Revenue uncertainty and the choice of tax instrument during the transition in Eastern Europe

The author examines the eroding tax base facing transitional economies by employing a framework that allows risk factors in assessing tax instruments. In an uncertain world, the author asks, which tax instruments should be used? The author examines Eastern Europe's revenue problem, including the implications for public revenue of different causes of uncertainty - and investigates which taxes are"better"at generating revenue. The author defines a"better"tax as one that has greater stability in a risky environment (that is, less variation in generating a target revenue) and has the least adverse impact on the economy (for example, on consumption). The author employs the framework to explain much of the output and revenue fall in transitional economies. The term-or-trade shocks from the collapse of the CMEA trade as well as the rigid but uncertain economic responses in transitional economies are all important factors. The results of the authors modelindicate that import tariffs are more effective than other traditional tax instruments in raising revenue, especially if real revenue is defined in dollar terms (the price anchor). The contraction in domestic output and prices and the devaluation of the real exchange rate needed in the transition are significant reasons that favor imports as a tax base over other revenue sources. To emphasize the transitory nature and reversibility of the policy recommendation, import tariffs should be implemented in the form of a temporary uniform import surcharge. This conclusion seems to hold whether the government formulates tax policy with correct or incorrect expectations. But the choice of revenue target matters. All tax instruments will do almost equally well if the commonly used tax-to-Gross Domestic Product ratio is the target. But it is a misleading measure since the ratio does not reflect the immense erosion of domestic tax bases in the economy and how real revenue in absolute level may actually be decreasing rapidly as a result. The revenue decline and uncertainty can also be viewed as a necessity toward downsizing the large state sector and in redirecting trade away from former nonmarket partners. The results emphasize that restoring revenue should never lead to maintaining subsidies toward nonprofitable state enterprises or other public spending no longer relevant in market system. Doing so will only lead to unreasonably high taxation. No less important is moving assets out of collapsing sectors, privatizing them, and making them productive again.