and a predominantly cash-based economy.

Abstract

The government of the Kyrgyz Republic is determined to consolidate its finances over the coming years. This note describes the main elements of the tax regime in the Kyrgyz Republic, looks into tax incentives, and provides some reform options to raise revenues. The second note is on monetary policy in the Kyrgyz Republic, which faces challenges with respect to formulation and efficacy given the low monetization, the shallow financial system, high dollarization, and a predominantly cash-based economy.

Tax Policy in the Kyrgyz Republic1

A. Background

1. The government of the Kyrgyz Republic is determined to consolidate its finances over the coming years. Therefore, continued strong revenue performance is important. In the short term, introduced tax policy measures and continued tax administration reforms are expected to ensure sufficient revenue. In the medium term, additional tax policy measures, including eliminating some tax incentives, will have to be put in place to ensure sustained revenue growth needed to finance development.

2. This note describes the main elements of the tax regime in the Kyrgyz Republic, looks into tax incentives, and provides some reform options to raise revenues. A detailed assessment of the tax policy system was conducted under the IMF’s technical assistance in 2009. In 2011, IMF staff held discussions with the authorities on tax policy measures that could increase revenues. The note draws on these assessments and provides an update on changes since 2009. It also discusses existing tax incentives. Lastly, the note examines tax measures that could raise revenues in the medium term.

B. Main Characteristics of the Tax Regime and Tax Performance

3. In 2009, a new tax code was put in place to ease the tax burden on business and simplify tax procedures. The main changes of the new 2009 tax code included:

  • Reducing the number of taxes from 16 to 8.

  • Decreasing the value added tax (VAT) rate from 20 to 12 percent.

  • Establishing the turnover (sales) tax that replaced the retail sales tax, road tax, and emergency funds.

  • Introducing a new property tax.

  • Establishing five special tax regimes (mandatory payments, voluntary payment, a simplified single tax, contract-based tax, and free economic zones).

4. Since 2009, no substantial changes have been introduced in the tax code except for some tax incentives and amendments to profit and excise taxes. The introduced tax incentives include: VAT exemptions in agriculture, a new high technologies park tax regime, and some additions to personal income tax (PIT) exemptions. VAT exemptions on internet and roaming services were removed. The authorities also raised the excise tax rate for tobacco and alcohol products, introduced new gross income tax for gold-mining companies in lieu of profit tax or corporate income tax (CIT), and eliminated the tax on special funds.

5. Revenue collection has been encouraging with VAT being the main source of revenue (Figure 1). Total tax revenue increased to 24 percent of GDP in 2011 from 21 percent of GDP in 2006. After a decline in 2009 (when the rate was reduced), VAT revenue was gradually increasing relative to GDP but still remained below the pre-2009 levels. Collections of income tax increased markedly mainly on account of strong growth in CIT. Social contributions were rising steadily reaching about 5 percent of GDP in 2011.

Figure 1.
Figure 1.

Revenue from Each Tax

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 176; 10.5089/9781484322796.002.A001

Source: Kyrgyz authorities.

6. At 24 percent of GDP, tax revenue in the Kyrgyz Republic is not insignificant. Figures below show the relationship between per capita income and the tax-to-GDP ratio. Figure 2 depicts all countries, whereas Figure 3 includes countries with incomes ranging from US$600 to US$2,200. The Kyrgyz Republic is above the average compared with other low income countries.

Figure 2.
Figure 2.

Tax-to-GDP and GDP per capita

(All countries, in percent)

Citation: IMF Staff Country Reports 2013, 176; 10.5089/9781484322796.002.A001

Source: IMF.
Figure 3.
Figure 3.

Tax-to-GDP and GDP per capita

(Low-income countries, in percent)

Citation: IMF Staff Country Reports 2013, 176; 10.5089/9781484322796.002.A001

Source: IMF.

