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Fiscal Risks of Georgia: Tax Revenues and Public Debt

August 20, 2012

Contents
Introduction .........................................................................................................................................3 Data and Methodology ........................................................................................................................6 Overview the Fiscal Situation of Georgia in 2004-2012 ...................................................................9 Dynamics of Future Tax Revenues ..................................................................................................13 Fiscal Sustainability Analysis ...........................................................................................................18 Research Results ................................................................................................................................22 Findings and Recommendations ......................................................................................................24 References...........................................................................................................................................26 Schedule ..............................................................................................................................................27

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Introduction
Fiscal stability is a necessary condition for sustainable economic development of any country. Recent global financial crisis has made the issue more actual and hence created the need to study the fiscal sustainability. Even some developed countries were under the default risk. In order to prevent the similar scenario, it is necessary to assess the country’s long-term fiscal sustainability, and determine whether the country’s economy is ready to respond to any possible negative challenges. PMC Research Centre has highlighted two fiscal sustainability risks: 1. Reduction of the tax revenue dynamics to GDP; and 2. Growth in the public debt to GDP. Study the dynamics of tax revenue is important itself as 84 percent of the budget revenue comes from taxes. According to the Economic Freedom Act, from 2013 the budget deficit shall not exceed 3 percent of GDP, the budget expenditures – 30 percent of GDP, while the public debt – 60 percent of GDP. In addition, under the same Act, the government will not be able to increase national taxes without referendum. Taking all this into consideration, the Research Centre studied how real it is to meet these conditions, whether the tax revenues will be reduced to the extent that the state will not be able to fulfil its obligations or the public debt will increase rapidly. The years of 2011-2012 were positive for the economy of Georgia. This is the period of exiting from the crisis and improving the main macroeconomic indicators. For example, the public debt to GDP was 45 percent in 2010, while it will be reduced to 33 percent by the end of 2012. The budget deficit to GDP was 6.7 percent in 2009, while the forecast for 2012 is 1.5 percent. A group of researchers has studied how sustainable is the positive tendency and if the economy of Georgia can respond to undesirable challenges, for example, the repeated financial crisis. In the first part of the research we discuss the fiscal situation of Georgia during 2003-2011.

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The dynamics of the future tax revenues is studied in the second part of the research. Based on the study of all types of taxes, we have concluded that the value added tax (VAT), from which almost half of the tax revenue comes, does not follow the economic growth in direct proportion. According to the model used by the Ministry of Finance, the excise tax on imported goods is forecasted by the economic growth rate, we have associated this tax with the import growth rate. Given these findings, we have developed a model for tax revenues, and concluded that tax revenues to GDP are expected to decrease in the long run. Percentage change is not significant but cumulative difference for the year 2025 is estimated to be 3 billion GEL. In the third part of the research we study the fiscal sustainability to the public debt. The results show that the debt crisis does not threaten Georgia in the medium term and the long term. Moreover, the country’s fiscal sector is prepared to withstand 3-year shocks of economic growth, foreign exchange rate and budget deficit as well. Stress tests have shown that the macro-economic indicators, which are considered to be the marginal fiscal sustainability parameters, do not exceed the maximum limit. However, the shock resistance ability should not be understood as the measurement of the level of economic development. We do not come to a conclusion that the current level of Georgia’s economic development is desirable and does not require further reforms and success. We have studied the stress scenario for tax revenues, when the tax revenue growth rate is significantly lower than the nominal GDP growth rate. This scenario describes the case when country’s economy grows at the expense of the sectors exempted from VAT (education, healthcare, financial intermediation, agriculture, lotteries and gambling, urban and interregional transport). Also, the decrease in share of excise goods was assumed, while the dependence of direct taxes on the economic growth will not change. According to the above scenario, tax revenues to GDP will significantly reduce: in 2012 it makes 24.6 percent, while it will reduce to 20.5 percent by 2020.

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Final part of the research is devoted to the analysis of the stress scenario results, on the basis of which we have made final conclusions and recommendations regarding the fiscal sustainability of Georgia. The aim of the study is not to make an accurate forecast of future economic growth rates, exchange rates, inflation rates and other key macroeconomic indicators but it is to discuss the country’s fiscal sustainability and solvency at the time of various economic growth rates, inflation rates and exchange rates.

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Data and Methodology
The data used in the research are mainly obtained from the Ministry of Finance of Georgia, National Statistics Office of Georgia and National Bank of Georgia. According to the methodology and targets of the study we have used both the annual and quarterly data. For the regression analysis we have adjusted the quarterly data on the seasonal basis. Part of the data has been obtained from 1996 that resulted in the statistically significant findings. The studies are based on the econometric and mathematical research methods: regression analysis (the least-squares method), extrapolation, trend identification and financial programming. The regression analysis, trend identification and extrapolation were used for determining the causal relationship between economic variables. The financial programming elements were used to build the tax revenues and fiscal sustainability study models. The tax revenues and fiscal sustainability study models have common assumptions. First of all we have introduced exogenous variables: the real GDP growth rate, inflation rate and foreign exchange rate. For the period through 2016 we have matched the GDP growth rate with the estimated figures of the Ministry of Finance. As the estimated growth of the economy for 2012-2016 is 6-7 percent subject to the economic growth convergence theory we have assumed that economic growth rate in the following years (2017-2025) will have the decreasing trend (see the Schedules, Table 3). According to the convergence theory, the economic growth rate tends to the convergence point that is equal to the long-term technological progress rate. Also, the economic growth rate is the marginal value. To attain the growth rate of a previous year, it requires more investments than one year ago. Consequently, the countries fail to achieve the high rate of annual economic growth within a long-term period. The inflation rate is the target of the monetary policy in Georgia. Before 2015 it is at the rate of 6 percent and in the next years (2016-2025) it will gradually decrease to 2 percent (see the Schedule, Table 3).

