1. On the relevance of fiscal deficit measures

In this section, general issues of fiscal policy are discussed. It is argued that variables that routinely guide policy actions in market economies, particularly the budget deficit, must be treated with caution during the period of transition. This is necessary to ensure that tight limitations on these variables do not create inverse incentives which may slow down the process of transformation to market economies. The need to separate fiscal from monetary policy more sharply is also highlighted.

In spite of occasional divergent views, most economists normally assume that the fiscal deficit is a good guide for assessing fiscal policy. A large deficit is taken as an indication that (unless a strong case to the contrary can be made) fiscal policy should become more restrictive. The concept of fiscal deficit implies that the activities of the government can be sharply delineated from those of an important and independent private sector. ^1/ Thus, expenditures and revenues are either public or private. The measure of the fiscal deficit requires that the difference between what-the public sector spends in all its activities and what it collects through taxes, fees, and sales of services to the public can be accurately measured. With full employment, if the public sector spends more, the private sector must spend less, unless the economy is able to attract foreign saving. Thus, the existence of a fiscal deficit implies some (unwanted) crowding out of the private sector unless Ricardian equivalence or a Keynesian multiplier can be assumed to operate.

There are several reasons for caution in the traditional use of this concept as an important guide in policy action during the transition. Some of these are conceptual. Others deal with measurement problems. Some of these are discussed below.

2. Separation of fiscal and monetary policy

A total and sharp separation between fiscal and monetary policy is next to impossible in any economy. There are always overlapping areas. For example, when central banks change the discount rate or engage in open market operations, these actions always have an impact on the budget deficit. In general, these two policies are less clearly separated in developing countries than in industrial countries. In Latin America, for example, the Central Banks have, in several cases, engaged in activities that have caused them to experience large quasi-fiscal deficits. ^1/ In Chile, for example, the growth in quasi-fiscal deficit in the 1980s resulted from the assumption by the central bank of the bad debts of the commercial banks. This assumption was clearly a fiscal operation that could have been carried out by the budget if budgetary conditions had been more sound. ^2/ In other cases, the central banks assumed the foreign debt of enterprises. In general, the less developed are the institutions of a country, the more difficult it is to separate monetary and fiscal policies and the more difficult it is to measure the true size of the fiscal deficit. More often than not it is the weakness of the fiscal institutions (for example, the inability to raise needed revenue) that forces the monetary institutions to assume a fiscal role by providing subsidized credit to enterprises or by directly financing the fiscal deficit. ^3/ However, the objective of making the fiscal deficit look better than it is also plays a role in this function.

Normally, economic policy is improved when monetary and fiscal policies pursue their own specific roles. In this case; if an enterprise needs to be subsidized, the subsidy should be given through the budget. If this results in a fiscal deficit, the deficit should be financed through the sale of bonds by the country’s treasury carrying market interest rates. ^1/

The budget deficit is a highly watched economic barometer. A larger deficit always sends warning signals, both domestically and internationally. Therefore, countries have an incentive to limit its size either by genuine fiscal adjustment, or by pursuing second-best policies whose result may even be more damaging than if the budget deficit had been allowed to rise. In other words, the bias is almost always for showing a budget deficit that appears smaller than it would be if it were correctly measuring the true fiscal deficit. At times this reduction is achieved through policies that do not reduce the real or underlying fiscal deficit, but only the measured budget deficit. In other words, gimmicks are used to artificially lower the budget deficit. ^2/

3. Implications of preceding discussion

During the transition, to the extent possible, it is important to contain the inflation rate without resorting to direct price controls. ^3/ To achieve this objective, however, the most important macroeconomic instrument for both market economies and economies in transition is credit expansion, not the budget deficit. Once total credit expansion is determined, the countries should be encouraged to continue improving the efficiency of the economy as well as the fiscal accounts. They should be encouraged to reduce particular categories of public expenditure, to make others more productive, and to raise government revenue to contain the public sector fiscal deficit. ^4/ They should also be encouraged to speed up the various adjustments mentioned above, even when these adjustments may result in increases in (measured) budget deficits. Important among these adjustments is the transfer to the government of the essential social functions shouldered by the state enterprises.

