TAX REFORM IN ARMENIA

Introduction

In a market economy, taxes play an important role—so important that it can be definitively stated that without an efficient tax system, an effective market economy is not possible. The effective functioning of the whole economy depends on how correctly the tax system is built.

Taxation is a major tool by which governments direct and influence how resources necessary for economic and social objectives are allocated. Taxation also plays the role of one of the most important economic regulators. 

Furthermore, the importance of a tax policy is due to the fact that taxes are a major source of governmental funds, and every government must rely on taxes to finance all or part of its operation and spending. Thus, one of the most important objectives of taxation is to generate sufficient revenues. 

Meeting this objective has become very important in countries in transition. Many socialist countries have experienced serious budgetary problems. Tax reform was needed to meet the revenue needs of government budgets in the transition period and to achieve macroeconomic stabilization. 

Tax reform was needed not only for achieving this stabilization and revenue raising in transition, but also because tax reform actually facilitated and support many other economic reforms necessary for economic restructuring. 

Implementing tax reform engendered enormous technical and informational, not to mention political, difficulties in all countries. Transition processes are not simply reforms, but abstruse changes in systems that affect nearly all spheres of social life—cultural, moral, psychological, sociological, economic and political. These changes involve painful contradictions between old and new mechanisms: shocking situations and general instability. 

In this paper we will look at tax reform in Armenia, explore the changes that took place in tax policy from 1992 to the present and underline existing problems, especially in tax administration, that hamper achieving optimal tax performance. In conclusion, we will try to assess the degree of overall success of tax reform in Armenia. 

Literature Review

Over the past ten years there has been a virtual revolution in applied taxation in the countries of the former USSR and Eastern Europe. In their attempt to catch up with western economic systems, there has been an considerable interest in implementing some of the aspects of tax systems found in market economies, although their economies demanded a system of change which is much more fundamental (Hussey and Lubick).
The fundamental tax reform required junking old tax systems and replacing them with completely new tax laws and regulations. It required the creation of a new system of taxation of both companies and private individuals: that is, physical and juridical persons. 
Reformation of tax systems was needed for three reasons.
•	First, because the tax systems that had existed in socialist countries were completely incompatible with a market-oriented economy. Indeed, they were not even tax systems in the usual sense (Gandhi and Mihaljek 1995);
•	Second, since the break-up of the Soviet Union in December 1991 deficit financing has been one of the most serious problems for financial stabilization. Tax reform was the only way to ensure that budget deficits were able to be financed without undermining overall macroeconomic stability (V. Gandhi and Mihaljek 1995);
•	Third, tax reform, being itself a part of the minimum package of simultaneous reforms, also facilitates and supports many other economic reforms, such as price reforms, financial and external sector liberalization, labour market reforms, etc. (Gandhi and Mihaljek 1995).

A major theme of tax reform has been the widespread adoption of VAT. The popularity VAT is due to its well-known characteristic that, in its ideal form, it is the least distorting type of broad-based consumption tax. At the same time, has a built-in self-enforcing mechanism (Tait 1995). Furthermore, its record of generating large amounts of revenues quickly, and in comparatively painless fashion, has given it a reputation of a money machine.

The tax-credit type of VAT has three principal advantages over single-stage retail and non-retail sales taxes in limiting the scope for evasion. First, VAT is self-policing to some extent because underpayment of the tax by a seller (except, of course, a retail firm) reduces the tax credit available to the buying firm. Second, crosschecking of invoices enables the tax administration to match invoices received by purchasers against those retained by sellers. This crosscheck ability is a valuable aid in audit activities, though not a substitute for a true, systematic audit. Third, the fact that a large share of VAT is collected prior to the retail level is an advantage, particularly because in most transitional countries an abundance of small-scale retail firms do not keep adequate records (Gillis et al 1992).

The tax system plays also important role in regulating capital flow and attracting investment, which is crucial for increasing production and—consequently—economic growth. In more integrated financial markets, the allocation of resources is more sensitive to differences in national tax rates. Differences in tax systems between countries can result in capital flow affecting both the location of investments and ownership of capital (Andersson 1995).
In order to stem capital outflow, and also to direct private investment into priority areas, governments selectively offer substantial tax incentives to investors, such as tax holidays and tax credits for investments. But by far the most effective tax incentive is lower tax rates for all firms (Gillis et al 1992).

