Tax Reform in CIS Countries: Multi-Stage Transition and a Few Political Economy Lessons

1. Tax Reform in CIS Countries:Multi-Stage Transition and a Few Political Economy Lessons Core Course on Governance and Anti-Corruption April 24, 2007 Luca Barbone

2. Model: Multiple party, multistage transition • Tax reform the result of interaction among several parties: • State apparatus • Old industrial/state interests • New Industrial interests • Foreign advice/influence • Multistage, as it mimicks the change in power relations among groups

3. Four Conceptual Stages • Stage zero: Meltdown of old system • Stage 1: The arrival of the consultants and the set-up of the formal system • Stage 2: Economic interests take over • Stage 3: Return of growth, yearn for a better system, mature politics

4. Stage Zero: Institutional-Economic Setting • Incomplete Institutions—mix of old and new rules and substantial lacunae • Economic decline—drastic drop in GDP • Dramatic decline in revenues • Disappearance of the old compliance/control mechanisms.

5. Stage 1: Arrival of the Consultants • Early adoption of a “western-style” tax system (VAT, CIT, PIT) • Depending on the country, quick implementation • But complications appear, due to multiple levels of government, lack of fiscal discipline, enforcement, use of tax administration as a political weapon, etc. • It becomes clear that the binding constraint is not legislation

6. Stage 2: Economic Interests Take Over • Early winners seek to establish rights, and later on to protect them, but to protect them they have to access the state. • Hence, economic interests seek direct representation in the political process and borderline between political and economic interests becomes blurred. Political parties directly created by economic interest groups.

7. Example: Ukraine—Tax Arrears and Amnesties • In every year between 1996 and 2003 tax amnesties were implemented—either sector specific or general. • The combined amnesties issued in year 2001 amounted to 10 percent of GDP • Amnesties favored the energy complex and agriculture, but also regional interest, industries, the works • Tax arrears were the “adjustment variable” (in parallel with generalized arrears in payments)

8. Example: Ukraine—Tax Exemptions and Free Economic Zones • Besides tax amnesties, tax exemptions likewise became popular. • Tax exemptions proliferated to cover agriculture, industry. • Emergent practice of tax free zones linked to regional political pressure.

9. Stage 3: Self-propelled Modernization • As growth resumes and economic interests become established, demand for rules increases endogenously • “Ownership” appears, but with unusual country characteristics

10. The Faces of the Protagonists

11. Politics in Stage 3: Contrast Ukraine and Russian Federation • Ukraine: Fractionalized political system, resulting in a lot of special-interest legislation, and very strange bedfellows • Russia: Stronger control by the executive, suppression of opposition, capacity to pass legislation.

12. How to approach? • Avoid innocents-abroad syndrome • Understand where you stand • Who are your friends?

13. Lessons Learned (a Partial List) • Tax legislation is not necessarily the main obstacle or even concern for tax reform • Need to understand the institutional environment before offering technical assistance or conditionality • Tax reform is hampered by events that happen outside the tax arena: need to address those (non-payments, regional disputes) • Tax reform, or more precisely tax incentives, make very strange bedfellows • The workers in the tax complex matter—you need to buy them • Beware of the foreign advisors • Hire local expertise