Bringing the Construction Sector Out of the Shadows Through Tax Control

In the current active debate over the Government's proposals to reform the tax system, I think we should start with the gray areas where tax revenue could be increased. The parameters of all the VAT proposals are not yet known, so it is too early, and there is little point, in commenting on them. I would rather begin by analyzing where our reserves lie.

One of the most opaque industries in Kazakhstan is construction, and this is hardly surprising. Main contractors in construction companies hire crews, most of whom come from other countries, and all of them demand payment in cash. For law-abiding developers who operate in the white economy, this is the biggest challenge, because they have to find ways to "extract" cash. Meanwhile, most construction crews will quote two prices when hired: a white one and a black one, and the black one is always cheaper, by an order of magnitude.

In this situation, it is law-abiding developers who suffer first, because they become uncompetitive against gray-market players. The state's task is to foster fair competition and create a level playing field for everyone. Companies that play by the rules cannot grow quickly when non-market conditions prevail around them.

The problem is common to both residential and non-residential construction, where small companies bid very low prices at tenders and then try to optimize their costs through various tax schemes.

Besides law-abiding developers, the budget also suffers heavily under this arrangement, losing billions of tenge in tax revenue.

Solving this problem requires a package of measures:

Desk-based tax audits. Every industry has its own tax burden, and construction is no exception. It is simply a matter of calculating how much tax would have been paid in the absence of tax optimization, and then checking how much tax has actually been paid on each project, taking into account all subcontractors. If the volume of tax payments is below the calculated level, a full tax audit should be carried out of both the construction company and all its subcontractors. To ensure the audit is objective, its findings should be validated by a separate team from the head office of the State Revenue Committee, which would set out why the tax burden ratio differs from the calculated one.

Price control over developers of residential property. As a rule, double contracts are used to obtain cash: officially one price is stated, while in reality part of the money is paid to the developer in cash by individuals. Controlling such transactions is not difficult, since databases of actual transactions exist. Transactions financed through mortgages always go through in the white, because second-tier banks need to confirm that a deal is valid. Valuation models can be built on mortgage transaction data from the Ministry of Justice, which sees all encumbered transactions and sale and purchase agreements in its database. This sample would be sufficient for a reliable assessment. Of course, correction factors would have to be applied. The transfer pricing law is in force in the country, and under it additional income can be assessed against construction companies whose prices are significantly understated. At first, a 20% deviation from the estimated price could be used, and this variation could then be gradually reduced as the valuation models improve. All second-tier banks that work with mortgages already have such models.

Cashless real estate transactions. At one time the idea was raised that all real estate sale and purchase transactions should be conducted in cashless form only, but it was never implemented because of bureaucratic barriers. The logic is simple: second-tier banks could be given the ability to register real estate in place of notaries and become transaction operators. Buying real estate with cash should be prohibited by law. Besides registration, it is also important for banks to carry out compliance checks and establish the origin of funds. For second-tier banks these would be potential clients with account balances, and for the state it would mean greater transparency in the industry and higher tax revenue.

These measures will help to substantially clean up the construction industry and resolve part of the task of increasing the revenue side of the state budget. For business, it will mean an end to non-market competition and equal opportunities, which in turn will motivate construction companies to raise labor productivity rather than engage in tax optimization.