WlJA I &7 POLICY RESEARCH WORKING PAPER 2947 Tax Systems in Transition Pradeep Mitra Nicholas Stern The World Bank Europe and Central Asia Region Office of the Regional Vice President and Development Economics Office of the Senior Vice President and Chief Economist January 2003 POLICY RESEARCH WORKING PAPER 2947 Abstract How have tax systems, whose primary role is to raise before citizens had access to the remainder, to one with a resources to finance public expenditures, evolved in the greatly diminished role for the public sector, as reflected transition countries of Eastern Europe and the former in a lower ratio of public expenditure to GDP, where the Soviet Union? Mitra and Stern find that: (1) the ratio of government needs to collect revenue in order to spend. tax revenue-to-GDP decreased largely due to a fall in Can expected levels of public expenditure be financed revenue from corporate income tax; (2) the fall in by the basic instruments of a modern tax system without revenue from the corporate income tax led to a decline creating significanit distortions in the private sector? The in the importance of income taxes, notwithstanding a authors suggest that transition countries, depending on rise in the share of individual income tax; (3) social their stage of development, should aim for a tax revenue- security contributions together with payroll taxes became to-GDP ratio in the range of 22 to 31 percent, less important in the Commonwealth of Independent comprising value-added tax (6 to 7 percent), excises (2 to States; and (4) domestic indirect taxes gained in 3 percent), income tax (6 to 9 percent), social security importance in overall tax revenues. contribution together with payroll tax (6 to 10 percent), Apart from the increased role of personal income and other taxes such as on trade and on property (2 taxation, these developments go in a direction opposite percent). to those observed in poor countries as they get richer. The authors' analysis also sheds light on the links They show a key aspect of transition, namely a between tax policy, tax administration, and the movement from a system where the government investment climate in transition countries. exercised a preeminent claim on output and income This paper-a joint product of the Office of the Regional Vice President, Europe and Central Asia Region and the Office of the Senior Vice President and Chief Economist, Development Economics-is part of a larger effort in the Bank on the subject of transition meets development. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Sossena Tassew, room H12-220, telephone 202-458-8212, fax 202-522-2758, email address stassew@worldbank.org. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The authors may be contacted at pmitra@worldbank.org or nsternaworldbank.org. January 2003. (53 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issuies An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished The papers carry the names of the authors and should be cited accordingly. The findings, zinterpretations, and co,iclustons expressed in this paper are entirely those of the authors They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Produced by the Research Advisory Staff Tax Systems in Transition Pradeep Mitra* and Nicholas Stern** World Bank * Chief Economist, Europe and Central Asia Region ** Senior Vice President, Development Economics and Chief Economist An earlier version of this paper was prepared for a conference on "Beyond Transition: Development Perspectives and Dilemmas" in Warsaw, Poland on April 12-13, 2002. We thank Daniel Daianu, Yegor Gaidar and Alari Purju, who were the discussants at the conference, for their comments, Jit Gill for a written communication on tax administration in transition countries, Andriy Storozhuk for putting together the tax revenue data for the transition countries and for his invaluable assistance to us with the data, calculations, and charts and Lodovico Pizzati, Afsaneh Sedghi, Giedre Tarbuniene and Ekaterina Vashakmadze for compiling the public expenditure data base for the transition countries under the supervision of Bernard Funck. TABLE OF CONTENTS Pages 1. INTRODUCTION 1-3 2. PUBLIC EXPENDITURE IN THE TRANSITION COUNTRIES 4-8 3. TAX SYSTEMS IN TRANSITION 8-23 4. BENCHMARK LEVELS AND COMPOSITION OF TAX REVENUE 23-28 5. TAXATION AND THE INVESTMENT CLIMATE 28-37 6. ADMINISTERING THE TAX SYSTEM 37-40 7. TAXATION AND FOREIGN DIRECT INVESTMENT 40-44 8. CONCLUSION 44-45 9. APPENDIX TABLES 46-51 10. REFERENCES 52-53 1. INTRODUCTION The transition economies of Eastern Europe and the former Soviet Union which most successfully resumed growth and made progress towards a market economy by the end of the first decade of transition (i) imposed market discipline on the enterprise sector and (ii) established an investment climate conducive to the creation of new firms. These firms became the most dynamic sector of the economy and they flourished without special favors dispensed by the State. Figures 1 and 2 show that countries such as Hungary, the Czech Republic, Poland, Lithuania and Latvia, which witnessed a quick return to growth, following the "transitional recession" which affected all countries, were those where small enterprises defined as those employing fewer than 50 workers provided-by the end of the 1990s- over half of all employment and value added generated in the economy. Moreover, imposition of market discipline and creation of an attractive investment climate must go hand in hand: Figure 3 shows that countries where budget constraints on enterprises were softened, usually through tax exemptions, fiscal and financial subsidies and tolerance of arrears on payments of taxes and energy bills to utility companies, and which thereby created barriers to exit, for unviable firms also saw a low share of aggregate employment in small enterprises'. lFor more details, see World Bank (2002a) 2 Figure 1. Share of Employment in Small Enterprises, 1989-98 60 = Hungary {-Czech Rep 40 Poland 2 ~ ~~~~~~~~- Lithuania 2 Latvia 20 '~3 CZ° t:3 °l 93 m Russia :,= UNf- Ukraine 0 3 Belarus 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Kazakhstan Note: Small enterprises are defined as those employing 50 or fewer workers Source: World Bank database on SMEs. Figure 2. Share of Value Added in Small Enterprises, 1989-98 70 60 - -Hungory - Czech Rep. 50 - Poland E 40 - Uthuenle 2 ~~~~~~~~~~~~L.atvia CL30 - Russian Fed. 20 -ukraine 10 - Georgia -Kazakhta2n 0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Note: Small enterprises are defined as those employing 50 or fewer workers Source: World Bank database on SMEs. 3 Figure 3. Soft Budget Constraints and Employment in Small Enterprises, 2000 __60 50vE Czech Republic 5 0 - -- - - - - - - - - - -- - - - - I - - - - --- -- ----- V 6 li ' --------------------i~ ~ ~ ~ ~~ * gJ30 .. . .. . . EstoniRmania R .rati E i ~~~~~~~~~~Kazakhstart Ukra e ,, 1 3 0 - . . - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - . . - . . ... . . . - - - - - -.