This Selected Issues paper describes the current tax system in Bhutan and suggests options for tax policy reform. Though significant hydropower revenues are expected in the medium term as major projects come on-stream, reforms to the existing tax system in the interim will generate fiscal room and prevent recourse to domestic debt to finance development needs. Key reforms include reducing tax exemptions in the near term and introduction of value-added tax in the medium term. The paper also analyzes the adequacy of international reserves in Bhutan using a customized risk-weighted metric. The results indicate that Bhutan’s reserve levels are ample.

Abstract

This Selected Issues paper describes the current tax system in Bhutan and suggests options for tax policy reform. Though significant hydropower revenues are expected in the medium term as major projects come on-stream, reforms to the existing tax system in the interim will generate fiscal room and prevent recourse to domestic debt to finance development needs. Key reforms include reducing tax exemptions in the near term and introduction of value-added tax in the medium term. The paper also analyzes the adequacy of international reserves in Bhutan using a customized risk-weighted metric. The results indicate that Bhutan’s reserve levels are ample.

Options for Tax Reforms in Bhutan1

This chapter describes the current tax system and suggests options for tax policy reform in Bhutan. Though significant hydropower revenues are expected in the medium term as major projects come on-stream, reforms to the existing tax system in the interim will generate fiscal room and prevent recourse to domestic debt to finance development needs. Key reforms include reducing tax exemptions in the near term and introduction of a Value-Added Tax (VAT) in the medium term.

A. Introduction

1. Bhutan has ambitious development goals and related expenditure plans in the medium term, in the context of the recently initiated Eleventh Five Year Plan (11th FYP). It therefore needs to address resource constraints it is expected to face, given that external grant assistance is projected to decline with the increase in per capita income. Over 2003–12, budgetary foreign grants averaged 13.5 percent of GDP, accounting for 40 percent of total budgetary resources on average. However, official assistance from India and other countries is projected to decline to just around 7 percent of GDP by 2017/18 as per capita incomes rise, expected to be offset partially by increasing tax and non-tax revenues related to the new hydro power projects, Meanwhile, capital expenditure is expected to remain sizeable for most of the planning horizon.

Table 1:

Bhutan Eleventh Five Year Plan Fiscal Projections

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Sources: Royal Monetary Authority and Ministry of Finance, Bhutan

2. In addition to this projected decline in foreign grants, there are risks related revenue in the 11th FYP from new hydropower projects. Domestic revenues have ranged between 16–30 percent of GDP over the past 10 years, exhibiting volatility particularly for non-tax revenues, as the share of profit transfers and dividends from hydropower entities fluctuated year-to-year. While several large hydro power projects are expected to come on-stream at the end of the medium term and their revenue impact is likely to be felt in the outer years of the 11th Plan, it is subject to risks of delayed project implementation. The medium term prospects are dependent on whether projected hydropower revenue streams come on-stream in the outer years.

A01ufig1

Domestic Revenue

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 179; 10.5089/9781498342254.002.A001

3. In this chapter we address the issues and options for tax policy that may help to achieve a more predictable fiscal path. We will first examine the role of hydro power revenues in Bhutan, including its projected contribution to tax revenue. Secondly, we will examine the case for reducing tax expenditures, including tax holidays as well as exemptions. Finally, we will consider options for deeper tax reform, such as the introduction of VAT.

B. Role of Hydropower

4. Bhutan is among the most intensive producers of hydropower in the world. In terms of share of total electricity generation, virtually all electricity is generated using hydropower. Hydroelectric production is also large relative to the size of the economy; the electricity sector has accounted for 20 percent of real GDP over the recent past. Hydro power potential is estimated at 30,000 MW, of which presently around 1,500 MW has been harnessed, bulk of which is exported to India. The stated policy goal is to achieve additional 10,000 MW of installed capacity by 2020, mostly with Indian assistance and collaboration.

A01ufig2

Hydropower Production in 2010 1/

(Annual kWh relative to GDP in U.S. dollar)

Citation: IMF Staff Country Reports 2014, 179; 10.5089/9781498342254.002.A001

Source: World Bank WDI database.1/ Top decile in terms of the indicator.
A01ufig3

Hydropower Production in 2010 1/

(In percent of total electricity generation)

Citation: IMF Staff Country Reports 2014, 179; 10.5089/9781498342254.002.A001

Source: World Bank WDI database.1/ Top decile in terms of the indicator.

