I N T E R N A T I O N A L M O N E T A R Y F U N D

F I S C A L A F F A I R S D E P A R T M E N T

F I S C A L A F F A I R S D E P A R T M E N T

OFFICIAL USE ONLY

Uzbekistan Review of the Tax System

Geerten Michielse, Russell Krelove, Narine Nersesyan, and Jean-François Wen

Technical Assistance Report

April 2018

The contents of this report constitute technical advice provided by the staff of the International Monetary Fund (IMF) to the authorities of Uzbekistan (the "TA recipient") in response to their request for technical assistance. This report (in whole or in part) or summaries thereof may be disclosed by the IMF to IMF Executive Directors and members of their staff, as well as to other agencies or instrumentalities of the TA recipient, and upon their request, to World Bank staff and other technical assistance providers and donors with legitimate interest, unless the TA recipient specifically objects to such disclosure (see Operational Guidelines for the Dissemination of Technical Assistance Information— http://www.imf.org/external/np/pp/eng/2013/061013.pdf). Disclosure of this report (in whole or in part) or summaries thereof to parties outside the IMF other than agencies or instrumentalities of the TA recipient, World Bank staff, other technical assistance providers and donors with legitimate interest shall require the explicit consent of the TA recipient and the IMF’s Fiscal Affairs Department.

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CONTENTS

GLOSSARY _______________________________________________________________________________________ 5

PREFACE _________________________________________________________________________________________ 6

EXECUTIVE SUMMARY __________________________________________________________________________ 7

I. INTRODUCTION _____________________________________________________________________________ 11

II. TAX ON PERSONAL INCOME AND SOCIAL SECURITY CONTRIBUTIONS _________________ 16 A. Overview ______________________________________________________________________________________ 16 B. Analysis _______________________________________________________________________________________ 20 C. Dual Income Tax Model _______________________________________________________________________ 24

III. TAX ON BUSINESS INCOME _______________________________________________________________ 27 A. Overview ______________________________________________________________________________________ 27 B. Standard Regime ______________________________________________________________________________ 28 C. Simplified Regime _____________________________________________________________________________ 31 D. Analysis _______________________________________________________________________________________ 31 E. Effective Tax Rates _____________________________________________________________________________ 32 F. Reforming the Property Tax ___________________________________________________________________ 36 G. Investment Incentives _________________________________________________________________________ 37 H. Reforming the Simplified Regime _____________________________________________________________ 37

IV. VALUE-ADDED TAX AND EXCISES ________________________________________________________ 42 A. Value-Added Tax ______________________________________________________________________________ 42 B. Excise Duties __________________________________________________________________________________ 50

V. INTERNATIONAL TAXATION _______________________________________________________________ 53 BOXES 1. Impacts of Introduction of a Flat Tax __________________________________________________________ 21 2. The Dual Income Tax __________________________________________________________________________ 25 3: OECD BEPS Project Outcomes _________________________________________________________________ 55 FIGURES 1. Total government revenue as percent of GDP _________________________________________________ 11 2. Investment, as percent of GDP ________________________________________________________________ 12 3. Inbound FDI stock, as percent of ______________________________________________________________ 12 4. Composition of tax revenue ___________________________________________________________________ 13 5. VAT rates ______________________________________________________________________________________ 14 6. VAT productivity ______________________________________________________________________________ 14 7. Historical Top PIT Rates, Uzbekistan and ______________________________________________________ 18

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8. Top Statutory PIT Rates, 2017 _________________________________________________________________ 18 9. Bottom and Top PIT Income Thresholds, annual, 2017, USD __________________________________ 19 10. Distribution of Employee Income and Tax Burden, 2017 _____________________________________ 20 11. Scenario Analysis: Effective Tax Rates ________________________________________________________ 23 12. Distribution of Tax Burden under Alternative Tax Structures _________________________________ 23 13. Share of Revenues from Major Taxes on Business Income and Capita _______________________ 28 14. Number of Taxpayers in the Standard and Simplified Regimes ______________________________ 32 15. Withholding Tax Rate Limitation under DTAs ________________________________________________ 53 16. Comparative Overview of International Agreements _________________________________________ 54 TABLES 1. Key Recommendations _________________________________________________________________________ 9 2. Government Revenue _________________________________________________________________________ 15 3. Individual income taxation, 2018 ______________________________________________________________ 17 4. Scenario Analysis: Summary of Tax Structures Compared _____________________________________ 22 5. Average and Marginal Effective Tax Rates for Investments in Machinery and _________________ 34 6. Marginal Effective Tax Rates for Selected Countries ___________________________________________ 35 7. Distribution of Taxpayers by Turnover and Number of Employees ____________________________ 39 8. Distribution of Enterprises by Turnover Ranges _______________________________________________ 40 9. Uzbekistan: International Comparison of VAT, 2015. __________________________________________ 46 10. Comparative Overview of International Agreements _________________________________________ 54 APPENDICES I. Effective Tax Rates Analysis ____________________________________________________________________ 58 APPENDIX TABLES A.1. Economic parameters assumed in the analysis ______________________________________________ 58 A.2. Domestic tax variables used in the analysis __________________________________________________ 59

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GLOSSARY AETR Average effective tax rate BEPS Base Erosion and Profit Shifting CIS Commonwealth of Independent States CIT Corporate income tax CMAA Convention on Mutual Administrative Assistance in Tax Matters CRS-MCAA Common Reporting Standard Multilateral Competent Authority Agreement DIT Dual income tax DTA Double tax agreement FAD Fiscal Affairs Department FDI Foreign direct investment GDP Gross domestic product IBFD International Bureau of Fiscal Documentation ITC Input tax credit IMF International Monetary Fund LCU Local currency unit METR Marginal effective tax rate MMW Minimum monthly wage MNE Multinational enterprise MoF Ministry of Finance MSME Micro, small, and medium enterprise OECD Organization for Economic Cooperation and Development PE Permanent establishment PIT Personal income tax SME Small and medium-size enterprise STC State Tax Committee USD United States Dollar UTP Unified Tax Payment UZS Uzbekistani Sum VAT Value-added tax WBG World Bank Group WEO World Economic Outlook WTO World Trade Organization

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PREFACE In response to a request from the First Deputy Prime Minister, Minister of Finance, Mr. Jamshid Kuchkarov, a technical assistance mission from the Fiscal Affairs Department (FAD) of the IMF visited Tashkent during February 19-28, 2018. The mission comprised Mr. Geerten Michielse (FAD, Head), Mr. Russell Krelove (FAD), Ms. Nariné Nersesyan (FAD), Mr. Jean-François Wen (FAD), and Mr. Daniel Alvarez (WBG, observer). The mission undertook a general review of Uzbekistan’s tax system, and in consultation with the authorities, established a plan for developing tax policy options to improve its efficiency and equity. The mission met with the Minister, his First Deputy Minister of Finance, Mr. Akhadbek Y. Khaydarov, and other senior officials of the Ministry of Finance, Deputy Minister of Economy, Mr. Mubin Mirzayev, the State Committee on Statistics, the State Tax Committee, the Customs Committee, the Committee on Geology and Mineral Resources, and the National Agency of Project Management under the President of Uzbekistan; representatives of Uzbekistan’s Chamber of Commerce and Industry and members of the American Chamber of Commerce; and representatives of accounting firms; finally the mission had informal discussions with representatives of the World Bank Group and the European Union. The mission is grateful for the efficient support of the Uzbek authorities, and their hospitality. Special thanks belong to Mr. Dilshot Sultanov, the Head of State Budget Department, for tireless support; the mission greatly benefited from his deep insights into the tax system of Uzbekistan. The mission would also like to thank both interpreters, Messrs. Andrei Lagoiski and Alexander Bogdanov, for their excellent work and Ms. Galina Kostina (IMF) for her assistance in organizing this mission.

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EXECUTIVE SUMMARY Uzbekistan stands ready to fully shed the legacy of a planned economy, integrating into the global value-chains, and adopting necessary structural transformations to develop market-based institutions. The Presidency has recently announced a tax reform that should facilitate this transition. Within the government various option are considered, ranging from a radical approach, including a full new tax code by 2019, to a more gradual approach, that requires careful evaluation of tax policy changes in terms of their impact on budgetary revenue as well as investment climate in the country. The current tax system has served Uzbekistan reasonably well over the last two decades. The tax-to-GDP ratio of 20 percent is amongst the highest of its peers. However, the neutrality of the tax system is questionable. A high tax burden on income, the multiplicity of tax instruments, and its complexity discourage investment and growth. Although gross capital formation has kept pace with other CIS countries, the level of foreign direct investment (FDI) has seriously lagged—not entirely due to the tax system. A major overhaul of the tax system is inevitable, but caution to ensure sustainability of much-needed revenue is required. The transfer towards a market-oriented economy also requires adoption of a single widely-acceptable accounting standard in lieu of the current bookkeeping practices—not a simple or quick fix. In addition, tax administration procedures need to be brought in line with new economic practices. It is against this backdrop that the mission suggests a more gradual approach in reforming the tax system. This report provides an assessment of Uzbekistan’s tax system, and recommendations towards a modern tax system. Key elements of the mission’s findings concentrate around simplification, the multiplicity of tax instruments, and improvement of revenue productivity. The main areas that could benefit immediately from this assessment are found in the taxation of business income and the indirect taxes (value-added tax and excise taxes). Taxation of personal income and social contributions

The personal income tax (PIT) uses a schedular income concept. Only employment is subject to a progressive rate schedule, with a very small basic exemption (lower than the statutory minimum wage). Although the top marginal rate is not very high compared to other countries in the region applying a progressive rate, the tax wedge on labor income is high due to significant mandatory social contributions. Some inside the government have suggested moving towards a flat tax regime. Based on equity considerations, the mission does not recommend such move. Compared with the current tax regime, a flat tax requires a substantial increase of the basic exemption to maintain its progressivity. Such increase would likely result in a substantial revenue loss.

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Taxation of business income

The taxation of business income is complex, due to the multiplicity of tax instruments, and its revenue performance low. The tax system is complex as it distinguishes three tax regimes with different tax bases and different rate schedules that provide opportunities for tax arbitrage (splitting businesses, outsourcing certain business activities) and informality. As a first step, we recommend that the current fixed tax regime (patent) for individual entrepreneurs is maintained, but simplified by reducing and streamlining the number of business activities to a maximum of 20-30, and maintaining the location criteria. The mission further recommends moving towards a Unified Tax Payment (UTP) based on a turnover threshold in the range of UZS 750 - 900 million that would also apply as the VAT threshold. The tax base of the UTP should be determined by allowing the taxpayers a presumptive cost deduction. Finally, the multiplicity of tax instruments in the standard tax regime results in a high tax burden. The property tax (5 percent) is an asset tax and should—if revenue permits—be lowered and transformed into a real estate tax. The standard CIT rate could gradually increase to 20-25 percent to compensate for the lost revenues. Value-added tax

The value-added tax (VAT) is designed according to best practice: it has a single rate (20 percent) and a small number of exemptions. However, its C-efficiency ratio is low, which means that the VAT does not meet its full potential of revenue-raising capacity. A large number of high-turnover businesses are currently outside the VAT regime, because they are subject to UTP. The introduction of a turnover-based threshold for the UTP, most likely will broaden the VAT taxpayer population base. Furthermore, we recommend strengthening the input tax credit system: some input credits are simply denied and must be capitalized, whereas not all excess input credits result in cash refunds. Since any immediate correction of these omissions will most likely result in a revenue loss, the implementation requires a more careful analysis of the taxpayers’ micro data. Excise taxes

A number of excise taxes are used to protect domestic products. This different treatment between domestic and imported goods should be abolished to ensure access to WTO membership. For now, excises taxes should be limited in number, and cover the following items: tobacco, alcohol, cars, and gas and petroleum products.

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Table 1. Key Recommendations

Personal Income Tax Time-frame

Revenue impact

• Use the dual income tax as the framework for reforming the PIT. L1 + • Do not introduce a 12 percent flat rate tax on employment income. L - • Maintain the current structure of the PIT, including its progressivity

and the established rates S -/+

• Consider harmonizing the requirements for payment of social insurance contributions for self-employed individuals with those for employed workers.

M +

• Ensure horizontal fairness by aligning effective tax burdens on identical income earned by taxpayers in different sectors, and regardless of their organization as either natural or legal persons.

M -/+

• Maintain the fixed tax regime but begin to narrow down its scope by gradually withdrawing this privileged system enjoyed by certain professions, while retaining it for very small/micro-retailing.

M +

Corporate Income Tax • Introduce thin capitalization rules to protect the CIT base. S + • Restrict the number of investment incentives in the tax code to

protect the tax base and to retain simplicity. Favor investment allowances over tax holidays in future revisions of the tax code.

M +

• Reduce the property tax rate and raise the CIT rate. S -/+ • Gradually replace the property tax with further increases in CIT, and

with revenues from a conventional municipal property tax on the assessed market value of commercial and industrial real estate.

M -/+

• Estimate profit margins across broad sectors of business activities with a view to reforming the simplified regime. S -/+

• Recast the simplified tax regime as an income tax by introducing a presumptive cost deduction—companies should have the option to declare their actual expenses. The new UTP rate should be in the range of 20 percent to 25 percent. Use the same turnover threshold as for VAT.

M +

Value Added Tax and Excise Taxes • Phase out employment thresholds, and use a threshold based on

turnover. Set the threshold level in the range of UZS 750 - 900 million and ensure the threshold is the same as for the application of the UTP of the simplified regime

S +

• Allow voluntary registration for businesses below the threshold who mainly export or sell to VAT taxpayers. S -

1 L = long term, M = medium term, S = short term.

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• The threshold should apply to wholesale and retail trade, and to catering. S +

• Consider bringing fee-based financial services into the VAT base. Also consider an addition-method tax on banks. M -/+

• Review and shorten the list of exempt goods and services under Article 208. Remove the exemption for tourism, recreation and sports, as well as for printed material, postal services, housing maintenance and real estate provided by banks.

S +

• Bring agriculture into the VAT base at the standard rate, so that primary agriculture producers above the turnover-based threshold are required to become taxpayers.

M +

• Remove the zero-rating for supplies of gas and water to households, perhaps with an exemption threshold. M +

• Allow full input-tax credits for purchases of machinery and equipment used in the production of taxable supplies. M -

• Analyze the impact of VAT base broadening on low-income households and design offsetting expenditure and tax policies. M -/+

• Refunds of excess VAT credits should be paid in a timely manner. M - • Equalize excise tax rates on imports and domestic production.

