ARMENIA'S 2005 BUDGET: MORE BUTTER, STILL PLENTY

C O N F I D E N T I A L SECTION 01 OF 03 YEREVAN 000139

SIPDIS

DEPT FOR EUR/CACEN, EUR/ACE

E.O. 12958: DECL: 01/20/2015
TAGS: ECON EAID EFIN AM
SUBJECT: ARMENIA'S 2005 BUDGET: MORE BUTTER, STILL PLENTY
OF GUNS

REF: A) 04 YEREVAN 2510 B) 04 YEREVAN 2579 C) YEREVAN

52 D) YEREVAN 83

Classified By: DCM A.F. Godfrey for reasons 1.4 (b/d).

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SUMMARY
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1. (C) The GOAM has billed the 2005 budget as having a social
focus. Both tax receipts and social spending are set to rise
ambitiously in line with the GOAM's Poverty Reduction
Strategy. After much debate, official defense spending is
set to rise too, although spending on education will exceed
official defense expenditures for the first time. The
international donor community, especially the IMF, is
skeptical, noting that the GOAM has moved significant
revenues (and thus, presumably, expenditures) off-budget.
Substantial non-tax revenues from the well-known Kajaran mine
privatization are conspicuously absent from the budget. We
believe that the budget does not represent the full extent of
official expenditures. The government of Armenia appears to
be moving important revenues off-budget, presumably in order
to finance defense expenditures in Nagorno-Karabakh (ref B).
End Summary.

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BUDGET IN NUMBERS
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2. (U) The Armenian state budget is small, even compared to
Armenia's small GDP (forecast to be 2,058 billion dram or USD
4.12 billion in 2005). The 2005 budget predicts state
revenues of 345 billion dram (USD 690.7 million) and state
expenditures of 394 billion dram (USD 789.2 million),16.7
and 19 percent of GDP, respectively. The GOAM relies on
concessionary loans from International Financial Institutions
(IFIs) to finance 34 billion drams (USD 69.3 million) of the
budget deficit. The government will issue bonds -- sold
domestically -- to meet the remaining deficit of 14.6 billion
dram (USD 29.2 million). The lion's share of Armenia's
outstanding debt is to International Financial Institutions,
who agree that Armenia's debt is prudent and serviceable.
The 2005 budget relies on a reasonable assumption of 8
percent growth in nominal GDP during 2005. (Note: All
amounts are noticeably greater this year than last in dollar
terms, as the Dram appreciated 16 percent on the dollar in

2004. End Note.)

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SOCIAL SPENDING IN LINE WITH POVERTY REDUCTION STRATEGY
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3. (U) During parliamentary budget debates, MP's and Ministry
of Finance officials repeatedly stressed the social focus of
the 2005 budget. The government is changing the budget in
line with the guidelines set out last year by the Poverty
Reduction Strategy Paper, reducing expenditures on subsidies
and domestic interest payments, and increasing expenditures
on health, education, social security. Spending on public
health, education and social sector accounts for 35.6 percent
of budget expenditures. The 2005 budget allocates 61.6
billion drams (USD 123.3 million) to education and science,
up from 54.4 billion drams (USD 108.8 million) in 2004.
Social security spending will be 46.5 billion drams (USD 93.1
million),5 percent higher than in 2004, to meet programmed
pension increases. The average social pension will increase
by 1000 drams (USD 2) to 4000 drams (USD 8). These increases
are broadly in line with the Poverty Reduction Strategy,
which calls for increasing spending on health, education and
social security by 1 percent of GDP in 2005. Paying for
these increases depends on meeting the programmed increases
in tax revenues, or cutting back other expenditures (which is
how the government financed increased social payments last
year).

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MISSING REVENUES - PART ONE
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4. (SBU) The GOAM's inability to adequately collect revenues
continues to thwart full implementation of the Poverty
Reduction Strategy. President Kocharian has declared 2005
the year of tax and customs reform. The President and his
Chief Economic Advisor have publicly called for improvement
of the tax administration both to increase revenue collection
and to create a better tax environment for businesses (refs C
and D). The 2005 budget reflects this, calling for an
increase in tax receipts of nearly 20 percent to 292 billion
dram (USD 585 million). This would bring tax revenues to
14.1 percent of projected GDP, still shy of the 18.8 percent
goal set out in the GOAM's Poverty Reduction Strategy Paper.


