## 1. Former Soviet Union Countries: Progress on Tax Policy

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### I. INTRODUCTION
- Azerbaijan is experiencing a large but temporary oil production boom; oil production is expected to start its decline around 2011.
- Key challenge: ensure the non-oil tax system operates efficiently and generates adequate revenues while minimizing distortions.
- Paper structure:
  - Section II: reviews developments in tax policy and administration explaining the increase in the ratio of non-oil tax revenue to non-oil GDP during the last five years.
  - Section III: analyzes deficiencies of the current system and assesses sustainability of strong non-oil revenue performance.
  - Section IV: provides estimates of potential annual tax revenues from VAT and customs duties for 2005–07 and assesses revenue shortfalls from exemptions and administration shortcomings.
  - Section V: suggests measures drawing on theory, empirical evidence, and experience from BRO and some Eastern European countries.
  - Section VI: concludes with main findings and recommendations.
- Recommendation summary:
  - Phased implementation of proposed tax measures.
  - Short term: expansion of tax base, reduction of exemptions, improvements in tax administration to yield higher revenues.
  - Medium term: consider reducing some direct tax rates on efficiency and equity grounds once a robust revenue base is established.
- Key assumption: the non-oil tax revenue to non-oil GDP ratio should remain broadly unchanged over the medium term.

### II. NON-OIL TAX REVENUE DEVELOPMENTS
- Progress and trend:
  - Non-oil tax revenues increased from about 20 percent of non-oil GDP in 2003 to about 32 percent in 2007.
- Main components of the non-oil tax system: VAT, simplified tax, income taxes, social security contributions (SSCs), excise taxes, and customs duties.
- Notable policy changes during 2003–07:
  - Corporate income tax rate lowered from 24 percent to 22 percent in 2005.
  - Combined SSCs by employer and employee reduced from 28 percent to 25 percent in 2004.
  - Excise taxes were regularly increased.
- Average shares during 2003–07:
  - VAT contributed almost 38 percent of non-oil tax revenues.
  - Income taxes contributed 28¼ percent.
  - SSCs contributed 14¼ percent.
- Structural shift:
  - Budget became increasingly dependent on direct tax revenues; decline in share of indirect taxes.
  - VAT share declined from 42¾ percent in 2003 to 34¾ percent in 2007.
- Selected exact figures (non-oil tax revenues, millions of manats and percents, 2003–07):
  - Non-oil tax revenues (millions of manats): 837, 1,024, 1,454, 1,905, 2,984; average 1,641.
  - Non-oil tax revenues and SSCs (millions of manats): 986, 1,206, 1,652, 2,199, 3,535; average 1,915.
  - Non-oil tax revenues and SSCs (percent of non-oil GDP): 19.7, 20.6, 23.6, 25.4, 31.8; average 24.2.
  - VAT and simplified tax share (percent of non-oil tax revenues): 42.8, 38.9, 38.0, 34.9, 34.7; average 37.9.
  - Direct taxes share (percent of total): 38.2, 42.7, 42.0, 44.9, 44.6; average 42.5.
  - Indirect taxes share (percent of total): 61.8, 57.3, 58.0, 55.1, 55.4; average 57.5.