Remove many of the excises on imports, retaining taxes on alcohol, tobacco products, vehicles, and petroleum products.

S -/+

International Taxation • In the medium-term, Uzbekistan should join the international

community in curbing aggressive international tax planning. However, more consideration and assistance is needed as to the feasibility to implement various measures.

M/L -/+

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I. INTRODUCTION 1. Uzbekistan has high aspirations for the future. The long-run ambition of the nation is to fully transition to a modern, market-based economy that is diversified away from basic resource processing and better integrated in the global value-chains. It is against the backdrop of these objectives that the mission analyzed Uzbekistan’s policies and development in taxation to determine if the tax system is effective in balancing the country’s broad range of social and development objectives against the need to create an investment-friendly business climate.

2. The recent tax reforms, initiated by the Uzbek Presidency, are encouraging and in the right direction. For example, tax and mandatory social contribution system is significantly simplified by merging several taxes and mandatory payments. The authorities are aware of many of the remaining problems in the tax system; the mission aimed at elaborating on the key issues and offering possible solutions.

3. The level of government revenue collection in Uzbekistan is significant (Figure 1). While currently somewhat lower than the levels of collection a decade ago, total revenue has performed solidly compared to Uzbekistan’s immediate peers—the Commonwealth of Independent States (CIS)2—as well as other comparator groups (Figure 1).

Figure 1. Total government revenue as percent of GDP

Source: IMF, World Economic Outlook and MoF

2 Commonwealth of Independent States (CIS) an alliance of former Soviet republics formed in December 1991, including: Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russian Federation, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan.

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4. However, the neutrality of the revenue system is highly questionable. The Uzbek system distorts the level-playing field for investors by imposing non-uniform effective tax rates on different businesses, depending on their size, residency, business activity, or location. Preferential tax treatment on the level of individual companies and products is rampant, while compliant businesses within the tax net are overburdened. Informality thrives, encouraged by excessive complexity of the tax system and reinforced by a decades-long culture of non-compliance. Opportunities for tax arbitrage, aided by loopholes in the tax system are abundant. Overall, the fundamental requirement of a business- and growth-friendly tax system—its neutrality with respect to investment decision-making—is not satisfied.

5. Uzbekistan’s tax system, has significant impact on capital investment decisions. While non-tax factors, such as the limited access to foreign exchange, have constrained private sector development for years, the heaviness of the tax burden, the multiplicity and complexity of tax instruments, the lack of predictability, opaqueness, and excessive discretion in tax-related decision-making have played their roles in discouraging investment. Indeed, gross capital formation as a percent of GDP has stagnated over the last several years (Figure 2), while the inbound foreign direct investment (FDI) stock as percent of GDP has been on a declining trajectory (Figure 3) recently. This trend is especially remarkable in comparison to the performance of the FDI stock in the CIS. Despite being affected harder than Uzbekistan by both the global financial crisis and the consequences of the Russia-Ukraine conflict, most of the CIS countries managed to maintain and augment their attractiveness as foreign investment destinations, while Uzbekistan saw further shrinkage of its already low FDI stock.

Figure 2. Investment, as percent of GDP Figure 3. Inbound FDI stock, as percent of GDP

Source: IMF, World Economic Outlook and State Committee of Uzbekistan on Statistics

Source: UNCTAD

0

5

10

15

20

25

30

35

40

2000 2004 2008 2012 2016

Perc

ent o

f GDP

Interquartile range

Uzbekistan CIS average, exc. UZB

0

10

20

30

40

50

60

70

80

90

1992 1996 2000 2004 2008 2012 2016

Perc

ent o

f GDP

Interquartile range

Uzbekistan CIS average, exc. UZB

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6. An overhaul of the tax system is needed; however, caution needs to be exercised with respect to the timing and the process of tax reforms to ensure sustainability of much-needed revenue. The formulation of the business- and growth-friendly tax strategy needs to be based on solid, data-supported impact analysis, that is not limited to the next yearly budget cycle, but takes a longer-term perspective. All significant tax policy proposals should be conditioned on prevailing administrative and accounting practices of the country, as well as the human and institutional capacity of tax policy-implementing institutions, including that of State Tax Committee (STC) and Customs. Rushed tax policy changes could backfire if neither taxpayers nor tax administrators are able to absorb them. As such, close attention should be paid to the ambitious timeframe reflected in the Presidential decree of February 13, 2018 “On organizational measures for drastic improvement of tax legislation.”

7. Among the numerous tax reform priorities, the simplification of the tax system must take the center stage. Disproportionally high tax burdens and the complexity of the tax system have been shown to be the main drivers of informality. With a significant informal sector (estimated at 52 percent by the World Bank Group), a heavier tax burden must fall on a narrow base of formal entities, including state-controlled enterprises and banks, to raise the level of revenue needed for country’s economic development and social needs. This creates inefficiencies and propagates the culture of non-compliance.

8. The multiplicity of income tax instruments and their excessive complexity is especially unwarranted considering that consumption taxes are Uzbekistan’s main revenue (Figure 4). Indeed, more than 38 percent of the total government revenue is raised through indirect taxes.

Figure 4. Composition of tax revenue

Source: IMF, World Economic Outlook and MoF

28%

19%

19%

23%

36%

25%

25%

23%

11%

7%

6%

6%

15%

10%

8%

11%

11%

7%

6%

7%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

2011

2013

2015

2017

VAT

Excises

Other indirect taxes

EBF: Pension Fund

Other EBFs

PIT

CIT

Other direct taxes, includingEPTProperty and resource taxes

Other taxes and non-taxrevenues

Consumption taxes: 38% EBFs: 29% Income taxes: 16%

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9. While the level of revenue collection in Uzbekistan is comparable with that of an advanced economy, the revenue productivity of certain revenue sources is relatively low. Figures 5 and 6 demonstrate this pattern with respect to VAT; Chapter IV of the report provides a deeper analysis of the issue. As the figures show, Uzbekistan’s VAT rate is one of the highest in the world, while VAT productivity is one of the lowest. This low productivity is especially worrisome considering Uzbekistan’s restrictions on recovery of excess input tax credits (ITCs). Indeed, based on the Article 227 of the tax code only tax paid on export for foreign exchange can be fully refunded.3 All other ITCs, must be carried forward. As discussed in Chapter IV, this failure to refund excess tax credits artificially inflates VAT revenue and turns VAT into a distortive tax, effectively discouraging investment and production.

Figure 5. VAT rates Figure 6. VAT productivity

Source: IMF, VAT rates database

Source: IMF, World Economic Outlook and IMF Staff

10. With growing recognition by Uzbek authorities of the tax system bottlenecks, there is a need to thoroughly analyze the impact of tax policy options to support successful government decision-making. To be effective in evaluating the various tax policy proposals, it is essential that tax reform options are carefully assessed, quantitatively analyzed and openly debated. This requires that decision-makers and all stakeholders in the debate have access to all facts, the best available data and independent, evidence-based analysis, including about the impact of tax reforms on revenue, the income distribution, and the economy. There is a critical need for the MoF to play a leading role in explaining—in a non-politicized way—the economic rationale and intent behind changes in tax policy and tax legislation. Insufficiency of credible analysis of tax policy options complicates decision making, hampers the debate about tax reform and can lead to ill-designed tax policies or a tax system that fails the test of legitimacy in the eyes of the public—which can be detrimental for tax morale and compliance.

11. Comprehensive tax policy analysis is a data-intensive process. The key elements in this process are formalization and institutionalization of MoF’s access to the “raw data”, needed to perform tax policy analysis. For example, detailed micro-data of taxpayers, available at the STC, needs to be leveraged by the MoF to transform it into meaningful information, making it useful in tax policy decision-making. A firm institutional arrangement, in the form of a mutually-

3 Only after the tax liability for other taxes (e.g. CIT) is taken into account.

Emerging and Developing Europe 20%Uzbekistan 20%Advanced Economies 18%CIS 17%World 16%Sub-Saharan Africa 16%Latin America and the Caribbean 15%Middle East and North Africa 14%Emerging and Developing Asia 10%

VAT rate, unweighted averages CIS 0.48Emerging and Developing Europe 0.47Latin America and the Caribbean 0.44Advanced Economies 0.39World 0.39Emerging and Developing Asia 0.38Sub-Saharan Africa 0.35Uzbekistan 0.30Middle East and North Africa 0.21

VAT productivity, unweighted averages

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binding protocol for data exchange between MoF and STC needs to be established, delineating the data necessary for policy analysis and the timeframe and regularity of data transmissions.

Table 2. Government Revenue

Source: Ministry of Finance

2010 2011 2012 2013 2014 2015 2016 2017 2018

billions UZSExpected

Execution Budget

Total revenue 19,758 24,580 31,452 38,708 47,350 53,284 60,540 73,852 93,681

Direct taxes 3,163 4,047 4,854 5,759 6,857 8,062 9,132 10,853 12,805 Enterprise profit tax 645 862 1,001 1,039 1,120 1,180 1,215 1,476 2,511 Gross income tax-trade and catering enterpr 391 561 646 833 954 1,208 1,516 1,708 1,908 Unified tax for small enterprises with simplif 365 480 588 755 968 1,192 1,441 1,751 2,110 Personal income tax 1,595 1,919 2,302 2,717 3,262 3,801 4,137 4,877 5,199 Personal income tax for self-employed 168 225 317 416 553 682 822 1,043 1,078

Indirect taxes 6,859 8,225 10,435 13,399 16,852 19,194 21,131 25,627 33,102 Value added tax 3,900 4,761 5,967 7,552 9,476 10,851 11,892 14,686 22,019 Excises 2,219 2,542 3,176 4,168 4,941 5,618 6,259 7,449 8,344 Custom duties paid by legal entities 430 516 760 1,007 1,350 1,482 1,450 1,707 1,415 Custom duties paid by individuals - - - - - - - - - Petrol consumption tax 309 405 532 670 1,085 1,243 1,531 1,785 1,323

Property and resource taxes 2,096 2,626 3,313 3,888 4,312 4,816 5,306 6,867 9,714 Property tax 433 571 736 1,012 1,274 1,393 1,659 2,130 2,159 Land tax 323 437 486 583 647 750 967 1,092 1,267 Mining tax 1,285 1,555 2,016 2,191 2,276 2,515 2,518 3,474 6,203 Water use tax 55 62 74 102 115 158 163 172 86

Excess profits tax 240 362 474 590 660 653 1,402 1,415 1,368 Social Infrastructure development 383 450 560 594 576 736 722 686 - Other taxes and non-tax revenues 856 1,351 1,661 1,993 2,474 3,032 3,349 4,236 5,240 Extrabudgetary Fund 6,162 7,519 10,156 12,485 15,619 16,791 19,498 24,167 31,452

Pension Fund 5,022 6,177 7,779 9,742 11,784 12,534 14,672 17,707 23,240 Education/School Fund 322 378 784 907 1,114 1,217 1,353 2,075 2,973 Employment Fund 37 38 35 30 34 35 43 53 61 Road Fund 781 926 1,558 1,542 2,112 2,265 2,522 3,649 4,381 Privatization Fund - - - 44 88 103 165 228 244 Melioration Fund - - - 221 264 343 404 454 553 High school development fund - - - - 224 293 340 - -

Nomina GDP, in UZS billions 61,278 78,764 97,929 118,987 144,868 171,369 199,325 249,136 290,605

% of GDPTotal revenue 32.2% 31.2% 32.1% 32.5% 32.7% 31.1% 30.4% 29.6% 32.2%

Direct taxes 5.2% 5.1% 5.0% 4.8% 4.7% 4.7% 4.6% 4.4% 4.4% Enterprise profit tax 1.1% 1.1% 1.0% 0.9% 0.8% 0.7% 0.6% 0.6% 0.9% Gross income tax-trade and catering enterpr 0.6% 0.7% 0.7% 0.7% 0.7% 0.7% 0.8% 0.7% 0.7% Unified tax for small enterprises with simplif 0.6% 0.6% 0.6% 0.6% 0.7% 0.7% 0.7% 0.7% 0.7% Personal income tax 2.6% 2.4% 2.4% 2.3% 2.3% 2.2% 2.1% 2.0% 1.8% Personal income tax for self-employed 0.3% 0.3% 0.3% 0.3% 0.4% 0.4% 0.4% 0.4% 0.4%

Indirect taxes 11.2% 10.4% 10.7% 11.3% 11.6% 11.2% 10.6% 10.3% 11.4% Value added tax 6.4% 6.0% 6.1% 6.3% 6.5% 6.3% 6.0% 5.9% 7.6% Excises 3.6% 3.2% 3.2% 3.5% 3.4% 3.3% 3.1% 3.0% 2.9% Custom duties paid by legal entities 0.7% 0.7% 0.8% 0.8% 0.9% 0.9% 0.7% 0.7% 0.5% Custom duties paid by individuals 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Petrol consumption tax 0.5% 0.5% 0.5% 0.6% 0.7% 0.7% 0.8% 0.7% 0.5%

Property and resource taxes 3.4% 3.3% 3.4% 3.3% 3.0% 2.8% 2.7% 2.8% 3.3%Property tax 0.7% 0.7% 0.8% 0.9% 0.9% 0.8% 0.8% 0.9% 0.7%Land tax 0.5% 0.6% 0.5% 0.5% 0.4% 0.4% 0.5% 0.4% 0.4%Mining tax 2.1% 2.0% 2.1% 1.8% 1.6% 1.5% 1.3% 1.4% 2.1%Water use tax 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.0%

Excess profits tax 0.4% 0.5% 0.5% 0.5% 0.5% 0.4% 0.7% 0.6% 0.5%Social Infrastructure development 0.6% 0.6% 0.6% 0.5% 0.4% 0.4% 0.4% 0.3% 0.0%Other taxes and non-tax revenues 1.4% 1.7% 1.7% 1.7% 1.7% 1.8% 1.7% 1.7% 1.8%Extrabudgetary Fund 10.1% 9.5% 10.4% 10.5% 10.8% 9.8% 9.8% 9.7% 10.8%

Pension Fund 8.2% 7.8% 7.9% 8.2% 8.1% 7.3% 7.4% 7.1% 8.0%Education/School Fund 0.5% 0.5% 0.8% 0.8% 0.8% 0.7% 0.7% 0.8% 1.0%Employment Fund 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Road Fund 1.3% 1.2% 1.6% 1.3% 1.5% 1.3% 1.3% 1.5% 1.5%Privatization Fund 0.0% 0.0% 0.0% 0.0% 0.1% 0.1% 0.1% 0.1% 0.1%Melioration Fund 0.0% 0.0% 0.0% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2%High school development fund 0.0% 0.0% 0.0% 0.0% 0.2% 0.2% 0.2% 0.0% 0.0%

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II. TAX ON PERSONAL INCOME AND SOCIAL SECURITY CONTRIBUTIONS A. Overview

12. There is much to praise in Uzbekistan’s personal income tax (PIT) system: it is generally simple, transparent, and relatively easy to administer. The number of exemptions and deductions is minimal; the system relies to a large degree on final withholding arrangements. Employment income tax brackets are based on the minimum monthly wage (MMW)4 that is reviewed regularly.5 This allows for inflation adjustment and avoidance of the bracket creep. As shown further in the section, the current structure is sufficiently progressive.

