This statement summarizes discussions between the authorities and an IMF staff team in Tashkent during July 17-26, 2018. The authorities have made further progress on their far-reaching reforms to tackle the country’s most pressing economic and social challenges.
The discussions focused on the economic outlook, tax reform, state-owned enterprise (SOE) restructuring, and the fiscal strategy for 2019-21.
Economic Outlook
External trade has picked up significantly; but cyclical tailwinds from rising commodity export prices and external demand are projected to abate. Responding to foreign exchange and trade liberalization, as well as to the opening of Uzbekistan’s borders, both export and import growth in the first half of 2018 was significantly faster than expected. Looking ahead, the past upward trend in prices of key export commodities (gold, natural gas, cotton) is projected to level off in 2019.
At the same time, import demand growth by Uzbekistan’s trading partners is expected to soften, with significant downside risks if international trade tensions escalate. While the external position is projected to move from surplus to deficit in the coming years, this would reflect a welcome shift in the economy’s savings-investment balance toward higher investment. External stability risks should remain modest given large foreign exchange (FX) reserves and moderate foreign debts, which, in addition, are largely on concessional terms.
Consumer price index (CPI) inflation has been declining, but sustained macroeconomic policy discipline is needed to ensure that underlying inflation will trend downward . In comparison with the first half of 2017, CPI inflation in January-June 2018 slowed by 1 percentage point to 6¼ percent, while year-on-year CPI inflation gradually declined from its peak of 20½ percent in January of this year to 18½ percent in June.
It is noteworthy that during this period Uzbekistan’s nominal exchange rate—for the first time in the history of the country—appreciated for several months in a row. In the forecast period, the main drivers of inflation will likely be much-needed relative price and wage adjustments. In particular: (i) regulated prices (tariffs), for example natural gas, will need to be brought closer to cost-recovery levels; (ii) prices for tradable goods that are domestically consumed, for example fruit and vegetables, will need to adjust closer to the export prices of these goods; and (iii) the relative wage structure, especially in the public sector, will need to better reflect workers’ actual or required skill differentials. We continue to project CPI inflation to decline, and it will likely settle in the range of 12-14 percent by end-2019. The more important point is that the first- and second-round effects of relative price and wage adjustments on inflation will not be allowed to spill over into permanently higher inflation rates. Achieving this will require maintaining disciplined fiscal, credit, and monetary policies.
Growth and job creation are likely to react with delay to transition reforms. Official data suggest that GDP has continued to expand at its past rate of about 5 percent. This apparent lack of an immediate supply-side response seems at odds with the observed boom in exports and investment as well as the massive improvement in the price competitiveness of the tradable sector. However, as in earlier transition country experiences, economic agents’ response to reforms may only occur with significant delay and, to get to that tipping point where growth and job creation pick up, requires steady and patient leadership and clear communication that reforms will continue. In fact, key structural reforms, especially reforming taxes, restructuring SOEs, reducing bureaucratic red tape, and containing monopolistic pricing practices remain to be fully implemented.
Tax Reform
Tax reform is the government’s economic flagship project; it is needed foremost to create more and better jobs. Reflecting a bulging working-age population, about 500,000 new job seekers enter the labor market every year. These job seekers are met with a dearth of job opportunities. But not only is job creation persistently falling short of demand, better-paying and more secure formal sector jobs are especially scarce. In 2017, out of a reported 13.3 million employed persons, only 4.5 million workers were consistently paying taxes and social contributions. This stark segmentation of the labor market is mirrored by a similar segmentation of firms. In 2017, out of an estimated 350,000 firms operating in Uzbekistan, only about 8,000 firms were paying taxes under the standard tax regime.
Tax reform is also needed to forestall a potential sharp decline in future revenues. Uzbekistan has about 1,800 SOEs, which employ 800,000 workers, i.e. about 18 percent of the formal-sector work force. At the same time, SOEs account for about one half of tax collections. SOEs’ ability to carry their elevated tax burden in part reflects a wide range of privileges, including their preferred access to credit and monopolistic positions. Reforms aiming at leveling the playing field between SOEs and private firms will not only erode these privileges but also the SOEs’ ability to continue to provide half of fiscal revenue. Tax reform should foster the emergence of a broader private sector tax base.
At the same time, it was agreed that tax reform will have to be a multi-year project. Uzbekistan’s present tax system is far removed from best practices under market-based economic systems. Moreover, accounting practices and the tax administration will need to be given time to upgrade to cope with the demands of a more modern tax system that seeks to cover more than just a narrow group of tax payers. A reform that adopted right away a modern tax system typical for an advanced economy would have been disruptive for tax payers, difficult to administer, and could have triggered large revenue losses.
