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TRANSITION, TAXATION AND THE STATE
Transition and Development
Series Editor: Professor Ken Morita
Faculty of Economics, Hiroshima University, Japan
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Transition, Taxation and the State
GERARD TURLEY
National University of Ireland, Galway
© Gerard Turley 2006
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system
or transmitted in any form or by any means, electronic, mechanical, photocopying, recording
or otherwise without the prior permission of the publisher.
Gerard Turley has asserted his moral right under the Copyright, Designs and Patents Act,
1988, to be identified as the author of this work.
Published by
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British Library Cataloguing in Publication Data
Turley, Gerard
Transition, taxation and the state. - (Transition and
development)
1. Taxation - Russia (Federation) 2. Taxation - Europe,
Eastern 3. Tax administration and procedure - Russia
(Federation) 4. Tax administration and procedure - Europe,
Eastern 5. Russia (Federation) - Economic conditions - 1991-

6. Europe, Eastern - Economic conditions - 1989 -
I. Title
336.2'00947
Library of Congress Cataloging-in-Publication Data
Turley, Gerard.
Transition, taxation and the State / by Gerard Turley.
p. cm. (Transition and development)
Includes bibliographical references and index.
ISBN 0-7546-4368-9
1. Tax collection Europe, Eastern. 2. Tax collection Former Soviet republics. 3.
Tax collection Russia (Federation) I. Title. II. Series.
HJ320.E852T87 2005
336.2'00947 dc22
2005021078
ISBN 0 7546 4368 9
Printed and bound by Athenaeum Press Ltd,
Gateshead, Tyne & Wear.
Contents
List of Tables vii
List of Figures ix
List of Abbreviations xi
Foreword xiii
Acknowledgements xv
1 Introduction 1
2 Tax, Transition and the State: The Case of Russia 11
3 Budget Softness and the Russian Enterprise Sector 41
4 Tax Arrears and the Romanian Enterprise Sector 63
5 Effective Tax Administration in Transition Countries 97
6 Tax Capacity and Effort in Transition Countries 125
7 Conclusion 147

Bibliography 155
Index 167
To Monica
‘The revenue of the state is the state. In effect all depends
upon it, whether for support or for reformation ’.
Edmund Burke
Reflections on the Revolution in France
This publication was grant-aided by the
Publications Fund of National University of Ireland, Galway
List of Tables
Table 1.1 Tax Revenue/GDP Ratios, 1989-1998 7
Table 2.1 Index of Governance and Enterprise Restructuring/Reform,
1994-1999 19
Table 2.2 Revenue Share of GDP, 1992-1999 24
Table A.1 Development of Market-Supporting Institutions, 2000 34
Table B.1 Governance, State Capture and Intervention 35
Table C.1 Small Business Sector in Russia, 1998-2000 (000s) 36
Table 3.1 Distribution of Firms (437 firms) 44
Table 3.2 Difficulty of Obtaining Bank Credit on Commercial Terms
(Percentage of Firms) 47
Table 3.3 Ordered Logit Results for Difficulty of Obtaining Credit in 1999 48
Table 3.4 Difficulty of Obtaining Government Assistance
(Percentage of Firms) 49
Table 3.5 Financing a Shortfall in Working Capital 51
Table 3.6 OLS Regression Results for Financing a Shortfall in
Working Capital 53
Table 3.7 Levels of/Changes in Debts and Overdue Debts
(Percentage of Assets) 55
Table 3.8 Regression Results for Levels of Debts and Overdue Debts 56
Table 3.9 Regression Results for Real Changes in Debts and Overdue Debts 58

Table D.1 Extracts from Q uestions on Enterprise Finance 59
Table 4.1 EBRD Transition Indicators for Romania
(and Visegrad Four), 1994-1998 65
Table 4.2 Tax/GDP Ratios, 1994-1998 66
Table 4.3 Stock/Flow Analysis of Romel’s Tax Liabilities
in 1997, at Current Prices (in Thousand Lei) 69
Table 4.4 Stock/Flow Analysis of Romel’s Tax Liabilities in
1997, at Constant (End-Year) Prices (in Thousand Lei) 70
Table 4.5 Flow Analysis of Romel’s Tax Liabilities in 1997, at Constant
(End-Year) Prices (in Thousand Lei) 72
Table 4.6 Stock/Flow Analysis of 9,000 odd Firms in the
Romanian Enterprise Sector in 1997 (in Billion Lei) 73
Table 4.7 Stock of Tax Debt and Overdue Tax Debt at end-1997 74
Table 4.8 Flows of Tax Debt January-December 1997 75
Table 4.9 Groups of Firms with Tax Arrears in 1997 Compared 77
Table 4.10 Tax Arrears in Transition Economies 79
Transition, Taxation and the State
viii
Table E.1 Consumer Price Index, January-December 1997 84
Table F.1 Selected Indicators for Tractorul UTB S.A.,1990-1998 87
Table F.2 Selected Indicators for Brasov (County) and Romania, 1997 93
Table 5.1 Benchmark Tax Rates, Gross and Net Equivalents 103
Table 5.2 Statutory Tax Rates and Tax/GDP Ratios for 25 TEs, 1997 105
Table 5.3 Statutory and Effective Taxation, 1997 107
Table 5.4 Bribe Tax and Corruption for TEs 111
Table G.1 Data Sources for the 25 TEs 116
Table H.1 VAT Effective/Statutory Ratios, 1992-1998 117
Table H.2 SST Effective/Statutory Ratios, 1992-1998 118
Table H.3 CIT Effective/Statutory Ratios, 1992-1998 119
Table 6.1 Determinants of Tax Capacity 130

