I. Public Finance and Transition
Everyone who has been following the recent experience of the economies in transition should by now be aware that the success of the transformation from central planning to market economy will depend very much on how fast and how successfully these countries will be able to create the fiscal institutions essential for the functioning of a market economy. It will also depend on how well the policymakers of these countries understand the role that the new institutions will play. This paper surveys the fiscal landscape and discusses the main changes that must take place and the issues that deserve special attention. Section II discusses macroeconomic fiscal issues, arguing that policymakers and economists need to be careful when they use concepts (such as the fiscal deficit) that have fairly precise meanings in market economies but not in economies in transition. Section III discusses the reform of the tax systems and the establishment of tax administrations. Section IV discusses policy issues in public expenditure and the establishment of institutions that can facilitate the management of public spending. Section V is a concluding section.
In the era of central planning it was not meaningful to speak of
Many forms of taxation and public spending were carried out through implicit means, such as overvalued exchange rates (which implicitly taxed export activities and subsidized imports); low or negative real interest rates (which implicitly subsidized borrowers and taxed savers); price controls; and low
Despite this social or fiscal role of the state enterprises, that reduced the government’s own role, and despite the implicit taxes and subsidies, the
Special features of these economies made possible their high tax levels. The most important of these features were (a) close controls on, and thus knowledge of, the outputs and prices of what the state enterprises produced: in other words, through the plan, prices and outputs were known parameters to the government; (b) the concentration of production in relatively few and very large state enterprises 2/ so that only a manageable number of “taxpayers” needed to be controlled and taxed; (c) restrictions on how payments among enterprises were made; 3/ and (d) the role of the monobank and its branches in settling the accounts of the enterprises and in performing treasury functions for the government.
II. Issues in Fiscal Policy
1. On the relevance of fiscal deficit measures
In this section, general issues of fiscal policy are discussed. It is argued that variables that routinely guide policy actions in market economies, particularly the budget deficit, must be treated with caution during the period of transition. This is necessary to ensure that tight limitations on these variables do not create inverse incentives which may slow down the process of transformation to market economies. The need to separate fiscal from monetary policy more sharply is also highlighted.
In spite of occasional divergent views, most economists normally assume that the fiscal deficit is a good guide for assessing fiscal policy. A large deficit is taken as an indication that (unless a strong case to the contrary can be made) fiscal policy should become more restrictive. The
There are several reasons for caution in the traditional use of this concept as an important guide in policy action during the transition. Some of these are conceptual. Others deal with measurement problems. Some of these are discussed below.
a. Budget deficit and the government assumption of social expenditure responsibility
State enterprises in economies in transition continue to dominate economic activity and to provide many social services to workers and their families. Some of these services are provided in place of higher money wages. Others are provided in place of higher budgetary expenditure. These enterprises have been performing, and continue to perform, functions that in market economies are financed through the government budget.
The transition to a market economy requires that the budget assume the responsibility for those among these social functions that the country wishes to continue to be publicly financed. 1/ This transfer to the budget should occur regardless of whether the state enterprises are privatized or not. The faster it occurs, the easier it would be for them to be privatized or to become economically viable while remaining state enterprises.
The transfer of these functions to the budget will inevitably increase
If a decision were made to subsidize, for whatever reason, some loss-making state enterprises, it would be better economic policy if they were subsidized through the budget rather than through soft and cheap loans from the banking system. 1/ However, subsidies given through the budget increase the budget deficit, while cheap loans do not. Of course, such subsidies should be kept to a minimum by allowing the enterprises to adjust the prices of the products they sell. 2/
It would be unrealistic to assume that subsidies to enterprises, whether given through the budget or through cheap and/or soft loans, could be completely and permanently abolished in the short run although they can and should surely be reduced. Some of these enterprises (and especially those in the defense industry) will be able to restructure and become economically viable only if they receive financial support for some time. It would also be unrealistic to assume that those who make or influence economic policy would look at cheap credit given directly to state enterprises through the banking system in the same way as subsidies given through the budget. 3/ Thus, the argument that has occasionally been made--that the provision of subsidies through the banking system or the budget is only an accounting issue that would disappear
If the government raised taxes on state enterprises’ profits while, at the same time, the banking system extended cheap or soft loans to these enterprises, the budget deficit would fall
b. Budget deficit and inflation
The relationship between inflation, the budget deficit and the public debt is also relevant to this discussion. This relationship used to be very important in Mexico and Argentina in past years and continues to be important in high inflation economies. To the extent that there is a domestic public debt, an increase in the
c. Budget deficit and the unemployment rate
If state enterprises lay off redundant workers, in order to improve their efficiency, and, as a consequence, the government’s spending for unemployment compensation increases, the change will cause the budget deficit to rise. The rise will depend on the level of unemployment compensation per worker
The potential impact of this factor on the budget deficit of the countries in transition can be appreciated by the fact that falls in output that have, at times, been as large as, or larger than, 30 percent of GDP have not generally resulted, so far, in corresponding increases in unemployment. 1/ If these countries had behaved in the same manner as market economies, they would have experienced unemployment rates not seen since the Great Depression of the 1930s. 2/ As long as the state enterprises continue to hoard workers, they will not be able to restructure themselves and become efficient and competitive. And it will be more difficult to privatize them. However, when they fully adjust their employment to their greatly reduced production needs, and the governments take over the responsibility for financing the cost of unemployment, the budget deficits will go up. This factor must be taken into account in setting ex ante limits on the deficit. It will be important for the unemployment compensation not to be so generous as to discourage the search for employment in the emerging private sector by the workers who become unemployed. At the same time, it is obvious that large expenditure by the government will be required in this area during the transition.
d. Budget deficit and the exchange rate
If the country devalues its official exchange rate, (a) its interest payments on foreign debt
e. Shifting expenditures out of the budget
Another perverse incentive which may arise from the attempt to show a smaller budget deficit or to stay below a too rigid limit will be that of pushing expenditures out of the budget and into other parts of the public sector, be these extrabudgetary accounts or lower levels of government, where they will not swell the budget deficit. Extrabudgetary accounts have, indeed, proliferated in many economies in transition. Also, sizable expenditures have been shifted into local governments. In this context, it may be worthwhile to cite the excellent study of fiscal decentralization in Russia by Christine Wallich (1992, p.3).