Another important point to recognize is that what makes the economies in transition different from normal market economies is that, under present circumstances, for given total credit, an increase of the (measured) budget deficit does not necessarily crowd out what, in western economies, we would call the private sector. Much of the credit expansion goes to the state enterprises and the government and only a small residual goes to the emerging private sector. A large reallocation of credit between the budget and the state enterprises can take place without necessarily affecting the private sector. ^1/ This reallocation could be fully consistent with the objectives of the transformation. In fact, if state enterprises (a) shed redundant workers, (b) transfer to the government the responsibility for essential social functions, (c) no longer finance non essential social functions (such as vacation for workers) and (d) compensate the workers for a fraction of these reductions through some adjustment in the level of nominal wages, the net result of these changes could very well be a larger budget deficit with a more efficient economy. This change could also be achieved without additional credit expansion if the additional credit to the budget to finance its new assumed responsibilities, were compensated by lower credit to the state enterprises, to reflect their reduced social responsibilities.

In countries where the boundary, in terms of social responsibilities, between the budget and the state enterprises is blurred and changing and where very little credit has been going to the private sector, the standard argument for containing the budget deficit--that for given credit expansion, the resources flowing to private enterprises would be squeezed unless the deficit is contained--does not necessarily apply. Therefore, rather than trying to achieve a given quantitative budget target with any possible measure, it would be better to focus on the quality of the measures, bearing in mind that the most important concern should be to foster the structural adjustment process while limiting the inflationary pressures. Enforcing inflexible limits for the size of the budget deficit may do little for price stability, if credit continues to flow to inefficient state enterprises, while it may retard essential structural adjustment.

1. The level of taxation

By disbanding the planning mechanism and by removing constraints to private sector activities, the transition to a market economy (a) removes controls on quantities produced and on prices, thus reducing the information available to the government; (b) increases sharply the number of producers in the economy through the creation of private enterprises and the breaking up of state enterprises; (c) removes existing restrictions on the methods of payments by allowing enterprises to make payments in cash and to hold multiple accounts in different banks; (d) eliminates the role of the monobank in collecting revenue, ^1/ allowing the monobank to concentrate on its function as a central bank; and (e) stimulates the growth of those activities that have been difficult to tax in market economies (small shops, services, independent contractors). ^2/ In future years, the most dynamic sector of the economy is likely to be the one most difficult to tax.

For many of these economies, the bulk of their industrial production will remain in the hands of the state enterprises for some time to come. Under these circumstances, it will be tempting for the Government to squeeze additional revenue from these enterprises, either through explicitly discriminatory profits taxation or through other ad hoc confiscatory levies. ^3/ It is important that such temptation be resisted. In other words, even if many enterprises were to remain state owned in the medium term, the role of the state as tax collector and taxpayer must be rationalized so that both state and private enterprises are placed on level grounds. This requires that the tax laws become objective and transparent and that any discretion is removed from the government in the application of these laws. ^4/ However, as long as the government remains the only shareholder of the state enterprises, it would, in principle, be in the position to determine what proportion of the total profits of the enterprises it could appropriate. In this situation those who run the enterprises will have an incentive to minimize the profits by raising wages or by providing other benefits to their employees.