Table 6.2 Tax/GDP ratios 133
Table 6.3 GDP per capita, Agriculture and Export Shares of GDP for TEs 134
Table 6.4 Tax Capacity Regression Results 136
Table 6.5 Tax Capacity Estimates 137
Table 6.6 Tax Ratio and Tax Effort Rankings 139
Table I.1 Country Data 143
Table J.1 Tax Effort Estimates 145
List of Figures
Figure 5.1a VAT Effective/Statutory Ratio 1997 vs Progress in Transition 120
Figure 5.1b SST Effective/Statutory Ratio 1997 vs Progress in Transition 120
Figure 5.1c CIT Effective/Statutory Ratio 1997 vs Progress in Transition 120
Figure 5.2a VAT Normalised Tax Yield (NTY) 1997 vs Progress in
Transition 121
Figure 5.2b SST Normalised Tax Yield (NTY) 1997 vs Progress in
Transition 121
Figure 5.2c CIT Normalised Tax Yield (NTY) 1997 vs Progress in
Transition 121
Figure 5.3a VAT Effective/Statutory Ratio and the Average
Bribe Tax 122
Figure 5.3b SST Effective/Statutory Ratio and the Average Bribe Tax 122
Figure 5.4a VAT Normalised Tax Yield (NTY) and Average Bribe Tax 123
Figure 5.4b SST Normalised Tax Yield (NTY) and Average Bribe Tax 123
Figure 6.1 Tax Ratio and Est. Tax Capacity 142
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List of Abbreviations
ACIR Advisory Commission on Intergovernmental Relations
BEEPS Business Environment and Enterprise Performance Survey
CBR Central Bank of Russia
CEE Central and Eastern European
CIS Commonwealth of Independent States

CIT Corporate Income Tax
CMEA Council for Mutual Economic Assistance
CPI Consumer Price Index
CPI Corruption Perceptions Index
EBRD European Bank for Reconstruction and Development
E/S Effective/Statutory
EU European Union
FIGs Financial–Industrial Groups
FSU Former Soviet Union
GDP Gross Domestic Product
GKO Short-term Government Bonds (Treasury Bills)
IBFD International Bureau of Fiscal Documentation
IMF International Monetary Fund
MPS Material Product System
NBF Net Bank Financing
NNT Net New Taxes
NTE Net Tanzi Effect
NTY Normalised Tax Yield
OECD Organisation for Economic Co-operation and Development
OFZ Treasury Bonds
POF Private Ownership Fund
PSAL Private Sector Adjustment Loan
RA Régies Autonomes
RTS Representative Tax System
SAL Structural Adjustment Loan
SBC Soft Budget Constraint
SME Small and Medium-Sized Enterprises
SNA System of National Accounts
SOEs State-Owned Enterprises
SOF State Ownership Fund

SST Social Security Tax
Transition, Taxation and the State
xii
STS State Tax Service
TEs Transition Economies
UN United Nations
VAT Value-Added Tax
WB World Bank
Foreword
Revenue erosion and lax payments discipline, manifesting itself in low revenue
mobilisation, ineffective tax collection and widespread non-compliance, have been
a problem in many ex-socialist countries since the start of transition. This book
examines the problems of tax payments discipline and collection in the transition
countries of Central and Eastern Europe and the former Soviet Union in the context
of economic transition from a centrally planned economy to a market economy, the
transformation of a socialist state to a capitalist state, the nexus between government
and business, and the persistence of the soft budget constraint. Much of the literature
on the revenue decline in transition countries has focused on either economy-
wide transitional phenomena or on taxpayers’ non-compliance. In contrast, this
monograph examines the problem from the position of the tax collector, that is,
the state, and its ability or willingness to collect taxes. Using the concept of János
Kornai’s soft budget constraint, the book examines the problem of budget softness
and tax payments discipline in the postsocialist transition economies during the first
decade of transition. Appropriate methodologies are applied to new data for the
transition economies with the purpose of revealing incidences of budget softness (or
hardness) and, more generally, measuring the degree to which the enterprise sector
in postsocialist countries is not tax compliant. Tax collection problems, arising
from economic, administrative or political factors, are investigated in the context of
transition. The results indicate tax collection problems arise for a number of reasons,
including budget softness but also because of a general poor payments discipline,