13. PIT raises an adequate amount of revenue. In 2017, PIT, including tax payments by self-employed, generated UZS 5.9 trillion—equivalent of 2.4 percent of GDP. The bulk of the revenue—94 percent of total—is derived from the taxation of employment earnings, withheld at source. Investment income, including final withholding on dividends and interest income, contributed less than 4 percent of total PIT revenue in 2017. Rental income is an even less significant source of revenue; in 2017, it generated just 0.2 percent of total PIT revenue.

14. Resident taxpayers are taxed on worldwide income; nonresidents are taxed on income received from Uzbek sources only. A standard physical presence test is used to qualify for residence status, with physical presence of 183 days in any consecutive 12-month period used as a qualifier.

15. The PIT system is schedular, with a progressive tax on employment income, a flat tax on capital income, and a special “fixed rates” regime for individual entrepreneurs. Wage income is taxed based on a four-rate progressive structure (Table 3). One MMW serves as a basic allowance. Capital income, such as dividend and interest, is taxed at a flat rate of 10 percent through final withholding. Rental income is taxed at the minimum PIT rate—currently at 7.5 percent, collected either by withholding or on assessment.

4 As of February 2018, the Monthly Minimum Wage is set at UZS 172,240. 5 Starting in 2018, the authorities are considering twice-yearly adjustments of the MMW.

17

Table 3. Individual income taxation, 2018 Employment income Brackets Rate (in percent)

< 1 MMW 0 1 – 5 MMW 7.5 5 – 10 MMW 16.5 > 10 MMW 22.5

Non-residents Any amount 20 Employees under

“fixed-tax” regime 50 percent of the fixed amount for each individual employed by an individual entrepreneur in the “fixed-tax” regime

Dividends 10 percent Interest 10 percent Royalties Applicable to non-residents only, at 20 percent Rental income Taxed at minimum PIT rate—7.5 percent as of February 2018 Capital gains Residents: generally applicable PIT rates. Sale of immovable

property is taxed at the minimum PIT rate—7.5 percent as of February 2018. Non-residents: 20%

Income of individual entrepreneurs

Fixed amounts from 1 MMW to 10 MMW per month depending on the type of business activity and location.

Sources: Country Surveys International Bureau of Fiscal Documentation (February 2018), and Ministry of Finance

16. Employment income consists of all payments accrued and paid to individuals under employment contracts. Included are motivation payments,6 compensation payments,7 and payments for time-off.8 However, any in-kind benefit received from the employer is not included in the tax base. State pension payments are tax exempt, so is income received in connection with an individual’s involvement into agricultural works for harvesting of raw cotton.

17. A special tax on individual entrepreneurs is set as fixed tax amounts, depending on the type of business activity and location. The fixed taxes vary from 1 MMW to 7 MMW per month as of February 2018. To incentivize business activity and entrepreneurship, the fixed taxes have been reduced by 30 percent on average as of January 2018.9 The entrepreneurial activities that are allowed to be conducted by individuals are listed in the Presidential Decree No. PP-3454. Any entrepreneurial activity that is not listed, must be conducted by a legal entity and will be taxed according to the CIT rules (see Chapter III). Sole proprietors are allowed to employ a

6 For instance, annual bonuses, professionalism and tutorship allowances, long-service premiums. 7 For instance, hardship and overtime allowances, per diems exceeding statutory norms, but not payments for work-related injuries or payments by the employer for medical treatment. 8 For instance, various vacation pays, time for qualification courses attendance, material assistance. 9 Attachment No. 11 to Presidential Decree of 29 December 2017 No. PP-3454.

(continued...)

Residents

18

maximum of two employees; for each, 50 percent of the applicable fixed tax is contributed to the state budget in lieu of wage withholding.

18. All Uzbek residents are subject to a pension fund contribution at a rate of 8 percent of wage income. This tax is not deductible for income tax purposes. In addition, mandatory monthly contributions to individual accumulative pension accounts are made, at a rate of 2 percent.10 These amounts are subtracted from accrued individual income tax.11 Individual entrepreneurs make pension fund contributions for each of their employees at 50 percent of the prevailing MMW.

19. Top PIT rate has been relatively stable over the last decade (Figure 7). Figure 8 compares the top PIT rate of Uzbekistan against several comparator groups. Uzbekistan’s top statutory PIT rate (dotted red line) is higher than the averages of its immediate comparators—CIS countries—but lies below the interquartile range of advanced economies (Figure 8). Similarly, Uzbekistan’s top rate is considerably lower than the world average.

Figure 7. Historical Top PIT Rates, Uzbekistan and Comparators

Figure 8. Top Statutory PIT Rates, 2017

Note: 1--CIS excluding UZB; 2--Advanced Economies; 3--Emerging and Developing Europe; 4--Sub-Saharan Africa; 5--Middle East and North Africa; 6--Latin America and the Caribbean; 7--Emerging and Developing Asia; 8--World Sources: IMF, Fiscal Affairs Department Tax Rates Database, and IMF staff.

Sources: IMF, Fiscal Affairs Department Tax Rates Database, and IMF staff.

10 Since 2018; 1 percent contribution rate before 2018. 11 For example, out of 7.5 percent of payable PIT, only 5.5 percent is accrued to the state budget; 2 percent accumulates in individual accumulative pension accounts.

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20. The top and bottom PIT thresholds, expressed in USD for comparability purposes, are compared to that of Uzbekistan’s immediate comparator group—the CIS (Figure 9). The basic PIT exemption—at 1 MMW—stands exactly at the average of the immediate comparator countries. On the other hand, the top PIT threshold is considerably lower than the average of the group.

Figure 9. Bottom and Top PIT Income Thresholds, annual, 2017, USD

Sources: International Bureau of Fiscal Documentation, and IMF staff Note: PIT income thresholds are equal to nil for countries with flat tax regimes

21. The distribution of employment income is heavily skewed toward low- to middle-wage earners, with about 79 percent of employed taxpayers earning less than the average monthly salary of UZS 1,371 thousand12 in 2017. Cumulatively, this segment represented 55 percent of total wage income and carried 37 percent of the total PIT liability (Figure 10). At the high end of the distribution, individuals with income above 20 MMW13 per month represent a mere 1 percent of the entire taxpayer population, earning about 7 percent of total income and carrying about 13 percent of the total PIT liability.

12 This value represents the average for the whole economy, according to the State Committee on Statistics. 13 An equivalent of USD 420 at the exchange rate prevailing at the time this report is written.

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20

Figure 10. Distribution of Employee Income and Tax Burden, 2017

Sources: Ministry of Finance, IMF staff estimates

B. Analysis

22. No major PIT system reforms are envisioned in Uzbekistan, however, several proposals for reform are evaluated, among them the introduction of a flat tax on income. Box 1 summarizes the key considerations in introducing a flat tax. Under this proposal, the current progressive structure would be replaced with a flat tax on labor income, while maintaining the existing structure for the taxation of capital income. Static simulations based on the data supplied by the Ministry of Finance, which assume no behavioral response to tax policy changes, show that a flat tax rate of 12 percent can ensure revenue-neutrality of the tax reform.

23. Several objectives must guide the assessment of PIT reform options. Among them, progressivity and fairness of the tax system take center stage due to the uniqueness of PIT as a tax instrument for delivering vertical and horizontal equity of the overall tax system. Other important considerations include discouragement of the informal economy, and, of course, revenue neutrality, given the revenue needs of Uzbekistan. Less important for PIT is a consideration of competitiveness relative to other countries in the region in terms of labor taxation.

79%

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21

Box 1. Impacts of Introduction of a Flat Tax The original flat tax (Hall-Rabushka, 1983) was a combination of a cash-flow tax on business income and a tax on workers’ income, both levied at the same, single rate (with a personal allowance available against the wage tax). However, most flat taxes that have been introduced use a looser definition as they refer only to personal income. The key impacts of the introduction of a flat tax system: 1. Equity. So long as a flat tax has some basic exemption, the tax is progressive, since the

average rate of tax increases with the level of income. The more relevant question is whether it is more or less progressive than the tax scheme it replaces. The distributional impact of the flat tax reforms is commonly quite complex, and by no means unambiguously adverse for some of the least well-off.

2. Work incentives. Marginal tax rates will fall for some and increase for other taxpayers, which might impact labor supply decisions. There is a vast empirical literature (Ivanova, Keen, Klemm, 2005) on the effects of tax reform on labor supply decisions, the broad consensus of which is that the effects of tax changes on the effort of primary workers are modest (reflecting offsetting, but perhaps large, income and substitution effects).

3. Compliance, administration, and simplicity. There is indeed clearly an element of simplification in the flatness of a PIT, since this reduces the incentive to reallocate income across closely related individuals, makes withholding easier, and eases, for example, the need for income averaging for those with highly variable incomes. However, these effects could be nullified by the presence of the tax-free threshold, sometimes at quite high levels, resulting in two marginal tax rates.

4. Automatic stabilization. The common argument that a flat tax weakens an automatic stabilization of the economy, upon which increasing reliance is generally placed in coping with shocks, might not be correct. The level of the threshold amount under the flat tax, below which incomes are not taxed, turns out to be crucial: if there is no threshold, then MTR falls and the stabilizer weakens. However, with some taxpayers excluded from tax, the marginal tax rate applied under the flat tax will need to be higher than would otherwise be the case in order to raise the same revenue as the pre-reform tax. This tends to increase built-in stability.

Vertical Equity and Tax Progressivity

24. The concept of vertical equity refers to fairness across a group of people with different incomes (or levels of wealth). While most people accept the premise that richer people should pay more tax than poorer people, how much more tax they should pay is often highly contentious. The term “progressivity” refers to the rate at which taxes increase (as a proportion of income or wealth) as income or wealth rises. A “progressive” tax is one in which the effective tax rate increases as income (or wealth) increases. A “regressive” tax is one in which the effective tax rate decreases as income (or wealth) increases. A “proportional” tax is one in which the effective tax rate remains the same as income (or wealth) increases.

22

25. Using employment income data for 2017, the mission tested several proposals for wage taxation against the vertical equity and progressivity criteria. The current regime with a progressive rate structure (7.5, 16.5 and 22.5 percent) was first compared with the proposed 12 percent flat tax payable on income above the 1 MMW. Next, two alternative progressive regimes were simulated. First, an alternative progressive structure that incorporates a tax credit equal to 1 MMW was tested. Second, a structure with two, rather than three marginal rates of 10 and 20 percent was assessed. All simulated packages aimed at a revenue-neutral reform. The key parameters defining the 4 scenarios are summarized in Table 4.

Table 4. Scenario Analysis: Summary of Tax Structures Compared Current Structure Flat Tax Structure with

Tax Credit 2-tier progressive

structure Income tiers in MMW

Tax rates

Income tiers in MMW

Tax rates

Income tiers in MMW

Tax rates

Income tiers in MMW

Tax rates

First threshold 1 MMW 0% 1 MMW 0% 1 MMW 0% 1 MMW 0% Second threshold 5 MMW 7.5% >1 MMW 12% 5 MMW 8% 8 MMW 10% Third threshold 10 MMW 16.5% 10 MMW 17% >8 MMW 20% Forth threshold >10 MMW 22.5% >10 MMW 30% Tax credit 0 0 1 MMW

26. Plotting the effective tax burden across the full distribution of income shows that the flat tax reduces the progressivity of the PIT regime with respect to high earners (Figure 11). The tax burden is calculated in the form of the effective tax rate (ETR), or the ratio of the total tax liability to total income. The most progressive of the alternative scenarios is the 4-tier structure with a tax credit in the amount of 1 MMW. However, under the imposed revenue-neutrality condition, all marginal tax rates are adjusted upwards, including a 7.5 percentage point increase of top-tier rate. Under the most regressive 12 percent flat tax regime, the top earners benefit from a rate reduction of 10.5 percentage points relative to the current structure.

27. Simulation results further show that the proposed flat tax of 12 percent could affect distributional equity at the expense of the middle class. Figure 12 displays tax concentration curves, showing the cumulative proportion of taxes against the cumulative proportion of income-receiving units (using pretax income as the classifier). According to this measure, a tax structure is judged to be progressive if the tax is more unequally distributed among taxpayers than is pretax income, thus resulting in a tax concentration curve which lies below the Lorenz curve. The redistribution is less favorable under the 12 percent flat rate structure, but improved when a progressive rate structure with tax credit is introduced.

23

Figure 11. Scenario Analysis: Effective Tax Rates

Source: IMF Staff estimates.

Figure 12. Distribution of Tax Burden under Alternative Tax Structures

Source: IMF Staff estimates.

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Revenue Neutrality of a Flat Tax

28. Flat tax reforms are often associated with revenue losses. Among the Central and Eastern European countries that adopted flat-rate tax systems after Russia, the reforms generally seem to have caused a fall in PIT revenues that has not been fully offset either by changes in taxpayers’ behavior or by increases in other types of taxes. The introduction of a single personal income tax rate of 13 percent in the Russian Federation in 2001, was followed by an impressive increase in real PIT revenues of about 26 percent in the first year after its introduction (Engelschalk and Loeprick, 2016). However, research suggests that the substantial increase in compliance was more the result of parallel efforts to strengthen tax administration (Ivanova, Keen, and Klemm, 2005). Similarly, tax revenue rose markedly in Georgia in the aftermath of the 2004 reform, which introduced a flat tax, but the revenue increase was most likely helped by draconian measures adopted by the government to reduce the inefficiency and corruption of tax administration.

Horizontal Equity and Tax Planning

29. Horizontal equity means that different taxpayers (individuals or entities) with the same income or assets pay the same amount of tax. The concept is simple and generally non-controversial in principle. But in practice, there can be significant dispute over what “same income” (or same consumption or same assets) means. A tax system that includes exemptions or special rules to treat economically similar taxpayers differently will generally not achieve horizontal equity.

