Monday, January 08, 2007

Tax Holidays

2007 is the last year when new investments by foreign firms qualify for tax holidays in Armenia. Firms investing a minimum of 500 million Drams (1 USD=365 Drams) benefit from 100 percent forgiveness from the profit tax in 2008 and 2009.

Profits in Armenia are taxed at a flat tax rate of 20 percent, except for firms engaged in agriculture which are exempt. Generous depreciation allowances further reduce the effective tax rate that businesses face. Hotels, for instance, are depreciated over 10 years; 20 years for other buildings. Computers are expensed, and so are investments in structures in the earthquake zone, as well as all investments in Gyumri, Armenia's second largest city and also in the earthquake zone (see here and here for depreciation rates). These allowances have the effect of reducing the effective tax rate on normal profits to zero in Gyumri, and generally to much less than 20 percent for the rest of the country.



Source: Taxes, Investment Incentives, and the Cost of Capital in Armenia

Tax rates, both statutory and effective, are quite low. Even if these low rates are not sufficient incentives, the current tax holiday strikes me as too expensive a tool for a small and impoverished country like Armenia. Consider the case of Armentel, the second largest taxpayer in Armenia (I am not picking on this firm -- it just turns out that it is the most transparent firm operating in Armenia with readily available financial statistics). In 2005, this firm earned pre-tax profits of Euro 49.9 million off gross revenues of Euro 119.1 million. It booked an income tax of Euro 4.9 million, or 10 (and not 20) percent of its taxable profits (see here). Surely this highly profitable firm is able to pay more.

Not only one would object to this tax break on grounds of equity and fiscal soundness, but also object to it on the grounds that it is not directly related to the marginal investment put in place. Consider the case of a firm with pre-tax profits of Euro 10 million. By investing slightly over one Euro million, this firm is able to slash its tax bill by 2 Euro million. The government has cut back in the past on this form of subsidy. Firms with investments put in place in 2002, for instance, were accorded 100 percent exemption in 2003-2004, and 50 percent for tax on 2005 and 2006 profits (see here).

The existing accelerated depreciation provisions act as investment tax credits (they are equivalent), and already provide for targeted investment incentives. Would Armenia be better off with the tax holidays extended?

Are there any statistics on the amount of revenue loss to the government? This has to be in the tens of USD millions. Also, do we know who benefits from this tax break? Is anyone writing on the subject?

5 comments:

Anonymous said...

Even the IMF recommended the Armenian government to allow tax holidays for foreign investors to expire (see http://www.imf.org/external/np/sec/pn/2006/pn06138.htm)

I think this will benefit the Armenian economy by expanding the tax base and therefore increasing the revenue/GDP ratio which currently does not keep up with the high GDP growth rates. The question is whether these revenues will be put into beneficial use by the government (financing education, social services etc.).

nazarian said...

One should not forget that Armenia is a risky place to do business. The low taxes on investments is the premium that the government pays for those investments. Had these tax laws been in place in a different country that was not in war, and in hostile relations with a powerful neighbor, the economy would booming. But even with these laws Armenia is unable to attract major investments.

A solution would be to abolish all business income tax, and rely on employee income tax, and VAT. That would mean reducing the size of the government which would be a great achievement. As it is, Armenia has a huge government comprised of people with absolutely not value-added activity.

David said...

Repealing taxes on capital and relying on consumption taxes is a fine idea. The problem is that the current VAT is replete with holes. Agriculture is exempt, so are the jewelry industry, educational institutions, financial organizations, international organizations, embassies and diplomats, charities, ...

There are a lot of reasons why countries choose to tax businesses, or capital in general. Some of it is political and may reflect a policy that is reflective more of equity rather than efficiency considerations. (More on taxes in an upcoming post)

I am not sure if taxes have a significant impact on the investment environment in Armenia. I think education is by far more important, and we're not doing a good job at it at all.

Sergey said...

Consider a situation: you are importing an IT related technology. Yes, the "Favorable customs regime does not oblige you to pay 10% customs duty, and you pay VAT of 20 for the equipment brought in. Also, you will get the 20% back when you sell the equipment. But if you are not? If you use it for R&D or production or whatever, this means that you are paying this 20% anyway? I think this is absurd. What do you think!!?

Second question:
Again about our transparent and very professional customs regime. Well, I am not talking about what price they are considering as a base for counting customs duties and VAT payable when I import goods to Armenia, I am "ok" with this. They claim PC are not duty levied. Monitors are, it's 10%. Suppose I am bringing Lap-top in. Is it considered to be a monitor or a PC...

and my last concearn. If an IT sector is proclaimed to be a priority in Armenia, then why do we (IT sector companies) pay social and Income tax for our employees? Where are the incentives? Where is the E-Village, and Ok, if it's in Charentsavan-something how do I get there and are tax exemptions merely enough? I will need infrastructure, roads, water, internet... It's complicated.

What would you suggest?

David said...

Sergey,
You raise a number of interesting questions. Tax holidays are usually offered to attract capital (investments). Effectively the goal is to reduce if not eliminate the tax on the return to capital so as to attract it to the country or to a specific sector. In that sense, the treatment of labor income is not relevant.

Note that Armenia is a small impoverished country. There is no way that on its own it can subsidize (through tax exemption, build roads, and other infrastructure, ...) every industry. Personally, I hate to see the gov't pick winners and losers, and much prefer expanded attention to educational institutions (i.e. subsidize human capital). My gut feeling is that the IT sector will grow and expand as the demand from other domestic sectors expands (telecom, finance, hospitality, health care, ... ) and not from the tax treatment it is accorded -- but I can be wrong.

As to your example of the monitors, yes setting exemptions can get quite messy. The VAT application at the border, however, is an important policy question. I know that this was the subject of extensive debates and its adoption may have been forced on the gov't by external donors. The logic is simple. You need to levy the VAT the border to enhance compliance; hard to collect the tax later on. Usually, the VAT paid at the border is creditable. But what if you do not have enough of a liability to credit against or the tax authority is ill equipped to handle refunds (see AmCham's white paper on the Armenian tax), then you may be stuck with the tax or some portion of it. The VAT is supposed to be a consumption tax, and capital equipment is fully exempt!

I have read the tax laws many times over, and I am somewhat familiar with how tax administration works -- but nevertheless I feel I know so little. So it'll be good to see others write on the subject.