corruption and bribery, ineffective tax administration and low tax capacity and tax
effort arising from both economic and political factors. Furthermore, our evidence
indicates that cross country differences are not small, state control matters and, for
many transition countries, tax administration and political constraints, as opposed
to tax design and economic constraints, are more pressing problems. Transition,
Taxation and the State outlines the tax collection and discipline problems (particularly
in the context of the soft budget constraint and the state-enterprise relationship legacy
of the socialist era) that the postsocialist state in transition countries experienced
in the first decade of transition. As for the state (or the ‘tax state’ to use Joseph
Schumpeter’s expression) and tax revenue performance in the second decade…let
us wait and see the evidence.
Gerard Turley
National University of Ireland, Galway
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Acknowledgements
This book is based on research entitled Soft Budget Constraints, Tax Payments
Discipline and Tax Collection in Transition Economies, undertaken at the Centre for
Economic Reform and Transformation (CERT), Heriot-Watt University, Edinburgh
under the direction of Mark E. Schaffer. His guidance, encouragement and
thoughtful insights were invaluable and I hereby wish to acknowledge his significant
contribution to this monograph. I also wish to express my gratitude to Paul Hare
of Heriot-Watt University and the late George Blazyca of Paisley University who
gave me the idea for this book. I wish to pay gratitude to colleagues and friends at
Heriot-Watt University, Edinburgh and the National University of Ireland, Galway.
A special word of thanks must go to Michael Cuddy of the National University of
Ireland, Galway, Alan Bevan formerly of the European Bank for Reconstruction and
Development (EBRD) and Giovanni Mangiarotti formerly of the Aston Business
School, Birmingham for their direction and support. Also, my thanks to everybody
who assisted me during my time in Romania and Russia.
With respect to Chapter Two, I wish to thank Alan Bevan, Roger Clarke, Michael

Cuddy, Paul Hare, Marina Pavlushevich, Mark Schaffer and seminar audiences at
the National University of Ireland, Galway and BASEES, Fitzwilliam College,
Cambridge for useful comments. The analysis in Chapter Three arose from an
enterprise restructuring project in Russia involving CERT (Heriot-Watt University,
Edinburgh), LBS (London), NERA (London) and BEA (Moscow). Thanks must go
to Alan Bevan, Boris Kuznetsov, Giovanni Mangiarotti and Mark Schaffer for their
assistance and helpful suggestions. Useful comments were also received at a BEA
conference in Moscow. The work in Chapter Four was part of a PhareACE project
carried out for the Government of Romania. I wish to thank Lucian Croituru, Terry
Green, Constantin Munteanu, Alina Potter and Mark Schaffer. I am also grateful
to the Romanian Ministry of Finance for supplying me with a dataset. My thanks
to Alan Bevan and Paul Hare and to seminar audiences at Heriot-Watt University,
Edinburgh and at CREEB, Buckinghamshire for helpful comments.
The research in Chapter Five builds on collaborative work conducted for the
EBRD, to whom I am most grateful. I am also grateful to Michael Alexeev, Alan
Bevan, Wendy Carlin, Mark Schaffer and participants at the July 2000 National
University of Ireland, Galway workshop on ‘Institutions and their Change in
Transition Economies’ for helpful comments. Useful suggestions were also received
at a Foundation for Fiscal Studies seminar in Dublin and a Scottish West Coast
seminar in Glasgow. The analysis in Chapter Six was part of a research project entitled
Public Finance in Transition Countries: Problems of Compliance, Opportunism and
Transition, Taxation and the State
xvi
Soft Budget Constraints that involved a number of partners including myself and
Mark Schaffer, and was financed by PhareACE 1998 Programme to which I want to
express my appreciation. I am also indebted to Alan Bevan, formerly of the EBRD
and Matthias Reister of the National Accounts Section of the UN Statistics Division
for providing data.
My thanks to National University of Ireland, Galway, Heriot-Watt University,
Edinburgh, the British Council, the European Commission, Galway Development

