Transition to Market

Chapter 2 Bulgaria’s Transition to a Market Economy: Fiscal Aspects

Vito Tanzi
Published Date:
June 1993
  • ShareShare
Show Summary Details
Sheetal K. Chand and Henri R. Lorie 

The primary objective of modern economic systems is to promote orderly growth. After four decades of central planning under communism in Bulgaria, it became abundantly clear that a fundamental change in the economic system was required if a satisfactory rate of growth was to be restored. Accordingly, the Bulgarian authorities decided to move to a market-oriented system. The successful implementation of such a move requires at the outset the introduction of appropriate market infrastructure such as commercial laws, the right to private property, and accounting conventions. The reforms needed will have to go beyond liberalizing prices and promoting market clearance to include revamping many of the institutions on which central planning relied. In particular, the Government’s all-pervasive role in the economy will have to be reduced in favor of decentralized public and private decision making, and new instruments for indirect control will have to be established.

The reform of the public finances is at the core of the institutional adjustments required to operate successfully a market economy. Beginning in mid-1990, and especially in 1991, Bulgaria has initiated important steps in this direction. This paper describes these reforms in the light of what is needed under Bulgarian conditions to operate a satisfactory market economy.1 The paper begins with a brief macroeconomic overview of the situation in Bulgaria. This is followed by a review of the organization of the public finances prior to the reform. The next section examines the general nature of the fiscal reforms needed. The remaining sections consider the achievements to date and the unfinished tasks.

Macroeconomic Context

In the 1960s and 1970s, Bulgaria achieved fairly high rates of economic growth through rapid industrialization, particularly in heavy industries (such as machinery, metalwork, and chemicals), and increased trade integration within the area of the former Council for Mutual Economic Assistance (CMEA), in particular, the former Soviet Union on which it depended for cheap raw materials. Those results were obtained under a tightly controlled system of central planning that redirected resources toward large state-owned industrial enterprises and away from the agricultural sector. The latter was itself largely converted into inefficient agroindustrial enterprises.

The limits of this strategy were reached progressively in the 1980s, despite some attempt at upgrading industrial investments by the state (mainly in electronics, chemicals, and the energy sector). In particular, the high dependency on imported equipment and inputs both dampened domestic growth and placed increasing pressure on the balance of payments with the convertible area. A number of exogenous factors also contributed to the deterioration of Bulgaria's macroeconomic situation from 1985. These included years of drought, which reduced agricultural output, and the declining purchasing power of oil producing countries in the Middle East, as well as the end of the war between Iraq and the Islamic Republic of Iran, which depressed Bulgaria’s substantial exports to the countries in that region. The poor quality of much of these exports has prevented their redirection toward Western markets.

Increasingly since the mid-1980s, domestic economic activity, investment, and consumption were sustained by expansionary fiscal policies backed by growing recourse to external borrowing in favor of enterprises. In the process, broad money grew systematically faster than nominal GDP, which resulted in a slow but steady buildup of a monetary overhang.

Both the external and the domestic situation became increasingly unsustainable during 1989-90. As a result, Bulgaria was cut off from new external borrowing (and from March 1990 ceased to meet most external payments). Further, imbalances between goods demanded and supplied were heightened. Growing popular discontent, the demonstration effect of events in other East European countries, and the tacit agreement of the Soviet Union led to a change of political regime in December 1989 and the decision to move to a market-oriented economy. However, initial steps in that direction during 1990 were largely uncoordinated. In particular, a move toward external liberalization, including reliance on market forces to determine the exchange rate, was not immediately reflected in domestic prices. It encouraged diversion to exports and speculative buildup of inventories. Since budgetary and monetary policies were loosened rather than tightened, shortages worsened. On the supply side, the constraint on foreign exchange and imported inputs forced enterprises to cut back their activities.

Perhaps more than any other East European country, Bulgaria formulated and initiated a comprehensive reform program in early 1991 under especially difficult external circumstances; namely, the war in the Middle East and the dissolution of trade arrangements under the CMEA. Even the long-anticipated impact of the move to international prices from January 1991 for trade transactions with the former CMEA partners (including for oil and other raw materials from the former Soviet Union), which was projected to result in a 30 percent deterioration in terms of trade, did not fully anticipate the extent of the collapse of trade with the Soviet Union. The problem was compounded by the withdrawal of virtually every kind of trade financing and the delay in promised disbursements of foreign assistance.

Not only has the environment for reform not been propitious, but the adverse exogenous developments caused the fiscal situation to deteriorate. This, of course, makes it more difficult to employ fiscal policy, badly needed as it is, to stabilize the economy. The scope for employing fiscal policies to undertake the vital tasks of reconstructing the economy is further limited by the prior requirement to restructure the public finances in conformity with market conditions, so as to forge a usable instrument for indirect control.