### III. MAIN ISSUES OF THE CURRENT NON-OIL TAX SYSTEM
- Tax administration modernization (by 2004 and since 2005):
  - Enactment of a consolidated tax code.
  - Establishment of a full service large taxpayers unit.
  - Adoption of automated systems in several functions; introduction of electronic filing; integrated computer system for all taxes.
  - Creation of a taxpayers services program; one-stop shop business registration in early 2008.
  - Strengthening human resources management, performance measurement, and MOT facilities.
- VAT administration problems and remediation:
  - Fraud via fictitious businesses requesting VAT refunds; non-compliance with registration procedures.
  - Cleaning up VAT register resulted in a 50 percent reduction in the number of registered VAT taxpayers between 2005 and 2007.
  - VAT bank accounts became effective on January 1, 2008.
- Customs administration problems and responses:
  - Governance and administrative problems contributed to significant tax evasion at customs.
  - Customs Committee implemented a “single window” facility for customs clearance and card payments to increase transparency and reduce face-to-face interactions.
- Widespread exemptions and special regimes:
  - Special regimes favor firms participating in PSAs and JVs in the hydrocarbon sector: suppliers provide inputs at zero-rate VAT via certificates; this practice undermines tax system integrity and complicates enforcement.
  - VAT exemptions list (early 2008) included: some agricultural products; imports of grains; pharmaceutical products; fertilizers; military equipment; aluminum ore; electricity; some food and paper items; agro-leasing services.
  - Authorities reported a decline in exempt consumption share from 32.0 percent of total consumption in 2004 to about 29.6 percent by 2006.
- Informal economy:
  - Large informal economy using mainly cash undermines non-oil tax collection and erodes tax base.
  - One-stop registration facility operated by MOT expected to help reduce informal economy size.
- Fiscal sustainability concerns:
  - Corporate income tax collection boosted by withholdings on subcontractors in oil-and-gas-related construction projects, which are slowly ending.
  - Rapid increases in personal income taxes and SSCs reflect rapid growth of public sector wages and pensions, which is not sustainable longer term.
  - Projected decline in oil revenues around 2011 may coincide with a slump in direct taxes; public expenditure increases on wages and pensions need moderation to avoid a wage-price inflation spiral and keep non-oil fiscal deficit sustainable.

### IV. ESTIMATES OF THE VAT AND CUSTOMS REVENUE POTENTIAL (2005–07)
- Objective: quantify revenue losses from exemptions and administration shortcomings for VAT and customs duties for 2005–07.

- VAT potential and losses (2007, exact figures):
  - Total potential VAT revenues in 2007: AZN 1,791 million or 16.1 percent of non-oil GDP.
  - Actual VAT revenues in 2007: VAT 1,179 million; simplified tax 47 million; VAT plus simplified tax 1,226 million.
  - Estimated VAT losses in 2007: total AZN 565 million.
    - Losses due to exemptions: AZN 503 million.
    - Losses due to tax administration problems: AZN 62 million.
  - Losses represented about 31½ percent of potential VAT revenues (2007).
  - VAT administration losses estimated at about 0.6 percent of non-oil GDP in 2007 compared to 2.4 percent of non-oil GDP in 2006.
- Selected VAT-related exact figures (2005–07, millions of manat unless specified):
  - Final consumption (including VAT): 6,582 (2005), 8,443 (2006), 11,148 (2007).
  - Final consumption (excluding VAT): 5,879 (2005), 7,537 (2006), 9,951 (2007).
  - Total potential VAT revenues: 1,058 (2005), 1,357 (2006), 1,791 (2007).
  - Exemption rate (percent): 30.0 (2005), 29.6 (2006), 29.6 (2007).
  - Value of exemptions: 1,974 (2005), 2,499 (2006), 3,300 (2007).
  - VAT revenue growth rates (memorandum): Final consumption (including VAT) annual growth rates: 12.3, 28.3, 32.0; VAT and simplified tax revenues annual growth rates: 33.9, 22.1, 59.9; Non-oil GDP annual growth rates: 19.5, 23.6, 28.6.

- Customs duties potential and losses (2007, exact figures):
  - Non-oil imports: 4,080 (2007).
  - Total potential customs revenues at average statutory rate of 5.7 percent: AZN 233 (2007) or 2.1 percent of non-oil GDP.
  - Actual customs duties revenue in 2007: 159.
  - Estimated customs revenue losses in 2007: total AZN 73.
    - Losses due to exemptions (official estimates): AZN 42 million.
    - Losses due to customs administration shortcomings: AZN 31 million (or 0.3 percent of non-oil GDP) in 2007 compared to AZN 8 million (or 0.1 percent of non-oil GDP) in 2006.
  - Total revenue losses (percent of potential revenues): 22.9 (2005), 22.8 (2006), 31.5 (2007).
  - Average effective customs duty rate (memorandum): 4.4 (2005), 4.4 (2006), 3.9 (2007).

