Taxability and Low-Productivity Traps

When governments care about tax revenues, the taxability of different forms of economic activity will influence the decisions of governments about what activity to support. If factors of production are mobile across sectors which differ in their taxability, political economies will organize themselves into equilibria where governments support activity because resources are allocated to it, which in turn encourages that resource allocation. When resources and government support are organized in support of an “old” equilibrium, and the possibility of a “new,” possibly more efficient equilibrium beckons, the relative taxability of the old and new sectors will determine the likelihood of such a shift. In postcommunist Europe, such factors were influential in the creation of two general political-economic configurations: one where new economic activity is supported by the government and is common, and one where such support is lacking and new businesses are rare. Differences in relative taxability of new and old economic activity contribute to the prevalence of the first configuration in Eastern Europe, and the second in the former Soviet Union.