How to do it: Lessons from successful liberal reforms in CEE Edited by:

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How to do it:
Lessons from successful liberal
reforms in CEE
Edited by:
Remigijus Šimašius (LFMI)
Ulrich Niemann (FNF)
Estonian Free
Society Institute
How to do it:
Lessons from successfuL LiberaL reforms
in cee
Edited by:
Remigijus Šimašius (LFMI)
Ulrich Niemann (FNF)
Content
THE ROAD TO REFORM AND SUCCESS
5
Ulrich Niemann
FNF Regional Office for CEE, Sofia
THE AUTHORS
10
LIBERALISM UNDER THREAT
14
Siim Kallas
European Commission, Brussels
VOUCHER PRIVATIZATION
17
Jirˇí Schwarz
Liberal Institute, Prague
MONEY THAT BELONGS TO THE PEOPLE:28
THE SUCCESS OF LITHUANIAN MONETARY REFORM
Rùta Vainienè
Lithuanian Free Market Institute, Vilnius
including
THE CURRENCY BOARD ARRANGEMENT IN BULGARIA
Dimitar Chobanov
Institute for Market Economics, Sofia
THE GLOBAL TAX RACE AND ESTONIAN
CORPORATE TAX REFORM
44
Andres Arrak
Estonian Free Society Institute, Tallin
including
CORPORATE TAX REFORM IN BULGARIa
Veliko Dimitrov
Institute for Market Economics, Sofia
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How to do it: Lessons from successful liberal reforms in CEE
How to do it: Lessons from successful liberal reforms in CEE
| THE FLAT TAX REFORM IN SLOVAKIA
58
Ján Oravec
Hayek Foundation, Bratislava
THE ROAD TO REFORM AND SUCCESS
Ulrich Niemann
THE DEVELOPMENT OF E-GOVERNMENT AND the reforms
WHICH MADE IT POSSIBLE: THE CASE OF ESTONIA
77
Jüri Saar
Estonian Free Society Institute, Tallinn
PUBLIC FINANCE REFORM IN BULGARIA
88
Adriana Mladenova and Dimitar Chobanov
Institute for Market Economics, Sofia
FNF Regional Office for CEE, Sofia
Two decades ago, the people in the CEE/CA region lived under communist regimes. Their
countries were bankrupt and famished. Their citizens had to deal with empty store shelves,
they were denied the right to a passport, and a formidable communist secret service spied
on their private lives (Mungiu-Pippidi 2007). Twenty years later, a short time by a historical
perspective, the people in many of these countries had succeeded in establishing democracies and free-market economies. A complete ideological, political, economic, and social
system had just dissolved and a large part of the world, with some 400 million inhabitants,
was to choose a new form in every regard, even including what shapes their countries
should divide up into. This was one of the greatest revolutions the world has ever seen, and
it was a liberal revolution in the classic, European sense. The initiative was seized by liberal
revolutionaries, who hoped for a “normal society” and a “return to Europe”. These radical
reformers demanded the opposite of the petrified, state-dominated system. Communist
dictatorships had to give way to democracy, pluralism, and individual freedom, replacing
vertical state commands with horizontal market signals, and public ownership with private
property (Aslund 2003).
Since 1989, the FNF has strongly supported this continuous transformation of the politics
and economics of the region’s now 26 countries. Currently, the goals of our regional work
are:
• to give effective support to the integration of the new EU member states and the accession countries,
• to spread liberal ideas and concepts through all areas of politics, thereby strengthening
civil societies,
• to develop regional networks of liberal parties, foundations and think tanks
• and to provide a return flow of innovations and liberal reform concepts to the old member states of the EU and beyond.
The region’s experience shows that rapid macro-economic stabilisation and liberalisation,
as well as privatisation via transparent, fair and clear laws, not only helped the sustainable
development of the national economy but even promoted the creation of new and better
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How to do it: Lessons from successful liberal reforms in CEE
How to do it: Lessons from successful liberal reforms in CEE
| institutions, e.g. an independent judiciary system, an important guarantor of private property rights (Havrylyshyn, CATO Institute 2007).
Index of Economic Freedom in CEE/CA
Index of
Economic FreedomI
Economic Freedom of
the WorldII
Global Competitiveness
IndexIII
These quick, comprehensive reforms made it possible for the region’s countries to promptly
overcome their post-communist recessions while also achieving better, sustainable economic development, as indicated by higher growth rates and increased foreign investments
(Economic Freedom of the World, 2007 Annual report). The positive transition experience
of these countries, which were determined to reform their systems, is an example for the
entire region and beyond. In this way, the fundamental truths of liberal convictions are
again visible: a functioning economy needs the disciplining effect of competition and the
protection of legal rights. Under these conditions, a free-market economy produces social
benefits such as lower prices, higher productivity, more jobs and rising incomes. A country’s
economic and social development depends above all on its policies, i.e., on the population’s
and political leadership’s will for change. Economic and social success or failure is largely
decided by policies, not the country’s geography, scientific expertise, religion or culture. And
a country’s size need not be an obstacle; large countries can reform just as well as small
countries can (Munkhammar 2007).
TrendIV 2004 - 2008
TrendV 2003-2007
Trend 2006-2008
Although the attached table shows growing economic freedom in many countries in the
region, the transformation process and liberal reforms are far from complete. And change
always finds resistance among many voters, special interests, civil servants and political
opponents (Munkhammar 2007).
Country –
alphabetically
arranged
new EU-MS
Bulgaria
0
+++
0
Estonia
0
+
-
Latvia
0
+
0
Lithuania
0
++
0
Poland
0
+
0
Romania
++
+++
0
Slovakia
0
++
0
Slovenia
0
0
0
Czech Rep.
0
0
0
Hungary
0
+
0
The Balkans
Albania
0
0
0
Bosnia and
Herzegovina
+
n/A
0
Croatia
0
0
0
Macedonia
0
n/A
0
Montenegro
n/A
n/A
n/A
Serbia
n/A
n/A
0
Southern Caucasus
Armenia
0
n/A
0
Azerbaijan
0
n/A
0
Georgia
++
n/A
0
Eastern Europe
Belarus
0
n/A
n/A
Moldova
0
n/A
0
Russia
0
+
0
Ukraine
0
++++
0
Central Asia
Kazakhstan
++
n/A
0
Kyrgyzstan
0
n/A
0
Tajikistan
+
n/A
0
Turkmenistan
+
n/A
n/A
Uzbekistan
++
n/A
n/A
IThe Heritage Foundation’s Index of Economic Freedom measures: Business Freedom, Trade Freedom, Fiscal
Freedom, Government Size, Monetary Freedom, Investment Freedom, Financial Freedom, Property Rights,
Freedom from Corruption, Labour Freedom. Each one of these 10 Freedoms is graded using a scale from 0
to 100, where 100 represents the maximum freedom.
Meeting of the authors in Sofia, June 2008 (Photo: Elena Dimitrova)
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How to do it: Lessons from successful liberal reforms in CEE
IIThe Economic Freedom of the World Index (published by the Fraser Institute) evaluates: Size of Government: Expenditure, Taxes and Enterprises; Legal Structure and Security of Property Rights, Access to Sound
Money; Freedom to Trade Internationally; Regulation of Credit, Labour and Business.
How to do it: Lessons from successful liberal reforms in CEE
| Furthermore, political volatility and the population’s diminished confidence in the political
process has often encouraged accusations that free market reforms are unsuccessful and
that they increase social inequality. These accusations have made elected governments
stop or even reverse reforms. Decreases in production and growth in the mid-1990’s, more
severe than expected in some countries, created extreme social difficulties and resulted in
disappointment and disillusionment with the economic transition process. Since the costs
and benefits of reforms are both uncertain, and the reform process takes time, the fear of
incurring losses is from reform is different ex post and ex ante. This creates a bias in favour of the ex ante status quo and increases resistance to change (Debroy 2008). However
reforms that have proven to be controversial when launched (ex ante) have usually gained
general acceptance afterwards (ex post) (Munkhammar 2007).
Therefore it is important to generate bottom-up demand for reforms, rather than simply
supply them from the top-down. The advocacy, dissemination, timing and sequencing of
reform are all critical factors (Debroy 2008). The two processes, the development of a liberal democracy and the liberalisation of markets, strengthen each other. More liberty means
more innovations and more prosperity for all citizens. On the other hand, the legitimacy of a
parliamentary system comes under pressure if reforms are not completed. Any political elite
interested in reform should find the right way of implementing this model.
References
Aslund, Anders 2003: Building Capitalism, The Transformation of the Former Soviet Bloc,
Cambridge University Press, New York.
Debroy, Bibek 2008: Handbook of Transformation to Market Economy, Ideas on Liberty
Vol. 7, liberal Verlag, Berlin.
Economic Freedom of the World: 2008 Annual Report, Economic Freedom Network.
Havrylyshyn, Oleh 2007: Fifteen Years of Transformation in the Post-Communist World,
Rapid Reformers Outperformed Gradualists, CATO Institute, Development Policy Analysis,
No. 4, November 9, 2007.
Mungui-Pippidi, Alina 2007: EU Accession is no “End of History”, Journal of Democracy,
Vol. 18, November 4, October 2007.
Munkhammar, Johnny 2007: The Guide to Reform, How Policymakers can Pursue Real
Change, Achieve Great Results and Win Re-election, Timbro, Stockholm.
This publication should encourage all reform-minded readers by not only introducing examples of successful liberal market reforms but also by giving them practical insights about
how these reforms were achieved. To our readers we would like to send out the message: Let
us make this publication a never ending success story – there are more stories to be told.
On behalf of FNF I would like to thank our authors – all of them tireless advocates of the
liberal course – for their contributions. And I am especially grateful to our expert adviser
and coeditor Remigijus Šimašius, President of the Lithuanian Free Market Institute. Finally
I would like to express further gratitude to Elena Dimitrova, Csilla Hatvany and Thomas
Wilbur for their valuable work and support to accomplish this first publication. This job has
been done – but new work is hopefully waiting for us in the future.
Sofia, November 2008
III The Global Competitiveness Index, published by the World Economic Forum (WEF) measures Productivity
and Competitiveness of Institutions, Infrastructure, Macroeconomy, Health and Primary Education, Higher
Education and Training, Market Efficiency, Technological Readiness, Business Development and Innovation.
Prior to the 2006 year’s report, the WEF relied on a Growth Competitiveness Index.
IVIf the difference in score between the 2003 index and the 2008 index is at least 5, an improvement (+) or
decrease (-) is indicated. If the difference is 10 or greater, this is noted as a major change.
VThe trend, published in 2003 – 2007, corresponds to the measurement period of 2001 – 2005.
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How to do it: Lessons from successful liberal reforms in CEE
How to do it: Lessons from successful liberal reforms in CEE
| The Authors
Andres Arrak, is the Head of the Institute of Entrepreneurship at Mainor Business School in Tallinn, Estonia. He is
a lawyer by training but mostly known as a liberal economist, coauthor and editor of seven textbooks and numerous
articles. Mr. Arrak is a founding member of the Estonian Free
Society Institute as well as member of the Advisory Council
to the Estonian Ministry of Finance.
Estonian Free Society Institute
Dimitar Chobanov, is Chief Economist at the Institute
for Market Economics. He specializes in the area of public
finance, monetary policy and cost – benefit analysis. He is a
Ph.D. student in International Economics and is a coauthor
of an International Monetary Fund discussion paper. He is
currently an Assistant Professor at University for National
and World Economy in Bulgaria. He is the editor of the IME
weekly bulletin.
www.ime.bg
Veliko Dimitrov, is currently Senior Economist at the Institute for Market Economics, Bulgaria. His main spheres of
specialization include improvement of national legislation
process, labour market simplification, reduction of administrative burdens, deregulation of economic activity, telecommunications sector regulation peculiarities and cost-benefit
analysis. He is a member of the Bulgarian Macroeconomic
Association and the Council for Public Consultations at the
European Affairs Committee of the Bulgarian Parliament.
www.ime.bg
10 |
How to do it: Lessons from successful liberal reforms in CEE
Siim Kallas, has served in Estonia as Prime Minister, Minister of Finance, Minister of Foreign Affairs and President of
the Central Bank. He also held the position of the Chairman
of the Estonian Reform Party since the party’s creation in
1994 until November 2004, after which he became the Honorary Chairman of the party. In May 2004, Mr. Kallas was
appointed a Member of the European Commission, working
in the field of Economic and Monetary Affairs. Since November 2004, he is Vice-President of the European Commission
in charge of Administration, Audit and Anti-fraud.
Adriana Mladenova, is currently Senior Economist at
the Institute for Market Economics, Bulgaria. She has a Master degree in Finance from the University of Sofia. Her professional expertise includes pension reform and fiscal policy
analysis. She is an author of a number of articles in Bulgarian dailies and magazines and a columnist in the weekly
edition of the IME bulletin Economic Policy Review.
www.ime.bg
Ulrich Niemann, is Head of the Regional Office for Central, East and Southeast Europe, South Caucasus and Central
Asia of the Friedrich Naumann Foundation for Liberty (FNF)
in Sofia, Bulgaria. He is an economist by training and worked
previously as FNF‘s Representative for Northeast Asia in Seoul
and is a founding member of the Management of the AsiaEurope Foundation in Singapore. Before these assignments
abroad, he held various positions in the German Federal Government and Parliament, dealing with economic policy issues, German re-unification and European affairs.
www.freiheit.org / www.msoe.fnst.org
How to do it: Lessons from successful liberal reforms in CEE
| 11
Ján Oravec, is a founding member and President of the
F. A. Hayek Foundation Bratislava and the Slovak Taxpayers
Association. He is an economic advisor, he writes articles,
gives lectures, TV interviews, and public speeches on various topics. In October 2003 he was elected President of
the Entrepreneurs Association of Slovakia. He is a member
of the presidium of The National Union of Employers, he
represents Slovak employers in the European Economic and
Social Committee, and in the Economic and Social Council
in Slovakia. Mr. Oravec is also member of the Economic
Council of the Slovak Government.
www.hayek.sk
Jüri Saar, is a freelance writer and researcher in e-government, entrepreneurship and innovation policy, currently
associated with the Estonian Free Society Institute. His previous experiences include research on public private partnerships, the reorganization of public sector organizations,
managing a business incubator, and cost-benefit analysis
for large scale infrastructure projects requiring international cooperation.
Estonian Free Society Institute
Remigijus Šimašius, is the President of the Lithuanian Free Market Institute. His public policy work includes
competition, privatization, energetics, educational reform,
NGO sector regulation. Šimašius has a PhD from the Law
University of Lithuania for the thesis on legal pluralism. He
teaches theory of law at Vilnius University and is a member
of the International Association for Philosophy of Law and
Social Philosophy.
www.freema.org / www.lrinka.lt
Rùta Vainienè, is currently working as an associated
expert at the Lithuanian Free Market Institute. She is also
Head of the Tax Competition and Budget Reform Team of
the Coalition for a Free Europe. Ms. Vainiene teaches banking, macroeconomics and public sector economics at M.
Riomerio University in Vilnius. She served as a member of
the board of the Bank of Lithuania from 1998 to 2004. Ms.
Vainiene’s expertise includes monetary and banking issues,
capital markets, privatisation, PPP, and government finance
including tax and budgetary reform.
www.freema.org / www.lrinka.lt
ˇ Schwarz, is founder and President of the Liberal InJiri
stitute in Prague, Czech Republic. He serves as Dean of the
Faculty of Economics and Public Administration at the University of Economics, Prague. He is economist by profession
focused on economics of regulation, economics of politics
and history of economic thought. He is author of numerous
articles and two books: In Plea for a Liberal Order (2003)
and In Plea for a Real Transition (2004).
www.libinst.cz
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How to do it: Lessons from successful liberal reforms in CEE
How to do it: Lessons from successful liberal reforms in CEE
| 13
LIBERALISM UNDER THREAT
Siim Kallas
European Commission, Brussels
Democracy, freedom and the principles of economic openness that underpin the free market economy are the basis of our civil liberties and economic prosperity. They also form the
cornerstones of modern European civilisation. These values are enshrined in the Treaties of
the European Union and have been brought to life through these four freedoms: the free
movement of goods, of services, of people and of capital. The successful export of these
freedoms has turned the European Union into one of the most important liberal political
projects in history.
Unfortunately, at the start of the twenty-first century all four freedoms are subject to new
pressures. Red tape hinders the free movement of workers. The internal European capital
market is incomplete and the free movement of services is increasingly under threat from
economic nationalism. Opponents of the Services Directive, which the European Commission proposed in 2004, re-named it the “Frankenstein Directive”.
The threat is not just economic; it can be violent and ideological. Fundamentalists try to
achieve their goals by spreading fear, as they did with the terrorist attacks in Madrid and
London. This strategy of terrorism puts European democracies under intense pressure. It
leaves societies struggling to balance the free movement of persons with the protection of
civil liberties. The terrorists’ goal is to force democracies to abolish freedom altogether so
that they can declare the superiority of their own, perverted viewpoint.
As a rule, Liberals are the first to identify this ruse of sacrificing civil liberties for security.
Liberals instinctively oppose attempts to impose authoritarian rule and limit fundamental
freedoms. They understand that more security for our societies must not come at an unacceptable price in lost liberty for our citizens.
Can Liberalism make a Comeback?
So the essential liberal nature of Europe faces challenges from both religious fundamentalism and economic protection. There is a need to give European integration a new liberal
sense of direction and confidence. There is a lot of talk about the ‘social model of Europe’
and the need to provide ‘solidarity’. Few are against these principles. Liberals support them
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How to do it: Lessons from successful liberal reforms in CEE
because they are the basis of a sound and thriving democracy. But Europe has to earn the
means to sustain its social models. Strong social models need strong economies to pay their
way.
Europe needs more growth for more employment and more employment for stronger societies. Nowhere is this truer than in the services sector. The services sector is the largest
and fastest growing part of the European economy. It provides innovation, employment,
growth and – increasingly - exports. However, the services sector in Europe is still split into
27 national parts and cannot exploit the advantages of operating on a pan-European scale.
Protectionists want to keep it this way. They want to keep the ‘Polish plumber’ in Poland in
order to safeguard social privileges at home. This kind of protectionism undermines sound,
productive employment and goes against consumer interests. It reflects a narrow minded
self-interest that serves not an economy or a society, but the interests of a small clique of
insiders against outsiders.
In his introductory speech in the European Parliament on 10 July 2008, President Sarkozy
declared that he wanted to get rid of the ‚Polish plumber‘ image. He said that France will
open its labour market for all European workers. This is the only choice for economic modernisation.
A more focussed EU
To reestablish the four freedoms of goods, services, people and capital, the European Union
has to be more selective in what it is doing. Often the European Union does too many things
at the same time because it has too many good causes. The more things the EU tries to do,
the less able it is to perform its core tasks.
One of the messages which came out from the vote on the European Constitution in France,
the Netherlands and Ireland was that people do not want the EU micromanaging their lives.
Subsidiarity has to be a much greater guiding principle. In the past, the EU has too often
regulated through detailed proposals that attempt to harmonise all aspects of laws. Often,
‘mutual recognition’ is a much better principle to achieve a level playing field. Today, the
Commission is looking at all its proposals with a fresh eye and will scrap proposals which
are deemed unnecessary. It should deregulate wherever possible.
Europeans did not reject the European Constitution because they are against Europe. While
the Irish voted No, recent Eurobarometer polls show that Ireland is the most pro-European member state. It also shows that Europeans overall have a greater trust in European
Institutions and European policies than in their national governments and national policy.
European citizens simply fear a Europe that is too big, too intrusive, and too opaque. They
demand an accountable and transparent Europe. That is why the Commission has launched
How to do it: Lessons from successful liberal reforms in CEE
| 15
the ‘European Transparency Initiative’ which aims to increase transparency throughout the
European institutions. Citizens have a right to know what Europe does with taxpayers’ money. Who gets money from the Common Agricultural Policy or the Structural Funds? They
have a right to know.
VOUCHER PRIVATIZATION
Jirˇí Schwarz
Liberal Institute, Prague
Formerly, Member States did not have to disclose information on the amounts received by
beneficiaries of programs like the Common Agricultural Policy. Now citizens will be able to
look on the internet and see how their money is spent. The Commission also proposed to
improve ‘common ethical standards’ in the European Institutions. When citizens are assured
that Europe is subject to high ethical standards, the credibility of European Institutions can
only increase. Citizens may also monitor the activities of lobbyists and NGO’s through the
recently opened voluntary register, in which all lobbyists must provide full financial disclosure.
More than ever, we need to defend the four freedoms of goods, services, people and capital.
They are not only the four guiding principles of the European Treaties; they are the foundation of our societies. You might say that they face four dangers: protectionism, terrorism,
overregulation and lack of transparency. Renewing our commitment to these four freedoms
is crucial. Shaping policies that strengthen them is our task. Our ideal is freedom. We do
not need to re-invent the wheel. We just have to make clear what freedom stands for and
then fight for it.
Voucher Privatisation as a Second Best Solution
Privatization was an inevitable and key step in the process of Czech economic transition
from an Orwellian command economy to a market economy1. There was no alternative
because the Czech economy under the Communist regime was fully state-owned. Even
small services like barbershops, food service and lodging could not be owned and provided
by private persons. The functioning of such an Orwellian economy was based on perverted
incentives set by the ‘nomenklatura’ – directors appointed by the Communist party. These
directors focused on fulfilling five-year Central Plans without any regard to real demand.
State-owned companies produced specified products in volumes determined by the Central Plan. For many companies, there was no demand and hence production only increased
warehoused stock and perhaps some macroeconomic figures; a high rate of reported economic growth was an especially important argument in the Communists‘ political competition
with market economies. The zero unemployment rate caused by this inefficient “production
for production’s sake” was another argument used by Marxist ideologists to declare the
historic victory of “real socialism” over capitalism. In spite of officially zero unemployment
and a relatively high rate of economic growth, centrally planned economies were not able
to satisfy consumer demand. These Orwellian economies suffered from chronic shortages.
Restoration of a market economy from a communist one could not be realized without
a substantial change in the behaviour of economic agents. Ownership is the key criterion for responsible economic behaviour. Private ownership of the means of production is
the crucial element of an efficient market economy. Systemic change from an inefficient
communist command economy to an efficient and competitive market economy could not
be achieved without a mass transfer of vaguely defined state-owned property to real, individual owners. Many systems of privatisation were evaluated in Czechoslovakia in order
to find ones appropriate for a relatively quick transfer of a huge volume of state assets to
private owners. The privatisation methods chosen were expected to be appropriate to the
1 Price liberalisation, the de-monopolisation of foreign trade, and the internal convertibility of Czech currency were the other policy pillars of the economic transition in Czechoslovakia till 1992 and in the Czech
Republic after the country split in 1993. All these measures were realized under a regime of fiscal and
monetary austerity.
16 |
How to do it: Lessons from successful liberal reforms in CEE
How to do it: Lessons from successful liberal reforms in CEE
| 17
following particular conditions of the small, relatively closed Czech economy in transition
to a standard market economy:
1. Size of the asset transfer. The Communist government and its totalitarian institutions
controlled its citizens‘ everyday behaviour. Economic activity could be legally conducted
only under the control of the Central Planning Committee and in accordance with the
Central Plan. The economy was almost fully state-run, with only a small portion in
co-operative, i.e. quasi-state-run, ownership. The need for a systematic change in the
structure of property ownership was enormous.
2. Few foreign investors and no domestic ones. It was necessary to privatise the government sector covering almost the whole economy, excluding only households. There
were almost no domestic private investors who could bid for public assets. Demand by
foreign investors was limited and was focused on few large export companies. These
few foreign investors were problematic, asking for government subsidies in a form of
special incentives for foreign direct investments (such as tax holidays, support for employee educational training and the free provision of land and infrastructure). Czech
public finances could afford only a limited number of such FDI projects due to their
substantial financial demands.