Structure of Public Finances Inherited from Central Planning

Organization of Budget and Extrabudgetary Funds

The unified and all-encompassing state budget reflected the key role of public finances under central planning for meeting government requirements for managing the economy and promoting distributional objectives. The Bulgarian state budget has five constituent elements, of which the principal part is the so-called republican budget.2 It implemented undertakings of nationwide significance, including key redistributive and regulatory functions. In particular, it received or paid funds related to foreign trade equalization operations and managed subsidy payments during the 1980s; the latter consistently amounted to about 25 percent of budget expenditure, equivalent to about 15 percent of GDP (Table 1). Within the state budget, the social security budget, which derives its receipts mainly from social security contributions paid by employers in the form of a payroll tax, finances a comprehensive system of social benefits. These amounted to almost 20 percent of budget expenditure, equivalent to some 10 percent of GDP. The social security system has tended to operate fairly independently, but sizable surpluses in the early 1980s were systematically transferred to the republican budget; these surpluses have dwindled in recent years, and a deficit emerged in 1990, which necessitated support from the republican budget.

Table 1.Bulgaria: General Government Operations(In percent of GDP)
Total revenue58.060.160.553.141.439.3
Tax revenue47.449.551.342.239.536.4
Nontax revenue10.710.
Total expenditure63.761.663.265.744.954.2
Overall deficit (-)-5.6-1.4-2.7-12.6-3.5-14.9
Of which:
Bank financing6.
Cash deficit (-)2-5.6-1.4-2.7-8.50.1-3.7
Primary deficit (-)3-
Domestic deficit (-)4-
Memorandum item:
GDP (in billions of leva)38.339.540.045.6146.5138.4
Source: Ministry of Finance.

State Investment Credit Fund.

Includes only external interest paid.

Excludes all interest payments.

Excludes all external interest payments.

Source: Ministry of Finance.

State Investment Credit Fund.

Includes only external interest paid.

Excludes all interest payments.

Excludes all external interest payments.

Public policy objectives are also implemented through the operation of certain extrabudgetary funds. The largest of these funds is the State Investment Credit Fund (SICF). It was created in 1987 to finance high-priority large-scale investments (in sectors such as coal and electricity, metallurgy, and heavy and chemical industries) at extremely low interest rates to stimulate growth. In effect, this fund has allowed the removal of some government investments from the regular budget. Another extrabudgetary fund that is gaining greater importance under the reform process is the Professional Training and Retraining Fund; it is responsible for unemployment benefits, the training and retraining of dismissed and redundant workers, and labor market information. Because of the public policy character of these extrabudgetary funds, they have been included in the coverage of general government operations presented in Table 1.

Overall Deficit Trends

During most of the 1980s, the state budget (excluding the SICF and other extrabudgetary funds) was close to balance; and even the largest state budget deficit (in 1986) did not exceed 3 percent of GDP. However, the contribution of the state budget to direct money supply creation increased in the second half of the decade, reaching some 2 percent of GDP in 1988-89, a development that largely coincided with a falloff in foreign financing of the budget.

Nevertheless, the relatively small size of the overall fiscal deficits during the 1980s underestimates growing state budget difficulties and the expansionary stance adopted. Indeed, budgetary expenditure alone increased in the 1980s by almost 10 percentage points to nearly 60 percent of GDP. It largely reflected a rising trend in subsidies, social security payments, and (until 1987) in capital expenditure. In addition, during 1987-89 the SICF invested heavily in the energy sector and in heavy industries, averaging about 5 percent of GDP, and mostly financed by bank credit. Hence, the general government's overall deficit increased markedly in 1987-88, to more than 5 percent of GDP, before falling back to about 1.5 percent of GDP in 1989, as a consequence in large part of higher profits taxes and cuts in capital outlays. The general government's deficits are clearly better indicators of the more expansionary fiscal policy stance adopted during most of the second half of the 1980s.

Structure of Expenditure

The most striking feature of general government outlays, representing more than 60 percent of GDP at the outset of the reform program, was the importance of subsidies. As indicated earlier, these amounted to about 15 percent of GDP, compared with an average of 3 percent of GDP among member countries of the European Community. With the weakening of central planning, an increasing share of subsidies took the form of transfers to cover operating losses of certain unprofitable industrial sectors and, in 1990, of consumer subsidies, as higher factory purchase prices were not accompanied by increases in retail prices. Without clearcut reference to international prices, the distinction between producer and consumer subsidies can be blurred, but the allocation of subsidies among commodity groups clearly reflected the social objective to provide for the entire population basic foodstuffs (such as dairy products and meat) and consumer items (in particular, children's clothing) at very low prices, as well as the objective to sustain industrial growth. To some extent the application of subsidies was in lieu of wage increases, given the policy of keeping wages frozen at an artificially low level.