Reasons for preferring lower tax rates on broader income tax bases are not difficult to find. 
•	First, income taxes imposed at high marginal rates are not administrable. With high marginal tax rates, the incentive to avoid taxes is very high. Faced with high income tax rates, taxpayers everywhere tend to react in three ways: (1) they evade taxes by concealing their income, particularly capital income not subject to withholding arrangements; (2) they avoid taxes by altering economic behaviour to reduce tax liability, whether by supplying fewer labour services, shipping capital to tax havens abroad or hiring lawyers to find loopholes in the tax law; and (3) they bribe tax assessors to accept false returns;
•	Second, the growing mobility of capital across international boundaries has meant that the risk of capital flight from a particular country increases when that country’s top rates of income tax exceed those prevailing in industrial nations, where tax rates have been falling;
•	Finally, high marginal rates on income tax have not proven to be particularly effective in correcting severe inequalities in income distribution (Gillis et al 1992).

To stem the outflow of capital and create a favourable for investment conditions, more than tax rates have to be taken into account. Even more important are the overall macroeconomic conditions and the stability and transparency of rules and regulations. The tax system can support this by allowing general, rather than specific, provisions. This ensures that the revenue base is not eroded, a condition that inevitably leads to destabilizing tax changes in the future. Also, the tax system should be transparent to the investor, with no scope for a negotiated settlement of tax liabilities. Once institutions are established and markets are integrated, the tax system may play an increasing role in the ability of these countries to attract capital and promote adequate domestic levels of saving and investment (Andersson 1995).

It is important to keep in mind that any tax system ultimately has its performance limited by the administrative capabilities—legislation, enforcement, collection, human resources and record keeping—of the country that adopts it. This points to the importance of highlighting the administrative needs of long-term tax systems, and making adequate preparations for them well in advance of their actual implementation (Jantscher et al 1995).

It is also important to note that tax administration is a significant option for increasing tax revenues. Changes in tax administration permit more taxes to be collected form existing tax sources, even at unchanged tax rates. The potential for increased revenues from such actions is very large in virtually all countries in transition, although seldom realized. The reasons for this include shortages of well-trained tax administrators, excessively complex tax laws, corruption and outdated tax administration techniques. These combine to make tax evasion one of the most intractable problems of economic policy in countries in transition (Gillis et al 1992).

Methodology

This study has several purposes: first, to look at the dynamic of tax revenues and budget deficits from 1992 to the present in order to assess the success of tax reforms; second, to describe the present tax situation in Armenia; and third, to underline some problems of tax reform, especially in tax administration, that are hampering the achievement of an optimal tax performance. Given these purposes, the study involves elements of both explorative and descriptive research.  

In this study we will try to answer to the following research questions:
•	What have been the main directions of tax reform in Armenia?
•	What legal changes occurred that reflect tax reforms?
•	What was the dynamic of tax revenue during the specified period of time?
•	What was the dynamic of budget deficits during the specified period of time? 
•	What is the tax performance in Armenia presently?
•	What problems hamper optimal tax performance?

To answer these questions we will analyse existing statistics. The sources of the statistical data are the following: the draft of CEE/NIS Fiscal Review and Assessment by Barents Group LLC; Report on Fiscal Sustainability and Fiscal Indicators in Transitional Countries by Barents Group LLC; Statistical Report; and Armenia. Economic Trends. We will also analyse changes in the laws, reflecting directions of tax reform. The subject of the analysis in our research is tax policy, while units of observations are statistical data and laws.  

Before describing how we will answer these questions, and what indicators we will use to measure tax performance, we shall define what we mean by the ‘success’ of the reform and what it means to achieve optimal tax policy.
 
Given the role of taxes in transitional economies, we understand the optimal tax policy as one that maximizes economic growth and minimizes tax evasion. Therefore, to assess the success of the present tax system we will look at the ability of the system to produce large amounts of revenue, which ensures the macroeconomic stability necessary for the economic growth. To assess the success of raising revenues it is useful to look at the budget deficit, because (we assume) the optimal tax policy will reduce the budget deficit. But since revenues constitute only one variable in the budget deficit, we will also look at a second variable—expenditures—to avoid spurious relations. To measure tax performance, the following indicators have been chosen: those focusing on the level of taxation, those covering tax structure, and those that exhibit specific characteristics of taxes. 