Following open and intensive public debates, a comprehensive tax package has been adopted. Our private sector counterparts noted that tax reform is the first major economic reform that was the subject of an inclusive public debate. Regarding policy changes, taxation of firms will be subject to a new threshold based only on turnover, which will apply across all firms without sector exceptions, while tax rates on business incomes and property will be cut. The tax burden on labor, especially in the private sector, will also be reduced significantly. Indirect tax rates, especially the single rate value added tax (VAT), will be kept at present levels. At the same time, the VAT base will expand due to the decision to ensure the integrity of the VAT chain and implement a new turnover threshold. VAT reform will also introduce a more effective VAT refund mechanism.
The adopted reform is an important and courageous step toward a more rational tax system. The reform clearly improves the tax system’s efficiency by broadening tax bases while cutting tax rates. The large reduction of the tax burden on private sector labor is especially welcome given Uzbekistan’s urgent job creation needs; it should also incentivize formalization of jobs and the reporting of actual wage payments. VAT reform will not only raise more revenue but also safeguard investment by introducing an effective refund mechanism. At the same time, the shift to a flat income tax will reduce progressivity, and the two-tier social contribution system with much higher rates for public sector workers will have to be addressed in future reforms. The estimated cost of the tax reform to the, at 2 percent of GDP in 2019, seems manageable within the fiscal framework for 2019-21, assuming appropriate restraint on expenditures.
Looking ahead, drafting a new tax code will be a major challenge. Within the next few months, the authorities will need to draft a modern tax code that is understandable to relatively unsophisticated tax payers while consolidating a multitude of tax provisions, resolutions, and decrees. Moreover, they have indicated they will continue to adhere to the principle of transparency and open debate. In that context, the government will also need to make decisions about reducing the myriad of tax privileges and preferences, which are granted by 26 provisions of the present tax code and about 360 presidential resolutions. The authorities also plan to review customs privileges.
In the short term, reform of tax administration will focus on the implementation of tax policy and high-priority organizational changes. Over the next 6-8 months, the tax administration will need to prepare for the addition of some 15,000 firms to the standard tax regime and specify the details of the fixed tax for micro taxpayers. This will include simplifying VAT returns and improving the mechanism for VAT refunds. At the organizational level, short-term priorities will include restructuring and strengthening the tax administration headquarter along functional lines and setting up a full-function large-taxpayer office. Effective implementation and communication about the objectives of the reforms could help build trust that reforms are balanced and fair.
Over the medium term, the tax administration faces an even more challenging reform agenda . Over the next 2-3 years, the tax administration will aim at consolidating and reforming the field office network, transforming business processes, upgrading the information technology, professionalizing its workforce, and adopting a tax compliance improvement strategy that will help reduce informality and build compliance by the business community and the competence of their tax advisors.
State-Owned Enterprises
SOEs remain the nerve center of the economy, but they increasingly struggle with multiple challenges that could threaten their very survival :
Challenge (1): SOEs providing utilities and producing energy are suffering large losses in the face of rising input cost pressures, with losses compounded by these firms’ long-standing operational inefficiencies. At the same time, the regulated prices for utilities and energy distort the scarcity signal function of relative prices, particularly so for energy.
Challenge (2): Non-financial SOEs with large FX liabilities to state-owned banks and external lenders incurred large FX valuation losses during last year’s FX liberalization; dealing with the deterioration of their financial balance sheets has been postponed for now, including by a debt service moratorium on their main debts to state-owned bank.
Challenge (3): State-owned banks’ balance sheets, reflecting a history of directed lending, are dominated by loans to SOEs at preferential terms, undermining these banks’ profitability.
Challenge (4): The inherited structure of governance of SOEs provides little incentives for improving SOE operations. For example, SOE management, supervision of SOE management, and regulation and setting policies for the industry appear sometimes to be de facto consolidated under the same person.
The government needs to bring tariffs and energy prices closer to cost-recovery levels, thus beginning to address the first challenge. Energy prices for households have already increased significantly since last year, but those increases mainly compensated firms for higher import costs. More accurate cost data is needed to reliably benchmark the gap between tariffs and cost-recovery prices. These and other uncertainties argue for increasing tariffs gradually. Such gradual tariff increases would likely add about 4 percentage points to cumulative CPI inflation during 2018-19, assuming the impact is contained to first- and second-round effects on inflation. The government also will need to counteract the adverse consequences from tariff increases for low-income households, including by increasing targeted social benefits.
