VIETNAM'S FISCAL POLICY: STILL MUCH ROOM FOR

UNCLAS SECTION 01 OF 05 HANOI 003385

SIPDIS

STATE PASS USTR ELENA BRYAN
STATE PASS USAID FOR ANE/AA KUNDER/KENNEDY/WARD
USDOC FOR 4431/MAC/AP/OPB/VLC/HPPHO
TREASURY FOR OASIA

SENSITIVE - DO NOT POST ON THE INTERNET

E.O. 12958: N/A
TAGS: ECON EFIN EINV ETRD VM FINREF SOE
SUBJECT: VIETNAM'S FISCAL POLICY: STILL MUCH ROOM FOR
IMPROVEMENT


1. (U) Summary: After two years of implementation, it id
clear that the 2002 "Law on State Budget," which came into
effect on January 1, 2005, has significantly improved
Vietnam's budgetary fiscal transparency. Other new laws and
regulations have helped modernize Vietnam's revenue
collection and expenditure policies, especially with regard
to corporate taxation, trade tariffs and fiscal
decentralization. At the same time, the Government of
Vietnam's (GVN) USD 406 million subsidy of gasoline and
petroleum products in the first six months of this year has
had a detrimental effect on the budget balances. At
present, the GVN is focusing its spending on infrastructure
improvements, social services, science and technology
development, and poverty reduction. Vietnam has only a
slight budget deficit, but extra-budgetary financing for GVN-
sponsored development projects and State-owned enterprises
(SOEs) is a growing cause for concern among foreign
investors and the donor community. End Summary.

BUDGETARY FISCAL TRANSPARENCY
--------------


2. (U) Recent steps towards improved fiscal transparency
have led to more thorough public disclosure of Vietnam's
national budget. The new "Law on the State Budget," which
took effect on January 1, 2004, requires budget settlements
to be published within 18 months and budget estimates within
60 days of approval. The Law also requires, for the first
time, a public release of total expenditures by the
Ministries of National Defense and of Public Security. The
GVN has previously published State Budget Final Accounts
(for the fiscal year two years prior to the year of
publication) and the annual State Budget Plan since 2002.
The GVN's fiscal year is the same as the calendar year.

REVENUES
--------------


3. (U) Revenue totals constituted about 21-22 percent of
Vietnam's gross domestic product (GDP) in 2004 (total
revenue was VND 196,787 billion or USD 12.4 billion),a
relatively small amount for a nation of 83 million people.
Compared to per capita income in Cambodia (USD 320 in 2004),
Thailand (USD 2600 in 2004),and the Philippines (USD 1000
in 2004),Vietnam's USD 550 per capita (USD 550 is the World
Bank's 2004 number for Vietnam; the GVN estimates per capita
will rise to USD 640 when year-end numbers are calculated
for 2005) is rather low. Around 95 percent of the GVN's
revenue comes from taxes (including import/export duties).
In recent years, the most significant change to budget
policy-making has been the new "uniform tax policy," which
Ministry of Finance (MOF) officials say has created a "level
playing field" for all categories of industrial and
commercial entities, regardless of their ownership models.


4. (U) The GVN professes to have made a serious commitment
to reducing the public tax burden, and they have made some
progress in this area. Since the 2002-2003 fiscal year, the
GVN has nearly eliminated its taxes on agricultural land and
reduced and simplified the corporate income tax (CIT). The
GVN now levies a flat 28 percent tax on all corporate
income. The previous tax system involved several different
levels that usually resulted in a tax rate of around 32
percent, depending on a company's subsidies and preferences.
In addition to introducing the flat tax, the GVN also
recently eliminated the 20 percent value-added tax (VAT),
leaving the VAT at only five to ten percent.


5. (U) This expansionary fiscal policy has already proven
its worth. The new tax policies have encouraged investment,
so that even though tax rates have decreased, revenues have
been remained relatively stable. During the 2001-2005
period, budget revenues increased by 16 percent annually, a
higher rate than the seven percent average annual increase
in GDP.


6. (U) The GVN has also reduced import and export tariffs as
part of its commitment to international economic
integration, particularly to meet the Common Effective
Preferential Tariffs (CEPT) for the ASEAN Free Trade Area
(AFTA) agreement. Further reductions will probably be
necessary once Vietnam accedes to the World Trade
Organization (WTO),although the Vietnamese are trying hard
to maintain high tariffs in certain industries -
automobiles, for instance - which they want to protect. The
tariff reductions are certain to reduce budget revenues in
the short-term. Tariffs constituted 17 percent of Vietnam's
budget revenues and 23 percent of its tax revenues from 2001-

2003.


7. (U) According to sources at the MOF, the GVN has spent
nearly VND 6.454 trillion (about USD 406 million)
subsidizing gasoline and petroleum products in the first six
months of the this year. (NOTE: Year-end statistics are not
yet available. End Note.) The MOF eliminated import
tariffs on petroleum products on March 17 in an attempt to
curb price increases in Vietnam. This subsidy, coupled with
the tariff cuts, has resulted in a significant loss in GVN
budget revenue. To reduce pressure on the GVN budget in a
period of high world oil prices, the GVN has raised the
price of gasoline and petroleum products periodically
throughout the year.

