Local Tax Reform in Kyrgyz Republic

Research Paper Local Tax Reform in the KyrgyzRepublic Elima Karalaeva

Local Tax Reform in the KyrgyzRepublic

Elima Karalaeva[1]

Abstract

While the public finance system in the KyrgyzRepublic was inherited from commanded economy and remains quite ineffective, the government has made little progress over the past decades. The central budget and local budgets of self-governments are built on the principle of unity meaning that all budgets are linked to one revenue system. On one hand, the central authorities have a broad power and competencies to influence and coerce, and on the other hand, the local self-governments (LSG) are financially dependent and have limited right to review, approve, and execute their own budgets. Thus, the formation of budgets and determination of revenue sources and transfers lies within the competencies of the central government. A decentralized fiscal system could play an important role in improving governance mechanism, transparency and better targeting of fiscal resources as local government is better positioned and more responsive to local aspects of social needs with respect to resource mobilization and allocation. The Government of Kyrgyz Republic (KR) has chosen fiscal decentralization to enhance local governance system, to encourage private sector growth and to reduce poverty.

In an effective market economy, local taxes play an important role as a major revenue source of local governmental funds and important economic regulator. Thus, it is necessary for countries in transition (CITs) to achieve these objectives of taxation. While many CITs experienced serious budgetary problems, a rational local tax reform would be helpful to meet the revenue needs of local governments and to achieve fiscal stabilization in the transition period. Moreover, tax reform facilitates and supports other economic reforms necessary for restructuring of economic mechanism.

The paper is motivated by the questions about the main directions of local tax reform in KyrgyzRepublic, the performance and dynamic of local budget revenues and deficits during the transition period. The goals of the study are to review and evaluation the local finance reform process in KyrgyzRepublic, to identify particular reform components, their mutual relations, time and content restrictions, and to examine the effects of the actual financial and economic crises to local government finance. Organizational structure of the paper would include detailed discussion of data sources and procedures used to develop the county specific dataset, local budget revenue sources and expenditure analysis, and evaluation of the local taxes performance.

The overall objectives include looking at the dynamic of local revenues and expenditures in 1990-2008 period to assess the quality of the budget system at local government level and to develop an up-to-date picture of the regional economic situation in the Kyrgyz Republic, underlining some problems of local tax reform, especially in tax administration, and establishing a baseline for monitoring the progress of municipal finance reform in the future. Therefore, the study would involve elements of both explorative and descriptive research. The source of information data is the Ministry of Finance, the Treasury, the State Tax Inspectorate, the National Bank and the National Statistical Committee of the KyrgyzRepublic. Key materials would be obtained from the World Bank, the International Monetary Fund, the United States Agency for International Development, the UK’s Department for International Development, the Swiss Development Agency, and European Union TACIS. Archival materials would include legislative materials at the state and local levels, advocacy materials prepared by governmental and research institutions, diagnostic reports, transcripts, consultant reports, feasibility studies, official notices, and policy statements.

The paper is concluded by examining several lessons from the first decades of the local tax reform in Central Asia and offering some recommendations. The recommendations would propose immediate changes in local tax administration of KyrgyzRepublic to strengthen the existing tax system and to prepare the way for more fundamental public finance reform in the long-term.

1.Introduction

The past decades have been witness of the transition from centrally-planned economies (CPEs) to market-based economy as one of the largest experiments in the economic history. Virtually economic reform in the countries in transition (CITs) has encompassed every sector of the economy, and degrees and pace of the reform has varied significantly[2]. Particularly, tax reform has been widely recognized as critical one to the success of the economic transition[3].The available evidence suggests that the scope, speed, and stability of economic reforms, including tax policy and administration reforms, significantly influenced the ability of CITs to reestablish economic growth during the transition.[4]

While the public finance system in the KyrgyzRepublic was inherited from commanded economy and remains quite ineffective, the government has made little progress over the past decade. The central budget and local budgets of self-governments are built on the principle of unity meaning that all budgets are linked to one revenue system. According to the Musgrave-McLure,[5] revenues from progressive personal and corporate income taxes designed to redistribute income have been reserved by the central government. Also, the creation and execution of budgets is based on the central government ruling. On one hand, the central authorities have a broad power and competencies to influence and coerce, and on the other hand, the local self-governments (LSG) are financially dependent and have limited right to review, approve, and execute their own budgets. Thus, the formation of budgets and determination of revenue sources and transfers lies within the competencies of the central government.