7. The Kyrgyz Republic compares favorably in terms of tax collections, including among countries in the region (Text Table 1). The CIT rate was reduced from 30 percent to 20 percent in 2004 and further down to 10 percent in 2006 to increase competitiveness within the region. With the CIT rate remaining unchanged over the past years, its collection increased to a relatively comfortable level, though some space for further increases exist. Some of the other countries in the region have also seen declines in their CIT rates but the declines were not as substantial as in the Kyrgyz Republic. VAT revenue in the Kyrgyz Republic declined compared to 2008, in response to reduced rates, which were brought in line with VAT rates in Kazakhstan. Armenia, Azerbaijan, and Georgia, did not reduce their VAT rates, which were maintained at 18–20 percent over the past years. An increase in VAT productivity was most significant in the Kyrgyz Republic. VAT productivity in other countries has also increased except in Kazakhstan.

Text Table 1.

Kyrgyz Republic: Tax Systems in the Region

(In percent)

article image

Excludes oil revenue.

Sources: Kyrgyz authorities and IMF staff estimates.

8. Strong growth in VAT is not only attributed to the buoyant increase in imports, but also improved tax collection. The Kyrgyz Republic is one of the largest recipients of remittances (relative to GDP) in the world. In addition, the country benefits from trading activity that takes place in the trading “corridor” from China to Kazakhstan and Russia. Imports in the Kyrgyz Republic increased from 79 percent of GDP in 2006 to 87 percent of GDP in 2011. VAT revenue, as mentioned above, declined, mostly because of reduced rates (Figure 4). The decline was limited by improved VAT productivity and VAT efficiency, which grew substantially over the last years (Figure 5), helped by better tax compliance and more effective tax collection.2 However, the VAT refund mechanism has largely remained weak.

Figure 4.
Figure 4.

VAT Revenue and Imports

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 176; 10.5089/9781484322796.002.A001

Sources: Kyrgyz authorities and IMF staff estimates.
Figure 5.
Figure 5.

VAT Productivity and Efficiency

Citation: IMF Staff Country Reports 2013, 176; 10.5089/9781484322796.002.A001

Sources: Kyrgyz authorities and IMF staff estimates.

9. The turnover (sales) tax was introduced to compensate for the reduction in the VAT rate. The tax rate is 1.5 percent for commercial activities and 2.5 percent for other activities for taxpayers under the VAT system, or about 90 percent of all registered taxpayers (2.5 percent and 3.5 percent, respectively, for taxpayers who are not in the VAT system). This tax simplified the tax system to some extent, because it replaced the previous retail sales tax, road tax, and emergency funds. However, and even at the low rates, the turnover tax negatively affects the competitiveness of businesses in the Kyrgyz Republic. Because of the cascading nature, the effects of a low rate are multiplied when goods pass from one business to another, thus causing distortions to economic activity. With this tax, businesses are less competitive in both domestic and international markets. In addition, the turnover tax cannot be refunded because identifying the incidence of the tax in the product cost is not feasible.

10. Excises as a share of total tax revenue declined from 5 percent of GDP in 2006 to 3.3 percent in 2011 because of low rates and effects of inflation. Excises in the Kyrgyz Republic are imposed on certain domestically produced and imported goods, such as oil products, tobacco products, and alcoholic beverages. In 2011, excises accounted for 3.3 percent of tax revenue, a decline by about 2 percentage points since 2006. A major part of excises is handled by customs administration that collects the revenue at the borders. Therefore, the low revenue can be attributed to low rates. In addition, with most excises being specific (based on quantity) rather than ad valorem (based on value), revenue from this tax has been devalued by inflation. At the same time, given that specific excises are more predictable and easier to administer, they may be preferable to ad valorem excises. A combined, specific/ad valorem system for tobacco and alcohol products with higher rates was introduced recently to increase revenues from excises. The excise rate for oil products, in particular gasoline, is low at KGS 3000 (about US$60) per ton (e.g. in Belarus, the rate is five times higher than in the Kyrgyz Republic; in Slovakia, the rate is eight times higher; in the eurozone countries, the average rate is more than 10 times higher).

