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18
Revaz KAKULIA
D.Sc. (Econ.), associate professor, Ivane Javakhishvili Tbilisi State University (Tbilisi, Georgia).
GLOBALIZATION AND PROBLEMS OF IMPROVING THE GEORGIAN FINANCIAL SYSTEM
Abstract
This article examines matters relating to the creation and improvement of the Georgian financial system in the context of globalization. The author analyzes the proble. ms that arise in the process of reform
and development of the country’s fiscal system, spotlights the difficulties that prolonged the national economic crisis, and shows the successes achieved as a result of the measures taken by the new authorities.
I n t r o d u c t i o n
The profound scientific, technological, political and socioeconomic changes characteristic of the 20th century have led to the globalization of economic development. Nation-states (regardless of their political system, nature of socioeconomic relations and industrial development level) have been drawn into the global economic process.
The desire and attempt of the developed countries to protect their own economy against external influences points to the creation of a single global economic space. The world is going over from the “market-state” system to a system of “many states-one market.”1
1 Geoeconomia: II dominio dello spazio economico (Geo-economics. The Dominance of Economic Space), ed. by P. Savona, C. Jean, Franco Angeli, Milan, 1995, 192 pp.
The hierarchy of states in the international arena depends in large part not on their labor, production, natural climatic or geographic resources or potential, but on the level of development of the economy based on the power of money. Today the power of money and the market can determine real economic incentives.
Since the 1970s, the financial sector has changed dramatically. Finance, once a financial intermediary, is rapidly turning into a force that drives economic life. It is not only that the financial sector is developing faster than other sectors of the economy. What is more important is that major financial institutions are rapidly capturing entire areas of the international economy and the economies of developing countries, occupying key positions in these areas.
What are the factors behind this growing role of finance? What are today’s financial conglomerates and international financial centers? How do they influence the economies of developing countries?
The modern economy is a financial economy; it is not an economy with finances, but a financial economy, in which finances do not simply take part in the economy and service it but have a dominant position in it.2
Recent progress in technology, informatics and communications has played a special role in deepening financial relations. Faster communications make it possible to perform any financial transaction in world economic and social life in a very short time. Naturally, this is a factor of infinite importance.
A crucial role in strengthening the financial sector is played by globalization, when finance is released from the political and economic fetters of state regulation, although this process was also promoted by the operation of national economic complexes.
This raises the question: what awaits the financial systems of the post-socialist countries in a globalizing economy?
Since no state in the world can exist outside the domain of the financial economy, the major task is to determine the place of each in the global financial hierarchy. For this purpose, let us consider three groups of sociopolitical and economic contradictions of the world order that influence the actual position of the post-socialist countries.
■ The first contradiction is between the so-called “civilized world” and Russia. First, Russia has not abandoned its attempts to discredit the independence of the former socialist countries, and second, the financial center is increasing pressure on Russia in order to induce it to pay tens of billions of dollars of financial rent in favor of the center. This includes repayment of old debts, interest payments, etc.
■ The second group of contradictions relates to problems that exist between the centers and the regions in the post-socialist countries. In particular, the bulk of financial resources mobilized into central funds are concentrated in the state budgets of these countries. The development of territorial units is in effect a formality, which slows down the economic alignment of the regions. Meanwhile, two-thirds of Georgian territory, for example, is mountainous terrain and the conditions for regional development are insignificant. Use of the institution of transfers alone does not produce the desired results.
■ Finally, the third group of contradictions includes problems existing between the state and its citizens. This concerns the state’s failure to perform its obligations and the unresolved issue of public confidence in government (uncompensated deposits, shortcomings in the process of privatization, and problems in protecting property rights).3
2 See: V. Belolipetskiy, “Finansovaia ekonomika: kontseptual’nye osnovania i mekhanizm realizatsii,” in: Ekonom-icheskaia teoria na poroge XXI veka, ed. by Iu.M. Osipov et al., Yurist Publishers, Moscow, 2001, pp. 58-84.
3 See: R. Kakulia, The Financial Economy, Tbilisi State University, Tbilisi, 2007, pp. 50-54 (in Georgian).
Formation and Development of the Financial System in a Transition Economy
The market economy is increasingly invading those areas of Georgia’s economy and politics which were previously considered the prerogative of the state. The administrative-command system of management is a thing of the past, and the market economy in Georgia is irreversible. The course of events called for criteria that would help to assess the efficiency of market relations and market-based use of labor, material and financial resources by the center, territorial units and autonomous entities. Meanwhile, countries that freed themselves from the colonial regime as a result of the breakup of the U.S.S.R., including Georgia, plunged into a long and grave economic crisis.
