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Some Tax Advice for Latvia and Other Similarly Situated Emerging Economies

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Some Tax Advice for Latvia and Other Similarly Situated Emerging Economies Some Tax Advice for Latvia and Other Similarly Situated Emerging Economies Robert W. McGeet The design of an effective tax structure is one of the most dfficult tasks and controversialproblems faced by an emerging economy. Latvia faces not only the basic policy choices confronted by all nations in structuring tax policy, but also special problems connected with its transition to a market economy. This article outlines some of the key perils that Latvia and other emerging economies may face, and proposes means of avoiding many of those problems. The article begins with a discussion of the attributes of a good system of public finance in any country and the means of implementing such a system. The article then considers the problems which Western economies have encoun- tered in the formation and operation of their own tax systems, and identifies perils that nations in Latvia's position would do well to avoid. Following its analysis of the Western experience, the articlefocuses on the special problems that newly emerging economies may encounter, as well as the approach cur- rently in operation in Latvia itself Finally, the article presents guidelines for the construction of a tax system in Latvia and other emerging economies. I. Introduction ................................................ 225 II. Attributes of a Good System of Public Finance ................ 226 A. Introduction ............................................. 226 B. Philosophical Issues ..................................... 229 1. The Theory of Voluntary Taxation ..................... 229 2. Two Competing Views of Taxation .................... 233 3. Should Taxes Be Visible or Hidden? ................... 234 4. Should Government Support or Discourage Certain A ctivities? .......... 235 C. Economic Issues ......................................... 237 1. Tax Rates ........................................... 237 2. Should Tax Rates Be Uniform or Discriminatory? . 240 3. Administration ....................................... 242 t Robert W. McGee is a professor in the W. Paul Stillman School of Business at the South Orange, New Jersey campus of Seton Hall University. He has authored or edited more than 30 books and monographs and has written more than 300 articles and reviews for a variety of profes- sional and scholarly journals. The author would like to thank Vivian Lugo for her research assistance. 224 INTERNATIONAL TAX & BUSINESS LAWYER [Vol. 13:223 4. Collection ........................................... 242 5. Earmarking Taxes .................................... 242 6. Distortional Effects of Taxes on the Economy .......... 243 7. Effects of Taxes on Competitiveness and Economic G rowth .............................................. 245 8. Complexity .......................................... 248 9. C larity .............................................. 249 10. Rules Should Not Change Frequently ................. 251 11. Effects on Behavior and Incentives ................... 252 12. Effects on Social Harmony .......................... 252 13. Administrative Costs ................................ 255 14. Costs and Benefits .................................. 257 III. The Income Tax: Lessons from the U.S. Experience ............ 259 A . O verview ............................................... 259 B. The Individual Income Tax ............................... 261 C. The Corporate Income Tax ............................... 264 IV. The Value Added Tax: Lessons from the Western Experience ... 267 A. General Comments ...................................... 267 B. The Value Added Tax ................................... 267 C. The Turnover Tax ....................................... 270 V. Other Means of Raising Revenue ............................. 274 A . O verview ............................................... 274 B. Property Taxation ....................................... 274 C. Excise Taxes ............................................ 276 D. Estate, Inheritance and Gift Taxes ........................ 277 E. Social Security Taxes .................................... 278 F. Tariffs .................................................. 280 G. Capital Gains Taxes ..................................... 281 H. Printing M oney ......................................... 282 I. U ser Fees ................................................ 283 J. Lotteries ................................................ 284 VI. Special Problems of Raising Revenue in Emerging Economies .. 285 A. Lack of a Price System .................................. 285 B. Adopting Western Systems ............................... 286 C. Consumption Taxes ...................................... 287 D . Inflation ................................................ 287 E . Evasion ................................................. 288 F. The Anti-Capitalistic Mentality ............................ 289 G. The Welfare State Mentality .............................. 289 VII. The Latvian Tax System ..................................... 290 A . O verview ............................................... 290 B. The Profit Tax .......................................... 291 C. The Personal Income Tax ................................ 296 D. The Property Tax ........................................ 297 1996] TAX ADVICE FOR EMERGING ECONOMIES E. The Land Tax ........................................... 297 F. The Natural Resource Tax ................................ 298 G. The Turnover Tax ....................................... 299 H. The Excise Tax ......................................... 300 I. The Social Tax .......................................... 301 VIII. Recommendations for Latvia and Other Emerging Economies ... 302 I. INTRODUCTION The scope of this paper encompasses the tax systems and problems of every emerging market economy.' Although the author discusses the tax system of Latvia in particular, Latvia's tax situation is not unique. Many of the problems and policies that now exist in Latvia also exist in most other emerging market economies. The Latvian case is used only as an example for illustrative purposes. Latvia, like many other countries that are emerging from a centrally planned economic system to a market system, is in the process of establishing a tax system that will serve its future needs. During this transformation, it is likely to encounter a number of problems. Some such problems will be similar to those encountered whenever any government attempts to establish a tax pol- icy. However, some problems will be unique to emerging economies. This pa- per examines both types of problems and makes recommendations for easing this process based on the experiences of the Western democracies. The present study is not limited to a discussion and analysis of purely eco- nomic (utilitarian) approaches, but extends to issues involving political philoso- phy. Tax systems that are based on mere efficiency--collecting the most tax at the least economic cost-ignore many relevant issues. Yet nearly all economic studies either completely ignore noneconomic issues or give them cursory exam- ination and discussion. The present study begins by establishing a philosophical base upon which a tax system can be built, then expands the discussion to ex- amine the ways in which such a system can be structured. Part II outlines the attributes of a good system of public finance. Part III presents an overview of the income tax system in the United States. Part IV discusses the value added tax, which is used by most countries in Western Eu- rope as a means of raising revenue. Part V discusses and analyzes the pros and cons of alternative means of generating revenue. Part VI addresses the special problems of raising revenue in an emerging economy. Part VII provides an overview of the tax system in Latvia, and offers a commentary on its present tax rules. Lastly, Part VIII outlines possible guidelines for Latvian and other policy- makers engaged in structuring their respective tax systems. 1. Examples include any Eastern or Central European economy that was in the Soviet bloc, as well as many countries in Asia, Africa and Latin America. Some countries in the Middle East could also benefit by adopting the suggestions made in this paper. INTERNATIONAL TAX & BUSINESS LAWYER [Vol. 13:223 II. ATmIBUTES OF A GOOD SYSTEM OF PUBLIC FINANCE A. Introduction Before we can discuss what constitutes a good system of public finance, a few words must be said about what constitutes a good system of government. There is a diversity of opinion on this point, and the basic vision of government with which one begins affects the kind of public finance system one constructs. This author begins with the premise that the best government is one that governs least,2 a position consistent with the view that the private sector can do just about anything more efficiently than the government.3 Ample evidence sup- ports this idea. Efficiency is only one aspect. An even more important aspect to consider is whether the government should limit itself to the protection of life, liberty and property-a nightwatchman state-or whether it should be active in the redistri- bution of income as well. According to the "nightwatchman state" theory, the public finance system will be aimed merely at raising revenue for the support of essential government functions. Conversely, under a more expansive view of government, the public finance system will also be used to aid in the redistribu- tion of income and as a tool of macroeconomic policy. Several aspects of the more expansive
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