11. Customs duties and other taxes on international trade account for 11 percent of tax revenue but may decline in the future. Customs duties are levied on a few kinds of imports, namely vehicles and goods imported through the simplified customs clearance process (weight-based customs duties).3 The latter ensures low levels of customs duties, which together with specific geographical location, being a WTO member, and free trade agreements with Russia and Kazakhstan, provides an advantage for the Kyrgyz Republic in trade of goods from China. However, the weight-based valuation system results in a systematic underassessment of imports and therefore contributes to revenue loss. Recently, the authorities raised duties from 15 cents per kilogram to 35 cents and moved some goods to the price-based valuation system. This is expected to increase revenue but also to smooth potential future shocks, which could stem from the Kyrgyz Republic’s accession to the Belarus-Kazakhstan-Russia Custom Union (CU), or in case free trade agreements between the Kyrgyz Republic and Kazakhstan and Russia are annulled. In both cases, transit activity from China would be reduced.

12. The revenue from PIT and CIT increased considerably over the last years (Figure 6). In 2011, these taxes accounted for 26 percent of total tax revenue, an increase from 14 percent in 2006. With the 2009 agreement between the government and the Kumtor mining company, CIT was the main contributor to this increase.4 Recently, the authorities introduced a new revenue tax (linked to gold price movements) for gold-mining companies in lieu of CIT (Figure 7). Both CIT and PIT have rates at 10 percent, which is low by regional standards (the PIT rate is one of the lowest in the world). Employers and employees also pay social contributions at the rate of 17.25 and 10 percent, respectively. As many taxpayers participate in the low-yielding voluntary patent regime, they are outside of the regular profit tax system.

Figure 6.
Figure 6.

PIT and CIT Revenue

(In millions of KGS)

Citation: IMF Staff Country Reports 2013, 176; 10.5089/9781484322796.002.A001

Sources: Kyrgyz authorities.
Figure 7.
Figure 7.

New Gross Revenue Tax Rate for Gold-Mining Companies

(In percent for gold price per 1 troy ounce)

Citation: IMF Staff Country Reports 2013, 176; 10.5089/9781484322796.002.A001

Source: Kyrgyz authorities.

13. The Tax Code contains six special regimes for certain activities, which replace VAT, CIT, and sales tax with a lump sum tax, exist in for certain activities.

  • The mandatory patent regime covers seven specific activities and replaces CIT, VAT, and turnover tax. Voluntary patents are available to individual taxpayers below the VAT threshold (KGS 4 million) and replace CIT and the turnover tax. With 125 eligible activities, this regime remains complex. Revenues from mandatory and voluntary patents are low at about 1 percent of total tax revenue. The current patent regimes unevenly distribute the tax burden among taxpayers below the VAT threshold and discourage taxpayers in the voluntary patent system from migrating to the regular system.

  • The simplified single tax regime replaces CIT and turnover tax and is for taxpayers who are not registered for VAT. This regime yields negligible revenue (0.1 percent of total tax revenue).

  • Under the contract-based tax, taxpayers enter into a contract for the payment of a fixed tax, which is calculated as the highest tax liability (CIT, VAT, and sales tax) in the preceding three years and increased by 25 percent. This regime can be very discretionary and open to abuse.

  • Free Economic Zones (FEZs) are four areas free of taxes. Goods and services supplied from FEZs within the country are taxed in line with the general tax regime, while goods and services supplied to FEZs from other parts of the country are subject to VAT. No studies have been conducted to estimate tax expenditure (foregone tax revenue) as a result of setting up the FEZs.

  • Under the high technologies park regime, residents develop information technology products and are free of CIT, VAT, and sales tax. PIT is paid at the rate of 5 percent.

C. Tax Incentives

Existing incentives

14. Numerous VAT exemptions are the main weakness of the VAT system in the Kyrgyz Republic. The following exempt activities are the most important to focus on: the agricultural sector, residential buildings, public utility services, medical activity, financial and insurance services, transportation services, infant food, natural gas, and imported fixed assets (capital goods). Recently, the authorities removed VAT exemptions on internet and roaming services.

15. Most VAT exemptions aim to achieve social policy objectives but instead create complexity and erode the VAT base:

  • The main objective of VAT exemptions in the agricultural sector is to maintain lower prices for agricultural produce. However, with small farms below the VAT threshold constituting a major part of the agricultural sector, VAT exemptions may not result in lower prices. At the same time, larger firms, which are in the VAT system, do not provide needed revenue for the state budget.

