1. 1 Estimation of Transaction Costs during Tax Collection Process Prepared by: Tigran Jrbashyan Armenian Director AEPLAC Davit Harutyunyan Senior Capacity Building Expert AEPLAC 4 th International AIPRG Conference on Armenia World Bank January 14-15, 2006 Washington D.C.

2. 2 Compliance and Transaction Costs …Costs incurred by taxpayers, or third parties such as businesses, in meeting the requirements laid upon them in complying with a given structure and level of tax … (Sandford, C) …Costs incurred by taxpayers, or third parties such as businesses, in meeting the requirements laid upon them in complying with a given structure and level of tax … (Sandford, C) ….The costs of functioning of an economic system i.e. any costs are derived as a result of interrelation of economic agents regardless where it occurred … ….The costs of functioning of an economic system i.e. any costs are derived as a result of interrelation of economic agents regardless where it occurred … …Transaction costs derived during tax compliance… …Transaction costs derived during tax compliance…

3. 3 The main types of transaction costs Costs of obtaining information Costs of obtaining information Costs of negotiation Costs of negotiation Costs of measurement Costs of measurement Costs of protecting of property rights Costs of protecting of property rights Costs of opportunistic behavior Costs of opportunistic behavior

4. 4 Costs of obtaining information Indispensable expenses incurred by economic entities related to the acquisition of all documents necessary for submission to the tax authority and for tax inspection procedures. Cash operation books, sales books and incoming goods books Cash operation books, sales books and incoming goods books Publications or e-packages on tax legislation (including expenses for updating of these packages) Publications or e-packages on tax legislation (including expenses for updating of these packages) Advisory services Advisory services Personnel training Personnel training

5. 5 Costs of negotiation Financial resources and time needed to establish good relations with representatives of the tax authority. Business meetings (lunches) Business meetings (lunches) Gifts Gifts Extra salaries paid to an accountant or other employee Extra salaries paid to an accountant or other employee Other expenditures Other expenditures

6. 6 Costs of measurement Time and related expenses for preparation of a package of documents to be submitted to the tax authority. Salary paid to accountants Salary paid to accountants Salary paid to managers Salary paid to managers Salary paid to other specialists Salary paid to other specialists E-packages costs E-packages costs Documents submission costs Documents submission costs

7. 7 Costs of protection of property rights Time and related expenses for protection of property rights of economic entities during lawsuits and tax inspection processes. Costs of hiring of lawyers Costs of hiring of lawyers Costs of hiring of accountants Costs of hiring of accountants Costs related to lawsuits procedures Costs related to lawsuits procedures Salary to skilled accountant Salary to skilled accountant

8. 8 Costs of opportunistic behavior Costs emerged due to asymmetric information between the economic entity and the tax authority. Interest accrued on VAT advance payments to the State Budget Interest accrued on VAT advance payments to the State Budget Accrued interest of VAT on exports subject to a refund from the State Budget Accrued interest of VAT on exports subject to a refund from the State Budget Percentage over the sum of positive difference between the prepaid profit tax and real profit tax which is the subject of reimbursement by the state Percentage over the sum of positive difference between the prepaid profit tax and real profit tax which is the subject of reimbursement by the state

9. 9 Structure of transaction costs Costs of measurement – 74.4% Costs of measurement – 74.4% Costs of obtaining information – 17.4% Costs of obtaining information – 17.4% Costs of opportunistic behavior – 3.9% Costs of opportunistic behavior – 3.9% Costs of protecting property rights – 2.5% Costs of protecting property rights – 2.5% Negotiation costs – 1.9% Negotiation costs – 1.9%

10. 10 Considering the taxes paid per employee, taxes paid by companies with one employee are nearly 3.5 times more than those paid by companies with more than 101 employees. Considering the taxes paid per employee, taxes paid by companies with one employee are nearly 3.5 times more than those paid by companies with more than 101 employees. Tax burden (ratio of taxes paid by the relevant sectors to the volume of sales) accounts for 20% in industry, 3.3% in construction, nearly 2% in wholesale and retail trade, and 6.4% in services. Tax burden (ratio of taxes paid by the relevant sectors to the volume of sales) accounts for 20% in industry, 3.3% in construction, nearly 2% in wholesale and retail trade, and 6.4% in services. Main findings

11. 11 Transaction costs per employee in an entity with one employee is 51 times more than in companies with more than 101 employees. Transaction costs per employee in an entity with one employee is 51 times more than in companies with more than 101 employees. In companies with less than 1 million AMD turnover the ratio of transaction costs to taxes paid exceeds 21 times the figure of the companies with more than 500 million AMD turnover, while in the entities with one employee it exceeds 20 times the same indicator for companies employing more than 101 people. In companies with less than 1 million AMD turnover the ratio of transaction costs to taxes paid exceeds 21 times the figure of the companies with more than 500 million AMD turnover, while in the entities with one employee it exceeds 20 times the same indicator for companies employing more than 101 people. Main findings

12. 12 Transaction costs at national level The average level of transaction costs as a percentage share in the total taxes paid is 11.5%. The average level of transaction costs as a percentage share in the total taxes paid is 11.5%. The overall transaction costs of economy accounted to 13,538.4 million AMD or about 0.8% of GDP for 2003. The overall transaction costs of economy accounted to 13,538.4 million AMD or about 0.8% of GDP for 2003.

