Krassen Stanchev, Executive director of Institute for Market Economics

In 1996-1997, I had the pleasure to co-ordinate a think tank effort to initiate reforms in Bulgaria, Poland and Slovakia that would lead to the adoption of a flat tax.

Part of the effort included asking businesses whether or not they approved of low and flat tax. In all three countries, disapproval rates were higher than approval ones. In Bulgaria, the ratio was, roughly, 35:65.

I cannot comment on the reasons for this constellation in other countries, but in Bulgaria two sets of beliefs contributed to this attitude: the idea that a given business, say small and medium enterprises, should be treated more generously by the Government; and the idea that certain businesses should be compensated for losses incurred because of Government policies in the first half of the 1990s.

There were two key conclusions from this exercise:

1. Businesses were not likely to be the prime reform demanders, therefore, there was a need to recruit broad public support;

2. Broader reform issues needed to be addressed to get reforms (aimed at tax lowering and flatter taxes) accomplished, e.g. expenditure reforms and lowering, decomposition of the welfare state, etc.

The fate of that reform in those three countries was roughly the following:

· In Slovakia, Jan Oravec of the Hayek Foundation established a taxpayers’ association and through it, managed to push forward the introduction of a 19 per cent flat tax.

· In Poland, the idea of tax reform was dropped altogether, at least until 2001. In 2001 the finance minister, Leszek Balcerowicz, resigned because he was not able to persuade fellow cabinet members to implement his tax reform ideas; Poland focused on quasi-taxes instead (it implemented the Economic Activities Act in 2001, and the Economic Freedom Act was enacted on May 1 2004).

· In Bulgaria, there was no political party or politician that liked the tax reform objectives; there were three taxpayers’ unions, all established by employees and advisers to the treasury; so, the feasible strategy was to start a broad public education and focus reformists’ efforts on the welfare state, expenditures and a detailed (but yet understandable) argument for the need for reform.

Political constellations of the eve of lowering taxes
The Baltic countries seemed to have benefited from the fact that their respective treasuries did not have sufficient resources for any sort of substantial redistribution policy mix. In different years they pegged their currencies to the Deutsche mark (DM) or to a basket of the DM and the US dollar, a policy that motivated a flexibility, liberalisation of fiscal policies combined with strictly observed budget constraints and deepest than in Europe trade liberalisation, as it was implemented in Estonia. And it was Estonia, again, to prompt in the early 1990s with a flat tax system (at about a 25 per cent threshold on individual and corporate income). The Estonian system is now being further reformed towards lower tax rates (aimed at 20 per cent for personal income in 2007). Lithuania and Latvia did something similar (in 1994 and 1995) but with greater differentiations between personal and corporate taxes.

Flat taxes since then have been implemented in numerous countries: Georgia, Romania, Russia, Serbia (and Montenegro), Slovakia and Ukraine. Macedonia is next in line. In some countries, like Bulgaria, the policy is still one of multiple thresholds, but the difference between is one or two per cent and, thus, it is almost flat.

A closer look at the constellations at the eve of introduction of flat taxes, allow drawing a sort of a common denominator:

· Most countries introduced flat taxes with a view to increasing budget revenues, and rarely, if not never, there was a consecutive policy to reduce or restructure expenditures.

Peculiarities of lower tax reforms of the (EU) New Member States

Interestingly enough, the new member states behaved in this respect like most of the non-member states, similar to those of Former Soviet Union (FSU). Here are some comparisons:

· Often flat income tax is combined with lower rates of corporate taxation, and this is a common feature of Baltic with other EU countries, including those supposed to join the EU;

· This constellation is different from that of FSU, where corporate taxation is higher than the flat rate (which is, in turn, lower than respective taxes in the Baltic countries, Slovakia and Romania); this is to be explained by government ownership of natural resource companies and late or delayed privatization;

· It is obvious that apart from servicing to objective to increase revenues, the flat tax reform aimed at creating incentives to invest (Foreign Direct Investment in particular).

· No country has ever effectively reformed the welfare state, which is evident from the rates of the social taxes; the so-called social contributions rates are 1.5-2 time higher than personal income tax;

· On average government expenditures in the new member states in the past seven years have been considerably lower than the average share of government expenditures in the respective GDPs of the old members states; there are exceptions (e.g. Bulgaria’s government expenditures in the past five years have remained at about 41 per cent of GDP) but the overall level of the new member states and Romania is 36-37 per cent of GDP.

The impact of regulations and EU accession
The compliance cost of EU companies and individuals (i.e. the costs of operating within the laws and to deal with governments) were last studied by the OECD for the entire EU in 2001. For the new member states there are different estimates, and only rarely have there been profound surveys on these costs in the accession countries.
The picture is roughly the following: the EU compliance costs are 540 billion euro in 2000, three-four per cent of GDP for that year. In the new member states, these costs are believe to be up to two times higher, because of juridical harmonisation, the pace of the process and due to inherited administrative inefficiency. These impacts combined with much better visible impacts of the higher EU indirect taxes (most often duties on tobacco, gasoline and gas).

This was one of the factors to convince political establishments in the new countries to use the only available fiscal policy instrument to mitigate the costs, and they reduced the direct tax burdens. Politicians in countries that did not lower taxes, like Poland, dealt with indirect taxes, but the impacts are not yet studied.

Globalisation and taxes
There is yet little empirical research but it is possible to assume that the EU governments are doomed to collect less taxes. Factors that contribute to this are the following:

· The existence of jurisdictions that maintain low taxes, low transaction costs and better rule of law;

· Electronic money;

· The use of  the internet in channelling investment and savings and in retailing;

· The overall greater mobility of factors of production, particularly capital and people.

Conclusions
It is unlikely that new member states would reverse the policies of lowering direct taxes. However, the unreformed or rather semi-reformed social welfare systems (pay-as-you-go pensions, centralised healthcare) would probably work as a factor that requires constant if not upstream inflow of revenue.

With privatisation, in the some of FSU countries there might be a shift in the policies, e.g. lowering of corporate tax rates in order to boost investment; it is likely that the former Yugoslavia countries are moving in this direction, e.g. it is almost certain that Macedonia will have a 10 per cent flat tax on personal and corporate income two to three years from now. Lower levels of indirect taxes in countries neighbouring the EU would also pressure their EU neighbours to lower taxes or at least keep the existing levels. It is difficult to predict the pace but it is obvious that the tax competition is already out there.