The paper surveys the role of financial markets and fiscal institutions in the transformation process going on in Eastern and Central Europe. It highlights (a) the need to create some sort of “social ecological balance” necessary for the working of a modern market economy; (b) the need to develop appropriate financial institutions that can mobilize savings and allocate them efficiently; and (c) the major reforms necessary in the fiscal area. It also calls attention to the extent to which monetary and fiscal policies overlap in these countries and the implications of that overlapping.


The paper surveys the role of financial markets and fiscal institutions in the transformation process going on in Eastern and Central Europe. It highlights (a) the need to create some sort of “social ecological balance” necessary for the working of a modern market economy; (b) the need to develop appropriate financial institutions that can mobilize savings and allocate them efficiently; and (c) the major reforms necessary in the fiscal area. It also calls attention to the extent to which monetary and fiscal policies overlap in these countries and the implications of that overlapping.

I. Introduction

In an interesting and thoughtful essay on “Issues in the Reform of Socialist Economies” (in Corbo et al, 1991) Fischer and Gelb made an assessment of the time that it would take for various reforms to be completed. They estimated that most reforms would take at least a few years, but some would take longer. “Institutional reforms” and “large scale restructuring and privatization” would require ten years, while “other financial market reforms” would take more than ten years. The reform of the public finances was not included in this assessment, but it is unlikely that it can be completed within a decade.

The fact that different sectors will require different times to be successfully transformed implies that the process cannot be a smooth one. Rather, It will be a very bumpy one. The staggered introduction, or better completion, of institutional changes will create uncertainty and it will, thus, affect decisions. Economic agents will continually face the possibility that each step might not be followed by the next required one. In some cases the option value of waiting will become particularly high.

An important aspect of the transformation process that has not received the attention it deserves is the complementarity or interdependence of institutions and skills in a modern economy. 1/ Modern economies are like ecological systems: their various components--institutions, industries, professional skills--support each other. In planned economies, the planners tried to anticipate and cope with this interdependence directly but, as we now know, they often failed badly. In a market economy the required skills and institutions often develop on their own on the basis of competition, with some governmental assistance and, at times, with some governmental hindrance. The market mechanism and the freedom of actions of individuals not only ensure that the right amounts of goods and services (with well known exceptions) are produced. They also ensure that, to a large extent, the right amounts of skills and the right kinds of institutions come into existence. 2/

One can theorize that over several decades, advanced western economies have achieved a sort of social “ecological balance” among their institutions and the available skills. The demand for certain skills (accountants, tax lawyers, economists, managers, engineers) and certain institutions (commercial banks, savings and loans institutions, futures markets, real estate markets, regulatory agencies, investment banks) has brought those skills and institutions into existence so that some kind of institutional and professional equilibrium has been established.

As the centrally planned economies attempt to transform themselves into market economies they will come to require some of these skills. For example the restructuring of the commercial banks and of the public enterprises, or the introduction of a full-fledged tax on the profits of the enterprises, will require accounting and managerial skills not available in these countries and that cannot become available in sufficient quantities in the short or even the medium run. This deficiency will inevitably slow down the transformation process and will increase the chance of derailments. It will also require that, In order to economize on those skills, the institutions that are created, especially at the beginning, must be the simplest possible. Thus, transplanting sophisticated western institutions to these countries without major adaptations will not do. This particular problem must be kept in mind as we discuss future developments of financial and fiscal institutions.

The staggered introduction of institutional reforms implies also that at any one time the spotlight of reform will be on a particular social group, be this the workers or the managers of particular enterprises or the managers of commercial banks. As is well known, the most difficult reforms to carry out are often those which increase the general welfare at the immediate cost of particular groups. These groups will have a strong interest in organizing themselves politically and in opposing some of the changes. In a democratic environment they have the freedom to articulate and defend their views. It will take strong and enlightened governments and much public explanation of the need for reform to keep the process going. The need for public explanations will be particularly strong in justifying policies aimed at reducing government expenditures.

The subject of this paper is broad and accordingly can be dealt with only in broad strokes and by focussing on a few major issues. In Section II, the paper will briefly discuss the very limited role played by financial markets and public finance institutions under classical central planning; it will also highlight the fragility of the traditional set-up and the reasons why it could not survive the transition to a market economy. This is largely a descriptive section that could be skipped by those familiar with the institutions of centrally planned economies. Section III will discuss the main changes that need to take place in the financial institutions, some of which are already taking place. Section IV will discuss the needed changes in fiscal institutions. Section V will call attention to a few selected issues where the limitations in financial institutions may limit the scope for fiscal policy and where the limitations in the fiscal institutions may limit the scope for monetary policy. To my knowledge the issues discussed in this section have not been addressed before, even though they are fundamental to the reform process. Section VI will provide a brief conclusion.

II. Essential Fiscal and Financial Elements of Central Planning

We start with a situation where the typical citizen owns few if any assets besides money holdings. Much of the country’s wealth is socially or publicly owned. The citizen is not expected to save and accumulate wealth since the state will take care of him/her in old age or illness. Unemployment does not exist officially since the state enterprises are required to hire individuals even when they do not need them. 1/ These state enterprises account for anywhere between 70 percent and 100 percent of total production. 2/ The individual receives a cash income from work that is much smaller than the total compensation. A large proportion of the individual’s total income is in the form of subsidized housing, free education, free health services, subsidized transportation, subsidized food, subsidized vacation, etc. In other words, many consumption decisions for the individuals are made by the state (or the public enterprise in which he/she works). 3/

To a considerable extent the state decides and determines both the level and the pattern of consumption of the individual. Even the way the individual uses his/her cash income is greatly influenced by the state because of its influence on the availability of goods and services and on their relative prices. At times, the individual is forced to save by the unavailability of goods in the shops or by the long time required to buy goods (queues). 4/ Credit to individuals is rare and, when available, is directed toward particular and socially approved purchases, such as houses. Interest rates on individuals’ savings held in banks are low or even negative in real terms. Individuals are, for the most part, prevented from holding any other financial assets, except for the rare occasions when there are government bonds which they can buy.

Individuals, as individuals, have little influence on the allocation of resources, on the overall rate of saving, on the pattern of production, on the level and allocation of investment, on the rate of interest, on relative and absolute prices, or on imports and exports. Even decisions as to where the individuals will live or work are largely made centrally through the allocation of housing or jobs. These decisions greatly constrain the (free) mobility of labor within the economy.

The key instrument for the allocation of resources is the annual plan. The plan is conceived in physical terms and prices play largely an accounting role. The plan determines the shares of the total physical resources of the country that will go into consumption and investment. It determines the level of production of different products and the allocation of investment to different industries and enterprises. 1/ It is also through the plan that budgetary decisions are essentially made. Of course, the plan must occasionally cope with unexpected developments such as natural disasters, weather fluctuations, and large changes in import prices. As a consequence it cannot ensure the final outcome. In the 1980s planned outcomes and actual outcomes started to diverge by increasing amounts in all the centrally planned economies. The plan had been more effective in dealing with a simpler economy. Its effectiveness was reduced by the increasing complexity of a modern economy.