Typically, maintenance and operating expenditure tended to be high under central planning, at about 14 percent of GDP or nearly one fourth of total outlays. This indicated the important role of the state not only in the health and education sectors, with little attempt at cost recovery even from those most able to pay, but also in cultural and leisure activities, representation, and urban development. Indeed, visitors to Bulgaria cannot but be impressed by the relative opulence of the state and municipal facilities compared with the very modest standards of living of the population.

One feature of central planning has been a comprehensive system of social benefits reflecting the commitment by the state–often in return for relatively low nominal wages–to provide for old age, sickness, disability, and child care. However, the question of unemployment and poverty alleviation assistance did not typically arise, because of the artificially maintained full employment policies and the distributional policies. Nevertheless, social outlays typically reached more than 10 percent of GDP, mostly related to pensions for about one fourth of the population and to child allowances.

Revenue System

The Government relied heavily for the financing of these large outlays on its take in the state enterprises’ so-called profits, which at times was so excessive as to contribute to the growing recourse by the enterprises to bank financing for their operations, and the resulting large increase in their level of indebtedness. By 1989, 67 percent of profits was taxed. In Western terms this level of taxation is even higher since the system of accounting did not provide for items of deductions, such as interest payments, that are normally allowed as a cost of doing business. However, by the same token the state would bear many costs of enterprises that are more properly borne by those enterprises.

Another mainstay of the revenue system was the turnover tax, which earlier comprised more than 2,000 rates, varying by commodity, but was reduced at the beginning of 1988 to some 40 rates. This tax essentially functioned as a wedge between the retail and wholesale prices of the good, both of which were fixed and only infrequently adjusted. Excise duties were also levied on a variety of goods, including those considered dangerous to health, such as alcoholic beverages and tobacco products, with the rates set as percentages of retail prices, except for petroleum products for which specific taxes applied. Under central planning, which relied on comprehensive quotas on imports and exports and therefore had little need for tariffs, domestic and border prices at the overvalued exchange rate were reconciled through a complex system of trade-related revenues and subsidies in the form of price differentials. Substantial revenues were derived but large subsidies were also paid out.

Since wages were directly determined, there was little need for a personal income tax. The use of this tax was essentially to apply highly discriminatory rates to those few with privately earned incomes in an attempt to equalize their incomes with the relatively low wages in the public sector. The former could be subject to a top marginal rate of 85 percent, compared with a top marginal rate of 14 percent on wages. In contrast to the personal income tax, social security contributions paid by employers have been sizable, amounting to some 30 percent of total remuneration since the early 1980s.

Administrative Structures

With private sector activities virtually curtailed and the state enterprise the dominant mode of organization, some 98 percent of taxes was (and still is) collected through the state enterprises as the primary collection points. Broadly, this amounted to one part of government collecting tax from another, with the amounts to be collected determined as an outcome of the central planning exercise. The administrative requirements were therefore simple. Because the number of monolithic state enterprises was relatively small, periodic field audits of all enterprises easily ensured compliance. There was no functional organization of the revenue collecting department, which was instead organized on sectoral lines, with tax officers specializing in the activities of their assigned sectors and being responsible for all aspects of revenue collection and payments of subsidies. Revenue control was reinforced by giving the monolithic banking system the power to transfer periodically revenues from enterprises to the budget by adjusting their bank accounts.

In practice, there was no sharp distinction between taxes and subsidies. The payment of the latter was undertaken by the same department entrusted with revenue collection and could in fact be viewed as a negative tax. This department–the State Financial and Tax Department–was also responsible for auditing government accounts. Some devolution of authority to the municipalities was provided, whereby they received the profit and turnover taxes collected from the municipal state enterprises and all of the taxes levied on physical (private) persons.

Initial Reform Steps

Budgetary Difficulties of 1990

The decision to move toward a market-oriented economy from early 1990 was accompanied by a sharp deterioration in the budgetary situation. The original state budget approved by parliament in March envisaged only a small deterioration of the overall deficit of the general government to 2.7 percent of GDP, largely on account of higher interest payments as a result of a devaluation of the exchange rate, while the primary surplus was expected to improve to 2.6 percent of GDP (despite higher social security outlays in connection with a hike in minimum pensions). Revenue was to play a critical role in achieving this objective and was projected to rise to about 61 percent of GDP.

In the event, the revenue target proved overly ambitious, and tax revenue fell short of the budget target by 8 percentage points of GDP, largely on account of deteriorating profit taxes. This reflected the impact of a sharp decline in economic activity (by an estimated 12 percent), and excessive growth in real wages.