-.. ..... .......... Co 0 0 1 2 3 4 5 6 Soft budget constraints index Source: EBRD (2000); World Bank database on SMEs. What implications do these findings have for tax systems in the transition countries of Eastern Europe and the former Soviet Union? And, looking ahead, what are the reforms in tax policy and administration on which attention should be focused? These are the issues with which this paper is concerned. Section 2 outlines changes in levels of public expenditures and their current structure in order to provide a background for the tax analysis that follows. Section 3 sets out the stylized facts regarding tax systems in transition and relates them to the characteristics of public expenditures noted in Section 2. Section 4 appeals to comparative evidence to suggest in what combination different tax instruments might be used to finance public expenditure without introducing serious distortions in the private sector of the economy. Section 5 reviews the impact of tax systems on the investment climate in transition economies. Section 6 contains a brief review of outstanding issues in the reform of tax administration. Section 7 considers foreign direct investment. Section 8 concludes by bringing together the questions raised by the analysis of the paper and put to its commentators to stimulate discussion at the conference. 4 2. PUBLIC EXPENDITURE IN THE TRANSITION COUNTRIES The purpose of taxation is to raise resources to finance government expenditures on key public goods (such as a stable macroeconomic environment and legal and judicial systems to secure property rights) and the provision of basic social services. Taxation and expenditures should ideally be analyzed together. Figure 4: Public Expenditures and Income Level Per Capita, 2000 IL 55 s o CIS92, &SB92 400 45 A CSEO 0 35 L 25 E E 15 0 2.5 3 3 5 4 4 5 5 LOG of Per capita Income PPP based Trendline Y-12 7 X -18 , wifl R'=O 3, Based on a sample ot49 developed and developing countnes with comparable fiscal data Source Alam and Sundberg (2002) CSB refers to Central and Southeastern Europe and the Baltics and includes: Albania, Bosnia, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Macedonia, Poland, Romania, the Slovak Republic and Slovania CIS refers to the Commonwealth of Independent States and includes: Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Russian Federation, Tajikistan, Turkmenistan, Ulcraine and Uzbekistan. Figure 4, reproduced from Alam and Sundberg (2002), plots countries' shares of government expenditure in GDP against the log of their per capita income (adjusted for purchasing power parity) across a sample of developed and developing countries for which comparable fiscal data were available in 2000. The figure allows the following two points to be made. 5 • The magnitude of expenditure adjustment during the 1 990s was much greater in the CIS countries. Starting from levels of 50 percent or more in the pre-transition years [Tanzi (1991)] and between 45 to 50 percent in 1992, the latter comparable to those in the industrial countries, the share of government expenditure in the CIS countries, fell to levels comparable to those in countries at similar per capita income levels. In contrast, the share of government expenditure in the CSB countries was almost a third higher than that indicated by the figure for countries at similar per capita income levels. This does not necessarily imply, pending further analysis, that public spending in the CSB countries is excessive, since the size of government here, as elsewhere, is shaped, inter alia by both views about the role of the state and the costs of the tax systems needed to support public expenditures at different levels. * The size of government rises with level of income per capita. Public expenditure as a proportion of GDP is on average 29 percent in the CIS countries, a group of countries with a PPP-based per capita GDP of $3,850 that have made limited progress with transition to a market economy, compared with just under 41 percent in the CSB countries, a group of countries with a PPP-based per capita GDP of $9,350 that are further advanced in the transition. These may be compared with an average of 42 percent in the high-income OECD countries23. However, it should be noted that these numbers do not include spending that was moved out of the budgetary arena in the form of implicit and contingent liabilities which softened 2 Simple averages are used to arrive at figures for country groups 3The high income OECD countries include Australia, Austria, Belgium, Canada, Demnark, Finland, France, Germany, Greece, Iceland, Ireland, Japan, Luxembourg, New Zealand, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom and the United States of America. 6 budget constraints4. But these do not affect the thrust of the conclusions about tax systems drawn in this paper. Table 1 displays the functional structure of public expenditure both as a share of GDP and as a share of total public expenditure in these groups of countries: the high income OECD, the CSB and the CIS countries. 4 Examples are provided in World Bank (2000a) Table 1 Functional Structure of Public Expenditures: Country Groups (1999-2000 average; in percent of GDP)' Economic Affairs and Services GDP per Total General Defense Public Order Educaton Health Social Housing & Recreabional, Fuel Agnculture, Mining, Manufactunng, Transportabon Other Interest Other capita in 2000 Expenditure5 Public & Safety Security & Community Cultural, & & Forestry, & Construcbon & Economic Expenditures (PPP USS) Service Welfare Amenites Religrous Energy Fishing, & Communicaton Affairs & Affairs Huntng Services High-Incomre OECD2 26,200 424 2.9 16 1.2 53 54 156 15 08 02 0.8 03 2.2 1.0 46 -09 CSB 9,300 41.9 2 9 1 9 2 3 4.8 5.2 14 0 1 8 1.0 0 2 1 2 0 3 2 3 1 2 2.7 0 0 CIS, 3,850 291 18 1.7 15 43 22 78 13 06 05 15 06 1.5 05 19 1.3 Functional Structure of Public Expenditures: Country Groups (1999-2000 average; In percent of total expenditures)' Economic Affairs and Services GDP per Total General Defense Public Order & Education Health Social Housing & Recreatonal, Fuel Agnculture, Mintng, Manufacunring, Transportabon Other Interest Other capita in 2000 Expenditures Publc Safety Security & CommuntyA Cultural, & & Forestry, & Constructon & Economic Expenditures (PPP USS) Service Welfare menites Religrous Energy Fshing, & Communicabon Affairs & Affairs Huntng Services High-Income 26,200 1000 68 3.9 27 12.5 127 36.7 3.4 19 0.5 20 07 51 23 108 -21 OECD2 CSB3 9,300 1000 70 45 55 116 12.3 333 42 24 05 2.9 07 56 28 68 01 CIS' 3,850 1000 6.3 57 51 149 76 269 45 2.2 18 53 22 51 16 64 45 1 Consolidated budgetary, extrabudgetary and social secunty accounts of central, statelprovincial and local govemments For Hih-lncome OECD countres years of observabons vary 2Austna, Belgium, Denmark, Finland, France, Gemiany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, United Kingdom, Australia, Canada, Iceland, Japan, New