Within this classical system the role of financial markets and of public finances, as this role Is understood in the West, was very limited. Within its own parameters the system developed by classical central planning was very effective. It is easy to see how some Western economists came to be fascinated by it. There was an attractive aesthetic quality to it. It did not require messy financial and fiscal institutions, and the allocation of resources was achieved simply and effectively. 2/ The distribution of income was determined directly through the control of prices and wages, by government imposed obstacles to saving and wealth accumulation, and by the government-imposed utilization of labor on the part of the state enterprises. Private activities were forbidden or discouraged; when allowed, they were taxed at prohibitive rates. Economic fluctuations in output and prices were not supposed to occur; therefore, there was no need to develop policies aimed at stabilizing the economy.

Unfortunately, this simplicity and effectiveness carried a high and increasing price tag. While the resources may have been allocated simply and effectively, they were also allocated very inefficiently. Leontief once remarked that these economies had developed a peculiar input-input system: resources went into the system but nothing came out of it! As time passed, corruption became a national pastime and more and more resources were siphoned off to a growing underground economy. 3/ This underground economy became a cancer for the official economy leading to more and more distortions of the official accounts. The loss in output resulting from the inefficient allocation of resources also became progressively larger and the income gap between the centrally planned economies of Eastern Europe and the market economies of Western Europe became very large. This gap would eventually undermine the system. 1/

Let us consider briefly the financial and fiscal sectors within this classical central planning system. Normally, banking and credit operations were monopolized by a state bank (a monobank), with unlimited power to create bank deposits. 2/ Credit was allocated directly by this bank or by its branches, which specialized in various activities or regions. Interest rates and the exchange rate played no allocative role and no role in determining the total amount of money in circulation.

The monetary system--consisting broadly of the monobank and its specialized branches --was a tool of the plan. As Sundararajan has put It:

“…the physical plan dictates a financial plan, decomposed into a budget, a credit plan and a cash plan. Monetary policy is exercised through controlling the volume of credit to state enterprises and budget entities and making available the growth of cash in line with the planned gap between monetary receipts and outlays of the household sector. The state bank has little autonomy but is charged with monitoring the observance of the central plan by guaranteeing the enterprises the loans needed to carry out planned transactions and by seeing that these loans, and the enterprises’ own deposits, are used for these transactions. Every transaction of any importance, such as enterprise withdrawals of cash for wage purposes, must be affected through the drawing of a check on the state bank.” (p. 251).

The state bank combined the role of commercial bank and central bank and was also the treasurer for the government’s public finances. The accounting system for public finances facilitated immediate and automatic access to monetary financing of fiscal deficits. Risk considerations did not affect lending decisions to state enterprises since the borrowers were public entities and presumably could not or would not be allowed to go broke. When the monobank lent money to the state enterprises it was as if the public sector were lending to itself. In any case, the losses of some enterprises were expected to be covered by the gains of others. It should be emphasized that when the monobank lent money to losing enterprises which would be unlikely to pay back, it was performing not just a banking function but essentially a fiscal function. The state enterprises themselves, by providing several social benefits to the workers, were performing important fiscal functions. Therefore, it was difficult to separate fiscal from monetary or even industrial policy. This issue is addressed again in Section V.

The state bank with its branches also played another important fiscal function besides that of treasurer and cross-subsidizer of the activities of the state enterprises, namely, it facilitated the collection of taxes. Given that producer and consumer prices were both controlled, turnover tax rates reflected essentially the difference between these two sets of prices, a difference that, for some products, could be negative. 1/ Since producers and retailers both had accounts with the state banks 2/ and since production quotas indicated the level of production of the state enterprises, especially assigned fiscal agents could monitor the sales by the enterprises and, on the basis of the fixed prices, they could easily determine the required tax payment. Thus, the account of the producer was adjusted downward by the size of the tax payment.

Taxes on wages were also collected directly from the enterprises often by simply adjusting the cash transfers made to them to pay the wage bill. 3/ Profits taxes were not based on any clear and objective definition of income but were largely negotiated amounts which did not require precise measurement of the enterprise’s profits. 4/ All this means that these countries did not have, and did not need, western style tax administrations and the skills needed by those administrations except for the administration of local taxes on the few private activities. These activities were mostly levied with some kind of presumptive taxes so that detailed accounting was not required.

This was an almost idyllic situation from a tax administration perspective. The confrontational situation that exists in the West between taxpayers and tax administrators was largely absent. As the director of taxation of one of these countries recently put it, somewhat nostalgically: “the life of a tax administrator was easy. He often had to deal with just one enterprise. Much revenue came from an occasional telephone call. Now you have to work for every cent.” 5/ This highly effective mechanism was able to generate levels of taxation that exceeded those of most industrial countries. 6/ It was, however, a mechanism that could not survive the change to a market economy. That change would bring about (a) price and wage liberalization, (b) the growth of private sector activities, (c) the lack of controls on the output of enterprises, and (d) the liberalization of the methods of payment. These changes would sharply reduce the information available to the tax inspectors and would increase the confrontational nature of tax collection as well as tax evasion. 1/ These changes would require the development of a totally new statutory tax system and the creation, almost from scratch, of a new tax administration. Of course, both of these changes would need skills (accounting, legal, managerial) which are in scarce supply in these countries. It is a change that will require many years to complete.

The experience of countries that have started the journey toward a market economy indicates that the level of taxation achieved under central planning could not be maintained. A realistic expectation is that tax revenue as a share of gross domestic product will fall dramatically over the years. 2/ It is thus important to accompany this fall by reductions in public spending especially since, for a long time, these countries will not be able to finance large fiscal deficits in noninflationary ways. 3/ Efficient reduction of public spending will require, inter alia, the establishment of a competent budget office able to scrutinize the various budgetary requests, relate them to expected tax revenue, and attempt to maximize the benefits that the countries will get from the use of tax money.

III. The Reform of Financial Institutions

The economic transformation of the Eastern European countries will be complete when:

(a) a large proportion of their total wealth is owned by individuals and not by public sector entities;

(b) when most prices, including wages, interest rates, and exchange rates are free to reflect the opportunity cost of using resources and, thus, to influence decisions;

(c) when, within limits imposed by legitimate regulations, individuals are free to start and carry out any economic activity they wish;

(d) when individuals are free to buy and sell any asset (tangible or intangible);

(e) when savers can choose from a range of financial assets (reflecting different risks and maturity structures) to invest their savings;

(f) when individuals are free to make the basic decisions on how to allocate their earnings; and, finally,

(g) when they are confronted by a legally based and objective tax system which can only be changed by a legitimate legislative process.

The role of the financial market in this transformation process is very important. Citing the President of the Federal Reserve Bank of New York “… a particularly important function of a banking and financial system in a market economy is to help mobilize a society’s savings and to channel those savings rigorously and impartially into the most efficient and effective uses and investments” (see Corrigan, p. 2).

It is very important to keep in mind the two fundamental functions of a financial system: first, to mobilize savings and, second, to allocate them to the most efficient uses. It is not clear the extent to which centrally planned economies succeeded in mobilizing household savings. 1/ It is very clear, however, that they were very inefficient in allocating them. 2/ The transformation process must ensure that both of these objectives are achieved. To create institutions that replace the plan in mobilizing savings while letting them go down the drain into black holes would be the worse possible folly. In recent discussions on the process of transformation, too much emphasis has been placed on mobilization of savings and not enough on the efficiency of their utilization. 3/ Because of the imbalances in the “social ecologies” of these countries there is the possibility that the institutions and the conditions that make possible a greater mobilization of savings in the reformed economies come to be developed before those that make possible a better allocation of those savings. This point is discussed later.

