67969 Fiscal Consolidation and Recovery in Armenia Souleymane Coulibaly transition-related measures, including price liberalization, land privatization and titling, enterprise privatization, and Key Messages1 trade and investment liberalization. This led to a strong  Armenia’s strong economic growth from 2001– economic performance from 2001 to 2007, average annual 2008, when real GDP grew 12.6 percent per year on growth of 12.6 percent, and the tripling of per capita GDP average, boosted living standards and created the to $2,500 USD by the end of the period. The poverty fiscal headroom necessary for the Government to headcount fell from 50 to about 28 percent between 2001 respond to the 2009 financial crisis with a large fiscal and 2007. Prudent fiscal management helped to limit the stimulus. As a result, the fiscal deficit reached 7.6 fiscal deficit to 2.5 percent of GDP or less. Public debt percent in 2009 and helped limit the contraction in shrank from 49 to 16 percent of GDP. real GDP to 14 percent. The 2008 global financial crisis was particularly devastating  With the economy growing again, the stimulus for Armenia. Moreover, its crucial transit route through has to be gradually withdrawn. However, the neighboring Georgia was seriously disrupted by the August retrenchment will need to be designed carefully to 2008 conflict between Georgia and Russia. The economic limit negative impact on growth. crisis caused exports to decline by 33 percent and remittances by 35 percent in 2009. As a result, the economy  Improving the efficiency of all aspects of public contracted by 14.1 percent that year. The Government finances - tax policy, tax administration, and public introduced a large fiscal stimulus, whereby spending rose 13 expenditures - will be crucial to the planned fiscal percent and the deficit to 7.6 percent of GDP, helping adjustment. ameliorate the impact of the crisis on the poor and  With the ratio of tax revenues to GDP lower than vulnerable. The Government reduced the fiscal deficit to 5 that of comparator countries with similar levels of percent in 2010, but public debt was projected to reach 42 income per capita, the brunt of the fiscal percent in 2011. Further fiscal adjustment is needed to consolidation should be borne by an increase in tax reduce Government borrowing requirements, cut public revenues (the lower bound estimated to be between debt, and provide the necessary fiscal space in case of 2.3 and 5.8 percent of GDP). another external shock. Advancing adjustment without jeopardizing growth is now an important priority. Armenia’s Recent Economic History Figure 1: Armenia: Real GDP Growth, Per Capita GDP, Since gaining independence in 1991, the Armenian Inflation and Poverty Trends (1991–2010) economy has experienced extremes ranging from stagflation to overheating (Figure 1). The collapse of the planned 3,650 50 economy followed by heightened exposure to external 3,150 shocks led to volatile real growth. Changes in real GDP 2,650 30 ranged from a contraction of 42 percent in 1992 to a growth 2,150 10 of 14 percent in 2007. Price increases included both modest 1,650 -10 1,150 inflation of 4 percent per year and periods of hyperinflation. -30 The Government’s reform agenda initially centered on basic 650 150 -50 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1 This Knowledge Brief is based on the report, “Republic of Per capita GDP (atlas method, $) (LHS) Real GDP growth, % (RHS) Armenia: Fiscal Consolidation and Recovery,� Report 62587-AM Inflation, % (RHS) Poverty rate (% of total pop) (RHS) (Washington, DC: World Bank, 2011). Thoughtful comments from Ivailo Izvorski are gratefully acknowledged. Source: World Bank WDI data ECA Knowledge Brief Fiscal Consolidation Efforts on the Revenue Side covered by the presumptive taxation regime might be brought under the regular taxation system. In addition, tax Government tax revenues (excluding social contributions) compliance costs should be reduced and the tax privileges rose from 13 percent of GDP in 2001 to 16.8 percent in that entice formal businesses to rely on the informal 2008. However, this number is lower than that for economy eliminated. comparator countries with similar levels of income per capita in Europe, though it is similar or even higher than for Excises and Taxes on the Mining Sector other countries such as Chile and Thailand. From 2004 to 2008, Georgia’s tax ratio increased from 18 to 25 percent of Reform measures dealing with the excise regime and GDP, even as the number of taxes and tax rates were mining sector could have the highest impact. In the short dramatically reduced. Figure 2 compares tax revenues and run, revamping the excise regime could increase tax per capita income in Armenia to some benchmark countries. revenues by between 0.5 and 2.6 percent of GDP, if tobacco With the right reforms in place - notably in tax is brought back to the regular excise regime and all the administration, tax policy, and tax laws - revenues in excise rates are revised up to reflect negative externalities Armenia could rise by 2.3-5.8 percent of GDP. and inflation. Figure 2: Tax Revenue and Per Capita Income in Selected Countries, 