Transition, Taxation and the State docx

List of AbbreviationsACIR Advisory Commission on Intergovernmental RelationsBEEPS Business Environment and Enterprise Performance SurveyCBR Central Bank of Russia CEE Central and Eastern

TRANSITION, TAXATION AND THE STATE

Transition and Development

Series Editor: Professor Ken MoritaFaculty of Economics, Hiroshima University, Japan

The Transition and Development series aims to provide high quality research books that examine transitional and developing societies in a broad sense – including countries that have made a decisive break with central planning as well as those

in which governments are introducing elements of a market approach to promote development Books examining countries moving in the opposite direction will also

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Edited by Anton N Oleinik

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Transition, Taxation and the State

GERARD TURLEY

National University of Ireland, Galway

© Gerard Turley 2006

All rights reserved No part of this publication may be reproduced, stored in a retrieval system

or transmitted in any form or by any means, electronic, mechanical, photocopying, recording

or otherwise without the prior permission of the publisher.

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1988, to be identified as the author of this work

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British Library Cataloguing in Publication Data

Turley, Gerard

Transition, taxation and the state - (Transition and

development)

1 Taxation - Russia (Federation) 2 Taxation - Europe,

Eastern 3 Tax administration and procedure - Russia

(Federation) 4 Tax administration and procedure - Europe,

Eastern 5 Russia (Federation) - Economic conditions -

19916 Europe, Eastern Economic conditions 1989

I Title

336.2'00947

Library of Congress Cataloging-in-Publication Data

Turley, Gerard.

Transition, taxation and the State / by Gerard Turley.

p cm (Transition and development)

Includes bibliographical references and index.

ISBN 0-7546-4368-9

1 Tax collection Europe, Eastern 2 Tax collection Former Soviet republics 3.

Tax collection Russia (Federation) I Title II Series

HJ320.E852T87 2005

336.2'00947 dc22

2005021078 ISBN 0 7546 4368 9

Printed and bound by Athenaeum Press Ltd,

Gateshead, Tyne & Wear.

5 Effective Tax Administration in Transition Countries 97

To Monica

‘The revenue of the state is the state In effect all depends upon it, whether for support or for reformation ’

Edmund Burke

Reflections on the Revolution in France

This publication was grant-aided by the

Publications Fund of National University of Ireland, Galway

List of Tables

Table 2.1 Index of Governance and Enterprise Restructuring/Reform,

Table A.1 Development of Market-Supporting Institutions, 2000 34Table B.1 Governance, State Capture and Intervention 35Table C.1 Small Business Sector in Russia, 1998-2000 (000s) 36

Table 3.2 Difficulty of Obtaining Bank Credit on Commercial Terms

Table 3.3 Ordered Logit Results for Difficulty of Obtaining Credit in 1999 48Table 3.4 Difficulty of Obtaining Government Assistance

Table 3.6 OLS Regression Results for Financing a Shortfall in

Table 4.3 Stock/Flow Analysis of Romel’s Tax Liabilities

Table 4.4 Stock/Flow Analysis of Romel’s Tax Liabilities in

1997, at Constant (End-Year) Prices (in Thousand Lei) 70Table 4.5 Flow Analysis of Romel’s Tax Liabilities in 1997, at Constant

Table 4.6 Stock/Flow Analysis of 9,000 odd Firms in the

Romanian Enterprise Sector in 1997 (in Billion Lei) 73Table 4.7 Stock of Tax Debt and Overdue Tax Debt at end-1997 74

Table 4.9 Groups of Firms with Tax Arrears in 1997 Compared 77

Transition, Taxation and the State

viii

Table E.1 Consumer Price Index, January-December 1997 84Table F.1 Selected Indicators for Tractorul UTB S.A.,1990-1998 87Table F.2 Selected Indicators for Brasov (County) and Romania, 1997 93Table 5.1 Benchmark Tax Rates, Gross and Net Equivalents 103Table 5.2 Statutory Tax Rates and Tax/GDP Ratios for 25 TEs, 1997 105

Table 6.3 GDP per capita, Agriculture and Export Shares of GDP for TEs 134

List of Figures

Figure 5.1a VAT Effective/Statutory Ratio 1997 vs Progress in Transition 120Figure 5.1b SST Effective/Statutory Ratio 1997 vs Progress in Transition 120Figure 5.1c CIT Effective/Statutory Ratio 1997 vs Progress in Transition 120Figure 5.2a VAT Normalised Tax Yield (NTY) 1997 vs Progress in

Transition 121Figure 5.2b SST Normalised Tax Yield (NTY) 1997 vs Progress in

Figure 5.2c CIT Normalised Tax Yield (NTY) 1997 vs Progress in

Transition 121Figure 5.3a VAT Effective/Statutory Ratio and the Average

Figure 5.3b SST Effective/Statutory Ratio and the Average Bribe Tax 122Figure 5.4a VAT Normalised Tax Yield (NTY) and Average Bribe Tax 123Figure 5.4b SST Normalised Tax Yield (NTY) and Average Bribe Tax 123

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List of Abbreviations

ACIR Advisory Commission on Intergovernmental RelationsBEEPS Business Environment and Enterprise Performance SurveyCBR Central Bank of Russia

CEE Central and Eastern European

CIS Commonwealth of Independent States

CIT Corporate Income Tax

CMEA Council for Mutual Economic Assistance

CPI Consumer Price Index

CPI Corruption Perceptions Index

EBRD European Bank for Reconstruction and DevelopmentE/S Effective/Statutory

FIGs Financial–Industrial Groups

FSU Former Soviet Union

GDP Gross Domestic Product

GKO Short-term Government Bonds (Treasury Bills)

IBFD International Bureau of Fiscal Documentation

IMF International Monetary Fund

MPS Material Product System

NBF Net Bank Financing

NNT Net New Taxes

NTE Net Tanzi Effect

NTY Normalised Tax Yield

OECD Organisation for Economic Co-operation and DevelopmentOFZ Treasury Bonds

POF Private Ownership Fund

PSAL Private Sector Adjustment Loan

RTS Representative Tax System

SAL Structural Adjustment Loan

SBC Soft Budget Constraint

SME Small and Medium-Sized Enterprises

SNA System of National Accounts

SOEs State-Owned Enterprises

SOF State Ownership Fund

SST Social Security Tax

Transition, Taxation and the State

xii

STS State Tax Service

TEs Transition Economies

UN United Nations

VAT Value-Added Tax

of economic transition from a centrally planned economy to a market economy, the transformation of a socialist state to a capitalist state, the nexus between government and business, and the persistence of the soft budget constraint Much of the literature

on the revenue decline in transition countries has focused on either wide transitional phenomena or on taxpayers’ non-compliance In contrast, this monograph examines the problem from the position of the tax collector, that is, the state, and its ability or willingness to collect taxes Using the concept of János Kornai’s soft budget constraint, the book examines the problem of budget softness and tax payments discipline in the postsocialist transition economies during the first decade of transition Appropriate methodologies are applied to new data for the transition economies with the purpose of revealing incidences of budget softness (or hardness) and, more generally, measuring the degree to which the enterprise sector

economy-in postsocialist countries is not tax compliant Tax collection problems, ariseconomy-ing from economic, administrative or political factors, are investigated in the context of transition The results indicate tax collection problems arise for a number of reasons, including budget softness but also because of a general poor payments discipline, corruption and bribery, ineffective tax administration and low tax capacity and tax effort arising from both economic and political factors Furthermore, our evidence indicates that cross country differences are not small, state control matters and, for many transition countries, tax administration and political constraints, as opposed

to tax design and economic constraints, are more pressing problems Transition, Taxation and the State outlines the tax collection and discipline problems (particularly

in the context of the soft budget constraint and the state-enterprise relationship legacy

of the socialist era) that the postsocialist state in transition countries experienced

in the first decade of transition As for the state (or the ‘tax state’ to use Joseph Schumpeter’s expression) and tax revenue performance in the second decade…let

us wait and see the evidence

Gerard TurleyNational University of Ireland, Galway

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of Heriot-Watt University and the late George Blazyca of Paisley University who gave me the idea for this book I wish to pay gratitude to colleagues and friends at Heriot-Watt University, Edinburgh and the National University of Ireland, Galway

A special word of thanks must go to Michael Cuddy of the National University of Ireland, Galway, Alan Bevan formerly of the European Bank for Reconstruction and Development (EBRD) and Giovanni Mangiarotti formerly of the Aston Business School, Birmingham for their direction and support Also, my thanks to everybody who assisted me during my time in Romania and Russia