3. Time pressure. After the collapse of the totalitarian regime in 1989 and the Communist
Party’s loss of its leading position in Czech society, the Government did not have the
appropriate political and economic tools for the efficient management of the state economy. The perverted incentives of communist managers of state-owned companies to
focus on a five year plan had disappeared. Together with the onset of political freedom
and the awakening of market incentives, the property basis of state-owned companies
started to be eroded. There was neither formal nor real control over the activities of
managers of state-owned economic entities, and the threat of theft and economic
chaos was very real. These were the most important arguments for a speedy and substantial change of the ownership structure.
and church orders. Houses, buildings and land were the mostly common assets returned.
Any substantial investments undertaken during the period of nationalized ownership had to
be repaid by the former owners. Restitution was supposed to be a tool for speeding up the
privatization process, but the opposite was often the case. Because of ownership disputes
and court trials, many restitution claims, such as by Czech churches, could not be resolved.
Such property remains under government control but its condition is frequently poor, and it
is often a target of wanton damage and robbery.
II. Small-scale privatization
‘Small-scale privatization’ meant the sale of assets to new private owners via auctions and
direct sale. This least troublesome method was used for certain buildings or land as well
as of small businesses with rental contracts, such as shops and restaurants, and other services - small factories, workshops, etc. The first auctions began in Prague in the autumn of
1990.
III. Large-scale privatization
‘Large-scale privatization’ was the sale of assets of more substantial value like medium to
large size companies, large buildings, land of significant size and/or importance. For these
asset transfers, both conventional and unconventional methods were used. The unconventional method was employed due to the great extent of the transfers. It was impossible to
use only conventional methods in an almost completely nationalized economy – the privatization process would have lasted many decades under a government without efficient tools
for appropriate property and asset management. The conventional methods included direct
sales, auctions, public tenders, etc. The unconventional method was the voucher privatization which made Czechoslovakia, and later the Czech Republic, very popular in economics
literature.
The Voucher Privatisation Procedure
Privatisation Methods
Three basic privatization methods were used in the Czech Republic for the mass transfer of
state assets to private owners in the 1990s:
Restitution
Restitution is a return of physical assets, mostly real-estate, to their former (before nationalization) proprietors. Eligible claims were restricted to Czech or Slovak citizens only, with
exceptions for institutions or legal persons like political parties, sport associations, churches,
18 |
How to do it: Lessons from successful liberal reforms in CEE
Dr. Milton Friedman, Nobel laureate in Economics, was the first scholar to propose using
vouchers for the privatization of state assets, back at the beginning of 1960s. His proposal was put into action at the beginning of the 1970s in the privatization process in
British Columbia. In the late 1980s, two Polish economists, Janusz Lewandowski and Jan
Szomburg (Lewandowski, Szomburg, 1989) proposed that this unconventional method be
used for privatising assets in command economies with predominant state ownership. The
preconditions for using vouchers in the privatisation process were present not only in the
Czech Republic and in Slovakia, but also in other ex-communist countries with command
economies. In most of these countries, the voucher privatisation plan was prepared with
intellectual and technical assistance from international economic organizations. However,
How to do it: Lessons from successful liberal reforms in CEE
| 19
changes in Government after post-communist elections prevented many of them from executing their original plans. And yet there were some other countries, like Poland, Lithuania,
Ukraine, Russia, Moldova, Romania, Bulgaria and Slovenia, in which vouchers were used for
the mass transfer of at least some state assets to private owners. The voucher privatisation
procedure differed from country to country. Czechoslovakia was the first ex-communist
country where this mass privatization method was used. The key persons responsible for
the design and execution of voucher privatisation were Václav Klaus, Dušan Trˇíska, Vladimír
Rudlovcˇák and Tomáš Ježek.2
A necessary step before the start of voucher privatisation was commercialization. Commercialization was the transformation of the legal status of each state-owned enterprise from
a “national enterprise” to a “joint-stock company”. This change in legal status enabled the
State to subsequently organize a mass exchange of State stock for investment points. Voucher privatization comprised two waves. The first wave lasted from 18 May 1992 until 31
January 1993 in both the Czech and Slovak Republics. The second wave took place between
11 April 1994 and 31 December 1994 only in the Czech Republic. The Slovak Government
after the 1992 Parliamentary elections decided not to go ahead with the prepared second
wave of voucher privatization.3
The first wave of voucher privatisation consisted of five auction rounds. Bidders were either
individual voucher holders, who had been given 1000 vouchers each, or investment companies, which had collected vouchers from some individuals. The Bidders bid vouchers in each
auctioning round for the shares offered by state-owned joint-stock companies. In the first
auction round of both waves, the price of all offered shares was the same for all joint-stock
companies. After the initial share request announcements, the sum of demanded shares
was compared with their supply for each joint-stock company. If the supply of shares of a
company exceeded or matched their demand, the shares were sold (for vouchers) to bidders. If demand for a company’s shares exceeded supply by less than 25 %, the bids were
proportionately reduced and the shares were then sold as well. If excess demand was higher
than 25%, the bids for the company’s shares were cancelled and vouchers were returned
to bidders. The Centre for Voucher Privatization listed these same shares in the following
auctioning round but at a new, higher price. The price in each subsequent round therefore
depended on several variables: the size of excess demand for a company’s shares, the total
2The current President of the Czech Republic, Václav Klaus, was then the Federal Finance Minister and later
the Prime Minister of the Czech Republic; Dušan Trˇíska and Vladimír Rudlovcˇák were Finance Minister
Deputies, with responsibilities for the design and for the execution of the voucher privatization respectively; Tomáš Ježek was Minister for the National Property Administration and its Privatization of the Czech
Republic and later Chairman of the National Property Fund of the Czech Republic.
3The Slovak Prime Minister, Vladimír Mecˇiar, preferred the more conventional privatisation methods which
allowed for more arbitrary government interventions to benefit his political supporters. Under Mecˇiar’s
Governments, the second, planned wave of voucher privatisation was replaced by privileged privatisation
sales to political supporters and other forms of corruption.
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How to do it: Lessons from successful liberal reforms in CEE
relation between supply and demand, the amount of residual, unsold shares and how far
into the auction rounds one was.
Each auctions finished when more than 90 % of the total shares had been sold. The sold
shares were registered to the successful bidders’ accounts by the Securities Centre. The
Securities Centre, fully centralized and under government control, administered the lists
of joint-stock companies and of their new shareholders. This arrangement was expected
to create user-friendly and safe conditions for fast and massive share transfers. The subsequent trading of acquired shares supported the process of ownership concentration in
joint-stock companies and confirmed these expectations.
The Role of Investment Companies
The role of investment companies during voucher privatisation was essential for attracting
Czech and Slovak citizens to participate. Aggressive advertising campaigns by investment
companies substantially increased public participation. With 8,55 million participants, the
scheme ended up about three times larger than had been expected. The unexpectedly high
participation rate caused some troubles with the registration of voucher holders. The opening hours of the registration points in Czech and Slovak cities were extended in order to
accommodate and register all those interested. Those voucher holders who decided to use
the services of an investment company had to register with their investment companies
before the first auction, during a ‘Round Zero’. Those voucher holders who transferred their
vouchers to the investment companies could not use their vouchers any more during the
two waves of voucher privatization. The investment companies had to know the amount of
vouchers at their disposal in order to selecting the appropriate investment strategy before
‘Round One’.
Investment companies could be started by private persons or by private companies as well
as by state-owned enterprises whose legal status was either a limited-liability company or a
joint-stock company. Investment companies were allowed to establish investment funds for
the first wave of voucher privatization. For the second wave, they were also allowed to establish both closed-end and open-end mutual funds. Investment companies were thus able
to accumulate vouchers before the auctions started. The huge differences in the amount of
vouchers held by different investment companies led them to select very different investment strategies.
The expected result of each voucher privatisation was a privatised joint-stock company with
an ownership structure highly dispersed due to the participation of millions of bidders. The
real ownership structure was, however, a bit different in many joint-stock companies, and
very different in others. This difference was due to the unexpectedly successful accumulation of vouchers by investment funds. Investment funds were the tools that concentrated
How to do it: Lessons from successful liberal reforms in CEE
| 21
the initial ownership of privatised joint-stock companies, thereby creating more suitable
conditions for developing corporate governance than the very dispersed share ownership by
individual voucher holders. Dispersed ownership did not provide the proper conditions for
efficient corporate governance. The efficiency of corporate governance was dependent on
the degree of the company’s stock concentration. However, it had not been an ambition of
voucher privatization to solve corporate governance issues.
Second wave
Czech
Number of voucher holders transfering their voucher to investment companies
3.96 Mio.
of which those who transferred all of their investment vouchers
3.87 Mio.
of which those transferring their vouchers to only 1 investment companies
3.46 Mio.
Unsold shares
5.7 Mio (3.7%)
Used investment vouchers by individual investment holders
2.22 Mio.
Unused
Used investment vouchers by investment and mutual funds
Unused
Voucher Privatization in Figures
First wave
0.03 Mio (1.5%)
3.90 Mio.
0.01 Mio (0.1%)
Number of shares bought by individual voucher holders
75.1 Mio.
Number of shares bought by investment and mutual funds
74.2 Mio.
Average number of shares bought for 1000 investment vouchers by individual voucher
holders
33.8
Second wave
Facts
Czech R.
Slovak R.
Czech only
Filing rooms for bidders
3492
1610
730
Registration points
458
190
328
Registered voucher holders
5.95 Mio.
2.60 Mio.
6.18 Mio.
Inv. vouchers
controlled
Investment funds
265
164
194
1.56 Mio., i.e. 40%
Mutual funds
---
---
155
2.35 Mio., i.e. 60%
of which open-end
---
---
37
0.87 Mio., i.e. 22.2%
of which closed-end
---
---
118
1.48 Mio, i.e. 37.8%
Number of state-owned joint stock
companies for privatization
943
487
784
Number of supplied shares of joint
stock companies
206 424 419 90 111 742 155 000 000
Average number of shares bought for 1000 investment vouchers by investment and
mutual funds
First wave
Czech
Slovak
Investment vouchers provided by voucher holders to investment funds
4.33 Bln.
1.81 Bln.
Investment vouchers provided by Czech voucher holders investment funds
4.30 Bln.
0.03 Bln.
Investment vouchers provided by Slovak voucher holders investments funds
0.15 Bln.
1.68 Bln.
Total supply of shares
212.5 Mio.
86.9 Mio.
of which sold
198.0 Mio.
79.8 Mio.
unsold (in %)
6,8
8,1
Used investment vouchers by individual investment holders
2.32 Mio.
Unused
0.008; i.e. 3.3%
Used investment vouchers by investment funds
6.12 Mio.
Unused
0.02; i.e. 0.3%
19.0
If successful bids have fewer unused investment vouchers, then these data prove that the
second wave was more successful for bidders than the first wave, but also more costly to
conduct because there were 6 auction rounds in the second wave compared to 5 rounds in
the first wave. This increased operating cost was compensated by savings resulting from a
more efficient organization of the whole stock transfer process. More citizens participated
in the second wave in the Czech Republic. As a result of their experience with the first wave
they had likely positive expectations. This higher participation occurred despite the fact
that much less state-owned property was set for distribution in the second wave than in
the first.
There is no indication that investment companies were more efficient with their investment
bids than individual voucher holders except that they had fewer unused vouchers, perhaps
due to their economies of scale. However, individual voucher holders were able to get almost twice as many shares for their 1 000 vouchers compared to institutional investors.
Any more robust conclusions about relative investment performance are impossible due to
a lack of relevant data.
An Economic and Political Success Story
The voucher privatisation was a success, earning high marks from international economic
institutions such as the OECD, IMF, World Bank. Corruption is almost always present in decision making processes connected with massive property transfers from government to private owners but the carefully written and smoothly implemented rules prevented arbitrary
decisions by government bureaucrats about privatized assets, their prices and their new
proprietors. Voucher privatization also cut down the time necessary for transferring state
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How to do it: Lessons from successful liberal reforms in CEE
How to do it: Lessons from successful liberal reforms in CEE
| 23
property into private hands. It shrank the period over which there was no real control of
state-owned companies, when their mismanagement was most likely. This time factor was
crucially important! Without the use of voucher privatisation, the process of transferring
state property might have lasted for decades. Extending this period when state property is
most likely to be mismanaged would have caused financial losses and economic stagnation.
Instead, the rapid start of economic transition in the Czech Republic led to a much faster
economic recovery than in other ex-communist economies such as Poland and Hungary.
The importance of public participation in the privatisation process was enormous. Voucher
privatisation was an extremely efficient tool for actively involving inhabitants in the process of social and economic transition. It also had a positive impact on the 1996 election.
Political parties who drove economic transition succeeded in the election and set up the
same coalition government as before. Thus, at that point there was no political cycle in the
Czech Republic, as opposed to most other central European ex-communist countries such
as Poland, Hungary and Slovakia.
The Positive Side Effects of Voucher Privatisation
The voucher privatisation process can be viewed as a combination of the planned, the
centralized bidding arrangements, and the spontaneous, the behaviour of individual participants. It‘s a fine example of ‘learning by doing’: learning market economics and stock
exchange operations by evaluating assets, developing price expectations and bidding in
the auctions. Voucher holders started to use and understand economic terms like supply
and demand, excess demand, and equilibrium price. The very process of privatisation in the
Czech Republic changed the microeconomic behaviour of economic agents, which in turn
had a positive impact on the economic efficiency. Macroeconomic figures between 1993
and 1996 provide persuasive evidence of macroeconomic dependence on microeconomic
changes. The rate of economic growth in the Czech Republic and Slovakia was much higher than in other Central and East European countries under transition from command to
market economies.
The changes produced by privatising companies had a positive impact on the changing
structure of the Czech economy. The misallocation of scarce resources stemming from irrational central commands started to be replaced by the market allocation of resources following managerial decisions reflecting market information. Czech imports and exports were
redirected from former Comecon4 countries to more economically natural partners capable
of paying for their goods. These changes not only stabilized Czech economic development,
4The Council for Mutual Economic Assistance, 1949 – 1991, was an economic organization of communist
states and a kind of Eastern Bloc equivalent to—but more geographically inclusive than—the European
Economic Community. The military equivalent of the Comecon was the Warsaw Pact.
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How to do it: Lessons from successful liberal reforms in CEE
but also oriented the political environment towards further changes in domestic politics
and the economy.
Rapid privatisation established the institutions needed for a market economy such as the
stock exchange. Because of the high volume of trading, not one but three competing institutions organised securities trading after the first wave of voucher privatization. Czechoslovakia became a world-leader in the percentage of shareholders to population (8,55 million
in a population of 15 million). There were two main incentives for trading the shares of
newly privatised companies; purchasers attempted to get controlling stakes while sellers
wanted to satisfy their pent-up demand for consumer durables. The latter largely enabled
the former. People were keen to buy an imported colour TV, microwave, refrigerator, or a
PC from the money they could receive from the sale of their shares from the first wave of
voucher privatisation. Demand for shares arising from a desire for a controlling stake, thus
enabling the efficient governance of a privatised joint-stock company, was extremely important. The securities markets enabled the harmonization of these different preferences of
consumers and investors.
Criticism of Voucher Privatization
Criticism of voucher privatisation by its political opponents can be summarized in two
statements:
1. Voucher privatisation did not attract the missing foreign capital necessary for the restoration and restructuring of Czech companies.
2. Voucher privatisation did not create efficient stock markets in the Czech Republic and
Slovakia.
It must be said that neither of these ambitions was a declared goal nor even achievable with
a voucher privatisation process. It is true that voucher privatization brought neither foreign
investment for company development, nor additional domestic funds for the capital market.
It must be remembered that voucher privatisation was a response to the lack of domestic
and foreign capital necessary for purchasing state assets. Finally, it should be stressed that
the essence of privatisation is a transfer of state assets into private hands. The same is true
for the voucher version of privatisation. A stock market cannot be a by-product of either
conventional or of voucher privatisation. It is a product of the assets sellers’ and bidders’
decision to institutionalize their trades in order to minimize their transaction costs.
However, there are two major criticisms which, made at the time of voucher privatisation,
represented a minority opinion but in the end were found to be valid:
How to do it: Lessons from successful liberal reforms in CEE
| 25
1. The prohibition of voucher trading. Voucher trading was not allowed in the Czech Republic and Slovakia before the exchange of vouchers for shares. This prohibition created
an illegal shadow market for voucher transfers. With it came the familiar negative consequences known from all shadow markets – imperfect information, the unnecessary
growth in transaction costs and associated deadweight costs, and diminished protection of clients from bribery. 5
2. The participation of state-owned companies as institutional investors. Many investment funds and companies were themselves created by state-owned companies, mostly
banks that took part in the voucher privatization process. State-owned companies thus
privatised other state-owned companies, yet the resulting companies were mislabelled
as private commercial companies by the Czech Commercial Code. Critics of this privatisation practice call it “privatisation through incest”.
This privatisation of each other by these state-owned companies eventually caused substantial problems. Companies owned by state-owned banks had a lower aversion to risk
due to the survival of soft budget constraints in the state sector. Bank managers undertook
inappropriately risky investment decisions thanks to their expectations of a governmental
bail-out in extremis. Similarly, investment companies affiliated with state-owned banks
were less risk averse in their lending to privatized companies in their portfolios. Moral
hazard is an appropriate term for these decisions by managers of state-owned companies.
Not only did bad credit increase company indebtedness, but the resuscitation of non-competitive companies delayed structural changes in the Czech economy. Huge subsequent
bail-outs by the Government, necessary for the privatisation of the remaining state-owned
companies including banks, prove the relevance of this criticism. State-owned companies
should not be allowed to take part in privatisation process, even in the process of voucher
privatisation!
References
Friedman, Milton 1993: Capitalism and Freedom, Liberální Institut, Praha.
Holman, Robert 2000: Czech Economy Transition, In Comparison with Other Central European Countries, Centrum pro ekonomiku a politiku, Praha.
Klaus, Václav 1991: Economic Science and Economic Reform, Gennex & Top Agency, Praha.
Klaus, Václav 1995: Economic Theory and Reality of Transition Processes, Management
Press, Praha.
Klaus, Václav: The Third Way and Its Fatal Conceits, selected papers from the MPS Regional
Meeting, 1999, Vancouver, Canada.
Kouba, Karel; Vychodil, Ondrˇej; Roberts, Jitka 2004: Privatization without Capital, Increased Transaction Cost of Czech transition.
Lewandowski, Janusz/Szomburg, Jan 1989: Properte Reform as a Basis for Social and
Economic Reform, Communist Economies, Vol. 1, No. 3, Gdansk University, Gdansk.
Lewandowski, Janusz/Szomburg, Jan 1995: Research Project Working Paper: Transformation Model of Poland’s Economy, Research Center for Marketization and Property Reform, Gdansk.
Pavlík, Ján (ed.) 1998: Milton Friedman in Prague – Ideas, Opinions, and Comments, Liberální Institut, Praha.
ˇ
ˇ
TRIska,
Dušan/Klaus, Václav/Holman, Robert/RudlovCák,
Vladimír/Hrubý, Michal/
Mládek, Jan/Loužek, Marek 2002: Voucher Privatization, Collected papers, Centrum pro
ekonomiku a politiku, Praha.
Voucher Privatization in Figures 1995, Centrum kupónové privatizace, Praha.
Berthold/Gerken/Klaus/Lambsdorff/Schwarz/Ševcˇ ík 2003: Reform und Transformation, Liberální Institut, Prag.
Watrin, Christian 1999: Europe’s „New“ Third Way, Heritage Lectures, The Heritage Foundation, No. 634, May 7.
Erhard, Ludwig 1958: Prosperity through Competition, Thames and Hudson, London.
Eucken, Walter 1951: This Unsuccessful Age, or the Pains of Economic Progress, William
Hodge and Co., London, pp 31-36.
5In British Columbia in the 1960s, on the other hand, the free and legal transfer of privatisation vouchers
was permitted. Vouchers were traded everywhere, mostly in pubs, inns and restaurants. Hence the whole
process is now often called “pub privatization”.
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How to do it: Lessons from successful liberal reforms in CEE
How to do it: Lessons from successful liberal reforms in CEE
| 27
MONEY THAT BELONGS TO THE PEOPLE: THE
SUCCESS OF LITHUANIAN MONETARY REFORM
Rùta Vainienè
Lithuanian Free Market Institute, Vilnius
including
THE CURRENCY BOARD ARRANGEMENT
IN BULGARIA
Dimitar Chobanov
Institute for Market Economics, Sofia
Introduction
This article examines a success story – the Lithuanian monetary reform that introduced a
Currency Board-like Arrangement (“CBA”) and pegged the national currency, the Litas, to
the US Dollar at a fixed exchange rate of 4:1 on April 1, 1994.
A CBA is an arrangement where the amount of domestic currency in circulation – notes
and coins – must be fully (not less than 100 percent) backed by foreign reserves, and the
domestic currency must trade without restrictions at a fixed exchange rate with an anchor
currency. Under the CBA, the Central Bank must keep and invest these foreign reserves abroad, whose investment returns are a major source of income for the authority issuing the
currency. A fixed exchange rate is a necessary but not sufficient prerequisite of the CBA. A
CBA, unlike an ordinary fixed exchange rate system, has sufficient foreign reserves to ensure
the immediate and unlimited exchange of national currency into the anchor currency.
The anchor currency must be stable, convertible, and accepted by the local population,
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How to do it: Lessons from successful liberal reforms in CEE
corporations, and international trading partners.6 The CBA operates automatically, with
changes in the monetary supply determined solely by market forces, i.e. changes in the
demand for domestic money. A Currency Board Arrangement is simpler than an orthodox
currency board. The CBA does not act as a lender of last resort nor supervise banks as does
an orthodox currency board. The CBA may bear the name of ‘The Central Bank’, have the
impressive infrastructure of a central bank, but its functions are more circumscribed than
a central bank’s. Under a CBA, the government (on behalf of the central bank) cannot earn
extra income by creating credit and inflation. Instead, the central bank generates profits
from its assets (foreign reserves) by earning an interest on investment. By denying credit to
government, the CBA imposes strict monetary and fiscal discipline.
The Problem
Lithuania reintroduced its pre-war national currency, the Litas, on October, 19937. The Litas
replaced the temporary monetary units, or coupons, issued since Independence in 1990.
The Litas soon experienced significant fluctuations against the two main hard currencies in
local circulation – the US Dollar and the German Mark. Lithuania faced galloping hyperinflation – its CPI shot up by 382,7 % in 1991, 1162,2 % in 1992, and 188,7 % in 1993. Domestic interest rates were high and misaligned with global market rates – the average annual
interest rate on bank loans in Litas was 120,2 % at year end 1992; 88,21 % at year end
1993, and 29,81 % at year end 1994. The rise of commodity and credit prices was caused by
monetary reasons – a rapid and uncontrolled growth of the money supply.
The Bank of Lithuania was re-established as an independent institution in 1990 after the
proclamation of independence from the Soviet Union. However, independence from the
Soviet Union did not ensure the real independence of the Central Bank. Dependence on the
Soviet Central Bank was replaced with dependence on the new national government. The
newly established Central Bank was too weak to resist political pressure. Moreover, the staff
of the Bank of Lithuania had no experience in conducting a stable monetary policy for an
independent state.
The Lithuanian citizenry were harmed by their currency’s instability and rapid inflation. The
first currency, the provisional notes or “coupons” were viewed with distrust; the second
currency, the Litas, fared slightly better due to patriotic feelings. However, most savings
were held in foreign currencies, especially the US Dollar. This fact was the major argument
6Most currency boards have chosen a major central bank‘s currency money as an anchor, most frequently,
the US Dollar, the British Pound, the German Mark and recently, the Euro.
7 Lithuania first introduced the national currency in 1922 and kept it until 1940. During this whole period,
the Litas was backed by gold at a parity of 0,150462 g.
How to do it: Lessons from successful liberal reforms in CEE
| 29
for choosing the US Dollar as the anchor currency. German Marks played a smaller role
in Lithuanian economy. Deposits in foreign currencies far exceeded deposits in domestic
currency, as seen in the table below.
