Fiscal Reform in Eastern Europe

Michelle Phillips (Senior Sophister)

The current desire among Eastern Europeans to correct their formerly planned economies to market ones of limited intervention is one of the most significant features of the present phase of international economic developement. Such a process provides fascinating study for economists. In this essay, Michelle Phillips focuses attention on fiscal reform, addressing such associated issues as public expenditure, tax reform and the financing of emergent fiscal deficits.

One of the most prominent debates among different schools of economic thought has concerned the appropriate role of the state in the economy. The divergence of opinion on this issue can be seen by conkasting the Stalinist-Marxist with the Smithian conceptions. According to Stalin (in his interpretation of Marxist economics), the state should determine, inter alia, 'allocation of resources, distribution of income and consumption, levels of saving and investment, and relative prices of goods and services' (Tanzi, 1992). On the other hand the Smithian view was that the state is 'a spectator that steps in to correct the actions of the private sector when it commits errors of commission or omission'(Tanzi, 1992).

The contrast between these two viewpoints epitomises the difference of approach of the state between the former centrally planned countries of Eastern Europe and the Western democratic states. However, since the fall of communism, it has been widely recognised in the former that a reduction of the role of the state is appropriate. Since the most direct form of government intervention in the economy is fiscal policy, this requires, first of all, a redefinition of the role of fiscal policy, and then total reform of the fiscal system. This is possibly the greatest challenge facing these Eastern European administrations, as fiscal policy is both complicated and multi-faceted, and the required fiscal reform involves 'opting out' of the economy to an extent.

In this essay, I shall examine the issues associated with such fiscal reform in these countries. I will begin by focussing on public expenditure, and the need to reduce it drastically. Although there do exist taxation systems of sorts in these economies, there is urgent need for tax reform, as the revenue requirements of the transition process are substantial. I shall therfore discuss the issue of taxation at some length in this essay. It must be recognised that fiscal policy cannot be discussed or examined in isolation of the rest of the economy, so I will focus on how fiscal policy can relate to the stabilisation process. The importance of separating fiscal policy from monetary institutions and policy must be pointed out at this conjecture. Finally, the revamped nature of the fiscal system means that tax revenue is reduced and government expenditure may need to be increased; this leads to fiscal deficits. In the last section of the essay, I shall focus on the methods available to those financing fiscal deficits in Eastern Europe.

The Transition from 'Big' Government to 'Small' Government

In a nutshell, what Eastern European governments do as part of fiscal reform is to decrease the level of, and change the structure of, public expenditure. On first examination of data, one would be surprised to find how low the ratio of public expenditure to GDP actually is. In the late 1980s this ratio for Eastern European countries averaged at around 55%, a level very similar to many Western Economies with large social welfare systems, for example Ireland and Luxembourg, both of which had ratios exceeding 50% in 1988 (Chu and Holzmann, 1992). However we must approach these data with some cynicism. The actual level of government intervention via expenditure is understated by such figures, due to the existence of much implicit expenditure, for example enterprise subsidisation in the form of tax incentives. Also the quality of data comes under question because of the existence of price distortions, unrealistically low interest rates and a multitude of exchange rates in former centrally planned economies (Chu and Holzmann, 1992). But there can be no doubt that the role of the public sector in these economies was, and still is, too large, and a substantial downsizing of government is required.

Before transition began, the level of public expenditure was determined by the plan. If state enterprises needed subsidies of £100m to produce what the plan dictated, then this was accepted without question by governments and automatically provided. Government subsidisation was quantity-based. The high level of expenditure was also as a result of the governments' perceptions of themselves as employment guarantors to the people, which warranted further subsidies to enterprises to provide employment for a surplus labour force. But it is clear that an abandonment of 'the plan' in the transition to market orientation means that the level of public expenditure will have to be determined by different criteria. A distinction will have to be drawn between the public and private sectors, and the role of the government in the public sector will have to be made explicit. The central challenge here is to decide on the appropriate sizes of the two sectors, and therefore the role that the government will have.

Possibly of greater significance than the level of public expenditure is the structure it has had in the past, and what its composition should be. The major focus of expenditure in the past was on subsidies of state enterprises, the subsidisation of housing, the financial support of the state monobank, and military expenditure. Much expenditure also went on cushioning the effects of interest rate fluctuations on enterprises and households, and a very broad generalised social benefit system of a universal nature.