Broken economic ties, the continued imperialist aspirations of the Russian authorities, ethnic strife, violation of territorial integrity, buildup of the vestigial defects of the administrative-command system, and the need to provide for 300 thousand refugees—such is the range of problems that complicate the successful implementation of the market economy in the country.
The proposition that the market is self-regulating and can direct the country’s economic and social development without any problems needs to be specified. Meanwhile, the recent formation of a financial system adequate to the market development model took place without regard for local conditions in accordance with the monetarist theoretical concept, which has produced negative results. It should also be borne in mind that the construction of foundations for a market economy without a theoretically justified program does not for some time yield any positive results. “The market economy is not only a source of progress and self-realization of opportunities, but also a source of people’s insecurity, anxiety, suffering and torment.”4
The instantaneous transition to a market economy in Georgia had tragic results. The drop in production and the collapse of the existing economy led to unprecedented unemployment, hyperinflation, distortion of the economic structure, and a sharp decline in living standards. The catastrophic collapse of the economy to the lowest level (in 1994, the country’s GDP was down to 27.5% of the 1990 level) caused an unprecedented drop in household income and living standards.
The economic transformations launched in the country in the 1990s without prior preparation resulted in an all-round economic crisis. Moreover, this crisis in Georgia was deeper and longer than anywhere else in the post-socialist space. By 2003 (before the Rose Revolution), the country’s GDP had reached 46.6% of the 1990 level, compared to 80% in Turkmenistan and Estonia, 70% in Latvia, 65% in Russia, Kazakhstan and Lithuania, and 60% in Armenia.5
Professor Vladimer Papava is evidently quite right in saying that it is necessary to review, in some degree, the generally accepted proposition about the role of the state (government) in the market system.6 He regards the state’s “economic ability” as the fifth factor of production and emphasizes that whereas in the process of business management an entrepreneur determines the business strategy of a particular firm, government decisions influence the development strategy of all firms in the national economy.7
4 R. Kakulia, Theoretical and Practical Problems of Transition to a Market Economy, Tbilisi, 2003, p. 187 (in Georgian).
5 See: Ibid., pp. 100-101.
6 See: V. Papava, “Rol’ gosudarstva v sovremennoi ekonomicheskoi sisteme,” Voprosy ekonomiki, No. 11, 1993; V.G. Papava, T.A. Beridze, Ocherki politicheskoi ekonomii postkommunisticheskogo kapitalizma (opyt Gruzii), Delo i Servis, Moscow, 2005, Essay 13; V. Papava, “A New View of the Economic Ability of the Government, Egalitarian Goods and GNP,” International Journal of Social Economics, Vol. 20, No. 8, 1993; V. Papava, Necroeconomics: The Political Economy of Post-Communist Capitalism, iUniverse, New York, 2005, Chapter 6.
7 See: Ibidem.
The state should, in the first place, assume the function of monetary and fiscal policy, because this is what will help to promote economic growth, increase employment and reduce inflation.
It is no secret that the regulatory activity of any state designed to boost the economy manifests itself in ensuring, by means of financial tools, an optimal orientation of social capital in order to develop a competitive market mechanism that would create conditions for economic growth through the distribution and redistribution of national income.
From this perspective, it is important to pursue a prudent fiscal policy. Any incorrect action relating to budget expenditures is harmful to national economic life. Since Georgia still has a small revenue base, the state should focus its attention on the development of fiscal policy. Centralized financial resources should be freed from the operation of so-called fund-creating institutional organizations. One should accept the view that the state budget in Georgia should be the only one and that it is therefore necessary to abolish all other funds, which significantly increase unproductive, useless expenditure and lead to a waste of already limited financial resources. The new authorities were quite right to virtually eliminate such centralized funds and transferred their functions to the state budget.
The economic breakdown in Georgia at the start of the construction of a democratic system of government, high inflation, widespread corruption, problems with the shadow economy, and poor tax administration reduced budget revenues to a minimum. Up to 1995, the country had no budget to speak of.