“In the fiscal program for 1992, most of the major cuts were made in central government expenditures--centrally financed enterprise investment, producer and consumer subsidies, and defense. These cuts were followed by a decision to delegate an important part of social expenditures (early in 1992), and investment outlays (later on) to the subnational level. On the tax side, the budget envisages a marked increase in taxes, primarily on petroleum products and foreign trade. Thus, virtually all additional revenue will accrue to the
federalgovernment, while most of the additional social expenditures will emerge at the subnationallevel” (italics in original).
Wallich’s conclusion is also worth citing:
“The basic strategy has been to “push the deficit downward” by shifting unfunded expenditure responsibilities down in the hope that the subnational level will do the cost cutting” (pp. 3-4).
f. Other effects on the deficit
Finally, it will be difficult to fully anticipate the short-run impact of various reforms on the deficit. For example, changes in relative prices (resulting from reforms of consumer and producer prices, exchange rate, and interest rates) and reduction in subsidies to enterprises imply (a) a reduction in aggregate output, income, and economic activities during the transition, and (b) gains and losses for enterprises and household incomes. 1/ Even with no change in the tax system, there is bound to be a fall in the tax to GDP ratio because it will take time to identify new taxpayers and to collect taxes on new incomes and activities while losses of tax revenue from tax bases that have disappeared are immediate. Similarly, an increase in tax revenue from newly established taxes (e.g., VAT) may take time to materialize fully while the revenue losses from the taxes that have been, or are being phased out (e.g., turnover taxes) are immediate. 2/
Changes in relative prices may reduce budgetary subsidies, by, for example, increasing consumer prices, but they may also increase budgetary subsidies by transforming formerly implicit subsidies into explicit subsidies (e.g., in the case of an increase in producer prices). Furthermore, reduction in subsidies to loss making enterprises may not result in a reduction in expenditure because at least part of the social policy functions that had been carried out by the enterprises would be shifted to the budget and certain social protection expenditures (e.g., unemployment compensation) would have to increase.
These are just some examples of the possibilities that call for caution in the use of the budget deficit in guiding economic policy during the transition. They do not exhaust the possibilities. 3/ They all point to the need to ensure that perverse incentives are not created by the reliance on narrow concepts of the deficit. These incentives will exist when the deficit which is at the center of attention covers only a part of the public sector and when the limits imposed on it are too rigid. In this case there will be an incentive to “park” the deficit where it cannot be measured. In these situations, during negotiations with countries, the Fund has tried to enlarge the part of the public sector covered by the deficit measure that forms the basis for the agreement with the country. But this is always a difficult enterprise.
2. Separation of fiscal and monetary policy
A total and sharp separation between fiscal and monetary policy is next to impossible in any economy. There are always overlapping areas. For example, when central banks change the discount rate or engage in open market operations, these actions always have an impact on the budget deficit. In general, these two policies are less clearly separated in developing countries than in industrial countries. In Latin America, for example, the Central Banks have, in several cases, engaged in activities that have caused them to experience large quasi-fiscal deficits. 1/ In Chile, for example, the growth in quasi-fiscal deficit in the 1980s resulted from the assumption by the central bank of the bad debts of the commercial banks. This assumption was clearly a fiscal operation that could have been carried out by the budget if budgetary conditions had been more sound. 2/ In other cases, the central banks assumed the foreign debt of enterprises. In general, the less developed are the institutions of a country, the more difficult it is to separate monetary and fiscal policies and the more difficult it is to measure the true size of the fiscal deficit. More often than not it is the weakness of the fiscal institutions (for example, the inability to raise needed revenue) that forces the monetary institutions to assume a fiscal role by providing subsidized credit to enterprises or by directly financing the fiscal deficit. 3/ However, the objective of making the fiscal deficit look better than it is also plays a role in this function.
Normally, economic policy is improved when monetary and fiscal policies pursue their own specific roles. In this case; if an enterprise needs to be subsidized, the subsidy should be given through the budget. If this results in a fiscal deficit, the deficit should be financed through the sale of bonds by the country’s treasury carrying market interest rates. 1/
The budget deficit is a highly watched economic barometer. A larger deficit always sends warning signals, both domestically and internationally. Therefore, countries have an incentive to limit its size either by genuine fiscal adjustment, or by pursuing second-best policies whose result may even be more damaging than if the budget deficit had been allowed to rise. In other words, the bias is almost always for showing a budget deficit that appears smaller than it would be if it were correctly measuring the true fiscal deficit. At times this reduction is achieved through policies that do not reduce the real or underlying
3. Implications of preceding discussion
During the transition, to the extent possible, it is important to contain the inflation rate without resorting to direct price controls. 3/ To achieve this objective, however, the most important macroeconomic instrument for both market economies and economies in transition is credit expansion, not the budget deficit. Once total credit expansion is determined, the countries should be encouraged to continue improving the efficiency of the economy as well as the fiscal accounts. They should be encouraged to reduce particular categories of public expenditure, to make others more productive, and to raise government revenue to contain the public sector fiscal deficit. 4/ They should also be encouraged to speed up the various adjustments mentioned above,
Another important point to recognize is that what makes the economies in transition different from normal market economies is that, under present circumstances, for given total credit, an increase of the (measured) budget deficit does not necessarily crowd out what, in western economies, we would call the private sector. Much of the credit expansion goes to the state enterprises and the government and only a small residual goes to the emerging private sector. A large reallocation of credit between the budget and the state enterprises can take place without necessarily affecting the private sector. 1/ This reallocation could be fully consistent with the objectives of the transformation. In fact, if state enterprises (a) shed redundant workers, (b) transfer to the government the responsibility for
In countries where the boundary, in terms of social responsibilities, between the budget and the state enterprises is blurred and changing and where very little credit has been going to the private sector, the standard argument for containing the budget deficit--that for given credit expansion, the resources flowing to private enterprises would be squeezed unless the deficit is contained--does not necessarily apply. Therefore, rather than trying to achieve a given quantitative budget target with any possible measure, it would be better to focus on the quality of the measures, bearing in mind that the most important concern should be to foster the structural adjustment process while limiting the inflationary pressures. Enforcing inflexible limits for the size of the budget deficit may do little for price stability, if credit continues to flow to inefficient state enterprises, while it may retard essential structural adjustment.