In an effective market economy, local taxes play an important role as a major revenue source of local governmental funds and important economic regulator. Thus, it is necessary for countries in transition to achieve these objectives of taxation. While many CITs experienced serious budgetary problems, a rational local tax reform would be helpful to meet the revenue needs of local governments and to achievefiscal stabilization in the transition period. Moreover, tax reform facilitates and supports other economic reforms necessary for restructuring of economic mechanism.[6]

The goals of the study are review and evaluation the local tax reform process in Kyrgyz Republic during the first decades of the transition to the market economy, assessment of the revenue-generating prospects of local budget system during global financial crisis, identification of the problems hampering the achievement of an optimal local government finance performance, and suggestion the ways to overcome barriers to local tax reform. Organizational structure of the paper would include overview of the local tax system, detailed discussion of data sources and procedures used to develop the county specific dataset, local budget revenue sources and expenditure analysis, and evaluation of the local tax performance.

Review of the analytical works is focused on similar researches and covered reports on progress comparable to World Bank, International Monetary Fund, United States Agency for International Development, UK’s Department for International Development, Swiss Development Agency, and European Union TACIS. Key materials would be obtained from the Ministry of Finance,[7] the Treasury, the State Tax Inspectorate, the National Bank and the National Statistical Committee of the KyrgyzRepublic. Therefore, Section 2 reviews the major works undertaken by government agencies and international organizations and providesbackground information on political and economic context of the KyrgyzRepublic to allow sufficient understanding of the core characteristics of the local public finance system and the wider context to local tax reform. Section 3presents the evaluation of the local tax system and identifies the arguments for economic policy reforms to strengthen local financial management, fiscal decentralization and an efficient tax administration. Finally, Section 4 presents conclusion and recommendations, provides summary of the lessons from the in Central Asia Region (CAR) tax reform experiment.

1.1.Objectives and Research Methodology

Accomplishment of the objectives would require the following tasks:

Conduct a review of research literature on local tax reform in countries in transition.
Develop a critical review of current local finance practices and key problems in KyrgyzRepublic.
Identify and describe the types of data that are available regarding local tax administration and revenue sources. Determine the accessibility, limitations, and credibility of the data.
Develop methodology to measure and evaluate local revenues and expenditures.
Analyze the main features of the local tax system in KyrgyzRepublic and examine the progress in modernization of the local financial management.
Develop recommendations for local tax reform in KyrgyzRepublic.
Present the preliminary paper to selected coordinatorsof working group to validate the assessment and obtain feedback.
Based on review, revise the recommended strategies, methods, and tools included in the methodology.
Prepare and submit a final paper including the final methodology.

1.2.Data Sources

The source of information data is the Ministry of Finance (MOF) and the National Statistical Committee of the Kyrgyz Republic (NSC).[8]Archival materials would include legislative materials at the state and local levels, advocacy materials prepared by governmental and research institutions, diagnostic reports, transcripts, consultant reports, feasibility studies, official notices, and policy statements.

Regular reporting data is a basis of the statistical system, and it is considered to be the most important information source for making estimations. During using statistical reporting data of branches affected by the shadow economy, researchers can face the problem of analyzing the quality of direct information. As a statistical body does not carry out controlling function, information obtained from the companies by the statistical body is strictly confidential and could not be used as a ground for imposing fines, penalty fees and taxes. In fact, it is difficult to distinguish wrong and reliable information, containing in the reports. Theoretically, casual errors can be corrected by the law of large numbers,because assignable errors may cause significant perversities. Despite the lack of independent statistical information, there are some sources that help to conduct research and to obtain the definite results, including thescientific institutes, universities, think-tanks, public organizations and individual experts.

2.KyrgyzRepublic: Local Revenues and Expenditures

2.1. Macroeconomic Analysis and Trends

The KyrgyzRepublic is a small, mountainous country with an agricultural economy and a population of 5.1 million. In 2006, GDP per capita was 536.00 USD (Exhibit 1.). The country obtained independence on August 30, 1991 and enjoyed a wide-spread reputation as the most democratic and market-oriented country in Central Asia. In 1990s, the KyrgyzRepublic experienced substantial transformation shock and macroeconomic instability, loss of transfers, oil price adjustments, collapse of economic relations with former partners and great reduction in tax collections. As spending was financed through domestic credits and donor assistance, an institutional collapse was avoided. In mid-1990s, the initial economic indicators have been recovered. Despite the regional financial crisis of 1998, the average annual growth of real GDP was 5.2% in 1996-2004 varying between 9.9% in 1997 and 0% in 2002, and reflecting a substantial decline in poverty rates from an estimated 52% in 2000 to 35% in 2004.[9] The GDP growth has gone primarily to private consumption, while government consumption experienced only a minor increase. Since 2000, the macroeconomic performance has improved significantly in comparison with other countries in Central Asia region. For the period 2001-2006, the average consumer price index (CPI) was below 5%, reflecting a prudent monetary policy during a rapid demonetization of the economy. Responsible fiscal and monetary policies have helped to reduce annual inflation to 5% and the budget deficit to 5% of GDP, diminish the current account deficit, and stabilize the national currency. Also, the fiscal position has changed from a primary balance of -6.9% of GDP in 2000 to an estimated balance of -2.5% in 2004.[10] However, the economic growth was concentrated in few sectors, such as gold mining, agriculture and trade, and lagged behind the most CIS countries. Long-term macroeconomic sustainability needs stability of the national currency, low inflation and keeping fiscal and current account deficits under control. The economic and political comparison with other CIT could be complicated because of the country size, unique geopolitical position and significant natural recourses (gold and water).