30. In Uzbekistan, the multitude of tax regimes creates arbitrage opportunities across different types of income. The resulting tax burdens are widely divergent, suggesting that they may encourage tax planning opportunities. An important difference between the employee and self-employed regime rests in the requirements for payment of social insurance contributions. Currently, employed workers’ wages are subject to proportional payments of 8 percent of gross wage value for social security contributions payable by employees and employers; while self-employed individuals pay a flat fee of maximum 1 MMW. This differentiation creates distortions. Further analytical work is required to show the divergence of tax burdens across different types of individual taxpayers.

C. Dual Income Tax Model

31. For taxing individual income in the future, a dual income tax model is recommended for Uzbekistan. First introduced in Scandinavia in the early 1990s, the dual income tax combines a progressive tax on labor income and a lower flat rate tax on income from capital. Labor, being less mobile than capital, can absorb higher graduated rate structure without triggering migration of the tax base. The single rate on all capital income avoids arbitrage between different capital streams. Box 2 summarizes the key characteristics of the dual income tax.

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Box 2. The Dual Income Tax

The essence of the Dual Income Tax (DIT) is that it combines a relatively low flat tax rate on capital income with progressive taxation applied to labor income. The DIT was pioneered by the Nordic countries in Europe, but many of its features have also been adopted by others.

Separation of income: All income is separated into either capital income or labor income. Capital income includes dividends, capital gains, interest, rents and rental values. Labor income consists of wages and salaries, fringe benefits, pensions and social security benefits. Royalties can be taxed as labor income or as capital income.

Tax rates: All capital income is taxed at a proportional tax rate (in the pure DIT, equal to the CIT rate), while labor income is subject to progressive personal income tax rates. The single rate on all forms of capital income avoids forms of arbitrage among dividends, interest, rents, rental values, royalties, and capital gains.

Avoidance of double taxation: Under a pure DIT, the double taxation of distributed profits at the corporate level and the shareholder level can be avoided through a full imputation system. To avoid double-taxing capital gains, investors can be permitted to increase their tax base each period by the amount of retained earnings.

Withholding: The single taxation of capital income can be ensured through withholding taxes at the corporate level or at the level of other entities paying interest, royalties or other capital income. Some forms of income, such as rent paid by individuals or capital gains not disbursed by financial institutions retaining purchase records, are difficult to withhold on, however. The rates of these taxes should be set at the same level as final withholding taxes on other forms of capital income. Withholding at company level (i.e., for dividends) reduces compliance costs.

32. The labor income category under the DIT consolidates income from wages and salaries, business income, professional income and director’s remunerations. The mission recommends the following features in the design of this tax:

• Income would be taxable according to a progressive marginal tax rate schedule. Based on the analysis illustrated in this chapter, the mission believes that a schedule with existing three rates, would strike a good balance between equity, simplicity and buoyant revenue mobilization.

• The basic tax allowance could be transformed into a tax credit, which further strengthens tax progressivity.

• A targeted tax credit for dependent children might further contribute to the fairness of the PIT, aligning its base more closely with the ability to pay tax. However, the addition of other targeted tax allowances (often included in other countries’ PIT systems) is not recommended, as these typically do not pass any serious cost-benefit test.

26

• Small businesses with turnover below the VAT threshold should continue to be subject to a simplified tax regime with a single tax based on turnover to mitigate compliance costs of the PIT, with provisions for the fixed tax regime for activities from micro-trades.

33. Capital income should be taxed at flat rates, based on final withholding. This second category under the DIT comprises all forms of capital income. The following considerations are critical:

• The overall tax burden on distributed business income, comprising corporate profit taxes, capital gains taxes, and taxes on dividends, should be roughly similar to the top marginal tax rate on labor income. A roughly equivalent treatment will reduce incentives for arbitrage between capital and labor income, which can be particularly problematic in the taxation of small businesses.

• All capital income taxes should be levied through final withholding. While this leaves no room for progressivity or loss offsets—a compromise in terms of fairness—it does significantly simplify administration and enforcement, especially since it precludes the use of artificial business losses to offset labor income. In practice, these are critical considerations for the effective taxation of capital income and, therefore, for its de facto fairness.

Recommendations

• Use the dual income tax as the framework for reforming the PIT.

• Do not introduce a 12 percent flat rate tax on employment income.

• Maintain the current structure of the PIT, including its progressivity and the established rates.

• Consider harmonizing the requirements for payment of social insurance contributions for self-employed individuals with those for employed workers.

• Ensure horizontal fairness by aligning effective tax burdens on identical income earned by taxpayers in different sectors, and regardless of their organization as either natural or legal persons.

• Maintain the fixed tax regime but begin to narrow down its scope by gradually withdrawing this privileged system enjoyed by certain professions, while retaining it for very small/micro-retailing.

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III. TAX ON BUSINESS INCOME A. Overview

34. Business incomes are taxed under different fiscal regimes, depending on the number of employees and the legal status of the enterprise.14 Incorporated businesses (“legal entities”) with more than 200 employees are subjected to the standard tax regime. If they have 200 or fewer employees, they are taxed under the simplified regime, consisting of a unified tax payment (UTP).15 However, trade and catering companies are required to be in the simplified regime, regardless of their number of employees. Companies producing excisable goods or engaged in subsurface extraction may not opt for the simplified regime. All businesses in the simplified regime are VAT exempt. Agricultural businesses are in a separate category and have the option of paying a single tax of 0.95 percent of the land value (paid by the landowner) in lieu of all other taxes. Unincorporated entrepreneurs with not more than two employees, and who are not registered for VAT, are subjected only to the fixed tax system of taxation (lump-sum payments). If they have more than two employees, they are required to register as a legal entity and pay taxes according to the simplified or the standard regime. The fixed tax system is described in Chapter II.

35. As a proportion of GDP in 2017, business income taxes (excluding the UTP of the simplified regime) generated 2.1 percent of GDP, while the UTP yielded 0.7 percent. Specifically, corporate income tax (including social infrastructure development tax) was 0.9 percent, the income tax on trade and catering was 0.7 percent, and the excess profits tax yielded 0.5 percent. The property tax generated 0.5 percent of GDP (Table 2). In total, business income taxes and property tax on business assets yielded relatively weak revenues. An examination of the tax-trend since 2010 of the four major taxes on business income or capital assets, as a proportion of the total revenue obtained from these four taxes, shows the CIT (including the social infrastructure development tax) represents a declining share of the principal taxes levied on business income and capital, with the share from property tax rising (Figure 13).

14 There were several important changes to the business income tax legislation, effective January 1, 2018. We confine our description to the system currently in effect. 15 This tax is sometimes referred to as the “single tax payment.” The term “simplified tax regime” is used in some documents to encompass both the UTP and the fixed tax system for individual entrepreneurs, as well as the unified land tax for agricultural producers. In this report, “simplified tax regime” will be used to refer specifically to the unified tax payment based on turnover, and not to the fixed tax or the land tax.

28

Figure 13. Share of Revenues from Major Taxes on Business Income and Capital

Source: State Tax Committee of the Republic of Uzbekistan

B. Standard Regime

36. The standard regime consists of the corporation income tax, property tax on the book value of immovable property, the unified social payment, the mandatory contribution to off-budget funds, and a withholding tax on dividend distributions. Firms in the standard regime must be registered for VAT. In 2017, there were 9,592 enterprises in the standard regime, or 6.3 percent of the total number of legal entities.

Corporate Income Tax (CIT)

37. CIT is levied on the worldwide income of all legal entities that are resident in Uzbekistan and on the Uzbekistan-source income of non-residents operating through a permanent establishment (PE). Taxable income is defined as the revenues from the sale of goods and services and other income sources, including dividends, interest, royalties, capital gains, and rental income, less deductions for expenses incurred from business activities. Losses may be carried forward for up to five years, but the amount available for offset in a given year is limited to 50 percent of the taxable income. The general statutory CIT rate is 14 percent, while for commercial banks the rate is 22 percent, and for companies deriving income from organizing and carrying out auctions and shows, the rate is 35 percent.16 The higher tax rates in these sectors is probably due to their regulated nature and higher profit margins. The tourism sector is exempt from income tax.

16 Prior to 2018, the general tax rate was 7.5%, but companies also paid a social infrastructure development tax of 8%, assessed on net income after corporate income tax. As part of the efforts to simplify the tax system, the tax was consolidated with the CIT rate.

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38. There is an excess profits tax for telecommunications companies and mining companies, based on the profit margin, although the details of the excess profits tax differ between these two industries. For telecommunications companies, the excess profits tax is 50 percent of the portion of profit exceeding 20 percent of costs. The excess profits tax for mining is based on the difference between the selling price and a statutory price determined by legislation, which represents an estimate of the unit cost of production.17 The tax base for the excess profits tax is the net revenue determined by the product of this price difference and the volume of sales, net of the portion of payments of subsurface use tax and earmarked turnover tax that is attributable to the excess profit. The excess profits tax rate is 50 percent.

39. The tax code specifies maximum rates for straight-line depreciation for different assets, ranging from 5 percent to 20 percent. The maximum rate for buildings is 5 percent and the maximum for industrial machinery and equipment is 15 percent. Companies must use the same straight-line depreciation rates in their financial accounting as they use for CIT. However, accelerated depreciation in the form of double-declining balance or sum-of-the-digits is also permitted for accounting (with implications for the property tax), but in that case the difference between the accounting depreciation and the tax depreciation is deferred to future periods as a temporary difference.

40. Dividends and interest paid to resident and non-resident companies are subject to a 10 percent withholding tax. Royalties, lease payments, and fees for services (including management services and expert advice) paid to non-residents that are not connected to a PE in Uzbekistan are subject to a 20 percent withholding tax.

41. There is an absence of general anti-avoidance legislation or thin-capitalization rules in the tax code. The tax code does contain transfer pricing provisions, allowing the tax authorities to adjust transfer prices if they differ from prices that would have been set between independent parties.

Property Tax

42. Companies (legal entities) are required to pay a tax at the rate of 5 percent on book value of immovable assets and overdue construction in progress. The book value is net of depreciation (based on the depreciation rates used for accounting, rather than for CIT purposes) and revalued for inflation using an index that is specified by legislation. The tax rate is doubled for construction that is not fully completed within the timeframe defined by the construction agreement and on equipment that is not installed in due time. Legal entities pay a land tax per hectare of land. In Tashkent, the rates per hectare vary from UZS 22 million per hectare to UZS

17 Depending on the commodity, there can be a second component of the excess profits calculation, based on the difference between the selling price and a “cut-off price” that represents a smoothed market price. In that case, the other component of the assessment is based on the difference between the cut-off price and the statutory price.

30

114 million, depending on the zone where the company is located. Property tax and land tax are imposed by municipalities and are deductible for corporate income tax purposes. In 2017, 59 percent of the companies paying CIT also paid property tax. The gap is apparently due to special exemptions from property tax granted to specific sectors or to certain companies.

Mandatory Contribution to State Funds

43. Companies pay a mandatory contribution equal to 3.2% of turnover. Prior to January 1, 2018, the percentage of turnover was separated into rates for the Road Fund, Pension Fund, and Educational and Medical Institutions Fund. As part of the tax simplification process, these three turnover taxes were combined into a single tax rate.

44. Employers pay social security contributions—the unified social tax—of 25 percent of the payroll cost. The unified social tax covers insurance benefits for old age, disability and death, accidents, and unemployment.

Investment Incentives

45. Various tax incentives are contained in the tax code:

• Textile companies deriving at least 60 percent of their total revenues from certain products are exempt from CIT and property tax, mandatory contributions to the Road Fund, the UTP for firms in the simplified regime, and customs duties for imported equipment.

• A “capital expenditure relief” of an amount up to 30 percent of taxable income may be deducted over a 5-year period for expenditures incurred for the purchase or construction of a company’s business premises, plant and machinery, or the settlement of loans for this purpose, less the total annual depreciation charge.

• Tax holidays are provided for companies making large foreign direct investments. They are exempt from paying CIT, property tax, mandatory contributions to the Road Fund and Educational and Medical Institutions Fund, or from UTP if they are in the simplified regime, for a period varying between 3 and 7 years, depending on the size of the investment, with the lowest threshold being USD 300,000. The beneficiaries are required to reinvest 50 percent of their tax savings for the exemption to be granted.

• Companies investing in new technological equipment benefit from a tax reduction under terms that appear identical to the capital expenditure relief for firms in the standard regime; for firms in the simplified regime, they are permitted to deduct the cost of the new technological equipment from the UTP amount over 5-years, not exceeding 25 percent of the UTP amount in any given year.

• Companies located in Free Economic Zones are exempt from CIT, property tax, land tax, mandatory contributions to state funds, UTP for firms in the simplified regime, and customs

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duties. The duration of the benefits varies from 3 to 10 years, depending on the size of the investment. By the Presidential Decree of January 12, 2017, the Free Economic Zones are currently established for 30 years but could be extended. Companies in the Free Economic Zones are not restricted to exporting; they are permitted to serve the domestic market.

C. Simplified Regime

46. The simplified tax regime is for companies with 200 or fewer employees.18 Under the simplified regime, companies make a unified tax payment (UTP) of 5 percent tax of turnover, although the tax rate differs for some industries: wholesale trade (5 percent), retail trade (1, 2, or 4 percent), and public catering (10 percent). Payers of UTP are exempt from CIT, property tax, mandatory contributions, VAT, and other local taxes and duties, but are subject to the unified social tax at the rate of 15 percent. In 2017, there were 141,965 companies in the simplified regime, or 94 percent of legal entities.

D. Analysis

47. The absence of a general anti-avoidance and thin capitalization rule makes Uzbekistan’s CIT susceptible to base erosion. There are several options for instituting thin-cap rules. The simplest is to limit the debt-equity ratio allowable for tax purposes. An alternative is to restrict the amount of interest deduction as a percentage of earnings.19

48. There are some questionable non-deductible expenses in the CIT system. The issue is whether certain expenses should qualify as being incurred for business activities. Article 159 of the tax code gives the main tax deductions for CIT. By international practice, in-kind benefits provided to employees would be deductible for CIT, but typically are taxable at the personal income level (which is not the case in Uzbekistan). Contributions to the off-budget Pension Fund is a cost of business. Similarly, expenses for public works or donations can be regarded as creating goodwill for the company and hence is a cost of business. These items (and perhaps others in the list) appear as, in principle, legitimate expenses and should be tax deductible. However, the value of in-kind benefits should be included in personal incomes and taxed at the PIT level.

