Republic of Kosovo: Selected Issues
Author: International Monetary Fund. European Dept.
Publication Date:
23 Jul 2013
eISBN:
9781484307854
Language:
English
Keywords:
ISCR; CR; Kosovo; tax; trade; revenue productivity; revenue collection; tax revenue structure; trade openness; VAT system; Consumption taxes; Europe; VAT rate
Download PDF (493 KB)

This Selected Issues paper on the Republic of Kosovo’s 2013 Article IV Consultation highlights growth and Kosovo’s external environment. In the wake of the global financial crisis, Kosovo’s economic growth slowed but remained positive, while most other Western Balkans slipped into recession. Moreover, the annual average growth rate has been among the highest in the Western Balkans since the onset of the financial crisis in 2007. Kosovo’s tax-to-GDP ratio is comparable to the average of Southeastern Europe, although its tax system relies significantly more on indirect taxation—including a high share of trade taxes. Kosovo’s reliance on trade taxes may create budgetary pressures in the event of further trade liberalization.

Abstract

This Selected Issues paper on the Republic of Kosovo’s 2013 Article IV Consultation highlights growth and Kosovo’s external environment. In the wake of the global financial crisis, Kosovo’s economic growth slowed but remained positive, while most other Western Balkans slipped into recession. Moreover, the annual average growth rate has been among the highest in the Western Balkans since the onset of the financial crisis in 2007. Kosovo’s tax-to-GDP ratio is comparable to the average of Southeastern Europe, although its tax system relies significantly more on indirect taxation—including a high share of trade taxes. Kosovo’s reliance on trade taxes may create budgetary pressures in the event of further trade liberalization.

Tax Revenue Structure and Trade Liberalization1

While highly skewed towards indirect taxation, Kosovo’s tax system is revenue effective. The import-heavy, transfer-dependent nature of the economy, and a well designed VAT system support tax collection, but its revenue structure is still heavily dependent on trade tax revenues. While econometric analysis does not provide robust evidence of replacement of trade taxes with domestic revenue in the region, further trade liberalization in Kosovo may be hindered unless alternative sources of revenue are developed in the mid-to long-term. A summary of alternative options is provided.

A. Introduction

1. Kosovo’s tax-to-GDP ratio is comparable to the average of Southeastern Europe, although its tax system relies significantly more on indirect taxation—including a high share of trade taxes. Average tax revenue2 for the period 2006–11 was about 22 percent of GDP (Table 1). The structure of Kosovo’s tax system is heavily tilted towards indirect taxes—as in Bosnia and Herzegovina, Croatia, Montenegro, and Serbia—with more than 80 percent of tax revenue coming from this source. In particular, import duties account for about 2.5 percent of GDP and 11.5 percent of tax revenue. By contrast, the contribution of direct taxes (including income tax and property taxes), is about half the regional average.

uA02fig01

Tax Structure

(in percent of total tax revenue)

Citation: IMF Staff Country Reports 2013, 223; 10.5089/9781484307854.002.A002

Sources: Government Financial Statistics (GFS); and Kosovo authority.1/ Countries as included in first table.

2. Kosovo’s reliance on trade taxes may create budgetary pressures in the event of further trade liberalization. Kosovo has introduced a liberal trade regime as part of the regional trade liberalization process. It has signed free trade agreements (FTA) with Albania, Macedonia, Bosnia and Herzegovina, and Croatia. More recently, the Central European Free Trade Agreement (CEFTA) was extended to the West Balkan countries, and Kosovo acquired full CEFTA membership. At present, Kosovo is negotiating a FTA with Turkey. While trade liberalization may be beneficiary in many respects, the literature suggests that any further step in this direction would reduce trade tax revenues, possibly more in the advanced stages of trade liberalization.3

3. This paper assesses the main elements of Kosovo’s tax system in a regional perspective, analyses the challenges to tax collection in the context of further trade liberalization, and provides some tax policy recommendations for strengthening revenue mobilization. The paper is organized as follows. Section B summarizes the rationale behind the current tax structure in Kosovo. Section C presents an econometric analysis on possible replacement between domestic and trade taxes in a panel of southeastern European economies. Section D provides policy recommendations and concluding remarks.

