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Tax surprises from new EU countries

In spite of attempts at reducing the scope of tax incentives, there is still the propensity, on the part of the policy-makers of these countries—certainly stimulated by their past experience with central planning—to try to direct or influence the economic decisions of enterprises or even of individuals with incentives. This of course reflects a lack of trust in the ability of a market economy to make the right choices. It is an indication that the period of transition is not yet complete.


In some ways classical central planning was an effective and esthetically attractive social instrument that fascinated many western social scientists. Unfortunately, by limiting individual liberties and by killing individual incentives, it carried an enormous cost in terms of economic efficiency and political liberty.

This cost became progressively higher with the passing of years when the revolutionary enthusiasm, which existed in the earlier years, faded and cynicism and corruption rose. As time passed, the centrally planned economies became increasingly inefficient and unable to satisfy the consumption needs of their populations.

In that central-planning environment, the role of the tax system was limited and there was hardly any need for a western-style tax administration. Taxes on labor income were collected directly from the state enterprises, by simply adjusting the cash transfers that they received from the central bank to pay the wage for all employees. There was no objective definition of enterprise income to determine precisely the taxes on profits.

The payment from an enterprise to the state was negotiated; it was not based on the actual profits. The depreciation allowances for the use of capital assets bore little or no relation to the useful life of the real assets used. There were no laws that defined the turnover taxes. These were determined arbitrarily in the plan and reflected both social considerations that favored particular items (children’s clothes, art books, etc), as well as supply and demand conditions. When there was excessive inventory of an item, the turnover tax was reduced to induce citizens to buy more of this item. Therefore, the turnover taxes could be in the thousands and changed frequently.

The reforms introduced by the new EU countries had to cope with economies in which prices and wages are free to fluctuate, private sector activities become important, there are no controls on the output of enterprises, so that their incomes are not known and payments can be made in various forms and no longer through just one ‘monobank’.

This new situation would demand both new tax systems and new tax administrations. Furthermore, these had to be adjusted over the years to conform with the changes in the structure of the economy. It would not be imprudent to say that the tax systems of these countries have come a long way and that from now on they will need more fine tuning than radical surgery.

When we look at the current situation of the countries, we are surprised by some aspects.

The first surprise is the closeness of their current tax burdens. In fact these tax burdens are all close to 40 percent of GDP, having come down from higher levels. A tax burden of 40 percent of GDP may be close to, or even lower than, the European average but it is very high considering these countries’ still low per capita incomes. From an international statistical perspective, the tax burden of these countries could be expected to be somewhat lower. Thus, a question that needs to be raised is whether the current tax levels are sustainable over time. It would be reasonable to speculate that they are likely to fall as the transformation of these economies continues. This fall would require a reduction in public spending.

The second surprise is that, in spite of their high tax levels, all of these countries, with the exception of Estonia, have developed high budgetary deficits, which have been growing in recent years. This implies that these countries have not succeeded yet in reducing the role of the state to a level that can be financed through ordinary tax revenue. The state is still expected to do too much despite various reforms aimed at reducing its role and responsibilities. This aspect could become a problem that would extend beyond the need to meet the Maastricht criteria. The fiscal gap must be closed by reducing public spending rather than by increasing the high level of taxation.

The third surprise is the extent to which labor income is taxed. This is partly due to the large payments for social security contributions, which in some of these countries, such as the Czech Republic, are among the highest in the world. This heavy burden on labor income must be reduced if the development of growing underground activities is to be prevented. This growth of underground economic activities is already under way in several of these countries and is likely to accelerate with the passing of time.

The fourth surprise is the almost uniform move towards fiscal decentralization. Undoubtedly this is a political reaction against the powerful central governments of the past. Once the communist regimes were replaced, the citizens of these countries were anxious to have more ‘voice’ and more control over decisions that affected their lives. However, regardless of its political merit, this process of decentralization is likely to constrain future tax reform and to affect negatively future macroeconomic developments. Experience from around the world indicates that it is often more difficult to reduce fiscal deficits in a fiscally decentralized environment.

A fifth and pleasant surprise is the growing use of environmental taxes in these countries. The centrally planned past had left these countries with major environmental problems that affected health and life expectancies. Many in these countries have low life expectancy, perhaps due to the quality of the environment. Thus, the attempt to reduce this problem through the use of tax instruments is one that deserves praise.

After labor income, consumption is the other tax base that carries much of the tax burden. All these countries have introduced value added taxes, which with some adjustments will conform with the requirements of the European Union. However, there are still too many excises and other small taxes. Some of these will have to disappear in future years. Property taxes are still playing a marginal role. This is not surprising since, until a few years ago, there was no or little private property.

However, in future years, it would be preferable to give a growing importance to this tax base, especially for financing the local governments, while reducing the reliance on revenue sharing arrangements that transfer to the local governments parts of the revenue from personal income taxes and corporate income taxes.

It is surprising the extent to which incomes from capital sources are lightly taxed. This is an element that will contribute to the faster growth of these countries’ economies but at the cost of lower tax revenue and a less progressive tax incidence. If not-taxing capital requires overtaxing labor and, thus, giving a strong incentive to the shadow economy, then over the long run the stimulative effect of low capital taxation on the economy will be much reduced. There is also evidence that Gini coefficients have been growing in several of these countries so that equity issues might become more important in determining tax reforms in future years. The income tax rates on labor income, per se, are not unusually high but when they are combined with high social security taxes they tend to overburden labor income.

There is some evidence of tax experimentation in some of these countries. For example, Estonia has introduced a linear (i.e. flat rate) tax on labor income. The tax rate is 26 percent. Thus, it has given up the idea of using the income tax for redistributive purposes. This tax combined with the exemption from taxation of much capital income makes it almost a twin of the value added tax in its effects. The result is that consumption is taxed much more than saving. This probably promotes more saving, but at the cost of increasing income inequality over time. Another interesting innovation in the tax system of Estonia is that, for enterprises, only distributed profits are taxed (also at 26 percent) while retained profits are tax free. This feature is a strong incentive to reinvest the earnings of enterprises. Thus, it promotes investment.

In future years the road chosen by Estonia, i.e. a simpler tax system with fewer or no tax incentives should be the favored one.


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