Tax Reform: Three Budget Tiers, Progressive PIT, VAT and SMEs

Note: this text was written in 2016. The proposals on imputed-income and simplified regimes for SMEs reflect the views of that time; the author later came to advocate abolishing thresholds and special tax regimes.

Everyone has been talking about the tax system lately.

A sound tax system is a key instrument for economic growth and public welfare.

As it happens, the key roles in Kazakhstan's tax structure are played by taxes on subsoil use (including the export customs duty), corporate income tax (CIT) and indirect taxes (VAT and excise duties).

The main purpose of a tax system is to stimulate the economy and secure budget revenues. That requires a balanced system of taxation.

The tax system as an instrument can be used both through administration and through the taxes themselves.

All taxes should therefore be divided into three tiers:

1. Taxes credited to the National Fund of Kazakhstan: taxes from the oil sector
2. Taxes credited to the national budget: VAT, CIT, excise duties, customs duties and social taxes
3. Taxes credited to regional budgets: personal income tax (PIT), property taxes, vehicle tax, land taxes, and taxes on SMEs and agriculture

For regional taxes, local authorities should be allowed to set rates independently within limits established in the Tax Code.

This would let regions shape their own budgets and use taxes to attract investment and regulate economic activity in their territory.

This applies especially to the land tax and the taxation of SMEs. For example, it is clear that an SME in central Almaty earns more than one on the outskirts. To encourage SMEs on the outskirts, they should be given reduced rates, while rates in the center should be raised.

As for tax reform, apart from subsoil use taxes (which must be reformed first), the following need to be reformed:

1. Personal income tax: move to a progressive system with a large number of deductions and a high tax-free threshold. This would redistribute income from high earners to low earners.

The main aim of this reform is to stimulate domestic demand. By raising the income of low earners, we raise demand in the country, since high earners save less and overall consumption grows.

To encourage high earners to spend, they should be given generous deductions, for example for medical services, education, housing, medicines and so on. This would stimulate consumption of services that are almost entirely of Kazakhstani origin and would have a positive effect on the country's economy.

2. VAT: the main problem with VAT is the use of input VAT that is never actually paid later, owing to various schemes.

Here we need to move to a cash-basis system, under which only VAT that has actually been paid by the supplier of goods, works and services can be claimed as a credit. Then, if a supplier does not pay VAT, the buyer will pay it. This would completely eliminate companies with fictitious input VAT.

VAT on loan interest should also be abolished, which would stimulate investment in the country. The existing system does not allow for borrowing between companies within a group. VAT relief for geological exploration should also be introduced (I will devote a separate post to this in the future).

VAT exemptions in the form of non-taxable turnover should be removed from the Tax Code altogether. Better still, simply exempt SMEs that use the simplified tax system or imputed-income taxation. This would be fair, since only SMEs will be able to use the simplified systems (described below).

3. SMEs: SME taxation should encourage the development of small business and be a very simple tax, so that SMEs do not bear additional bookkeeping costs. The task of SMEs is to create jobs and build a middle class, not to supply budget revenue. SMEs can serve as a source of revenue only for local budgets.

SME taxation therefore needs the following:

• An imputed income tax. This means calculating imputed income for particular types of activity and taxing it. Imputed income would depend on physical indicators, such as square meters, number of tables and so on. This greatly simplifies tax administration and calculation, and lets local authorities use the instrument to zone SMEs within a city.
• A simplified tax system based on income for SMEs. Here it is essential to identify clearly who counts as an SME. For example, criteria should be set such as headcount, assets, revenue and expenses, and the founder of the SME should be an individual. Types of activity that cannot qualify as SMEs should be listed separately.

A clear definition of an SME is needed so that large companies cannot use it as a mechanism for tax evasion.

For simplicity, a fairly simple tax should naturally be introduced, calculated as a rate applied to income. Income should be measured on a cash basis.

Profit could also be considered as the base for a simplified tax system, but here too, to keep bookkeeping simple, the cash method should be allowed.

In addition, SMEs should have the right to choose between these systems.

These are just brief thoughts. I will write about subsoil use separately, but it is precisely these taxes that need to be reformed, rather than wasting time on nonsense and trying to reinvent the wheel.