III. Reform of the Tax System
1. The level of taxation
By disbanding the planning mechanism and by removing constraints to private sector activities, the transition to a market economy (a) removes controls on quantities produced and on prices, thus reducing the information available to the government; (b) increases sharply the number of producers in the economy through the creation of private enterprises and the breaking up of state enterprises; (c) removes existing restrictions on the methods of payments by allowing enterprises to make payments in cash and to hold multiple accounts in different banks; (d) eliminates the role of the monobank in collecting revenue, 1/ allowing the monobank to concentrate on its function as a central bank; and (e) stimulates the growth of those activities that have been difficult to tax in market economies (small shops, services, independent contractors). 2/ In future years, the most dynamic sector of the economy is likely to be the one most difficult to tax.
For many of these economies, the bulk of their industrial production will remain in the hands of the state enterprises for some time to come. Under these circumstances, it will be tempting for the Government to squeeze additional revenue from these enterprises, either through explicitly discriminatory profits taxation or through other
The transition creates confrontation between the government and the taxpayers, who become adversaries where they were supposed to be partners before. 1/ The phenomenon of tax evasion common to market economies makes its appearance and, given the prevailing circumstances, can become highly significant. In these economies paying taxes may not be perceived as a civic duty of good citizens. On the contrary, tax evasion is perceived as part of the “ground rules” in market economies. 2/
The loosening of controls by the
An aspect of this conflict that deserves a separate mention is that between the central government and the state-owned enterprises. It involves the distinction between wages and salaries on the one hand and profits for these enterprises on the other. In market economies the distinction between the employees and the owners of enterprises is clear cut. As a consequence, the total income produced by an enterprise can be separated objectively between wages and salaries on one hand, and profits on the other. Each of these can be taxed separately and at least from the point of view of an enterprise, increasing taxes on one component (say on profits) does not reduce the size of the other component (wages). 5/
In state-owned enterprises, when the government no longer fully controls them, the distinction between owners and employees becomes fuzzy and so does the distinction between wages and profits. Those who control the enterprises, by controlling wages and other expenditures for the employees’ benefits have the power to allocate the total income produced by the enterprises between profits and wages. In a way they duplicate the situation of partnerships in market economies. As a consequence, there will be an incentive to reduce profits and profit taxes by inflating wages. This tendency has led some of these countries to put special taxes on “excessive” wage increases (Poland) or to consider taxing the full income (e.g., wages plus profits) of enterprises rather than wages and profits separately (Russia). Of course, a broad-based value-added tax already taxes the “full income” of enterprises. But VAT are rarely truly broad-based.
Under central planning most tax revenue came from three major sources: turnover taxes, “profits taxes,” and payroll taxes. 1/ As indicated above, the institutional setup that accompanied central planning facilitated the collection of these taxes. For example, to a large extent the monobank performed the function of a tax collection agency. The kind of separate tax administration, with clear legal powers over taxpayers, that exists in a market economy was largely nonexistent. The average citizen
The developments discussed above imply that the transformation will almost inevitably be accompanied by a gradual fall in the share of taxes in total production (T/GDP). This fall would eventually leave these countries with levels of taxation comparable to those prevailing in middle-income developing countries with similar per capita incomes--say, about 25-35 percent of GDP. All countries that have taken the road toward a market economy have witnessed a fall in tax revenue 1/ (see Table 2). Table 2 may, in fact, underestimate the fall due to the fact that, the growing private sector activities are not properly assessed by the national accounts authorities, therefore, GDPs may be underestimated in more recent years. 2/
|Viet Nam 3/||10.1||8.9||7.5||6.8||n.a.|
The fall in tax revenue creates great difficulties for macroeconomic policy and for policymakers, especially if public spending does not fall similarly. That fall can be contained, but not fully neutralized, by major restructuring of the tax system and by short-term measures. However, a major restructuring of the tax system will inevitably take time. 3/ Short-term measures (for example, the temporary use of import duties) while useful and often necessary to maintain macroeconomic stability, may render more bumpy the road toward that restructuring since changes introduced now may not be easily reversible later, especially when strong legislators come into existence. In any case, tax reform must attract the full attention of senior policymakers. It cannot be treated as a minor issue.
It would be an illusion to assume that these countries can become efficient market economies while maintaining their former level of taxation since that level would be a major obstacle to the efficiency of the economy. But it would equally be a folly to let the level of taxation fall well ahead of the fall in public spending. Some western, private and, often, self-appointed advisors to these countries have been doing a disservice in advocating sharp cuts in tax levels regardless of the level of public spending and of the macroeconomic situation. Reducing tax rates, when the tax base is shrinking and the need for some new public expenditure is increasing due to the output collapse, would be out of touch with reality.
2. Issues in tax policy 1/
The transition to a market economy requires (a) the legislation of a new tax system; (b) the enactment of the many rules and regulations that accompany a modern tax system and that make the administration of that system possible; and (c) the setting up of an appropriate tax administration.