In spite of the constraints on spending by households, owing to scarcity of goods in the shops and long lines, the saving ratios of households in the Eastern European countries have been relatively low in recent years (see Table 1). Whether the propensity of households to save will increase or not during the transition will depend on various developments such as: (a) the availability of goods in the shops, (b) the availability of relatively safe and liquid financial instruments paying positive real rates of return to store the savings, and (c) the extent to which there is a pent-up demand for consumption goods. To the extent that financial markets development provides a menu of financial instruments with varying risks and maturities, this should be an important factor toward mobilizing savings and perhaps even toward raising the rate of saving of households. 1/

Table 1:

Savings Ratio of Household,a 1987-1990

(In percent)

article image

Ratio of increment in savings deposits to money incomes of the population.

Savings as percentage of disposable income.

Data for 1989 and 1990 for the Soviet Unon are somewhat lower than those reported by other sources.

Source: Economic Commission for Europe, Economic Survey of Europe in 1990-1991 (New York: United Nations, 1991), p. 54.

The transformation of the Eastern European economies will require that the power to allocate resources shifts largely from the government to the private sector. 1/ If this shift is not accompanied by the establishment of private monopolies, and is not hindered by excessive government regulations, it should improve the allocation of resources. To be completed, this transformation would require the establishment of a financial and equity market, a market for labor, a market for the exchange of real property (houses, apartments, land), a market for foreign exchange, and many other more specialized markets (private pensions, insurance). To the extent that citizens come to recognize that there is a relationship between the taxes they pay and the public services they receive from the government, an implicit political market would also have been established for government services. This market would, of course, use votes as a form of currency. Under central planning the connections between taxes paid by individuals and the services received by them was neither emphasized nor obvious. Thus a public campaign may be required to sensitize the population to this connection in order to raise tax compliance.

Many obstacles will need to be removed before this transformation is complete. For example, the establishment of a market for real property and a genuine market for labor will very much depend on the privatization of land and especially of houses and apartments. As long as land and houses are publicly owned, or property rights over them are unclear, they will not be traded and many workers will continue to be immobilized by their places of residence and by the difficulty they would face to find lodging close to potential new jobs. The scarcity of housing has created enormous constraints on the mobility of labor in these countries. Restructuring would be facilitated if these constraints were reduced.

In a society where incomes have been relatively even and where access to credit is very limited, the number of individuals who would be able to purchase a house or a piece of land will be limited. 2/ It will be much more difficult to find domestic buyers for large state enterprises even assuming that these enterprises were viable or could be restructured to make them viable. 3/ Thus, privatization would be facilitated by the existence of a capital market. If such a market existed, it could at least be able to finance the purchase of small properties and the setting-up of small new activities.

A priority in the development of a capital market should be the reform of commercial banks and the creation of an interbank money market, even if only a rudimentary one. A less immediate objective could be the establishment of an equity market. Commercial banks can to a large extent perform some of the functions of a stock market while the latter cannot perform the functions of the commercial banks. It has been pointed out that, historically, the commercial banking system has been far more important in allocating resources to enterprises than the stock market in the majority of industrial countries. 1/

An important first step toward the reform of the banking and financial systems of the economies in transition has already been taken by most of these countries with the creation of two-tier banking systems. This transition occurred in 1987 in Hungary, in 1988 in the U.S.S.R., in 1989 in Poland, and in 1990 in Czechoslovakia and Romania. The two-tier banking system involves the splitting of the monobank into a national bank and a group of (public) commercial banks. The national bank has assumed some of the traditional functions of a central bank, namely the conduct of monetary policy (that is, regulating overall credit and interest rates), the broad oversight of the financial system (the regulatory function), and the direct participation in selective aspects of the operation of payments system. 2/ The commercial banks have taken over the responsibility of deposit and loans transactions with households and enterprises.

Many legal and organizational problems need to be solved before this separation parallels closely that of western countries. The establishment of a clear delineation of the respective functions of these institutions and a clear separation of commercial and central banking functions has taken longer than initially envisaged in many countries. The national banks have not yet assumed the full range of the activities expected from a mature central bank and they continue to perform activities of a commercial and fiscal nature. They are still groping for a well-defined role and the degree of independence from the government is still a major issue, although some attempts have been made in some of these countries to provide independence to these new institutions. As long as they are not independent, they will provide the government and even the commercial banks with a kind of “soft budget.” 3/ It is important for these banks to reduce their fiscal functions and to concentrate on their basic monetary roles.

For the commercial banks to be able to perform well the functions of mobilizing savings and allocating them to the most efficient uses, several conditions must obtain, of which the most important are the following:

(a) Their decisions vis-à-vis lenders and borrowers must be guided by arm’s length principles. Special relationships carried over from the past or developed currently should not influence their borrowing and especially their lending decisions;

(b) They must have good information as to the risks they are taking when they lend to particular customers and must know how to use this information;

(c) Each lending decision should be relatively independent of past ones, in other words, the existence of past loans must not be a key factor in providing new loans;

(d) They should be able to push customers into bankruptcy if they default on servicing their loans; 1/ and, finally,

(e) They must be guided by bottom line considerations: they should see themselves as profit making operations and worry about their own solvency.

The reform that brought the two-tier banking structure into existence was potentially important. However, at least for the time being it has not created a banking system that would be able to mobilize savings and efficiently channel those savings toward the most productive uses. The problem is that the reform did not solve many of the existing problems. The new commercial banks were born with particular handicaps. 2/

First of all, these commercial banks are, in most cases, very large and public. Both of these characteristics imply that competition may be limited. Second, they continue to depend on the central bank for subsidized funds even though the central banks have tried to raise the cost of borrowing. Third, their clients continue to be, for the most part, state enterprises, many of which are not profitable. Fourth, the banks are under pressure to continue lending to these state enterprises because of long established relationships. 3/ Fifth, they are often still run by the same individuals who had run them before the banking reform and are constrained by lack of specialized skills and well defined statutes. Sixth, and most importantly, many of the assets that the commercial banks inherited from the monobank were low-interest loans to the state enterprises. Many of these loans are nonperforming. To a large extent the banks have continued to lend to the state enterprises in order to be able to continue showing as assets the loans on their books. When interest comes due, or loans mature, the banks often extend new loans to the enterprises to allow them to pay or service the old loans so that these “assets” can be carried on their books. It is a pity that there is no secondary market to assess the real value of these assets as happens with the loans of commercial banks to developing countries. If such a market existed, the market value of these loans would be far less than their book value.