With respect to Chapter Two, I wish to thank Alan Bevan, Roger Clarke, Michael Cuddy, Paul Hare, Marina Pavlushevich, Mark Schaffer and seminar audiences at the National University of Ireland, Galway and BASEES, Fitzwilliam College, Cambridge for useful comments The analysis in Chapter Three arose from an enterprise restructuring project in Russia involving CERT (Heriot-Watt University, Edinburgh), LBS (London), NERA (London) and BEA (Moscow) Thanks must go

to Alan Bevan, Boris Kuznetsov, Giovanni Mangiarotti and Mark Schaffer for their assistance and helpful suggestions Useful comments were also received at a BEA conference in Moscow The work in Chapter Four was part of a PhareACE project carried out for the Government of Romania I wish to thank Lucian Croituru, Terry Green, Constantin Munteanu, Alina Potter and Mark Schaffer I am also grateful

to the Romanian Ministry of Finance for supplying me with a dataset My thanks

to Alan Bevan and Paul Hare and to seminar audiences at Heriot-Watt University, Edinburgh and at CREEB, Buckinghamshire for helpful comments

The research in Chapter Five builds on collaborative work conducted for the EBRD, to whom I am most grateful I am also grateful to Michael Alexeev, Alan Bevan, Wendy Carlin, Mark Schaffer and participants at the July 2000 National University of Ireland, Galway workshop on ‘Institutions and their Change in Transition Economies’ for helpful comments Useful suggestions were also received

at a Foundation for Fiscal Studies seminar in Dublin and a Scottish West Coast seminar in Glasgow The analysis in Chapter Six was part of a research project entitled

Public Finance in Transition Countries: Problems of Compliance, Opportunism and

Transition, Taxation and the State

xvi

Soft Budget Constraints that involved a number of partners including myself and

Mark Schaffer, and was financed by PhareACE 1998 Programme to which I want to express my appreciation I am also indebted to Alan Bevan, formerly of the EBRD and Matthias Reister of the National Accounts Section of the UN Statistics Division for providing data

My thanks to National University of Ireland, Galway, Heriot-Watt University, Edinburgh, the British Council, the European Commission, Galway Development Services International, the Romanian Centre for Economic Policies, the EBRD, the

UK Department for International Development and the Adam Smith Institute for their financial assistance and support

I wish to thank Ashgate Publishing Company and its staff for the work undertaken

in the publication of this book In particular, my thanks to Brendan George, Senior Commissioning Editor of the Transition and Development series, Ken Morita, Academic Series Editor of the Transition and Development series, and last, but by no means least, Carolyn Court and Pam Bertram for their assistance in the preparation

of the manuscript for publication As always, I wish to thank Claire Noone and Imelda Howley of National University of Ireland, Galway for their time and support

in helping me to understand the finer points of formatting I bear full responsibility for all errors and any omissions

Finally, and on a personal note, I wish to thank my family for the patience and support that they have shown during the time that it has taken to research, write and edit this book – almost, but not quite, as long as transition itself

Chapter One

Introduction

One of the stylised facts of economic transition from a centrally planned economy

to a market economy was the decline in tax revenue Given the nature of transition where the role and size of government is reduced, a fall in tax revenue was predicted The revenue erosion, particularly evident in the early years of transition, is often explained in the context of a change from the repressive and distortionary tax system

of Soviet times where taxes (and subsidies) were the key mechanisms for fiscal redistribution from profitable to unprofitable enterprises and where tax collection from large state-owned enterprises (SOEs) was a simple task, to a more Western-style tax system where voluntary compliance and self-assessment are the norm and where confrontation between the tax collector and the taxpayer is not uncommon Furthermore, as transition economies (TEs) witnessed a recession of historical proportions, a decline in the profitability of the SOEs (and other traditional tax bases),

an expansion of the unofficial economy and a rise in tax evasion, corruption and bribery, the tax share of GDP was to fall even further After a decade of transition, and despite a recovery in tax revenues in a number of leading transition countries by the late 1990s, the tax ratio in some TEs had fallen to levels below what is considered normal in market economies Many regard this fall as excessive and view the decline

in tax revenue as a serious obstacle in the attempts to finance public expenditure, redistribute income and, at the same time, embrace effective fiscal policy

Much of the literature on the revenue decline in TEs has focused on wide transitional phenomena (the transformational recession or the rise in the unofficial economy are two examples) or on taxpayers’ non-compliance (related to, for example, rising tax evasion and a primitive tax culture) as explanations for the fall in tax revenues In contrast, this book examines the problem of revenue erosion from the position of the tax collector, that is, the state, and, in particular, the weakness

economy-of the state as creditor, i.e its (in)ability or (un)willingness to collect taxes An appropriate theoretical framework for analysing the role of the state as creditor and the volatile state-enterprise relationship that exists in postsocialist times, particularly

as it relates to tax payments and collection, is János Kornai’s soft budget constraint (hereinafter SBC) In this context, the book examines the problem of budget softness and tax payments discipline in transition countries and, particularly in Russia, a country where tax collection is considered a problem (despite the observation that tax revenue relative to national income is not unusually low given Russia’s level of economic development) In Russia and in other transition countries, the falling tax share of national income needs to be seen in the context of the fluid state-enterprise relationship that is common in the transition from plan to market, the capacity of

Transition, Taxation and the State

2

the reconstituted state and its willingness to tax, the nexus between government and business and the persistence of the SBC in the transition setting In respect of tax collection, the research undertaken and reported in this monograph indicates that problems arise for a number of reasons, including budget softness but also because of a general poor payments discipline, corruption and bribery, ineffective tax administration, poorly designed intergovernmental fiscal relations and low tax capacity and tax effort arising from both economic and political factors

1.1 Paradigms of Economic Transition

The standard paradigm of economic transition that dominated in the early years

of the 1990s and had the support of the international financial organisations (more notably the International Monetary Fund and, less so, the World Bank) is often referred to as the Washington Consensus.1 This orthodox or mainstream approach views the transition from a centrally planned to a market economy as a reform process emphasising the universality of the laws of the market and the undoubted economy-wide efficiency gains accruing from the standard policy prescriptions of the trinity of liberalisation (‘getting prices right’), stabilisation and privatisation This blueprint for transition, based on the spontaneity of markets, traditional neoclassical price theory and general equilibrium theory, promotes the primacy of policy reforms and economic fundamentals and the replication or transplantation of international best-practice institutions (with the emphasis on laws and the legal and regulatory framework) of the West to the ex-socialist countries of the former Soviet bloc (a kind

of utopia based on ‘societal engineering’)

Although the Washington Consensus emerged from a different set of conditions,

it argues that these one-size-fits-all market-oriented reforms are appropriate to any setting, including the postsocialist Central and Eastern European (CEE) and former Soviet Union (FSU) countries A knowledge or experience of the state socialist system and the centrally planned economy is not required Policy reform strategies are implemented along a scorched-earth approach, with textbook reforms being designed by technocrats and introduced as rapidly and comprehensively as possible

in view of the reform complementarities that exist Not surprisingly, in terms of the speed of the radical reforms, this approach is often referred to as the ‘big bang’ or

‘shock therapy’ view of transition This also applies to the economic role of the state

1 Strictly speaking, the Washington Consensus refers to a set of policy guidelines for most Latin American countries in the late 1980s for which, it was argued, a consensus was reached among Washington-based international agencies, the US government and mainstream economists John Williamson of the Institute for International Economics, the person who coined the phrase, viewed these reforms as the lowest common denominator of policy advice

by ‘Washington’ to Latin American countries as of 1989 The ten economic reforms focused primarily on structural adjustment policies of price and trade liberalisation, macroeconomic stabilisation and fiscal discipline, deregulation of entry barriers and privatisation of state- owned enterprises.

Introduction 3where what is required is a depoliticisation of the economy, a break of the nexus between government and business and a dismantling of the state, or, according to critics of the Washington Consensus approach, in the extreme case of neoliberal market fundamentalism, state desertion.