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In the fiscal sustainability model the exchange rate of a Georgian Lari to US dollar is fixed at the current rate (1.65). Further, we assume its rapid devaluation within the exchange rate test. The objective was not to forecast future exchange rate of GEL precisely. We identified what will be the fiscal sustainability in case of rapid devaluation of GEL. GEL Exchange rate devaluation test is significant because 82 percent of the public debt is the foreign debt and devaluation will increase the value of foreign debt in GEL considerably. In addition, the debt service is accounted in US dollars and in case of devaluation of the national currency the debt service amount will go up. In the tax revenue model the taxes are calculated by types. The revenues depend on the economic growth rate, change in inflation rate and foreign exchange rate, import growth rate and improvement of tax administration. We assumed the improvement of administration by 1 percent annually before 2015. According to the basic model (in compliance with Ministry of Finance of Georgia methodology) the main principles of the tax revenue forecast are as follows: The income tax increases pro rata the nominal GDP growth rate (by coefficient 1); The profit tax increases pro rata the nominal GDP growth rate of the previous year (by coefficient 1); The value added tax – pro rata the nominal GDP growth rate (by coefficient 1 as will be changed further as a result of the study); The excise tax – pro rata the real GDP growth rate (by coefficient 0.5); The custom duty – pro rata the import growth rate (by coefficient 1); Other taxes increase pro rata the real economic growth (by coefficient 0.5).

For the analysis of fiscal sustainability we have used the methodology of the International Monetary Fund. According to this methodology, a country is fiscally sustainable if the government can service the debt without extraordinary financing. The criteria of the International Monetary Fund for the fiscal sustainability risks are determined as follows: Low risk: Medium risk: All indicators of the debt burden are lower than the marginal values; The basic scenario indicators are satisfactory but the indicators of the alternative scenario exceed the marginal values;

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High risk: Debt stress:

The debt burden indicators by the basic scenario exceed the marginal values; The country fails to service the debt.

The values of the sustainability indicators are determined by the level of economy development of a country. The IMF identifies Georgia as a lower-middle-income country to which confirms the “strong policy” (Table 1).
Table 1. Marginal indicators of fiscal sustainability Weak policy Medium policy Strong policy Public debt (%) Export 100 150 200 GDP 30 40 50 Revenues 200 250 300 Debt service (%) Export 15 20 25 Revenues 25 30 35

Source: International Monetary Fund

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Overview the Fiscal Situation of Georgia in 2004-2012

Since 2004 the reforms have been implemented in Georgia very rapidly. Among them, the most significant ones were the economic reforms. Enhancements of the public institutions were accompanied with the fiscal reforms aimed at improving business environment, which had a clear impact on the economic development during the years 2004-2007. The gross domestic product is a good indicator of the country’s development course and its fiscal sustainability. The growth of GDP in Georgia could be divided into three stages: 1) from 2005 to 2007, which could be called as years of economic prosperity when the GDP was characterized by the high growth rate; 2) The year 2008 and 2009, which could be named as years of economic downturn, when the economic growth was 2.3 percent and then decreased by 3.8 percent, mainly due to the global financial crisis and Russia-Georgia war of August 2008; 3) The years of 2010-2011 were the phase of economic recovery, as in 2010 the GDP growth rate was 6.3 percent and in 2011 – 7.0 percent. The indicators of public debt and budget deficit were changing according to the tendencies of the gross domestic product. The public debt and budget deficit are significant variables for assessing the fiscal sustainability. When country has a high deficit, its public debt grows gradually. If the country fails to pay the debt it will face a default.

Source: Ministry of Finance of Georgia and National Statistics Agency of Georgia

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As it is shown in the figure the dynamics of the public debt may be also divided into 3 parts: 1. 2004-2007, when the public debt decreased from 63.2 percent to 25.5 percent of GDP, resulted from the rapid growth of GDP and reinforcement of the GEL exchange rate, when up to 85% of the public debt of Georgia was nominated in US dollars. In the same years, according to the IMF Government Finance Statistics 2001, Georgia ran the surplus budget (see the Schedule, Figure 1); 2. 2008-2010, when the public debt raised as a result of the significant increase in the budget deficit; 3. 2011-2012 when the public debt to the GDP began to drop and in 2012 decreased to 33.4 percent of the GDP. Since 2004, Georgia chooses the policy of economic liberalization which had a great influence on the fiscal sector. The type of taxes decreased from 21 to 7 together with decreasing the tax rates (see Table 2 below).

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Table 2. Types of tax and dynamics of tax rates
2004 Taxes VAT Income tax 21 20% 1220% 33% 20% 2005 6 20% 12% 2006 6 18% 12% 2007 6 18% 12% 2008 5 18% Social + income 25 % _ 15% 2009 5 18% Social + income 25 % _ 15% 2010 5 18% 20% 2011 5 18% 20% 2012 5 18% 20%

Social tax Profit tax Custom duty

20% 20%

20% 20%

20% 20%

_ 15%

_ 15%

_ 15%

Difference 0-30 %

Differentiated 0%, 5%, 12%.