- Methodology notes:
  - VAT potential estimates incorporate an exemption rate provided by the Ministry of Taxes and IMF staff calculations of final consumption excluding VAT.
  - Customs potential used reported average statutory customs duty rate of 5.7 percent provided by Customs officials; officials noted the rate declined after 2004 but new rate not provided to IMF staff.
  - Estimates do not capture possible underinvoicing of imports.

### V. REFORMING THE NON-OIL TAX SYSTEM
- Short-term measures (summary and key recommendations):
  - Expand the non-oil tax base by reducing exemptions and phasing out special regimes.
  - Quantify fiscal cost of existing exemptions and special tax regimes and specify intended time span.
  - Increase transparency in granting tax privileges to mobilize political support for reducing exemptions and phasing out special regimes (e.g., publish names of individuals or firms enjoying tax benefits).
  - VAT-specific recommendation: phase out the special tax regime for PSAs and JVs; prefer suppliers charge VAT in the usual way and provide PSAs and JVs with a timely refund.
- Short-term revenue and administration recommendations (selected actions):
  - Quantify cost of exemptions, submit proposals for new exemptions to Parliament for approval, and indicate their time span.
  - Strengthen customs administration by eliminating ad-hoc implementation of regulations and reducing direct contacts between customs officials and importers.
  - Strengthen voluntary compliance and conditions for effective self-assessment.
  - Introduce more targeted risk-management approaches for audits.
  - Develop an effective fraud intelligence network for early warning of potential fraudulent and evasion activities.
  - Reduce compliance costs by simplifying procedures and reducing frequency of filing.
  - Strengthen governance and performance measurement (including client satisfaction indicators).
  - Build capacity to deal with complex compliance issues (e.g., transfer pricing and oil-related tax issues).
  - Improve quality of tax statistics for analytical purposes.
- Tax administration priorities:
  - Implement risk management approaches within key taxpayer segments.
  - Reduce compliance costs of doing business in meeting tax obligations.
  - Shift toward a modern system of self-assessment.
- Customs administration priority:
  - Continue simplification of customs procedures and modernization of the regulatory framework, including putting in place a new Customs Code, currently under preparation, as expected in the context of WTO accession.
- Conditions for an effective self-assessment system (summary):
  - Simple tax laws: understandable laws, uniform application, limited exemptions, simple rate structure, appropriate registration thresholds, simplified systems for small taxpayers.
  - Services to taxpayers: tax office assistance with clear information, advance notice of changes, easy access to information and forms, consistent interpretation with binding rulings.
  - Filing and payment procedures: simple forms, clear instructions, convenient submission means.
  - Collection enforcement: prompt detection and expeditious enforcement actions, administrative actions quickly against large taxpayers.
  - Audit: sufficient resources to audit a reasonable percentage of taxpayers each year; taxpayers maintain records and issue invoices; simplified bookkeeping for small taxpayers as needed.
  - Penalties: strict and uniform penalties; distinguish interest from penalties; non-financial penalties and criminal prosecution for tax fraud where appropriate.
  - Access to independent review: administrative and judicial appeal processes for taxpayers.
- Data, reporting, and accounting:
  - Availability and quality of tax data must be further improved.
  - Financial and accounting reporting practices of many individuals and firms in Azerbaijan make it difficult to generate reliable and detailed tax statistics.
  - The mandatory implementation of the International Financial Reporting Standards starting in 2008 would provide a good basis to assess the economic impact of tax policy if the new reporting standards are effectively enforced.
- Medium-term measures and objectives:
  - Once the tax base is expanded and administration strengthened, consider more far-reaching tax reforms to:
    - Maintain revenues close to their full potential.
    - Minimize economic distortions associated with taxation.
    - Improve equity and simplicity of the tax system.
  - Review composition of non-oil revenues, currently skewed in favor of direct taxes, weighing advantages and disadvantages of indirect and direct taxes in Azerbaijan.
- Theoretical and empirical considerations (summary):
  - Consumption taxes (e.g., VAT) are considered more efficient (less distortionary) but less equitable than direct taxes.
  - Direct taxes are more equitable in principle but often less efficient and in practice less progressive in developing countries due to exemptions and deductions.
  - Corporate income taxes can reduce return on capital, negatively affect investment, and are often accompanied by exemptions and special regimes favoring larger firms.
  - Empirical evidence on taxes and growth is mixed; consumption taxes show inconclusive impacts; high personal income taxes linked to negative impacts on growth in advanced countries; taxation of capital income generally negatively correlated with savings and investment rates.
- Proposed measures and quantitative scope:
  - Boost the share of indirect taxes in total revenues by reducing exemptions and improving compliance.
  - Significant scope for improving collection of indirect taxes (up to 6 percent of non-oil GDP) and direct taxes as well—allowing for possible lowering of direct tax rates while remaining revenue neutral through better compliance and fewer exemptions.
  - By regional standards, tax rates on personal and corporate incomes are relatively high in Azerbaijan.
- Suggested tax reforms for Azerbaijan:
  - Simplify the tax system: curtail exemptions and consider establishing a single rate income tax (single personal and corporate income tax rate).
  - In Azerbaijan, currently a single corporate income tax rate and multiple personal and capital income tax rates exist; these could be unified into a single rate.
  - Personal and capital income tax rates range from 14 to 35 percent; these could be unified with the existing single corporate income tax rate at a level equal to or below the current 22 percent.
  - The SSCs rate, at 25 percent, is broadly in line with those in other BRO countries and could remain unchanged. 1/
  - Indirect taxes: VAT rate in Azerbaijan is 18 percent and no changes are suggested.
  - Footnote: "Changes in social security contribution rates should only be considered in the context of a wider reform of the social security system."