Indicators of tax policy

•	Ratio of tax revenues to GDP. The tax-GDP ratio is likely to be among the most important indicators of tax policy. The overall tax ratio is in many ways the single most significant indicator of national fiscal development and revenue performance.
•	Ratio of budget deficit to GDP. This indicator is needed to see how changes in tax revenues affect (if they do) the budget deficit, and thus to assess the success of tax policy.
•	Ratio of expenditures to GDP. This indicator is important to assure that the relation between changes in tax revenues and the budget deficit is not spurious. 
•	Tax buoyancy. This indicator provides us with probably the single meaningful measure of overall ‘tax effort’. Tax buoyancy is the change in tax revenues compared to the change in GDP over the same period. 
•	Coefficient of variation of annual buoyancy numbers. This provides a useful indication of the stability of tax performance. 
•	Ratio of direct taxes to indirect taxes. The ratio of direct/indirect can give us estimates of the importance of VAT, since VAT is the most important indirect tax. This information can also be assumed to reflect the degree of modernisation of the tax system, because the modernity of the tax system may be measured to some extent by the importance of VAT, since the old revenue system relied heavily on enterprise taxes. 
•	VAT efficiency ratio. This is a measure of VAT performance: VAT revenues as percent of GDP over the standard VAT rate. 
•	Top marginal rates of personal income tax and corporate income tax. Another way of assessing the ‘growth-friendliness’ and ‘investor-friendliness’ of a system is to use marginal tax rates. Moderate tax rates on broad bases are, as a rule, more conducive to both simplicity and efficiency—and thus to growth and investment—than higher rates on narrower bases. 
•	Relative size of the basic exemption. This can give us a rough estimate of the ‘depth’ of tax coverage, in the sense of how deeply it reaches into income distribution. The relative size of the basic exemption is measured by the ratio of exemptions to GDP per capita.

Tax administration is a factor of extreme importance for the optimal tax system. Therefore, we will look at several indicators of tax administration. 

Indicators of tax administration

•	The degree of computerisation of the tax administration. The degree of computerization is an indicator of the modernity of the tax administration. This is important, as one of the challenges of transition is the shift from a reliance on manual to computerized systems.
•	The ratio of registered taxpayers to total population. This ratio may give a rough idea of the efficiency of the tax administration. 
•	The size of the tax gap. The bottom line with respect to tax administration in many ways is the size of the ‘tax gap’, the difference between the potential tax revenue if all taxes were fully enforced and the actual taxes collected
•	The corruption index. This indicator helps in assessing the size of the tax gap.   
•	The size of the hidden economy as a percent of GDP. This is another helpful indicator to assess the size of the tax gap. 

Since no ‘ideal’ or optimal level of taxation can really be calculated, it may be useful for some purposes to compare measurements of tax performance in Armenia with relevant data from other, formerly centrally-planned countries. For this comparison we will use data provided by the Barents group LLC. In the data provided by Barents group LLC, the countries are grouped in two groups. In our comparisons we will follow the same grouping. 
The first group, will be referred to as the NIS group. It includes the countries of the former Soviet Union except the Baltic states. The countries of this group are: Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine and Uzbekistan. 
The second group, referred to as the CEE/NIS group, includes countries of the first group plus countries of Central Eastern Europe and the Baltic states. The countries of this group are: Albania, Armenia, Azerbaijan, Belarus, Bosnia, Bulgaria, Croatia, the Czech Republic, Estonia, Georgia, Hungary, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Macedonia, Moldova, Poland, Romania, Russia, Slovak Rep., Slovenia, Tajikistan, Turkmenistan, Ukraine and Uzbekistan. 

Analysis

Armenia has been implementing an independent tax policy since 1992, when new principles were set forth. In fact, the whole sphere of taxation was renewed, with new laws pertaining to VAT, revenue tax, and income tax adopted. While speaking about tax reform we should first of all consider the creation of a new tax system. The old, centrally planned tax system, as was mentioned above, was not tax system in the usual sense. Essentially it did not tax individuals (or households) as such, but instead financed state expenditure by, in effect, diverting some enterprise profits to the government budget as they flowed though the banking system. 

The diversion of enterprise profits was organized through a system of norms (obligatory contributions) set for the enterprises, which in practice were not only extremely differentiated, but also very often subjective. Instead of being integral, the requirements were adjusted to the capacities of each company. Moreover the size of the norms depended greatly on the relations with bureaucracy officials, rather than on objective conditions and requirements. This meant that the tax system of a command economy had no clearly defined, transparent, commonly recognized legal tax base or commonly applied tax rate structure.