Expenditures were subjected to upward pressures, partly because of the adverse consequences of piecemeal liberalization, which had the effect of making explicit previously implicit subsidies, particularly with respect to the overvalued exchange rate and the low fixed nominal interest rate. Accordingly, total expenditure reached 66 percent of GDP, or some 3 percentage points higher than the budget target. Expenditure overruns in social security payments arose from a de facto indexation and an agreement by the Government to reduce further the effective retirement age for certain occupations, which increased pensions. An overrun occurred in subsidies, which reached 15 percent of GDP, on account of unprofitable production as output prices were not adjusted in line with factor costs. The composition of subsidies also shifted, from agricultural producers to consumers of food products as agricultural purchase prices were raised without similar adjustments in retail prices. Most important, interest obligations reached 9 percent of GDP on a due basis, compared with the original budget estimate of 5 percent as a consequence of the depreciation of the market exchange rate used to value (and effect part of) these obligations.

As a result, the overall deficit of the general government reached 12.6 percent of GDP in 1990 instead of the budgetary target of 2.7 percent. A part of the financing needs was met by the moratorium on most external debt payments, but domestic financing still amounted to 10 percent of GDP. In an attempt to contain monetary expansion, the Government floated securities to the nonbank public in late 1990, essentially state enterprises with surplus liquidity, carrying an effective interest rate of almost 45 percent. As a consequence, bank financing was reduced to about 6 percent of GDP, and was entirely responsible for the 7 percent (in terms of leva) broad money growth during the year (higher than nominal GDP growth).

Developments in 1991

Fiscal Program

Early in 1991, a coalition Government launched a comprehensive reform program aimed at rapidly transforming the Bulgarian economy along market lines. The key immediate elements of the program were comprehensive price liberalization, unification of the exchange rate—which would be determined on an interbank market—and sharp increases of domestic interest rates in line with market conditions. A few prices were to remain administratively determined but only for a transitional period. These prices were mainly in the energy sector, and were increased by threefold to as much as tenfold in some cases. Incomes policy was to be tightened substantially to generate a decline in measured real wages of about 30 percent, in part to offset a similar decline in terms of trade. (However, the actual decline in real wages would be less, because the widespread shortages in 1990 at the official retail prices, now removed, overstated real wage levels.) These measures had significant effects on the 1991 budget.

Fiscal policy was intended to be supportive of the stabilization and restructuring program. Both to contain inflationary expectations that were bound to accompany the large once-and-for-all increase in the retail price index (projected to be nearly 300 percent) and to channel new foreign financing expected from the Group of Twenty-Four and the World Bank directly to the enterprise sector–especially the emerging private business sector–the 1991 general government budget aimed at a balance on a cash basis (after external rescheduling). This was to be consistent with a domestic surplus of 1.8 percent of GDP,3 compared with a deficit of 3.9 percent of GDP reached in 1990, while the overall deficit (on a due basis as regards external interest payment) would be limited to 3.5 percent of GDP.

Price reforms were expected to affect both the revenue and expenditure sides of the budget. First, the elimination of receipts from price and exchange rate differentials and other ad hoc transfers from enterprises was projected to reduce nontax revenue by almost 10 percentage points of GDP. Second, tax revenue was expected to decline by 6 percentage points of GDP,4 largely on account of (1) a tight wages and incomes policy and higher unemployment that would shrink the base for the income tax and social security contributions; and (2) the specific nature of excises on petroleum, which were not increased with inflation, essentially because of already large increases in the wholesale prices since mid-1990. In addition, a reform of the income tax toward greater equality of treatment for all sources of income was expected to lower revenue. However, despite a lowering of the effective overall profit tax rate on state enterprises from 67 percent to 52 percent as part of the ongoing reform of the tax system, profit tax receipts were expected to remain stable in terms of GDP at about their reduced level of 1990. This was to result entirely from the projected decline in real wages, which was expected to favor profits, and from measures taken to limit depreciation allowances and interest deductibility. The latter were viewed as critical to maintaining the base of the profit tax under transitional high levels of inflation.5

Turnover tax receipts were projected to rise as a result of streamlining tax rates and broadening of the base. As indicated earlier, the turnover tax was to be applied first at the ex factory level, and subsequently on the trade margins at the wholesale and retail levels.

More than half of the budgeted 25 percentage points of GDP reduction in general government expenditure was to reflect the sharp reduction in subsidies made possible by the price reform and liberalization, from 16 percent to 3 percent of GDP. The remaining subsidies would include small amounts for heating and electricity, and transfers to certain enterprises in agriculture and industry to cover operating losses. The budget also provided for most other expenditure categories to decline, especially maintenance and operating outlays in nonessential areas.

In formulating fiscal policy, account was taken of the need to redirect social benefits, noting the implications for self-sufficiency of higher income differentials, and to provide for unemployment and welfare benefits for those (temporarily or permanently) affected by the transition to a market economy. Social outlays were expected to show a significant increase, owing to rising unemployment, the specific welfare problems associated with changes in relative prices, and the impact of the removal of consumer subsidies on the purchasing power of pensions. However, it was not thought possible to change rapidly the “universal” feature of many social benefits in the short run; this is of course necessary for realizing the expenditure savings that should accompany better targeting. Hence, in 1991, social security outlays were projected to be above 13 percent of GDP.


