Political constellations around tax “innovations” in New Europe(1)

Background

In 1996-1997, I had the pleasure to coordinate a think tank effort to instantiate reforms in Bulgaria, Poland and Slovakia that would lead to the adoption of flat tax(2) . Part of the effort included asking businesses to approve or disapprove low and flat tax. In all three countries disapproval rates were higher than approval ones. In Bulgaria, the ratio was, roughly, 35:65.

I cannot comment on the reasons for this constellation in other countries but in Bulgaria two sets of believes contributed to this attitude: the idea that a given business, say SME, should be treated more generously by the government; and the idea that certain businesses should be compensated for losses incurred due to government policies in the first half of the 1990’s.

There were two key conclusions from that effort:

1. Businesses were not likely to be the prime reform demanders, therefore, there was a need to recruit broad public support;

2. Broader reform issued needed to be addressed for having reforms (aimed at tax lowering and flatter taxes) accomplished, e.g. expenditure reforms and lowering, decomposition of the welfare state, etc.

The fate of that reform in those three countries was, roughly the following:

• In Slovakia, Jan Oravec of the Hayek Foundation established a tax payers’ association and through it managed to push forward an introduction of 19-% flat tax.

• In Poland, the idea for tax reform was dropped altogether, at least until 2001, in 2001 one finance minister, Leszek Balcerowicz, resigned for not being able to persuade fellow cabinet members to implement his tax reform ideas; Poland focused on quazi-taxes instead (implemented Economic Activities Act – in 2001, and Economic Freedom Act – enacted on May 1 2004).

• In Bulgaria, there was no political party or a politician to like the tax reform objectives; there were three tax-payers’ unions, all established by employees and advisors to the treasury; so, the feasible strategy was to start a broad public education and focus reformists’ efforts on welfare state, expenditures and detailed (but yet understandable) argumentation of the need for reform.

Political constellations of the eve of lowering taxes

The Baltic countries seemed to have benefited form the fact that their respective treasuries did not have sufficient resources for any sort of substantial redistributionist policy mix. In different years they pegged their currencies to Deutsche Mark or to a basket of DM and US Dollar, a policy that motivated a flexibility, liberalization of fiscal policies combined with strictly observed budget constraints and deepest than in Europe trade liberalization, as it was implemented in Estonia. And it was Estonia, again, to prompt in early 1990’s with a flat tax system (at around 25% threshold on individual and corporate income). The Estonian system is now being further reformed towards lower tax rates (aimed at 20% for personal income in 2007). Lithuania and Latvia did something similar (in 1994 and 1995) but with greater differentiations between personal and corporate taxes.

Flat taxes since then were implemented in numerous countries: Georgia, Romania, Russia, Serbia (and Montenegro), Slovakia and Ukraine. Macedonia is the next in line. In some countries, like Bulgaria, the policy is still one of multiple thresholds, but the difference between is 1-2% and, thus, it is almost flat.
A closer look at the constellations at the eve of introduction of plat taxes, allow drawing a sort of a common denominator:

• Most countries introduced flat taxes with the view on increasing the budget revenues, and rarely, if not never, there was a consecutive policy to reduce or restructure expenditures.

Peculiarities of lower tax reforms of the (EU) New Member States
Interestingly enough, the new member states behaved in this respect as most of the non-member states, similar to those of former Soviet Union (FSU). Here are some comparisons:

• Often flat income tax is combined with lower rates of corporate taxation, and this is a common feature of Baltic with other EU countries, including those supposed to join EU;

• This constellation is different from that of FSU, where corporate taxation is higher than the flat rate (which is, in turn, lower than respective taxes in the Baltics, Slovakia and Romania); this is to be explained by government ownership on natural resource companies and late or delayed privatization;

• It is obvious, that apart from servicing to objective to increase revenues, the flat tax reform aimed at creating incentives to invest (FDI in particular).
• No country have ever effectively reformed the welfare state, which is evident from the rates of the social taxes; the so-called social contributions rates are 1.5-2 time higher than the personal income tax;

• On average government expenditures in the new member states remain in the last seven years considerably lower than the average share of government expenditures in the respective GDPs of the old members states; there are exceptions (e.g. Bulgaria’s government expenditures in the last five years stay at around 41% of GDP) but the overall level of the new member states and Romania is 36-37% of GDP.

The impact of regulations and EU accession

The compliance cost of EU companies and individuals (i.e. the costs of operating within the laws and to deal with governments) were last studied by OECD for the entire Union in 2001. For the new members states there are different estimates, and only rarely there profound surveys on these cots in the accession countries.

The picture is roughly the following: the EU compliance costs are EURO 540 billion in 2000, 3-4% of GDP for that year. In the new member states, these costs are believe to be up to two times higher, because of juridical harmonization, the pace of the process and due to inherited administrative inefficiency. These impacts were combining with much better visible impacts of the higher EU indirect taxes (most often duties on tobacco, gasoline and gas).

This was one of the factors to convince political establishments of the new countries to use the only available fiscal policy instrument to mitigate the costs, and they reduced the direct tax burdens. Politicians in countries that did not lower taxes, like Poland, dealt with indirect taxes, but the impacts are not yet studied.

Globalization and taxes

There is yet little empirical research but it is possible to assume that the EU governments are doomed to collect less taxes. Factors that contribute to this are the following:

• The existence of jurisdictions that maintain low taxes, low transaction costs and better rule of low;

• Electronic money;

• The use of Internet in channeling investment and savings and in retailing;

• The overall greater mobility of factors of production, particularly capital and people.

Conclusions

It is unlikely that new member states would reverse the policies of lowering direct taxes. However, the unreformed or rather semi-reformed social welfare systems (pay-as-you-go pensions, centralized healthcare) would probably work as a factor that requires constant if not upstream inflow of revenue.
With privatization, in the some of FSU countries there might be a shift in the policies, e.g. lowering of corporate tax rates in order to boost investment; it is likely that the former Yugoslav countries are moving in this direction, e.g. it is almost certain that Macedonia will have a 10-percent flat tax on personal and corporate income two to three years from now. Lower levels of indirect taxes in countries neighboring the EU would also pressure their EU neighbors to lower taxes or at least keep the existing levels.

It is difficult to predict the pace but it is obvious that the tax competition is already out there.

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(1) First presented at the 30th Summer University on New Economics in Aix-en-Provence, August 29, 2006.

(2) See, collection of reports at: www.ime.bg (discussion)