Thus creation of a new tax system replacing system of norms was a necessary step in removing subjectivity and voluntarism from the relations between the state and companies, since no business activity can develop effectively where relations with the state and budget are not strictly defined, but depend on somebody’s will and change from case to case. 

So with creation of a tax system there was a shift from what may be broadly called ‘enterprise’ to ‘personal’ taxes: that is, taxes paid by households explicitly (e.g., through a personal income tax) or implicitly (through VAT). 

The tax policy aimed at reducing the pressure of direct taxation in order to create supportive conditions for the development of the private sector and to promote savings. These objectives, as well as the fact that sectors such as agriculture and small-scale private sector enterprises are difficult to tax directly, contributed to the shift from direct to indirect taxes. This increased the importance of enhancing the yield from indirect taxes, which became the main contributions to the state budget (see Graph 1).

Source: Peculiarities and Stages of Economic Reform in Armenia. 1991-1998. Statistical Manual. (For details of the dynamics of the Structure of Tax Revenues see Table 1.)

While speaking about the shift from direct to indirect taxes it is important to mention the introduction of VAT (as well as further adjustments facilitating its efficiency), as VAT has became the most significant tax contributor, at 6.9% of the GDP in 1999. (Source: Armenia. Economic Trends). VAT was introduced in Armenia in 1992 with a standard rate at introduction of 28%, later reduced to 20%. Furthermore, the VAT threshold was introduced in July 1997 to encourage small and medium business. Prior to this there was no threshold for legal entities and the only threshold applied to physical entities. Physical entities were not required to charge and collect VAT on their taxable sales if their turnover was no more than 75 times the minimum wage (Davis et al 1995).

At its introduction the threshold was equal to AMD 1 million. This meant that businesses were not considered to be VAT taxpayers if their revenue from taxable transactions during the year preceding each quarter did not exceed AMD 1 million. This policy was continued—in the next year, 1998, the threshold was increased to AMD 2 million. In 1999 the threshold was further increased by 1 million, and has remained at AMD 3 million. (Overview of the tax system of Armenia 1999). 

A positive development in facilitating the efficiency of VAT was the adoption of the Law on Value Added and Excise Tax, which came into effect on July 1st, 1997. This law helped simplify the treatment of imports and exports by shifting totally to the destination principle. Previously, Armenia had a dual VAT system, which treated NIS-traded items according to the origin principle and non-NIS trade according to the destination principle. That is, for NIS countries imports were zero-based and exports were taxed. In the case of non-NIS countries, imports were taxed and exports were zero-rated. According to the new law, VAT is assessed according to the destination principle on internationally traded goods and services; i.e. imports are taxed while exports are zero-rated. 

As a consequence of reducing direct taxes and introducing indirect taxes, the portion of direct taxes as a percent of total taxes decreased by half from 1993 to 1997, from 60% to 29%. (Source: Fiscal Sustainability and Fiscal Indicators in Transitional Countries. Barents Group LLC) This trend continued, and in 1999 the share of direct taxes in total tax revenues remained relatively small (24%), while VAT and excises together accounted for 56% of total tax revenue. (Source: Armenia Economic Trends) 

The change in the ratio of direct to indirect taxes and shift from direct to indirect changes indicates the growing importance of VAT and the modernization of the tax system. But although the VAT has become the major contributor to the GDP, the VAT efficiency (the share of GDP collected for each percentage point of the standard VAT rate) in Armenia remained low. It is at 0.2, while the average countries of the NIS group have a rate of 0.3 and the CEE/NIS countries have an average of 0.46 (see Table 2). This can be explained by the fact that, although all countries that had formally and centrally planned economies have approximately the same rate of VAT (20%), the coverage of VAT varies widely from country to country. 

The main reason for the difference in coverage is the proliferation of exemptions. The proliferation of exemptions in law not only narrows the base, but also makes proper enforcement more difficult. Withholding and verification also creates problems where the tax base is ill defined and there are many exemptions and deductions.

Here we should note that beginning from June 1997 the power of the government to give exemptions was ended. Now exemptions are given only by law and not by governmental decree. This seems to be a positive development, since the proliferation of exemption outside the tax law was of special concern.

In Armenia, a number of steps were taken to reduce the number of exemptions: in November of 1994 exemptions from VAT were removed. This includes gas, electricity, communications and telecommunications, transportation (all but tram, trolley bus and metro), as well as the provision of food to workers and students and cultural, educational and leisure activities. VAT on the turnover of gaming machines and racetrack winnings has been replaced by a 50 percent special tax. The government removed exemptions for sugar, edible oil, and butter as of July 1, 1995, and for water and sewage as of September 30, 1995 (Davis et al 1995).