The macroeconomic program pursued from early 1991 had two immediate and noteworthy effects. First, massive “once-and-for-all” price increases were effected without creating underlying inflationary pressure (indeed, the retail price index hardly increased at all during April-May). Second, the interbank exchange rate stabilized rapidly, although at a much more depreciated exchange rate than initially targeted (which necessitated a second round of price increases in June-July), with some partial reversal of the overshooting thereafter. Both these occurrences point to a successful early stabilization phase with regard to abating monetary pressures on price increases. However, inflation still averaged some 4 percent a month for the remainder of the year. Domestic demand–in particular household consumption–declined much more than anticipated and was not offset by the projected higher exports, which collapsed with the dismantling of the CMEA arrangements, while encountering difficulties in penetrating markets in the hard currency area. As a result, economic activity as measured by the GDP declined by an estimated 23 percent for 1991 as a whole, or substantially more than anticipated. However, unemployment rose by considerably less, to some 10 percent of the labor force or about 400,000 workers by year’s end, indicating substantial labor hoarding and declines in productivity. Most of the deterioration occurred in the first half of 1991.

The larger-than-projected decline in household consumption in early 1991 resulted from (1) wage increases by enterprises that were well within the ceilings set under the program’s incomes policy, leading to a decline in real wages of some 50 percent; and (2) an overshooting of prices that were freed, owing to the exercise of monopoly power by firms at the outset of the price reform, which further lowered real wages and depressed demand (the jump in the retail price index in the first three months of 1991 was substantially larger than expected–280 percent instead of 240 percent (at the end of the period)). Surprisingly, there was hardly any spending response from households to the large increase in their interest incomes. Indeed, despite mortgage interest rates being lower than deposit interest rates, households to a significant extent repaid loans, further reducing real monetary assets on hand and depressing consumption demand. Nominal wage increases exceeded inflation in the fourth quarter of 1991 and contributed to a recovery of real wages, which by the end of the year reached about 70 percent of their level of 1990. It appears, however, that this recovery was largely at the cost of rekindling inflation.

Broadly, the high interest rate policy appears to have had a much stronger contractionary effect than anticipated. The demand for new credit–to come from state enterprises restructuring and from new private sector businesses–was depressed, while other highly indebted state enterprises in difficulty attempted to capitalize the much higher interest due on their old debt. At the same time, they found the squeeze on liquidity made it difficult to secure new credits as long as they were not servicing their old loans. Such reluctance of banks–supported by regulatory and prudential measures imposed by the central bank–may have been quite rational since the restructuring of prices–in particular, of energy and other imported inputs–is likely to have made a large part of existing industries nonviable.

The macroeconomic developments in the first half of 1991 dramatically reduced government revenue. The bases of the two key revenue sources, the turnover tax and the profit tax, essentially collapsed, the first because of a decline in retail turnover by an estimated 70 percent, and the second because of the negative impact of demand-induced lower capacity utilization, in addition to terms of trade deterioration and higher costs of nonlabor inputs. Furthermore, the general liquidity squeeze and the uncertainty surrounding the massive realignment of prices and their effect on taxable profits made tax assessment and collection that much more difficult in an environment used to centrally planned tax liabilities and limited scope and incentives for noncompliance. Developments regarding the wage bill also contributed to shortfalls in social security contributions, while commitments on entitlements had to be met. In comparison with the original budget's target, the revenue shortfall in the first half of 1991 reached about 30 percent in real terms. However, the situation improved in the second half, which allowed the partial unwinding of noninterest budgetary arrears.

Two other institutional reforms have contributed additional pressures and uncertainty on the Government’s ability to collect revenue. The first is the introduction on April 1, 1991 of the new accounting system, which, as noted earlier, lowers the profit base while giving greater freedom to enterprises in determining depreciation expenses. To contain the immediate erosion in revenue, authorities have responded with the transitional measure of limiting interest deductibility for state-owned firms. In addition, because of its emphasis on prudential rules, the accounting law treats asymmetrically unrealized short-term capital losses and gains, with the latter not being treated as current revenue and thus not taxable.

The second change affecting revenue collection is the breaking up of the monolithic banking system and highly integrated system of firms into independent commercial banks and enterprises. This process affects in particular the tax payment system. While essential for developing the financial sector and the economy, it has loosened the control of the tax administration, as a growing number of state enterprises have different accounts in a growing number of banks. In any event, it is likely that profit-motivated banks will increasingly demand remuneration for operating tax-withholding services on behalf of the Government.

