The Heritage Foundation

Backgrounder #830 on Europe

May 23, 1991

May 23, 1991 | Backgrounder on Europe

A Pro-Growth Tax Reform Agenda for Eastern Europe

(Archived document, may contain errors)

830 May 1991 A PRO-GROWTH TAX REFoRlM AGENDA FOR E ASlERN EXJROPE INTRODUCIION h the wake of their successful revolutions, Eastern Europes new democracjes now face fundamental decisions that will decide their economic destinies. One of the most important is the choice of new tax systems to replace those i n herited from commdt regimes. Under communism, East European governments supported themselves mainly by raking off revenues tom state-owned industries.Today, as these countries make the transition from communist to market economies, they need new tax polic i es designed to promote economic growth through the expansion of private enterprise So far, East Europeans have been inclined to follow the example of West European states which, by and large, tax their citizens at some of the worlds highest rates.These sy s tems are designed to fund social welfare states rather than to spur economic growth.This approach has not worked particularly well in Westem Europe -where it has failed to deliver on its promise of social jus tice and has ensured sluggish economies and it would be disastrous in East em Europe If East European governments impose a heavy tax burden on struggling businesses and suffering consumers, the growth of these countries nascent free markt emnodes will slow down, perhaps leading to further social and P o int No. 3: Be wary of the Value Added Tax (VAT Consider it only in lieu of, not in addition to, income taxes; and adopt political safeguards to ensure that theVAT is not used to fuel the growth of government as it has been in Western Europe and elsewhere.

Point No. 4: Do not use tax incentives to steer investment to preferred in dustries. The marketplace, not government bureaucrats, should decide which industries and technologies are best suited for in vestment.

Point No. 5 Do not impose high tariffs to discourage imports. Ultimately tariffs hurt consumers and producers, and slow economic growth.

Point No. 6 When possible, finance government operations and services with user fees through which most government services are paid for by those who benefit fro m them LOW TAXES: Rx FOR ECONOMIC GROWTH Since the dawn of government, statesmen have debated the merits of tax policies geared toward economic growth and progress versus those aimed at redistributing wealth to the poor. The debate still rages, despite st r ong histori- cal evidence that low taxes and minimum government regulation are the surest path to economic growth and to raise people out of poverty. Low levels of taxation and a hands-off government attitude toward the economy, after all, helped the U.S. to launch its industrial revolution in the nineteenth cen- tury and in a short time to become the most prosperous country in the world.

Heavy taxation, by contrast, is a surefire recipe for economic stagnation and collapse. High taxes were a major reason for the fall of the Roman Em- pire. By fifth century Rome, taxes rose tozuch crippling, oppressive levels that Romans had little incentive to work.

ViciousTax Cycle. High levels of taxation slow growth and development be cause they discourage the sort of economic activity needed to build a strong economy, including hard work, savings, investment and the production of goods and services. High taxes create a cycle devastating to economic growth.

Example: High personal income taxes discourage hard work, part icularly if people are taxed at higher rates for earning more money what is known as an increasing marginal tax rate; less work leads to a decrease in the amount of goods and sexvices produced; lower production means businesses have less profit to invest i n increased personnel and in new and more efficient plant and equipment; less efficiency ultimately translates into lower profits and 4 Charles Adams, Flight, Fight, Fmud 7Re Stoy qf Tdn (Curacao: Euro-Dutch Publishers, 1982 p. 97 3 earnings, and therefor e less money deposited in banks as savings; and lower savings rates mean that less money is available for banks to invest in new busi nesses and other ventures.This leads to decreasing economic growth, which means lower incomes and decreasing job opportuni t ies. University of Dallas economist Gerald Scully has found that over time, the effect of high taxes on individual incomes can be devastating I How Different TaxRatesWould Affect Future Income 2,396 $1,618 I Pretax per capita income4 Aftertaxincome5 1,934 $919 Policy Analysis, Po& Rem No. 98 1. The chart is based on an empirical study that examines the relationship between tax rates and economic growth in 103 countries. The projections are for a hypothetical country with a real per capita income of SlJOo t h e average in 1980 of 103 countries 2. Based on the empirical estimates produced in the study, if the hypothetical country adopts I tax rate of 193 percent, it will have an annual growth rate of 2.4 percent. If the country adopt a rate of 43.2 percent, the economic growth rate will be only 0.4 percent 3. Measured in 1980 dollars 4. Assuming all the other relevant factors remain constant over the period, by the year uloo the low-tax policy will produce greater per capita income because the low-tax policy gen e rata the higher rate of economic growth 2.4 percent, as opposed to 0.4 percent for the high-tax policy. Thus under the high-tax rate, people will pay nearly $700 in taxes, and also lose an additional $778 in income because of the effect of the taxes on ec o nomic growth. Thus, the high-tax policy imposes a "growth tax" on its citizens 5. The citizens under the high-tax policy will pay a direct tax of $700 pluS the growth tax of 778, a total tax equal to $1,4/Z,6l8 91 percent 6. By the year 2020, people under the low tax rate will have three times as much after-tax income as they would have had at the higher tax rate.

Heritage Infochart 199 In addition to slowing economic growth, high taxes also encourage tax evasion, particularly in developing countries where governments do not have the resources or experience to track down offenders. If tax rates are too high 4 people find ways to evade taxes: the rich find tax loopholes; others work in the gray economy; and businesses remain underground.

As taxes rise ever higher, economic growth grinds to a halt and tax evasion becomes rampant. Ultimately, the government that raised taxes in the first place becomes a victim of the higher taxes as its own revenues drop owing to a shrinking economy.This me ans fewer business and working individuals to tax and declining tax compliance.

Government officials in Eastern Europe are rightly concerned about rais ing enough money to balance their budgets and run the government. They worry that cutting the high tax r ates will cause budget deficits and insufficient revenues to provide essential government services.

Underground Operation. These concerns are ill founded; only by cutting taxes will East European countries be able to generate steady increases in governmen t revenues.There are two reasons for this.The first reason is that taxes on business are now so high throughout Eastern Europe that businesses are driven underground to operate in the informal, or gray, economy where they pay no taxes. This deprives the g overnment of substantial revenues. Only by significantly cutting taxes on businesses can the governments induce private businesses to enter the formal, legal economy and pay taxes.

The second reason why lower tax rates ultimately can mean higher govern ment revenues in Eastern Europe is that tax cuts stimulate economic growth.

This means that there are more incomes and production to tax. This, after all is what happened in America in the 198oS. The Reagan tax cuts, inspired in part by the economic studies of economists such as Arthur Laffer, ignited economic growth and increased federal revenues The federal deficit grew only because federal spending increases outpaced the revenue gains The result: the longest peacetime economic expansion in U.S. history, a 31 per cent increase in the tax base, and significant growth in real tax revenues?

Lower Taxes =Economic Growth: The Evidence Mounts. Substantial evidence collected over the past decade supports the proposition of Laffer Scully and others that high taxes stifle economic growth and low taxes en courage growth. A seminal 1983 study for the World Bank by economist Keith Marsden examines the relationship between economic growth and taxa tion in twenty countries during the 197oS. Ten of these countries imposed high tax burdens on their citizens, and ten had low tax levels! Without excep 5 Victor A. Canto and Arthur B. Laffer The Mismeasure of Man La Jolla: A.B. Mer, VA. Canto Associates, August 10,1990) p. 14 6 Meaning they had high total tax revenues relative t o their Gross Domestic Product (GDP).GDP iS the total of all economic transactions in a country excluding trade. Gross National Product (GNP) includes trade 5 II Selected Industrial and Developing Countries Source: Keith Marsden Taxes and Growth F-ce Deve lopment, Vol. 20 (September 1983 pp. 40-

43. See also Keith Marsden Links Between Taxes and Economic-Giowth: Some Empirical Evidence Washington, D.C World Bank Staff Working Paper No. 605,1983 1. Central government tax revenue only 2. Gross Domestic Produc t (GDP) is the total of all economic transactions in a country excluding trade 3. Including nontax revenue but excluding social security contributions Heritage InfoChart 1991 6 tion the countries with lower tax burdens had faster growth in employment inve stment and productivity, and ven in government services. All had higher rates of overall economic growth.

Among the more interesting of Marsdens findings: investment grew at nearly 9 percent in low-tax countries, but declined by 0.8 percent in high-tax cou ntries. Strong private sector investment is critical to economic growth be cause it finauces factory modernization, technological breakthroughs entrepreneurial firms and other important elements of a dynamic economy.

Marsden found that high taxes imposed directly on business income were par ticularly destructive to investment. According to his study, every 1 percent in crease in corporate income tax relative to Gross Domestic Product (GDP led to a 2 percent decrease in the growth rate of investment 8 LOWE R TAXES = ECONOMIC GROWTH: THREE CASES IN POINT Case one: West Germanys postwar economic miracle. In post-World War 11 West Germany, the Allied occupation regime imposed extremely high mar- ginal income tax rates on German workers. For instance, in 1947 a G erman with an income of $600 was taxed at a rate of 50 percent for each extra dollar earned; by the time the worker reached an income of $15,000, the tax8was at the astronomical rate of 95 percent for each additional dollar earned. Be cause of these high rates, the West German economy sputtered and tax evasion was widespread; half of the taxes on total income were not paid?

Ludwig Erhard, the economics minister, announced a program of tax cuts on June 22,19

48. Under Erhards reforms, the 50 percent rate k icked in at $2,200 instead of $600, and the 95 percent rate was pushed up to $63,000 from $lS,ooO. The next year Erhard nudged the threshold for the 50 percent rate to $S,OOO. Deeper cuts followed in 1953,1954,1955 and 19

58. By 1959, the highest tax rate was down to 53 percent.The tax cuts improved tax com pliance, broadened the tax base, increased production and spurred economic growth, thus playing a large role in the German Economic Miracle among the high-growth, newly industrialized Asian tigers of t h e Pacific Rim The Republic of China onTaiwan, Hong Kong, Singapore and South Korea are the result of rapid growth in exports, minimal government regulation, and Case two: Rise of the Asian Tigers. Economic growth and prosperity 7 Because of their diversit y , American states also provide a good laboratory for studying the comedon between taxes and economic growth. A 1981 report from the Joint Economic Committee found that economic growth in Americas states is inversely related to their tax burdens 8 Jude Wan u iski, Ihe Way rhe World Workp (New York Simon Schuster, 1M) p. 205 9 Bruce R. Bade& Reaganomics: Supply-Si& Economics in Action (New York Quill, 1981) p. 191-2 7 low taxes. In his study of the tigers, Hoover Institution of War, Peace, and Revolution econo mist Alvin Rabushka finds that all used a low-tax policy to propel themselves in a single generation from the ranks of low-income developing nations to upper-middle income advanced nations."

The most successful of the tigers is Hong Kong, which has the wor ld's lowest taxes. The maximum tax on individual income is 15 percent, while the maximum rate on business profits is 16.5 percent; compared to 3 1 percent and 34 percent respectively for the'U.S. Hong Kong cut income tax rates eleven times from 1954 to 19 7 4 and corporate rates six times." Hong Kong has no social security taxes, and no taxes on wealth, gifts, inheritance dividends, interest or capital gains. Largely as a result of these policies, Hong Kong is booming. In Hong Kong, average individual income increased from 180a year in 1948 to 10,940 a year in 1989, well over a sevenfold increase in real terms.

The per capita gross national product grew an average of 6.4 percent Economic Growth and Government Spending Hong Kong vs. Sweden 1980 1988 I i ami. Domado Pmduot r uj 1 2 9 4 6 8 7 8 lb Annual Average Qrowlh Ralo and 1976 during the same period, per capi t a GNP grewp average of only 3.3 percent in West Germany and 2.4 percent in the U.S The rapid economic growth generated by low taxes and free markets led to huge increases in Hong Kong government revenues. Some of these revenues were given back to Hong Kon g 's citizens in the form of tax cuts, and some were used to finance generous government spending on such social programs as education, housing and welfare. In fact, owing to its low tax rates and con 10 Alvin Rabushka, Tax Policy and Economic Growth in Adv a nced Developiag Nations," report prepared for the U.S. Agency for International Development, 1987, p.8 11 Bartlett, p. 194 12 Melvin B. Krauss, Development Wirhotct Aid. Gmwrh, Pow* and Gwwnment (New York New Press McGraw Hill Book Company, 1983) p.72 8 s e quent high growth rates, Hong Kong was able to increase public expendi tures faster than the welfare state of Sweden. Between 1980 and 1988, a 7.3 percent yearly growth rate allowed Hong Kong to increase government spending by 5.4 percent; during the same period in Sweden, a mediocre 1.7 percent growth rate held government spending increases to 1.6 percent.

The experience of the Asian tigers also debunks the oft-made assumption that only high taxes -particularly on the wealthy -lead to a more equitable dis tribution of national wealth. Taiwan and South Korea impose very low in come tax burdens on individuals and businesses, relying instead on taxes on consumption, such as the Value Added Tax, and user fees for government revenues.These taxes allegedly are h i ghly regressive. Yet Taiwan and South Korea are number one and two respectively among the world's over 100 developing nations in equitable income distribution Case three: Overhauling of Swedish System. The government.of Sweden apparently has learned the h a rd way that excessively punitive tax rates suffo cate an economy, and do not equitably distribute wealth. After years of dis mally low growth rates, hovering around 1.8 percent annually in the 198Os the Swedish government overhauled-its tax system, effect ive this year. Prior to 1991, Sweden had some of the highest marginal tax rates in the world some wedes officially faced a total income and wealth tax of over 100 per cent.

The Swedish government since has slashed marginal income tax rates and wealth taxes ; it now will rely primarily on indirect taxes such as taxes on con sumer goods for government revenues.14 According to Eric Asbrink, the government minister who oversees Swedish tax poli were the inspiration for Sweden's change of heart lJ the Reagan tax cuts lP COMMUNIST TAX SYSTEMS POISON FOR A MARKET ECONOMY East Europeans cannot make the transition from poverty-stricken com mand economies to prosperous, free market economies unless they dismantle the tax systems inherited from four decades of communis m and replace them with new systems conducive to economic growth. The systems of taxation employed in communist economies simply do not work in market economies.

In communist countries, virtually all business enterprises are owned by the l3 Goran Grosskopf The SwedishTax Reform: Rules and Effects Bulletin for International Fiscal Documentation (International Bureau of Fiscal Documentation, Amsterdam: AugustBeptember lm p. 377 14 There remain municipal income taxes ranging from 26.9 percent to 33.45 percent depending on the municipality 15 Robert Taylor, "Sweden's tax shake-out 7he Financial Ti, January 4,1991 9 government. Taxation mostly is a matter of the government transferring money from the accounts of its own enterprises to other accounts earmarked fo r government expenditures In effect, most taxes are paid by the state to the state.16 Taxes in communist countries can take various forms. One is the payroll tax This often is levied on the payrolls of state enterprises and private com panies in lieu of ta x ing workers incomes directly This method is meant to give the illusion that workers pay no taxes. Of course, all it really means is that taxes are taken out in the form of lower salaries. Another ploy is the profits tax. State-owned enterprises or private businesses typically pay tax rates between 40 and 85 percent on profits cept that it is levied at thousands of different rates depending on the product.

In communist countries, the turnover tax really is just the difference between the price consumers pay for goods and the one retail outlets pay to wholesalers. It functions in raising revenue and in assisting the state in setting The one advantage to communist taxation is that without a history of high income taxes, it may be possible for the countries of Eastern Europe either to avoid income taxes altogether, or to impose very low, simple income taxes A third major revenue source is the turnover tax, which is like a sales tax ex prices LOW GRADES ON TAX REFORM The need for fundamental tax reform in Easter n Europe is urgent. As state enterprises are allowed to fail or to become private companies, tax revenues from the state-owned sector, the main source of revenue under communist tax systems, will tumble. Moreover, if newly privatized firms continue to be t axed at the astronomically high rates now imposed on state enterprises, they will not be able to accumulate the profits needed to invest in new plant and machinery, pay higher wages and compete on world markets.

Despite the widespread recognition that fund amental change is in order there is no consensus on whether Eastern Europes new tax systems will fol low a low-taxhigh-growth model, or a high-Mow-growth model. Based on the reforms instituted so far, East European governments seem to be heading toward hi g h-tax disaster 16 Cheryl W. Gray, Tax Systems in the Reforming socialist EconomieS of Europe, World Bank, Pre-Working Paper 501, September 1990, p. 2 10 Budding entrepreneurs throughout Eastern Europe face steep taxes. Ex ample: In Hungary, the former Eas t bloc country with the most Western orientedlax system 54.2 percent of the entire national output is gobbled up in taxes. The top income tax rate in Hungary is 50 percent; private busi nesses must pay a 40 percent profits tax, an 18 percent dividend tax o n after tax profits and a 43 percent payroll tax; and businesses and c nsumers pay a 25 percent Value Added Tax on nearly every item they buy.

The story is much the same elsewhere in Eastern Europe. Private busi nesses in Poland must pay a 40 percent tax o n profits, a 43 percent tax to the social insurance fund, a 20 percent tax on all wages paid, and a turnover tax ranging from 10 percent to 20 percent.lg Such tax rates contribute to economic stagnation and increase unemployment.

Throughout Eastern Europe , payroll and social security taxes on business remain so steep that companies risk going out of business unless they find ways to avoid the taxes. Naturally, they are finding creative ways to do so.The 500 Czech workers in Miroslav Svarcs construction co m panies, for example all declared themselves self-employed.a0 The result: the workers are paid double or triple the average Czech wage, the business prospers, and new homes and buildings are constructed. This would not be possible if Svarc ac tually paid t he prohibitive taxes.

In Czechoslovakia, as in other developing countries, poor economic condi tions raise the risks of entrepreneurial activity. The need for new investment and higher work effort are great. Yet these activities are discouraged by high tax rates that dampen economic activity and discourage new ventures.

The VAT Trap. The Value Added Tax (VAT) figures prominently in the tax reform plans of Eastern Europe. The VAT is similar to a sales tax, except that it is levied not only on consumers at t he point of sale, but on producers at various stages in the production process. Hungary already has a VAT; Bul garia, Czechoslovakia and Poland plan soon to convert their turnover taxes to standard West European-style VATS.

Since it first was adopted by F rance in the early 195Os, the VAT has spread to more than half the world. The VAT is popular because it raises enormous revenues while remaining relatively invisible to the consumer He is unaware of it because largely it is paid indirectly as higher price s for products, instead of being levied directly like an income tax or sales These virtues of the 11 17 Government Finance Statistics Yearbook, International Monetary Fund, Washington, D.C Volume Xm 1989, p. 1

04. This is one of the highest tax burdens in the world 18 The profits tax on Hungarh-owned businesses was cut to 20 percent in January 1991 19 U.S. Chamber of Commerce, International Division 20 Reawake+ A Market EconomyTakes Root in Eastern Euro= Business Week, April 15, p. 50 11 VAT also constitut e its dangers. VAT's relative invisibility and efficiency give politicians a way to increase taxes without thegolitical backlash that inevitab ly comes with an increase in income tax rates Bad Reform Advice. East Europeans are getting tax reform advice fro m several quarters, including the International Monetary Fund (IMF and the World Bank. But they may be getting bad advice. Often the IMF, for ex ample, pressures developing countries to increase taxes. In the winter of 1990, for instance, Argentine Preside n t Carlos Saul Menem wanted to cut the VAT rate to spur economic growth. The IMF opposed this tax cut and instead urged Menem to raise the VAT rate by 2 percentage points. Throughout much of 1990, the IMF pressured the Philippine government to institute a tax on luxury items. When the Philippine Congress balked at the unpopular tax the IMF pressed for a 9 percent supplemental levy on imports, which was adopted by the Philippine government in January 19

91. Such anti-growth policy prescriptions if forced on Eastern Europe, would doom the region's economies to economic stagnation. Eastern Europe needs better advice A PRO-G.ROWTH TAX REFORM AGENDA FOR EASTERN EUROPE If East Europeans are to jump start their moribund economies, they need a major overhaul of the i r tax syste'ms. Old communist tax systems should be dis mantled. An aggressive, pro-growth tax agenda is needed to eliminate exces sive taxes on business, simplify tax codes and minimize government inter ference with the workings of Eastern Europe's nasce nt free markets ly to be a strong redistributionkt impulse left over from decades of com munism.There will be enormous pressure on legislators to adopt heavily progressive income taxes, wealth taxes and high corporate income taxes.

These pressures must be resisted and the arguments strongly rebutted.

Many governments worldwide have gone the high-tax route, often trying to soak the rich in the hope of helping the poor. They have succeeded only in keeping everyone poor. Economic growt h is the best way for East European countries to raise themselves out of poverty. The tax systems of Eastern Europe should be structured to promote growth.

America can help, mostly by offering expertise and advice. America also can use its influence with the IMF and World Bank to prevent these institu tions from luring Eastern Europe down the high-tax path. George Bush should offer as an alternative America's own Six Point Pro-GrowthTax Reform agenda for Eastern Europe. The agenda There will be opposition to this program.The foremost impediment is like 21 John Blundell Britain's Nitmare Value Added Tax The Heritage Foundation Intematio& Briefing No.16, June 13,1988, p. 11 12 Increasing marginal tax rates discourage people from earning that extra dol lar si n ce they know that less of it will be theirs and more will belong to the government A flat tax does not penalize added income, and therefore en 22 The "flat tad' on individuals and businesses was 6rst proposed by Henry George, and in this century by Milton Friedman. A version of the flat tax was popularized in 1982 by American economists Alvin Rabushka and Robert Hall, and a variation of the tax is now often referred to as the Simplified AlternativeTax (SAT 23 Charles E. McClure A Consumption-based Direct T ax for Countries inTrdtion from Socialism paper prepared for the World Bank Socialist Economies Working Group, December 1990, pp. 8-10 24 Jan= Komai, The Rwd to a Fee Economy: Shipingfrorn a Socialist System: The Example of Hungary (W.W.

Norton and Company , 1990) p. 119 13 courages work. More work ultimately means more and improved goods and services Increased savings and investment The emerging market economies in Eastern Europe cannot afford to punish people for making the economy stronger by saving and i nvesting. By exempting saving from taxation, the flat tax on income will encourage invest ment-andstimulate economic growth. It .also will keep capital in Eastern Europe, to be invested at home, instead of flowing to other parts of the world where it migh t be taxed at lower rates No bracket creep.

In inflationary environments -temporarily unavoidable in post-communist countries because prices, controlled for decades, must rise to their market levels -progressive tax rates cause a phenomenon termed bracket creep.

Bracket creep occurs when people are forced into higher tax brackets owing to inflation, rather than to income increases. Bracket creep was a major cause of Americas stagflation in the 197Os, when there were high levels of un employment and high in flation. The flat-rate tax eliminates bracket creep since there only is one tax bracket Fairness.

Flat taxes strictly limit the tax burden on poor families. By taxing everyone at the same rate, the rich still pay more because their incomes are higher.

Further, wealthier individuals may in some cases pay a higher percentage of their incomes to taxes once personal and family allowances are considered.

Example: A family of four with an annual income of $8,000 claims a $l,OOO personal allowance for each fami ly member; this family pays taxes on $4,000 which at a 15 percent flat rate equals $600, or 7.5 percent of total family in come. A family of four with an income of $16,000, however, pays $1,800 after allowances, or 11.3 percent of family income.

Point No. 2: Cut tax burdens on business; adopt a flat business tax that ex Without exception, East European countries impose very high tax burdens on private businesses. Examples: Czechoslovakia has a 55 percent tax rate on profits; private businesses in Hungary a re forced to pay social security taxes at five times the rate of state-owned enterprises. These taxes higher than in America, Western Europe or among the Asian tigers -put East European countries at a strong competitive disadvantage. Business taxes in Eas t ern Europe must be lower than those in the West if technologically backward and inefficient East European businesses are to compete with the West medium-sized companies. High business taxes rob these firms especially of the capacity to expand: Reason: Mos t smaller businesses finance expansion through their own savings and by reinvesting their profits. High taxes on 2 empts capital investment Most business expansion and job creation takes place in small- and 14 I savings and profits mean businesses can hire fewer workers, purchase fewer raw materials and tools, and thus produce fewer goods and services No Double Taxation. East European countries should replace the cor porate profits tax with a single, low, flat business tax. Optimally it should be the same r a te as the personal income tax around 15 percent; otherwise in dividuals simply will try to find ways to have taxable income counted under whichever rate is lower. Nothing taxed as personal income should also be taxed as business income and vice versa. Exa m ple: Corporate dividends paid to shareholders should be taxed only once as business income for the corpora tion issuing the dividends, rather than being taxed twice once as business in come and again as personal income. To keep. things simple, there shoul d be no deductions for dividends, interest payments, depreciation allowances fringe benefits or for state and local taxes.

There should be but one exception to the flat business tax. Any money in vested back into a business for plant, equipment, land or ot her investments should be deducted from the businesses gross revenues for tax purposes. A lack of investment capital is a key problem facing East European businesses today; investment capital is critical to the creation of new enterprisesand to modernizin g and expanding existing businesses. A total exemption for busi ness income invested back into a company, known as full expensing, would free needed capital for investment. Due to high start-up costs for new busi nesses full expensing should mean that many entrepreneurs will pay no taxes in the first year or two of operation stead of discouraging investment by taxing it, East European governments can expand entrepreneurial activity, tax compliance and productivity By treating all business investment as full y deductible business expenses, in Point No. 3: Be wary of thevalue Added Tax.

Most East European countries are planning to adopt the VAT in part be cause they wish eventually to join the European Community (EC and the VAT is an important part of the ECs h armonized tax system. East Europeans should approach the VAT gingerly. The VAT should be con sidered only in lieu of an income tax on individuals and corporations, not in addition to these taxes. As Hungarys experience already shows, the imposi tion of a VAT on top of new income taxes imposes a tremendous tax burden on a countrys citizens. The result is predictable: economic growth is lowered and tax evasion increases.

Political safeguards, meanwhile, are needed to ensure that the VAT does not become an ev er expanding government money machine. One safeguard would be to require a two-thirds majority of parliament to approve anyVAT rate increase. Or, governments could require any increases in the VAT rate to be approved by public referendum 15 To reduce the V ATs administrative burdens, the same rate should be levied on all goods. In Western Europe different VAT rates apply to different products.This can create bookkeeping nightmares for small businesses. A uniform VAT rate applied to all items would eliminate these problems Point No. 4: Avoid investment incentives for preferred industries In the old days, East European central planners would pick industry win nemand.losers by explicitly directing-the flow of investment. In Western economies, however, the metho d is subtle. Bureaucrats pick industry winners and losers by granting tax incentives for investment in preferred industries often high-tech or other enterprises identified as strategic by the govern ment. Example: The tax holidays that temporarily exempt b u sinesses in selected industries from paying taxes Hungarys tax system is already rife with many tax holidays and other exemptions for favored industries. Selective tax incentives to preferred industries distort market forces by artificially directing reso u rces to uses which may be unproductive. For example if a poor country makes taxes for the semiconductor industry much lower than for textiles, capital will be redirected from textiles to semiconductor manufac tiuhg. But developing .countries generally com p ete better in such labor inten sive industries as textiles than in high tech industries. Thus, in this case, less investment in textiles results in high unemployment in the economy because job loss in textiles is not offset by job creation in semiconducto r s. In the end the country becomes less competitive, and hence poorer Point No. 5: Do not impose high tariffs to discourage imports The eternal rationale of protectionists is that high tariffs protect local in dustries and jobs from foreign competition. In fact, tarif& are very destructive to local economies. High tariffs hurt consumers because they have to pay more for foreign goods, which are taxed at a higher rate. They also pay more for domestic goods because competition to local industries from foreign producers is reduced, allowing the local industries to charge higher prices and become sluggish and inefficient. Domestic businesses, too, are hurt by high tariffs; they are forced to pay higher prices for imported supplies and raw materials to produce go ods. This, in turn, makes them less competitive on international markets, decreasing exports.

The domestic economy as a whole is hurt by protection because capital and labor are diverted away from their most efficient uses, and move instead toward the production of goods needed to replace lost imports. This process known as import substitution, da m ages local economies because it drains resources from the industries and services in which a country is most competi tive. Result: Prices go up; locally produced goods become less competitive on international markets; unemployment increases; and economic g rowth suf fers out investment, too, since declining growth rates induced by protectionism mean decreased opportunities for profitable investments from abroad. Im Protectionist measures designed to keep out foreign goods ultimately keep 16 port quotas and o ther non-tariff trade barriers should be eliminated; tariffs should be eliminated, or at least kept at the lowest possible levels I Point No. 6 Where possible, finance government operations with user fees User fees can finance a wide range of government o p erations. A common user fee in America and Western Europe is the toll charged to motorists for the use of some highways. People are not forced to pay for roads they may never use;.Fees also can be charged for the use of libraries and public parks for garb a ge collection, or to land on airport runways. By increasing the use of user fees in lieu of taxes, countries can increase the probability that only those government projects and services that are economically justified will be undertaken. Reason If there a re not enough users to finance the operating costs of the government service, then the operation will not be provided CONCLUSION After years in the economic shackles of communism, Eastern Europe is struggling to free itself from state control and to build strong, free market economies. Eastern Europe 'has tremendous economic potential Its greatest asset is a highly educated, skilled and energetic population; but for decades this tremendous human resource was locked up under tight state control.

With these controls lifted, East Europeans can in time raise themselves to the economic levels of the West.

Creating Wealth. The success of this effort in part will depend on whether old, communist tax systems are redesigned in a way that spurs economic growth. For this, East European countries should tax individuals and corpora tions at very low rates, leaving them with more time and money to devote to creating wealth and raising themselves out of poverty. Time and again around the world from Hong Kong to America e xperience demonstrates that lower taxes equal economic growth. Eastern Europe would do well to heed the message.

Predictably, there will be opposition to this simple and obvious path to economic development. Politicians with a socialist hangover will argue that the tax system should be used to raise revenues for huge government programs and to redistribute income from the rich to the poor. Yet the ex perience of the Asian tigers the Republic of China onTaiwan, Hong Kong Singapore, and South Korea -shows th a t the fastest way out of poverty is not via government programs, but by allowing people to use market oppor tunities to start new businesses, earn money and enrich themselves Poisonous Taxes. High, rising marginal income taxes on working men and women poi s on a growing economy. Income taxes, particularly steeply rising marginal rates, should be avoided If an income tax must be adopted, it should be a single, flat tax on wages and salaries at a rate of 15 percent or below. Further, dynamic growth of the priv a te sector should be encouraged by sharply cutting the tax burden on business and replacing the corporate income tax with a low flat business tax without 1oopholes.The single exception would be a total deduction for all revenues reinvested in the business.

Governments, moreover, should get out of the business of picking winners and losers in the economy by granting tax holidays and other tax breaks for designated industries. Four decades of central planning were enough; the bureaucrats had their chance and failed. Now it is time to give the free market a chance.

East Europeans should be wary of the Value Added Tax. If adopted, it should be imposed only instead of income taxes on individuals and busi nesses, not in addition to these taxes. The VAT should be simple, applied to all goods equally; clear political limits should be placed on its expansion. Im ports should not be discouraged by employing quotas or high tariffs. Finally whenever possible, government services and operations should be financed by cha rging users directly.

Tax reform is not a panacea for all the ills brought on by the decades of communism. But combined with other essential free market reforms as cur rency convertibility, freeing prices from state control, privatizing state-owned enterpr ises, liberating entrepreneurs from stifling regulation and ending government subsidies to state enterprises, a pro-growth tax agenda can help Eastern Europe move toward prosperity and political stability. This serves the interests not only of East Europe ans, but of Americans as well.

William D. Eggers Policy Analyst

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