A common goal of the European countries in transition has been the setting up of tax systems broadly similar to those prevailing in Western Europe. 2/ These systems rely on (a) income taxes on individuals and, to a much lesser extent, on enterprises; 3/ (b) value-added taxes; (c) payroll taxes collected from both employers and employees; (d) a few excises; and (e) some taxation of wealth. In theory, the countries in transition could simply “copy” the tax laws of the Western European countries. These laws, however, are often too complex and, in part because of this, they require skills, for both compliance and enforcement, not now available in the countries in transition. 4/ Besides, the tax systems of Western Europe operate in a relatively stable economic environment (low inflation, small fluctuations in output, stable productive structures). This is not the environment likely to prevail in the economies in transition for some time, 5/ so that tax systems that are put into place must be protected, through indexation or other measures, from the effects of inflation.
It would be wise for these countries to adopt tax systems which, while moving toward the long-run goal of creating European-style systems, reflect current local conditions. This may require, in some cases, the adoption of measures that may appear primitive from the point of view of an advanced industrial country. For example, at the
Czechoslovakia replaced hundreds of turnover taxes with a few while starting the preparation for the introduction of the value added tax in 1993. In 1992, Russia introduced a value added tax with little preparation. Not surprisingly, it encountered difficulties and, given the 28 percent rate at which the VAT was introduced, revenue from this tax has, so far, been disappointing. The preparation for a VAT should start as soon as possible since it will be much easier to introduce such a tax when the number of taxpayers is still limited and is dominated by large, state-owned enterprises. In the medium term, as more private businesses are established, the tax administrations will have had experience in administering a VAT for relatively few taxpayers and will be better able to cope with increases in their number. There is no doubt that, with proper preparation, the more advanced among the economies in transition will be able to successfully administer a VAT. After all, about 40 developing countries have introduced VATs in their systems, and many of them have done so quite successfully.
Significant use could be made of excise taxes on particular goods. Taxes on imports could also provide some revenue over the short and medium term. Schedular taxes could be used in taxing the incomes of individuals, instead of attempting to introduce global income taxes which require far more sophisticated administrative capability. 2/ Presumptive taxes, applied with simple criteria could be adopted for taxing new and small activities which would be difficult to tax in any other way. Agricultural activities could be taxed through the use of simple land taxes. In fact, some of these countries are considering such taxes.
In conclusion, the tax systems of developing countries could provide some lessons for the transition period since the social, structural, and administrative characteristics of the economies in transition will, for some time, resemble more those of the developing than of the developed countries. As these characteristics change and begin to look more like those of the industrial countries, the tax systems could, then, be progressively restructured to bring them closer to those of the industrial countries.
During the transition, simplicity should be the guiding norm. Sophisticated systems and the pursuit of multiple objectives for the tax system must be resisted. Attempts on the part of governments to promote industrial or social policies through the tax system would be misguided. Such attempts would, for example, result in a proliferation of tax incentives to enterprises and in the preferential treatments of particular groups of taxpayers and particular incomes through various forms of fringe benefits. 1/ Taxes ought to be as broad based and as single rated as possible. Value-added taxes with multiple rates or multiple exemptions or zero rating of particular products would create excessive difficulties for tax administrators and would encourage tax avoidance and tax evasion. Income taxes with special treatments of groups or particular investments guarantee that they cannot be properly administered and that their contributions to revenue will be less than possible. These special treatments always lead to abuses and to high tax rates on the taxed activities and individuals. High tax rates generate disincentive effects and encourage tax avoidance behavior. They also generate political resentment. An additional problem with tax incentives or other special treatments of groups or enterprises is that once they are legislated, they develop strong constituencies that make it very difficult for them to be removed. 2/ And, of course, once they are legislated for one group or one activity, they will be requested by other groups.
3. Issues in tax administration
A few basic principles should be followed in the setting up of tax administrations adequate for market economies remembering that, in the period of transition, the administrative resources at hand will be particularly scarce. The number of tax returns must be kept low by establishing final withholding of income taxes for most wage earners and by maintaining relatively high exemption thresholds for businesses. 3/ This would allow the tax administration to concentrate on medium size and large enterprises which usually account for the bulk of sales and profit tax revenues. Because privatization will take time to materialize for the large enterprises, for some time most tax revenue will continue to be collected from state-owned enterprises. But, these enterprises will be more difficult to control than in the past, especially in periods of inflation when difficulties in getting credit may lead to a buildup of arrears, as experienced by many of these countries. In these situations, technical issues, such as whether taxes are based on cash or accrual concepts, can acquire great significance in determining revenue. 1/
Tax administration efforts should concentrate on the most important revenue sources--excises, general sales taxes, taxes on wages, and enterprise profits taxes. Tax reform should aim at creating a tax system with only a few major taxes so that administrative effort is not wasted among too many taxes. Furthermore, at least for the short and medium run, the importance of setting up proper customs administrations should not be minimized. This is, of course, an urgent necessity for the countries that were born out of the breakup of the Soviet Union. 2/
Tax reform efforts should be complemented by measures aimed at establishing modern accounting standards and invoicing requirements so that new taxes (such as a modern tax on profits and a value-added tax) can be implemented. Other complementary measures include those related to the rights and obligations of taxpayers, as well as those pertaining to the behavior of tax officials. 3/ All these measures represent aspects that were either missing or not needed under central planning.
Particular attention must be paid to issues such as (a) staffing requirements 4/; (b) computerization; (c) establishments of modern taxpayer identification systems and master files; (d) modern registration and collection procedures; (e) audit systems; (f) information systems for taxpayers. All of these aspects require time, attention, knowledge, and specialized resources. They determine to a large extent how good a tax system will be and describe areas where significant mistakes can and are being made. Furthermore, they must be considered within a broad strategy of reform. None of the above can be treated in isolation. They are all instruments that must be shaped in relation to a specific design of tax administration.
Finally, given the fact that, as already stated earlier, these countries are likely to experience periods of significant inflation, the impact of inflation on the tax system will need to receive particular attention. This attention will have to be aimed, first, at the introduction of adjustment schemes for the statutory tax system. In this aspect once again the experience of developing countries, and especially of Latin American countries, can provide useful guidance. Second, it will be aimed at insuring that collection lags are not so long as to significantly reduce the real value of taxes collected.