Zealand, Norway, Swrtzerland, Unrted States 3Albania, Bosnia, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, Slovenla, Yugoslavia. For purposes of expendIture, the CSB exdudes Macedona where a comparable disaggregabon rnto functons was not avaabble and indude Yugoslavia, for which the data pertains to 2001 'Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Russian Federation, Tajiktstan, Turkmenistan, Ukraine, Uzbekistan 5Excluding grants and transfers between budgets of different levels Source GFS, IMF sfaff reports 8 Social security and welfare account for over a third of public expenditure in the high income OECD and CSB countries and for roughly a quarter of public expenditures in the CIS countries. Public expenditures on health and education make up a quarter of public expenditure in the high income OECD and CSB countries and a little under 22 percent in the CIS countries. They are split roughly evenly between health and education in the OECD and EU accession countries , but health expenditures are around twice as much as those for education in the CIS countries. Altogether expenditures on education, health and social protection account for nearly 60 percent of public expenditures in the high income OECD and CSB countries and nearly a half in the CIS countries. It will be recollected however that both GDP and the share of public expenditures in GDP are significantly lower in the CIS countries, so that public expenditures on education and health, for example, have each fallen to $10 per capita or less in the poorest CIS countries such as the Kyrgyz Republic and Tajikistan. 3. TAX SYSTEMS IN TRANSITION What are the characteristics of the tax systems which raise resources to finance those public expenditures? This section sets tax systems in transition countries in comparative international perspective. Cross sectional comparisons We begin by comparing features of the tax systems in the CIS countries with those in the CSB countries and the high income OECD countries. The stylized facts emerging from 9 such a comparison at the end of the first decade of transition, 1999-2000, are as follows (see Table 2, Figure 5 and, for country details, Appendix tables 1-6). * The share of tax revenue in GDP rises from 22 percent in the CIS countries through 33 percent in the CSB countries to 37 percent in the high income OECD countries. * The share of direct taxes, viz., personal and corporate income taxes plus social security contributions-cum-payroll taxes, in total tax revenue rises from 43 percent in the CIS countries through 54 percent in the CSB countries to 63 percent in the high income OECD countries. While the share of personal income taxes in total tax revenue increases, that of corporate income taxes falls sharply reflecting in part the integration of personal and corporate taxes, with collection at the corporate level counting as advance payment for the personal income tax. It should also be noted that the share of social security contributions-cum-payroll taxes in total tax revenue is significantly higher in the CSB countries at the end of the decade compared, not only to the high income OECD countries but also to the European Union where, social security contributions are higher than in the non-EU countries of the high income 5 OECD group5. 5 It may be noted that social security in the USA generally refers only to pensions whereas social secunty in Europe covers the area called social protection in the USA. 10 Table 2. Tax Structure of Industrial and Transition Countries (in percent of GDP) Total Tax Other Taxes on Income, Profits, and Social Domestic Taxes on Intemational Trade Wealth Othe Revenue Revenue Revenue Capital Gains Security Goods & Services of Taxes & Tax & & & which Property Revent Grants Grants Of which Payroll General sales, tumover Of which Taxes Total Individual Corporate tax Total VAT Excises Total Import Export _______I duties duties High 42.9 36 6 63 14.4 10.1 26 8.9 10 7 6.1 3.1 0.1 0 1 0.0 1 8 0.7 income OECD European 45 2 39.4 5 8 14.3 9 6 2 6 10.8 11.9 6.7 3.7 0.0 0.0 0.0 1.5 0 9 Union 2 _ CSB 40.8 35.0 5 8 9 7 5.3 4 3 11.2 11.0 8.4 2.2 2.0 2.0 00 0 3 0 8 (early transition) _ _ CSB (late 37.7 33 0 4.7 7.4 5.2 2 1 10 6 12.4 8 7 3 4 1.3 1.3 0.0 0 4 0.7 transition) II___ CIS . 29.3 24.4 4 9 8.0 1.7 6 2 6.2 9 0 6.2 2 5 0.7 0.5 0.1 0.2 0 3 (early transition) _ _ CIS(late 25.5 222 32 53 20 3 1 45 97 6 1 2.5 1.2 1.1 0 1 08 06 transition) I I I. - _ Tax Structure of Industrial and Transition Countries l (in percent of tax revenues) Total Tax Other Taxes on Income, Profits, and Social Domestic Taxes on International Trade Wealth Otht Revenue Revenue Revenue Capital Gains Secunty Goods & Services. of Taxes & Tax & & & which Property Reven Grants Grants Of which Payroll General sales, turnover Of which Taxes Total Individual Corporate tax Total VAT Excises Total Import Export _________ _______ I duties duties High 117.4 100 0 17.4 39.6 28 2 7.6 23.3 29 6 16.8 89 0 5 0.4 0.0 5.3 1 8 income OECD I I_I European 114.9 1000 14.9 36.0 24.2 70 266 31.3 17.8 10.0 0.0 0.0 00 3.9 22 Union 2 CSB 1177 1000 177 27.5 14.7 12.6 31.5 31.7 24.0 6.5 62 62 0.0 07 24 (early transition) I I CSB(late 114.9 1000 14.9 225 15.6 65 31.6 37.9 26.6 10.3 43 4.3 00 1.3 2.4 transition) I l I CIS 126.8 100.0 26.8 33.1 7.7 24.6 23.9 37.0 28.1 9.7 3 2 2.4 03 0.8 2.1 (early transition) __ _ _ __ _ _ _ CIS (late 1153 100.0 15 3 23.9 9.8 12.6 19.4 44.0 31 0 11 6 5.9 5.4 04 3.3 3.4 transitionL __ __ _ I__ _ _ __ _ _ _ __ _ _I__ _ _ _ _ I___ _ __ _ _ __ _ _ _ _ _ _ i Consolidated General Govermnent unless indicated otherwise. For those latter indications, see Appendix Tables 1 to 6 2Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, Netherlands, Portugal, Spain, Sweden, United Kingdom I1 Figure 5 Tax Revenues in High Income OECDand Transition Economies (% of GDP) 40 35 30 2S3 15 15 - Tax Rove nues in High Incom e OECD and CSB Economle s (%of GDP) 35 30 25 3s - _ ' , , O - 15: r0 C35(mIyt¶~~t~onp~O~ cm (1MS.0) MCI) Tax R9venues in CSB and CIS Economies (% of GDP) 35 30 3s --e -:' 20* . - _ 0 CSi(imrytriKItsnixrIrd) r E(low EBW 9a 12 o The share of domestic indirect taxes, viz., VAT/sales/turnover taxes and excises in total tax revenue decreases from 44 percent in the CIS countries through 38 percent in the CSB countries to 30 percent in the industrial countries. With the share of excises remaining broadly unchanged, this reflects a decline in VAT/sales/turnover taxes. o Trade taxes are relatively unimportant in transition countries and their contribution to tax revenue is negligible in the industrial countries. Comparisons over time The stylized facts presented above, involving a comparison both in levels and in composition of tax systems in the CIS, CSB and industrial countries from the lowest to the highest levels of GDP per capita, are broadly similar to those observed in comparisons of developing with industrial countries.6 However, in understanding why tax systems in transition countries look the way they do now, it