Over the past decade, many socialist countries with centrally planned economies have embarked on a process of change aimed at transforming them into market economies. If this process proves successful, it will in time provide these countries with the institutions necessary for private markets to operate successfully and with a government whose role is complementary rather than hostile to a market economy.

Over the past decade, many socialist countries with centrally planned economies have embarked on a process of change aimed at transforming them into market economies. If this process proves successful, it will in time provide these countries with the institutions necessary for private markets to operate successfully and with a government whose role is complementary rather than hostile to a market economy.

Although much has been written about the economic changes that must take place for these countries to become market economies, much less has been written about the changes that will occur in the role and function of the state in the economy. In the “shock therapy” approach to transition advocated by various economists, including Jeffrey Sachs, the main elements of the transition during the early phase are assumed to be price liberalization, macroeconomic stabilization, and privatization. Although the advocates of shock therapy were not explicit about it, they conveyed the impression that these elements would be sufficient to take these economies from where they were to where, at the time, their policymakers indicated that they wanted to go, that is, to become market economies.

In an interesting paper, Andrei Shleifer (1996) pointed out that although price liberalization eliminates government control over prices, and stabilization imposes a harder budget constraint on the government, and privatization deprives it of direct control over firms, these changes may be sufficient to destroy a centrally planned economy but not to change it into a market economy. For that to occur, many other, deeper changes have to take place. And to be sure, the proponents of shock therapy were silent about the role that the government should play in the new economic world.1

To function well, market economies need governments that are efficient at establishing and enforcing essential rules of the game (say, on competition), at promoting widely shared social objectives, at raising needed revenue to finance public sector activities, at spending productively the revenue thus raised, at bringing needed corrections to and controls over the working of the private sector, at enforcing contracts and protecting property, at producing public goods, and so on. Without the constable at the street corner, the private sector game can become very rough.

To perform these tasks, governments need well-developed institutions run by competent persons who are guided by correct incentives. In other words, the objectives of those running the institutions must not diverge from the objectives of the institutions, which must in turn be consistent with the public interest. Such institutions do not arise by magic. They need to be created and, once created, continually reformed. In industrial countries the creation of these institutions took centuries, and in some cases they are still being developed and improved. In transition economies their creation has had to be compressed into a much shorter time span and pursued under much less favorable circumstances. Given that some of the skills these institutions need were not easily available domestically, errors were inevitable. To perform its useful and essential functions, the government need not be large, as measured by taxes collected and money spent, but it does need to be efficient, especially in its regulatory role. Inefficient governments often cause major problems, especially when their sphere of action is broad and their powers are extensive.

When the needed public institutions do not exist, or when the incentives facing those who run these institutions are perverse, the government can easily become an impediment to economic activity, because it ends up being controlled for private gain. That is what normally happens with corruption (Tanzi, 1998). Corruption is the effective privatization of some parts of the government apparatus for the benefit of certain special interest groups or individuals. Social objectives then become difficult to achieve, and some actions of the government acquire a predatory nature. Governments cease to be market-friendly and become instead an impediment to the proper working of the market. In this context, and as a commentary on the limitations of the shock therapy approach, it should be noted that governments have many ways, besides price controls, ownership of enterprises, and macroeconomic imbalances, of influencing economic activities.

To set the stage for the discussion that follows, we outline some of the essential characteristics of the economic environment that prevailed at the beginning of the transition. At that time, the share of GDP derived from private sector activities was very small in all of the transition countries. It was less than 1 percent in such countries as Czechoslovakia and Russia and reached a high of almost 20 percent in Poland. By contrast, it was about 80 percent in the United States (see Saving, 1998). Economic production in the transition economies was overwhelmingly in the public sector, because few productive assets could be privately owned and few private activities were allowed—the government was everywhere.

Prices and genuine economic profits played a small role in the allocation of resources, which was determined by political decisions made within the planning office. In market economies political decisions have a major influence on the use of public resources but much less in the economy at large. In the environment that prevailed under central planning, it made little sense to speak of “public finance,” because the existence of public finance presupposes that of private finance.