Despite these changes, a significant number of VAT exemptions still remain (24), including the following: transportation services by urban passenger electric transport; education payments for secondary, professional, and high schools; scientific research work; agricultural produce in Armenia; products and services imported to Armenia for humanitarian and charitable purposes (Overview of the tax system of Armenia 1999).

The situation is approximately the same with personal income tax and the enterprise profit tax. In order to broaden the tax base, a number of exemptions were also eliminated from personal income tax and the enterprise profit tax. Nevertheless, the ratio of PIT Exemption/GDP per capita is higher in Armenia (0.37) than in countries of the NIS group (0.3) and the CEE/NIS group (0.27) (Fiscal Sustainability and Fiscal Indicators in Transitional Countries. Barents Group LLC).

To broaden the tax base, not only have exemptions been removed, but also the tax rates on profit and income tax have been cut. This was done not only to ease the tax burden on the general population, but also to create favourable conditions for investment. In general, countries that attempt to impose substantially heavier taxes on capital income often experience outflows of capital to countries with lower tax rates on capital. In this respect, Armenian legislation is milder than that of other CIS countries; the top margin rates of personal income tax (PIT) and corporate income tax in Armenia are lower than the average of the other countries. According to 1998data, top margin personal income tax in Armenia is 30% (the NIS group average is 34%, the CEE/NIS group average 35%). Armenian corporate income tax is 25% (the NIS group average is 30%, the CEE/NIS group average also 30%) (Fiscal Sustainability and Fiscal Indicators in Transitional Countries. Barents Group LLC).

Although tax rates play important role in creating favourable conditions for investment, their proper, objective and consistent enforcement is even more important. Here it is worth mentioning that the main concern of foreign investors has been not the tax burden, but the general instability of the tax system and its frequent amendments. In addition, there has been fear that there will be unpredictable changes in the tax system in the future, because within the existing framework, companies are very often not sure whether they will have problems with state inspection bodies. The reason for this is the fact that tax legislation in Armenia, from the moment of its formation, was subject to frequent changes. This can be explained, first of all, by the general political and macroeconomic instability, which produced a constant need for revising legislation and adjusting it to existing conditions. Secondly, legislation could not be satisfactory in the long run, as it had been made in the style of the Supreme Council of the Soviet Union with the acquisition of some normative documents on the basis of recommendations from international organizations. Furthermore, over the short term—that is, for a society that taking its first steps in creating property—the legislation was too ponderous. In addition, it very often included many laws that were artificial and regulations that contradicted each other. This by itself made the relatively undeveloped tax administration even more difficult to carry out. 
 
Apart from ambiguous tax laws and amendments, the tax administration in Armenia has faced a large number of problems: 
•	The lack of professionals. Here particular attention should be paid to changes in the roles of tax inspectors. From simple verification of transfers, they have shifted to more challenging compliance activities—auditing—that demand entirely new skills and abilities from the tax officials and a totally different operational strategy from the tax administration. The lack of professionals has contributed to a weak, underdeveloped level of auditing, where the goal of new tax audits has become to detect underreporting of taxes. 
•	The lack of computerization. Though the information is collected on computers in the districts, there is little systematized analysis of the data. Each district maintains its own computerized list of taxpayers, but there is no central master file of all taxpayers in the republic. This exposes the individual districts to risks like possible destruction of their files due to power failures. The file of registered taxpayers is not updated to clearly distinguish those enterprises that are currently active from those that are temporarily inactive or those that are permanently out of business (Davis et al 1995). 
•	A low level of accountancy. The accounting standards adopted in the Soviet system were incompatible for a market economy, and the introduction of new accounting standards has been slow and prolonged.
•	The shadow economy. The size of the shadow economy in Armenia is larger than in the NIS or CEE/NIS group, according to 1996 data. If reckoned as a percentage of GDP, Armenia has a rate of 52%, the NIS group has 39% and the CEE/NIS group 28% (see Table 3).