5. Despite this predominance of the hydropower sector, its revenue generation capacity is constrained. The export price per unit is fixed at between INR 1.80–INR 2 per unit2, while domestic sale prices per unit are also fixed. Thus, power sector earnings are capped in nominal terms at installed capacity times the negotiated price. As a result, tax and non-tax revenues from hydro power are also capped (given installed capacity), resulting in a downward trend in share of total revenues as the economy grows.

A01ufig4

Composition of Domestic Revenue

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 179; 10.5089/9781498342254.002.A001

6. Revenue generation from hydropower stems from both tax and non-tax revenues. The share of hydro revenues in total domestic revenues has declined recently, though is expected to rise as the large power projects under construction begin to come on-stream from 2016–17 onward. On average, the direct share of hydropower revenues in total revenues has been just over 30 percent, ranging between 25–35 percent over 2003–13. Thus, a significant proportion of total revenues are concentrated in a single sector of the economy.3

C. The Current Structure of Taxes

7. From a cross country perspective, Bhutan ranks below the average in terms of tax revenues from among a wide set of low and low-middle income countries. Previous IMF studies4 showed that while total revenue in Bhutan compared favorably with the average in the Asia-Pacific region, the share of tax revenue was relatively low, compensated for by higher non-tax revenues which are mainly attributable to the hydropower sector. Although the share of tax revenue has recently exceeded that of non-tax revenue, there is evidence to suggest there is room for Bhutan to improve its tax revenue performance.

A01ufig5

Tax Revenue in Low and Low-Middle Income Countries

(% GDP, 2010)

Citation: IMF Staff Country Reports 2014, 179; 10.5089/9781498342254.002.A001

Source: World Bank WDI database.
A01ufig6

Domestic Revenue

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 179; 10.5089/9781498342254.002.A001

8. Domestic revenues are split between direct taxes, indirect taxes, and non-tax revenue. Direct taxes consist of business income tax (BIT), personal income tax (PIT) and corporate income tax (CIT). Among indirect taxes, bulk of the revenue is generated by sales and excise taxes levied both at point of entry (POE) on imports and at points of sales (POS). As well, the excise duty refund received from India on Indian exports to Bhutan is an important source of indirect tax revenue.5 Among non-tax sources, dividends from the major hydropower entities, Drug Green Power Corporation, and Druk Holdings and Investments are a key item (Table 2a).

Table 2a.

Structure of Taxes

(% shares in domestic revenue, 2012/13)

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Source: Budget Report 2013/14, Ministry of Finance, Government of Bhutan.

9. The structure of tax rates for direct and indirect taxes is shown in the table below. There is a multiplicity of tax rates for indirect taxes, although previous studies show that bulk of the sales tax revenue at POE is collected in 5–15 percent slabs. About one-quarter of imports enter at a zero sales tax rate, and an equivalent amount is exempt from sales taxes at the POE. Secondly, most goods and services are exempt from POS sales taxes, barring 6 items (Table 2b).

Table 2b.

Structure of Tax Rates

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Source: Aide Memoire of 2009 Indirect Tax Reform mission, IMF.

10. In terms of sectoral contribution to revenues, the top contributions arise from the trade related sector, including excise duty refund from India6, sales tax collections from goods and alcohol products, customs duties, and corporate and business income taxes from entities involved in wholesale and retail trade, followed by electricity and manufacturing. Services (including hotels and restaurant) are also an important contributor, and relatively smaller contributions are from finance and the primary sector. Together these 6 sectors accounted for almost three-fourths of total revenues in 2012–13. Relative to its high imports, Bhutan receives a low share of tax revenue from customs. Since nearly three-quarters of total imports are from India, with which Bhutan shares a free trade agreement, and treats imports from the SAARC region preferentially, this is not surprising.

A01ufig7

Sector Revenue Contribution - 2012/13

(Percent of total)

Citation: IMF Staff Country Reports 2014, 179; 10.5089/9781498342254.002.A001

Source: National Revenue Report, 2012/13, Ministry of Finance, Government of Bhutan.
A01ufig8

Customs Revenue and Imports

(In percent of GDP)

Citation: IMF Staff Country Reports 2014, 179; 10.5089/9781498342254.002.A001

Source: World Bank WDI database.