### VI. MAIN FINDINGS AND RECOMMENDATIONS (CONCLUDING POINTS)
- Main findings:
  - Azerbaijan’s non-oil tax revenues increased significantly as a share of non-oil GDP in the last five years, but remain below potential.
  - The non-oil revenue shortfall is mainly due to widespread tax exemptions, with further scope to strengthen tax and customs administration.
  - Recent buoyancy of direct taxes does not seem sustainable over the medium term; both oil and non-oil revenues may start to decline relative to non-oil GDP in the next decade.
- Key recommendations:
  - Short-term: expand the tax base by reducing exemptions, phase out special tax regimes, and strengthen tax and customs administration to yield more revenues.
  - Medium-term: once the base is expanded and revenues stabilized close to potential, consider far-reaching reforms (including merit of reducing some direct tax rates) and make the overall reform package broadly revenue neutral by improving compliance and reducing exemptions.

*Extracted from the IMF working paper chapter titled "1. Former Soviet Union Countries: Progress on Tax Policy" (Azerbaijan non-oil tax analysis, 2003–07).*

### 1. Former Soviet Union Countries: Progress on Tax Policy................................................ 4

### 1. Former Soviet Union Countries: Progress on Tax Policy................................................ 4

### I. INTRODUCTION
- Azerbaijan is experiencing a large but temporary oil production boom; oil production is expected to start its decline around 2011.
- Key challenge: ensure the non-oil tax system operates efficiently and generates adequate revenues while minimizing distortions.
- Paper structure (summary of sections):
  - Section II: reviews developments in tax policy and administration explaining the increase in the ratio of non-oil tax revenue to non-oil GDP during the last five years.
  - Section III: analyzes deficiencies of the current system and assesses sustainability of strong non-oil revenue performance.
  - Section IV: provides estimates of potential annual tax revenues from VAT and customs duties for 2005–07 and assesses revenue shortfalls from exemptions and administration shortcomings.
  - Section V: suggests measures drawing on theory, empirical evidence, and experience from BRO and some Eastern European countries.
  - Section VI: concludes with main findings and recommendations.
- Recommendation summary:
  - Phased implementation of proposed tax measures.
  - Short term: expansion of tax base, reduction of exemptions, improvements in tax administration to yield higher revenues.
  - Medium term: consider reducing some direct tax rates on efficiency and equity grounds once a robust revenue base is established.