The breaking up of firms into many enterprises, and in particular the multiplication of wholesale and retail outfits as distinct from factory outlets, together with price liberalization, have led to a massive increase in the burden on tax administration. It is virtually impossible for the limited tax administration capabilities that were inherited to collect the turnover tax on trade margins at the wholesale and retail level, as was intended by the new turnover tax law. This has contributed to the revenue shortfall and points to the nature of the tax administration improvements that will have to be realized before the value-added tax (VAT) can be successfully introduced. The authorities, who plan to introduce the VAT in 1993, are in the process of strengthening their tax administration personnel, through both recruiting and training on a crash basis.

For reasons mentioned earlier, systemic changes in Bulgaria are bound to reduce considerably receipts from the profits tax on state enterprises. While there are signs of an emerging private business sector, this has been largely autonomous and the sector has escaped the tax net. Progress in privatization has been very slow so that state enterprises will remain the principal sector for taxation for some time to come. The authorities are fully aware that in addition to broad-based taxation of consumption, taxation of incomes of physical and juridical private persons will need to gain importance. Indeed, it is from this source that incremental revenues are most likely to be obtained through broadening of the base even if rates are cut.6 But as noted above, the required administrative capabilities remain to be developed.

The authorities reacted to the revenue shortfall in the first half of 1991 by cuts in expenditure, other than entitlements, and by delaying payments. This meant further declines in real terms for maintenance and operating outlays, defense and security, and capital expenditure. However, on an accrual basis, subsidies were somewhat above targets, largely because of the needs of the electricity and petroleum sectors, whose domestic prices reflected until May a less depreciated exchange rate than that prevailing early in the year. Social security outlays–including unemployment compensation–were protected and remained at the fairly high level of 13 percent of GDP. The resulting shift to a more expansionary fiscal policy stance appeared justified in view of recessionary tendencies that had developed in the economy. However, the authorities managed to keep the growth of expenditures below that of revenues in the second half of 1991, which enabled the domestic deficit to be contained to 3.3 percent of GDP, compared with the original target of a surplus of 1.8 percent of GDP.

The growing imbalance between maintaining the universality of social benefits as currently provided and the capacity to mobilize revenue to finance them has become a major structural problem on the expenditure side of the budget. It is a factor crowding out outlays on government economic services needed for the restructuring of state enterprises and for effecting the privatization program, and no allocations have so far been made for these purposes in the budget.

Another dramatic budgetary implication of the reform program in Bulgaria relates to the move to market-oriented interest and exchange rates. This has resulted in an official depreciation of the lev from 3 leva per U.S. dollar to about 20 leva per U.S. dollar, and a tenfold increase in domestic interest rates to some 50 percent in 1991, which has put considerable pressure on budget outlays.

Under central planning, it was not customary to tie servicing of debt liabilities to the end borrower, in part because the state owned both the enterprises and the banks. This was particularly evident in the case of external financing, for which the entire, sizable, external debt of Bulgaria (about US$ 11 billion) was contracted by the Foreign Trade Bank on behalf of the state, but which remained on the books of that bank. Only limited amounts were actually on-lent to the state budget (to pay for some capital expenditure), the borrowing being largely used to finance enterprise imports of material and equipment. Most enterprises paid cash for the foreign exchange, or borrowed leva at a low interest rate with no foreign exchange risk. In consequence, the Foreign Trade Bank found itself with large net foreign liabilities on which it paid international interest rates, while it earned very little on domestic assets, thereby progressively going into debt. This situation forced the state budget to take over the interest payments falling due. The recent large devaluations of the lev made it more difficult for the enterprises to service their debt and further weakened the balance sheet of the Foreign Trade Bank. As a result, the full amount of the quasi-fiscal deficit had to be transferred to the state budget. The latter encountered a huge increase in its external interest payments (in leva), from the equivalent of 3 percent of GDP in 1989 to an estimated 18 percent of GDP in 1991. Bulgaria’s declaration of a moratorium on its external debt servicing does not alter the fact that devaluation has made more transparent the eventual resource needs of the budget if inflationary financing is to be avoided.

Higher domestic interest rates have sharply increased the domestic interest payments of the budget. They have also dramatically increased the cost of house financing for the population and of circulating and investment capital for the enterprises. Given the extremely high level of indebtedness of enterprises, market-oriented interest rates have resulted in massive losses, creating severe liquidity problems, while showing how nonprofitable many past activities were. As a result, the loan portfolio of banks has become increasingly nonperforming and resources will have to be found to prevent the inflationary financing of resulting losses and to recapitalize the banks. The pressure of these various demands on the budget will be felt, especially when the planned substitution of government bonds for nonperforming loans takes place, which will have significant net costs for the budget.

Legislative Goals in Taxation

A noteworthy feature of the fiscal reform was the work initiated in mid-1990 to rewrite the tax laws. This formed part of broader legislative initiatives, which included a new accounting law and a privatization law, to meet the requirements of a market-oriented economy.

