317. The Decline of Domestic Politics and Other Taxing Problems in Eastern Europe

Hilary Appel is Associate Professor of Government at Claremont McKenna College. She spoke at an EES noon discussion on October 19, 2005. The following is a summary of her presentation. Meeting Report 317.

While all governments face the challenge of specifying fiscal arrangements that guarantee the state adequate resources to ward off physical or material threats to the citizenry, the new governments after the collapse of communism faced certain challenges specific to their capitalist transformation. They had to design tax systems within the context of creating an entirely new economic system. Fundamental public sector reforms eliminated the previous system's main source of taxation. As a result of privatization, East European states could no longer rely on appropriating profits from state-owned enterprises. In the past, the state would finance expenditures primarily by transferring revenue from state firms to the federal budget. With a large portion of these enterprises undergoing privatization, the state had to develop a tax policy to collect revenue from private sector production and private individuals. Thus, a wide range of taxes had to be put into place or be significantly reformed, including private property taxes, personal income taxes, inheritance taxes, consumption taxes, real estate taxes, capital gains taxes and excise duties. In allocating the tax burden across these different tax forms, leaders had to reconcile several competing considerations: which kinds of taxes would reliably raise budgetary revenue, which tax forms were hardest to evade, which forms would seem distributionally just to a population raised in a paternalistic state and lacking personal experience in honoring tax responsibilities and which would advance the country's foreign policy goals and international interests.

Despite the fact that creating a tax policy required the fundamental reallocation of responsibility for government revenue and despite the distributional consequences of tax policy, domestic politics have been surprisingly inconsequential in much of the prevailing tax structures. Although during the first few years of capitalist transformation, East European governments enjoyed much flexibility in designing the institutions of the new tax regime, over time the room to maneuver became more and more constrained by the imperatives of regional and global economic integration. Like other areas of policy making, the pursuit of EU membership limited the ability of governments to respond to the demands and pressures stemming from domestic constituents. This is especially true in the area of consumption taxes, given that they fell under the competency of the EU. As they began the accession negotiation process, East European governments had to harmonize their consumption taxes with directives and codes specified in the acquis communautaire. Although they could attempt to negotiate exemptions and transitional periods in the chapter ten negotiations (the chapter dedicated to consumption taxes), very few exceptions were granted. This left the East European EU members with highly similar indirect tax structures despite differing domestic political arenas.

Although direct taxes are not covered by the acquis and do not fall under the accession negotiations, East European governments also found themselves highly constrained in designing income tax policy due to external imperatives. In direct taxes, East European governments on both the right and left sides of the political spectrum faced strong pressures and incentives to rely on less mobile sources of revenue over more mobile sources of revenue. While the data on income taxes in the region are still poor, certain trends appear to be developing consistently across East European countries. Governments have been relying less on corporate taxes to satisfy budgetary needs. When both the economic liberals and the social democrats (or former Communists) are in power, there has been a downward trend in nominal corporate tax rates in the new EU member states of Eastern Europe.

Why are corporate taxes falling? Clearly these patterns are not the product of right-wing governments pursuing a particular partisan approach or catering to a specific constituency, since in none of the new EU countries does the reallocation of the tax burden from business to labor or to consumers follow traditional party lines. The left has not undone the gains for corporations achieved by the right; and in fact many advantages for corporations and capital investors arose or were augmented during the left's tenure in office (for example, under Premiers Gyula Horn in Hungary, Leszek Miller in Poland and Milos Zeman in the Czech Republic).

Nor does the relative power of interest groups explain the allocation of the tax burden. Even though labor is stronger in Poland, workers have been no more influential in diminishing their tax burden than their counterparts in Hungary or the Czech Republic. In fact, Polish labor, if anything, has had a slightly higher tax burden than its counterparts in Hungary and the Czech Republic, where labor is weak. Moreover, in Poland workers were the first to absorb the budgetary shortfalls under Leszek Miller's left-of-center government, due to the prime minister's moratorium on annual adjustments of income tax brackets for inflation. The income tax policies of Polish leaders suggest a greater interest in attracting and maintaining investment through low corporate tax rates than in catering to traditional domestic constituencies.

