Fiscal Policy and the Transition to a Market Economy

Richard J. Stendardo

The entrance into the long process of transition by many East European nations requires a major reexamination and possibly a complete reconstruction of fiscal policy. For some of the nations shifting to a market economy, the added pressures of huge government deficits and high inflation make reform of current fiscal policy an immediate concern. Also of great concern is the distortionary effect of pre-transition policy on economic behavior after government control over the allocation of resources has been lifted. In addition to this distortion of economic incentives, the opening of borders to foreign trade in combination with left over fiscal policy could create irregular and potentially harmful trade patterns.

Gordon suggested in his paper that the privatization of firms would create a new revenue for the governments--possibly through the sale of state owned firms--and a loss in revenue associated with future dividends of the privatized firms. A comprehensive fiscal policy would be necessary to adjust to the evolution of government revenue as well as the expenditures that would be required for building infrastructure, making social services available to the newly unemployed, and providing cheap credit and trade protection.

Before making any suggestions for revision of current fiscal policy, it is necessary to examine the policies maintained by many pre-transition governments. While the East European and OECD governments collected similar portions of their GDPs in taxes (43.2% and 38.1%, respectively), the portion based on profit taxes was much greater in the East while personal income taxes were less emphasized. In Czechoslovakia and Poland the statutory rates were 75% and 65%, respectively, and the firm's assets were often taxed separately as well. (38) However, these taxes often meant little or nothing. The government withheld the right to change tax rates ex post which could result in anything from the government's complete confiscation of a firms profits to the assumption of an enterprise's yearly operating deficit. And, as a final reservation on the firms' powers, the government often restricted the way firms could make use of their profits. On the other hand, if the firm experienced negative profits, the government would subsidize both current activities and investment.

The distortionary effect of sweeping taxation and large subsidies to the firms was held in check by the central planners' resource allocation. While the high implicit taxation of firms had little direct effect (Gordon suggests it provided a system for accounting), the indirect effects were especially relevant to allocation decisions. As it is every firm's goal to get more for producing less, the firms can (and did) manipulate their yearly budgets and projected outputs to take advantage of the government's willingness to take responsibility for a firm's debt. This is obviously not optimal behavior for a firm in the free market.

It should also be noted that the government could indirectly influence taxes by lowering wages, increasing the prices of consumer goods, and even reducing production of consumer goods such that implicit rationing would occurre (queues). Also the government could impose high taxes on savings (by artificially adjusting interest rates) and provide cheap credit. Finally, according to Gordon, taxes were not the chief source of government revenue. The government could order goods delivered and reimburse firms at ridiculously low prices. However, the net effect is that the budget of the government and those of the state owned firms are minimally separated and that separation is of little consequence.

With the basics of pre-transition fiscal policy in mind, it is necessary to examine the effects of reforms on both government revenue and expenditures. Recognize that post transition allocation decisions are made by firms, households, and local governments rather than the government's central planning boards. Markets now determine the prices of goods, wage structure, and interest and exchange rates.

On the revenue side, price liberalization was immediately followed by increased profits for firms due to the substantial rise in price levels. (For Poland: 19% in 1988, 45.5% in 1989, and 29.4% in 1990.) (Gordon 40) As most of this increase was taxable, the government experienced a jump in revenue. However, this boost in revenue was short lived, partly because the numbers did not represent true profits and also because the reforms that had been initiated began to slow growth. Profits in Poland continued to decline past 1991 when they equaled 8.3% of GDP. (Gordon 39) A further decline in government revenue came from a relatively new concept to the Polish government: tax evasion. Auditing firms was found to be an extremely difficult process due to the lack of both comprehensive records and institutions to analyze them.

As a result of price liberalization and of new taxation the share of wages in company's expenditures increased. This would not have such a great effect on government revenues if the income tax was not at such a low rate. Noting that Poland made an attempt to tax "excess" wage payments at a higher rate. The overall effect of these factors has been a decrease in government revenue from taxes which Gordon expected to continue for the next few years.

Gordon also predicted that reforms would result in a decrease in spending comparable to the decrease in revenues, however he noted that the two changes would not occur at the same rate. Early reforms should decrease subsidies that had previously distorted the choices of both firms and households. Also, firms become more responsible for their own investment, causing a further reduction in government expenditure (although investment would continue to be at least partially financed by government operated banks). While these factors would be pushing expenditures down, the creation of a social safety net as well as the government's inability to order deliveries of goods at below market prices would both cause rising costs for the government.

Gordon gave a number of suggestions for creating a macroeconomic fiscal policy during the transition process. He first targeted inflation as the most pressing obstacle. Gordon said inflation was more costly for transition countries than for those with established market economies because it undermined the allocative function of prices when it was most needed. He pointed out that prices and interest rates respond too slowly to market pressure, making the decisions of both firms and households inaccurate, and possibly causing rationing and black market. Finally it is almost impossible to enforce tax codes when rampant inflation makes nominal profits very deceptive.

To stop inflation the governments of transition countries must stop printing large quantities of money. However, this makes it extremely difficult to pay for the politically necessary increase in expenditures. To create the necessary increase in revenues taxes could be used, but this would require major tax reforms. The pre-transition rates would hurt the fledgling private sector immensely, pushing down new investment that is crucial to a successful privatization process and thus to the transition as a whole. In addition to its effect on investment, high tax rates would also cause distortions in choices made by firms and households by making prices less accurate sources of information. (This is partly the same effect inflation has on prices, although to a lesser extreme.)

The other option to pay for increased expenditures is to borrow from foreign banks following the theory that a nation should borrow capital until its interest rate equals the world market rate. However, due to large national debts and seemingly unstable political positions, it has become very difficult to borrow from abroad. Gordon thinks that by pledging to adopt policies favorable to the development of the private sector under threat of punishment by the IMF or European Bank for Reconstruction and Development, transition countries may be able to make a case for both their credibility as borrowers and the profit potential of their markets.

Gordon concluded that the best fiscal policy was an immediate revision of the tax system in order to reduce its effect on economic decisions, increase revenue, and maintain investment in combination with short term borrowing from foreign banks. In this manner the government can cover the necessary increase in expenditures without excessive money creation.

Works Cited

Gordon, Roger H. "Fiscal Policy During the Transition in Eastern Europe." The Transition in Eastern Europe. Chicago: The University of Chicago Press, 1994.



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