The effects of this behavior are fourfold: first, by continuing to lend to inefficient enterprises, the banks are contributing to a major misallocation of savings. As Brainard has put it: “the existing banking structure… is acting as a fiscal “black hole”, misallocating capital to cover the losses of the state-owned enterprises” (op. cit., p. 15). Technically these loans are fiscal subsidies that, if justified, should be made through, and financed by, the budget. By being made through the banking system, they do not swell the fiscal deficit and, thus, distort the fiscal accounts giving an inaccurate view of the tightness of the country’s fiscal policy. 1/

Second, the accumulation of bad loans implies that it is difficult to assess the real value of the banks’ capital assets. Therefore, the profitability of the banking system and its basic soundness is an open question. The situation and behavior of the commercial banks imply the existence of large and increasing contingent liabilities for the government and raise concerns about future fiscal outcomes. In the absence of clear and believable protection schemes for depositors, this situation discourages them from putting their savings in these institutions and (because of the fiscal implications) may discourage private investors from investing in these countries. 2/

The poor quality of the loans reduces the profits (or increases the losses) of the banks. This leads either to increases in the subsidies the commercial banks receive from the central bank (or in some cases from the government), and/or to a lowering of the compensation paid to depositors, thus discouraging financial saving further, or to the raising of interest rates on performing loans. Finally, to the extent that the lending to the public enterprises absorbs much of the funds available, new private enterprises face greater difficulties and higher costs in getting needed funds. Therefore, this process creates an obstacle to the development of the private sector. 3/

Progress from a two-tier banking structure to a three-tier one in which the third tier would be made up of additional and hopefully private banks has been uneven. 1/ But, provided that the private banks could be closely supervised so that the savings of depositors could be protected, they could play a very important role in mobilizing savings and in channelling them to the booming but small and credit-hungry new private activities. Over the longer run it is the success of these new activities that will determine the success of the transformation. Unfortunately, given the high rates of inflation prevailing in many of these countries, banking is a very difficult and precarious activity which can only be supervised with great difficulty. 2/

The discussion above has shown the close links that exist among policies. Until state enterprises are privatized, successfully restructured, or, at least, are allowed to go bankrupt, they will continue misallocating resources on a large scale. They will also impair the banking system and progressively reduce its solvency thus preventing it from playing a major role in financing new private enterprises. Under these conditions, mobilization of savings may not be as desirable an objective as one would wish. It might be better to leave the resources in the hands of potential savers. In such case an informal market for credit would come into existence and perform more efficiently than the official market. 3/ The political choice may come to be that between, on one hand, continuing to subsidize the state enterprises and, on the other hand, subsidizing for a while the workers who become unemployed when the enterprises close through training and unemployment compensation. If unemployment benefits are not high, are limited in time, and are restricted to those who genuinely lost their job, this second alternative would be clearly preferable on efficiency grounds.

The cleaning of bad debts from the books of the commercial banks is a necessary though not a sufficient condition for their restructuring. It is not sufficient to ensure that they will not refill them with future bad debts. Only the enforcement of arm’s length relationships, competence, and good judgement on the management’s part can ensure this. This would require adequate prudential supervision designed to contain various banking risks, and well conceived licensing policies to ensure good management. It is not clear whether such progress is possible as long as the managers of these banks and the managers of the state enterprises come from the same background and respond to the same signals as in the past. The umbilical cord between these two groups must be cut. Recent financial and banking scandals reported for some of these countries have shown how important it is to cut that cord. Abuses may be particularly serious during the process of privatization when valuable assets of state enterprises may be bought by insiders using highly subsidized credit from the banks.

If banks were assured a solid capital base and became profit-oriented, they could play a major role in the restructuring of public enterprises, a role similar to that played by Japanese and German banks. 1/ In any case their restructuring would put them in a position to assist the booming but credit-hungry private sector. With the growth of the private sector and the shrinkage of the state enterprises the latter would become progressively less important in any case.

In principle, the commercial banks could raise the lending rate while increasing the spread between what they pay to the depositors and what they pay to the borrowers. However, this might crowd out new businesses while allowing the state enterprises to continue borrowing. One solution that has been suggested by some writers is the one adopted by Chile in the mid-1980s and by some other countries. In Chile, the Central Bank bought the bad loans of the commercial banks with long-term bonds carrying negotiated and positive real interest rates. In this way, the commercial banks were assured a secure stream of income to facilitate recapitalization. However, the fiscal position of the public sector obviously deteriorated. 2/ In a way this solution shifts the problem from the financial to the fiscal sector and highlights the importance of a fiscal reform. 3/ Buy-out operations of bad debts similar to that of Chile seem to be “in the pipeline” in Czechoslovakia and Bulgaria. 4/ Romania took a different approach; in 1990, as part of introducing the two-tier banking system, fairly large amounts of bad debts of state enterprises were written off against unusually large government deposits with the new commercial banks.

In conclusion, the reform of the financial sector must create conditions and institutions that make possible for individuals to channel their savings toward financial assets which are relatively safe and which pay a reasonable real rate of return. In order to satisfy these conditions the financial institutions and particularly the commercial banks must be able and free to allocate those savings toward investments which generate rates of return high enough to compensate the lenders and to cover the costs of intermediation. Under present circumstances the financial institutions are not able to perform both of these functions in a satisfactory way. As long as they continue to accommodate the financial needs of unprofitable state enterprises, they can pay reasonable compensation to savers only if they receive implicit fiscal subsidies from the central banks or explicit fiscal subsidies from the government. In either case this becomes a fiscal problem.

IV. Reform of the Public Finances

Many of the current reforms in the Eastern European countries essentially deal with accommodating the existing institutional setup to the changing role of the government and defining its scope. In the pre-reform situation, when much of the economy was public, it was difficult to separate an area that could properly be called “public finance.” In a way, all finances were “public” and many social objectives were pursued directly by the public enterprises rather than by the spending ministries. The transition must focus on what should remain public and what should become private and should draw a sharp distinction between these two areas. 1/ In this context, a discussion of the proper role of the state would be highly appropriate. This role is also likely to diverge in the short run from what It would be in the long run when the process of transition is complete. At least for a while, there will be many grey areas but these areas should progressively be reduced. The final role of the government in taxing citizens and in supporting social activities should become explicit and well focused. This role would determine the objectives to be achieved in terms of, say, level of taxation and public spending in the economy.

Many of the existing public subsidies are implicit rather than explicit. They are given through subsidized interest rates, through overvalued exchange rates for qualifying imports, through the provision of free or inexpensive lands for some activities, through the provision of cheap energy and housing, and so forth. These subsidies do not show up in fiscal statistics. The same is true for some implicit forms of taxation. For example, many banking regulations such as under-remunerated reserve requirements, and liquid asset ratios requiring captive holding of government securities, serve as implicit taxes on the banking system.

Most western economists generally agree that in a well-working private economy, subsidies and taxes should be explicit. In other words, they should be given through the budget since only in this way they can be subjected annually to a full political scrutiny. 1/ However, explicit subsidies and taxes are more demanding in terms of institutional requirements than implicit subsidies and taxes. In other words, they require good institutions such as tax systems, good budgetary systems, and other various institutions through which government programs are carried out (social security, welfare institutions). Until the proper institutions are in place, the government may have the choice between abandoning the pursuit of particular objectives or continuing to depend, to some extent, on implicit subsidies and taxes to achieve some goals considered socially desirable. 2/ Since the pursuit of these objectives through implicit means is inefficient, the need to speed up the process of reform is obvious.

These countries have been raising levels of tax revenues that have exceeded those of most industrial countries. 3/ It is unlikely that they will be able to maintain these levels over the longer run. The fragility of the revenue system to the undergoing changes in the economy was emphasized in Section II. This fragility makes imperative a substantial rapid reduction in the level of public spending accompanied by the restructuring of the tax system. To achieve these objectives, many legislative and institutional changes must be made. These changes will be made difficult by the fact that many of the policies that these countries need to pursue over the next several years will have important linkages among them and will have major implications for the public finances.

A couple of examples will help highlight this point. Whether some state enterprises will be able to pay taxes may depend on whether they continue to receive credit from the banks and on whether the government can force them to pay. In Poland, many state enterprises are reported to be in arrears in making tax payments. Sometimes arrears toward state enterprises by other state enterprises may bring about tax arrears by the former toward the government as well as arrears in servicing bank loans. Therefore, the netting out of debt among state enterprises and the securitization of such debt would be useful steps. The revenue contribution of some forms of commodity taxes will depend on the price liberalization policy. As long as prices remain controlled, it might seem pointless to introduce modern value- added taxes. 1/ However, price liberalization is progressing rapidly in many of these countries.