2008 Taxes on Armenia’s mining sector are low by international standards. The effective tax rate has declined over the past several years, even though the volume and prices of mineral exports have increased. Furthermore, the old mining tax regime comprising a natural resource user fee (collected by the SRC) and a profit-based royalty (collected by the Concession Agency) has proved ineffective. The new mining tax regime approved by the parliament in 2011 combines the natural resource user fee for metallic minerals and the profit-based royalty into a single royalty that uses sales as the tax base and has a higher sliding scale tax rate to capture windfall profits. These changes will increase tax collection from the mining sector if implemented, adding between 0.4 and 0.6 percent of GDP to the tax revenue currently collected from this sector. Source: World Bank WDI database, OECD, IFS, and staff calculations Revamping Tax Laws The Armenian Tax System A number of recent changes in various tax laws have been The Armenian tax system comprises two parallel taxation identified as revenue-reducing and might benefit from a structures: a regular regime, reflecting contemporary taxes careful review. Some of the old laws may need to be such as VAT, and a presumptive one, covering the bulk of reversed. One good example is the threshold for VAT the informal merchants. VAT is the key contributor to tax exemption for small and medium enterprises; raised in 2009, revenues; the presumptive system, although it solves the it is considered too high by both World Bank and IMF problem of informal taxpayers, yields little revenue. assessments. Enforcing tax laws in the informal economy is difficult and corruption within the enforcement process requires much Fiscal Consolidation Efforts on the Expenditure Side more concerted attention. Government Decree, Nº 1972 of October 8, 2009, provides the basis for an ad hoc anti- The fiscal headroom provided by the growth dividend corruption program, but more needs to be done with the allowed for a steady increase in spending for social security enforcement of the action plans developed since then. services (up from 4.8 percent of GDP in 2006 to 7.9 percent in 2009), in defense (from 3 to 4.2 percent), in general To tap Armenia’s revenue potential fully, the tax public services (from 2.4 to 3.6 percent), in education (from administration system needs rethinking. The State Revenue 2.5 to 3.5 percent), and in public order and law enforcement Committee (SRC) has so far focused on reviewing the (from 1.6 to 2.2 percent). On the other hand, infrastructure returns that have been filed, but its audit function needs to expenditure has been fluctuating between 1.8 and 4.3 be reformed, with a particular focus on reassessing tax percent of GDP, and health expenditure between 1.5 and 1.8 privileges and enforcing tax collection. Some activities now ECA Knowledge Brief percent. Yet, Armenia’s expenditure to GDP remains lower set of essential, generic pharmaceuticals accessible to than that of comparators with similar levels of income everyone at a modest cost would be a good measure, even (Figure 3). though this would increase public health care expenditure. Figure 3: Public Spending and Per Capita Income in Selected Over the medium term, the Government needs to decide Countries, 2009 whether to continue expanding health coverage and reducing out-of-pocket health spending for the general public, or scale back promises and focus on health care for the poor. The first option would require additional funding, and the second that middle- and high-income families pay fully for health care out of their own pockets. Education Spending in Rural Areas Education spending in Armenia is inefficient. Small rural schools, for example, appear to deliver inferior results at a higher cost than their urban counterparts. Since 40 percent of the country’s children attend rural schools, this cost is considerable. The Government needs to take several steps here, beginning with a thorough assessment of the quality of Source: World Bank WDI database, staff calculations rural education. The current per capita financing arrangements might also need to be reviewed to account for Boosting the Efficiency of Public Expenditure the cost difference in the different levels of education. Alternative ways of providing education in rural areas, Public expenditure could be made more efficient, thereby while boosting the low quality of teaching there, might be contributing to the reduction of the fiscal deficit. Overall, explored as well. poorly targeted subsidies should be cut, and reforms to public administration should focus on reducing waste. Maintaining the Road Network However, fair public sector wages and adequate spending on health care and education are critical for nurturing the Finally, too little money goes into maintaining and country’s human capital. Similarly, spending on physical rehabilitating Armenia’s road network. Road maintenance infrastructure such as roads, which help connect products to expenditures were little changed and inadequate at 0.2 the markets, is vital as well. Evidence suggests that percent of GDP per year during