These countries, moreover, did not need market-type tax systems to raise public revenue, because the government could simply appropriate any share of total, and mostly public, production for its own needs. As the owner of almost everything, the government would decide how it wanted to divide and use total output. Taxes were, in effect, mostly transfers from some activities to others. Thus there was little need for the tax administrations found in market economies. The function of these administrators was mostly to ensure that funds were transferred to the government account and that they were accounted for. More surprising is the fact that there was no budget office or budget law and no treasury.2 In this environment there could be no well-defined or fixed rules of law to which individuals or enterprises could appeal if they disagreed with the actions of the government.

Transition cannot be assumed to be complete at the point when prices have been liberalized, state enterprises have been privatized, and the macroeconomy has been broadly stabilized. It requires a far deeper transformation of the economy, institutions, and processes. Shock therapy deals with the easy or superficial part of the transition. A mature transition requires that most prices be liberalized and that many public enterprises be not only privatized, but privatized in a process that is seen as transparent and as fair as possible. Furthermore, not only the ownership of enterprises but especially their management must be freed from political interference. In this environment profitability becomes the guiding criterion for most investment decisions. Those activities deemed socially desirable are financed by the government and not by enterprises, public or private. The government needs to perform well its basic or core functions in the economy, and it should withdraw from, or drastically reduce its role in, many secondary or less basic activities. This is especially important with respect to its regulatory function.

Economies, like traffic, need some regulations. Like those that regulate traffic, the rules that regulate the economy must be few, must be clear, and must leave little scope to interpretation or discretion by either the citizens or the bureaucrats who enforce the rules. Whereas the guiding principle under central planning was that nothing was permitted unless explicitly authorized, the guiding principle in a market economy should be that everything is permitted unless expressly forbidden. Adherence to this principle would eliminate a substantial portion of unnecessary governmental interference in the economy and would reduce corruption.

In the fiscal domain, which includes public revenue collection and public spending, a successful process of transition requires the creation of necessary and well-functioning fiscal institutions and of reasonable and affordable expenditure programs. Spending programs should include the provision of basic safety nets against fundamental risks such as becoming unemployed or old or ill. These safety nets and expenditure programs must be similar to some of those common in market economies rather than those inherited from the past. The yoke of past commitments must be minimized. This is particularly important in the area of pensions and employment. A market economy cannot guarantee a job for everyone; therefore, social provisions for unemployment are necessary. The pension commitments made by the government must be consistent with the new fiscal reality. Also, in an environment where real GDP is shrinking, as it has in many of these countries, budgeting becomes extremely difficult. It is especially in this environment that the government must focus on essential social needs and reduce its commitments to realistic levels. This requires major reforms.

When the transition economies reach their final destination, their governments will have spending programs that can be financed from public revenue, generated without creating an excessive burden on the private sector.3 Because public expenditures are financed primarily by tax revenue, and a country’s level of taxation, other things being equal, depends on its economic development and on the sophistication of its tax systems and tax administrations, this revenue constraint must be kept in mind when determining the programmed level of public spending. Once spending plans are made, they may be difficult to change, especially in a downward direction. This is especially relevant for expenditures, such as pensions, health benefits, and public employment, that involve long-term commitments.

Tax revenues in developing countries are generally about half as large as a percentage of GDP as those of industrial countries. In terms of income per capita and economic structure, most of the economies in transition are, by and large, much closer to developing countries than to the industrial countries. Thus one would expect to see, over time, a tendency for the share of taxes in GDP to fall toward the 15 to 25 percent range prevailing in the richer developing countries, even though in some transition economies the ratio of taxes to GDP might still be much higher today. This points to the need for countries to be realistic in the expenditure programs to which their governments commit themselves.4

Finally, because the desirable role of the government emerges not just from economic considerations but also from the interplay of political and economic forces, the views of the executive branch of government must broadly match those of the legislative branch if a coherent definition of that role is to result. This outcome, of course, is influenced by the political process by which legislators are chosen and the executive branch of government is created. If the executive and legislative branches are miles apart in their views of what the government should do, as has been the case in Russia and in some other countries, it is unlikely that an optimal government role or rational policies can emerge.