Services International, the Romanian Centre for Economic Policies, the EBRD, the
UK Department for International Development and the Adam Smith Institute for
their financial assistance and support.
I wish to thank Ashgate Publishing Company and its staff for the work undertaken
in the publication of this book. In particular, my thanks to Brendan George, Senior
Commissioning Editor of the Transition and Development series, Ken Morita,
Academic Series Editor of the Transition and Development series, and last, but by no
means least, Carolyn Court and Pam Bertram for their assistance in the preparation
of the manuscript for publication. As always, I wish to thank Claire Noone and
Imelda Howley of National University of Ireland, Galway for their time and support
in helping me to understand the finer points of formatting. I bear full responsibility
for all errors and any omissions.
Finally, and on a personal note, I wish to thank my family for the patience and
support that they have shown during the time that it has taken to research, write and
edit this book – almost, but not quite, as long as transition itself.
Chapter One
Introduction
One of the stylised facts of economic transition from a centrally planned economy
to a market economy was the decline in tax revenue. Given the nature of transition
where the role and size of government is reduced, a fall in tax revenue was predicted.
The revenue erosion, particularly evident in the early years of transition, is often
explained in the context of a change from the repressive and distortionary tax system
of Soviet times where taxes (and subsidies) were the key mechanisms for fiscal
redistribution from profitable to unprofitable enterprises and where tax collection
from large state-owned enterprises (SOEs) was a simple task, to a more Western-
style tax system where voluntary compliance and self-assessment are the norm and
where confrontation between the tax collector and the taxpayer is not uncommon.
Furthermore, as transition economies (TEs) witnessed a recession of historical
proportions, a decline in the profitability of the SOEs (and other traditional tax bases),
an expansion of the unofficial economy and a rise in tax evasion, corruption and

bribery, the tax share of GDP was to fall even further. After a decade of transition,
and despite a recovery in tax revenues in a number of leading transition countries by
the late 1990s, the tax ratio in some TEs had fallen to levels below what is considered
normal in market economies. Many regard this fall as excessive and view the decline
in tax revenue as a serious obstacle in the attempts to finance public expenditure,
redistribute income and, at the same time, embrace effective fiscal policy.
Much of the literature on the revenue decline in TEs has focused on economy-
wide transitional phenomena (the transformational recession or the rise in the
unofficial economy are two examples) or on taxpayers’ non-compliance (related to,
for example, rising tax evasion and a primitive tax culture) as explanations for the
fall in tax revenues. In contrast, this book examines the problem of revenue erosion
from the position of the tax collector, that is, the state, and, in particular, the weakness
of the state as creditor, i.e. its (in)ability or (un)willingness to collect taxes. An
appropriate theoretical framework for analysing the role of the state as creditor and
the volatile state-enterprise relationship that exists in postsocialist times, particularly
as it relates to tax payments and collection, is János Kornai’s soft budget constraint
(hereinafter SBC). In this context, the book examines the problem of budget softness
and tax payments discipline in transition countries and, particularly in Russia, a
country where tax collection is considered a problem (despite the observation that
tax revenue relative to national income is not unusually low given Russia’s level of
economic development). In Russia and in other transition countries, the falling tax
share of national income needs to be seen in the context of the fluid state-enterprise
relationship that is common in the transition from plan to market, the capacity of
Transition, Taxation and the State
2
the reconstituted state and its willingness to tax, the nexus between government
and business and the persistence of the SBC in the transition setting. In respect of
tax collection, the research undertaken and reported in this monograph indicates
that problems arise for a number of reasons, including budget softness but also
because of a general poor payments discipline, corruption and bribery, ineffective

tax administration, poorly designed intergovernmental fiscal relations and low tax
capacity and tax effort arising from both economic and political factors.
1.1 Paradigms of Economic Transition
The standard paradigm of economic transition that dominated in the early years
of the 1990s and had the support of the international financial organisations (more
notably the International Monetary Fund and, less so, the World Bank) is often
referred to as the Washington Consensus.
1
This orthodox or mainstream approach
views the transition from a centrally planned to a market economy as a reform
process emphasising the universality of the laws of the market and the undoubted
economy-wide efficiency gains accruing from the standard policy prescriptions of
the trinity of liberalisation (‘getting prices right’), stabilisation and privatisation. This
blueprint for transition, based on the spontaneity of markets, traditional neoclassical
price theory and general equilibrium theory, promotes the primacy of policy reforms
and economic fundamentals and the replication or transplantation of international
best-practice institutions (with the emphasis on laws and the legal and regulatory
framework) of the West to the ex-socialist countries of the former Soviet bloc (a kind
of utopia based on ‘societal engineering’).
Although the Washington Consensus emerged from a different set of conditions,
it argues that these one-size-fits-all market-oriented reforms are appropriate to any
setting, including the postsocialist Central and Eastern European (CEE) and former
Soviet Union (FSU) countries. A knowledge or experience of the state socialist
system and the centrally planned economy is not required. Policy reform strategies
are implemented along a scorched-earth approach, with textbook reforms being
designed by technocrats and introduced as rapidly and comprehensively as possible
in view of the reform complementarities that exist. Not surprisingly, in terms of the
speed of the radical reforms, this approach is often referred to as the ‘big bang’ or
‘shock therapy’ view of transition. This also applies to the economic role of the state
1 Strictly speaking, the Washington Consensus refers to a set of policy guidelines for