Large price changes will have major impacts on real wages, on employment, and on income levels of different social groups. If the standard of living of some groups, for example, pensioners, is reduced too sharply, there will be a need for compensating them. An increase in subsidies will, to some extent, reduce the positive impact on the budget coming from price liberalization. In some cases, prices may change so drastically that it will become very difficult to estimate the measures needed to reduce the impact of those changes on vulnerable groups. In these cases, measures taken to alleviate these effects may end up being either too generous or too austere. If they are too generous, they will create a precedent for the future and will reduce the ability of the government to improve its fiscal accounts. If they are too austere, they will create a political backlash that will in some cases force a reversal of the policies. All this implies that many difficult decisions will have to be made by policymakers who have had no training to deal with these questions and that may have little information on which to base their policies. 2/

The major building blocks of the reform of the public finances are five: (a) the setting up, almost from scratch, of a tax administration; (b) the reform of the tax system; (c) the setting up of budgetary institutions; (d) the reform of the public expenditures; and (e) the reform of social security systems. 3/ In the rest of this section a few observations will be made on each of these.

1. The setting up of tax administration 4/

The need to set up a modern tax administration is overwhelming. This objective should receive the immediate and full attention of the policymakers in all countries. 1/ The tax revenues that these countries collected in the past are no indication of what they will be able to collect in the future. These revenues were essentially transfers from some part of the public sector, mainly state enterprises with surpluses, to other parts of the public sector, such as state enterprises with losses, and spending ministries. The number of taxpayers (i.e., the state enterprises) was only in the thousands, and they could be easily controlled. The transformation of these economies will: (a) increase the number of taxpayers from the thousands to the millions; (b) by liberalizing prices and removing production quotas, it will sharply reduce the information available to the tax administration; and (c) by stimulating services and small public sector activities it will increase the proportion of total income originating in the part of the economy that is most difficult to tax.

It will be important to preserve some good administrative features of the former system, namely the payment of taxes through the banks and the widespread withholding at the source. These two features would be an important asset in the new tax administration and would release staff resources to pursue more important activities such as audits, taxpayers identification, taxpayer assistance, and so forth. The need to preserve withholding at the source and to limit the number of taxpayers who need to file returns will or should influence the kind of tax systems that are brought into existence.

2. The reform of the tax system 2/

The tax system that comes to be established should be simple and of easy administration. Anything that requires complex administrative procedures or a large number of filing taxpayers will not work. It is thus important that foreign experts do not try to experiment with their pet ideas and do not try to simply transplant the tax systems with which they are familiar. For example, the attempt to introduce a global income tax, a pet idea of many western economists, would almost surely lead to disappointment. A global income tax would require large-scale filing and complex administrative procedures for which these countries are not prepared. Such a tax does not easily lend itself to widespread withholding at the source, especially when it is accompanied by highly progressive rates. Therefore, income taxes with relatively low rates which minimize filing and thus rely on withholding at the source for wages, interest, and perhaps dividend incomes, would be desirable. Similar considerations could be made vis-à-vis value-added taxes with multiple rates and zero rating of some commodities. For these taxes, the close link that exists between the exemption threshold and administrative simplicity must be recognized. The lower the threshold, the greater the number of taxpayers, and the greater will be the administrative complications. The interest that many of these countries have to become part of Europe implies that they will attempt to develop tax systems that are compatible with those of the western European countries. While this is a worthwhile objective, compatibility may be achieved by a simplified system rather than by the cloning of the European tax systems.

They should resist the temptation to continue discriminating among groups and activities. The point of going to a market economy is to let the market make the choices. This mistake was originally made by the first reforming country, Hungary, when it introduced a western tax system. It was forced to levy high tax rates because of preferential treatment accorded to many groups or industries. That country has recently been trying to correct these mistakes. These countries should resist the temptation to pursue too many social objectives through the tax system and, for sure, they should try to minimize policy mistakes at the beginning. Some of these mistakes (as, for example, the provision of widespread deductions and exemptions), once made, are difficult to correct, especially at a time when parliaments are trying to make their presence felt.

3. Social security reform 1/

One area deserving special attention is social security. Many of these countries are experiencing serious crises in their social security systems. In may of them, for example in Hungary, Czechoslovakia, and the republics of the former U.S.S.R., the level of social security taxation is so high as to be unsustainable over the longer run; in spite of this, these systems are in many cases experiencing large losses. 2/ A market economy with social security taxes on employers as high as those existing in some of these countries will give strong incentives to underground economic activities to avoid paying them. 3/ Furthermore, such high taxes on labor will inevitably hurt the competitiveness of these countries. There is a strong need for a major reform of the social security system, i.e., increasing the retirement age, scrutinizing potential pensioners more closely, especially for disabilities, and of course, reducing the number of beneficiaries and the level and the coverage of benefits to what the country will be able to afford in future years, considering the many claims on the reduced government revenues.

4. Setting up a modern budgetary system 1/

Under central planning, there was no budget office in the sense understood in market economies. Allocation for some social expenditures by the relevant ministries were made by the planning office with limited input from the spending ministries. The state enterprises themselves played an important role in providing social services to their workers and their families. In a market economy, the enterprises will no longer play this role so that the importance and the financial needs of the spending ministries will increase. Budgetary decisions must be made keeping in mind (a) resource availability, and (b) efficiency considerations. The budget office must establish close links between total budgetary appropriations for the budget year and expected government revenue, which are in turn influenced by developments in the economy. The budget office must develop good forecasting techniques to assess the impact of the economy on revenue and expenditures. It must also closely scrutinize the results of public spending in order to maximize its welfare impact and to keep costs under control. A unified budget format which encompasses all programs would enhance the usefulness of the budget as a policy tool. In sum, a modern budget office must be established. Given the complexity of this task, it will take several years before it is completed.

5. Reform of public expenditures

The level of public spending will need to fall substantially over the next few years and the current structure of public spending will need to change drastically in order to reduce the importance of subsidies. The newly created budget office will have to play an important role in making the basic decisions on public spending. These decisions will be politically difficult because of resistance on the part of those who will find their benefits reduced, and technically difficult because of uncertainties over the development of the economy and because of the difficulty in quantifying the effects of certain policies on certain groups. In any case, substantial savings should come from the elimination or reduction of subsidies to enterprises and consumers and, in several of these countries, from reducing military expenditures. The rationalization of the system of social insurance should also reduce spending. On the other hand, there will be strong pressures in particular areas. For example, the need to generate new skills may have significant impact on educational spending. The health sector has been somewhat ignored in recent years. In fact, life expectancy in some of these countries has been going down. Thus, health expenditure will need to increase. 2/ The growing number of unemployed will create strong pressures to assist them. And, of course, the restructuring of the state enterprises will require some spending. In any case, the more competent is the technical staff involved in these decisions, the more likely it will be that the final outcome will be more efficient.