The tax liberalization fuelled the high economic growth rates during the several years and decreased the level of corruption and shadow economy. As a result, compared to 2003 the tax revenues in 2008 increased by 5.5 times (see the Schedule, Table 1). Throughout the growth of budget revenues, the budget expenditures were increasing as well (see the Schedule, Table 2). In 2004, the share of wages increased as a result of increasing salaries in public sector and it had a decreasing trend in the following years. During 20052008, procuring equipment and developing material base for public institutions has caused a rapid growth of expenses under the item “Goods and Services”. Increase in public debt has increased a debt service as well, by 2008 it decreased to 1.7 percent of expenditures and increased up to 4 percent in 2011. Among the recent tendencies, the growth of social expenses, both in nominal and relative indicators, was significant. About a quarter of the budget expenditures had been spent on the social expenses. Being affected by the Russia-Georgia war and the global financial crisis of 2008, the fiscal policy of Georgia has changed radically. In 2009, subject to the GDP decrease, the budget revenues decreased as well, while no reduction was achieved in the expenditures. To the contrary, in order to overcome the economic crisis, government employed the fiscal encouragement and allocated 2- billion GEL for that. As a result the budget deficit increased

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up to 6.7 percent of GDP. Georgia’s reliance on the public debt and donor aid was significantly increased. Since 2011 Georgia has begun to overcome the economic crisis and turned again to the economic growth. In 2011 the budget deficit to GDP decreased to 1.3%; the economy growth rate exceeded the public debt growth rate. As a result, the public debt to GDP started to decrease. Despite the positive fiscal tendencies of the recent years, our goal is to assess the readiness of the Georgian economy against the economic shocks. As it was mentioned above, we will discuss the test of significant decrease in tax revenues and increase in public debt, which can be caused by decrease in economic growth rate, increase in budget deficit, and devaluation of GEL exchange rate.

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Dynamics of Future Tax Revenues
For making a medium- and long-term forecast of tax revenues, we have studied the dependence of revenues on the GDP growth rate and inflation during the years 1996-2011. In the first scenario, we made a long-term forecast of the tax revenues based on the mediumterm forecasting model of the Ministry of Finance (Table 3). According to the government policy the income tax rate will decrease to 18 percent from 2013 and to 15 percent from 2014. Based on this model the revenues from income tax and excise tax significantly decrease as a percent of the GDP whereby and in 2025 the total tax revenues will decrease up to 22.4 percent of the GDP.

Table 3. Tax revenues to GDP, the medium-term forecast
2012 2013 2014 2015 2016 2020 2025

Total tax revenues
Income tax Profit tax VAT Excise tax Custom duty Property tax Other taxes

24.6%
6.4% 3.3% 11.2% 2.4% 0.4% 0.8% 0.2%

23.9% 22.9% 22.8% 22.8%
5.9% 3.3% 5.1% 3.4% 5.1% 3.4% 5.1% 3.5%

22.5%
5.2% 3.6% 11.5% 1.3% 0.4% 0.4% 0.1%

22.4%
5.2% 3.7% 11.5% 1.0% 0.5% 0.3% 0.1%

11.2% 11.3% 11.3% 11.4% 2.2% 0.4% 0.7% 0.2% 2.0% 0.4% 0.7% 0.1% 1.8% 0.4% 0.6% 0.1% 1.7% 0.4% 0.6% 0.1%

Tax revenues in the nominal (million GEL)

6,625

7,232

7,833 8,824

9,806

14,184

19,720

In the second scenario, we have modified the tax revenue model based on the thorough study of the tax revenues. The relationship between taxes (value added, income, profit and property taxes) and economic growth and inflation rate have been established using the regression analysis (see the Schedule, Charts 2-5, Table 4-5).

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Chart 2: Dynamics of the Value Added Tax

Source: Ministry of Finance of Georgia

During 2005-2007, high growth rate of VAT was caused by high economic growth and improved tax administration. In 2008-2009, due to the economic crisis, revenue from VAT decreased, but its ratio to the GDP was maintained. As shown in the Chart 2, revenues from VAT were increasing together with GDP growth rate. Revenue from VAT is around 46 percent of the total tax revenues and therefore it is very important to study and accurately forecast this type of tax. Based on the regression analysis, we have concluded that the revenue from value added tax is positively related to the real GDP growth rate, with a coefficient of 0.84 but not 1.0, as it is in the medium-term model of the Ministry of Finance (see the Schedule, Table 4), meaning that the growth of the real GDP by 1 percent will increase the revenue from VAT by 0.84 percent.

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Chart 3: Dynamics of Excise Tax

Source: The Ministry of Finance

The revenue from excise tax to GDP is stable over time; the high growth rate of the excise tax revenue was observed in 2010 mainly caused by the increase in the excise tax rates and imposing excise tax on mobile operators. 70 percent of the excise tax is coming from taxing imported goods. In our tax forecasting model we connected the income of excise on the imported goods to the import growth rate. The import growth rate is in correlation with the economic growth rate. Based on the research, we can conclude that the growth of the excise tax from the imported goods is related to the amount of total import with a coefficient of 0.7, while the income from excise tax on domestic production is related to the growth of GDP with a coefficient of 0.5 (see the Schedule, Chart 3-4). Hence, the growth of total import by 1 percent will increase the excise tax revenue from the imported goods by 0.7 percent and the growth of GDP by 1 percent will increase the excise tax income from domestic goods by 0.5percent. Based on the research results, we have justified the positive relationship between the direct taxes and the economic growth with the coefficient of 1.0. The income tax revenue increases by the same rate as the GDP of the same year while the profit tax increases by the same rate as the GDP of the past year.