*Key assumption*: the non-oil tax revenue to non-oil GDP ratio should remain broadly unchanged over the medium term.

### II. NON-OIL TAX REVENUE DEVELOPMENTS
- Progress since independence and by 1999: ranked well among BRO countries in a Fund staff comparison.
- Non-oil tax revenues increased from about 20 percent of non-oil GDP in 2003 to about 32 percent in 2007 (Figure 1).
- Non-oil tax system composition (main components): VAT, simplified tax, income taxes, social security contributions (SSCs), excise taxes, and customs duties.
- Notable policy changes during 2003–07:
  - Corporate income tax rate lowered from 24 percent to 22 percent in 2005.
  - Combined SSCs by employer and employee reduced from 28 percent to 25 percent in 2004.
  - Excise taxes were regularly increased.
- Average shares during 2003–07:
  - VAT contributed almost 38 percent of non-oil tax revenues.
  - Income taxes contributed 28¼ percent.
  - SSCs contributed 14¼ percent.
- Structural shift:
  - Budget became increasingly dependent on direct tax revenues; decline in share of indirect taxes.
  - VAT share declined from 42¾ percent in 2003 to 34¾ percent in 2007.
- Table 2 (selected exact figures, in millions of manats and percents):
  - Non-oil tax revenues (2003–07, in millions of manats): 837, 1,024, 1,454, 1,905, 2,984; average 1,641.
  - Non-oil tax revenues and SSCs (2003–07, in millions of manats): 986, 1,206, 1,652, 2,199, 3,535; average 1,915.
  - Non-oil tax revenues and SSCs (in percent of non-oil GDP, 2003–07): 19.7, 20.6, 23.6, 25.4, 31.8; average 24.2.
  - VAT and simplified tax share (in percent of non-oil tax revenues): 42.8, 38.9, 38.0, 34.9, 34.7; average 37.9.
  - Direct taxes share (in percent of total): 38.2, 42.7, 42.0, 44.9, 44.6; average 42.5.
  - Indirect taxes share (in percent of total): 61.8, 57.3, 58.0, 55.1, 55.4; average 57.5.

### III. MAIN ISSUES OF THE CURRENT NON-OIL TAX SYSTEM
- Tax administration modernization steps (by 2004 and since 2005):
  - Enactment of a consolidated tax code.
  - Establishment of a full service large taxpayers unit.
  - Adoption of automated systems in several functions.
  - Creation of a taxpayers services program.
  - Since 2005: tightening VAT registration controls; implementation of an integrated computer system for all taxes; introduction of electronic filing; establishment of a one-stop shop business registration in early 2008; strengthening human resources management and performance measurement; improvements in Ministry of Taxes (MOT) facilities.
- VAT administration problems and remediation:
  - Fraud via fictitious businesses requesting VAT refunds; non-compliance with registration procedures.
  - Cleaning up VAT register resulted in a 50 percent reduction in the number of registered VAT taxpayers between 2005 and 2007.
  - VAT bank accounts became effective on January 1, 2008.
- Customs administration issues:
  - Governance and administrative problems contributed to significant tax evasion at customs.
  - Customs Committee implemented a “single window” facility for customs clearance and card payments to increase transparency and reduce face-to-face interactions.
- Widespread exemptions and special regimes:
  - Special regimes favor firms participating in production sharing agreements (PSAs) and joint ventures (JVs) in the hydrocarbon sector: suppliers provide inputs at zero-rate VAT via certificates; practice undermines tax system integrity and complicates enforcement.
  - VAT exemptions list (early 2008) included: some agricultural products; imports of grains; pharmaceutical products; fertilizers; military equipment; aluminum ore; electricity; some food and paper items; agro-leasing services.
  - Authorities reported a decline in exempt consumption share from 32.0 percent of total consumption in 2004 to about 29.6 percent by 2006.
- Informal economy:
  - Large informal economy using mainly cash undermines non-oil tax collection and erodes tax base.
  - One-stop registration facility operated by MOT expected to help reduce informal economy size.
- Fiscal sustainability concerns:
  - Corporate income tax collection boosted by withholdings on subcontractors in oil-and-gas-related construction projects, which are slowly ending.
  - Rapid increases in personal income taxes and SSCs reflect rapid growth of public sector wages and pensions, which is not sustainable longer term.
  - Projected decline in oil revenues around 2011 may coincide with a slump in direct taxes; public expenditure increases on wages and pensions need moderation to avoid a wage-price inflation spiral and keep non-oil fiscal deficit sustainable.

