Transition Studies Review (2006) 13 (1): 131–141 DOI 10.1007/s11300-006-0102-3
Transition Studies Review Ó Springer-Verlag 2006 Printed in Austria
Tax Reforms as Capital Market Development Factor Edward Sandoyan, Samvel Mkhitaryan, and Samvel Sahakyan Russian-Armenian (Slavonic) State University, Yerevan, Armenia (E-mail:
[email protected])
Abstract. The article presents the preconditions of Armenian capital market development. A few hypotheses are proposed concerning correlation between direct taxes (in particular, profit tax and income tax) and financial sector development mediated with shadow economy. On the basis of studied theories and our empiric research (regression analysis of key indicators), our hypotheses were proven. So for the further development of Armenian capital market we consider it necessary to depart from profit tax, concurrently reducing income tax and social security tax rates. Keywords: taxation; income tax; profit tax; financial sector; capital market; corruption; transparency. JEL classification: E62.
In the Republic of Armenia the process of market economy development has become irreversible. However, many spheres have not yet come about. More than that, many of the market economy institutions either do not exist as such or are just imitations of the supposed institutions. At present, the institutional insufficiency is a tendency seen in the newly shaped financial system, on the whole, and in its different sections, in particular. This can be seen in Table 1 from the analysis of quantitative indices of the financial market. It must be noted that according to these indices Armenia has been left behind even by average indices of the low-income countries. This has many reasons, but the main reason is that the government has failed to take all measures necessary to enforce the financial system, including functions of productive financial intermediation. Like in most countries in this transition period, in Armenia the banking system is more developed than other sectors of the financial market. The reforms of the recent years resulted in appreciable growth of the banking system which is also illustrated in Fig. 1. With regard to GDP these indicators
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Sandoyan et al. Table 1. Indices of financial market Country or group of countries
GDP per capita (USD)
Market capitalization (% of GDP)
Domestic credit to private sector (% of GDP)
Stocks traded, total value (% of GDP)
Armenia Low income Middle income High income
873.00 425.78 1793.06 26821.56
0.80 22.74 32.12 82.62
6.02 44.19 67.12 154.63
0.09 30.20 22.10 108.20
Source: World Bank, World Development Indicators 2004
400000
Assets
Deposits
Credits
Capital
350000 300000 250000 200000 150000 100000 50000 0 1995
1998
2001
2002
2003
2004
Fig. 1. Indicators of the Armenian banking sector; values are millions AMD (Central Bank of the Republic of Armenia, Annual Reports 1995–2004)
have not expressed a tendency of observable growth, though. Meanwhile, the formation of other sectors of Armenia’s capital market has not been proportional to the development of the banking system. In particular, the equity market is making its first steps; there is dearth of some important institutions, such as of collective investment, pension and mortgage, and other nonbank organizations. The main reason for this is that the official policy on financial market reforms was limited in the framework of the banking sector with the hope that the enforcement of this system would facilitate and promote the development of other capital market sectors. But the experience of other countries shows that the essential condition of an efficient banking system is the parallel formation and development of other financial institutes, as the variety of the financial instruments in the market makes it possible to diversify bank assets and shape more optimal constructions of assets. A lack or backwardness of those institutions and instruments lessens the role of the 24
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banking system in Armenia even in the case of a small economy that is inadequate to the potential of the country (Table 1). The development of the working part of the Armenian economy is bounded by the current status of the financial mediation system too. Relations between the financial mediation system and qualitative characteristics of the economic development have often been discussed in literature. For example, Walter Bagehot (1999) and Joseph Schumpeter (1934) have emphasized the necessity of developing a banking system harmonized with growth and level of national income. Joan Robinson (1979) assured that growth of the economy created demand for financial and other services. But the opposite may also be maintained, according to which the development of the financial intermediation system has a considerable effect on GDP growth. It follows that the financial intermediation system is an essential part of the economy and should not be considered as less important in relation to the real sector. This becomes more important in transition economies as the development of the real-sector institutions takes place on an already existing basis, whereas the developing system of the financial intermediation is an entirely new sphere characteristic only of market