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Chart 4: Income tax dynamics

Source: Ministry of Finance of Georgia

Chart 5: Profit tax dynamics

Source: Ministry of Finance of Georgia

As a result of studying each type of taxes, we developed a modified model of tax revenues (Table 4), according to which, tax revenues to GDP in the long-term period decreases more than according to the basic model. The percentage change is not significant, but for 2025 the difference sums up to 3 billion GEL. The modified model of tax revenues is given below: TR(t) = IT(t-1)*(1+gt)*(1+it)*(1+at) + PT(t-1)*(1+g(t-1))*(1+i(t-1))*(1+at)+ +VAT(t-1)*(1+0,84gt)*(1+it)*(1+at) + ATD(t-1)*(1+gt/2) + ATI(t-1)*(1+0,7mt) + CT(t-1)*(1+mt)*(1+et) + RT(t-1)*(1+gt/2)*(1+at) + AT(t-1)*(1+0,02)

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Where:

TR – tax revenues IT – income tax revenue PT – profit tax revenue VAT – value added tax revenue ATD – excise tax revenue from domestic goods ADI – excise tax revenues from imported goods CT – custom tax revenue RT – property tax revenue AT – revenue from other taxes t – reporting period t-1 – previous year g – economic growth rate i – inflation rate a – administration improvement m – import growth rate e – percent change of the exchange rate

Table 4: Tax revenues to GDP, modified model
2012 2013 2014 2015 2016 2020 2025

Total tax revenues
Income Profit Tax Excise Custom Property Other taxes Tax revenues in nominal (million GEL)

24.6%
6.4% 3.3% 11.2% 2.4% 0.4% 0.8% 0.2% 6625

23.9%
5.9% 3.3% 11.1% 2.3% 0.4% 0.7% 0.2% 7226

22.9%
5.1% 3.4% 11.1% 2.2% 0.4% 0.7% 0.1% 7815

22.7%
5.1% 3.4% 11.0% 2.1% 0.4% 0.6% 0.1% 8787

22.6%
5.1% 3.5% 10.9% 2.0% 0.4% 0.6% 0.1% 9744

22.1%
5.2% 3.6% 10.6% 1.8% 0.4% 0.4% 0.1% 13942

21.7%
5.2% 3.7% 10.3% 1.6% 0.4% 0.3% 0.1% 19075

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Fiscal Sustainability Analysis
For the analysis of fiscal sustainability we studied the ability of Georgian fiscal sector to service the liabilities and in the long run, not to increase the public debt up to the marginal indicators of debt burden discussed in the methodology section. As of 2012, the amount of public debt of Georgia does not constitute any threat to the fiscal sustainability (33 percent of the GDP). Currently, 78 percent of the public debt is the external debt (see the Schedule, Table 6, Chart 6) and in the recent years, the annual weighed rate of the debt service varies from 2 to 3 percent. To study the fiscal sustainability, in addition to the above mentioned exogenous variables, we introduced the following assumptions: According to the basic scenario, from 2013 to 2025, the budget deficit (overall balance according to the IMF GFS 2001) is 3 percent of GDP. This is the maximum value of the deficit allowed by the law; The current proportion of external debt/internal debt in financing deficits will be maintained in future years – 78%/22%; From 2016, the debt service interest rate will grow by 0.25 percentage point annually; For the calculation of budget revenues we use the modified model of tax revenues. First of all we have studied the fiscal sustainability according to the basic model:

Table 5
Parameters Debt/GDP Debt/export Debt/revenues Debt service/export Debt service/revenues 2012 2013 2014 2015 32.4% 29.4% 27.3% 26.4% 77.0% 65.4% 58.1% 55.6% 113.0% 111.4% 108.3% 105.8% 4.7% 6.1% 5.5% 3.8% 6.8% 10.4% 10.2% 7.2% 2016 25.8% 53.7% 104.2% 3.7% 7.2% 2020 24.6% 49.2% 102.0% 4.3% 8.9% 2025 26.4% 50.2% 110.7% 5.1% 11.2% Margin 50 200 300 25 35

Budget revenues/GDP Budget expenditures/GDP

28.6% 29.6%

26.4% 29.4%

25.2% 25.0% 24.7% 24.1% 23.8% 28.2% 28.0% 27.7% 27.1% 26.8%

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At the next stage of the study, we considered the possible economic shocks that will have biggest impact on fiscal sustainability. Those are: GDP shock; Budget deficit shock; GEL exchange rate shock; Combined shock; Tax revenues shock. We consider the shock on 3-year period, during 2013-2015. We assume two types of shocks, individual and combined. In the combined version drop in the GDP growth rate, increase in budget deficit and GEL devaluation will take place simultaneously. The probability of having all the shocks at the same time is quite high, as was already observed in 2009, when decrease in GDP caused increase in budget deficit and devaluated GEL. At the last stage, we will study the tax revenues shock.

