Communist countries in Europe developed large planning bureaucracies and the infrastructure needed to confirm and force compliance with plans. Yet, bureaucracies are not entirely fungible. These systems proved unnecessary in the new capitalist economy. However, a capitalist economy does require one bureaucracy that is not needed, at least not in anything like its usual form, in a communist economy, namely a tax system. The ex-communist countries struggled to develop new tax systems and the ones they built varied.
New Fiscal Systems
For all their central planning capacity, ex-communist countries often struggled to collect taxes, especially from the incomes of ordinary people and small businesses. At least on the scale now required, this was a novel challenge unfamiliar to formerly communist governments. Not helping matters, central governments were weakened as economic power became more widely distributed. In any case, these governments never built substantial systems for extracting tax revenues from private incomes because this was largely unnecessary in a communist system. Since almost all income went to the state first, and there were hardly any private incomes to tax, the ability to measure incomes and tax them was never well-developed.
To the extent they existed, taxes in socialist economies also served a different purpose. Rather than raise revenues as their primary objective, taxes merely corrected for surpluses or deficits that arose due to arbitrarily set prices. When central planners raised wages or input prices for a manufactured product, taxes would be reduced on that firm to maintain stability in consumer prices. The reverse would happen if input prices were set too low.
So, to some extent, taxation in communist economies consisted of redistributing the earnings of state enterprises, which was often an exercise characterized by case-by-case bargaining, rather than the application of a consistent and efficient set of tax rules. Developing and enforcing the latter would not be straightforward.
During the communist period, firms were required to remit the vast majority of their surpluses back to the state. Only a small part might be retained to fund investment or repay debts. Thus, taxes on firm profits in communist Poland were in the region of 75-80% for example, and this level was by no means unusual. By contrast, tax collections from ordinary people were minor in communist economies. All of this illustrates the fundamental differences in taxation between capitalist and communist systems; a tax system built for the latter is of little use in the former.
Common Challenges
The outcomes of communist countries in their transition to capitalism were varied. Their histories have unique aspects but many of these countries faced common challenges. One was a weak revenue base in the early years of transition. The private incomes of firms and workers were depressed. Indeed, not only was the economy struggling but private incomes comprised a small share of total incomes; much of the latter still remained in the hands of struggling state-owned firms. High inflation, as price controls were lifted in the transition to capitalism, also eroded the potential tax burden people could bear. Protective trade barriers came down and state subsidies were eliminated, shrinking certain types of industrial production, further damaging the incomes available to be taxed.
Russia
Russia famously experienced a deep recession and encountered fiscal difficulties in the 1990s. Shedding responsibility for managing the entire economy was not enough to bring the Russian state budget into balance. Indeed, amidst economic difficulties, public spending between 1989 and 1995 declined only modestly as a share of GDP and still comprised 43% of GDP in 1995.
To fund this spending, Russia relied on its most profitable industries. Commodity exports and the earnings of large corporations made up a large share of the country’s potential tax base; its fairly impoverished households contributed little by comparison. Indeed, the personal income tax delivered the Russian state almost none of its tax revenues in the early to mid-1990s. The fuel and pipeline sector, by contrast, contributed more than a quarter of tax revenue in 1997.
Taxes on firm revenues and profits contributed nearly two-thirds of Russian public revenues in the late-1980s and early-90s. Large firms, particularly those exporting commodities, came to be relied on to provide tax revenue rather than workers and households which the Russian state largely overlooked in its early transition years. Considering the concentrated nature of numerous Russian industries, this meant that a shockingly large fraction of state revenues came from a few taxpayers. In fact, by the mid-90s, the twenty most profitable corporations alone provided two-thirds of central government tax revenues.
Russia’s post-transition economy remained characterized by large firms. Even in 2001, small businesses contributed just 10% of total employment in Russia; compare this to 44% in Poland. It was also easy for small firms to evade taxes as compared to larger firms, contributing further to the reliance on the latter.
When the Russian state encountered fiscal trouble in the 1990s, tax authorities were empowered to combat noncompliance but focused their efforts on large firms. Small businesses and individuals went undertaxed. For example, the retail trade, which was comprised of a multitude of small businesses, contributed only 7% of tax revenue in Russia despite comprising 18% of GDP.
Extracting taxes from large firms was usually an exercise in bargaining; negotiation with large firms drove the development of Russia’s tax system. Negotiations with regional governments were also notable. There was frequent squabbling between the central government and regional governments as to the right to certain revenues. The latter relied on large corporates too; the government of Samara Oblast received 25% of its budget revenues from one company, Yukos Oil.