Reform of the composition of public expenditure should include some very obvious measures, such as the removal of (or at least downscaling of) military expenditure, and a social benefit system that is less universal and more focussed on poverty alleviation, targeting the poorest sectors of society. The widespread subsidisation of state enterprises (most of which will become private enterprises as transition progresses) should be stopped, and if this proves too difficult, it should at least be based on criteria of profitability or efficiency, rather than output.

Essentially, public expenditure should have a growth-orientation (implying contributions to national savings, expenditure on infrastructure, incentives to invest and cleaning up of the remaining public debt between enterprises and banks). It should also be more market-orientated, undertaken like private investment with cost-benefit analyses done prior to investment (Chu and Holzmann, 1992). For the public good of these middle-income countries, there should also be more expenditure devoted to health and education.

Of course, there are large difficulties associated with this downsizing of government. The cessation of subsidisation of enterprises means that the previously unheard of problem of unemployment will become an issue. Expenditure outlays will have to be increased to pay for increased unemployment benefits. The restriction of expenditure means that greater attention will have to be paid to forecasting of economic conditions when appropriations are being made for the budget, a difficult task when faced with an unstable economy. The implicit nature of much government expenditure makes this difficult to remove. Finally, during all of this, the government will have to be strong, as many of these measures will be (and have been in the past) fiercely opposed by certain political activists and interest groups. The need for reform will have to be re-emphasised many times in certain cases (Tanzi, 1993).

In conclusion then, although it seems like a very difficult task at first, the importance of firm restructuring and downscaling of public expenditure cannot be over-emphasized in the transition to market economy. Stabilisation of the economy is impossible unless the budget deficit is at least stabilised. Even with tax reform, this is impossible without reform of the public finances.

In the next section, I shall highlight the importance of the tax side of the budget, and the urgent for reform in this area, often considered much more important than expenditure reform.

The Transformation of the Tax System

In the days of the command economy in Eastern Europe, the methods employed to extract revenue from the people were totally unlike anything ever seen in Western, market-based economies. In a market-based economy, the government only has the power to define the tax base, set rates, and try to penalise evaders. However, in a centrally-planned economy, the collection of tax is very simple, as it really only represents the transfer of funds from one area of 'the state' to another.

Tax revenue accruing to the government in centrally-planned economies came through four channels, namely the enterprise profits tax, the tumover tax, payroll taxes, and foreign trade taxes. The latter are mainly used to protect the planning process from the effects of intemational trade. Their importance from a fiscal revenue point of view, however, is often negligible. The remaining three channels of tax extraction are much more significant in revenue terms. The payroll tax is a sort of implicit personal income tax, except it is not taken from individual incomes, but rather as a lump-sum from the payroll of the state enterprises which employ the individuals. Therefore, the individuals do not see the tax being taken from them, and are not obliged to file tax retums (although there are exceptions to this). The amount of the tax is just automatically debited from the enterprise's account with the state-owned monobank. The tumover tax is collected in the same way, except it is levied as the difference between the administratively-set producer price and the administratively-set consumer price; as the name suggests, it is a tax on the tumover of enterprises. Any remaining surplus accruing to the enterprise, a somewhat arbitrary figure, is then extracted via its bank account as the enterprise profits tax.

The system as it has stood in the past has perfommed its functions extremely well, and the revenues accruing to the state in these centrally-planned economies were very impressive. However, in recent years, as these economies have embarked on the transition to market-orientation, their tax systems have failed. For example, in the years 1989, 1990 and 1991, the level of tax revenue received by the state in Bulgaria fell from 60% of GDP to 53% in 1990, and then to 39% in 1991, an absolute decline of 20% (Bristow lectures, Nov. 1994). Other European Countries have experienced similar declines as the central planning system collapsed. The implications of this for fiscal deficits are startling, as the ability of these govemments to cut spending by similar proportions is very limited. It is clear that the reason for this revenue collapse lies in the incompatibility of the old taxation system with a market-based economy.There are many reasons why the old system should fail utterly when faced with a market regime. Firstly, whereas previously the state had to extract taxes from hundreds, or perhaps thousands, of enterprises over which they had great control, with privatisation, the state was faced now with millions of individuals and privately-owned enterprises, which meant a reduction of infommation available to tax collectors, and increased difficulties associated with collection (Tanzi, 1993). Secondly, the liberalisation of prices and wages to market-detemmined levels, meant that neither payroll nor tumover taxes could be relied on as much for revenue, as the state could no longer administratively set the payrolls or the tumovers of enterprises. The excessive levels of inflation which accompanied liberalisation also spelled a fall in the remaining profits of enterprises, which meant that there was less taxable income in the fomm of company profits, and less potential tax revenue. Thirdly, the onset of a market-based economy led to the privatisation of what were state-owned enterprises, making the private sector larger, and more fimms difficult to tax. Finally, the financial reform which had to accompany transition meant that the state had to sell off the banking sector to private interests. However, this meant that withholding taxes at the source was no longer possible; rather than just debiting enterprises' bank accounts, the state now had to rely on the enterprises to pay the tax.