GDP growth rate shock In 2013, the economy drops by 2%, in 2014 the economic growth rate is 1%, in 2015 – 3% and in 2016 – 6%. The budget deficit remains at 3% of GDP and exchange rate stays the same:

Table 6
Parameters Debt/GDP Debt/export Debt/revenues Debt service/export Debt service/revenues 2012 2013 2014 2015 2016 2020 2025 Margin 50 200 300 25 35

32.4% 31.6% 30.5% 30.1% 29.0% 26.4% 27.4% 77.0% 70.2% 65.0% 63.4% 60.4% 52.9% 52.3% 113.0% 116.8% 117.7% 117.2% 114.9% 109.0% 116.4% 4.7% 6.6% 6.2% 4.5% 4.2% 8.0% 4.6% 5.3%

6.8% 11.0% 11.3% 8.2%

9.5% 11.8%

Budget revenues/GDP Budget expenditures/GDP

28.6% 27.1% 26.0% 25.7% 25.2% 24.2% 23.6% 29.6% 30.1% 29.0% 28.7% 28.2% 27.2% 26.6%

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Budget deficit shock In 2013, budget deficit increases to 7% of GDP, in 2014 – 5.5%, in 2015 – 4.5% and in 2016 – 3%. The economic growth rate and exchange rate remain the same:

Table 7
Parameters Debt/GDP Debt/export Debt/revenues Debt service/export Debt service/revenues 2012 2013 2014 2015 2016 2020 2025 Margin 50 200 300 25 35

32.4% 33.4% 33.3% 33.3% 31.5% 28.0% 28.4% 77.0% 74.3% 70.9% 70.0% 65.7% 56.0% 54.2% 113.0% 126.6% 132.5% 133.7% 128.2% 118.1% 123.2% 4.7% 6.1% 5.5% 3.8% 4.5% 4.9% 5.5%

6.8% 10.4% 10.2% 7.2%

8.9% 10.3% 12.4%

Budget revenues/GDP Budget expenditures/GDP

28.6% 26.4% 25.2% 24.9% 24.6% 23.7% 23.1% 29.6% 33.4% 30.7% 29.4% 27.6% 26.7% 26.1%

Foreign exchange rate shock In 2013, the exchange rate of GEL to US dollar will drop by 50% (1 USD will be equal to 2.48 GEL) and will be kept stably until 2025. The economic growth rate and budget deficit remain the same:

Table 8
Parameters Debt/GDP Debt/export Debt/revenues Debt service/export Debt service/revenues 2012 2013 2014 2015 2016 2020 2025 Margin 50 200 300 25 35

32.4% 40.5% 37.1% 35.2% 33.5% 29.0% 28.9% 77.0% 90.0% 78.9% 74.0% 69.7% 58.0% 55.1% 113.0% 152.2% 146.2% 140.3% 135.0% 121.2% 124.1% 4.7% 9.2% 8.2% 5.6% 4.8% 5.1% 5.6%

6.8% 15.5% 15.2% 10.7% 9.3% 10.6% 12.5%

Budget revenues/GDP Budget expenditures/GDP

28.6% 26.6% 25.4% 25.1% 24.8% 23.9% 23.3% 29.6% 29.6% 28.4% 28.1% 27.8% 26.9% 26.3%

Combined shock All of these three shocks take place simultaneously during 2013-2015: economic growth drops, budget deficit increases and GEL devaluates and from 2016 all three indicators changes back to the basic model state: 20

Table 9
Parameters Debt/GDP Debt/export Debt/revenues Debt service/export Debt service/revenues 2012 2013 2014 2015 2016 2020 2025 Margin 50 200 300 25 35

32.4% 47.6% 47.9% 47.7% 44.2% 35.3% 32.6% 77.0% 105.7% 102.0% 100.4% 92.1% 70.5% 62.2% 113.0% 174.5% 183.3% 184.4% 173.8% 144.3% 137.3% 4.7% 9.9% 9.3% 6.7% 6.4% 6.1% 6.3%

6.8% 16.4% 16.8% 12.3% 12.0% 12.6% 13.9%

Budget revenues/GDP Budget expenditures/GDP

28.6% 27.3% 26.1% 25.9% 25.4% 24.4% 23.8% 29.6% 34.3% 31.6% 30.4% 28.4% 27.4% 26.8%

Tax revenue shock In the economic growth decreases the share of sectors subject to the value added tax and the share of goods subject to excise tax (petroleum products, tobacco, telephone communications etc.).As a result, tax revenues do not grow by the forecasted proportion. The correlation coefficient of value added tax and economic growth is 0.5 instead of 0.84 and correlation coefficient of excise tax revenue from local product and economic growth is 0.25 instead of 0.5. The ratio of direct taxes to GDP stays the same:

Table 10: Tax revenues to GDP
2012 2013 2014 2015 2016 2020 2025

Total tax revenues
Income tax Profit tax VAT Excise tax Custom duty Property tax Other taxes

24.6%
6.4% 3.3% 11.2% 2.4% 0.4% 0.8% 0.2%

23.6%
5.9% 3.3% 10.9% 2.3% 0.4% 0.7% 0.2%

22.4%
5.1% 3.4% 10.6% 2.2% 0.4% 0.7% 0.1%

22.0%
5.1% 3.4% 10.3% 2.1% 0.4% 0.6% 0.1%

21.7%
5.1% 3.5% 10.0% 2.0% 0.4% 0.6% 0.1%

20.5%
5.2% 3.6% 9.1% 1.7% 0.4% 0.4% 0.1%

19.4%
5.2% 3.7% 8.1% 1.6% 0.4% 0.3% 0.1%

Tax revenues in nominal (million GEL)