is also necessary to compare the evolution of tax structures of the CIS countries as well as those of the CSB countries from the early years of transition to those prevailing at the end of its first decade. The stylized facts emerging from this comparison may be summarized as follows (see Table 2, Figure 5 and for country details, Appendix tables 1-6) o The share of tax revenue to GDPfell from 24 percent to 22 percent in the CIS countries and from 35 percent to 33 percent in the CSB countries between the beginning and end of the 1990s, paralleling the reduction in public expenditures noted 6 Burgess and Stem (1993) 13 in Section 2. This left the CSB countries and, a fortiori the CIS countries in 1999- 2000 with a lower tax revenue to GDP ratio than the 37 percent prevailing in the high income OECD countries. * The share of direct taxes, viz., personal and corporate income taxes plus social security contributions-cum-payroll taxes, to total tax revenue fell from 56 percent to 43 percent in the CIS countries and from 59 percent to 54 percent in the CSB countries. This left the transition countries with a share of direct taxes in total tax revenue in 1999-2000 much lower than the 63 percent obtaining in industrial countries. The decline was primarily due to a sharp fall in the share of the corporate income tax-from 25 percent to 13 percent in the CIS countries and 13 percent to 7 percent in the CSB countries-and reflected the elimination of a captive source of revenue, viz. taxes on profits of publicly owned enterprises. This more than offset an increase in the share of the individual income tax in total tax revenue in both groups of transition countries. The share of social security contributions-cum-payroll taxes to total tax revenuefell in the CIS countries to levels below that in the high income OECD economies but remained broadly unchanged in the CSB countries. * The decline in the share of direct taxes is reflected in movements in the share of domestic indirect taxes, viz., VAT/sales/turnover taxes plus excises, which rose from 37 percent to 44 percent in the CIS countries and from 32 percent to 38 percent in the CSB countries. There was an increase in the share of both VAT/sales/turnover taxes as well as excises. This left the CIS and, a fortiori the CSB countries in 1999-2000 with shares of domestic indirect taxation to GDP higher than the corresponding share 14 of 30 percent in the industrial countries. Moreover, this observation applied equally to the shares of both VAT/sales/tumover taxes and excises in total tax revenue. Granhing the tax transition A visual perspective on how the composition of tax revenue varies between high income OECD, CSB and CIS countries in cross section and over time is provided, following Burgess and Stem (1993), by Figure 6. With trade taxes accounting for a very low proportion of total tax revenue, the figure focuses on the shares of income tax, social security contributions- cum-payroll taxes and domestic indirect taxes in non-trade tax revenue (total tax revenues less trade tax revenue). The points A, B, and C in the triangle represent 100 percent of (non- trade) tax revenue from personal and corporate income taxes, 100 percent from social security contributions cum-payroll taxes and 100 percent from domestic indirect taxes respectively. A point on the line BC corresponds to a zero level of income taxes, while a point on the line AC corresponds to a zero level of social security contributions-cum-payroll taxes and a point on the line AB corresponds to a zero level of domestic indirect taxes. Figure 6, where the three points show unweighted averages for the high income OECD, CSB and CIS country groups, allows the following points to be made. Figure 6: Breakdown of Non-trade Tax Revenue by Type: High Income OECD, CSB, and CIS Economies (unweighted group averages) Individual and Corporate Income Taxes A 90 10 t High Income OECD 80 20 o CSB 70 A CIS 60 40 50 \0 40/ K \60 30/ 70 20 A 20/ O \~~~~~~~~~~80 10 90 Social Security and Payroll Taxes B 90 80 70 60 50 40 30 20 10 c Domestic Indirect Taxes The high income OECD countries are on average closer to the income tax corner and towards the axis AB compared to the transition countries. The CIS countries are on average closer to the domestic indirect tax corner and towards the axis AC compared to the industrial and CSB countries. The CSB countries are closer to the social security contribution - cum- payroll tax corner and towards the axis BC compared to the CIS countries. Figure 7 shows the scatter for the countries in each group. 16 IFigure 7: Breakdown of Non-trade Tax Revenue by Type: High lincome OEC1D, CSB, and CIS Economies Individual and Corporate Income Taxes A 90 10 80 20 T High Income OECD 0 CSB 70 ~.30 60 40 50/ r; \ 50 40 60 30-- -- - --7A00 20 ¢ X 80 Social Security and Payroll /'\ Taxes 0 90 Domestic Indirect Taxes B 90 80 70 60 50 40 30 20 10 C o More than 95 percent of industrial countries derive 30 percent or more of (non-trade) tax revenue from income taxes, while more than 75 percent of transition countries derive less than 30 percent of tax revenue from income taxes. O More than 80 percent of CIS countries derive 40 percent or more of (non-trade) tax revenue from domestic indirect taxes, while more than 80 percent of industrial countries derive less than 40 percent of tax revenue from domestic indirect taxes. o More than 75 percent of CSB countries derive 30 percent or more of (non-trade) tax revenue from social security and payroll taxes, while more than 80 percent of CIS 17 countries derive less than 30 percent of tax revenue from social security and payroll taxes. Figures 8 through 11 compare the characteristics of tax system in the CSB and CIS countries as between the early years of transition and the end of its first decade. Figures 8 and 9 show that, on average the CSB and CIS countries in 1999-2000 were further away from the income tax corner and closer to the domestic indirect tax corner than they were in early transition. This was a move away from the composition found in high income OECD countries. While the share of social security contributions- cum-payroll taxes (non-trade) tax revenue remained broadly unchanged in the CSB, so that the points representing the CSB countries in early transition and 1999-2000 are equally far away from the AC axis, the CIS countries moved away from the social security contributions-cum-payroll tax corner during the first decade of transition. Figure 8: Breakdown of Tax Revenue by Type: Hign lincome OECD and CSB E-conomies During Early Transition and in 1999-00 (unweighted group averages) lIndividunRl and Corporate Jincome Taxes A 90 < 1 0 HDigh Rncome OECD o CSB, 1999-00 70/ \30° $S 9- 40 + CSB, IEzrly Transition 40/ ;60 30 + \70 0 Social Securityand 2n d Payroll Taxes 10 90 Domestic Indirect 13 C Taxes 90 80 70 60 50 40 30 20 10 IFigure 9: Breakdown of Non-trade Tax Revenue by Type: CSB and CS Economies dudring Early Transition and in 1999-00 (unweighted group