The transition creates confrontation between the government and the taxpayers, who become adversaries where they were supposed to be partners before. ^1/ The phenomenon of tax evasion common to market economies makes its appearance and, given the prevailing circumstances, can become highly significant. In these economies paying taxes may not be perceived as a civic duty of good citizens. On the contrary, tax evasion is perceived as part of the “ground rules” in market economies. ^2/

The loosening of controls by the central authority over the rest of the public sector also creates adversity and confrontation within the public sector between the authorities who control the central government budget and those who control extrabudgetary accounts, local governments, and state-owned enterprises. ^3/ Doubts and conflicts arise among “public” institutions as to who has legal rights to particular sources of revenue or who owns particular assets, such as mineral deposits. Therefore, the national government encounters increasing difficulties not only in collecting tax revenue from the taxpayers, but also in attracting resources from the “public” institutions that are outside its immediate and effective control. This has become a major problem in most of these countries. ^4/ This question of “ownership rights” within the public sector affects also the process of privatization. This has led some observers to argue that enterprises need to be genuinely nationalized before they can be privatized.

An aspect of this conflict that deserves a separate mention is that between the central government and the state-owned enterprises. It involves the distinction between wages and salaries on the one hand and profits for these enterprises on the other. In market economies the distinction between the employees and the owners of enterprises is clear cut. As a consequence, the total income produced by an enterprise can be separated objectively between wages and salaries on one hand, and profits on the other. Each of these can be taxed separately and at least from the point of view of an enterprise, increasing taxes on one component (say on profits) does not reduce the size of the other component (wages). ^5/

In state-owned enterprises, when the government no longer fully controls them, the distinction between owners and employees becomes fuzzy and so does the distinction between wages and profits. Those who control the enterprises, by controlling wages and other expenditures for the employees’ benefits have the power to allocate the total income produced by the enterprises between profits and wages. In a way they duplicate the situation of partnerships in market economies. As a consequence, there will be an incentive to reduce profits and profit taxes by inflating wages. This tendency has led some of these countries to put special taxes on “excessive” wage increases (Poland) or to consider taxing the full income (e.g., wages plus profits) of enterprises rather than wages and profits separately (Russia). Of course, a broad-based value-added tax already taxes the “full income” of enterprises. But VAT are rarely truly broad-based.

Under central planning most tax revenue came from three major sources: turnover taxes, “profits taxes,” and payroll taxes. ^1/ As indicated above, the institutional setup that accompanied central planning facilitated the collection of these taxes. For example, to a large extent the monobank performed the function of a tax collection agency. The kind of separate tax administration, with clear legal powers over taxpayers, that exists in a market economy was largely nonexistent. The average citizen qua citizen was never confronted by the tax system or by tax inspectors. He never had to file a return and, in most cases, was not even aware of the existence of taxes. For the average citizen of these countries taxes are a negative externality brought in by the transition to a market economy. In some of these countries, there were not even laws against tax evasion. ^2/ For all these reasons, tax evasion is likely to be a major problem in these countries. ^3/

The developments discussed above imply that the transformation will almost inevitably be accompanied by a gradual fall in the share of taxes in total production (T/GDP). This fall would eventually leave these countries with levels of taxation comparable to those prevailing in middle-income developing countries with similar per capita incomes--say, about 25-35 percent of GDP. All countries that have taken the road toward a market economy have witnessed a fall in tax revenue ^1/ (see Table 2). Table 2 may, in fact, underestimate the fall due to the fact that, the growing private sector activities are not properly assessed by the national accounts authorities, therefore, GDPs may be underestimated in more recent years. ^2/

Table 2.

Fall in Tax Revenue During the Transition

(In percent of GDP)

Source: Based on national data.p = projected outturn

^1/In percent of GNP. As recently as 1978 the T/GNP ratio was 34.0 percent.

^2/1992 budget.

^3/Excludes revenue from crude oil.

Table 2.

