Tax Potential vs. Tax Effort: Factors Behind the Stubbornly Low Tax Collection in Armenia

Hamid R. Davoodi and David A. Grigorian

Armenia: Challenges of Sustainable Development

Conference in Honor of Professor Armen Alchian

UCLA, May 6, 2006

Outline

I. Overview

II. Armenia’s Tax Performance• Evolution over time and vis-à-vis other CIS• Fund-supported programs, 1996-99 and 2001-04• Current PRGF program 2005-08

III. Cross-Country Regression Analysis• Methodology and Data• Regression Results• Robustness

IV. Conclusion

I. Overview of Economic Performance

Generally strong macroeconomic performance Yet, weak structural foundations:

– Large scale emigration– Poverty– Corruption– Weak fiscal package/incentives

Need to improve tax collection because:– Long-term growth potential– Poverty reduction goals (as outlined in the PRSP) – Expected decline in concessional borrowing

Figure 1. Armenia: Central Government Tax Revenues(In percent of GDP)

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10

11

12

13

14

15

16

17

18

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Figure 1a. Armenia: Main Components of Tax Revenues(In percent of GDP)

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

VAT Excises CIT PIT Customs

2000 2001 2004

Figure 1c. Direct Taxes(In percent of total taxes)

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10

20

30

40

50

60

70

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Figure 1f. CIS: Tax Revenue, 1998-2004(In percent of GDP)

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5

10

15

20

25

30

Figure 1g: CIS, Direct Taxes, 1998-2004(In percent of GDP)

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2

4

6

8

10

Figure 2. CIS: Total Tax Revenues vs. Direct Taxes, 1998-2004

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5

10

15

20

25

30

5 10 15 20 25 30 35 40 45

Share of direct taxes in total tax revenue (%)

Tota

l tax

reve

nue-

GD

P ra

tio (%

)

T ajikistan

Armenia Kyrgyz Republic

Moldova

Russia

Azerbaijan

Figure 2a: CIS, VAT Revenues, 1998-2004(In percent of GDP)

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2

4

6

8

10

Figure 3. CIS . Tax Revenues vs. VAT Productivity

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10

15

20

25

30

0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50

VAT productivity

Tax

-GD

P ra

tio

Armenia

Russia

AzerbaijanTajikistan

Figure 3a. CIS: Tax Revenue Buoyancy, 1998-2004

0.6 0.8 1.0 1.2 1.4

Ukraine

Uzbekistan

Armenia

Moldova

Belarus

Turkmenistan

Kyrgyz Republic

CIS11

CIS6

Russia

Tajikistan

Azerbaijan

Georgia

Kazakhstan

Figure 3b: CIS, VAT Revenue Buoyancy, 1998-2004

0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80

Ukraine

Uzbekistan

Armenia

Belarus

Moldova

Turkmenistan

Kazakhstan

Russia

CIS11

CIS6

Kyrgyz Republic

Azerbaijan

Georgia

Tajikistan

Figure 3c: CIS, Direct Tax Buoyancy, 1998-2004

0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80

Armenia

Tajikistan

Uzbekistan

Belarus

Turkmenistan

Ukraine

Moldova

CIS6

Kyrgyz Republic

CIS11

Russia

Azerbaijan

Georgia

Kazakhstan

Figure 4. Tax Revenues in Armenia: Performance Under ESAF and PRGF

(Percent of GDP)

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10

11

12

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17

1996 1997 1998 1999 2001 2002 2003 2004

Program Outcome

What’s wrong with this picture? Tax collection low compared to other CIS

countries Tax collection low compared to its potential Decline in share of direct taxes → Poor balance

between equity and efficiency Lowest buoyancy of (especially direct) taxes in

CIS Low VAT productivity, reflecting problems in

administration and exemptions

Eighteen revenue measures in 2005-08 PRGF– Six tax policy measures– Seven tax administration measures– Five customs administration

III. Regression Analysis

Following the literature, determinants of tax-GDP ratio across countries and time are:

Per capita GDP Institutional quality Inflation Share of agriculture Openness of the economy Shadow economic activity Fuel share of merchandize exports Share of Urban population

Data Sources

Publicly available data on up to 113 countries For the period of 1990-2004 Indicators of institutional quality from the

International Country Risk Guide (ICRG) Estimates of Shadow economy from Schneider (2005) VIOLENCE, constructed based on the dataset

provided by Center for Systemic Peace

Determinants of Shadow Economy

All coefficients have expected signs: Bureaucratic quality reduces shadow

economic activity, but at a declining rate Corporate tax rate is not significant Higher per capita income is associated

with lower shadow economy More political/social violence leads to

more shadow economic activity

Dependent Variable:

Total Tax Revenue as a Share of GDP

Time trend -0.033 -0.034 -0.027 -0.029 -0.032 -0.082 -1.25 -1.29 -1.00 -1.04 -0.92 (1.93)* PPP-adjusted income p.c. 7.0E-05 7.0E-05 9.0E-05 9.0E-05 8.0E-05 1.1E-04 (2.20)** (2.24)** (2.55)** (2.59)*** (1.76)* (2.33)** Composite institutional quality 0.045 0.043 0.041 0.040 0.038 0.038 (3.94)*** (3.75)*** (3.61)*** (3.41)*** (3.04)*** (3.11)*** Shadow economy-1 -0.025 -0.026 -0.026 -0.025 -0.031 -0.029 (1.83)* (1.88)* (1.88)* (1.77)* (2.12)** (2.00)** Inflation -0.012 -0.012 -0.011 -0.021 -0.021 (1.72)* (1.72)* -1.6 -1.08 -1.1 Openness -0.009 -0.011 -0.005 -0.005 (1.76)* (1.98)** -0.77 -0.86 Share of agriculture in GDP -0.024 -0.001 -0.001 -0.93 -0.02 -0.01 Share of fuel in exports 0.081 0.084 (4.83)*** (5.03)*** Urban population 0.104 (2.00)** Constant 79.11 81.15 67.18 73.41 76.54 170.72 -1.52 -1.56 -1.28 -1.32 -1.12 (2.06)** Number of observations 898 898 896 863 775 775 Number of countries 113 113 112 111 107 107 Hausman test 1/ 48.43(8) 51.59(9) 52.90(10) 56.24(11) 53.37(12) 53.34(13) R-squared 0.03 0.03 0.04 0.04 0.06 0.07

Main Results

Positive effect of per capita GDP on tax revenue level

Positive and strong impact of institutional quality Negative and significant impact of the shadow

economic activity Negative but insignificant impact of agriculture Negative sign on inflation Negative correlation between openness and taxes Finally, OIL and URBAN are both positive and

significant

Post-estimation Analysis

Table 11. Summary Statistics for Actual vs. Predicted Total Tax Revenue 1/

Mean No. of Obs. Std. Dev. Min Max

Armenia Actual Tax Revenue 13.89 9 1.50 10.64 16.08 Predicted Tax Revenue 15.25 9 0.18 15.04 15.53 Ratio of Actual to Predicted 0.91 9 0.10 0.69 1.05

CIS 9 2/ Actual Tax Revenue 16.25 44 4.27 11.24 26.20 Predicted Tax Revenue 14.94 44 1.97 10.97 18.79 Ratio 1.10 44 0.30 0.71 1.85

Low-Income Countries Actual Tax Revenue 14.33 180 5.38 2.00 26.20 Predicted Tax Revenue 13.84 180 1.01 10.97 16.92 Ratio 1.05 180 0.41 0.15 2.05

Lower Middle-Income Countries Actual Tax Revenue 15.93 254 6.18 2.56 37.15 Predicted Tax Revenue 15.55 254 1.11 12.48 18.79 Ratio 1.03 254 0.41 0.17 2.28

Full Sample Actual Tax Revenue 16.46 851 6.52 0.09 37.15 Predicted Tax Revenue 16.46 851 2.36 10.97 22.38 Ratio 1.01 851 0.40 0.00 2.28 Memorandum items: All CIS 11 obs., including those not in the regressions 3/ 16.16 85 4.20 11.24 27.90 Baltic countries, including obs. not in the regressions 4/ 15.95 31 1.92 13.22 21.08

1/ Unweighted averages over the values of the indicators used in the regressions, unless specified otherwise. 2/ Includes Azerbaijan, Belarus, Moldova, Kazakhstan, Kyrgyz Republic, Russia, Tajikistan, Ukraine, and Uzbekistan. 3/ In addition to CIS 9, includes Georgia and Turkmenistan. 4/ Includes Estonia, Latvia, and Lithuania.

Post-estimation Analysis

Figure 6. Armenia: Tax Potential vs. Tax Effort, 1996-2004

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1996 1997 1998 1999 2000 2001 2002 2003 2004

0.60

0.65

0.70

0.75

0.80

0.85

0.90

0.95

1.00

1.05

1.10

Actual tax revenue (Left scale) Predicted tax revenue (Left scale) Ratio (Right scale)

Table 13. Armenia: Short-term Impact on Tax Revenue of Improvements in Institutional Quality

Resulting improvement in

potential tax revenue, based on:

Benchmark value of the

indicator Required

improvement Baseline

regressions Truncated regressions

Overall Institutional quality at the level of Baltic countries 75.6 15.3 0.58 0.74 Shadow economy at the level of Baltic countries 32.9 18.3 0.51 0.33 of which,

through improvements in Bureaucratic quality to the level of Baltic countries 2.5 1.5 0.17 0.11

Total impact (of improving institutional quality to the level of Baltic countries) 0.75 0.85

Conclusions Armenia demonstrates low (particularly direct) tax

buoyancy While finding oil may not be a feasible alternative, other

tools are available Better institutions appear to cause higher tax-GDP potential

both directly and indirectly (through shadow economy) Improvements in tax policy and administration would help

so long as they address the fundamental incentive issues Therefore, for any attempt to increase the tax performance

in Armenia to be successful, measures to improve governance, rule of law, and bureaucratic quality—all in the realm of the political will—should be in its core