Regarding direct taxation, the draft new law proposed:

  • (1) A lower corporate, flat rate, profits tax of 40 percent in lieu of the variable rates amounting to an average effective rate of 67 percent in 1990 and earlier. The new profits tax would apply to all juridical persons, whether state owned or private; multiple past exemptions and special privileges are to be eliminated, although lower rates will apply to agriculture and joint ventures. The base for taxable profits would also be determined under the new accounting law, modeled after Western European standards. A main difference with the socialist accounting practices applied earlier was that certain payments made out of after-tax “balance sheet” profits under the old rules would become expenses before profits under the new rules, in particular interest payments, overhaul and repairs expenditure, management salaries and workers’ bonuses, insurances, and a number of research and social outlays.7

  • (2) Uniformity in the taxation of individual incomes, whether resulting from labor, professionals' and artists' activities, or business activities of physical persons. The proposed taxation eliminates the punitive taxation of nonlabor incomes, for which marginal rates quickly reached 85 percent. Interestingly, taxation of interest and dividend incomes would be introduced (the proposal is for final withholding of 20 percent), which under the existing regime are tax exempt, a feature that was earlier justified by the extraordinarily low (and administratively set) remuneration of capital and savings. The draft individual income tax law envisages marginal tax rates starting at 20 percent for incomes above the minimum wage, rising to a maximum marginal tax rate of 40 percent.

By the beginning of 1992, the above draft laws had still not been approved by parliament. However, a series of amendments to existing laws were passed as a transitional measure that largely affected the main provisions of the draft profits and income tax laws; in addition, the new accounting law became effective from April 1, 1991. Indicative of the confusion that can surround the move to a market economy, these amendments also introduced a number of tax incentives for private physical persons, such as full deductibility of investment expenses and loan amortizations, in addition to the deductibility of interest, a combination that has probably never been seen in most capitalist countries. While such excesses are to be repealed under the proposed law, they may have encouraged purely speculative activities.

In the area of indirect taxation, the Bulgarian authorities indicated from the outset their intention to replace the turnover tax with a modern VAT system similar to that in EC countries, but with strong preference for a single-rated VAT. During the transition, the turnover tax has been rapidly revamped, particularly to take account of price liberalization, since the turnover tax could no longer be defined as the difference between administratively set retail and wholesale prices, and the emphasis on the turnover tax as a main instrument to mobilize revenue under price and trade liberalization rather than to regulate demand and supply as under central planning. The turnover tax law was amended at the beginning of 1991, also to pave the way for the introduction of the VAT in 1993. Under the new turnover tax, rates of 0, 10, and 22 percent apply on final consumption goods and services, with the lower rates applicable to necessities. In theory, the base of the turnover tax was the retail prices (inclusive of the tax), although the law provides for it to be levied at different stages: first at the ex factory level, and second at the wholesale and retail levels, where it would be based on the trade margins. This provision seems to have anticipated difficulties in effectively administering the tax at the trade level in the context of newly liberalized price and trading practices, with a tax administration still only geared to taxing a few integrated large-scale state enterprises.

Interestingly, trade taxation has received only limited attention, although most quantitative restrictions have been removed and certain revenues have been eliminated from import price differences following price and trade liberalization. Most import duties have remained low (between 0 percent and 30 percent) on imports from industrial countries, while higher tariffs apply to certain luxury items such as imported alcoholic beverages and tobacco. Imports from former CMEA trading partners have continued to enjoy de facto duty-free status.

A draft law on tax administration has been prepared that will permit a revamping of the tax administration and provide it with the powers needed to enforce effectively a market-based tax system. The draft law proposes a much-needed centralization of the tax administration, whose functions were formerly distributed among several different agencies. Specific responsibilities and obligations are set up for taxpayers and the tax administration. These include powers that were formerly not needed, such as those allowing the tax administration to inspect business premises and books of account, as well as to ask for tax returns and, if necessary, to require taxpayers to come to the tax administration office with needed documentary evidence. Without such enabling legislation, the assessment of tax and its collection would remain a matter of voluntary compliance.


Bulgaria has initiated several important steps to bring about the profound transformation to a market-based economic system. A major beginning has been made in revising the laws to give legal expression to key market institutions, such as property ownership rights and the rendering of accounts in a manner that facilitates market transactions. A beginning has also been made in changing the institutions so as to give proper vent to these laws. Such actions are essential for price liberalization and market orientation to work well so as to secure the benefits of greater economic efficiency that are now being sought, which requires decentralization in decision making, preferably in the context of widespread private ownership and competitive modes of organization, in place of centralized command and control.

