Some of the Baltic countries, as well as Russia and other states of the former Soviet Union have recently reduced taxes. But do tax reductions lead to improved revenue performance? This research from the International Monetary Fund (IMF) reviews the tax reform experiences of these countries during the 1990s, particularly with regard to value-added tax (VAT), personal income tax (PIT) and enterprise profit tax and finds little improvement in revenue.
In the early 1990s, structural changes and fast moving external economic conditions required fundamental tax reforms in the countries studied that would allow the governments to maintain fiscal stability and provide a framework for economic efficiency. The substantial reduction in tax rates, which some of the countries implemented between the mid-1990s and 2000, was justified by the idea that the reduction of taxes would lead to improved revenue performance (the Laffer effect). Furthermore, it was thought that reducing the marginal tax rate might reduce the potential benefit from tax evasion and thus enhance compliance and serve to integrate the shadow economy into the formal sector. The reforms, with the exception of those carried out in the Baltic States, have been slow and have proceeded with difficulties for several reasons:
- Tax administration has been a highly politicised function of government with tax liabilities largely negotiated rather than determined by law.
- Benefits from tax evasion are substantially greater than expected penalties and the detection efforts by tax authorities are not enhanced.
- Savings rates have declined as the population experienced a fall in living standards with a greater share of national income being spent on consumption.
- Tax administration reforms have mainly focused on enactment of legislation, establishment of organisational structures and development of systems and procedures. Little has been accomplished in collection and enforcement.
- Unemployment is estimated at more than 10 percent of the working-age population and in cases where there is only one primary income earner in a family, individuals have little choice about labour participation.
A close review of tax reforms in the countries studied suggests the experience has been mixed and that it is difficult to disentangle the rate-reduction effects as policy reforms were often accompanied by efforts to strengthen tax administration. However, there seems to be little evidence of a substantial improvement in personal income tax revenues resulting simply from a reduction in the top marginal tax rates. Taking into account the current fiscal situation in many of the countries studied:
- Tax reforms should aim to be revenue neutral.
- Tax policies should focus on maintaining the overall burden while broadening the base and rationalising the structures to remove all tax-related distortions.
- Reform efforts should go well beyond mere changes in tax policies to fundamental reform of the broader system that also involves measures to strengthen administration and compliance.
- Aggregate savings will not increase much when personal income tax rates are reduced.
- A decrease in the profit tax rates is likely to lead to larger investment volumes both domestic and foreign.
- There may be little response, in terms of additional labour supply, to a reduction in labour income taxes.