In a similar vein, clear rules must establish the fiscal responsibilities of the subnational and the national governments, because the role of government cannot be defined only in terms of the national government.5 These rules cannot be allowed to become too flexible, and they must be precise enough to indicate when one level of government is overstepping its limits. In several transition countries the fiscal arrangements between national and subnational governments are vague, and the activities of local governments have been largely uncontrolled. In some countries, despite the importance of subnational governments in the fiscal area, a kind of iceberg mentality has developed in which all the attention has gone to the visible part (the national government) while the role and activities of the subnational governments have been largely ignored. In Russia, for example, so much attention has been paid to the difficulties of the national government in raising revenue that a widespread perception has developed that Russian taxes are low and that the solution to Russia’s fiscal problem is an increase in tax revenue. Rather, what is needed is a rationalization of total spending or a reallocation of tax revenue between national and subnational governments.6

Progress Toward General Reforms

How far along has the process of transition come? Focusing only on the shock therapy aspect of the transition gives the impression that much progress has been made (see EBRD, 1998). Indeed, in some countries and in some areas, this is the case. But in other countries and in other areas, transition still has a long way to go. In some countries one gets the impression that the old system is largely gone but that a new system is far from coming into existence. A kind of institutional vacuum has thus developed.

The private sector share in GDP, which was almost insignificant 10 years ago, has risen dramatically in many countries, to 70 percent or more in countries like Albania, Czech Republic, Estonia, Hungary, Lithuania, Russia, and Slovak Republic. Only in Belarus, Tajikistan, and Turkmenistan does it remain at 30 percent or lower. Although impressive, these percentages refer to privatization of ownership and not necessarily of management. In many countries either the same managers are running the enterprises as were running them 10 years ago, or the managers continue to behave as if the enterprises were still state owned.

One intriguing aspect of the privatization experience is the low correlation between what has happened to state ownership and the fiscal proceeds from privatization. As already mentioned, the state owned almost everything before the transition, and “everything” probably meant a multiple of GDP in total value.7 Yet the fiscal revenue that the government realized from the sale of its assets was minuscule (Table 1). Privatization proceeds in transition economies were, in fact, much smaller than those in many developing or developed market economies (with the notable exception of Kazakhstan, where privatization centered around the primary sector).

Table 1.

Proceeds from Privatization in 25 Transition Economies

(In percent of GDP)

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Source: Data provided by the national authorities and Fund staff estimates.Note: BRO = Baltics, Russia, and other former Soviet Union countries; … = no data.

Averages are unweighted.

There are several reasons for this outcome, but the results are the same. A small group of individuals used their positions or their connections to amass enormous wealth. Privatization was in effect a fire sale to which only a privileged few were invited. In Russia, for example, it was reported that assets valued at $50 billion to $60 billion were bought for $1.5 billion. Schleifer (1996) has raised the question of whether a society where individuals have become so rich by essentially raiding the public treasury would be inclined to pass laws that protect private property. In these circumstances, privatization, which must be a fundamental step toward a market economy, becomes itself an obstacle to the enforcement of a fundamental prerequisite for a market economy, namely, the protection of private property.

Privatization of enterprises to the nomenklatura (communist elite) and other similar developments have dramatically changed the income distribution of the transition countries. Before the transition these countries had some of the most equitable income distributions in the world, an achievement of which the leaders of these countries were very proud. As Table 2 shows, the Gini coefficients for the period 1987–88 were in the low 20s in most centrally planned economies, which was very good by international standards. By the mid-1990s, however, the Ginis had increased sharply, and in the Kyrgyz Republic, Russia, and Ukraine they had reached values seen only in a small group of developing countries. These coefficients have probably increased further more recently. What is worse is that this increase in inequality occurred not because those who had moved up in the income distribution had created wealth, but because wealth had been raided from the government, at times with the implicit connivance of the government.8

Table 2.