the last five years. High- spending more in these sectors may help support the growth income countries with mature road networks in good required for a sustainable fiscal policy. condition normally allocate about 1 percent of GDP on maintenance. Armenia suffers from two problems: road The public sector wage structure needs to be reviewed and standards that are too high for the actual traffic and a lack of reformed. Armenia currently has different public sector road maintenance. High traffic implies high standards; yet remuneration systems that should be harmonized, with a the traffic level in Armenia warrants lower standards than unified grading structure and job classification system. New those currently used by the Ministry of Transport, which performance appraisal and bonus practices could be has cost implications. The two combined result in high costs introduced to end current wage discrepancies; however, this for drivers and the national budget. Reforms are needed to area requires further data collection and analysis before any modify road standards to reflect traffic, adopt performance- reforms are carried out. based contracts that include rehabilitation and maintenance, and ensure adequate maintenance of the most used parts of Rethinking Health Care Spending the network. Armenia also has a high level of out-of-pocket expenditure The policy recommendations for fiscal consolidation and for health care and a high adult mortality rate. In the short their fiscal impacts are summarized in Table 1. term, the Government could expand programs for strengthening health and alleviating poverty, like the landmark Family Poverty Benefit Program. Making a core ECA Knowledge Brief Table 1: Policy Recommendations for Fiscal Consolidation and their Fiscal Impacts Fiscal Imp act Policy M easures Policy Area (as a share of 2010 GDP) Revenue Short Term Revamp the excise regime (bring tobacco to the excise regime, adjust up Tax Policy 0.5-2.6 rates to reflect inflation, introduce VAT pay ment on excisable goods) Revamp the mining taxation regime (combine natural resource user fee and royalty into a single royalty with sales as the tax base and a higher rate on Tax Policy 0.4-0.6 a sliding scale to cap ture windfall profits) Reinforce risk-based audits using regression analy sis (firms with turnover higher than 10 billion AM D tend to underpay VAT, while firms with Tax Administration 0.4-1 turnover between 1 and 10 billion AM D tend to underpay CIT and PIT) M edium Term Identify tax exp enditures, quantify revenue losses and p hase out if Tax Policy not quantified necessary Exp and base to shadow economy by bringing back the presump tive regime Tax Administration 1-1.3 to regular taxation Reinforce ICT infrastructure and build analy tical cap acity Tax Administration not quantified Establish a strong Tax Policy Analy sis Unit in the M oF, closely working Tax Policy not quantified with SRC Introduce a fully functioning Green Channel by default operation of customs clearance, (backed by robust post release verifications, controls, Tax Administration 0-0.3 audits, and investigations) and strengthen customs preventive and enforcement cap acity Exp enditure Short Term Exp and the health poverty package by aligning the score required to that of Healthcare -0.1 the Family Benefit Program (from 30 to 36) Protect the road maintenance and rehabilitation budget at US$110 million Road Transp ort -0.3 M edium Term Reorganize the delivery of educational services in rural areas Education not quantified Harmonize the various public service pay sy stems Wage Bill not quantified Introduce co-pay ment for category II and III disability program Healthcare not quantified Introduce performance-based contracting for road maintenance and Road Transp ort not quantified rehabilitation Source: World Bank staff estimates. The Way Forward order to implement a counter-cyclical fiscal policy in the event of another major economic shock. How quickly the The Government has begun the fiscal consolidation process, fiscal consolidation is done will affect the country’s debt although its heavy reliance on expenditure rationalization trajectory. To grow sustainably, Armenia’s growth strategy may be at odds with the need for stronger growth. The brunt will need to rely less on the domestic market as in the recent of the fiscal consolidation should be borne by tax revenue past and channel its resources to diversify its production and increases. Focusing on a narrow range of revenue sources, export. namely large taxpayers (CIT, PIT, and VAT payments), About the Author customs duties, presumptive taxation, and excise and Souleymane Coulibaly is a Senior Economist for the mining taxation, the potential increase in tax revenue is Poverty Reduction and Economic Management Unit of the estimated to be in the range of 2.3 and 5.8 percent of GDP. Europe and Central Asia Region of the World Bank. Looking ahead, some debt reduction is also desirable in “ECA Knowledge Brief� is a regular series of notes highlighting recent analyses, good practices, and lessons learned from the development work program of the World Bank’s Europe and Central Asia Region http://www.worldbank.org/eca