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The business environment in Turkey was in the past characterised by high administrative burdens. and uneven application and enforcement of requirements across firms. Important differences remain between formal and informal sector enterprises. Product, capital and labour market reforms have recently been launched with the aim of streamlining regulations and providing the business sector with a more level playing field. These efforts have started to provide companies with more transparent and predictable framework conditions, as well as more supportive physical, technical and legal infrastructures. The authorities should continue the regulatory reform process in order to fully establish business friendly administrative practices and to make it possible for firms to exploit their entire potential for productivity enhancement and employment creation.
The bank restructuring following the 2001 crisis improved banking regulation and supervision significantly and there are already signs of improving credit funding for investment. With the recovery in the economy, postponed consumption is being realised and with declining government borrowing requirements banks turned more towards the consumer credit market. At the same time, sharply falling nominal interest rates fostered demand for credits. As a result, household indebtedness has increased markedly. The Authorities are confident that recent reforms have put in place adequate institutional safeguards to prevent any systemic risks in the financial sector, including those arising from consumer loans. Nevertheless, conditions should be improved for channelling more savings to private investment. Reforms of corporate governance structures under way in banks have the potential to improve the integrity of the financial system and need to be carried through without deviation. Although draft legislation addresses many corporate governance issues in the banking sector, adjustments in the ownership of banks, including through privatisation of public banks, would make them less vulnerable to external influences. In parallel, the government should encourage long-term equity investment and public listings on the Istanbul stock market in order to foster transparency and expose companies to market discipline.
How to reduce the very large extent of the informal sector?
The large extent of informality is a major policy concern. The informal sector employs more than half of all workers. High labour taxes, in particular social security charges, and stringent regulations constitute barriers to becoming formal which trap firms and workers in the informal economy, where they are deprived of access to public and banking services and cannot reap benefits from economies of scale. Given the large negative effects of informality on fiscal balances, tax wedges and productivity growth and the complexity of the informality phenomenon, an integrated government strategy is required to reduce it. The authorities already envisage strengthening enforcement through a tax administration reform. While effective application of existing laws and regulations is doubtless of importance, the government should consider complementing enforcement by improving the economic incentives for formalisation. The burden is particularly heavy for firms that employ large numbers of workers at minimum wages, such as those operating in regions of high underemployment. The new Labour Code adopted in 2003 has eased the burden of regulations on temporary and part-time employment. These reforms are welcome, but further action in the labour market is indispensable in order to reduce the labour tax wedges. One important element in an overall strategy to reduce informality and tax evasion could be to significantly reduce the social security contribution burden on wages. Indeed, Turkey’s labour tax wedges are among the most substantial in the OECD. The authorities might, therefore, consider to fund part of the social security charges on labour through other taxes and efficiency gains (e.g. if half of the social security charges would be cut additional revenues of about 2 per cent of GDP would be needed without considering any second-round effects). In addition, improvements in the conditions of financing of business investment by banks (notably via cuts in financial transaction taxes) would make formalisation more attractive. The supply of high-quality public services for small-scale firms, in order to facilitate their technological modernisation and access to international markets, would also provide a pull towards formalisation.
To stimulate demand for low-skilled labour in general the authorities should slow down the growth of minimum wages and reverse the sharp increase in the minimum wage relative to the average wage. Furthermore, they should regionally differentiate the minimum wages, in order to adjust them to differences in the costs of living in different parts of the country and to foster job creation in the poor, high-underemployment areas. As the reduction of the relative minimum wage will also reduce the tax base of those employees who are declared at the minimum wage but earn more, it should be accompanied by strengthened enforcement, particularly in sectors and among smaller firms where such under-reporting is most prevalent.
What to expect from privatisations and FDI?
Infrastructure services have for a long time been offered at comparatively high costs, particularly for business users. One major reason for this poor performance is that competition and private investment in electricity, natural gas, air transportation and parts of telecommunications have remained underdeveloped. In response to these problems, liberalisation reforms in accordance with EU rules have been launched since 2001. Some tangible benefits from increased competition have already become apparent, with real fares in air transportation declining by 60 per cent. However, in other infrastructure industries, competition-enhancing rules are not always sufficiently well enforced and in several cases the scope of and the funding sources for public service obligations, notably concerning supply to households and less developed regions, need to be clarified. A step in the right direction is recent legislation which prohibits cross-subsidisation in state-owned enterprises. A further crucial prerequisite for achieving a successful involvement of the private sector will be the phased introduction of a cost-based tariff structure, which would have the added benefit of reducing the rate of growth of greenhouse gas emissions. The authorities should address these problems by providing transparent funding sources for well specified public service obligations rather than relying on cross-subsidies within incumbent firms. Moreover, independent sectoral regulators and competition authorities should co-operate to fully implement the existing market rules and facilitate new entries into the monopolistic or oligopolistic parts of infrastructure industries.
Inflows of foreign direct investment (FDI) have been paltry, amounting to less than 1 per cent of GDP in recent years. The streamlining of procedures in the 2003 Law on FDI is an important step to improve the attractiveness of Turkey for foreign investors. These reforms should be backed by policies to overcome implementation difficulties. The original approach of identifying problem areas in co-operation with the independent Investor Advisory Council has proved productive and should be continued. The privatisation of public banks and large industrial and network service firms should be an occasion to attract highly-performing international operators to Turkey. Besides generating FDI inflows, privatisation has the potential to significantly improve the efficiency of the economy. Any remaining legal and judicial obstacles to smooth privatisation should be cleared in order to encourage international investments.
Even though more than 30 per cent of the labour force is employed in agriculture, this sector contributes only 12 per cent to Turkey’s GDP, indicating very low productivity. Many farmers, among whom illiteracy is high, limiting access to modern agricultural know-how and technology, still rely on traditional production methods. The recent agricultural policy reforms have started to replace input and production-linked subsidies by direct income support payments, which will expose farmers more directly to domestic and international market competition and thereby improve production efficiency. Deficiency payments for some products and livestock subsidies are still applied. Turkey has very favourable natural conditions to expand its output of labour-intensive, high value-added agricultural produce, such as fruit and vegetables, and could increase its exports of these products, particularly if there is greater opening of foreign markets. However, in order to realise this potential, an upgrade of the training and advisory services in agriculture is crucial to support farmers in the new, more market-oriented environment with advice on appropriate cropping patterns, new farming technologies, and the improvement of marketing practices. Where the overall supply of irrigation water is limited, realistic pricing is necessary to contain demand and ensure that the resource is used efficiently. Non-farm rural activities also deserve to be promoted as alternative employment and income sources. Foreign direct investment could play an important role in diffusing new technologies in rural areas and should not be impeded.
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