economy. Connected with this, the government’s policy towards the formation and development of a financial intermediation system becomes extremely important and will provide institutionalization of all financial market sectors. Unfortunately, during the previous period of economic reforms in Armenia this approach was not implemented. Thus, the whole financial system of Armenia and banking, the most developed sector of that system, in particular, have not yet become full and efficient institutions. This has a number of reasons, such as the inadequacy of the law regulating the field, the absence of an integrated forwardlooking program of the financial sector strategy, unfavorable tax policy, the huge shadow economy, the insufficiency of the institutions in supporting property rights and contractual relations, and the inefficiency of legal support towards reforming these institutions. But the target of our consideration will be only one of the above factors. We will try to analyze the negative impact of the current Armenian tax system on the financial market and show that the main problems hindering the financial-sector development may be solved, if not completely so at least partially, through the implementation of an effective tax policy. The efficiency of tax policy first can be described having in mind one of the essential obstacles of the development – the shadow economy. The main attribute of the shadow economy is not only the circulation shaped as a result of financial and business relations between individuals acting beyond tax regulations and its consequences but also the distortion of free competition and investment activity. The shadow economy seriously hinders the capital market development. Enterprises working in the shadow lose transparency and limit their ability to fund their own businesses by means of open Transition Finance and Banking Research
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market instruments, which, in its turn, hampers the financial-market development. We think that many of the explanations of such a big shadow economy can be found in the tax system having shaped in Armenia. High rates of direct taxes heavily affect the final outcome of the taxpayers’ activities forcing them into the shadow. In particular, if we made an average calculation on the basis of official statistical data (neglecting the fact that most people avoid declaring their incomes), we would have AMD 81 billions of income instead of the officially declared AMD 16.7 billions (in 2003, income on capital, not including interest-free social loans, was AMD 809 891 millions with a minimum rate of income tax of 10%). Therefore, we may arrive at the conclusion that the essential part of the population income is circulating in the shadow economy. On the whole, on the basis of the analysis of macroeconomic indices of the country and our empiric assessments we come to the conclusion that the most important reasons for the shadow economy can be found in the tax policy. These reasons are divided into two aspects: tax burden and corruption of the governmental institutions. Many conscientious taxpayers avoid paying taxes wholly or partly when their business rivals are in the shadow and when after paying all taxes they get too little income and lose their competitive abilities. This is why many taxpayers seek to pay as little as possible or simply stop their businesses. Corruption of the governmental institutions (state machinery) creates wider demand for corruption and encourages taxpayers to go into the shadow and take the opportunity of paying fewer taxes. Both these reasons exist in Armenia. But we think that the priority should be given to the tax burden. With regard to this, we have carried out an analysis of some per person indices of low- and middle-income countries. We have chiefly studied the regressive connection between the corruption perceptions index (calculated by Transparency International [Berlin, Germany] with the support of 13 other international organizations, including the European Bank of Reconstruction and Development, the World Bank, and PriceWaterhouseCooper) and maximum marginal corporate (profit) tax rate (Fig. 2). The study showed that these two indices are in proportion to each other, that is, the maximum marginal profit tax rate corresponds to a higher level of corruption. In particular, correlation index (multiple R) is 0.64 and the results (P value) are of 99% of accuracy. Besides, it was also determined the connection between the corruption perceptions index and the share of the income and profit taxes in the tax revenues. In this case the results showed an inverse proportion – the higher corruption, the smaller the share of the mentioned taxes within the tax revenue (Fig. 3). On the other hand, businesses in the shadow cannot enter the capital market, as the nonshadow low profitability disclosed by them and lack of transparency of activities push away the possible investors. Consequently, 26
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35
40
Corruption Perceptions Index
8 7 6 5 4 3 2 1 0 10
15
20
25
30
Highest marginal corporate tax rate rate (%) Fig. 2. Relationship of corruption perceptions index to maximum marginal corporate tax rate. A higher level of the corruption perceptions index corresponds with a lower level of corruption. Regression statistics: multiple R, 0.64; R square, 0.41; standard error, 0.92; observations, 63