These problems, together with weak enforcement and low wages for the tax inspectors create an environment conducive to corruption, where small volume quick cash turnovers make it possible to avoid taxes. This necessarily leads to a decrease in the overall efficiency of the tax administration. A rough indicator of this is a low ratio of registered taxpayers to the total population (in Armenia 0.04, whereas the average for the NIS and CEE/NIS groups is 0.16). Another factor is a decrease in tax collection, an indicator of which is the size of the ‘tax gap’, the difference between the potential tax revenue if all taxes were fully enforced and the actual taxes collected. Data from 1998 indicates that this level in high in Armenia, at more than 35% (see Table 3).

Here we should also mention accumulating tax commitments. At present Armenia is experiencing significant shortfalls in direct tax revenues due to non-compliance. Enterprises often premeditatedly hide the real volume of their production in their reports, which lead to tax derelicts and tax avoidance. The more important the hidden economy is, the harder it is to enforce taxes properly and the larger the ‘tax gap’ is likely to be. 

The volume of tax commitments has impacted directly on the level of GDP and the budget deficit. In the first half of 1999, the net flow of arrears accounted for 3.2% of GDP, while one year ago this ratio was 1.9%. According to data from the Tax Inspection of RA, tax commitments comprised 86.7 billion drams as of January 1, 1999. The pace of accumulating arrears is alarming. The tax arrears were 35.6 billion drams, an increase of 89.2%, in comparison with 1997. In the total amount of arrears, VAT has the greatest share (49%) (Peculiarities and Stages of Economies Reforms in Armenia).

When we turn to the dynamic of total revenues we will see that in 1991 revenues constituted 29% of GDP. With the introduction of the new tax system in 1992, this sharply declined to 20.3% of GDP. This happened because old sources of revenues came under stress, while the new sources of revenues took time to develop. Furthermore, measures to decrease tax evasion also do not promise quick fixes to the revenue problem. Over the next few years, revenues continued to fluctuate until 1996, when they began stabilizing and slowly increasing, though not reaching the level of 1991 (see Graph.2).   

Source: Peculiarities and Stages of Economic Reform in Armenia. 1991-1998: Statistical manual. 

This dynamic of total revenues is mostly conditioned by the dynamic of tax revenues, but it is also caused by changes in non-tax revenues From 1993 to 1997, the coefficient of the variation of annual tax buoyancy was 1.12—that is, the average changes in taxes (20%) and GDP (18%) were almost the same. The percentage of tax revenues to GDP was rather stable and equalled on average 12% if payroll taxes are excluded, yet the percentage of total revenues to GDP declined (Fiscal Sustainability and Fiscal Indicators in Transitional Countries. Barents Group LLC). This can be explained by changes in the non-tax sectors of revenues, revenues that rapidly decreased during this period: from 1994 to 1997 revenues from grants decreased approximately ten times, from 11.8% to 1.7% (Human Development Report. Armenia. 1998). 

From 1996 we can observe a gradient increase in revenues as a percent of GDP. State Budget revenues increased 4.5% in 1996 compared to 1995; by 34.7% in 1997 compared to 1996; and by 33.6% in 1998 compared to 1997 (Peculiarities and Stages of Economic Reforms in Armenia). This increase in revenues is mainly caused by the increase in tax revenues, because non-tax revenues for this period did not fluctuate that drastically (see Graph 3). 

Source: Armenia Economic Trends 2000 (for the details of tax and non-tax revenues see Table 4).  

Source: Armenia Economic Trends. April-June 1999
The increase in tax revenues, and thus total revenues, had a positive impact on the development of the budget deficit. Here we should bear in mind that even 100% tax collection cannot ensure the absence of a budget deficit, since only one half of the budget deficit depends on revenues, with another half depending on expenditure. 

Looking at the dynamics of the budget deficit from 1995-1999 we can see that for the first two years (1995-1997) reductions are caused by both a decrease in expenditure and the relative stability of revenues. During the second period (1997-1999), we should note that although expenditures have increased, the budget deficit continued to decrease. This should be definitely attributed to the steady increase in revenues, which could support an increase in expenses and keep down the budget deficit (See graph 4).

The increase in total revenues and the decrease of the budget deficit to a rather significant extent can be influenced by improvements in tax policy and successes in tax reform. However, a high ‘tax gap’ and large, accumulating arrears suggest that collection could have been much higher than it actually was.

Conclusions 

As we have seen, the tax policy of Armenia has undergone substantial changes from 1992 to the present. In actuality, a new tax system was created. The changes included a shift from ‘enterprise’ to ‘personal’ taxes, from direct to indirect taxes, a reduction in exemptions, a decrease in tax rates and simplifications of procedures. 