The legal and institutional framework of the KyrgyzRepublic has changed considerably. Local government spending as a percentage of GDP was 6.33% in 2007, which is the average for 16 countries with similar income levels in Europe and Central Asia (Exhibit 3). While tax rates and contributions are suitable to international practice, tax compliance is very poor resulted in low revenue outturns. Local revenues and grants are counted 6.33% of GDP in 2007, and external debt is amounted to $1.98 billion or 1.75% of GDP in 2006 (Exhibit 6). As high debt continues to be a key policy constraint, the Paris Club of creditors granted a relief for the KyrgyzRepublic in 2005 with estimated reduction in the Net Present Value of official bilateral debt by 36%. Despite the Paris Club action, the fiscal consolidation is required for further reduction of debt levels.

The events of March 24, 2005 and April 7-8, 2010 have created a unique opportunity to reform the KyrgyzRepublic’s economy, to shift towards human rights, the principles of free elections, freedom of political parties and the mass media, and to increase the efficiency, transparency, and accountability of government agencies. The government identified that low living standards, high unemployment, and corruption are the three key problems in the country.

Therefore, the objectives of tax reform are continued fiscal consolidation, building fiscal institutions, promoting fiscal transparency and improving public sector accountability.

According to the Index of Economic Freedom, the KyrgyzRepublic's economy is free by 59.9% ranked 79th in the world in comparison with 82.0% in US and 81.7% in UK. Fiscal freedom and labor freedom in the KyrgyzRepublic score highly, while monetary freedom, trade freedom, and freedom from government somewhat less highly. The labor system is very flexible, and the implementation of a new Labor Code has helped to adopt employers to free-market conditions. The top income and corporate tax rates are low, and government expenditure is moderate. The investment freedom, property rights, and freedom from corruption are weak. Foreign investments are harmed by bureaucratic incompetence and opaque regulatory enforcement. The weak rule of law allows for significant corruption and insecure property rights.[11]

2. 2. Legal and Organizational Framework

According to the subsidiary standard, local governments are more efficient than national government in the provision of public services and management of infrastructure projects because of closer supervision, proximity to the work site, “ownership” and greater accountability to local clientele. Therefore, strong and well-focused system of decentralized governments needs to clearly delineate the rights, duties, responsibilities, and functions among local and central government in the constitution, national laws, and regulations. However, the subsidiary framework is invalid for KyrgyzRepublic with five million inhabitants, as local self-government is carried out by the central government administration through de-concentrated units in the form of oblast administrations.

The Constitution of the Kyrgyz Republic[12] does not elaborate clearly on the separate functions of local state administration. Article 76 indicates that executive power on the territory of the respective administrative territorial unit is carried out by the local state administration in oblasts, rayons and gorods. Oblast governors and rayon akims are responsible for administration of state policies and programs within their respective territorial domains carried out by the popularly elected kenesh (local council).

Chapter Seven of the Constitution defines the responsibilities and authorities of “local self-governance.” Particular, local self-government is exercised through the local keneshes and other bodies, which may be formed by the population itself in the procedure established by law. Bodies of local self-government may have communal property in their own possession and may be endowed with separate governmental powers, accompanied by transfer [to them] of the material, financial, and other means necessary for their execution. Bodies of local self-government are accountable to state bodies concerning delegated power. Local keneshes approve and control programs of social-economical development of the territory and social protection of the population; approve the local budget and report on its implementation; and, hear information on the use of extrabudgetary funds. In practice, rayon pursues an independent budget policy as no differentiation of powers exists within oblast.

Chapter Three, Section Two, Article 46, 1, 5) states that the President of the KR appoints in consultation with the Prime Minister and with the consent of the appropriate local keneshes, the heads of state administration of oblasts, rayons and cities, and relieves them of their offices.

The law Local Self-government and Local State Administration,first promulgated in 1991,[13] defines local self-governance as system of local keneshes, territorial local governance bodies (micro rayon and housing complex councils and committees, house, street, quarter, posyolok, and ail committees and other bodies) as well as local referendums, meetings of citizens, and other forms of direct democracy. However, this broad and confusing definition of local self-governance is beyond the capacity of the intergovernmental fiscal system.[14]