EXPENDITURES
--------------


8. (U) The GVN has tightened its budget expenditure
objectives over the last several years and is now
concentrating on a narrower set of priorities. MOF
officials list those priorities as infrastructure (with
particular emphasis on transport and irrigation); social
services, education and culture; science and technology; and
poverty reduction. Investment and development spending
makes up approximately one-third of total budget
expenditures. The GVN has boosted education spending twice
over the last seven years, so that in 2005 more than 19
percent of total spending will go to education. By 2008,
the GVN expects spending on education to reach 20 percent.
Although science and technology expenditures have doubled
during the last five years, MOF officials say that this
increase was not part of the National Assembly's "Five-Year
Plan," but was one element of a long-term development
strategy. Despite spending constraints, the GVN has made
significant progress in poverty reduction. In 1993, some 58
percent of Vietnamese households subsisted on incomes below
the poverty line, but by 2003, the GVN reported that number
to be 26 percent. (Note: According to a government-
controlled newspaper, impoverished households earn less than
USD 7.50 per month in rural and mountainous regions and USD
10 per month in cities. Policy makers are considering
whether to raise the poverty line. End note). With regard
to poverty reduction, the GVN budget targets specific
preferential policy and geographical regions, allowing some
room for discrimination against the minority peoples who are
often the poorest but also the lowest priority for GVN
poverty alleviation efforts.

FISCAL DECENTRALIZATION
--------------


9. (U) A notable element in the GVN's efforts to alleviate
poverty and improve fiscal management is the growing shift
towards budget decentralization. The 1996 "Law on the State
Budget" provided the first impetus for decentralization, and
an amended "Law on the State Budget" passed in 2002 advanced
the process even further. The 2002 law makes few
fundamental changes to the expenditure decentralization
effort, but allows far more autonomy for provincial
governments to manage fiscal policy on the district and
commune levels. According to the World Bank, Vietnam's
expenditure structure is among some of the world's most
decentralized fiscal models. Whereas sub-national
governments (provinces, districts and communes) spent 26
percent of total revenues in 1992, that figure rose to 43
percent in 1998 and 48 percent in 2002.


10. (U) Vietnam faces several expenditure decentralization
policy problems. Chief among them is a lack of legal
clarity that has caused imbalances between the central
government's expenditure assignments and the capacity of
local budgets to handle those assignments. Some local
governments have been handed disproportionately large
spending assignments, but allocated inadequate funding to
carry them out.


11. (U) In addition to these vertical budget imbalances,
subnational governments are legally incapable of borrowing
adequate capital. The World Bank estimates subnational debt
to be 0.43 percent of 2003 GDP and considers this percentage
rather low by international standards. Given that many
provincial governments are responsible for building and
maintaining costly infrastructure projects, it is even more
impressive. Current regulations keep outstanding provincial
debt below 30 percent of each locality's capital budget.
The World Bank recommends that restraints on provincial
borrowing be loosened, perhaps by instituting caps on debt
service spending or by regulating total debt as a percentage
of subnational revenues.


12. (U) The 2002 "Law on State Budget" also gives
considerable discretion to provincial governments to
determine revenue assignments to district and commune
governments. The central government claims revenues from:
export and import taxes, VAT and excise taxes on imports;
taxes and other revenues from the petroleum industry; and
corporate income taxes on enterprises with uniform
accounting. Tax revenues assigned to the subnational level
include land and housing taxes, natural resource taxes
excluding those on petroleum activities, license tax, taxes
on transfer of land use rights, fees on land use, land rent,
revenues from the leasing and sale of publicly owned
dwellings, registration fees and most other fees and
charges. The central and subnational governments also share
taxes based on formulas unique to each province. The GVN
believes that budget revenues allocated to subnational
governments accounted for about 30 percent of all tax
revenues at the end of 2004.


13. (U) Allocating revenue to local governments while
avoiding internal trade barriers is a policy challenge for
the GVN. The World Bank recommends granting more tax
autonomy to provincial governments by allowing subnational
governments to select tax rates for at least one significant
source of revenue at a rate somewhere between the minimum
and maximum rates stated by the National Assembly. (Note:
The Vietnamese constitution stipulates that the National
Assembly is charged with approving the national and
consolidated subnational budgets. End note.) In addition,
the World Bank recommends greater specificity for tax
sharing regimes, especially with regard to the corporate
income tax (CIT) and the VAT. The current tax regime tends
to benefit larger cities, where CITs are actually collected
and debited. The World Bank believes an equitable
apportionment regime between provinces would allow more
appropriate revenue distribution, such as a VAT system based
on final consumption in each jurisdiction. In the case of
the CIT, a regime based on the geography of the company's
payroll would distribute revenue more equitably.

