Chapter 7 Scope for Reform of Socialist Tax Systems (2024)

Table 1.

Composition of Tax Revenue in Central and Eastern Europe, 1989

Source: National data; and IMF, Government Finance Statistics Yearbook (various years).

¹1988.

²Unweighted average of 124 developing countries for die period 1980–88.

Enterprise Profits Tax

Several features distinguished the enterprise profits taxes of socialist economies from normal corporate income taxes existing in market economies. (1) In the definition of the tax base, one or more categories were usually directly determined by planners. For example, in the U.S.S.R., deductions from profits were calculated as the difference between the amount of profits provided for in the enterprise’s financial plan and the amount of such profits that were actually used for capital outlays and repayment of loans. In Bulgaria, the Council of Ministers usually established the minimum amount of the general profits which should be realized by each state enterprise. Indirectly, the level of profits was affected by wages, interest rates, exchange rates, and pricing policies. (2) Extreme arbitrariness (from the economic point of view) was present in the definition of allowable expenses, exemptions, and deductions and this, in turn, served as an open invitation to bargaining. As an example, in Poland, the list of exemptions and deductions was particularly elaborate, and the tax base of certain enterprises was adjusted by the addition of expenses and losses which were considered “unjustified” and “unwarranted,” while the tax was reduced for other enterprises by the application of various allowances and reliefs (viz., to exporters, producers of children’s clothing and shoes, and even to providers of hairdressing and dry cleaning services). (3) The practice of differentiating the applicable tax rates, by branches of industry and even by enterprises, was widespread. In Romania, for example, tax rates were differentiated across ministries, centrale, and enterprises with a view to evening out the profitability of the respective subordinate economic units. (4) In many socialist countries, as the enterprises were not in competition with those abroad, the highest tax rates were well above the levels commonly observed internationally (e.g., 70 percent in Angola and Viet Nam; 75–80 percent in Czechoslovakia and Poland). (5) The liability of the enterprise profits tax could be, and often was, waived if an enterprise could show a financial need. Clearly, none of these characteristics is consistent with a market economy.

In addition to an explicit enterprise profits tax, enterprises in socialist economies in transition were also often taxed “implicitly.” The government, depending on its revenue needs, often set producer prices for goods and services with a markup over money wages and other costs. This markup determined the enterprises’ economic surplus, which was automatically deposited with the state bank (because the means of production were owned or controlled by the state), and which implicitly became revenue and financed the general government budget or an economy-wide investment fund (see McKinnon (1990)). As the state was both the tax collector and the taxpayer, the payment of profits tax as well as other budgetary contributions of enterprises were often negotiated and determined ex post at levels consistent with the planned allocation of resources between enterprises and industries within the public sector.

For an enterprise profits tax to function as it normally does in a market economy, there has to be a restructuring of property rights and state-owned enterprises have to be legally distinguishable from the state management apparatus. Otherwise, the earnings of socialized enterprises will be indistinguishable from those of the Treasury, and enterprises will not be able to legally challenge the explicit and implicit profits taxes imposed on them.

Thus, before a market economy can be ushered in, the links between the enterprises and authorities would need to be severed. The arbitrary, and more or less automatic, transfers of profits to the treasury and/or subsidies to enterprises would need to be replaced by a transparent and legally binding (on both the tax collector and the taxpayer) enterprise profits tax. In addition, the enterprise profits tax will have to be structured in such a way as to create a “level playing field” for all investors. Clear definition of property rights will also help the establishment of enterprise autonomy and financial discipline. Thus, from the point of view of sequencing, the issues relating to the restructuring of property rights will have to be given the highest priority.

Turnover Taxes

In socialist countries, where most prices are fixed by the government, turnover taxes are not really taxes. Instead, they represent predetermined margins between the producer and consumer prices.3 From an analysis of the turnover tax structure in selected socialist countries in transition, the tax appears to have been expressed in three ways:4 (1) as the retail-wholesale price differential (this has been the most widely used method); (2) in a specific form (i.e., as a fixed amount on specified products); or (3) as an ad valorem rate applied to some measure of turnover.