  • Exempt fixed assets (exceeding KGS 200,000) that businesses import for their own use present risks of revenue loss. These risks could materialize if fixed assets are imported for other use (selling the assets in the domestic market).

  • VAT exemptions for residential buildings and public utilities and transportation services erode the tax base and are not well targeted to poor households.

16. Other exemptions and the patent regime continue to weaken CIT collections. CIT exemptions in the agricultural sector are the most substantial (given that the sector accounts for about 20 percent of GDP). In addition, firms that process agricultural produce are also exempted from CIT (except for goods subject to the excise tax). Other exemptions relate to FEZs, charitable organizations, interest income, and dividend income received from domestic activities. The low-yielding voluntary patent regime results in a large number of taxpayers to be outside of the CIT system.

17. The authorities contemplate lowering the CIT rate for newly opened businesses in remote regions. If implemented, the reductions would be temporary, for five years (2 percent until 2015, 4 percent until 2017, and 5 percent until 2019), and would be reflected in the Tax Code. The main rationale is to develop remote regions where income levels are low and labor migration is high. Given that lower CIT rates will apply to new businesses only, direct revenue loss is expected to be zero. However, some future revenue losses would still arise if businesses could have started even in the absence of lower tax rates. In addition, if incentives open new routes for evasion, their costs could increase significantly. For example, businesses could engage in “transfer pricing”, that is, minimize their tax obligations by reporting profits in the remote regions where the tax rates are lower. The Tax Code allows the tax authorities to revise taxpayers’ assessment of prices if the following transactions are not considered to be conducted at market prices: (i) between related parties, (ii) on barter transactions, and (iii) on external transactions.

International experience review and pros and cons of incentives

18. Empirical studies and international experience suggest that tax incentives do not appear to have sizable effects on investment in the long term. At the same time, fiscal costs from tax incentives can be substantial. The analysis of the effects of tax incentives in transition economies (OECD, 1995) showed that incentives were unlikely to spur FDI inflows. Another OECD study demonstrated the limitations of the effects of tax incentives on economic growth (OECD, 2010). In Brazil, tax incentives distorted the tax system, lowered revenue, and did not stimulate investment (Estache and Gaspar, 1995). Tax holidays in Malaysia could not promote investment in targeted activities (Boadway, Chua and Flatters, 1995). In Thailand, investment would have increased even in the absence of incentives because the rate of return was high enough (Halvorsen, 1995).

19. To decide whether incentives should be applied, the Kyrgyz government needs to have clear estimates of costs and benefits, which, however, are difficult to assess. Direct costs that are challenging to quantify include rent-seeking behavior and distortions to the economy. In addition, administrative costs from running regimes with tax incentives can take substantial resources. Indirect effects of incentives include crowding out other investment that could have generated more tax revenue. Revenue growth would only take place if tax incentives result in total investment growth, which would spur taxes on additional inputs and employment. The Kyrgyz authorities work toward boosting specific sectors or some areas of the country, including through introducing tax incentives. It should be noted, however, that aggregate investment is not likely to increase in this case. Instead, targeted sectors or areas may experience investment inflows relocated from other parts of the economy.

20. If the introduction of tax incentives is unavoidable, the Kyrgyz government needs to apply the principles of good tax policy. Transparency and predictability are essential for investors who make long-term investment decisions. Reflecting incentives in the tax law of the country is a better choice than introducing incentives as separate decrees or contracts with private firms because scope for corruption will be significantly lower. As mentioned above, incentives should be designed in a way that ensures robustness to tax evasion.

21. Tax incentives can be granted in various forms with different cost-effective structures (Text Table 2).

  • Tax holidays relieve tax authorities of the administrative burden but are mostly attractive to short-term investment with unclear amounts of foregone revenue. In addition, tax holidays provide strong incentive for tax avoidance (through transfer pricing). Usually, a new administration chooses these temporary types of incentives to signal its readiness to improve the business environment. With the business environment improved, investment would stay even when tax incentives expire. In practice, however, reforms to make the business environment more friendly stall often but tax holidays or reduced tax rates last for many years being continuously renewed.