Fall in Tax Revenue During the Transition

(In percent of GDP)

	1988	1989	1990	1991	1992p
Albania	n.a.	44.2	42.2	27.5	17.8
Bulgaria	47.4	48.3	42.4	36.8	30.8
China 1/	18.4	19.0	17.7	16.5	16.0	2/
Czechoslovakia	51.7	53.1	54.8	45.5	44.4
Hungary	54.0	48.2	48.7	46.4	44.5
Latvia	n.a.	n.a.	n.a.	37.4	27.2
Kazakhstan	25.2	25.0	21.9	18.5	n.a.
Poland	40.2	37.0	43.8	35.3	n.a.
Romania	29.9	33.2	35.7	31.8	33.9
Viet Nam 3/	10.1	8.9	7.5	6.8	n.a.

Source: Based on national data.p = projected outturn

^1/In percent of GNP. As recently as 1978 the T/GNP ratio was 34.0 percent.

^2/1992 budget.

^3/Excludes revenue from crude oil.

View Table

Table 2.

Fall in Tax Revenue During the Transition

(In percent of GDP)

	1988	1989	1990	1991	1992p
Albania	n.a.	44.2	42.2	27.5	17.8
Bulgaria	47.4	48.3	42.4	36.8	30.8
China 1/	18.4	19.0	17.7	16.5	16.0	2/
Czechoslovakia	51.7	53.1	54.8	45.5	44.4
Hungary	54.0	48.2	48.7	46.4	44.5
Latvia	n.a.	n.a.	n.a.	37.4	27.2
Kazakhstan	25.2	25.0	21.9	18.5	n.a.
Poland	40.2	37.0	43.8	35.3	n.a.
Romania	29.9	33.2	35.7	31.8	33.9
Viet Nam 3/	10.1	8.9	7.5	6.8	n.a.

Source: Based on national data.p = projected outturn

^1/In percent of GNP. As recently as 1978 the T/GNP ratio was 34.0 percent.

^2/1992 budget.

^3/Excludes revenue from crude oil.

The fall in tax revenue creates great difficulties for macroeconomic policy and for policymakers, especially if public spending does not fall similarly. That fall can be contained, but not fully neutralized, by major restructuring of the tax system and by short-term measures. However, a major restructuring of the tax system will inevitably take time. ^3/ Short-term measures (for example, the temporary use of import duties) while useful and often necessary to maintain macroeconomic stability, may render more bumpy the road toward that restructuring since changes introduced now may not be easily reversible later, especially when strong legislators come into existence. In any case, tax reform must attract the full attention of senior policymakers. It cannot be treated as a minor issue.

It would be an illusion to assume that these countries can become efficient market economies while maintaining their former level of taxation since that level would be a major obstacle to the efficiency of the economy. But it would equally be a folly to let the level of taxation fall well ahead of the fall in public spending. Some western, private and, often, self-appointed advisors to these countries have been doing a disservice in advocating sharp cuts in tax levels regardless of the level of public spending and of the macroeconomic situation. Reducing tax rates, when the tax base is shrinking and the need for some new public expenditure is increasing due to the output collapse, would be out of touch with reality.

2. Issues in tax policy ^1/

The transition to a market economy requires (a) the legislation of a new tax system; (b) the enactment of the many rules and regulations that accompany a modern tax system and that make the administration of that system possible; and (c) the setting up of an appropriate tax administration.

A common goal of the European countries in transition has been the setting up of tax systems broadly similar to those prevailing in Western Europe. ^2/ These systems rely on (a) income taxes on individuals and, to a much lesser extent, on enterprises; ^3/ (b) value-added taxes; (c) payroll taxes collected from both employers and employees; (d) a few excises; and (e) some taxation of wealth. In theory, the countries in transition could simply “copy” the tax laws of the Western European countries. These laws, however, are often too complex and, in part because of this, they require skills, for both compliance and enforcement, not now available in the countries in transition. ^4/ Besides, the tax systems of Western Europe operate in a relatively stable economic environment (low inflation, small fluctuations in output, stable productive structures). This is not the environment likely to prevail in the economies in transition for some time, ^5/ so that tax systems that are put into place must be protected, through indexation or other measures, from the effects of inflation.