There can be no doubt, then, of the need for tax reform in Eastem Europe. Or rather, what has been suggested instead of refomm of the existing system, is the creation of a totally new system, which many agree should broadly mirror the systems in place in Westem economies, without, of course, the inherent flaws in these systems. It goes without saying that some form of value-added tax and personal income tax should be simplemented. However, it is unreasonable to expect that these can be just introduced ovemight with no effects on revenue. There will have to be some sort of transitional arrangements made to ensure that the effects on the fiscal deficit of the tax reform are minimal. With highly unstable prices, the introduction of a VAT may take some time, as , with a view to prospective EU membership, there has to be a change from a multi-rate system to a system with one or two rates of VAT and a very broad base of taxable goods. The introduction of a personal income tax shouldn't pose too much of a problem if it is levied at a low rate, on a PAYE basis, with a tax allowance system that is initially quite simplified (Gandhi and Mihaljek, 1992).

In addition, two extra transitional taxes have been suggested by Holzmann (1992) to ease the effects of economic stabilisation on the public finances, namely a transitional import surcharge (which would have revenue benefits and has the advantage of protecting domestic industry from extemal competition) and a capital gains tax (which would ensure an equitable distribution of income). But it must be emphasised that these would have to be transitional measures and specified as such from the outset, as their imposition in the long run would be detrimental for many reasons.

The orchestration of tax reform should be done as speedily as possible, but various experts in the field have laid down some golden rules on this issue. There should be discontinuation of negative discrimination against the private sector via the profit tax. It should be recognised that the sole purpose of taxes are to collect revenue for the state; they should not be used to achieve the objectives of the plan. There have been many calls by public sector economists to experiment with new and untried taxes in Eastem Europe. However, according to Vito Tanzi (1992), these countries should 'refrain from excessive experimentation, that is, from the temptation to go for untried taxes, which may look good in theory, but may be difficult to administer'. A tightening of tax accounting regulations has also been suggested because a reduction in the profit tax base will result from a market-oriented accounting system (Chu and Holzmann 1992).Finally, in conclusion, tax reform will have to be focussed on economic efficiency (minimising the deadweight loss of taxes), administrative efficiency, equity, and, above all, simplicity.

Fiscal Policy in a Broader Context

There can be no doubt that elements of fiscal policy have a role to play in the stabilisation process, or at the very least can help to ease the hardships associated with the transition to a market economy. In an ideal situation, fiscal reform should reduce expenditure sufficiently so that budgetary surpluses result, and with these surpluses the state is in a position to mobilise savings in the private sector, facilitating ease of privatisation, supporting the banking sector and fostering investment. However, no situation is ever ideal, and we can only hope for some positive effects of fiscal policy in the transition period, while ensuring a balance between private and public savings. Since alternative institutions tend to be too weak in the early stages of transition, it is often up to the state (via public expenditure) to subsidise key industries, improve infrastructure, ensure minimum subsistence wages for all in the face of spiralling prices, foster goals of equitable income distribution and encourage foreign investment. But even though fiscal policy should foster private sector development, it is, however, imperative that it 'contribute to stabilisation without delaying the necessary fiscal restructuring' (Chand and Lorie, 1992), as the latter should take priority.

But, as mentioned previously, the stabilisation process usually spells disaster for fiscal coffers. Instability in the economy as well as terms of trade deteriorations lead to a fall in enterprise profits (be they public or private sector), and this means a fall in revenue. The emergence of current account deficits for the first time in these former centrally-planned economies is daunting enough, but even more so when we consider the possibility of this leading to hyperinflation, causing depression on the economy and hindering investment. I shall deal with the problem of deficits in the next section.

