Turkey: Challenges in tax reform in an international perspective

1. Turkey: Challenges in tax reform in an international perspective Presentation by Teresa Ter-Minassian at the MoF-UNDP seminar on “Tax Policy Options for Turkey in the wake of EU accession” Ankara, Jan. 12-13, 2009 The views expressed are those of the author and not necessarily of the IMF

2. Overview of presentation • Revenue trends and composition in Turkey in an international perspective • Recent reforms • Main remaining challenges for tax policy and administration

3. Overall revenue trends • Turkey increased its overall tax revenue to GDP ratio significantly between 1995 and 2001, by more than the OECD average and most emerging markets (EM) countries, but progress has stalled in recent years • The revenue ratio remains significantly below the OECD and EUaverages, albeit slightly above the EM average • In a medium-term perspective, a gradual further rise in the revenue ratio may be needed, together with expenditure reforms, to create sustainable fiscal space for new priority spending.

4. Revenue trends in the OECD

5. Revenue trends in Turkey General government tax revenue in selected OECD countries, 1998-2006

6. Tax ratios in the OECD

7. Revenue composition • The share of taxes on goods and services in general government revenues, albeit declining in the more recent years, is significantly higher in Turkey than in the rest of the OECD • The share of excises (Special Consumption Tax, SCT) is especially high (about 20%, compared with less than 8% on average in the OECD), reflecting: • Very high rates (as much as 275%) on some products; and • The relative ease of collection of these taxes • The revenue productivity of the VAT remains relatively low (around 30%, compared to the 40% more typical in better-performing VATs). This reflects broader than average range of exemptions and coverage of reduced rates, as well as weaknesses in the administration of the tax

8. Revenue composition • Since the PIT and CIT rates are not substantially lower than OECD averages, the relatively low share of income taxes in total revenues (21.5% vs over 36% on average in the OECD) reflects: • Leakages from the base (significant exemptions and other preferential treatments); and • Weak compliance and enforcement. • Despite relatively high rates, revenue from social securitycontributions is also below the OECD average, reflecting the high degree of labor market informality and enforcement weaknesses • The small weight of property taxes (less than 1% of GDP) mainly reflects inadequacies in property valuation

9. Revenue composition in Turkey and the OECD

10. Recent tax reforms in Turkey • Main steps taken in recent years to rationalize the tax system • Move towards a modern dual PIT: • Some simplification of the PIT structure • A more uniform taxation of financial income • A design of the CIT (including a rate cut, and rules on transfer pricing and thin capitalization) more in line with the growing internationalization of the Turkish economy • Tax administration reforms • Establishment of a semi-autonomous, functionally organized Revenue Administration (RA) and a large taxpayer office (LTO) • Strengthened IT infrastructure for the RA • But, also some retrogression: • Introduction of new special treatments and tax incentives • Repeated tax amnesties, weakening compliance morale

11. Agenda for further reforms • Additional efforts to mobilize revenue over the medium term should be consistent with efficiency and equity objectives, and take into account Turkey’s growing trade and financial integration into the global economy, and in particular Europe • These considerations argue for focusing further tax reform efforts on: • Broadening the bases of the major taxes • Reducing those rates that are relatively high in an international perspective • Continuing to strengthen the tax administration, facilitating voluntary tax compliance and making enforcement more effective; and • Seeking to expand own revenue-raising capacity of local governments

12. Broadening the tax base:Income taxes • PIT • Subjecting public pensions to the PIT, with (possibly partial) offsetting adjustment in value of pensions, and reducing generosity of treatment of private ones • Eliminating current exemption of certain types of employment income • Reducing threshold for agricultural incomes • Capping all deductions • Subjecting all financial income to uniform final withholding • CIT • Significantly reducing existing incentives (with respect of acquired rights), and refraining from introducing new ones