It would be wise for these countries to adopt tax systems which, while moving toward the long-run goal of creating European-style systems, reflect current local conditions. This may require, in some cases, the adoption of measures that may appear primitive from the point of view of an advanced industrial country. For example, at the very beginning of the transition (cascading) turnover taxes, applied with few rates, could be used instead of introducing value-added taxes before effective preparations have been completed for the latter. ^1/ After all, the Western European countries used turnover taxes, though with low rates, until the 1960s without noticeable damage to their growth.

Czechoslovakia replaced hundreds of turnover taxes with a few while starting the preparation for the introduction of the value added tax in 1993. In 1992, Russia introduced a value added tax with little preparation. Not surprisingly, it encountered difficulties and, given the 28 percent rate at which the VAT was introduced, revenue from this tax has, so far, been disappointing. The preparation for a VAT should start as soon as possible since it will be much easier to introduce such a tax when the number of taxpayers is still limited and is dominated by large, state-owned enterprises. In the medium term, as more private businesses are established, the tax administrations will have had experience in administering a VAT for relatively few taxpayers and will be better able to cope with increases in their number. There is no doubt that, with proper preparation, the more advanced among the economies in transition will be able to successfully administer a VAT. After all, about 40 developing countries have introduced VATs in their systems, and many of them have done so quite successfully.

Significant use could be made of excise taxes on particular goods. Taxes on imports could also provide some revenue over the short and medium term. Schedular taxes could be used in taxing the incomes of individuals, instead of attempting to introduce global income taxes which require far more sophisticated administrative capability. ^2/ Presumptive taxes, applied with simple criteria could be adopted for taxing new and small activities which would be difficult to tax in any other way. Agricultural activities could be taxed through the use of simple land taxes. In fact, some of these countries are considering such taxes.

In conclusion, the tax systems of developing countries could provide some lessons for the transition period since the social, structural, and administrative characteristics of the economies in transition will, for some time, resemble more those of the developing than of the developed countries. As these characteristics change and begin to look more like those of the industrial countries, the tax systems could, then, be progressively restructured to bring them closer to those of the industrial countries.

During the transition, simplicity should be the guiding norm. Sophisticated systems and the pursuit of multiple objectives for the tax system must be resisted. Attempts on the part of governments to promote industrial or social policies through the tax system would be misguided. Such attempts would, for example, result in a proliferation of tax incentives to enterprises and in the preferential treatments of particular groups of taxpayers and particular incomes through various forms of fringe benefits. ^1/ Taxes ought to be as broad based and as single rated as possible. Value-added taxes with multiple rates or multiple exemptions or zero rating of particular products would create excessive difficulties for tax administrators and would encourage tax avoidance and tax evasion. Income taxes with special treatments of groups or particular investments guarantee that they cannot be properly administered and that their contributions to revenue will be less than possible. These special treatments always lead to abuses and to high tax rates on the taxed activities and individuals. High tax rates generate disincentive effects and encourage tax avoidance behavior. They also generate political resentment. An additional problem with tax incentives or other special treatments of groups or enterprises is that once they are legislated, they develop strong constituencies that make it very difficult for them to be removed. ^2/ And, of course, once they are legislated for one group or one activity, they will be requested by other groups.

3. Issues in tax administration

A few basic principles should be followed in the setting up of tax administrations adequate for market economies remembering that, in the period of transition, the administrative resources at hand will be particularly scarce. The number of tax returns must be kept low by establishing final withholding of income taxes for most wage earners and by maintaining relatively high exemption thresholds for businesses. ^3/ This would allow the tax administration to concentrate on medium size and large enterprises which usually account for the bulk of sales and profit tax revenues. Because privatization will take time to materialize for the large enterprises, for some time most tax revenue will continue to be collected from state-owned enterprises. But, these enterprises will be more difficult to control than in the past, especially in periods of inflation when difficulties in getting credit may lead to a buildup of arrears, as experienced by many of these countries. In these situations, technical issues, such as whether taxes are based on cash or accrual concepts, can acquire great significance in determining revenue. ^1/