How the Idea of a Reform Was Born
The idea of a monetary reform in Lithuania was developed by the Lithuanian Free Market
Institute (LFMI), a private think tank.8
SAVINGS DEPOSITS: Domestic vs. Foreign Currencies
Million. of national currency units – coupons or litas (percentage of total savings)
period ending
Domestic Currency (% of Total)
Foreign Currencies (% of Total)
1990 12
22.4 (51%)
21.7 (49%)
1991 12
23.3 (11%)
186.3 (89%)
1992 12
24.0 (4%)
621.4 (96%)
1993 03
48.8 (7%)
678.8 (93%)
1993 06
62.1 (9%)
620.2 (91%)
1993 09*
92.5 (12%)
655.3 (88%)
1993 12
234.3 (25%)
711.6 (75%)
1994 03
428.1 (35%)
811.6 (65%)
1994 06**
639.9 (41%)
922.9 (59%)
1994 09
784.3 (41%)
1128.9 (59%)
1994 12
761.9 (35%)
1418.6 (65%)
2008 02
6897.8 (74%)
2363.6 (26%)
During this period, the LFMI cooperated closely with other free market oriented think tanks
and economists. Among them was a dedicated supporter of currency boards, Kurt Schuler9.
Elena Leontjeva, the president of LFMI, first met him in 1990 during her visit to Sweden
where Kurt Schuler shared the results of his research on currency boards. In 1991, Elena
Leontjeva traveled to the USA with a group of Lithuanian policymakers and convinced them
to include the idea of instituting a currency board in their economic reform agenda. She
also met with Prof. Steve Hanke10, a renowned expert on currency boards and their implementation in many countries, and invited him to visit Lithuania. Prof. Hanke later became
an Adviser to the Prime Minister of Lithuania.
There was a need to popularise the currency board idea among Lithuanian economists, policy makers, media and general public. Elena Leontjeva presented a proposal for a currency
board at the then leading forum for debating economic reform issues – the “Economists’
club” roundtable, led by a former parliamentarian, the economist Kazimieras Antanavicius.
Later, the discussion was extended to the general public by publishing articles in the media.
* - after the introduction of the Litas
** - after the introduction of the Currency Board Arrangement on 1 April, 1994
The success of neighbouring Estonia in introducing its national currency, the Kroon (EKK)
and pegging it to the German Mark in June 1992 helped to promote the idea of a currency
board in Lithuania. The Estonian’s early embrace of the currency board system led to a rapid
stabilization of their economy and to economic growth.
Although the Litas was the sole legal tender, Lithuanians routinely used hard currency for
large transactions such as loans and real estate sales. Capital movement and foreign exchange was limited and under control, leading to a limited convertibility of the national
currency.
8From an interview with Prime Minister Adolfas Slezevicius, „I would like to particularly emphasise LFMI
president Elena Leontjeva’s role in advocating for a currency board in our country. She and the Lithuanian
Free Market Institute were very important in promoting the idea of a currency board in Lithuania.”
9 Kurt Schuler has worked as a consultant on monetary matters in Africa, Asia, Eastern Europe, and Latin
America. His publications include ‘Should Developing Countries Have Central Banks?’ (1996). He maintains
a World Wide Web site on currency boards, dollarization, and related topics, <http://www.dollarization.
org>.
10Steve H. Hanke is Professor of Applied Economics at The Johns Hopkins University in Baltimore; Chairman
of the Friedberg Mercantile Group, Inc. in New York; a columnist at Forbes magazine; and a contributing
editor to Forbes Global magazine. He was a Senior Economist on President Ronald Reagan‘s Council of
Economic Advisors from 1981 to 1982 and has served as an economic advisor to many governments, including those of Argentina, Indonesia, Lithuania, Venezuela, and Yugoslavia. Currently he is an advisor to
the presidents of Bulgaria and Montenegro. He has written and edited many studies on monetary reform,
privatization, and economic development, including Russian Currency and Finance (written with Lars Jonung and Kurt Schuler, 1993), Prospects for Privatization (editor and contributor, 1987) and The Revolution
in Development Economics (contributor, and editor with James A. Dorn and Alan A. Walters, 1998). In
1998, he was named one of World Trade magazine‘s 25 most influential people. His World Wide Web site
is <http://www.forbes.com/hanke>.
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How to do it: Lessons from successful liberal reforms in CEE
| 31
Other alternatives, which would have abandoned the Litas as sole legal tender, such as
dollarization, free banking or the free circulation of competing foreign currencies, were not
seriously considered in public debate. The opinion of the public and the government was
strongly in favour of a national currency since it was a symbol of independence from Russia. Furthermore, mainstream economic opinion was against even slight changes in existing
monetary arrangements and any other, more radical, proposals would have been immediately rejected.
Opposition and Obstacles to Reform
The proposed Currency Board Arrangement was the object of an intense public debate. The
main opposition came from the Central Bank, the Bank of Lithuania. The main argument
against the CBA reform was that the Bank of Lithuania would lose its traditional functions
and hence be unable to counteract economic and monetary shocks, to resist speculative
attacks against the Litas, and ensure a stable price level.
One Bank of Lithuania official, Dr. Gitanas Nauseda, was among the most vehement opponents of the CBA. Dr. Nauseda worked at the Financial Institutions Division of the Bank
of Lithuania and when this reform was discussed in the Government and the Parliament,
he voiced his opposition in the leading national daily, ‘Lietuvos Rytas’. Dr. Nauseda was
expressing the opinion of the Bank of Lithuania where nearly everybody was against the
CBA. Most CBA opponents changed their mind after several years under the CBA. Dr Nauseda himself recognised this when, on the tenth anniversary of the CBA’s operation, he said
“Although at first I was sceptical about currency boards, I think it would be simply unfair to
label them as either bad solutions or very good solutions.”
Opponents of CBA reform were: interest groups that sought to gain by influencing the Litas exchange rate, politicians or bureaucrats who wanted to benefit from the unrestricted
creation of money and academicians who believed that an individual at the helm of the
money-printing machines could perform much better than the market. The main practical
obstacle to implementing a CBA was that Lithuania did not have sufficient foreign reserves
to fully back the national currency in circulation. This problem was solved with the help of
an IMF loan.
Whether a currency board system increases economic freedom is still debated, even among
pro-market economists. Proponents say that a monetary policy free from political influence
both enhances a nation‘s economic freedom and brings its money closer to its true market
value. However, the creators of the Index of Economic Freedom at the Heritage Foundation
disagree – they consider an independent central bank an attribute of monetary freedom
and likely to lead to lower inflation. So the Foundation lowered the index of Lithuania‘s
monetary freedom after the introduction of the CBA, despite the fact that it was the esta-
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How to do it: Lessons from successful liberal reforms in CEE
blishment of the CBA that lowered inflation in the country. This decision shows that there
is a lack of understanding of how a currency board can increase monetary stability reducing
the government‘s freedom to control the money.
Inputs from other Parties
The strongest official support for the introduction of the Currency Board Arrangement came
from the IMF. This support took the tangible form of an IMF loan used to back the fixed exchange rate of the national currency against the reserve currency and to ensure the smooth
operation of the CBA system. The loan amounted to 64.6m USD (it was given 88m in Special
Drawing Rights – the value of which was based on a basket of key international currencies). At the introduction of the CBA, Lithuania‘s total reserves of gold and foreign currency
amounted to 400m USD. Over the following years, the IMF continued to strongly support
the CBA, stating in 2001 the importance of “maintaining the currency board arrangement
as the cornerstone of macroeconomic stability”, (‘Memorandum of Economic Policies’, July
26, 2001).
How the Reform was Decided Upon
The persistent instability of the national currency convinced the Government of the need to
adopt a currency board. It became absolutely clear that only a monetary policy independent
of the Bank of Lithuania and immune to political pressure could secure the currency stability vital to the viability of the Lithuanian economy.
Both local and foreign experts helped convince the policymakers to decide on a CBA. Since
1993 Lithuania was governed by a Social Democratic government headed by Prime Minister
Adolfas Slezevicius. Elena Leontjeva made a comprehensive presentation to the Government. Mr. Slezevicius became an ardent supporter of the reform after a trip abroad, in his
words,
“My meeting with Argentina’s economic minister D. Covallo during the 1994
World Economic Forum in Davos played an important role in the process of implementing a currency board in Lithuania. It was Mr. Covallo who was the main
architect of very successful economic reforms, including the introduction of a
currency board, in Argentina. Our long discussion revealed a host of aspects and
benefits of having a currency board regime. This meeting dispelled any doubts
regarding the need to adopt a currency board arrangement in Lithuania once
and for all.”11
11Argentina‘s currency board was not implemented properly since its reserves were kept at a low level. However, one can learn from failures as well as successes.
How to do it: Lessons from successful liberal reforms in CEE
| 33
The CBA‘s Introduction and Success
The CBA transformed the Litas into a fully convertible currency – exchanged for the anchor
currency without interruption or delay.
The CBA has played a crucial part in stabilizing the Lithuanian economy.
„In April 1994, the Government of Lithuania introduced a currency board which
pegged the Lithuanian currency to the U.S. dollar (4 Litas = $1). This was done
to reduce political pressure on monetary policy and ensure a stable currency.
This goal was successfully achieved […]“12
Just two years after the Currency Board began to work, inflation and nominal interest rates
fell markedly. Both citizens and markets immediately started showing more trust in the Litas
– savings in the national currency rapidly increased.
1400
1200
1000
800
600
400
200
0
01
Interest
rate
19
91
19
93
19
95
19
97
19
99
20
01
%
Year
70
60
50
40
30
20
10
0
Year
12USAID/Lithuania: Success Stories (2000) <http://www.usaid.gov/locations/europe_eurasia/countries/lt/
success.html>
34 |
By denying the Central Bank discretionary power over the money supply and the regulation
of interest rates, the currency board reduced political pressure on the Central Bank. Indeed,
how could the Parliament or the Government force the Central Bank to cut the interest
rate or to “correct” the exchange rate or to extend a loan to finance a budget deficit if the
Central Bank had neither the right nor ability to do so? Still, Lithuanian politicians did try to
seek short-term political dividends by imposing requirements on the Bank of Lithuania. For
example, Prime Minister Gediminas Vagnorius advocated the idea of using official foreign
reserves to stimulate domestic lending, but after several years of failure, the politicians
gave up.
20
99
19
19
97
95
19
93
CPI
19
19
91
%
See the graphs below.
The CBA has also proved to be a fairly effective safeguard against the Government’s expansionary fiscal policy. Under a floating exchange rate regime, the Government‘s fiscal policy
errors as reflected in a reduced exchange rate of the national currency against foreign
currencies can always be blamed on improper decisions by the Central Bank. Under a fixed
exchange rate arrangement such as a currency board system, an overly generous fiscal policy causes a loss of official foreign reserves and an increase in interest rates. When budget
expenditures and borrowing needs on the domestic market grow, there is no option to borrow cheaply directly from the Central Bank, so the State is forced to seek more expensive
funding from private creditors, such as banks, insurance companies, etc., In extreme cases,
loose financial policy may “bar” the State from the market altogether, putting the State on
the edge of a financial crisis. Lithuania faced a situation like this in the second half of 1999,
and this experience taught its politicians not to repeat this mistake.
How to do it: Lessons from successful liberal reforms in CEE
Over time, as Lithuania‘s business ties with the EU increased, the peg to the US dollar became less compatible with the composition of Lithuania’s trade. In late 1999, the Bank of
Lithuania first announced its intention to re-peg the Litas from the dollar to the euro at
parity. To reduce uncertainty, the manner and timing of the re-pegging were made public in
advance. The re-pegging operation was implemented without difficulties in February 2002.
In May 2004, Lithuania became a Member State of the European Union and on 28 June
2004, joined the ERM II with a unilateral commitment to maintain its exchange rate at the
central parity, i.e. to keep the fixed exchange rate regime based on the CBA.
The Currency Board Arrangement has survived multiple attempts to dismantle it by politicians afraid to lose popular support. The Currency Board also worked smoothly during the
banking crisis of 1995 and the financial crisis of 1999. While direct attacks on the CBA have
failed, a more subtle attempt to dismantle it was tried recently. In July 2008, the Lithuanian
Parliament approved a resolution to fight rising inflation. Among the resolution‘s 12 different measures, there was a proposal for the Government to “restore the classical functions
of the Central Bank so that it could perform active monetary policy”, which could only
mean „unpegging“ the exchange rate. The Lithuanian Free Market Institute took the lead in
How to do it: Lessons from successful liberal reforms in CEE
| 35
an appropriate unilateral commitment within ERM II”. These decisions sent the
signal that a euro-based currency board would be a feasible exchange rate regime in the run-up to EU and euro area membership given that a CBA country
had established central bank independence with a clear mandate to enforce
price stability, the proper functioning of financial and payment systems, a functioning market economy capable to cope with competitive pressures, and sound
fiscal policies to preserve macroeconomic stability and ensure the sustainability
of the convergence process.” – says Reinoldijus Sarkinas, Chairman of the Bank
of Lithuania.
The Future of the Lithuanian Currency Board
Lithuanian money (Litas) which was pegged to the U.S. dollar in 1994
revealing to the public the resolution‘s threat to currency stability. The Institute published
both a commentary and a press article, then lobbied the Parliament to revoke the resolution.
The media created a scandal by discovering that many MP‘s had voted for a resolution they
did not understand – that changes to the CBA were hidden under the resolution‘s „inflation
fighting measures“. It took only two weeks for Parliament to revoke the resolution.
“Our small and open economy, with its flexible structure, has successfully operated under the fixed exchange rate regime since 1994 while undergoing dynamic changes. Back in 1994, Lithuania introduced the framework of a U.S.
dollar-based currency board to establish an anchor for policy discipline. However, since then, the choice of the anchor currency and, at times, the hard
peg exchange rate regime itself has been questioned. Initially, EU institutions
had serious doubts about the suitability of a currency board during the EU accession process, since it was believed that a fixed exchange rate regime would
obstruct economic adjustment and convergence and would contradict the ERM
framework.
Fortunately, in April 2000 the ECB Governing Council concluded that “accession
countries with a euro-based CBA deemed to be sustainable might not be required to go through a double regime shift in their strategies to adopt the euro”.
In November 2000, the ECOFIN confirmed that “fixed exchange rate regimes,
including Currency Board arrangements, can be sustainable in small and open
economies with sufficient wage and price flexibility, strict fiscal discipline and
sound financial systems” and that CBAs “may in some circumstances constitute
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How to do it: Lessons from successful liberal reforms in CEE
As a member of the European Union, Lithuania has made a commitment to join the euro
zone once it meets the Maastricht Criteria. On its first attempt to join in 1 January 2007,
Lithuania failed to qualify by the smallest of criteria - its CPI was high by 0.1 %. CPI growth
has recently accelerated so it is difficult to forecast when Lithuania will join the euro zone.
Until then, Lithuania must preserve the currency board system. The challenge when entering
the Euro zone will be to ensure that all of the nation‘s currency is exchanged for Euros at
the fixed exchange rate.
Currency Boards and Currency Board-like Systems as of December 2007
(Population and GDP data from approximately 2000)
Country
Population GDP (US$)
Began
Exchange rate / remarks
Bermuda [UK]
63,000
$2 billion
1915
Bermuda $1 = US$1 / Loose capital controls
Bosnia Hercogovina
3.8 million
$6.2 billion
1997
1.95583 convertible marks = 1 euro
Brunei
336,000
$5.6 billion
1952
Brunei $1 = Singapore $1 / Currency boardlike
Bulgaria
7.8 million
$35 billion
1997
1.95583 leva = 1 euro / Currency board-like
Cayman Islands [UK]
35,000
$930 million 1972
Cayman $1 = US$1.20
Djibouti
450,000
$550 million 1949
177.72 Djibouti francs = US$1 / Currency
board-like
Estonia
1.4 million
$7.9 billion
1992
8 kroons = 0.51129 euro / Currency boardlike
Falkland Islands [UK]
2,800
unavailable
1899
Falklands £1 = UK£1
Faroe Islands [Denmark]
45,000
$700 million 1940
1 Faroese krone = 1 Danish krone
Gibraltar [UK]
29,000
$500 million 1927
Gibraltar £1 = UK£1
Hong Kong [China]
7.1 million
$158 billion 1983
Hong Kong $7.80 = US$1 / More orthodox
since 1998
Lithuania
3.6 million
$17 billion
1994
3.4528 litas = 1 euro / Currency board-like
Saint Helena
very small
unavailable
1976
Saint Helena £1 = UK£1
Grey shade – EU member states
Source of population and GDP data: CIA World Factbook 2001.
How to do it: Lessons from successful liberal reforms in CEE
| 37
Some Shortcomings of Currency Boards
The Currency Board Arrangement in Bulgaria
While Lithuania‘s Currency Board Arrangement has worked smoothly, one cannot expect a
currency board to solve all economic problems nor be the ideal choice for every economy.
Some shortcomings of a currency board as a monetary system need to be mentioned. While
a currency board is a relatively market oriented system, it nonetheless relies on publicly issued fiat money as an anchor currency. It is protected from the pressure of local politicians,
yet it relies on a foreign state’s monetary policy. In the modern world, it is difficult to get rid
of state money and return to purely market money such as gold and silver. However, other
alternatives such as ‘coexisting money’, dollarization (‘euro-ization’) or free banking should
be considered before choosing the best monetary policy for the country.
Dimitar Chobanov, Institute for Market Economics
The second shortcoming of the CBA is that it protects currency in circulation (mainly cash),
yet excludes all the foreign reserve banking accounts. The CBA can fight inflation caused by
the unlimited issue of notes and deposits. However, the CBA cannot stabilize prices if the
inflation is caused by non-monetary reasons or by an extensive inflow of foreign currency.
Lithuania has been recently facing inflation mainly caused by generous EU support, a public
deficit and by emigrants’ money transfers. This automatic increase in the money supply
brought inflation up to a 12 % annual rate. Still, the national currency maintained its full
convertibility.
The third shortcoming is inherent to any monetary system - it may be changed by the same
government that instituted it. The means that the stability of any system is relative, depending on the how difficult it is for the government to change it. For example, The Law on the
Credibility of Litas states that the exchange rate of Litas may be changed only under extraordinary circumstances – if the further retention of the exchange rate would be damaging
for the economy. This means that the exchange rate can still be changed by the Central
Bank with the approval of the Government.
There were several issues involved in the introduction of the currency board in Bulgaria.
The choice of reserve currency was between the US dollar, the German mark and a basket
of both of them. The dollar dominated the foreign trade, personal savings and foreign exchange reserves of the central bank at that time. On the other hand, Bulgaria is geographically closer to the European Union than to the United States and one of the Government‘s
long-term objectives was to join the EU. So the Government chose the German mark. It was
then the most important currency in Europe and the Deutsche Bundesbank was internationally renowned for maintaining price stability for a prolonged period.
The currency board was introduced through a special law that fixed the Bulgarian lev to the
German mark and later, to the euro. The exchange rate was initially 1000 levs per German
mark, and recalculated in 1999 to 1.95583 levs per euro. The Bulgarian National Bank, the
BNB, is obliged to buy and sell euro for levs on demand at this exchange rate.
There are three departments at the BNB – Issue, Banking and Bank Supervision. The Issue
Department functions as a currency board, as its assets cover 100 % of its liabilities. Assets
consist of foreign currency in cash, gold, and marketable securities. The liabilities consist
of money in circulation, government and other state institutions‘ deposits, the deposits of
commercial banks and the deposits of the Banking Department.
There are strict rules for investing the foreign reserves – only in securities issued by institutions with the highest credit rating. Assets cannot be invested in Bulgaria thereby precluding implementation of monetary policy. There is an explicit prohibition for the BNB to
credit the government except for the credits given by the IMF, which must be accounted for
in the BNB’s balance sheet before granted to the government.
There are some characteristics that make the system in Bulgaria different from orthodox
currency boards, which make it only a currency board-like system. The additional functions
are:
•There are deposits of state agencies in the balance sheet of the Issue Department
- the so called fiscal reserve accounts. These accounts enable the Government to
implement a monetary policy by drawing its deposits from the BNB or, conversely, by
increasing them. This happened in 2003 when the Government intentionally influenced short-term interest rates on the inter-bank market;
•There is a minimum reserve requirements on liabilities which is a genuine monetary
policy tool – the requirement was increased from 8 % to 12 % in September 2007;
•The BNB supervises the commercial banks;
•The BNB is allowed to lend as a last resort to the commercial banks during liquidity
crises. The lending amount is strictly limited to the size of the Banking Department‘s
deposit at the Issue Department and the loans must be collateralized.
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How to do it: Lessons from successful liberal reforms in CEE
How to do it: Lessons from successful liberal reforms in CEE
| 39
Results of the Currency Board
The immediate effect of the introduction of the currency board was a rapid decline in the
inflation rate, in the variability of inflation and in inflationary expectations. A low and
predictable inflation facilitated long-term planning, reduced hedging costs and increased
efficiency. The consequent rise in economic growth and investment led to higher real income and better living standards. Apart from this, the currency board imposed strict fiscal
and financial discipline leading to budget surpluses, significantly lower public debt and
upgrades in the country‘s credit rating. Foreign exchange reserves have risen considerably,
contributing in turn to the stability of the currency board. These results are summarized in
the following table:
Table 1: The Bulgarian Economy Before and After the Currency Board
BEFORE
AFTER
Indicator
1991-1997
1998-2007
Inflation (%)
210.1
7.3
Inflation Tax Rate (%)
57.7
6.7
Real GDP growth (%)
-4.7
5.1
Gross fixed capital formation growth (%)
-8.8
18.8
Budget deficit (% of GDP)
-6.3
1.2
Government debt (% of GDP)
168
50.8
Foreign direct investment (USD mill.)
135.3
2950.3
Foreign direct investment (% of GDP)
1.7
11.4
Source: the National Statistical Institute, the Bulgarian National Bank, the Ministry of Finance and the author‘s own calculations.
Practical Advice for Reformers
Countries that are willing to reform their monetary systems to provide a better alternative
than a freely floating currency should consider several alternatives; a currency board, parallel currencies, dollarization or euro-ization, or even a return to a gold standard. A currency
board might be recommended for economies:
– that experience high inflation caused by credit creation (where the central bank is issuing notes and deposits without restraint);
– in which “bad money” is driving out “good money” from the market (per Gresham’s
Law);
– that run a large public deficit;
– with a high level of corruption and political instability;
– in which money cannot achieve convertibility.
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How to do it: Lessons from successful liberal reforms in CEE
If a Currency Board Arrangement is selected, then following steps are recommended to help
its introduction:
1. Promote and explain the idea of a Currency Board among the general public and government. Be prepared to deal with determined resistance. Choose a reserve or anchor
currency that is acknowledged as a legitimate choice by both local markets and foreign
trading partners. Pass a Law that clearly specifies the Currency Board‘s operating principles and obliges the Central Bank to act according to strict regulations.
2. Allow a period of unrestricted floating exchange rates for the domestic currency. The
most appropriate real exchange rate is the unrestricted market rate, the rate which
reflects supply and demand. Accordingly, the first step in fixing an exchange rate for
the domestic currency is to allow the exchange rate to float for a brief period, three
months is sufficient. If there is no domestic currency introduced yet, the exchange rate
may be selected as any ratio. The float should be a “clean” one – governed by market
forces only, rather than a dirty float governed by the intervention of the Central Bank.
To promote a clean float, all existing foreign-exchange regulations should be abolished. The exchange rate between the reserve currency and the domestic currency must
be appropriate. An overvalued real exchange will price exports out of world markets,
while an undervalued real exchange rate will make imports more expensive, preventing
people from buying foreign machinery and other goods needed for modernizing the
economy.
3. Make the actions of the central bank transparent and predictable. During the free float
period, the actions of the Central Bank should be transparent and predictable, so that
they cause no destabilizing effects on exchange rates. When the government allows the
domestic currency to float without restrictions, it should announce its choice of reserve
currency and the date it will fix the exchange rate. The reason for making the announcement is to reduce uncertainty that otherwise may tend to undervalue the domestic
currency.
The Central Bank should be required to disseminate weekly reports of its activities and
its balance sheet. Another way of making the actions of the central bank more transparent and predictable is to require that it holds significant reserves against further
increases in the monetary base. It should be required to increase its foreign reserves
by 100 % of any increase in the monetary base that occurs after the government announces the monetary reform.
4. Get rid of the deposit liabilities (except for reserve requirements deposits) of the Central
Bank with commercial banks – convert them to notes and coins or foreign securities.