13. Broadening the tax base:VAT and property taxes • VAT: • Reducing the coverage of exemptions • Eliminating the 1% rate (not consistent with the EU acquis communautaire): • Exempting wholesale sales of unprocessed agricultural foods • Moving other categories to 8% or standard rate • Moving some categories of goods and services (e.g. textiles; entertainment tickets; restaurants; tailoring; and hotel services) to the standard rate, in line with international experience • Limiting scope of free trade zones, especially in view of likelihood of leakages • Property tax • Potentially important source of own revenue for local governments • Local governments should be given limited authority to set rates of the tax • Ensuring up-to-date valuation of properties through development of modern national cadaster

14. Reducing high rates and distortive taxes • SCT • Very high rates on some products may promote smuggling and other forms of evasion. • The rate structure for certain products (e.g. alcoholic beverages and tobacco) favors domestic production over imports, and will need to be modified to adjust to EU requirements on accession • To the extent that some of the taxed goods are used as inputs into production, and the SCT cannot be rebated for exports, it reduces competitiveness • The fiscal dividends of base broadening for other taxes, and of improved compliance could be used for selective reductions in the SCT rates

15. Reducing high-rate and distortive taxes • Financial intermediation taxes (BITT and RUSF) • While for the most part acting as substitutes for the VAT on financial services, in some cases (e.g. purchases of foreign exchange and financing of imports) they represent actual turnover taxes, with distortive effects. • Even as substitutes for the VAT, these taxes may be incompatible with the EU Sixth Directive • Social security contributions • Relatively high social security contributions rates promote labor market informality, and reduce employment, as well as competitiveness (since they are not eligible for border tax adjustment). Improved enforcement of their collection (including through avoiding further amnesties) would open space for some reduction in the rates.

16. Promoting voluntary taxpayer compliance • Effectively promoting voluntary tax compliance requires both facilitating the latter and increasing enforcement deterrence. Possible actions to facilitate compliance include: • Firmly and publicly committing to not introducing new tax amnesties • Streamlining taxation of small businesses • Introducing a threshold for VAT payers (aligned with the simplified PIT regime ceiling) • Eliminating the rental ceiling for application of the simplified PIT regime. Developing and announcing industry-specific standards for input credits and sales for the regime, to guide audit efforts in this area. • Continuing to improve taxpayer services, in particular by developing a national outreach service for new businesses • Implementing a risk-based and timely export refund system, to promote VAT compliance and export competitiveness

17. Strengthening tax enforcement • Vigorously pursuing implementation of RA-led multi-agency Action Plan to Reduce Informality • Substantially strengthening the audit function • Consolidating the audit function under the RA • Increasing the number and capacity of RA auditors • Developing improved, risk-based audit selection strategies (including with respect to employers and high net-wealth individuals) • Better exploiting data matching and cross checking IT capabilities in audits • Allowing indirect determination of tax liability, based on clearly specified criteria • Establishing a specialist investigation unit for criminal tax frauds, and publicizing results of successful prosecutions • Developing and implementing modern approach to tax arrears management • Focusing on larger, more recent debt • Establishing automated debt collection procedures • Introducing clear criteria for debt write-offs

18. Concluding remarks • Turkey has already made significant progress in establishing a modern tax system and tax administration • Although the overall tax burden is not out of line with those of many countries at a comparable level of development, it maywell have to rise further over the medium term, as the economy integrates further into the OECD and ultimately the EU • Tax and tax administration reforms to mobilize additional revenue should also pursue other important objectives: • Efficiency (reduction of distortions) and international competitiveness • Reduction of incentives to informality • Horizontal and vertical equity • Facilitation of voluntary tax compliance; and • More effective deterrence of non-compliance

19. Concluding remarks • In my view, the reforms advocated in this presentation would support these objectives, in as far as: • Effectively broadening the bases of the VAT, PIT and CIT would enhance horizontal equity and reduce distortions • The additional revenue generated by these reforms could be used to reduce certain rates (of e.g. employers’ contributions, certain excises and the financial intermediation taxes), with favorable impact on growth and competitiveness, and to fund additional targeted spending for the poor • A significantly strengthened tax administration would certainly enhance both equity and economic efficiency • I look forward to a lively discussion of these and other possible reforms in the course of the seminar

20. Thank you!