The main directions of tax reform were aimed at raising more revenue in the short term, ensuring the tax burden was distributed equally, broadening the tax base to reflect the changing structure of the economy, easing the tax burden on the general population, creating favourable conditions for the development of the private sector and furthering the ongoing adaptation of the tax structure to fit a market economy.
 
Tax reforms have brought some success. Evidence of it can be seen in increased revenues during this time period, which contributed to the reduction of the budget deficit. This was possible because of substantial improvements in tax revenue collections. But we should note that with the increase of revenues, increases in tax arrears also took place, implying that there is still much room for improvement. 

This is reflected in the ratio of taxes to GDP, which still remains lower than in other formally planned countries. In 1997, revenue as a percentage of GDP was 17% in Armenia, whereas the average for the NIS group was 25% and for the CEE/NIS group was 32%. The percentage of revenues to GDP in Armenia is half that in countries like Estonia, Latvia or Poland (see Table 5). This low ratio can be explained by a number of reasons: many exemptions, which narrow the tax base; the proliferation of special incentives, which complicate tax administration. One of the biggest set of reasons comes from problems in tax administration, ranging from such trivial ones as a lack of equipment to major ones such as the large size of the hidden economy, a high level of corruption, weak enforcement powers, a lack of professionals, weak audit functions and a lack of systematized computer systems. 

To improve the situation, the first thing to do is to make the existing taxes more transparent and stable. The tax system should facilitate—rather than complicate—compliance and tax administration. This is best supported by adopting relatively simple taxes, with low rates, broad bases and few exemptions. A pyramid with a broad base and a narrow apex represents a tax administration that has been relatively successful in fostering voluntary compliance as well as in creating an environment that is conducive to investment. Not only must the tax system be transparent and free from ad hoc decisions, but it must also remain stable for the foreseeable future. This will simplify and improve tax compliance and tax administration, and will also facilitate investment, since domestic and foreign investors need to know what their various tax liabilities will be when they undertake specific investments. 

Tax compliance must be created, cultivated, monitored and enforced. To a considerable extent, tax compliance depends upon the perceived ability of the tax administration to detect and penalize tax violators. But it is also important to facilitate voluntary compliance. Here people’s perception about the fairness of the system is very important. For these reasons the tax authorities need to strengthen enforcement efforts, applying sanctions fairly and with sufficient publicity, because much depends upon the consistency with which the state penalizes those who ignore the rules, which in this case means avoiding taxes. But voluntary compliance cannot succeed where taxpayers find it hard to calculate their obligations correctly, as is the case when laws change frequently, are not clearly explained and, in all too many cases, are not administered properly. 

This means that in order to raise revenues, Armenia’s tax policy should further expand the tax base, through eliminating exemptions and decreasing tax rates, as well as increasing the efficiency of consumption-based taxes, which are more favourable for private savings growth than are income-based taxes. Policy should also aim for long-term goals, simplify procedures and legislation, make the system more transparent and facilitate voluntary compliance. To sum up, the system should become more incentive-enhancing and equity-improving, and promote further compatibility with market economies. 

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Patker.com. “Wealth and Corruption.” URL: http://www.patker.com/elections99/eng/problems.html.

Roberts, B. W. (1999). Armenian Fiscal Developments in the First Half of 1999. USAID Tax and Fiscal Reform Project.

Tax Inspectorate of Armenia: Educational Methodical Centre. Overview of the Tax System of Armenia. (1999). Yerevan.

Tait, Alan A. (1995). “Introducing Value-Added Taxes.” In V. Tanzi (ed.), Fiscal Policies in Economies in Transition. International Monetary Fund.

Table 1
Table 1: Dynamics of the Structure of Tax Revenues

	1991	1992	1993	1994	1995	1996	1997	1998	
Indirect taxes	0	39.5	24.4	20.7	20.6	33	42.1	44.9	
1. VAT		32.5	19.8	17.7	18.1	21.6	28.3	33.7	
2. Excise tax		7	4.6	3	2.5	11.4	13.8	11.2	
Direct taxes	26.5	43.8	24.7	45	32.7	25.9	23.6	15.6	
3. Profit tax	11.2	32.4	18.4	36.7	25.4	16.9	12.7	7	
4. Income tax	15.3	11.4	6.3	8.3	7.3	9	10.9	8.6	

Source: Peculiarities and Stages of Economic Reform in Armenia. 1991-1998. Statistical manual