11. Previous IMF TA missions have identified issues arising from the existing tax structure, particularly for indirect taxes. A summary of the key issues with the existing tax system is provided in the box below.

Issues with Existing Indirect Tax System

The problems that can potentially arise from the existing system of indirect taxes are as follows:

  • Cascading: Though there is an extensive system of exemptions in place to prevent cascading of POE taxes, but the exemptions are only partial. However, this is not considered to present a major issue as the effective import taxes paid by users of imported intermediate inputs such as hotels and restaurants appear to be quite low.

  • Protection: This can arise when goods taxed at POE also have domestic producers who are tax-exempt. For example, certain types of steel produced in Bhutan are exempt from tax but Indian imports are taxed at 10 percent, which is contrary to the free trade agreement with India.

  • Multiple tax rates: These can complicate tax administration by creating an incentive to misclassify goods. However, since in Bhutan’s case POE sales tax collections arise from the lower (5, 10 and 15 percent) rates, this risk is somewhat mitigated.

  • Narrow tax base: About one quarter of the value of imports are exempt from tax. Domestic value added is largely not taxed. Effective tax rates are estimated to be generally lower than the statutory rate in each slab.

  • Exemptions: The existing set of exemptions in place to remove POE taxes on inputs is incomplete. Traders do not receive exemptions, the definition of plant and machinery is restrictive, and not all raw material imports used by manufacturing units are exempted. In combination with non-taxation of domestically produced inputs, this can distort production decisions by altering relative prices, which should be avoided to preserve the productive efficiency of the economy.

D. Indirect Tax Reform

Reducing exemptions and tax holidays

12. Numerous exemptions and tax holidays are costly for Bhutan in terms of forgone revenue. According to the 2011/12 revenue report, the total fiscal cost of tax holidays and tax exemptions amounted to more than Nu. 3 billion, equivalent to more than one-fifth of total tax revenue in 2011/12 or 3 percent of GDP (Table 3). Among possible tax policy reforms available to policymakers, reducing the number of exemptions and targeting/rationalizing the list of tax holidays would be a good starting point.

Table 3.

Forgone Taxes

(In millions of Nu.)

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Source: National Revenue Report 2011–2012, Department of Revenue and Customs, Ministry of Finance, Royal Government of Bhutan.

The introduction of a VAT

13. In addition to reducing exemptions and other improvements to the existing system of indirect taxation (e.g. narrowing the range of POE sales tax rates and expanding the POS tax base), Bhutan should aim for a deeper overhaul of the existing tax system by introducing the VAT. Previous Fund TA has recommended the introduction of the VAT set at a low rate in of around 10 percent, with a high threshold7 (proposed at 2.5 million ngultrum), and limited exemptions (mainly limited to health and education sector), along with a few chosen excise taxes such as those imposed on alcohol.

14. Using national income accounts and budget data for 2010, staff estimates suggest that assuming a C-efficiency ratio8 in the region of 50–60 percent, a VAT rate of around 10–12 percent would be able to raise the entire indirect tax revenue collection in the same year. Moreover, it is likely that the such a rate would have a relatively small impact on prices (as most customs and sales tax collections occur in the 5–15 percent bracket), and such a rate would be competitive in the region given that most countries in the Asia Pacific region apply VAT rates ranging between 5–17 percent, at an average of just over 11 percent.9

15. The choice of a threshold reflects the important trade-off between revenues and administrative costs. Too high a threshold would compromise revenue collections though having lower administrative costs, whereas too low a threshold may make the VAT system too cumbersome to enforce and implement. Moreover, threshold setting can have important effects on firms’ incentives to reveal their true size or break up firm activity into multiple firms of smaller size in an effort to minimize taxes.

16. Based on available data on CIT and BIT paying firms, a threshold of 2.5 million ngultrum would bring all CIT filers within the purview of VAT. While the smallest 60 percent of BIT filers (57.5 percent of all CIT and BIT filers) would be below the threshold, these account for only around 2.5 percent of total revenue generated by all CIT and BIT filers. Thus, significant scope may exist for savings on administrative costs without sacrificing too much revenue.