V. Fiscal-Monetary Links

A total and clear separation between fiscal and monetary policy is next to impossible in any economy. There are always areas where they overlap. However, well-managed market economies attempt to keep these two policies separate and try to use each policy toward the objectives for which it is comparatively more efficient. Normally, price stability and the mobilization and efficient allocation of savings are promoted through the use of monetary policy while short-term demand management, the provision of public goods, and the redistribution of income are pursued through fiscal policy. 1/

In the Eastern European countries, these two policies are greatly intertwined and a clear separation between them may be difficult to achieve for a long time. 2/ At the moment the two policies intersect in many areas; fiscal goals are pursued through monetary policy and, to some extent, monetary goals through fiscal policy. In these countries, an explicit goal of economic policy should be the reduction in the scope of these overlapping areas. Some of these areas have already been mentioned earlier. However, a listing of some of them may help attract attention to an important but relatively unknown problem.

First, the banking system has financed and continues to finance many economic activities through highly subsidized credit. If these activities deserve to be financed, in principle this should be done through the budget. If this were the case, the fiscal deficit would reflect more precisely the current imbalance between public revenue and public expenditure and would give a clearer indication of the required fiscal adjustment. As reported earlier, in some countries, balanced budgets, or even budgetary surpluses, have at times coexisted with high rates of inflation. In these situations the budgetary outcome (the fiscal deficit) clearly sends wrong signals which may confuse policymakers and other observers on needed policy changes. 1/ The policy implication of this is that (a) either these subsidies should be eliminated, or (b) they should be shifted from the monetary to the fiscal area. However, if the tax system is not well developed, the second is not a realistic alternative. If the government insists on subsidizing the activities, or if the political process forces it to do so, it may have no choice but continue using monetary instruments to pursue fiscal objectives.

Second, in some of these countries, the internal public debt has reached very high shares of gross domestic product. In the Soviet Union, for example, that share reached more than 60 percent of GDP. In this situation the level of the real interest rate at which public debts are serviced will have a large impact on the measured fiscal deficit. There has been a tendency to keep real interest rates low so or even negative as to facilitate the financing of the deficit and to reduce its measured size. This action once again shifts the burden of adjustment from fiscal to monetary policy and implies that no real adjustment takes place. 2/ Once again this sends wrong signals and distorts the objectives of policy. This danger is particularly acute during high inflation. If the holders of the debt are the commercial banks, their earnings will be reduced. On the other hand, they will gain from the seignorage they receive from unremunerated or under-remunerated deposits. Of course, if the holders of the debt are enterprises, their profits will be reduced.

Third, recent writing by M. Boskin, W. Buiter, and others has emphasized the importance of the net worth of the public sector. As the public sector acquires better defined boundaries, so that it is more clearly distinguishable from the private sector, attention comes to be paid to its net worth. Recently there have been pressures to push the governments of these countries to pursue policies that tend to nationalize debts while shifting valuable assets in private hands. 3/ As Mark Allen has pointed out, 4/ the public sectors of these countries were supposed to own much of the economy’s wealth since most assets were publicly owned; therefore, their net wealth could be reduced mainly by foreign indebtedness. However, as time passes, because of the nationalization of debt and the privatization of assets, their net wealth appears smaller and smaller, raising concerns about the long-run fiscal solvency of these countries. The possibility that the government or the central bank may have to inject large, but still undetermined, capital in the commercial banks implies that the public sector’s net worth will fall and that its long-run fiscal stance will be weakened. 1/

Fourth, and closely related to the previous point, several economists have recently called attention to the importance of the public sector’s contingent liabilities in assessing a country’s fiscal stance. The bad loans of the commercial banks, the foreign debts of the national banks or the governments, which with large devaluations can grow enormously in domestic currency and can, thus, sharply increase the measured fiscal deficit, and the many other implicit or explicit future commitments, including those provided through social security institutions, Imply that the present value of future public sector liabilities may be very large. This again highlights the underlying weakness of the public finances and the need for a major fiscal adjustment.

Fifth, at the moment, public spending not financed by ordinary government revenue is financed either through implicit subsidies (for example through the overvaluation of the exchange rate or bank credit to state enterprises provided at concessional rates) or through monetary expansion. The development of a financial market, with the introduction of securities with different characteristics and maturities, can introduce a channel through which the government could mobilize financial savings to finance fiscal deficits in ways other than those mentioned above. The example of Italy indicates that, if the government stimulates a fast rate of innovation in the financial market, the financing of substantial fiscal deficits is facilitated, especially if the saving rate of the household sector is high (see Caranza, 1991). This development would help preserve the separation between monetary and fiscal policy. 2/ It would also reduce the possibility that, by using different financing sources, governments can intentionally manipulate the measures of their fiscal stance. However, the government must not have the power to force banks, enterprises, or even individuals, to buy government securities.

When a government can force banks to buy securities to finance the deficit, or when enterprises can pay “profit taxes,” which are not based on real profits, only by borrowing from the banking system, a balanced budget or an apparently noninflationary deficit might hide the fact that it is the fiscal policy that is out of control and not the monetary policy. In this case inflationary finance may be masked as tax revenue.

Lastly, as governments bail out banks and other financial institutions, fiscal deficits are likely to widen. At the same time, if privatization is ongoing and is generating significant revenue, there will be a temptation to use privatization receipts to finance current expenditure rather than to reduce public debt. This will contribute to the precariousness of the fiscal situation because, while privatization revenue is transitory, increases in current expenditure tend to become permanent. Under these circumstances, one way of containing fiscal deficits might be to recapitalize financial institutions using equity in state enterprises rather than by transfers from the public sector. If the financial institutions became major shareholders in enterprises and could influence their business decisions--much along the lines of the German and Japanese models of corporate control--there could be a significant improvement in efficiency and profitability. This would benefit enterprise managers, workers, and shareholders--who therefore would have an incentive to seek such an improvement-- and the economy as a whole. There would also be additional tax revenue for the budget, which would allow some increase in productive spending without threatening fiscal instability. 1/ Of course, the quality of the banks’ management and the existence of hard budget constraints for the banks would be very important in determining whether this option is a realistic one.

VI. Concluding Remarks

This paper has surveyed the role of financial markets and fiscal institutions in the transformation process that is going on in Eastern and Central Europe. It has highlighted many areas: (a) the need to create some sort of “social ecological balance” necessary for the working of a modern market economy; (b) the need to develop financial institutions that mobilize savings; (c) the need to solve some fundamental problems faced by the commercial banks so that the savings that are mobilized by them can be efficiently allocated; (d) the need to reform the public finances including the setting up of modern tax administrations and budgetary institutions, the enactment of tax laws, the solution to urgent problems faced by social security institutions, and the need to reduce and restructure public spending.

The paper has called attention to the extent to which monetary and fiscal policies overlap in these countries and the extent to which fiscal objectives are often pursued through nonfiscal instruments. It is, thus, important to create institutions that allow a separation of these policies. But the creation of these institutions will take time. Until the right fiscal institutions are created, certain social objectives can only be pursued through less efficient means. Therefore the policymakers can only choose between abandoning those objectives or pursuing them inefficiently. To a large extent the success or failure of the transformation process will depend on how quickly modern fiscal institutions can be created.


  • Allen, Mark, “Government Debt Management,” in Tanzi (1992), pp. 6779.

  • Atkinson, Anthony B. and Renato Brunetta, editors, Economics for the New Europe (London: MacMillan, 1991).

  • Atkinson, Anthony B. and John Micklewright, “Economic Transformation in Eastern Europe and the Distribution of Income,” in Atkinson and Brunetta (1991), pp. 14774.

    • Search Google Scholar
    • Export Citation
  • Blommestein, Hans, and Michael Marrese, editors, Transformation of Planned Economies (Paris: OECD, 1991).