The institutional-evolutionary paradigm, more popular within academic circles, views transition as a large scale institutional transformation where the focus is on the institutional underpinnings of capitalism appropriate to the specific conditions of each country and in accordance with the initial conditions at the outset of transition This approach is critical of the revolutionary vision of transition and, instead, views transition as a process involving systemic change in the face of great uncertainty and complexity, unlike the competitive neoclassical model and its notion of equilibrium, which is inherently static As opposed to equilibrium processes, the emphasis of the institutional-evolutionary approach is on the dynamics of institutional change within

an evolutionary perspective, based on contracting and noncooperative games in modern microeconomic theory Here, the focus is on the gradual development of the institutional supports or arrangements for a market economy, accepting the dangers

of institutional voids and that not all existing or inherited institutions, organisational forms or social capital are redundant Transitional second-best institutions and the preservation of social capital can be both worthwhile and necessary in order to prevent further economic disruption

Whereas the Washington Consensus view of transition is a top-down approach, the institutional-evolutionary perspective is a bottom-up view focusing on the institutional design of market economies, the importance of social norms and the organic development of the private sector Markets and economic agents do not exist in a vacuum but in an institutional framework – ‘the rules of the game’ – that facilitates exchange and interaction Institution building and the provision of a framework for well-functioning market structures and organisations is the focus

of this approach and it argues for the gradual or incremental implementation of sequenced reforms (often through experimentation and learning by doing) in order

to ensure growing support for policies In the institutional-evolutionary approach, although there is recognition for the need to reduce the role of the state, the emphasis

is on a reconstituted state and improving state capacity (so as to, among other things, enhance the market environment) as opposed to a weakened state It also stresses the path dependency of system development and is mindful of the historical continuity and the communist legacy unlike the ahistorical, tabula rasa Washington Consensus

approach (Clague and Rausser 1992; Roland 2000; Bönker et al 2002).

Although an outline of the two major paradigms of transition is useful in the context of this book, many observers feel that the debate between the two approaches and, in particular, the controversy between ‘shock therapy’ and gradualism and the tendency to label countries as either one or the other, has not been very helpful and has unintentionally diverted attention away from some of the more important aspects

of economic transition One such feature of transition is the SBC

Transition, Taxation and the State

4

1.2 Definition and Interpretation of the SBC

The incentive problem inherited from the socialist system known as the SBC takes its name from the budget constraint faced by households in standard microeconomic theory The budget constraint was first extended to organisations and firms by Kornai (1979, 1980) and applied to the socialist economies of Central and Eastern Europe The budget constraint is softened when a firm is not held to a fixed budget, but finds its budget constraint non-binding The enterprise sector is said to exhibit a SBC when there is a recurring or persistent expectation of a refinancing or bailout of

loss-making firms; firms receive financial assistance because they are loss making

and the expectation of aid is close to certainty as the external support is more than

just a once-off event The channels or mechanisms by which the ex post rescue of

unprofitable firms takes place vary, from budgetary subsidies and tax arrears (by government) to inter-enterprise arrears (by trade suppliers and utility companies) to overdue loans (by banks) Since transition began over a decade and a half ago, the more traditional forms of the SBC, namely, arbitrary pricing and direct subsidies, have given way to new and, often, more implicit instruments, such as tax arrears and overdue payables to banks, trade suppliers and utilities Another mechanism that is evident in predominately FSU countries, where banking intermediation is generally underdeveloped, is non-cash payments (barter, promissory notes, offsets) by firms to its creditors Either way, this expectation of a bailout influences and undermines the

ex ante behaviour and incentives of firms

The objective of the organisation that is bailed out is straightforward, namely, survival The motive of the rescuer varies, depending on the interpretation of the SBC (as there is no consensus on a precise definition of the concept) For the purposes of this book Kornai’s bureaucratic hierarchical model (1980, 1992a) is used, as opposed to Dewatripont and Maskin’s dynamic commitment model (1995) and Stiglitz’s gambling banks model (1994), of a paternalistic and benevolent state willing to support unviable firms in order to avoid politically and socially costly layoffs A fourth interpretation is Shleifer and Vishny’s politicians and firms model (1994), a theory that is employed in Chapter Two Using the Kornai model, the SBC syndrome can be viewed as a theory of exit and, thus, complements Schumpeter’s theory of creative destruction (Schumpeter 1911) Whereas Schumpeter focused on the birth or creation of organisations, the SBC phenomenon explains the survival (or demise) of organisations By preventing certain firms from bankruptcy, the SBC alters the natural selection process inherent in a competitive environment (whether it

be market socialism, transition or market economy)

Since the term first appeared in 1979, there have been a number of different explanations of the SBC According to Kornai (1979, 1980), the source of the budget softness, in the context of the socialist system, is the paternalism of the state Firms are not responsible for losses, or for profits, hence, the levelling effect This explanation

is system-specific, focuses on political considerations and is based on the vertical relationship between superior and subordinate In contrast, the explanation advanced

by Dewatripont and Maskin (1995) focuses on economic causes, namely the inability

Introduction 5

to commit to no bailout ex post and the centralised financial system Using a

game-theoretic model, the SBC is viewed as a time-consistency problem in the presence

of irreversible investment.2 With asymmetric information and adverse selection, bad projects get refinanced – the phenomenon of ‘throwing good money after bad’ A different explanation, espoused by Stiglitz (1994), argues that, in the context of the financial system, soft budgets arise when financial institutions have an incentive to make large gambles when appraising projects In this explanation, an insolvent bank may be willing to invest in a risky project because the bank will become solvent if the gamble pays off and, in the case of the project turning bad, will be no worse off than it was before the loan was made i.e still insolvent A fourth model is presented

by Shleifer and Vishny (1993, 1994), where subsidies are paid to enterprises to retain excess employment These transfers result from bargaining that takes place between managers of firms and government politicians, the latter driven by non-economic objectives, namely their own narrow self-interest and self-preservation. 3

In the context of transition and economic theory, there are two broad perspectives

on the SBC One approach is the Washington Consensus view, which treats the SBC

as an exogenous variable and a matter of direct policy choice The implication here

is that political will is all that is required in order for the budget constraint of firms to

be hardened The alternative perspective is the institutional-evolutionary approach that views the SBC as endogenous to the institutional set-up Here, the hardening of budget constraints is possible only as an outcome of institutional change Credible commitment to hardening budget constraints is a matter of devising suitable institutional mechanisms and arrangements (Roland 2000)

1.3 Evidence of SBC in Transition Countries

Despite the problems with the short time horizon (the start date for transition is generally accepted to be 1990 for CEE countries and 1992 for FSU countries) and the usual data problems, the empirical evidence on the SBC is now quite considerable (Schaffer 1998; Roland 2000; Kornai 2001)

The evidence appears to indicate that in the early years of transition, trade credit arrears and overdue payables to banks were often the main instruments of budget softness as opposed to the budgetary subsidies and arbitrary pricing mechanisms of earlier pre-transition years Among other changes, price liberalisation and reform of the public finances ensured that these old channels of the SBC were to disappear (in

2 Schaffer (1989) also presents a game-theoretic model where the centre is unable to make credible commitments to the enterprise Unlike Kornai’s SBC where the paternalism

of the state is known, it is possible, under imperfect information, for the state to build a reputation for toughness and, in doing so, is able to impose hard budget constraints on the enterprise.

3 A useful taxonomy for classifying SBC models, in the context of ex ante and ex post

(in)efficiencies, is outlined in Mitchell (2000) This includes the SBC model based on bank or creditor passivity (Mitchell 1998)

Transition, Taxation and the State

6

the case of arbitrary pricing) or to decline in importance (in the case of budgetary subsidies) As transition progressed, banks and trade suppliers imposed hard budget constraints on firms and customers by insisting on payment, and, in the case of late or non-payment, refusing to extend new flows of finance to delinquent firms (Schaffer 1998) These firms, often loss-making or unviable, managed to stay afloat by extracting new forms of assistance, either from their workforce (in the form of wage arrears), from utilities (in the form of payment delays or non-cash payments), or, more commonly, from the state (in the form of tax and social security contributions arrears) In the case where the SBC manifests itself in the form of inter-enterprise arrears or overdue payables to banks, the source of the budget softness is frequently the state In the case of the former, firms accumulate trade credit arrears in anticipation

of a general government bailout (for example, by means of a clearing scheme) In the case of the latter, banks with large non-performing loans (to non-viable and/or favoured firms) are often state-owned or subject to political interference or operate under a SBC regime i.e insolvent banks expect a bailout by government

This perception of government is particularly true in some of the FSU republics where the state is often viewed as the softest creditor; a perception that is tolerated and sometimes even instigated by the state itself These forms of budget softness were also evident in CEE countries but have diminished as transition has progressed

As the state, through its tax system, appears to be the main source, and instrument,

of budget softness, this monograph addresses the issue of state governance with respect to taxation and, in particular, the problems of tax discipline and collection The motivation for focusing on taxation and tax collection stems from observing the general decline in tax revenues witnessed by the majority of ex-socialist countries since the start of transition with a view to providing, from the perspective of the tax collector (i.e the state) as opposed to the taxpayer (i.e for our purposes, the enterprise)

or the general economic environment (i.e the transition setting), an explanation for revenue erosion In the wider context of the SBC, it is the government-firm relation that is of interest here, with government acting as the supporting organisation or funding source and the firm acting as the budget constraint organisation Other relations where the SBC is evident include government-government (Wildasin 1997), government-bank (Mitchell 1998) and bank-firm (Dewatripont and Maskin 1995)