Tax administration efforts should concentrate on the most important revenue sources--excises, general sales taxes, taxes on wages, and enterprise profits taxes. Tax reform should aim at creating a tax system with only a few major taxes so that administrative effort is not wasted among too many taxes. Furthermore, at least for the short and medium run, the importance of setting up proper customs administrations should not be minimized. This is, of course, an urgent necessity for the countries that were born out of the breakup of the Soviet Union. ^2/

Tax reform efforts should be complemented by measures aimed at establishing modern accounting standards and invoicing requirements so that new taxes (such as a modern tax on profits and a value-added tax) can be implemented. Other complementary measures include those related to the rights and obligations of taxpayers, as well as those pertaining to the behavior of tax officials. ^3/ All these measures represent aspects that were either missing or not needed under central planning.

Particular attention must be paid to issues such as (a) staffing requirements ^4/; (b) computerization; (c) establishments of modern taxpayer identification systems and master files; (d) modern registration and collection procedures; (e) audit systems; (f) information systems for taxpayers. All of these aspects require time, attention, knowledge, and specialized resources. They determine to a large extent how good a tax system will be and describe areas where significant mistakes can and are being made. Furthermore, they must be considered within a broad strategy of reform. None of the above can be treated in isolation. They are all instruments that must be shaped in relation to a specific design of tax administration.

Finally, given the fact that, as already stated earlier, these countries are likely to experience periods of significant inflation, the impact of inflation on the tax system will need to receive particular attention. This attention will have to be aimed, first, at the introduction of adjustment schemes for the statutory tax system. In this aspect once again the experience of developing countries, and especially of Latin American countries, can provide useful guidance. Second, it will be aimed at insuring that collection lags are not so long as to significantly reduce the real value of taxes collected.

1. Public expenditure policy ^1/

Paying close attention to tax policy and administration will slow down the fall in the ratio of taxes to gross domestic product and will improve the quality of the tax system. It will not, and should not, however, prevent that fall over the longer run since many of these countries cannot become successful market economies while maintaining their current tax burden. The main objective should be to limit over the medium term the gap between public expenditure and public revenue that will accompany the transition period. This gap can generate serious inflationary problems since the sources for financing the fiscal deficit in noninflationary ways will remain very limited for years to come. ^2/ In time development of an efficient capital market and easier access to foreign sources may facilitate the noninflationary financing of a fiscal deficit.

In the short run, public expenditure can be reduced mainly by: (a) the elimination of most price subsidies to consumers; (b) the reduction or elimination of budgetary subsidies to loss-making state enterprises; (c) cuts in public investment since a large part of this investment has been directed, and is likely to continue to be directed, toward unproductive, or low return, activities; ^3/ (d) cuts in military expenditures; and (e) restructuring of social protection programs.

Over the medium run the government will need to pay close attention to the maintenance and the enhancement of social and economic infrastructures, to the conversion of military to civilian expenditure, to the need to reduce surplus public employment, and to the cleaning of the environment. ^1/ These changes will reduce some spending but raise other public spending. This is one of the reasons why public spending as a proportion of GDP will tend to fall less significantly than tax revenue in the near future. Other aspects that will need to receive attention are (a) the integration of extrabudgetary expenditures in the budget ^2/; (b) the integration in the budget of the cost of recapitalizing banks; (c) the elimination of nonessential government functions; and (d) the improvement of the efficiency with which remaining public sector functions are carried out. Also, the conversion of enterprises which have been producing military equipment into enterprises producing products for the nonmilitary economy will require public spending.

Over the long run the level of government expenditure will have to depend on the countries’ capacity to finance that expenditure and on the demand for social services. Therefore, it will depend largely on their ability to raise taxes, and on the role that the state will play in the reformed economies. A European role, with socialized health care, free education, public enterprises and generous social insurance systems, will imply a larger public sector and a greater need for public revenue; an American role will imply a smaller public sector and lower revenue needs.