Changes in Income Inequality in 18 Transition Economies

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Sources: United Nations Development Program (1996); Kolodko (1998).Note: For most countries, the income category for 1993–95 is disposable income. In 1987–88 it is gross income, since, at that time, personal income taxes were small, as was the difference between net and gross income. Income includes consumption in kind, except for Hungary and Lithuania in 1993–95.

Data are for 1989.




Countries where income differences had been sharply compressed in the past found themselves, within a few years, with some of the richest men and women in the world living a life of conspicuous consumption. Some of these newly rich individuals also acquired substantial political power. It is easy to guess the reaction of the populations of these countries toward the economic changes that allowed this to happen. In such an environment, many of the measures necessary to make a market economy vibrant and efficient will be seen by the majority of the population as measures taken to protect the ill-gotten wealth of the new rich. It should therefore be no surprise if such measures do not encounter an easy time in the political process.

In conclusion, it should not be surprising if privatization is not seen as a sign of positive progress toward a market economy. At some point, the governments of these countries will have to take seriously their role in promoting equity. After all, the pursuit of a socially accepted income distribution is one of the fundamental roles of government. It remains to be seen what form this role will take, although it is not likely that it will be one friendly to a market economy.

Much progress has been made in the liberalization of prices and in some other reforms. Table 3, from EBRD (1998), ranks countries on an index of price liberalization that goes from 1 (little progress) to 4 (much progress). Although some countries (Belarus, Turkmenistan, Uzbekistan) score poorly, most show some progress, and a few (Hungary, Poland) display significant progress. Of course, although a movement from 1 toward 4 is a welcome indication of progress toward complete price liberalization, in a second-best world the removal of one restriction while others remain in place provides no guarantee that efficiency has increased. If the remaining price controls are in large and vital sectors such as energy, they may imply large distortions.

Table 3.

Private Sector Share of GDP and Indexes of Economic Reform in 26 Transition Economies

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Source: EBRD, (1998).Note: Indexes are from 1 (least) to 4 (most reform).

EBRD estimate.

Figure 1, also from EBRD (1998), is a useful visual presentation of the pattern of shock therapy reforms summarized in Table 3. This would lead one to conclude that much has been accomplished, but that there is still a long way to go.

Figure 1.
Figure 1.

Average Transition Indicator Score by Region

(Average score)

Source: EBRD (1998).

Fiscal Reforms in the Past Decade

The 1990s saw major reforms in most transition economies. Some were much more successful than others. As a consequence, as Figure 1 shows, countries differ widely in the extent of progress achieved. In general, the Central and Eastern European countries and the Baltic countries have made rapid progress, whereas the other countries have been less successful in establishing fiscal institutions, in controlling fiscal imbalances, and in redefining the role of the state. But even within these broad groups of countries, differentiation is very important. The discussion that follows provides a broad overview of some of these changes.

In the pretransition economies, most tax revenue was obtained from three major sources: turnover taxes, taxes on enterprises, and payroll taxes. Foreign trade taxes also provided some, but never much, revenue. These revenue sources generated very high tax revenues (at times up to 50 percent of GDP) without the need for full-fledged or sophisticated tax administrations. Taxes were not collected on the basis of detailed and codified tax laws that precisely defined tax bases and taxed them at parametric rates while respecting taxpayers’ rights. Rather, especially for taxes on enterprises, they were collected largely on the basis of negotiations between the enterprises and government officials. The government was always free to change the rates and, in fact, it did so often (Tanzi, 1994). Turnover tax rates, for example, were not even published and were often changed. In this environment, tax liabilities tended to be soft and negotiable rather than well-defined and rigid obligations. When an enterprise was in difficulty, its taxes were negotiated downward; when the government needed extra revenue, they were negotiated upward. Under central planning, then, taxes, unlike death, were not certain.