In trying to identify evidence of budget softness, researchers encounter endogeneity and causality problems when examining the relationship between the financial position of a firm (usually gauged by some measure of profitability) and its rescue (usually measured by some form of financial aid) Although we encounter the same measurement problems when investigating the various channels of budget softness, we then proceed to focus on the more general matter of tax discipline, compliance and collection Tax collection problems can arise for a number of reasons, including budget softness (Chapter Three) but also because of a general poor payments discipline (Chapter Four), ineffective tax administration (Chapter Five) or because of low tax capacity and effort arising from economic and non-economic factors (Chapter Six)

Introduction 7

1.4 Soft Taxation in Transition Countries

An important feature of the evolving state-enterprise relationship in TEs is the tax system The transition to a market economy involved replacing the old system (dominated by the turnover tax and transfers from state enterprises) with a tax system more in line with market economies On a practical level, this involved the introduction of Western-type corporate and personal income taxes, a value-added tax (VAT) and improving tax administration On a higher level, it involved detaching the enterprise sector from the state This has proven more difficult than expected (EBRD 1999) As a result, tax arrears, poor tax collection and revenue erosion were common

in many of the transition countries during the first decade

Table 1.1, where the tax/GDP ratios are reported for the transition countries

of Central and Eastern Europe and the former Soviet Union, shows the general decline in tax revenues This fall in tax revenues is particularly true of the laggard reformers (Bulgaria, Romania and Russia for example) – as opposed to the rapid reformers (Czech Republic, Estonia and Poland for example) or those

Table 1.1 Tax Revenue/GDP Ratios, 1989-1998

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Albania 42.2 26.7 16.4 18.1 19.1 17.7 15.3 13.5 15.9 Bulgaria 43.0 37.7 33.1 28.9 31.8 29.3 26.5 26.6 30.6 Croatia 40.1 41.4 41.5 40.3 43.5 Czech Republic 38.8 41.2 40.3 39.7 38.8 38.0 36.9 Hungary 46.6 47.9 45.6 45.2 42.9 41.9 43.5 42.9 41.2 FYR Macedonia 41.9 38.8 37.9 36.1 34.4 Poland 35.4 36.5 39.1 39.6 38.7 38.3 37.5 35 Romania 35.8 36.2 34.2 31.5 28.3 28.9 27.1 28.0 28.2 Slovak Republic 39.4 36.5 38.8 42.0 41.1 38.4 37.2 Slovenia 41.7 42.9 42.6 42.3 41.3 40.4 41.2

Average (CEE) a 41.9 36.8 35.7 35.4 36.5 36.1 35.1 34.2 34.4

Armenia 20.5 13.1 13.1 12.7 12.9 16.3 16.9 Azerbaijan 31.1 33.2 16.9 10.4 14.2 17.0 15.0 Belarus 45.3 39.0 38.6 43.2 43.7 Estonia 30.8 36.5 38.8 37.8 37.1 37.1 37.1 Georgia 8.2 2.0 4.6 5.4 10.9 13.0 13.4 Kazakhstan 21.5 16.7 12.3 11.0 11.3 12.2 16.2 Kyrgyzstan 14.6 14.8 13.6 15.0 13.2 12.5 14.4 Latvia 36.1 36.1 35.1 33.7 34.8 34.3 Lithuania 30.3 27.8 31.4 31.6 28.8 32.0 32.9 Moldova 20.8 21.1 26.4 28.8 27.4 29.9 29.0 Russia 35.9 31.7 30.9 28.3 28.3 29.3 29.2 Tajikistan b 40.6 12.8 11.7 13.3 11.7 Turkmenistan 16.4 19.2 14.4 20.8 16.2 Ukraine 41.6 41.1 39.1 34.8 34.7 35.6 31.8 Uzbekistan 26.4 28.4 23.3 27.7 32.3 27.7 29.4

Average (FSU) a 38.5 c 25.6 25.2 25.9 23.3 23.3 25 24.7

Notes: a Unweighted average b The data for 1995 are from 11 May–31 Dec c Estimate of

tax revenue/GDP ratio for the USSR.

Source: OECD 1991; Tanzi and Tsibouris 2000; Author’s calculations.

Transition, Taxation and the State

of the actual decline was both dramatic and surprising (Cheasty 1996)

We use the SBC framework to conceptualise the tax collection problems The empirical evidence on the SBC indicates that the tax system is a mechanism commonly used by which the budget constraint of firms can be softened In particular, late, non-cash, or non-payment of tax liabilities by loss-making firms (although not exclusively as tax arrears of high profile profitable firms in Russia and elsewhere are not uncommon) suggests that the hardening of budget constraints, expected in transition countries in the 1990s, did not fully materialise (Kornai 2001)

We begin by looking at taxation in the context of the transition from a planned

to a market economy Under the socialist system, high tax shares of GDP were common; tax ratios in excess of 50 per cent of GDP were not unheard of As the transition process accelerated, many of these countries witnessed a dramatic decline

in the tax/GDP ratio Russia, with late, non- and in-kind payments of tax evident during the 1990s, is an appropriate setting within which to begin our analysis.5 We then examine the role of taxation in the context of the SBC In particular, we apply appropriate (in some cases, modified) methodologies to new data for the TEs with the purpose of revealing incidences of budget softness (or hardness) and, more generally, measuring the degree to which the enterprise sector in TEs is not tax compliant Tax collection problems, either arising from economic, administrative or political factors, are investigated in the context of transition Our evidence indicates that cross country differences are not small, state control matters and, for many transition countries, tax administration and political constraints, as opposed to tax design and economic constraints, are more pressing problems

In Chapter Two we set out to assess the problems of taxation in the context

of the Russian State, its relationship with the enterprise sector and the transition from plan to market It is argued that Russia’s well-known tax collection problem

is a manifestation of an ineffective and poorly governed state, supported by weak institutions Central to this problem is the symbiosis of politics and economics that

4 The other set of TEs where tax revenues plummeted were the countries involved in war and internal strife (Azerbaijan, Georgia and Tajikistan for example).

5 In this book, the term ‘Russia’ is used for the ‘Russian Federation’.

Introduction 9was common in Soviet times and is still prevalent in postsocialist Russia In the early years of transition, Russia witnessed an ineffective state and a systemic crisis

of governance This crisis of a weak state and poor governance, manifesting itself

in a severe fiscal crisis, culminated in the August 1998 crash The chapter begins with a short analysis of the models of government Following this, we focus on the weak state and the symbiotic relationship or nexus that exists between government and business The symptoms of an ineffective state that were evident in Russia’s fis-cal system are described later The chapter concludes with an account of the August

1998 fiscal crisis and some tentative policy prescriptions

In Chapter Three, a survey of over 400 Russian manufacturing firms is used

to look for evidence of SBC We distinguish between three categories of creditors – banks, suppliers, and government – and use several different measures of the SBC – ease/difficulty of obtaining credit, how a shortfall in working capital would

be financed, and observed levels of and changes in debts and overdue debts The evidence suggests that on average suppliers and banks are unwilling to extend credit to unprofitable enterprises and hence are imposing hard budget constraints

on firms Subsidies from government of various forms are not uncommon, and we find evidence, albeit weak, that these are more likely to be allocated to loss-making firms

Since transition began, overdue tax liabilities have emerged as one route

by which firms have their budget constraints softened We examine this issue in Chapter Four Using a stock/flow analysis on comprehensive firm-level data, for Romania, we establish that many firms are obtaining cheap working capital from the government by means of tax arrears; stocks and flows of overdue tax debts indicate

a sizeable tax arrears problem in Romania There is also some evidence to indicate that the problem is not confined to loss-making firms Profitable firms with flows of tax arrears suggest a general poor payments discipline problem

Chapter Five looks at the issue of tax administration and compliance in transition countries Wide differences between effective or realised average tax rates and tax yields that would result if statutory tax rates were strictly applied indicate tax compliance and collection problems Due to the greater politicisation of tax systems

in TEs, we would expect the shortfalls in effective tax yields for TEs to be larger than a benchmark for the mature market economies where tax systems are well established, the administrative capacity is stronger and tax arrears are tolerated less frequently

We find a positive correlation between progress in economic transition and effective tax administration For slow reformers, the effectiveness of tax collection appears to vary with the extent of state control Those TEs that have maintained the apparatus

of the state have done well in tax collection compared to those countries where there

is evidence of state decay

In Chapter Six we examine the issue of tax capacity (potential) and effort (performance) The decline in the tax/GDP ratio for many ex-socialist countries has raised fears of further revenue erosion and low tax potential for these countries in the post-transition era The purpose of this chapter is to apply a tax capacity methodology, favoured by the International Monetary Fund (IMF) in the 1970s to study international