The social insurance sector, defined broadly to include old-age and survivors’ assistance, disability and sick pay, unemployment compensation, social assistance, and health care, will need to receive a lot of attention in the short and medium term, especially since the transformation of the economy and the liberalization of prices dramatically reduce the relative incomes of some groups making them particularly vulnerable. The pensioners and those who lose their jobs and become unemployed are visible examples of such groups. The increasingly severe budgetary constraints will require that only high priority, or essential, expenditure is undertaken. Thus, strict expenditure priorities must be established, both within sectors, such as health or pensions, and across sectors. Once again, the efficiency with which public services are delivered and social objectives are translated in spending decisions must be raised to keep spending down. Expenditure decisions must be conditioned by macroeconomic necessities to prevent inflation and other macroeconomic difficulties. ^1/

The removal of implicit subsidies, given through low producer prices, through products imported at overvalued exchange rates, through negative real interest rates, or through other means, will improve the efficiency of the economy but will also reduce the real incomes of many consumers. These reductions can be so large as to necessitate at least partial compensation for the most affected groups. However, limitations in budgetary resources will require a careful evaluation and containment of social expenditure. The beneficiaries of these programs cannot be a large proportion of the population, and the benefits that they receive cannot be close to the average level of wages. For example, in one of these countries, in 1992, expenditures on social protection programs have been estimated at almost 30 percent of GDP. Such a level is clearly unsustainable. In many of these countries the proportion of the population that can claim government assistance of some sort is so large as to make it difficult to contain public spending to a level that can be financed without strong inflationary pressures.

Even considering the low life expectancy of these countries, the retirement age is often too low and will need to be raised. Requirements for disability pension are too flexible and must be tightened. Sick pay benefits are too generous and must be reduced. Maternity leave benefits in many of these countries are excessively generous, often allowing paid leaves that extend to many months or even years. Unemployment compensation must be limited in time and in amount so as not to affect incentives to work or to look for employment. Public works program may need to be provided for those who have exhausted their unemployment benefits and are unable to find jobs in the emerging private sector. Pensions and other social benefits would continue to be financed through payroll taxes, but these taxes should be limited in order to achieve international competitiveness. In many economies in transition payroll taxes remain exceptionally high. ^2/ However, their reduction will be possible only if social expenditure can be reduced.

Social assistance for families or individuals will need to be provided for those who have been most affected by the elimination of the subsidies to consumer goods and are unable to take advantage of the emerging opportunities in the private sector. These are likely to be old people, people with serious disabilities, and families with children. Over the short term it may not be possible to provide assistance based mainly on past contributions or on means tests (i.e., on income levels) since the information for such an approach may not be immediately available and the administrative costs of this approach may be too high. ^1/ As a consequence, it will be desirable to keep the system of allowances as simple as possible--for example, a flat allocation per child below a certain age, or through the provision of food stamps for particular categories, with benefit levels set in relation to available resources. Over the medium term, means tested cash benefits should be introduced. ^2/ In many economies in transition, the level of family allowances is excessive and may represent an unnecessary incentive to population growth.

The provision of social benefits is often carried out through a multitude of programs some administered by state enterprises, some by trade unions, some by local governments and some by the Government. This often allows beneficiaries to take advantage of more than one program, thus receiving benefits that can significantly exceed their basic needs. This arrangement not only creates confusion but raises the total cost of social protection and creates inequity among beneficiaries. It often favors unionized workers over non-unionized workers and members of old trade unions over members of new trade unions. Such arrangement is inconsistent with the features of a market economy. The central government needs to take control of this area both to reduce costs and to improve the equity and efficiency of social expenditure.