most Latin American countries in the late 1980s for which, it was argued, a consensus was
reached among Washington-based international agencies, the US government and mainstream
economists. John Williamson of the Institute for International Economics, the person who
coined the phrase, viewed these reforms as the lowest common denominator of policy advice
by ‘Washington’ to Latin American countries as of 1989. The ten economic reforms focused
primarily on structural adjustment policies of price and trade liberalisation, macroeconomic
stabilisation and fiscal discipline, deregulation of entry barriers and privatisation of state-
owned enterprises.
Introduction
3
where what is required is a depoliticisation of the economy, a break of the nexus
between government and business and a dismantling of the state, or, according to
critics of the Washington Consensus approach, in the extreme case of neoliberal
market fundamentalism, state desertion.
The institutional-evolutionary paradigm, more popular within academic circles,
views transition as a large scale institutional transformation where the focus is on
the institutional underpinnings of capitalism appropriate to the specific conditions of
each country and in accordance with the initial conditions at the outset of transition.
This approach is critical of the revolutionary vision of transition and, instead, views
transition as a process involving systemic change in the face of great uncertainty and
complexity, unlike the competitive neoclassical model and its notion of equilibrium,
which is inherently static. As opposed to equilibrium processes, the emphasis of the
institutional-evolutionary approach is on the dynamics of institutional change within
an evolutionary perspective, based on contracting and noncooperative games in
modern microeconomic theory. Here, the focus is on the gradual development of the
institutional supports or arrangements for a market economy, accepting the dangers
of institutional voids and that not all existing or inherited institutions, organisational
forms or social capital are redundant. Transitional second-best institutions and the
preservation of social capital can be both worthwhile and necessary in order to
prevent further economic disruption.

Whereas the Washington Consensus view of transition is a top-down approach,
the institutional-evolutionary perspective is a bottom-up view focusing on the
institutional design of market economies, the importance of social norms and the
organic development of the private sector. Markets and economic agents do not
exist in a vacuum but in an institutional framework – ‘the rules of the game’ – that
facilitates exchange and interaction. Institution building and the provision of a
framework for well-functioning market structures and organisations is the focus
of this approach and it argues for the gradual or incremental implementation of
sequenced reforms (often through experimentation and learning by doing) in order
to ensure growing support for policies. In the institutional-evolutionary approach,
although there is recognition for the need to reduce the role of the state, the emphasis
is on a reconstituted state and improving state capacity (so as to, among other things,
enhance the market environment) as opposed to a weakened state. It also stresses the
path dependency of system development and is mindful of the historical continuity
and the communist legacy unlike the ahistorical, tabula rasa Washington Consensus
approach (Clague and Rausser 1992; Roland 2000; Bönker et al. 2002).
Although an outline of the two major paradigms of transition is useful in the
context of this book, many observers feel that the debate between the two approaches
and, in particular, the controversy between ‘shock therapy’ and gradualism and the
tendency to label countries as either one or the other, has not been very helpful and
has unintentionally diverted attention away from some of the more important aspects
of economic transition. One such feature of transition is the SBC.
Transition, Taxation and the State
4
1.2 Definition and Interpretation of the SBC
The incentive problem inherited from the socialist system known as the SBC takes
its name from the budget constraint faced by households in standard microeconomic
theory. The budget constraint was first extended to organisations and firms by Kornai
(1979, 1980) and applied to the socialist economies of Central and Eastern Europe.
The budget constraint is softened when a firm is not held to a fixed budget, but finds

