We are publishing the position paper “Amendments to the Tax Code in the light of the reasons for, and consequences of, the 2018 revolution in Armenia”. This research was carried out by independent researcher Artak Kyurumyan for a project by Friedrich Ebert Foundation and Political Discourse Journal. You can download the full document here: “Amendments to the Tax Code in the light of the reasons for, and consequences of, the 2018 revolution in Armenia” (PDF).
1. Introduction
The Government of the Republic of Armenia (GoA) initiated amendments to tax legislation with a goal to shift from progressive system to flat system of taxation of income. This document presents positions of a group of citizens who do not agree with the idea of the above-mentioned changes initiated by the Government of the Republic of Armenia and is a position paper in this sense.
Changes in income tax rates will result in AMD 27-37 billion loss for the state budget in the first year. The GoA could have used these funds to:
- improve the potential of defense of the Republic of Armenia;
- improve significantly the quality of general education to help pupils studying at schools in disastrous conditions to obtain thorough knowledge in different areas of studies, continue their education at universities, get high salaries in the future and live a prosperous life;
- improve the quality of health services, that will allow providing quality services to wider groups of the society, many of who are deprived of those services;
- solve various problems related to social protection , e.g., raise pensions,
- solve environmental and other problems Armenia faces.
Transition to flat taxation might not harm the progressivity of fiscal policy if it envisaged exemptions for employees with low salaries and the tax legislation was fully applied in case of those having high income. In such cases the tax system may be more progressive compared to models considered as progressive in traditional sense. However, the tax system with large loopholes cannot be considered as progressive. Taking into consideration the fact that among justifications of abandoning the progressive system of taxation the GoA has mentioned that those earning high income are able to avoid high tax rates, other methods to achieve progressivity might not be productive. The fiscal policy may become progressive if taxes collected as a result of implementation of flat rates and taxes levied on consumption are used to foster economic growth and finance expenditures targeting poverty reduction.
The GoA may not succeed in reducing the shadow economy by means of implementation of flat taxes because part of the society believes that in a couple of years, the Government may be forced to raise taxes with the view to address challenges faced by the country. The progressive taxation is a tool to protect the financial and economic system from external shocks. In case of such a shock revenues generated by means of progressive taxation may serve as a source to fund commitments associated with the national security and protection of socially vulnerable groups of population and . These means will serve as the first line of defense in case of shocks. By cancelling progressive taxation, the GoA makes this first layer weaker. There are number of cases when countries reinstituted progressive taxation after economic crises (in some cases upon recommendation of IMF).
2. Taxes and tax policy
Tax policy is the very important part of the economic policy and many researches were conducted by academic community, governments, international organizations, experts and other stakeholders. Usually taxes are classified into two main types: direct and indirect taxes.
Individuals or the organizations are responsible for paying direct taxes out of their income, profit or for property they own. The GoA collects the tax from a person or an organization that has income or profit. The person or organization receiving an income or profit cannot evade paying it. In several countries the employer charges the tax from the salary of the employee and transfers the amount of tax to the budget. Personal income tax (PIT) and the corporate profit tax (CPT) are direct taxes.
Indirect taxes are usually collected by a supplier of goods, services or those implementing works from buyers of goods, consumers of services and entities for who the work is done at the time when they pay for goods, services or works or agree to accept them. If there are goods or services that are exempt from value added tax[1] (VAT), the consumers can evade a VAT or reduce their VAT payments by consuming more VAT exempt goods and services. Usually the amount of the VAT is indicated in the payment document. The organization charging the indirect tax regularly transfers the amount to the government. In case of indirect taxes the consumer — not the supplier of goods or services or the entity that performs the activities – shall bear the burden of the tax. The VAT, the excise tax and the consumption tax are considered as indirect taxes[2].
More often, the indirect taxes have regressive nature, while the direct taxes can have progressive as well as regressive nature. The indirect taxes can have progressive nature if, e.g., food items of the first need that has big share in the structure of the costs of households with low income are exempt from VAT. Indirect taxes most often have regressive nature while direct taxes can be progressive as well as regressive. The indirect taxes can have progressive nature if, e.g., the food of first need that takes substantial amount from the budget of low income families is exempt from VAT. Similarly, the income tax can be regressive, if lower rate is applied to higher levels of income or if some income, e.g., capital gains is exempt from taxation.
In many countries the income tax and the VAT are the two main components of tax system. Based on experience of Latin American countries, Barreix and Roca (2007) recommend paying special attention to the opportunities provided by the income tax. In addition to ensuring revenues, the income tax has a special role in supporting social cohesion because the large part of the amounts being collected as a result of applying income tax is generated from the contributions of tax payers having high income. According to Bird (2009), to have a viable comprehensive PIT system, the developing countries need to expand the tax base which in different countries may mean taxing interest earned on government bonds, taxing non-cash compensation to employees, taxing capital gains, exception of preferences and reducing the volume of unrecorded economy. All governments tend to create favorable tax environment and provide tax preferences. High income countries create favorable tax treatment of research and development (IMF 2015), while low-income countries offer tax preferences and low tax rates. Middle-income countries often create preferential tax zones.