As a result, the number of turnover tax rates tended to be almost as great as the number of different commodities. Moreover, the effective rates kept on changing over time with changes in price differentials. The example of Bulgaria illustrates this point. Until 1988, the turnover tax was levied according to the differential between the wholesale and retail price, the latter having been set by the state authorities for about 23,000 goods and services. The instability that was introduced by frequent changes in turnover tax rates was serious and would be unacceptable in a competitive market economy. Competitiveness between enterprises would also suffer if their inputs and outputs were subject to hundreds, perhaps thousands, of different tax rates.

The number of transactions to which the reduced rates of turnover tax or exemptions from turnover tax were applied also was great. Thus, the tax base tended to be narrow and turnover tax revenues were generally raised from a few selected commodities. The tax on alcohol in the U.S.S.R., for example, generated about 40 percent of turnover tax revenue and 13 percent of total tax revenue in the early 1980s. As a result, the authorities’ anti-alcohol campaign had serious budgetary consequences during 1985–88.

Despite this complexity, the collection of turnover taxes remained remarkably efficient (see Tanzi, (1991)). Since the only legal form of payment between the enterprises and retailers was transfers on accounts in the state bank, and since prices were administratively fixed and the volume of their turnover closely monitored, there was practically no possibility for tax evasion nor of tax arrears. The banks would simply reduce the outstanding balances of the enterprises by the amount of the tax due and credit that amount to the state as a tax payment. In that sense, socialist countries did not have normal turnover tax administration (nor did they need one), and control was already built into the system of central planning.

The transition to a market economy, and the introduction of comprehensive price liberalization, will sound a deathblow to the present system of turnover taxation. Once the producers and retailers are free to set their prices in accordance with the perceived relation between supply and demand, the authorities will no longer be able to levy a tax “equivalent” to retail-wholesale price differentials, nor will they be able to defend a multi-rate and cascading-type turnover tax. Liberalization of prices will also imply that the tax department will have to actually check monthly declarations of sales by taxpayers and administer the tax properly in order to control evasion. Finally, the authorities will no longer have control of enterprise accounts once the firms are granted autonomy. In other words, the whole socialist system of turnover taxation will have to be replaced.

Payroll Taxes

Next in importance among the revenue sources in socialist countries are social security contributions and payroll taxes, both of which are collected from enterprises.5 Since incomes of individuals, other than wages in the socialized sector, are small, and since the wage payment to workers was “net” of income tax, the burden of both the social security contributions and income taxes rests with the enterprise and its effect on the economic behavior of individuals and households tends to be minimal.

Theoretically, the workers’ share of social security contributions is calculated as a percentage of their net wage and these amounts are then added up to yield gross income. However, gross income is only an accounting entry which serves as the basis for all retirement and benefit calculations. Changes in tax rates do not affect the net wage and social security contributions have little to no effect on the economic behavior of workers. Enterprises paid their share of social security contributions out of a different accounting entry, based on the usual definition of the payroll. Regardless of formal liability, both components of social security contributions represent part of the labor cost of socialized enterprises, over which they have little or no control and which they were unable to shift forward onto consumers or backward onto workers.

Much of the revenue of individual income tax in socialist countries is derived from payroll tax paid by state-owned enterprises on behalf of their workers. As the workers of socialized enterprises are not even aware of the fact that their take-home pay is an after-tax pay, payroll tax, for all practical purposes, has no impact on individual labor supply behavior. Given that the state administers interest rate policy and restricts the ownership of income earning assets, individuals in socialist countries often do not pay tax on interest incomes, dividends, and rental incomes. The personal income tax, thus, applied only to the incomes of performing artists, writers, sportsmen, inventors, and the smallest of retailers and service providers and they alone are required to file tax returns. The scope of personal income tax in socialist countries is, thus, limited. Nevertheless, to the extent any western-style personal income tax existed in socialist economies, it was extremely progressive. Besides, it was so structured as to help discourage private economic activity and to make it difficult for anyone to leave the socialized sector.