2. Management of public spending

Policy decisions related to government expenditure will lead to better results if the institutions required for the efficient management of spending are in place. In market economies, the most important among these are the budget office and the treasury. ^3/ Under central planning these institutions played a secondary role in the management of public expenditure since the budget was largely the financial appendix of the plan and the monobank was the main institution involved in the execution of the budget.

Decisions about the distribution of social resources within the all-encompassing public sector were largely taken within the framework of the plan. Some of these resources were assigned to finance social objectives, such as education, health, and social assistance, carried out by spending ministries. The function of the budget was mainly to authorize the transfers of funds to these Ministries. Furthermore, many of the functions which in market economies are assigned to the budget and, through it, to the spending ministries, were carried out directly by the state enterprises. Such institutional and organizational arrangements made difficult the identification of fiscal policy as a separate and important activity of the government.

The monobank was in charge of (a) crediting to the government accounts the tax revenue collected through the banking system from the state-owned enterprises; (b) distributing the budgeted funds to the spending ministries and organizations or, when authorized, to particular enterprises; (c) keeping the accounts for government revenue and expenditure operations; and (d) financing budget deficits and loss making state enterprises, through domestic bank credit or occasionally through external borrowing. Thus, when the monobank financed a social activity, it was performing a fiscal rather than a monetary function.

The above description highlights the extent to which monetary and fiscal policies were intermingled. Good economic policy in a market economy requires the separation of these policies. The reinforcement of the role of the budget office and the creation of a treasury, and a separate and independent central bank would help promote that separation. It would leave the central bank free to focus on monetary policy and would shift to the budget office and the treasury the main responsibility for the conduct and implementation of fiscal policy. ^1/ The government must develop an administrative capacity for quick response to unanticipated changes in revenue and for ensuring that whatever pragmatic changes are introduced for short-term crisis management, or for other reasons, can be pursued through effective budget management system.

An efficient budget office and a well functioning treasury will undoubtedly improve the quality of policymaking, especially in situations that are likely to continue to be characterized by large economic fluctuations, significant inflation, and great uncertainty. Efforts in reinforcing the role of these institutions must be accompanied by the development of a fiscal reporting system so that the policymakers are on top of current information that they can use to make their policy decisions.

An efficient budget office would be better able to forecast trends in revenue and expenditure on the basis of prospective macroeconomic developments. It would also be better able to estimate taxation and expenditure levels required to achieve particular economic objectives, such as a given rate of inflation and a given balance of payment outcome. It would also be a more efficient tool for assessing the efficiency with which public expenditure is being carried out by the spending ministries. In other words, the budget office would provide the policymakers with an important tool for resource allocation and for stabilization.

A well-functioning treasury would allow the government to manage its cash balances better and better execute and control budgetary decisions. This can reduce the need for borrowing on the part of the government and can thus reduce the fiscal deficit. Without such an office, the probability that expenditure will exceed the budgeted limits will be higher. The treasury should also be in charge of the management of public debt and should have full and current information about extrabudgetary accounts. By entrusting the management of public debt to the treasury, the financing of the deficit could also be kept under constant surveillance in order to avoid or limit inflationary financing. Such an institution would keep the policymakers informed on a timely basis about expenditure and revenue developments so that necessary changes can be made as needed. When such a knowledge is not available, or is not available when needed, the probability of making serious policy mistakes undoubtedly rises.

In conclusion, the creation of a competent budget office and of an efficient treasury is an essential development in institution-building that needs to take place in all the countries that seriously aim at becoming well-functioning market economies. This need is now well understood by the policymakers of many of the previously planned economies. Several among them are proceeding to set up modern budget and treasury offices. This process, however, will inevitably require time and effort, as well as resources for the acquisition of equipment and for the training of personnel. By removing some of these functions from the central bank, it will also facilitate the transition of that institution to a more limited but more effective role. But, once again, a vacuum is created when the central bank gets out from performing this treasury function before a modern treasury is in place.