Table 2
Table 2: VAT Indicators

Country	Standard VAT rate, 1999
(%)
	Year of VAT introduction	Standard VAT rate at introduction
(%)	VAT as % of GDP, 1997
	VAT Efficiency (VAT as % of GDP/VAT rate, 1998)	
Armenia	20	1992	28	4	0.20	
Azerbijan	20	1992	28	4	0.22	
Belarus	20	1992	28	10	0.48	
Georgia	20	1992	28	4	0.19	
Kazakhstan	20	1992	28	7(98)	0.36	
Kyrgyz	20	1992	28	6	0.29	
Moldova	20	1992	28	10	0.50	
Russia	20	1992	28	4(98)	0.21	
Tajikistan	20	1992	28	2	0.08	
Turkmenistan	20	1993	28	8	0.42	
Ukraine	20	1992	28	8	0.42	
Uzbekistan	18	1992	30	8	0.38	
Mean for NIS group	20		28	6	0.31	
Croatia	22	1998	22	17	0.78	
Czech R.	22	1993	23	7	0.32	
Estonia	18	1992	10	10	0.54	
Hungary	25	1988	25	8	0.30	
Latvia	18	1992	14	9	0.49	
Lithuania	18	1994	18	9	0.49	
Poland	17	1993	22	8	0.37	
Slovak R.	23	1993	23	8	0.37	
Slovenia	…	1999	…	14	0.69	
Albania	20	1996	13	14	0.69	
Bosnia	…	…	…	…	…	
Bulgaria	20	1994	18	6	0.28	
Macedonia	…	1999	…	…	…	
Romania	18	1993	18	5	0.21	
					0.46	
Overall mean	20		23	8	0.39	

Source: Fiscal Sustainability and Fiscal Indicators in Transitional Countries. Barents Group LLC 

 Table 3

Table 3: Tax Administration Indicators

	Armenia	Mean for NIS group	Mean for CEE/NIS group	
Computerization of Taxpayers Accounts	No			
Number of Registered Taxpayers/Total Population	0.04	0.16	0.16	
Personnel Appraisal System 	No			
Tax Gap, 1998	High			
Size of hidden economy as% of GDP, 1996
	52%	39%	28%	

Source: Fiscal Sustainability and Fiscal Indicators in Transitional Countries. Barents Group LLC 

Table 4

Table 4: State Budget Revenues by Major Source 
(including the Central Government and Local Authorities accounts)

	1995	1996	1997	1998	1999	
Tax Revenues	10.7	10.6	13.3	14.3	16.8	
Enterprise Profit Tax	4.6	2.5	2.1	1.3	2.2	
Personal Income Tax	1.3	1.3	1.8	1.6	1.9	
VAT	3.3	3.3	4.7	6.2	6.9	
Excise Tax	0.5	1.7	2.3	2.1	2.2	
Customs Duties	0.5	0.9	1.3	1.1	0.8	
Other Taxes	0.6	0.9	1.2	2.0	2.8	
o/w Local Government Taxes	0.4	0.5	0.5	0.5	0.5	
Non-Tax Revenues	3.4	3.0	1.4	2.6	2.0	
Profits from the Central Bank	2.3	1.7	0.7	0.8	0.6	
Local Government Non-Tax Rev.	0.3	0.3	0.2	0.3	0.3	
Other Non-Tax Revenues	0.9	1.0	0.5	1.5	1.1	
Grants	3.6	1.5	1.8	1.7	1.5	
Total Revenues and Grants	17.8	15.1	16.5	18.5	20.3	

Source: Armenia Economic Trends 2000

Table 5

Table 5: Revenues as % of GDP, 1997

Country	Percent	
Armenia	17	
Azerbaijan	17	
Belarus	41	
Georgia	10	
Kazakhstan	23	
Kyrgyz	18	
Moldova	34	
Russia	33	
Tajikistan	12	
Turkmenistan	29	
Ukraine	38	
Uzbekistan	30	
Mean for NIS group	25	
Croatia	47	
Czech R.	41	
Estonia	39	
Hungary	45	
Latvia	39	
Lithuania	34	
Poland	44	
Slovak R.	42	
Slovenia	45	
Albania	16	
Bosnia	Info not available	
Bulgaria	32	
Macedonia	42	
Romania	27	
Overall mean	32	
Standard deviation	11	

Source: Fiscal Sustainability and Fiscal Indicators in Transitional Countries. Barents Group LLC