A corresponding sea change is needed in the public finances. Instead of providing the bulk of the needs of the population, the role of the government will have to be greatly reduced and the extent of state ownership of assets curtailed, so that government confines itself more to functions that are supportive of the private sector rather than discharging these functions itself. The resources to finance these limited activities will have to be raised with the consent of the population and in a manner that does least damage to economic efficiency, while the reduced outlays are more carefully related to their purposes, which will also have to be acceptable to the taxpayers. Many reforms are required of the various public finance components to bring about the needed overhaul, and some initial steps have been taken. The tax system is to be changed in the direction of a nondiscriminatory set of rules so as to provide a level playing field, dependent on lower marginal rates of tax that apply to a reasonably broad base. However, much of the proposed legislation has still not been enacted and in the meantime transitional rules are being applied, some of which are discriminatory and not consistent with the objective of raising revenue. An overhaul of the tax administration is needed urgently to ensure that state-owned enterprises pay their share to the budget, despite full decentralization of their activities, and that the newly emergent private sector is taxed effectively. The present state of confusion over tax laws in the minds of taxpayers, together with a highly deficient tax administration, can only lead to erosion in the revenue base.

On the administrative side, several comprehensive institutional restructurings are necessary, with the appropriate enabling legislation. Freeing private enterprise and promoting privatization will result in an explosion of private entities registering. It will no longer be practicable to audit each entity frequently and comprehensively; instead, a system of selfassessment will have to be encouraged. The size of the tax administration will have to be increased sharply, and officers with a different set of skills will have to be trained. Further, new procedures and functional specializations will have to be developed, while certain functions, such as disbursing subsidies and audit activities, will have to be assigned to other agencies set up for these purposes.

Price liberalization with full pass-through is eliminating one source of subsidies but it is making explicit those that were hidden because of below-market interest rates or foreign exchange rates. The macroeconomic reforms are also exposing the nonviability of several lines of activity, causing increased unemployment, which is unfortunately being further affected by the general contraction in demand aggravated by the collapse in demand from traditional export channels and a severe deterioration in the terms of trade. This is exerting pressure for increases in social welfare outlays. At the same time, greater outlays are also needed for infrastructural reforms to facilitate a more vibrant private sector.

The public sector compensation policy has to be reformed to internalize into the wage structure many of the benefits that were provided through generalized subsidies. But this will erode some of the savings from price liberalization. Above all, ensuring the efficient functioning of the new administrative structures will require adequate attention to incentives and the conditions of service of their staff. This will need to be combined with the elimination of overmanning so as to contain costs.

More effective systems of budgeting and targeting outlays are needed, with much greater reliance on contracts to ensure performance, than the past practice of direct orders. However, the appropriate budgeting procedures remain to be developed. A critical requirement is to have an accurate overview of the evolving budget, which will now be affected by variables such as interest rates and the exchange rate that are free to move and are beyond the direct control of the authorities. A flexible framework for estimating the changes in the budget and responding in time is needed that would be operated by a properly constituted macroeconomic policy and analysis unit in the Ministry of Finance.

As the account in this chapter demonstrates, a great deal remains to be done before the budget can become a satisfactory instrument of policy in a market context. The budgetary reforms required are difficult even in the best of circumstances, but in Bulgaria have to be undertaken while the budget itself is adversely affected by the macroeconomic reforms and the exogenous shocks. This greatly limits the tasks that the budget can accomplish in the short term. For the immediate future, the emphasis will have to be on stabilizing the economy, while meeting social safety net requirements that are urgently needed to maintain the consensus behind the reforms.

Sheetal K. Chand is Chief of the Fiscal Analysis Division of the Fiscal Affairs Department, and Henri R. Lorie is Advisor in European II Department.

For an account of some of the requirements for a successful fiscal policy in economies in transition, see Sheetal K. Chand and Henri R. Lorie, “Fiscal Policy,” in Fiscal Policies in Economies in Transition, ed. by Vito Tanzi (Washington: International Monetary Fund, 1992).

The other elements are (1) the budgets of the ministries; (2) the budgets of the regional people’s councils; (3) the budgets of the municipal people’s councils; and (4) the social security budget.

On excluding external interest due, which is a better indicator of fiscal policy stance as it is more directly correlated with domestic aggregate demand.

Based on an earlier estimate of 1990 GDP

Projections on profit tax receipts took into account the expected negative impact on the base of both the deterioration in the terms of the trade and of systemic changes related to the move to a market-oriented economy. The latter included (1) replacing consumer subsidies by higher prices that would not affect enterprises’ receipts (but increase GDP at market prices), and eliminating subsidies on inputs that would reduce accounting profits; and (2) the fact that real labor costs faced by the enterprises could decrease by less than the real wages of population because of the need to compensate for the removal of consumer subsidies by higher nominal wages. Higher interest rates were also expected to increase sharply profit tax receipts from banks.

Income tax receipts represent less than 4 percent of GDP in Bulgaria, compared with about twice that level on average in the European Community (EC).

It is estimated that the effect of the new accounting rules, had they been applied in 1990, would have been to reduce taxable profits by some 30-40 percent.

    Other Resources Citing This Publication