Once the deposit liabilities of the central bank cease to exist, all that will remain are
notes and coins in circulation and its net worth on the liability side of the balance
sheet, and its foreign reserves and miscellaneous holdings such as its offices on the
How to do it: Lessons from successful liberal reforms in CEE
| 41
asset side. To convert what remains of the central bank into a currency board, the government must now establish a fixed exchange rate with the reserve currency it chose
in step 2. Simultaneously, the government must ensure that reserve assets for currency
board notes and coins in circulation equal 100 %.
5. On a day announced in advance, establish a fixed exchange rate with the reserve currency within the range of recent market rates. If uncertainty exists about an appropriate
exchange rate, it is best to err on the side of an apparent slight undervaluation rather
than a slight overvaluation compared to the range of recent market rates, so as to be
certain that the exchange rate does not price exports out of world markets. As long as
the new rate is credible and not deliberately grossly under or overvalued, the economy
will tend to quickly make the minor adjustments necessary to accommodate the new
exchange rate.
6. Ensure that foreign reserves are not less than 100 % cent of domestic-currency notes
and coins in circulation. The Currency Board should begin with foreign reserves not less
than 100 % of its notes and coins in circulation. Allowing the Currency Board to operate with a lower reserve ratio might create possibilities for the Board to administer a
discretionary monetary policy.
7. Introduce safeguards in the Law that makes the Currency Board hard to disestablish.
That may be mean constitutional provisions or sweeping majority requirements to
change the establishing Law.
All the steps can be completed within 4 months of the decision to establish a Currency
Board. They could take as little as 30 days. Historical experience has been that monetary reform is usually most successful at encouraging economic recovery once enacted.
Conclusions
References13
Hanke, Steve H. 1991: Teeth for the Bulgarian Lev: A Currency Board Solution, Washington:
International Freedom Foundation.
Hanke, Steve H. 1992: Currency Boards for Eastern Europe, Heritage Lectures no. 355 (Heritage Foundation, 1991). Also appeared as Geld und Währung Working Paper no. 23, Wolfgang Goethe Universität, Frankfurt am Main. French translation by Jacob Arfwedson 1991:
Réformes monétaires à l‘Est: * currency boards + contre banques centrales. Paris: Institut
Euro 92, also available online at <http://users.erols.com/kurrency/french.html>. Portions
were also translated as articles in the Romanian newspaper Capital.
Hanke, Steve H. 1994: Currency Boards for Developing Countries: A Handbook, International Center for Economic Growth Sector Study No. 9. San Francisco: ICS Press. Available online at <http://users.erols.com/kurrency/icegrev.htm>. Spanish translation by Gustavo Toro
and Adriana T. de Undreiner Juntas monetarias para países en desarrollo: dinero, inflación y
estabilidad económica. Caracas: CEDICE/Editorial Panapo, 1995. Bulgarian translation Valutniyat bord nachalo il krai. Sofia: Bard, 1996. Authorized Bulgarian translation by Ina
Byachvarova and Margareta Chakapska Valutniyat bord i finansovata stabilizatsiya. Sofia:
Klub AEkonomuka 2000,@ 1997. Turkish translation, with revisions GeliÕmekte olan ülkeler
¥çin para kurullari: el kitab2. Ankara: Association for Liberal Thinking, 2001. (Bulgaria, Latin
America, Turkey).
Hanke, Steve H. 1994: Valiutu taryba pasiulymai Lietuvai, Lietuvos laisvosios rinkos institutas (A Currency Board Proposal for Lithuania), translated by Ruta Vainiene. Vilnius.
Hanke, Steve H./Jonung, Lars 1992: Monetary Reform for a Free Estonia: A Currency Board
Solution, Stockholm: SNS Förlag. Estonian translation by Avo Viiol 1992: Rahareform vabale
eestile: valuutafondi lahendus,. Tartu, Estonia: Tartu Ülikool.
Hanke, Steve H./Jonung, Lars 1993: Russian Currency and Finance: A Currency Board Approach to Reform, London: Routledge.
Stable money is an essential prerequisite for any other economic reform or long-term economic activities. Central Banks often fail to ensure currency stability because they aim for
price stability and significantly intervene in the money markets by influencing interest rates
and creating inflation. A Currency Board Arrangement is a trustworthy system to limit the
discretionary policy of central bankers. It works smoothly at all times including economic
recession or even worse – during banking, financial or economic crises. A CBA takes money
away from the government and returns it to the people – where it belongs and where it
should be.
Institute of Economic Affairs 1996: Should Developing Countries Have Central Banks?
Currency Quality and Monetary Systems in 155 Countries, Research Monograph No. 52,
London.
13For an extensive Currency Board Bibliography look at http://users.erols.com/kurrency/cybdbib.
htm#Bookmark1.
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How to do it: Lessons from successful liberal reforms in CEE
How to do it: Lessons from successful liberal reforms in CEE
| 43
THE GLOBAL TAX RACE AND ESTONIAN
CORPORATE TAX REFORM
Andres Arrak
Estonian Free Society Institute, Tallin
including
CORPORATE TAX REFORM IN BULGARIA
Veliko Dimitrov
Institute for Market Economics, Sofia
Estonia’s Initial Economic Success
After a half-century of experience with a centrally planned economy, where public ownership prevailed and plagued by large macro-economic imbalances, Estonia regained independence in mid-1991. Yet within a decade, Estonia has been able to establish a well-functioning market economy deserving of the name Baltic Tiger.
Figure 1 shows that Estonia “reached the bottom” in 1994. It wasn’t the logical outcome
of a global recession but the result of the collapse of Estonia’s Soviet-style economic system. For the next couple of years, the Estonian economy achieved nearly a 10 % annual
growth rate, with some quarterly growth rates above 12 %. With rapid privatisation and
restructuring, a liberal labour market policy and a new legal framework for private activity,
these economic reforms have enabled Estonian GDP to grow an average of 6,5 % during the
period 1995-2007.
Figure 1. Estonian real GDP Growth, Annual % 1990-2008.
Source: Statistics Estonia
Estonia’s economic success in the first half of the 90’s has been boosted by some basic, clear
economic rules as well as by openness and the fostering of private enterprises. The Estonian
economic model was originated by the coalition run by the liberal party Isamaliit (‘Pro Patria’) in the years 1992-1994. Economic independence was based on the monetary reform
of June 1992 which introduced the Currency Board system with the Deutsche Mark as its
anchor currency. Together with a balanced budget policy, the Estonian economic model
instilled confidence in foreign investors and initiated a massive capital inflow.
In 1994, Estonia undertook its next radical reform, a truly flat, proportional income tax. For
long time previously, the only country to have a really flat tax was Hong Kong, which in
1947 introduced a 15 % personal income tax.
Estonia’s original tax code, introduced in 1993, applied a flat tax rate of 26 % to businesses,
personal earnings, and capital gains. There were annual depreciation allowances of up to
40 % for equipment and up to 8 % for buildings. The personal income tax rate was 26 %.
The rate was scheduled to fall to 24 % in 2005 and 20 % in 2007. Dividends were also taxed
at an effective rate of 26 %.14
14 http://findarticles.com/p/articles/mi_qa5485/is_200210/ai_n21323250/pg_2?tag=artBody
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How to do it: Lessons from successful liberal reforms in CEE
How to do it: Lessons from successful liberal reforms in CEE
| 45
Box 1. Former Prime Minister Mart Laar (named “the best student of Margaret
Thatcher”) launched the ‘European flat tax revolution’ in 1994 by instituting a 26 %
flat tax on individual and corporate income.
Mart Laar: “The freedom of people is connected with fair taxes.
The progressive income tax system used in most countries of
the World today is not fair. The idea behind such a system is
simple: the more you earn, the more you have to pay in taxes.
Such an attitude however, reduces the motivation of people to
work more and plan for their own future. It makes them rely
more heavily on the public welfare system. Although this is
known all over the world, there are not many countries which
have been able to take any real steps towards the re-introduction of a proportional income tax although the progressive
income tax was actually first introduced only in the 19th century”.
On 8 December 1993, the Estonian ruling Coalition, overcoming massive protests from
“economic experts” and left-wing populist parties, pushed through Parliament a reform
of the personal income tax to a flat 26 % level, and a national insurance wage tax of
33 %.
The success of Estonia’s tax reform encouraged neighbouring countries to follow its example. Latvia legislated a flat tax in 1995, Lithuania in 1996, and Russia in 2003. And
that was just the beginning. In 2003, Serbia implemented a 14 % flat tax on personal
and corporate income, Ukraine in 2004, Slovakia and Georgia in 2005. Flat tax fever has
spread to the rest of Eastern Europe and even reached Kyrgyzstan and Macedonia. Recently, Iceland became the very first Western country to end its progressive and highly
discriminatory tax system. Its corporate tax rate of 18 % is one of the lowest in the industrial world.
even say that tax reform has been his personal, sacred goal. Achieving it wasn’t easy and
can be described as a sacred war against the old way of thinking.
Estonian Corporate Tax Reform – the War against the
Old Way of Thinking
The general idea of implementing market-based laws into the ruins of the centrally planned
Soviet economy were already being discussed near the end of the 1980s. From the very
beginning, Mr. Kallas has been a voice for liberal market reforms. In the late 1980s, he was
among the first economists in Estonia to introduce the idea of economic independence from
the Soviet Union. As an active proponent of this new thinking, he contributed significantly
to shaping Estonia’s economic environment. In 1989-1990, a series of his articles was published in the Estonian paper Peoples Voice (“Rahva Hääl”) titled “Something is Cooking ….”
The proposed cornerstones of this new economic policy were: a new currency, the sale of
state property, reforming the national income distribution system, restructuring the whole
economy and renovating investment policy.
Box 2. The Chronology of Estonian Corporate Tax Reform
Siim Kallas
1989-1990 – article ‘Something is Cooking ….’ by Siim
Kallas in Peoples Voice newspaper
9 December 1994 – the Estonian Reform Party is established, its Chairman, Siim Kallas)
1995 – Siim Kallas article ‘The Manifest of the Citizens
State’ is published
After a period of fast GDP growth and catching up to western living standards, Estonia
experienced a sharp slowdown at the very end of the 20th century. In 1998, the growth
rate halved while in 1999, it was zero. This wasn’t a normal cyclical slowdown but rather
one initiated by the Asian and Russian crises. Neither crisis was Estonia’s fault but clearly
the initial boost from the flat tax reforms had faded and the country needed a new push.
Estonia needed another extraordinary measure to give local and foreign investors a new
stimulus and the implementation of the zero tax rate for re-invested profits was designed
to do that.
January 1996 – the first law granting a corporate tax exemption is proposed in the Estonian Parliament, the Riigikogu
7 March 1999 – The right-wing Parliamentary Coalition is formed from the Pro Patria,
Reform, and the Social Democratic parties; Siim Kallas becomes Minister of Finance. Corporate tax reform is written into the Coalition agreement.
10 November 1999 – The first hearing of the Corporate Tax Law proposal (143 SE) in the
Estonian Parliament
The main initiator of the Estonian Corporate Tax reform is former Estonian Prime Minister
and the current Vice-President of the European Commission, Mr. Siim Kallas. One could
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How to do it: Lessons from successful liberal reforms in CEE
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18 November 1999 – 4 opposition parties, the Estonian Center Party, the Estonian People’s
Union, the Estonian Coalition Party, and the United People’s Party, try to stop the proposed law.
22 November 1999 – 2 opposition parties, the Estonian People’s Union and the Estonian
Centre Party, try to cancel the proposed law.
24 November 1999 – The second hearing in Parliament begins for the Corporate Tax Law
proposal (143 SE).
25 November 1999 – a ‘no confidence’ motion against the Minister of Finance, Siim Kallas is defeated, with,37 members for and 51 deputies against it.
15 December 1999 – Parliament passes the Corporate Tax Law (143 SE) by 52 votes for,
38 votes against, and no abstentions.
1 January 2000 – the Corporate Tax Law comes into effect
January 2002 – A new coalition is formed by the Reform Party and the Central Party, Siim
Kallas becomes Prime Minister
Early 2004 – tough discussions with the EU leadership (G. Shröder, J.Pärsson, R.Prodi)
about Estonian tax exceptions to standard EU practice.
May 2004 – Estonia joins the EU, Siim Kallas becomes Vice-President of the European
Commission
March 2008 – Parliament passes amendments to the Estonian Corporate Income tax
system (hereinafter the CIT system) to ensure its compatibility with the EU Parent-Subsidiary Directive (hereinafter PS Directive).
The Manifest is also the paper where the idea of abolishing the corporate income tax was
clearly stated for the first time. If a man makes a dinner table himself and sells it, he is not
a company and pays income tax just as an individual. If the same man co-operates with
other men, becoming more productive and making more tables, the whole society benefits.
So why in this latter case do we tax him double as a company? Isn’t it strange? How distinct
is corporate income anyway? Isn’t it actually the owners’ income, as well as the workers’
salaries plus investments, which in turn become the owners’ income and salaries in some
other company? Why shouldn’t we abolish this company income tax?”
Although the first draft law about exempting corporate income from tax was presented in
Parliament in January 1996, the first real chance to accomplish this reform came up after
the March 1999 elections. A Centre-Right parliamentary coalition was formed including the
Reform Party, Pro Patria and the Social Democrats. Mr Kallas became the Finance Minister.
Corporate tax reform was written into the coalition agreement, therefore all three parties
declared themselves in favour of tax reform.
The first hearing of the proposed Corporate Tax Law (#143 SE) began on 10 November 1999.
The Law’s most important change was its tax relief for corporate investments. In his speech,
the Minister of Finance, Siim Kallas, quoted Albert Einstein: “The hardest thing in the world
to understand is the income tax.” He added that reform would change the whole philosophy
of taxation, and the fact that there is no other tax system like the one proposed, well, that
is a good enough reason alone to implement it. And the time was perfect for reform, during
a sharp slowdown in growth and a tightening of the Government budget, since the reform
would build a solid foundation for future economic growth.
With this reform, Estonia achieved a remarkable competitive advantage compared with the
other countries. There were 61 700 registered companies in 1998, 33 500 of them which
declared income (that is, about half were economically active), and 16 250 (or about a
quarter) of them declared a profit. The estimated amount of money which would be exempt
from tax under the proposed Law, and thus available for investment, was about one billion
kroons (6,5 million �).
1 January 2009 – the Amendments becomes effective
In 1994, Mr Kallas founded the Reform Party which from the very beginning has advocated
a liberal-democratic ideology. His article The Manifest of the Citizens State (1995) became
the ideological platform for the party. “We have told “A” and we have to say ”B”. No one can
validate traffic laws which allow both the left hand and the right hand to drive at the same
time. […] A free market economy itself implies elements of social justice. Exploiting these
elements will provide much more confidence to all members of the society than any other
system,” said Mr Kallas in The Manifest.
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The most difficult things to change are peoples’ minds. Of course the Parliamentary Opposition couldn’t agree with such a radical change. Their first reaction could be summarised as:
“The social and political price of such a revolutionary idea is intolerable.” Twice in November
the Opposition parties (the Center Party, the People’s Union, the Coalition Party, and the
United People’s Party tried to defeat the proposed law. They failed twice, the first time by
just a single vote.
The second hearing for the proposed Corporate Tax Law took place on November 24, 1999.
During the time between the two hearings, 73 amendments were proposed, including one
to abolish the flat tax. The main arguments against the reform were these:
How to do it: Lessons from successful liberal reforms in CEE
| 49
• that the exemption would mainly benefit a few heavily capitalised companies;
• that the rich would win at the poor’s expense (This type of thinking is frequently heard
- a social cost of our “communist experiment.”);
•
that the tax reform’s entire ideology belongs to an earlier era, of piracy and unrestrained capitalism, an era inappropriate for modern civilization;
• “How will Europe react?” was also a common refrain.
The Coalition argued that the Law would attract more foreign investment but the Opposition countered that respectable investors would avoid such a ‘tax haven’. There was a real fear
among advocates of big government that the Law will lead to the loss of billions in revenue
and that many public services will be cancelled, that this kind of liberalism is superficially
attractive but disastrous in consequence, that it has a “beautiful blossom, but bitter fruit.”
As the debates dragged on, emotions rose and erupted in vulgarities, rational arguments
were often forgotten.
The hearing finally ended on 24 November. The next day, a vote of no confidence was taken
against the Finance Minister, 37 deputies voted for, 51 against. The Opposition lowered itself to dredging up old allegations from the early 1990s that Mr Kallas, the then President of
the Estonian Bank, had allowed some questionable monetary transactions. It really looked
like any weapon was now allowed in this sacred war.
The second hearing of the Corporate Tax Law proposal was wrapped up in Parliament during
its last working session on 15 December 1999. During the final arguments, Mr Kallas stated
that he was still sure that the Estonian economy, in its present situation, was hungry for
new, positive signals and that this income tax reform should certainly play that role. An opponent asked if the Minister of Finance was able to find a moment to write his resignation
letter.
Every political party had its final say. For the Opposition:
• the People’s Union was in no doubt that the reform was unethical, socially unacceptable, and designed to make a billion krona present to the rich.
• the Coalition Party considered the reform simply inappropriate for a civilized country
in which honesty is the foundation for human virtue, and their opponents, the Reform
Party, didn’t need this foundation since they had no plan to build something on it.
• the United People’s Party said this reform was at the poor’s expense, that living standards will fall and social tensions will rise.
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How to do it: Lessons from successful liberal reforms in CEE
• the Estonian Center Party’s argument was succinct - the reform will generate a budget
crisis next year.
The Law’s proponents were:
• the Social Democrats, who supported the reform because it would promote additional
economic growth which would provide additional support for social programmes;
• the Reform Party, defending its liberal ideology, argued that by shifting more investment decisions from the government to the private sector, better, economically intelligent decisions would result;
• Pro Patria’s position was that instead of thinking how to distribute poverty, we should
find ways to increase wealth.
The final vote came after a couple of breaks: 52 votes for, 38 votes against, no abstentions.
The new Corporate Tax Law passed and went into effect on 1 January 2000.
European and foreign concerns about Estonian tax reform
This new system for taxing corporate profits was unique in its distinction between re-invested profit, which was not taxed, and distributed profit, which was taxed. Thus, taxation is
shifted from the moment when profits are earned to the moment when profits are distributed. For this reason, the Estonian system of corporate taxation became known as the ‘zero
corporate profit on re-invested profit’.
On January 1, 2000, Estonia turned the old corporate income tax approach upside down.
Under the Income Tax Act of 2000, companies became subject to income tax solely with
respect to distributions (which includes dividends and such hidden profit distributions as
fringe benefits, gifts, donations and other expenses unrelated to business activities). The tax
rate was initially 26/74ths of net dividends. In other words, under the new income tax legislation, corporate entities are exempt from income tax on undistributed profits, regardless
of whether they are re-invested or retained. Since there are no taxes on corporate income
per se, there is also no need for depreciation allowances. Capital gains remain untaxed as
long as the receiver is an incorporated Estonian firm. When the receiver of capital gains is
a natural person, the tax rate on capital gains is 26 %.
In 2004, the Parliament decided to cut the tax rate from 26 % in 2004, and to 24 % in 2005,
then 23 % in 2006 and finally a 20 % tax rate in 2007. The tax base is the gross distributed profit (including the tax), i.e. the new tax rates on net distributed profit were 24/76ths,
23/77ths and 20/80ths of the total.
How to do it: Lessons from successful liberal reforms in CEE
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The reform’s very uniqueness created apprehension in Parliament. Some deputies raised
questions about possible foreign reactions. Foreign opinion was especially important because Estonia was then a candidate for European Union membership. Mr Kallas had already stated in his first speech during the Law’s first Parliamentary hearing, that the major western
countries like Germany were themselves reforming their tax systems and cutting taxes. In
addition, the initial reaction was positive to Estonia’s efforts to simplify its taxes from internationally respected financial publications like the Financial Times and Wall Street Journal
Europe. Furthermore, Mr Kallas stressed that was no European directive regulating income
taxation in Member States.
The next time the tax reform had to be defended was when Estonia joined the EU. The Estonian distribution tax met with resistance from the European Union, which considered it to
be just a withholding tax on dividends rather than a true corporate income tax. According
to the EU Parent-Subsidiary Directive, EU Member States are not allowed to impose withholding taxes on dividends paid from a subsidiary in one Member State to a parent company
residing in another Member State. The EU politicians most opposed were Gerhard Schröder
(Chancellor of Germany) and Göran Persson (Swedish Prime Minister). Intense discussions
between the EU and Estonia were lead on the highest level by the Prime Minister himself,
who was forced to defend his own creation. At one critical meeting, both the Estonian
President, Arnold Rüütel, and President of the European Commission, Romano Prodi, were
present.
As a result of these EU accession negotiations, Estonia agreed to reform her corporate tax
system to conform to the Parent-Subsidiary Directive, effective from 1 January 2009. In
March 2008, the Estonian Parliament duly passed amendments to the Estonian corporate
income tax system in order to comply with the EU Parent-Subsidiary Directive. At the same
time, the basic principle of the current corporate income tax system – the deferral of taxation of corporate profits until their distribution – will be retained. Hence, re-invested profits
will still benefit from tax exemption under the amended system. Additionally, amendments
eliminate the differential treatment of resident owned and non-resident owned companies.
The changes are designed to reduce the taxpayers’ administrative burden.
end of the millennium were partly explained by outside factors – the global and domestic
economic slowdown. But in addition it was connected with a transitory rule, which allowed
companies that pay dividends to have a tax credit for their profit tax paid before 2000.
Figure 3: Estonian Government Revenues from the Corporate Tax, mln. kroons
Source: Statistics Estonia
If we cut taxes today, it’s easy to calculate how many kilometres of roads and how many
schoolhouses will be not built as a result of lost revenue. But one should not forget the
purpose of the tax cut – increased revenues in the future. The construction of three schoolhouses will be cancelled this year, but five schoolhouses will be built next year. The drop in
Estonian government tax revenues was short lasting – in 2004, the tax revenues from the
corporate tax, 2522 million kroons, were nearly four-fold those of 2001. Despite the zero
corporate tax on re-invested profit, the revenues from the corporate tax recovered within
a few years.
Did It Help?
According to the main opposition parties, government revenues should have dropped dramatically after the tax reform. The reality was opposite though the recovery took several
years. In the first years after the introduction of the zero corporate tax on re-invested profits, the revenues from this tax in the consolidated budget decreased by nearly half. After
the slowdown in revenues in 1999 (1638.8 million kroons), in 2000 (854.5 million kroons)
and 2001 (748.3 million kroons), government revenues from the corporate tax tripled in
two years – by 2003, revenue was well above 1999 (Figure 3). Decreasing revenues at the
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CORPORATE TAX REFORM IN BULGARIA
Veliko Dimitrov
Institute for Market Economics, Bulgaria
One of the most successful market-oriented reforms in Bulgaria, along with the introduction of the currency board, was the gradual reduction of the corporate tax rate down to
10 % in 200715. Back in 1997 the rate was still slightly over 40 %, meaning that within a
decade the three consecutive parliaments (the last one still in service) have managed to
lower it several times. The following table represents the development of the corporate tax
rate over this period.
Figure 4: Estonian Government Revenues from the Corporate Tax, % share of GDP
Source: Statistics Estonia
We get the same effect, a short term drop followed by a long term gain, if we calculate the
corporate tax revenues as a percentage of the Gross Domestic Product (GDP) (Figure 4). In
the first two years after the introduction of the zero corporate tax on re-invested profit,
corporate tax revenues dropped more than two times, but after that rapidly recovered. Moreover, the corporate tax revenues reached percentage levels higher that the average level
for the last nine years, though of course, Estonia’s GDP had grown dramatically over that
period.
The reduction in the corporate tax burden has created incredible investment incentives and
boosted economic growth. The introduction of the zero corporate tax on re-invested profit
had only a temporary negative effect on budget revenues, which after that rapidly recovered
above the previous levels. The principal effect of the Laffer Curve has clearly worked – that a
tax cut can lead to higher budget revenues because of dynamic effects – more investments,
production and taxable income. The Estonian Government came to the same conclusion in
the National Report on Economic Reform 2004: “Estonia’s example is therefore sufficient to
say that lower taxes contribute to economic growth while increasing budgetary revenues
of the state.”
