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World Bank Document POLIcy RESEARCH WORKI-ING PAPER 128 6 Public Disclosure Authorized Economic Transformation The fiscal crisisin central Europe in the early 1990s is and the Fiscal Crisis attributable mainly to increased social spending Public Disclosure Authorized A Critical Look at the ratherthan to the collapsein Central European Experience profitabilityof state-owned of the 1990s enterprises. Luca Barbone Domenico jr. Marchetti Public Disclosure Authorized Public Disclosure Authorized The Wofld Bank Europe and Central Asia Country Department H Country Operations Division April 1994 Poi( -YR?t. Ak(iH WORKIM; PAPI'FA12 86 Su,mmaryfindings iAI10ot1 1nMid NaIrLitCrti argue that tradition,il the nrCnill1)n I I sahIouCltl )11 IiLiIttd tII thiII exphi si iI explantations it the fiscal crisis in retornling cx-sociahst spendoig (especially social spending) ratheLr than to the LCo:iiii0e1 oicrlItokve rilcial icitonnctjions betrwee key crisis in revcLn1e. comiipolientsof the deficit - partICUlarlyhbtween MNa.nVot tilh social costs (Otadj litSitiWI teeW rT I!! -A redcuctioinsin spending and declines in reve noes. hidden wlithi the stat-t-owned enterprises sestew. 'I Alt0o4t all stLIdiesot the tiscal aspects ot the transition Social costs inClude UICIneiJplkmennt heCneits a1d thil Stressthe impact oni the fiscal budget ot the pertormtance of supportinig - tht(oiugh pensil is or s cial assi3 lk e cIriSiS itl state-owVned e nrerplises. Barboiteanid Miarchetti the people displaced troni tWe vi irk ior.e t.s the conitenldthat this aspect ot the fiscal crisis haSbeen tranisformiiation. overstated. It 1 inip ortatit to conitintiu retoriiliiog the tax systei Ihe enterprise sector's net contribution to the and tax administration - to deal with the widesprelad government budget - that is, tict incomie from prot'it hiding of profits aind cheating oil taxes - hut all th%te taxes after subtracting sutbsidies- hias !increased dtiritig coutitries already have relativelr Ihightlevels ot taxation the transition in Czechoslovakia anid Poland and has not Society in tte thiree couinitries tas not be willing to changed substantially in Hungary. provide thc resouircesrequired to support or exttend After reexatimliitig the data, Barbotle and Marchetti currtitt spentdinglevels. argue that although the fiscal crisis is certainly structural, 'I'his paper - product of ttheCountry Operations Division, Europe and Central Asia, Country Department 11-- is pr of a larger e ffort in the region to draw cross-country iessonson tht issuesraised by the econoticic transtorttt.ttioni ot toritier socialisteconorrmies.Copiesof thepaperareavailablefree from theWorld 13ank,18 1 8 H Street NW, \VWashingtonD)C24 3 Pleasecontact Sahra Harbi, rooni H11-121, exteinsion 37143 (34 pag '. April 1994, DinePolwc; Re earch AXOrkirnPaper Series thi fesetninatesfindings of uwork in progressto encourjge therrxehanygc iii ais ;:. |o.i' lc,pinent issues. .4n ohb eitiz e of th, seres is t('ett; the tinding's ourt quic kly. cr in 1,1rh,' prl Sentartu(n ar less tln.t ,fu/dib }/! e{ ' ietttrsa carrr the names ot t/c .;th, IT . ndsss izh(, Id e uxsedland sted aLc '' dingl. th fndingsi'ie interprets oans. azan-,i 0luSue ,nS a'e the authors ' oun and shouhli n t ie attrinutcd to the World Bank. its Fxexutive B ard 1 )i)rec tors. or an\ fits mc,n er isosintries. Produced hy the Policy ResearchDissemiiiation Cetticr ECONOMIC TRANSFORMATION AND THE FISCAL CRISIS A Critical Look at the Central European Experience of the 1990s Luca Barboneand Domenicojr. Marchetti World Bank The views contained in this paper are the authors' only and not those of the World Bank group. ECONOMIC TRANSFORMATION AND THE FISCAL CRISIS A Critical Look at the Central European Experience of the 1990s I. INTRODUCTION An (unfortunate) stylized fact common to virtually all reforming ex-socialist economies (RESEs) is the deep fiscal crisis in which they have found themselves after the onset of the liberalization programs (Table 1). Table 1. Selected Economies in Transition: General Government Balance (in percentage of GDP) 1989 1990 1991 1992 1993 (proj.) Albania -8.6 .15.4 -30.6 -22.6 -19.6 Bulgaria .. -8.5 -4.1 -5.0 -8.0 former Czechoslovakia I/ -2.4 0.1 -2.0 -3.6 -2.2 Hungary -1.3 0.5 -2.5 -8.0 -7.6 Poland -6.1 2.7 -3.7 -7.1 -2.8 Russian Republic 2/ .-3.1 -6.3 -19.9 -7.4 -8.4 Sources: Ministries of Finance; World Bank staff estimates. 