### IV. ESTIMATES OF THE VAT AND CUSTOMS REVENUE POTENTIAL
- Objective: quantify revenue losses from exemptions and administration shortcomings for VAT and customs duties for 2005–07.
- VAT potential and losses (2007, exact figures):
  - Total potential VAT revenues in 2007: AZN 1,791 million or 16.1 percent of non-oil GDP.
  - Actual VAT revenues in 2007: VAT 1,179 million; simplified tax 47 million; VAT plus simplified tax 1,226 million.
  - Estimated VAT losses in 2007: total AZN 565 million.
    - Losses due to exemptions: AZN 503 million.
    - Losses due to tax administration problems: AZN 62 million.
  - Losses represented about 31½ percent of potential VAT revenues (2007).
  - VAT administration losses estimated at about 0.6 percent of non-oil GDP in 2007 compared to 2.4 percent of non-oil GDP in 2006.
- Table 3 selected exact figures (2005–07, in millions of manat unless specified):
  - Final consumption (including VAT): 6,582 (2005), 8,443 (2006), 11,148 (2007).
  - Final consumption (excluding VAT): 5,879 (2005), 7,537 (2006), 9,951 (2007).
  - Total potential VAT revenues: 1,058 (2005), 1,357 (2006), 1,791 (2007).
  - Exemption rate (in percent): 30.0 (2005), 29.6 (2006), 29.6 (2007).
  - Value of exemptions: 1,974 (2005), 2,499 (2006), 3,300 (2007).
  - VAT revenue growth rates (memorandum): Final consumption (including VAT) annual growth rates: 12.3, 28.3, 32.0; VAT and simplified tax revenues annual growth rates: 33.9, 22.1, 59.9; Non-oil GDP annual growth rates: 19.5, 23.6, 28.6.
- Customs duties potential and losses (2007, exact figures):
  - Non-oil imports: 4,080 (2007).
  - Total potential customs revenues at average statutory rate of 5.7 percent: AZN 233 (2007) or 2.1 percent of non-oil GDP.
  - Actual customs duties revenue in 2007: 159.
  - Estimated customs revenue losses in 2007: total AZN 73.
    - Losses due to exemptions (official estimates): AZN 42 million.
    - Losses due to customs administration shortcomings: AZN 31 million (or 0.3 percent of non-oil GDP) in 2007 compared to AZN 8 million (or 0.1 percent of non-oil GDP) in 2006.
  - Total revenue losses in percent of potential revenues: 22.9 (2005), 22.8 (2006), 31.5 (2007).
  - Average effective customs duty rate (memorandum): 4.4 (2005), 4.4 (2006), 3.9 (2007).
- Methodology notes:
  - VAT potential estimates incorporate an exemption rate provided by the Ministry of Taxes and IMF staff calculations of final consumption excluding VAT.
  - Customs potential used reported average statutory customs duty rate of 5.7 percent provided by Customs officials; officials noted the rate declined after 2004 but new rate not provided to IMF staff.
  - Estimates do not capture possible underinvoicing of imports.