6625

7152

7646

8503

9342

12913

17110

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Research Results

The research showed that, according to the basic scenario the economy of Georgia is fiscally sustainable, all parameters of the public debt burden are below the margin, and sustainability is not under threat in the medium and long-term periods. Tax revenue to GDP decreases to 24 percent by the year 2025. The three year shock of GDP growth does not cause the loss of fiscal sustainability. The debt service and long-term sustainability indicators do not deteriorate dramatically. The fiscal sector of Georgia does not lose sustainability from the three-year budget deficit shock. However, the relative indicators of the public debt increase more significantly than in case of the GDP growth shock. A 50 percent devaluation of GEL exchange rate rapidly increases the public debt service and debt stock parameters. In 2013, the public debt to GDP reaches 40.5 percent, but it is still under the marginal indicators - fiscal sustainability is maintained. The worst shock for the economy will be the combined shock, one when the stress scenarios of economic growth, budget deficit and exchange rate develop at the same time. The simultaneous development of all of these shocks is more likely than the occurrence of only one of them. The economic downturn or slowing down of growth rate, results in the growth of the budget deficit and devaluation of exchange rate as similar thing already happened in Georgia during 2009-2010. When there is an economic downturn, reducing the budget expenditures becomes politically difficult and pushes the budget deficit to increase. The decrease in economy also negatively effects the stability of the national currency. The combined shock test has shown that during 2013-2015, the relative ratio of the debt to GDP (47.9%) is close to the marginal rate of debt burden (50%) and consequently, a more severe combined shock will be danger for the fiscal sustainability. We can conclude that the combined shock parameters we assumed (GDP growth rate, budget deficit, GEL exchange

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rate) are “cautions” and their further deterioration will cause the loss of sustainability. However, in this case, the debt service indicators will be again lower than the marginal parameters. The debt service to export will increase up to 10 percent and the debt service to budget revenues – up to 17 percent, while their marginal rates are 25 and 35 percents accordingly. As a result of considerations of the stress scenarios we can conclude that according to the methodology of the International Monetary Fund, the fiscal sustainability of Georgia is under the low risk, all debt burden indicators are lower than the margins and do not reach critical levels during the three-year shock period. In the tax revenue shock test the ratio of tax revenues to GDP significantly decreases (to 20% by 2020, to 19% by 2025).If this scenario develops from 2013 to 2025, the tax revenues will be by 15 billion (cumulatively) GEL less than of the basic model and by 12 billion GEL less than of the modified tax model.

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Findings and Recommendations

Based on the research we can conclude that the public debt of Georgia is not a heavy burden for the national economy and the relative ratios of the public debt should be further reduced by using the relevant fiscal policy and debt management. Rapid decrease of the tax revenues to the gross domestic product is not anticipated, if the national economy continues its growth with the same tendency and the discriminative taxation will not be extended, when certain sectors are taxed heavily (e.g. the Economic Freedom Act does not limit extension of the excise tax and the growth of excise tax rate, as well as the growth of the land and property taxes) and some sectors are tax exempted. The tendency in decrease of government interventions in the economy (reflected in the size of the state budget as a percent of GDP) will continue in the medium and long-term periods and the budget volume as a share of GDP will decrease by 3 percent (to 26.1% of the GDP) by the year 2025. The decrease of tax revenues to GDP contributes to the economy development, but it is necessary that government should meet its liabilities in conditions of significant reduction in state expenditures to GDP. The research has shown that the debt service indicator is not at that level that could be a threat for country’s solvency. The other issue is the social liabilities (wages, pensions, social allowances etc.) which will decrease in relative terms but in nominal value will preserve growth tendency. This is a challenge for the government, how it will intervene in the economy and distribution of revenues. The most undesirable scenario for the economy is the maintenance of high share of social expenditures at the expense of budget deficit. If such practice continues permanently, the fiscal sustainability of the country will be under the threat. Another finding of the study is that in case of the proper fiscal management, the maintenance of the fiscal sustainability of Georgia is realistic, both in the medium and longterm periods. For this purpose it is necessary to make a good forecast of future revenues and 24

expenses; to draw a well-balanced budget will increase the Georgian economy resistance against possible fiscal risks and will promote the high indicators of the economic growth. If the government tries to maintain the current ratio of the budget expenses to GDP (29.6%) in the long-term, it will have to identify ways to increase non-tax revenues, because even in case of the most positive scenario, this indicator decreases to 26.8%.

Our recommendations:
1. To take into consideration the research concludes about the tax revenues forecast model, especially findings related to value added tax and excise tax tendencies. 2. Not to use the 3 percent budget deficit limit without emergency and to move to the balanced budget. This will strengthen the fiscal sustainability of the country and reinforce it against the possible economic shocks. Also, the balanced budget contributes to the high economic growth; when state borrows money it often results in the rise of the internal interest rates and hinders implementation of investments. Though the marginal indicators of the public debt of Georgia do not approach the marginal levels of debt burden parameters and the budgetary system is fiscally sustainable, we should not forget the total external debt of the country, which currently exceeds 11 billion US dollars (see the Schedule, Table 7). The goal of our research was to study and analyse external public debt and not the total external debt. However, we are highlighted this topic here as the total external debt has significant impact on the country credit ratings, which in turn determines the interest rate of country’s future liabilities, including the accessibility and interest rates of the sources of financing the state budget deficit. In addition, if country’s private sector has problems in servicing foreign liabilities, government will have to take certain measures to maintain country’s economic sustainability.