IV. The Reform of Public Expenditure
1. Public expenditure policy 1/
Paying close attention to tax policy and administration will slow down the fall in the ratio of taxes to gross domestic product and will improve the quality of the tax system. It will not, and should not, however, prevent that fall over the longer run since many of these countries cannot become successful market economies while maintaining their current tax burden. The main objective should be to limit over the medium term the gap between public expenditure and public revenue that will accompany the transition period. This gap can generate serious inflationary problems since the sources for financing the fiscal deficit in noninflationary ways will remain very limited for years to come. 2/ In time development of an efficient capital market and easier access to foreign sources may facilitate the noninflationary financing of a fiscal deficit.
In the short run, public expenditure can be reduced mainly by: (a) the elimination of most price subsidies to consumers; (b) the reduction or elimination of budgetary subsidies to loss-making state enterprises; (c) cuts in public investment since a large part of this investment has been directed, and is likely to continue to be directed, toward unproductive, or low return, activities; 3/ (d) cuts in military expenditures; and (e) restructuring of social protection programs.
Over the medium run the government will need to pay close attention to the maintenance and the enhancement of social and economic infrastructures, to the conversion of military to civilian expenditure, to the need to reduce surplus public employment, and to the cleaning of the environment. 1/ These changes will reduce some spending but raise other public spending. This is one of the reasons why public spending as a proportion of GDP will tend to fall less significantly than tax revenue in the near future. Other aspects that will need to receive attention are (a) the integration of extrabudgetary expenditures in the budget 2/; (b) the integration in the budget of the cost of recapitalizing banks; (c) the elimination of nonessential government functions; and (d) the improvement of the efficiency with which remaining public sector functions are carried out. Also, the conversion of enterprises which have been producing military equipment into enterprises producing products for the nonmilitary economy will require public spending.
Over the long run the level of government expenditure will have to depend on the countries’ capacity to finance that expenditure and on the demand for social services. Therefore, it will depend largely on their ability to raise taxes, and on the role that the state will play in the reformed economies. A European role, with socialized health care, free education, public enterprises and generous social insurance systems, will imply a larger public sector and a greater need for public revenue; an American role will imply a smaller public sector and lower revenue needs.
The social insurance sector, defined broadly to include old-age and survivors’ assistance, disability and sick pay, unemployment compensation, social assistance, and health care, will need to receive a lot of attention in the short and medium term, especially since the transformation of the economy and the liberalization of prices dramatically reduce the relative incomes of some groups making them particularly vulnerable. The pensioners and those who lose their jobs and become unemployed are visible examples of such groups. The increasingly severe budgetary constraints will require that only high priority, or essential, expenditure is undertaken. Thus, strict expenditure priorities must be established, both within sectors, such as health or pensions, and across sectors. Once again, the efficiency with which public services are delivered and social objectives are translated in spending decisions must be raised to keep spending down. Expenditure decisions must be conditioned by macroeconomic necessities to prevent inflation and other macroeconomic difficulties. 1/
The removal of implicit subsidies, given through low producer prices, through products imported at overvalued exchange rates, through negative real interest rates, or through other means, will improve the efficiency of the economy but will also reduce the real incomes of many consumers. These reductions can be so large as to necessitate at least partial compensation for the most affected groups. However, limitations in budgetary resources will require a careful evaluation and containment of social expenditure. The beneficiaries of these programs cannot be a large proportion of the population, and the benefits that they receive cannot be close to the average level of wages. For example, in one of these countries, in 1992, expenditures on social protection programs have been estimated at almost 30 percent of GDP. Such a level is clearly unsustainable. In many of these countries the proportion of the population that can claim government assistance of some sort is so large as to make it difficult to contain public spending to a level that can be financed without strong inflationary pressures.
Even considering the low life expectancy of these countries, the retirement age is often too low and will need to be raised. Requirements for disability pension are too flexible and must be tightened. Sick pay benefits are too generous and must be reduced. Maternity leave benefits in many of these countries are excessively generous, often allowing paid leaves that extend to many months or even years. Unemployment compensation must be limited in time and in amount so as not to affect incentives to work or to look for employment. Public works program may need to be provided for those who have exhausted their unemployment benefits and are unable to find jobs in the emerging private sector. Pensions and other social benefits would continue to be financed through payroll taxes, but these taxes should be limited in order to achieve international competitiveness. In many economies in transition payroll taxes remain exceptionally high. 2/ However, their reduction will be possible only if social expenditure can be reduced.
Social assistance for families or individuals will need to be provided for those who have been most affected by the elimination of the subsidies to consumer goods and are unable to take advantage of the emerging opportunities in the private sector. These are likely to be old people, people with serious disabilities, and families with children. Over the short term it may not be possible to provide assistance based mainly on past contributions or on means tests (i.e., on income levels) since the information for such an approach may not be immediately available and the administrative costs of this approach may be too high. 1/ As a consequence, it will be desirable to keep the system of allowances as simple as possible--for example, a flat allocation per child below a certain age, or through the provision of food stamps for particular categories, with benefit levels set in relation to available resources. Over the medium term, means tested cash benefits should be introduced. 2/ In many economies in transition, the level of family allowances is excessive and may represent an unnecessary incentive to population growth.
The provision of social benefits is often carried out through a multitude of programs some administered by state enterprises, some by trade unions, some by local governments and some by the Government. This often allows beneficiaries to take advantage of more than one program, thus receiving benefits that can significantly exceed their basic needs. This arrangement not only creates confusion but raises the total cost of social protection and creates inequity among beneficiaries. It often favors unionized workers over non-unionized workers and members of old trade unions over members of new trade unions. Such arrangement is inconsistent with the features of a market economy. The central government needs to take control of this area both to reduce costs and to improve the equity and efficiency of social expenditure.