B. The Rationale Behind Kosovo’s Current Tax Structure

4. Kosovo’s reliance on indirect taxes is compatible with the import-heavy, transfer-dependent nature of the economy. Government revenue is heavily tilted toward indirect taxes, with more than 80 percent of receipts stemming from VAT, excises, and customs duties. This revenue structure is well aligned with the nature of Kosovo’s economy, with a share of imports-to-GDP of about 60 percent, a trade deficit of roughly 40 percent of GDP, and recorded remitances of about 14 percent of GDP, the largest in the western Balkans.

5. A large portion of indirect taxes is collected at the border, which has proven fairly revenue effective. Revenue collection at customs contributes to 80 percent of total tax revenue—specifically all excises and ¾ of VAT. This renders revenue collection fairly productive and lessens the risk of evasion. VAT collection is expected to be stronger, all else equal, in economies with a heavier reliance on international trade.4 VAT productivity in Kosovo–measured by its c-efficiency—is above average for both the region and a sample of small open economies.5

uA02fig02

Revenue Structure and Structure of the Economy

(annual average, 2006-11)

Citation: IMF Staff Country Reports 2013, 223; 10.5089/9781484307854.002.A002

Tax structure, selected European countries, 2006-2011

(In percent of GDP)1/

article image
Sources: Government Financial Statistics (IMF), and country documents.

General Government

2006-2008

Excluding Kosovo

6. While the structure of the economy matters, a well designed VAT system has reinforced its revenue performance. Kosovo’s VAT system is consistent with EU standards; it is single-rated—with the lowest rate in the region—, and has a very limited number of exemptions. The threshold for compulsory registration of EUR 50,000—the highest in the region—excludes importers and exporters that are required to register for VAT, and thus appears to be justified in order to avoid high collection costs for small taxpayers.

7. Direct taxation in Kosovo, by contrast, is low compared to other southeastern European countries. Revenue from taxes on income is about 3.5 percent of GDP, while property tax—collected at municipal level—is less than ½ percent of GDP. Altogether direct taxes make up about half the revenue collected in the region from this source. The low revenue performance on income taxes is due to a combination of low tax rates—CIT current rate is 10 percent—, lack of sufficient progressivity in the structure of the personal income tax, and narrow tax bases, to some extent due to a large informal sector. Regarding property taxation, while important steps are being taken in improving property registration, its revenue productivity is low, due to both low rates and insufficient compliance efforts.

VAT Rates, Revenue, and Productivity in Selected southeast Europe, 2006–2011

article image
Sources: IMF, Country documents; Government Finance Statistics (IMF)

General governemnt.

Revenue productivity = Total VAT revenue as percentage of consumption or GDP, divided by the VAT standard rate.

In Turkey 26 percent and 40 percent rates apply to luxury goods.

Excluding Kosovo.

C. Revenue Replacement with Trade Liberalization: Empirical Analysis

8. Kosovo’s share of trade taxes is the largest in the region, which would create budgetary pressures in the event of further trade liberalization. Import duties account for about 2.5 percent of GDP and 11.5 percent of tax revenue. While econometric evidence is mixed—depending on the level of economic development and the stage of trade liberalization—it suggests that countries may face difficulties to make up for revenue losses from trade taxes, in particular in the short-term.

9. The empirical analysis assesses the potential for revenue replacement from any loss of revenue from trade taxes that countries have experienced. Using data for the selected 17 countries in the region over the period 1992-2010, this paper estimates the impact on domestic tax revenue for a given change in trade-related tax revenue, as in Baunsgaard and Keen (2010). The estimating equation takes the form:

Di⁢t=αi+β0⁢⁢Di⁢t−1+β1⁢Ti⁢t+β2⁢Xi⁢t+μt+εi⁢t

where D is domestic tax revenue, T is trade tax revenue, expressed in percent of GDP, and X is a vector of control variables. Estimators used are fixed-effects, difference- and system-GMM. All regressions include country- and year-dummies. A negative coefficient for the trade tax variable would imply positive contemporaneous replacement.

10. Econometric results for the region find no robust evidence that trade taxes would have been replaced with domestically raised taxes.