Certain characteristics of the centrally planned economies made the collection of these taxes relatively simple. First, the authorities knew, from the central plan, the quantities of goods being produced by the state enterprises. Second, the monobank played an important role in processing payments and in imposing restrictions on how payments were to be settled. Third, the high concentration of economic activities in a few very large enterprises made controls and tax collection much easier. In this environment, most individuals never met a tax inspector and never had contacts with the tax authorities. As most taxes were hidden from those who finally bore them, most people were not even aware that, indirectly, they were paying high taxes. Thus, a “tax consciousness” or a tax culture never developed. This tradition created a hostile attitude toward the payment of explicit taxes brought about by the transition (Kornai, 1997) and has made the imposition of a transparent tax system more difficult.

The impact of the transition on the traditional revenue system was radical and damaging. The process of transition destroyed the plan and thus eliminated the information (good or bad) that the plan had provided on quantities produced and on prices at which output was sold. The government now had to rely on other sources, including taxpayers’ declarations, to get this information. As a consequence, the prospect of tax evasion arose. The number of producers, and thus the number of potential taxpayers, increased dramatically with transition, as many new private sector activities came into existence. Tax administrations that had been used to dealing with relatively few, friendly enterprises had to deal with hundreds of thousands or even millions of unfriendly taxpayers. Some of these administrations were hardly prepared for this change and were slow to adapt. The large state enterprises that had provided the bulk of tax revenue began to lose importance, while the new, small, and difficult-to-tax private producers became the most dynamic sector of the economy, where much of the growth originated. These required a lot of close attention on the part of the tax authorities because of their high propensity to evade taxes. At the same time, however, they required protection from unscrupulous tax officials. Tax evasion and corruption on the part of tax officials had hardly existed in the previous system. Restrictions were also removed on methods of payments among enterprises and taxpayers in general that had existed when all payments were channeled through accounts with the monobank. Unfortunately, in the new environment, payments in the form of barter and tax arrears have grown, creating major difficulties for the new tax system. Finally, the transition created income and production in areas such as financial markets that had not existed in the previous system and that often involved foreigners.

All these changes and others not mentioned reveal why the old tax systems could not simply be reformed at the margin. Rather, totally new tax systems, capable of operating in the new environment, were needed. Yet such systems required not only new tax laws but also new fiscal institutions and new skills. Tax laws could be imported or even copied from other countries. The new fiscal institutions, however, had to be created from scratch, in circumstances that were far from ideal. These new institutions (such as tax administrations) needed financial resources (for computers and new staff, for example) and specialized skills (accountants, lawyers, computer specialists, auditors, and others). At the same time, they needed clear strategies and objectives, well-defined legal powers vis-à-vis the taxpayer, and well-defined legal obligations toward those taxpayers. These would establish clear rules of the game, which, like Chinese walls, would separate them from the inevitable pressures—from powerful political figures in the legislative branch, in the executive branch, or in local governments—to reduce the tax liabilities of specific taxpayers or to close their eyes to tax arrears.

All these reforms are necessary to establish a market-oriented system guided by the rule of law. However, they are so demanding in terms of time, resources, skills, technical knowledge, and political capital that only a few transition economies have been able to meet them. Even the leaders of the transition, such as Hungary and Poland, have not yet completed the process of creating new tax systems and tax administrations. Many other countries lacked the financial resources, the specialized skills, or a clear understanding of what needed to be done, or the ability or willingness to insulate the day-to-day administration of the tax system from political interference.

Many countries tried to patch up the old institutions to make them behave like new ones. But as the saying goes, it is difficult to teach old dogs new tricks. Often the poorly paid personnel of these institutions, schooled in the old ways, were themselves the main obstacle to change, and those put in charge of these institutions often had very limited knowledge of how tax administrations work in market economies. The incentives facing them were to maintain the old system. It would have been far better at the outset to create new institutions from scratch.

Many governments have failed to accept or to understand that, in a market economy, a tax system should be a parametric tool with one overwhelming objective, namely, to raise revenue in as efficient and equitable a way as possible. Rather, the tax system came to be seen as a multipurpose tool that should accomplish many things, including keeping failing enterprises in business, sustaining employment by allowing money-losing enterprises to pay wages instead of taxes, and stimulating economic activity. In some ways, the tax system replaced the plan as the key instrument for economic and social policy. Thus, in some of these countries, taxes have continued to be soft or nonpara-metric, especially for large enterprises, and key ministers have continued to spend much time dealing with individual taxpayers’ tax problems rather than reforming the tax system (Tanzi, 1998).9 This may have sharply increased the tax burden on that part of the economy that could not benefit from this preferential treatment.