18 The simplified regime was intended for micro- and small-enterprises. The Law on Entrepreneurship (No.69-II “On the Guarantees of Freedom of Entrepreneurial Activity,” adopted May 25, 2000 and consolidated by No. ZRU-328, adopted May 2, 2012) defines these terms based on employment levels, but the tax code specifies its own employment threshold to separate the simplified and standard tax regimes. There is no compelling reason why the tax code should adopt the definitions of the Law on Entrepreneurship. Hence, to avoid confusion, we shall refer to the simplified regime, without directly associating it with the terms “micro-” or “small-enterprise.” 19 See OECD (2012) for a discussion of the topic and Johansson et al. (2016) for a comparison of international practices.

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49. The number of enterprises in the simplified regime has risen steadily since 2013, while the number of companies in the standard regime is stagnant or even declining slightly since 2015 (Figure 14). The data provide evidence that the standard regime is unattractive for taxpayers, compared to the simplified regime. The simplified regime is especially attractive for highly profitable enterprises, because the tax on turnover under the UTP represents a small share of their profits. Later we discuss possible solutions for rebalancing the tax regimes.

Figure 14. Number of Taxpayers in the Standard and Simplified Regimes

Source: State Tax Committee of the Republic of Uzbekistan

E. Effective Tax Rates

50. It is useful to combine the effect of all corporate income tax rules — the statutory corporate income tax rate, the level and type of depreciation allowances, investment incentives, property tax, and turnover taxes — into a summary measure of the tax burden on capital owners from undertaking an investment. The basic approach is to construct a forward-looking hypothetical investment project for which the impact of tax on the cost of capital can be computed. The Average Effective Tax Rate (AETR) expresses the tax liability incurred due to the investment, expressed as a proportion of the financial profits expected from the investment, over the lifetime of the project. We assume that the investment project earns a before-tax rate of return of 20 percent (net of depreciation). This rate of return is chosen, because it represents a highly profitable investment. Appendix I provides the technical details behind the calculations.

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51. The AETR is most commonly used to determine the attractiveness of a country’s tax regime for a multinational company’s decision of where to locate its production plant. However, our use of the AETR will be mainly to compare the tax burden associated with undertaking an investment when the company is in the standard tax regime in Uzbekistan versus undertaking the same investment when the company is in the simplified regime. For companies close to the threshold of employment separating the two tax regimes, the differences in the AETR between the regimes can be indicative of their incentives to manipulate employment levels (e.g., by splitting the company), or to misrepresent them in their declarations, in order to be able to make their investment under one regime, rather than under the other regime. More broadly speaking, the comparison of effective tax rates across tax regimes is indicative of the unevenness of the fiscal treatment of firms in the standard versus simplified regimes, even without considering the role of social taxes on payroll.

52. In addition to the AETR, another summary tax measure, called the Marginal Effective Tax Rate (METR) is presented. The METR is a special case of the AETR, where a project just breaks even after paying taxes (i.e., the investment generates a rate of return that is right at the “margin” of non-profitability). This is the relevant effective tax rate for companies operating in competitive industries, where profit margins are thin. In this case, the decision is not where to locate a profitable project, but whether it is worth it for a company to expand its production capacity within a given location. A high METR will tend to restrict the overall level of investment in a country. The reason for this is that, over time, most (unregulated) industries become competitive and so the before-tax rate of return on new investments will be low. Again, we present the METR for both tax regimes.20

53. In addition to the taxes that affect the cost of capital, businesses pay the employer portion of social insurance contributions, based on payroll. However, in an economy where wages are determined by market forces, a large share of the taxes on labor are likely to be borne by the employees themselves, in the form of lower wages than the workers would have been paid in the absence of the employers’ social insurance contributions. For this reason, we focus only on the taxes borne by capital owners, while acknowledging that labor taxes can also affect business decisions, especially in the short run. To the extent that wages are regulated in the

20 In calculating the AETR and METR, we abstract from certain other features of the tax system. In particular, we ignore personal income taxes on dividends and capital gains. In general, taxes on dividends and capital gains would increase the AETR/METR from a shareholder perspective. However, withholding tax on dividends paid to foreign shareholders would not affect the AETR/METR if they receive an offsetting tax credit for the tax in their home country. We also leave out of our calculations the effects of ruptures in the VAT chain. When a VAT-exempt company purchases capital, e.g., machinery and equipment, it is unable to obtain a tax credit for the VAT it pays on the purchase, which will increase the AETR and METR. This adversely affects investment by firms in the simplified regime, as they are VAT-exempt. However, when VAT-exempt and VAT-nonexempt firms compete for final consumers, the nonexempt firms are placed at a competitive disadvantage. In contrast, a well-functioning VAT would have no impact on the cost of capital and would be neutral in its treatment of all businesses.

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economy, less of the payroll tax burden can be shifted from employers to employees via wage adjustments.

54. Table 5 presents the results of our AETR/METR analysis. The first column shows the taxes under consideration in each scenario. The second column shows the AETR and the third column contains the METR. Recall that the statutory corporate income tax rate is 14 percent. The final row in the table gives the AETR and METR under the UTP, which contains only the 5 percent tax rate on turnover. As the first column shows, we consider various tax scenarios to highlight the impacts of the different taxes applicable in the standard regime.

Table 5. Average and Marginal Effective Tax Rates for Investments in Machinery and Equipment in Uzbekistan, on January 1, 2018.

55. The effective rates are relatively elevated, despite the low statutory CIT rate of 14 percent. We estimate an AETR of 34 percent and an METR of 48 percent for investments in machinery and equipment in Uzbekistan, as the combined effect of CIT, property tax, and mandatory contributions to state funds. For a comparison, a recent IMF mission, using the same methodology, concluded that the AETR is 25.1 percent in Namibia, where the statutory CIT rate is 20 percent. Similarly, Botman, et al. (2008) found AETR rates in the range of 15 percent to 30 percent for seven Asian countries in the mid-2000s.21 A recent study by Barzel and Mintz (2016) report the METR for a weighted average of investments in machinery and equipment, buildings, inventories and land for Uzbekistan and other countries.22 Table 6 provides their METR figures for selected countries. At 49.0 percent, the METR calculated by Barzel and Mintz for Uzbekistan is much higher than for other countries in the region. For instance, the METR in Kazakhstan and Russia are both below 30 percent. The comparatively high effective tax rate in Uzbekistan will tend to deter foreign and domestic capital investments.

21 The 7 countries are Philippines, Cambodia, Thailand, Malaysia, Indonesia, Lao P.D.R., and Vietnam. While the figures are not up-to-date, they are suggestive that the AETR in Uzbekistan is relatively high. 22 The authors also make slightly different modeling assumptions than we do and their tax data is from 2015.

Statutory CIT tax rate = 14% AETR (%) METR (%)Taxes assumed in the calculations at 20% profitability break-evenCIT + mandatory contributions + property tax 34 48CIT + mandatory contributions 20 26CIT 16 19CIT + mandatory contributions + property tax - capital expenditure relief 33 46CIT + mandatory contributions + property tax - investment allowance 32 46CIT at 20%, no other taxes 23 27Unified Tax Payment (5%) 8 14Notes: Calculations by the mission. Assumes a straight-line tax depreciation rate of 15%. Mandatory

contributions (to state trust funds) is a tax on turnover. The property tax is a tax on the book value

of immovable property, including industrial plant and equipment. The UTP applies to turnover.

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Table 6. Marginal Effective Tax Rates for Selected Countries

56. The AETR and METR fall dramatically when the property tax is dropped from the calculations. The second row in Table 5 shows the effective tax rates in Uzbekistan when the property tax rate on immovable property (including industrial plant and equipment) is set to zero. The AETR falls from 34 percent to 20 percent and the METR goes from 48 percent to 26 percent. These results show that the property tax is a major deterrent to investment in Uzbekistan by firms subjected to the standard regime. The reason the property tax has such an impact on the effective tax rates is that the property tax is levied directly on the value of capital. Although most countries impose a commercial and industrial property tax at the municipal level of government, the rates are typically much lower than the 5 percent national rate applied in Uzbekistan.

57. The AETR and METR decline further to 16 percent and 19 percent respectively, when the mandatory contribution to state funds are also eliminated from the calculations. As a tax on turnover, the mandatory contribution permits no depreciation deductions and hence its tax base does not reflect profitability. This represents an implicit tax on capital; its elimination therefore reduces the effective tax rate. However, this tax at 3.2 percent is not as damaging to investment incentives as the property tax at 5 percent. Note that the METR at 19 percent is still higher than the statutory CIT rate; the principal reason for this is the relatively high inflation rate in Uzbekistan. Inflation reduces the value of depreciation deductions, which are based on the historical cost of the acquisition, which pushes the METR upward. The effect is less pronounced on the AETR because of the excess profit of 20 percent assumed to be generated by the hypothetical project. Hence, a lower inflation rate would also tend to improve the investment climate.

58. The capital expenditure relief, provided in the tax code as an investment incentive available to all producers of goods and services, has only a small effect in reducing the AETR and METR. An amount of up to 30 percent of the taxable profits may be deducted for investments in a company’s business premises or plant and equipment, less the annual depreciation charge. As the fourth row of Table 5 shows, the AETR and METR decline by about 1 percentage point. The limitation of the relief to 30 percent of taxable profits restricts the value of the benefit. We also consider the effect of an investment allowance at 30 percent, as an alternative investment incentive. The result is shown in the fifth row of Table 5. The AETR and METR are (very slightly) improved relative to the capital relief incentive.

Uzbekistan 49.0Kazakhstan 26.9Russia 29.0Georgia 23.2South Korea 24.1USA 34.6Source: Barzel and Mintz (2016)

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59. Eliminating or reducing the property tax rate and/or the mandatory contribution would reduce revenues; hence we analyze the effect of compensating for a portion of the potential revenue losses by increasing the statutory CIT rate. The sixth row of Table 5 suggests that a CIT rate of 20 percent would result in an AETR of 23 percent and an METR of 27 percent. However, by itself the hypothetical 6 percentage point increase in the CIT rate would be unlikely to fully recapture the tax revenues lost from the elimination of the other taxes.23 Nevertheless, trading some increases in the CIT rate for some reductions in the property tax rate would enhance the incentive for investment in Uzbekistan, even if the overall tax reforms were calibrated to be revenue-neutral.

60. The effective tax rates for investments in the simplified regime are very low. The final row of Table 5 shows the AETR and METR when investors pay only the UTP. At 8 percent and 14 percent respectively, the effective tax rates are considerably less than in the standard regime. This observation strongly supports the contention that the business tax systems in Uzbekistan encourage enterprises to migrate from the standard regime to the simplified regime, either by remaining below the threshold of 200 employees, or by misreporting their headcounts, as reflected in Figure 14 shown earlier.

F. Reforming the Property Tax

61. As demonstrated with the AETR and METR analysis, the tax on the immovable property of companies has a negative impact on their incentives to invest in Uzbekistan and to remain in the standard regime, which makes gradual reductions in the property tax rate a compelling tax reform. A longer-term reform option is to introduce a conventional, municipal property tax on commercial and industrial properties, to accompany the existing municipal residential property tax. Municipal property taxes are commonly levied by governments to pay for local amenities, such as schools, roads, and other local public goods and services. Although municipal property taxes are a tax on capital, the tax rates are typically much lower than the immovable property tax in the standard business tax regime of Uzbekistan.

23 Consider the 5 percent tax on immovable property. For every USD 1,000 investment, the tax generates USD 50 per year (ignoring tax deductions for depreciation). In contrast, assuming a 32.25 percent gross rate of return on the investment—i.e., 12.25 percent to compensate for the economic depreciation of the asset and 20 percent net rate of return, as assumed in our simulations—a 6 percentage point increase in the CIT rate would generate an increase in annual CIT revenues of USD 19.35 on the USD 1,000 investment. However, even a much more substantial CIT rate increase, say to 30 percent, would not result in as high an AETR or METR as the numbers in the first row of Table 4 (of course, this is a highly stylized illustration of the expected tax revenue impacts.) Furthermore, the more efficient tax structure resulting from some substitution of a higher CIT rate for a lower property tax rate may encourage additional investments and hence higher tax revenues from the increased economic activity.

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62. Best practice in municipal property taxes is to use market prices of real estate to determine the value of the capital tax base. When market prices are unavailable, some proxies must be used to estimate the value of property. The methods for assessing the value of commercial and industrial real estate are based on the observation that, in competitive markets for assets, the price of an asset will equal the present value of the stream of rental payments the asset can generate. Thus, when the market values of real estate properties are unknown (for example, because of the infrequency of sales of industrial plants), observations of market rental prices, or estimates of rental values based on the sales and costs of the business, may be used to assess the commercial or industrial property value.24

G. Investment Incentives

63. Tax holidays are not cost-effective ways to attract investment. Companies earning large profits would likely have invested even without the tax holiday, resulting in a large loss of tax revenues, while companies investing in long-lived assets are likely to be in a loss-position during much of the holiday period. Moreover, tax holidays are costly to administer, because of the necessity to verify that the companies continue to respect the conditions under which the exemptions were granted. Often the authorities have little incentive to monitor the tax declarations of these companies during the holiday period, leaving open the possibility that the exempt companies may misreport capital expenditures, in order to reduce their future taxable income when the tax holiday expires.

64. The numerous tax incentives listed in the tax code to favor investment in specific industries makes the tax system complex and narrows the tax base. Instead, a broader approach to attracting investment should be stressed, with a focus on the general corporate income tax rate and depreciation allowances.

H. Reforming the Simplified Regime

Principles

65. The usual purpose of a simplified regime is to reduce taxpayer compliance costs and the costs of tax administration by simplifying the requirements for bookkeeping and enforcement. Taxing turnover serves this purpose by eliminating the need to keep track of costs in the declaration of income. Estimates of the compliance costs of CIT reporting requirements are 0.057 percent of turnover for the smallest companies to 0.001 percent for the largest

24 For a long-lived asset, the asset price will approximately equal the rental value divided by the risk-adjusted interest rate. Thus, if an examination of market rents for properties that are similar to the one under consideration is R and the risk-adjusted interest rate is i, then the market value of the industrial property, K, is estimated to equal R/i. The property tax rate, tK, may then be levied on K; or, equivalently, a tax rate, tR, can be applied directly to the rental value, R, at the equivalent rate of tR = tK/i.

(continued...)

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companies.25 A study by the World Bank Group has found extremely regressive patterns in the developing economies, with small businesses subjected to tax compliance costs of up to 15 percent or more of turnover (Coolidge, 2012).