Corruption Perceptions Index
12
10 8
6 4
2 0 0
10
20
30
40
50
60
Taxes on income, profits and capital gains (% of current revenue)
Fig. 3. Relationship of corruption perceptions index with share of the income and profit taxes in the tax revenues. Regression statistics: multiple R, 0.61; R square, 0.36; standard error, 1.8; observations, 89
they lose the opportunity of funding their businesses through allocating securities. Meanwhile, against the background of the shadow economy and corruption in Armenia, some companies seeking to enter the capital market or meet the market conditions tried to implement corporate governance principles Transition Finance and Banking Research
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and be more transparent, but their steps, inadequate to the positive expectations, resulted in the tax burden going up and their competitive abilities going down compared with the businesses operating mostly in the shadow. Besides, the high tax burden deeply affects the income of the population and reduces the volume of their personal savings, cutting down investment offering as well. According to our observations, financial sectors have had their full and normal (usual, standard) development in countries in which the development of free (open) market instruments had been the primary goal of the government’s economic policy which promoted not only the development of a full-fledged financial market and progress of the really existing sector but also the efficiency of some of the government’s functions, such as monetary policy (achieving a wide variety of tools for the implementation of a policy targeted at inflation), pension insurance and housing (the problems with the latter can be solved, chiefly, by means of developing a mortgage market, which, in its turn, creates prerequisites for boosting house construction, formation of so-called long money, and widening of investment activities both by population and the banks). In this respect the growth of the companies’ potential of operating in an open market (particularly through issuance of shares and stocks) and widening of the abilities of allocating owned assets in open market instruments are more sensitive and complicated problems. From this point of view great importance is attributed to the tax system because, as we saw, an unfavorable tax policy seriously hampers the companies’ activities in the capital market. Thus, we can come to the conclusion that income tax and profit tax can serve as strong lever to enhance efficiency and transparency of corporative companies, growth of the national savings, and consequently, effectiveness of the financial market. The main way to reduce the shadow of the economy is the improvement of tax regulation aimed at easing the tax burden and widening the taxation field which will lead to a growth of tax income, which in addition will lead to improvement of competition conditions (rules), reduction of corruption risks, provision of economical conditions and expediency for implementing corporate governance principles, improvement of transparency and predictability of the companies’ activities, attractiveness for investments, and so on. As it is seen, today a lighter tax burden and more effective implementation of tax regulations are not only crucial provisions for capital market development, but also assume vital importance for the development of financial institutions and qualitative enhancement of the economic and social spheres. This problem has drawn the attention of many scientists of the world. Specifically, Peter and Kerr (2001) in their research analyzing the data of the South and East Asian countries have shown that there is an inverse rela28
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tionship between tax burden and savings and capital accumulation. Also it must be mentioned that the experience of many countries (e.g., Estonia and Russia) shows that a reduction of profit and income tax rates does not lead to a reduction of budget incomes, just on the contrary, after some time they grow sharply. This phenomenon has several reasons, such as the following. Rate reduction considerably encourages the business activity. Reduction of the profit tax rates has also great influence on the investment decisions of the companies, as after paying taxes the return rate on capital changes (swallow, grow). Thus investment activity of the economy rises which has its direct influence on the economic growth. After tax reduction, when transaction costs serving corrupt mechanisms of tax avoidance and shadow activities become comparable with the relevant tax payments, businesses return to the legal tax zone, simultaneously expanding the tax base and improving transparency of their activities, competition conditions, and investment environment (De Soto 1989). Expenses on financial management of businesses and on tax bureaucracy, to be directed to providing tax regulations and their implementation, lessen. Connected with this, it must be underlined that a function for tax on profits application by the businesses, as well as tax bureaucracy is the most moneygrubbing and laborious. As we see, reduction in tax on profits