  • Reduced CIT rates have mostly the same characteristics as tax holidays but on a smaller scale. The difference between tax holidays and reduced CIT rates can also be seen when analyzing the revenue cost, which is lower under the latter.

  • Investment allowances and tax credits can be implemented in a transparent way and can be better targeted than tax holidays for promoting certain types of investment. However, these incentives can distort the choice of capital in favor of short-lived assets because a further allowance becomes available each time an asset is replaced.

  • Accelerated depreciation is considered the least harmful among CIT associated incentives. Its disadvantages are largely similar to investment allowances and tax credits with the exception that this incentive does not distort in favor of short-lived assets.

  • VAT exemptions are prone to abuse as businesses can redirect exempt assets to other recipients outside of the exempt area. In addition, given that VAT on zero-rated inputs is creditable, VAT exemptions may be of little benefit. Moreover, usually those who spend more get proportionally more benefits if VAT exemptions are in place.

  • In case of export processing zones, revenue costs can be significant if profits are shifted to these zones.

Text Table 2.

Kyrgyz Republic: Assessment of Typical Tax Incentives

article image
Sources: Chalk (2001); Zee, Stotsky, and Ley (2002).

D. Tax Policy Reform Options

22. Although tax revenue in the Kyrgyz Republic is already high compared with countries with similar income levels, efforts are still needed in the medium term to further increase revenue. In the short to medium term, existing tax policy measures and ongoing tax administration reforms are expected to improve the efficiency of the tax system and generate the needed revenue. However, these efforts may be undermined by existing and new tax incentives. Further down the road, more significant tax policy measures, in addition to administrative improvements, are needed to support the government’s development agenda. The Kyrgyz government needs to safeguard economic and social stability, if higher growth is to be sustained. Moreover, tax policy measures could reduce distortions and administrative costs.

23. Eliminating some VAT exemptions should be a priority for the medium term to achieve the broadest possible VAT base. Given that VAT exemptions are not guaranteed to be reflected in the final price of the product, VAT exemptions should not be applied for the purposes of social benefits. A more effective resource reallocation policy would be to collect full VAT and use the revenue for targeted social assistance programs. Without being effective in reducing the tax burden on those in need, VAT exemptions weaken the VAT chain of enforcement. As an important step toward broadening the VAT base, the government has recently eliminated VAT exemptions on roaming and internet connectivity. The agricultural sector, public utility services, transport services, residential buildings, and fixed assets would also bring additional revenue if no VAT exemptions apply (or exemption thresholds are raised, e.g. in case of fixed assets). Improving the VAT refund system would also be needed. With a weak refund mechanism, VAT would be, in principle, a cascading tax. The authorities need to conduct, perhaps with technical assistance from the IMF, a broad review of VAT exemptions. This review would provide a detailed assessment of the cost of these exemptions, which would help the authorities take steps in removing the exemptions.

24. The pros and cons need to be assessed carefully before introducing tax incentives; where incentives are already in place, close monitoring or removal is needed. The preferred instruments, if pressure to introduce tax incentives does not subside, include accelerated depreciation or investment allowances and tax credits. Temporarily lower CIT rates for newly created businesses in remote regions does not necessarily stimulate additional investment in those regions, but if introduced, monitoring of their implementation will be important. In addition, the tax authorities will need to monitor transfer pricing in the domestic market to ensure that prices are not misstated in order to shift the source of profit to remote regions where lower CIT rates are in effect. This monitoring, however, requires specialized skills. In this regard, the tax authorities will need to strengthen their capacity to deal with transfer pricing issues. Moreover, enforcing tax compliance of existing businesses would help ensure that new routes for tax evasion are not opened and no revenue costs follow the introduction of this incentive. To broaden the tax base, CIT exemptions for agricultural producers could be eliminated. The cost of these CIT exemptions could also be assessed under the review of exemptions mentioned above.