1/ The figure for 1993 is the weighted average of projected Czech and Slovak Fiscal Deficits 2/ Figures prior to 1991 refer to the USSR To a certain extent the emergence of a fiscal crisis should not be surprising, since almost all the reforming economies have also experienced, at least during 1990-91, considerable output losses, of a magnitude not previously seen in market economies. Inasmuch as automatic stabilizers were built into the structure of thf socialist public sector (at least on the revenue side), one should have expected that the recession would be accompanied by a large swing in fiscal balances. But, as Fiscal Crisis in Central Europe 2 several authors have pointed out, there are more serious, structuralreasons underiyingthe crisis, which require the policy-makers' attention.' At least four factors are commonly cited: On the revcnue side, the traditional tax base of RESEs was the state-owned enterprise (SQE) sector. The sector has bome the main brunt of the recession, thus driving down tax collection,and is likely to further lose relative importance in the economy, as privatizationadvances and industry is downsized. In addition, the loss of the traditional tax base cannot easily be compensatedfor by increasing contributionsfrom other sectors, since either these are traditionally difficult to tax (some services, small businesses), or the administration is not prepared to implementthe new tax laws that are approved by the legislature. On the expenditure side, despite the relief provided by the sharp cuts in govermnentsubsidies, the central governmentis likely to be burdened with many of the social costs of adjustment,which were previously hidden within the SOE system. These include, in addition to unemploymentbenefits which are likely to be high for a number of years, the cost of supporting,either through the pension system or the social assist.ancesystem, the people displacedfrom the work-force by the transformation. Finally, the switch to positive real interest rate policies, together with the emergence of large deficits and non-bank financing of the budget, has led to increasingdebt-service pressures. These factors are present, to a certain extent, in all countries, and can therefore be used to provide partial explanations for the overall crisis. In this paper we examine relevant data for Poland, Hungary and Czechoslovakia,and assess their congruence with the theses enumerated ' See, for example, Tanzi (1991 and 1993). Fiscal Crisis in Central Europe 3 above. We also analyze data on tax payments from the private sector in Poland, providing the first comprehensiveevidence available on the subject for any RESE. The main thesis of this paper is that traditional explanations fail to overlook crucial interconnectionsbetween key components of the deficit, particularly between the reduction in expendituresand the decrease in revenues. We therefni try to provide a somewhat different perspective.We argue that the impacton the fiscal buc of the crisis of the SOEs performance - which is stressedby almost all the studiesof the fiscal aspects of transition - has been largely everestimated.Indeed, the net contributionto the governmentbudget from the,enterprise sector - defined as profit taxes net o,fcross-subsidization - has increasedduring the transitionin Polaned and Czechoslovakia,and has not changed substantially in Hungary. We posit that this net measure is the mreaningfulvariable to considerin order to assess the "fiscal performance"of the enterprise sector in a socialist economy. After reexaminingthe data, we conclude that - while it is undoubtablethat the fiscal crisis in RESEs should be consideredof a structuralnature - its main cause lies with the explosion of expenditures,rather than in the crisis in revenues. Within our 3nalyticai framiework,we can provide a consistent explanation of the outstanding fiscal performanceof Czechoslovakiavis-a-vis Poladlu aa.d Hungary. flnparticular, the increaseof social insuranceexpenditure - a typical developmentduring transition- has been moderatein the former Czechoslovakia,while it has been dramatic in the other two reforming economies. The paper is organizedas follows. In the next section,we briefly review the economicmission of the public sector under socialist and market economies,and present a flow-chartmodel of the resulting fiscal flows among main sectors of society. We also review traditional theories regarding fiscal crisis during transition. In the third section,we present evidence- from Poland, Hungary and Czechoslovakia- supportingto a varying degree an explanationof the fiscal crisis consistent with the traditional theories (mainly revenue-based).We also provide a different perspective, and reach quite a different conclusion - that the explanation of the fiscal crisis is mainly to be found so far on the expenditureside. In section four we review the reasons for the Fiscal Crisis its Central Europe 4 increase in expenditures,and review some ev;dence on behavior of private sector taxpayers in Poland. II. ECONOMICMISSION OF THE STATE AND BUDGETARYCONSEQUENCES OF ECONOMIC TRANSFORMATION. Is there a structuralreason why RESEs are experiencingsevere fiscal
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