Turkey - Fiscal policy and tax reform : issues from the past and options for the future (Vol. 2 of 2) : Methodological and statistical annex

Report No. 6374-TU Fiscal Policy and Tax Reform in Turkey (In Two Volumes) Volume li: Methodological and Statistica! Annex July 7,1987 Country Operations Division Country Department I Europe, Middle East and North Africa FOR OFFICIAL USE ONLY Document of the World Bank This report has a restricted distribution and may be us.ed by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENT 1981 TL 111.22 1982 TL 162.55 1983 TL 22'.46 1984 TL 3f6.68 1985 TL 521.98 1986 TL 674.50 1987 First Quarter TL 762.96 1987 May TL 821.05 FISCAL YEAR March 1 to February 28 - through 1981 March 1 to December 31, 1982 January 1 to December 31 - from 1983 ABBREVIATIONS CBT - Central Bznk of Turkey CPI - Consumer Price Index DIF - Defense Industry Support Fund DSF - Development and Support Fund EBF - Extra Budgetary Fund EECF - European Economic Community Fund EEF - Export Encouragement Fund EIF - Export Improvement Fund FF - Financing Fund GNP - Gross National Product at market prices IAF - Investment Acceleration Fund IGMEF - Investment Goods Manufacturing Encouragement Fund IRDF - Interest Rate Differential Rebate Fund ISKI - Istanbul Water Supply and Sewerage General Directorate LAF - Local Administration Fund MASF - Mutual Assistance and Support Fund ("Poor People's Fund") MHF - Mass Housing Fund PCF - Petroleum Consumption Fund PEF - Petroleum Exploration Fund PPF - Public Participation Fund PPSF - Petroleum Price Stablization Fund PTT - Postal, Telephone and Telegraph Authority QR - Quantative Restrictions RUSF - Resource Utilization Support Fund SAF - Special Administration Fund SCF - Selective Credit Fund SEE - State Economic Enterprises SIS - State Institute of Statistics SPO - State Planning Organization SPSF - Support and Price Stabilization Fund TAF - Tax Administration Development Fund TEKEL - State Monopoly TFTU - Undersecretariat of Treasury and Foreign Trade TZDK - Agricultural Supplies Agency VAT - Value-Added Tax WPI - Wholesale Price Index  FOR OMCL41 USE ONLY This report is based on the fi.adings of a World Bank Mission that visited Turkey in March 1986. The mission consisted of the following: Ritu Anand (Mission Chief) Faezeh Foroutan Charles E. McLure (Consultant) Anthony Pellechio Parthasarathi SI-me (IMF) Sweder van Wijnbergen Tthe analysis is based on data and tax structure until January 1987. Major changes that occurred between January and April 1537 are mentioned in footnotes. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization,  FISCAL POLICY AND TAX REFORM IN TURKEY: Table of Contents Volume II: METHODOLOGICAL AND STATISTICAL ANNEX l/ Page No. Annex II: INFLATION AND THE FINANCING OF GOVERNNENT EXPENDITURE A. Analytical Framework 1 B. Measurement of Fiscal Deficits 4 Annex III: PERSONAL INCOME TAX ANALYSIS: A. The Effect of Changes in Tax Rates 7 and Exemption Levels B. Expenditurer in Categories of 11 Consumption Eligible for the Rebate C. The Calculation of Fiscal rrag 12 Table A 3.1 - Distribution of Taxpayers Filing 10 Income Declarations in 1980-86 A 3.2 - Expenditures as a Percentage of Income on 11 Categories of Consumption Eligible for the Rel-ate Annex IV: CORPORATE INCOME TAX ANALYSIS A. Marginai Effective Tax Rate Calculation 13 B. Effect of Inflation on Present Discounted Value of Depreciation Allowances and Investment Incentives 21 Table A 4-1 - Corporate Tax Model: An Example (1) Parameters 17 (2) Results 18 A 4.2 - Marginal Effective Tax Rates: Inflation 0 Percent 19 A 4.3 - Marginal Effective Tax Rates: Inflation 50 Percent 20 A 4.4 - Present Discounted Value of Depreciation Allowances and Investment Incentives by Seccor, Region, and Asset Type 21 Inflation Rate - 25 Percent A 4.5 Present Discounted Value of Depreciation Allowances and Investment Incentives by Sector, Region and Asset Type Inflation rate - 50 percent 22 l/ Annex numbers correspond with chapter numbers.  - ii - Page No. Annex V: A V.1 - POTENTIAL VALUE-ADDED TAX FROM DOMESTIC BASE A. Calculation for 1985 23 B. Calculation for 1986 25 C. Calculation of Potential VAT from 26 Imports in 1986 A V.2 - TREATMENT OF SMALL ENTERPRISES IN THE EEC AND LATIN AMERICA A. Special Provisions in EEC Countries 27 B. Special Provisions in Latin 29 American Countries Table A 5.1 - Turkey: Percentage of 1985 GDP in VAT Base 24 Aninex VI: A MODEL FOR TAX POLICY ANALYSIS 31 Annex VII: SOURCES AND USES OF INDIVIDUAL EXTRA BUDGETARY FUNDS A. Defense Industry Support Fund (DIF) 38 B. Development and Support Fund (DSF) 39 C. EEC Fund (EECF) 41 D. Export Encouragement Fund (EEF) 41 E. Export Improvement Fund (EIF) 43 F. Financing Fund (FF) 44 G. Investment Goods Manufacturing Encouragement 44 Fund (IGMEF) H. Mutual Assistance and Support Fund (MASF) 45 I. Mass Housing Fund (MHF) 45 J. Petroleum Consumption Fund (PCF) 48 K. Petroleum Exploration Fund (PEF) 49 L. Public Participation Fund (PFF) 50 M. Petroleum Price Statilization Fund (PPSF) 52 N. Resource Utilization Support Fund (RUSF) 52 0. Selective Credit Fund (SCF) 55 P. Support and Price Stabilization Fund (SPSF) 55 Q. Tax Administration Development Fund (TAF) 57 Table A 7.1 Sources and Uses of DIF, 1986 39 A 7.2 Sources and Uses of the DSF, 1985-85 40 A 7.3 Revenues and Expendit%tres of the 41 EEC Fund, 1982-85 A 7.4 Revenues and Expenditures of the 42 EEF, 1980-85 A 7.5 Sources & Uses of the EEF, 1985 43 A 7.6 Revenues & Expenditures of the EIF, 1975-85 43  -iii - Page No. A 7.7 Revenues & Expenditures of the Financing Fund, 1981-85 44 A 7.8 Sources & Uses of the MHF, 1985-86 47 A 7.9 Distribution of Revenues of the PCF, 1985-86 48 A 7.10 Uses of the PCF by Type of Activity, 1985-86 49 A 7.11 Revenues & Expenditures of the PEF, 1981-86 50 A 7.12 Sources & Uses of the PPF, 1985-86 51 A 7.13 Sources & Uses of the RUSF, 1985-86 54 A 7.14 Revenues & Expenditures of the SPSF, 1980-85 56 A 7.15 Sources & Uses of the SPSF, 1985-86 57  ANNEX II - INFLATION AND THE FINANCING OF GOVERNMENT EXPENDITURE ANALYTICAL FRAMEWORK AND MEASUREMENT ISSUES A. Analytical Framework A 2.1 There is no doubt that increases in cost factors, such as wages, oil prices, the exchange rate or even real interest rates, lead to increases in the price level. No oil-importing country saw prices fall after 1974. Moreover, such a price level shift can in practice not be dist4nguished from an increase in inflation; we live in a world where prices are not measured or, for that matter, adjusted, continuously. A 2.2 However, prolonged inflation cannot really be traced to any of these factors. Any real wage can be sustained at any rate of inflation, especially in the presence of indexation agreements. Imported intermediate price rises (e.g. oil) would not explain sustained domestic inflation rates in excess of world levels, since world relative prices of intermediate goods obviously cannot go up for ever. Finally, continued nominal devaluation of the exchange rate of course can explain a matching excess of home inflation over world inflation. That, however, begs the question of what is behind this continued process of nominal devaluation. A 2.3 A similar problem exists with the second empirical explanation of inflation, money growth. It is clearly true that no rate of inflation can be sustained unless matched by a corresponding rate of money growth. Moreover, equations linking inflation to real income and monetary expansion always work well, also for Turkey. A 2.4 But tracing inflation back to money growth through what, in effect, is an inverted money demand function, runs into the same problem that mars the exchange rate explanation: it begs the question of what drives the sustained increase in money growth in excess cf what would be compatible with announced inflation targets. A 2.5 The answer to that question is more straightforward in most developing countries than in industrial countries, and points to what theory suggests is the root cause of sustained inflation: fiscal deficits in excess of what can be financed through debt issue on a sustainable basis. A 2.6 The fiscal view of inflation posits that short term links between inflation and deficits are likely to be tenuous; but that any deficit, coupled with sustainable debt-output ratios, implies a particular inflation rate. The argument runs through what is known as the inflation tax. The concept of inflation tax is based on the very relation that makes monetarist explanations of inflation work so well ex-post: the real money stock is usually a stable function of interest rates and income within a given financial structure. If for given interest rates, level of income and structure. of the financial  - 2 - system, consumers wish to maintain money balances fixcd in real terms, they will have to accumulate nominal balances at the rate of inflation and in proportion to their desired level of real balances, M: IT x pM(i,y) (1) where p equals inflation, i the nominal rate of interest, y real income and IT the revenue from inflation tax. But money is an interest-free liability of the public sector, which can thus cover real expenditure through the issue of nominal liabilities: after all the private sector will run a matching surplus of income over expenditure to accumulate these money balances (pay the inflation tax). A 2.7 By analogy with more conventional txzes, p can be considered the tax rate and M, the level of real money demand, the tax base. The fiscal authorities only make a net gain to the extent that the inflationary erosion of the money stock is not offset by inflationary gains by domestic borrowers; hence the proner tax base is not the broad money stock, say M2, but the more narrow concept of inside or base money, none of which is offset by private sector debt owed to the banking system. A 2.8 In addition, the Government can issue