In 1991-1994, the budget system was in effect left to drift. The first independent budget (1991) provided for the accumulation of all revenues generated in the country in the national budget. The 1992 budget was not approved until May. The budget deficit that year exceeded 55%. The authorities were unable to draft a budget balanced in terms of revenues and expenditures. The 1993 and 1994 budgets were not passed by the Georgian parliament, but were considered and approved on a quarterly basis.
Although real budget revenue sources were concentrated in the central budget, revenue plans for 1991-2003 were never once fulfilled.
It should be noted that serious problems in Georgia’s economic recovery and economic security were also created by the 1998-1999 budget crisis. This crisis pointed to the impossibility of a consistent implementation of monetarist methods in the conditions of a market economy and showed that mechanical transfer of government economic policy from other countries was a faulty practice.
Reform of the Financial System and Successes in the Budget Sector
The ways of transforming and restructuring the Georgian financial system have changed radically since the Rose Revolution. The authorities have developed a program designed to overcome the socioeconomic contradictions inherited from the previous period and to ensure harmonious development of society. This program will undoubtedly help to create and develop a market economy, without which it is impossible to ensure market conditions for economic growth and development: a free market, free and protected property, low inflation, and free trade between countries. These preliminary conditions are necessary to achieve price liberalization, full employment, a favorable business environment, noninterference in business management, development of contractual relations in economic affairs, independence of the judicial system, and minimal administrative regulation.
In order to resolve employment problems, ensure national defense and protect public order, the state should collect enough taxes to cover the costs required to perform these functions.
Data on the execution of Georgia’s consolidated budget give a good idea of the successes it has achieved: in 2004, revenues and grants reached 2,282.3 million lari (up 69.2% from the previous year), and revenues as a share of GDP rose from 14.2% to 23.3%.
These trends continued in 2005 and 2006. In 2005, revenues and grants reached 3,256.8 million lari (up 53.3% from 2004), and in 2006 they reached 4,429.9 million lari (up 36% from 2005).
The country’s new authorities formulated the main goal of reform in the financial system as the implementation of a mechanism for the generation and use of financial resources that would promote effective distribution of national income in order to develop the productive forces, raise living standards and even out to some extent the economic development levels of the regions.
As regards fiscal reform, it provides for the following: development of an appropriate conceptual framework for the budgets of all levels; impact of public finance on all segments of the national economy; an objective assessment of the financial balance and balance of payments; financial planning, accounting and budget analysis; development and improvement of financial market infrastructure; transformation of the budget mechanism at every level into an instrument of socioeconomic policy; and training and retraining of financial personnel.
Economic progress in Georgia is directly associated with the efficient operation of the tax system. Theoretically and practically justified and scientifically validated taxes can have a positive impact on the national economy, helping to eliminate negative phenomena and place taxation on a sound economic and legal basis.
A Law of the Republic of Georgia on Amendments and Addenda to the Tax Code of Georgia, which addresses problems of national importance, was adopted in July 2007. This was due to a number of objective circumstances. In order to maintain high rates of economic growth, it is necessary to stimulate investment and exports so as to enhance, in particular, the competitiveness of local goods by reducing production costs and encouraging reinvestment. With this aim in view, further liberalization of taxes, i.e., cuts in wage and profit taxes, was recognized as a major stage in this process. The point is that the previous income and social taxes were often identical by their very nature, i.e., from the standpoint of the object of taxation, and this not only made it difficult for taxpayers to do business, but also placed some of them at a disadvantage as regards the taxation of one and the same income. For example, income tax on individual entrepreneurs was 29.6%, while tax on income in the form of wages was 26.7%.
Under the new tax legislation regarding land for agricultural use, individuals who owned less than 5 hectares of land were exempt from property tax.
On the whole, the Law on Amendments and Addenda to the Tax Code of Georgia was designed to:
—improve the investment environment by means of the most liberal tax laws in the region;
—promote investment and exports;
—maintain high rates of economic growth in the medium term;
—improve the balance of payments;
—enhance agricultural efficiency;
—simplify tax payment procedures for taxpayers;
—enhance the efficiency of tax administration.
A natural question arises: how will these amendments and addenda to the Tax Code influence budget revenues?
The abolition of social tax and the new (reduced) income tax rate will lead to a reduction in income tax revenues during the first year, but owing to simplified tax administration, measures to encourage official legalization of income, and an easing of the tax burden the possible losses at the first stage (approximately 20 million lari) will be compensated in subsequent years.