66. If the objective of the authorities is to promote the growth prospects of micro, small and medium enterprises (MSMEs), rather than concern about compliance costs, then promoting MSMEs may be better achieved simply by lowering the CIT tax rate for MSMEs, while maintaining income, not turnover, as the tax base. A lower CIT rate for MSMEs could also be accompanied by cash-in-cash-out bookkeeping, rather than the standard accrual accounting reporting requirements for CIT. Reduced CIT tax rates for SMEs is common practice in OECD countries. Lower CIT rates enable small firms to accumulate retained earnings to finance their investments, given that they often lack adequate access to financing in capital markets.26 However, this view been criticized for promoting the growth of inefficient firms, since small companies may be small precisely because they are less efficient than their larger counterparts in the sector. In any case, it is important for the authorities to consider carefully what is the purpose of their special regime for SMEs and then to design the regime to match the purpose.

Threshold

67. About 13 percent of the companies registered under the simplified regime have turnovers exceeding UZS 1 billion (approximately equal to USD 122,000 at an exchange rate of USD1=UZS 8200) and about 1 percent of companies have turnovers greater than UZS 10 billion (USD 1.22 million) (see Table 7). These turnover levels are relatively high for a tax regime that is intended for small enterprises. Good practice for setting the VAT threshold is often taken to be close to USD 100,000, based on research that tries to balance the government’s revenue needs with the compliance costs of taxpayers and the cost of tax administration. Similar considerations apply to the threshold for the simplified tax regime, especially since companies in the simplified regime are also exempt from VAT.

25 See Sapiei et al. (2014). 26 See Vigneault and Wen (2002).

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Table 7. Distribution of Taxpayers by Turnover and Number of Employees

Annual turnover (Sales revenue)

Number of Employees

up to 5 pers.

6 to 20 pers.

21 to 50 pers.

51 to 100 pers.

101 to 200 pers.

more than 200 pers.

up to UZS 20 million 23097 463 51 - - - from UZS 20 - UZS 100 million 28213 3295 281 8 3 - from UZS 100 - UZS 1 billion 30147 14117 2242 78 24 1 from UZS 1 - UZS 10 billion 3684 5774 3645 420 176 21 more than UZS 10 billion 184 357 382 191 176 32

Source: State Statistics Committee of the Republic of Uzbekistan 68. The number of employees of a company is not a good indicator of profitability. Table 7 shows that over 500 companies with fewer than 21 employees have turnovers greater than UZS 10 billion. While turnover is certainly not a precise indicator of profitability, it is generally more closely related to profitability than the number of employees.

69. It is easier for companies to reorganize themselves to meet employment thresholds, than it is to meet turnover thresholds. For example, an integrated company with upstream and downstream activities can separate its activities into multiple companies to meet the employment threshold for the simplified regime with each of its companies. However, in the case of a turnover-based threshold, even if the upstream segment supplies the downstream segment at a low transfer price (so that the upstream company remains below the turnover threshold), the downstream company will want to achieve the same value of sales to its final consumers, as before the segmentation of the integrated company. Hence, at least the downstream company will have to remain in the standard regime and pay income tax on its profits, equal to its revenues net of its costs established by the transfer price. Thus, from the perspective of the consolidated company, there may be little or no advantage from splitting itself to avoid paying income tax in the standard regime. Similarly, a firm’s turnover level cannot be manipulated by outsourcing some of its production to reduce the number of employees attached to the firm for tax purposes. Hence, a threshold that is based on turnover better protects government revenues than a threshold based on employment.

70. A turnover threshold in the general range of UZS 750 million to UZS 900 million for the simplified regime, instead of the current employment-based threshold, would move between 17 percent and 14 percent of the companies currently in the simplified regime to the standard regime (Table 8). This represents between 84.5 percent and 81.4 percent of the total sales of companies in the simplified regime. At UZS 900 million, the threshold is equivalent to about USD 110,000, very much in the range generally recommended for the VAT threshold to mitigate the regressive feature of compliance costs.

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Table 8. Distribution of Enterprises by Turnover Ranges

Source: State Statistics Committee of the Republic of Uzbekistan Design Issues

71. Turnover taxes used in simplified tax regimes have certain drawbacks. Because turnover taxes ignore the costs of production, they are only partially sensitive to profitability. Firms may have to pay the turnover tax even when they are in a loss position. Firms with high profit margins are favored over those with low profit margins. When a company in the simplified regime eventually “graduates” into the standard regime, it must adjust from the bookkeeping requirements for tax on a turnover to the reporting requirements for a profit tax. Finally, it is not straightforward for taxpayers to be able to compare the statutory tax rate in the simplified regime with the rate in the standard regime, because the tax bases differ.

72. An attractive alternative design for a turnover tax is to include a presumptive cost deduction, fixed by legislation and expressed as a percentage of turnover. For example, in France, micro-entrepreneurs in the (Regime de Base) can deduct 71 percent of turnover as a cost, if their activities are classified as commercial sales, resulting in an income of 29 percent. The income is then taxed according to the standard income tax regime. In the Uzbekistan context, although the CIT rate is 14 percent, the presence of additional taxes on businesses in the standard regime, as well as the compliance cost of the CIT reporting requirements, suggest that the UTP rate should be distinctly higher than 14 percent. An option to consider is to set the UTP

Annual turnover(Sales revenue)

Number of enterprises

Percentage of total number of enterprises

Total sales revenue in the

category (UZS million)

Cumulative prcentage of

total sales

up to UZS 20 million 23,611 20.2% 199,899.4 0.2%UZS 20 - UZS 100 million 31,800 27.2% 1,665,621.7 2.1%UZS 100 - UZS 200 million 16,589 14.2% 2,390,159.5 4.8%UZS 200 - UZS 300 million 9,262 7.9% 2,273,466.9 7.3%UZS 300 - UZS 500 million 10,328 8.8% 4,022,481.3 11.8%UZS 500 - UZS 700 million 5,596 4.8% 3,316,092.0 15.5%UZS 700 - UZS 900 million 3,483 3.0% 2,763,422.6 18.6%UZS 900 million - UZS 1000 million 1,351 1.2% 1,282,061.1 20.0%UZS 1000 million - UZS 3000 million 9,778 8.4% 16,507,983.1 38.4%UZS 3000 million - UZS 5000 million 2,251 1.9% 8,657,394.4 48.1%UZS 5000 million - UZS 10 billion 1,691 1.4% 11,665,368.0 61.1%more than UZS 10 billion 1,322 1.1% 34,784,114.3 100.0%

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equal to the top personal income tax rate of 22.5 percent. In general, the tax burden in the simplified regime should mimic the tax burden on profits in the standard regime.27

73. Since profit margins differ across sectors, the legislation should distinguish between 2 or 3 categories of activities that have significantly different profit margins. In France, there are distinct presumptive cost ratios for three categories of business activities: commercial sales, services, and professional. The tax authorities should examine the data in Uzbekistan to determine profit margins across a small set of business classifications to determine fair ratios for the presumptive cost.28 Businesses should always have the option to report their actual expenses, instead of the presumptive cost, if they can support the claims. A drawback of the system is that the tax administration must be able to verify the activities of the businesses to ensure that they do not misrepresent their type to benefit from the highest level of presumptive deduction. For this reason, it is unwise to create more than 2 or 3 classes of business activities in the simplified regime.

Recommendations

• Introduce thin capitalization rules to protect the CIT base.

• Restrict the number of investment incentives in the tax code to protect the tax base and to retain simplicity. Favor investment allowances over tax holidays in future revisions of the tax code.

• Reduce the property tax rate and raise the CIT rate.

• Gradually replace the property tax with further increases in CIT, and with revenues from a conventional municipal property tax on the assessed market value of commercial and industrial real estate.

• Estimate profit margins across broad sectors of business activities with a view to reforming the simplified regime.

• Recast the simplified tax regime as an income tax by introducing a presumptive cost deduction—companies should have the option to declare their actual expenses. The new UTP rate should probably be in the range of 20 percent to 25 percent. Use the same turnover threshold as for VAT.

27 It can even be argued that the burden in the simplified regime should be higher than in the standard regime, because companies in the simplified regime face relatively low compliance costs. On the other hand, too high a tax burden in the simplified regime can lead firms to become informal operators to escape taxation altogether. 28 The presumptive cost deductions in France are 71 percent for commercial sales, 50 percent for services, and 34 percent for professional activities (e.g., accountant, architect, lawyer).

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IV. VALUE-ADDED TAX AND EXCISES 74. This chapter reviews the main domestic indirect taxes, the VAT and excise taxes, as well as a few other taxes that have characteristics similar to excises, and makes recommendations for reform. Broadly, the VAT comports with good international practices, although there is considerable scope for broadening the base of the tax, both directly, and through modernizing the criteria used to assign businesses to the regular or simplified tax regime. When registration requirements are adjusted, the treatment of businesses in certain sectors—in particular agriculture production, processing and distribution, currently almost exclusively in the simplified regime—will need to be reviewed. On excises, the current structure taxes too many types of goods, and treats imports and domestically-produced goods differently. It is best to use excises for revenue and for addressing adverse social effects of consumption of the taxed commodities, while tariffs should have the role of protecting domestic consumers.

A. Value-Added Tax

A Modern VAT—Key Design Features

75. Four basic principles of taxation are used to measure the quality of any tax:

Neutrality – taxes should have minimal impact on the behavior of economic agents except when the intention is to change it; Equity – taxes should be fair, in the sense that they should be charged according to the benefits that the taxpayer receives from government activities or they should be assessed in such a way that taxpayers in similar circumstances should be identically treated (horizontal equity) and those with higher ability to pay should pay more (vertical equity). Vertical equity is usually associated with the concept of progressive taxation; Simplicity – taxes should be simple, i.e., the rules for their application should be easily understood and their administration and compliance costs should be low. Productivity – taxes should be able to yield the required revenue with reasonable rates, implying a preference for broader and buoyant bases, immobile bases, and difficult to evade taxes. 76. A modern VAT is a consumption tax that rates high according to these principles:

• Its base is broad (consumption) implying high productivity if evasion is controlled;

• It is intended to be borne by consumers, though paid by businesses, thus not affecting directly production decisions. If applied with a single rate to all goods and services consumed, it does not change relative prices and, therefore, has no substitution effect on demand;

• It does not burden savings and investment, and is thus amenable to economic growth;

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• It is neutral with respect to international trade;

• It satisfies horizontal equity as individuals with comparable value of consumption, no matter what their consumption mix, bear the same burden;

• It may not be entirely satisfactory with regard to vertical equity if ability to pay is measured by income and if, as is usually the case, consumption is a larger proportion of income for low-income families than for high-income families. But under this definition any general consumption tax is regressive. Provisions can be introduced into the VAT to make the tax less regressive, but it is important to verify that this is the best-targeted instrument to achieve that goal.

77. To be a good tax, the VAT should have:

• a comprehensive base that includes services;

• few—ideally no—exemptions;

• a single positive rate on domestic consumption of goods and services;

• no burden on capital goods;

• an adequate threshold to exclude small and micro businesses; and

• an expeditious refund procedure to deal with excess net credits.

78. A best-practice VAT includes all goods and services in its base, unless specifically exempted. This implies that the taxation of services is fully integrated with the taxation of goods and that the number of exemptions is very limited. While experience establishes that some exemptions will be adopted, it is good to keep them to a minimum.

79. Exemptions create serious problems for VAT compliance and administration, and they cause cascading and excessive taxation if applied to pre-retail stages. They also create a bias against outsourcing since by producing inputs in-house rather than purchasing them from third parties the business can reduce the tax burden. Furthermore, exemptions favor imports over domestic products since the former would bear no tax while the latter will bear the tax paid on inputs, which cannot be credited. Exemptions also complicate tax administration, as tax payers who sell both taxed and exempted goods must apportion their purchases between the two. Exemptions tend to proliferate as exempt sectors want their suppliers to be exempt too, and other sectors lobby for equal treatment.

80. A single positive rate (and a zero rate that applies only to exports and international transportation) is an important feature of a modern VAT. Multiple rates change relative prices of goods and services thus distorting consumers’ choices. This, in turn, affects the structure

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of production and the allocation of resources, reducing economic efficiency. Furthermore, multiple rates increase substantially compliance costs, particularly for small businesses, as well as administration costs, in particular by increasing the number of tax refund claims that have to be processed and creating in many instances the need for interpretation by the taxpayers and the tax administration regarding the application of the appropriate rate. Finally, it should be noted that complexity invites fraud and evasion.

81. Though there is some empirical evidence29 that a good VAT tends to have a proportional rather than a regressive tax burden distribution, several countries have adopted exemptions or reduced rates for the taxation of goods considered essential. These essential goods usually constitute a larger fraction of expenditures of low-income families than of high-income families. Notwithstanding the increased progressivity of the tax obtained by this practice, it is a badly targeted policy as empirical studies show that high-income groups benefit disproportionately from this concession. Collecting the full VAT and using the revenue on expenditures that benefit the poor is a far more effective redistributive policy.

82. The VAT eliminates cascading or cumulative effects by granting taxable firms a full and immediate tax credit or deduction for the tax paid in respect of purchases against their own VAT payable on sales. In principle, the right to a tax credit arises at the same time that the taxable supplier has to account for the VAT on sales. Accordingly, no good or service anywhere within the taxable production-distribution chain has VAT attached to it, and inventories are held fully free of VAT.

83. VAT registration thresholds are important to exclude small taxpayers for whom the required accounting system would be too costly to maintain. Some recent research by IFC (2010), including for Uzbekistan, shows that taxpayers’ compliance costs as a share of total annual sales can be very high for smaller businesses; for Uzbekistan, these costs are over 11 percent of turnover for the smallest businesses. As turnover increases, the ratio falls quickly, and eventually the share becomes relatively constant as turnover rises to the range of UZS 500 – 1,000 million.30 The appropriate level of the threshold varies from country to country according to the characteristics of production and distribution as well as the amount of resources, including human resources, available to the tax administration. One desirable feature is a simple definition of the threshold, usually based only on turnover and applied uniformly to all sectors. Small traders that wish to adopt the normal VAT regime should be allowed to do so, provided they are able to carry reliable books of account.

84. Another important issue is how to treat small taxpayers whose turnover is below the threshold. Two alternatives have been used: exemption or use of simplified taxation. An important point to consider is that concessionary treatment of small taxpayers (i.e., a lower 29 See Richard Bird and Pierre-Pascal Gendron, The VAT in Developing and Transitional Countries, Cambridge University Press (2007). 30 See IFC (2010).