  • Turning first to the control variables, the pattern of coefficients is broadly as expected: the overall development of the economy—measured by GDP per capita—is expected to show a positive correlation with revenue because of a higher degree of economic and institutional sophistication. A higher share of agriculture in value-added is expected to be negatively associated with revenue because agriculture is harder to tax, particularly if carried out informally. The degree of trade openness—measured as the sum of the share of imports and exports in GDP—can present either sign, but in transition economies a negative association with revenue is likely due to the negative impact of competitiveness on prices and margins. Finally, inflation, important in the first years of transition, has potentially powerful positive revenue effects.6

  • With respect to the relationship between domestic and trade tax revenue, contemporaneous replacement emerges as non-significant, independent of the chosen model specification.7 While the time frame under analysis is probably too short to capture long run replacement potential, the results clearly point to challenges in the substitution of trade taxes in the region in the short run.

Econometric Results a/

article image
Notes:

Dependent variable is ratio of domestic tax revenue to GDP. Full set of year dummies in all regressions. Robust standard errors, in parenthesis; ***(**,*) indicate significance at 1(5,10) percent.

One step, instruments based on second lags of Domestic and Trade Tax.

One step, instruments based on first lag of differences in Domestic and Trade Tax in levels equation and second lags of their levels in the differences equation.

D. Policy Options and Concluding Remarks

11. While currently effective in term of revenue collection, Kosovo’s tax structure may present future challenges due to increased trade liberalization. Kosovo’s revenue structure is heavily tilted towards indirect taxes, and in particular still relies significantly on import duties. The empirical evidence suggests that replacement of lost trade tax revenue may be difficult.

12. In the short-term options include strengthening further VAT and excise taxes. Losses in revenue from customs duties—that upcoming free trade agreements would likely phase in—could be replaced with VAT and excises, both taxes with still relatively low rates in Kosovo. While broadening the tax base is desirable, a reduction in the VAT registration threshold should only be considered once the tax administration has built the needed capacity to avoid creating an unnecessary burden without clear gains in revenue terms.

13. A gradual shift to direct taxation appears appropriate in the medium-to long-term, as domestic production increases. A higher share of direct taxes is both, desirable—given the need to replace the potential loss from trade taxes—and potentially aligned with the gradual shift in the structure of the economy to higher domestic production. The structure of tax rates could be reviewed—with both corporate and personal income tax rates low by regional standards—along with the progressivity in the structure of the personal income tax. Broadening of the tax bases, by avoiding unnecessary tax exemptions is necessary (see IMF, 2011) Further improvement of the recurrent property tax system is a must, in particular in the context of increased fiscal decentralization that may result hindered if local governments are not effective at strengthening administration and compliance capacity.

References

  • Ebrill, L., M. Keen, J. Bodin, and V. Summers (2001): The Modern VAT, IMF, 2001.

  • Keen, M. and T. Baunsgaard (2010): Tax revenue and (or?) Trade Liberalization, Journal of Public Economics, 94, pp. 563-77

  • IMF (2011): Kosovo: Reform Proposals Towards a More Balanced and Revenue-Productive Tax System, FAD Technical Assistance Report

1

Prepared by Ernesto Crivelli.

2

Excluding revenue from social security contributions.

5

Including a sample of 31 countries with population below 5 million and a VAT system.

6

In addition, real GDP growth was included to isolate changes in fiscal policy which are not related to the current state of the economy that is, on the component of fiscal policy that does not respond systematically to output conditions.

7

Alternative specifications to allow interaction with dummy variables capturing the adoption of a VAT system, or the run-up to join the EU have turn equally statistically insignificant.

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Cover IMF Staff Country Reports
Republic of Kosovo: Selected Issues Paper
Author: International Monetary Fund. European Dept.
Volume/Issue:
Volume 2013: Issue 223
Publisher:
International Monetary Fund
ISBN:
9781484307854
ISSN:
1934-7685
Pages:
28
DOI:
https://doi.org/10.5089/9781484307854.002

Tax Structure

(in percent of total tax revenue)

Revenue Structure and Structure of the Economy

(annual average, 2006-11)