Good Intentions and Bad Consequences: How Overregualation Impedes Uzbekistan's Growth
February 11, 2004
By Elena Suhir
In 2001, Uzbekistan embarked on a self-proclaimed economic reform program aimed at accelerating its transition to a market economy that better complied to international standards. A key goal of the Uzbek government was to decrease the share of the economy operating outside the formal system of licensing, taxation, certification, and other administrative barriers to business.
By the end of 2003, however, the government’s ambitious program had unnecessarily damaged the Uzbek private sector. The good intention of increasing the number of legitimate small- and medium-sized enterprises (SMEs) succumbed to the ill effects of poorly designed legislation and overregulation.
Promising steps have taken place in recent months as the Uzbek government has reconsidered several onerous measures, but many barriers to enterprise development and economic growth remain firmly in place.
With roughly half of the private economy operating outside the law, the Uzbek government’s interest in formalizing more enterprises is evident. However, despite the government’s efforts aimed at helping business, new SME registration has drastically dropped from 40,000 in January 2001 to 15,000 in June of that year, according to the World Bank. Businesses in the informal sector do not pay taxes, yet have very high operating costs aimed at bypassing the law. These costs are directly passed on to the consumers. Such a large share of informal business activity not only deprives government of revenue, but undermines its very authority.
Informal businessmen sacrifice legal title of their property, the protections of the courts, the ability to contract, and the use of their property, as collateral for bank loans. The price is steep. Why do so many small-scale entrepreneurs make that trade-off?
While operating in the shadow economy is not cheap for businesses, it can be significantly less expensive than entering the formal sector, say entrepreneurs. Bribe-seeking Uzbek government officials regularly make it clear that paying them under the table is more advantageous than paying the full burden of official taxes or fines. While remaining in the shadow is costly, emerging into the official economy is even more so. The complicated documentation procedures for obtaining official licenses require businessmen to run through a bureaucratic maze. The exorbitant costs expended in pursuit of legal requirements directly subtract from time spent on gainful and productive business activities.
Any cursory examination of the informal sector quickly reveals that it is merely the symptom of a much more serious disease: overregulation. Regulations that set excessively high barriers to property ownership and its use by its rightful owner tie down the wealth of the country. Bureaucratic overregulation in the form of taxation, licensing, certification, registration, and other numerous administrative procedures that require mandatory permission at every step places a heavy burden on the entrepreneur. Government-made barriers to the establishment of valid property rights trap assets in less than fully productive uses.
Recent legislation has choked much business activity, particularly that of small and medium enterprises. Wholesale operations with strong political connections were boosted by new decrees, while significantly reducing competition from smaller wholesalers and traders. When passing these new decrees, legislators proclaimed their commitment to spurring the economy through the promotion of SMEs and the creation of badly needed jobs by fostering a healthier business environment, increasing economic growth, and generating much needed tax revenue.
However, rather than providing incentives for informal businesses to enter the formal economy, the government imposed regulations of control and protectionism that habitually infringe on property rights. In addition, the local business community believes that these regulations were designed with a short-term vision and were intentionally written in vague and often contradictory language. In addition, when businesses are not encouraged to expand, they are unable to provide employment opportunity which is badly needed in Uzbekistan. Consequently, the new regulatory framework that emerged has practically devastated local businesses, sharply increased informal sector activity, and has traumatized the local economy.
Restricted access to cash, hampered by a crippled banking system, has significantly curtailed the amount of business activity in Uzbekistan. Withdrawing money from the bank is now only permitted under a narrow set of circumstances that is closely monitored by bank staff. Despite the fact that entrepreneurs are withdrawing their own money from their own bank account, if the reasons sited for withdrawal are incompatible with the narrow categories under which withdrawal is permitted, cash is not distributed. Despite more recent legislation adopted in August 2002, stating that cash should be made available to the account bearer on his or her first request, banks continue to dispense cash according to outdated legislation. Entrepreneurs believe that this is due to a lack of an enforcement mechanism within the new law itself; hence, banks follow the only procedure ever provided, which belongs to the “superceded” legislation. Even though most basic transactions must be executed via a bank transfer mechanism, buyers and sellers still frequently arrange supplemental cash payments outside the legal system in order to avoid documenting the true value of goods and services, and thus reducing their formal tax liability. This type of “banking system” encourages SMEs to maintain their “accounts” as cash sitting unproductively in their private safes.
These severe restrictions on cash have driven numerous small- and medium sized enterprises out of business because of their reliance on the cash-and-carry commerce. For example, when a small sewing company operating in Tashkent was contracted by a large factory to manufacture uniforms, the particular fabric material required for the uniforms was available only through import. The factory agreed to advance the sewing firm 600,000 Uzbek Sum to obtain the sewing materials by transferring the money into their bank account. However, it was not able to withdraw the cash in order to make the purchase. All efforts on behalf of the owner to obtain the materials legally failed, as no material-supplier accepted non-cash payment. Consequently, the contract could not be fulfilled.
