At a lunchtime meeting on 28 February, organized by the Centre for Economic Policy Research and the UK office of the Commission of the European Communities, David Newbery reported the results of research prepared for the group of consultants to the PHARE programme of the Commission of the European Communities (see separate box). Newbery's preliminary findings appeared as CEPR Discussion Paper No. 371,`Tax Reform, Trade Liberalisation and Industrial Restructuring in Hungary'.
David Newbery is a Research Fellow in the International Trade and Applied Microeconomics programmes at CEPR, and is jointly organizing a new research programme (with Irena Grosfeld and CEPR Director Richard Portes) on economic transformation in Eastern Europe. Funding for this meeting was provided by the Economic and Social Research Council, as part of its support for the Centre's dissemination programme. The views expressed by Professor Newbery were his own and not those of the ESRC, the European Commission or CEPR, which takes no institutional policy positions.
Newbery argued that the events in Eastern Europe at the end of 1989 were truly revolutionary, and therefore contrasted with the earlier Hungarian programme of economic reform, which had been evolutionary and gradual. While evolutionary reform aims to modify institutions in order to improve economic performance, revolution is more concerned to destroy existing institutions and power bases, even at the expense of economic performance. Much of the debate on East European reform concerns the issue of whether a revolutionary or evolutionary approach is best suited to achieving the transition to a market economy, which is illustrated most clearly by the differing degrees of priority attached to the privatization of state-owned assets in the sequencing of reforms.
A gradual transfer of ownership could be achieved by setting up institutions such as pension funds and investment banks, to which ownership could initially be transferred while markets are liberalized and prices find their equilibrium levels, so that the assets may be properly valued. On the other hand, a revolutionary approach would require rapid privatization as an essential first step, in order to ensure the irreversibility of the change from social ownership to capitalism. It remains to be seen which approach will be adopted in Hungary, where the tradition of gradual reform is meeting increasing pressure from more revolutionary spirits.
Newbery noted that simply replacing central planning with a free market will create neither the competitive pressures for efficiency nor the predictable regulatory and fiscal regimes that are necessary to avert the danger that state socialism will be replaced by monopoly capitalism. For example, if handing over economic power to banks creates no new competitive pressures, but merely removes the constraints on the concentration of wealth, then markets may be subverted by the exploitation of political power to influence the allocation of subsidies or negotiate over tax regimes. Such problems will clearly be accentuated if the regulatory environment is unpredictable. Conversely, the creation of stable expectations about future market regulation will reduce the value of political influence and increase the value of improved economic efficiency.
The reform of the tax system, which was first implemented in Hungary in January 1988, and supplemented by additional reforms in January 1989, is an essential first step of this process. This reform will replace the firm-specific taxes and subsidies of the centrally planned economy, which typically removed surplus profits and made up shortfalls, with a system of predictable and non-discriminatory taxes to enable firms to reap the benefits of their improved efficiency. The creation of stable and statutory tax structures will lead to a hardening of the `soft' budget constraint that firms currently face, and will encourage agents to make sensible long-term decisions.
Newbery noted further that the Hungarian reformers had inherited a highly concentrated industrial structure, in which individual enterprises had considerable domestic market power. The reformers recognized that in the absence of a full-scale liberalization of foreign trade, price controls would be required to prevent enterprises from exercising this market power once they were encouraged to pursue and retain profits. Although they also recognized the desirability of breaking up large enterprises into their constituent, more specialized branches, the experience of planning and the perceived advantages of exercising collusive market power have nevertheless led to the emergence of a number of product-specific cartels. The dismantling of multi-product, multi-plant enterprises remains highly desirable, since it will make the exercise of market power more difficult, prevent cross- subsidization, and accelerate the introduction of competition into the markets for labour and capital.
These results could not be obtained simply by exposing firms to foreign competition, i.e. by drastically liberalizing Hungary's international trade, because its trade with the other CMEA countries is governed by long-term contracts and its balance of payments remains fragile. Nevertheless, the trade regime should be liberalized gradually to enable firms to import components when domestic suppliers perform unsatisfactorily.
Newbery also noted that Hungary faces a major problem of foreign debt, and requires substantial further capital inflows. It must therefore raise its growth rate to convince foreign lenders of its ability to repay, which will require a more elastic supply of labour to firms in the more dynamic sectors and the shedding of labour by inefficient firms. This will require a radical restructuring of the labour market, which will not be easy since total workforce is in decline and there is little surplus labour to be transferred to the dynamic sectors. High unemployment may be unavoidable for a transitional period, and the unemployment benefit scheme introduced at the beginning of 1989 will play an important role in this process.
Newbery maintained that the interconnected issues of the reform of capital markets, clarification of ownership rights and privatization are the most contentious and least well-thought-out aspects of the reform programme. It is not necessary to privatize existing firms by selling shares to their managers, workers or the wider public in order to achieve the economic restructuring that is required. Indeed, this would complicate the issue of how to recognize the claims of the state on the assets of socialist enterprises, which constitute the asset side of the public sector balance sheet (in which foreign debt is the major liability).
Newbery concluded that the success of Hungary's reform will depend largely on the commitment of the authorities to the introduction of predictable competitive pressures. The necessary foundations are a non-discretionary tax system, a liberal foreign trade regime, the abolition of discretionary subsidies (with the consequent risk of firms' liquidation) and the freedom of entry of new firms into production. The Hungarian reformers appear to accept this diagnosis. They will remain under pressure, however, to rescue firms where local employment is jeopardized, to protect inefficient production, and to maintain full employment and hence existing labour market rigidities.