The competition for revenues was aggressive. In the early-90s, some regions withheld certain tax revenues they were responsible for collecting from the central government. Also, the employees of tax authorities reliant on regional governments for housing, wages, and other benefits often colluded with the regions to keep tax revenues there. The government had to reach deals with each region as to the division of revenues; these created inconsistent splits in certain tax revenues between the central and regional government.
In the 1990s, a deep depression deteriorated Russia’s fiscal capacity further. Tax revenues fell from 30% to 25% of GDP between 1992 and 1993 while GDP itself contracted by more than 20%. New agreements were reached with major tax-paying firms and these provided some relief to the government; the budget deficit was reduced in 1995. Yet, Russia would encounter new problems in 1997-98 as commodity prices fell and the tax system relied on far too narrow a base of taxpayers. This caused the government to default on its debts.
Poland
Just as in Russia, a new tax system also needed to be devised to support a large state in Poland. Despite austerity measures, public spending in Poland actually rose from 47% of GDP in 1989 to 50% in 1995. That said, Russia’s fiscal evolution was not in every respect representative of the entire ex-communist world. For one, commodity extraction was less important in Poland. Poland’s tax base was also somewhat more diverse. At the start of Poland’s transition away from communism, 7,800 state-owned firms may have accounted for 80% of tax revenues but the small firm or farm was still fiscally relevant in Poland to a greater extent than in Russia.
That said, the large base of taxpayers did not necessarily prompt consistent treatment of taxable incomes. The system of corporate taxation in Poland was convoluted. There were so many adjustments in the calculation of taxable income that seemed to favor or disfavor various industries that the system more-or-less amounted to an exercise in bargaining over taxes on a case-by-case basis. This was a reflection of the old role of taxes on firms in socialist economies.
In Poland though, workers also were relied on to provide tax revenues to a greater degree. From 1% in 1990, the share of tax revenue raised by means of personal income taxes grew to 25% in 1993; that year, personal income taxes still comprised just 1% of tax revenues in Russia. That said, the introduction of these taxes in a struggling economy was not straightforward. Negotiations with trade unions drove some of the development of the Polish tax system and the politically-active trade unions fought hard to limit personal taxation that the Polish state was desperate for.
Settlements were reached with unions but amidst a deep recession, tax revenues fell from 28% of GDP in 1990 to 23% in 1991. A peculiar new income tax was introduced, called the ‘popiwek’; it was a tax on wage increases for workers that exceeded a certain threshold. The tax constituted an attempt to limit inflation, limit high wage demands by workers, and raise new revenues. This very targeted tax made up 7.8% of tax revenues in 1991.
Despite all this progress, problems remained. Direct taxation of the public prompted numerous strikes in 1990-91 and tax avoidance was routine; although the popiwek was to be withheld by employers, many firms disregarded the tax. Starting from 1993, the Polish state began to negotiate a reduction in overdue popiwek with many firms, penalties for noncompliance were reduced, and the tax was gradually phased out altogether. Yet, this accompanied progress. Though the popiwek was eliminated in 1994, in its place came a more conventional income tax on personal incomes; the tax base was broadening. By 1996, sixteen million tax returns were filed in Poland; by contrast, in Russia, a far larger country, not until 2000 would the number of tax returns reach even ten million.
Lesson
Developing a tax system is no simple task. Some taxes can be quite complicated to collect. An income tax requires a means of verifying income and a fair bit of cooperation from a large group of people. Popular opposition is to be expected of course. Yet, Poland set out to build a tax system where a tax on personal incomes raised a large fraction of the state’s revenues. This was a response to the relative lack of natural resources in the country, rendering taxes on export commodities and the firms that extract them, insufficient. In contrast, Russia built a very different system suitable to its own circumstances.
More from the Tontine Coffee-House
Read about the re-emergence of a market economy in various countries, from banking in Poland and stock and bond markets in Hungary to insurance in China. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.
Further Reading
1. Easter, Gerald M. “Politics of Revenue Extraction in Post-Communist States: Poland and Russia Compared.” Politics & Society, vol. 30, no. 4, Dec. 2002, pp. 599–627.
2. Gandhi, Ved P., and Dubravko Mihaljek. “Scope for Reform of Socialist Tax Systems.” Fiscal Policies in Economies in Transition Fiscal Policies in Economies in Transition, 1994.
3. Gehlbach, Scott. Representation Through Taxation Revenue, Politics, and Development in Postcommunist States. Cambridge University Press, 2008.
External links to recommended reading are affiliate links. When you click on links to various merchants posted here and make a purchase, this will result in The Tontine Coffee-House earning a commission.
Consider Subscribing:
Mert Ceylan