Leaders have justified lowering corporate taxes by emphasizing the need to remain competitive, especially vis-à-vis other EU states. This has created tensions with the older EU members, who have long bemoaned the shift of the tax burden from corporations to workers and consumers. Since expanding the EU to include postcommunist states in May 2004, concerns about tax competition and factor mobility have grown stronger among EU leaders. West Europeans especially fear the flight of businesses to the east. The previous German chancellor chastised the new member states for setting corporate tax rates too low, accusing them of "tax dumping." Chancellor Schroeder's push for tax coordination has gained momentum in Finland, France and Sweden since the 2004 enlargement.

Corporate tax rates and tax competition in Europe are controversial issues with European leaders. Despite the tensions developing in elite level politics, corporate tax rates and the burden corporations should bear in taxation are not hot button issues in mass politics, however. Indeed, there seems to be very little domestic political pressure on East European governments to readjust the downward trend in corporate tax rates.

Over time domestic political logics seem less and less important in postcommunist taxation and the area of taxation that remains politicized is shrinking. As noted, consumption taxes were essentially beyond the political debate due to the way the EU accession process was managed, and the move away from corporate responsibility for tax revenues is strangely overlooked or under-politicized. That said, it should be noted that some areas of direct taxation remain politically sensitive at the level of the voting publics. For example, tax areas that have been hotly debated include deductions for families with children, small business taxes and taxes on the self-employed.

Most importantly, political parties can still go to battle over the distribution of the personal income tax across income brackets and economic groups. Indeed the division of budgetary responsibility across the rich and the poor has featured in political debates for years. More recently, personal income tax debates include discussions about the merits of introducing a flat tax, such that one low rate would apply to all income classes. The major parties in Poland, Hungary and the Czech Republic have proposed flat tax reforms. The seriousness of these proposals is fueled by the widespread implementation of the flat tax elsewhere in the postcommunist region, including Slovakia, Romania, Estonia, Lithuania, Latvia, Russia, Ukraine and Serbia. The popularity of the flat tax and the speed with which the flat tax has been spreading in the postcommunist region over the last several years is truly remarkable.

There are several important caveats and considerations of the continuing politicization of personal income taxes in the domestic political arena. Personal income taxes concern a rather limited portion of budgetary revenue, and thus the overall relevance of this area must be kept in mind. Specifically, the revenue generated from the personal income tax concerns a small portion of the overall budgetary revenues. Second, the recent rise of the flat tax approach—which is quickly becoming one of the main forms of personal income taxes—necessarily leads to the further depoliticization of the tax system in the medium term. Even if implementing a flat tax is politically heated in the short term, the realization of the flat tax diminishes tax debates all the more. After all, a flat tax that imposes one low tax rate on all households is made feasible only by closing the exemptions, deductions and loopholes that interest groups fight for in the political arena. The flat tax stands to make the tax system even less subject to domestic politics.

Third, the very fact that the flat tax is spreading because leaders feel the need to follow the lead of neighboring countries suggests that personal income taxes are driven by policy trends in the international community. Thus, to some extent the personal income tax is joining other areas of taxation that are driven by external rather than internal factors. In explaining their reasons for advocating a flat tax, East European leaders have repeated over and over again that they are following international trends.

Some of the loss of autonomy discussed in postcommunist Europe applies to governments in emerging markets in Asia and Latin America as well. Many scholars have identified a similar pattern in the developing world in which the competition for international investment occurs through the lowering of wage and non-wage labor costs, the provision of special tax holidays for foreigners, and the relaxing of environmental and employee safety standards. It has been problematic for any state, postcommunist or otherwise, to impose a high tax burden on business and capital. What makes the East European cases different is they have ceded enormous control over indirect and most of direct tax policymaking. In other words, both consumption and income taxes are in large part externally constrained or determined. And while there are still some tax areas in which the standard left-right political divide can influence the positions of leaders on taxation—such as the setting of personal income tax brackets—these areas are of less consequence since the majority of the tax revenue comes from sources in which the new democratic regimes have either ceded control to Brussels or lost policy flexibility due to the competitive conditions of the international economy.