5. (SBU) The programmed increase in tax collections seems
optimistic when compared to past outcomes. Last year's
budget called for a 16 percent increase (on top of growth) in
tax collection, but in fact tax revenue fell as a percentage
of GDP in 2004. According to the budget, the programmed
higher tax revenues are based solely on "expected
improvements in (tax) administration" and the introduction of
the minimum tax to catch businesses who evade taxation.
Comment: If the government is successful in genuinely
reforming the tax administration, there is enough slack in
the current tax system to increase revenues considerably.
But such reform would require political will that has proven
elusive in the past (ref C). End Comment.

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MISSING REVENUES - PART TWO
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6. (C) Another cause of Armenia's anemic on-budget cash flow
is that the GOAM moves some revenue streams off the official
budget (refs A and B). (Comment: While Armenia claims it
does not provide for the defense of the ostensibly
independant Nagorno-Karabakh, in fact it is common knowledge
that it does. Keeping expenditures for the defense of
Nagorno-Karabakh out of public documents is almost certainly
the primary reason the GOAM keeps revenues and expenses off
the official budget. End Comment.) In a December 7, 2004
meeting with the Ambassador, the IMF Resident Representative
James McHugh said that he suspected that the Government of
Armenia has been increasing the amount of expenditures and
revenues that it kept off-budget in 2004.


7. (C) The recent sale of the Kajaran Copper Molybdenum plant
for USD 132 million (18 percent of officially projected 2005
tax revenues) was conspicuously absent from the government's
non-tax revenue report. (The 2004 operational profits from
the Kajaran mine, more than USD 20 million, were also
diverted off-budget to a Fund under the control of the
Ministry of Defense (ref A).) From a final sale price of USD
132 million, only 17.5 billion dram (USD 35 million) appears
in the state budget. According to a December 2004 government
signed by the Government's Chief of Staff, the rest of the
money is to be directed to various off-budget
state-controlled funds. Some of this redirection is for the
type of spending that is traditionally on-budget in other
countries. For example, the City of Kajaran (where the mine
is located) is to receive 32.1 million dollars. An appendix
to the decree cites a decision by the City of Kajaran to then
give USD 5 million to the Ministry of Defense and another USD
27 million to Armgasard, a defunct state-owned energy company
whose debts are administered by the Ministry of Energy. The
municipality will in fact keep only USD 100,000 to refurbish
a kindergarten and a municipal building.

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ON-BUDGET DEFENSE EXPENDITURES ARE UP
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8. (C) After an initial official press announcement that
defense spending would not rise, and then a heated cabinet
debate, the official defense allocation is up 22.4 percent
from the 2004 budget to 61 billion drams (USD 122 million).
Official defense expenditures account for 3.6 percent of
estimated GDP, the second highest ratio in the former Soviet
Union. The President's economic advisor, Vahram
Nercissiantz, told us that the Minister of Finance wanted to
keep the increase in defense spending entirely off-budget
because he (incorrectly) thought that an IMF rule prohibited
defense spending above a certain level. Nercissiantz said
that, in a heated cabinent debate, he and others urged the
Minister to move a large portion of the increase on budget,
in part to improve transparency and in part to make a show of
the increased defense spending.

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COMMENT: STILL A DEFENSE BUDGET
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9. (C) The characterization of Armenia's 2005 budget as a
social budget is slightly disingenuous. The government has
programmed significant increases in social spending, but the
official budget represents only part of government spending.
While increasing tax revenues still remains an important part
of the government's poverty reduction strategy, a large part
of the missing revenues are intentionally moved off budget.
(Armenia has the lowest revenue-to-GDP ratio in the CIS.)
There is no public debate in Armenia about the propriety of
financing the defense of Nagorno-Karabakh. Published
government decrees show that the Ministry of Defense receives
more money than is accounted for by its line in the budget,
and that important revenue streams are diverted to funds
controlled by the Ministry of Defense with no accountability
to the National Assembly or Ministry of Finance auditors.
Were these expenditures to be counted, the 2005 "social"
budget would look more like the defense budget that it does.
EVANS