Small scale entrepreneurs who continue to import or export face yet another major hurdle with certification requirements; customs remains one of the most problematic areas for entrepreneurs in Uzbekistan. In January 2003, the Customs Administration began to impose harsh measures on goods crossing the Uzbek border. Private cargo that does not completely comply with the excessive documentation requirements is subject to confiscation and sold on the spot to consumers or other trading companies at nominal prices with the proceeds going into the pockets of the border agents. Customs officers who are in clear violation of the law and ethical norms are seldom held accountable for their actions.
Sadly, this behavior is not confined to customs agents. The uncompensated seizure of property from businesses and individuals has been reported throughout the country. According to the U.S. Department of State, agricultural land is particularly vulnerable. In the commercial sector, stores that cannot furnish documentation proving that their consumer goods were imported legally are subject to having them seized as contraband.
For SME owners who insist on remaining within the formal economy, exhaustive registration and certification procedures further debilitate the export industry. Not only must the entrepreneur obtain excessive documentation from agencies scattered around town, but these agencies also require samples of the goods on which they conduct an “expertise process” to ensure compliance with international standards. While certification is a necessary part of doing business, excessiveness is choking business. Certification in Uzbekistan is an expensive and lengthy process costing entrepreneurs from $200-$500 and up to ten full days’ time. Ultimately, foreign investors tend to lose patience and abandon the deal. The result is that Uzbek producers and farmers forfeit traditional and new markets for their products, further lowering the local living standard and destabilizing the economy in the region.
Entrepreneurs complain that while a formal recognition of private property value exists in Uzbekistan, their rights are continuously violated with little repercussion, thus severely harming their businesses and, in the process, undermining the rule of law. Any attempts to thwart this ongoing abuse have usually resulted in heightened tensions between the entrepreneurs and the authorities, further deteriorating the relationship between government agencies and the business community.
When SMEs suffer, local consumers and the general population feel the effects. Entrepreneurial difficulties have led to a deteriorating standard of living in Uzbekistan because both international and domestic competitiveness has plunged.
At present, for example, a resident in Tashkent will pay on average twice the price for everyday consumer goods, such as butter or bread, than a resident in Moscow despite the fact that the average Uzbek salary is only a fraction of that of a Muscovite. Paying 1,400 Uzbek Sum (about $1.50) for a stick of butter out of an average monthly salary of about 18,000 Uzbek Sum (about $20) has led to a significant deterioration in the living standard.
Even attempts at some levels of government to ameliorate the plight of entrepreneurs have been undermined by the national government’s enforcement of restrictions. In February 2003, the Tashkent city government converted a sports stadium into an open-air market, where the first 200 booths were allotted at no charge and the rest were sold. The intent, once again, was to revive small business at any cost by allowing booths to operate without cash registers. After the market thrived for three months, state authorities found this arrangement to be illegal, and all market activity ceased. Citing the Cabinet of Ministers decree requiring the use of cash registers, booth vendors were offered two options: either use cash registers or give up their lots (without compensation). By using cash registers, these vendors would move from the semi-formal market into the formal one – an unprofitable proposition for most because of the high costs of doing business legally. Hence, most chose to give up, depriving wholesale and retail trade of its most profitable venue for business. This move affected the whole country, since entrepreneurs nationwide traveled to Tashkent to do business. Up to 80% of goods produced in Tashkent were sold to buyers from outside the capital city. Uzbek businessmen suggest that commerce levels sunk as much as 5-10 percent compared with August 2002 due to this single event.
To reverse the country’s economic slide, the following three steps should be taken. First, the SME business sector needs immediate relief from the myriad regulations imposed that hinder business growth. It is encouraging to see that the Uzbek government has undertaken some initiatives in this regard. Easing of the requirement that exporters receive full payment in order to export their goods removes one ill-designed measure. The formal introduction of currency convertibility is also a step in the right direction.
Second, in order to reduce the number of enterprises operating informally, new legislation must provide entrepreneurs with incentives to operate within the formal sector. Most importantly, ownership issues lingering from the post-Soviet privatization of state assets must be resolved. The surge in credit accompanying the availability of undisputed property as collateral will infuse the economy with new functioning capital.
Finally, in the future the voice of the business community needs to be heard when legislation is being written. These unfortunate results came about from policies made behind closed doors with little private sector participation (or the participation of only a favored business elite) to supply information about the practical effects of changes. True economic reform is possible only when the private sector is widely represented in transparent policymaking to reflect the best interests of the wider citizenry.
Elena Suhir is the Center for International Private Enterprise’s Program Officer for Eurasia. This article is based on personal observations and interviews conducted with Uzbek business owners and mangers during visits to the country over the course of 2003. This essay is adapted from a longer report issued by CIPE and available at http://www.cipe.org/pdf/publications/fs/suhir.pdf.