Over the last decades, the PIT rates declined. In Latin America the average top rate on personal income declined from 51% in 1985 to 28% in 2003 (Lora և Cardenas 2006, referred to in Bird 2009). In most of the advanced countries of the Organization of Economic Cooperation and Development (OECD) the tax rates are progressive and high. According to a Report by Deloitte (2017), income tax rates in Japan are progressive (5-45%) and worldwide income including the income earned outside Japan serves as the base.
In XIX century, the flat income tax system was applied almost in all countries. In Hungary, the progressivity was incorporated into the tax system in 1909 during the reforms initiated by Sandor Wekerle, which entered into force only in 1922 (Ambrus 2012). Ambrus recorded that in 2012, the developed countries use progressive tax system. The International Monetary Fund (IMF) carried out a number of researches on progressive and flat taxation. When number of countries shifted to implementation of flat tax rate, the IMF experts (Keen, Kim and Varsano 2006) noticed that discussions about this radical reform concentrate on assertion and rhetoric instead of analysis and evidence. According to authors, the main question is not whether more countries will adopt a flat tax system, but whether those countries that adopted flat tax rates will move away from it.
Other IMF experts (Norregaard and Khan 2007) noted worldwide spread of the VAT and reductions in rates of direct taxes, duties and tax wedge on labor (which is the difference between the gross income and the income received in hand, after deduction of the taxes). At the same time they forecasted that the reduction of the CPT rates and adoption of the flat rates by more countries will continue. However, taking into consideration the need for the revenues, according to Norregaard and Khan, the main issue is about the “equilibrium” level of the rates. Norregaard and Khan also believed that the more countries adopt flat tax rates it will lose its positive impact on the new countries and economic decline at the time of research (2007) will lead to fiscal difficulties forcing some countries to move away from flat tax system.
IMF (IMF 2017) expressed an opinion that the wealthy people don’t pay their fair share of taxes and records that the reduction of rates on high income individuals in 1980s contributed to the decline in progressivity. The IMF considers this trend as a significant factor contributing to income inequality in the US and other high income countries, which is a consequence of reduction of average income tax rate in OECD member countries from 62% in 1981 to 35% in 2015. In 1990s the tax reforms were accompanied by an increase in the exemption threshold that transferred the tax burden on middle class. IMF expressed an opinion that “excessive inequality can erode social cohesion, lead to political polarization and ultimately lower economic growth”.
While considering the rate reduction trend as a consequence of concerns about potential negative impact of progressivity on economic growth IMF publication (IMF 2017) suggests drastic increase of tax thresholds within the progressive system. At the same time it records that according to optimal tax theory the current marginal rates must be higher while we witness a declining trend. Developed economies with low level of progressivity may raise the top marginal tax rates without creating problems for economic growth.
A number of countries having introduced flat taxes faced decline in revenues and problems associated with fiscal balance. The economic crisis in 2008-2009 resulted in drastic decline of revenues in Latvia. In November 2009, the IMF recommended to Latvia to abolish the flat-rate system (Ambrus 2012). While Poland also received a similar recommendation, it refused to move to progressive taxation. Romania, which moved to flat taxation in 2005 asked for a EUR 20 billion assistance from the IMF and started discussions about radical tax reforms, the main component of which was restoration of progressivity of rates on income and corporate profit taxes (Tax Justice Network 2010).
Using OECD data for 1982-2009 Attinasi, Checherita-Westphal and Rieth (2011) concluded that, ceteris paribus, countries with more progressive income tax system have stronger automatic stabilizers[3] which at the time of economic decline can serve as a first line of defense.
The next parts of this section below present issues related to progressive and flat taxation of income and profit, increase of collected revenues by reducing the rates (Laffer curve), other payments and structure of taxes collected in western countries.
[1] To address social issues the government may decide to exempt some goods consumed by socially vulnerable groups of population from VAT. In some European countries child garment is exempt from VAT.
[2] Some economists classify the consumption tax as direct tax. However, it has the same feature as the VAT with an exception that it is paid at the very end of the value chain by the consumer, while VAT is charged at every stage.
[3] Automatic stabilizers are the economic policies that allow offsetting fluctuations in economic activity without government intervention. The income tax and the corporate profit tax, as well as unemployment and social security benefits are the best known automatic stabilizers.
Artak Kyurumyan is an independent researcher and consultant with experience in international development, public policy and administration. He has worked for the Ministry of Finance of Armenia. As an independent consultant he worked in the World Bank, European Union, USAID, DFID funded projects on implementation of medium term expenditure framework, programme budgeting, public debt maangement, etc. He got Master in Engineering degree from the American University of Armenia and an MBA from Tulane University.
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