and income tax rates, and social security contributions lead to the increase of economic growth. Negative effects of the tax on profits have been considered by a number of well-known economists. In particular, Samuelson and Nordhaus (2004) have mentioned that a corporation is nothing else but a juridical fiction, so it is senseless to impose taxes on it. Imposing taxes on profits, then also on dividends, the government doubles the tax burden, thus reducing the return of the invested capital. From this point of view, tax on profits turns out to be an inefficient type of taxation, as either it is paid by those who are not the final consumers if the profit is capitalized, or the final consumer falls under double taxation if the profit is distributed in the form of dividends. This principle is being applied by many countries (e.g., Estonia) which have refused taxing undistributed profits. This greatly raises the companies’ interest in making investments, while at the same time it lessens the economic motives for businesses not to be transparent or to operate in the shadow and consequently evade the demands and services of the capital market in trying to avoid tax on profits. To our mind, this kind of model is quite applicable for Armenia. Moreover, this idea, which at first sight does not seem to be appropriate enough, will become one of the high-priority preconditions for solving some problems of the Armenian economy. Seemingly, a removal of tax on profits would lead to a large budget deficit. However, it will not have an essential impact on budget income because when we observe the budget income structure for the last Transition Finance and Banking Research
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50 40 30 20 10 0 1997
1998
1999
2000
2001
2002
2003
Fig. 4. Percentages of the tax revenue of Armenia for the main taxes (Armenian Statistical Yearbooks 1999–2004).), value-added tax; j, excises; n, profit tax; m, income tax
five years, it will appear that resources received from this tax form are a very small part of the budget income of Armenia. In particular, as shown in Fig. 4, since 1994 the volume of income tax in budget earnings has fallen to merely 6% in 2003. This is mainly due to high tax rates which force the organizations and companies to avoid payments, chiefly by concealing their real profits, enlarging artificially expenses, and so forth, which indirectly also affects other tax forms. Besides, the National Statistics Service reports show that 24.3% of the organizations registered in Armenia in 2003 have been making losses with AMD 99.4 billions of balance loss, which even exceeds budget receipts from income tax by 5.6 times. But the government pursues granting tax privileges to enterprises which are actually or officially bankrupt, which are not able (or pretend not to be able) to gear their activities to the requirements of regulations. In fact, there is a disguised implementation of budget loans. More than that, to provide the needed amount of the tax receipts, the whole machinery of the tax bureaucracy is focused on the law-abiding taxpayers to make them meet the deficit of the tax income by advance payments. Thus, because of the bankrupt businesses or those which operate in the shadow to avoid taxes, the law-abiding taxpayers are subjected to more pressure and competition discrimination. It must be noted that the mentioned advance payments exceed the limits of the efficiency of taxation, as in fact they are taxes on values which have not been produced yet. Consequently, they make the profit tax rather destructive. As we see, tax on profits appears to be a rather ineffective tax form, the implementation of which results in causing problems to the development of the economy, chiefly of the capital market. So, we suggest to withdraw tax on profits as a type of taxation and move the whole burden onto the income and dividend taxes. 30
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The same problems are faced in the sphere of income tax. High rates of the income tax force most employers to hide the real amount of the resources targeted to the wages or declare only part of them. This is one of the most widespread reasons prompting the shadow economy. That is why, as it was shown above, the essential portion of the income of the population is formed and circulated in the shadow. We believe that this problem too can be settled by reducing the income tax rates. Observation of the state budget structure of Armenia shows that during the last 10 years the income tax receipts fluctuated between 6 and 8% of tax revenue. This gives hope that at the beginning the income tax rates reduction will not have a strong impact on the budget revenues of the country, and afterwards, according to the experience of some other countries (in particular, Russia), it will lead to an increase of the tax revenue. While speaking about income tax, we should neither ignore social insurance payments, which are obligatory and have no connection with social security. This is in essence a kind of social tax which comes to provide minimum social guarantees for pensioners. However, the social difficulties would be overcome more efficiently if together with the social insurance system a system of obligatory accumulative pension insurance would be implemented