17. The introduction of a modern VAT system could confer several benefits for Bhutan, including:

  • Reducing cascades by crediting taxes on inputs; thereby also reducing indirect taxation of exports.

  • Reducing incentives for tax evasion, such as through under-invoicing of imports, as purchasers are incentivized to fully reflect dues for tax credit.

  • Potentially higher revenue yields, ascribed to stronger enforcement mechanisms and lower economic costs which also allow for higher rates compared to turnover tax or retail sales tax.

  • Potential increase in investment, as taxes on inputs and capital goods are removed.

  • Anecdotal evidence suggests that a large number of commercial establishments in Bhutan are not in the habit of keeping sales records and receipts. The introduction of VAT would incentivize more careful record keeping.

  • Though adoption of VAT typically entails significant setup costs for administration and taxpayers, compliance costs can be kept low by a well-designed VAT system. Moreover, the current indirect tax system has complicated procedures to prevent cascading, relying on numerous and narrowly differentiated tax rates, and by creating categories of goods such as “raw materials” and “capital equipment” that can introduce identification problems, open the system to abuse, and raise administration costs.

Streamlining Direct Taxes

18. In addition to indirect tax reforms, the system of direct taxes could also be streamlined, by merging the PIT and BIT. 10 The current system of taxing individual and business income gives rise to inequalities between taxation of salary and wage earners and business income earners, with the latter bearing a significantly higher tax burden. Merging these two taxes would eliminate the inequity and encourage better record keeping by business owners.

E. Summary and Conclusions

19. Bhutan’s tax system is characterized by a relatively narrow base and heavy reliance on the hydro power sector for a large share of its revenues. While this is perhaps unsurprising given the small size of the economy and its emphasis on using hydropower development as the engine of growth, revenues from hydropower are not buoyant as electricity prices are fixed in nominal terms. Given the impending decline in grant assistance as Bhutan’s income rises, the need to generate adequate domestic revenue to make up the difference is key to financing its development plans in the context of the upcoming 11th FYP.

20. Efforts to enhance revenues and improve the tax system should be multi-pronged. These should focus on (i) rationalizing the system of tax holidays and pruning the list of exemptions in the near term, and (ii) reforming the system of indirect taxation in the medium term. In this context, introduction of a VAT, with its attendant advantages including increased revenue collection, should be seriously considered. In addition, the system of direct taxes could be streamlined by merging the PIT and BIT into a single tax.

References

  • International Monetary Fund, 2009, “Indirect Tax Reform,” Aide Memoire of the 2009 FAD Tax Policy mission to Bhutan.

  • International Monetary Fund, 2003, “Review of the Personal Income Tax and other Taxation Issues,” TA Report of the 2003 FAD Tax Policy mission to Bhutan.

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1

Prepared by Adil Mohommad (APD).

2

INR = Indian Rupee to which the Ngultrum is pegged one for one. 1 unit = 1kWh.

3

In comparison, Lao P.D.R., another landlocked country with large hydropower potential and relatively small installed capacity, receives only about 4.8 percent of total revenue from hydropower projects. Paraguay receives roughly 10–12 percent of total revenues from the Itaipu Dam on the Parana River.

4

Aide Memoire of the 2009 FAD TA report on indirect taxes in Bhutan.

5

Under the Bhutan-India free trade agreement, the Indian government directly refunds excise paid on Indian exports to the government of Bhutan, rather than refunding the manufacturer.

6

As per the Agreement on Trade and Commerce between the Royal Government of Bhutan and Government of India (GOI), there is free trade and commerce between the two countries of goods produced in either country. Article VIII of the Agreement provides that: “Each of the Government agree to provide appropriate refund to be mutually decided annually in respect of excise duties on goods of its origin exported to another.” In pursuance of the above provision, GOI has been annually paying refund of excise duties collected on goods exported from India to Bhutan.

7

The threshold is a minimum turnover size that firms must meet to be registered in the VAT system. Firms with turnover below this threshold may be subject to alternative modes of taxation other than VAT.

8

C efficiency = VAT revenue/(rate x consumption expenditure) is a diagnostic to assess the efficiency of VAT.

9

Aide Memoire of the 2009 FAD TA report on indirect taxes in Bhutan.

10

FAD Tax Policy mission TA Report, 2003.

Bhutan: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept