Restructuring and taxation in transition economies

One challenge in transition economies has been to avoid being caught between overrapid restructuring (harmful to the private sector) and gradual change (can undermine robust private sector emergence). Empirical evidence suggests thatin most of Eastern Europe and the former Soviet Union, insiders, by exerting decision making control, have materially affected the restructuring rate. Still, shocks to firms have generally led to sharp rises in unemployment. Unemployment benefits, initially generous, combined with lost payroll taxes substantially increased fiscal costs. In the former Soviet Union, both restructuring and unemployment have remained limited and firm subsidies remained high. The private sector expanded, but chiefly in the gray (untaxed) part of the economy. The authors examine the implications of various restructuring speeds, explicitly introducing probabilities of closure and restructuring. They find that when the probability of closure is small, unemployment will peak at a lower level than when the probability of closure is high, although the transition speed will be much slower. They also find that widespread private sector tax avoidance can stimulate that sector's growth and result in a speedier transition. Thus, while a private sector low tax burden can drive unemployment up rapidly by increasing the state sector closure probability, it can also help speed up the transition by provoking a quicker private sector response. The authors show that while the state sector restructuring speed is sensitive to the tax burden, (dependent on unemployment and the ability to tax the private sector) it is also true that the private sectors growth depends on the tax burden it faces. In particular, capturing the private sector in the tax net early in the transition can lead to collapse and hence to the failure of restructuring.