Tables 4 and 5 report data on tax revenue and total general government revenue and grants as percentages of GDP since 1992 or, in the case of some Eastern European countries, since the late 1980s. Although Table 4 shows a large fall in tax revenue across most countries since the late 1980s, it also shows the wide range in tax burdens. For example, at the low end of the spectrum, the ratio of taxes to GDP ranged from under 6 percent in Georgia during 1993–95 to about 13 percent of GDP in the Kyrgyz Republic and Tajikistan during 1996–98. At the high end of the spectrum, one finds Slovenia, Czech Republic, Slovak Republic, and Poland with tax burdens exceeding 37 percent of GDP. Hungary and Slovenia have the highest tax rate at over 41 percent. These higher tax ratios are unlikely to be sustainable over the medium or the long run.

Table 4.

Tax Revenue in 25 Transition Economies

(In percent of GDP)

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Source: Data provided by the national authorities and Fund staff estimates.Note: BRO = Baltics, Russia, and other former Soviet Union countries; … = no data.

Averages are unweighted.

Table 5.

General Government Revenue and Grants in 25 Transition Economies

(In percent of GDP)

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Source: Data provided by the national authorities and Fund staff estimates.Note: BRO = Baltics, Russia, and other former Soviet Union countries; … = no data.

Averages are unweighted.

Despite the high tax ratios still prevailing in many of these countries, it has not proved possible to completely close the fiscal deficit. In many of these countries, especially the larger ones, public spending has remained very high as a percentage of GDP. One reason is, of course, that many of these countries have experienced falls in their output, which would have required extraordinary cuts in spending to reduce the ratio of spending to GDP. Another reason is that there has not yet been a well-thought-out policy of shrinking the role of the state. The government remains engaged in far too many activities.10

Table 6 reports data on general government expenditure and net lending as a percentage of GDP. For 1998 one still finds shares of 41.7 percent in Belarus, 36.7 percent in Ukraine, and about 40 percent in Russia. The Central and Eastern European countries also show very high shares. With such high expenditure rates, it is not surprising that most of these countries are still experiencing large fiscal deficits (Table 7).

Table 6.

General Government Expenditure and Net Lending in 25 Transition Economies1

(In percent of GDP)

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Source: Data provided by the national authorities and Fund staff estimates. Note: BRO = Baltics, Russia, and other former Soviet Union countries; … = no data.

Including identified expenditure arrears.

Averages are unweighted.

Table 7.

Overall General Government Balance in 25 Transition Economies1

(In percent of GDP)

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Source: Data provided by the national authorities and Fund staff estimates.Note: BRO = Baltics, Russia, and other former Soviet Union countries; … = no data.

Data are on a cash basis. Negative numbers represent deficits.

Averages are unweighted.

Two observations emerge from these tables. First, the data in Table 6 indicate clearly that either governments are budgeting on the basis of past national incomes and have not reacted to the fact that most of these countries are much poorer than they used to be, or they have not recognized that, as market-oriented economies, their capacity to sustain high levels of expenditure will be limited. Some of the Central European transition countries, for example, are trying, imprudently, to maintain expenditure levels typical of rich welfare states. Second, the fiscal deficits shown in Table 7 are measured on a cash basis and do not show fully the pressures exerted on the fiscal authorities when budgeted expenditures far exceed financial resources. As a result, the authorities have to rely on unorthodox methods for cutting expenditure, such as across-the-board freezes, sequestration, and cash rationing. Such actions may help preserve macroeconomic balance but at the cost of corrupting the budgetary process. This raises an important question: If the government does not abide by its legal obligations, how can it expect that others will?