Transition, Taxation and the State

10

differences in tax ratios among developing countries, and extend it to the TEs using data for the 1990s The results indicate that many Commonwealth of Independent States (CIS) transition countries resemble more closely the low- and middle-income countries of Asia and Latin America than their fellow transition countries of Central and Eastern Europe and the Baltic States, and that TEs, in general, are no worse at tax collection than other countries of similar economic structure and development Although the tax capacity and tax effort estimates indicate that binding constraints for some of the TEs may be low incomes and a high agriculture share of GDP, political and administrative constraints cannot be dismissed as possible reasons for low tax revenues and tax collection problems

The main findings of the research concerning tax collection problems in transition countries are summarised in Chapter Seven Since the start of transition, most ex-socialist countries have witnessed declines in tax/GDP ratios Tax collection problems have emerged for a number of different reasons, including the SBC and the nature of the postsocialist state-enterprise relationship As with other studies of the TEs, our research indicates that cross-country differences are significant, institutions (in our case, an effective tax administration system) matter, and that, as with non-transition countries, taxation is a vexed topic with economic, political and social dimensions

Chapter Two

Tax, Transition and the State:

The Case of Russia

2.1 Introduction

The power to impose and collect tax is a defining characteristic of a modern capitalist state It was Joseph Schumpeter who, prior to his appointment as Finance Minister in the Austrian Government after World War I, described the capitalist state as the ‘tax-collecting state’ In his 1918 paper entitled ‘The Crisis of the Tax State’, he wrote that ‘…“tax” has so much to do with “state” that the expression “tax state” might almost be considered a pleonasm.’ (Schumpeter 1918) For Schumpeter, the origins

of the capitalist state (at least in Germany and Austria) arose, not from political needs, but from fiscal needs It is the fiscal demands and the tax-collecting powers, born out of a ‘common exigency’ that distinguishes the modern capitalist system from its predecessor, the feudal system, he argued

In contrast, the origins of the socialist state (and all its manifestations including the SBC) are the political one-party system (Kornai 1992a) One of the characteristics of this system, as observed by Mancur Olson, was its ability to collect an extraordinary amount of ‘taxes’ (Olson 2000) It is within this context that we examine the transition from the socialist state to the capitalist state that took place at the end of the 20th century As our primary interest lies in a sovereign state’s power to tax, it

is appropriate to assess Russia’s (the most important of the successor states to the Soviet Union) transition to a ‘tax-collecting state’ Since transition began, many ex-socialist countries have experienced a dramatic fall in tax revenue Russia is no exception In 1992, total government revenue as a share of GDP was 39.3 per cent; by

1998 the revenue/GDP ratio had fallen to 33.4 per cent Moreover, federal revenues fell from 16.6 per cent of GDP in 1992 to only 11 per cent in 1998, of which two percentage points was non-cash (IMF 2000a) This inability to collect ‘sufficient’ taxes is a manifestation of an ineffective and poorly governed state, supported by weak institutions whose authority is not legitimate in the eyes of its citizens.1 Many Russians view the efforts of the central government as the private affairs of the elite and certainly not aimed at enhancing the common interests of its citizens This crisis

of a weak state and poor public governance, manifesting itself in a severe fiscal débâcle, culminated in the August 1998 crash It was Sergei Kiriyenko, the Russian

1 According to one commentator, ‘The revenue extraction process in Russia reveals an inherent mistrust between state and society’ (Easter 2003)

Transition, Taxation and the State

1998 crash – a fiscal crisis that had its origins in a weak and ineffective Russian state The policy implications arising from the analysis of poor state governance are examined in the final section of the chapter

2.2 The Theory

Our primary interest is in taxation and different models of government In a functioning market economy, governments oversee the provision of public goods and the orderly payment of taxes, where taxes are defined as compulsory, unrequited (in the sense that benefits provided by government to taxpayers are not normally in proportion to their payments), nonrepayable payments exacted by government for public purposes In postsocialist Russia, the payment of taxes has been problematic What follows is a stylised account of tax payments (and its sister activity, bribery) in the context of transition from plan to market

well-When an enterprise produces goods/services or engages in trade or employs workers, it incurs tax liabilities of all sorts (for example, VAT or export tax or social security tax) Once a tax liability arises and is known to the tax authorities, the enterprise can do one of three things

One, the tax is paid, either in cash or non-cash form Non-monetary tax payments were not uncommon in Russia during the 1990s Explanations vary from liquidity shortages and the demonetisation of the economy that resulted from tight monetary policy to poor financial intermediation leading to lower transaction costs for barter than for non-barter to the facilitation of tax avoidance or evasion whereby the barter transaction circumvents the use of bank accounts and the chances of confiscation of revenue by the tax authorities (Gaddy and Ickes 1998; Commander and Mumssen 1999)

2 Ironically, Jeffrey Sachs, much maligned for his advice on Russia’s transformation, did recognise the dangerous prospect of state collapse or insolvency in Russia In 1994, in warning about the dangers of a ‘bad’ equilibrium for the Russian State, he wrote, ‘Several simple examples of immediate relevance to Russia illustrate the risks of state collapse.’

He went on to list six, namely tax evasion, criminality, regional separatism, flight from the rouble, foreign debt overhang and panic by government creditors (Sachs 1995) Although Sachs was quite right in his analysis, namely of a state in near collapse, it was his policy recommendations, including his claim, at that time, that radical reform by itself revives the collapsed state, that were to attract most public attention For lessons on government collapse

in transition countries, including Russia, see Roland (2000).

Tax, Transition and the State: The Case of Russia 13Two, the tax is not paid (or paid with such a delay that the tax payment is, given interest charges and inflation rates in the early years of transition, in effect, a subsidy.) The delinquent taxpayer (for our purposes, the enterprise) can be either a profit-maker or a loss-maker If it is a case of profit-making firms not paying taxes, the problem is generally one of a poor payments discipline (aside from the possibility

of individual and legitimate tax disputes with the tax authorities) Alternately, if it is

a case of loss-making firms not paying taxes, the problem is one of a SBC (Kornai

1980, 1986).3

Three, payments are made arising from the tax liability but are paid in the form of

a bribe to government officials in order to, among other things, reduce or eliminate the known tax liability This behaviour, both on the part of the recalcitrant firm and the politician or bureaucrat, can be described by reference to Shleifer and Vishny’s predatory government and corruption model (Shleifer and Vishny 1993, 1998)

We begin, however, with János Kornai’s analysis of how the socialist system comprised a paternalistic, all-powerful, helping-hand state that gave rise to the SBC and financial indiscipline on the part of state-owned enterprises (Kornai 1980, 1992a) Unlike private firms in a market economy where the state is, in general, neither paternalistic nor pervasive, SOEs in a socialist economy may face ‘soft’ budget constraints.4 The budget or financial constraint is softened when the state bails out

or refinances loss-making firms The recurring expectation of a bailout, in whatever

form it takes, influences ex ante the behaviour of enterprises This helping-hand

model of government depended on a strong and benevolent state whose primary aim was to provide for the enterprise which meant maintaining employment, preventing firm closures and job losses and, ultimately, ensuring security

As socialist economies are transformed into market economies, the SBC syndrome was expected to diminish It is true that many of the features of Kornai’s socialist system have indeed disappeared There are no longer shortages of consumer goods, nor do people spend time and energy queuing for goods Many firms operate

in the private sector offering a variety and quality of goods that were not available under the Soviet system; many firms that remain in the state sector are forced by market conditions to restructure These economies are now more integrated with the market economies of Western Europe Of course, it was expected that some aspects of Kornai’s paternalism might linger longer than others, or might manifest themselves in new ways For example, some loss-making firms (not to mention healthy firms) are still extracting subsidies from the state, but by means of tax arrears and/or utility arrears rather than by explicit on-the-budget subsidies The incidence of tax arrears and other non-market economic phenomena suggest that,

in some respects, the state is still ‘soft’ in its relationship with certain loss-making

3 A loss-making firm will not be liable for profit tax but it will have other tax liabilities (VAT and social security taxes, for example).

