Cablegate: Government Officials Deny Election-Year Fiscal Loosening

DE RUEHAK #1537/01 1661313
R 151313Z JUN 07






E.O. 12958: N/A
SUBJECT: Government Officials Deny Election-year Fiscal Loosening

1. (SBU)Summary: A series of Government announcements on fiscal
policy have led to increased suspicions of populist, election-year
fiscal loosening. The most high-profile and IMF-unfriendly of these
was the announcement of Value-Added Tax rate cuts for tourism food
and restaurants. 2007 tax revenues are also showing signs of
weakness. Both Government ministers, publicly, and ministry of
finance bureaucrats, privately, deny or downplay the significance of
policy changes and claim they will still be able to meet yearend
fiscal targets. End Summary.

Signs of Fiscal Loosening

2. (SBU) In recent weeks there have been a series of Government
announcements and press reports suggesting the government is taking
populist spending or tax policy measures which could undermine
fiscal discipline. Among these have been:

---Cutting Value-Added Tax (VAT) rates on some foods to 8%,
effective immediately, and on tourism, restaurants, and remaining
food items effective in 2008;

--Expanding the regional investment incentives to allow firms with
only ten employees to benefit from the incentives, and removing the
requirement that the employees be new hires;

-- Reducing social security payroll taxes in 2008;

--The press has also reported such items as free government
circumcisions, payments to holders of bonds fraudulently sold by the
failed Imar Bank, amnesties on loans to farmers, conversions to
permanent status of public sector temporary workers, and partial
debt forgiveness for municipalities.

3. (SBU) As a result, market analysts are increasingly concerned
that the government is loosening the purse strings in the run-up to
July 22 elections and will have difficulty achieving yearend fiscal
targets agreed with the IMF. After the VAT rate cut was announced,
Finance Minister Unakitan denied it was a violation of the
government's commitments to the IMF, only to be publicly
contradicted by the IMF Resrep. More recently, IMF Deputy Managing
Director John Lipsky, in Istanbul for the annual Investors Advisory
Council, lamented the VAT rate cuts but said any election-year
loosening would not "break the bank," and should be viewed in the
context of the overall performance in Turkey. The IMF has long made
the case that only after revenue collection improved could rates be
cut, and that they be cut across the board rather than sector by

--------------------------------------------- -
Data Show Spending on Track, but Weak Revenues
--------------------------------------------- -

4. (SBU) January-May central government fiscal data, however, do not
show a notable opening of the fiscal spigot. Total non-interest
expenditures were YTL 59.8 billion or 39% of the full-year target.
This level of spending -- broadly in line with the target --
supports a mid-level budget official's claims that any election-year
spending was minor, and that the government would not have any real
problem meeting the yearend primary surplus target or falling within
the IMF-agreed spending cap.

5. (SBU) The revenue side on the other hand, showed surprising
weakness. Total January-May tax revenues increased only 8% in
nominal terms from the same period in 2006 -- i.e. tax revenues fell
in real terms and as a percent of GDP. Corporate tax receipts
declined 9%, Special Consumption Tax collections declined 1% and VAT
increased only 4%. The weak revenue performance raised questions as
to the government's willingness to collect taxes aggressively in an
election year.

6. (SBU) Thanks to privatization revenues and profit transfers from
state-owned banks and the Savings Deposit Insurance Fund, the
overall budget balance was a modest YTL 3.3 billion deficit, only
20% of the full year targeted deficit, and the primary surplus was
56% of the full-year target. The IMF, however, does not include
privatization and profit transfers in its primary balance
calculation, since the GOT committed not to spend this kind of
one-off revenue. By the Fund's calculation, the January-May primary
balance is only 31% of the full-year target.

Tax Administration Explains Weak Revenue Performance...