25

References
1. Georgia: Request for a Stand-By Arrangement and an Arrangement Under the Standby Credit Facility – International Monetary Fund, IMF Country Report No. 12/98, April 2012 2. The Joint World Bank–IMF Debt Sustainability Framework for Low-Income Countries – IMF, April 2012 3. Aghion, P., and S. Durlauf, 2005, Handbook of Economic Growth, Vols. 1A and 1B (Amsterdam: North-Holland) 4. Becker, S., Deuber G., Stankiewicz, S. (2010). “Public Debt in 2020: A sustainability analysis for DM and EM Economies.”, International Topics, Current Issues. Deutsche Bank Research. 5. Glenday, Graham, “Estimation of VAT Revenues based on Import and Domestic VAT Returns and Collection Data”, Duke Center for International Development, Duke University, 2003 6. Disclosing Fiscal Risks in the Post-Crisis World - Greetje Everaert, Manal Fouad, Edouard Martin, and Ricardo Velloso, IMF, 2009 7. Fiscal Risks: Sources, Disclosure, and Management - Aliona Cebotari, Jeffrey Davis, Lusine Lusinyan, Amine Mati, Paolo Mauro, Murray Petrie, and Ricardo Velloso, IMF, 2010 8. Managing Fiscal Risks, Teresa Ter-Minassian Annual Meeting of the Spanish Economic Association, Zaragoza, December 12, 2008 9. A Practical Guide to Public Debt Dynamics, Fiscal Sustainability and Cyclical Adjustment of Budgetary Aggregates, Julio Escolano, Fiscal Affairs Department, IMF, 2010 10. Economic Cooperation and Development Organization. 2010. Restoration of Fiscal Sustainability: A Lesson for Public Sector. The Research Institute of Politics (in Georgian) 11. Financial Sustainability Report, National Bank of Georgia, 2011(in Georgian) 12. Tax Code of Georgia 13. 2012 State Budget of Georgia 26 6, 4: 1-20

Schedule
Chart 1. Budget deficit structure

Source: Ministry of Finance of Georgia

Table 1: Consolidated budget
2003 Revenues Indirect taxes 1175 608 2004 1937 910 2005 2821 1397 2006 3910 1801 2007 5139 2454 2008 6552 2639 2009 5476 2531

(mln GEL)
2010 6086 2834 2011 7200 3499 2012 7450 3788

Revenue %
Direct taxes

51.7%
420

47.0%
621

49.5%
585

46.1%
846

47.8%
1215

40.3%
2113

46.2%
1858

46.6%
2033

48.6%
2591

50.8%
2833

Revenue %
Grants

36%
48

32%
125

21%
105

22%
168

24%
102

32%
617

34%
389

33%
472

36%
307

38%
239

Revenue %
Other revenues

4.1%
69

6.5%
210

3.7%
294

4.3%
378

2.0%
479

9.4%
484

7.1%
487

7.8%
526

4.3%
563

3.2%
450

Revenue %
Privatization

5.9%
30

10.8%
73

10.4%
439

9.7%
719

9.3%
888

7.4%
698

8.9%
212

8.6%
220

7.8%
240

6.0%
140

Revenue %

2.6%

3.8%

15.6%

18.4%

17.3%

10.7%

3.9%

3.6%

3.3%

1.9%

Source: Ministry of Finance of Georgia

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Table 2: Consolidated budget
2003 Expenditures Payroll 1446 289 2004 1977 415 2005 2993 550 2006 3947 565 2007 5719 676 2008 6920 1008 2009 6685 1048

(mln GEL)
2010 7023 1120 2011 7505 1165 2012 7964 1218

Expenditure %
Goods and services

20.0%
312

21.0%
328

18.4%
564

14.3%
767

11.8%
1581

14.6%
1614

15.7%
1105

15.9%
1139

15.5%
1179

15.3%
1188

Expenditure %
Interest

21.6%
169

16.6%
141

18.8%
120

19.4%
104

27.6%
97

23.3%
121

16.5%
171

16.2%
206

15.7%
290

14.9%
341

Expenditure %
Subsidies

11.7%
105

7.1%
217

4.0%
441

2.6%
343

1.7%
413

1.7%
524

2.6%
435

2.9%
393

3.9%
426

4.3%
447

Expenditure %
Social affairs

7.3%
383

11.0%
434

14.7%
558

8.7%
762

7.2%
851

7.6%
1379

6.5%
1506

5.6%
1624

5.7%
1660

5.6%
1821

Expenditure %
Other expenditures

26.5%
0

22.0%
16

18.6%
100

19.3%
527

14.9%
636

19.9%
750

22.5%
944

23.1%
1001

22.1%
833

22.9%
954

Expenditure %
Capital expenditures

0.0%
189

0.8%
426

3.3%
660

13.4%
879

11.1%
1465

10.8%
1524

14.1%
1476

14.3%
1540

11.1%
1952

12.0%
1995

Expenditure %

13.1%

21.5%

22.1%

22.3%

25.6%

22.0%

22.1%

21.9%

26.0%

25.1%

Source: Ministry of Finance of Georgia

Table 3: Key figures
2013 Debt % GDP Foreign debt (mln GEL) Internal debt (mln GEL) Total public debt (mln GEL) 29.4 7373 1954 8910 2014 27.3 7700 2074 2015 26.4 8330 2217 2016 25.8 9100 2385 2017 25.2 2018 24.8 2019 24.6 2020 24.6 2021 24.8 2022 25.0 2023 25.5 2024 25.9 2025 26.4