The second challenge calls for increasing SOEs’ financial transparency in several respects. At this point, there is no consolidated report available on the overall financial position or performance of the SOE sector. Such a report would clearly disclose financial transactions and support payments between the government and SOEs. Moreover, where SOEs are charged with undertaking activities for public policy purposes, these activities should also be disclosed, quantified, and, if feasible, compensated from the budget. As a response to this challenge, the government could set up an agency to monitor and provide financial oversight of all SOEs.
The third challenge calls for restructuring state-owned banks and putting them on a more commercial footing. One option under consideration is to set up a development bank using resources from the Fund for Reconstruction and Development (FRD), while state-owned banks—which in the past have effectively operated as development banks—would be privatized. This option raises complex policy issues, including the design of effective governance for a new development bank. The restructuring of the financial sector deserves especially careful study and preparation, and it should not be rushed.
Addressing the fourth challenge, improving governance through restructuring of non-financial SOEs, will have to be the centerpiece of reform. The government needs to unbundle activities and remove non-core activities from several of the key SOEs, thus separating activities that could be privatized from other activities that could remain under state control. The next step to improving governance should be to strengthen and clearly separate management and supervision. The setting of policy in sectors dominated by SOEs—such as energy and transportation—should be assigned to ministries, which would likely also have to operate as sector regulators for the foreseeable future.
Fiscal Policy Strategy: 2019-21
Fiscal policy in 2018 is posed to remain prudent, notwithstanding pressures to expand public spending . A surge in tradable sector prices triggered by FX liberalization and improved tax administration have generated a revenue windfall relative to the 2018 budget; given this and other factors, overall revenues are estimated to have increased by 3½ percent of GDP relative to the approved 2018 budget. At the same time, spending plans have been revised to add expenditures of 4½ percent of GDP mainly on housing, education, rural development, and public investment. In addition, spending on targeted social benefits to mitigate the impact of tariff increases on low-income persons will need to be accommodated under the new 2018 spending envelope. Based on these preliminary plans, we project the general government deficit in 2018 will amount to 1½ percent of GDP, close to the 1¼ percent of GDP projected during the Article IV consultation discussions in March.
With the upcoming 2019 budget, the government will for the first time submit to parliament a three-year fiscal framework covering 2019-21 . Given the present macroeconomic outlook, the government’s fiscal framework aims to keep annual fiscal deficits during 2019-21 at 2 percent of GDP, in line with a continued stability-oriented fiscal policy. The deficits are planned to be covered by foreign financing. It is also planned to introduce major improvements in the transparency of fiscal policy in the 2019 budget, including recommendations from IMF technical assistance on public financial management.
Staff’s preliminary fiscal projections for 2019 suggest that securing strict overall spending discipline will be essential to reach the envisaged fiscal targets. In 2019, revenue losses from tax reform—estimated by staff at 2½ percent of GDP—will constrain the available spending envelope. The authorities’ noted that the formation of spending plans for 2019 is still at an early stage, but is clear that difficult trade-offs will have to be faced, especially with respect to public wage policy and spending on other government priorities. While the authorities plan to continue to index public wages to CPI inflation at half-year intervals, there are also immense pressures to realign relative wages within the government sector in favor of groups of employees, including medical doctors, teachers, and scientists, that are considered underpaid or underappreciated. The budget cost of a realignment of public sector wages could be significant and could trigger similar wage hike demands across the board, which would raise concerns about the broader implications of public wage increases for the inflation outlook. Therefore, the government needs to develop a public wage strategy that responds to concerns about misaligned relative wages. But the public wage strategy also needs to be consistent with the deficit limits of the fiscal strategy for 2019-21 and needs to avoid fueling the country’s overall inflation rate.
There was agreement that the transparency of fiscal policy during the coming years should be enhanced by several measures:
Improving fiscal reporting: The government continues to aim at including all activities of government institutional units in the general government accounts, including off-budget accounts of budgetary organizations. As foreseen in a recent presidential decree, the 2019 budget will also report on the estimated fiscal revenue losses from tax and customs privileges and preferences. The presentation of fiscal data in reports will be upgraded; the mission noted that adopting a presentation of expenditures in economic classification would facilitate the analysis of fiscal policy options and gauging the impact of the budget on the economy.
Improving fiscal forecasting and budgeting: It is planned to explain and publish the medium-term economic and fiscal forecasts.
Improving fiscal risk management : This would be promoted by publishing an annual statement of the main fiscal risks.