4 Of course, the SBC is usually defined in the context of the market socialist system where a price mechanism existed rather than to the classical socialist system where money was passive and plans were expressed in terms of physical quantities and output targets

Transition, Taxation and the State

14

enterprises Despite these incidences, for countries like Poland and Hungary, the

‘helping hand’ has been replaced by Adam Smith’s ‘invisible hand’.5 For Russia and other FSU states, neither the helping-hand model nor the invisible-hand model can adequately explain the behaviour of the state with respect to some firms in the state-owned (and, indeed, privatised) enterprise sector.6

In addition, Kornai’s model of a paternalistic state and the SBC has the state redistributing profits from ‘profitable firms’ to ‘loss-making’ firms, the so-called levelling effect Given that price controls were set with social objectives in mind, enterprises were not responsible for losses Profits were redistributed through various subsidy and tax channels Bargaining took place along the vertical chain between managers, local bureaucrats and central planners In postsocialist Russia, some politically-connected, profitable firms manage to engage in socially-costly rent-seeking behaviour, namely, lobbying for subsidies and tax concessions from the government while, at the same time, tolerate delayed trade payments, or payments

in kind, from their customers In turn, politicians (often with short time horizons) extract bribes in return for these lucrative favours, whether they are subsidies, cheap credits, licenses, quotas or permits

It is in this context that we draw upon the second of the theories, that of Andrei Shleifer and Robert Vishny’s ‘Politicians and Firms’ model (Shleifer and Vishny

1993, 1994).7 Shleifer and Vishny’s model is predicated on a predatory, activist,

5 The symbiosis of politics and economics that manifested itself in different ways was far more ingrained in the Soviet Union that it was in Central and Eastern Europe and this observation may go some way in explaining the cross-country performance differences since

1990 On the subject of performance, although Russia’s record since 1992 is considerably worse than most of Central and Eastern Europe, it compares favourably to many other CIS countries This is often ignored in the transition literature on Russia and Eastern Europe.

6 It is important to acknowledge that the enterprise sector that exists in Russia today

is not monolithic It is made up of state, privatised and de novo private firms, profitable and

unprofitable firms, viable and nonviable firms, domestic and foreign firms and so on In this chapter, we are primarily concerned with the nonviable firms and the well-connected firms (sometimes one and the same) that are, at times, kept alive by political interference

7 With respect to the interaction between bureaucrats (government officials) and entrepreneurs (private sector actors), there are different models of government, as explained

by Frye and Shleifer (1997) and, again, by Shleifer and Vishny (1998) There is the friendly ‘invisible hand’, the more interventionist-type ‘helping hand’ and the predatory

market-‘grabbing hand’ As the transition from Soviet-style socialism (a kind of ‘clenched hand’) to

a market economy based on private property and enterprise (Adam Smith’s ‘invisible hand’) continues, Russia seems to be caught halfway, in a state of limbo Although Frye and Shleifer (1997) refer to the state-enterprise relationship in China as an example of the helping-hand model, we extend its applicability (without changing the basic features of the model i.e a well- organised, interventionist, welfare-maximising government) and use it to explain the state- enterprise relationship that existed in other socialist countries pre-transition As indicated by Frye and Shleifer, these models of government are ‘ideal types’; in reality, governments may

be a mixture of all or a combination of some A variant of these types of government models

is presented in Treisman (1995).

Tax, Transition and the State: The Case of Russia 15grabbing-hand state whose aim is self-preservation and wealth accumulation, leading to rent seeking, corruption and bribes.8 Using standard economic theory of industrial organisation, Shleifer and Vishny (1993) show that the type of organised corruption that was prevalent in the former Soviet Union (where the person paying the bribe was assured of getting the government good) was less damaging than the unorganised crime and corruption that became prevalent in Russia in the early years

of the reform period

According to Shleifer and Vishny (1994), bureaucrats are self-interested economic agents often acting independently of each other who use their power and position

to pursue their own agendas They did so under the socialist system by restricting output and keeping prices low, resulting in endemic shortages (Shleifer and Vishny 1992) As bureaucrats did not have any legitimate cash flow rights to goods produced

in the state sector, corrupt officials turned their attention to creating, or taking advantage of, shortages in order to enhance their opportunities for collecting bribes The underground barter economy was used to produce goods that the state failed to supply In postsocialist Russia, the well-connected, state-owned or privatised firms,

often run by the old elite (the nomenklatura) frequently engage in rent or

subsidy-seeking behaviour rather than profit-subsidy-seeking behaviour.9 By lobbying, they manage

to extract soft credits, subsidies and tax concessions from the state, often in return for kickbacks Effort is exerted and resources are wasted in the pursuit of these rents

The effect of this is that compliant firms, often de novo private firms, are penalised

The behaviour of these compliant firms is adversely affected as they, in turn, bargain with government officials for tax concessions and soft loans The cosy networks and personal exchange that exist between officials of government and managers of these enterprises reduce the risk of exposure and, in doing so, reduce the relative transaction costs of bribery In this type of environment, firms are more likely to seek

a maximisation of political connections – relational capital - rather than of profits (Gaddy and Ickes 1998; Åslund 1999)

In developed market economies, the job of market-friendly, representative institutions like the political parties, the media and social organisations is to ensure that the type of distortive and corrupt bureaucratic behaviour described above does

8 Others, including Jan Winiecki (1992) and Anders Åslund (1994, 1999) have highlighted corruption and the rent-seeking activities of the old elite in explaining Russia’s problems in its transition to a market economy Of course, a predatory view of the state is not new and has followers in both the neoclassical and Marxian traditions.

9 In the early years of reform in Russia when inflation was high, certain sectors (agriculture and coal, for example), enterprises and bankers gained large rents, either in the form of subsidised credits, loans at negative real interest rates or arbitrage opportunities

As Treisman (1998) and Hellman (1998) have argued, these winners gained at the expense

of the population at large According to Treisman, the Russian government managed to opt the winners and, in the process, achieved lower inflation Hellman argues, contrary to conventional wisdom, that reform governments must restrain these ‘winners’ (by expanding political participation and competition) as they are more of a threat to successful reform than the ‘losers’

co-Transition, Taxation and the State

16

not go unpunished In Russia, these ‘checks and balances’ were either open to abuse or were simply too weak to prevent the rent-seeking activities of politicians,

government officials and nomenklatura-appointed enterprise managers The

political and institutional vacuum that existed in Russia allowed the rent-seeking elite to pursue their political objectives (securing voters’ support and maintaining power) and, at the same time, to enrich themselves by accumulating vast sums of personal wealth (Åslund 1999) The more efficient allocation of resources that the transition to capitalism was promised to bring was hindered by the activities of these rent-seeking interest groups (Olson 1965, 2000; McFaul 1995; EBRD 1999) These special interest groups competed for the resources of the state (sometimes colluding with government officials) rather than seeking greater market share Due to a number of factors, including the large rent-seeking opportunities, the weak central authority, the lack of representative institutions and the failure to build a sufficient constituency for market-oriented reforms, these entrenched groups have been able

to advance their own narrow interests at the expense of the reform process and the welfare of the population at large

In summary, Russia’s ‘peculiar’ (a word often used to describe the postsocialist Russian economic system) transition from a planned to a market economy has been

a story of winners and losers, and powerful vested groups with conflicting and narrow interests, made stronger by the weakness of political parties, of democratic institutions and of the rule of law The early years of transition left the Russian state

in a position of limbo, some place between the ‘helping hand’ and the ‘invisible hand’, what Shleifer and Vishny call the ‘grabbing hand’ This view was espoused

by Boris Yeltsin in his State of the Federation address in March 1999 when he talked about Russia getting stuck halfway, and left with ‘…a hybrid of the two systems…’ (i.e plan and market) This vacuum has being partly filled by oligarchs, rent seekers, corrupt government officials and the mafia This is what George Soros calls ‘robber’ capitalism, Grigory Yavlinsky calls ‘phony’ capitalism, Marshall Goldman calls

‘bastard’ capitalism and John Gray calls ‘mafia-dominated anarcho-capitalism’ It manifests itself in a number of different ways; the problem of tax collection is one of these manifestations But this is only one side of the story

There is another side to the story Russia, in many respects, resembles a market economy The majority of its output, estimated at 70 per cent in 1999, is produced in the private sector (EBRD 1999) For most goods, prices are not controlled and are close to world levels Certainly, some Russians are better off today than they were over a decade ago, despite the setbacks associated with transition As for taxation,the tax/GDP ratio in Russia is higher than the ratio for some of the Organisation for Economic Co-operation and Development (OECD) countries and some of the ex-socialist transition countries Given Russia’s level of national income, this level of government capacity is quite surprising Here is one of postsocialist Russia’s many paradoxes This is the other side of the story, a side that is often neglected and seldom recognised Leaving this aside, the rest of this chapter explores the relationship between the ‘tax-collecting state’ and the ‘tax-paying enterprises’ in a particular transition economy, namely Russia (in the first decade of transition) In effect, it is