These features of personal income taxation clearly are incompatible with the market philosophy, and will, therefore, have to be changed in the course of transition. Most importantly, the reform of personal income taxes will become necessary once wage determination becomes a market-determined process. This will require that various hidden subsidies given to workers (for housing, health care, education, retirement benefits, etc.) be eliminated, and, therefore, that wages be adjusted upward. By failing to establish a clear link between the productivity and benefit levels, the wage policy itself had a built-in egalitarian bias; this role will have to be played by an appropriately structured personal income tax in the future. The entire structure of the tax base and tax rates will have to be redesigned with a view to encouraging instead of discouraging the private sector. Payroll taxes too will have to be restructured to ensure that individuals make appropriate contributions to the social security system.

Foreign Trade Taxes

Unlike advanced market economies, but similar to developing countries, taxes on foreign trade are important in socialist countries. Foreign trade in such countries essentially has the sole purpose of protecting the domestic planning process from outside influences. Consequently, foreign trade tends to be strictly controlled by the planning authorities, which allow only imports of those goods that cannot be supplied in sufficient quantities by domestic producers, and exports of those goods which are in excess supply domestically. Since domestic producers are always guaranteed the predetermined input and output prices in domestic currency, and since the exchange rate is chosen arbitrarily, the foreign trade organization has no objective criteria to guide its decisions. As a consequence, it incurs some losses or realizes some gains in intermediation of imports and exports. It is these gains and/or losses that are recorded in the budget and the use of ad valorem tariffs for fiscal or protective purposes is negligible. To the extent that protection is needed, the preferred device is quantitative restrictions. As a result, nominal tariff rates are relatively low. Moreover, most raw materials and intermediate goods are imported duty free, so the effective rates of protection vary considerably. As far as the fiscal role of tariffs is concerned, customs policy is not considered to be an element of tax policy.

As socialist countries move toward market economies, tariffs will increasingly become an impediment to trade, and trade being an “engine of growth,” the role of tariffs will have to be reviewed and reassessed. The fact that tariffs have low collection costs compared with alternative taxes and that ongoing inefficient industries may need some protection in the transition will have to be borne in mind (see Mihaljek (1990b)). But these will have to be weighed alongside the longer-term distortion costs (excess burden) induced by high protective tariffs.

To summarize, the first reason why tax reform is a necessary condition for transition, as well as part of the minimum package of simultaneous reforms, is that the existing tax systems, although rational from the central planning perspective, are incompatible with the functioning of a market economy. In the past, economic agents were not independent decision makers and, therefore, the microeconomic effects of various taxes on economic behavior could be, and were often, ignored. Obviously, the continuation of existing tax systems, with their present features, would be highly inefficient and distortive from the point of view of a market economy.

If macro-fiscal control is to be relied upon during the transition period and beyond, and if firms and households are to be given the right signals, the tax system must become transparent and much more efficient (that is, tax-induced distortions in economic behavior must be minimized), and revenue must be collected at minimum cost. These qualities can be gained only if the existing systems of taxation in socialist countries are thoroughly reformed.

The fact that competitive markets and private enterprises cannot function in an environment characterized by the existing socialist tax system also implies that tax reform cannot be delayed until some later date in the transition process. It must be implemented promptly, because any delay would undermine other economic reforms and, therefore, bring about a stalemate in the transition process.

Price Reform

Besides its immediate impact on the budget, price reform is likely to have a series of fiscal implications at the micro level. On the enterprise side, price reform will mean a new structure of relative prices, which will imply a new pattern of resource allocation, and significant but unavoidable costs of adjusting the existing capacity to new production patterns. On the household side, price reform, combined with the elimination of consumer price subsidies and prospects for unemployment resulting from enterprise restructuring, would significantly erode real incomes.