averages) WIdhoidual and Corprate Encome Taoes 90 10 0 CSB, 1999-00 80 20 A C¢iS, 1999-00 70 30 .C CS, Farly Tlransition 60 40 50/ S50 40 60 30/ 7 0 0 20/ \80 Social Security and Payroll Taxes 10 Domestic Indirect Taxes 13 90 80 70 60 50 40 30 20 10 C Figure 10: Breakdown of Non-trade Tax Revenue by Type: High Income OECD and CSB Economies during Early Transition and in 1999-2000 Individual and Corporate Income Taxes High Income OECD 90 10 o CSB, 1999-00 80 20 70 \X0 + CSB, Early Transition 60 40 50/ 8 50 4 + I, 40 ' ++ + + 60 30 O O 70 Social Security and 20 + + o \80 Payroll Taxes / +) 10 90 \, C Domestic Indirect Taxes 90 80 70 60 50 40 30 20 10 Figure 11: Breakdown of Non-trade Tax Revenue by Type: CSB, and CIS Economies during Early Transition and in 1999-2000 Individual and Corporate Income Taxes A o CSB, 1999-00 90 10 80 CIS, 1999-00 80 20 - CIS, Early Transition 70 30 ____________________ 60 40 50 s0 40 ~ ~ ~ X60 x X' &" 30 C&'0 AX A& 70 20 80 Domestic Indirect Taxes Social Security and AR Payroll Taxes 10 0 90 B C 90 80 70 60 50 40 30 20 10 20 Figures 10 and 11 show the scatter for the individual countries. o More than 50 percent of the CSB countries and more than 80 percent of the CIS countries in early transition derived 30 percent or more of (non-trade) tax revenue from income taxes, while more than 90 percent of the CSB countries and nearly 60 percent of the CIS countries in 1999-2000 derived less than 30 percent of non-trade tax revenue from income taxes. o More than 75 percent of the CSB countries and more than 55 percent of the CIS countries in early transition derived 40 percent or less of (non-trade) tax revenue from domestic indirect taxes, while more than 60 percent of the CSB countries and more than 80 percent of the CIS countries in 1999-2000 derived 40 percent or more of (non-trade) tax revenue from domestic indirect taxes. What happened and why ? The results of these comparisons, in cross-section between the CIS, CSB and the high income OECD countries, and for two time periods between the CSB and itself as well as the CIS and itself, illustrate the challenges that transition countries have faced in developing a tax system appropriate for a market economy. The opposing movements in key ratios describing levels and composition of taxes (i) between the onset of transition and the end of its first decade in the transition countries and (ii) in cross-section compared to the industrial countries at end-decade suggest that the evolution of tax systems in transition countries is "U-shaped", with regard both to the share of tax revenue to GDP as well as the shares of 21 major taxes in tax revenue. The comparison across the same subgroups of transition countries between the onset of transition and the end of its first decade, inter alia, reflect two sets of developments. First, the loss of traditional profit, turnover and payroll tax revenues from erstwhile captive State enterprises rendered uncompetitive by price liberalization and either downsized by hardening budget constraints or kept afloat by tax exemptions and a tolerance of tax and other arrears. And, second, the inability to institute quickly a well- administered tax system covering a broad base with low rates which would encourage tax compliance among new and restructured enterprises rather than driving them underground. Both considerations illustrate a key aspect of transition, viz. a movement from a system, where the government exercised a preemptive claim on output and income before citizens had access to the remainder to one with a greatly diminished role for the public sector, where the government needs to collect revenue in order to spend. These developments led to * a fall in the tax revenue-to-GDP ratio, a significant part of which was accounted for by a decline in revenue from the corporate income tax, the latter arising from the loss of revenue from profits of publicly-owned enterprises; * a fall in the public expenditures to GDP ratio caused by the need to reduce fiscal deficits in order to stabilize inflation; * a decline in the importance of income taxes, mainly accounted for by the fall in the share of corporate income taxes; * a decline in the importance of social security contributions-cum-payroll taxes in the CIS countries; 22 o a rise in the share of individual income taxes; and o a sharp increase in the importance of domestic indirect taxes in tax revenue-both VAT/sales/turnover taxes and excises- reflecting in part the decline in the role of direct taxes. What needs to be done The cross-sectional and intertemporal comparisons between the CIS, the CSB and the high income OECD countries show, that viewed from the perspective of taxation, outcomes associated with an unraveling of the command economy in the early transition and those that occurred subsequently were different, the latter being analogous to those seen in the development of poor countries. With the exception of the increase in the importance of personal income taxation, the former set of developments needs to be reversed in order to move towards a market economy. However, this needs to be done, not by reclaiming the traditional bases and instruments of central planning but instead by accessing bases in the emerging private sector not under direct state control and using the apparatus of a modem tax system, viz., a personal income tax, a corporate income tax with deductions for the costs of generating those incomes, social security contributions and payroll taxes, a value added tax levied on consumption, excises on items such as tobacco, alcoholic beverages and petroleum and low customs tariffs and implemented by a rule-based tax administration. The developments to be brought about through tax reform are o a rise in the share of tax revenue to GDP; o an increase in the share of direct taxes in tax revenue; 23 * a continuing rise in the share of revenue from personal income taxes; * a decline in the share of revenue from domestic indirect taxes; and * a decline in the contribution of trade taxes to revenue to negligible levels. 