Fiscal reform is central to the process of transforming a centrally planned economy into a market economy. The traditional methods of raising revenue in the Central and Eastern European countries (CEECs) no longer work. With the emergence of a significant private sector, the old system – in which most taxes came from state-owned enterprises – must be replaced by a legally-based, incentive-oriented and preferably stable system for raising government revenue. Even though the role of the state has diminished in these countries, the need for revenues remains strong; in order to fund the replacement of outdated infrastructures, fiscal reform cannot be delayed.

These issues formed the background to a talk given by David Newbery (Cambridge University and CEPR) at an EPI meeting organized by CEPR, IEWS and KTI/IE and held in Budapest on 15 November 1996. The talk was based on a recent CEPR Report, edited by Newbery and entitled ‘Tax and Benefit Reform in Central and Eastern Europe’. The Report took stock of the first five years of fiscal reform in the four Visegrád countries – Hungary, Poland and the Czech and Slovak Republics – that have been at the forefront of the transitional process. The issues examined included the impact of tax and benefit reforms on households; the taxation of enterprises, in many ways the pivot of tax reform; and the critical area of labour market policy, where institutions have had to be created from virtually nothing over a very short period of time.

In Newbery’s view, the taxation of enterprises presents one of the greatest challenges to the tax-reform process. Smaller, newly emerging private companies have been growing rapidly at the expense of the large, easily taxed state enterprises that previously constituted the tax base. Getting the right structure for these taxes is vital; changes in the tax regime for entrepreneurial income in Poland had an important effect on the pace and pattern of growth in the small business sector. Tax holidays granted in 1990 for unincorporated firms in the retail sector were a major factor in the development of private retail trade firms, and in the structure of this sector.

The two most severe transition difficulties concern (1) the lack of good valuation evidence from market transactions – which suggests, for example, that floorspace taxes and other non-value measures should be preferred to real estate taxes; and (2) the shortage of administrative resources. In this context, the Polish authorities’ introduction of a ‘revenue lump-sum tax’ appears to have been sensible. It also seems the case that the most useful contribution to long-term efficiency in taxation would be to avoid excessive discrimination in taxation between sectors or classes of activity. Tax privileges similar to those in place in Western Europe could prove costly to reform later.

Newbery’s second major policy area concerns public subsidies to enterprises, which can appear either in the form of explicit budgetary transfers, or as tax arrears that eventually may be written off. There is striking evidence from some countries that the flow of tax arrears to the manufacturing sector is much larger than the flow of budgetary subsidies. If governments cannot altogether avoid formal tax forgiveness programmes, they should engage in them only with extreme caution in order to avoid the risk of decreasing subsequent tax discipline. On the other hand, as long as the integrity of the overall tax system is not in danger, a continuation of the status quo would be tolerable. Nearly all accrued taxes are now being collected, and tax discipline is fairly high. The main culprits running tax arrears are severely financially distressed firms that for the most part do not have the money to pay. Forcing these firms into bankruptcy would not yield much revenue, and redeployment of their assets and labour forces would be difficult to achieve. As long as these firms can cover their costs to their suppliers, the tax arrears subsidy can be justified as generating positive value added.

Since payment of unemployment assistance can help underpin economic reform, the introduction of such a system is an important step in the transition to a market economy. But the fear is often voiced that the benefit systems introduced in the CEECs have been too generous, and are discouraging the unemployed from leaving the unemployment register. In Newbery’s view, however, the evidence for this claim is unconvincing. In Hungary, for example, the evidence suggests that reducing the generosity of unemployment insurance would have only a small impact in encouraging the unemployed to leave the register more rapidly. The effect is even smaller for women than for men. Given that the major cause of transitional unemployment in Hungary has emanated from the demand side, the limited impact may not be surprising. It may also provide some comfort to those who argue that, in the turbulence of transition, the disincentive effects of taxes and benefits should not be exaggerated, and that fiscal rectitude and the provision of social safety-nets should be more important considerations in setting transitional policy. Nevertheless, given the difficulty of making fiscal reforms in quieter times, it remains desirable to attempt to get the basic structure correct as soon as possible. Such a structure would take more account of incentives for re-employment.

More general labour market policy issues can be illustrated with reference to the Czech and Slovak Republics, which had different unemployment experiences after their ‘velvet divorce’. Newbery noted that industry structure and demographics can explain the persistently higher rates of unemployment incidence in the Slovak Republic (SR), and that the higher rate of outflows from unemployment in the Czech Republic (CR) has been due, in part, to the underground economy. But these higher outflows can be attributed also to well-implemented active labour market policies (ALMPs) in the CR. Following the split into two republics, ALMP spending was reduced by 71% in the SR. This must bear some of the blame for the further deterioration of Slovak labour market conditions. However, the estimated sizes of the effects of ALMPs are modest and should not be regarded as a general panacea for the woes of Central and East European labour markets, although they can be used as a catalyst to help ensure more rapid exit from the unemployment pool.

Other aspects of the fiscal system, including VAT rates and social benefits, have direct impacts on households. Newbery noted that making VAT uniform in the CEECs could have adverse distributional effects. These could be eliminated by adjusting other taxes and benefits, but only at the cost of increasing the overall marginal tax rate. Similarly, improved targeting of social benefits could reduce both poverty and government expenditure, but again only at the cost of increasing marginal tax rates. There is thus a trade-off between equity and efficiency. These issues can be illustrated by the Hungarian experience of transitional fiscal reforms. Personal income tax payments by the lower quintiles of the population increased faster than those in the upper quintiles. As a result, the progressivity of the direct tax system was somewhat reduced during the period in which incomes were falling and becoming more dispersed. On the targeting issue, based on the 1991 system of benefits, poverty could have been reduced by making transfers from employed families with children to pensioners and unemployed. The conclusion is that the succession of fiscal reforms in Hungary has been undertaken without a clear strategy, and particularly without a foundation of research to establish that the areas chosen for policy reform are indeed the areas that really matter in terms of the ultimate objective.