### V. REFORMING THE NON-OIL TAX SYSTEM
- Short-term measures (summary and key recommendations):
  - Bring tax revenues closer to potential by reducing exemptions and phasing out special regimes.
  - Quantify fiscal cost of existing exemptions and special tax regimes and specify intended time span.
  - Increase transparency in granting tax privileges to mobilize political support for reducing exemptions and phasing out special regimes (e.g., publish names of individuals or firms enjoying tax benefits).
  - VAT-specific recommendation: phase out the special tax regime for PSAs and JVs; prefer suppliers charge VAT in the usual way and provide PSAs and JVs with a timely refund.
- Box 1 referenced: Short-Term Recommendations (box contents summarized above in key recommendations).

*Italic source attribution: Extracted from the IMF working paper chapter titled "1. Former Soviet Union Countries: Progress on Tax Policy" (Azerbaijan non-oil tax analysis, 2003–07).*

### Box 1. Short-Term Recommendations

### _wp08225 - Box 1. Short-Term Recommendations

### Short-term revenue and administration recommendations
- Expand the non-oil tax base by reducing exemptions and improving compliance with the VAT, customs duties, and other taxes without changing tax rates.
- Specific measures suggested by IMF tax experts:
  - Quantifying the cost of exemptions, submitting proposals for new exemptions to Parliament for approval, and indicating their time span.
  - Strengthening customs administration by eliminating ad-hoc implementation of regulations and reducing direct contacts between customs officials and importers.
  - Strengthening voluntary compliance and the basic conditions needed for an effective system of self-assessment.
  - Introducing more targeted risk-management approaches for audits.
  - Developing an effective fraud intelligence network that gives early warning of potential fraudulent and evasion activities.
  - Reducing the cost of compliance by simplifying procedures and reducing the frequency of filing.
  - Strengthening governance and performance, including refinement of outcome reporting and measuring an agreed set of key performance indicators (such as measuring client satisfaction).
  - Building capacity to deal with complex compliance issues (e.g., transfer pricing and oil-related tax issues, particularly those associated with PSAs).
  - Improving the quality of tax statistics for analytical purposes.

### Tax administration priorities
- Implementing risk management approaches to improve compliance within key taxpayer segments.
- Reducing the compliance costs of doing business in meeting tax obligations.
- Shifting toward a modern system of self-assessment (Box 2).

### Customs administration priority
- Continue the on-going simplification of customs procedures and modernization of the regulatory framework, including putting in place a new Customs Code, currently under preparation, as expected in the context of WTO accession.

### Conditions for an effective self-assessment system (Box 2)
- Simple tax laws:
  - Laws must be understandable and provide for uniform application, limited exemptions, a simple rate structure, appropriate registration thresholds, and simplified systems for small taxpayers.
- Services to taxpayers:
  - Tax office must assist taxpayers with clear information, advance notice of changes, easy access to information and forms, and consistent interpretation of laws with binding rulings.
- Filing and payment procedures:
  - Tax forms should be simple, clearly instructed, and submitted through means convenient to taxpayers.
- Collection enforcement:
  - Prompt detection and expeditious enforcement actions are critical; collection enforcement must be able to start administrative actions quickly, especially against large taxpayers.
- Audit:
  - The tax office must have sufficient resources to audit a reasonable percentage of taxpayers each year; taxpayers must maintain records and issue invoices; simplified bookkeeping for small taxpayers as needed.
- Penalties:
  - Noncompliers must face strict and uniform penalties; distinguish interest from penalties; non-financial penalties (e.g., temporary closure) and criminal prosecution for tax fraud where appropriate.
- Access to independent review:
  - Taxpayers must have access to administrative and judicial appeal processes if they disagree with assessments.