its budget constraint non-binding. The enterprise sector is said to exhibit a SBC
when there is a recurring or persistent expectation of a refinancing or bailout of
loss-making firms; firms receive financial assistance because they are loss making
and the expectation of aid is close to certainty as the external support is more than
just a once-off event. The channels or mechanisms by which the ex post rescue of
unprofitable firms takes place vary, from budgetary subsidies and tax arrears (by
government) to inter-enterprise arrears (by trade suppliers and utility companies) to
overdue loans (by banks). Since transition began over a decade and a half ago, the
more traditional forms of the SBC, namely, arbitrary pricing and direct subsidies,
have given way to new and, often, more implicit instruments, such as tax arrears and
overdue payables to banks, trade suppliers and utilities. Another mechanism that is
evident in predominately FSU countries, where banking intermediation is generally
underdeveloped, is non-cash payments (barter, promissory notes, offsets) by firms to
its creditors. Either way, this expectation of a bailout influences and undermines the
ex ante behaviour and incentives of firms.
The objective of the organisation that is bailed out is straightforward, namely,
survival. The motive of the rescuer varies, depending on the interpretation of the
SBC (as there is no consensus on a precise definition of the concept). For the
purposes of this book Kornai’s bureaucratic hierarchical model (1980, 1992a) is
used, as opposed to Dewatripont and Maskin’s dynamic commitment model (1995)
and Stiglitz’s gambling banks model (1994), of a paternalistic and benevolent state
willing to support unviable firms in order to avoid politically and socially costly
layoffs. A fourth interpretation is Shleifer and Vishny’s politicians and firms model
(1994), a theory that is employed in Chapter Two. Using the Kornai model, the SBC
syndrome can be viewed as a theory of exit and, thus, complements Schumpeter’s
theory of creative destruction (Schumpeter 1911). Whereas Schumpeter focused on
the birth or creation of organisations, the SBC phenomenon explains the survival
(or demise) of organisations. By preventing certain firms from bankruptcy, the SBC
alters the natural selection process inherent in a competitive environment (whether it
be market socialism, transition or market economy).

Since the term first appeared in 1979, there have been a number of different
explanations of the SBC. According to Kornai (1979, 1980), the source of the budget
softness, in the context of the socialist system, is the paternalism of the state. Firms are
not responsible for losses, or for profits, hence, the levelling effect. This explanation
is system-specific, focuses on political considerations and is based on the vertical
relationship between superior and subordinate. In contrast, the explanation advanced
by Dewatripont and Maskin (1995) focuses on economic causes, namely the inability
Introduction
5
to commit to no bailout ex post and the centralised financial system. Using a game-
theoretic model, the SBC is viewed as a time-consistency problem in the presence
of irreversible investment.
2
With asymmetric information and adverse selection, bad
projects get refinanced – the phenomenon of ‘throwing good money after bad’. A
different explanation, espoused by Stiglitz (1994), argues that, in the context of the
financial system, soft budgets arise when financial institutions have an incentive to
make large gambles when appraising projects. In this explanation, an insolvent bank
may be willing to invest in a risky project because the bank will become solvent if
the gamble pays off and, in the case of the project turning bad, will be no worse off
than it was before the loan was made i.e. still insolvent. A fourth model is presented
by Shleifer and Vishny (1993, 1994), where subsidies are paid to enterprises to retain
excess employment. These transfers result from bargaining that takes place between
managers of firms and government politicians, the latter driven by non-economic
objectives, namely their own narrow self-interest and self-preservation.
3
In the context of transition and economic theory, there are two broad perspectives
on the SBC. One approach is the Washington Consensus view, which treats the SBC
as an exogenous variable and a matter of direct policy choice. The implication here
is that political will is all that is required in order for the budget constraint of firms to

be hardened. The alternative perspective is the institutional-evolutionary approach
that views the SBC as endogenous to the institutional set-up. Here, the hardening of
budget constraints is possible only as an outcome of institutional change. Credible
commitment to hardening budget constraints is a matter of devising suitable
institutional mechanisms and arrangements (Roland 2000).
1.3 Evidence of SBC in Transition Countries
Despite the problems with the short time horizon (the start date for transition is
generally accepted to be 1990 for CEE countries and 1992 for FSU countries) and
the usual data problems, the empirical evidence on the SBC is now quite considerable
(Schaffer 1998; Roland 2000; Kornai 2001).
The evidence appears to indicate that in the early years of transition, trade credit
arrears and overdue payables to banks were often the main instruments of budget
softness as opposed to the budgetary subsidies and arbitrary pricing mechanisms of
earlier pre-transition years. Among other changes, price liberalisation and reform of
the public finances ensured that these old channels of the SBC were to disappear (in
2 Schaffer (1989) also presents a game-theoretic model where the centre is unable to
make credible commitments to the enterprise. Unlike Kornai’s SBC where the paternalism
of the state is known, it is possible, under imperfect information, for the state to build a
reputation for toughness and, in doing so, is able to impose hard budget constraints on the
enterprise.
3 A useful taxonomy for classifying SBC models, in the context of ex ante and ex post
(in)efficiencies, is outlined in Mitchell (2000). This includes the SBC model based on bank or
creditor passivity (Mitchell 1998).
Transition, Taxation and the State
6
the case of arbitrary pricing) or to decline in importance (in the case of budgetary
subsidies). As transition progressed, banks and trade suppliers imposed hard budget
constraints on firms and customers by insisting on payment, and, in the case of late or
non-payment, refusing to extend new flows of finance to delinquent firms (Schaffer
1998). These firms, often loss-making or unviable, managed to stay afloat by