Corporate tax rates in Bulgaria over the last decade
Year
1997
1998
1999
2000
2001
2002
Rate
40.2%
37%
34.3%
32.5%
28%
23.5%
Year
2003
2004
2005
2006
2007
2008
Rate
23.5%
19.5%
15%
15%
10%
10%
Source: Ministry of Finance of Bulgaria, own summary
Indeed, this was a great achievement in terms of establishing freer market economy and
more favorable business environment in particular. For some conceptual reasons, not to be
overlooked is yet the fact that probably the main reason for this development, at least in the
beginning of the process, was the severe economic crises that had overtaken the country in
the early and mid 1990’s. Against falling GDP, mass unemployment and steadily decreasing
standard of living, such a measure, together with the introduction of the currency board and
the abolishment of state control in many sectors, seemed to be the only remedies for the
broke government and people. And yet for a good reason – along with the gradual reduction
of the corporate tax (and of the personal income tax) the annual GDP growth rate turned
positive, reaching a pace of over 6 % in the last five years and 7.0 % in the first quarter of
2008, the FDI climb up to record levels generally each year and the economy has already
surpassed the production and income levels in the beginning of the transition period. Although Bulgaria is still the poorest member of the European Union, the undertaken classic
liberal economic reforms have made it possible for the people to enjoy more opportunities
and unprecedented level of welfare in the history of the country. Now we have to ask our15As of 2008 Bulgarian economy also enjoys a 10% flat rate tax on personal income. More details about this
remarkable success can be found in the part of the book dealing with public finance reform in general.
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How to do it: Lessons from successful liberal reforms in CEE
| 55
selves the question whether such economic policy measures and in particular the decrease
of the corporate tax rate are to be taken solely in countries in deep economic crisis seeking
a way out, or these measures are also appropriate for well-developed countries willing to
boost their economic growth? The answer is intuitively more than clear - if such policy can
help a broke country to get back on its feet, there is no reason to believe that it would harm
or not help wealthy countries become more prosperous.
vestment and business environment16 the increase of the corporate profit tax by 10 percentage points leads to reduction of investment as a percentage of GDP with two percentage
points and increase of the shadow economy. Hence, the reduction of corporate taxes implies
certain positive effects for investment activity and the overall economic growth. The data
about Bulgaria indicate how these macroeconomic relations work in real and prove the
claim that tax revenues grow faster at lower levels of tax rates.
Of course, there has been always strong opposition to the reform. Major government concern and main argument of all opposing parties was that the lower tax rate would inevitably result into less government revenues and eventually imbalanced state budget. Yet,
this concept has definitely proved not true. The following table presents the change of the
corporate tax rate and the corporate tax receipts (as % of GDP) in the last several years.
References
DEVEREUX P. Michael/SØRENSEN P. Birch 2006: The Corporate Income Tax: international
trends and options for fundamental reform. European Commission Economic Papers, N°
264, December.
25,0%
20,0%
Corporate tax rate
15,0%
10,0%
Corporate tax
revenues (% of
GDP)
2008
2007
2006
2005
2004
2003
5,0%
0,0%
Corporate tax rate and respective state budget revenues (as % percentage of GDP)
in the last six years
Source: Ministry of Finance of Bulgaria, own summary (forecast for 2008)
From the beginning of 2007 the corporate tax rate was reduced from 15 % to 10 %. Surprisingly for the state authorities the revenues from corporate taxes in 2007 were BGN
1.68 billion (EUR 859 million) or 140 % compared to the collected amount in 2006. For the
entire year (2007) the economy registered a huge 33 % growth of FDI, reaching the highest
level since statistical records have existed in the country. These favourable results were due
to the naturally positive impact of lower taxes – more companies came out from the grey
economy and more foreign investments flowed into the country providing at the end of the
day for even more tax receipts. The dynamic effects are expected to continue working in the
coming years as well, since lower taxes generally mean more incentives to work and invest
for all entrepreneurs.
According to one of the latest empirical studies of the effect of corporate taxes on the in-
56 |
ANGELOV Georgi 2006: Zero Tax on Reinvested Profit – the Example of Estonia, Institute for
Market Economics, Issue 36, February 15th.
How to do it: Lessons from successful liberal reforms in CEE
EDWARDS Chris 2006: Catching up to Global Tax Reforms, Cato Institute Tax Budget Bulletin, N° 28, November.
FUNKE Michael 2002: Determining the Taxation and Investment Impacts of Estonia’s 2000
Income Tax Reform, Finnish Economic Papers – Volume 15 – Number 2 – Autumn.
KALLAS Siim 2003: Market Economy and Citizens State, Tallinn.
KPMG’s Corporate Tax Rate Survey 2006: Corporate Income Tax Rate – A Trend Analysis,
October.
LAAR Mart, Flat Tax, http://blog.irl.ee/Mart/flat-tax/
LÄTT Priit, EIDEMILLER Rainer 2006: Estonia: The Year 2009 and Estonian Corporate Taxation System, http://www.mondaq.com/article.asp?articleid=42384, August 27th.
MITCHELL J. Daniel 2007: Baltic Beacon, Wall Street Journal, June 20th.
ODDSON David 2007: Iceland Joins the Flat Tax Revolution, http://rspruk.blogspot.
com/2007/02/iceland-joins-flat-tax-revolution.html, February 10.
RABUSHKA Alvin 2005: Four More Years: Real Tax Reform, Hoover Digest¸ N° 1.
16 “The Effect of Corporate Taxes on Investment and Entrepreneurship”, Simeon Djankov, Tim Ganser, Caralee
McLiesh, Rita Ramalho, Andrei Shleifer; accessible at the World Bank’s website: http://www.doingbusiness.
org/documents/AEJ-Manuscript.pdf
How to do it: Lessons from successful liberal reforms in CEE
| 57
THE FLAT TAX REFORM IN SLOVAKIA
Ján Oravec
Hayek Foundation, Bratislava
Thirdly, Slovakia is the first OECD country to introduce the flat tax. Opponents of the flat tax
frequently argue that the flat tax is only an appropriate option for poor, desperate countries,
like former communist ones, rather than for rich, developed countries. Slovakia brought the
flat tax into the club of the richest countries in the world. There the flat tax can be studied
more carefully and serves as a reference for those advanced countries willing to implement
it.
Introduction17
Slovakia adopted a 19 % flat tax as of 1 January 2004. It was neither the first country to
implement this idea18 nor was the 19 % rate the lowest among the flat tax countries. It was
not introduced in its purest form either. Nonetheless, the implementation of the 19% flat
tax in Slovakia was a unique venture from several points of view.
Firstly, Slovakia adopted the flat tax before any other Central European country. That is a
remarkable achievement considering developments in the region since the beginning of the
1990s. Slovakia´s peer group – the Czech Republic, Hungary, and Poland – were far ahead
of Slovakia back in the second half of the 1990s. They had already all became members of
NATO, while Slovakia had not even been invited. They had all started accession negotiations
with the EU, Slovakia had been told it was not ready yet. Today, just a decade later, Slovakia
shares both NATO and EU membership with its peer countries. And not only that – Slovakia
now even outperforms them in many respects because it has progressed more in several
crucial areas of economic and social transformation. The flat tax reform is certainly one of
them.
Secondly, Slovakia is the first country that managed to introduce the flat tax just months
before entering the EU. When Slovakia joined the EU with 9 other countries on 1 May, 2004,
the flat tax system had been introduced only 4 months earlier. The Baltic States joined the
EU after their flat tax systems had been in place for more than a decade. Although many
17This text was edited from previous contributions of the author on the topic: Jan Oravec, “Tax Competition
or Tax Harmonization in Enlarged Europe?”- a paper prepared for the 19th Leipzig seminar organized by
The Center for the International Economic Relations, University of Leipzig, November 24-25 2005, Germany; Ján Oravec, “Government Regulations And Taxation In Slovakia: The Effects On Property Rights”, a paper
prepared for the Liberty Fund conference on Private Property Rights and Liberty, Dallas, Texas, November
16-19, 2006, Ján Oravec; „Introduction Of 19% Flat Tax In Slovakia In 18 Months”, a paper prepared for
an international conference Freedom, Commerce, and Peace: A Regional Agenda organized by The Cato
Institute, the New Economic School of Georgia, the Atlas Economic Research Foundation, the Heritage
Foundation, the Friedrich Naumann Foundation, and the Center for International Private Enterprise, October 25-27, 2006, Tbilisi, Georgia.
Fourthly, Slovakia will soon be the first ‘eurozone’ country with the flat tax. As a result of
wider economic and social reform efforts, Slovakia nowadays meets the Maastricht criteria
and will become the 16th eurozone member country as of 1 January 2009. It was thought
for a long time that the Czech Republic, Hungary, and Poland were better prepared for the
euro and would adopt it before Slovakia did. The 19 % flat tax is a major reason for the
remarkable success of the Slovak economy in recent years. While the long term impact of
the euro will not be known for years, it is obvious even today that by bringing the flat tax
into the eurozone, Slovakia can help other member countries by generating peer pressure
to change their old-fashioned tax systems. This much needed ‘fresh air’ could improve the
conditions for doing business in the entire eurozone and thus energise the other, moribund
national economies.
Description of the Problem
In November 1989, Slovakia19 had a tax system that was typical of a communist country,
with many irrational and complicated forms of individual and company taxation.
Personal income taxation was progressive and many taxes were dependent on the social
status of the taxpayer. Corporate taxation was based on taxing enterprise turnover. Various
enterprises were taxed differently depending on their legal status or specific industry. Tax
rates ranged from 55 % to 100 %.
In 1990-92, several important adjustments were made in order to make the tax system more
compatible with the transition towards the market economy. At the same time, there was
an intense preparation going on to introduce a completely new tax system as of 1 January
19At that time it was a part of Czechoslovakia.
18Baltic countries pioneered it a decade earlier.
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in the EU leadership disliked the very idea of the flat tax, there was little they could do to
change it so long after its implementation. In the case of Slovakia, they tried hard to use the
final stages of negotiations on EU membership as leverage against the flat tax. Fortunately,
they did not succeed and now the pressure is mounting on these other EU countries to do
something with their poorly performing, graduated tax systems.
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1993. This system had the parameters of a typical European tax system with a value-added
tax, excise duties, real estate taxes, corporate and personal income taxes. This system was
eventually introduced by both newly established independent countries – Slovakia and the
Czech Republic.
In the following decade, 1993-2003, the tax system evolved primarily via further minor
changes like the separation of the social security and the health contributions from the
tax system, reductions in the number of tax rates, the flattening of the tax rates structure,
etc.
Despite these limited improvements, there were still many problems associated with the
Slovak tax system as it evolved in the 1990s. The tax system had been distorted by efforts
to stimulate economic growth via tax policies favouring certain economic activities, industries, locations, business types, etc. It was dominated by special regimes and allowances,
e.g. tax incentives for job creation and foreign direct investments, tax regimes favouring
small businesses, etc.
An unavoidable result of these policies was a high tax rate environment with many loopholes. The system’s most serious problems were nearly textbook examples of serious distortions of competition, administrative complexity, and the unintended consequences of
government actions.
The Flat Tax Revolution of 2004
A New Task for Tax Policy
These serious problems drove the Slovak government to prepare and implement an ambitious tax reform that is today well known as the ‘flat tax of 19 %’. Such a sweeping tax reform
would have been impossible without a fundamental shift in policy-makers’ views about
taxes. Taxes increasingly started to be understood not as an active tool of economic policy
but as a burden that was distorting economic incentives.
This shift has led to a new priority for tax policy: to minimise the effect, the distortions, of
taxation on the economy by marginal tax rate reductions, and the elimination of tax holidays, tax breaks, and special tax regimes.
Major Changes as of 1 January 2004
Progressive income taxation was eliminated, 5 tax brackets ranging between 10 % and
38 % were replaced by one flat rate of 19 % both for personal income tax (PIT), and corporate income tax (CIT):
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How to do it: Lessons from successful liberal reforms in CEE
Data 1993: 6 rates ranging between 15-47 %; 1994: 6 rates ranging between 15-42 %;
1999: 7 rates ranging between 15-46 %; 2000: 7 rates ranging between 15-42 %;
2002: 5 rates ranging between 10-38 %; 2004: one flat rate 19 %.
Source: INEKO
The tax system was radically simplified:
1. two rates of value added tax (VAT), a standard rate of 20 % and a reduced rate of 14 %
were reduced to one rate that was also set up at 19 %;
2. several taxes were abolished: today there is no dividend tax, no inheritance tax, no gift
tax and no real estate transfer tax in Slovakia;
3. most loopholes and special tax regimes were eliminated, e.g. personal income was formerly subject to 9 different tax rates and corporate income to 3 different rates:
Number of Income Tax Rates 2003 vs. 2004
BEFORE REFORM (2003)
AFTER REFORM (2004)
Personal Income Tax
2, 2.25, 2.5, 2.75,
10, 20, 28, 35, 38
19
Corporate Income Tax
15, 18, 25
19
However, some exemptions remained after the reform. A basic personal income tax exemption was even introduced as part of the reform and has not only been preserved, but even
been doubled20 in order to protect low income taxpayers. As a result of it, Slovakia did not
20From SKK 38 760 to SKK 80 832 of annual income.
How to do it: Lessons from successful liberal reforms in CEE
| 61
introduce a pure version of the flat tax since implicitly there are two rates – 0 % and 19 %
– instead of just the one rate of 19 %.
was therefore to facilitate the transformation of unfavourable conditions for the tax reform
into favourable ones.
Tax Brackets and Marginal Tax Rates
After 1993, when Slovakia adopted a standard European tax system, neither experts nor
government officials could see any reason for introducing any further significant changes
to the tax system.
BEFORE REFORM (2003)
Tax Bracket In SKK Marginal Rate In
(monthly)
%
< 3 230
0
3 230 – 10 730
10
10 730 – 18 230
20
18 230 – 36 230
28
36 230 – 50 230
35
> 50 230
38
AFTER REFORM (2004)
Tax Bracket In SKK
(monthly)
Marginal Rate In %
< 6 736
0
> 6 736
19
Effective Marginal Income Tax Rates: Single Tax Payer
For a long time, the Ministry of Finance refused even to speak of the necessity for tax reform. The only thing the government officials were ready to discuss was a “fine tuning”, in
other words minor changes and adjustments, to the existing tax system.
Almost nobody seemed to understand that Slovakia, with a weak and inefficient economy
and a high tax burden, was simply unable to finance an expansive welfare state like those
in Western Europe. Under these conditions, the most important challenge was to persuade
both the general and expert publics that Slovakia needed fundamental tax reform.
A crucial role was played by the small circle of people associated with the F. A. Hayek
Foundation, established in 1991 as the first free-market think-tank in Slovakia. The Foundation had a significant impact on the public policy making process in Slovakia during the
country’s transition period, especially during the second half, after 1995. The Foundation
proved to be a very efficient vehicle to introduce innovative ideas like the flat tax into debates on public policy-making in Slovakia, as would be expected from a think-tank. What
was equally important, however, was its capability to also act as a ‘do-tank’ – to make sure
that these ideas were also implemented.
In order to increase public awareness of the growing tax burden and the need for fundamental tax reform, people from the Hayek Foundation in 1996 decided to establish a specialised association focused exclusively on taxation: The Slovak Taxpayers’ Association.
Its mission was defined as follows:
•To decrease the total tax burden
Source: Slovakia´s introduction of a flat tax as part of wider economic reforms, OECD, Economics Department working papers No. 448, p. 6, October 2005
•To ensure better media coverage of issues of public interest
•To assure the more efficient advocacy of taxpayers interests
How the Idea of the Reform Was Born
Favourable conditions for any fundamental reform, including a tax reform, rarely exist. That
was also true in Slovakia in the mid-1990s. The most important challenge of that period
•To protect the interests of taxpayers by supporting initiatives in reducing tax rates,
public expenditures and balancing the state budget
•To strengthen public debate about state finances and the tax burden
•To involve citizens in control over public finances
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•To increase knowledge about public finance issues.
The Association started to conduct polls on tax related issues, to carry out studies comparing the Slovak Republic’s tax system to other countries in the OECD and the EU, to organise debates on taxes and public expenditures for both general and expert audiences, and
publish an annual, The Analysis of Public Expenditures and the Tax & Contribution Burden in
the Slovak Republic.
However, the Association’s most successful project by far was the Tax Freedom Day Project,
an annual calculation of ‘Tax Freedom Day’ that attracted enormous media interest. A Law
on the Tax Freedom Day was even proposed in Parliament. All these activities were preparing
a fertile soil for more courageous ideas about how to change the tax system, including the
flat tax idea.
It was also important that The Slovak Taxpayers Association was internationally recognized
and became a member of the World Taxpayers Association (WTA) and The Taxpayers Association of Europe (TAE).
Domestically, the Taxpayers Association´s activities encouraged a public debate on taxes in
the mass media. The ideas of cutting the tax burden and of tax reform became much more
widely accepted.
However, it still had a long way to go. In order to put their ideas into practice, two more
very important steps needed to be made:
1. to plant the idea of tax reform into the public political debate and
2. to then do the same with the nation’s public administrators and policy-makers.
The Taxpayers Association´s publications and analyses of taxes and public expenditures,
along with its legislative proposals discussed in the Slovak Parliament, attracted the interest
of both the public and politicians. The Association‘s ideas and activities started to have an
impact on the programs of political parties. Two useful tools proved to be a preparation of
a handbook for policy and decision makers on taxpayers’ benign behavior and a taxpayers’
audit of political programs. The smaller political parties were the first to come up with the
flat tax idea, later followed by the larger, more relevant parties which in following years
became members of the Government coalition.
In 1998, a reform oriented coalition came into power in Slovakia that reflected voter frustration with the policies of the previous government which had brought the Slovak economy to
a serious financial crisis. However, despite reform oriented policies of the new Government,
the executive power, especially the Finance Ministry, still resisted any fundamental changes
to the tax system.
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In order to accelerate the elaboration, implementation, and adoption of much needed
changes by the executive power, some members of the Hayek Foundation and The Taxpayers’ Association decided to accept executive positions at the responsible ministries, first, in
the 1999-2002 period at the Ministry of Economy, and later, in a period after 2002 at the
Labor Ministry. The fight was brought into the internal structures of the Government.
For example, one of the documents developed by the team at the Ministry of Economy and
submitted to the Government for approval, proposed the introduction of a 20 % flat tax,
(and this back in 2000-2001!), as one of the potentially most powerful measures to make
the business environment more favourable for both domestic and foreign businesses. Since
at that time the Minister of Finance was a representative of a left-wing party, the proposal
failed. However, the first seeds were planted, and this venture brought its fruits several years
later when the comprehensive flat tax proposal was implemented on 1 January 2004.
There were also two very positive immediate results of this pioneering activity: 1. under
growing pressure, the Finance Ministry finally stopped talking about ‘fine tuning’, and was
forced to admit that a much more ambitious change to the tax system was needed, and 2.
the corporate income tax rate was cut from 40 to 29 per cent as a compromise between
the gradualist proposal of the Finance Ministry 21 and the “radical” proposal of the Economy
Ministry.22
How the Decisions to Reform Were Achieved
In September 2002 there were regular Parliamentary elections called and it was a good sign
that several political parties’ campaign programs contained the flat tax idea. It was decided
that it was a good time for The Slovak Taxpayers’ Association, in co-operation with the WTA
and the TAE to strengthen the reform message by organising in Bratislava an international
conference on recent trends in taxation policies.
Since a reform oriented Government was re-elected, the prospects for the implementation of the flat tax increased. In November 2002, the new government approved its reform
program, announcing an ambitious plan to implement a long list of fundamental reforms,
including the flat tax and pension reforms. The wording of the text on tax reform did not
commit the Government to implement a completely flat tax. It was defined more broadly
as an intention to reduce income tax rates and consider the possibilities of implementing
a flat tax.
21 The Finance ministry was proposing to take a cautious approach and cut CIT from 40 to 38 per cent.
22 The Ministry of Economy was proposing to bring down rates for both CIT and PIT to 20 per cent.
How to do it: Lessons from successful liberal reforms in CEE
| 65
In November 2002, the new Finance Minister, Ivan Miklos, set up a task force to come up
with a proposal. One of the major underlying principles of the tax reform was its fiscal neutrality. The government took a cautious approach and wanted to calibrate all changes in the
tax system with an aim to collect about the same amount of tax revenues after the reform
as before its implementation.
•Based on this assignment, the team in less than 12 months23 designed a fiscally neutral
proposal, including:
• a shifting of the tax burden from direct to indirect taxes
• the introduction of low standard tax rates and the elimination of all exceptions, exemptions and special regimes
• the introduction of a flat rate of personal income tax, replacing the regime of different
tax brackets
• the elimination of tax policy distortions as instruments for achieving non-fiscal goals
• the elimination, as much as possible, of the double taxation of income.
Opposition and Obstacles to the Reform
While the government officials and expert teams were working on the specifics of the draft
laws, there was a public debate, both domestically and internationally, that began at the
end of 2002 and continued through 2003.
The International Monetary Fund
Political and ideological opponents of the reform mobilized themselves. In summer 2003
the debate peaked. And one of the major supporting arguments for the opponents was
provided by the International Monetary Fund (IMF). The IMF sent its experts on a mission
to Slovakia in the second half of 2003 to analyze the flat tax proposal. They produced a
report24 to the Slovak Government that, in essence, said while the flat tax was a very good
idea in principle, it was inappropriate for Slovakia at the current time, though it might be
introduced by gradually sometime in future:
“Despite its appropriate aims, the ambitious program could be difficult to implement, especially on a fast track. In this context, it will be essential to reduce risks
with respect to loss of revenue, net of expenditures to compensate vulnerable
groups, given the government‘s commitment to deficit reduction. […] Forecasting
the revenue impact of the reform involves major uncertainties. These reflect the
scale of taxpayer responses, the wide range of other factors affecting economic
activity and output in any particular year, and some serious gaps in the statistics
that are presently available for estimating the impact of important taxes. […]
With these caveats, we estimate that the tax reform proposal in its present form
risks revenue losses. […] Therefore, to mitigate revenue risks, it would be more
prudent to introduce the tax reform gradually, by first adjusting indirect taxes
and then phasing in the reduced income taxes over a number of years.”
Internal Discussions and Decisions
These conclusions persuaded even a majority of advisors to the Finance Minister. They in
turn did not encourage the responsible Minister to go ahead with the reform plan after the
IMF report has been released. In his Collegium, an advisory body consisting of his internal
(ministerial) and external advisors25, there were just two external advisors trying to persuade others to give a green light to the reform. The remaining members of this body were
– although reform-oriented – in favour of other reform measures to be taken first, e.g. a
reform of social security contributions.
The Minister himself seemed to be undecided until the very last moment. Unlike Mart Laar
in Estonia, Ivan Mikloš was not the driving force of the flat tax reform in Slovakia. His priority was to reduce the distorting effects of tax policies, not necessarily via the introduction
of the flat tax. He had never before fought for the flat tax. He had never publicly expressed
his firm support for this idea.
It was therefore one of the most interesting moments of the flat tax story in Slovakia when
this Minister, until that time not especially enthusiastic about the flat tax, finally made the
decision to adopt it. His decision was taken despite the many other uncertainities of that
period such as impending EU accession and fiscal decentralisation, despite the IMF’s negative recommendation, and despite the opinion of the majority of his advisors – he deserves
considerable credit for this bold decision.
23MINISTRY OF FINANCE, “Fundamental Reform of The Tax System”, November 2003.
24INTERNATIONAL MONETARY FUND, Slovak Republic—2003 Article IV Consultation Mission, Preliminary
Conclusions, May 7, 2003, http://www.imf.org/external/np/ms/2003/050703.htm
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How to do it: Lessons from successful liberal reforms in CEE
25 including author of this text
How to do it: Lessons from successful liberal reforms in CEE
| 67
The European Union
The EU, representing Slovakia’s most important economic and political partners, played a
negative role similar to the IMF’s. Outside pressures on Slovakia from old EU member countries were manifest even before negotiations on EU accession began.
