Poor Kyrgyzstan

Poor Kyrgyzstan

Mini Teaser: A snapshot of how well-intended but misguided development assistance has failed one of America's new Central Asian partners.

by Author(s): Richard A. Slaughter

It is indisputable that an underdeveloped country requires investment
capital. How the capital is obtained, however, matters a great deal.
In the Kyrgyz case, it is obtained almost entirely through foreign
loans (for infrastructure) or subsidized foreign investment (for
industry). Almost no capital investment in Krygyzstan comes from its
own citizens. This contrasts with nearly all successful development
cases, where most capital is raised internally and most foreign
direct investment is private.

Foreign loans underwrite the entire infrastructure program, social
sector rehabilitation and reform and other projects in Kyrgyzstan.
Tax concessions include a Free Economic Zone in which manufacturing
activity is freed from 70 percent of taxes that would otherwise
apply, and concessions are offered for specific projects. These
concessions result in a very uneven playing field for business. In
Bishkek, the new American hotel enjoys tax-free status, while the
older Turkish hotel does not. The difference enables the more
luxurious hotel to offer rates competitive with its less desirable
cousin, and may well drive the latter out of business. On another
front, the government has made a large investment in the Kumtor gold
mine, which now accounts for one-third of the debt service. Total
debt service accounted for 25 percent of government outlays in 1999,
and nearly 50 percent in 2000. Mine profits, of which the government
is to receive two-thirds, have made scarce appearance.

International best practices, too, coming from a different economic
environment, sometimes have perverse effects in Central Asia. One
example is pension reform. In Kyrgyzstan, the pension tax was raised
to fund future obligations, in line with defined benefit systems
standards. The resulting tax rate, 38 percent combined tax on
employee and employer (since reduced to 33 percent) is higher than
the individual and business income tax rates. In a country whose
relevant experience has been rapid inflation with non-indexed Soviet
pensions, the population has no faith in the system. People work as
hard to avoid the pension tax as they do to earn a living. Most
workers outside what is left of the old industrial sector record the
monthly minimum wage (now about $2), and take the remainder under the
table, while their employers cook the books and negotiate with both
suppliers and customers to make things balance for the tax inspector.
When a problem is found, the tax inspector, for a fee, will provide
advice on how to fix it. The result is a massive loss of tax revenue
(and an underestimation of GDP) with a stifling effect on growth.
Combined with trade restrictions imposed by Kyrgyzstan's neighbors
(the Uzbeks and Kazakhs) in retaliation for Kyrgyz entry into the
WTO, the tax structure and administration drive the economy
underground and stifle growth.

Another example of institutional dysfunction is provided by energy
policy. Energy, which inhibits economic development in Kyrgyzstan
because it is unreliable, is wasted on a massive scale because
subsidies leave no incentive for modernization or conservation. The
Kyrgyz consume between three to five times as much energy as do
Americans per unit of GDP, and yet produce, officially, 1/200 as much

For most consumers, there is little incentive to conserve electricity and much incentive to waste gas. Our house in Jalal-Abad had an electric furnace, while the cookhouse had a gas stove and a gas-fired heater
for washing and for the sauna. The electricity was metered at six
mills per kilowatt--about a fifth the cost of its production and
delivery. The gas was metered, too, but because the meter only had
three digits, the monthly bill was negotiated with the meter reader.
Our landlady would regularly turn the electric furnace off at six
every morning, in freezing weather, to save "that expensive
electricity", but she cared less about the gas, even though the
burners are so crude that they waste most of the energy used. We once
fired the sauna for four hours; because the gas pressure was low, it
would not heat to the required temperature. From the standpoint of
the individual consumer, such profligate behavior is entirely

Other features of Kyrgyz fiscal policy are also dysfunctional in
macroeconomic terms. Most derive from political conditions that
reward favoritism, nepotism and patronage, or are part of the social
safety net (e.g., utilities priced well below cost). Public service
amounts to clan-based sinecures for the connected.