extracting new forms of assistance, either from their workforce (in the form of wage
arrears), from utilities (in the form of payment delays or non-cash payments), or,
more commonly, from the state (in the form of tax and social security contributions
arrears). In the case where the SBC manifests itself in the form of inter-enterprise
arrears or overdue payables to banks, the source of the budget softness is frequently
the state. In the case of the former, firms accumulate trade credit arrears in anticipation
of a general government bailout (for example, by means of a clearing scheme). In
the case of the latter, banks with large non-performing loans (to non-viable and/or
favoured firms) are often state-owned or subject to political interference or operate
under a SBC regime i.e. insolvent banks expect a bailout by government.
This perception of government is particularly true in some of the FSU republics
where the state is often viewed as the softest creditor; a perception that is tolerated
and sometimes even instigated by the state itself. These forms of budget softness
were also evident in CEE countries but have diminished as transition has progressed.
As the state, through its tax system, appears to be the main source, and instrument,
of budget softness, this monograph addresses the issue of state governance with
respect to taxation and, in particular, the problems of tax discipline and collection.
The motivation for focusing on taxation and tax collection stems from observing the
general decline in tax revenues witnessed by the majority of ex-socialist countries
since the start of transition with a view to providing, from the perspective of the tax
collector (i.e. the state) as opposed to the taxpayer (i.e. for our purposes, the enterprise)
or the general economic environment (i.e. the transition setting), an explanation for
revenue erosion. In the wider context of the SBC, it is the government-firm relation
that is of interest here, with government acting as the supporting organisation or
funding source and the firm acting as the budget constraint organisation. Other
relations where the SBC is evident include government-government (Wildasin
1997), government-bank (Mitchell 1998) and bank-firm (Dewatripont and Maskin
1995).
In trying to identify evidence of budget softness, researchers encounter
endogeneity and causality problems when examining the relationship between the

financial position of a firm (usually gauged by some measure of profitability) and
its rescue (usually measured by some form of financial aid). Although we encounter
the same measurement problems when investigating the various channels of budget
softness, we then proceed to focus on the more general matter of tax discipline,
compliance and collection. Tax collection problems can arise for a number of
reasons, including budget softness (Chapter Three) but also because of a general
poor payments discipline (Chapter Four), ineffective tax administration (Chapter
Five) or because of low tax capacity and effort arising from economic and non-
economic factors (Chapter Six).
Introduction
7
1.4 Soft Taxation in Transition Countries
An important feature of the evolving state-enterprise relationship in TEs is the
tax system. The transition to a market economy involved replacing the old system
(dominated by the turnover tax and transfers from state enterprises) with a tax
system more in line with market economies. On a practical level, this involved the
introduction of Western-type corporate and personal income taxes, a value-added tax
(VAT) and improving tax administration. On a higher level, it involved detaching the
enterprise sector from the state. This has proven more difficult than expected (EBRD
1999). As a result, tax arrears, poor tax collection and revenue erosion were common
in many of the transition countries during the first decade.
Table 1.1, where the tax/GDP ratios are reported for the transition countries
of Central and Eastern Europe and the former Soviet Union, shows the general
decline in tax revenues. This fall in tax revenues is particularly true of the
laggard reformers (Bulgaria, Romania and Russia for example) – as opposed to
the rapid reformers (Czech Republic, Estonia and Poland for example) or those
Table 1.1 Tax Revenue/GDP Ratios, 1989-1998
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Albania 42.2 26.7 16.4 18.1 19.1 17.7 15.3 13.5 15.9
Bulgaria 43.0 37.7 33.1 28.9 31.8 29.3 26.5 26.6 30.6

Croatia 40.1 41.4 41.5 40.3 43.5
Czech Republic 38.8 41.2 40.3 39.7 38.8 38.0 36.9
Hungary 46.6 47.9 45.6 45.2 42.9 41.9 43.5 42.9 41.2
FYR Macedonia 41.9 38.8 37.9 36.1 34.4
Poland 35.4 36.5 39.1 39.6 38.7 38.3 37.5 35
Romania 35.8 36.2 34.2 31.5 28.3 28.9 27.1 28.0 28.2
Slovak Republic 39.4 36.5 38.8 42.0 41.1 38.4 37.2
Slovenia 41.7 42.9 42.6 42.3 41.3 40.4 41.2
Average (CEE)
a