2. Management of public spending
Policy decisions related to government expenditure will lead to better results if the institutions required for the efficient management of spending are in place. In market economies, the most important among these are the budget office and the treasury. 3/ Under central planning these institutions played a secondary role in the management of public expenditure since the budget was largely the financial appendix of the plan and the monobank was the main institution involved in the execution of the budget.
Decisions about the distribution of social resources within the all-encompassing public sector were largely taken within the framework of the plan. Some of these resources were assigned to finance social objectives, such as education, health, and social assistance, carried out by spending ministries. The function of the budget was mainly to authorize the transfers of funds to these Ministries. Furthermore, many of the functions which in market economies are assigned to the budget and, through it, to the spending ministries, were carried out directly by the state enterprises. Such institutional and organizational arrangements made difficult the identification of fiscal policy as a separate and important activity of the government.
The monobank was in charge of (a) crediting to the government accounts the tax revenue collected through the banking system from the state-owned enterprises; (b) distributing the budgeted funds to the spending ministries and organizations or, when authorized, to particular enterprises; (c) keeping the accounts for government revenue and expenditure operations; and (d) financing budget deficits and loss making state enterprises, through domestic bank credit or occasionally through external borrowing. Thus, when the monobank financed a social activity, it was performing a fiscal rather than a monetary function.
The above description highlights the extent to which monetary and fiscal policies were intermingled. Good economic policy in a market economy requires the separation of these policies. The reinforcement of the role of the budget office and the creation of a treasury, and a separate and independent central bank would help promote that separation. It would leave the central bank free to focus on monetary policy and would shift to the budget office and the treasury the main responsibility for the conduct and implementation of fiscal policy. 1/ The government must develop an administrative capacity for quick response to unanticipated changes in revenue and for ensuring that whatever pragmatic changes are introduced for short-term crisis management, or for other reasons, can be pursued through effective budget management system.
An efficient budget office and a well functioning treasury will undoubtedly improve the quality of policymaking, especially in situations that are likely to continue to be characterized by large economic fluctuations, significant inflation, and great uncertainty. Efforts in reinforcing the role of these institutions must be accompanied by the development of a fiscal reporting system so that the policymakers are on top of current information that they can use to make their policy decisions.
An efficient budget office would be better able to forecast trends in revenue and expenditure on the basis of prospective macroeconomic developments. It would also be better able to estimate taxation and expenditure levels required to achieve particular economic objectives, such as a given rate of inflation and a given balance of payment outcome. It would also be a more efficient tool for assessing the efficiency with which public expenditure is being carried out by the spending ministries. In other words, the budget office would provide the policymakers with an important tool for resource allocation and for stabilization.
A well-functioning treasury would allow the government to manage its cash balances better and better execute and control budgetary decisions. This can reduce the need for borrowing on the part of the government and can thus reduce the fiscal deficit. Without such an office, the probability that expenditure will exceed the budgeted limits will be higher. The treasury should also be in charge of the management of public debt and should have full and current information about extrabudgetary accounts. By entrusting the management of public debt to the treasury, the financing of the deficit could also be kept under constant surveillance in order to avoid or limit inflationary financing. Such an institution would keep the policymakers informed on a timely basis about expenditure and revenue developments so that necessary changes can be made as needed. When such a knowledge is not available, or is not available when needed, the probability of making serious policy mistakes undoubtedly rises.
In conclusion, the creation of a competent budget office and of an efficient treasury is an essential development in institution-building that needs to take place in all the countries that seriously aim at becoming well-functioning market economies. This need is now well understood by the policymakers of many of the previously planned economies. Several among them are proceeding to set up modern budget and treasury offices. This process, however, will inevitably require time and effort, as well as resources for the acquisition of equipment and for the training of personnel. By removing some of these functions from the central bank, it will also facilitate the transition of that institution to a more limited but more effective role. But, once again, a vacuum is created when the central bank gets out from performing this treasury function before a modern treasury is in place.
V. Concluding Remarks
The economic transformation of previously centrally planned economies will depend on the creation of new institutions and new skills. It will also depend on policies that at times are difficult to formulate because of the unusual circumstances faced by these countries. In many cases the policymakers of these countries know where they are and know where they want to go. What they don’t know is how to get there. This paper has discussed several important fiscal issues. It has identified essential changes and has warned about the automatic application of Western concepts to situations where they may not be totally appropriate. It has warned about the mechanical transplanting of institutions that exist in industrial countries. It has also shown that, at least for the period of the transition, the formerly planned economies have much to learn from the developing countries.
More specifically, the paper has shown that in situations where the role of the government has not yet been determined, where the budget must assume some responsibilities now carried out by state enterprises, and where “property rights” within the public sector are vague, the budget deficit, which is calculated by looking at the behavior of
The paper has discussed various tax issues calling attention to (a) the almost inevitability of a reduction in the T/GDP ratio over future years; (b) the need for simplicity; and (c) the need to pay close attention to tax administration. It has been emphasized that the transplanting of the fiscal institutions of advanced industrial countries to the countries in transition may lead to costly mistakes.
Several expenditure issues have also been discussed including (a) the need to streamline, and reduce, social expenditure; (b) the probability that public spending will tend to fall more slowly than public revenue; (c) the need to create efficient institutions for the management of public expenditure. The budget office and the treasury have been singled out for special attention.
The paper has also referred, in various places, to the need to clarify “ownership rights” within the public sector. Until a clear assignment of responsibilities is agreed upon among the various institutions that constitute the public sector, the fiscal signals sent by those most responsible for the budget will not carry the clear instructions necessary for the conduct of an efficient fiscal policy.
Three important fiscal issues have been left out of the discussion of this paper. These are complex issues that deserve more specialized and detailed treatment than could be given here. The first is the allocation of fiscal responsibilities (and the revenues to meet them) between the central government and the local governments. Questions of fiscal federalism have become very important in many of the countries in transition. 1/ The second issue is what to do with the bad loans on the books of the commercial banks. The third is the fiscal implications of privatization as well as the relationship between privatization and some of the issues discussed in this paper.