These pressures became more intense after the Government’s first intentions to introduce
the 19 % flat tax were made public. Many political leaders of the old EU member countries,
including then German Chancellor Schröder and Swedish Prime Minister Persson, were criticising Slovakia for its intention to reduce tax rates. They were afraid that the traditional
European economic and social model based on a high degree of income redistribution, high
government expenditures, and a high tax burden, would be seriously undermined by the
reform efforts of EU candidate countries. In addition, these EU leaders were generating
pressure on Slovak politicians at the EU level by talking repeatedly about a necessity for tax
harmonization in Europe.
•The Hayek Foundation and Steve Forbes
•In order to counterbalance this growing criticism, the Hayek Foundation and The Taxpayers Association invited to Slovakia Steve Forbes, an American billionaire whose then
current campaign for the US Presidency was based on the flat tax idea.
•It proved to be an excellent idea. He gave the annual lecture at the Hayek Foundation,
attracted the interest of all the media in Slovakia and he also met the Slovak President
and the Finance Minister. His visit was the best promotion of the idea of the flat tax
and it positively influenced the public debate on the Government’s proposal.
Also he did not hesitate to add to his impressions a personal note from his visit to Slovakia
called “Tocqueville Would Have Understood”:
“I visited Slovakia recently at the invitation of the F.A. Hayek Foundation and one
of its offshoots, the Slovak Taxpayers’ Association. The Foundation was founded
in 1991 to promote free-market ideas and political principles in a country where
such traditions had never existed before. That Slovakia is emerging as a beacon
of democratic capitalism is in no small part because of the Foundation‘s work.
For example, it persistently and effectively pushed the flat tax idea, which should
become effective 1 January 2004. All of us, including savvy investors, should be
grateful that such civic institutions as the Hayek Foundation are taking root in
former Communist countries. They are providing the real push, the impetus for
Western-style reforms and ideas.”
However, in Europe the criticism of the Slovak’s flat tax continued even after 1 January
2004. Only a month before May 1, 2004, the date the ten candidate countries would become new EU members, the German Chancellor and the Swedish Prime Minister publicly
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How to do it: Lessons from successful liberal reforms in CEE
criticized the low income tax rates of these candidate countries. They even threatened them
with cuts in EU funding if they continued what they called ‘inadequate taxation’.
In reaction to their verbal attacks, the Slovak Taxpayers’ Association sent an open letter to
Chancellor Schroeder and Prime Minister Persson:
“We strongly disagree with your statements. We believe that high taxes are
incompatible with high growth rates, the accumulation of wealth, and high
standards of living. We believe that in the long-term, countries cannot either
maintain or achieve prosperity without a low tax environment. […] We strongly
believe in the benefits of tax competition. That is why we encourage you to try
to learn lessons from countries reforming their tax systems instead of trying to
teach them lessons.”
Countries like Germany and Sweden criticised Slovakia for what they called ‘tax dumping.’26
The results of the reform clearly demonstrated that this criticism was both unreasonable in
tone and unproven in fact.
A Demonstration of the Success of the Reform
The introduction of the flat tax accelerated economic growth in Slovakia: in its first analytical report in 2005, the Finance Ministry estimated that the GDP growth rate accelerated
by 0,5 % in 2004 because of the flat tax reform. Economic growth of the Slovak economy
accelerated even further in following years, especially in 2006 and 2007, with 8.5 % and
10.4 % growth rates respectively.
Although it is difficult to separate the impact of other factors like EU accession, a strongly
positive overall impact of the flat tax reform on the macroeconomic performance of the
Slovak economy cannot be disputed. The following two charts illustrate this impact: a sharp
acceleration of GDP growth and an equally sharp decline in the unemployment rate.
26In their interpretation, the country is involved in ‘tax dumping’ by attracting investors from the West
through reduced tax rates and at the same time receiving EU subsidies from high tax countries.
How to do it: Lessons from successful liberal reforms in CEE
| 69
The flat tax reform kept the total tax burden/GDP 27 ratio unchanged: it stayed at less than
30 %, the second lowest burden in the EU after Romania, with tax revenues representing
about 18 % of GDP.
12
10,4
10
8,5
2004 Flat Tax Reform
8
60
6,6
EU (27 countries)
6
4,8
4,4
4
4,8
5,2
Slovakia
3,4
2
50
39,9
40
1,4
29,3
30
0
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
20
2007
10
Real GDP Growth in %
Source of Data: Eurostat
0
20
18,8
19,3
18,7
17,6
18
FI
IT
AT EU- NL
27
DE
SI
UK HU CY ES CZ
PT LU BG MT PL
IE
EL EE
LV LT
SK RO
Total Tax Burden in the European Union, 2006
Source: Eurostat.
18,2
16,4
DK SE BE FR
16,3
16
14
13,4
12,6
12
11,1
10
8
2004 Flat Tax Reform
6
4
2
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Unemployment Rate in %
Source of Data: Eurostat
70 |
The flat tax was introduced in the final stage of a far-reaching reform program resulting
in a general decline of the total tax burden. Slovakia is No. 1 in Europe in reducing the tax
burden as measured by a share of taxes and social security contributions on GDP. While in
1995-2006 the average overall burden in the EU increased slightly (0.3 %), significantly
so in some countries like Cyprus (9.9 %), Slovakia achieved a record decline in its total tax
burden, almost 11 %!
The flat tax reform significantly reduced tax avoidance and increased tax compliance:
taxpayers perceived the new system, with its low 19 % flat income tax rate, as more just,
and they were more willing to pay their taxes as is demonstrated by the increased number
of personal income tax returns filed after the reform. In 2004, the number of tax returns
increased 14.6 % .
27 including social security contributions representing about 12 % of GDP.
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How to do it: Lessons from successful liberal reforms in CEE
| 71
The flat tax proved to be an excellent marketing tool for the country: For example, Steve
Forbes wrote an article for Forbes Magazine called Investors‘ Paradise28:
12
9,9
8
4
0,3
0
CY MT
PT ES UK EL
IT
BG FR LT SE BE RO AT DK EU- CZ
27
IE DE NL
SI
LU
FI
LV PL HU EE SK
-4
-8
-10,9
-12
% Changes In Total Tax Burden In European Union, 1995-2006
Source: Eurostat.
The reform successfully passed its first political test: in June 2006, early elections29 were called in Slovakia. Left-wing parties campaigned under the slogan of “a return to the European
welfare state”, and severely criticised right-wing parties for their efforts to diverge from the
so-called ‘European social model’. This strategy helped the leftists to win the election and
form the new Government. One of their election promises was to change the tax system in
a way which would, in effect, have ended the flat tax in Slovakia.
Fortunately, Slovakia will not be the first country to eliminate a flat tax – the new leftist
Government eventually only made minor changes to the flat tax system. That was a result
of a combination of lobbying and a public campaign by NGOs and businesses to keep the
flat tax system.
450000
446206
440000
Some Advice for other Reformers – Things to Avoid
2004 Flat Tax
2004 Flat Tax Reform
Reform
430000
The list of countries implementing flat tax reforms has been getting longer and longer. As
Slovakia demonstrated, it can be introduced relatively unchanged even in countries with
strong previous egalitarian traditions, and with an inherited extensive welfare state. It also
demonstrated that the influence of the EU makes this type of reform more difficult both in
terms of its initial introduction and later its defence.
420000
410000
400000
389453
390000
380000
“The Slovak Republic is set to become the world‘s next Hong Kong or Ireland, i.e.,
a small place that‘s an economic powerhouse. […] Slovakia is about to enact a
19% flat tax, for both individuals and corporations. The death tax is being consigned to the graveyard and the tax on dividends, abolished. The Government
plans to chip away at the high payroll tax that funds various social programs
such as health care. It is also considering ways to fundamentally reform its social
security pension system, perhaps privatizing a portion of it.”
383788
There are many conditions that are necessary for the successful implementation of a flat tax
reform program. In Slovakia’s case, the following three factors played a crucial role:
375399
373 235
370000
360000
350000
2000 - 2003
2004
Tax Returns Increase 2004/2003
Source of data: SAAVEDRA Pablo, “Flat Income Tax Reforms”, p. 267.
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How to do it: Lessons from successful liberal reforms in CEE
28Steve Forbes, Fact and Comment, The Forbes Magazine, August 11, 2003.
29Instead of originally scheduled September 2006.
How to do it: Lessons from successful liberal reforms in CEE
| 73
A Crisis and a Sense of Urgency
•Slovakia was the first country in Central Europe to adopt a flat tax
Experience with economies in the transition process shows it is much easier to implement
any significant reform change when a sense of urgency is widely shared. Politicians, policymakers, and citizens must be persuaded that there is a real problem that needs to be solved
urgently. Creating the need for action is the very first step (and a major challenge for any
think-tank) before any innovative idea or radical reform can be implemented.
•Slovakia was the first country to introduce a flat tax just months before entering the
EU
•Slovakia is the first OECD country to introduce the flat tax
•Slovakia is soon to be the first eurozone country with a flat tax.
Quick Implementation
Various interest groups actually prefer the sub-optimal status quo – they are usually powerful and dangerous enemies of the flat tax. That is why it is important to avoid any gradualism and implement reform changes as quickly as possible, before these beneficiaries of
the old system can organise and stop the reform efforts. One reason for the success of the
Slovak tax reform was its quick implementation. A mere 14 months passed between the
adoption of the reform plan by the new Government (4 November 2002) and when the new
legislation took effect (1 January 2004). The flat tax only became an important public issue
during the four months prior to the election, or just 18 months before its implementation.
A Comprehensive Reform Package
The introduction of the 19 % flat tax was just one element of the Slovak Government’s reform program of 2002-2006. During 2002-2006, seven fundamental reforms were adopted:
1. Labour Market Reform, 2. Flat Tax Reform, 3. Pension Reform, 4. School System Reform, 5.
Health Care Reform, 6. Fiscal Decentralisation Reform, and 7. Business Environment Reform.
Thus, the introduction of a flat tax was not an isolated act, but an integral part of much
broader reform efforts.
In order to get this sort of reform done successfully, it must be realized that it is a long
and difficult journey. Both the preparatory and implementation stages are equally complicated. The preparatory stage is about getting the reform idea into the center of the public
policy debate, of increasing the idea’s awareness among the general public, and generating
pressure on politicians to implement the idea. The most useful and efficient strategy is to
establish a grass movement early on, an active taxpayers´ association promoting projects
like Tax Freedom Day. Even if these efforts are successful, and there is a reform idea ready
to be implemented, the implementation stage is impossible without politicians ready to implement it. At the end of the day, the final success depends critically on the decisions of an
individual politician, his or her courage to take risks and continuing support to implement
the idea when confronted with heavy opposition.
Ambitious goals, a comprehensive reform strategy with the flat tax as only one part of the
broader reform package, quick implementation; these are all crucial elements of success of
any potential reformer.
Conclusions
The introduction of the 19 % flat tax represents one of the fundamental elements of the
Slovak Government’s reform program of 2002-2006 – arguably the most consistent and radical free market program of any developed country in the first decade of the 21st century.
There were several specific circumstances that made the Slovak flat tax reform experience
unique:
74 |
It was important that the flat tax idea was consistently implemented in its original version,
thus radically flattening the structure of tax rates, and in conjunction with a tax simplification that set CIT, PIT, and VAT all at 19 % too. One of the major limitations of the reform
was the ‘revenue neutrality principal’. The Government did not intend to reform the tax
system in order to reduce the tax burden. It intended to keep tax revenues at pre-reform
levels. Also, the tax reform did not even touch upon the painful problem of the high and
complicated social security contributions paid by both employers and employees. It remains
unreformed today, representing one of the major barriers for doing business as identified by
entrepreneurs themselves.
How to do it: Lessons from successful liberal reforms in CEE
All in all, the Slovak flat tax reform experience and its results is proof that the flat tax
works. Slovakia can serve as an inspiration for other countries, especially for post-communist countries of a Central and Eastern Europe, including the former Soviet Republics.
Its most inspiring element is the experience of a country, once desperately lagging behind
others, who implemented an ambitious reform plan which then put it far ahead. If Slovakia
did it, other countries can do it as well.
How to do it: Lessons from successful liberal reforms in CEE
| 75
References
EUROSTAT, http://epp.eurostat.ec.europa.eu
EUROSTAT 2008: Statistical Books, Taxation trends in the European Union: 1995-2006,
http://ec.europa.eu/taxtrends
FORBES Steve 2003: Fact and Comment, The Forbes Magazine, August 11.
ˇINA Robert 2005: Slovak Tax Reform: One Year After, INEKO, April, p. 5.
GOLIAŠ Peter/KIC
INTERNATIONAL MONETARY FUND 2003: Slovak Republic—2003 Article IV Consultation Mission, Preliminary Conclusions, May 7th, http://www.imf.org/external/np/ms/2003/050703.
htm
THE DEVELOPMENT OF E-GOVERNMENT AND THE REFORMS WHICH MADE IT POSSIBLE: THE CASE OF ESTONIA
Jüri Saar
Estonian Free Society Institute, Tallinn
Introduction
MINISTRY OF FINANCE 2003, Fundamental Reform of The Tax System.
OECD 2005: Slovakia´s introduction of a flat tax as part of wider economic reforms, OECD
Economics Department working papers No. 448, p. 6.
ORAVEC Ján 2005: Tax Competition or Tax Harmonization in Enlarged Europe?, a paper prepared for the 19th Leipzig seminar organized by The Center for the International Economic
Relations, University of Leipzig, November 24-25, Germany.
ORAVEC Ján 2006a: Government Regulations And Taxation In Slovakia: The Effects On Property Rights, a paper prepared for the Liberty Fund conference on Private Property Rights
and Liberty, Dallas, Texas, November 16-19.
ORAVEC Ján 2006b: Introduction Of 19 % Flat Tax In Slovakia In 18 Months, a paper prepared for an international conference Freedom, Commerce, and Peace: A Regional Agenda
organized by The Cato Institute, the New Economic School of Georgia, the Atlas Economic
Research Foundation, the Heritage Foundation, the Friedrich Naumann Foundation, and the
Center for International Private Enterprise, October 25-27, Tbilisi, Georgia.
SAAVEDRA Pablo, with contributions from MARCINCIN Anton and VALACHY Juraj 2007:
“Flat Income Tax Reforms”, pp. 253-280, in “Fiscal Policy and Economic Growth. Lessons for
eastern Europe and Central Asia”, World Bank.
During the second half of the 1990s, as the number of people using the Internet in Estonia
began to grow exponentially, it became increasingly obvious that it would change the way
that people communicate, find, and access information. It didn’t take long for the public
sector to see the Internet as a medium with enormous potential for providing access to
almost any public information or service for anyone at a place and time of their choosing.
This paradigm shift in the public sector became known as ‘e-government’.
In the first section of this paper, an overview is given of the educational and technological
conditions in Estonia before the implementation of e-government reforms. The second section will focus on the specific underlying ideas and principles of the Estonian e-government
project, while the third section considers some of the obstacles to reform in Estonia. The
fourth and fifth sections will look in greater detail at some of the more successful initiatives
with the sixth section providing some advice to potential reformers before concluding with
some final remarks.
The Foundations of E-government in Estonia
One of the more interesting side effects of the Soviet occupation of Estonia was that Estonian institutions of higher education were not allowed to offer too many courses in
philosophy or the social sciences. This meant that more emphasis was placed on natural
sciences such as physics, mathematics, chemistry, and various branches of engineering (Levine, 2004).
Limits and restrictions on what could be taught and to whom in the social sciences ended
up usually in guiding promising potential students toward less ideological fields of study
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| 77
related to engineering such computer science, cybernetics, and information technology. In
addition, the emphasis on theoretical teaching in these fields meant that the focus was on
basic principles that rely more on mathematics and physics, not concrete technical applications (Högselius 2005).
By the late 1980s, it had become obvious to top officials in the Ministry of Communications
that most of the telecommunications equipment and infrastructure in the Soviet Union was
outdated. The anticipated institutional changes would, however, allow for new and advanced technologies to be utilised in the local telecommunications network.
By the time Estonia began to move toward independence in the late 1980s, the Soviet influence on higher education mentioned previously had caused a situation where a significant
part of the people in charge of coordinating and planning the various activities of this small
Soviet republic had engineering backgrounds. This was also fertile ground for a technocratic
elite that understood the importance of technology and technological solutions for economic growth.
The creation of Eesti Telefon was directly related to the Concession Agreement according to
a trilateral (Finnish, Swedish, and Estonian) joint venture which was awarded a monopoly
license by the Government of Estonia in 1992 for fixed voice telephony services until the
end of the year 2000. In return, the Nordic partners were obligated to invest in the modernization of Estonia‘s telecommunications infrastructure. This ten year investment program,
worth $25 million annually, was launched to cover the installation of 30 000 digital lines
each year. However, the Concession Agreement did not extend to the fields of mobile telephony nor data communications (Högselius 2005).
Enthusiastic technocrats also played a significant role in the updating of Estonia‘s telecommunications infrastructure that would lay the ground work for the adaptation of various
Internet based solutions, IT businesses, and eventually e-government initiatives.
Even before Estonia regained its independence from the Soviet Union in 1991, it had become
clear that the institutions of a totalitarian regime would not be suitable for a democratic
and market oriented country. About seven months before Estonia officially regained its independence, the foundations of e-government were already being laid with the liquidation
of the Soviet-era Ministry of Communications.
From an Emergent Technology to Achieving E-government
By the early 1990s, it had become clear that in the coming years only information societies
could guarantee prosperity for their citizens. To this end, the first information society strategy document, „Estonia‘s Road to an Information Society“, was drawn up in 1994 by the
government of Mart Laar. The document was inspired to a large extent by developments
in the EU as well as the US, where infrastructure issues were taking centre stage (Kalvet
2007).
One of the more important policy documents, „The Principles of Estonian Information Policy“, was ratified by the Parliament a few years later in 1998 and emphasized the importance
of modernizing legislation, supporting the private sector, and raising awareness of issues
associated with an information society. Subsequent versions of the same policy document
prioritized the continuing development of the e-state. The 2004-2006 version singled out
the importance of e-government solutions on all levels of government along with schooling
and the raising of awareness on ICT issues (Principles of Information Policy 2003).
All political parties in Estonia were in public agreement on the objective of turning Estonia
into a successful information and knowledge-based society. However, connections between
political rhetoric and concrete actions are unclear even in the best of cases.
One of Estonia’s leading ITC and e-government researchers, Tarmo Kalvet, recently pointed
out that one can observe a very pragmatic approach to e-government in Estonia, but the
connections between strategy documents and actual developments can best be described
as „strategies based on development“ rather than „development based on strategies“.
Estonian government in the “e-cabinet room”, Prime Minister´s Office (Photo: http://gallery.
vm.ee)
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How to do it: Lessons from successful liberal reforms in CEE
This somewhat entrepreneurial approach meant officials who were willing to act and pro-
How to do it: Lessons from successful liberal reforms in CEE
| 79
pose practical solutions to existing problems quite often found themselves with both the
people and resources to carry out their plans. To a large extent, this was possible for three
reasons: (1) as the public sector was reformed after independence, the newly created jobs
were staffed with a younger and more enthusiastic generation; (2) new institutional arrangements meant that there was little to no loyalty to the “old way of doing things”, so new
solutions that could take advantage of the cost effectiveness of IT were adopted; (3) Mart
Laar as Prime Minister of Estonia (twice, in 1992-1994 and 1999-2002) was a vocal advocate of e-government, the use of IT in government, and liberal modernization.
Opposition and Obstacles
The signing of the Concession Agreement on 16 December 1992 awarded a monopoly license to Eesti Telefon for fixed voice telephony services in Estonia. The agreement was the
result of a preparatory negotiations period that had started in 1990, but was severely complicated by the lack of a constitution and a convertible currency until June 1992 (Högselius
2005). In addition, most of the nation‘s legislation was in flux and from the end of 1990
until the end of 1992, three different Estonian governments held office. It was the last of
these governments, lead by Prime Minister Mart Laar, that turned out to be the most sceptical of an agreement that would grant “exclusive rights for” almost a decade. After intense
lobbying during the last months of 1992, the agreement was signed, but not by the Prime
Minister as originally planned.
One of the main arguments for the Concession Agreement had been the modernization of
Estonia‘s telecommunications infrastructure. After the agreement was signed, the government usually took a critical stance toward the pace of modernization and expansion of
telecommunications infrastructure making it increasingly difficult for the company to get
approval for its business plans. Eesti Telefon was by no means a popular company among
a population that wanted modern services now, not two or five years down the road. Their
constant criticism was echoed in political circles where the Minister for European Affairs
eventually resigned in 1996, citing, among other reasons, what he regarded as „a policy of
monopoly in the telecom business“ (Högselius 2005).
Eesti Telefon was forced to rewrite its three-year business plan for the period 1997-1999
to get the approval of the Government. The new plan resulted in a faster pace of modernization with the number of digital lines added annually raised from 30 000 to 50000. This
meant that the investment requirements set down in the Concession Agreement in 1992 of
$25 million annually were almost doubled.
The first few steps in providing a legislative framework for future Internet-based government services was taken in 1997 with the Databases Act which provided procedures „for
the possession, use and disposal of state and local government databases“. This was follo-
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How to do it: Lessons from successful liberal reforms in CEE
wed by the Official Statistics Act a few months later, but both of these laws also initiated
several processes that led to the systematic consideration of security issues. That in turn
led to the Digital Signature Act as well as the Public Information Act in 2000 – significant
for its provisions on electronic access and the disclosure of information. This meant that
government agencies now had a duty to maintain websites and were obligated to insure
that their information was neither outdated nor inaccurate. In addition, for the first time
e-mail requests for information had to be treated as official requests.
Legislation alone, however, is not enough. One of the more significant obstacles for the development of an Information Society was the lack of competence. To remedy this lack, the
Estonian ambassador for the United States in 1995, Toomas-Hendrik Ilves, proposed a simple idea: equip all Estonian schools with computers and thereby take a big leap into the information society. The idea was supported by the Minister of Education, Jaak Aaviksoo, and
gained momentum as the use of the Internet began to grow unexpectedly rapidly (Högselius
2005). This computerization project was officially announced in February of 1996 under the
name of Tiigrihüpe or ‘Tiger Leap’ and enjoyed wide ranging political support while relying
extensively on the private sector participation.
Co-opting the Private Sector
Estonian banks were a significant force in driving the development of e-government in
Estonia. As mentioned in the previous section, the banks were not simply purveyors of financial services, but also active participants in schooling and training Estonians in the use
of computers and the Internet through the [email protected] project. Active participation by
the banks was to a large extent driven by various electronic banking solutions that proved
to be both innovative and popular among users – a development that can be attributed to
the fact that banking in general was only some five years younger than the first (offline)
electronic banking solution introduced in 1993 (Lushtshik 2003).
The first Internet banking solutions were offered by two Estonian banks in 1996 and shortly
thereafter several other local banks followed suit (Kerem 2003). Since Internet banking services were under constant development, the services became increasingly sophisticated and
eventually several banks began to set up partnerships with other service providers.
It didn‘t take long for the public to notice that while almost all financial transactions could
be performed over the Internet, you could not pay electronically for even the simplest of
taxes. The Tax Board sensed a clear demand for services that would allow the submission of
income tax declarations directly over the Internet. Work on the e-Tax Board began in 1999
(largely thanks to Aare Lapõnin, the Tax Board’s IT Manager) and the first 12 000 individuals
submitted their income tax declarations over the Internet in 2000. Later that same year, the
How to do it: Lessons from successful liberal reforms in CEE
| 81
e-Tax Board was opened up to businesses. In as little as three years, almost 50 per cent of
all tax declarations were filed electronically (Högselius 2005).
One of the more unusual aspects of the e-Tax Board was its customer identification and
authentication solution that relied on the existing solutions developed by banks. Since there
was no public sector equivalent of an authentication method as secure and widespread, nor
as popular, as those of the banks, the e-Tax Board decided that the simplest way to provide secure access would be through the authentication solutions of internet banking. This
meant that to gain access to the e-Tax Board, you had to log in through your Internet bank
and you would be redirected to the e-Tax Board where your pre-filled income tax declaration was waiting for your confirmation or corrections.