45

effective tax rate) may result in unfair competition with larger taxpayers and, hence, in an incentive not to expand activities beyond the threshold (for example, by misreporting turnover or splitting the business). Therefore, the best practice is to provide simplified but not concessionary taxation.

85. In the absence of refund procedures, VAT taxpayers may have excess net tax credits that may accumulate over time. The main sources of net VAT credits are exports, the acquisition of capital goods, and the use of multiple rates, especially zero-rating of domestic transactions. Without proper refund procedures, accumulated net credits become costs and cascading occurs. This harms the competitiveness of domestically produced goods vis-à-vis foreign products both in the domestic and international markets. It also hampers investment since, without the refund or enough tax on output to compensate the credits; VAT becomes a tax on capital, in violation of the consumption tax principle.

86. Expeditious refund procedures are, therefore, an integral part of the modern VAT. Ideally, net VAT credit should be immediately refunded. Some countries, however, require taxpayers to carry the net credit forward for a number of tax periods before allowing a refund. In these cases, special rules are used to accelerate refunds relating to exports and, in some countries, investment in capital goods in excess of a specified threshold (absolute or expressed in terms of turnover).

87. The VAT must be distinguished from excise tax systems which can be defined to encompass all selective taxes on goods and services – taxed uniformly whether imported or produced domestically. Goods usually taxed include tobacco products, alcoholic beverages, petroleum products, motor vehicles, pollutants, luxury items, and several other goods and services, including telecommunications. Unlike VATs, the main economic function of excise taxes is to promote efficiency in resource allocation by internalizing the external cost of the production or consumption of the products on which they are imposed; they also promote efficiency in cases where demand for the product does not change much when the price is increased.

88. Furthermore, the VAT (and excises) should be distinguished from tariff duties on imports. In theory, import duties are viewed as an instrument to protect domestic producers, and should not be used as a major revenue source because of their non-neutral effects. In practice, however, import duties are used to fulfill this role if no other convenient tax handle is available.

89. In conclusion, VAT is best thought of as being levied for and only for revenue purposes. It is not the instrument to correct for externalities, to enhance the progressivity of the tax system, or to conduct trade policy. Other instruments are usually available that are better targeted to pursue these non-revenue objectives.

46

The VAT in Uzbekistan

90. VAT in Uzbekistan exhibits a number of the qualities of a good VAT, and raises a significant amount of revenue. Table 9 presents information on main parameters and some performance indicators for the VATs in Uzbekistan and a number of comparator countries. Uzbekistan has a single positive rate, and the tax raises revenue over 6 percent of GDP.

91. However, empirical evidence suggests that the gap between the revenue raised by the VAT in Uzbekistan and the revenue that could be raised is significant. One measure of the performance of VAT is the productivity, discussed in Chapter I. There it is shown (Figure 6) that Uzbekistan ranks low relative to other countries. Another measure of performance is the C-efficiency ratio, which measures countries’ VAT performance against private consumption in the economy, the theoretical base for the tax. As shown in the last column of Table 9, the C-efficiency ratio (with a value of 1 indicating no productivity gap) is equal to 0.49 for Uzbekistan, which is comparable to a number of other countries in the region, where the ratios range from 0.24 - 0.72.31 However, many countries have a C-efficiency above Uzbekistan’s. A main reason for this is the current manner in which businesses are assigned to the simplified (exempt from VAT) tax regime or the regular regime where the business would be required to collect VAT. As discussed in the income tax chapter above, assigning on the basis of employment, rather than turnover, has the effect of allowing too many businesses to be outside the VAT. Another reason is that there is some use of domestic zero-rating and also exemptions allowed under the VAT, narrowing the base for the tax. This rest of this section discusses the main weaknesses in the current VAT regime, and makes suggestions for improvement.

Table 9. Uzbekistan: International Comparison of VAT, 2015.

31 The c-efficiency ratio for 2017 is 0.42 for Uzbekistan, somewhat lower than in 2015 and suggestive of a deterioration in the performance of the VAT.

Standard Other TurnoverCountry Per Capita GDP VAT Rate VAT Rates Threshold VAT Revenue C-Efficiency

USD % % USD (000s) % of GDPArmenia 3,690 20 119 8 0.48Azerbaijan 4,098 18 118 7 0.46Belarus 5,585 20 10 ; 25 None 8 0.54Georgia 4,123 18 41 11 0.72Kazakhstan 8,585 12 180 2 0.24Kyrgyz Republic 1,140 12 115 8 0.56Russia 10,248 18 10 None 5 0.41Tajikistan 819 18 5 58 13 0.52

Uzbekistan 2,128 20 None 6 0.49

Source: IBFD. LCU converted into USD using WEO average annual exchange rates. Revenue data from IMF GFS (IMF WEO for Tajikistan)

47

Registration threshold

92. As discussed previously in this report, the current system of using the employment level to determine whether a business is in the regular tax system has serious weaknesses. The Uzbek authorities are considering moving toward using turnover, and the mission concurs with such a move, in fact eliminating almost completely employment-size criteria.32

93. The largest single-tax payers are quite large, and bringing them into the VAT could significantly increase revenue. In chapter III, the analysis suggests a turnover threshold in the range of UZS 750-900 million would be appropriate for business taxation; and this is also appropriate for VAT. From Table 8 in Chapter III, it can be seen that the largest 16,393 single-tax payers—about 14 percent of the total—with turnover levels exceeding UZS 900 million accounted for total sales in 2016 of about UZS 73 trillion, equivalent to about 81.5 percent of the total turnover of all firms paying single tax. This turnover is equivalent to 37 percent of GDP, and bringing this turnover into the VAT has the potential to significantly increase revenue. Whether UZS 900 million is the appropriate turnover level will need further analysis to determine whether the STC has the capacity to absorb this increase in VAT taxpayers,33 but it is likely that a level in this range would be appropriate.34 Lowering it below USZ 900 million would mean several thousand more taxpayers would need to be controlled by the administration; the cost of doing this should be determined to be significantly less than the extra revenue that can be collected.

94. A simplified regime should be preserved for businesses that remain below the threshold. The alternative would be to exempt them; however best international practice is close to the system currently used: charge a fixed (quarterly or annual) fee to the smallest businesses, and a single-rate turnover tax to all other businesses below the threshold.

95. Firms below the threshold are currently allowed to register voluntarily, and this should continue. This option is currently offered to single-tax payers, and a few do avail themselves of the opportunity, mainly those businesses—as one would expect—who sell mainly to VAT taxpayers or who export. Businesses that do choose to register for VAT should be required to meet the recordkeeping requirements for VAT, and should be required to remain registered for at least 2-3 years.

32 The mission rejects the suggestion to maintain the current system, but allow VAT taxpayers to take a deemed input tax credit on purchases from VAT-exempt businesses. Such a measure would address only one of the problems arising from the current regime. 33In 2017 there were 9,592 taxpayers in the general regime, of which 6,317 were VAT taxpayers; adding about 16,000 businesses to VAT would represent about a 250 percent increase. 34 The mission did not have access to data on the size distribution of VAT taxpayers; some of them may have turnover levels below the threshold suggested here, which would have the opposite effect on registered taxpayers.

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Exempt sectors

96. Wholesale and retail trade and catering should be brought into the VAT. Currently trade and catering must be registered for the simplified regime, regardless of turnover; and in fact, many of the large businesses by turnover in the single-tax regime are traders. There is no longer a strong rationale for this treatment; larger firms should be expected to keep appropriate records, and smaller firms will be relieved of the compliance costs by the registration threshold.

97. The treatment of agriculture and food in the new regime will require difficult decisions. Currently primary agriculture is required to be in the simplified regime; and processing and distribution are organized so that businesses are overwhelmingly in the single-tax regime as currently determined by employment levels. With the move to a turnover-based threshold, many processors and distributors will be required to register for VAT; so, will large farms (smaller farms below the threshold would not be required to register). Many countries exempt primary agriculture; and many either tax basic food items at a lower rate, or zero-rate basic foodstuffs, in order to reduce the burden on lower-income households. However, as discussed above this is a poorly-targeted approach; a better solution would be to tax food at the standard rate, and address the impact on lower-income families on the expenditure side of the budget.

98. The scope for bringing the financial sector more fully into the VAT should be investigated. The sector is currently exempt; this treatment mirrors that in a number of other countries, in particular those adopting the VAT early. This has led to concern that the exemption has caused the financial sector to grow too large relative to the economy. Better practice is to include fee-based financial services in the base where practicable; this could include taxing insurance premiums. Where this still excludes a large part of the base, consideration could be given to taxing the financial sector on by the addition method – that is, tax the sum of payroll and profit (which is theoretically equivalent to value-added in the sector).

Exempt goods and services

99. Article 208 of the tax code provides a list of 37 supplies that are exempt, not all of which have a strong rationale and could be reviewed. This list includes various education, medical, funerary, and elderly-care goods and services, that are often exempt in other countries. The list also includes veterinary services, spas, resorts, recreational, tourist and excursion services (for example, packaged tours), sports establishments, printed material, postal services, house maintenance and repair provided to individuals, and some real estate built by commercial banks. This list is relatively extensive, many items lack a convincing rationale, especially taking into account that they seriously complicate administration and compliance (for example, accounting for VAT on purchases used in producing taxed supplies vs. exempt supplies). The list should be reviewed, and where possible shortened. Likely candidates to be brought into the tax net are tourism, recreational and sports events, printed material, postal services and housing maintenance and real estate built by commercial banks.

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Domestic zero-rating

100. Household gas and water, currently zero-rated, should be brought into the VAT, possibly with a consumption threshold, and no new domestic zero-rated items should be introduced. As mentioned, zero-rating in order to relieve the burden on low-income families is poorly targeted, and should be avoided. As a second-best policy for these utilities, a small monthly amount of consumption, corresponding to the consumption of lower-income households could be zero-rated or exempted. All consumption above that level should be taxed in full.

Restricted input-tax credits on capital equipment

101. VAT paid on purchases used to produce taxable supplies should be fully credited. Currently, credit for tax paid on purchases of machinery and equipment for own use is not allowed. While there are numerous exemptions available for import and purchase of equipment, where the tax is paid it becomes built into production costs, acting in this way as a tax on investment. The impact is attenuated to some extent because the taxpayer can capitalize the tax paid and deduct it over time to determine taxable income. That some tax remains uncredited means in particular that exports are made less competitive in world markets. Since there is no longer a sound rationale for this treatment, it should be rescinded.35

VAT refunds

102. Criteria to receive a VAT refund are restrictive, and should be liberalized. Currently only exporters qualify for refunds; other taxpayers in an excess-credit position are required to carry forward the excess to future periods. However, timely payment of refunds is critical to the operation of the VAT, and measures should be taken to allow a greater variety of businesses to receive refunds. This may require concomitant improvements in refund procedures and documentation.36

Revenue potential of the measures

103. The base-broadening measures outlined above are likely to have a significant impact on VAT collections. This could permit a lowering of the VAT rate. However the overall tax reform is likely to involve the reduction in the rates or elimination of a number of taxes (e.g. the unified extrabudgetary fund turnover tax; rationalization of the excise tax system; tariff adjustments as a consequence of WTO accession), and that revenue will need to be compensated; on the other hand there can be a positive effect on revenue with the elimination 35 With full crediting of input VAT, the tax would no longer be capitalized and amortized along with the machinery for income tax purposes, as is the current practice. 36 The 2013 IMF/FAD technical assistance mission on tax administration found that refund procedures were cumbersome, with excessive documentary requirements, and checking by the tax administration. See Martens et al. (2013).

50

of tax incentives both on income tax and tariffs and other taxes on imports, and from other reforms of the income tax. While there is no compelling case that the current rate is too high, it is feasible that the overall reform program could include a reduction in the standard VAT rate.

104. The revenue impact of threshold reform could be significant. As noted above, single-tax payers with turnovers over UZS 900 million had aggregate turnover in excess of 36 percent of GDP. If only 20 percent of this turnover represents value added in the economy that is currently escaping VAT, then bringing these firms into the tax could raise VAT collections by an additional 1.5 percent of GDP, representing a 25 percent increase in collections.

B. Excise Duties

105. Excise duties in Uzbekistan raise significant revenue, but are poorly designed and discriminate between domestic production and imported goods. In 2017 excise revenue represented 3.1 percent of GDP, which is high by international comparison. However, many goods that are not normally excisable are taxed in Uzbekistan when imported. In this respect, the tax is acting as a tariff, which can help explain the high revenue yield (and this is confirmed by the low level of customs duties collections, which in 2017 yielded only 0.7 percent of GDP). Domestic excises fall mainly on goods that are subject to excises on imports, but at different rates. In addition, telecommunications services that are often excised in other countries do not bear excise in Uzbekistan, but are subject to a special tax. There is scope to rationalize the system, bringing taxation of domestic production and imports and of services into a modern structure of taxation of a limited set of taxes levied uniformly on domestic production and imports.

106. Domestic excises fall on the usual excisables of alcoholic drinks, cigarettes, petroleum products, and domestically produced passenger vehicles; however domestic production of vegetable oils and jewelry is also taxed.37 The latter two are not usually taxable under excises, and their treatment could be reconsidered. In addition to the excises, there is a specific tax levied at the retail level on consumption of gasoline, diesel and natural gas; this tax raised 0.8 percent of GDP in 2017. In addition, telecommunications companies bear a specific tax of UZS 4,000 per subscriber; this tax raised 0.2 percent of GDP in 2017. Since the tax is specific, it bears relatively heavily on low-intensity uses (for example, smart appliances). For this reason, it would be preferable to apply the tax according to the value of the service.

107. Excises are levied on hundreds of imported goods, including consumer products like fresh and processed foods, bakery products, carbonated drinks, furniture and appliances, and jewelry and paper products, but also on construction materials. Goods are classified according to the harmonized system, and rates are both specific and ad valorem; ad

37 Under the tax, natural gas exports are taxed at 25 percent and (for compressed gas) 26 percent. In addition, the tax otherwise collected on fuel products remains with the refiner to subsidize costs. These measures can have significant, but offsetting effects on revenue collection.

51

valorem rates range from 5-70 percent. In addition, vehicle imports are taxed (with a combination of ad valorem and specific taxes based on engine displacement), as well as tobacco and alcohol products, but at (specific) rates in general differing from those levied on domestic production. Imports of petroleum products do not bear excise.