25. Additional medium-term measures that could strengthen revenue mobilization and at the same time improve the efficiency and equity of the tax system include:

  • Overhauling the patent system. This would distribute the tax burden among taxpayers below the VAT threshold more evenly. A new patent system could consist of a simplified patent system with just few categories for micro-businesses (e.g. with turnover of less than US$10,000) and a presumptive tax regime based on turnover for businesses between US$10,000 and the VAT threshold. Presumptive tax regimes could also be based on gross profit and physical characteristics.

  • Phasing out the contract-based regime. This would minimize the risk of corruption that is often present in administering such kind of tax regimes. The contract-based regime can be a temporary solution to raising revenues but not a permanent one. Instead, a system that would consist of assessing the turnover of businesses and applying a margin ratio to appreciate their benefit should be introduced.

  • Switching completely from the weight-based to a price-based valuation system. This would allow to tax a major part of goods imported from China and re-exported to Kazakhstan. In addition, the price-based valuation system would result in a substantial increase in VAT revenue. To avoid undervaluation at customs, reference pricing methods could be applied.

  • Raising excise rates. Given that demand for these goods is relatively inelastic and the revenue base is wide, the rate increase would bring immediate growth in revenue. In addition to being a productive source of revenue, excises can also discourage excessive consumption of the relevant goods. Periodic adjustments for specific excises would be needed to ensure the proceeds are not eroded by inflation.

26. Phasing-out the turnover (sales) tax in the medium term would remove distortions. At the same time, the authorities will need to find an alternative source of revenue that would compensate for the revenue loss stemming from eliminating this tax. A VAT increase would be the most effective solution. A one percentage point increase in the VAT rate is estimated to bring additional KGS 1.5 billion in revenue. Therefore, to offset the loss from the removed turnover tax, the VAT rate would need to be raised by three percentage points. An increase in the VAT rate would not result in lower investment or trade because VAT does not fall on businesses. In addition, under the VAT regime, taxes on inputs are credited against taxes on output. Another important feature of VAT is that it matters little that a country has a higher VAT than its neighboring country because under the “destination principle” VAT paid on a good is determined by the rate levied in the country of the good’s final sale with revenue accruing to that country.

27. To increase transparency, the authorities need to introduce a tax expenditure statement and include it in the budget. No study has been conducted to thoroughly examine the current tax incentives and determine the revenue cost. Also, measuring the revenue cost of the FEZs and carrying out a cost-benefit analysis of the system would help taking a decision of whether to continue maintaining the FEZs. Assessing incentives’ costs and publishing them as a tax expenditure statement would strengthen monitoring and transparency. Moreover, this would effectively inform policy formulation.

References

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1

Prepared by Bahrom Shukurov. The note has benefited from comments from Selcuk Caner, Ricardo Fenochietto, and Agustin Roitman from the Fiscal Affairs Department of the IMF.

2

VAT productivity is the ratio of VAT revenue to GDP divided by the VAT rate. VAT efficiency, which is a better indicator of VAT performance, is the ratio of VAT revenues to consumption divided by the VAT rate.

3

Under the simplified customs clearance regime, which was introduced in December 2004, most goods are assessed according to their weight (not their value).

4

From 2009, following the agreement with Kyrgyz authorities, the Kumtor mining company has been paying 13 percent of its gross revenue. These proceeds are reflected as CIT in the government’s budget. The company also pays social contributions to the Issyk-Kul Fund (1 percent of gross income), and the pollution tax (US$310 thousand a year).

Other IMF Content

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Cover IMF Staff Country Reports
Kyrgyz Republic: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.
Volume/Issue:
Volume 2013: Issue 176
Publisher:
International Monetary Fund
ISBN:
9781484322796
ISSN:
1934-7685
Pages:
47
DOI:
https://doi.org/10.5089/9781484322796.002

Revenue from Each Tax

(In percent of GDP)

Tax-to-GDP and GDP per capita

(All countries, in percent)

Tax-to-GDP and GDP per capita

(Low-income countries, in percent)

VAT Revenue and Imports

(In percent of GDP)

VAT Productivity and Efficiency

PIT and CIT Revenue

(In millions of KGS)

New Gross Revenue Tax Rate for Gold-Mining Companies

(In percent for gold price per 1 troy ounce)