The identification and authorization competence that the banks had accumulated during
the development of their various internet banking solutions played a significant role in
guiding the development of Estonian Public Key Infrastructure (PKI) – the indispensable method that enables computer users without prior contact to be authenticated to each other.
The first research into PKI and electronic identification in Estonia were made in 1994 and
1996 by the Institute of Cybernetics. However, as the technology was not yet mature nor
the public ready to use such authentication solutions, it faded into obscurity. The idea was
revived in 1997 when the Citizen and Migration Board floated the idea of a new identification document, something more convenient than a passport (Certification Center 2003). A
formal ID-card project proposal was presented a few months later by a private IT developer
and one of the largest banks in Estonia.
The following year the concept was presented to the wider public and preparations for a
pilot project began that was launched at the end of 1999. During the initial development
phase the ID-card project consisted of two projects – a new identification document and
PKI for electronic authentication – that were merged into single solution only during the
final stages of the project, when in 2000 the Identification Document Act came into effect
and the following year the Digital Signatures Act was ratified. It is at this point that interest in PKI among Estonia‘s two largest banks, SEB and Hansabank, as well as the largest
telecommunications companies Eesti Telefon and EMT, lead to the creation of Certification
Centre – a private company that would eventually issue, manage and renew electronic certificates for all Estonian ID cards (Certification Centre 2003).
Demonstration of the Reform‘s Success
The first ID cards were issued to the general public in the first half of 2002, while the first
digital signatures were given out at year-end. Initially used mostly as a convenient travel
document, the authentication possibilities of the ID card have slowly but surely gained a
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How to do it: Lessons from successful liberal reforms in CEE
wider use. By the end of March 2008, more than 991 000 Estonians or about 80 % of the
population had ID cards, roughly 4,3 million digital signatures had been given out and 7,3
million electronic identifications made.
The three prerequisites of telecommunications infrastructure modernization, ID cards with
electronic authentication, identification for higher security, and the changes in legislation
necessary for an information society, were all implemented successfully enough to enable
interesting developments on the solutions side. Some of the more successful of these solutions were:
• X-road – During the use of various databases by public sector organizations it became
increasingly clear that a lot of the information was being duplicated in different databases leading to time wasted by re-inputting existing data. The X-road project was
proposed in 2000 for the modernization of databases with the aim of changing them
into a public service-rendering resource, which would enable agencies, legal and natural persons to search data from national databases over the Internet, provided they are
entitled to do so.
• e-Tax Board – launched in late 2000, the e-Tax Board has become one of the most popular e-government services in Estonia. While in 2001 only about 9 per cent of income
tax declarations were made online, the number has reached more than 80% of Estonians in 2006 (Estonian Tax Board 2007).
• „Today I Decide“ portal – the success of the e-Tax Board inspired the development of
further public services, the first of which was „Today I Decide“. The service addressed the
ability of Estonians to participate in the state‘s decision-making process by allowing
anyone to submit ideas and comments on draft legislation or even propose amendments to existing legislation. Despite the service receiving a European Commission egovernment prize at a conference in Brussels in 2001 (Vallner 2002), the portal has not
gained traction among most Estonians and will be replaced by August 2008.
• e-voting – the first proposals for e-voting were made in 2001 and strongly supported
by Mart Laar, the Prime Minister of Estonia at the time. Legislative questions associated
with e-voting were integrated into several election laws (local, country, EU parliament)
and debated during 2002 (Drechsler 2003). In the end, ID-card based e-voting over the
internet was delayed until the local elections of 2005, when slightly more than 9 000 or
about 1 % of eligible Estonians voted electronically. During the parliamentary elections
of 2007 – about a year and a half after local elections – almost 5,5 % of Estonians voted
over the Internet (OSCE 2007).
•Company Registration Portal (CReP) – the project was initiated in 2006 and launched in
early 2007 with the aim of allowing the registration of new companies online by anyone with an Estonian ID card. This meant that instead of a week, a new legal entity could
be created in as little as 12 minutes without leaving home (RIK 2007). During the first
How to do it: Lessons from successful liberal reforms in CEE
| 83
four months, 25 % of new companies were registered through CReP and that number
continues to increase. It‘s also worth mentioning that the World Bank’s „Doing Business
Survey“ ranked Estonia the 53rd easiest country to start a business in 2007, but 20th in
2008.
The five e-government solutions presented above are but a sample of some of the more
prominent ones developed and adapted in Estonia.
The fact that e-government will be increasingly important in the future has not gone unnoticed by most governments. However, this does not mean that there is a clear understanding
of what services a true e-government should provide online and how. This is substantiated
most clearly by various e-government surveys. For example, the „UN e-government survey
2008“ ranked Estonia 5th in Northern Europe and 13th in the World and the Economist
Intelligence Unit‘s „The 2007 E-Readiness Rankings“ ranked Estonia 1st in Eastern Europe and 28th in the World. Meanwhile, the Capgemini survey „Online Availability of Public
Services“ ranked Estonia 2nd in Europe after Austria which contrasted sharply with Brown
University‘s „Global E-Government, 2007“ survey, where Estonia came in at a humble 128th.
The uncomfortable fact is that there‘s plenty of room for different interpretations of what
the most essential elements of e-government are as well as what should actually be measured.
Suggestions and Ideas for Reformers
3.Different departments have different leaders with unique visions on how services could
be developed further. Decentralization should be preferred to avoid turf wars between
government agencies and allow them the freedom to direct the development of their
own systems as long as interoperability with other e-government solutions is guaranteed.
4.There is no substitute for people with strong convictions willing to make e-government
a priority, if they allow for input and initiative by anyone willing to implement concrete
solutions. Not limiting initiative with overly narrow top-down policy documents creates a space for these actors to produce actual results.
5.Open source solutions can encourage participation by the public in developing services.
The number of services developed by private individuals and companies across the globe is increasing daily and several of them can be used to provide innovative solutions
ranging from reorganizing available information to aggregating information in new and
novel ways.
There are at least two interesting solutions that have been built on e-services by private
individuals. In one case, the electronic State Gazette, which publishes all legislative acts,
was notorious for its inadequate search features and interface design, but received a more
user friendly interface from Peeter Mõtsküla based on an open source solution, wLex.
The development of e-government in Estonia has been an ongoing process that has proved
to be as successful as it has due to several different factors, not all of them planned. The
location of Estonia close to Finland and Sweden, the orientation toward engineering in
higher education under Soviet rule as well as the emergence of the Internet as a significant
force for change in the second half of the 1990s all played significant roles. However, there
are certain policies and priorities that Estonia pursued that might be of use to reformers
interested in accelerating the development of e-government in their country:
In the second case, proposals from the „Today I Decide“ (TOM) portal were integrated into
the social bookmarking site del.icio.us by Peeter Marvet. This particular solution tagged all
TOM ideas to show clusters of relevant policy issues. While these two examples are by no
means an e-government solution, they are potential trendsetters and provide a general idea
of what is possible if private individuals can build on existing government solutions.
1. Local businesses are usually better informed about the cultural, economic and educational background of the potential users (their customers!) and therefore able to utilize
local knowledge to overcome obstacles, solve and in some cases foresee problems. The
inclusion of private sector organizations as partners in schooling and training programs
should be considered.
Conclusion
2.There are limits to what central planning by a single government agency can achieve.
Action is often preferable to planning since it provides direct feedback into the development process by revealing unforeseen problems and obstacles. Since starting with
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even small initiatives builds competence, there is also no reason to prefer huge all-encompassing projects to smaller projects that can gradually be built upon later.
How to do it: Lessons from successful liberal reforms in CEE
The Estonian experience in developing e-government solutions has shown that while some
success is usually determined by people interested in change and willing to act to achieve
this change, a lot depends on initial conditions and how free people are to take advantage
of them. A single vision or plan might guide the various stakeholders in developing their solutions, but its also increasingly obvious that grand visions should leave plenty of room for
the modest visions of the implementers, who can come up with novel solutions to difficult
problems, if unconstrained by detailed directions.
How to do it: Lessons from successful liberal reforms in CEE
| 85
References
Capgemini 2006: Online Availability of Public Services: How Is Europe Progressing?
http://ec.europa.eu/information_society/eeurope/i2010/docs/benchmarking/online_availability_2006.pdf
Certification Center 2005: The Estonian ID Card and Digital Signature Concept: Principales and Solutions
http://www.id.ee/public/The_Estonian_ID_Card_and_Digital_Signature_Concept.pdf
Department of Economic and Social Affairs Division for Public Administration and Development Management 2008: United Nations e-Government Survey 2008:
From e-Government to Connected Governance
http://unpan1.un.org/intradoc/groups/public/documents/UN/UNPAN028607.pdf
Drechsler, Wolfgang 2003: The Estonian E-Voting Laws Discourse: Paradigmatic Benchmarking for Central and Eastern Europe.
http://unpan1.un.org/intradoc/groups/public/documents/nispacee/unpan009212.pdf
OSCE 2007: Republic of Estonia Parliamentary Elections: OSCE/ODIHR Election Assessment
Mission Report
http://www.vvk.ee/english/OSCE%20report_EST_2007.pdf
Principles of Estonian Information Policy 2004–2006:
http://www.riso.ee/en/files/Principles%20of%20the%20Estonian%20Information%20Polic
y%202004–2006_0.pdf
RIK 2007: Company Registration Portal
http://www.epractice.eu/files/upload/gpc/document/1791-1181299960.pdf
Vallner, Uuno 2002: An E-community, E-citizens and E-services – A New Infrastructure
and Reengineering of Institutions, Baltic IT & T Review, no. 4
http://www.ebaltics.com/00705052?PHPSESSID=8cded15b521b0a64365777d4d6807ee7
West, Darrel M. 2007: Global E-Government, http://www.insidepolitics.org/egovt07int.pdf
Economist Intelligence Unit 2007: The 2007 E-Readiness Rankings: Raising the Bar
http://www.eiu.com/site_info.asp?info_name=eiu_2007_e_readiness_rankings&rf=0
Estonian Tax and Cutoms Boards Yearbook 2007:
http://www.emta.ee/doc.php?21262
Högselius, Per. 2005: The Dynamics of Innovation in Eastern Europe: Lessons from Estonia,
Cheltenham, UK and North-Hampton, MA, USA: Edward Elgar Publishing.
Kalvet, Tarmo. 2007: The Estonian Information Society Developments Since the 1990s,
PRAXIS Working Paper No 29/2007.
http://www.praxis.ee/data/PRAXIS_WP_29_NETIS_Kalvet.pdf
Kerem, Katri. 2003: Internet Banking in Estonia, PRAXIS Working Paper No 7/2003.
http://www.praxis.ee/data/PRAXIS_Internet_Banking_in_Estonia4.pdf
Levine, Joshua. 2004: If it Works, You Can Break It. Forbes Magazine, 12 December 2004.
http://www.forbes.com/global/2004/1220/016_print.html
Lushtshik, Olga 200: E-pangandus Eestis: kiire kasvu põhjused ja tegurid, Kroon & Majandus No.3/2003
http://www.eestipank.info/jump?objId=925685
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How to do it: Lessons from successful liberal reforms in CEE
| 87
PUBLIC FINANCE REFORM IN BULGARIA
Adriana Mladenova and Dimitar Chobanov
Institute for Market Economics, Sofia
Introduction
In 2008, the Bulgarian economy is strong and its fiscal position is sound. However, in 1996
and 1997, the economic situation looked rather gloomy and few believed that Bulgaria
could become one of the most desirable destinations for foreign direct investments in Central and Eastern Europe, not to mention a member of the EU.
The economic collapse in 1996 and 1997 triggered major changes in public institutions,
fiscal and monetary policy governance and public finance management. As of the beginning
of 2008, Bulgaria has recorded five consecutive years of budget surplus and of decreasing
government debt both in absolute terms and as a percentage of GDP. The fiscal reserve at
the end of March 2008 amounted to 4,135 billion EUR or 13 % of the forecasted GDP in
2008.
Finland
Denmark
Sweden
Bulgaria
Cyprus
Luxembourg
Estonia
Spain
Netherlands
Ireland
Latvia
Germany
Slovenia
Belgium
Austria
Euro area
Lithuania
Czech Republic
Malta
Italy
Poland
Slovakia
Romania
Portugal
France
Greece
United Kingdom
Hungary -5,5
-1,2
-1,6
-1,8
-1,9
-2
-2,2
-2,5
-2,6
-2,7
-2,8
-2,9
EU (15 countries)
EU (27 countries)
0
0
-0,1
-0,2
-0,5
-0,6
2,2
0,4
0,3
3,5
3,4
3,3
2,9
2,8
4,4
5,3
-0,8
-0,9
-6
-4
-2
0
2
4
6
Figure 1: Budget Balance as a % of GDP in 2007 in EU Member States
Source: Eurostat
Bulgaria runs the fourth largest budget surplus in EU in 2007, after Finland, Denmark and
Sweden. The general Government debt of the country is 18 % of GDP in 2007, while the
average for the EU-27 is 58.7 % and in the Euro-area, 66.6 %, according to Eurostat. The
economy is open, with relatively high economic growth, exceeding 6 % per annum for the
last four years.
A successful transformation of any economy can be achieved only through the integration
of various reforms in many aspects of the economy. As such, we should bear in mind that
public finance management reform, although important, is only one of the many steps
that have been taken in Bulgaria to achieve structural transformation. Other steps were the
introduction of a currency board arrangement, the privatization of state owned enterprises,
tax reform, the introduction of a capital based pillar in the pension system, the liberalization of trade, and the liberalization of industries and prices.
A budget surplus alone may be a fiscal „mixed blessing” – these extra revenues can stimulate corruption and attract interest groups looking for government support. Therefore, it is
significant that for the last 5-6 years, while the surplus has been increasing, Government
expenditures as a share of GDP have been decreasing.
Bulgarian parliament
88 |
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How to do it: Lessons from successful liberal reforms in CEE
| 89
However, we should bear in mind that Bulgaria is in the last place in EU in terms of Gross
Domestic Product per capita in Purchasing Power Standards (PPS); according to Eurostat
data, GDP per PPS is 39.2 % of the EU-27 level in 2008. Bulgaria is a long way from convergence with average EU income per capita and crucial reforms are still needed to reach the
best-performing member-states in terms of economic growth.
1991
The lack of economic restructuring, poor governance and public finance mismanagement
resulted in huge budget deficits, decreasing output and hyperinflation in the middle of
the 1990s. The high tax rates (the marginal tax rates on personal and corporate incomes
reached 40 % in 199730) and complex tax codes, with a number of tax deductions and special tax regimes, caused an expansion of the informal economy and a massive evasion of
taxation and social security payments. Maintaining state-owned enterprises that incurred
substantial losses was a source of huge internal debt that escalated and led to a loose
monetary policy. As a result, average annual inflation (measured by CPI) reached 1058 %
in 1997. Public official debt peaked at 105 % of GDP. The external debt in 1997 amounted
to 9.574 billion USD, while the foreign exchange reserves of the Central Bank reached minimum levels of 400 million USD in February 1997. Bulgaria was hit by a severe financial
crisis that resulted in a number of bankruptcies of commercial banks. The savings of many
people were simply wiped out.
Table 1: Tax rates in Bulgaria, 1997-2008 (in %)
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
VAT
22
22
20
20
20
20
20
20
20
20
20
20
Corporate tax
rate*
40.2
37
34.3
32.5
28
23.5
23.5
19.5
15
15
10
10
Income tax rates
0-40 0-40 0-40 0-40 0-38 0-29 0-29 0-29 0-24 0-24 0-24 10
Source: State Gazette
*Top marginal tax rate
30See Table 1.
How to do it: Lessons from successful liberal reforms in CEE
1995
1996
1997
-2.9%
-3.7%
-5.2%
-5.7%
-8%
At the beginning of the transition period in the early 90s, the public finances of Bulgaria
were deteriorating. On 29 March 1990, Bulgaria unilaterally declared the discontinuation
of its the principal and interest payments on the foreign debt of its London Club creditors
– a total of over 300 private institutions. After three years of negotiations, on 28 July 1994,
Bulgaria signed a Brady Contract for the reduction and restructuring of its debt. The Bulgarian debt held by London Club creditors was repurchased or converted into discount bonds,
front loaded interest reduction bonds, and interest arrears bonds.
90 |
1994
-2%
-6%
Tax rates
1993
0%
-4%
Description of the Problem
1992
-5.6%
-10%
-12%
-10.9%
-10.3%
Figure 2: Budget Deficits as a % of GDP in Bulgaria, 1991-1997
Source: Ministry of Finance of Bulgaria, National Statistical Institute
How the Idea of Reform Was Born
On 10 November 1989, the transformation period began with the fall of the National Communist regime in Bulgaria. In 1990, two American economists, Richard W. Rahn31 and Ronald
D. Utt32, helped newly democratic Bulgaria to adopt the principles of the market economy.
Both men are well known in USA and worldwide as proponents of the low-tax, pro-growth,
minimalist-government economic policies that became known as „Reaganomics.“
31Dr. Richard W. Rahn is Director General of the Centre for Global Economic Growth. He is a senior fellow
of the Discovery Institute, and an adjunct scholar at the Cato Institute, and an economic columnist. In
the 1980s, Dr. Rahn served as Vice President and Chief Economist of the Chamber of Commerce of the
United States. Previously, he was the Executive Director of the American Council for Capital Formation.
He has advised senior government officials on tax and monetary policy matters in a number of countries,
including Russia, Estonia, and Hungary. In 1982, President Reagan appointed Dr. Rahn as a member of
the Quadrennial Social Security Advisory Council. During the 1988 Presidential campaign, he served as an
economic advisor to President G.H.W. Bush.
32Ronald Utt is Senior Research Fellow for the Thomas A. Roe Institute for Economic Policy Studies at The
Heritage Foundation where he conducts research on housing, transportation, federal budgetary matters
and privatization issues. He served as an economic and privatization consultant to government officials in
Russia, Bulgaria, Romania, Latvia, Lithuanian, Estonia, and Slovakia. Dr. Utt served as the Executive Vice
President of the National Chamber Foundation, the research and education division of the U.S. Chamber of
Commerce. There, he created and edited the Journal of Economic Growth, a scholarly publication focusing
on free market solutions to economic development and the Journal of Regulation and Social Costs, which
investigated the economic costs of government‘s social regulations. Utt previously served as John M. Olin
Fellow in Political Economy for Heritage, and also in the Reagan administration as the associate director
for Privatization at the U.S. Office of Management and Budget.
How to do it: Lessons from successful liberal reforms in CEE
| 91
Rahn was approached by Bulgarian government officials when he was in Hungary giving a
lecture on the transition to market economics, and was asked to formulate a “comprehensive series of policy recommendations“ for rebuilding the ruins of the old socialist system
into market economy. Rahn agreed and together with Utt assembled a team that worked
on the project for six months while economic and political figures from Bulgaria and the
United States exchanged working visits. The final version of the project was a 600-page
document titled „The Bulgarian Economic Growth and Transition Project”.
The Project‘s proposals for restructuring the economy and for the transition to market-based principles included:
• Privatizing more than 2 200 state enterprises, farms, and small trade and service companies;
•Reforming the monetary, banking, and tax systems to suit a market economy. The tax
code should be easy to administer and the tax rates should not unduly hinder economic growth. Banks should be in the hands of the private sector and the circulation of
foreign currencies should be free.
•Removing impediments to private enterprise, including barriers to international trade
and restrictions on investments;
Rahn says that executing this project was „the most fascinating thing I have ever done in my
life.“ But he emphasizes that it was not only intellectual challenge to him: „Since its founding, one of the missions of the U.S. Chamber of Commerce has been to promote free-market
democratic capitalism throughout the world. Why? American business gets stronger as the
world economy gets stronger: Economic growth is not a zero-sum game.“
On 1 November 1991, the right-wing party, the Union of Democratic Forces, formed a Government led by Prime Minister Filip Dimitrov. The Government worked out a package of tax
laws, including regulations on individual and company income tax, tax procedures and tax
administration. Prices, the exchange rate, and interest rates were liberalized and the first
steps towards restructuring the economy were made.
There is a consensus that the birth of this “neoliberal project” in Bulgaria is due to the project document put together by Rahn and Utt. A natural continuation of their efforts was
the creation of a free market think tank in Bulgaria called the Institute for Market Economics (IME) in 1993. The first Executive Director of the Institute was Dr. Krassen Stanchev,
a former Member of Parliament (1990-1991). Being a personal friend of Dr. Rahn, he promoted IME as one of the most respected public policy institutes in the emerging European
democracies. Dr. Rahn is a member of the Advisory Board of the Institute and has supported
the efforts of the Institute to defend the principles of economic and personal freedom and
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How to do it: Lessons from successful liberal reforms in CEE
advocate market-based solutions in Bulgaria since its founding. IME proved to be a focal
point for an exchange of views on market economics and relevant policy issues.
Hardly any important reform issue in the last twelve years has escaped the attention of
the IME. It has acted both as a faithful watchdog over the government‘s fiscal policy and
as a relentless proponent of reforms in the public sphere. The IME pioneered the debate
over the introduction of flat taxes in Bulgaria and the reforms of pensions, healthcare and
the educational system. The IME also thoroughly analyzes the draft budget each year and
makes policy recommendations as well as comments on the spending rationale of different
programs.
Opposition and Obstacles to Reform
After a promising start, the reform effort stalled in the mid-90s when the former Communists, who had renamed themselves Socialists, won the 1994 elections. The continuation
of the tax reform was delayed. Vague legislation, retroactive regulations that aggravated
the tax burden, corruption, and unequal treatment of taxpayers led to insufficient budget
revenues. The tax system produced many preferences, mostly for powerful firms which were
simply buying off the tax inspectors. Small businessmen were also evading taxes in various
ways. The government did not take decisive measures to tighten tax discipline. Obviously,
the lobbies of those interested in preserving the status quo were more powerful than the
voices of ordinary taxpayers.
The Socialist Government of Prime Minister Zhan Videnov limited privatisation as it wanted
to resume managing substantial parts of the nation‘s industry and maintain the welfare
state. It cooperated closely with Russia and China. As a result, the West stopped its cooperation with the Government and the IMF refused to grant the funding the Government
expected. The result of the Socialist Party‘s disastrous economic policy was the financial
crisis of 1996-1997.
Privatisation was also strongly opposed by the trade unions. Although union membership
was an insignificant percent of total employment after 1993, the unions were still politically powerful, still able to use well-organized strikes and walkouts to defend their positions.
During the entire transition period, the trade unions faithfully followed left-wing economic
policy ideas. Because the economic reforms brought substantial unemployment and workforce cutbacks, the unions were against many of the market-based reforms and called for
more ‘social governance’.
How to do it: Lessons from successful liberal reforms in CEE
| 93
•More than 50 % of the goods and services comprising the consumer price index (CPI)
were controlled or administered by the state;
•The state-owned companies were incurring substantial losses, nearly 8 % of GDP.
•Trade was hampered by import tariffs, export taxes, non-tariff barriers, trading licenses
and administrative regimes.
The introduction of the currency board regime in 1997 as a remedy for the financial crisis
was followed by other reforms in the spheres of public finance and the real sector of the
economy. These reforms determined Bulgaria’s economic progress in subsequent years and
put the economy on the path to steady and stable economic growth. What triggered reform
was a combination of the Government‘s political commitment and the populace‘s increased
awareness of and engagement in the governance process – a gradual change in the way
people thought. Pressure from third parties such as the IMF and the World Bank also played
an important positive role in economic restructuring and reform.
National protests in the winter of 1997 against hyperinflation in Bulgaria (Photo: BTA)
How Were the Reforms Accomplished?
The financial and political crisis of 1996-1997 was a catalyst for major changes and the
start of real structural reforms in many sectors of the economy. It became clear that the
Bulgarian economy needed a tighter monetary policy and a sound fiscal stance in order to
cope with its problems. The intensity of the economic meltdown necessitated quick, radical
reforms in many spheres of the economy. Third parties such as the International Monetary
Fund and the World Bank played an important, positive rule in restructuring the economy.
