IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
WP 2016-03. Executive Summary
After the end of communism, the countries of Central and Eastern Europe shared very similar challenges. Despite the different patterns of transition, the dominant model of “catching up with the West” included the adoption of western legal and institutional standards. In economic terms, this meant privatization, liberalization and the prompt accumulation of capital that was devastated during the communism. The ultimate goal was to promptly achieve dynamic economic development and sharp improvement of living standards. The inadequate taxation policies inherited from the communist system had to be adjusted to the demands of the free market economy. New taxation policies were necessary not only to serve the purposes of the “catching up” process, but also to stabilize the countries fiscal conditions and to attract foreign direct investments.
The newly created taxation systems in the countries from the region were complex, confused and replete with exemptions. The solution appeared to be the flat tax system, which made an impressive career throughout the region. The flat tax was supposed to encourage capital accumulation; lead to the growth of disposable income and enhance foreign investments; promote equal treatment of taxpayers; stimulate investments, savings, labor, and entrepreneurship; encourage political responsibility and feature administrative simplicity, so as to reduce tax evasion and enhance tax collection. Finally, the flat tax was supposed to eliminate the shadow economy, encourage tax compliance and lead to economic growth.
This paper puts forward a comparative review of the Bulgaria, Slovak and Polish tax systems during the past 25 years, and analyses whether the flat tax system was able to meet the hopes reposed in it. The three countries were selected because they nominally contain different taxation systems: Poland has a progressive one; Slovakia has a flat tax while retaining some elements of progressive taxation; whereas Bulgaria has the most radical flat tax system in the region. Furthermore, after a quarter of a century their economic and tax experience does not correspond with the expectations of the flat tax dogma.
The paper argues that the flat nature of the taxation system in the region is actually of secondary importance, despite the fact that all the tax systems in their essence aim to perform in a very similar “flattened” taxation pattern. Moreover, it is maintained that the quest for foreign direct investments is not just a matter of tax structure and design. More generally, it is shown that the virtues of the flat tax system are all but nullified by operational difficulties such as high compliance gaps, tax evasion and weak tax administration.
Having in mind that after a quarter of a century the three countries reached different levels of economic development, the question remains whether the current taxation systems are still relevant or they have lost their appropriateness. Poland and Slovakia are approaching the challenge of a “middle income trap”, whereas Bulgaria still needs to “catch up”. Thus, the former two should reconsider the current weaknesses of their taxation systems, whereas the latter should reassess its approach towards foreign direct investments and reconsider the direction of its economic policy.
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