To help enterprises and households adjust their behavior to a new market environment and, thus, to facilitate price reform, the enterprise profits tax and turnover tax systems of the socialist era will need to be carefully reviewed. To the extent the present enterprise profits tax rates are kept high to finance large budgets and turnover tax rates are kept high to help “clear” the commodity markets, they would become irrelevant and many of the tax rates may have to be reduced. The revenue loss from this reform, if any, should not be a cause for concern as the need for consumer and enterprise subsidies would have been almost completely eliminated by price reform. Some reform of the tax system is, therefore, essential to support price reform; continuation of high tax rates as prices are being liberalized would simply not be economically advisable or politically acceptable.

Financial Reform

The main implication for tax reform of financial sector reform, which consists of the introduction of a two-tier banking system and prudential supervision, creation of money markets, and reforms of the payments system and macro-monetary management, is that the government no longer will have automatic access to central bank credit or money creation for financing of its budget deficits or be responsible for the losses of the banking sector. Instead, the government will increasingly have to rely for this purpose on tax revenues, bond financing, and expenditure control measures.

There is, therefore, a direct link between tax reform and financial sector reforms: the quicker and more successful the tax reform, the easier it will be to achieve the autonomy of commercial and central banks, consolidate their losses, decontrol interest rates, and establish a functioning bond market. The more one hesitates with the reform of major taxes and the institution of the presently nonexisting taxes, the fewer fiscal resources will be at the government’s disposal. This will inhibit financial sector reforms because the pressure will be put on banks to perpetuate the old practices of granting “soft” loans to preferred users, with all the negative consequences for financial discipline and market competition.

External Reforms

External sector reforms, which, among other things, will involve the immediate removal of quantitative restrictions and nontariff barriers, such as foreign exchange allocations, will mean opening up the economy and domestic industry to world competition and major price and technology shocks. Should the domestic industry be incapable of facing these shocks in the short run, the levy of tariffs and import surcharges, as transitory measures, may need to be considered to support the process of trade reform. Similarly, designing an appropriate enterprise profits tax to encourage joint ventures and foreign investment can facilitate not only the process of external sector liberalization, but also the restructuring of domestic industry.

Factor Market Reforms

Labor market reform, which involves decontrol of wage and incomes policies, revision of laws which discourage labor retrenchment or protect full employment, and easing of other constraints on labor mobility, can be greatly facilitated if the country’s social insurance system, and the accompanying system of payroll taxes, are appropriately reformed. Measures aimed at reform of the social security system should also help mobilize household savings and direct them to the emerging capital market, whereas in the past they were typically invested in unproductive uses, such as hoarding of foreign exchange and black markets.

Capital market reforms, whose main purpose is to ensure a steady flow of investment finance between the deficit and surplus units in the economy, can hardly take place without a thorough revision of personal income taxation. Potential investors in new financial instruments and savers, attracted by the freeing up of interest rates, as well as emerging entrepreneurs, would be strongly discouraged by present highly progressive income tax schedules. Similarly, enterprises would have little incentive to borrow in the capital market if interest payments were not deductible. Tax reform can, therefore, help both on the demand side and on the supply side of capital markets.

Revenue Needs of Restructuring

As a consequence of price reform, the authorities are likely to lose control over output and input pricing and, therefore, over the profit-earning capacity of state-owned enterprises. With privatization, they are likely to lose their receipts in the form of dividends and implicit taxes they used to receive. With the decline in aggregate demand, government revenues from the turnover tax are likely to decline for some time to come. With the possible loss of full employment, the base of payroll taxes is likely to narrow, while at the same time the demands on the social insurance system for payment of unemployment and welfare benefits are likely to increase. Thus, the major revenue sources of socialist economies can be expected to come under stress while other revenue sources, viz., personal income tax, tariffs, etc., will take some time before they can be restructured.

