What’s holding back the Kyrgyz Republic private sector?

John Pearson (R), Centerra Gold company's Vice President Investor Relations, looks on at the gold-mining plant at the Kumtor mine in Kyrgyzstan May 31, 2011. With around 100 sizeable gold fields mapped -- but never tapped -- by Soviet geologists, the country is ripe for a mining boom. Gold has doubled in value since 2007 and prices around $1,500 an ounce could help resuscitate an economy that contracted 1.4 percent last year after the revolution and ethnic violence that killed hundreds. Picture taken May 31, 2011. To match Special Report KYRGRZSTAN-MINING     REUTERS/Vladimir Pirogov (KYRGYZSTAN  - Tags: ENERGY BUSINESS) - GM1E76S1HLY01

The Kyrgyz Republic could be Central Asia’s Switzerland. It neighbors important global economies, it has maintained democracy since 1991, it has improved its business environment, and it has beautiful mountains. So, why hasn’t the economy taken off? Why hasn’t an $8 billion economy with 6.3 million smart people been able to create dynamic medium- and large-sized companies?

The Kyrgyz Republic private sector consists mainly of micro- and small-sized enterprises. The country has only 800 medium-sized companies and 1,840 large companies, which are mainly state-owned. By contrast, due to demographic momentum and improvements in the business environment, the number of individual entrepreneurs has doubled over the past decade to an estimated 400,000, while small firms grew by 45 percent, to 15,000 (Figure 1).

Entrepreneurs and small firms growing in the Kyrgyz Republic (by number of employees)

The usual suspect in such circumstances is the ease of doing business. In fact, the Kyrgyz Republic has been making progress in the Doing Business rankings—which measures business regulations globally—and is now ranked in the top 10 percentile for starting a business. But while it is now easy to start a business, it is hard to run one. In the latest Global Competitiveness Index, it placed 97th among 137 countries. This low ranking illustrates the stagnation of medium and large companies over the past decade, as well as the innovation and technology transfer typically delivered by medium and large companies.

It is harder still to grow a business.  Companies in Kyrgyz Republic start small and stay small.  There could be two explanations for why companies aren’t growing—bureaucracy and high taxes. It turns out that it is actually a home-brewed concoction of both.

Red tape

At 23.6 percent of GDP, the size of the informal economy in the Kyrgyz Republic is rather large for a formerly communist country. From the labor supply side, informality is as high as 37 percent. Informality is high in sectors with the prevalence of a “patent regime.”  Patent tax regime is a form of tax registration designed for micro-businesses and entrepreneurs to avoid complex tax burden and enable quick entry and operations in the country. In other words, the number of issued “patents” directly determines the size of the informal sector.

The patent regime offers a favorable tax treatment relative to other tax regimes. Compliance requirements are minimal under patent, and the patent threshold is generous at $110,000 annual turnover (second highest in Europe and Central Asia). As the patent regime does not require any books and records and is not, for the most part, subject to inspections, business growth and migration into the VAT system and the general tax regime is not particularly advantageous. Between 2014 and 2017, for example, the number of patents grew by 37 percent; on the other hand, the number of small- and medium-sized enterprises (SMEs) (that are not part of patent regime) grew by just 18 percent.

The taxman

The effective tax burden is modest and not a great concern for the private sector. The share of commercial profits that goes to the main taxes, for a medium-sized company, is 29 percent. This is on par with Kazakhstan (29.2 percent) but well below Uzbekistan (38.1 percent), Russia (47.4 percent), and Tajikistan (65.2 percent).

Social security allocations are largely perceived by the private sector as an excessive burden both in terms of the amount of allocations and because of compliance procedures. Companies of all sizes have an obligation to report on a monthly basis to the Social Fund, but entrepreneurs who work under patent regime are exempt. So many companies opt for the patent regime to avoid administrative burden and frequent inspections; under the general tax regime, the employer pays seven times more than an entrepreneur working with patent. Also, reporting requirements, as well as inspections and compliance, are different for individual entrepreneurs—no reporting, little or no burden by inspections and compliance—than they are for other companies. Finally, governance and corruption issues are affecting businesses and add to the reluctance of businesses to formalize.

Growing a business is a patently bad idea

The table below summarizes the additional burden that companies bear as they grow—from a microenterprise to an SME to a large firm.

Table 1

Kyrgyz Republic authorities have made it easier to start a business, and this is why the number of individual entrepreneurs and small businesses is growing. But it remains difficult to grow a business, because the tax and regulatory burdens rise quickly as a firm grows. Many companies stay artificially below the threshold to avoid the administrative burden. But without rapid growth in the private sector, the Kyrgyz Republic will remain a lower-middle-income economy. Today, it is a country caught in a trap—of its own making.