41.9 36.8 35.7 35.4 36.5 36.1 35.1 34.2 34.4
Armenia 20.5 13.1 13.1 12.7 12.9 16.3 16.9
Azerbaijan 31.1 33.2 16.9 10.4 14.2 17.0 15.0
Belarus 45.3 39.0 38.6 43.2 43.7
Estonia 30.8 36.5 38.8 37.8 37.1 37.1 37.1
Georgia 8.2 2.0 4.6 5.4 10.9 13.0 13.4
Kazakhstan 21.5 16.7 12.3 11.0 11.3 12.2 16.2
Kyrgyzstan 14.6 14.8 13.6 15.0 13.2 12.5 14.4
Latvia 36.1 36.1 35.1 33.7 34.8 34.3
Lithuania 30.3 27.8 31.4 31.6 28.8 32.0 32.9
Moldova 20.8 21.1 26.4 28.8 27.4 29.9 29.0
Russia 35.9 31.7 30.9 28.3 28.3 29.3 29.2
Tajikistan
b
40.6 12.8 11.7 13.3 11.7
Turkmenistan 16.4 19.2 14.4 20.8 16.2
Ukraine 41.6 41.1 39.1 34.8 34.7 35.6 31.8
Uzbekistan 26.4 28.4 23.3 27.7 32.3 27.7 29.4
Average (FSU)

a
38.5
c
25.6 25.2 25.9 23.3 23.3 25 24.7
Notes: a. Unweighted average. b. The data for 1995 are from 11 May–31 Dec. c. Estimate of
tax revenue/GDP ratio for the USSR.
Source: OECD 1991; Tanzi and Tsibouris 2000; Author’s calculations.
Transition, Taxation and the State
8
countries that have not started or have delayed reforms (Belarus and Uzbekistan for
example) – where the state has proven either too weak or too corrupt to collect taxes,
to enforce the laws governing taxation and to resist the demands of vested interests
and well-connected firms.
4
Mitra and Stern (2003) observe a ‘U-shaped’ (a decline
followed by a recovery) trend in tax revenues over the transition period. This is true
when we examine transition beyond the first half dozen years and it is particularly
evident in the advanced transition countries, of which many managed to halt the
decline in the tax ratio and, in some cases (Estonia and Slovenia for example), even
reverse the trend. This pickup in tax revenues should not be surprising given the
recovery in national output and the improvement in the administrative capacity of
the tax systems. This book purports to address the earlier period in transition when a
decline in tax revenue was predicted but the extent, and the cross-country variation,
of the actual decline was both dramatic and surprising (Cheasty 1996).
We use the SBC framework to conceptualise the tax collection problems.
The empirical evidence on the SBC indicates that the tax system is a mechanism
commonly used by which the budget constraint of firms can be softened. In particular,
late, non-cash, or non-payment of tax liabilities by loss-making firms (although not
exclusively as tax arrears of high profile profitable firms in Russia and elsewhere
are not uncommon) suggests that the hardening of budget constraints, expected in

transition countries in the 1990s, did not fully materialise (Kornai 2001).
We begin by looking at taxation in the context of the transition from a planned
to a market economy. Under the socialist system, high tax shares of GDP were
common; tax ratios in excess of 50 per cent of GDP were not unheard of. As the
transition process accelerated, many of these countries witnessed a dramatic decline
in the tax/GDP ratio. Russia, with late, non- and in-kind payments of tax evident
during the 1990s, is an appropriate setting within which to begin our analysis.
5
We
then examine the role of taxation in the context of the SBC. In particular, we apply
appropriate (in some cases, modified) methodologies to new data for the TEs with
the purpose of revealing incidences of budget softness (or hardness) and, more
generally, measuring the degree to which the enterprise sector in TEs is not tax
compliant. Tax collection problems, either arising from economic, administrative or
political factors, are investigated in the context of transition. Our evidence indicates
that cross country differences are not small, state control matters and, for many
transition countries, tax administration and political constraints, as opposed to tax
design and economic constraints, are more pressing problems.
In Chapter Two we set out to assess the problems of taxation in the context
of the Russian State, its relationship with the enterprise sector and the transition
from plan to market. It is argued that Russia’s well-known tax collection problem
is a manifestation of an ineffective and poorly governed state, supported by weak
institutions. Central to this problem is the symbiosis of politics and economics that
4 The other set of TEs where tax revenues plummeted were the countries involved in
war and internal strife (Azerbaijan, Georgia and Tajikistan for example).
5 In this book, the term ‘Russia’ is used for the ‘Russian Federation’.