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Comments on this paper were received from S. J. Anjaria, Gerard Bélanger, Guillermo Calvo, Milka Casanegra de Jantscher, Sheetal Chand, Ke-young Chu, Carlo Cottarelli, David Driscoll, Laszlo Garamfalvi, Manuel Guitian, George Iden, Malcolm Knight, George Kopits, Neven Mates, John Odling-Smee, Gur Ofer, Teresa Ter-Minassian and Howell Zee. I am grateful to all. I remain, of course, solely responsible for its content, especially since not all the above readers share all the views expressed in this paper. Needless to say, the views expressed are strictly personal and not official Fund views.
We must recall that, in market economies, public sector activity is largely justified by (private) market failure. See Joseph E. Stiglitz,
Of course this does not imply that the government needs to assume
The time spent by individuals to buy scarce consumer goods was another form of taxation. In the United States during World War II, shortages forced a high rate of saving for families even though real interest rates were negative. At that time the main borrower was the government.
The joint study by the IMF, EBRD, IBRD, and OECD on the Soviet Economy highlighted the unusual concentration of production in gigantic enterprises. See
State enterprises were allowed to hold only one account in a state bank and were restricted to making payments and receiving payments only through that account.
It also implies that the fiscal activities of the government can be separated from the monetary activities. For example, the fiscal activities of central banks must be assessed as part of
The functions not taken over by the budget should no longer be the public sector’s and the state enterprises’ responsibility. By adjusting money wages, workers could be given greater discretion over the use of the
Throughout the paper, I shall use the term “budget deficit” for the part of the fiscal deficit that is actually accounted for by the budget. This is the measure of deficit normally reported in newspapers and in government reports. The theoretical concept of the fiscal deficit is much more comprehensive and much more difficult to measure (see various papers in Blejer and Cheasty, 1993). It extends to the whole public sector and includes quasi-fiscal deficits.
There is no available estimate about the magnitude of these social functions. The World Bank is attempting to quantify them for Russia. The assumption is that they are quite important.
These limits may be self imposed or negotiated with international institutions or other creditors.
The current situation in Russia, where the Central Bank continues to subsidize the state enterprises in particular sectors through subsidized credit and, in the process, it creates inflationary pressures, shows how important this issue is.
Many of the enterprises receiving subsidized credit may be those which have not been allowed to increase freely the prices of the products they sell.
For one thing, it is difficult to calculate the subsidy element of subsidized credit. See, for example, the paper by Michael Wattleworth, “Credit Subsidies in Budgetary Lending: Computation, Effects, and Fiscal Implications,” in Blejer and Chu (1988). Also, subsidies, given through the budget, would, most likely, be associated with more careful, or at least more politically debated, decisions about which enterprises should be subsidized.
This measure would count the social expenditure by state enterprises in the same way as budgetary expenditures. It would also count the subsidies given by the banking system as public spending. See, for example, Begg and Portes (1992).
The relationship between fiscal deficit, public debt, and the inflation rate was discussed in “Inflation and the Measurement of Fiscal Deficits” by Vito Tanzi, Mario Blejer, and Mario 0. Teijeiro, IMF
Thus, for example, the subsidized credit financed by the Central Bank of Russia not only substitutes for budget deficit and thus hides the true extent of the fiscal deficit, but it also reduces the cost to the government of servicing its debt.
The situation is changing. For example, the unemployment rate in Hungary has risen from less than 1 percent in the first half of 1990 to over 11 percent in September 1992. In Bulgaria, it has risen from 1.6 percent in 1990 to 14 percent in 1992. In Poland, from 6.3 percent in 1990 to 13.5 percent in October 1992. In Romania from zero in 1990 to 10 percent in 1992. For the fall in output up to 1991 see IMF (1992a), p. 46. For the estimated falls for 1992, see IMF (1992b), p. 19.
That is, rates of 25 percent or higher.
If the government is unable to pay the interest on the foreign debt, there will be a difference between accrued and cash measures of the budget deficit. Domestic arrears to and from the government also create differences between cash and accrued measures of the budget deficit.
The difficulties on the part of the central governments of many of these countries, to control the accounts and the actions of the whole public sector, indicate that the budget may not be the beneficiary from devaluation.
This discussion points to the importance of bringing the foreign trade area within the tax net. For example, it is important for imports to be subjected to the value-added tax. In Russia imports have not been taxed with the VAT. However, they will soon be subject to the VAT.
The change in relative prices will make obsolete the productive structure of some enterprises while it will not create in the short run the productive capacity required by the enterprises that gain from the change.
There is a “learning-by-doing” process for the tax administration with respect to new taxes.
For example, a solution to the bad debt problem of the commercial banks and the arrears among enterprises might be delayed by the fact that the solution would raise the budget deficit. Begg and Portes (1992) have argued that if the deficit were properly measured, these policies would not change its size. However, the assumption on the part of the government of the bad debt of the banks, by replacing bad assets with good assets in the hands of the banks, would allow them to give more loans which might increase the liquidity of the economy. See also van Wijnberger (September 1992).
See the recent paper by Maxwell Fry (1993) on fiscal operations by central banks.
However, in Chile this policy was followed by clear rules of games for the banking sector, to remove the possibility that bad debts might again damage the net position of banks. It was also followed by major reforms in the public finances which created a surplus in the public sector other than the Central Bank.
In Italy, for example, for many years the fiscal institutions were unable to support the country’s fiscal requirements. For a long time the Central Bank and the banking system were forced to perform important fiscal functions by indirectly financing some government spending.
When the financial market is not well developed, or when the credibility of the government is not good, this source of financing is not available. However, if the deficit is to be financed through inflationary finance, it may still be better if this finance is directly allocated to the budget and the budget finances the various activities including subsidies to state enterprises.