  • Brainard, Lawrence J., “Reform in Eastern Europe: Creating a Capital Market” in Finance and the International Economy: 4. edited by Richard O. Brien and Sarah Hewin, published by Oxford University Press for the Amex Bank Review (1991), pp. 722.

    • Search Google Scholar
    • Export Citation
  • Calvo, Guillermo, “Financial Aspects of Socialist Economies: From Inflation to Reform,” in Corbo et al (1991), pp. 197206.

  • Campbell, Robert W., The Socialist Economies in Transition (Bloomington and Indianapolis: Indiana University Press, 1991).

  • Caranza, Cesare, “Government Financing, Domestic Debt Management, and Monetary Policy: Some Lessons from the Italian Experience,” in Downes and Vaez-Zadeh (1991), pp. 915.

    • Search Google Scholar
    • Export Citation
  • Casanegra, Milka, Carlos Silvani, and Charles Vehorn, “Modernizing Tax Administration,” in Tanzi (1992), pp. 12041.

  • Cheasty, Adrienne, “Financing Fiscal Deficits,” in Tanzi (1992), pp. 3766.

  • Commission of the European Communities, European Economy: The Path of Reform in Central and Eastern Europe. Special Edition No. 2 (1991).

    • Search Google Scholar
    • Export Citation
  • Corbo, Vittorio, Fabrizio Coricelli and Jan Bossak, editors, Reforming Central and Eastern European Economies: Initial Results and Challenges (Washington, D.C.: The World Bank, 1991).

    • Search Google Scholar
    • Export Citation
  • Corbett, Jenny and Colin Mayer, “Financial Reform in Eastern Europe: Progress with the Wrong Model,” in Oxford Review of Economic Policy. Vol. 7, No. 4 (Winter 1991), pp. 5775.

    • Search Google Scholar
    • Export Citation
  • Corrigan, E. Gerald, “The Role of Central Banks and the Financial System in Emerging Market Economies”, FRBNY Quarterly Review (Summer 1990), pp. 17.

    • Search Google Scholar
    • Export Citation
  • Downes, Patrick and Reza Vaez-Zadeh, editors The Evolving Role of Central Banks (Washington, D.C.: IMF, 1991).

  • Easterly, William, “Distortionary Policies and Growth in Socialist Economies,” in Corbo et al (1991) pp. 17789.

  • Economic Commission for Europe, Economic Survey of Europe in 1990-91 (New York: United Nations, 1991).

  • Feige, Edgar L., editor, The Underground Economies (Cambridge: Cambridge University Press, 1989).

  • Fischer, Stanley and Alan Gelb, “Issues in the Reform of Socialist Economies,” in Corbo et al (1991), pp. 6782.

  • Gábor, Istvan R., “Second Economy and Socialism: The Hungarian Experience” in Feige (1989), pp. 33960.

  • Grossman, Gregory, “The Second Economy of the U.S.S.R.” in Tanzi, editor (1982), pp. 245270.

  • Hemming, Richard, “Privatization of State Enterprises,” in Tanzi (1992).

  • Institute of International Finance, Inc., “Financial Sector Reform: Its Role in Growth and Development” (Washington, D.C.: 1989).

  • Kessides, Christine, Timothy King, Mario Nuti, and Catherine Sakie, Financial Reform in Socialist Economies (Washington: The World Bank, 1989).

    • Search Google Scholar
    • Export Citation
  • Kopits, George, “Social Security,” in Tanzi (1992).

  • Liviatan, Oded, “The Impact of Public Financial Institutions on the Fiscal Stance,” in Mario Blejer and Adrienne Cheasty (eds.), How to Measure the Fiscal Deficit: Analytical and Methodological Issues (Washington: IMF, 1992).

    • Search Google Scholar
    • Export Citation
  • Marer, Paul and Salvatore Zecchini, editors, The Transition to a Market Economy (Paris: OECD, 1991).

  • McKinnon, Ronald I., The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy (Baltimore: The Johns Hopkins University Press, 1991).

    • Search Google Scholar
    • Export Citation
  • Newbery, David M., “Sequencing the Transition,” CEPR Discussion Paper Series, No. 575 (August 1991).

  • Premchand, A., and Lazlo Garamfalvi, “Government Budget and Accounting Systems,” in Tanzi (1992).

  • Sundararajan, V., “Financial Sector Reform and Central Banking in Centrally Planned Economies,” in Downes and Vaez-Zadeh (1991), pp. 24968.

    • Search Google Scholar
    • Export Citation
  • Tait, Alan, “Introducing Value Added Taxes,” in Tanzi (1992), pp. 188208.

  • Tanzi, Vito (1991a), “Fiscal Issues in Economies-in-Transition”, in Corbo et al (1991), pp. 22128.

  • Tanzi, Vito (1991b), “Mobilization of Savings in Eastern European Countries: The Role of the State” in Atkinson and Brunetta (1991), pp. 17595.

    • Search Google Scholar
    • Export Citation
  • Tanzi, Vito (1991c), “Tax Reform and the Move to a Market Economy: Overview of the Issues”, in The Role of Tax Reform in Central and Eastern European Economies (Paris: OECD, 1991), pp. 1934.

    • Search Google Scholar
    • Export Citation
  • Tanzi, Vito The Underground Economy in the United States and Abroad (Lexington: Hewitt and Company, 1982).

  • Tanzi, Vito editor, Fiscal Policies in Economies in Transition (Washington: IMF, 1992).

  • Tanzi, Vito and Howell Zee, “Time Constraints in Consumption and Savings Behavior,” forthcoming in Journal of Public Economics.

  • Thumm, Ulrich R.W., “World Bank Adjustment in Central and Eastern Europe,” in Corbo et al (1992).

Paper prepared for the CEPR Conference on “The Economic Consequences of the East”, held at the Deutsche Bundesbank in Frankfurt/Main, March 20-21, 1992. The views expressed are strictly those of the author. They should not be interpreted as official Fund views. Comments received on an earlier draft from Adrienne Cheasty, Carlo Cottarelli, Manuel Guitian, Richard Hemming, Henri Lorie, Erik Offerdal, Jim Prust, and V. Sundararajan are much appreciated. Tomas Balino was very helpful in directing me to essential material.


Some aspects of this issue have been discussed by the sequencing literature. See, for example, McKinnon (1991).


This discussion does not wish to imply that the market achieves this objective smoothly and optimally. It would be easy to think of exceptions (cobweb situations, monopolies, etc.). It also does not imply that all institutions are created by the spontaneous action of the market. Clearly the government needs to play a significant role in several areas.


This, of course, is one of the reasons for their low productivity.


In Czechoslovakia (1986), the German Democratic Republic (1982), and the USSR (1985), the output of state enterprises was about 97 percent of total output. See Thumm (1991), p. 49.


Some of this non-cash compensation is provided by the government, some by the state enterprises.


Thus the consumption function of individuals would have to include, as independent variables, time as well as income. For a theory that emphasizes the importance of time in consumption, see Tanzi and zee (forthcoming)


For example, enterprises have either not been allowed to keep depreciation funds on their capital assets or the depreciation allowed has been too low. The reason was that investment decisions even for replacement should be made centrally.


See Campbell (1991) especially Chapter 5, pp. 92-118.


For a discussion of the misallocation of savings and resources in Eastern Europe see Easterly (1991), Thumm (1991), and Tanzi (1991a). Over the past decade the incremental capital output ratios for these countries became extremely large. See Thumm (1991), p. 48.