We began with a brief discussion of the role of government in the old system. This role was overwhelming. We also argued that major changes need to occur to complete the transition. Some of these changes—essentially those visualized by the shock therapy approach—are superficial. Others—such as the creation of many new institutions, changes in incentives, changes in processes, changes in the role of government, and so on—are deep. The latter are much more difficult and time-consuming because they involve profound structural reform and major changes in attitudes, incentives, and relations.

In the new world of market economies, the role of government must change dramatically. Government will no longer seek to achieve its objectives through direct controls, but rather mostly through the tax system, the budget, and a few essential regulations. The tax system should be totally reformed to make it efficient and equitable and to provide a reasonable level of taxation. Expenditure policies should be changed to bring them more in line with reduced public resources. At the same time, regulations must be fundamentally modified. New essential regulations will have an important role to play, for example in setting the rules of the game, regulating private pensions, and enforcing competition, but most permits, authorizations, and other things that lend themselves to the extraction of bribes must disappear. It is a known fact that these regulations promote corruption, which for many of these countries remains very high (Table 8).

Table 8.

Corruption Perception Indices for 15 Transition and Socialist Economies

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Source: Compiled by Johann Graf Lambsdorff, Göttingen University.

Data are averages of several subsidiaries. An index of 10 denotes the absence of corruption, and an index of zero denotes maximum corruption.

Given what has happened to Gini coefficients in these economies, and given the experience with privatization, it is reasonable to expect that governments will be asked to play a more positive role in income redistribution. It is not unthinkable to expect that those who made fast money by raiding the public treasuries will be singled out for special attention in future years.

Policymakers should work hard at harmonizing the conception of the role of the state that seems to prevail in many legislatures with one that is feasible, given existing macroeconomic conditions and the level of institutional and economic development in these countries. A campaign to educate the public and legislators on what the state is expected to do in a market economy and the limits to what it can do would be useful. However, those who take on this function will have to be persons of great credibility.

A fuller realization is needed that, although large fiscal deficits are often a macroeconomic problem, they also become fundamental problems when they force governments into reneging on their legal contracts by imposing across-the-board expenditure freezes and sequestrations. These actions represent a form of corruption of the whole budgetary process and, more generally, of a market economy. When a public employee puts in a day’s work and is not paid, or when pensioners do not receive the pensions to which they are legally entitled, there is something fundamentally wrong with the whole political budgetary process.11


The papers in Bokros and Dethier (1998) give a feel for what deep reform means.


Budgetary allocations to various functions and programs were made through the central plan, and the treasury function, especially in its cash allocation role, was performed by a department of the single state bank, called the monobank.


For example, some economists have argued that, in countries with defined benefit pension systems, high pension commitments required high payroll taxes, and high payroll taxes discouraged employment or forced enterprises to go underground to evade taxes, thus reducing public revenue. The empirical relevance of this observation is not clear.


There is no question that in some transition economies, such as Hungary, the level of public expenditure is much too high (see Bokros and Dethier, 1998).


Obviously the assignment of revenue must bear a clear relationship to the assignment of expenditure. Subnational governments must be given adequate resources to meet their commitments, and their budgets cannot be soft.


At 28 percent of GDP, tax revenue in Russia is not very low. General public revenue is even higher. As large sectors of the economy are not taxed, however, the fully taxed sector of the economy is likely to experience particularly high tax burdens.


In fact, given that resources were not used productively, the total wealth-GDP ratio is likely to have been particularly high.


The sharp fall in the incomes of some groups (such as pensioners) also contributed to this deterioration in Gini coefficients.


In countries where local governments are important, the personnel of the tax administration have had difficulty determining whether their allegiance is to the national government or to the local governments that often provided them with housing, offices, and so forth. Often, national taxes have received less attention than local taxes.


For example, in many countries the government is still heavily engaged in the provision of housing and continues to subsidize energy consumption. The price of energy in the majority of transition economies remains much lower than in market economies.


On the other hand, when macroeconomic difficulties lead to inflation, which reduces the real value of what some individuals receive, at least the legal obligations have been met.


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