### Data, reporting, and accounting
- Availability and quality of tax data must be further improved.
- Financial and accounting reporting practices of many individuals and firms in Azerbaijan make it difficult to generate reliable and detailed tax statistics.
- The mandatory implementation of the International Financial Reporting Standards starting in 2008 would provide a good basis to assess the economic impact of tax policy if the new reporting standards are effectively enforced.

### Medium-term measures and objectives
- Once the tax base is expanded and administration strengthened, consider more far-reaching tax reforms with aims to:
  - Maintain revenues close to their full potential.
  - Minimize economic distortions associated with taxation.
  - Improve equity and simplicity of the tax system.
- Review the composition of non-oil revenues, currently skewed in favor of direct taxes, weighing advantages and disadvantages of indirect and direct taxes in Azerbaijan.

### Theoretical considerations (summary)
- Consumption taxes (e.g., VAT) are considered more efficient (less distortionary) but less equitable than direct taxes.
- Direct taxes (personal and capital income taxes) are more equitable in principle but often less efficient and in practice less progressive in developing countries due to exemptions and deductions.
- Corporate income taxes can reduce return on capital, negatively affect investment, and are often accompanied by exemptions and special regimes favoring larger firms.

### Empirical findings (summary)
- Evidence on the impact of taxes on growth is mixed.
  - Consumption taxes: results inconclusive; some studies find no negative impact on employment and growth; others find possible negative impacts via reduced savings.
  - Direct taxes: in advanced countries, high personal income taxes linked to negative impacts on growth; taxation of capital income generally negatively correlated with savings and investment rates. Corporate income taxes shown to have negative impact on growth in advanced countries; results less clear for middle-income countries.

### Proposed measures and quantitative scope
- Boost the share of indirect taxes in total revenues by reducing exemptions and improving compliance with these taxes.
- Significant scope for improving collection of indirect taxes (up to 6 percent of non-oil GDP) and direct taxes as well—allowing for possible lowering of direct tax rates while remaining revenue neutral through better compliance and fewer exemptions.
- By regional standards, tax rates on personal and corporate incomes are relatively high in Azerbaijan.

### Suggested tax reforms for Azerbaijan
- Simplification of the tax system:
  - Curtail exemptions and consider establishing a single rate income tax (single personal and corporate income tax rate), noting some regional examples where unified rates were implemented.
  - In Azerbaijan, currently a single corporate income tax rate and multiple personal and capital income tax rates exist; these could be unified into a single rate.
- Reduction of direct tax rates:
  - In many BRO and Eastern European countries, personal and corporate income tax rates and SSCs were lowered.
  - In Azerbaijan, personal and capital income tax rates range from 14 to 35 percent; these could be unified with the existing single corporate income tax rate at a level equal to or below the current 22 percent.
  - The SSCs rate, at 25 percent, is broadly in line with those in other BRO countries and could remain unchanged. 1/
- Indirect taxes:
  - In other BRO countries the VAT was kept at pre-reform rates (18 percent in most countries).
  - In Azerbaijan, the VAT rate is 18 percent and no changes are suggested.

1/ "Changes in social security contribution rates should only be considered in the context of a wider reform of the social security system."

### Main findings and recommendations (concluding points)
- Azerbaijan’s non-oil tax revenues increased significantly as a share of non-oil GDP in the last five years, but remain below potential.
- The non-oil revenue shortfall is mainly due to widespread tax exemptions, with further scope to strengthen tax and customs administration.
- Recent buoyancy of direct taxes does not seem sustainable over the medium term; both oil and non-oil revenues may start to decline relative to non-oil GDP in the next decade.
- Short-term: expand the tax base by reducing exemptions, phase out special tax regimes, and strengthen tax and customs administration to yield more revenues.
- Medium-term: once the base is expanded and revenues stabilized close to potential, consider far-reaching reforms (including merit of reducing some direct tax rates) and make the overall reform package broadly revenue neutral by improving compliance and reducing exemptions.

*Source: _wp08225 - Box 1. Short-Term Recommendations (IMF).*

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