For details see Sundararajan (1991, especially pp. 250-252).


There were hundreds or even thousands of these implicit tax rates. These rates were not legislated and could be changed at the discretion of the planners.


Each enterprise was constrained to have an account in only one branch and to make all payments, except wages which were paid in cash, by checks drawn on that branch.


All wages were paid in cash.


For a more detailed description of these taxes see (Tanzi 1991c) or the various relevant chapters in (Tanzi, 1992).


Oral communication to the author.


The fact that the state enterprises were very large and relatively few in number facilitated the task of tax collection.


Since tax evasion did not exist, or was not supposed to exist, in centrally planned economies, there were no laws against tax evasion.


The fall in the tax level in China, Hungary, and Poland in recent years gives empirical support to the statement. It should be added that reducing the level of government revenues and expenditures has also been an important structural goal for the governments in the region in order to reduce the influence of the state in resource allocation.


See, on this point, the chapter by Adrienne Cheasty in Tanzi (1992).


Given the extremely high investment ratios in these countries, one could argue that they were successful in mobilizing total savings, although “mobilizing” may be the wrong word for the process that took place.


As indicated by the very low growth rates that accompanied the high investment rates.


For a discussion of this point, see Tanzi (1991b).


Actually, if at the same time that individuals have greater access to financial instruments to place their savings they also have greater access to credit to finance their current spending, the net result may not be an increase in the rate of saving. It must be understood that eventually saving by household and private enterprises will need to replace saving by the state.


This does not imply that the government will not play any role in resource allocation. However, that role must be limited to the existence of public goods, externalities, and other conditions that justify government intervention in market economies.


Information on distribution of earnings in Eastern European countries Is provided in Atkinson and Micklewright (1991).


In some of these countries consideration is being given to the distribution to the population of vouchers which would allow them to purchase houses and shares in enterprises. There is still no experience of how well such schemes work.


One strong indication is the payment of reserve requirements with government paper.


For this reason bankruptcy laws are essential.


Thus to some extent state enterprises continue to face soft budget constraints.


This explains how, at times, the fiscal accounts of some countries have been in surplus while they were experiencing high rates of inflation. This has been Yugoslavia’s experience and, to a more limited extent, Poland’s. For a discussion of the experience of Yugoslavia, see Liviatan (1992).


Like large public debts, these contingent liabilities may require higher tax payments in the future.


This also raises questions about the effects of credit restrictions on the economy. To the extent that these restrictions crowd out private sector borrowers before they crowd out state enterprises, they may slow down the process of restructuring and reduce the efficiency of the economy.


In Poland, Hungary, and Russia, new banks have been licensed. While Poland and Russia have pursued liberal licensing policies leading to the creation of many small banks, Hungary has pursued a more cautions licensing policy.


The lack of proper supervision of these new private banks has led to questionable practices on the part of some of them. Unfortunately, the skills needed for proper supervision are still in very scarce supply.


The informal market that I have in mind is similar to the “curb market” that was so important in Korea. The kind of informal market for credit that has been established among state enterprises in the economies in transition (which have been lending to each other) is contributing to distortions and is reducing the effectiveness of credit policy. It is also allowing some of these enterprises to remain in existence.


See Corbett and Mayer for a discussion of this point. However, the question of whether they would have the competence to perform this important function remains.


Because of the interest that it had to pay on the bonds, the Central Bank ran large quasi-fiscal deficits. A very conservative fiscal policy by the government was required to compensate for this fiscal deterioration.


A convinced Ricardian might argue that the increase in public sector debt would be accompanied by an increase in private saving with no effect on the economy. However, given the institutional set up of these countries, even convinced Ricardians might have doubts on the realism of that outcome.


In Czechoslovakia, there is a plan to use the proceeds from privatization to buy out some of the bad debts on the books of the banks.


This is not going to be an easy task since there are great differences between, say, the American view and the European continental view. The economies in transition must at some point choose between these two views of the role of the state.


Of course, some subsidies may be explicit but given outside the budget. Most economists would be against extrabudgetary activities.


For example, it is generally better to give cash to families rather than subsidies through what they buy. But cash transfers may require higher tax revenue and institutions that may not be available in the short run. Implicit transfers can be achieved simply but less efficiently through, say, the overvaluation of the exchange rate or the subsidization of the price of energy.


All the Eastern European countries have plans to introduce value-added taxes by 1993 at the latest. Hungary was the first to do so after a long preparation. Russia and most of the other countries of the CIS have just introduced one, on January 1, 1992, with very little preparation, Bulgaria, Czechoslovakia, and Romania are planning the introduce a value-added tax on January 1, 1993. For a full treatment of value-added taxes in these countries, see Tait’s chapter in Tanzi (1992), pp. 188-208.


For example, nobody knows the impact on various income groups that would result from the bringing of the energy price in Russia to the world level. In fact, in the absence of an equilibrium rate of exchange, it is even difficult to determine what the world price would be in rubles.


All these areas have been discussed at length in various papers included in Tanzi (1992).


For a full treatment of Issues of tax administration, see Casanegra, Silvani, and Vehorn’s chapter in Tanzi (1992), pp. 120-41.


In Hungary, the setting up of a modern tax administration is well advanced since that country started earlier. In other countries only limited progress has been made so far.


For details on various aspects of tax reform, see Chapters 5 to 11 in Tanzi (1992).


See “Social Security” by George Kopits in Tanzi (1992), pp. 291-311.


The demographic situation in some Eastern European countries is an important continuing factor to the unsustainability of the current social security scheme.


For the connection between high social security taxes and the underground economy, see the chapters by Del Boca and Forte and by Contini in Tanzi (1982).


For details, see the chapter by Premchand and Garamfalvi in Tanzi (1992).


Whether health expenditure will remain a responsibility of the public sector or is shifted to the private sector is one of the many important decisions to be made regarding the role of the state.


Whether monetary policy should also be used for stabilization remains a controversial issue. The recent recession in industrial countries seems to have promoted once again such a role for monetary policy.


In general, these two policies are less clearly separated in developing countries than in industrial countries. For example, in Latin America, the Central Banks have, in several cases, financed activities that have caused them to experience large quasi-fiscal deficits. The reason is the one mentioned earlier--the less developed are the institutions, the more difficult is the separation of policies.


When fiscal objectives are being pursued through monetary instruments, the fiscal deficit as commonly measured is not as significant a variable as often assumed. In this case, balancing the budget may not necessarily be a worthwhile policy goal.


When the measured fiscal deficit is given great prominence in the negotiation of adjustment programs, there is the danger that countries may be induced to keep the deficit low by perpetuating the recourse to policies that artificially keep the deficit down.


Some observers are urging the government of these countries to assume the debts of the enterprises before privatizing them.


See his chapter in Tanzi (1992), pp. 67-79.


Given the weakness of current fiscal institutions, this may not be the right time to inject this capital in the commercial banks. But waiting will only increase the size of these liabilities. The Chilean solution, which required the Central Bank to assume debt equivalent to about 25 percent of GDP, was introduced when the government was making great and successful efforts to improve the public finances. There must be a firm cut-off date when a Chilean-type solution is contemplated. All debt and financial problems prior to the cut-off date may be alleviated, as long as it is understood that, after the cut-off date, banks face hard budget constrains, and are on their own.


However, by facilitating the financing of the deficit, it might also delay the required adjustment, as it has happened in Italy.


See Hemming’s chapter in Tanzi (1992) for a discussion of this point.