One of the more alarming aspects of the legacy of centrally-planned economies is the degree to which fiscal policy is fused with monetary policy. These fiscal-monetary links are numerous. The banking systems in Eastern Europe have been giving out credit at will for many years to struggling enterprises, and then relying on the state to finance them when they turn into bad loans. Thus, in effect, fiscal policy (i.e. the subsidising of state enterprises) has been exercised via the monetary institutions. The banks have also been keeping interest rates low to reduce the burden of the internal public debt, traditionally a fiscal responsibility. In more recent years, as government revenue has collapsed, and budget deficits have emerged, there has been a reliance on monetary expansion to finance any extra public spending (Tanzi, 1992). As these economies approach market status, it is becoming increasingly important that many of these fiscal-monetary links be severed, so that each policy is directed at the area in which it is relatively more efficient.

Dealing with Deficits

It may seem an oversimplification to assert that under the old command economy systems in Eastern Europe, budgets always balanced, but essentially it is the truth. The planning system largely ensured that government expenditures were matched by government revenues. If there was ever any shortfall, due to the administration mechanism of the budget, or, more significantly due to exogenous shocks to the economy, the deficit was usually camouflaged by 'creative accounting' (Cheasty, 1992), or prices were adjusted so that more money could be extracted from enterprises. However, with the onset of the market-based system, such methods were no longer available to the state, and all deficits had to be announced and publicly financed (i.e. they became 'below the line' deficits). This became more of a problem considering the aformentioned revenue collapse experienced by these countries, and the difficulties associated with reducing public expenditure. As they began their journey into market-orientation, the governments of these formerly centrally-planned economies found themselves, for the first time, exploring Western methods of deficit financing.

In her paper 'Financing Fiscal Deficits' (1992), Adrienne Cheasty has discussed various options open to these countries for the financing of deficits. In doing this, she has orchestrated various simulations analysing the various effects on the economies in question of the different options, assuming an initially loose policy that gets progressively tighter. Although some specific recommendations are made for specific countries, these are beyond the scope of this paper. Some general conclusions did emerge, however. Foreign financing is the least costly option, but is only appropriate for those countries that do not already have a large external debt, and have a good trade balance. However, it should really only be a last resort, to relieve inflationary pressures. Theability to use this method also depends on the domestic-world interest differential. As a temporary option, bank financing is often suggested for those countries with an existing large external debt. However, this invariably leads to inflation, and the danger of hyperinflation. The third option examined by Cheasty is domestic non-bank financing, the main disadvantages of which are that the interest burden is often quite substantial (relying on the domestic interest rate), in that it tends to depress the economy. It also defeats the purpose of reducing public sector interests in the economy. The broad conclusion which can be drawn from this is that different financing options are more appropriate in different countries, and no sweeping policy recommendations can be made for Eastern European countries in general.


In conclusion, then, complete fiscal reform remains one of the greatest challenges facing the governments of economies in transition. They must try to 'step back' from the workings of the economy in order to allow the market to do its job, while simultaneously trying to construct modern Western-style tax systems, all to be done as quickly as possible. This is made all the more difficult by the fact that they must try to minimise the size of, or at least the effects of, deficits resulting from the precariousness of the system. It can only be hoped that valuable lessons can be learned from the experiences of the well-established fiscal systems of the West.


Bristow, John <1994) Senior Sophistor European Transition, Course Notes, Economics Department, Trinity College, Dublin.

Chand and Lorie, (1992): Fiscal Policy, Ch 1 of Tanzi V. (ed.), Fiscal Policies in Economies in Transition, IMF.

Cheasty A. 'Financing Fiscal Deficits', Ch 2 of Tanzi V. (ed.), ibid

Chu and Holzmann 'Public Expenditure: Policy Aspects', Ch 12 of Tanzi V. (ed.), ibid

Gandhi and Mihaljek 'Scope for reform of Socialist Tax Systems' , Ch 7 of Tanzi V. (ed.), ibid

Holzmann R., (1992) 'Tax Reform in Countries in Transition: Central Policy Issues', Public Finance Supplement.

Tanzi V., (1992) Fiscal Policies in Economies in TransitionIMF.

Tanzi V.,(1993) 'Financial Markets and Public Finance inthe Transition Process', in Transition to Market : Studies in Fiscal Reform, IMF.