Tax, Transition and the State: The Case of Russia 17the story of an economy that has experienced a transformation (albeit traumatic and uneven) from an administrative-command economy to a market economy but whose state is in crisis; an incapacitated state that has failed to change in line with the economy and whose actions, and in some cases inactions, have adversely affected the behaviour of enterprises, not only state and privatised, but also the new private sector (often with new firms going underground or failing to grow, or in some cases, even start up, due to the predatory nature of government and its officials, particularly

at regional and local level).10

2.3 The State and the Enterprise Sector in Russia

In this section, we provide an explanation for Russia’s tax problems in the context

of the state-enterprise relationship We argue that the real cause of the problem is the ineffective state, the behaviour of an enterprise sector that is often dominated

by powerful vested interests and the non-market relationship that exists between the state and parts of the enterprise sector in postsocialist Russia We will deal with each

as Kornai (1992a) emphasised the importance of ‘norms’ under the socialist system,

we need to emphasise the importance of institutions in the new market system Ironically, much of this requires a strong state

Secondly, the actions and inactions of the state in postsocialist Russia are at odds with its responsibilities in a market economy On the one hand, it is not doing what

10 This view of a dysfunctional Russian state is shared by others, including Sapir (1999), Brown (1999), Gustafson (1999) and Nagy (2000) For example, in their separate accounts

of the August 1998 crisis, they explicitly refer to ‘a large-scale failure of state power’ (Sapir 1999); ‘a bloated state that …was incapable of performing satisfactorily such basic functions

as collecting taxes, paying public service workers, and maintaining law and order’ (Brown 1999); ‘ a failure of the central state’ (Gustafson 1999) and ‘…the on-going meltdown of the state’ (Nagy 2000).

Transition, Taxation and the State

18

it should be doing, whether that is enforcing the rule of law, building an effective public administration, ensuring property rights and contract enforcement, providing essential public services, legitimising the informal sector, ensuring a social contract

or encouraging competition The national state has, in effect, abdicated on these responsibilities Weakened, it became particularly vulnerable to the small groups

of lobbyists and vested interests (agricultural lobby, bankers, energy sector) that sought privileges and favours In particular, it is the politically-connected firms that have managed to ‘capture’ the state in pursuit of their own narrow interests (EBRD 1999; Hellman and Schankerman 2000) This leads us to the other dimension of governance in Russia today (Appendix B) In sharp contrast to the above, the state is frequently doing what it should not be doing whether it is softening budget constraints

of nonviable firms, indiscriminately bailing out insolvent ‘banks’, exchanging government goods in return for kickbacks, stifling enterprise with punitive taxes, incessant inspections, costly regulations and draconian penalties, keeping power at the regional level at the expense of local government, and maintaining, or in some cases, fostering features of the old system (the privileges and favours, the ‘patron-client’ networks, the regulations, the bureaucracy, the extortion and so on) This view of a state that is irresponsible in its inactions (weak and ineffective) and actions (predatory and interventionist) is shared by others, including Åslund (1994), Mau (2000) and Nagy (2000) Peter Evans (1992) remarks that the ‘…conjunction of leviathan and the invisible hand…’ is not as contradictory or as uncommon as it might appear.11 In that context, the problem in Russia, as distinct from other countries where a symbiotic relationship between government and business is common, (Japan and Korea, for example) is that the Russian state lacks the ‘embedded autonomy’ prevalent in so-called developmental states (Evans 1992)

2.3.2 The Enterprise Sector

The changes in the enterprise sector in Russia since transition began have been mixed, with evidence of significant sectoral and regional differences Whereas the resources sector generates substantial value added and much needed hard currency earnings, the value added and foreign currency earnings generated by the manufacturing sector are less substantial This is a legacy of Soviet times when negative value added was quite common and enterprises did not trade directly with foreign firms, other than through the trading bloc, the Council for Mutual Economic Assistance (CMEA) Although many of these enterprises have been privatised, they (pre-1998 crisis) have

11 The publication’s editors, Stephan Haggard and Robert R Kaufman write that, ‘For governments to reduce their role in the economy and expand the play of market forces, the state itself must be strengthened.’ Evans supports this thesis of a complementarity between state

and market by quoting from such figures as Karl Polanyi, who in The Great Transformation

wrote ‘The road to the free market was opened and kept open by an enormous increase in continuous, centrally organised and controlled interventionism’ and Max Weber, writing in

Economy and Society that ‘Capitalism and bureaucracy have found each other and belong

intimately together.’

Tax, Transition and the State: The Case of Russia 19

been slow to restructure (Frydman et al 1996; Blasi et al 1997) Table 2.1 reports

the EBRD’s indicator of governance and enterprise restructuring for a number of transition economies, including Russia, for the period 1994–1999 It is evident from the table that the improvement in enterprise restructuring in Russia, in the judgement

of the EBRD, has been slow and erratic, since 1994

Note: The classification system is based on the judgement of the EBRD’s Office of the Chief

Economist The scores represent the following: 1 = SBC (lax credit and subsidy policies weakening financial discipline at the enterprise level); few other reforms to promote corporate governance 2 = moderately tight credit and subsidy policy but weak enforcement

of bankruptcy legislation and little action taken to strengthen competition and corporate governance 3 = significant and sustained actions to harden budget constraint and to promote corporate governance effectively (e.g through privatisation combined with tight credit and subsidy policies and/or enforcement of bankruptcy legislation) 4 = substantial improvement

in corporate governance, for example, an account of an active corporate control market; significant new investment at the enterprise level 4+ = standards and performance typical

of advanced industrial economies: effective corporate control exercised through domestic financial institutions and markets, fostering market-driven restructuring.

Source: EBRD 1999.

In post-privatisation Russia, corporate governance mechanisms are generally weak with insiders retaining control This resulted from the mass privatisation programme where the stakeholders (incumbent managers and workers) were co-opted in order

to secure their support for the privatisation scheme Much of the capital stock in the Russian state-owned enterprise sector is old and obsolete Modes of organisation are often antiquated Labour hoarding by some state-owned and private enterprises is evident, with some social provisions still provided by the enterprise In rural Russia, many of the mono-enterprise towns remain, isolated from the marketplace and even more isolated from the international capitalist world Labour mobility is often restricted by enterprise provision of social services, derisory unemployment benefits, wage arrears and, sometimes even, the registration (propiska) system (Broadman and Recanatini 2001) Despite the reforms (and the difficulty in acquiring verifiable evidence), many enterprises in Russia, over a decade into transition, are still likely to

Transition, Taxation and the State

20

operate with two sets of books, a shell or daughter company, an offshore subsidiary and have unregistered activities Regular payments to the mafia, government officials and local politicians are not uncommon Enterprises are as likely to engage in late payment, informal, personalised, private methods of contract enforcement and other non-market activities as they are to engage in prompt payment, formal, anonymous, legal methods of contract enforcement and other market activities

As with other transition economies, differences in enterprise performance and restructuring in Russia may be accounted for by a number of factors, including ownership, market structure and competition, corporate governance, finance and budget softness (Djankov and Murrell 2002) Since privatisation began, improvement

in enterprise performance has been delayed, and in some cases hampered, by lack

of investment finance, domestic and foreign competition, regional administrative

barriers and inadequate corporate governance mechanisms (Angelucci et al 2002)

Of course, the enterprise sector in Russia is not monolithic We can distinguish

between state, privatised and new private, with de novo private firms showing strong

performance relative to both state-owned and privatised firms (Appendix C) Each of these three categories is likely to have a different relationship with the state Often, the incumbent (state or privatised) is protected by the (subnational) government

whereas de novo private firms are often harassed by the state (McKinsey 1999;

Broadman 2002) We now examine the state-enterprise relationship in more detail

2.3.3 The State-Enterprise Relationship

Central to the behaviour of enterprises and the slow pace of restructuring is the political economy nexus that exists between the state and the enterprise sector or, more particularly, between subnational government and incumbent state or privatised firms In a well-functioning market economy, the certain provision of public goods in exchange for the orderly payment of taxes is a central feature of the state-enterprise relationship This is not the case in Russia (or in many other FSU countries) In the case of a federalist state with weak central authority, the state-enterprise relationship

is more likely to be dominated by subsidies, tax breaks, payment arrears, stripping and bribes than by public goods and compulsory, unrequited payments to government i.e taxes

asset-Although the state has been weakened in many respects since the dismantling of state socialism, the state still retains ‘interventionist’ features of both the helping-hand and the grabbing-hand models with respect to its relationship with the enterprise sector Some politically-connected firms manage to extract rent from the state in return for bribes to government officials and bureaucrats This is the case of the activist, predatory state ensuring its survival, while at the same time enriching public officials (Shleifer and Vishny 1994; EBRD 1999) Likewise, it is not uncommon for loss-making firms to be bailed out by the state (particularly at the regional level

of government), by means of tax and utility arrears This is the case of the SBC

phenomenon (Pinto et al 2000; Kornai 2001) In this case, it would appear that

its behaviour is influenced by a desire to maintain employment and prevent social