This is not a problem of only economies in transition. In fact, it has been a frequent problem in adjustment programs. See Tanzi, “Fiscal Policy, Growth, and the Design of Stabilization Programs,” in Martirena-Mantel, editor (1987).
However, because of the changes in relative prices during the transition, it may not be wise to aim for an inflation rate that is too low since this would require a fall in prices in some sector.
For this reason, structural policies in the fiscal area are very important and require close attention and close integration with the macroeconomic policies.
However, state enterprises that behave like private enterprises may be squeezed out by a larger credit allocation to the budget. Therefore, improving the public finances is still a fundamental objective. However, where credit is highly subsidized and continues to be given to loss-making enterprises, regardless of their chances to become competitive, this factor may not be too important. The situation is likely to differ among economies in transition.
The monobank collected tax revenue by simply debiting the accounts of the enterprises.
For an earlier review of some of these issues, see Vito Tanzi, “Tax Reform and the Move to a Market Economy: Overview of the Issues” in
See Kolodko (1992).
In his latest book, Kornai has referred to “soft taxes”. These are taxes which are essentially negotiated between the government and the enterprises. They do not reflect clear obligation spelled out in legislation. See Kornai (1992) p 142. See also Kopits (1992).
Perhaps they were less partners than assumed here since it had been necessary to create increasingly extensive and intrusive rules about the creation and operation of numerous funds to be financed from pre- and post-tax profits.
See Kornai (1990).
Even within the central government budget there may be conflict between the legislature and the executive branch until their relative roles are clarified.
It has also been a common problem in some developing countries. In Argentina, for example, until recently the central government had been unable to control the state petroleum company.
Of course, dynamically and for the whole economy, increasing taxes on profits may reduce capital accumulation and, over the long run, wages. See Feldstein (1974).
Note that profits taxes refers to the taxes on the activities of the enterprises. The concept of profit was a vague and flexible one. Therefore, there is little similarity between profits taxes in these countries and in the market economies.
The few private activities that were allowed to exist were often taxed on the bases of presumptive or forfeit methods. Thus, they did not have to present a declaration.
See on this Janos Kornai (1990).
Note, however, that part of the falls shown in Table 2 may reflect explicit decisions by the government to reduce the size of the public sector. On the other hand, in several of these countries the transformation has not yet proceeded very far. Therefore, the negative impact on revenue is still to come.
See Andrew Berg’s paper on Poland, “A Critique of Official Data,” presented at the Joint IMF-World Bank conference on
It will be slowed down by hesitation on the part of the policymakers and, as importantly, by lack of skills within the countries. Well-coordinated foreign technical assistance can help but cannot accelerate the process dramatically.
For detailed analysis of tax policy and tax administration in economies in transition see
Of course, this goal is unlikely to be shared by non-European economies in transition. Still all of them would want to develop market-compatible tax systems.
This reverses the relative importance of these taxes since, under central planning, taxes on the incomes of individuals were much less important than taxes on enterprises.
One could just think of the “tax industry” made up of lawyers, accountants, and economists that has grown in the United States. This industry has been stimulated by the complexity of the tax code. European tax systems are no simpler. For an elaboration on the need to develop an “ecological balance” among institutions and available skills, see Vito Tanzi, “Fiscal Issues in Economies in Transition” in
It can also be argued that the mistakes made by the tax systems of the industrial countries should not be copied by the countries in transition.
All of the European transition countries have either introduced or announced their intention to introduce value-added taxes. Several intend to introduce the VAT in 1993. Hungary was the first of these countries to introduce a VAT after considerable preparation.
It would thus be a mistake to encourage these countries to introduce global income taxes similar to those in existence in the United States, which require the filing by more than 100 million taxpayers.
Preferential treatments to “joint ventures” have already given rise to many abuses.
Unfortunately, the habit to control the allocation of resources through planning has created a predisposition on the part of many policymakers to attempt to control the allocation of resources through the tax system. This has been a major problem in the tax reform process.
If inflation is present, this will require periodic adjustments of these thresholds.
There is some evidence that in Russia, in calculating the liability toward the value-added tax, some enterprises have been using a cash basis for reporting sales and an accrual basis for reporting purchases. In this way, they have been able to reduce their tax liability. Some of the increase in arrears among enterprises may be traceable to this factor.
Now barter trade is often not taxed. As a consequence, it remains very important. There is, however, no reason why it should not be taxed. The nontaxation of barter trade is clearly a disincentive to normal trading? and to the development of market economies.
Some tax administrators of these countries have shown surprise when first told that taxpayers have rights and they deserve to be treated with courtesy.
Often better tax administration does not require more staff but a better utilization of the existing staff.
For detailed discussion of public expenditure policy in economies in transition, see Vito Tanzi,
However, as argued earlier, the limitation of the budget deficit should not be achieved by slowing down the restructuring of the economy or by a continuous recourse to subsidized or soft credit to state enterprises.
See Vito Tanzi, “Mobilization of Savings in Eastern European Countries: The Role of the State” in
Unsafe atomic plants will also need to be replaced at very large costs.
Extrabudgetary expenditures are likely to grow when the central government does not have the political power to control all public institutions. This happens when “property rights” broadly defined are not clearly established
As argued below, this requires the establishment of efficient expenditure management institutions.
For example, contribution rates for social security in Bulgaria, Czechoslovakia, Hungary, and the Ukraine range between 50 and over 60 percent of the wage bill.
The information is often not available to the government because these programs were administered by state enterprises, which kept poor or no records of contributions made by workers.
For a discussion of these issues, see Ehtisham Ahmad and Ke-young Chu, “Russian Federation: Social Safety Net Options and Budgetary Implications,” forthcoming in Tanzi (1993).
Not all market economies have the same institutional arrangements for managing public spending decisions. In some countries the responsibilities that, in this paper, are attributed to the budget office may be divided between different offices within the Ministry of Finance.
Here we find a classic case of sequencing problem. The central bank should not get out of its treasury function until an independent treasury is in place.
It would also include the public institutions outside the budget.