4. BENCHMARK LEVELS AND COMPOSITION OF TAX REVENUE Could the current levels of public expenditure in the transition countries arrived at in part through socio-political as well as economic judgments about the role of the state, be financed by these taxes without creating significant distortions in the private sector? The following considerations are relevant in answering this question. * The value added tax, a very successful innovation in tax practice, raises on average around 7 percent of GDP in the high income OECD countries. Empirical evidence based on those countries suggests that in all countries where the VAT collects more than 7 percent of GDP, there is a clear tradeoff between a higher tax rate and a broader tax base. Countries facing such a tradeoff have rates of 14 percent to 22 percent on bases between 60 percent and 40 percent of GDP. The evidence also suggests that the longer a VAT has been in place, allowing taxpayers and administrators more time for improved compliance and enforcement, the higher is the rate of compliance with the tax.7 It therefore seems reasonable to suppose that transition countries, which have limited experience with the VAT, could not, for the next few years, expect to raise more than around 6 to 7 percent of GDP, depending on the quality of their tax 7 Agha and Haughton (1996), IMF (2001) 24 administration, without encountering problems with compliance or introducing significant distortions into their economies. The other major item of indirect taxation, viz., excises, which are generally levied on alcohol, tobacco and petroleum, can be expected to yield around 2 to 3 percent or so of GDP. Given that these products are associated with 5% or so of total expenditure, this implies high rates of taxation. With trade taxes becoming less important, the share of indirect taxes in GDP can thus be expected to yield roughly 8 to 10 percent of GDP. * Income taxes as a share of GDP, average around 15 percent of GDP in the high income OECD countries. Within the category of income taxes, personal taxes are usually about three to four times as important as corporate taxes in the industrial countries. Corporate taxes typically account for between 2 and 3 percent of GDP, partly reflecting the fact that, with a well-functioning tax administration, there is less need to use income taxes on corporations as a withholding device for collecting personal income taxes. Furthermore, a high corporate income tax rate has the potential for discouraging investrnent in a world where capital is very mobile across national boundaries. The base for income taxation is assumed to be roughly half of non-agricultural income. The latter as a share of GDP ranges from below 50 percent in Albania to over 90 percent in the Central European countries depending on the country's per capita income level, yielding a range of 25 percent to 45 percent for the tax base. With average rates of income tax in the range of 20 to 25 percent, and taking into account tradeoffs between a higher tax rate and a broader tax base, it may then be expected that the income tax could eventually raise between 6 and 9 percent of GDP depending on a country's per capita 25 income, with the relative share of personal taxes compared to corporate taxes increasing with the level of economic development and the quality of the tax administration. * Social security contributions and payroll taxes as a share of GDP average 11 percent in the EU accession CSB countries which, despite the significantly lower per capita income in these countries, is comparable to the share prevailing in the European Union. This reflects in part their socialist legacy, and, in part, the successful use of social expenditures to cushion the impact on the poor of downsizing in the early years of transitions. In fact, payroll taxes in the EU accession countries range from 33 percent in Estonia to 50 percent in Slovakia, while Italy, Spain and Sweden have rates about 30 percent and in no case higher than 40 percent.9 Evidence from a recent empirical analysis of Slovakia, where the unemployment rate averaged 19 percent in 2001, suggests that while the unemployment insurance, social assistance and social support schemes have been effective in alleviating poverty, they have exerted significant disincentive effects on labor supply. Reforms of the benefit program designed to "make employment pay" rather than penalizing unemployment, have the potential to reduce double digit unemployment and lower social spending, thereby making possible an eventual reduction in payroll taxes'°. This is also broadly consistent with the findings from other OECD countries and argues for reforms in social expenditures and a reduction of the distortions arising from payroll taxes. The situation is, however, quite different in the CIS countries where social security contributions 8 For a further discussion of this point, see World Bank (2000) 9 Riboud, Sanchez and Silva (2002) 1° The analysis is reported in World Bank (2001) 26 on average account for less than 5 percent of GDP. Turning to the role of these taxes in an overall revenue package, with the wage bill in the formal sector of the economy as a share of GDP ranging from 20 percent to 50 percent or more across countries of the region, and taking into account tradeoffs between a higher tax rate and a broader tax base, a payroll tax rate averaging 20 percent to 30 percent could yield between 6 percent and 10 percent of GDP. Table 3: Benchmark Levels and Composition of Tax Revenue Base, % of Rate Yield, % of GDP GDP VAT 40%-60% 12%-22% 6%-7% Income tax 25%-45% 20%-25% 6%-9% Social Security contribution cum payroll tax 20%-50% 20%-30% 6%-10% Subtotal 18%-26% Excises (tobacco, alcohol, petroleum) 2%-3% Other taxes (trade, property, etc.) 2% Total tax revenue 22%-31% Adjusted downward by one percentage point from 7%-8% for inexperience with the tax On the basis of these broad efficiency considerations and consistency with comparative evidence on public expenditure shares for countries at comparable income levels, it is suggested that the transition countries, depending on their stage of development, aim for a tax revenue-to-GDP ratio in the range of 22 to 31 percent or so, comprising VAT (6 to 7 percent), excises (2 to 3 percent), income tax (6 to 9 percent), social security contribution-cum-payroll tax (6 to 10 percent), and other taxes such as on trade and on property (2 percent)". o While the upper end of this suggested range is lower than the 33 percent of GDP that tax revenue represented in the CSB countries in 1999-2000, it is close enough to the l A similar analysis for China is presented in Hussein and Stern (1993) 27 expenditure to GDP ratio of 33 percent, typical of countries at comparable per capita income levels, to be financeable with non tax revenue sources, which usually account for roughly 2 to 3 percent of GDP. In any event, most EU accession countries, as part of their 2000-2004 Pre-Accession Economic Program, are aiming to cut taxes on the order of 2 percent of GDP and incur incremental expenditures on the order of 3.5 percent of GDP to comply with the requirements of the EU's acquis communautaire, while at the same time improving budget balance by around 0.5 percent of GDP'2. These ambitious goals can only be accomplished through a sharp reduction in the share of regular public expenditures to GDP, together with a tight prioritization within that envelope, which requires a thorough going reappraisal of the role of the state in the economy. The lower end of the 22 to 31 percent range for tax revenue to GDP is equal to the average for the CIS countries. However, the average tax revenue to GDP ratio for the low income CIS countries which face the most acute development challenges (Armenia, Azerbaijan, Georgia, the Kyrgyz Republic, Moldova, Tajikistan and Uzbekistan) is only 18 percent. Raising this share in order to finance public expenditures, especially in the social sectors, where they have fallen to extremely low levels in those countries (for example, on education $4 per capita in Tajikistan, $9 per capita in the Kyrgyz Republic and $11 per capita in Armenia in 1999, compared to $180 per capita in the EU accession countries, and on health $1 per capita in Tajikistan and $7 per capita in the Kyrgyz Republic and Georgia in 1999, compared to $176 per capita in the EU accession countries) together with appropriate prioritization of those expenditures, is an important policy priority. 