US embassy cable - 04YEREVAN2071

C O N F I D E N T I A L SECTION 01 OF 02 YEREVAN 002071 
 
SIPDIS 
 
DEPT FOR EUR/CACEN, EUR/ACE, USTR FOR KKUHLMAN, TREASURY 
FOR JEFFREY BAKER 
 
E.O. 12958: DECL: 09/20/2014 
TAGS: ECON, EAID, ETRD, KCOR, AM 
SUBJECT: IMF TEAM LEAVES ARMENIA UNIMPRESSED WITH PROGRESS 
 
REF: A) YEREVAN 1453 B) YEREVAN 1899 
 
Classified By: DCM A.F. Godfrey for reasons 1.4 (b) and (d). 
 
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SUMMARY 
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1. (SBU) The IMF team conducting the Sixth review of 
Armenia's Poverty Reduction and Growth Facility (PRGF) 
program has left Armenia concerned about Armenia's progress 
in key areas of reform.  The Resident Representative, James 
McHugh, told us that he anticipated problems completing the 
sixth review and disbursing the program's final tranche to 
the GOAM.  While the government has successfully completed 
many of the easy reforms, it has been loath to or incapable 
of addressing those reforms that touch most heavily on 
corruption in the economy -- namely, reform of the tax and 
customs services.  According to McHugh, Armenia has reached a 
critical juncture:  it must decide if it has the political 
will to reform in the way that will fundamentally change the 
nature of its crony capitalist economy.  "Put bluntly," said 
McHugh, "We have to see if they are willing to tax rich 
people."  End Summary. 
 
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UNMET CONDITIONS 
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2. (SBU) During the donor out-brief the visiting IMF review 
team described their concerns about Armenia's unmet 
obligations in guarded language.  While the GOAM has 
expressly asked for a waiver of one energy sector measure 
(ref A), it seeks to address what the GOAM itself has called 
"severe deficiencies" in meeting its fiscal measures with "a 
two-year action plan to deal with pending tax and customs 
reforms."  The action plan would establish a timeline that 
presumably would be part of a conditionality under any 
follow-on program.   The proposed reforms would purportedly 
aim to reorganize the structures of the tax and customs 
services in order to control the enforcement and audit 
functions, which currently harass medium-sized businessmen 
into overpaying in order to make up for lost revenues that 
large businesses do not pay.  The government claims to have 
met technical tax and customs conditionalities (concerning 
VAT administration and customs valuation) that the IMF sees 
as indicative of larger administrative problems and as a 
burden on medium-sized business and foreign investment.  The 
IMF team is skeptical of the government's claims and has gone 
back to the government requesting more information:  the team 
doubts reports that the customs service has used transaction 
or invoice prices to value 50 percent of imports; the tax 
service's claimed progress in accruing only a negligible 
amount of VAT refund arrears belies the stories of 
medium-sized businesses, who uniformly claim that the 
government's arrears to them are increasing. 
 
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TAXING THE MIDDLE CLASS ONLY 
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3. (SBU) In less formal meetings, including two meetings with 
the Ambassador, the IMF representatives spoke more candidly 
about Armenia's progress, and talked less about the specific 
conditionalities than the overall status of corruption. 
Although the suspect conditionalities are technical, they all 
reflect the reluctance of the tax and customs services to tax 
big businesses and the concomitant need to extract extra 
revenues from medium-size businesses to compensate.  The 
customs conditionality requires the Customs Service to use 
the actual invoice price to value goods for purposes of 
tariffs and value added tax:  customs currently uses flexible 
valuation methods with the dual goals of increasing revenues 
from medium sized importers and soliciting bribes.  According 
to the IMF, discriminatory valuation by customs keeps 
Armenia's oligarchs in control of the lion's share of 
Armenia's basic food imports because well-connected importers 
are bribing customs officials in exchange for not paying 
taxes on the import of basic goods (ref B).  Similarly, large 
enterprises pay almost no taxes, while medium-sized firms 
complain of harassing audits, demands for prepayment, and the 
inability to get their refunds due from overpayment of value 
added tax.  At the time of the last IMF review, the 
government's arrears of non-refunded VAT equaled nearly 1.5 
percent of GDP, owed mostly to small and medium firms.  While 
the government has claimed, per agreement, not to have 
increased the total stock of arrears during 2004, American 
firms have uniformly reported to us that the arrears owed to 
their respective companies was growing. 
 
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COMMENT:  SQUEEZING A BALLOON? 
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4. (C) The IMF conditionalities all aim to make corrupt 
behavior more difficult.  Because these are also the areas 
that currently affect the interests of U.S. investors, VAT 
refunds and customs valuation also appear on our bilateral 
agenda in the U.S.-Armenia Task Force on Economic Development 
(USATF).  But the larger battle concerns not these technical 
procedures but whether the government is willing to raise 
significant revenue from the well-connected oligarchs who 
control much of the economy, or whether the tax and customs 
service will continue to extract revenue only from the middle 
classes by semi-legal or harassing means.  In order to 
realize progress in the area of VAT refunds or customs 
valuation without substituting another evil, there must be 
true change in the nature of taxation and its relationship to 
Armenia's oligarchs.  Notably, offices in the administration 
of tax and customs must cease to be seats of rent-seeking 
activity.  Unless the government can reorganize the tax and 
customs services in a way that truly brings them under the 
control of officials who are genuinely interested in reform, 
the tax burden will continue to fall disproportionately on 
medium-size businesses and foreign investors, who lack the 
necessary contacts and influence to make favorable 
arrangements with corrupt officials. 
EVANS