ANKARA 00001537 002 OF 003

7. (SBU) Like his budgetary counterpart, a Deputy Director of the
Tax Administration, while admitting to fiscal impacts from the rate
cuts and other measures, downplayed the extent of the problem. The
tax official offered a point-by-point explanation of the relatively
weak revenue performance. Corporate tax revenues only looked weak
in relation to the first 5 months of 2006 because the corporate tax
rate reduction from 30% to 20% had come into effect as of April 1,
2006. Special Consumption Tax (SCT) collections were weaker largely
because of the slowdown in domestic sales of automobiles, a major
source of SCT revenues.

8. (SBU) The Tax Administration official explained that the slowdown
in VAT collections was entirely attributable to a surge in VAT
rebate payments to exporters. Gross VAT collections were growing at
a healthy 14-15% rate but rebates had surged about 35%. Though much
of this surge can be attributed to strong export growth so far this
year, the Tax Administration was investigating firms showing
outsized increases in rebates. (Comment: Combating export tax
rebate fraud has long been a challenge for the Tax Administration.
End Comment.)

--------------------------------------------- --
...denies Government going soft on collections...
--------------------------------------------- --

9. (SBU) The tax official denied that the Government was going soft
on tax collection in an election year. On the contrary, the Tax
Administration continued to implement its restructuring -- a key
structural reform supported by the IMF and World Bank -- which is
designed to improve tax enforcement and collection. The Tax
Administration now has regional offices -- as opposed to less
effective Finance Ministry offices -- in 29 provinces accounting for
94% of total tax revenues. The IMF-mandated Large Taxpayer Unit has
been established in Istanbul to handle the 500 largest taxpayers
(soon to be expanded) and has its own special team of auditors.
The Tax Administration continues to invest in more elaborate
information technology systems. Its improved data base now allows
auditors to monitor taxpayers' bank account data, for example. The
Tax Administration is working with the EU to establish a risk-based
auditing system which will better identify which taxpayers should be

--------------------------------------------- -----
...but Admits Costs Associated with Policy Changes
--------------------------------------------- -----

10. (SBU) The Tax Administration Deputy Director admitted there were
costs associated with some of the recently-announced measures. His
boss, Tax Administration Director Osman Arioglu, had announced
publicly that next year's VAT rate cuts would cost about 800 million
YTL (about $600 million) and that the immediately-effective food VAT
rate cuts would cost about 100 million YTL this year. In our
meeting, the Deputy Director defended both the tourism rate cut as
necessary to bring Turkey's taxes on tourism into line with
competitor countries, most of which had single digit VAT rates for
the tourism sector. He said the lower VAT rate for restaurants,
while discouraged by an EU directive, was allowed by derogations for
many accession countries and still exists in many of the
pre-enlargement EU-15 countries, in some cases at rates lower than
Turkey's 8% rate.

11. (SBU) The government has yet to disclose the details of its
plans to cut social security payroll taxes, but a five percent cut
was recently floated by Minister Unakitan. The Tax Administration
official confirmed that this cut would be part of a package of labor
market reforms the Government is working on with the World Bank,
which is expected to be announced after the new government is
formed. He said the income tax withholding on wages was only 6%,
whereas the social security taxes accounted for the bulk of the tax
"wedge": 14% from the employee and 19% from the employer. Comment:
World Bank officials tell us their studies show that any tax loss
from lower payroll taxes will be partially offset by increased
registration of employees with the social security system, as lower
payroll taxes reduce the incentive not to register. End Comment.

12. (SBU) The Tax Administration confirmed that parliament had
passed legislation expanding access to the (IMF-opposed) regional
investment incentives scheme. Whereas in the past firms had to
employ 35 new hires to be eligible for the incentives, under the new
law they would only need to have 10 employees and they need not be
new hires. He expects a loss of revenue from this change of
approximately YTL 900 million per year.


ANKARA 00001537 003 OF 003


13. (SBU) Government Ministers' statements that they are not
relaxing fiscal discipline are contradicted by the announced
measures. Nevertheless, as Lipsky's remarks suggest, the measures
so far do not seem severe enough to put yearend targets -- or
agreement on remedial measures with the IMF -- out of reach of the
next government.


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