12 Funck (2002) 28 This motivates our first question for the commentators: o What is the level and composition of tax revenue that raises enough resources to flnance public expenditures without introducing excessive distortions in the private sector? IEs tax revenue as a share of GDP1 "too high" in the CSB countries and "too low" in the CItS countries? 5. TAXATION AND THE INVESTMENT CLIMATE As noted earlier, small enterprises employing fewer than 50 workers, many of them de novo but also some firms spun off from state enterprises, have been key to generating employment and creating wealth in transition economies. A major policy-cum-institutional challenge facing governments across the region has been the creation of an attractive and competitive investment climate in which restructured and new enterprises have incentives to absorb labor and assets, rendered inexpensive by the downsizing of old and unviable enterprises, and invest in expansion. This challenge includes reducing excessively high marginal tax rates, simplifying regulatory procedures, establishing security of property rights, and providing basic infrastructure, while maintaining a level playing field among old, restructured and new enterprises. The Business Environment and Enterprise Performance Survey, covering a large number of enterprises in over 20 transition economies, and conducted jointly by the European Bank for Reconstruction and Development and the World Bank in 1999, 29 unbundled factors influencing the investment climate into microeconomic variables (including taxes and regulations), macroeconomic variables (including policy instability, inflation and exchange rates) and law and order (including functioning of the judiciary, corruption, street crime, disorder, organizational crime, and mafia)'3. According to the respondents, taxes and regulations were consistently among the most important impediments to expansion by new enterprises. Table 4 reports the number of taxes and the average rates that are imposed on businesses14. The number of national taxes-profit tax, VAT/sales tax, income tax and social security taxes (in the form of payroll taxes, the latter here consisted as one tax), together with turnover taxes to support various special funds -which is shown in column 5 of the table, is a rough indicator of the complexity of the tax system'5. On this measure, Poland and Hungary have the least complex national tax systems, as contrasted with Belarus, Turkmenistan and Uzbekistan. However, the last four columns of Table 4 also report the extent to which countries attempt to relieve the burden on small firms through tax breaks or simplified arrangements 16 17 Whatever the merits of rules and legislation, the arbitrary bureaucratic harassment to which the administration of taxes and business licensing gives rise continues to be a significant problem. For example, a survey of some 2000 predominantly small and medium 13 For details, see EBRD(1999) 14 We thank Kjetil Tvedt for producing Table 4, which updates Table 8.3 in EBRD (1999). Definitions on SMEs and micro businesses are those used in national tax codes. Is Column (4) of the table also reports the maximum rate of personal income tax since businesses registered as sole proprietors and often subject to personal income tax. 16 The column for 'tax incentive for new start-ups/investments' emphasizes tax breaks either in favor or disfavor of SMEs. Incentives disfavoring SMEs would be all incentives promoting large investments. Tax breaks for FDIs are interpreted in disfavor of SMEs, based on the assumption that foreign investors normally faces some initial obstacles in form of administrative problems or lack of information, which are in the nature of fixed costs and which play a more significant role for small start-ups firms. 17 General SME tax break is here to be understood as cases when SMEs face a discount in the profit tax because of their size. Simplified tax in form of a gross turnover tax or lump sum tax may cause a reduced tax burden as well. However, the information is not clear on the tax burden following simplified arrangements, and such procedures are never interpreted as an SME tax discount. 30 enterprises (with a mean firm size of 22 workers and a median firm size of 10 workers) done in Russia in March-April 2002 by the Center for Economic and Financial Research (CEFIR) and the World Bank found that in 2001, between 5 and 21 percent of those who had been in business before and after the passing of legislation designed to improve the investment climate, were visited between 2 and 3 times each by sanitary, police and fire safety Is inspectors, which is in excess of that prescribed by the law . la CEFIR and World Bank (2002) Table 4. SME Taxation Country GENERAL TAXATION TAXATION RELATED TO SMES Standard Standard Max Number of VAT tumover tax incentives for new General Simpiified tax for SMEs and profit tax VAT personal national threshold (US$) start-ups/investments SME tax sole Income tax taxes break propnetors (lump sum or presumptive) Favounng Favouring large SMEs firms Albania 25% 20% 25% 5 57000 No No No Lump sum or gross turnover Armenia 20% 20% 20% 4 17200 No Yes" No Lump sum"'l Azerbaijan 27% 18% 35% 4 6400 No No No gross tumover taxoe Belarus 30% 20% 30% 8v 6000 No No Yes Lump sum Bosnia & Herzegovina 30% 24% sales 50% 4 No No Yes v,"' No No (Federation) tax I Bosnia & Herzegovina 20%-10% 18% sales 25% 5 No No Yes' No No (Rep) (regressive tax I Bulgaria 23,5% 20% 29% 4 33000 No No Yes" Lump sum"' Croatia 20% 22% 35% 4 6000 No Yes No LumP sum Czech Republic 31 % 22% 32% 4 91000 No Yes""' No Lump sum Estonia 26% 18% 26% 4 No No No No No Georgia 20% 20% 20% 5 11000 No No No Lump sum""v Hungary 18% 25% 40% 4 No Yes27 No No No Kazakhstan 30% 16% 30% 4 25000 No No No Lump sum or gross tumover Kosovo 20°/a 15% 20% 4 92000 No No No gross tumover tax E Kyrgyzstan 20% 20% 20% 6 2100 No No No gross tumover tax Latvia 22% 18% 25% 4 16000 No Yes ml' Yes"_ _ _ No Lithuania 15% 18% 33% 4 2600 No No Yes"" Presumptive tax (FYR) Macedonia 15% 19% 18% 4 76000 No Yes"' No Lump sum Moldova 25% 20% 35% 4 No Yes"""' Yes ""v No Lump sum"xx Poland 28% 22% 40% 4 9000 No No No Lump sum Romania 25% 19% 40% 6 1500 Yes x Yes""" No Gross turnover tax """ Russia 20-24% 20% 13% 5(4 from No No No No mx Gross turnover tax 20031 Slovak Republic 25°/a 23% 38% 4 16000 No Yes' No Lump sum Slovenia 25% 20% 50% 4 20000 No No No No Tajikistan 30% 20% 20% N.A. N.A. N.A. N.A. N