money to the extent that real money balances rise with the level of real income; if this increase is one-for-ones, we can define seigniorage revenue as SR = nM(i,y) (2) where n is the growth rate of real income. A 2.9 To link this to budget deficits, one needs to look at the government budget identity linking expenditure categories to sources of financing. Define D as the total public sector deficit exclusive of all interest payments, and deflated by the price level (we will use the CPI as the domestic deflator throughout). Also, define B (B*) as the real value of domestic (external) public sector debt expressed in terms of home (foreign) goods carrying an interest rate r (r*); and finally e as the relative price of foreign goods in terms of domestic goods or the real exchange rate. We can then write down the budget identity: D + rB + r*B*e = B + B*e + (p + n)M (3) Equation (3) states that the non-interest deficit D plus real interest payments on domestic and foreign debt can be covered either 'b new debt issue or by seigniorage and inflation tax. A 2.10 Equation (3) does not yet give the deficit as the change in the real value of the public sector's debt, which we argue below is the appropriate measure. The missing element involves the changes in the real value of foreign debt, B*e, due to changes in the real exchange rate e. These capital losses equal: (e/e)B*e  -3- the real rate of depreciation times the real value of the debt. If we add those capital losses from both sides of the equation, we get: D + rB + (r* + e/e) B*e = B + B*e + (B*e) e/e + (p + n)M (4) Finally (- pM), minus the inflation tax, can be interpreted as the real interest payments on monetary liabilities; we can then obtain symmetric treatment of all three forms of government debt by writing (4) as: D + rB + (r* + e/e) B*e -pM = * . B + B*e + (B*e) e/e + M (5) Equation (5) tells us that the non-interest deficit D plus real interest payments on the three forms of public sector liabilities equal the change in the real value of the public sector's net indebtedness, L. A 2.11 Equation (3) can be used to derive a value for the fiscal deficit consistent with a given set of debt/output ratios and whatever inflation target policy makers wish to reach. A few preliminary steps are needed. Target values for the ratio of domestic and foreign debt to output, b - B/y and b* = B*e/y), imply that B cannot grow faster than y and B* not faster than y/e: B = nb, B* = (n-c)b* where n is the real growth rate y/y and c equals e/e, the rate of real appreciation. Also, define d = D/y, m = M/y Inserting this in (5) yields the consistency condition we are after: d + rb + (r* + c)b* = nb + nb* + (p + n)m (6) or the non-interest deficit D plus real interest payments on foreign had domestic debt cannot exceed what can be financed through debt issue at target debt-output ratios (n(b + b* +m)) plus the inflation tax pm. Consistency requires that (6) holds with pm (p,y) evaluated at the target inflation rate.  -4- A 2.12 The deficit measure in (6), d + rb + (r* + c)b* differs from L in that -m has been brought to the other side: rather than interpreting minus pm as real interest payments on monetary liabilities, an expenditure item, it is brought to the right hand side and viewed as a source of financing, the inflation tax pm. We call this deficit measure crd, the comprehensive real deficit. A 2.13 Two important factors will shift the relation between public sector deticits and inflation embedded in equations (5) and (6). First, a financial sector reform influencing the demand for base money. For example. lower reserve requirements or the introduction of attractive liquid alternatives to domestic money, such as the foreign deposits introduced in Turkey in 1984, all lower the base ovez- which the inflation tax is levied. They hence require higher inflation rates to finance the same non-interest deficit at given income levels. A 2.14 A second factor influencing the relation between public sector deficits and inflation is a differenit bond issue policy. In the short run, higher bond issues than necessary to maintaini b, lead to less required inflation tax revenues and so, possibly, to less inflation. However, this effect will be reversed as time goes by, if at least the economy grows at a rate less than r, as one can see from equation (6). Debt-output ratios cannot be raised ad infinituim, so they will have to settle down at some higher level, say bl. But equation (6) then tells us that, as long as r> n, long run revenue requirements will in fact have increased rather than decreased! Cutting money growth through issues of interest-bearing debt will thus increase long run inflation, its potentially favourable short-term effects notwithstanding. 