Due to a reduction in profit tax by 5 percentage points, first-year losses are projected at 134 million lari, but in subsequent years this reduction will produce a certain economic effect with a resulting increase in profit tax revenues.
The amount of property tax on land and penalties to be written off is 85 million lari, but this write-off does not result in actual losses. The Law will not lead to any additional budget allocations and will not create any new financial obligations for the state.
Taxpayers covered by the new Law will derive significant benefits: private national savings and hence investment will increase; growing savings will reduce interest rates; the loan structure will change in favor of long-term corporate borrowing; incentives to foreign private investment will increase; production costs will go down; all of this will boost exports and offset the appreciation of the national currency; employment will grow; the agricultural land market will develop; agricultural efficiency will increase; and high rates of economic growth will be sustained over the long term.
So, the said Law has established the rate of income tax on individual entrepreneurs at 25% (instead of the previous 29.6%); income received in the form of wages and income received by persons providing services without a taxpayer’s certificate are to pay a tax of 25% (instead of the previous 26.7%). The rate of profit tax is reduced from 20% to 15%.
Problems of Improving the Georgian Financial System
The recent rise in inflation is among the serious problems that have a negative effect on the Georgian economy. Accelerating inflation in the country is due, in the first place, to rising grain prices in the world market and the increase in Russian gas prices. “But apart from these causes there are immediate objective and subjective causes in Georgia itself, predetermined by government mistakes... Georgia has been captured by mutations of the Dutch Disease, which is directly associated with inflation.”8
After the change of power in Georgia as a result of the Rose Revolution, the country’s law enforcement agencies detained many corrupt officials, who were then released in return for dollar payments; privatization was carried out in dollars; and Georgians working abroad make large dollar remittances to the country, which leads to a strengthening of the national currency against the dollar and has an adverse effect on exporters. The National Bank of Georgia is obliged to withdraw excess foreign currency (dollars) from circulation by selling lari. The issue of lari leads to higher inflation and is one of the main causes of rising prices. Another contributing factor is the government’s current spending policy.
Let us consider another problem. As we know, the authority in charge of budget preparation is the Ministry of Finance. This process begins ten months before the start of the new fiscal year. By that time, the ministries and agencies financed from the state budget have to submit their budget requests for the coming fiscal year.
In countries with an effective budget process, requests submitted by agencies that receive and spend budget funds (spending agencies) imply a high degree of responsibility and are based on proper standards and estimates, while the executive authorities carry out a thorough expert analysis of these requests. So, one can say that budget requests in these countries are very well justified.
8 V.G. Papava, “Georgia has been Taken Ill with Mutant of Dutch Disease,» Interview to the Verssia (Dossier) newspaper, 1-7 August, 2007, p. 6 (in Georgian) (see also: V. Papava, “Currency Board against the Background of Dutch Disease,” Georgian Economic Trends—Quarterly Review, October 2007).
Under the practice that existed in Georgia prior to 2003, most requests submitted by spending agencies to the Ministry of Finance were poorly justified, their estimates were unreliable and, most important of all, they did not take into account the possibilities of the budget, particularly the situation with budget revenue. They drew up their requests on the principle: “ask for more than you need and try to make sure that the cutback in the request is only marginal.” In 1995-2000, for example, an absolute majority of ministries and departments submitted budget requests far exceeding their actual requirements, and this under conditions where the executive authorities could not meet even the reasonable demands of spending agencies in view of a severe revenue shortfall.9
C o n c l u s i o n
So, the validity of budget requests depends in large measure on the existence of a proper regulatory framework. In the past few years, such a framework has been created for a significant part of economic and social areas, but much remains to be done along these lines.
In our opinion, budget planning in Georgia has a number of shortcomings. It is intolerable that budget revenues and expenditures approved by parliament undergo significant changes during the fiscal year. For example, the budget approved for 2007 was increased by 661 million lari in May and by another 450 million lari in September. A 20% increase in the approved budget during the year does not testify to optimal budget planning, especially since this process fuels inflation.
The budget preparation process should be changed radically and the budget deficit should be reduced to a minimum. An annually growing deficit covered by foreign loans instead of internal revenue with a resulting increase in the national debt is undesirable.
9 Materials of the Ministry of Finance of Georgia.