A. N.A. Turkmenistan 25% 20% 25% 6 Small-scale firms No Yes"-x' Yes ' Lump sum"""'" exempt. .v Ukraine 30% 20% 40% 5 11500 No No No Gross tumover tax Uzbekistan 26% 20% 36% 6 Small firms are No Yes """ No Gross tumover tax or lump -exempt sum____ FRY Montenegro 20% 8-17% Sale 40% 4 No N A N.A N.A. N A. _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ ~ta x _ _ _ _ _ _ _ _ _ _ _ FRY Serbia 20% 20O/r sale 20%4 No W s ' No No No tax 'Lump sum for micro businesses annual tumover under 2 million leks (US$14000), 4% gross tumover tax for small businesses = annual tumover 2-8 miflion leks (US$57000) 32 PFLD r ADM 500 million (US$ 860,000) a Fixed payment for small scale activites such as hairdressers, gas stations commercial fishing, and aWing acivities conducted in locals wit trading area ess fthan 30 square meters. Azerbailan ~ 2% gross tumover tax when tumover tess than 300 times the mnimum tax-exempted wage (US$ 6400). Belani In addition to the standard 4, there is Road tax, Chemobyt fund, Public housing fund, and R&D fund. 50% discount on pmft tax for smalD enterprises = profit iess than 5,000 MMW (5000YR3600=US$10,000) and having number of staff as mentioned below; for industnes - less than 200 people; in science and scintifc servces - less than 100 people. for construction and other productive sectors up to 50 people: for non-productive sectors up to 25 people. s Lump sum tax for stores that are single owned and total trading space less than 25 square meters, plus public catering enterprses, and at markets and sals exhibibons. Bosnia & Hemaorovrna (Federation) profit generated by foreign capital Bosnia A Herzeoiaa (eJub I profit generated by foreign capial Bubada '20% profit tax for small businesses defined by taxable promfd ess than BGN 50,000 (US$22,200) n for sole traders. Croatia 1f Newly established companies quaiify for reduoed tax rates and the reducion is higher for targer investments. Czech Reoubli for mv Over CZK 350 million (US$ 10 million) Geogia wfor enterprises with turmover less than GEL 24,000 (US$ 1,000) Hungary I SMEs can wrdte off ts tax by interest on loan used for investrnent In assets. Koswovo " 3% gross tumover tax for SMEs - tumover under 200,000 DEM (US$ 92,000) Kvyrastan ISMEs(total revenue up to 3 million sorrs or approximately US63 000) may pay Irom 5 to1O% gross turnover tax instead of eli natonal taxes above (apparentiy SMEs find this system unfavourabte and rather use the general system). Individual entrepreneurs can optionally get a patent and pay a monthly gross tumover tax, i.e. in retaiD trade - 4% Latva 5 For inv. over US$ 16 milton. d 20% profd tax for SMEs meeting at least two of the following three conddions: book value of tangible assets - 70000 tats (EUR 123 700);net tumover- 200 000 ats (EUR 353 400);average number of employees - 25 parsons. 13% profit tax for small businesses with less than 11 employees and a gross annual Incomb less than LTL 500,000 (US$ 130000). - Optonal for fimis with gross income less fthan 100,000 LTL (US$ 26,000) Maeoia (FYR) tax holiday for tax generated by foreign capital I SMEs rmy benefit from a 35% discount on proft tax for tto years 50% tax discount given the first five years if foregn investments exceeds US$ 250,000 Individual entrepreneurs can buy patent which involve a monthly fee. RomWn&a for reinvested profit Z for large FDI micro enterprises with ess than 10 employees and an annual tumover bess than Euro 100,000 Planned frm 2003; Small enterpnses with annual tumoverof 10 million roubbes (US$320,000) and up to 20 employees will be entted to choose between 8% tumover tax or 20% profit tax (standard 24%). 5 years tax holiday for FDI over EUR 5 mfilion I1rmenistan Tax breaks subect to negotiatons. It is assumed that large fims have more negotiabon power. I 20-24% profit tax, depending on nature of acdivity, for small legal entites defined by annual tumover tess than TMM 72 million (US$ 14,000), or less than 50 persons in producing firm,s or less than 10 persons in trading fimts, or tess than 25 persons in all other tpes of fimis. Xg Lump sum license for entrepreneur without a lagal entity and with annual tumover less than 72 million manats (US$14,000). Lmswith up to 50 emp!oyees ard tumover less than UAH 1 rtllion (US$190,000) can pay a 6% gross tumover tax whith does notexempt actor from VAT, or 10% gross tumover tax which do exempt finm from VAT Uzbeldstan for FOI 0 mallysmal trading enfteprises can pay 25% and small production enterprtiss can pay 10% tax of gross tumover instead of entire set of nafional taxes. Lump sum tax for individual entrepreneurs without a legal entity. tax discount amounting 30/o of new investmnents for SM4Es (in companson to 10% of new investmnrns for non-SMEs) 33 While steps to improve the investment climate are important, the hardening of budget constraints on all enterprises has also been key to the resumption and sustenance of growth in successful transition economies. The experience of the transition economies in the 1990s suggests that a sharp and early decline in aggregate employment preceded the rapid growth of new firms. This made assets cheaply available to new enterprises, which was useful when financing was not readily available and new investment was not forthcoming. When the proportion of employment in small firms reached a threshold of around 40 percent, the sector evolved from being a passive receptacle for absorbing resources into an active competitor, rapidly increasing its share of employment (see figure 12a). In countries where aggregate employment picked up, it did so after the recovery of aggregate output. When the threshold was not reached, people remained "unemployed on the job" as in the CIS and some countries in southeastern Europe. Aggregate employment started to fall only late in the process (see figure 12b). These observations suggest a sequence where hard budget constraints are imposed and the old sector declines before the new sector can grow. The complementarity between hardening budget constraints and improving the investment climate has been extremely important. Our next question for the commentators is: * Is it generally understood that hardening budget constraints for all firms and improving the investment climate to create new flrms and stimulate entrepreneurship without the state dispensing special favors to old or new firms must go hand in hand? 34 Figure 12a. Index of GDP and Shares of Value Added and Employment Accounted for by Small Enterprises, 1989-98 Czech Republic Russian Fedeation Index Percent Inedex etnt 120 6D 120 o0 -0- GW nd9x 100 50 10 0 so Value atddd by eo v / - 40 WWna'I 80 40 , < ~~~~~~~~~~~~entavseas as 6030 pfd oso3 r ~ ~ ~ ~ ~ C} p~~~~~added eo i 30 s~~~~~~~~~~~~~~~~~~~otatvt!u3 o3 40 20 40 20 Percentage of 20 10 - yen ssn 20 10 0 0 a 0 1989 1to 1991 1t92 1839 1894 1888 18M 1997 1988 1t89 1990 1991 1t92 1393 1994 1995 1ee 1997 1tee Ukraine Lithuania tndax Perctent Index Percent 120 6- 120-- -*-- - -- 60 -o-GOP index 0 sO 100