The next scheduled parliamentary elections were won by the right-wing party, led by Ivan
Kostov, who promised commitment to free-market reforms. From this point onward, citizens, international organizations and independent experts demanded greater transparency
and accountability from government decision makers.
In 1997, the Government faced the following economic situation33:
•Only 24 % of state assets were privatized;
•Only 40 % of all employees in the country were employed in the private sector;
The currency board arrangement meant that the Central Bank was no longer able to finance
the budget deficit. The Law on the Bulgarian National Bank prohibits the Bank from providing credit to the Government except against purchases of Special Drawing Rights from the
IMF as part of a stabilization program supported by the Fund. The Government‘s fiscal policy
had to be quickly adapted to the new monetary institutional framework. Because fiscal policy can affect monetary policy, both by changing demand and by changing how the supply
side responds to monetary measures, the IMF insisted on a correcting fiscal imbalances and
public sector restructuring.
In April 1997, the IMF approved a loan to support the Government’s 1997-98 economic
program: a USD 510 million stand-by credit line available over the next 14 months. The
importance of this credit for stabilising the Bulgarian economy can be judged by the IMF‘s
press release (Nr 97/15):
“The authorities’ program, supported by the new stand-by credit, represents a
break with the past and aims to restore confidence in public institutions and
to put Bulgaria firmly on the path to a market economy. The basic strategy is
one of rapid stabilisation of the economy underpinned by durable structural reforms. Key to this strategy is the commitment to establish a currency board arrangement by mid-year. The program aims to limit the decline of real GDP to 4.8
percent in 1997, as growth turns positive by midyear; reduce monthly inflation
to 2 percent by the end of the year; maintain a small surplus in the current account; and double official reserves to the equivalent of three months of imports
of goods and non-financial services.”
33See Hristova, Slanchev, Angelov, Stoev, Chobanov, Stanchev, Bogdanov, Dimitrov, The Anatomy of Transition: Bulgaria Economic Policies from 1989 to 2004, Sofia, CIELA, 2004.
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How to do it: Lessons from successful liberal reforms in CEE
| 95
Fiscal policy has been designed to support the objective of rapid stabilization by cutting the
overall budget deficit to 3.8 % of GDP in 1997 from 10.9 % of GDP in 1996 and by eliminating the need for Central Bank credit to the Government. This will be accomplished through
a major effort to strengthen revenues and rationalize expenditures, and an ambitious privatisation program.
In September 1998, the IMF, content with the reforms accomplished so far, approved a
three-year credit for Bulgaria equivalent to USD 864 million to support the Government’s
medium-term economic reform program from July 1998 to June 2001. The IMF credits
spurred reformation and restructuring of the economy. In 1997, the Bulgarian G0overnment
needed money to avoid a second default on the public debt, which would meant a complete
loss of credibility and the total financial isolation of the country. However, IMF funding was
conditional it stipulated the specific policies and measures Bulgaria agreed to implement
to resolve its balance of payments problem. The economic program underlying the funding
was formulated by the Government in consultation with the IMF. So, these loans were not
traditional credits which simply finance the public deficit, but support for the Government’s
economic program and the means for the reformation of the economy.
The new monetary regime was the main driving force behind the reforms in public finance.
The Currency Board Arrangement had to be underpinned by prudent fiscal policies. Monetary policy had been loosened in 1996 to help refinance insolvent banks. The root of the
overall economic collapse was the dissipation of resources through subsidies to loss-making
state-owned companies in order to maintain employment at an artificially high level.
To exercise financial discipline, a key elements in the economic program was the rapid privatization of state owned banks and enterprises. Companies sold to the private sector could
no longer rely on the State to cover their losses. Private companies that work at a loss have
to either implement restructuring, or liquidate. Also, the surviving state owned banks’ balance sheets were improved due to hyperinflation, which was a crucial prerequisite for their
successful privatization. Transparency during the bank privatization process was critical for
building independent banking system with market based management.
The areas of public finance reform were extensive and complex, including public expenditures (healthcare, pension system reform), revenues (tax reform) and public finance management. However, our focus is on public finance management and public expenditures.
Several issues contributed to the positive outcome for the Bulgarian economy in this respect:
1)Budget Resource Management
In 1998, the Bulgarian Government began an extensive program for improving the budget‘s
resource management. The reform played a significant part in stabilising the economy and
stimulating economic development. It contributed to the consolidation of budget processes,
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increased financial transparency and strengthened financial discipline as a whole. It included the following main components:
–The development and improvement of a management system through the creation of
a single account system at the Bulgarian National Bank (BNB) for all budget expenses
and revenues and the creation of a new accounting framework, through which information is summarized from all budget organizations and which provides up-to-date,
reliable budget performance data. A new system for electronic budget payments. ‘SEBRA’, was developed and introduced to manage and exert a computer assisted control
over payments ordered by the spending agencies. All autonomous budgets and judiciary
accounts are included in SEBRA.
– Rationalization of the budget structure – the number of extra-budgetary funds was
very high between 1991 and 1998. They were characterized by a lack of transparency
and monitoring and were a proven source of inefficient resource allocation and extra
public sector spending. At the end of the 1990s and the beginning of the new century, on insistence by the IMF, most of them were incorporated in the state budget and
closed down; those that remained were usually incorporated within the consolidated
general government reporting framework. In the Law on the State Budget for 2005, the
number of extra-budgetary accounts and funds was decreased to 4 at the central level
and 3 at the local level. The Government intends to close down all remaining extrabudget accounts and funds, except for the funds for social and health insurance.
– Greater transparency through monitoring and reporting – since the end of 2002, the
Ministry of Finance has prepared and presented to the public monthly, quarterly and
annual reports on the implementation of the fiscal budget. The annual reports for the
budget‘s cash operations are subject to certification by the Audit Office, as are all budget entities‘ balance sheets and income statements. Since 2000, the Ministry of Finance
has prepared and presented monthly reports on the Government debt.
– Simplification of the collection and administering of taxes – as of January 2006, the
National Revenue Agency consolidated the collection and administering of state taxes
(income taxes, value added tax, corporate taxes) with mandatory social security contributions (health insurance contributions, pension insurance contributions, contributions
for additional mandatory pension insurance, etc.). Previously, state taxes and social
contribution were collected and administered separately, which was costly and far less
efficient in terms of collection rates.
2) Introduction of Numerical Fiscal Rules and the Medium-term Expenditure Framework (MEF) – the introduction of the Currency Board Arrangement in Bulgaria can be seen
as having adopted a form of a proxy fiscal rule – a restriction on access to central bank
borrowing by the government.
How to do it: Lessons from successful liberal reforms in CEE
| 97
After 1997, remaining state enterprises were subjected to greater financial discipline
through restrictions on wage increases and by implementing financial recovery plans. A
wage freeze bill was imposed on the 100 state companies with the largest losses and on
state monopolies. For these enterprises, the Government agreed in 1999 to keep the aggregate wage bill, in nominal terms, at the 1998 third quarter level during the first two
quarters of 1999.
A 90 % ceiling on discretionary spending by budgetary bodies was introduced on 1 July
1997. A provision in the Budget Law for 2007 specified that 10 % of primary, planned
expenditures by government bodies would not be allowed if the current account deficit
widened further. This provision would be binding until a general government surplus of 2 %
of GDP was achieved. In 2008, this instrument was replaced by the establishment of an
“Emergency Reserve” that accounts to 1.1 % of GDP. The resources in this reserve will be
spent only if a target surplus of 3 % of GDP is achieved and if the nation‘s budget balance
has not deteriorated. Its function is to accumulate a certain amount of funds whose purpose is to reduce financial risk during emergencies. The Government must approve any of
these expenditures.
In 2005, a new coalition was formed consisting of three parties led by the Socialist Party.
Their coalition agreement set a target not to increase budget expenditures over 40 % of
GDP (excluding the national contribution to the EU budget). During debates in Parliament
on the 2006 State budget, Finance Minister Plamen Oresharski said: “I can assure you that
the preliminary plans for the 2006 Budget are to limit state expenditures to 40 % of GDP.”
This aim was accomplished in the period 2005-2007 and is explicitly stated in the budgetary
forecast for the period 2008-2010.34
The IMF has criticised the provisions of the Organic Budget Law that allow the Minister of
Finance to increase expenditure above the total amount approved by the National Assembly
if revenues are higher than expected and the budget deficit target would not be compromised: Over recent years, revenue has exceeded expectations by a considerable margin, and this
has given the executive arm of government the capacity to spend, on a discretionary basis,
well above the level approved by the National Assembly. Amendments in the Law in 2005
were made limiting the amount the Minister of Finance can spend without authorization by
the National Assembly to a maximum of 1.5 % of the planned budget revenues. In effect,
there is still considerable room for discretionary spending at the end of each year.
Since Bulgaria became an EU Member State in 2007, it has been required to follow rules
established by the European Commission under the Stability and Growth Pact. Compliance
with the rules and medium-term budgetary objective (MTO) assures fiscal discipline and the
sustainability of public finances. One of the key goals of the Stability and Growth Pact is to
place fiscal policy into a multi-annual framework by requiring Member States to aim for a
sound budgetary position in the medium term (the general rules are a 3 % of GDP ceiling on
34Budgetary forecast for the period 2008-2010, p. 20.
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How to do it: Lessons from successful liberal reforms in CEE
general government net borrowing and a 60 % target for gross government debt-to-GDP).
These rules serve as a guarantee that member states do not ease their fiscal stance. Although the general rule is that there may be no deficit higher than 3 % of GDP, the European
Commission uses a special methodology that assesses the cyclical stance of the economy
and proposes fiscal objectives in order to avoid a pro-cyclical fiscal policy. Thus, the threeyear budgetary forecast of Bulgaria for the period 2008-2010 states an objective of at least
a 3 % budget surplus.
3) Introduction of Program Budgeting
Program budgeting is a method of justifying public expenditures by specifying the objectives and assessing the benefits of public programs. Program budgeting is more result-orientated than traditional budgeting and allows for interim monitoring and the evaluation of
accomplishments – which goals have been achieved and which remain.
Budgeting in Bulgaria has traditionally operated on a bottom-up, historic cost principle.
This means that all agencies and ministries send requests for funding to the Finance Ministry based on the prior year‘s budget, some inflation plus new expenditures for newly
proposed activities. This process has an inherent bias for increasing expenditures and there
is no system for reallocation of spending within ministries and no pre-set spending goals.
It is also difficult to reflect political priorities with in the traditional system, since it is a
bottom-up exercise with the budget “emerging” at the end of the process. This manner of
budgeting was gradually replaced with program budgeting.
The major goal of program budgeting is to achieve greater expenditure efficiency. The focus
is on the public program‘s purpose and outcome rather than its specific spending components. By grouping government activities by their relation to specific government objectives
and priorities, it presents program spending in a more transparent and comprehensible way,
simplifying the monitoring of whether the expected results have been accomplished or not.
Ideally, every program proposed by any government agency should be accompanied by a
cost-benefit analysis and well-defined performance indicators. In Bulgaria, ministers and
government officials, unaccustomed to justifying their programs‘ benefits and economic
rationale, opposed program budgeting because inefficient or old-dated programs were harder to fund. While program budgeting in Bulgaria by ministries and other agencies is still in
many ways pro forma, it has laid the foundation for further development in this sphere.
For example, for the first time, at the end of 2007, the Ministry of Finance published on its
website the draft budgets submitted to it by Ministries and agencies. More than 0.5 billion
EUR (1.7 % of GDP in 2007) were not approved, which means that the public expenditures
would be 4 % more had the Ministry of Finance agreed on the draft budgets of first-level
spending agencies. Some expenditure in the program budgets of most budgetary agencies
proved unjustified in terms of benefits.
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| 99
4) Expenditure Reform
salaries, the distribution of the teachers’ workloads, the number of pupils in classes, and
the number of staff.
The crisis of 1996-1997 was followed by the restructuring of public expenditures. As interest payments decreased substantially35, non-interest expense spending rose and peaked
at 42 % of GDP in 2000. Afterwards, expenditures as a percentage of GDP have tended to
decrease. In 2001, the expenditures on social protection (pensions, social assistance, labor
market programs, and family benefits) peaked at 14.1 % of GDP, up from 11.3 % in 1998. In
2007, they were down to 12 % of GDP. Capital expenditures have increased from 3.9 % of
GDP in 2000 to 6.8 % of GDP in 2007 due to the country‘s need for infrastructure investments. At the same time, maintenance and wage spending have decreased from 34 % of
GDP in 2000 to 30.2 % of GDP in 2007.
In 1999, the Government undertook a wide-ranging reform of the health sector. The central
component of the new system is the National Health Insurance Fund (NHIF), which combines
the roles of pooling risks and purchasing medical care through contracts with physicians,
group practices and hospitals. The system is essentially a publicly administered insurance
fund. The NHIF is funded through mandatory contributions unrelated to costs, through an
earmarked payroll tax. Since 2001, hospitals have functioned as non-financial enterprises.
Since 2007, their money comes from the budget of the National Healthcare Insurance Fund,
based on the number of their patients and their corresponding clinical procedures. Physicians are paid on a capitation basis, i.e., a fixed amount per patient, with a premium for patients with chronic diseases – not according to the treatments they administer. Healthcare
spending has eased slightly from 4.9 % of GDP in 2003 to 4.2 % of GDP in 2007.
Despite these reforms, the healthcare system in Bulgaria is still far from efficient and needs
to provide better health services to its citizens. The system is an uncompetitive monopoly,
with the consequent poor service quality and lack of incentives for a more efficient allocation of resources.
It is important that public expenditure reform in Bulgaria was not abandoned once the
country‘s fiscal position came into a positive balance. In 2007 and 2008, important reforms
were taken towards greater resource efficiency in school education. These measures include:
•A reform in the mechanism for financing of schools through the introduction of delegated budgets system and a unified standard allocation per student that functions on
the basis of a “money follows the student” principle;
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5) Debt
Since 1997, Bulgaria‘s fiscal policy stance has been designed to support the Currency Board
Arrangement and to reduce the debt-to-GDP ratio to below 60 % of GDP. Interest payments
dropped sharply from 20 % of GDP in 1996 to 4.05 % in 2000, and 1.03 % in 2006, this
decline was crucial for achieving a balanced budget in the post-crisis years.
In 2001 and 2002, the Government executed some significant long-term external debt
transactions. In spring 2002, two types of global bonds were issued – for EUR 535.5 million
and for USD 513 million. These were followed by another issue of global bonds for USD 759
million in autumn 2008. Those global bond issues were used to buy back and exchange the
Brady bonds already in circulation. The debt-bond swaps proved unsuccessful due to adverse, unforeseen changes in interest and exchange rates. As a result, the country has paid
about EUR 1 billion more than planned to service its external debt36. Sensibly, Bulgaria has
abandoned this kind of active debt management. However, the complete buy-back of all
Brady bonds and of IMF credits has enhanced the country‘s financial image – Bulgaria has
proven its ability to finance its obligations on international markets. Moreover, the public
debt reduction led to gradual rise in the country’s credit rating, which has decreased the
price of new financing for the private sector.
Since 2003, the active management of foreign public debt has been limited to debt repurchasing, debt reduction or conversion into domestic debt. In 2007, the general government debt amounted to 18.9 % of GDP.
6) Revenues
Despite the crucial role played by expenditure reform and the fiscal discipline imposed by
the Currency Board, the Government‘s fiscal surplus during the past few years has been
achieved more by revenue expansion than by expenditure cuts. The broadening of the tax
base and the economic growth stimulated by cuts in tax rates have raised revenues at an
accelerating pace.
•An increase in the principals’ authority with regard to the allocation of budget resources and the administration of school finances including the allocation of individual
All governments after 1997 have pursued a consistent policy of lowering direct tax rates.
The Government under Ivan Kostov (1997-2001) reduced corporate tax rates from 40.2 %
to 28 % and the top marginal income tax rate from 40 % to 38 %. The next Government, of
the National Movement Simeon II (NDSV) party led by Simeon Saxe-Coburg-Gotha, further
decreased the corporate tax rate to 15 % and the top marginal income tax rate to 24 %. In
35See the next point for more information.
36See Minassian, Garabed; “Conversion of Bulgarian Brady Bonds: Five Years After”; Economic Thought,
7/2007.
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How to do it: Lessons from successful liberal reforms in CEE
| 101
2005, a coalition was formed consisting of three parties – the Socialist Party as the leader
and the two liberal parties of NDSV and Movement for Rights and Liberties as partners.
They decreased corporate tax rates to 10 %, social contributions by 9 % and introduced a
flat income tax rate of 10 %.
The revenues in the 2007 state budget proved that the opponents of lowering tax rates (like
IMF officials37) were not right and that the state budget benefited greatly from the reduction of the corporate tax rate. The budget surplus was 3.4 % of GDP instead of the planned
0.8 % and the revenues from corporate taxes grew up by 39 % on an annual basis despite
the reduction of the rate by one third (from 15 % to 10 %).
THE SUCCESS OF THESE REFORMS - A DEMONSTRATION
120
100
105.10
79.60
80
6.6
6.0
4.1
4.0
4.0
4.5
53.6
5.0
6.2
6.3
6.2
37.9
40
29.2
22.7
20
1998
1999
2000
2001
2002
2003
18.9
2004
2.3
2005
2006
2007
Figure 4: General Government Debt as % of GDP
Source: Eurostat
3.6%
3.5%
3.0%
3.7%
2.3%
2.5%
1.7%
2.0%
1.5%
0.0
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
1.0%
0.5%
0.0%
-4.0
-6.0
45.9
4.0%
2.0
-2.0
67.30
0
The figures below show the successful results from the reforms in the public sector
finance that began in 1997 – the State budget moved to a surplus, the public debt declined to record lows and public expenses as a percentage of GDP have decreased.
5.4
74.30
60
1997
8.0
79.30
-5.6
-8.0
-0.5%
2000
-1.0%
-0.6%
2001
-0.6%
2002
-0.6%
0.0%
2003
2004
2005
2006
2007
Figure 5: Budget Surplus/Deficit as % of GDP in the period 2000-2007
Source: Ministry of Finance of Bulgaria, National Statistical Institute
Figure 3: Real Economic Growth (%)
Source: National Statistical Institute
37In October 2006 Robert Hagemann, head of IMF mission to Bulgaria, made it clear that the decrease of the
corporate income tax to 10 % did not follow IMF prescriptions for Bulgaria’s economic development.
102 |
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How to do it: Lessons from successful liberal reforms in CEE
| 103
long-term impact on the economy. For example, money from the fiscal reserve can be spent
on restructuring of the pay-as-you-go pillar of the pension system into a capita-based one,
which will make the implicit pension debt explicit, with the transition deficit having to be
financed by the state.
43%
42%
42,0%
41%
40,6%
40,4%
39,7%
40%
39%
39,1%
39,3%
38%
39,1%
37%
37,0%
36%
–The release of budget data – the systematic and timely release of all relevant fiscal
information is a prerequisite for achieving fiscal transparency but is not enough.
35%
34%
2000
2001
2002
2003
2004
2005
2006
2007
Figure 6: Government Expenditure as % of GDP for the period 2000-2007
Source: Ministry of Finance of Bulgaria, National Statistical Institute
Advice for Other Reformers, Especially on Things to Avoid
Public finance management reform should be focused on the following areas:
•Creation of a system for the establishment of a stable medium term public finance
framework;
•Strengthening transparency in public finance;
•Transition to a result-oriented budgeting and cost-benefit analysis of various public
programs. Budget deficit bias can be successfully addressed through the introduction
of numerical fiscal rules and by imposing constraints on the discretion of policymakers
such as the introduction of an explicit limit to public expenditures and ceilings on the
expenditures of different public bodies.
Also, the lesson that Bulgaria learned is that a Central Bank‘s policy-making decisions should
be independent of political influence. Otherwise, they may be too loose in their monetary
policy, which inevitably leads to an acceleration of inflation and the diminishing purchasing
power of money.
The allocation of funds from the fiscal reserve is prudent. Without clearly set rules, there
is a risk that the accumulated fiscal surpluses will be spent on irrational projects that distort market incentives. The best ways for the fiscal reserve to be used are 1) retiring of the
public foreign debt, and 2) for implementing structural reforms that would have positive
104 |
Fiscal transparency is essential for making government officials accountable for the decisions they make and to justify that the resources of taxpayers are spent efficiently, in their
best interest, and for the benefit of society. There are three essential elements of fiscal
transparency:
How to do it: Lessons from successful liberal reforms in CEE
–The quality of budget procedures and rules set in laws should also be evaluated. Independent public institutions and experts should be able to scrutinize budget reports and
influence budget policy.
The role of civil society – media and non-governmental organizations should act as watchdogs of government activities. Citizens, directly or through these vehicles, must be in a
position to influence budget policy and hold the government accountable. The Access to
Public Information Law (adopted in 2000) has played a major role as a tool to enhance
transparency and accountability of the Bulgarian Government and to raise public awareness of the governing process. Also, the case of Bulgaria proved the thesis that free market
reforms can be accomplished by left-wing as well as right-wing parties, once the seeds of
the reforms have been sown38. Think tanks have a vital role – to spread ideas and increase
public awareness on the need of reforms and convince both experts and the general public
that good, pro-market, ideas do matter.
Since 2003, the IME has produced an alternative budget using a 10 % flat income tax,
10 % corporate tax and 10 % social security payment rate to demonstrate to lawmakers
and politicians in power that fiscal balance could be accomplished if accompanied by a
reduction in spending and by certain reforms. In 2008, two of the targets of IME are already
accomplished – the 10 % corporate tax was adopted in 2007 and the 10 % flat income tax
was introduced in 2008. The reduction in the social security payment rate is already in the
pipeline.
38Still, we should take into consideration that the present cabinet is composed by a coalition of socialist and
liberal parties.
How to do it: Lessons from successful liberal reforms in CEE
| 105
References
Blöndal, J. 2003: Budget Reform in OECD Member Countries: Common Trends, OECD Journal on Budgeting – Vol. 2, No. 4, OECD.
Hristova, A., Slanchev, V., Angelov, G., Stoev, G, Chobanov, D., Stanchev, K., Bogdanov, L., and Dimitrov, M. 2004: The Anatomy of Transition: Bulgaria Economic Policies
from 1989 to 2004, Sofia, Ciela Soft and Publishing, (in Bulgarian).
Jackson, M. 1991: The Rise and Decay of the Socialist Economy in Bulgaria, The Journal of
Economic Perspectives, Vol. 5, Num. 4, pp. 203-209.
Institute for Market Economics, Economic Policy Review, http://ime.bg/en/pr_en/.
Institute for Market Economics, Flat Tax Bulletin, http://ime.bg/bg/bulletin-for-lowtaxes/.
International Monetary Fund 2005: Bulgaria: Report on the Observance of Standards
and Codes – Fiscal Transparency Module, IMF Country Report No. 05/300,Washington, D.C.
Minassian, G. 2007: Conversion of Bulgarian Brady Bonds: Five Years After; Economic
Thought, No.7, (in Bulgarian).
Rahn, R./Utt, R. 1990: Bulgarian Economic Growth and Transition Project, National Chamber Foundation, Washington.
World Bank 2002: Bulgaria: Public Expenditure Issues and Directions for Reform, A World
Bank Country Study, August, Washington, D. C.
Zaimov, M./Hristov, K. 2002: Shadowing the Euro: Bulgaria’s Monetary Policy Five Years
on, Discussion Paper DP/27/2002, Bulgarian National Bank, Sofia.
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How to do it: Lessons from successful liberal reforms in CEE
| 107
Imprint:
Editor
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Friedrich-Naumann-Stiftung für die Freiheit
Karl-Marx-Straße 2
D-14482 Potsdam
Phone +49 3 31.70 19-2 10
Fax
+49 3 31.70 19-2 16
[email protected]
www.freiheit.org
Production
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Office Berlin
2008
20,0%
15,0%
10,0%
Corporate tax rate
2008
2007
2006
2005
0,0%
2004
5,0%
2003
How to do it: Lessons from successful liberal reforms in CEE
2008 25,0%
Corporate tax revenues (% of GDP)
How to do it:
Lessons from successful liberal
reforms in CEE
Edited by:
Remigijus Šimašius (LFMI)
Ulrich Niemann (FNF)
Estonian Free
Society Institute