This clearly indicates that the main objective of tax reform in the short run must be to generate sufficient revenue. As noted earlier, if revenue needs of transition are not met, efforts to achieve macroeconomic stability would be seriously affected, and the entire reform effort jeopardized.

Rationalization of Existing Taxes

The first step in the restructuring of socialist tax systems toward a structure appropriate for the longer run is to make the existing taxes more transparent and stable. Domestic and foreign investors need to know what their various tax liabilities would be as and when they undertake specific investments. Similarly, when deciding about their labor supply, individual agents must know what their tax obligations would be if they undertook one economic activity or another.

Not only must the tax system be transparent and free from ad hoc decisions of the type hitherto prevalent in socialist economies, but it must also remain stable for the foreseeable future. This is because many economic decisions are of a longer-term character, so any uncertainty regarding the tax system can be very unsettling for economic agents and, hence, detrimental for resource allocation efficiency and long-term growth.

Support for Other Economic Reforms

As noted earlier, in addition to their positive budgetary effects, the adoption of appropriate measures of taxation can also help support institution of the most important economic reforms. Given that price reforms, financial and external sector liberalization, labor market reforms, etc., can take time, and can have major socioeconomic effects, the potential of interfacing them with tax reform in the transition becomes an important goal in its own right.

In general, as most socialist countries lack tax laws which are detailed enough to allow policymakers to achieve their intentions and, at the same time, safeguard the rights and responsibilities of taxpayers, such tax laws will need to be carefully drafted and processed through Parliament. In the same vein, as most socialist countries lack tax organizations and procedures which are relevant to dealing with taxpayers who are independent of the tax authorities, they too will have to be established and the present tax officials retrained.

Reform of Turnover Taxation

In many socialist countries of Central and Eastern Europe, tax reform has begun with changes in the system of turnover taxation (see Kopits (1991), and Tanzi (1991)). This is a logical development, because price liberalization normally has priority in the sequence of economic reforms. The main characteristics of turnover tax reforms have been (1) the elimination of price subsidies (i.e., of turnover taxes levied with negative rates); (2) the introduction of ad valorem tax rates; (3) a reduction in the number of tax rates; (4) the introduction of selected excises; and (5) the initiation of work toward the introduction of a VAT.

While all these changes are steps in the right direction, in most cases they have not been accompanied by the necessary widening of the tax base, so the main benefit of the rationalization—higher revenue collected at lower distortion costs—in general has not been realized. In Hungary, for example, a number of basic commodities (especially food products) and most services, accounting roughly for one half of the potential tax base, are effectively exempt from the VAT. This tendency to narrow the scope of tax is due partly to the commitment of the authorities to various social objectives and partly to ignorance about the distortionary effects of partial taxation.

Short-Run Tax Reform Measures

With price liberalization and liberalization of wage and income policies, implicit taxes on, and subsidies to, enterprises and consumers will be removed. As discussed above, this by itself will require that the governments of socialist countries in transition initiate comprehensive tax reform, and start designing long-term tax systems consistent with the market orientation of the economy. The governments of former socialist countries of Central and Eastern Europe, should also ensure that their longer-term tax systems will be consistent with the tax systems of European Community countries. Socialist countries in transition will also need to start developing their administrative capacity and procedures for implementing the revised tax system.

At the same time, the budgetary needs of the transition will require that tax reform be implemented in the short run as well. Guided by this and other short-run objectives (such as support for market-oriented economic reforms and repealing of those aspects of the existing tax system which are inconsistent with market orientation of the economy), reforms of taxation for the transition period will need to focus on at least the reform of turnover taxes, customs duties, and income taxes. In addition, certain second-best measures may have to be adopted in the interim to support macroeconomic stabilization efforts. Some of the possible short-run tax reform measures are elaborated below. It must be kept in mind, however, that details of tax design and implementation are likely to differ significantly from country to country and that the measures proposed below are by no means universally applicable (they will differ greatly depending on initial conditions).