1/ B. Measurement of Fiscal Deficits A 2.15 Problems with the measurement of public sector deficits involve both accounting conventions and issues of economic analysis. Most countries have several layers of government - national, provincial and local. In Turkey, this is complicated once further by the recent proliferation of Extra Budgetary Funds and by the existence of an extensive State Economic Enterprise (SEE) sector. All their accounts should be incorporated in computing the size of the public sector deficit, since all have to be financed. A 2.16 Accurate and internally consistent data on expenditure and revenue flows are not available; moreover what is available is not consistent with national accounts data, complicating comparisons with say private savings and investment flows. We have therefore chosen another approach to measurement of fiscal deficits, an approach that starts from the stock of indebtedness. A properly measured deficit should equal the change in net indebtedness of public sector; an alternative measure of deficits is therefore the change in indebtedness aeasured directly. Since much better information is available on, for example, foreign debt than on the combined profit and loss accounts of the SEEs, such an approach is an improvement over flow-based measures. 1/ This argument was first made by Sargent and Wallace (1982). See also Buiter (1984), and van Wijnbergen (1986).  A 2.17 Definitional problems also arise over the treatment of inflation. If, for example, prices are rising at 25 percent per year, a debt of TL 100 will, after a year, have a real value of only TL 75. Inflation acts as a hidden capital levy on outstanding debt. So the inflation component in nominal interest payments on government debt really represents repayment of principal rather than the real cost of borrowing. It therefore is a capital account transaction and does not belong in estimates of "above-the-line" fiscal deficits. In the deficit measure used above, this is recognized by including only real interest payments, not nominal, in the definition of expenditure. Then the deficit will in fact equal the change in the real value of the debt A 2.18 Similar problems exist with the treatment of the capital losses arising out of exchange rate changes. Once again we use the change in the real value of net public sector indebtedness as our measure; this implies that capital losses on foreign debt due to changes in the real exchange rate should in fact be included as part of the servicing cost of that foreign debt and hence as part of a proper deficit measure. In any forward looking discussion, expected real exchange rate changes will enter as part of the real cost of foreign borrowing. However, in the reconstruction of historical time series, one will in fact use actual changes in the real exchange rate. The difference is occasionally quite large, especially after large nominal "maxi" devaluations. Wher. projecting such historical series forward, once-off "surprise" capital losses should of course be taken out. A 2.1 A final issue concerns the Central Bank and its foreign assets position. Since profits of the Central Bank are transferred to the Treasury, it is best considered part of the public sector for debt accounting purposes. This means that the variable B*, public sector foreign debt, should be measured net of the Net Foreign Assets position of the Central Bank.  -6 References: Buiter, W. (1984), "Comment on Sargent and Wallace: Some Unpleasant Monetarist Arithmetic", in Monetarism in the United Kingdom, ed. by B. Griffith and G. Wood, McMillan, London. Liviatan, N. (1984), "Tight Money and Inflation", Journal of Monetary Economics. Sargent, T. and Wallace, N. (1982), "Some Unpleasant Monetarist Arithmetic", Federal Reserve Bank of Minneapolis Quarterly Review. van Wijnbergen, S. (1986a), "Fiscal Deficits, Exchange Rate Crises and Inflation", Foerder Institute Discussion Paper, February 1986, Tel Aviv University. van Wijnbergen, S. and Anand, R. (1987), "Fiscal Defici .s and Inflation in Turkey", mimeo.  - 7 - ANNEX III - PERSONAL INCOME TAX ANALYSIS: A. The Effect of Changes in Tax Rates and Exemption Levels A 3.1 The revenue implications of changes in the personal income tax system were drawn from the distribution of taxpayers over the tax brackets in the system. These distributions were available only for taxpayers who filed income declarations in 1980, 1981, 1983, and 1984 from the Ministry of Finance. Distributions for 1982, 1985, and 1986 were imputed by extrapolating from the 1983 and 1984 distributions. The actual and imputed distributions for 1980 - 1986 are given in Table A 3.1. A 3.2 The distributions for 1982, 1985, and 1986 were obtained using a straight-line projection method. To illustrate this procedure, let Ni denote the number of taxpayers in the ith tax bracket. Consider the first bracket, N1, in which the number of taxpayers is declining over time. The number of taxpayers in the first tax bracket in 1985, NjS, equals the number of taxpayers in the first tax bracket in 1984, N1 , plus the difference between 1984 and 1983, N