Tax, Transition and the State: The Case of Russia 21unrest McKinsey (1999) found that ‘… policies are often put in place to achieve social objectives, namely protecting existing jobs, but in many cases, the suspicion

is that they also serve the personal financial interests of government officials in collusion with businessmen…’

What has changed is the way that the state channels funds to these loss-making enterprises Arbitrary pricing and budgetary subsidies have been replaced by new, and often implicit, ways of extracting subsidies from the state, including tax exemptions, arrears and offsets, utilities arrears, non-payment and, in some cases, barter This intervention by the state (and in increasing amounts by regional government) prevents

a reallocation of resources to the sectors of the economy where there is potential for further value added Although Russia may be a ‘market’ economy in the sense that most of the output, officially or unofficially, is produced in the private sector and resources are allocated through a decentralised price mechanism, it still retains some features of the old Soviet socialist system One of these features is the state-enterprise relationship that still lingers, preventing the state from carrying out its ‘market’ duties and preventing enterprises from restructuring By condoning informal activities, reneging on its obligations to its suppliers and its workforce, taking bribes and by allowing rent-seeking behaviour, accepting tax offsets, negotiating tax liabilities with well-connected enterprises, allowing mutual indebtedness and barter chains to flourish, tolerating arrears, allowing the resources sector to subsidise the manufacturing sector, and by maintaining ‘relational capital’ with the enterprise sector, the state is implicated

in the economic and political crisis of the 1990s in Russia, culminating in the rouble devaluation and the debt default of August 1998

Since 1992, governments in Russia have been described at various different stages as soft, weak, corrupt or interventionist With respect to its relationship with the enterprise sector, we can say that Russian governments have proved to be all of the above at some stage or other In a market economy the state has responsibilities

to the enterprise sector Among others, it is sometimes an owner (although not often),

a creditor (tax collection agency), a legal guardian (courts and contract enforcement, bankruptcy) and a regulatory body (to promote competition and prevent monopoly practices) With respect to the Russian enterprise sector, we can say that as an owner the state is often corrupt, sometimes paternalistic; as a creditor it is sometimes ‘soft’;

as a legal guardian it is weak and open to abuse; and, finally, as a regulatory body, it

is frequently bureaucratic and interventionist (while, at other times, ineffective and even absent) The state-enterprise relationship suffers as a result, failing to develop into a market-type relationship as exists in mature market economies and in some of the leading transition economies (Hungary and Poland, for example)

To summarise, Russia has experienced a ‘soft’ transition in terms of the symbiosis between politics and economics, or what ex-acting PM Yegor Gaidar refers to as the ‘…intertwining of property and power…’ and of ‘…business and

Transition, Taxation and the State

22

bureaucracy…’ (Winiecki 1992; Gaidar 1999a).12 This is a legacy of the socialist political-economic system, described as ‘…the unique symbiosis of the state with society and the economy.’ (Kaminski 1996).13 This is not a case for state desertion, but for the relationship between the state and the enterprise sector to be made more formal within an appropriate institutional setting

Although this symbiotic relationship is best exemplified by the existing enterprise relationship, the implications reach beyond the enterprise sector For example, the results for many ‘ordinary’ Russians have been catastrophic, despitethe increase in individual liberty and choice In the early years, this was reflected in rising mortality rates, greater income inequality and even larger numbers of people living in ‘poverty’ In later years, it has been reflected in rising crime and in a general mistrust of state institutions and in the entire political process Recall Thomas

state-Hobbes treatise Leviathan wherein he stated that life without an effective state is

‘…solitary, poor, nasty, brutish and short.’ (Hobbes 1651) As the state continued

to weaken, many Russians found themselves disengaging from the national state

It is not surprising that the general public do not have trust in the government or its institutions when arrests and charges against state employees of the Central Bank of Russia (CBR), Goskomstat, the Federal Bankruptcy Service, the State Tax Service (STS) and other state agencies for fraud, evasion and other criminal activities were not uncommon throughout the 1990s

What are the symptoms of an ineffective state? How does the symbiotic relationship between government and business manifest itself? How can the umbilical cord of the state be detached without damaging the fiscal capacity or the tax powers of the state?

In the next section, we focus on Russia’s weakened fiscal system and the problems

of fiscal discipline and tax collection

12 Of course, this ‘…intertwining of property and power…’ can be traced back to Soviet and Tsarist times, as far back as the 14 th century and remained a characteristic of the Russian state throughout most of its history (Pipes 1974; Hedlund 1999)

pre-13 This symbiotic relationship is portrayed in Ericson’s depiction of the Russian economic system as characteristic of ‘industrial feudalism’ with regional fiefdoms (Ericson 1999) He describes the state-enterprise relationship as one where there ‘…is a tendency at all levels

to look to governments, with their ability to command resource flows, for direction, support and the solution of economic problems’ and where there ‘…is a tendency for governments

to look to business organisations for access to the resources needed to maintain their power and control.’ Easter (2003) makes a similar claim when writing, ‘While the state may be dependent on large corporations for tax revenue, Russia’s corporate elites remain dependent

on state patronage for wealth and status.’ In support of this, one of the key findings of the EBRD/WB BEEPS survey was that ‘States and firms continue to be tied together in a web

of interactions in which the state provides a wide range of direct and indirect subsidies to firms, while firms provide public officials with some combination of control over company decisions and bribes.’ (EBRD 1999).

Tax, Transition and the State: The Case of Russia 23

2.4 Taxation and Russia’s State-Enterprise Relationship

A central feature of the state-enterprise relationship in any economy is the fiscal system and taxation Moreover, since transition began a decade ago, nothing portrays the fusion between government and business in Russia better than the taxation issue

In a market system, the tax obligation of an enterprise is determined by tax law

In the socialist system, the ‘tax’ obligation of an enterprise was determined by the bureaucrats and was subject to change, depending on the circumstances In the early years of postsocialist Russia, the tax obligation of many enterprises was determined,

in theory by statutory tax legislation, but in practice, by personal relations and open

to negotiation and subject to lobbying and bargaining Ex-acting PM Yegor Gaidar,

in relating the tax collection problem to the SBC and the interface between the state and the enterprise in postsocialist Russia, writes ‘…the problem of tax collection was not a problem of tax administration in the usual sense It was more a political struggle about what constituted the essence of the emerging economic system, whether it was

to be a system in which the relationship between the state and the enterprises was

to be regulated by law or whether it would be business as usual, based on political influence and personal contacts’ (Gaidar 1999b)

Taxation in the traditional (pre-reform) socialist system was very different to the Western-style tax system, both in terms of objective and composition Taxes were mostly transfers within the public sector, from profitable SOEs, that is, state-owned enterprises with surpluses, to loss-making SOEs For the enterprise, taxes were implicit and negotiable As for the state, taxes were easy to collect as taxpayers, that is, enterprises, tended (relative to the capitalist system) to be fewer in number and larger in size In addition, the State Bank, in processing enterprise payments, acted as a tax collection agency The main forms of ‘tax’ revenue were enterprise profits tax (= profit remittances), turnover tax and payroll tax The collapse of the socialist system meant that fiscal institutions, as exist in market economies, had to

be built from scratch Statutory tax systems were required in order to raise enough revenue to pay for the provision of public goods Income tax systems (both corporate and personal), value-added taxes and tax administration systems were all introduced

in the early years of transition Russia was confronted with a Western-style tax system where voluntary compliance and confrontation between the tax collector and the taxpayer are the norm For these and other reasons, it was inevitable that the transition to a market economy would bring a fall in the tax share of GDP By

1998, the total government revenue/GDP ratio was 33.4 per cent Moreover, federal revenues were only 11 per cent of GDP, of which two percentage points were in non-cash form (see Table 2.2).14 We use total government revenue as a share of

14 This problem of insufficient federal government revenues was even recognised by Anders Åslund (a critic of government intervention) who, in the immediate aftermath of the

crisis, (in 1999), wrote ‘ Russia’s federal revenues are small, and the central government

can hardly manage without additional resources…’ Admittedly, there were improvements in (federal) tax revenue in 1999, due largely to discretionary changes in policy, namely, the reintroduction of export taxes and the centralisation of tax receipts