BUDGET NEARLY IN BALANCE
--------------


14. (U) The MOF has recently been maintaining a budget
deficit of less than three percent of GDP. (Note: By law,
the budget deficit cannot exceed five percent of GDP. End
note.) The GVN restricts on-budget borrowing to investment
expenditures. For the most part, foreign commercial
borrowing and domestic bonds covered the deficit. Greater
dependence on domestic borrowing over the last two years has
caused interest rates to rise relative to foreign borrowing,
which is comprised almost entirely of concessional loans.


15. (U) To look only at on budget borrowing, however,
distorts the reality of Vietnam's public debt situation.
Some bonds issued to finance infrastructure and education
have been kept off budget, along with expenditure arrears
from past transport sector infrastructure improvements. In
the former case, the GVN's 2004 expenditure report says VND
5 trillion (about USD 316 million) in bonds were issued to
finance infrastructure improvements (namely, the Ho Chi Minh
Highway, rural road improvements and irrigation projects in
the central provinces) and VND 2.5 trillion (about USD 158
million) were issued for education. While the published
budget does not reflect the principal payments on these
loans, interest payments will be shown on budget in the
future. State-owned commercial banks (SOCBs) and insurance
firms were the primary purchasers of these bonds, reflecting
the continued dependence on policy lending by GVN
institutions and banks. Transport sector arrears represent
a growing disparity between the Ministry of Transport (MOT)
and MOF's expenditure records. Specifically, MOF records
show that transport spending reached 3.5 percent of GDP in
2002, whereas MOT records showed spending of about 5
percent. The problem stems from past MOT expenditure
commitments that were not shown on budget. The subsequent
accumulation of about VND 6.5 trillion (about USD 411
million) in arrears should be paid on budget in the future.


16. (U) Financed through Official Development Assistance
(ODA) and loans from the Vietnam Postal and Savings Company
(VPSC),the Development Assistance Fund (DAF) is yet another
substantial extra-budgetary policy lending vehicle. The DAF
floated VND 7-8 trillion (USD 441 - 504 million) in bonds in

2004. According to the GVN's expenditure report, the DAF's
domestic capital sources amount to roughly 9 percent of
annual GDP in 2004, "making it the biggest financial
institution in the country." About 80 percent of the DAF's
lending went to State-owned enterprises (SOEs),though the
DAF also reserves the right to lend to private and joint
venture firms and even to lend ODA to foreign governments.
Despite its bank-like functions, the DAF is not subject to
standard banking regulations and its accounting practices,
risk management and reporting standards are still very
rudimentary. The DAF has to seek annual budget approval
from the National Assembly. The recently issued decree
106/2004/ND-CP is a step towards regulating the DAF while
maintaining the GVN's ability to continue its policy lending
to GVN institutions. The decree narrows the list of
eligible borrowers while establishing a more market-oriented
basis for the DAF's on-lending activities by imposing new
requirements on borrowers for direct repayment, collateral
assets and feasible business plans. Both the World Bank and
the International Monetary Fund (IMF) have expressed serious
concerns about the DAF and the fact that it increases the
number of poor quality loans.

SOE AND DEFENSE BUDGET ITEMS
--------------


17. (U) MOF officials confirmed that SOE revenues are
reported on budget, but only as corporate tax revenue. Only
crude oil exports from cooperative contracts with foreign
firms are reported on budget. Using this accounting regime,
oil-producing SOEs contributed 34 percent of CIT revenues in
2003 (which accounted for 31 percent of total tax revenues
that year),according to the World Bank.


18. (U) Defense expenditures are also now shown on budget in
accordance with the new Law on State Budget. However, no
defense items appear on any of the published budget reports,
possibly because budget projects are published 18 months
after the end of a given fiscal year (the revised law only
came into effect in 2004).


19. (SBU) It is also worth noting that the GVN is loosening
its control on price setting for commodities. The GVN will
continue to set prices for certain public services like city
buses.


20. (SBU) Comment: While the GVN's fiscal policy appears
healthy on paper, its persistent dependence on directed
lending and extra-budgetary financing has resulted in
several contingent liabilities. Greater budget transparency
and SOCB restructuring will be necessary to improve the
GVN's fiscal stance. Both are required as part of WTO/BTA
commitments, but progress has been slow to date. Short of
immediately dissolving or "equitizing" on lending and policy
lending financial institutions like the DAF, such
institutions should at least face the same regulatory
scrutiny as chartered banks and firms. Regarding tax
revenues from trade, it is difficult to predict when lowered
tariffs will bolster foreign trade to the extent that they
compensate for lost budget revenues. It is more likely that
as the domestic economy improves due to global economic
integration, the importance of trade tariffs on the budget
sheet will decline. Vietnam's fiscal priorities and poverty
reduction achievements are commendable. The GVN should
avoid letting budget decentralization impede the central
government's short and medium-term plans for fighting
poverty and instituting market reforms. It should also seek
similar rather than different tax regimes in each province,
which could hinder domestic trade and investment. End
comment.

MARINE