13. 13 The cost of collection ratio increased by 93.4% and reached from 1.7% to 3.24% The cost of collection ratio increased by 93.4% and reached from 1.7% to 3.24% The ratio of % change of tax revenues to % change of administrative expenses was 0.1 The ratio of % change of tax revenues to % change of administrative expenses was 0.1 The tax buoyancy was 0.58 The tax buoyancy was 0.58 Transaction costs of businesses are large relative to tax administration costs approximately 3.6 times Transaction costs of businesses are large relative to tax administration costs approximately 3.6 times An efficiency of tax administration in Armenia for 2002-2003

14. 14 Conclusions The database of the State Tax Service needs to be regularly updated. The database of the State Tax Service needs to be regularly updated. Tax administration is one of the painful and sensitive issues for economic entities. Tax administration is one of the painful and sensitive issues for economic entities. Business culture is still at quite a low level in Armenias business reality. Business culture is still at quite a low level in Armenias business reality. The largest expenditures on information gathering fall to the share of companies running in the industry sector. The largest expenditures on information gathering fall to the share of companies running in the industry sector.

15. 15 The better the entities are informed about the tax system, the less they are exposed to the opportunistic behaviour of tax authorities. The better the entities are informed about the tax system, the less they are exposed to the opportunistic behaviour of tax authorities. An increase in the number of software users may contribute to the decrease of measurement costs. An increase in the number of software users may contribute to the decrease of measurement costs. The availability of skilled specialists within the staff of economic entities leads to a decrease in the level of expensiveness of contacts with tax authorities and reduces the number of companies dissatisfied with the behaviour of tax officers. The availability of skilled specialists within the staff of economic entities leads to a decrease in the level of expensiveness of contacts with tax authorities and reduces the number of companies dissatisfied with the behaviour of tax officers. Conclusions

16. 16 The establishment of good relations with tax authorities is basically stipulated by the expensiveness of contacts with tax authorities, drawbacks of tax legislation and the unfriendly attitude of tax officers. The establishment of good relations with tax authorities is basically stipulated by the expensiveness of contacts with tax authorities, drawbacks of tax legislation and the unfriendly attitude of tax officers. There is no direct correlation between the amounts of collected taxes and the frequency of tax inspections i.e. tax inspections are costly for the state because they do not ensure adequate collection of tax revenues. There is no direct correlation between the amounts of collected taxes and the frequency of tax inspections i.e. tax inspections are costly for the state because they do not ensure adequate collection of tax revenues. Dissatisfaction with the tax system depends also on the frequency of inspections. Dissatisfaction with the tax system depends also on the frequency of inspections. Conclusions

17. 17 The expensiveness of legal proceedings (in terms of both money and time) is a serious obstacle for the actions of economic entities in the context of protecting their rights. The expensiveness of legal proceedings (in terms of both money and time) is a serious obstacle for the actions of economic entities in the context of protecting their rights. The main reasons for tax-related disputes are as follows: drawbacks of tax legislation, advanced payments levied by tax authorities, the unfriendly attitude of tax officers. The main reasons for tax-related disputes are as follows: drawbacks of tax legislation, advanced payments levied by tax authorities, the unfriendly attitude of tax officers. One of the reasons for an opportunistic behaviour is the drawbacks of tax legislation. One of the reasons for an opportunistic behaviour is the drawbacks of tax legislation. Conclusions

18. 18 Most companies that paid advanced payments have not filed a lawsuit since they have always agreed with the findings of tax inspection, i.e. the opportunistic behavior of tax authorities has, in its turn, provided some guaranty for economic entities. Most companies that paid advanced payments have not filed a lawsuit since they have always agreed with the findings of tax inspection, i.e. the opportunistic behavior of tax authorities has, in its turn, provided some guaranty for economic entities. In terms of the percentage share of transaction costs per employee and the taxes paid, it can be noted that on the whole these are more costly for small and medium enterprises. In terms of the percentage share of transaction costs per employee and the taxes paid, it can be noted that on the whole these are more costly for small and medium enterprises. Small and medium-sized businesses are in an unfavourable situation in terms of the relations with the tax authorities (in terms of expensiveness). Small and medium-sized businesses are in an unfavourable situation in terms of the relations with the tax authorities (in terms of expensiveness). Conclusions

19. 19 The shortcomings of tax legislation and tax administration have an adverse effect, first of all, on medium-sized businesses, as small businesses fall out of the focus of attention due to their size, while the large ones use their institutional capacity and are generally inaccessible for tax authorities. Main conclusion

20. 20Recommendations To update the tax database To update the tax database To exclude the possibility of personal contacts between the representatives of economic entities and tax authorities To exclude the possibility of personal contacts between the representatives of economic entities and tax authorities To eliminate implementation of so-called planned system of tax collection To eliminate implementation of so-called planned system of tax collection To make tax legislation more precise and simplified To make tax legislation more precise and simplified To change mechanism of tax inspection (separation of large, medium and small enterprises) To change mechanism of tax inspection (separation of large, medium and small enterprises) To stop the practice of advance payment clearance To stop the practice of advance payment clearance

21. 21 To specify and maximally simplify the hearing procedures for tax-related disputes To specify and maximally simplify the hearing procedures for tax-related disputes To strengthen the factor of information within tax authorities To strengthen the factor of information within tax authorities To specify the procedure of providing accounting services by specialized structures To specify the procedure of providing accounting services by specialized structures To implement structural reorganization of the tax system To implement structural reorganization of the tax system To simplify the VAT calculation and supervision procedures To simplify the VAT calculation and supervision procedures To conduct similar studies on regular basis To conduct similar studies on regular basis Recommendations

22. 22 Thank you Thank you