parallel to the development of nongovernmental pension foundations. The latter will give citizens an opportunity to settle their pension problems on their own, according to schemes and amounts that suit them best (Sandoyan and Karyan 2000). Besides the above, it is necessary to ease considerably the tax burden on obligatory social insurance payments which rest mainly on the employers. Today, connected with these payments, only the conscientious employers are taxed. The rates implemented in this case are regressive. Taking into consideration this regularity, a number of countries have adopted the policy of reducing obligatory social insurance payments. Georgia, for instance, is a vivid example of such policy in the last few years. Reforms in 2004 brought great relief to the tax burden on the economy. The government of Armenia should also pursue this policy and lower the obligatory social insurance payments rates so that the payments, including income tax, would not exceed 20% of the money prescribed for wages. The study of a big amount of tax arrears also helps to judge the efficiency of the mentioned tax forms. As shown in Fig. 5, in 1997 they started to grow reaching AMD 55 billions in 2001. At the same time 34.6% of the tax arrears (or AMD 19 billions) fall to the income tax share. Because since 2001 there have not been any new data on tax arrears recorded in official statistics, we have made an independent assessment of tax arrears for 2002–2004 on the basis of the average rate of growth of the preceding period. The buildup of the tax arrears and the move of the underreported incomes, which much surpass tax arrears, to the shadow circulation depend not only Transition Finance and Banking Research
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Profit tax 120 90 60 30 0 1997
1998
1999
2000
2001
2002
2003
2004
Fig. 5. Tax arrears (Armenian Statistical Yearbook 2004). Values are billions AMD
on high tax rates but often also on ambiguous formulations of tax regulation and complicated tax management. One of the most important problems of the last 10 years concerning tax management is that they failed to institute off-site inspection for tax monitoring. It is still conducted by the methods of direct control and in accordance with a forced ‘‘plan’’. It is worth mentioning that the principle of effective tax management is provided by article 22 of the Tax Law of the Republic of Armenia, which sets a very essential norm of how the tax bodies should clarify the responsibilities of the taxpayers by indirect methods. The law also states that the implementation of these methods must follow the procedure set by the government. To date this procedure has not been established, though, which hinders the adequate application of the mentioned article. To make the taxation system more effective, competitive relations shall be established between tax bodies and taxpayers to provide a fair environment in which tax bodies will be able to administer legally acceptable penalties or punishments instead of using administrative pressure. With regard to enhancing the tax management efficiency in the income tax sphere, many countries have introduced the institution of income and property filing. It is one of the important tools of tax management which, with the help of annual comparison of the citizens’ incomes and properties, allows prevention of the ‘‘underground’’ circulation of incomes. We believe, that today the availability of software programs is very favorable for introducing this institute in Armenia as well, which would make the income tax collection more effective. Besides, we think it necessary to review some items of the income tax law, especially those concerning gross income tax reduction. We are sure that this reduction should be geared to the strategy of the country. Apparently, high rates of taxes on profits and income taxes, as well as of social insurance payments, are a serious obstacle for free and effective business activity in Armenia, often forcing the businesses to partially or wholly 32
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evade taxes and enter the shadow. On the other hand, the government does not have any mechanisms to manage the implementation of the taxes effectively. Thus, the above mentioned taxes not only fail to serve their main purpose but also hinder the growth of the economy. In particular, they hamper the transparency of the enterprises, corporate governance implementation, and investment risks mitigation, encouraging possible investors and issuers to get more interested in the securities market. The suggested reforms would enable to fight corruption and shadow economy, encourage free and fair competition, improve the investment environment, promote transparency, increase savings, revive the capital market, and finally enhance the development of the economy. To reach these goals the government should consider the tax system not only as one of the fiscal policy tools but also as a strong incentive to integrate the activities towards financial-market improvement. The latter, in its turn, will conduce to meet, completely or partially, the difficulties of the financial market and enhance the formation of a more effective financial intermediation system.
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