108. Excises on imports have the effect of protecting domestic production, and would likely run counter of WTO rules, and moreover runs counter to the usual rationale for levying excise taxes. As mentioned earlier in the chapter, tariffs should be the sole tax instrument for protection; and the extent of their use is usually constrained as part of the process of WTO accession. In addition, use of other instruments that have the effect of protecting domestic production would also be constrained; for this reason, the excises on imports is likely to the subject of negotiation. A phased reduction in the list of excises on imports is warranted to liberalize trade. In the final stage, the list of excisable imports should be reduced to alcohol, tobacco products, petroleum and vehicles, and rates should match those levied on domestic production.

Recommendations

• Phase out employment thresholds, and use a threshold based on turnover. Set the threshold level in the range of UZS 750 million - 900 million and ensure the threshold is the same as for the application of the UTP of the simplified regime.

• Allow voluntary registration for businesses below the threshold who mainly export or sell to VAT taxpayers.

• The threshold should apply to wholesale and retail trade, and to catering.

• Consider bringing fee-based financial services into the VAT base. Also consider an addition-method tax on banks.

• Review and shorten the list of exempt goods and services under Article 208. Remove the exemption for tourism, recreation and sports, as well as for printed material, postal services, housing maintenance and real estate provided by banks.

• Bring agriculture into the VAT base at the standard rate, so that primary agriculture producers above the turnover-based threshold are required to become taxpayers.

• Remove the zero-rating for supplies of gas and water to households, perhaps with an exempt threshold.

• Allow full input-tax credits for purchases of machinery and equipment used in the production of taxable supplies.

52

• Analyze the impact of VAT base-broadening on low-income households and design offsetting expenditure and tax policies.

• Refunds of excess VAT credits should be paid in a timely manner.

• Equalize excise tax rates on imports and domestic production. Remove many of the excises on imports, retaining taxes on alcohol, tobacco products, vehicles, and petroleum products.

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V. INTERNATIONAL TAXATION 109. Domestic international tax rules are laid down in Uzbekistan’s tax code. Individual residency is established if the individual permanently resides in Uzbekistan or is present there for at least 183 days in a 12-month period. Corporate residency is established by being registered in Uzbekistan (formal criteria) and omits the more economic criteria set by “effective place of management”. Nonresident businesses are taxed like resident businesses. Nonresident individuals earning employment income are subject to a 20 percent flat rate. Cross-border dividend payments and interest are subject to 10 percent withholding tax, whereas royalties and service fees are subject to 20 percent withholding tax. There is no unilateral double tax relief available.

110. Uzbekistan has concluded 52 Double Tax Agreements (DTAs) that limit cross-border withholding taxes, provide for double tax relief, and enable exchange of information. Almost half of DTAs reduce withholding taxes on cross-border dividends and interest substantially, a few abolish them completely (Kuwait, Netherlands, and the United Kingdom). On royalty payments abroad, the domestic withholding tax will be limited in all but 2 cases.38 Figure 15 summarizes the limitation of withholding taxes under DTAs for intragroup dividends and interest payments, as well as for royalty payments related to patent rights. Most DTAs do not – or at least insufficiently – protect the withholding tax on service fees by establishing a service-PE.39

Figure 15. Withholding Tax Rate Limitation under DTAs

Source: IBFD Database, February 2018

38 Jordan and Kuwait. 39 The threshold-period for service-PEs varies from 3 months in a 12-month period to 12 months in a 24-month period.

54

111. Uzbekistan is not (yet) member of the Inclusive Framework, nor a signatory of important multilateral conventions/agreements to curb aggressive international tax planning (Figure 16). The IF is a group of over 100 countries and jurisdictions that collaborate on the implementation of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Package (Box 3). Uzbekistan is neither a signatory of the Convention on Mutual Administrative Assistance in Tax Matters (CMAA) that allows for exchange of information outside DTAs, nor a signatory of the Common Reporting Standard Multilateral Competent Authority Agreement (CRS-MCAA) that would allow for automatic exchange of information and exchange of country-by-country reports.

Table 10. Comparative Overview of International Agreements

Country DTAs BEPS CMAA CRS-MCAA Armenia 45 N Y40 N Azerbaijan 50 N Y Y Georgia 53 Y Y N Kazakhstan 52 Y Y N Kyrgyz Republic 27 N N N Tajikistan 38 N N N Turkmenistan 41 N N N Uzbekistan 52 N N N Belarus 68 N N N Russia 84 Y Y Y Ukraine 73 Y Y N

Source: IBFD Database, OECD, and IMF Staff, February 2018

40 Armenia signed the Protocol, but the MCAA has not yet been in force.

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Recommendation:

• In the medium-term, Uzbekistan should join the international community in curbing aggressive international tax planning. However, more consideration is needed as to the feasibility to implement various measures.

Box 3: OECD BEPS Project Outcomes The outcomes of the BEPS project take a variety of forms. In four areas, there are minimum standards, the expectation being that domestic law and/or treaties will be amended to adopt them:

(1) To counter treaty abuse, countries should include in treaties a “principle purposes test” provision and/or a limitation of benefits clause restricting access to treaty benefits.

(2) On transfer pricing documentation and country-by-country reporting, MNEs should be required to make available general information on their activities to all countries in which they are active; more detailed transaction information specific to each country; and—for those with group turnover of more than EUR 750 million—information on pre-tax profit and taxes paid and accrued in each jurisdiction. These data should be shared by the parent country in a manner consistent with its exchange of information agreements.

(3) In relation to harmful tax practices, taxpayer rulings that raise BEPS concerns should be shared automatically. Deliberations on patent boxes led to a “nexus” principle that the preferential tax regime should only apply to taxpayers who have incurred substantial R&D expenditure in the jurisdiction.

(4) For dispute resolution, countries should enact measures that ensure timely and good faith outcomes.

In some areas, guidance is captured by amendments to core OECD reference documents (permanent establishment and transfer pricing). In other areas, the outcome is guidance on a common approach (hybrid mismatches, interest deductions, controlled foreign corporation rules, and mandatory disclosure of aggressive tax planning), with an aspiration of convergence. Some recommendations, and the minimum standards in particular, will require treaty changes. By the end of 2016, a multilateral instrument was adopted that simultaneously modify signatories’ treaties.

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REFERENCES Allingham, Michael G. and Agnar Sandmo, “Income Tax Evasion: A Theoretical Analysis,” Journal of Public Economics 1, 323 – 338 (1972). Barzel, Philip and Jack Mintz, “2015 Tax Competitiveness Report—Canada is Losing its Attractiveness,” School of Public Policy, University of Calgary (SPP Research Papers, Vol. 9, Issue 37, November 2016). Botman, Dennis, Alexander Klemm, and Reza Baqir, “Investment Incentives and Effective Tax Rates in the Philippines: A Comparison with Neighboring Countries,” Fiscal Affairs Department and Asia and Pacific Department, International Monetary Fund (IMF Working Paper WP/08/207 (September 2008). Coolidge Jackie J., “Findings of Tax Compliance Cost Surveys in Developing Countries,” eJournal of Tax Research, 10(2), 250 – 287 (2012). Devereux, Michael P. and Rachel Griffith, Evaluating Tax Policy for Location Decisions,” International Tax and Public Finance 10: 107 – 126 (2003). Hall, R. E. and A. Rabushka, Low Tax, Simple Tax, Flat Tax. (New York: McGraw-Hill), (1983). Ivanova, Anna, Michael Keen, and Alexander Klemm, “The Russian Flat Tax Reform,” IMF Working Paper WP/05/16 (January 2005). Martens, P. et al., “Republic of Uzbekistan: An Enhanced Level of Tax Administration,” IMF (May 2013). IFC (2010), “Tax Compliance and Reporting Costs for Businesses in Uzbekistan.” OECD (2012) “Thin Capitalization Legislation: A Background Paper for Country Tax Administrations,” OECD Secretariat (August 2012). Klemm, Alexander, “Effective Average Tax Rates for Permanent Investment,” Journal of Economic and Social Measurement 37, 253 – 264 (2012). OECD (2016) Åsa Johansson, Øystein Bieltvedt Skeie and Stéphane Sorbe, “Anti-Avoidance Rules Against International Tax Planning: A Classification,” (OECD, Economics Departments Working Papers No. 1356 (December 2016). Sapiei, Noor Sharoja, Mazni Abdullah, Noor Adwa Sulaiman, “Regressivity of the Corporate Taxpayers’ Compliance Costs, Procedia - Social and Behavioral Sciences 164: 26 – 31 (2014).

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Sandmo, Agnar, “A Note on the Structure of Optimal Taxation,” American Economic Review 64, 701 – 706 (1974). Vigneault Marianne and Jean-Francois Wen, “Profit Taxes and the Growth of Fringe Firms,” Canadian Journal of Economics, Vol. 35, Issue 4: 717 – 736 (2002). Yitzhaki, Shlomo, “A Note on ‘Income Tax Evasion: A Theoretical Analysis,’” Journal of Public Economics 3, 201 – 202 (1974).

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Appendix I. Effective Tax Rates Analysis

The analysis of effective tax rates uses the Devereux and Griffith model (Devereux and Griffith, 2003), extended by Klemm to permanent investment (Klemm, 2008), and by the mission to include the property tax and turnover taxes. The theoretical discussion of the model, as well as its practical application for policy analysis has been widely documented41, and is not repeated here. The discussion below presents only the formulas used in the analysis (without showing the derivation of the formulas) to allow for replication of the results by an interested reader. Economic and tax law data used in the analysis, together with behavioral assumptions underpinning the model, are presented below.

The calculations are made under the following basic assumptions:

• The hypothetical capital investment is made by profit-making value-maximizing business.

• The new investment consists of purchasing machinery and equipment.

• The investment is financed by retained earnings.

• The business acts in an open economy that takes the world rate of return as given;

• Personal taxes do not affect investment decisions (i.e. analysis is done on the company-level and not on a shareholder-level).

The effective tax rate calculations are illustrative. None of the main conclusions would change if the investment is, instead, in buildings or financed by new equity instead of retained earnings. However, the effective tax rates would be significantly lower if the investment is financed by debt, because the interest payments are tax deductible for corporation income tax.

Economic and fiscal parameters are summarized in Table A.1 and Table A.2 below.

Table A.1. Economic parameters assumed in the analysis

Economic variables Symbol Value

True economic depreciation δ 12,25%

Inflation π 3,19%

Real interest rate r 5,75%

Pre-tax profit rate p 20%

41 See, for example, Abbas and Klemm (2012), or Botman, Klemm, and Baqir (2008).

59

Table A.2. Domestic tax variables used in the analysis Tax variables Symbol Rate/Notes

Depreciation allowance θ Straight-line depreciation

The cost of machinery and equipment may be deducted at a rate of 15% per year, beginning in the year after the acquisition.

Corporate tax rate τ 14%

Investment allowance ϕ 30%

Property tax tp 5%

Turnover tax ts 3,2% or 5%

The formulas presented in this Appendix are the ones used in modeling of this tax regime.

In the model, the AETR is calculated as present discounted value of taxes over the present discounted value of the profit of a project in the absence of taxation. Adopted by Klemm (Klemm, 2008) to permanent investment, rather than one-period perturbation, AETR is defined as:

𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 = 𝐴𝐴∗ − 𝐴𝐴𝑝𝑝/(𝑟𝑟 + 𝛿𝛿)

Where R* is discounted value of the economic rent earned in the absence of taxation, R is the same in the presence of taxation, p is the pre-tax profit (net of depreciation), r is the real interest rate, and δ is true economic depreciation.

R* — the economic rent in the absence of taxation — is determined as:

𝐴𝐴∗ = 𝑝𝑝 − 𝑟𝑟𝑟𝑟 + 𝛿𝛿

Economic rent after-tax, R, is determined as:

( )( ) ETAtpR PS +−−+−−−

++−++

= )1(1)1()1(

1 ττπδπρπδ

where

𝜌𝜌 is the investor’s discount rate; i the nominal interest rate, determined as 𝑖𝑖 = (1 + 𝜋𝜋)(1 +𝑟𝑟). In the absence of personal taxes 𝜌𝜌 = 𝑖𝑖.

π is the inflation rate

τ is the corporate tax rates applicable to the investment project under consideration

60

A is the present discounted value of depreciation allowances and includes the possibility of an investment allowance. Depreciation on a new investment is assumed to begin when the capital enters the production process. Depreciation takes place over T years at an annual rate of θ=1/T.

TP is the present value of the property tax, which is deductible from corporate income. The book value of property is the depreciated value of the asset, adjusted for inflation.

E is the present value of the tax benefit of the capital expenditure relief in Uzbekistan. Expenditure relief is a permitted deduction of up to 30 percent of taxable profits each year over a 5-year period for expenditures on incurred for the purchase or construction of a company’s business premises, plant or machinery, or the settlement of loans used for these purposes, less annual depreciation charges.

The value of A, for straight-line depreciation over T years, is given by

( ) ( )

( )

+−−+=

+++

++

+−+=

T

TA

ρρτθφτφ

ρτθ

ρτθ

ρτθφτφ

111)1(

1...

11)1( 2

where ϕ is the investment allowance, taken in the period of the investment.

With straight-line depreciation, the present value of the property tax, TP, is given by

( ) ( ) ( )

( ) ( ) ( )

+−−

+++−

++−

++−

+=

++−−

+++

+−+

++−

++

+−+=

−

−

−

132

1

1

3

3

2

2

1))1(1(...

1)31(

1)21(

1)1(1

1)1)()1(1(...

1)1)(31(

1)1)(21(

1)1)(1(

TP

T

T

PPPPPP

rT

rrrt

TtttttT

θθθθ

ρπθ

ρπθ

ρπθ

ρπθ

The value of the capital expenditure relief investment incentive, E, is given by

( ) ( )

( )( )

( )( )

( )( )

+−+−+

+

+−+−+

++

−+−++

+

−+−++−+=

4

44

3

33

2

22

1)1()1)((3.0

1)1()1)((3.0

1)1()1)((3.0

1)1)(1)((3.0)(3.0

ρθπδδτ

ρθπδδ

ρθπδδτ

ρθπδδθδτ

p

pp

ppE

61

To calculate METR, R is set to zero and solved for a pre-tax net profit p̃ (see, for example, Abbas and Klemm (2012), or Botman, Klemm, and Baqir (2008)).

δπ

πδπρττ

−

+++−

−−

−−+−=

1)1(

1)1(1~S

P

tETAp

Marginal effective tax rate is calculated as:

𝑀𝑀𝐴𝐴𝐴𝐴𝐴𝐴 = 𝑝𝑝𝑝 − 𝑟𝑟𝑝𝑝𝑝

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