Corruption is endemic. It is tempting to think that ending corruption
could bring an end to poverty, and some development agencies assume
exactly that. But it isn't that simple when everyone (including young
children) is involved in demanding payments, making them or evading
taxes; where tribes and empire, not the nation-state, have been the
political norm for millennia, and where Western legal and financial
institutions have never existed. It would be a mistake, however, to
ascribe corruption, inequality and poverty to traditional patterns
alone. The present corruption in Central Asia--the "informal economy"
as it is locally known--arose out of the collapse of the Soviet
Union. Industry designed to serve European Russia succumbed quickly
to market realities and most workers reverted to home production and
barter. While the Soviet system had many problems, including its own
forms of corruption, it was breathtakingly efficient compared to what
exists now.

Corruption exists on several levels in contemporary Kyrgyzstan, two
of which are of particular significance. The first is technically not
corruption because it is government policy; it consists of the almost
literal confiscation of cash flows wherever they can be found. The
second, resulting from economic collapse, is best termed functional
corruption. From the cop who bids for lucrative street corners to the
teacher who sells access to class, passing grades and good
references, to the public health surgeon who demands an
under-the-table fee, corruption is a rational response to the absence
of other economic opportunities. Most Kyrgyz engage in the informal
cash economy, which produces no tax revenue at all.

The combined effect of an irrational tax structure, functional
corruption and rent-seeking by government is that 80 percent or more
of the Kyrgyz economy is underground, unreachable by taxes--which, of
course, has the effect of leading government, under pressure from the
IMF, to raise tax rates on the economic activity it can reach. The
official GDP for 2000 was $242 per person, of which 25 percent was
estimated to be underground, and from which the government collected
35 percent in taxes. Estimates of GDP on a purchasing power parity
(PPP) basis range from $1,800 to $2,500 per person. While PPP
estimates have different meanings, the true level of economic
activity is up to ten times what is reported and taxed. So Kyrgyzstan
is not as poor as it seems. On the other hand, the greater the extent
to which an economy is driven underground to home production, barter
and unreported cash--the greater the extent to which economies of
scale cannot be achieved and growth is inhibited. This and other data
lead to the conclusion that if Kyrgyzstan and its neighbors were to
adopt institutional forms that enable the realization of potential
output, they would no longer be poor.

It is clear from talking with businessmen and officials in the
Finance Ministry that to do business in Kyrgyzstan one must either be
based in a fez, plan to go bankrupt or operate illegally, all the
while paying for official favors and evading taxation. Smuggling,
keeping duplicate sets of books, negotiating tax evasion with
employees, suppliers and clients, and paying bribes--all of which are
rampant in Kyrgyzstan--would not occur if it were possible to make
money legally. In short, a downward spiral is at work: economic
activity produces little revenue for the government, leaving it with
no money to invest or even to pay rudimentary salaries, so it
attaches what it can find; and because government cannot pay for
services and preys on whatever wealth it can locate, economic
activity remains rudimentary and veiled. This cycle is death for any
prospect of sustained or serious economic growth. This is, of course,
precisely what the institutional theory of development predicts: If
the system rewards unproductive expenditures of human time and
energy, then unproductive consequences will inevitably ensue.

The government is not unaware of this reality. In 2001 the income tax
was reduced from 30 percent to 10 percent--but the IMF objected, so
the new rate is 20 percent. Small business (under $62,000 annual
sales) taxes have been simplified. The pension system is under
discussion, but President Akaev is opposed to change for financial
reasons. The value-added tax remains 20 percent and the tax
inspectorate has not been reformed.

In March, international creditors agreed to re-schedule the Kyrgyz debt on favorable terms, with five- and ten-year grace periods. This re-scheduling, together with the economic boost provided by the new U.S. military presence, should enable the government to resurrect social programs, adjust education, health, and police wages for past inflation, and institute necessary reforms. Such measures are not likely, however, and the government is running out of time. On March 17, a protest in Jalal-Abad triggered by the corruption trial of a popular southern parliamentarian turned deadly, producing the worst violence since a minor riot the night of the presidential elections in October 2000. For the last year President Akaev has increased the suppression of political dissent in the face of escalating opposition efforts to provoke incidents. After twelve years in office, busily supervising the disintegration of his country's economy, the President is becoming increasingly unpopular; he is openly blamed for persistent corruption and worsening poverty. Combined with the ethnic discrimination felt by the Uzbek population in the south, the potential for violence is increasing even if the Taliban-backed Islamic Movement of Uzbekistan (IMU) is no longer a threat, having been largely eliminated by the U.S. campaign in Afghanistan.

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