9916 10811 11788 12852 13995 15216 16503 17862 19286 2578 2798 3046 3321 3624 3954 4310 4694 5104

9335 10202 11101 12029 13078 14234 15498 16861 18321 19865 21499 23218

Inflation Economic growth Nominal GDP (mln GEL) GEL to USD rate of exchange

6.0% 6.5%

6.0% 7.0%

6.0% 7.0%

5.5% 6.0%

5.0% 6.0%

4.5% 6.0%

4.0% 5.5%

3.5% 5.5%

3.0% 5.0%

2.5% 5.0%

2.0% 4.5%

2.0% 4.5%

2.0% 4.0%

30256 34189 38634 43077 47815 52836 57855 63062 68107 73215 77974 83042 88025 1.65 1.65 1.65 1.65 1.65 1.65 1.65 1.65 1.65 1.65 1.65 1.65 1.65

Revenues % GDP Expenditures % GDP Revenues (mln GEL) Expenditures (mln GEL) Current expenses Capital expenses Budget expenses

26.4% 25.2% 25.0% 24.7% 24.5% 24.3% 24.2% 24.1% 24.0% 23.9% 23.9% 23.9% 23.8% 29.4% 28.2% 28.0% 27.7% 27.5% 27.3% 27.2% 27.1% 27.0% 26.9% 26.9% 26.9% 26.8% 8002 8910 7932 978 908 8623 9644 10656 11719 12864 14001 15194 16353 17529 18648 19809 20970

9648 10803 11949 13154 14449 15737 17086 18397 19725 20987 22300 23611 8553 1096 1026 9574 10606 11669 12814 13951 15144 16303 17479 18598 19759 20920 1229 1159 1342 1292 1484 1434 1635 1585 1786 1736 1942 1892 2093 2043 2246 2196 2389 2339 2541 2491 2691 2641

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Table 4. Value added tax
RYI – real GDP + import, INF - inflation, ADM – administration improvement variable Dependent Variable: LOG(VAT) Method: Least Squares Sample (adjusted): 1996Q2 2011Q4 Included observations: 63 after adjustments Variable C LOG(RYI(-1)) INF(-1) ADM R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient -4.704441 0.845993 1.835530 0.336177 0.971970 0.970545 0.178022 1.869819 21.40160 1.187378 Std. Error 1.527700 0.231202 0.221837 0.096577 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic) t-Statistic -3.079428 3.659116 8.274227 3.480912 Prob. 0.0031 0.0005 0.0000 0.0009 5.152089 1.037276 -0.552432 -0.416360 681.9684 0.000000

Chart 2. Value added tax regressive analysis result
7 6 5 .4 .0 -.4 -.8 1996 4 3

1998

2000

2002

2004

2006

2008

2010

Residual

Actual

Fitted

29

Chart 3. Excise tax on import
LOG(AQ) = 2.636460681 + 0.7015591837*LOG(IMP) AQ – excise tax revenue; IMP – import amount
12.0 11.6 11.2 .4 10.8 .2 10.4 .0 -.2 -.4 2005 2006 2007 2008 2009 2010 Fitted 2011

Residual

Actual

Chart 4. Excise tax on domestic products
LOG(DAQ) = 3.936758528 + 0.5663236657*LOG(DOM) DAQ – excise tax revenue, DOM – excise goods produced in Georgia
10.8 10.4 .4 .2 9.6 .0 -.2 -.4 -.6 2006 2007 Residual 2008 Actual 2009 2010 Fitted 9.2 10.0

30

Table 5. Income tax
NY- nominal GDP, ADM – administration improvement variable
Dependent Variable: LOG(PITSA) Method: Least Squares Sample: 1996Q1 2011Q4 Included observations: 64 Variable C LOG(NYSA) ADM R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient -4.774058 1.206037 0.324934 0.978719 0.978022 0.127365 0.989528 42.60906 0.730652 Std. Error 0.429644 0.058965 0.068079 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic) t-Statistic -11.11165 20.45352 4.772905 Prob. 0.0000 0.0000 0.0000 4.779460 0.859115 -1.237783 -1.136586 1402.726 0.000000

Chart 5. Income tax regressive analysis result
7 6 5 .4 4 .2 3 .0 -.2 -.4 1996 1998 2000 2002 2004 2006 2008 2010

Residual

Actual

Fitted

31

Chart 6. Public debt structure
Creditor Total Foreign debt Multilateral creditors Bilateral creditors Securities (Eurobonds) Foreign debt of the National Bank Internal debt Thou $ Thou GEL 5,392,068 8,939,070 4,215,704 2,457,193 634,811 564,750 558,950 1,176,364 6,998,070 4,078,941 1,053,786 937,485 927,858 1,941,000

Chart 6. Public debt structure

Chart 7. Public debt statistics of different countries

Source: International Monetary Fund

32

Table 7. Total foreign debt structure, as at March 31, 2012, in million US dollars
Governmental sector National Bank Banks Other sectors Intercompany loans Total
Source: National Bank of Georgia

3 805 783 2 086 2 107 2 616 11 397

33